Meeting of the Federal Open Market Committee on

August 9, 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, August 9, 2011, at 8:00 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

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

Matthew M. Luecke, Assistant Secretary

David W. Skidmore, Assistant Secretary

Michelle A. Smith, Assistant Secretary

Thomas C. Baxter, Deputy General Counsel

Richard M. Ashton, Assistant General Counsel

Thomas A. Connors, David Reifschneider, 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

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

Robert deV. Frierson, Deputy Secretary, Office of the Secretary, Board of Governors

Andreas Lehnert, Deputy Director, Office of Financial Stability Policy and Research, Board of Governors

Transcript of the Federal Open Market Committee Meeting on

August 9, 2011

CHAIRMAN BERNANKE. Good morning, everybody. This is a joint FOMC'Board meeting. So I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you very much. Before we get down to business, we have a few people to whom we have to say farewell'first, Carol Low. Carol, an FOMC specialist in the Secretariat, is retiring. She's worked at the Board for only 41 years, begun at age six. [Laughter] She has attended 222 FOMC meetings, which turns out to be the same number that Don Kohn attended. So that gives you a measure'

MR. WILCOX. One Don Kohn unit. [Laughter]

CHAIRMAN BERNANKE. One Don Kohn unit. That's right. So that's quite a record. Carol, you've been here for many, many years, and we thank you for your service. [Applause]

It was announced yesterday that Nathan Sheets will be leaving the Board to take a position in the private sector, and hence he recused himself from the last meeting and obviously has had nothing to do with this meeting as well. I'm sorry he's not here to accept our congratulations, but as you know, Nathan did a wonderful job piloting the Division of International Finance through some very choppy international waters over the past few years, and we're going to miss him and his insights and understanding of the international situation very much. Steve Kamin will be acting director as we try to regroup in International Finance, and we appreciate Steve taking on that responsibility. For the record, let me acknowledge our thanks to Nathan Sheets for his many contributions.

And finally, this is the last meeting for our colleague Tom Hoenig. Tom began attending

FOMC meetings in 1991 and has attended a total of 161 meetings, which exceeds the sum of any

two other members around the table. The only problem I've ever had with Tom is that I'm

unable to get him to say what he really thinks. [Laughter] It's a 20-year record of service

through three recessions'I'm not implying any causality'and we have all benefited very

much, Tom, from your perspective, your banker's insights, and your wide range of experience.

MR. HOENIG. Thank you. I will note to the Committee that I want to apologize. I had

no idea the markets were going to react this way to my leaving. [Laughter]

CHAIRMAN BERNANKE. Well, we will have a chance to make jokes like that at a

lunch in your honor after the next FOMC meeting, and I suspect that your retirement might get

mentioned once or twice at Jackson Hole. I'm just guessing.

MR. HOENIG. I would imagine.

CHAIRMAN BERNANKE. All right. Tom, thank you. You have our great

appreciation and admiration.

MR. HOENIG. Thank you. [Applause]

CHAIRMAN BERNANKE. Okay. Without further ado, let's go to item 1 on our agenda

and turn to Brian Sack for a report on financial developments. Brian.

MR. SACK.1 Thank you, Mr. Chairman. Over the intermeeting period, financial market participants became very concerned about the prospects for U.S. economic growth and had to contend with significant risk events related to the fiscal situations in Europe and the United States. These developments led to dramatic declines in equity prices and interest rates, and they prompted widespread discussion about whether the Federal Reserve will deliver additional policy stimulus.

The increasing pessimism in the market about economic growth prospects was driven in part by the incoming economic data. The data indicated that the economic recovery has been more anemic than had been appreciated, despite the degree of policy accommodation that the Federal Reserve has put in place, and raised questions

1The materials used by Mr. Sack are appended to this transcript (appendix 1).

To summarize, I will simply say that we have had better intermeeting periods than this one. Thank you.

CHAIRMAN BERNANKE. Thank you. Are there questions for Brian? President

Fisher.

MR. FISHER. I want to go back to panels 1 and 3 in your exhibits. In your view, from the standpoint of our New York Fed surveys, is there a substantial concentration of people who expect us to either raise rates or shrink our balance sheet in the foreseeable future? When we say 'extended period,' it appears to me that these are confirming the fact that it's really an extended period, not the next one or two months. Is that correct or incorrect from the standpoint of what you hear on the street?

MR. SACK. Well, certainly the path of the expected federal funds rate conveys that. As you note, the dealer survey also asks about other steps in the direction of policy tightening. In addition to what is shown in panel 3, there's another side of that question, in which we ask about the probability of a number of exit steps. Those probabilities are not that low, and they're particularly high over the two-year horizon. What you see is a relatively big difference between the probabilities in the one-year horizon and the probabilities over the two-year horizon. So I think the Desk survey suggests that there are decent probabilities being assigned to exit options being adopted within two years, but more likely in the second year.

MR. FISHER. And do you sense that that has increased or decreased over the past few weeks? Just in terms of your gut.

MR. SACK. I would say unchanged to slightly decreased, and perhaps decreased less so than I would have anticipated in the sense that the probabilities over two years are still quite high for many of these steps. We initiated this question in a new form in this survey, and we intend to repeat it in this form. So we'll have a clear time series to see how it evolves going forward.

MR. FISHER. And as to panel 6, where would you say we are in terms of historic valuation guidelines in terms of the S&P 500, even after this correction?

MR. SACK. Extremely cheap. In fact, I think the dividend yield on the S&P 500 is about equal to the yield on a 10-year Treasury at this point. In our models, the valuations are very cheap, although it's hard to incorporate these abrupt shifts in expectations about the economy into the models. So that makes it hard to assess how much of it is pessimism about growth and how much of it is valuation. I think the big picture here on equities is, obviously, that the move has been very abrupt. Many of us were puzzled by how well equities had held up, given how the macro outlook had been shifting. I think what we are seeing in part is just a catch- up to that more pessimistic outlook, but then one that has intensified as confidence has eroded. We have ventured into a very negative dynamic in the equity market that's given us this very abrupt repricing.

MR. FISHER. Mr. Chairman, I'll remark on that during my comments. I just have one other question for Brian, if I may. And that is, because there is a lot of the chatter in the market about substantial liquidity parked in excess reserves, I just want to understand the dynamics there. Do we know what percentage or what amount of excess reserves is foreign banks versus domestic large banks?

MR. SACK. I believe what we've seen over the past month or two is the foreign bank holdings coming down and the domestic holdings going up. I think this in part reflects some of the funding pressures that have been faced by the European institutions, and that rotation, I believe, has been around $200 billion. And with that rotation, the level of reserves is about evenly split between domestic and foreign institutions.

MR. FISHER. So 50'50.

MR. SACK. Yes.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. In terms of the stock market, I agree with Brian's view, but there's a different view as well, which is looking at the stock market irrespective of what bond yields are. Just looking at 10-year trailing earnings, the P/E ratio is actually quite a bit above the long-term, historical average. Someone like Shiller would say the stock market is actually very overvalued today. I don't think that's the right way of looking at the stock market, but there is an alternative view of stock valuation that leads to a quite different conclusion.

MR. FISHER. Actually, Mr. Chairman, Bill makes a good point there. This goes back to Ben Graham's original analysis. You know that Shiller did a substantial amount of work in terms of cyclical adjustment. After yesterday's correction, we're at 19 times earnings, and I do want to remind the Committee that things can be worse. The normal valuation is about 19 and a half. We got down to 6.6 in August of '82, 8.3 in '74. So' just to pump up the enthusiasm at this table'I think one of the arguments that might be made is that there is substantial downside left. This is just one of many valuation models that we can look at. I think Bill has a good point.

MR. SACK. Can I add a comment? In terms of your question about reserves, as I noted in the briefing, we are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we've seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it's worth pointing out that this is all happening with $1.6 trillion of reserves in the system. I think that if we had started without that degree of excess liquidity in the system, what we'd be seeing in terms of these pressures would

be much more severe. But even with that, we're getting to the point where the market feels that additional liquidity injections might be needed.

MR. FISHER. Thank you, Brian. Thanks for your good work.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD: Thank you, Mr. Chairman. I just have a brief question on exhibit 1, panel 1, which is 'Implied Federal Funds Rate Path.' I just want to make sure I understand this. If I'm reading this correctly, the market expects no action until June, certainly summer of 2013. And the other part I want to ask about is, why is this light blue line going down to zero at one year, whereas it's above that today? That seems odd to me.

MR. SACK. Remember that the futures rate is going to reflect the mean of the future distribution of short rates. So, the futures rate moving above 25 basis points in the middle of 2013, that appears to reflect a modal forecast that policy will be on hold and then some risk that that policy could be tightened. Of course, the risks around the short rates are one-sided when you're at the zero bound.

MR. BULLARD. I thought in the past, when we've looked at these, we've looked at the modal prediction, not the mean.

MR. SACK. I was just about to come to that. The Board staff does look at a modal forecast derived from interest rate caps, and what it shows is that the modal forecast is actually farther out. I believe it is unchanged through 2013.

MR. ENGLISH. It's basically flat through 2013.

MR. BULLARD. Okay. Suppose you made a promise, then, to 2013. Would it back up from what the modal expectation is? The modal expectation is beyond that.

MR. SACK. If there were a statement that you were definitely going to tighten in the middle of 2013, then possibly. If there were a statement that you weren't going to tighten until then or later if appropriate, then I would think not. In fact, that reassurance that you were willing to say, 'There will be no tightening until 2013, and we'll continue to evaluate''I think that would probably, if anything, push down the expectations modestly.

MR. WILCOX. Even with a modal rate hanging close to zero through the end of 2013, if you made a promise not to raise by then, you'd be chopping off the upper part of the tail of the distribution. As Brian was saying, all of the risk is to the upside.

MR. ENGLISH. So the mean would move down.

MR. SACK. As for why these rates are at zero, that point is where we splice from the fed funds to the Eurodollars. We have to make a federal funds-Eurodollar basis assumption that's probably a little bit too big. So my guess is that the true implied rates are in the low single digits. They're not actually zero. If they were at zero, there would be a pretty good arbitrage opportunity. But I just interpret that as policy being on hold.

MR. BULLARD. Thank you.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Brian, I don't know if I'll ask this question correctly, but it follows up on President Fisher's to some extent. In the conversations we have with the market participants' most markets, like anyone else, talk what they want, or it's not so much about expectations, but the way they form their answers is to guide us to what they want. What kinds of conversations do you have around that? Are they looking for something specific right now'ease because we have to'or are they more up in the air themselves?

MR. SACK. We should keep in mind that dealers are not always long duration. Their positions can be all over the place. There's no bias through which dealers should always want us to do more to lower the interest rate structure. So I don't think the conversations are distorted by their self-interest. I think the conversations that we have reflect their views on what is appropriate for policy to do, given the macroeconomic outlook. I think we've seen the perceived probabilities of all of these policy actions increase, and I would argue they're probably much higher than reflected in panel 3 at this point because those dealers have become much more worried about the outlook. They've seen the substantial tightening of financial conditions, and they think some kind of policy response is appropriate.

MR. HOENIG. But that's not in their self-interest? Or are they able to look beyond that in terms of longer-term outcome? They are dealers and they are working on their own book, and I worry because some of the conversations I've had suggest that their focus is very short term and that they are trying to influence where we come out by how they skew the information toward us. That gives me some pause. But you think they're more objective than that?

MR. SACK. I do because it's not clear that they all have a self-interest in this direction. Dealers are actually short duration in recent months and have been scrambling to cover, according to some data. I will also point out that there are other surveys. Our surveys are limited to the primary dealers right now, but there are broader surveys conducted by others, including Bloomberg. I just read a story this morning that 51 percent of the respondents from the Bloomberg survey expect some policy action this year. So I think what we see in the dealer survey is also reflected in surveys with a broader set of respondents who wouldn't have direct interest in their dealings with the Desk.

CHAIRMAN BERNANKE. I have a two-hander from the Vice Chairman.

VICE CHAIRMAN DUDLEY. As someone who used to do this for a living, let me just say that the surveys are filled out predominantly by economists who sit on the trading desks. They're basically going to write down what they think is going to happen as opposed to what they want to see happen, because they want to basically get it right, and getting it right is what's important to them in terms of their call to the markets.

MR. HOENIG. Thank you.

CHAIRMAN BERNANKE. Any other questions for Brian? President Kocherlakota. MR. KOCHERLAKOTA. Yes, thank you, Mr. Chairman. Brian, I've been hearing this

story, and you had mentioned it as well, about how the downgrade on Friday triggered the decline in equities on Monday. But I'm struggling with putting that together with the fact that Treasury yields went down so much. Is there a story that's going around that tries to rationalize all of that?

MR. SACK. I would actually like to argue that the declines on Monday were not entirely driven by the downgrade. I think they were a continuation of the decline in sentiment and the concerns about economic growth that we had already seen develop very intensely over the previous week. The downgrade did seem to add to those concerns. There could be several reasons for that. For example, one is that it just further reduces the chances of having a flexible fiscal policy response to economic weakness. And I do think that a lot of the pessimism about the outlook is partly related to this idea that there aren't many policy tools to address the weakness in the economy. My point would be that the downgrade just added to that, but I think the primary driver of all this is really the revision to the economic outlook.

MR. KOCHERLAKOTA. Thank you.

CHAIRMAN BERNANKE. All right. Seeing no other questions, we need to vote to

ratify domestic open market operations. Can I have a motion?

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Without objection. Thank you. Item 2, 'Economic

Situation.' Let me turn to David Wilcox to begin the briefing. David.

MR. WILCOX.2 Thank you, Mr. Chairman. I will eventually be referring to the single exhibit behind the cover that says 'Staff Report on the Domestic Economic Situation,' though I'll warn you that it'll take me a while to get there. Coming on the heels of a seemingly unrelenting stream of negative news about the pace of the recovery that we received during the intermeeting period, Friday's employment report provided a welcome respite. The unemployment rate was one-tenth lower than we had expected on the eve of the report; private payroll employment increased a little more in July than we expected, and previous estimates for May and June were revised up modestly; and government employment seemed to be on a slightly shallower downtrend adjusting for the influence of the temporary shutdown of the state government in Minnesota.

That said, Friday's report looked good only relative to expectations that had been greatly beaten down in the wake of the previous employment report. Taking a slightly longer perspective that may be more relevant for your purposes, Friday's report portrayed a labor market that is weaker on nearly every important dimension than we expected as of the June FOMC meeting: The unemployment rate was one- tenth higher and the employment-to-population ratio three-tenths lower in July than we projected in the June Tealbook. Private payroll employment increased 105,000 less than expected over the three months ending in July, while for total payroll employment the shortfall relative to expectation was 150,000. None of these changes are decisive, but they all run in the same direction.

Perhaps the best metric of the net change in our assessment over the intermeeting period of labor market conditions is the fact that, even after taking Friday's news on board, we have private payrolls increasing 70,000 less per month in August and September than we had in the June Tealbook, and we have the unemployment rate hanging up near its current level through the end of the year rather than edging down a couple of tenths.

The upper-left panel in the 'Forecast Summary' exhibit shows the outlook for the unemployment rate that we presented in the August Tealbook (the black line) compared with the June Tealbook (the dashed red line). As you can see, we rotated up the trajectory of the jobless rate over the entire forecast period. Had we known about Friday's employment report in time for the Tealbook, we still would have

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

6 percent in the second, below what we'd written down in June. But import growth also slowed, to only about 1 percent, so that the contribution of net exports to GDP growth was a still-solid '' percentage point. Going forward, we are projecting another '' percentage point contribution in the second half of this year, as both export and import growth rebound, and '' percentage point in 2012. These are much stronger net export contributions than are usually seen during U.S. recoveries, largely reflecting a faster bounceback in foreign economies and previous and prospective declines in the dollar. Over the past year, the broad real dollar has depreciated

8'' percent, and we are projecting it to move down at an annual rate of about a 2'' percent during the remainder of the forecast period. Thank you.

CHAIRMAN BERNANKE. What do we think is the GDP effect of the Royal Wedding?

[Laughter]

MR. LEAHY. Well, I don't have the exact numbers split out, but we did see GDP drop

from about 2 percent to about '' percent between the first and second quarters.

CHAIRMAN BERNANKE. Another failure of fiscal policy, no doubt. [Laughter] Any

questions for our colleagues? President Fisher.

MR. FISHER. I have one question for Mike and one for David. Mike, you talked about

the widening of spreads. You mentioned Italy and Spain. You did not mention France. This is

something that I raised last time. I believe the spreads have widened somewhat in France.

MR. LEAHY. Yes.

MR. FISHER. I'm hearing more noise about concern about the French fiscal situation, in

addition to their bank exposure. Could you take a minute to comment on France? Is this

something serious, or is it something that people are just piling onto as they look for other

problems?

MR. LEAHY. Well, I think there may be a little of both there. The spreads of French

longer-term bond yields over German bund yields have gone up some. There have also been

rumors about downgrades for France circulating in the market. I don't really know how much

truth there is to those rumors, but there are rumors. We have seen some funding pressures for

some French financial institutions' cutbacks on credit lines and such, and paying higher spreads in overnight funding markets. The pressures are nowhere near the same degree that we're seeing, say, for Italian or Spanish banks, but they're creeping up and it's something to watch.

MR. FISHER. Very quickly, David, we seem to be lurching back and forth'all of us, by the way; not just Board staff, but Bank staff as well'in terms of our outlook for the economy. And we're constantly asking ourselves, what have we been missing, or what did we miss, and how useful are our various models, depending on their degree of sophistication, in terms of being of assistance to us in trying to get a sense of what's developing in the economy? I wonder if, at some point'we may not do it now, but it strikes me that one of the issues that I don't think we understand very well'this is my working hypothesis'is how our models are affected by overall deleveraging. Consumer sector deleveraging, for sure. Certainly a releveraging has taken place in the business sector amongst corporate credits, and, right now, what I expect to be a significant deleveraging is happening in the fiscal sector'that is, with the federal, state, and local governments. This is just really a request that we pursue this a little bit more. I see by your nodding of your head, I think I may be correct. But I do think it's something that's inhibiting our understanding'a better understanding of this would probably enhance our understanding of what's going on with the economy.

MR. WILCOX. Yes, I think the only part of your statement that I would take exception to is the pejorative word 'lurching.'

MR. FISHER. Well, I didn't mean that in a pejorative sense. I mean, we're trying to come to grips, let's put it that way.

MR. WILCOX. We've been marching determinedly in a negative direction. John Stevens had a nice exhibit in yesterday's Board briefing that showed just how much we'd taken

the forecast down over the course of this year. Also, I want to just emphasize that I think the gaps in our understanding of the interactions between the financial sector and the real sector are profound, and they have, over the past few years, deeply affected our ability to anticipate how the real economy would respond, and they are continuing to do so now. This is an ignorance that we share with the entire rest of the profession, and I think one thing that is good to see is the enormous amount of work that's going on at the Board, in the System, and in the profession at large in an attempt to develop a better understanding of the interactions between the real sector and the financial sector, operating in both directions. But boy, I don't know whether that literature is in its infancy, but I would not put it at any more beyond toddlerhood. We've got just an enormous amount yet to learn and incorporate in that regard.

CHAIRMAN BERNANKE. President Fisher, as I'll mention at the end of the meeting, this is going to be part of a special topic for the FOMC coming up pretty soon. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I have a question for Dave Wilcox. In your discussion of unemployment, do you have an explanation for the decline in participation that we've been seeing? What are the underlying forces causing that decline?

MR. WILCOX. It's hard to know. We've been surprised how weak it's been. We think it's importantly driven by demographic or structural factors associated with the aging of the population, but it's also pretty clear that there's an important cyclical component. And there's a lot of disagreement, some disagreement among members of the staff here at the Board, lots of controversy in the economics profession. Getting that decomposition right is very difficult. But I'd like to ask Bill Wascher to comment.

MR. WASCHER. Well, I guess I don't have a lot to add to what you've just said. We do think there's a significant downward trend in the participation rate that's been associated with the aging of the population, and that's been going on for a while now, for the past decade or so. We think there's a cyclical component to the low participation rate that's associated with the lack of job opportunities and some people dropping out. That's offset to some degree by the extended unemployment insurance benefits, which we think are keeping some people in the labor market who would have dropped out in the absence of those benefits. But that cyclical component is pretty big now. The unemployment rate is quite high; the labor market's very weak. And I think a number of people have dropped out because they've become discouraged about job prospects. But as David noted, I think we're a little surprised by how low the participation rate is, and we're not quite sure why. Much of the surprise is in the teenage categories, and that's always been an age group that's been difficult to understand. [Laughter] The participation rate is a few tenths lower than what we would have expected, given our models. And we're not quite sure whether that extra few tenths is just a bigger cyclical effect than we normally would see, given the labor market slack more generally, or whether there's something special going on for teenagers or for some other particular age group that we don't quite understand yet.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Just to follow up with that a little bit. In terms of the people who are dropping out of the labor force, you mentioned teenagers. What about the 55- to 65-year-olds? Are there people who have lost their jobs, with a large fraction of them just saying, 'Well, I'm never going to get another job. I'm going to go ahead and take retirement and move out'?

MR. WASCHER. For that group, the participation rate has actually edged up, I think, a little bit.

MR. PLOSSER. Oh, is that right?

MR. WASCHER. That effect could be going on, and some people might just get discouraged and take early retirement. I'm sure that's true for many people. But there are others who have lost a lot of wealth, for example, in their 401(k) retirement plans, and they can't afford to do it, so they're staying in. And more generally, in terms of the longer-term trends, older people are healthier and, I think, more generally likely to stay in the labor market longer. That has only a small offset to the aging of the population because their participation rates are quite a bit lower than for the prime-age individuals. But that does go the other way in a longer-term sense, in general. And those factors are offsetting, I think, in the current environment.

MR. PLOSSER. Thank you.

MR. LOCKHART. Mr. Chairman, a second question for Dave Wilcox. I think I heard you mention that the rebound in auto manufacturing or assembly in this country in the second half that you anticipate is associated a lot with Japanese nameplates. Was that the comment?

And do you mean by that foreign nameplates? Does that include Koreans and others? Or is it really specific to Toyota and Honda?

MR. WILCOX. I think, and Larry can correct me, that it's specifically Japanese nameplates. We've seen days' supply, for example, for Japanese models just plummet to extraordinarily low levels. This is one of the relatively few aspects of our projection that's actually stayed on track. Toyota's quite confident about its ramping up its production. Honda's been running a little behind, but on net, its ability to ship autos to the United States has come in about in line with expectations. We don't have final assembly data yet for July; we'll get that in the next couple of days. At this point, we're expecting a 10 percent increase, not at an annual rate, in motor vehicles IP, so that's going to provide an extra five-tenths to top-line IP growth in

July. It's a big piece of our output projection for the very near term. And we think that consumer spending in the second quarter was held back simply by lack of availability on dealer lots. And one might have thought that they'd go next door and shop for a Chrysler or something else, but they seem not to have done that. Those other domestic nameplates had very soft sales in the second quarter as well, so we're still thinking that that story is in place for the moment.

MR. LOCKHART. Thank you.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. This is a question for Mike Leahy about the international work. Your description suggested that expansion of the European Financial Stabilization Facility was a key issue. Stories that I've heard out of Europe are that that was not expanded on the grounds that it might incite panic. Perhaps that was unwise, but can the fund be expanded? If it is, would that solve the problem or not? And what should we expect as a Committee going forward on that issue?

MR. LEAHY. I think the markets clearly were looking for, and many others were also looking for, some greater political commitment to resolving the debt crisis that seems to be spreading around the euro area. That took the form, for the most part, of the EFSF. Right now, it isn't even fully funded at this point, but it's slated to have '440 billion. And the July 21 plan expanded the range and scope of operations that it could do to try to provide more assistance to countries, but they did not expand the size of the fund. And '440 billion is just not enough if we run into problems in Spain and Italy, who seem to be the next in line.

Ultimately, the European situation is just really difficult'the debt burden is too high, there's going to have to be some losses taken, and they have to decide how they're going to allocate those. Is it going to be done in a disorderly default, and they recover from that, or is it

going to be socialized, in a sense, through government support? And the Europeans have said that they're going to do what it takes to hold things together and provide the funds, but it's not obvious that the political rhetoric is being supported yet by the political decisionmaking. So there is a way out, perhaps, but it's difficult in one respect because the governments have too much debt. They need to cut back. It's the same situation for the United States, I suspect. Cutting back in the near term is going to slow economic growth and puts them in an even worse situation. And it's very difficult for them to commit to cutting back in the longer run, so it's just very tricky. And we're in one of these multiple equilibrium situations, where if the markets can believe them, the rates might come down and they'll get through, but if they don't, it could be a little messier.

MR. BULLARD. Thank you.

CHAIRMAN BERNANKE. President Hoenig.

MR. HOENIG. Thank you. Dave, I think I understand, but the equipment and software revisions that you did were pretty drastic, and given the balance sheets of some of the industry, this has to be, then, driven by confidence. But my other question is, where are they redirecting this to? Just Treasuries, or are they going overseas with it? Because the BRIC countries still have demand growing'would they be investing there? To see this kind of a drop-off, you wonder what their thinking is and where they're going with this. Do you have any sense of that in any discussions you've had?

MR. WILCOX. I don't have a detailed sense of what they're doing with the liquid assets that they've been accumulating. We've spent a lot of time debating whether this is, to some degree, the new normal. We think that those assets are substituting for other forms of liquidity. I don't remember who it was who presented a nice briefing sometime in the past month or so that

talked about the fact that these liquid assets that have drawn a lot of attention are a substitute for other forms of financial buffers that firms have been holding.

MR. REIFSCHNEIDER. Bank lines of credit, for example. Unused commitments. MR. WILCOX. I guess I'd say that the downward revision to E&S is certainly notable,

but by and large, it's a pretty standard response to just a markedly softer general macroeconomic outlook. The climate that businesses are facing is going to involve a lot less growth in business sales, and therefore we think they'll be motivated to build a smaller stock of E&S capital. That's mostly what's going on.

MR. HOENIG. You don't think that much of it is going into foreign direct investment elsewhere?

MR. WILCOX. I don't think so.

MR. HOENIG. I mean, if I were them, I'd be doing something with this stuff, especially given the growth in the BRIC countries.

MR. WILCOX. That could be part of it. But if that is part of it, I don't think it's coming at the expense of domestic investment. And you're right, I think there has been, to be sure, some reduction in business confidence, as reflected in the purchasing managers' surveys, at both the national level and the regional level. So I think there's been, for sure, some wind taken out of the sails there. But we still have E&S growing, now in the mid-single digits, through this year. So to paraphrase President Fisher, it could be worse.

MR. REIFSCHNEIDER. Stepping back from the recession and the slow recovery, it is true that well before we got into the recession there was a longer-run trend of very slow capacity growth in the United States in manufacturing. And that was presumably'and in a lot of cases, you can track it down'growth in China and other places like that. While that's operated in the

background, whether that shifting of production to other countries has really stepped up at the moment is much more difficult for us to say.

MR. HOENIG. Okay. Thank you.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I don't know if this is a question or a comment. David, I thought this picture that you showed about households expecting an increase in income was extremely interesting. I'm not sure that I'd be so quick to associate it with a change in demand conditions. If households are expecting a slowdown in potential income growth, maybe even sharper than the markdown that's occurred in the Tealbook, I think if you asked them this question, they would answer it in the same way'that they don't expect as much income growth as they had in the past. While I think it is consistent with the story you said about 'Boy, this is showing up as a slowdown in demand,' it could also be a sign of the households realizing that potential is just not as good as it was in the past.

MR. WILCOX. Yes, again, this taken alone is not dispositive, but I think that the main takeaway for us from this series is, boy, it looks like there's something going on in the household psyche that has very persistent characteristics.

MR. KOCHERLAKOTA. Yes, I'm sympathetic to that.

CHAIRMAN BERNANKE. Other questions for our colleagues? [No response] Seeing none, we're ready for the economic go-round, and I'll start with Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Let me say up front that I asked to go first today, not to parse economic data so much as to talk about cognitive dissonance and, specifically, to make a plea to all of us and to remind myself audibly how important it is to resist

the temptation that we all naturally feel to cling to our own past beliefs and predispositions, even in the face of a slew of dissonant data.

For a year or more, I think that the implicit debate in these go-rounds during FOMC meetings has been between those who argued that we are in an economic recovery that would be steady, though unspectacular, with occasional soft patches, and those who argued that we are in a weaker, halting recovery that would take a much longer time to return us to trend points in growth and employment. Well, I think that debate is over. The side arguing steady but unspectacular growth has lost, but it's by no means clear that the side arguing that the recovery was weak and halting has won. I think the meaningful debate today is whether even a weak and halting recovery can continue or whether we're already at or below stall speed and quite possibly slipping into another recession. Equity markets'which, as Brian mentioned, seemed to reflect for quite some time some of the more optimistic sentiment'have, in the past couple of weeks, been marking down economic prospects. Yesterday they appeared to be siding with those who think the most likely scenario is a recession, a probability assignment that strikes me as somewhat high, or at least it would have last week.

Despite the past year's debate in which we've had different views, every member of this Committee is united in having been too optimistic. I think that the most pessimistic among us, of whom I was one, certainly did not expect that growth over the past four quarters would be only about 1.6 percent, and would not have thought so even if we had been told about the impact of Fukushima. Who among us today would stand behind the projections we made last year for GDP growth during this year'and particularly in the second half of this year? Almost none, if any, I suspect.

Most of us, I'm sure, still expect some increase in Q3 growth because of the resumption of auto production that David mentioned a moment ago, but it seems plausible that this impact itself will be transitory. And to the degree that expectations for a pickup in economic growth in the remainder of this year and into 2012 were dependent on some assumed momentum from a decent first half of the year, they are clearly unfounded. It's not immediately clear what other factors will contribute to an acceleration of the underlying pace of growth. Even the most sanguine view of current conditions must acknowledge that the economy is now sufficiently vulnerable that a modest shock could send us back into recession. Needless to say, the euro zone situation described by Mike Leahy a few moments ago could be considerably more than a modest shock. Many of us have been saying for some time that the Europeans had the financial and technical resources to solve their problems if only they would exert the political will. I fear we are fast approaching the point when this will no longer be the case. Plummeting equity markets and tightening financial conditions, along with the blow to confidence they bring, could surely also be more than a modest external shock to what is at best now a fragile recovery.

Like investors rethinking their market positions, each of us needs to rethink our analytic and policy positions to question the assumptions that lay behind our past expectations, and not just to try to fit the most recent data into our prior views. We will, I am sure, spend a good bit of time in future meetings analyzing, in the Tealbook's rather understated formulation, the 'forces imposing greater-than-expected restraint on the expansion,' into which an honest inquiry is likely to yield challenges to premises and beliefs held variously by most, if not all, of us in the past year or more. This inquiry and the debates around it will surely be important in shaping our policies and response to these forces and eventually in deciding when and how to exit. But I would suggest that there is a more immediate task for us today'that is, to consider just how

perilous the current situation is and then, in light of the dangers identified by that assessment, to consider what measures could be taken to reduce the probability of those dangers being realized. Given that the 'steady growth' position has been thoroughly controverted and the 'slow but halting growth' position seriously undermined, it seems to me that the cost'benefit analysis of additional monetary policy measures must have changed significantly. After all, both the string of bad intermeeting data and the substantially reduced expectations, not to mention the recent declines in markets, suggest that the factual predicates for our policy dispositions during the past year were, to a greater or lesser extent, misplaced.

Now, the economic go-round in a typical FOMC meeting is a pretty formal, almost'and sometimes literally'scripted affair, and even the policy portion of most of our meetings tends to play out in a fairly structured fashion, and properly so, since proposed language and alternative policy options will quite sensibly have been proposed, modified, and much discussed before we convene. Today, I think, should be different. The cumulative effect of the gathering evidence of stagnation, the psychological impact of the ratings downgrade, the growing concerns that euro zone problems may not be contained, and the global market drama of the past couple of days has made this a potential inflection point. I hope that we can this morning operate in less scripted, less structured fashion so that we can formulate the most appropriate response to the delicate circumstances that confront us for actions that may be taken today or in the coming weeks. I think we need to be a bit more nimble than we're accustomed to being, and I hope that in the spirit of all of us questioning ourselves, we can do that for the rest of the day. Thank you,

Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Yesterday's equity market selloff certainly gives pause, but I don't think it obsoletes the views that I prepared as long ago as Sunday afternoon, the diagnosis that pertains to the context of policy. I wanted to start by saying that President Bullard in an earlier meeting posed a good question when he asked if there was ever a time in the past 25 years when uncertainty did not seem higher than at other times, and he got quite a laugh when he asked about that. I do think the context of this meeting really does present a lot more uncertainty than whatever the Committee could consider normal. It seems to me that there's simply a lot that we don't know at the moment. We don't know if the growth- restraining effects of the first half will fall away as expected. I think the Tealbook nicely captures the central forecasting challenge of the moment, which is determining the forces responsible for what it calls the 'greater-than-expected restraint on the expansion.' We don't know whether the consensus base-case forecast of a stronger second half and stronger 2012 will materialize. We're one month into the third quarter, a quarter that the Tealbook projects GDP growth at 3 percent, with little indication in the data of that level of growth. We really don't know how the European debt situation is going to play out in coming weeks. We don't know beyond yesterday's developments and this morning's, if we're tracking them without BlackBerrys, how the market will sort out the implications of the downgrade. We don't know whether the projection of inflation settling out will come true, and we don't really know whether there are underlying forces at work, forces captured in the Tealbook's phrases 'persistent spending weakness' and 'supply-side corrosion and damage,' that portend a longer and deeper problem of sluggish growth.

The outlook, of course, always involves a lot of uncertainty, but it certainly feels to me that the combination of uncertainties at this juncture is unusual. And, at least going into this past

weekend, it inclined me, obviously excluding extreme financial instability, to emphasize an agnostic view regarding the outlook. So I am holding to the base-case outlook that I submitted in my last forecast in June of stronger economic growth and subsiding inflation in the second half, but with less conviction. The BEA's NIPA revisions somewhat changed the narrative in my thinking. The revisions, along with the negative tone of the incoming data, make it harder to sustain my previous forecast. When I submitted my projections in June, I was thinking of restraints on economic growth primarily in terms of commodity shocks and the economic fallout from the earthquake and tsunami disaster in Japan. I think now the list has to be expanded to the uncertainties associated with the ongoing government debt messes here and in Europe. Friday's employment report somewhat took the edge off of accumulating doubts, but at this point, I'm reluctant to entirely dismiss the possibility of an outright contraction, which is also a change in my thinking since June. The Tealbook also references the possibility that 'the self-equilibrating tendency of the economy has been greatly weakened by the damage resulting from the financial crisis' and/or that 'the economic weakness reflects structural factors' that have lowered the potential path of GDP. I think these are plausible scenarios as well, and they imply much longer periods of relatively slow growth than have been reflected in any of the projections I or the Committee has published at this point. In many ways, that's Governor Tarullo's point. So going into the past weekend and before yesterday's market instability, I felt that a wait-and-see approach to the incoming data over the next weeks or perhaps months is especially warranted.

Now let me turn to input from my District, and once again, there is some contrast between anecdotal reports we've heard and the picture presented by the incoming data. Listening to reports from my directors and business contacts, I find it hard to identify major shifts in overall business conditions in my District. Overall, activity appears to be growing at a

modest pace. Business sentiment has slipped a little since June, but I wouldn't say there has been a significant deterioration in assessment of the near-term outlook of our various boards of directors and affiliated business contacts. In fact, for the most part, the feedback across contacts was not qualitatively different from June. Large firms are still reporting a favorable business environment, while small firms continue to struggle. Improvements in residential real estate have been spotty by property type and region, though overall the housing market remains depressed. Industrial activity is still expanding, but at a softer pace than earlier in the year. Auto producers and sellers, however, are seeing a pickup in activity following tsunami-related supply disruptions, and the expectations for auto production and sales are reported to be favorable for the balance of the year. Consumer spending has slowed, consistent with the national indicators. Retailers continue to note significant differences between upmarket spending, which has been reasonably good, and middle- to lower-income spending, which has been exceptionally weak. Many households appear to be reprioritizing their spending baskets in response to constraints on disposable income and heightened uncertainty. The Atlanta Bank's chairwoman, who represents the country's largest home-improvement chain, reports strong sales across stores, with some emphasis on what might be called 'home-value investment spending.'

Wage and other compensation pressures in general remain very modest, and commodity price pressure evident earlier in the year has lessened. The capacity to pass through price increases seems to be mixed. The same home-improvement retailer expressed surprise at the willingness of customers to absorb price increases and noted that they expect to test the limits of that willingness over the second half of the year. A firm that represents several thousand grocery products opposite supermarkets said their suppliers will be pushing through price increases in the coming months. A major auto retailer, however, indicated that pricing power has largely played

out in that business. Although a few pieces of anecdotal feedback could cast doubt on the 'subsiding headline inflation' scenario, on balance I detected no clear movement of price pressure in one direction or another.

As regards the balance of risks, none of my discussions in the past several weeks have revealed sentiment that the economy is sliding back into a recession, but the tone of these discussions was decidedly cautious, and many acknowledged that the downside risks outweighed those to the upside. I share the view that downside risks to the outlook for economic growth over the near term have risen, and regarding inflation, I still judge the risks as broadly balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I'll start with some remarks about the Fifth District economy. Recognize that all these are based on reports received before last week's financial market events. The indicators we have suggest Fifth District economic activity has softened in the past couple of months. Our manufacturing index came in right about at breakeven in June and July, and that's a level that's retraced much of the improvement it showed earlier in the year. In the services sector, our Fifth District retail index returned to positive territory, but our nonretail services index remained above even as well. Of the two, the retail index has been more volatile, and comments from retailers in the District continue to suggest a high level of consumer caution. For example, we heard from a supplier of waffle ingredients that while sales at the stores he services are up, average waffle size has taken a hit. [Laughter] Presumably, that means people are ordering smaller ice cream cones and waffles on average. Construction, both residential and commercial, remains fairly weak in most of the Fifth District. Government contracts seem to be the primary source of new, nonresidential work in our District,

and the construction industry is one where we often hear that uncertainty about long-range fiscal policy has a direct effect on them, damping their willingness to invest in equipment or to hire young workers who would need a few years to attain proficiency. Measures of current price pressures in the Fifth District have eased a bit in recent months; expectations about future price trends have declined a bit in services but remain elevated in manufacturing. So the overall picture we get from the indexes and our contacts resembles what President Lockhart reported about the Sixth District: The economy's still growing, but it softened a little bit recently, especially in the manufacturing sector. Caution is widespread, but the mixed tenor of comments is very similar to recent months, and we didn't see any signs of an imminent collapse in activity. However, as I said, these all came from before recent financial market events.

At the national level, there's no question the outlook's deteriorated. The GDP revisions were disheartening. They showed that the contraction was deeper, and the recovery slower, than we had previously thought. One reading is that they increased the odds that we're not returning anytime soon to the trend line that characterized growth in per capita income in the 20th century. Nonetheless, what the revision means for economic growth might be hard to discern. I think it's striking that the Tealbook showed so much confidence in its estimates of the output gap that it translated the GDP revisions, I guess, about one for one in revisions in estimated potential output. We've discussed the notion about output gap at several recent meetings, including during our presentation on DSGE models in June. And how one thinks about the output gap is obviously closely related to the question of whether monetary stimulus is capable of increasing real activity, or offsetting declines in real activity, to any measurable extent.

I don't want to recapitulate that debate, but I want to mention a little bit of recent research at the Richmond Fed that has to do with the elevated level of long-term unemployment coming

out of this recession. The work is by Andreas Hornstein, and it's based on work by Robert Shimer that used data on short-term unemployment, as well as total unemployment, to estimate rates at which workers enter and exit unemployment. And Shimer, who's focusing on short-term flows and short-term fluctuations, found that variations the rate at which workers exit from unemployment predominantly accounted for variations in unemployment. But Shimer's framework doesn't allow for the negative duration dependence'the negative association between how long you've been unemployed and the rate at which you get out of unemployment. Specifically, his model significantly underpredicts long-term unemployment and overpredicts short-term unemployment. What Andreas does is write down'I won't call it a model' essentially an accounting framework that allows for unobserved heterogeneity in the unemployed. He allows two types in this framework, and if you use more data, you can allow more types. And he does that. But one type has a lower rate of exit from unemployment and is more prone, thus, to long-term unemployment. And the other has a higher rate of exit and thus is more prone to coming in and out of the labor market more quickly. The entry and exit rates of these can vary independently over time. They don't have to be proportional or anything. And he allows for the short-term unemployed to change types and become long-term unemployed at a rate that can vary over time. He uses the data on short-term unemployment, less than 5 weeks, and long-term unemployment, 26 weeks or more, to essentially infer all of these transition rates from the data we have.

He confirmed Shimer's finding that fluctuations in unemployment are due mostly to fluctuations in exit rates rather than entry rates. But unlike Shimer, he's able to match, more or less, the elevated level of long-term unemployment. The interesting part of his analysis is that it nests two alternative explanations for the negative duration dependence'the negative

association between how long you've been unemployed and a low exit rate. One explanation is that exit rates simply go down because of the time you spend unemployed. For example, skills are lost the longer you spend outside the workforce or there's some scarring effect. You might call this pure duration dependence, and he captures this with the flows between types'if you start as a good type, you might end up on long-term unemployment. You might change types while you're unemployed. The other source of duration dependence is through unobserved ex ante heterogeneity. When workers become unemployed, some have relatively high exit rates, some have relatively low exit rates. Over time, the ones with the low exit rates are a higher fraction of those who have been unemployed for a long time, so it's essentially a composition effect. His model allows for both types, and he uses the data to just tell him which type of negative duration dependence is going on. What he finds is that the transition between types is negligible, so pure duration dependence, just pure time being unemployed, doesn't seem to be empirically important. Duration dependence instead appears to be more attributable to ex ante heterogeneity among those entering unemployment. Some enter the pool of unemployed less likely to find jobs, and they become a larger fraction of those who remain unemployed for a long time.

So, why is this relevant? Well, I emphasize that this is an accounting framework, so this isn't a fully fleshed-out model of the economy. But the most natural interpretation of ex ante heterogeneity is that it's related to the characteristics of the worker, and the natural thing to think about is skills and labor market mismatch that is brought about by structural change in the economy. And the idea here is that differences in exit rates reflect differences in the degrees to which workers' skills are a good match for employers' needs. According to Andreas's calculations, fluctuations in entry and exit rates for the long-term unemployed have accounted

for three-fourths of the fluctuations in unemployment in the United States over the postwar period. Moreover, the rise in unemployment in 2008 and 2009 is predominantly attributable to the increase in the rate at which long-term unemployed entered unemployment and to the decrease in the rate at which they've exited unemployment. And as I said, between-type transitions are negligible and have made virtually no contribution to the increase in unemployment in this recession. The takeaway is that the rise in long-term unemployment in this recession seems plausibly related to more labor market mismatch''more ex ante heterogeneity' is the more precise way to say it. Whether that's skill mismatch or not is obviously just an interpretation of the data. Others have made that argument, I realize, but the unique contribution of Andreas's work is that he allows for the possibility of pure duration dependence and finds that its contribution is negligible.

A digression of this sort might seem a bit odd in the midst of the apocalyptic market behavior of the past few days, but I think it's still important for us to focus on understanding fundamentals. A couple of times this morning, 'our profound ignorance,' I think, was the phrase used about key aspects of how our economy behaves. My guess is that the recent market movements were substantially driven'it's just a guess'by concerns about growth prospects. That seems to be the likely leading candidate. I found it surprising, but the work I described has bolstered my belief that unemployment is disappointingly high and economic growth is disappointingly low for reasons that are related to economic fundamentals rather than insufficient monetary policy stimulus'or insufficient fiscal policy stimulus, for that matter. Right now, the European growth outlook has worsened in light of the political difficulty of constructing a sustainable fiscal regime for the euro area. Amid all of this gloom, I think we can take some comfort from inflation trends. Inflation seems to be headed toward a range of 1'' to 2 percent,

and I think it's worth pointing out that that's quite a bit different'and, I think, better'than the situation we faced last year at this time. And I think that has obvious relevance to our policy discussions, and I'll leave my comments there. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. I'll take a chapter from Governor Tarullo's opening monologue and dispense with the average presentation. I do want to note from my corporate contacts that, regardless of the sector, whether it's rail activity, electricity usage, cargo hauled through the air or on the seas, airline traffic advance bookings, restaurant pricing, or even one of my favorite leading indicators, elective surgery'which, by the way, has declined significantly nationwide, but showing the difference between my District's performance and elsewhere, cosmetic and elective surgery is up in Texas [laughter]'there is no question that we are seeing, in the reports given by business leaders, a mystically stated 'slowdown in the pace of play.' Also, in terms of not embracing shibboleths that are dear to some of us, I think I have been reporting that inflationary pressure, particularly as we look at it from a trimmed-mean standpoint, certainly seems well contained and within reasonable bounds. It's not an issue that I find myself preoccupied with any longer.

I must say, Mr. Chairman, I'm a little concerned when I hear people talk about the way the markets'and they're talking about the equity markets, but I think we're also talking about broader market phenomena'have behaved in the past few days. And having been a market operator, working under the strong sense that markets are manic-depressive mechanisms, I think we have to be very careful not to overreact. We do know'as we mentioned earlier in the previous discussion we had, particularly with Brian'that we've had worse periods: '82, '74,

March of 2009. So there is substantial downside here. I would simply say that I think things have gotten worse. I think we have to call a spade a spade.

One of the things that I believe firmly has compounded the pessimism or, put it this way, the lesser enthusiasm I am hearing from my corporate interlocutors'which is one difference I bring to this table; whether it's valid or not is to be decided by others'is that we cannot ignore the fact that the debt ceiling negotiations were an absolute debacle. And we have, if not an incompetent government'and I'm not referring to the Administration, I'm talking about the structure'then certainly one that does not give rise to confidence. Now, I spent 10 days in Italy, away from the lead-up to the congressional vote. By the way, full disclosure: President Pianalto was in Italy also. We were not together; we were in separate parts of Italy. And I was reading the correspondence we had through encryption in terms of possible alternative actions that might be taken in the event of a default. One thing I did not see was any television for 10 days. When I got back, I got off the plane, went to exercise to get over my jet lag the night before the House vote, turned on the television, and scanned through CNN, the networks'even Fox, which I don't ordinarily watch. I was taken aback by the frenetic nature of the discussion, but most importantly by what I felt would be a signal that would be received by average consumers, which is having been told by their President, their congressperson of either party, and their senator that the sky is falling. My immediate reaction would have been to turn to my spouse, if I were an ordinary consumer, and say, 'My God, we cannot take this trip. We cannot buy X or Y, and we cannot do this or that.' If I were a business leader'and this is what I did hear in my subsequent discussions with CEOs'I'd be standing, arms crossed, legs spread, saying, 'Show me. Where is the tax regime going to change? What about the subsidies that I hold so dear for my

industry'that I've lobbied so hard over generations to get? How are spending patterns going to change? And very, very importantly, what are you going to do to me on the regulatory front?'

Here's my point: The problem we have now is, there's no question we've had very weak demand. If you look at mall traffic, which is aspirational goods largely'nothing necessary is sold in a mall'and talk to the interlocutors I talk to, it has dropped to zero from a pace in the first quarter of 3 percent. Off-mall traffic has dropped to 2.6 percent over the past three weeks, largely owing to sales of food, which is a necessity. But there's been weak confidence. There has been a very tenuous'and Governor Tarullo used the term'a sort of 'halting' one step forward, one step back; it's not continuous. But we all know it's been somewhat tentative in terms of confidence, and confidence has been undermined. It has not been undermined by monetary policy. It's been undermined by nonmonetary factors. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. The economic news since our last meeting has been dreadful, and it is becoming more and more difficult to ignore the large cracks that have emerged in our monetary policy framework. Accordingly, it's almost impossible for me to present my economic reports in a business-as-usual manner. I suppose that's like

Governor Tarullo'going first in a sympathetic fashion. And my comments are based on economic developments that largely preceded the events of Monday and last Friday. So I hope I am not overreacting, as President Fisher was suggesting.

The weak incoming data indicate that it's highly unlikely that the U.S. economy, in the foreseeable future, will achieve anything like a launch velocity, so I certainly agree with Governor Tarullo's comments. For me, the single most significant number was the downward revision to first-quarter GDP growth to 0.4 percent. It now looks as though growth began

slowing in the second half of 2010. It seems to me that's before the emergence of the various temporary factors that we've been pointing to as explanations for weaker growth in the first half of this year. Most of our business and financial contacts are very concerned about continued weakness, both here and globally. Again, that's before Friday and Monday. Many expect a considerable period of below-trend economic growth. They're quite concerned about what seems to be a broad decline in the confidence of almost everyone they deal with, spanning both the household and business sectors. Some of the pessimism appears to be a reaction to the difficulties in Europe, and some has been a reaction to the messy political fight over the debt ceiling in the United States, which presumably has been reinforced by the S&P downgrade of U.S. Treasury debt. And on the part of businesses, the recurring stalls in final demand seem to repeatedly validate their aversion to making significant forward commitments of resources that would result in new hiring or the expansion of capacity.

I suppose there must be some good news somewhere, or else the economy would be in a full-fledged downturn at this point. The Detroit Three automakers are enjoying a better profit environment, which is driven by a markedly lower cost structure, substantially improved sales relative to the depths of the recession, and strong retail prices that have been made possible by price discipline, better inventory control, and the competitive disadvantages accruing to their Japanese competitors. However, the importance of cyclical demand is not lost on the automakers. GM and Ford have already marked down their sales forecasts for 2012 by about half a million units. Auto production plans that remain amenable to changing, like those for the fourth quarter, currently are being reassessed in light of economic developments. Obviously, this includes making contingency plans in the event a new recession emerges, which at least one of them views as a significant possibility. I got a similar message from the big temporary

employment firms. They saw some modest softening of demand in the second half of July, but so far nothing too far out of line with normal patterns. Their main complaint continues to be that their clients remain extremely cautious about starting significant new projects. Furthermore, they note that many firms are nervous about the outlook and are currently able to pull back on hiring on very short notice. Recent developments also suggest that inflation risks over the medium term continue to recede. My reasons for this assessment are unchanged'well known from past meetings'and, I believe, stronger given recent developments and greater forward- looking risks. I continue to believe that inflation over the medium term will underrun our mandate-consistent inflation objective.

I said there were large cracks in our monetary policy framework. The essence of my argument is somewhat simple: Our legally mandated responsibilities are to provide monetary conditions to support price stability and maximum employment. During less conventional times, our standard, Taylor-like approach to policymaking has served us well with respect to these dual mandate responsibilities. This has been true even when inflation and unemployment were unsatisfactory but still within their more normal ranges. And Mr. Chairman, it is my lasting opinion that no one could have navigated the Federal Reserve and the U.S. economy through the recent period of crisis any better than you did. But today's challenges are still severe. A standard way to score our policy performance on our composite responsibilities is to use a policy loss function like the one the Tealbook, Book B, uses in its optimal policy simulations. The next three sentences are somewhat tedious. [Laughter] The simulations put equal weight on squared deviations in inflation from 2 percent, and the unemployment rate from the effective NAIRU, with an Okun's law coefficient of ''. That's equivalent to putting weights of 1 on the squared inflation gap and '' on the deviation in output from potential. So I think that's somewhat

conservative in the central banker camp''' on an output gap relative to 1 on inflation. With this context, here's the simplest statement of our current policy crisis: Today's 9 percent unemployment policy loss is equivalent to an inflation crisis on the order of 5 percent. Does anyone believe we would be sitting on our hands waiting for inflation to come down from such an elevated level as 5 percent? I don't think so. I think we should have the same attitude toward an unemployment rate of 9 percent. The fact that we don't express that same revulsion exposes the very large cracks in our dual mandate policy framework, and I think we really need to discuss that more. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I was struck over the weekend by how many articles mentioned the word 'recession' while describing the economic outlook, and that was before the opening of financial markets on Monday. The memo from Vice Chairman Dudley highlights how much the deterioration in incoming data since the spring has increased the New York Fed's estimate of the probability of recession. Many private-sector economists, using similar models, come to similar conclusions. With real GDP for the first two quarters of the year averaging less than 1 percent, it is not surprising that these models are predicting an elevated recession probability, even ignoring intangibles such as congressional dysfunction, European political dysfunction, and the first downgrade of the United States in recent history.

Recent data have been sufficiently downbeat that a relatively weak employment report is now viewed as a source of good news. Yet, with the employment-to-population ratio the lowest since 1983, there should be little rejoicing. It is interesting to note that even those with higher educational attainment had significant declines in their employment-to-population ratios. When talking to people around New England, I hear that the only bright spot seems to be rental

housing. Buyers not convinced their home prices will increase, buyers with little or no equity for a down payment, buyers no longer qualifying for credit, and possibly a sectoral shift away from homeownership have all contributed to an improving rental market. However, those same factors would indicate that the most interest-sensitive component of GDP, residential investment, is less sensitive to interest rate movements, requiring larger movements to have an effect.

Housing finance is not the only area that has been disrupted. Concerns about the debt ceiling and European financial difficulties have prompted investors to expand already substantial cash holdings. As money market funds have significantly increased liquidity, indicators of dollar funding problems, such as the three-month currency swap rate, indicate an increase in dollar funding problems for European banks. When European banks have trouble rolling funds with money market funds, they often return to the swap market to satisfy their dollar funding needs. Stock prices for European and domestic banks have declined substantially. In fact, Bank of America shares yesterday closed at under $7 a share, a low not seen since the bad old days of 2009. Their credit default swap rate was over 200. Note that with possible downgrades, uncertainty about lawsuits, and further deterioration in housing prices, there remains a possibility that the next financial shock could still be generated by a large, troubled domestic bank.

Given the large degree of resource slack in the economy, it is quite possible that the inflation rate will soon be falling. Businesses are worried and labor markets are weak'not an environment conducive to increases in prices or wages. The Michigan survey measures of inflation expectations, both short term and longer term, were down. In fact, the Tealbook forecasts that both total and core PCE inflation will hover at 1.4 percent by the end of 2012. Models at the Boston Fed expect inflation to be a bit lower. The evolution of the forecast in the Tealbook since the spring has been striking. The economic growth forecast has been materially

reduced, and unemployment is now expected to remain quite elevated through the forecast period. Inflation is forecast to remain well below 2 percent in the medium term. I unfortunately concur with this outlook. I fear that, in fact, we are currently underestimating the risk of a recession, given the change in domestic and foreign financial conditions. I concur with Governor Tarullo that this may require a more flexible and innovative approach to our policy discussion. Thank you.

CHAIRMAN BERNANKE. Thank you. It's 10:00, and I understand coffee is ready. Why don't we take 20 minutes and come back at 10:20? Thank you.

[Coffee break]

CHAIRMAN BERNANKE. Okay. Why don't we recommence? President Plosser, if you're ready, you're up.

MR. PLOSSER. Thank you, Mr. Chairman. Business conditions in the Third District continue to improve modestly since our last meeting, but the pace of that economic expansion is slower than earlier in the year. Payroll employment growth for the region remains weak. July employment data for the states won't be released until the middle of August, next week sometime, but in June the unemployment rate for our three states moved up to 8.4 percent'still significantly below that of the nation as a whole. Manufacturing activity in the region firmed a bit in July but remains weaker than we saw earlier in the year. Our BOS general activity index moved back into positive territory after being at a rate of negative 7.7 in June. It moved up to

3.2in July. The indexes of future activity moved up considerably, indicating more optimism about future conditions on the part of District manufacturers. One supply shipper I talked to on Friday said that volumes had fallen off the cliff after early in the year, particularly in May and June. But she was somewhat encouraged by the last two weeks of July, when actually their

volume of shipments was creeping back up again. Although not to the level they'd like to see them, at least they were moving in the right direction.

Turning to the nation, the incoming data have been weaker than I anticipated in June. A month ago, I expected that most of the temporary effects of the shocks of the winter and spring, including bad weather, earthquakes, and political turmoil in the Middle East and Europe, were waning. That was clearly premature. The resurgence of the sovereign debt crisis in Europe and the debt ceiling debate in the United States have damaged confidence and increased uncertainty, even as oil prices were stabilizing and industrial activity in Japan was returning to more normal levels. To add insult to injury, we learned from the latest BEA revisions to output growth that the recession was deeper and the recovery weaker than we originally thought. Payroll employment continues to underperform relative to the previous two recoveries, but this is primarily due to the government sector, which has shed jobs in this cycle. Private-sector employment, in fact, has been on about the same pace as we saw in similar stages of the past two recoveries. Despite the below-expected output growth in recent quarters, there are signs the economy is gradually improving rather than continuing to deteriorate. For example, our research staff in Philadelphia maintains a high-frequency business conditions index called the ADS index, which is updated daily as new data become available. This short-term, high-frequency index began to slide in late 2010 and early 2011. However, beginning in June and into July, that slide has been reversed and the index is now beginning to gradually rise, suggesting that conditions are improving, not continuing to deteriorate.

The reactions of the financial market, I think, are telling and important, and they appear to arise from three basic sources. One is the failure of the European Union to deal with their sovereign debt crisis and that flared up, as we've talked about. Another is the deterioration in the

debates about U.S. fiscal policy and downgrades. And finally, perhaps more important than anything, I think, are the BEA revisions to GDP growth. I think that the market is reading in an assessment that this is telling them something about a reduction in longer-term growth, not just about cyclical patterns. And with lower potential growth, you would expect the stock market to respond a lot if they're discounting a longer stream of lower growth. I don't know that those are the right stories. They seem plausible to me. But if that is the correct interpretation of what has happened and what's going on, it's nothing to be very happy about. It's discouraging and something that is quite concerning. And yet, it's not clear at all, if that's what's going on, whether monetary policy can do much about those factors'either the fiscal policy challenges in Europe or the United States or the reductions in potential GDP growth. We do have the potential to deal with liquidity problems and crises in the financial markets to retain financial stability. And we should be prepared to adjust those as needed. It is not clear at this point whether financial markets are truly disrupted or dysfunctional, as they were in 2008, but clearly there is a lot of volatility.

Much of the recent economic commentary is focused on weaker-than-expected real activity, but we've also seen higher inflation than many anticipated. I remain concerned about recent movements in the economy's broad-based price measures. Headline inflation and core inflation measures have been on an upward trend for most of the past year. Core PCE inflation ran a bit more than 2 percent in the second quarter and appears to be on track for a similar reading in the third quarter. As the Tealbook notes, we've now had three months of upward revisions in prices for core goods and services. Thus, while we are seeing weaker economic activity, we are also seeing rising inflation. This is a quite different situation than we faced in the fall of 2010, when we resumed our asset purchases. At that time, real activity was weakening

and inflation was falling, and there were fears of deflation. The recent stabilization and even retrenchment in the prices for energy and commodities hold a prospect for some reprieve in the near-term inflation rates. I think we should be careful not to be too sanguine. We have provided a great deal of monetary accommodation to the economy, and given the stubbornness of the unemployment rate and the potential for potential GDP to revise downward, the unemployment rate has been, despite all that, very stubborn in falling. We should be cautious and vigilant that our previous policies, and perhaps easing actions we might contemplate in the near future, may translate into a steady rise in inflation over the medium term, even while the unemployment rate remains elevated. If that were to occur, we would find ourselves in a very, very uncomfortable predicament.

I think that as we contemplate any action today, we should, as Dave Wilcox indicated, take a longer-term perspective'at least longer term than what the actions of the stock market have been over the past three or four days. And we must be careful not to leave the impression that we are reacting to stock market movements. While we may not intend that to be the case, it could very easily be the result of any actions that we take when we act in the midst of such great volatility. I would remind everyone of the story that they all know'the famous quote by Paul Samuelson that the stock market has predicted nine of the past five recessions'and we should not overreact to the admittedly very tumultuous times in the stock market. I'll save my other recommendations for the policy go-round. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy continues to grow at a moderate pace. The general tone from business contacts is that business is broadly satisfactory, but there is also substantial anxiety concerning macroeconomic developments. A

few business contacts reported hard data confirming a slower economy during the May/June/July period, but not consistently, and the overall tone was actually mixed. The Eighth District unemployment rate, for 16 District metropolitan statistical areas, increased during the spring from 8.5 percent to 8.9 percent. Residential real estate markets continue to look very weak. Market participants were hopeful for 2011, but better results have not materialized. Reports from around the District seem to confirm that automobile production will return to full strength sooner than previously anticipated.

The national economy is in the middle of what may become a severe dislocation. My view is that four uncertainties have held back growth during the first half of 2011. First, Japan. But reports now seem to indicate a faster-than-expected return to full production. This seems bullish for the second half of the year. Second, energy and commodity prices. This was possibly the largest concern in the first half of the year, but oil prices in particular have retreated substantially from their highs earlier this year, so I think this is another bullish factor for the second half of the year. Third, the U.S. fiscal situation. This is not a new issue. From a macroeconomic perspective, there is very little news here and really no surprises in the way the debt deal was finally put together. However, the long debate focused attention on the political intractability of the situation. Still, so far, Treasury yields have remained extremely low. There may be a crisis of confidence in U.S. governance, but it is not showing up in yields to date. The real problem, in my view, is the fourth uncertainty, which is Europe. The key news during the intermeeting period has been the blowout in Italian and Spanish debt yields. This seems to indicate exactly the type of contagion that could turn the sovereign debt crisis into a global macroeconomic shock. The most recent euro zone agreement is proving insufficient for the European policymakers to stay ahead of the curve. I conclude that the risks from Europe remain

substantial and are a key driver of the global selloff in equities. If this is the main disturbance, I do not think we have a natural policy response. I would expect U.S. Treasury yields to remain low on flight-to-safety grounds, which is exactly what seems to be happening.

One additional factor, which has been mentioned many times already this morning, is the second-quarter GDP report, which showed very sluggish first-half growth and substantial downward revisions to earlier data. In my opinion, this is causing many to rethink U.S. potential growth going forward. Lower potential growth may reasonably imply a lower value for U.S. equity markets, which seems to be happening. It also makes the U.S. fiscal situation so much worse. However, as President Plosser was just emphasizing, lower potential growth is not a problem that monetary policy can fix. I will have one side remark on the GDP report. Anecdotal reports from around this table from the first half of 2011 did not seem to indicate an economy at stall speed. I would not be surprised if further revisions again changed the picture of the first half of 2011.

Current monetary policy remains extremely accommodative and has ratcheted up inflation expectations over the past year. With the policy rate at zero, higher inflation expectations translate into lower real interest rates, the very definition of easier monetary policy. The real five-year rate, calculated from the TIPS market, is negative 67 basis points as of Friday'that's a five-year rate'substantially lower, by approximately 100 basis points, than last summer. So this Committee has done a lot, and I think further balance sheet policy is the most potent tool that we have. It also carries with it substantial inflation risk, as has been repeatedly emphasized around the table.

Our goal today, in my view, is to effectively acknowledge the slower economy and the difficult situation in financial markets and to remain prepared for action in the event that the

anticipated strengthening in the second half does not materialize. I counsel against taking direct policy actions today for two reasons. Any action today with respect to further asset purchases, number one, would be viewed as helping the Congress with fiscal problems that weren't solved and, number two, would solidify the notion that there is a so-called Greenspan'Bernanke put in the equity markets. Still, despite not taking action today, it's completely reasonable to plan for further action if necessary, given the very volatile markets of the past few days. Any policy action we take going forward should be appropriately tied to specific outcomes in the macroeconomy and not to the calendar. We have been burned twice by tying the end dates of key policy moves to the calendar, only to have the data contradict our decisions. This occurred in March 2010; we had to reconsider our policy in August 2010. It now happened again in June 2011, and we are back here contemplating further action today. We should adopt an approach closer to our interest rate policy, in which we make adjustments meeting by meeting in response to incoming data.

Other policy approaches, besides balance sheet policy, do not sound like they will be effective to me. The new Twist policy, in my view, would have questionable effects that would complicate our exit strategy. Also, rates are puzzlingly low already out on the yield curve, so I'm not sure how much impact it would have there. Also, the effects of that are not on expected inflation, which I think is the key variable from our perspective. I think that an explicit promise into 2013 has many problems. It's not state contingent, which I have just emphasized. I don't think it's credible to make promises that far out into the future, and I think there's a substantial probability that a promise like that could backfire. As I've emphasized before here, instead of generating higher inflation expectations by promising to keep rates at zero, we may get deflation. Markets might take the promise of low rates as a signal that potential growth is actually very

low. They'd come to expect zero policy rates for a very long time, which is only consistent with a mild deflation in the long run. In addition, following that kind of path, as inflation expectations fall, policy actually gets tighter, not easier. So I think there are a lot of problems with the explicit promise into 2013. On targeting rates, we can talk about that more during the policy round, but I think the main issue there is the possibility that we would lose control of the balance sheet if we tried to target rates. Those are my comments for now, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Over the past six months, there's been a decline in optimism among our business contacts in the Ninth District, at least among those who are not in resource-related businesses and who do not live in the Dakotas. [Laughter] More specifically, I am now hearing a renewal of the 2010 wait-and-see attitudes on both cap-ex and hiring. The fading optimism in the Ninth District is reflective of national economic conditions. As we are all aware, the economy grew slowly in the first half of 2011.

I think we can look to housing as being a potential source of this slow growth. In my view, the roots of this recession and of the slow recovery lie in the loss of housing value and the concomitant shrinkage of wealth and borrowing capacity. And this process continues. For example, the flow of funds data tell us that the value of real estate owned by households fell another 7 percent from the second quarter of 2010 through the first quarter of 2011. We often focus on the impact of this loss of net worth on demand. However, it also affects the supply side of the economy. As Governor Duke emphasized in a speech last spring, entrepreneurs rely heavily on their personal assets and savings to initiate new businesses. Hence, declines in household net worth disrupt the process of business formation and so disrupt the process of innovation and job creation that fuels the expansion of potential output. And here, I think, the

Census Bureau's data on job creation from 2006 and 2007 are suggestive. Housing values began to fall in 2006, and financial conditions generally worsened in 2007. But growth remained positive until the first quarter of 2008. If you looked at overall job creation, it remained higher in 2007 than in 2006. But the number of jobs created by newborn firms fell from 2006 to 2007 by 12 percent, and of course, it's gone on to fall sharply further since then.

I've stressed one channel that links financial frictions and the supply side of the economy. There are other channels that one could point to. What was initially a demand shock can actually turn into a supply shock. And I offer some evidence that actually countervails the thesis that President Lacker was describing. There's a host of empirical papers that document how spells of non-employment are associated with significant wage losses. And the question is, is this due to screening or signaling effects, or is it due to actual deterioration of skills? There's a paper by Edin and Gustavsson from 2008 that uses a Swedish longitudinal data set that links measures of general literacy and numeracy to measures of employment, and they estimate that a year of non-employment is associated with an individual moving down 5 percentile points in the distribution of these general skills in the population. This kind of erosion of skills is another effect of the fall of net worth generating unemployment and then translating into a corrosive effect on the supply side of the economy.

What's my point? My point is, these joint effects on demand and supply make it hard for us to establish with any certainty to what extent the low growth of the economy translates into disinflationary pressures, whether the surprising low growth in real GDP reflects slow growth in potential output or a worsening output gap. And the revisions in the Tealbook arising from the recent revisions in the NIPA are consistent with this abstract statement. Thus, the August Tealbook says that the potential GDP grew at only 1.1 percent in 2009 and only 1.7 percent in

2010, while in April the Tealbook said the potential GDP grew at 2 percent per year in both years. These uncertainties about potential output imply that we need to use additional sources of information as we seek to measure changes in resource slack in the economy. For example, despite the recent modest employment reports, the Tealbook predicts that unemployment will fall

0.4percentage point over the course of 2011, and we generally would view this kind of decline in unemployment as a sign of diminishing resource slack. Now, I talked about it at earlier meetings'at length, I would say. Unemployment itself is only an imperfect signal about the amount of slack in the economy. I think it's useful to turn to inflation itself as a complementary source of information.

And here I think Governor Tarullo is absolutely right, and I'll put myself in the group that was surprised on the downside by events in the first half of the year in terms of economic growth. I think I'll be surprised on the downside relative to my January forecast by what happens in the second half of the year. But it's also true that most of our forecasts were low for PCE core inflation for 2011. I was probably on the high side relative to most of the people around the table, and I was forecasting 1'' percent PCE core inflation for 2011. Now I agree with the Tealbook that we're likely to come in at something closer to 1.8, and possibly even higher, for the entire year. This is something we have to take into account as we think about the degree of slack and the effectiveness of monetary policy in the economy. So from 2009 to 2010, core inflation was falling from 1.7 percent to 1 percent. From 2010 to 2011, as I just talked about, it's going to be rising from 1 percent to something like 1.8 percent. At a minimum, you would normally think about this increase in the rate of change of inflation'this is the third derivative of the price level, for those of you who are keeping track of these kinds of things. President Williams appreciates that. [Laughter] It would seem to indicate that resource slack is

lower in 2011 than in 2010. GDP growth in 2011 has been slow, but as the Tealbook emphasizes on its very first page, we don't exactly know why it's been slow. The falling rate of unemployment and the rising rate of inflation suggest that, despite the slow growth, resource slack is diminishing. In the next go-round, I will talk about how these considerations should impact our thinking about policy. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. A couple of things. In our region, things are about as they were'modest economic growth. We still have an energy boom. Whether that stays, given recent events, we can all guess at. It depends on whether it's temporary or longer term. Agriculture's still doing well. We're still seeing very significant increases in the value of properties as people deploy their liquidity into any kind of a hedge they think they can find. One thing we have found, in talking with some of the major railroads in our part of the world, is that traffic is up in the past month'pretty importantly up, using their words. So we have this modest economic growth. It's at risk given all the world events that we see today, and who knows for sure?

I realize, in terms of the comments that I'm making, that we're all well intentioned, and I take the original comment that we have to be open minded about this, but we are products of experience. As you mentioned, I've been through three recessions here, but it is actually more than that, since I was in the Fed before that. The question I ask myself as we go through this stuff is, what's wrong? Is it that capital's not available, that there's no liquidity in the system, that we're not able to deploy it because of the impediments that monetary policy might have contributed to? Is the policy rate too high? Is there a liquidity shortfall somehow? Or, perhaps, are there other issues? The consumer in America is highly leveraged and remains so. The states

are highly leveraged with their future promises, and they have to deal with that. Do we have a U.S., but also a global, sovereign debt issue that people are thinking about'whether it's real or not, they feel it's real? Is this affecting confidence, and is it inhibiting the deployment of capital around the world and especially in the United States? And can we, as a policy body, increase confidence by actions we take? Perhaps. But I think we're finding out that we tend to do it on a temporary basis as we revert to the real issues that are ours, our country's, and others' to deal with, and that is the highly, highly leveraged world economy today that needs to be worked through. Our political systems'not just here, but also in Europe'are having difficulty coming to grips with that because it requires significant adjustments in how we use our resources. And that's really what we're facing today.

I suspect that we are going to struggle through this for some time to come, and I worry that what actions we take now, with our good intentions, will have longer-term consequences as they are deployed. And I'm not just talking inflation. I mean consequences for the allocation of resources'I think the misallocation of resources is a risk as much as anything. President Evans, I understand what you're saying in terms of, 'Would we be reacting this way if inflation were

5 percent?' But I will tell you, history and experience tell me, that over time, we'because we do care so much'tend to favor trying to bring the unemployment down over our inflationary goals. We did it in the '70s. Inflation systematically got up because we were constantly pushing to try to keep unemployment lower, until finally inflation was so high that we had to take a pill, a very bitter pill. Yes, I think we could easily find ourselves, if unemployment were to stay high or come down more slowly than any of us want, biasing our outcomes toward 5 percent inflation'not today, maybe five or six or seven years from now. But I remind people that in economics that's not a long time, actually. And this housing crisis started in the 2002'2003

period and didn't erupt until 2007'2008. So my only point is to say that I agree. I wish we could do more. Don't misunderstand me'I wish we could do more. But I think flooding more liquidity into the market, while it may have a temporary impact, has intermediate-term consequences'not just longer-term consequences'that I think force us to be more careful right now. And I think we would be wise if we are more careful. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. The economic news since our last meeting has been very discouraging, and it's getting harder to argue that the weakness that we saw in the first half of the year was an aberration. After the GDP revisions, the recovery now looks like a tough slog with occasional bright spots that have been increasingly rare. So, like many of you, I revised down my forecast for GDP growth over the next year and a half. While a variety of inflation measures have been surprising to the upside, I think the sources of those pressures will prove to be temporary.

I'll briefly elaborate on my assessment of the outlook. For some time now, I've projected a pace of recovery that's been on the lower end of the Committee's range of forecasts, but the incoming data have been even weaker than I have anticipated. While some estimates of recession probabilities have moved into the danger zone, I don't think a decline in GDP is the most likely scenario. Instead, I expect output growth to pick up, albeit to a still-disappointing rate, in the second half of the year. In my judgment, the key source of restraint on the pace of GDP growth is consumption. Household spending is likely to remain soft while income growth is limited and households continue to repair their balance sheets. The recent revisions to the NIPAs have highlighted these forces by significantly marking down income and consumer spending over the past three years. My business contacts have long stated that retail sales have

been unusually bifurcated, with lower-income consumers still struggling and behaving as if the recession hasn't ended. Still, my business contacts are reporting some growth, although most are reporting only small gains. That said, on a more positive note, households are making grudging progress on debt reduction, and in my view, this progress will support modest growth in the economy and not lead to further deterioration.

Key auto plants in my District are swiftly returning to normal production levels, which are about 50 percent higher than production levels were as recently as June. This pickup in production is occurring despite some risks of a slowdown in overall retail sales, because dealer inventories have been left exceptionally low by the disruption in production stemming from the earthquake in Japan. As the Tealbook suggests, the planned acceleration of auto production should provide a pretty sizable increment to output growth. The last dramatic recovery of auto production was in 2010, and it was an important factor in one of those rare bright spots in the recovery. Nevertheless, like the Tealbook, I'm concerned by the risk that this bump-up in manufacturing activity is going to prove to be transitory.

Turning to the inflation outlook, I had been expecting to see measures of both total and underlying inflation moderate in the second half of this year. And overall inflation has moderated, but inflation excluding food and energy has not. I still consider underlying measures of inflation to be useful predictors of future headline rates, and the Cleveland Fed's median and sticky price measures both indicate a lower underlying rate of inflation than does the measure excluding food and energy. In addition, my downward revisions to the pace of economic growth induce me to expect reduced price pressures as the months roll by. It also appears that financial markets are less concerned about inflation amid the signs of a global slowdown. Inflation expectations, as measured in the Cleveland model, fell significantly across most durations

following the debt agreement and the S&P rating announcement. For example, the three-year expectation two years forward, which I think is perhaps the most relevant policy horizon, has declined 23 basis points to just under 1'' percent since the July CPI release. It looks like inflation expectations could again be shifting, and if inflation expectations dip much further, inflation itself may move away from our price stability mandate.

Turning to the risks surrounding my outlook, with the momentum to economic growth already so weak, I would put the risk to output as largely to the downside. In recent meetings, I have viewed the inflation risks as skewed to the upside, in light of both inflation rates and expectations coming in higher than anticipated. But today, the shift to lower inflation expectations that I've observed in the data has caused me to return the risk to inflation to being balanced. These recent changes in risks have added to the challenges for monetary policy, and I think they suggest carefully exploring a range of policy options. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. The deterioration in the economic outlook has been dramatic and equally disturbing. Early this year, the economy downshifted to a rate of expansion that fell well short of the growth rate of potential output, which we'd traditionally call a growth recession. Some of this weakness reflected transitory factors, and economic growth should pick up modestly in the second half of the year. But even with that improvement, the pace of recovery will be insufficient to make meaningful progress on unemployment until next year. Moreover, I see significant downside risks to the forecast. Anemic growth and high unemployment leave the economy especially vulnerable to further adverse shocks and a double dip. The debt crisis in Europe provides one example of such a shock. Concerns regarding the recovery's vulnerability have been a major reason for the recent volatility in financial markets,

and I'm especially worried about the fragile confidence of households and businesses, which likely took another big hit with the stock market downturn. Perhaps more worrisome is that the self-correcting process, key to past recoveries, appears to be largely AWOL this time around. Despite our efforts to account for the effects of fallout from the financial crisis, we have consistently been too optimistic about the pace of improvement in the economy. I have become increasingly concerned that we may not have managed to avoid a Reinhart'Rogoff pattern of weak and prolonged recoveries that have followed past financial crises. Perhaps this time is not so different after all.

The extent to which persistent headwinds are hindering the recovery can be quantified in terms of the medium-term equilibrium real interest rate. In my comments, I will refer to a particular model that I developed with Thomas Laubach some years ago. In this model, the equilibrium real interest rate equates supply and demand over the medium term of several years. It changes in response to highly persistent shifts in aggregate supply and demand. A decline in the equilibrium real interest rate would imply a negative shock to demand relative to supply. I think this measure gets at the issue of supply versus demand shocks or persistent ones. Since the outset of the recession, the estimated medium-term equilibrium real funds rate has fallen from

2.4percent to nearly zero today. And for comparison, before the current episode, the lowest reading that we had on our estimate was 1.8 percent during the headwinds period of the early 1990s. Other measures of the equilibrium real interest rate that we look at, as well as those that are reported in the Tealbook, Book B, have also declined considerably over the past few years.

I am also increasingly concerned that the sluggish pace of growth may permanently scar the economy. The magnitude and duration of this downturn will mean that the millions of long- term unemployed are seeing their human capital deteriorate or actually be destroyed, along the

lines of the comments of President Kocherlakota. I found the alternative scenario 'More- Persistent Spending Weakness with Supply-Side Corrosion' to be a very real risk, although not quite yet my modal forecast.

Turning to inflation, with oil and some other commodity prices having declined sharply from earlier peaks, headline inflation is moderating. Core inflation also rose noticeably this year, albeit from a very uncomfortably low level. Some of the rise in core inflation reflects temporary factors that, as mentioned in the Tealbook, should fade in coming quarters. For example, our staff has looked at the issue of pass-through of import prices, and we find that pass-through of higher import prices likely contributed about 0.3 percentage point at an annual rate to core inflation in the first half of the year. With non-oil import price inflation moderating, the impulse to higher core inflation should also diminish in coming quarters. Indeed, my business contacts tell me that the pass-through of higher import prices to consumer prices either has already occurred or will be completed soon.

In sum, I expect the recovery to continue, but at a frustratingly slow pace that leaves the unemployment rate elevated for many years. I expect inflation in coming quarters to return to levels of around 1'' percent, below my preferred long-run goal of 2 percent. Unfortunately, I don't see light at the end of the tunnel. The staff's long-term projection sees us falling short on both of our mandates through the end of 2015, the final year reported in the table. Apparently the long run is just not long enough to reach our goals, at least without additional monetary support. But that's a topic I'll leave for my comments later. Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. First, I'm going to talk about financial market developments, and then I'll talk a little bit about the economic activity data we've seen.

My view is very similar to Brian's that the market reaction is really about the deterioration of the economic growth outlook. If you look at the confluence of the market indicators'stocks down, credit spreads wider, flight into safe-haven currencies, drop in Treasury yields'all are consistent with anxiety about the growth outlook. What's dangerous about this, of course, is that there's a risk that this becomes a self-fulfilling process'that markets weaken, which then causes people to revise down their economic growth forecast, which leads to further market weakness. Letting this run unabated is not without considerable risk, and I think the risks are higher than normal because, one, the economy was very close to stall speed even before this, and, two, the market understands that there's a lack of potent policy tools that can be used to arrest this.

I think that the market developments that are most disturbing to me right now are what we saw yesterday with bank stocks falling very, very sharply and CDS spreads widening. What was interesting was that the stocks that fell the most were those for the weaker institutions. I guess that's not really surprising because obviously they'd be hit most by a poor economic environment. But we did hear something that was actually very interesting. It was that the inability of some banks to buy back their shares may have been contributing to greater price weakness in their stocks. This could be because people who were putting on short positions knew that these companies would not be able to resist as easily as other companies. I think that the key issue in terms of this dynamic is that it's not obvious what the banks can do to break it. It's not as if the bank could say, 'I'll go out and raise more capital,' and that's going to make everybody feel better, because that's going to be taken as a signal that the bank may actually be weaker than what people thought. The key questions on this note are likely, one, will this dynamic continue, and, two, will it lead to funding pressures? And where I guess I would be

particularly nervous is among the broker'dealers. So far we haven't really seen much evidence of this, but that would be a very, very dangerous channel. And, three, will this lead to credit rating downgrades? In other words, if this process goes on long enough, will the credit rating agencies feel some need to respond to the deterioration in the stock prices and the widening credit default swap spreads by cutting the credit ratings, which then could feed back through in terms of the funding, which would be pretty dangerous? Now, S&P said yesterday that the government downgrade would not lead them to mechanically downgrade the ratings of the major financial institutions, but that's now, and things could change as we go forward.

In terms of Europe, I think that it is disturbing, first, that we're seeing renewed bank funding pressures. Money market mutual funds are shortening their tenors, and they're shortening them now to financial institutions that were really pretty protected and not being swept up by this a few months ago, especially some of the major French institutions. We're seeing it in markets more broadly in terms of widening in the FX dollar swap basis and a bit of upward pressure in dollar LIBOR rates. It's hard to know if this is it or if we're going to see a lot more of that, but it is certainly disturbing. The second issue in Europe is that there really is no long-term plan. The ECB's intervention'the fact that they're willing to buy Italian and Spanish bonds'buys you some time. But in some ways, the ECB intervention is very inconsistent with the commitments that have been made in terms of the EFSF because there has been no commitment made to increase the size of the EFSF beyond '440 billion. If you really bring Italy and Spain into the picture, the EFSF needs to be orders of magnitude larger than that, and so far at least, the German officials have said that they have no intention to expand the size of the EFSF. Until that changes, I guess I'm going to be pretty nervous about how this is all going to play out.

In terms of the economic news, as President Rosengren mentioned, we decided to circulate a memo just talking about the conditional probability of recession given how weak output growth has been. I'm not sure I would take those probabilities literally. Obviously every business cycle is different, but it does, I think, show you that we are at a very dangerous point in terms of how slow the economy is growing and what that typically foreshadows regarding future outcomes in terms of recession. The second thing I just want to say is that I wouldn't take much comfort at all from the payroll employment data. As David said, it wasn't quite as horrible as it could have been, but it was pretty bad. Aggregate hours worked were up only 0.1 percent; that's not very strong. And I would emphasize that this is not very timely information; this is the survey for the week that includes July 12. To the extent that there was a deterioration in confidence and business activity in the run-up to the debt limit fiasco, we haven't seen that yet in the employment data. It's very possible that the next employment report could actually be quite a bit weaker than that one. And the last thing I would say in terms of the employment report is that the household survey was much weaker, with, as David mentioned, the drop in the unemployment rate due solely to the decline in the labor force participation.

From my perspective, the weakness of the economy was very well established even before the market retrenchment. On top of that, we have the risk that these market dynamics will continue, and that suggests to me that we should do more on the monetary policy front. Now, I agree with President Hoenig that the problem is one of deleveraging at the household sector and at the government sector, and monetary policy cannot solve the deleveraging problem. That's something that has to take place. But I would argue that the rate at which this deleveraging process takes place does matter, and monetary policy can affect the rate of deleveraging. And by affecting the rate of deleveraging, it can determine how many things actually break in the

financial system, and I think that can be important. So I still think there's a role for monetary policy, even though I agree with you that this is really mostly about deleveraging. Thanks.

CHAIRMAN BERNANKE. Thanks. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I've marked down my economic growth outlook substantially in light of the information received over recent weeks, and I've become increasingly concerned about the downside risks. The latest data indicate that the U.S. economy has been running alarmingly close to stall speed over recent months, and I anticipate only a modest pickup in growth over coming quarters. Indeed, as David Wilcox mentioned, the staff's econometric analysis suggests a 1 in 4 probability that the economy has already slipped into recession. In other words, given the recent evolution of GDP, gross domestic income, and the unemployment rate, the NBER might well conclude that another recession began sometime last quarter. One particularly troubling sign of economic weakness is that real personal consumption expenditures have declined in each of the past three monthly readings. It's worth noting that a pattern of three consecutive monthly declines in real PCE has occurred only on a handful of occasions over the postwar period'namely, 1959, 1974, 1980'81, 1990'91, and, most recently, in late 2008 and early 2009. In every single one of these previous occasions, the three-month sequence of real PCE declines was associated with an NBER-dated recession.

Of course, there are some special and temporary factors depressing consumer spending. Supply chain disruptions had a dramatic impact on the auto sector last quarter. So it seems reasonable to anticipate a significant pickup in motor vehicle production and sales over the course of this summer, providing a transitory stimulus to consumer spending and GDP growth. Nonetheless, we should keep in mind that those supply-side factors cannot fully account for the recent weakness in household spending. The nondurables and services components of real PCE

were both completely flat, on net, over the past three months. Energy price increases also depressed spending in the first half of the year, but careful staff analysis suggests that the decline in real disposable income resulting from higher energy prices can explain only a portion of the negative consumption surprise.

Consumers are more downbeat than can be explained by trends in income, wealth, inflation, and unemployment. To gain greater insight into the American consumer's psyche, over the past few weeks I've been quizzing various friends, relatives, taxi drivers, and even innocent bystanders in the supermarket checkout line concerning their perspectives on the economy. I could report some interesting anecdotes, but I'm reluctant to draw definitive conclusions from these interactions with a fairly small and arguably nonrandom sample of contacts in Georgetown, Berkeley, and Lanai. [Laughter] To gain a more accurate read on the wider population of American households, I devoted a few hours last weekend to analyzing the plethora of consumer sentiment surveys, including several conducted on a daily basis that are now readily available on the Internet. Most of the survey results are free, but to support aggregate demand and in the interest of monetary policy, I shelled out $19.99 for a premium subscription to one of them. In evaluating surveys of consumer sentiment, it's important to keep in mind that there are marked differences in methodology that might be innocuous during normal times but have crucial implications under present circumstances. For example, the Conference Board survey has served as a long-standing benchmark on consumer sentiment. I was surprised to discover that this survey is still conducted via the U.S. mail, just as it was a few decades ago. Thus, it's easy to see how the Conference Board's measure will be heavily weighted toward the sorts of consumers who don't move very often and promptly notify the U.S. Postal Service whenever they do so. By comparison, the Michigan survey contacts households by a phone-

based approach, developed about two decades ago, in which telephone numbers are randomly selected from the phone book. One pitfall is that this approach may systematically underweight consumers who have a cell phone but no landline. There are, however, polling organizations like Gallup and Rasmussen that conduct daily surveys using state-of-the-art methods and that use a whole raft of demographic data to help ensure that the results are representative of the population.

The Conference Board survey indicates only a modest drop in consumer sentiment over recent months, but I no longer find that result very reassuring. In contrast, the Michigan survey and the Gallup and Rasmussen polls all indicate that consumer sentiment started moving down during the spring and then plummeted last month to levels not seen since March 2009.

According to the Gallup poll, about three-fourths of households view national economic conditions as getting worse, while the Michigan survey indicates that only 10 percent of households are expecting any increase in their own real income over the next year or two. Moreover, the latest daily readings of the Gallup and Rasmussen polls suggest that consumer sentiment has continued drifting downward over the past week in spite of the debt ceiling resolution and bits of good news from the latest employment report. Yesterday the Rasmussen index showed that sentiment among the roughly half of Americans with at least $5,000 invested in stocks, bonds, or mutual funds fell to lows not reached since March 2009. I would also mention that this morning, an NFIB small business survey was released for July; it shows a further fall to recessionary readings in business confidence this spring and indicates that this result is almost entirely driven by respondents' concerns about their likely sales.

Returning now to econometric evidence, staff analysis of Markov regime-switching models suggests that an elevated level of consumer pessimism is by no means unwarranted. For

example, the recession probabilities that David Wilcox presented in his briefing were derived from a Markov regime-switching model in which the economy periodically transitions between three possible states: an expansion state, with normal GDP growth; a recession state, with negative GDP growth; and a stall-speed state, in which GDP growth is positive but well below normal. The estimated parameters indicate that the stall-speed state is a harbinger of bad news because that state is almost invariably followed by a recession. Unfortunately, this model currently implies that the probability is greater than 60 percent that the economy is either at stall speed or in recession. Of course, this model-based approach could be overestimating the magnitude of downside risk to the economy. The model doesn't account for the extent to which economic growth during the first half of this year was damped by the supply chain disruptions and other transitory factors. However, the model is blissfully unaware of other significant risks, such as the S&P rating downgrade, the weakness of the housing sector, and the serious challenges facing our European counterparts.

In summary, incoming information since our last meeting points to a modal outlook of sluggish economic recovery over coming quarters, and I see very substantial downside risks attending this outlook. In my view, these circumstances clearly call for additional monetary policy accommodation, a point to which I will return in the policy go-round.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I celebrated my third anniversary with the FOMC with markets once again fluctuating wildly. [Laughter] So I really had to fight growing posttraumatic stress disorder stemming from my early experiences here. However, at the risk of seeming too Pollyanna-ish, there are a few factors that seem better today than they were in 2008 or even last August. The banking system is in much better shape, and indeed, our policies are

focused on incenting them to take more risk rather than to de-risk. Corporate balance sheets and earnings are strong, and banks report that incoming financial statements show notable strengthening in businesses of all sizes. Consumer balance sheets are also in better shape due to voluntary and involuntary deleveraging, and the weight of debt has been reduced through refinancing at lower rates. But their income picture is grim, and the value of their primary asset, their home, is still drifting downward. And finally, while uncertainty is still shading every financial decision, a few things have become clearer or will become clear in the near term. The debt ceiling has been increased. We no longer have to wonder whether and how far S&P is likely to downgrade U.S. debt, and we will soon know what that downgrade means for markets.

Turning to the banks, the same themes that I've been reporting continue. Credit metrics continue to improve. In particular, credit card metrics are approaching, and in some instances have moved through, expectations for norms going forward. Loan demand is still quite weak, but the banks are seeing slow, steady improvement from very low levels. Interest in mortgage refinance picked up recently as rates tipped lower. Credit card response rates are a bit better, and the Treasury has begun announcing approvals for investment under the small business lending program. However, many of the banks that applied are under enforcement orders requiring permission to pay dividends and are therefore not eligible, and it looks now like approval rates will be disappointing. Further, I did talk to at least one bank that had been approved, but they're now concerned that they won't be able to find the loan growth that they had anticipated. So they're not sure they're going to accept the funds. Deposits are still growing, but with no place to invest the money, price is ratcheting down.

The most discouraging part of my recent discussions is that while banks no longer seem to be fighting for survival, very few have a clear vision of how they can achieve long-term

growth or robust profitability. Bank earnings are somewhat like the economy'modestly positive, which is better than negative, but still vulnerable to shocks. Problem assets are being worked out, but there's no replacement demand to offset liquidating portfolios. Interest margins are weak and falling as funds from liquidating loans and new deposits are invested at very low rates, and banks have less room to lower deposit rates as they find themselves facing the zero lower bound. Noninterest income has taken hits from regulations on overdrafts and interchange fees, and increases in other fees will only partly mitigate these costs. Compliance costs from Dodd'Frank are expected to be substantial, and elevated deposit insurance premiums seem likely to continue for the foreseeable future. This was the first quarter since 2005 in which upgrades in supervisory ratings outpaced downgrades, but I would characterize this statistic as pointing to less weakness rather than more strength. One other note of caution: I believe there are a lot of banks carefully watching the BNY Mellon decision to charge for new deposits. With weak profitability, nowhere to invest new deposits, and rising FDIC and regulatory costs, the temptation to charge at least for deposit insurance is high. As asset rates get closer to zero, negative nominal interest rates on deposits could quickly become a reality. While monetary economists might cheer this outcome, I'm not sure what kind of market or banking distortions would ultimately follow.

Finally, as we think about what actions we might take to support growth, I think it's important to look at how improvements in the various loan segments are evolving. Knowing that many are loath to allocate credit, I would still argue that our tools are more limited now and that we should consider targeting our actions to the weakest credit segments to yield better results. Looking at the results of the Senior Loan Officer Opinion Survey, I find the responses to questions about the level of tightness to be quite instructive. Business credit seems pretty fully

healed, with large fractions of respondents reporting credit standards about in the middle compared with levels that existed between 2005 and today. Even with commercial real estate, nearly half report standards in the middle or easier. With a combination of declining past-due rates, lower corporate leverage, building cash positions, and improving earnings, the corporate sector does not appear to be credit constrained or likely to respond to lower rates by borrowing or investing more. In contrast, the charts for consumer credit are a sea of red, the color indicating tighter conditions. Only auto lending shows some level of neutral and easier lending, and to be fair, the slightly tighter conditions in credit cards may be more of a reaction to the CARD Act than anything else. Moreover, the improvement in delinquencies and a resumption of growth in non-real-estate-secured consumer credit provide some evidence that creditworthy customers are able to access credit, and those who do still have credit outstanding are not experiencing as much difficulty paying it. But standards for first mortgages and home equity loans are extremely tight. Outstandings are steadily declining, and delinquency rates remain stubbornly high, reflecting both high levels of stress among borrowers and a backlog of delinquency resolution. So I believe we need to look at problems in the mortgage market as the area where policy is most likely to result in improvements in the economy. We have a housing task force at work here at the Board, and we are reaching out to other parts of the government to try to advance some policies that we think might help. But if, as seems likely, this Committee considers further monetary policy actions, for me one yardstick for judging potential effectiveness will be an estimation of the extent to which the action will affect refinancing or new mortgage lending. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. To me, the economy appears to be faltering, and the probability that this faltering exposes us to increased sensitivity and vulnerability has risen materially. Labor market conditions are certainly weaker than in June. Although the unemployment rate ticked down last month, I don't see any good news in the labor market situation. For one thing, I think discouraged workers are holding down the unemployment rate. Indeed, the household survey indicates that the share of the working-age population that is now employed stands at 58.1 percent, the lowest level since 1983. In addition, more-forward-looking indicators of labor demand, like the number of temporary employees or the claims figures, are not at all encouraging. According to the Labor Department, there are 4.6 unemployed workers for every job opening, and these job figures were added in the middle of July before the debt ceiling debate and before stocks began their steep descent. The economy may not be falling back into recession, but neither does it appear to be growing at the 3 percent rate many had hoped to see in the second half of the year.

One of the theories suggested in the Tealbook to explain the notable weakness is that the self-equilibrating tendency of the economy has been greatly weakened by the damage resulting from the financial crisis. This theory is only partially plausible to me, and here is my evaluation of it. Consumer and business confidence are not recovering the way they usually do following a downturn, and this lack of confidence could be, as it seems to be already, snowballing into a self- reinforcing cycle of anxiety. Businesses are hunkering down, weakening the job market further, and consumers, in turn, are launching their own programs of austerity, curbing the spending the economy needs to grow. If you think through the usual determinants of consumption' disposable income, employment, stockholder wealth effects, housing wealth effects, and

confidence'they all are currently a drag on consumer spending growth, and it's not obvious to me how they are going to get turned around.

Most disturbingly, the interactions among these factors seem to be dragging down economic growth even more. For example, I have a neighbor with an elite MBA but a job that doesn't need one, and she is so embarrassed about the real possibility of losing her home that she used to call me repeatedly when I was the banking commissioner, pleading for secrecy but needing a sustainable modification. On this past Saturday morning, when I went to retrieve my newspaper in the yard, she drove by in her car and stopped to chat. I asked her how she was doing, and she said something like, 'Thank goodness I squandered my savings fighting foreclosure so I don't have investments to tank after the debt deal that won't get us anything.' [Laughter] That formulation kind of took my breath away, so we talked about the weather. But her remark makes me wonder about the self-correcting part of the staff's possible hypothesis. If the components of consumption are weak and households don't expect much improvement, what moves the economy back to its trend level of growth? It may well be that the overhang of private debt needs to be reduced before we get a sustainable recovery. After all, taking a long look back, personal debt had become a cornerstone of economic and capital market activity. While initially consumer debt existed at the fringes of the economy, the prevalence of installment loans, national mortgage markets, and credit cards permitted consumers to borrow against money they did not have. As the future of middle-class incomes becomes much less stable, the logic of borrowing against such hypothetical future incomes begins to unravel. In the run-up to the crisis, credit was closing the gap between the haves and the have-nots, but without rising real wages and with a burst credit bubble, vast amounts of debt remain. If debt deleveraging takes about seven years, we're smack in the middle of slower growth, with more to

come, and the question becomes less about what the outlook for the economy is and more about how monetary policy can help with the pace of this debt deleveraging.

There are two dynamics that I think will hold back growth for a while. First, households and businesses don't have confidence in the future and so they're not willing to spend money and take risks right now. Second, households need to deleverage and aren't willing to borrow in order to spend ahead of their incomes. If I'm right about these, the economy isn't going to recover quickly on its own and is going to need considerable policy support. Thank you.

CHAIRMAN BERNANKE. Thank you very much. Thank you, all. Let me try a summary and then make a few comments.

Participants were concerned about an apparent ebbing of economic growth momentum, notwithstanding the possibility that the reversal of temporary factors such as the supply chain disruptions and high energy prices could bump up activity in the near term. Significant downward revisions to GDP data for both the first half and earlier years contributed to the weaker outlook, as have financial disruptions. Many saw the risk to the recovery as now to the downside, and some worry that the economy might be near stall speed. As one measure, the estimated real equilibrium federal funds rate has fallen sharply. Others noted, however, that slower potential growth may account for some of the weaker performance. Leverage and debt also are retarding growth over a longer period. As to inflation, lower commodity prices will reduce headline inflation, and overall, people see approximately balanced risks to the forecast with respect to inflation. Uncertainty about the forecast may be, really and truly in this case, higher than usual.

Consumer spending has been slow or even declining, especially for low- and moderate- income households, as households have continued to repair their balance sheets and as sentiment

has been poor. The declines in automobile purchases associated with the Japan disaster account for some but not all of this weakness, which has been widespread across sectors. Conditions in the labor market remain weak, as unemployment has increased, participation rates have fallen, and the employment-to-population ratio is very low. Some of these phenomena can be explained by heterogeneity among workers, including both skill loss ex post and ex ante differences, but long-term unemployment can leave permanent scars on the labor force. Housing and nonresidential construction remain weak, even though the rental housing sector is stronger. The weakness of the housing sector has broader macro consequences through wealth, credit, and business formation, for example.

Business attitudes vary, with some seeing modest growth but a number of participants citing issues of confidence, both economically and politically related. Large firms are doing reasonably well as smaller firms struggle. For many firms, demand remains insufficient to motivate significant hiring and investment, and uncertainty, including uncertainty about the fiscal situation and the debt limit, has also limited expansion plans. Auto firms have done a good job of overcoming supply chain disruptions and expect higher near-term production and profits. State and local governments continue to lay off workers, and federal spending will also be a drag.

Financial conditions have been turbulent, reflecting the European situation, the U.S. debt limit uncertainties and fiscal policy, the S&P downgrade, and increasing concerns about U.S. economic growth, both short term and long term. In Europe, rising borrowing rates for Italy and Spain threaten a significant widening of their sovereign debt crisis, with implications for global markets. Questions remain as to whether European authorities can stabilize the situation. Reflecting this turmoil, bank funding conditions continue to tighten in Europe, and U.S. money

market mutual funds have reduced their exposures. There are also banking issues in the United States, as several institutions have seen sharp declines in stock values and rises in their CDS spreads. Credit rating downgrades could exacerbate that situation. However, the U.S. banking sector is generally stronger, with improved credit quality'for example, in credit cards'and lending conditions returning somewhat more to normal, especially for business borrowers. Negative deposit rates, however, are a striking development.

Inflation has recently moderated somewhat as prices of oil and other commodities have receded, although reports of attempts to pass through cost increases persist. Core inflation has been running high, but trimmed-mean and similar measures suggest that inflation remains controlled. Nominal wages have remained subdued. Survey and financial measures of inflation expectations have remained stable. Substantial uncertainties surround inflation forecasts, including the difficulty of judging the degree of slack in the economy. Measurements of the output and unemployment gaps are also important for assessing the ability of monetary policy to stimulate growth. However, the combination of inflation and unemployment that we currently see could be interpreted as putting too high a weight on inflation in our collective objective function.

I tried to make that organized. I don't always succeed. Are there any comments or questions? [No response] Let me just make a few comments. A lot of the main points have been taken.

I do think that the data we received during the intermeeting period were exceptionally disappointing, and in particular, unusually, they came from three separate sources. First, we had a two-year NIPA revision, which gave us a different perspective on the depth of the recession. Second, we had the downward revision to GDP in the first half of the year, particularly in the

first quarter. And then the intermeeting data on spending as well as the developments in the financial markets were, on the whole, pretty weak. So it clearly is the case that, since the last meeting, it's appropriate to downgrade our outlook for the economy.

One area of particular concern, I think, in terms of looking at the economic growth potential, is consumption. Even given the poor performance of income and wealth, consumer spending has been extremely restrained. There are various explanations for this. I think you could put together standard economic models to help understand it. Of course, one standard model is the permanent income hypothesis, which says that people spend based on their expectations of future income, whether it's cyclical or secularly induced. I think it's very notable that consumers may have been better forecasters than the FOMC in the past few years, because their pessimism has been quite striking. I took note of a Michigan survey question that has been asked since 1978: Over the next year or two, do you expect that your family income will rise more or less than prices will go up? In other words, will your real income rise? A strong majority of consumers now polled expect prices to rise faster'that is, they expect their real income to fall. The degree of that is the all-time low. It is in fact a little bit lower than in 1979'80'when inflation, of course, was much higher than it is today'and even much lower than during the recent recession. So people are very pessimistic about future income, whether correctly or not we don't know yet. Related to that and related to some of these leverage discussions, another popular model of consumer spending is the buffer-stock model, which says that people, generally speaking, do not have much wealth, and they try to maintain a moderate- sized buffer to protect themselves against various emergencies like health problems. As we know, through the crisis, we now have a great reduction in access to credit'for example, through home equity lines and through home equity in general. Financial resources have been

substantially reduced; income has become much more uncertain. People have required payments like rent and interest, gas, and so on. In that kind of world, people will also tend to be very conservative about spending given the uncertainty in the environment. That consumption is as cautious as it is is not unexplainable, but it certainly is one of the main factors that have been affecting the outlook. Now, there are some factors that might make things look a little better. Real disposable income may grow more quickly in the third and fourth quarters as energy prices decline. And, auto spending, which we've talked a lot about, may come back to some extent in the third quarter. All of that said, I think, as has been pointed out, that we've been repeatedly disappointed in economic growth overall. Consumer spending has been a very important part of that, and interpreting that, I think, is a very important issue.

Clearly, one of the factors affecting household spending and confidence is the labor market. I only want to make two observations here, both of which have been alluded to already. One is that simply looking at the deeper recession that we had, based on the revisions, may reduce the sense that there is some pent-up demand for labor. It could be that in some sense labor is about appropriate given the amount of demand and production going on. I think that should make us a little bit more pessimistic about future hiring intentions. The other thing that I found very striking, and David Wilcox mentioned this in his remarks, is that currently in the forecast the entire decline in the unemployment rate between now and the end of 2012 comes from the fact that unemployment insurance programs are being ended, leaving the unemployed to move from unemployment out of the labor force. Our government's anti-unemployment program seems to consist primarily of cutting off unemployment benefits so people won't report themselves as unemployed, and that's really not an exaggeration. I think that labor market conditions are quite concerning. Demand remains quite weak, and I think it remains the most

important single factor affecting the willingness of firms to hire and invest, although uncertainty and other issues are also at work.

I take note of the fiscal drag situation. We've been seeing, for example, as a very concrete example, 20,000 to 30,000 jobs a month being lost in state and local governments, which is pulling back overall job creation. We know there's very significant fiscal drag on the horizon coming from the federal side. We are hoping that there will be self-equilibrating factors in the private sector to offset that. We don't know that for sure, but we do know that fiscal drag is going to happen.

In the past few weeks, financial developments have been, of course, very important. I think the developments in Europe are having real effects, not just in Europe but also in the United States, by affecting optimism, risk-taking, and concerns about financial stability. And we have seen our own issues, of course, related to the debt limit. These financial developments since the last meeting are another major reason to cause us to downgrade our growth outlook.

On the inflation side, as always, we want to be vigilant about inflation, but with oil down almost 30 percent since its peak in April, with commodity prices in general down 15 percent from their peaks in April, with automobile prices receding, and with inflation expectations apparently reasonably stable, it doesn't seem that high inflation is a near-term concern. Of course, again, we'll always want to pay close attention to that.

Let me turn from this discussion of the outlook to try to say a few words to set the table for our policy discussion. As you know, things have been changing rapidly in the past few weeks. A week ago or so, when we sent out the statements for FOMC consideration, the way I was thinking about it was as follows: On the one hand, we had significantly downgraded the outlook for the economy while reducing our inflation concerns. That in itself would suggest a

serious consideration of additional monetary stimulus to try to achieve our dual mandate. On the other hand, a week ago we had a lot of uncertainty about both output and inflation in the second half. There was certainly some basis for waiting to see if we could learn more about how the economy was going to evolve. In addition, we had a second dimension of uncertainty, which is that besides deciding whether or not to take action, it's a question of what action to take. In our current regime, we now have, of course, a range of possible actions. It was my sense at that time that having further work done by the staff and having a full discussion in September about what, if any, action should be taken were probably the right ways to go. In that respect, it was my view about a week ago that a statement that reflected the state of the economy and indicated our willingness to respond as necessary would probably be sufficient. Over the past week, we've seen a number of developments, most prominently the very severe stresses in the financial system, including both the European stresses and those in our banking system'two banks, in particular, were mentioned earlier'as well as the response to the downgrade and so on.

Now, should we respond to those financial developments? As President Bullard mentioned, we don't want to be engaging in giving out free puts. I don't think that's what we're talking about here. I think instead that there are some important connections between what's happening in the financial markets and what's happening in the economy. First of all, financial markets are giving us information. They're telling us that there has been a general darkening of mood and expectations about where the economy is going. Second, financial conditions themselves have real effects on the economy. Not just lower asset prices, but increased stress and reduced risk-taking will affect the ability of the economy to recover. Moreover, I think at this point we're going beyond just lower asset prices and an increased risk of financial crisis. In

addition, the decline in commodity prices, which is part of this financial adjustment, is reducing inflation risk.

My view at this point, and I'm just going to put this on the table before the go-round so that everybody can comment and take the opportunity to respond, is that simply darkening our statement'putting that out there'and taking no action have one big and one small disadvantage. The big disadvantage is that I think the markets and the economy would react very poorly to that. It seems as though the Fed is saying that the situation has gotten significantly worse, but we're not willing to do anything about it. I think that would raise questions about what the Fed's thinking is, what our objectives are, and what we plan to do in the future. Perversely, also, if we don't do anything but suggest that we may, I have a concern that QE3 speculation may rise very significantly, and I actually would like to control that. I think all of us'potentially all of us'would think that it's not time yet, and we would much prefer not to get into that particular policy direction.

Is there something we can do today that would be meaningful, would show that we are engaged, that would indicate that we are taking a step to try to improve economic conditions and financial conditions, and that would give some clarity to our future plans but would still be something that would be a reasonable step in the current context? What I would like to propose is to consider the idea of changing the 'extended period' language to refer specifically to mid- 2013. That basically involves taking the 'extended period' language from alternative A and putting it in alternative B, and the language would just say that the Committee now expects that the conditions that we've described, including low resource utilization and subdued inflation expectations, are likely to warrant very low policy rates at least through mid-2013. I think that doing that would be encouraging. As a response, it would be a reasonable response, a measured

response. Let me anticipate a few concerns about it. First, is this tying us down in a way that's dangerous or uncomfortable? First of all, I would just note that it is, of course, quite consistent with where markets are today. It's also consistent with the Tealbook. It's consistent with the Taylor rule, at least the '99 version of the Taylor rule. It's consistent with the Taylor rule applied to our projections. It's consistent with our optimal control analyses as well. So clearly, it's not an outlandish proposal. At the same time, I think it would have some benefit because it would cut off, or at least reduce, the probability of a near-term tightening, and again, it would convey the sense that the Fed is willing to try to support recovery.

President Bullard appropriately raised the question of contingency. Is this sufficiently contingent? Of course, the language is contingent. What it is saying is that we expect that these specific conditions will lead to a situation in which low rates are warranted. What I would suggest, and I think we'll have more discussion of this, is that going forward'perhaps at Jackson Hole and perhaps in September'we can spell out even more concretely how those contingencies tie into our policy so that it becomes explicitly a rule-based or reaction function type of behavior. In doing this, again, I think one of the benefits is that it will put a very high bar on QE3 as we focus on this action and on other actions that we might take, but I think that would be useful from a communication perspective. Will it do anything? Again, I think at this point, confidence and psychology are very important. I worry about us just leaving the situation completely unaddressed, and, as I mentioned, I think it would have some effect on rates via the expectation mechanism. I would note that there has been, for example, a lot of discussion about leverage. Keeping inflation from being too low and keeping interest rates low actually help reduce leverage, and so I think that it actually might have some direct benefit.

This is a suggestion. I want to put it on the table initially. I think we could do more. I

think we could consider a commitment with respect to the balance sheet reinvestment policy as

well, and I'm certainly prepared to discuss that, but my own view is that this is the minimum we

should do if we want to avoid conveying essentially insouciance in the face of what is clearly a

deteriorating situation. With those initial observations, let me ask Bill to make his initial

comments, and then questions to Bill or to me will be fine, and then we'll do our go-round on

policy. Bill.

MR. ENGLISH.3 Thank you, Mr. Chairman. I'll be referring to the handout labeled 'Material for FOMC Briefing on Monetary Policy Alternatives,' which was distributed earlier. That packet contains the revised draft statements that we distributed yesterday as well as the associated draft directives.

Yesterday's revisions to the draft statements were intended to accomplish five objectives. First, a new sentence in paragraphs A.1 and B.1 recognizes the deterioration in financial conditions over the intermeeting period and especially in recent days. Second, additional words in paragraphs A.2 and B.2 clarify that the pace of the recovery is expected to be slower than was anticipated at the time of the June meeting, not slower than during the first half of the year. Third, the change at the end of the final paragraphs of alternatives A and B suggests that the main risk to the Committee's dual objectives is the weak recovery. Fourth, writing 'although only in part' in the sentence about temporary factors in paragraph B.1 is intended to discount somewhat the importance of such factors in explaining the slow pace of growth this year. Finally, some small changes were made to paragraph 1 in all three alternatives in response to recent information about the labor market and energy prices.

Turning first to alternative B, on page 4, the Committee may view the information received over the intermeeting period as pointing to a notably weaker economic outlook than was expected at the time of the June meeting, but also to less moderation in inflation. Members may see temporary factors as accounting for part of the disappointing economic growth and higher inflation during the first half of this year, and so continue to expect that economic activity will gradually strengthen while inflation returns to a subdued pace. Although the Committee might now see the recovery as likely to be more gradual than anticipated at the time of the June meeting, members may judge the level of uncertainty about the economic outlook to be unusually high'and so choose to leave the stance of policy unchanged at this meeting, as in alternative B.

3The materials used by Mr. English are appended to this transcript (appendix 3).

goods, and that the risks to the inflation outlook are tilted to the upside. Paragraph 3 would state that the target for the federal funds rate will remain 0 to '' percent and reiterate the 'extended period' language. But it would also indicate that the Committee was maintaining its existing reinvestment policy only 'for the time being,' and so suggest that redemptions could begin relatively soon.

The adoption of alternative C would greatly surprise market participants and would likely have substantial effects in financial markets.

Draft directives for the three alternatives are presented on pages 7 through 9 of your handout. Thank you. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Are there any questions? President Lacker.

MR. LACKER. Yes. The sentence that appeared yesterday, 'Financial conditions have

become more restrictive''I can understand the equity markets' behavior contributing to that

characterization, but how do you think it'll be interpreted against things like mortgage rates and

other rates that have not risen and, if anything, have fallen? Treasury rates, of course, more

broadly have fallen precipitously.

MR. ENGLISH. That's right, though as you say, equity prices are down a lot, risk

spreads are wider, and I think that on net, we view them as more restrictive in terms of their

implications for economic growth.

CHAIRMAN BERNANKE. President Lockhart, two hands.

MR. LOCKHART. I had the same question as President Lacker because if you think

about the debt markets'the 10-year Treasury, the number of things that are priced off the

10-year Treasury'it's hard to say that this has created financially more-restrictive conditions

across the board. I think it's the equity markets themselves and potentially the wealth effect

down the road. But I had the same question, and I'm glad President Lacker brought it up.

CHAIRMAN BERNANKE. Are there others with this concern? President Fisher.

MR. FISHER. Yes. Why not say 'financial conditions have become more volatile'? I

don't believe, particularly after Governor Duke's intervention and the point that Dennis just

made with regard to Treasuries, that you could argue, other than the downturn in the equity markets and a slight widening in spreads, that financial conditions have become 'more restrictive.' Volatile? Yes. Restrictive? I'd question that.

CHAIRMAN BERNANKE. All right. Shall we just delete the sentence? Any objection? President Kocherlakota, you were supporting that view, right?

MR. KOCHERLAKOTA. I was supporting President Fisher's view. CHAIRMAN BERNANKE. Why don't we just delete the sentence then?

MR. ENGLISH. You could say financial conditions have been volatile as a way of acknowledging recent developments.

MR. FISHER. Everybody knows that.

CHAIRMAN BERNANKE. Why don't we just delete it?

MR. FISHER. Delete it.

CHAIRMAN BERNANKE. Any other questions for Bill? President Plosser.

MR. PLOSSER. I have one question. In the same first paragraph, I was puzzled a little bit by where we said the pace of recovery appears to reflect 'in part,' and we added 'although only.' What does 'although only' add to this discussion'what was the purpose of adding that? Because 'in part' is 'in part.'

MR. ENGLISH. I think the intention was to downplay to some degree the importance of the temporary factors.

MR. TARULLO. Bill, wasn't that intended in part to change the language from this last statement and to suggest that there's been some shift since the last statement?

MR. ENGLISH. I agree. The last statement certainly used 'in part,' and so 'although only in part' would suggest a downshift in that knob.

CHAIRMAN BERNANKE. Any other questions? [No response] Are we ready for the go-round? Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I consider the case for policy action compelling. Even though transitory factors played a role in depressing growth during the first half of the year, the data we have received since June revealed broad-based weakness that is very likely to persist. How can a forecast in which resource utilization and inflation both linger at levels below the Committee's targets possibly be consistent with an optimal monetary policy? At the very minimum, we should ease policy until our medium-term inflation forecast is centered on 2 percent. The argument for policy easing becomes yet stronger when we consider the balance of risks to economic activity and inflation. The downside risk to growth is particularly serious now because the potential for fiscal policy to respond in the event of a downturn is limited, if not nonexistent. Should those downside growth risks materialize, we would likely be facing significant disinflationary risks, too. Our arsenal is not empty, and we should avoid any inclination to save our ammunition until a later date.

I strongly support your proposal to substitute the language related to 'extended period' proposed in paragraph 3 of alternative A for that in alternative B. As you mentioned, such forward guidance would be broadly in line with the implications of the staff's estimated outcome-based policy rule and with FRB/US model simulations of the Taylor 1999 rule. Both of those rules prescribe a funds rate trajectory that remains at the zero lower bound until the second half of 2013, at which point the unemployment rate would be in the vicinity of 7'' percent and inflation would be around 1'' percent. I would also note that the optimal control rule calls for significantly later action to raise the funds rate off its lower bound at a significantly lower unemployment rate.

To further enhance the clarity of our forward guidance, I believe it would be helpful to provide more-specific quantitative information about the economic conditions that are likely to warrant the continuation of exceptionally low levels of the funds rate. For example, I would propose language along the following lines: 'The Committee anticipates that exceptionally low levels for the federal funds rate are likely to be warranted as long as the unemployment rate exceeds 7'' percent and the medium-term outlook for inflation remains subdued. The Committee currently expects those economic conditions to prevail at least through mid-2013.' Such a formulation seems roughly consistent with the implications of our June economic projections, which had a central tendency of 7 to 7'' percent for the unemployment rate in 2013:Q4 and a central tendency of 1'' to 2 percent for overall PCE inflation in 2013. Providing a quantitative threshold for the unemployment rate would also underscore the conditionality of our forward guidance and hence might help ensure that the public interprets the reference to a calendar date'namely, mid-2013'as a forecast, not an unconditional promise. Indeed, this approach would help the markets and the public understand how a shift in the economic outlook would be likely to affect the anticipated timing of policy firming. For example, if there were a further downward revision of the economic outlook, investors would recognize that the

7'' percent unemployment threshold would not be reached until a later date, and hence they would push back the anticipated time of policy liftoff.

I'd also like to suggest one further change'to paragraph 4 in alternative B to make it a bit more forward leaning. I would propose changing the word 'will' to 'is prepared to.' In other words, I propose, 'The Committee will carefully assess the economic outlook in light of incoming information and is prepared to employ its policy tools as appropriate to promote a stronger pace of recovery in a context of price stability.'

Looking toward September, without a clear improvement in the outlook, there are a number of reasonable options for policy action that we should consider. For example, I think that extending the duration of our Treasury holdings along the lines suggested in alternative A has some merit. Such a program is attractive because it might push down longer-term yields, including mortgage rates, and might offer greater support to the housing market. Another promising approach would be to establish some sort of peg or cap on shorter-term interest rates. Because capping rates at the short end involves buying at the short end, whereas lengthening the duration of our portfolio involves selling at the short end, we would need to analyze which alternative approach is preferable. I'm somewhat less inclined to make further cuts in IOER, but I would certainly be willing to entertain such an approach. At any rate, given the plethora of policy tools and the potential urgency of taking some further action in September, I hope we can plan on having a two-day FOMC meeting to ensure that we have enough time to consider the various options and to make specific decisions as appropriate.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. PLOSSER. Mr. Chairman. Excuse me.

CHAIRMAN BERNANKE. Sorry. President Plosser.

MR. PLOSSER. Can I ask Governor Yellen to read her revised sentence'just to make sure I got it?

CHAIRMAN BERNANKE. Certainly.

MS. YELLEN. 'The Committee anticipates that exceptionally low levels for the federal funds rate are likely to be warranted as long as the unemployment rate exceeds 7.5 percent and the medium-term outlook for inflation remains subdued. The Committee currently expects those economic conditions to prevail at least through mid-2013.'

MR. PLOSSER. Can I ask a question? You attached a specific number to the unemployment rate, but inflation 'remains subdued'?

MS. YELLEN. Correct. The 'medium-term outlook for inflation remains subdued.' MR. PLOSSER. Why'okay. Thank you.

MR. FISHER. You wouldn't be willing to put a number on that'2 percent, or a number?

VICE CHAIRMAN DUDLEY. We could talk about that.

CHAIRMAN BERNANKE. Certainly we can talk about it, or that's a step we could take next time'either way. Michelle, did anyone get this? Is it possible to circulate that sentence?

MS. SMITH. I can get you copies.4

CHAIRMAN BERNANKE. Okay. Any other questions? President Evans.

MR. EVANS. Thank you, Mr. Chairman. Although it might be standard to say that another meeting's worth of data might resolve uncertainty, the most recent NIPA revisions have answered enough of these questions for me. Without substantial clarification of our policy intentions in line with our dual mandate responsibilities, I think there's a distinctly high probability that we will continually revisit these periods of anemic growth without ever escaping the current malaise. Consequently, I favor a strong indication today of additional accommodation. I think alternative A is certainly a plausible demonstration of that.

Alternative B doesn't do that. I am quite attracted to the suggestion that you're making today and to Governor Yellen's proposal. So let me talk about a few things in that regard.

Governor Yellen says that she would entertain this accommodative monetary policy to better center our inflation forecast at 2 percent, which is our objective. I would do more. I believe clarifying our policy framework in order to better achieve our dual mandate

4The material distributed by Ms. Smith is appended to this transcript (appendix 4).

responsibilities would help provide further policy accommodation, at least along the lines suggested in Eggertsson and Woodford, and this helps by defining that as extending through mid-2013. What is clarity? Conducting monetary policy in accordance with our dual mandate should mean that as long as high unemployment is generating an extraordinary policy loss, the FOMC is willing to provide very large amounts of accommodation and tolerate medium-term inflation substantially above 2 percent. I want to thank President Hoenig for listening to me earlier, and I certainly take your point.

MR. HOENIG. I'm listening.

MR. EVANS. As I mentioned earlier, a 9 percent unemployment rate against a very conservative natural rate of 6 percent generates a policy loss that is as large as if inflation were running at 5 percent against a 2 percent objective. But my stronger point is this: We talk and act as if 2 percent is an almost unacceptable inflation rate and a ceiling that limits further policy accommodation. A couple of examples: First, the common view seems to be that we will consider further LSAPs and more only if the risk of deflation is significant. I'm glad there's a floor, but the ceiling is too low. Second, in an interview the other day, Don Kohn'for whom I have the highest regard'spoke in the following way. He said that additional quantitative easing might be appropriate if inflation keeps coming down. His option for QE3 was handcuffed by an inflation ceiling that's too low in my opinion. Today's medium-term inflation pressures are overstated. I do not see how this ceiling-like framework is consistent with our dual mandate responsibilities, at least not if the ceiling is 2 percent. Our objective can be 2 percent. We should average that, but it shouldn't be our ceiling.

In favoring alternative A, I'm attracted to the additional commitment'defining 'extended period' to be at least mid-2013. I certainly support that. I suspect that we would have

ended up there anyway. So we should reap the benefit of reducing the uncertainty. I'm also quite attracted to the additional language that Governor Yellen used in terms of stating that this could be appropriate as long as the unemployment rate is above 7'' percent. But again'and I don't have the exact language'regarding 'as long as medium-term inflation is subdued,' I would agree with that if we understood better that 'subdued' could include 2'' percent in the current environment or even 3 percent. But I do like that type of language.

I think we need to avoid signaling that we're AWOL, and so I agree with your suggestion, Mr. Chairman. One thing that does seem missing in the current formulation of alternative B, as I understand it, is that it doesn't include the characterization that the downside risks have increased, and I wonder how that would be interpreted. I really think that should be included. Alternative A has language like that as well as, frankly, I think, a better description of the temporary factors. I would have been happy to take paragraphs 1 and 2 from alternative A, but I'm quite happy to support your suggestion, Mr. Chairman. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Well, I came into the meeting supporting alternative B, at least as of Sunday afternoon, and I am prepared to support your recommendation, Mr. Chairman, about transferring from alternative A to alternative B the language that basically employs the idea of it being explicit about the time frame of 'extended period.' I see that as a modest, almost minimalist, but probably meaningful recognition of what's happening at the moment, and it certainly overrides the wait-and-see approach that, short of yesterday's events, I might have recommended. I think this is a well-calibrated action. It's responsive, concrete, but not overreacting. In some respects, I think it buys some time for more- deliberate planning. I very much support Governor Yellen's suggestion. Others have made the

same suggestion of having a two-day meeting in September to have enough time to do that. And I don't mean to sound cavalier, but I also don't think an explicit time frame on 'extended period' is irreversible. I think most observers understand the conditionality of our policies and statements. I think that if we were surprised to the upside in terms of economic growth and the circumstances of the economy, we could certainly reconsider it.

I have to be a little cautious. I'd like really to hear more discussion regarding Governor Yellen's suggestion of an explicit quantification of an unemployment trigger. It just seems to me that being explicit on that while being more general and not explicit regarding the inflation situation may create some misinterpretation. There may be a whole lot of questions about how we chose that particular number. So at this particular juncture, I guess I just feel it's better to be non-explicit than explicit on that. I would like to hear more about what other people have to say.

A small thing regarding wording in the statement. I supported the idea of moving from 'will act as needed' to 'will employ its policy tools as appropriate.' I understood that the drafters thought that was stronger language, and I supported it from the point of view of it being stronger language. I think we need a very strong statement combined with a modest action at the moment. And I do support the suggestion that Governor Yellen made'that is, to change the very last paragraph to 'is prepared to.' I think, again, the economy and the market are hoping to hear that we stand ready to act. We will show that with the Chairman's recommendation, but I think standing ready to act further is appropriate. That relatively small change of verb conveys that. Those are my thoughts, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. There is a two-hander.

MR. TARULLO. Mr. Chairman. Could I just intervene here? I wonder whether, in order to crystallize points of agreement or disagreement, it might be useful'I don't want to put the onus on either Charlie or Janet'for one or both of them to briefly describe what is, in effect, the transmission mechanism that they would expect. That is, if we adopted your language, Janet, how would you see that affecting the economy? And thus, why do you think it's an efficacious step to take right now? Because I think some of the points of disagreement arise because people are skeptical that a step will have an effect, and if we could specify that and maybe talk about that as well as language, it might be helpful in reaching some consensus.

MS. YELLEN. Okay. Let me be clear that I would support the language in A.3 and think that the language I've proposed is consistent with what's there. And the reason for its being useful even though it coincides with market expectations is that it does show concern, and it does indicate that some transitory pickup in economic growth in the next quarter or something is not going to cause us to move off 'exceptionally' or 'extended period.' It takes some upside risk off the potential that we would be raising the funds rate. I guess the reason that I like the quantitative threshold pertaining to unemployment is that it gives a clearer rationale for how we came up with this particular date and, by making our reaction function clearer, shows that we want to see a sufficient improvement in the economy before we would consider lifting the funds rate'as long as, I wrote, 'the medium-term outlook for inflation remains subdued.' I'm not sure if that's the best language. One could say 'as long as the medium-term outlook for inflation is consistent with the dual mandate.' That might be more general, and President Evans might like that better. The idea is that there's an escape clause having to do with inflation, but we're giving a sense of concreteness. What do we expect to see before we would contemplate raising it? And given that the outlook can weaken or it can strengthen, we're bringing into play a

helpful and stabilizing market mechanism. Bad data? Markets automatically say, 'Wow, 7'' percent'that's not going to occur until 2019. The Fed's going to be on hold for years and years. It's a lot longer than 2013.' Or vice versa in the event that we get strong data. That's what I'm seeing is the advantage.

MR. TARULLO. That's helpful. Thanks.

CHAIRMAN BERNANKE. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. The staff studies on additional monetary policy options were quite helpful. I would find it both timely and helpful to explore these options in detail, as, to date we have spent far more time managing risks associated with the exit strategy than managing the risks associated with the need for additional stimulus. Unfortunately, we do not have time in a one-day meeting to fully discuss the memos. I strongly support the September meeting being two days to more fully map out action should the economy continue along this path. In particular, it would be useful to try to roughly calibrate the effects of the various policy options. If we are looking to have an impact equivalent to at least a 25 basis point cut in the federal funds rate, which combination of staff suggestions meets this hurdle? That way, the Committee could more clearly evaluate the options based on the impacts on the economy and the difficulties in unwinding the policy when that became appropriate. This would allow a better assessment of the costs and benefits of further accommodation options. I'm increasingly worried that what we viewed as a tail occurrence is becoming the most likely outcome, and we have not yet fully prepared for the policy options should that result.

If we were not at the zero bound, I have little doubt that we would today be considering at least a 25 basis point easing. Most of the reaction functions discussed in the Tealbook B, imply that we should be easier than we were in June. I am not certain that alternative A provides

the best way to achieve further easing. I fear that the change in language we have discussed does little to signal further easing. It says that exceptionally low levels of the federal funds rate are likely to be maintained at least through mid-2013, but this matches the path of the federal funds rate that the market already expects, as described on page 53 of Tealbook A. A statement that matches current market expectations is not likely to have much of an effect on market rates.

My own sequencing of accommodation would be as follows: Step 1, I would announce a fixed ceiling on Treasury securities through 2012 and a fixed floor on the balance sheet through 2012, with an escape clause if the unemployment rate falls unexpectedly below 7'' percent or the core inflation rate unexpectedly rises above 2'' percent. I would couple this with lowering the interest on reserves 25 basis points. Foreign branches hold many of the reserves, and reserves pay 25 basis points while three-month Treasury bills have paid close to zero. This amounts to a subsidy for foreign branches. I see no reason to subsidize foreign branches with our interest on reserves, and coupled with the new language, I would expect this would amount to the equivalent of a 25 basis point easing. Should further easing be necessary, I would extend the period of the ceiling on Treasury securities and the floor on our balance sheet with communication that the floor and ceiling would continue unless the unemployment or inflation triggers were reached. We could continue to extend out the period of ceilings and floors until we had greater confidence of achieving desirable monetary policy goals. If the floor and ceiling were extended to three years and more accommodation was still needed, I would begin by first extending the maturity of the SOMA holdings by exchanging short-term securities for long-term securities. If that proved insufficient, I would then expand our balance sheet with purchases of longer-maturity securities.

In an unconstrained world, I would take step 1 today. Given the limited time to fully discuss alternative options, I would prefer to take all of the language in alternative A but exclude

paragraph 4. I would include Governor Yellen's language, and I would actually use core inflation of 2'' percent as the second trigger. I view Governor Yellen's proposal as changing something that is highly conditional to something that's unconditional unless the triggers are hit, and so I think it is a much stronger statement to use Governor Yellen's language. Now, we've somewhat boxed ourselves in by using inflation at the medium term because we're talking about a short period of time, and we're talking about inflation. We're in effect trying to forecast oil prices. So I would use core inflation at 2'' percent to take care of President Evans's concern. And I would use core inflation, but since I doubt I will get consensus on that, I would be comfortable with Governor Yellen's language. Thank you.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I support alternative B for today. As I said earlier, our goal is to acknowledge the reality of slower-than-expected economic growth and the difficult situation in financial markets and to remain prepared for a policy move in the event that the expected rebound in the second half does not materialize. More aggressive action than that today, in my view, could be counterproductive. Number one, it will be viewed as trying to compensate for a failure of the Congress to effectively address medium- and longer-term fiscal uncertainties. Number two, stronger action today will definitely emphasize the idea, already popular in financial markets, that there is a Greenspan'Bernanke put on the equity markets. Both of these will be damaging to our credibility, in my view, and credibility is our most valuable asset. Markets are not expecting much action at this meeting. So I think we'll be consistent with those market expectations if that's the way we play this. This does not prohibit us from having meetings during the intermeeting period if we think that the situation is deteriorating further or that we're simply going to have to take action.

Now, on the extended period through 2013, as I said earlier, I do not think we would be wise to tie policy action to the calendar. We've already been burned by this twice, and if we do it today, we'll be headed down for a third time. The data have a way of contradicting what you expect. If you track the macroeconomy for a long time, you know that there are wide bands of uncertainty, and the economy could be in a completely different place from what you expect two years out. The 90 percent confidence intervals are so wide as to be laughable. So I do not think you should tie it to a calendar date. It will look very political to delay any rate hikes until after the election. I think that will also damage our credibility. I also doubt that we can credibly promise what this Committee may or may not do two years from now. So I don't think it's all that meaningful. I think that going with the 2013 language will put us in a box that we may not want to be in going forward. Further, as I emphasized earlier, this move could backfire badly. This would keep policy rates at zero for at least four and a half years, unless we decide to renege, which will cost us some credibility chips if we want to do that. Japan has been at zero for a decade and a half, and that policy has definitely not produced price stability. Instead, they got mild deflation. There are good theoretical reasons for why they would get that and why that has occurred. I think we have to be more cognizant of this than we are around this table. Worse, if we do get on that kind of a track and inflation expectations start to drift down because of this policy, monetary policy will actually be getting tighter, not easier, exactly at the point where we're trying to provide stimulus. I also agree with President Rosengren that to be effective, a move of this type has to go beyond what markets already expect, and I think that we've established at this meeting that the markets are expecting the policy rate, given the recent data, to be at zero through 2013. So this would only ratify market expectations. It wouldn't have any

stimulative impact of the types emphasized by authors like Gauti Eggertsson and Mike Woodford.

I also disagree with the Chairman on the QE3. I do not think we will be able to avoid a discussion of QE3 going forward, as much as many of us may like to. This is our most potent weapon, and it's more promising as having effects on the economy'and we can debate what those effects are'than any of the other tools in our toolbox. This is because the QE program influences inflation expectations and therefore has potential to drive real interest rates lower if that is what the Committee desires. The most important aspect of a further QE program would be to purchase or sell securities in response to economic conditions instead of according to calendar dates. If we had this program in place as of today, we could simply announce a certain amount of purchases today, and that would be a much simpler way to react to events than what we're forced to contemplate, which are alternative policy actions. We could behave much more as we would in an interest rate environment where we would lower the policy rate in reaction to worse-than-expected economic data.

The new language suggested by Governor Yellen to tie the fed funds rate move to a

7.5percent unemployment rate sounds super risky to me. I might remind the Committee that Europe has not seen 7'' percent unemployment, except on rare occasions, over the past two decades. We really have no idea where the unemployment rate may or may not be going as we go forward in time because we have that little of an understanding of what causes and perpetuates high unemployment. The European example is one that should give us pause about tying anything to a specific number. To me, that would be a very large move with very little thought behind it at this juncture. I would certainly like to see a lot more study on that before we would tie it to a specific number. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. May I defer two or three slots until I have listened to others, Mr. Chairman? I'd like to hear some more arguments.

CHAIRMAN BERNANKE. Sure. President Hoenig.

MR. HOENIG. Thank you, Mr. Chairman. You know, I keep coming back to the fact that the fundamental problem is, we have issues outside of monetary policy that we're not willing to address, and this country has a problem'an economy that has systematically consumed more than it produces. And that means leverage has to continue to increase, and we have to move that forward. If we're going to take care of our employment problem, we have to increase production. And I keep asking the question as I look at the projections'that's why I was asking Dave about the investment outlook. It's going down, not up, even though we have dumped tons of money into this economy of ours, and here we are. How is further quantitative easing or further guarantees of zero rates going to take care of the fundamental problems that we're not willing to step up to as a nation? I think that the central bank should be pushing other elements of this government to address long-term problems when it's not. The same thing is going on in Europe where you've got the central bank in Europe now doing a bridge loan so they can have time to get their bailout, which the markets are already saying isn't going to be enough. And we have a problem in this country where we need to be boosting investment, and it is languishing.

I think that monetary policy that goes and says things about 2013 is going to have a temporary effect for today, which will die off very quickly, and we're going to be back here again. We are going to be talking about QE3 until we take care of these long-run problems. And I think we're in a box, and we need to be pushing other sectors of this economy toward longer-

run solutions, and we're not willing to do it. So I'll leave it at that. My parting words, Richard. [Laughter]

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I recommend taking no action today, as proposed in alternative B. I'd prefer the language to be a little bit different, and we've already made one change. I think our goal should be to be careful not to feed a panic by an excessively negative characterization of the economy, but also not to appear that we have our heads in the sand and don't know what's going on. That's clearly a delicate balancing act. We need to be prepared to act in certain circumstances in the future, but we also want to avoid knee-jerk reactions.

My argument for standing pat today is based on five related factors. First of all, I think it's too soon to tell the extent to which the disappointing economic data are telling us that the current weakness is temporary and will soon abate, or alternatively, that the economy has entered a more persistent regime of slower growth, driven by some combination of headwinds, supply- side disruptions, and lower potential GDP growth. That scenario of lower GDP growth plays into what President Bullard said. Europe is in a world where they haven't seen unemployment rates below 7.5 percent for most of the decade. We may be headed for that world as well, and monetary policy is not the solution to that problem. I don't think we have enough data in hand at this point to firmly establish between these alternatives, but clearly the nature of the shock that we face here should govern, and will guide, the type of response we have. We will always be uncertain, of course, but we must guard against reacting too quickly when we don't know. That leads to my second point, markets have no doubt been volatile, but I'm very dubious of changing the course of monetary policy at a time when the change could be interpreted as a direct reaction

to the turbulence in the stock market, the S&P downgrades, or the policy actions in Europe. It's important that financial markets recognize that a systematic approach to achieving our dual mandate helps policy avoid exacerbating the effects of asset price swings on the economy. Our credibility would surely suffer if markets perceived us as directly responding to stock market prices. And whether we say we are or not, I worry that the perception will be there, and the next time the stock market moves overly aggressively one way or the other, we will be called to action. Third, I'm very dubious that even more accommodative monetary policy is likely to be a potent tool that can speed up the renormalization of the economy. As much as I might like it to be, the evidence seems to be dubious on that front. I think that the portfolio balance effects on the yield curve that we would be counting on in alternative A policy, or Operation Twist, are likely to be miniscule. They are easily overwhelmed by actions of investors in flight-to-quality moves or by shifts in the Treasury supply of securities at various maturities. Fourth, in addition to being ineffective, further action might actually be bad news. Our near-term zero interest rate policy is creating distortions in the market and real challenges for banks and money market mutual funds, not to mention the repo market. As Governor Duke said, banks are turning away very large deposits because the cost of taking these deposits exceeds any return the bank can expect to earn on them. At least one money market center bank is charging depositors to keep larger than their typical amount of funds in the bank. This is an unprecedented action, and we don't really know how this will play out. We've had a zero interest rate policy now for a long time, yet economic activity has moved both up and down, and it isn't clear that further action will change that pattern. Fifth, monetary policy cannot and should not substitute for fiscal policy. Fiscal policy in this realm may be more effective than monetary policy in dealing with some of our concerns. If we overreach and promise more than we can deliver, we will

undermine our ability to achieve both our mandates by losing credibility. At the risk of being somewhat flippant, I will say it anyway. I'm reminded of the old story that, given the path of the economy, insanity is characterized by repeating the same action over and over and over again, hoping you will get a different result. So based on these five factors, I prefer to stand pat and carefully monitor the incoming financial data.

You might ask, what might motivate me to reenter in terms of policy? Well, I think they both have been alluded to. I certainly think that developments in Europe pose the risk of significant financial disruptions to the economy. We cannot solve their problems for them, but we have to act if financial disruptions and dysfunctions in the financial markets spin off from events in Europe. We need to be prepared to support financial stability and the payment systems, and we need to do so explicitly for those reasons, not saying that that it will speed up the necessary structural adjustments in the real economy that we need to work through. To the extent there are financial strains in dollar funding in Europe, we already have the swap lines in place. But should that spill over and create dysfunction, I'd be prepared to move and act aggressively on financial stability. I think we should continue to act if the accumulated data suggest that the economy is in a protracted period of slow growth and is vulnerable to negative shocks. And more important, if significantly declining inflation expectations'not just deflation'were to happen, we might want to act further.

Turning to language, I generally supported alternative B. I have some preferences. I think we removed one sentence that I agree with President Lacker on''financial conditions.' I think that the 'although only in part' phrase was unnecessary, but I don't want to hang on that. I think the tone of the statement could be read as a signal that we have already decided that further accommodation is needed and will be forthcoming. I think it's very important we be careful

about setting those expectations. I think it's premature. We can meet in intermeeting periods if we need to, as President Bullard suggested. I don't think we want to convey a sense of panic to the stock market. That would not help them. A voice of stability and reason, I think, is still a role that we can play.

In terms of the change, Mr. Chairman'in terms of 'extended period''I am torn there. I don't think it will do much good. Since it matches where the market already expects us to be, I don't know that providing that date will help. I'm generally, like President Bullard, not in favor of time-dependent policies'I prefer contingent. In that sense, I think Governor Yellen's recommendation is an interesting one, but that would be a huge step. And we run the risk of confusing the markets and, in fact, even this Committee without making our contingent policies more explicit and thinking about exactly what those numbers ought to be. I have some sympathy for moving toward systematic policies like that where we can articulate them, but I think doing it at this juncture would be risky. But I'm willing to entertain further discussions about that. In fact, I think that the statement as it is, as I think President Hoenig suggested, will not'I wish, but I don't think it will'quell demands, requests, and speculation about QE3. That will be rampant in the marketplace. I don't think we will be successful in calming that by this action, and indeed, we may even be fostering more discussion about it going forward. One more statement about language. In paragraph 4 of alternative B, where we changed the language to 'promote a stronger pace of economic recovery in a context of price stability,' I don't like that language. I would prefer that we just stick to what we've said, which is that we will 'act as needed to best foster maximum employment and price stability.' I don't see a particular need to change that. Again, it will raise speculation in the marketplace about, what do we mean by that?

Are we preparing to do something different? And I would prefer to stick with the original language on that. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. On your point about communications, I do face a speech in a few weeks. And I'd be more than interested, either now or in some other context, in taking instruction from this Committee about how you want me to phrase it. And in particular, one thing I could do'I know there's not unanimous agreement on this'is downplay that particular option in favor of continuing to look at options, et cetera. But that's something we could discuss.

CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Charlie, could you just give us an idea of what kind of action you might consider in the event that you became convinced that economic growth was substantially slowing and that inflationary expectations were declining?

MR. PLOSSER. Well, I think I would respond by saying there would be two pieces to that. One is why we think the growth is slowing. If I thought that basically we were facing lower potential growth rates on into the future, I'm not sure monetary policy can do much about that'the right policy responses are probably different. However, if I thought inflation was beginning to fall to unacceptably low levels'and President Evans and I could talk about when that trigger might be met, but certainly deflation would fall into that category'we would talk about policies where we would want to raise inflationary expectations to prevent that from happening, which would also help on the side of lowering ex ante real interest rates. So those would be the ways I would think about. But it would depend on the real side, what we thought the source of the shock was. How temporary do we believe this is? If we are moving into a world, as President Bullard suggests, of a European steady state of low economic growth and a very high unemployment rate, that's going to call for a different set of policies.

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. If I could just ask a question, because I know that President Bullard mentioned that an unemployment trigger of 7'' percent could be super risky, and I thought you mentioned it this way earlier, President Plosser. Governor Yellen's proposal has jointly with the unemployment rate trigger the admonition that inflationary pressures ought to be'and we can disagree over what it is'subdued or some number. In pointing to unemployment, do you have in mind some risk beyond the inflationary risk?

MR. PLOSSER. I didn't say the word 'risky.' I just said I think we need more discussion about what that number ought to be. If we want to talk about it in the September meeting, I'm willing to have that conversation. But I think there's more uncertainty, it seems to me, about what we think the path of the unemployment rate's going to be and what's appropriate. I think that's a subject for debate.

MR. EVANS. As long as you've got the inflation safeguard'I mean, I could say

6 percent unemployment. And as soon as inflation got up to like 2'' percent, that would come out of that conditionality. So I'm not quite sure that's such an issue.

MR. BULLARD. I called it risky, so let me clarify what I meant. I think there's a large literature that says, as I interpret it, that we don't understand why unemployment is very high in some countries and states'there's hysteresis in unemployment, and there are all these papers about comparing U.S. with European unemployment. That tells me that unemployment is a difficult variable to understand, and I wouldn't want to tie policy numerically to it. Of course, we're all very concerned about unemployment. And I'm very concerned as well, but I wouldn't want to tie policy numerically to unemployment for that reason, because I think it's one of the least-well-understood variables of all the variables that we look at.

MR. TARULLO. But what's the risk, Jim?

MS. YELLEN. Because, if you're right, you have an inflation escape clause there. MR. BULLARD. Sure. Having said what I said about the literature, I'll also say that I

agree with President Plosser that making it state contingent in that way is something we could study and look at, and I'd be willing to look at it further.

CHAIRMAN BERNANKE. I'm going to call on President Williams and then President Fisher, if he's ready, after that. President Williams.

MR. WILLIAMS. Okay. Thank you, Mr. Chairman. I support alternative A. And given the significant downgrade to the outlook for output and unemployment, and the heightened risks to the recovery, I think an additional accommodation is needed for the very reasons that you said. In this regard, I, too, very much appreciate the very helpful staff memos on possible policy actions for providing additional monetary accommodation. In following Governor Tarullo, I have been changing my comments very much in real time, so let's see if I've kept up with everything. I support incorporating the more explicit forward-looking policy guidance as you suggested. This step is a small one. It may help markets better understand our policy framework and our intentions, and it may reduce uncertainty. But as Brian pointed out earlier, if you look in the modal forecast, markets don't expect us to raise rates until sometime in 2014, I think. And of course, this is a conditional commitment, as the proposed language makes clear. But I don't think that's actually enough. Based on what's going on in the economy and the forecast for inflation, I think we do need to go further, and I support extending the maturity of our Treasury holdings as described in paragraph 4 of alternative A. Research by my colleague Eric Swanson on Operation Twist shows that that policy indeed did reduce longer-term interest rates. His findings are completely consistent with the research that was done on the effects of the first stage

of the LSAP program in the current episode. So I think that it's a small step. I know it's not a panacea, but I do think it's a step that would help, and it would have relatively small downside risks. I also think we should be thinking about all the other options, and I agree with the idea of a two-day meeting in September. I think one option that I am also in favor of is lowering the target fed funds rate and IOER to zero, but I know that's an issue that's more complex. We'll have a good discussion of that at the next meeting. I also prefer, by the way, when I said alternative A, the language regarding the downside that I think President Evans also mentioned''Moreover, downside risks to the economic outlook have increased''which was in paragraph 2. I think that's actually an important piece of the language that's missing in alternative B.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I'm sympathetic to your concern. We're expressing, as you said, a general darkening of mood and expectations. The issue is, what action do we take? And there is a proposal on the table by Governor Yellen, which I'm not willing to support. I'm not willing to support it because it's asymmetric'that is, it talks about maintaining rates low as long as unemployment exceeds 7'' percent and a medium-term outlook for inflation remains subdued, undefined. We have a lot of work to do to define our comfort level here. I'm sympathetic to President Evans, but I think the asymmetry of it will create problems further down the path.

I worry about paragraph 1 because there's a lot that's unspoken in here. I would like to actually add a sentence'which I don't think I'll get, but I'm going to state it anyway. That is, after we talk about how housing has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed, which is true, I would like to add the following

language: 'Uncertainty regarding non-monetary-policy initiatives appears to have added to the hesitancy of businesses' willingness to expand payrolls, utilize existing capital, and add physical capacity, although business investment in productivity-enhancing equipment and software continues to expand.' I would further insert that 'uncertainty has been compounded by financial developments in Europe.' For some reason, we're not mentioning this. I think these are significant factors.

I think there are risks to us going further than we've already gone. I understand the desire to act, but I think we have to think through those actions, and presently I don't think we have a consensus at the table that we should do more. I am not willing to vote in favor of doing more. I think the proposal that Governor Yellen has put forward, which I'm somewhat sympathetic to, is too asymmetric. I take President Bullard's point seriously'that is, that pushing things out to 2013 looks too politically convenient'and I just think we don't have enough information at this juncture. I would endorse alternative B with the enhancement or complication that I've added, and I'm not willing to support much more than that. I think we have to be extremely careful here. We need to conduct monetary policy in the most deliberate way, not a reactionary way. We have had a significant market selloff, which we talked about earlier with Brian. In terms of valuation levels, we could have a great deal further to go. I think the tool kit that we have in place has limited potential because we've exhausted much of what we have still in our pocket. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Of necessity more than preference, I am going to have to follow Governor Tarullo's admonition to be nimble in my remarks, and I'll do my best to do that at the cost of being even less articulate than usual. I am

willing to support alternative B as written and circulated. I do not see myself being able to support any of the emendations except the one that President Plosser offered for paragraph 4. Let me talk about my thinking in that regard. That thinking is framed by the following issue, and I'm often asked this: What's the most difficult thing for you in terms of formulating policy relative to being an academic and thinking about policy? I think the difference is, for an academic, it's a relatively sterile exercise where you write down models and you formulate what you're supposed to do, and you come up with some long-term framework that you're supposed to use. And I think as a policymaker, quite rightly you're keeping track of short-run movements in data and responding to that because there are movements that take place that are outside the realm of your models, and you have to be moving your thinking accordingly. I think it's very challenging to keep hold of your longer-term framework while you're confronting the short-term data, and I'm a little concerned about the idea of changing our long-term framework in response to one week's worth of information. That's what I find troubling.

Let me talk about our longer-term framework, and I'll say some things that are going to be unabashedly hawkish, and I'm going to say some things that I think are fairly dovish. Let me talk about both of those. My thinking about our longer-term framework is that it's not just what we talk about among ourselves and how we understand the dual mandate or exactly what objective function gets used in the staff simulations. It's about what we communicate to the public and to our overseers, the Congress of the United States. My understanding of what that communication is, and we reiterated this last November, is that our commitment is to follow policies that will keep inflation at 2 percent or a bit under, and my thinking about further accommodation is shaped by that commitment.

What we're doing right now is using two forms of accommodation'low target interest rates and large-scale asset holdings. And the way the monetary policy rules work is'and the rules are designed to target a particular inflation rate, in this case 2 percent'that you tailor the level of accommodation to the level of underlying inflation and to the level of the output gap.

We adopted our current level of accommodation in November 2010, when inflation was very low, 1 percent and decelerating, and unemployment was 9.8 percent. What's the situation now? Unemployment is lower than it was at that point. Core PCE inflation ran over 2 percent over the past six months. Other measures of medium-term inflationary pressures'for example, the median CPI and the trimmed-mean CPI calculated by the Cleveland Fed'have also run near

2 percent over that period. None of these changes in the economic position since November' the fall in unemployment and the rise in available measures of underlying inflation'argue in favor of easing given, as I said, that our longer-term framework that we effectively communicated was that we're trying to keep inflation at 2 percent or a bit under, with the idea that when pressures that are pushing up unemployment are coming along, they're also pushing down inflation, and as we act to move inflation back up to 2 percent, we're also acting to keep unemployment low. In fact, as I argued last time, I think the changes in the economic picture relative to November could well argue for reducing accommodation, but I think that that would really be ignoring the data. I think the data do lead one to think we could be facing a substantially wider output gap than even what's in the Tealbook. The way we would see that is, we should start to see downward pressures on inflation. I think this is the scenario, for example, of the New York Fed forecast. The New York Fed is forecasting 1.1 percent core inflation next year. I think one way to resolve this is to see more information about incoming data on core inflation and inflationary expectations. So I just don't see adopting more accommodation at this

stage as being consistent with our public commitment to keep inflation at 2 percent or a bit under.

The other way to put this is, if we want to follow policies consistent with our public commitments, we should be prepared to change what our communication of our longer-run framework is. I think this gets to some of the statements about lack of self-equilibration in the economy that Governor Raskin talked about and the staff talked about. So what's going on'or one story of what's going on'is that we've got deleveraging that's pushing down on consumption, and that means there aren't enough jobs. But if there was equilibrium, what should happen in the marketplace is that real interest rates should decline enough to generate enough consumption demand. Even though people don't want to eat as much now because of all the shocks that have hit them, if real interest rates fall enough, they're not going to want to save, and that will make them spend, and that will generate jobs, and that will generate employment. So what's interfering with this possibility? Well, one argument for what's interfering with this possibility is the zero lower bound'and that if you're at the zero lower bound, and you have a commitment, as we have, to keep inflation at 2 percent or a bit under, that means you've put a lower bound on the real interest rate. It can't go below negative 2 percent, which sounds really, really low, but maybe it needs to be lower. Making a public commitment to a higher target inflation rate'at least temporarily, as perhaps President Evans is advocating, or possibly permanently'would expand the range of possible outcomes you could attain. In particular, you could generate policies that would lead the real interest rate to fall below negative 2 percent. This is not something I would argue we should adopt today. It is something we should be thinking about and considering in response to what has been a long-term issue'that the economy is not recovering anywhere near as rapidly as we think it should, given conditions. We

should be thinking about whether or not that's because of the fact that we're not able to generate the real interest rates we need to get equilibrium.

One thing that I certainly agree with Governor Yellen on is that I think it would be great to have a two-day meeting in September, and one of the things I think we should be talking about at that point is the possibility of adopting a hard target inflation rate. I also don't rule out the possibility of changing our framework and our way of thinking given the data we have seen coming in. I think we should do that. What I object to is the notion that we should be doing that on the fly in response to a relatively short flow of information. I think it would be useful to have staff analysis of the costs and benefits of taking such a step. But failing that, given that we have a particular framework in place that we have communicated to the public, which is that we are interested in keeping inflation at 2 percent or a bit under, I don't see ourselves being able to adopt further accommodation. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Okay. I need to interject here. I guess it won't help to argue for my position any further. We have two dissents, is that right?

MR. FISHER. At this juncture.

CHAIRMAN BERNANKE. President Plosser, do you intend to dissent?

MR. PLOSSER. I'm inclined to, unless I hear something different.

CHAIRMAN BERNANKE. Okay. That's a very difficult position for me, obviously. Just to get a sense of the Committee's preferences so that I understand them, if we were to go back to alternative B as written with the forward-leaning language of the last paragraph, without the 'financial conditions', how many dissents would I have? Any dissents? [Simultaneous speakers] I'm asking the question, just so I understand Committee preference.

MR. EVANS. No reference to mid-2013?

CHAIRMAN BERNANKE. That's right. Alternative B as written, except we take out the 'financial conditions' language and we use the more forward-leaning paragraph 4.

MR. TARULLO. So no action at all?

CHAIRMAN BERNANKE. No action at all.

MR. EVANS. Mr. Chairman'

CHAIRMAN BERNANKE. I'm trying to get preferences.

MR. EVANS. I could not. I mean, it just seems clear that we would simply be postponing that very discussion until September, when we would have the very same outcome. And so I could not support that.

CHAIRMAN BERNANKE. Okay. Thank you. We have to get this done by 1:30. Yes? MS. YELLEN. You might have other negative votes.

CHAIRMAN BERNANKE. Well, I'm going to stick with what I have. Let me just make a comment, and I understand your concerns, but I just need to say a couple of things. Number one, I'm perfectly willing to accept the argument that monetary policy is not the main tool, that this is not the main thing wrong with the economy, but it's our duty to do what we can, to be palliative, to help where we can, even if we can't solve fiscal, structural, and other problems. Number two, we have a mandate that says we should look at employment and inflation. We've had a very marked reduction in the outlook since the last meeting. Not responding in any way not only raises a question of whether we're following our mandate, but it also makes the markets uncertain because they don't know what we're doing. They can't follow our logic. Again, to put out a much darker statement and not to do anything strike me as being inconsistent. I believe this step is the most modest possible step we could take. It's completely conditional; it could be offset by any change in conditions. It could be offset by asset sales, if

necessary. We will elaborate going forward exactly what the conditionality is, and I will look forward to our discussions around the table. We will have a two-day meeting. I think I can accede to that point, at least, for September. [Laughter] And we will discuss all of this, and we'll continue with the subcommittee's discussions about the appropriate use of an inflation objective, which I do not believe is in any way inconsistent with this perspective, because what we're saying is, we believe that conditions will warrant, and 'conditions warranting' means that we meet our objectives. I don't see any inconsistency of this with the inflation objective or that framework. Again, I feel that not signaling to the market and to the public that we are at least engaged in understanding that there is an issue here and that we're trying, at least in a palliative way, to respond to it, risks a real disconnect in terms of our communication, which I'm unfortunately not willing to accept. It would be very unpleasant to have three dissents, but I guess if that's where we end up, that's where we end up.

MR. PLOSSER. Mr. Chairman, I have a question.

CHAIRMAN BERNANKE. Yes.

MR. PLOSSER. Your proposal for my question about paragraph 4, the language'what was your'

CHAIRMAN BERNANKE. Well, when I was talking about going back to the old version, I was going to take the most aggressive language. But if you will not dissent, I will certainly listen to your suggestions.

MR. PLOSSER. I need to think about that a little bit.

CHAIRMAN BERNANKE. Okay. Let's go to President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I support your recommendation of alternative B with the firmer 'extended period' language from alternative A. As I noted during

our economic go-round, I revised down my outlook for economic growth, and I see further downside risks since our last meeting. In addition, I have greater confidence than I did at our last meeting that inflationary pressures are gradually subsiding. If we had a fed funds rate well above zero, given my outlook, I would be supporting a rate reduction. But instead, we have to contemplate using tools that are less well understood and are more difficult to explain to the public. Clearly, as many have said, and as you have just repeated, monetary policy can't solve all of our problems. But we should do what we can on the margin. So I am open to providing further accommodation using nontraditional tools. As others have said, I look forward to our meeting in September, where we can carefully weigh the costs and benefits of the options that were laid out in the staff memo. In my view, Mr. Chairman, you have clearly laid out the reasons for taking some actions today. I also agree with your comments regarding your desire to control the QE3 speculations.

As others have noted, I have a strong preference for our policy responses to be contingent on evolving economic conditions rather than a date specific; however, I think it's going to be difficult in the short time we have left today to come up with that language and those measures, although I like the language that Governor Yellen has suggested. In fact, if the FOMC was currently publishing the fed funds rate path that underlies our current economic projections, then the public would already know that we don't expect to raise the fed funds rate until about mid- 2013, that we expect at that time the unemployment rate is going to be at 7'' percent, and that we anticipate having subdued inflation until mid-2013. I would encourage you, Mr. Chairman, to use the Jackson Hole speech to elaborate on some of these economic conditions, and I also think it would be helpful for you to articulate how the firmer 'extended period' language, and perhaps

some of the other policy options, would be expected to affect our economic outlook. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I think we find ourselves in uncharted waters, and that's a phrase we've been using for four years now. But we've again veered farther away from the charts we have. I welcomed Governor Tarullo's opening of this round, which I interpret as an appeal for humility and openness to question how we know what we think we know about things. My question, as you know, is whether monetary policy can have a big effect on economic growth right now. I think the key question for us is, why is growth so low? And I'd just remind you that our traditional approach to this'loss functions like the one President Evans referenced'rests on a dichotomy between the determinants of longer-run trend growth and fluctuations around that, where technologies and preferences and population growth are viewed to influence the former, but policy is the tool that moves around things in the meantime. And I don't think we really know that that can never change. The 20th-century trend growth in the United States is remarkably constant, but it's also a fact that many other advanced countries with access to the same technology as us, and presumably the same types of human preferences involved, have converged to growth paths that are markedly lower than that in the second half of the 20th century. And it's not obvious to me that we're not capable of shifting from the path we were on in the 20th century to one more like Europe's, and it's not obvious they can't shift up. Given that, I think we should be circumspect about taking measures of the output gap, measures of the unemployment gap, as measures of how much further policy has to go. My sense of things is that further monetary stimulus at this point is unlikely to change real outcomes very much at all. If you look back at QE2, we didn't have much of an effect on economic growth. The effect

we had was temporary, and we got a more sustained increase in inflation. This is the classic prediction of what happens after a monetary policy impulse. I think that in hindsight August is likely to be a Romer date. You look at the impulse response after that, and it looks like the classic thing: temporary effect on real activity, sustained effect on inflation.

So I think we should be sitting pat. I think we should avoid encouraging people to look to us, to look to monetary policy, to fix economic growth problems. And so I favor alternative B. And I guess a lot of options have been put on the table. I strongly oppose putting in numbers for unemployment. I share President Bullard's discomfort with putting in a calendar date as well, just for the reasons he said. I don't think we can be sure that we're not in the situation in which Europe found itself in the '80s, and that we're not going to see unemployment well above 8 percent for a decade or more. And it's through no fault of monetary policy. So I don't want to hang our hat on unemployment. I don't think we should. That concludes my remarks. Oh, and about the two-day meeting, can I get back to you when I see my BlackBerry? [Laughter]

CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. Our position is incredibly uncomfortable. Many around the table have pointed out that the factors contributing to the disappointing results are not monetary in nature, and that it's not clear that monetary policy can cure the ills. Well, it might not be our fault, and it might not be our job, and we might not be in the best position to act, but I still see our responsibility as taking whatever action we can that we believe will result in the best outcome, regardless of how it fits with our own preferences or comfort level. But we have to weigh carefully the costs and benefits of our options. I don't see the change in our guidance as high risk. It communicates our best estimate of the future outcomes. And even

though the statement might not be different from market expectations today, it could keep markets from prematurely anticipating our exit if this uneven recovery results in a spurt of good data as a result of those same temporary factors. And I do see the rewards of this action as not raising expectations for QE3. As to the clarification proposed by Governor Yellen, I could support it but would prefer to take more time to think about it. I do support a two-day meeting and perhaps an intermeeting conference to give us time to assess the relative costs and benefits of all of our options. As I said in the economic go-round, I believe our remaining ammunition is limited and therefore must be carefully aimed. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. President Bullard was first, I think. MR. BULLARD. I just wanted to make a small suggestion in an effort to try to round up

some consensus. Instead of '2013,' could we change 'an extended period' to 'a period substantially longer than previously envisioned'? [Laughter]

CHAIRMAN BERNANKE. I don't know that that helps, really. Tell me if it does. President Kocherlakota.

MR. KOCHERLAKOTA. Yes, I'm not sure that helps, unfortunately. I was just going to point out that while it is true that using 'extended period until 2013' accords pretty much with our estimates of what our mean would be'or actually, I think, it's even to the left of that'the reason it's useful policy from one perspective'why it's accommodative'is that you're shearing off the possibility of raising rates or reversing accommodation before that. We can't both argue that it's not going to have any effect and view it as increasing accommodation. That's my only point.

CHAIRMAN BERNANKE. No, that's not true because, first of all, it is conditional. It's absolutely conditional. But even if it's not an ironclad commitment, it's communicating an

expectation and to the extent that there's a misunderstanding or a disagreement it can be effective. President Fisher.

MR. FISHER. I'm sorry, because we do have two more to go, and then we should probably have a discussion, but I'd be extremely cautious on '2013,' Mr. Chairman. It just looks so politically convenient. I really think that through your good efforts of communication, through the actions taken by this Committee, we've in essence, removed ourselves from the heat of the political debate. I think we're less suspect in the eyes of our critics than we have been. And I think the attention is rightly focused on getting this fiscal situation under control. I might have different prescriptions than what has been suggested, but the focus is back on the Congress, with the assistance of the executive. The '2013' just looks too politically convenient, and I don't want to fall back into people being suspicious about the way we conduct our business. So I just want to plead on that front. I think it's a mistake. I think it would then allow those who are trying to squirm out of their duties of actually getting their act together on fiscal policy' whatever that act is'to put the finger back on us. And it's unfortunately after an election, and it's a declaration before we know what the outcome is of what's likely to happen on the fiscal side, which is critical here. So I wanted to plead that we do not adopt that specific date, given that it is ultra-inconvenient and given that we have worked very hard'and you have taken special personal risk in terms of your communications'to lower the temper and suspicion about monetary policy. I think this would raise the suspicion and make us look like we're way too politically acquiescent, whatever our personal politics may be.

MR. TARULLO. President Fisher, would you be happier with '2014'?

MR. FISHER. No.

PARTICIPANT. 'End of 2012,' then.

MR. FISHER. It depends on the conditions. But look, again, we have restored our integrity to a great degree, and I don't want to put a dent in it.

CHAIRMAN BERNANKE. Some may interpret it that way, I suppose. But that's the appropriate date given our information.

MR. FISHER. Right now you have 'extended period.' 'Extended period' is indefinite. VICE CHAIRMAN DUDLEY. It's two or three meetings according to some.

[Simultaneous speakers]

MR. EVANS. We really should let everybody else have an opportunity.

VICE CHAIRMAN DUDLEY. We have a couple more people who'd like to speak. CHAIRMAN BERNANKE. Could I turn to Governor Tarullo, please?

MR. TARULLO. Thank you, Mr. Chairman. I want to begin, again, by invoking the legal authority under which we act every time we gather around this table. And that legal authority gives us a dual mandate. One, it doesn't say we are supposed to promote price stability and maximum employment so long as the rest of the government does what we'd like them to be doing. And it does say that we have to promote both price stability and maximum employment, and you cannot read one of those phrases out. How one balances those has obviously been a centerpiece of U.S. monetary policy at least since the late '70s and probably before, but it is our responsibility. Point two, if what I said earlier about this being a possible inflection point is correct, I'm actually a bit concerned that simply changing the understanding of 'extended period' to what was already anticipated is not going to do much. And Mr. Chairman, I do agree with Charlie Plosser that we're not going to dispense with speculation about QE3 by either making or not making that change in the language.

I've been listening to everybody and trying to figure out how we could maximize the support for a particular statement here, and I'm not at all sure that I've got the way to do it. But rather than state further my views on where the economy is and what monetary policy would do, let me see if I can at least offer two suggestions that might help. First, I wonder whether there is a way to add a qualifying or descriptive phrase that reinforces the sense that this date already accords with our expectations for when we'd be converging on an appropriate moment to either begin to remove or no longer grant accommodation, and thereby make it more obviously contingent and more obviously predictive. I suggest this, Richard, mindful more of Jim's points about setting a date out there arbitrarily, no matter what it is, because I'm not as concerned about the political implications of saying '2013.' Second, in trying to respond to, I think, some of Charlie Plosser's concerns and some that I heard from other people, I wonder whether inserting an additional sentence in paragraph 4 might help give the public a more accurate sense of what we did today, and thus tamp down a little bit of unwarranted speculation. We might think about adding as a first sentence that 'the Committee discussed the range of policy tools available to'' whether it's 'promote a stronger pace of economic recovery in a context of price stability' or 'best foster maximum employment and price stability''and then say, 'It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.' The purpose for inserting that first sentence is to make clear (a) that a lot of things other than QE3 were discussed and (b) that precisely because there's a range of things under discussion, action may be forthcoming, but there is by no means a commitment to do so. I think the purpose is also to just accurately reflect to the world before the minutes come out, which is in three weeks, that a lot of what we did today was to talk about what we might do and why we might do it. I would hope that that could address the concerns of people who don't want us to

seem too passive, while not going over the line with the concerns of people who think that we're not ready or that we don't know enough to take some more tangible step right now. Having said that, I'm going to withhold a judgment on anything because I'm not sure what's on the table right now. But I trust, Mr. Chairman, you're going to try to come back, distill everything, and give us a concrete proposal on which you can again solicit people's opinions.

CHAIRMAN BERNANKE. Well, I'm still with the '2013,' unless I have a suggestion that will accommodate'

MR. FISHER. That's an interesting suggestion.

MR. TARULLO. Okay. I'm not sure what the right language is to try that. MS. DUKE. What if it said, 'The Committee currently projects,' rather than

'anticipates'?

MR. TARULLO. 'Projects'?

MS. DUKE. Yes.

MR. TARULLO. Ask the guys at the end of the table.

VICE CHAIRMAN DUDLEY. I think people are very much overstating the degree of commitment in that language. It says 'currently anticipates that these conditions are likely to warrant.' It's qualified all over the place. I don't understand why people view this as some binding commitment. It's not a binding commitment. There are all sorts of escape clauses. I don't understand why people view this language as so binding that they'd be willing to dissent. This is the Committee. The Committee has a forecast. Now, people may disagree with the forecast, but is it unreasonable for the Committee to have a view, that the Committee, in its totality, today anticipates that this is what is likely? That's not binding.

MR. TARULLO. Bill, maybe that's the point. I think this is what Betsy was trying to get at. If the sense of the forecast, and the forecast-dependent nature of this statement, were a bit more explicit, that might give a little bit of comfort to those who worry that a date is being placed out there absolutely.

CHAIRMAN BERNANKE. 'The Committee currently projects that economic conditions'? Would that help anybody?

VICE CHAIRMAN DUDLEY. If the projections change, then the date could change. MR. EVANS. Were we working on Governor Yellen's language?

CHAIRMAN BERNANKE. No. [Simultaneous speakers]

VICE CHAIRMAN DUDLEY. I think it's off the table for now.

MR. BULLARD. First of all, I agree very much with what Governor Tarullo said about saying that we had discussed a lot of options. That's very helpful, I think. The other thing is to get rid of the '2013,' how about something very simple? Instead of 'for an extended period'' 'for a very substantial period'?

CHAIRMAN BERNANKE. No, that doesn't change anything.

MR. BULLARD. I think if you move off the 'extended period' language and switch it to something else, you'll get a lot of market attention, and they will see that as a further commitment.

CHAIRMAN BERNANKE. Does that help anybody?

MS. DUKE. No

CHAIRMAN BERNANKE. No.

MR. FISHER. I'm confused as to where we are right now, Mr. Chairman. Maybe I'll let Governor Raskin finish, but I think Governor Tarullo's suggestion is worth thinking about.

CHAIRMAN BERNANKE. I only heard one suggestion'the thing about the range of tools'which is useful but doesn't address the controversy here.

MR. TARULLO. No, Betsy and I together, I think, are trying to address that by changing the words to make it clearer that we've picked the date because of our current projections. Maybe that's what I'm suggesting.

MS. DUKE. Yes.

CHAIRMAN BERNANKE. How about this: 'Based on current projections, the Committee anticipates that economic conditions . . .'? Is that all right?

VICE CHAIRMAN DUDLEY. Yes.

MR. EVANS. I'm sorry, I don't know what we're talking about. This is critical to me. CHAIRMAN BERNANKE. We're going to the sentence now'about the '2013.' MR. EVANS. I'm sorry, we're on alternative B?

CHAIRMAN BERNANKE. Paragraph 3 of alternative A, which says now, 'The Committee currently anticipates that economic conditions . . .', and would say 'Based on current projections, the Committee anticipates that economic conditions . . .'

MR. EVANS. But still 'through mid-2013'? It's the date that matters.

CHAIRMAN BERNANKE. Yes. Will that help? At all?

MR. KOCHERLAKOTA. I'll have to think about it more.

MR. FISHER. Me, too.

CHAIRMAN BERNANKE. All right, you have five minutes. [Laughter] All right. Governor Raskin, please.

MS. RASKIN. Thank you, Mr. Chairman. Now, before we take alternative B off the table with the statement on forward guidance, I want to say a couple of things in support of it.

First of all, I think it's appropriately forceful but accurate in its characterization of the incoming data. It now slightly de-emphasizes the role of temporary factors in the first-half slowdown. I think the slow economic growth in the first half of this year extends beyond the factors that we've labeled as transitory. Weaker growth in disposable personal income, to me, signals a protracted slowdown in consumer spending, particularly given the persistently low level of consumer confidence. Nonetheless, I think that the pickup in inflation over the first half of this year is a transitory phenomenon, and I think that inflation will be subdued over the medium term. In fact, it appears to me as if a moderation in inflation is already under way, especially given that energy prices have decreased significantly from their peaks during the spring. And as we've heard today, both survey- and market-based measures of longer-term inflation expectations have changed little, on balance, over the course of the year. There's going to continue to be considerable slack in labor markets over coming quarters, which will continue to exert significant restraint on wages and prices.

Now, the statement of forward guidance. Like you, Mr. Chairman, I think that alternative B without the statement of forward guidance runs the risk of communicating that the Committee is unable or unwilling to merely clarify its anticipation of responding to this protracted slowdown. Because I think that an important source of the weakness in the economy is that households and businesses don't have confidence that things will get better, I have reservations about a statement that leaves the impression that we cannot or will not clarify our anticipation. If we choose not to clarify our anticipation, as in alternative B without any additional language, I think we need to explain why more clearly. Otherwise, we run the risk of creating confusion.

I recognize that one problem is that not everybody on this Committee agrees on the diagnosis or the treatment plan for the ailing economy, but we can't let our lack of consensus cause us to confuse the public. At this point, we run the risk of giving the impression either that we can't do anything or that we won't do anything, and that we will not clarify our anticipation, which I fear would exacerbate the lack of confidence in the economy. So I think we should consider sending a stronger signal with our language about how long we are prepared to keep rates low. I'd be very supportive of clarifying our forward guidance and believe that this would be a significant step, not in terms of monetary accommodation, but in terms of providing greater transparency about our overall strategy and about the policy path that we see as most appropriate for fostering our dual mandate. So I think it would be helpful to include something. And here, again, this language that was circulated'to me, all that it does is really describe with more specificity the economic conditions that are likely to warrant the continuation of an exceptionally low funds rate. It also provides some loose indication of the time horizon over which we expect those conditions to prevail. In sum, even if I thought that not clarifying our anticipation would most likely end with us successfully fulfilling the dual mandate in the future, I find it prudent to clarify now, not because the language is going to have a big impact, but because the fragile state of the economy at the moment makes it very vulnerable to any new negative shocks or the worsening of ongoing shocks, and clarifying our anticipation may help on the margin.

CHAIRMAN BERNANKE. Thank you. All right. Well, let me get a proposal'sorry. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thirty seconds. First, we have to do what we can do. I completely agree with Governor Tarullo. This notion that 'It's someone else's fault, so that means we get to abdicate our responsibility''that's just ridiculous in my opinion. Second, I

think that what you proposed is the absolute minimum of what we need to do today. I'd be prepared to do more, but that's the absolute minimum. And third, I think people are dramatically overstating the degree of commitment in saying that 'we anticipate that something is likely based on our current projections.' It just doesn't bind us in any meaningful way. All it does is provide more clarity to the market and replace something that today is completely empty. The 'extended period' language today is absolutely empty.

MR. EVANS. Come on, you can't say empty.

VICE CHAIRMAN DUDLEY. Well, it's empty in the sense that it means that we're going two or three meetings out, that's it. So the 'extended period' language today doesn't really add very much. This actually provides a lot more than that, so I completely support you.

CHAIRMAN BERNANKE. Thank you. All right. Let me'Michelle tells us we need to get this done as soon as possible.

MR. FISHER. Let's get it right.

MR. KOCHERLAKOTA. Could I clarify one thing, Mr. Chairman?

CHAIRMAN BERNANKE. Yes, of course.

MR. KOCHERLAKOTA. I would not be able to support the alternative, even as rewritten with Governor Duke's proposed change of language.

MR FISHER. Which is?

CHAIRMAN BERNANKE. 'Based on current projections'? Can you conceive of any language that would help you?

MR. KOCHERLAKOTA. Not at this time, no.

CHAIRMAN BERNANKE. All right. So what I'm proposing is alternative B. In the first paragraph, we've struck the sentence'

MR. EVANS. Mr. Chairman, can I just say that a number of people have preferred alternative A? I mean, if you're going to take three dissents'

CHAIRMAN BERNANKE. No, alternative A involves the lengthening of the portfolio, and I'm not going to introduce that discussion at this time. I'm sorry, but I promise we'll do that at the two-day meeting, which everyone has agreed to.

So in alternative B, we're scratching the 'financial conditions' sentence from the first paragraph. The second paragraph is unchanged. The third paragraph'let me ask President Plosser now. Is there anything we can do for you in the last paragraph?

MR. PLOSSER. I prefer the old language for paragraph 4, but I'm not sure doing that is sufficient offset to the '2013' language.

CHAIRMAN BERNANKE. What about the language in paragraph 3, where it says now, 'The Committee continues to anticipate,' we'd say, 'Based on its current projections, the Committee anticipates that economic conditions . . .' Does that help?

MR. PLOSSER. I'm sorry to be slow here, but this very difficult. Putting that, along with the change in paragraph 4, would be an improvement.

CHAIRMAN BERNANKE. A sufficient improvement?

MR. PLOSSER. That's what I'm struggling with. I'm not sure it would be, Mr. Chairman.

CHAIRMAN BERNANKE. Okay.

MR. FISHER. Mr. Chairman, could you read the full sentence for me, please? I'm sorry. CHAIRMAN BERNANKE. With the proposed change?

MR. FISHER. Yes, sir.

CHAIRMAN BERNANKE. It would be, 'Based on its current projections, the Committee anticipates that economic conditions'including low rates of resource utilization and a subdued outlook for inflation over the medium run'are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.' 'At least two years.' How about 'for at least two years'?

MR. FISHER. Mr. Chairman, again, I think we have labored mightily to make clear that we are as politically independent as possible.

CHAIRMAN BERNANKE. It's not political.

MR. FISHER. But sir, it may well be interpreted as that by our critics. We have mitigated our critics substantially. Why don't we just say 'for a substantial period'? I mean, we're putting a date on here.

CHAIRMAN BERNANKE. 'Extended,' 'substantial''

MR. FISHER. The date happens to be right after the election'I cannot support that. CHAIRMAN BERNANKE. All right. Fine. President Rosengren.

MR. ROSENGREN. If you're going to take three dissents, then I think we should go to the language of alternative A and take out paragraph 4, because I think there was enough support for that. So if they're going to dissent anyway, I think we should have much stronger language, because I think that was the consensus of everybody else other than the people who are dissenting. If they really feel so strongly about that, I think we should go to alternative A, take out paragraph 4, and that would characterize how everybody else is viewing the economy.

CHAIRMAN BERNANKE. Are there any objections?

MR. ENGLISH. Sorry, that's alternative A, paragraphs 1 and 2?

CHAIRMAN BERNANKE. Alternative A'

MR. ROSENGREN. But take out the'

CHAIRMAN BERNANKE. Take out 'financial conditions' in the first paragraph. MR. ENGLISH. But take alternative A, paragraphs 1 and 2?

MR. ROSENGREN. 1, 2, and 3.

CHAIRMAN BERNANKE. And 3, which is identical now. Get rid of 4 completely. MR. ENGLISH. You can't take paragraph 3 of alternative A because there has to be the

reinvestment.

MR. LUECKE. That's two sentences of paragraph 3 in alternative B.

CHAIRMAN BERNANKE. All right. Paragraphs 1, 2, and 3 of A'but just add the sentence 'The Committee also will maintain . . .''and then paragraph 4 of A.

MS. YELLEN. So we're putting in the reinvestment''maintain its existing policy of reinvesting principal'?

CHAIRMAN BERNANKE. Yes. So it's alternative A as written, eliminate the 'financial conditions' sentence, and insert at the end of paragraph 3 the material on reinvestment.

MS. DUKE. Do you have Dan's change to paragraph 4?

CHAIRMAN BERNANKE. Paragraph 4 is as in alternative A, which is exactly what we had. What did you want to say, Governor?

MR. TARULLO. I think somebody's got it. [Simultaneous speakers]

MS. YELLEN. This is Dan's proposal for 4.

CHAIRMAN BERNANKE. The beginning of the last paragraph is, 'The Committee discussed the range of policy tools available to promote a stronger economic recovery in a

context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.'

MR. WILCOX. Do you want the last sentence from paragraph 3 in B'about the Committee being ready to 'regularly review the size and composition'?

CHAIRMAN BERNANKE. Yes, exactly what's in B. The last two sentences in B. Dan, I don't know. Is it worth the effort at this juncture?

MR. TARULLO. Unless there's an objection'

CHAIRMAN BERNANKE. Okay.

MR. TARULLO. I think that first sentence really does help us a little bit with that 'range of policy tools.'

CHAIRMAN BERNANKE. All right. Let's go through it now. So paragraphs 1 and 2 from alternative A'and 3 from A.

MR. ENGLISH. Paragraph 1 in A less the 'financial' sentence.

CHAIRMAN BERNANKE. Paragraph 1 in A less the 'financial' sentence; then paragraphs 2 and 3 from A and add to paragraph 3 the last two sentences''The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.' And then add the new 4: 'The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.' [Simultaneous speakers]

VICE CHAIRMAN DUDLEY. I'm a little concerned about whether the market will jump to the view that we're going to do QE3 because you have this language: 'The Committee

will regularly review the size and composition of its securities holdings.' I just think you might want to be aware of that potential.

CHAIRMAN BERNANKE. All right. We'll use communication to downplay the QE3. All right. Any further comments? Would you please read the current statement? And I apologize, everyone, for the rush.

MR. LUECKE. Paragraph 1 in A less the 'financial;' paragraph 2 from A, explicitly as is; paragraph.3 from A plus the last two sentences of paragraph 3 in B; and paragraph 5 from A, with the new language, which I don't have written down in full.

CHAIRMAN BERNANKE. Okay.

VICE CHAIRMAN DUDLEY. Let's get the new language read, if we could. CHAIRMAN BERNANKE. Michelle, are you taking this down?

MS. SMITH. Yes. It would help if you would read me the last paragraph of A. CHAIRMAN BERNANKE. Here it is: 'The Committee''capital C''discussed the

range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.' Have you got it?

MS. SMITH. Yes.

CHAIRMAN BERNANKE. Okay.

MR. SACK. The last sentence of 3 seems very repetitive, doesn't it?

MR. TARULLO. This is Bill's concern again?

CHAIRMAN BERNANKE. The last sentence'

MR. SACK. 'The Committee will regularly review the size and composition of its

securities holdings and is prepared to adjust those holdings as appropriate.' Isn't that one of the

tools that's covered now in paragraph 4?

MR. FISHER. It would be nice to see the whole thing so that we know what we're

voting on.

CHAIRMAN BERNANKE. No, let's just leave it.

VICE CHAIRMAN DUDLEY. That's been standard. That was in there last time.

CHAIRMAN BERNANKE. That's standard. Let's leave it. Okay. Any further

questions or uncertainties? Are you okay? Let's call the roll.

MR. LUECKE. Okay. This vote will be on the language that was just described, in

addition to the directive that is on page 8 of the packet that was handed out.

CHAIRMAN BERNANKE. Okay. Thank you. Lunch is available. Let's take

20 minutes to get lunch, and then Linda Robertson will give a report to those who are still here.

Our next meeting is September 20. Thank you.

END OF MEETING

Meeting of the Federal Open Market Committee on

September 20'21, 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 on Tuesday, September 20, 2011, at 10:30 a.m., and continuing on Wednesday, September 21, 2011, at 9:00 a.m.

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 and Eric Rosengren, Presidents of the Federal Reserve Banks of St. Louis and Boston, respectively

Esther L. George, First Vice President, Federal Reserve Bank of Kansas City

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

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, Simon Potter, David Reifschneider, Harvey Rosenblum, and David W. Wilcox, 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

September 20'21, 2011

September 20 Session

CHAIRMAN BERNANKE. Good morning, everybody. This is a joint meeting of the

Federal Open Market Committee and the Board. I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you. Let me start by welcoming Esther George to

the table. Tom Hoenig is still president of the Federal Reserve Bank of Kansas City for another

10 days, and so officially you're representing the Bank as first vice president, but at the next

meeting, you will, of course, be succeeding Tom. You're well known to everyone around the

table. You've been in the System a long time, and you have a great deal of high regard. So

again, welcome and congratulations.

MS. GEORGE. Thank you.

CHAIRMAN BERNANKE. Our first item is 'Financial Developments in Open Market

Operations.' Let me turn it over to Brian Sack.

MR. SACK.1 Thank you, Mr. Chairman. Financial markets continue to be

strongly influenced by concerns about economic growth prospects for the U.S. and other advanced economies, as well as perceptions of substantial risks surrounding the European sovereign debt situation. These factors led to considerable volatility in the prices of risky assets, large declines in interest rates, notable strains in short-term funding markets for some financial institutions, and greater market expectations that the Federal Reserve will deliver additional policy accommodation.

Although U.S. interest rates had already reached quite low levels at the time of the August FOMC meeting, they declined further over the intermeeting period. As shown in the upper-left panel of your first exhibit, the expected path for the federal funds rate derived from overnight index swaps now reflects an even later liftoff from the near-zero range.

Much of the downward shift in policy expectations came in response to the August FOMC statement, which indicated that the Committee expects economic

1The materials used by Mr. Sack are appended to this transcript (appendix 1).

this action, if taken, would involve lowering the IOER rate to 10 basis points or

12.5basis points, with only 20 percent of the respondents assuming that the IOER rate would be cut all the way to zero.

Lastly, respondents placed meaningful odds on further changes to the guidance for the federal funds rate. In their written comments, most suggested that this change would take the form of explicitly identifying the thresholds for unemployment and inflation that could prompt an increase in the policy rate, consistent with the possibility raised in the FOMC minutes.

Because respondents fill in their economic projections in the survey, it was straightforward for us to ask about the economic conditions that they expected to be in place at the time of the first increase in the federal funds rate target. In addition, we asked for a range of alternative economic conditions that, in their view, would prompt the FOMC to initiate increases in the federal funds rate. The average responses are shown in the bottom-right panel, plotted as combinations of the PCE inflation rate and the unemployment rate.

The locus of points suggests that respondents see a tradeoff between the variables'that is, the FOMC would wait for a lower unemployment rate if the inflation rate were lower. Such a tradeoff is what one would expect if the FOMC were setting policy along the lines of a Taylor-type policy rule. The point forecasts for the liftoff tended to fall around the middle of this locus, with most respondents expecting it to take place at an inflation rate of around 2 percent and with the unemployment rate somewhere between 7.5 and 8 percent. Thank you.

CHAIRMAN BERNANKE. Thank you. Questions for Brian? President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Brian, I'd like to get more clarification on

your discussion of the breakevens and probabilities of deflation. A number of things are going

on here, clearly. There are the effects of declining projections of real growth, perhaps, and a lot

of evidence of flight to quality from Europe into safe Treasury securities, all of which potentially

confuse the signals on the breakevens here and how we think about them. So can you talk more

about that'what you really believe these changes in the breakevens might be signaling and how

we can decompose that, if at all? And I would ask another question about the probabilities of

deflation that have arisen from the TIPS. If I go to, for example, our SPF surveys, those

probabilities really haven't changed that much. They're still much closer to 10 percent than to

the 20 percent in the TIPS, which suggests to me there's some differential here. I'd like to hear you talk more about those effects and the interpretations.

MR. SACK. Certainly. I think those are very good points. As always, we want to look at these market indicators of inflation expectations and inflation risks as having some noise, and we want to look at the collective evidence on inflation expectations, clearly. And in the current circumstances, there are some factors that could be contributing to the downward movement in the breakeven inflation rates. You mentioned the flight to quality as one possibility, which I think is important, and another one that's been discussed is the expectations of the maturity extension program. If it would be concentrated in nominal securities, the perception is that it could also be contributing to the downward movement. Having said that, it's moving down pretty aggressively. It's moving down at a time when markets in general are becoming more concerned about growth. I think to some extent, this likely does reflect some shift in the fundamental perspectives about inflation risks. And lastly, I'll just comment that you're correct that the survey evidence generally suggests a more stable outlook for inflation expectations and inflation risks, but we've generally found that the surveys often demonstrate more stability than we think perhaps represents the true views on risks. So maybe we want to look at the evidence as somewhere in between the surveys and the market-based measures.

VICE CHAIRMAN DUDLEY. Can I ask a follow-up question, Mr. Chairman? CHAIRMAN BERNANKE. Okay. Vice Chairman.

VICE CHAIRMAN DUDLEY. How about if we look at the TIPS market itself? You have TIPS yields in terms of the probability of deflation within a TIP that's already booked a bunch of inflation versus a newer one.

MR. SACK. Yes.

VICE CHAIRMAN DUDLEY. What does that show?

MR. SACK. Well, that's what the measure in the bottom right is. That's a very good point. It wouldn't be distorted by these differences.

VICE CHAIRMAN DUDLEY. That shouldn't be distorted by liquidity and things of that sort.

MR. SACK. That's right. I think for the measure in the bottom right, distortion to the implied deflation is less of a concern. Probably for the five-year, five-year forward breakeven rate, some of the considerations you raised are relevant, though.

VICE CHAIRMAN DUDLEY. Thank you.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Excuse me. Could you explain how this is taken out of the TIPS? VICE CHAIRMAN DUDLEY. Well, you have some TIPS securities that have been

outstanding for a while, and there's a bunch of inflation that's accrued, and so if you get deflation from here, that still gets embedded in the price'you give back that inflation that you've achieved because it's been outstanding for a while. But if a new TIP has just been issued, you have deflation from here; you don't have to give that back.

MR. LACKER. I've got you. It's a different basis.

VICE CHAIRMAN DUDLEY. Yes, exactly.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. This is just a comment, Mr. Chairman, but you gave a speech in October 2003, which was titled 'Monetary Policy and the Stock Market: Some Empirical Results,' and you spoke of how'and I loved the particular word that you used because it had such emotion to it'the market 'quivers' as they await the FOMC's decision. And you concluded, obviously,

that FOMC decisions can move markets. I'm interested, in listening to Brian today and the past many, many reports we've had'really, beginning with your third slide, you talked about the market's anticipation of our lengthening of duration. So we've moved from the meeting itself to expectations of what we'd accomplish at the meeting, which are oddly correlated with what we're actually contemplating. And we might be tempted to conclude that these quivers, or whatever you might call them, would then lead to tremors if we don't act according to what the market's expecting.

I guess the question I have is, is there a way we can better understand this? There's an uncanny resemblance, as I said earlier, to what we're actually discussing and what markets are thinking about, and then we are tempted, perhaps, to live in fear that if we don't deliver according to market expectations, we'll have a very harsh reaction. In other words, markets are anticipating quivering before we act rather than upon our action, as you articulated so well in 2003. I don't think things have changed that much since 2003. There's more information, the net is much more thorough, we have more market operators, et cetera, but something is amiss here. And I wonder if we could at least think about that. Maybe the Board staff or a group of us could form a committee to get a better feeling for how this is happening, what it means, and whether it is affecting the way we make decisions? Because I'm concerned about that'and this isn't a criticism of you, you're just reporting what you're finding in the marketplace'from slide 3 onward to the very last one. That's one point. The second point'and it's most un- central-bank-like, it's un-Bagehot-like'is that they're expecting us to move into assets that everybody else is demanding right now'until you got to your mortgage-backed security slide. Those are just observations, but I'm very concerned that we might be influenced by market expectations. I'm not sure how those market expectations are built, but things have progressed a

little bit, Mr. Chairman, since that speech in October 2003, which I thought, for the record, was a very good speech.

CHAIRMAN BERNANKE. Thanks. First of all, I think we all agree that the FOMC makes policy based on our economic outlook, and the markets have to adapt to that. There's a bit of an observational equivalence, though, between markets in some sense forcing policy actions and markets simply receiving good communication. We have become more transparent in the past eight years or so. Our minutes, for example, have been a big source of information. I recall very well the debates we had about moving the minutes, which used to be after the subsequent meeting, into the intermeeting period. Of course, the minutes describe the options and the discussion, and so I think that would be one mechanism. I take your point, and would emphasize that as conditions warrant, we need to act appropriately, but I do think part of it, at least, is coming from us guiding the markets in various ways in terms of what to anticipate.

MR. FISHER. Or transparency.

CHAIRMAN BERNANKE. And to the extent that that's true, it's a sign of success that we are transparent and communicating effectively. Other questions? Vice Chairman.

VICE CHAIRMAN DUDLEY. If I could amplify on your remarks'because I used to do this'I would comment that basically the people in the market are trying to think along with the Fed. They're trying to think, 'Well, if I were in their shoes, what would I do?' And I believe this has been the case for many years. It's just a little bit more vivid now because we're engaged in using policy instruments that we haven't used historically, but believe me, for the past 20 years, people have been thinking very hard about, 'Is the Fed going to move at this meeting. If they're going to move, how much are they going to move?' And that's all been priced in. I completely accept your point that at the end of the day, we have to do what is

appropriate, not just because the market has priced it in. But regarding the convergence of the marketplace and our actions, I don't think it's surprising in the sense that the market is observing us and learning from us and solving for what our reaction function is.

MR. FISHER. Again, because both of us used to do this for a living, I think you're right. I think what the Chairman said is most important. We let what is in the best interest of the real economy guide us, not what the markets expect us to do at any one meeting. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Other questions? President Kocherlakota. MR. KOCHERLAKOTA. Yes, thank you, Mr. Chairman. Brian, I just have a quick

factual question, which is, how much usage of the ECB swap lines has there been so far?

MR. SACK. Very little. There was just over $500 million in last week's operation from two institutions. It's possible that with the 84-day operation, there will be more usage. The pricing of obtaining dollar funding for three months is actually very close to the price of the swap line.

MR. KOCHERLAKOTA. Oh, I see.

MR. SACK. Whereas the current operations are 7-day operations, most firms, even under strained market conditions, can get funding in the markets much cheaper than the pricing of the swap lines. So we will see in mid-October if usage picks up with these new operations.

MR. KOCHERLAKOTA. Thanks. That was very helpful.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. The difference between the maturity extension program and an equivalent-sized quantitative easing is that with the quantitative easing, we issue more reserves, and with the maturity extension program, we force the private

sector to absorb, instead of reserves, more two-year securities. With our policy guidance, two- year securities are trading roughly under 20 basis points, and so they seem like virtually perfect substitutes for reserves. I'd be interested in the Desk's insight into the differences between those two. How much different would it be for us to force them to hold more two-year securities than it would for us to force the market to hold more reserves?

MR. SACK. In general, I think those are substitutes, and the staff would say that there won't be much of a difference in the effect on markets in terms of whether reserves are issued or two-year and other short-term Treasuries are sold. There are some differences, of course, though. The reserves have to reside in the banking system, and the Treasuries, instead, can be more broadly held. So to the extent that leverage ratios matter or other bank-specific behavior matters, you do have a difference there. But I think we would agree with the broad sense of your question. We see the mechanisms of maturity extension or asset purchase programs as being similar, with the effect coming more from the assets that are purchased than from the way they're sterilized or whether they create reserves or two-year Treasuries.

CHAIRMAN BERNANKE. It's a nice test of the two different theories of balance sheet expansion. Is it reserves or is it the asset side? Governor Raskin.

MS. RASKIN. Yes. Just a question, Brian, regarding the New York policy survey. In terms of the probabilities of additional policy actions, we are seeing a relatively high probability on providing SOMA guidance, and I was wondering if you could talk about your sense of what the participants in this survey are looking for. I think you said that they seem to be looking for explicit guidance on the path of the balance sheet, but of course, we've put out principles regarding how we would conduct an exit strategy. So my question is whether you can shed any light on what else they seem to be looking for.

MR. SACK. Some respondents just think it's a simple and logical step to put more of

that guidance into the FOMC statement. The FOMC statement right now obviously has very

strong guidance on one policy instrument and virtually none on the other, if you consider the

other to be the balance sheet. Having said that, I completely agree that with the exit strategy that

the minutes have laid out, the guidance on the short rate is, in effect, providing them with

guidance on the balance sheet. So that may limit the effectiveness of this step, but I think

respondents to the survey just see it as a logical step and maybe one that could have at least some

beneficial effect.

CHAIRMAN BERNANKE. Other questions for Brian? [No response] All right. We

need to vote to ratify domestic open market operations since the last meeting.

VICE CHAIRMAN DUDLEY. So moved.

CHAIRMAN BERNANKE. Thank you. Without objection. Okay. The next item is a

discussion of alternative policy tools. We'll start with a staff presentation. Our presenters are

Julie Remache, Seth Carpenter, and Dave Reifschneider. Who's going to go first?

MS. REMACHE.2 I am. Thank you, Mr. Chairman. In a memo provided to the Committee ahead of this meeting, the staff presented three options for managing the SOMA portfolio in order to provide additional monetary policy accommodation: a reinvestment maturity extension program, a SOMA portfolio maturity extension program included in alternative B in Book B of the Tealbook, and a long-maturity large-scale asset purchase program included in alternative A.

The intention of each of these options is to remove duration risk from the holdings of private investors, thereby putting downward pressure on longer-term interest rates and making broader financial conditions more supportive of economic growth. However, the amount of duration risk removed and the manner through which that occurs differ across the three options. The two maturity extension options maintain the current size of the portfolio while shifting its composition toward longer-term Treasury holdings, while the long-maturity LSAP option expands the size of the portfolio while shifting its composition.

2The materials used by Ms. Remache, Mr. Carpenter, and Mr. Reifschneider are appended to this transcript (appendix 2).

the FRB/US model; the bottom panel summarizes the results from this exercise. Our analysis suggests that the Committee could potentially provide modest near-term stimulus if it committed to keeping the funds rate near zero as long as specified thresholds for unemployment and inflation were not breached. In the simulations, the effectiveness of such guidance rests on two conditions. First, the announced policy must be credible, in that the public must be confident that future FOMCs will follow through on that guidance. Second, the guidance must indicate an appreciably later liftoff than currently expected by the public. The simulation results suggest the Committee probably should not expect much additional stimulus from this strategy unless it acts fairly aggressively by, for example, announcing its intention to keep the federal funds rate very low as long as unemployment is above, say, 6'' percent and the medium-term outlook for inflation is below 2'' percent.

In the simulations, forward guidance of this sort provides only modest stimulus because it alters expectations only for the likely date that policy firming will begin and not for the average stance of policy thereafter. But the announcement of thresholds might in fact change longer-run expectations more dramatically, particularly if supplemented with guidance about the pace at which the federal funds rate will be normalized after liftoff. If credible, such longer-term guidance could potentially yield more pronounced expectationally driven changes in financial conditions and other factors, and thus appreciably more stimulus. Additional model simulations reported in the memo suggest that if the Committee could convince the public of its intention to pursue policies later in the decade that are only somewhat more gradualist than the public would otherwise expect, it could bring about a noticeably faster decline in unemployment than in the baseline forecast, accompanied by inflation running modestly above 2 percent for a time. Such an outcome would be similar to the optimal policy simulation results reported in the Tealbook.

The memo also considered the robustness of this sort of forward guidance to unexpected economic developments. This analysis suggested that, while unconditional commitments to keep the federal funds rate near zero until some specified date are highly problematic, conditional forward guidance in the form of announced thresholds for unemployment and inflation appears to do reasonably well in a wide range of circumstances, including ones where policymakers significantly overestimate the amount of slack in the economy.

The final page of your handout reproduces the questions that were distributed to the Committee last week. During the go-round this morning, you may want to address these questions in the context of your remarks. Thank you; this concludes our presentation. We would be happy to take your questions.

CHAIRMAN BERNANKE. Thank you very much for a concise presentation of a much

more detailed set of memos, which were very helpful, and I thank you for that as well. Before

we go into a go-round, let's have a question period. Are there any questions for the staff? President Rosengren.

MR. ROSENGREN. Yes, thank you very much for a very complete set of memos. I do have a question on the interest on excess reserves memo'probably not surprising. After rereading your memo again this morning, I looked at the H.8 for foreign-related institutions in the United States, and the cash assets, which include reserves, were $943 billion; Treasury securities, were roughly $100 billion. I can't from that look at how much excess reserves are actually being held. Do you have the percent of excess reserves actually being held at branches and agencies?

MR. CARPENTER. I don't have that on me.

MR. ROSENGREN. Ballpark?

MR. CARPENTER. Yes, it's getting up close to just under half of the total quantity. MR. ROSENGREN. Half of the excess reserves of the foreign branches'

MR. CARPENTER. Most of the roughly $600 billion increase from the second LSAPs, in dollar terms, went to the foreign branches and agencies, in an adding-up sense. So it's a good portion of it.

MR. ENGLISH. On September 7, the numbers that I have show about $800 billion at the foreign DIs and about $700 billion at domestic.

MR. ROSENGREN. Just a second part to that question. There's been a big change in how foreign branches have been used in the United States. A year ago in August, they were supplying $323 billion over to Europe or over to their parents, which is more typical. They tend to raise funds in the United States, and send it over to their parent. More recently, though, that's reversed, and it was a $500 billion switch between last year and this year. So they're now

receiving on that September 7 date $238 billion from the parent. That's a very big swing. As I was trying to understand why that swing would occur'and President Lacker's observation is relevant'I noted that three-month T-bills are paying 1 basis point; six-month T-bills, 2 basis points; and a two-year Treasury is paying 16 basis points, very close to the 20 basis points that he mentioned. If, for example, a French bank is holding two-year Treasury securities at 20 basis points in order to be able to meet potential liquidity needs but has an option with a branch to hold reserves at 25 basis points in the United States, then it seems as though the strategy would be to sell the two-year Treasury security and put the funds in a branch getting 25 basis points. By doing so, they get a higher return and reduce the duration risk of their portfolio, and that seems to be reducing the demand for medium-term Treasury securities because they're choosing to hold overnight reserves paying a higher return with lower duration risk rather than holding medium- term Treasury securities. To what extent is our holding the reserve rate so high having an impact that is counter to what we're trying to do with medium-term Treasury securities? Is it discouraging demand for medium-term Treasury securities, particularly by foreign banking organizations? Do you have any observations on whether you're seeing that kind of trend actually occurring? And to what degree do you think that's important?

MR. CARPENTER. I guess I would offer the following. The transmission channel that you described about the switch in the funding position of the branches relative to their headquarters overseas is consistent with the anecdotal reports that we are hearing. And you can think about the reasons for this working independently and then reinforcing each other, with reserves being an attractive asset, paying more than other perfectly safe things, and the foreign supervisors wanting there to be more dollar-denominated liquidity on their books for liquidity reasons. We're definitely hearing that story. I think there are a couple of different ways it could

matter in terms of the effect on other market rates and intermediate-term market rates. The story that you told where there is reduced demand for two-year Treasuries and increased demand for reserves would tend to push up the two-year rate closer to the IOER rate. But that's in some sense just the more general point that the rate paid on reserves affects short-term rates and things that are close substitutes. To the extent that it's higher than it might otherwise be, if 25 basis points is higher than zero, then presumably if the IOER rate fell to zero, the two-year rate would also come down at least to some degree with it. Does that answer the question you were asking?

MR. ROSENGREN. Yes. That sounds consistent with the kind of story I was telling. MR. CARPENTER. I think your story is consistent with what we've been hearing and

the data we have.

MR. ENGLISH. I think that's right. Just one other thought. I'm not sure that the story you were telling depends on it being a foreign banking organization. The same story would be true for a domestic organization in terms of its decision between holding Treasuries and holding reserves.

MR. ROSENGREN. You might argue, though, that the optics of paying a very high return on an overnight fund to a foreign banking organization are a little bit different.

MR. ENGLISH. On the optics, I agree.

MR. ROSENGREN. The optics would show, I think, paying a very substantial premium that's higher than what they could get on a two-year. I don't know if people are going to be as worried about it for a domestic entity, but if it was widely understood that it was for a foreign banking organization, particularly because this is an important tool for us when we are exiting, you do wonder whether it undermines our willingness to be able to use this tool in the future if

people start being concerned about what its effect is on potentially subsidizing foreign organizations.

MR. ENGLISH. Just one other thought. If you literally look at holdings of Treasury securities and straight agency debt at the foreign banks, they've actually been growing over the past year or so, right through August. I think that's consistent with what Seth said. Some of these institutions are being urged by their supervisors to beef up their U.S. dollar liquidity, and so they may be holding both more reserves and more Treasury securities.

CHAIRMAN BERNANKE. President Fisher, you had a two-handed intervention? MR. FISHER. Eric's point is very good, and I think the point about domestic banks is

very good. But I thought that under Regulation D, we couldn't pay interest rates on bank balances that exceeded market rates. Is that true or false? What is the law, and what do the regulations require?

MR. CARPENTER. The statutory requirement is that the rate paid on reserves can't exceed the general level of short-term interest rates.

MR. FISHER. Short-term interest rates are defined as?

MR. CARPENTER. Not defined.

MR. FISHER. But Eric just laid out all the way to two years. It must be defined somewhere. Did we not codify this in Regulation D'was it section 204?

MR. CARPENTER. The statutory requirement is pretty vague. In terms of putting things into practice, it ends up being a little bit more judgment. You could look at several other market rates, and so you'd have to define the universe of short-term interest rates. You'd have to define what 'general level' means. So if you were to look at just federal funds, the effective federal funds rate is 6, 7 basis points, but every day there's a distribution of trades, and some of

those trades are outside of the 0 to 25 basis points target range. As a result, there are, every day, trades in short-term money markets that are above 25 basis points. In that sense, it's not obvious, at least to me, that paying 25 basis points is at odds with the vague definition of the law.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I had a question and a comment. The question was about the observation that if we executed either the MEP or the LSAP, we'd be holding 40 percent of the Treasuries with maturity over six years. To me, that suggests that these operations might not be all that scalable. So in the sense that if we faced further deterioration in the economy and we wanted to provide more accommodation at that stage, it would be difficult for us to think about working through augmenting these programs. Is that a fair conclusion?

MS. REMACHE. I think that would be fair to say.

MR. SACK. They're not scalable in terms of purchasing in this region. They're also not scalable in the ability to sell securities because obviously we just have a fixed quantity at the short end of the yield curve.

MR. KOCHERLAKOTA. Thanks. And then the comment is about how, if we were to lower the IOER, banks could begin imposing explicit negative deposit rates. This is reminiscent of conversations I've had with people'they typically tend to be older people'who are complaining about the low interest rates they're earning on their savings. The comment that I'm tempted to make, but which I have not made yet in public, is that this is actually a feature, not a bug. [Laughter] We're trying to get them to consume, as opposed to saving, to spend money on their grandkids and lend to that promising young entrepreneur down the street, as opposed to holding money, and so this actually would be a sign of the program working.

MR. CARPENTER. Right. What we tried to characterize in the memo, and I alluded to it in the briefing, was that this would be in some sense a reputational risk. From an economic perspective, banks have, since time immemorial, imposed fees on checking accounts, giving at least effective or implicit negative rates. But writing down a negative interest rate as their deposit rate is psychologically different for people.

MR. KOCHERLAKOTA. No, that's fair.

CHAIRMAN BERNANKE. Other questions for the staff? President Bullard. MR. BULLARD. Thank you, Mr. Chairman. I have two comments on exhibit 3,

'Forward Guidance.' I think one aspect of these simulations is that the announcement inside the model to keep rates low for longer is assumed to be a credible announcement, as you note here, and I'm not sure that that's really the right way to think about this. You're talking about a central bank that has never done this in the past and an unprecedented situation. You make an announcement far out into the future'say, for 2015'and my baseline would be that the market's not initially going to believe that you're going to be able to carry through on that commitment far out into the future. That is, when you actually get to 2015, you'll be tempted to revert to normal Committee behavior as it has evolved over many years. And so my sense is that because of this assumption, these effects are probably overstated in the simulations, and that you should allow the guys in the model to gradually learn that the Committee is actually going to come around and actually carry through on this, even if the data may come in somewhat differently than anticipated at the time of the announcement.

The other area'obviously I've been an advocate of this'was that I was disappointed to see that simulations like this don't take into account the possibility that you would just get stuck at a zero nominal interest rate equilibrium and you'd end up at zero nominal interest rates for a

very long period of time. Japan has been at zero for about 15 years. I think you have to have that also in the simulation so that you can say with some confidence, 'You take on this action, and you'll be able to move off zero at some point in the future,' instead of eliciting expectations that are going to actually keep you at zero for a very long period of time. Those are two aspects of the simulations I was disappointed with.

CHAIRMAN BERNANKE. Other questions? President Rosengren.

MR. ROSENGREN. One more observation on interest on excess reserves. I did spend some time talking to asset managers over the past month, and on the retail side, a company like Fidelity already gives you an option to sweep into an FDIC-insured account. So for the retail, you already have an option outside of the government or the prime money market fund. At the wholesale level, the way they described it to me is it's like selling turkeys at Thanksgiving'you sell turkeys under cost, but you care about the fact that the entire shopping cart is full'and so they think of an account as a suite of assets that people are actually doing. The government securities money market fund pays 1 basis point at Fidelity and roughly that at almost all the others, but they're interested in the suite of assets that the people put in. They need a place to park the funds. Their indication to me was that it wouldn't change their behavior very much. They aren't going to lower the rate below zero, but they do view it as a loss leader for the other services. So I'm not sure it's going to be quite as disruptive as the memo indicated'at least the perspective from the asset managers I talked to.

And just an observation on the negative interest rate. BONY did announce its negative interest rate. Shortly after that, the stock price dropped, the CEO left the company, customers complained, and no other custody bank chose to follow suit. I would say that I've talked to two

custody banks, and they're gleeful at the negative interest rate. So I'm not sure that is actually a trendsetter for other organizations. Just an observation that I'm not as worried about that.

MR. CARPENTER. Yes. On the first point about the money fund, I think we agree with you entirely, and I should point out that there is a distribution across the staff as to how big the costs are. I think the ability of a sponsor to subsidize a fund that's operating at a loss then means either that some of the disruptions won't happen or that the disruptions might happen more slowly through time, allowing this greater intermediation that may ultimately have to take place going from one steady state to another. It could happen more gradually'again, mitigating the potential disruptions. So the scenario you paint seems entirely plausible. We just can't be certain that that's going to be the case.

CHAIRMAN BERNANKE. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. Actually, I think President Rosengren just answered my question. Because this idea that we might lower the interest rate on excess reserves has been in the public for some time now, I was going to ask whether the Desk or the Board staff had conversations with money market fund managers about how they viewed the effect. And President Rosengren's response about the managers he has talked to answers it.

MR. CARPENTER. I think from the money fund management perspective, the view that President Rosengren brings up is one that we've heard a lot here at the Board. Brian, I don't know whether you want to characterize the Desk's discussions.

MR. SACK. We did not do an extensive reach-out recently on this issue, but we always have conversations with money funds. This has been in play for some time. I'd just say that you do hear some anecdotes on the other side as well: They've been subsidizing; if we take another 5 or 10 basis points out of returns, there's a limit to their ability to subsidize; and at least one or

two have suggested that they would close funds. Now, it's hard to know whether that's a forecast or a way of trying to lean against this possibility. I think some anecdotes say it would not be disruptive or important, but they don't all go in that direction.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. I think that's an important question. I think an even more important question is whether it would induce banks to lend more. Have we had a chance to survey banks? Seth, you may have an answer to this.

MR. CARPENTER. We have not recently done a survey of banks on that specific question, but the way we look at it is to ask how big of an effect could it be and what are the current impediments to lending right now? That's why we tried to allude to some of the surveys that we have on a regular basis about business lending from banks, and banks tend to point to a shortage of qualified borrowers'their terms'and low demand for loans. The economy is weak. The need for bank credit is low, and as a result, there's less demand. While it seems clear that this should, at the margin, provide banks with a greater incentive to lend, at most we're talking about a 25 basis point change. In that sense, it's not clear that it could be that large to begin with. Moreover, banks have some balance sheet constraints. An individual bank may try to get rid of reserves and get more loans, but the banking sector as a whole can't get rid of reserves. And if, in fact, the real constraint on bank lending now is on the demand side and not so much on the supply side, again, at the margin it should go in the right direction, but it doesn't seem like it could be 'the answer.' That said, we've seen a small increase recently in bank lending, and so to the extent that this could help with that momentum, maybe there's something at the margin.

CHAIRMAN BERNANKE. Thank you. Other questions? [No response] Okay. If you would indulge me, I would like just to take a couple minutes to frame our go-round on our policy tools. I see the Committee as having faced two challenges over the past two years. First, with policy at the zero lower bound, we have had to be more creative and more unconventional in trying to find ways to provide stimulus. All else being equal, we want to do as much staff preparation, Committee buy-in, and Committee discussion on these alternative tools as possible. That is very important. However, it does create a little bit of inertia in the policy process. The second challenge is that the economy has been very disappointing. It has underperformed, at least relative to our expectations; it is a fact that our forecasts have been consistently too optimistic, and we've had to respond with policy actions.

And so those two facts create a certain kind of tension. On the one hand, you want to move expeditiously to deal with an evolving situation. On the other hand, you want to make sure that policies are well thought through and that the process is respected and everyone has had a chance to have input. Now, those two things clearly came into conflict to some extent in August. I felt, and I still believe'and I think the evidence supports the view'that our policy action in August was both sensible and consistent with our economic objectives. At the same time, even those who were comfortable with the outcome may have been less comfortable with the process, and I apologize for that. I think the only way to address this conflict is to do more contingency planning, and that's what this is all about. The idea here is to think forward and to think about what we might do as the situation evolves. In particular, because we know what to do if the economy gets stronger, what we really have to think about is what we're going to do if the economy weakens further.

I would draw another distinction'which again will, I hope, provide some context'the distinction between frameworks and tools. Our current framework is essentially a flexible inflation-targeting framework, which means that in the medium term, we try to get inflation near 2 percent or something in that vicinity, consistent with price stability. But in the shorter term, flexibility means that we have the ability to respond to shocks to the real side of the economy and to try and guide the economy back toward its longer-term equilibrium. So that is the approach we've been using, and that is, I believe, consistent with our dual mandate and with central bank practice around the world.

There are alternative frameworks'for example, nominal GDP targeting and price level targeting as advocated, for example, by President Evans. These are obviously different, and, in particular, they allow inflation to be at least temporarily higher than the long-term price stability objective, albeit in what I would hope would be a transparent and disciplined way. In terms of alternative frameworks, we are planning currently to talk about some at the next meeting. You have already received some materials, and you should be receiving additional supporting materials within the next few weeks, I hope, so that we can talk about frameworks in November.

Now, that said, for today I think it is best for us to continue to assume that we are in a flexible inflation-targeting framework. And then the question is, how can we best achieve the objectives of that framework? Putting aside the IOER'which a number of people are interested in discussing, so I don't mean to in any way eliminate that from the conversation'broadly speaking, the tools that we have in a flexible inflation-targeting framework at the zero lower bound are two. They are balance sheet tools and communications tools, and we've seen presentations on each of those two areas. Our goal, as we go around the table, is to try to make some assessments and provide some comments about those tools. In doing so, again, what we're

doing today is contingency planning. We're not making a policy decision today. So I hope that we can talk about these alternative approaches and try to separate this discussion to some extent from our policy preferences and our outlook.

Let me just say a couple of words about communication because I think this is an area where we've really only scratched the surface. I'll say, just speaking personally, that at the zero lower bound, communication tools are attractive. They are flexible. They don't involve many of the costs and risks associated with balance sheet tools, and they have a lot of academic support from people like Michael Woodford as being an appropriate way to deal with the zero lower bound. So I do think that this is something we should be looking at. In particular, as Woodford's work has shown, the communications approach is very consistent with flexible inflation targeting. And alternative A, which has been excerpted in the memo and contains some of this proposed communications approach'I will come back to this'was written in a way that was intended to be consistent with a flexible inflation-targeting perspective. Specifically, I'd like to say up front'and maybe it, I hope, will short-circuit some discussion'that it is not the intention of this language to set a target for unemployment. We know the hazards of doing that. What instead is happening is that the policy projections are being made conditional on three conditions'unemployment, inflation, and inflation expectations'and, in particular, the last two are consistent with our flexible inflation-targeting framework. We could change it and say that we'll hold policy at zero until the Red Sox win the pennant'[laughter]'and inflation expectations are at mandate-consistent levels, and it still would be consistent with our framework, because we would have the outlet, the safety valve, that we will not press expansionary policies beyond the point that an inflation-targeting central bank would accept.

I do think this language, or something similar to it, is consistent with a flexible inflation- targeting framework. And it's robust, as was discussed briefly by Dave Reifschneider, even if we, for example, misestimate the NAIRU or whatever the equivalent concept is. I think it has some advantages over the '2013' language. In particular, like the language about mid-2013, it's a policy forecast, but instead of being time dependent, it's state dependent, and it explains at least the sufficient conditions that would keep us at zero. And because it is state dependent, (a) it provides more clarity, more information; and (b) it allows the markets to respond to changes in the data. Bad news, for example, would lead the market to expect that those conditions will not be satisfied for a longer period, and interest rates would respond accordingly. The main point I want to make here is, first, that communication is an important tool. I suspect that if conditions continue to be disappointing, we will want, going forward, to use more communication tools, and that's why it's very useful to have a conversation today. Second, the objective was to write a communications approach that's consistent with flexible inflation targeting. To the extent that it's not, we need to discuss that.

Two final observations. I've heard a few people say that they were supportive of the general approach, but they had concerns about the language or the exact implementation of the approach. If that's the case, I'm personally very open to alternatives. I'm very interested to hear how we can better express our intentions and make a policy forecast that's state contingent and that also respects the dual mandate'I think that's very important. So please don't hesitate. The other comment I've heard is that, while this may or may not be a constructive direction, we need to do more work to prime the public, to talk to the Congress, et cetera. Speaking personally, that also is something that I'm entirely willing to do. We'll have the minutes describing this conversation. I have a testimony in just a couple of weeks at the Joint Economic Committee.

We have, of course, all of the various mechanisms for both public and congressional communication. And if that's the concern, I'd like to hear that, and maybe people would have suggestions about how to go about that.

To close, I look forward to the conversation. I hope we can talk about tools, at least to some extent in the abstract, away from the policy decision, which will be tomorrow. And again, I look forward to the input. So we'll do a full go-round on these issues, and we'll begin with President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I was willing to go first, and often a willingness to go first implies that you are going to talk for a long time. That's not always true. But it turns out to be true in this case. [Laughter] I'll start by framing things to a certain extent. My decision in August and my words today are centered on a simple premise that a central bank's primary asset is its credibility. I think we need to communicate our objectives clearly and consistently make choices that are in keeping with those announced objectives. Without that communication and that consistency, we'll lose our credibility and our effectiveness. In that context, I'm going to touch on three issues. The first is objectives and communication, the second is forward guidance, and the third is quantitative easing.

I am going to talk about the three messages. The first is on the communication and objectives issue. I think that before adding more accommodation, the Committee, and especially its leadership, should clearly communicate to the public that in light of the disappointing state of the labor market, it is willing to allow core inflation to rise above 2 percent, and potentially near to 3 percent, for possibly several years. The second is that I think we need a method of providing incremental variation and accommodation at the zero lower bound. And I have another suggestion to throw into the mix, and that is that the Committee should vary the level of

accommodation by announcing changes in its expectation of the duration of the stay at the zero lower bound under what it perceives to be an optimal monetary policy. So not a date, as we currently have'mid-2013'but rather a duration. I'll discuss why I think that would be preferable to the date that we currently have. Actually, Governor Tarullo has already touched on this in his memo. The third is that we should keep an LSAP in reserve. Rather than using it now, I think we should keep an LSAP in reserve in case we have to raise inflation expectations, as in 2010.

Let me start with the objectives and communication issue. Right now, I perceive a large disconnect between the Committee's objective function and our communication to the public about that objective function. I got the sense at our last meeting that, given the state of the labor market, many'possibly most'meeting participants would be willing to follow monetary policies that would expose the economy to a significant risk of inflation being as high as

2'' percent, or possibly even 3 percent, over a multiyear period. In contrast, our communication to the public, as well as our earlier actions, has been widely interpreted as being very clear that we will not allow inflation to rise above 2 percent. I think that before we engage in further accommodation, this disconnect needs to be repaired. One way to do this is by repeating the following sentiments through speeches, testimony, and the like to basically state what I have just said, that the Committee believes, given the parlous state of the labor market'you don't have to use the word 'parlous,' but I like it [laughter]'appropriate monetary policy could result in PCE core inflation rising above 2 percent, possibly to 3 percent, for several years. And I think this message would be most effective if it came from the leadership of the Committee'the Vice Chairman of the FOMC, the Vice Chair of the Board of Governors, and the Chairman. So on objectives and communication, I think we need to fix the public perception of what our objective

is'or at least what our communication to the public has been'and what the feeling is within the room.

Let me turn to the right form of accommodation, and I'll talk about the language in alternative A first. I'm not supportive of the proposed language in paragraph 2. In terms of inflation, I think the SEP already provides a way to communicate our perspectives about appropriate medium-term inflation goals. And the language in paragraph 2 just seems designed to undercut what I view as the valuable heterogeneity in those perspectives. There is heterogeneity within the room. That is communicated through the SEP. I don't see any reason to take that out of our communication. In terms of unemployment, I do report a number for my five-year forecast for the unemployment rate, conditional on optimal monetary policy, in the SEP. But I'm not asked to report a standard error bound of any kind for that. Let me tell you, it would be large. My own five-year forecast for the unemployment rate, labor force participation, and the employment-to-population ratio are all highly uncertain, even assuming we do follow optimal monetary policy. I would say it's a mistake to put a long-run unemployment number into the statement, given how much uncertainty at least I feel about that number.

Now, I'm very sympathetic to the goal of paragraph 4, and that is, it tries to provide a partial description of the reaction function of the Committee. I'm a big fan of rules-based approaches to monetary policy, and I think I'd really like us to continue to work toward formulating an appropriate reaction function. That work, I think, has to continue within this room first, before we are really ready to start communicating to the public about it. I'd be very interested in hearing what others have to say about it. My own guess is that we are still some way from achieving what I view as the necessary degree of consensus on the form of our reaction function.

But in any event, even if we do get some kind of consensus within the room, I'm skeptical about the utility of using the compressed language of the statement to communicate, even partially, our reaction function. In the past, we've used the statement to describe the results of feeding current conditions into what is our reaction function. When we say we arrive at a fed funds rate target, that's basically to say we have a reaction function, and what we have done is feed the current conditions into the reaction function. It spits out a target. This obviously operates at a more holistic level than the mechanistic level that I'm describing, but that's what gives rise to what occurs in the statement. And I'd like to continue that practice'to strive for a form of accommodation that can mimic that. Once we have some kind of agreement about the nature of the Committee's reaction function, I think we can convey its contours much more effectively using the richer forms of communication that are available to us, like the press conference tool, speeches, and testimony. That said, we do need some way to vary the level of accommodation in response to economic conditions when we are at the zero lower bound. And as I touched on in my questions, I do not think that the balance sheet adjustments are going to lend themselves to that, so I think communication is going to be the right way to be thinking about that.

Let me suggest an alternative approach that builds naturally from our previous statements. When you go to talk to the public'and they always ask it jokingly, but it really is what's on their mind'the main thing they want to know is, what's going to happen to interest rates? And I think that's what we should be communicating in our statement. The current statement addresses this by saying that interest rates will stay low 'at least through mid-2013.' But that lower bound itself generates some uncertainty that might be avoidable. Instead, I would suggest just telling the public what they want to know'it's going to have an impact on their

decisions'that is, our current best forecast of when liftoff will transpire, assuming that we follow what we view as optimal policy. For example, the November statement could read, 'The Committee currently anticipates that interest rates will remain extraordinarily low for the next

12 quarters.' And I said '12,' which is not 'mid-2013,' obviously, but 'mid-2013' was a lower bound, so presumably you are going to want to add beyond that. That is a fixed period of duration, and the reason I say that is, if in December the Committee decides to leave the level of accommodation unchanged, then you would just leave the statement unchanged. If you come back in December and conditions look exactly the same as in November, well then, you should have the same length of time at the zero lower bound coming out of your reaction function. It shouldn't be that you're going to be six weeks closer to the time of liftoff, which is what I think Governor Tarullo mentioned in his memo. In contrast, if conditions remain the same in December, the date of anticipated liftoff would just automatically roll forward by six weeks. If we removed accommodation, 12 quarters could become 11 quarters; if we added accommodation, 12 would become 13. Now, I think this obviously presents communication challenges. You want to make it clear that this is a projection, an expectation, not a commitment. But I think this can be done at the November press conference, where what I've just said could be articulated. I just think that the expected duration of this lower bound is an easily understood, relevant, and continuous variable that can be adjusted in response to economic conditions, just as we used to vary the fed funds rate. I think it is an approach that merits some attention as we think about what kinds of tools we're going to use to vary the level of accommodation at the zero lower bound.

What about balance sheet adjustments and the IOER? The staff memo just points to distinct limits on capacity for all of these tools. Obviously, on the IOER, I don't think we're

going to go negative on it, so there is a limit on the capacity on that. I think there are also limits on the balance sheet adjustments, as Julie and I talked about. We are essentially talking about almost a one-time use on that, and I just don't see them as a viable method of providing accommodation on an ongoing basis. The second LSAP was clearly effective in reducing the risk of deflation; it is a real positive of our implementation of that. I would think about providing incremental variation in accommodation using this expected duration of stay at the zero lower bound. Just keep the LSAP in reserve in case we feel the need to raise inflation expectations. Now, that time may be coming closer than I would like, given what Brian was talking about in terms of deflation possibilities. But in any event, I think the size of our balance sheet, whether it should or not, economically does seem to have an influence on people's inflation expectations. And I think we should keep that in mind.

I will close by returning to my first message. If you look at the staff's optimal control exercises in Tealbook, Book B, and in the forward guidance memo, they strongly suggest the FOMC could do better with respect to its dual mandate, even if one put relatively little weight on unemployment, if it follows policies that admit significant risk of inflation running above

2 percent and possibly close to 3 percent. And I think that before adopting the accommodation that is consistent with those outcomes, the Committee and its leadership need to clearly communicate their willingness to undertake those policies and to have those kinds of outcomes. Given my own baseline forecast for the economy, which I will talk about later today or tomorrow, I think of this kind of communication as really being necessary and sufficient for further accommodation. If the Committee is willing to undertake this kind of forthright communication about its willingness to have higher than mandate-consistent inflation for several years, I would be in favor of adding more accommodation. I would be opposed to adding more

accommodation if it is not. My concern is credibility. This communication fix would, I think, take care of that concern. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. Let me begin by addressing the question of the nature of further monetary easing should it be considered desirable by the Committee. And first of all, I think it is very appropriate for the Committee to consider ways in which it might ease policy further if necessary, just as we have made reasonably careful plans concerning exit from our extraordinary policy at the appropriate time. With the policy rate at near zero for two more years and possibly longer, the Committee badly needs a way to conduct a purposeful, systematic, countercyclical monetary policy. We need to be able to adjust policy on a meeting- by-meeting basis as data on the state of economic performance are received, knowing that we will be unable to adjust the policy rate for some time.

I see a maturity extension program as a one-time policy, which is constrained by the nature of the balance sheet, much as President Kocherlakota just mentioned. I do not think this policy can be used regularly and effectively as part of the policy process over the next two years or more. Lowering the IOER, as contemplated, also seems to be a one-time move. I think this meeting is a good opportunity to discard one-time policy changes with fixed end dates. It is counterproductive and unnecessary to reinvent the policy response each time the economy changes direction. Indeed, it damages our credibility and hurts our ability to function effectively.

I think it's reasonably clear that asset purchases are the Committee's most natural policy tool. Purchases tend to drive up inflation expectations and drive down real interest rates. This is conventional, accommodative monetary policy. I stress that last year at this time, the inflation rate was low and expected to remain low due to the degree of slack in the economy. Even

though the real economy gave a worse-than-expected performance over the past year, inflation actually increased both on a headline and a core basis during that period. That sounds like a clear fact of monetary policy to me. If the goal was to move inflation higher and real rates lower, we certainly accomplished that.

As you know, I prefer a meeting-by-meeting, state-contingent asset purchase program. I think it would be appropriate to vote on an amount to purchase between now and the next meeting. In the statement language, we can suggest that purchases will likely continue, conditional on the state of the economy. This continuation value, or bias, will set up private- sector expectations of further purchases, just as an interest rate move, coupled with a bias, sets up expectations of future interest rate moves in ordinary times. This private-sector expectation of future purchases would provide the so-called stock effect, as the impact would be pulled forward by financial markets. The expectation would also change in response to incoming economic data. This approach would prevent the Committee from being awkwardly committed to stopping purchases or any other program at a date certain independently of the state of the economy at that date. We will, of course, be criticized from all sides no matter what we do. However, an announcement of this type would be of a smaller total at a particular meeting and, I think, would mitigate criticism in that regard. But I think the effect would be the same because of the continuation value'and possibly even larger depending on what markets would expect going forward for the state of the economy. So this is a clear case where less is more.

Let me turn now to monetary policy communications as a policy tool, as an alternative, as the Chairman just laid out. The literature following Michael Woodford often suggests that longer and longer commitments by the central bank to keep the policy rate near zero can have a stimulative impact today. This is indeed true under specific circumstances inside some models

in which credibility is perfect. But I caution that we should be exceedingly careful in attempting to apply this doctrine to our actual policy situation. The key problem is that the literature has not come to grips effectively with the work of Benhabib, Schmitt-Grohe, and Uribe, at least not in a convincing way for me.

Benhabib et al. suggested that the macroeconomy could become stuck in an undesirable steady state in which the nominal interest rate remains zero forever. Japan, in fact, seems to be in this situation. Simply announcing that the policy rate will remain near zero for a long time can feed into the steady state identified by Benhabib et al. As it stands now, we're at four and a half years of expected zero policy rates. I think if we go longer, we'll increase the risk that we get stuck in this situation. Indeed, some of the reaction to the Committee's most recent announcement had this flavor. Some financial market participants saw it as stimulative in the conventional Woodford sense, but others saw it as increasing the probability of a Japanese-style outcome for the United States. They marked down their potential growth and their interest rate forecasts for a long time.

In Woodford's most recent Financial Times editorial, he notes that a permanent increase in the level of reserves in the banking system, not offset by an increase in IOER, would cause a permanent change in the price level'that is, would increase inflation'even in his framework, which tends to downplay this possibility. Indeed, I believe it is a fact that markets attach some positive probability to this outcome'that is, that some of the increase in the reserves in the system would be permanent and allowed to flow through to the price level. It is exactly that positive probability that increases both inflation expectations and actual inflation coming from balance sheet policy. The Committee has made no explicit statements about that other than to reiterate that we intend to take the large level of reserves back down to a more normal level at

some point in the future. However, I think the private sector puts only a large probability, not 100 percent probability, on that. To the extent the Committee wishes to ease further, I prefer this method, the balance sheet method, to the one that simply promises near-zero rates for a very long time, because in my view, the asset purchase method does not have the potential drawback of becoming trapped at the near-zero rate indefinitely. The outcome in Benhabib et al. occurs because of overemphasis on nominal interest rates as the only policy tool.

The Committee can also consider more fully describing the circumstances under which it would move off of the zero-rate policy, as suggested in the recent memos by the Board staff. I'll now turn to commenting on that. Generally speaking, I think it is not a good idea to explicitly commit U.S. monetary policy to a quantitative reaction function. This is the sort of commitment that might work well inside a macroeconomic model. Inside the model, we understand exactly how everything works, and therefore we can specify exactly how policy should be conducted in order to achieve the optimal allocation of resources. However, in an actual economy, we do not know enough to commit in a specific, quantitative way to a particular reaction function. I certainly think we can learn a lot by studying models and the quantitative reaction functions they recommend. We can employ those reaction functions informally in making judgments concerning monetary policy, but I would stop short of actually adopting a quantitative reaction function for U.S. monetary policy, as it could easily turn out to be an inappropriate choice. In short, we should not adopt this course because of model uncertainty. I think we're better off committing to goals than to instrument reaction functions.

It would be particularly questionable to tie U.S. monetary policy directly to the behavior of unemployment. I sent a memo to the Committee on this topic, and let me just touch on a few of the points here. I think the conventional wisdom has been that unemployment, empirically

speaking, moves in ways that are difficult to understand, which means that tying monetary policy directly and specifically to this variable is risky. The leading example is European unemployment over the past 30 years. Unemployment is importantly affected by labor market policies. So we could be subordinating monetary policy effectively to the labor market policies that are really the prime determinants of the unemployment rate in the medium to long term. I would also note'and this is a geeky point, I know'that available research does not give us much guidance on monetary policy and unemployment. The standard New Keynesian model, for instance, has no unemployment. You can read all of Woodford's book, and you will see no reference to unemployment. This is because it's all about output and consumption; actually, investment is not in there either. But to get to the unemployment issues, you have to go to search models, and search models tend to be very difficult to meld with other types of general- equilibrium macro models. Where that leaves us as policymakers is that we don't have a lot of available guidance. Newer models do have unemployment'there are some papers'and they do have the search frictions coming from the Diamond, Mortensen, and Pissarides tradition. I think the main take-away from that literature is that it is the difference between the flexible and the sticky price level of unemployment to which monetary policy should react. That's a very different conception of what's typically talked about around this table. Furthermore, to the extent we have research on this question, it says that wrong choices can throw the economy far off course. So this may be playing with fire in a way that we don't want to play with it. Models do have sharp predictions on employment, certainly equally as interesting a variable. Our mandate actually refers to employment, so I think it makes a lot more sense to think about employment than unemployment in this regard.

The final issue is'I'm not sure if we're discussing it at this meeting, but I guess some people are, so I'll discuss it, too'forward guidance on the federal funds rate. Generally speaking, I think this is an interesting idea. Other central banks have done it as detailed in the staff memo. I would make two comments on this. First, I think there's considerable confusion in our SEP process over the provision that forecasts are made under appropriate monetary policy versus an unconditional forecast that's simply trying to predict what will actually happen. Members understandably don't want to be predicting what their colleagues may or may not do. We may understand the difference and the subtleties of that, but the forecasts, I think, are generally interpreted as unconditional forecasts. Most of the studies that you see looking at past forecasts of the Committee just examine how accurate the forecasts are and compare the accuracy. One implication of our forecasts is that they never suggest that inflation will get out of control, because there is always the appropriate policy that keeps inflation under control.

Second, I'm unsure whether putting out 17 interest rate forecasts is really a good idea. This may be more confusing instead of less confusing. I'll make a different suggestion. I think what the Committee needs is something like an Inflation Report, which is put out by the Monetary Policy Committee in the United Kingdom. One option would be to simply publish the Tealbook or a variant of the Tealbook. What I like about that is that it would give a nuanced view of the likely path of policy and the likely path of the economy. It would put some pressure on the staff, which has been discussed in the past, but other central banks do it, and I don't see why we couldn't do it. I think this nuanced view would serve the Committee very well. It avoids trying to boil down the mass of information we have to a few words or phrases or to a few numbers. This approach would also allow Committee members to agree or disagree with particular aspects of the Tealbook view without having to disagree with the general thrust of the

entire analysis. I think this would be a helpful compromise on this issue. It would be a way to communicate to the public effectively in a nuanced way without trying to boil everything down to a particular number. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. We have been asked to address several questions regarding tools and language to provide further monetary accommodation if and when it is warranted. However, the tools that would be appropriate depend on the reason for our wanting to engage in accommodation and, in particular, on the underlying framework that is guiding our policy decisions. So I can't fully divorce my discussion from the current economic environment or our framework. As President Kocherlakota said, being credible is an important part of an effective monetary policy, but it's hard to be credible without a clearly articulated framework. I believe that the risk of financial turmoil, for example, arising from the European Union has increased, and discussing how the situation might play out and how we might respond seems more important than attempting to tweak our term structure by a few basis points. But I will return to that in a later go-round.

Let me talk about the various tools that have been raised. Maturity extension programs' I'm skeptical that balance sheet tools like the maturity extension program are going to do much to speed the recovery on the real side. Board staff estimates that $400 billion of MEP would lower long-term yields about 20 basis points and raise two-year yields about 5 basis points. As has been referred to, Swanson's study found that Operation Twist of 1960 had a slightly more moderate effect of a 15 basis point decrease in long rates and a comparable increase in short rates. However, the impact, even in that study, on corporate rates was only about 2 to 4 basis points. Why would we think a twist operation this time around would filter through to other

borrowing rates when it didn't in the past? The potential benefit for the real economy will be small, but there will be cost. Such actions undermine the Fed's credibility by giving the impression that we think our policies can have a significant impact on the speed of recovery when it seems highly unlikely that they can do so. That undermines the credibility that President Kocherlakota was talking about earlier. This loss of credibility will cost the economy in the long run when the time comes to unwind these policies in order to control inflation.

I have similar views of the LSAP programs being discussed. I think they'll do little to speed the recovery as much as we'd like and, indeed, run the risk of destabilizing inflationary expectations. If we were convinced we were headed into a very serious deflationary period where deflationary expectations were rising or began to emerge in a serious way, we might consider asset purchases as a credible way to commit to bringing inflation back up to our goal, as seems to have been the effect in QE2. At present, I don't see that risk coming about. Indeed, inflation continues to rise, forcing the Tealbook to repeatedly revise up its inflation forecast. Given this track record, we should not become too sanguine regarding the medium-term forecasts of inflation that come out of the Tealbook.

What about raising the targeted rate of inflation? The economics is very clear, as President Kocherlakota mentioned: At the zero bound, this is a sure way to lower real interest rates. But many questions, I think, remain. Given how low rates already are, do we think lowering them more will have much of an impact on growth and employment, the purported goal of running such a policy? And would we seriously be able to implement such a policy? I'm very open to a robust discussion on this dimension, but on this point, I remain very skeptical. For such a policy to work, it is critically dependent on its credibility. The markets have to believe we will run such a policy. Are we that credible? We don't yet have an explicit

numerical goal for inflation, yet we think we can credibly raise our target with the public through its communications?

What actions will we take to reinforce our announcement of a higher inflation goal? More LSAPs? Perhaps. Would this be a temporary increase in our inflation goal, or would we want this to be a permanent increase? Given the difficulties we have in even forecasting inflation, why do we think we can manage a temporary increase in our inflation goal? Alternatively, if we wanted a permanent increase, how do we justify it in terms of our mandate for price stability, given the fact that we have been saying that 2 percent is the mandate- consistent number? How do we calibrate the appropriate level of inflation? Presumably, we need to balance the cost of a permanently higher inflation rate with the temporary short-term benefit such a change in the expectation of inflation might actually bring. And indeed, in my mind, those benefits from that action are extremely uncertain. They give higher inflation as a way to get rid of the debt overhang problem. The debt overhang problem raises a whole host of questions. Distributional effects'at the end of the day, the debt overhang problem is about who pays. Changing the distribution of losses through inflation is a fiscal policy action, which I think we should be very cautious about. Other questions revolve around, can we actually speed the recovery in a process through debt deflation using inflation? Will inflationary expectations change in a way to devalue that debt very quickly? I think those are a host of questions that we have to grapple with if a higher inflation rate is something that we want to pursue.

On language'of course, I've been and continue to be a strong advocate of our being more explicit about our inflation goal. The work that I and some of our colleagues did at the suggestion of the Chairman earlier this year suggested a way forward. We produced a set of communications that we thought would allow the Committee to communicate a numerical

inflation objective and to distinguish such a goal from the employment part of our mandate. This takes more words of explanation than we can provide in our meeting statements. Thus, I'm opposed to using the statement language, such as in paragraph 2 of alternative A, to indicate a numerical goal for inflation and our projected longer-run employment rates. My bet is that the public and the markets would see this language and conclude that we had a numerical unemployment goal. President Bullard, in his comments, explains why that's problematic, both from a theoretical and a practical perspective. Indeed, we discussed these very issues in our special meetings on unemployment and DSGE models, both in the past year or so.

On paragraph 4 of alternative A, on the trigger policies, I don't support the trigger policy language of alternative A. I think it's very problematic. I've long advocated the use of rules as guidelines to systematic policymaking that we can convey to the public, and there is a long literature on the benefits of robust rules for monetary policymaking. A rule allows market participants and the public to infer the likely path of interest rates in response to changes in the economy. And as I said, the literature on robust rules is informative because it cuts across different models and talks about the viability of the robustness of various specifications, even when models may differ. Model uncertainty is a big problem. However, the proposed language is not a reaction function. Instead, it casts policy in terms of a trigger and differs from a Taylor- type rule, which calls for a continuous adjustment of our policy rate to deviations of inflation from target and some sort of real gap. As such, the proposed language does not provide any information to help the public infer the path of interest rates once tightening may have started. And so the benefits, it seems to me, of articulating a reaction function are very, very limited and small using this strategy.

The formulation is problematic for other reasons as well. As President Bullard pointed out, it's quite difficult to model and understand movements in the unemployment rate, and there is considerable uncertainty about the level of unemployment over the medium to longer term or its natural rate. President Kocherlakota mentioned the huge standard errors that would surround any of our forecasts. The trigger policy appears to be inherently biased toward more accommodation, since it's based on actual unemployment rates but only a forecast of the medium-term inflation changes. Inflation, we know, changes only very slowly. And as I have mentioned, our forecasts are not very accurate. It conveys to the public that we believe we can exploit the short-term Phillips curve tradeoff between current unemployment and the medium- run inflation forecast. I think this ignores the lessons of the '70s and the dangers that can arise from that. Moreover, underlying the triggers in alternative A are assumptions about policymakers' loss functions. We have never had a discussion about our loss function. It seems to me that before we develop a framework that relies heavily on that, we should have that discussion. Our models suggest that putting too much weight on output or unemployment gaps when setting monetary policy can lead to instability and far worse outcomes for both employment and inflation. Yet that appears what we run the risk of doing. We simply need a lot more discussion about what underlies these numbers to understand and communicate our reaction function in a meaningful way, and I would certainly welcome such a discussion.

I believe the alternative of using the SEPs for forward guidance is a much better approach than calendar dates or triggers or efforts to manipulate short-term markets to convey our forward guidance. The communications subcommittee circulated a memo on adding our fed funds path assumptions to the SEPs to give the public information on the expected path of policy. We will be submitting new forecasts at the next meeting, and I would hope the Committee participants

would be willing to provide their funds rate path assumptions internally as an experiment. The Chairman might continue to provide the table of projections as it's currently formulated at his press conference in November. But the staff could draft the SEP, including that information on forward guidance, and circulate it internally. If the Committee is comfortable with this, then we could publish those in November, or alternatively, it would provide a way forward for our January meeting'we could then transition away from calendar dates toward our projections of the SEP as indications of forward guidance. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thanks. I just want to ask one question. Obviously, a policy tied only to unemployment would risk destabilizing inflation if you misestimated the u*. But, as I said at the beginning, we have the escape clauses of both projected inflation in the medium term and inflation expectations. You mentioned that projected inflation is a weaker condition, but, of course, that's what all inflation-targeting central banks do. And then you also mentioned the unemployment rate as being interpreted as a target. I just wanted to note that the language describing the unemployment rate in A(2) comes directly from the FAQs that your group put together for a public presentation explaining what unemployment is. I think the SEP suggestion is an interesting one, for example, but I don't quite understand why it was inconsistent with the broad inflation-targeting framework.

MR. PLOSSER. I would suggest'and I have suggested this before'that I think this is about communications as much as anything else. And I don't think the statement is the place to do that. You've given several speeches about why the unemployment SEP number is different. I think that concept needs to be socialized more widely. I think you and the Vice Chair and others need to talk about it in speeches, help explain it to the public, so they understand this means something different before we try to get our policy statement, in which we are confined to very

few words, to convey that notion. I think that over a period of time, I would certainly become more comfortable that we could do this and not have it be misinterpreted. In the context of a policy statement, I think it's very difficult to do.

CHAIRMAN BERNANKE. Okay.

MR. LACKER. Just an observation, Mr. Chairman.

CHAIRMAN BERNANKE. Yes.

MR. LACKER. CNBC this morning aired a discussion of our possible policy tools, including this 'trigger strategy' idea. They referred to the unemployment rate trigger as a target. So I think the discussion has begun, and I think we're behind the curve on that if we're going to try to convince the public that it's not a target.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. What do we mean by 'target'? Do we mean 'target' as in when we think about starting to normalize policy or 'target' as in a long-term objective for unemployment? 'Target' can mean different things.

MR. LACKER. I understand what we mean about it. I'm just reporting that' CHAIRMAN BERNANKE. Okay. We understand the distinction between an inflation

target and an unemployment 'target' in quotation marks. We understand that's an important distinction to make.

MR. BULLARD. Mr. Chairman?

CHAIRMAN BERNANKE. Yes, Jim.

MR. BULLARD. Maybe we should just try to clarify this here. I thought if you put your stuff in your Taylor rule, then usually you said you're targeting those things. Now, here we don't have a Taylor rule, but you have this threshold for action that seems very close to me. So I

don't know. I think that there maybe is some confusion over the targets versus'I'm not sure what it is if it's not a target.

CHAIRMAN BERNANKE. That was the sense, I think, that the Vice Chairman was reacting to'that there is a u* and a ''* in the Taylor rule, and in that sense, it's an anchor for or a determinant of policy. The difference is that we can set ''*; we can't set u*.

VICE CHAIRMAN DUDLEY. Absolutely.

CHAIRMAN BERNANKE. President Evans.

MR. EVANS. Well, I remember hearing John Taylor, or maybe he wrote it down in his blog somewhere, say that he disagrees with that characterization. Now, I don't agree with how he described it, but at some point he said that output is only in there to capture inflationary pressures and things like that. So there is tremendous disagreement.

MR. BULLARD. Right. I'm recalling long papers by Lars Svensson that are defining all these things, and I don't think it was very clear.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. I'll refrain from making comments about how much CNBC has read Lars Svensson's work. [Laughter] As you referred to in your framing remarks, Mr. Chairman, I think it is important to keep in mind that the thresholds that are being used in paragraph 4 of alternative A are not u*. They are a way to describe when the Committee will raise interest rates as consistent with some notion of u* being maybe 5 to 6 percent.

CHAIRMAN BERNANKE. That's correct.

MR. KOCHERLAKOTA. Okay. So that's the way I took it. With all that said, I think we can get to a point where we all understand that in this room. I think the challenges in communicating that to the broader public might be pretty high.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I'll follow in the order that the questions were sent to us.

For question 1(a), I do think the maturity extension program is a useful tool. The estimates of the effect of the maturity extension provided by staff seem quite reasonable. In talking with financial market participants, they have suggested that the expectation of policy action of this type is one of the reasons that long-term Treasuries and mortgage rates declined so much recently. I agree with the comments of several of my predecessors, though, that it's a one- time action, and so we're going to need to deploy additional tools if we see a financial crisis or the probability of deflation rising substantially. I think it's a sensible one-time thing to do, but it is a one-time thing to do.

In terms of question 1(b), on the interest on excess reserves, I think that through my questioning it was probably pretty clear what my view was. I do worry about the optics'that so much of it's being held at foreign branches. I do think it helps signaling that we're serious about keeping rates low for quite a while. And I do believe it'll have a fairly modest effect, but given the signaling and optics, we should think about it. It's a one-time thing, and if we're doing one- time things, this would seem to be the appropriate time to think about it.

In terms of question 2(a), I think it is useful to make clear that we are intending to restore the economy over time to 2 percent inflation and an unemployment rate in a range of 5 to

6 percent, consistent with our forecast submissions. We've already stated in the SEP that that is what we're expecting to do in the longer run. And I don't think there will be a big impact from that, but it's probably useful to do it.

To the extent that we could be more transparent about our reaction function, a question in 2(b), I think that would also be useful, not only to the public but also to our own deliberations, where it's sometimes not as clear as it should be whether our policy positions reflect differences in our forecast, differences in our long-run objective, or differences in our reaction function. Getting more clarity around this table about which of those three things that we disagree on actually would help edify everybody and maybe help us have a more focused discussion.

In terms of 2(c), I'm actually not bothered by paragraphs 2 and 4. I think they're reasonable'other than that they're in alternative A rather than alternative B. But if I were to make a suggestion, I would combine 2 and 4 and maybe focus on three elements, particularly given that, as several people have noted, we haven't had time to communicate a long-run inflation target of 2 percent and to have some of the communications. But we do have the SEP projections, and if we were to do something like this conditional language at this meeting, or a meeting soon thereafter, I think it is reasonable, until we have had time to communicate, to focus on the SEP projections and on highlighting that 2 percent or a little bit below and unemployment of 5 to 6 percent'that has not changed. Also, how consistent is it with the objectives and our forecast?

And finally, to the extent that we can make our reaction function clear, I think that's useful. Several people seem to be talking about an inflation target as if it's an inflation ceiling; my understanding of an inflation target is it's just that'it's a target that is the midpoint, it's not a ceiling. If it is a midpoint, that means at times we would tolerate inflation that's a little bit higher, and at times we would tolerate inflation that's a little bit lower. Particularly at times when we're very far away from where we think the unemployment rate should be, it would be reasonable to take more risk on getting the inflation rate a little bit higher. And we could argue

whether the appropriate range was 1'' to 2'' or 1 to 3 percent, but I think it's actually quite consistent with what already is embedded in how we have described the inflation target.

I do think that if we're moving to be very explicit about inflation being 2 percent, we would need to have a conversation with the Congress. Over time, I would hope that we'd gravitate away from the SEP projections to being more explicit about what our longer-run goals are. But that would take more time. That's all I have.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, you're going to hear a lot of different views around this table, and some of them have already been expressed, so I will try to be concise, which means I won't be. I'll go in reverse order here. Generally speaking, I'd prefer focusing on communications policy over working our balance sheet. Parts of those reasons have already been expressed. I'm still at sixes and sevens trying to figure out the right communications policy, and actually, I was somewhat encouraged by paragraph 2 in alternate A. I was discouraged by the specifics that were outlined in paragraph 4. But I do think we should have a good, robust discussion about this as we go forward.

Going in reverse order up to number 1 and the questions that were asked, I'm quite sympathetic to what Eric argued earlier, but I'm undecided in terms of the efficacy, which is the key question, because it's not clear to me yet'and perhaps we could learn more'that if we did lower the IOER, it would indeed induce banks to lend. Therefore, I asked the question of Seth, and I think his answer was that it's not clear.

I'd like to focus my comments, if I may, on, first, 1(a), which is the potential efficacy of policy tools tied to the size and composition of our balance sheet. And I would say that if the choice is between more QE and twisting, then twisting wins hands down. That's the good news.

The bad news is, it's a Hobson's choice. And I believe both provide perverse incentives. The key questions are: (1) What are the magnitudes of the effects from the reduction in the outstanding supply of longer-term Treasuries? (2) How do these effects extend beyond the market for Treasuries to yields on corporate debt or mortgages or into the stock market? and (3) What is its impact on savings and consumption? Well, that's what I think we're trying to deal with. The answers to 1 and 2 are 'not that big'; that is, they don't have much influence. And the answer to 3 is 'not so much.'

Krishnamurthy'which, by the way, always sounds to me like a Hindu'Irish combination of bloodlines'and Vissing-Jorgensen at Northwestern University estimated that QE2 had roughly a 20 basis point reduction in Treasury yields but that it had a much smaller effect on corporate yields; they estimated we had a 7 to 12 basis point effect for investment-grade securities. Swanson's study at the San Francisco Fed has been referred to twice, I believe, in this conversation so far. He went back and looked at the original Operation Twist, which, I might add, was announced by President Kennedy on February 2, 1961, roughly corresponding to the bottom of the business cycle. But Swanson estimated, as was mentioned by Charlie, that the original Operation Twist had about a 15 basis point reduction in long-term yields and, very importantly, as President Plosser mentioned, a 2 to 4 basis point impact on corporate yields. What worries me is that the confidence bands that surround the studies that were sent to us are awfully wide. I found it interesting that the Board staff memo now concludes that QE2 had half of the impact that we had originally guessed, and the Board and the New York Fed memo now estimates the maximum effect of a reinvestment maturity extension program transfer of, say, $275 billion as lowering 10-year yields 7 basis points. So these are very modest effects or benefits, Mr. Chairman, which I think need to be weighed against the cost of exposing the Fed's

balance sheet to a greater amount of interest rate risk, because longer-duration assets decline more in value versus short-duration assets in response to interest rate increases.

In summary, I want to mention that, as I said earlier, most of these variations that have been suggested are very un-Bagehot-like. And what I mean by that is, twisting entails purchasing assets that investors are fleeing toward, not assets that they are fleeing from. When I talk about perverse incentives, I'm worried about any action along these lines incenting people to hoard more, particularly savers. I'm actually concerned about its impact on pension funds. I don't know if we've gone through the numbers and studied that or not. But the way pension fund accounting works, and particularly for government and organized labor workers who are more given to defined-benefit programs, is that lower interest rates raise the expenses required and require more funding. Incidentally, I asked our staff to examine a decline in the interest rate or return assumption from 5'' percent return to 5 percent, just on Federal Reserve employees alone, and it increases the expense requirement or the additional reserving by $300 million. So we need to think through the practical consequences of this in terms of the cost and what impact it would have, not only on the sense of a need to hoard more for those who earn less, are out of work, or are worried about the small value of their savings, but also on institutional investment and what impact it might have.

Also, larger holdings of longer-term debt may make future decisions regarding short-term rate increases more politically contentious. The good news is that the bind of extending the maturity or duration of our portfolio might encourage investors short term, but it could hurt our maneuverability and undermine confidence'a key word that's been mentioned many times around this table'in our ability to conduct independent policy. Similarly, long-term duration exposes us to losses, and yes, we might take comfort under that very adverse scenario that you

had in your chartbook, that we can book these curtailed future advances to Treasury as a deferred credit asset on our books. It's reasonable, however, to hypothesize that the prospect of such losses could discourage rate increases when the time comes. Conversely, the stronger the recovery, the greater the losses the Fed is likely to suffer should it actually want to tighten. And the political incentive to hold rates down becomes stronger precisely when you want to unmoor it. So those are my comments on 1(a). Again, I would prefer to stress communications than deal with the balance sheet.

Just a general comment in terms of the SEP exercise, because I think President Kocherlakota, or maybe it was you, opened up the discussion of fed funds. I'm a little bit concerned about how that exercise would work. It's one thing to state our destination. Let me use a simple analogy. If I say I want to drive to Abilene, and I want to get there by a certain hour, that's my goal. As far as the fed funds rate is concerned, to me that's the degree to which I press down on the accelerator'how many inches or, to the degree we talk about things, how many angstroms. And I don't think that's a very realistic exercise. What counts is the topography that we encounter, the roadblocks that we encounter, and how we're going to maneuver our way around them. But it's not terribly practicable or sensible to forecast the degree to which we're going to press the accelerator by so many inches or so many angstroms, because that's likely to change depending on the conditions that govern either the vehicle we're driving or the terrain through which we're trying to drive. So I have some questions there, Mr. Chairman, that I think would be worthy of discussion. But in general, as I said earlier, it's important for us to think about communications. There are real dangers for dealing with the balance sheet under the two different options that have been suggested, and the point that this is a one-time effect is of great concern.

When we talk about contingency planning, my concern is, what do we do if the S&P goes to 600? I talked about that before. It's a real possibility. What do we do if we end up with a disaster in Europe? A real possibility. What do we do if there's some kind of exogenous development that just completely takes us for a whack? That's the kind of contingency planning I think we should be talking about, rather than diddling at the margins here for limited returns. Governor Duke made a very good point in the last meeting, which is that we have limited ammunition. We must use it very carefully. And I believe the proposals that we've seen so far are expending that limited ammunition for a limited return. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Again, we're in a process of contingency planning, and that's exactly what motivates that.

MR. FISHER. Yes, sir. And let me also just add, if I may, that I'm delighted with the framework exercise because I think that's really what we should be discussing, and I look forward to it. Thank you.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I realize you have emphasized that this is contingency planning. I'd like to focus my attention really on my reactions to the policies suggested in terms of their immediate potential. There's a caricature of the French that they tend to think along the lines of, 'It works in practice. Will it work in theory?' And I think our situation is, 'Will it work in practice, or are we just dealing with psychological operations, and will they work?' So let me start with an overview of how I reacted to the whole set of memos and questions. I doubt that the balance sheet tools will have much real effect through the credit channel. Looked at on a benefits versus potential costs basis, I think the MEPs are safer considering the projected modest effects. However, for 'psych ops''to use an Army term'

effects, the LSAP is much more powerful if we conclude that shock therapy is needed. Dropping interest on reserves will have little or no effect and carries significant uncertainties. And I'm unconvinced about, but not closed to, employing explicit unemployment and inflation policy triggers in a statement versus using the SEPs to communicate participants' projections. But, as I said, I'm open to further discussion and could be convinced. And finally, I thought Governor Tarullo sent out a quite useful memo, and I am substantially in agreement with Governor Tarullo's position.

Rather than go through each of these points, let me just highlight some thoughts on two or three of these elements. As I said, I doubt that there will be much in the way of real effect from the use of our balance sheet tools. I concede that we can drive down long-term rates a bit, but rates are already low. We'd be doing this in a context of continuing deleveraging. Credit standards are necessarily higher. There's plenty of liquidity, and from a business point of view, even a better revenue outlook from some anticipation of growth may not generate much hiring. I'd like to see further analysis'and my staff and I discussed this at some length' along the lines of the question, with lower longer-term rates, who'meaning, which borrower class'will actually borrow and for what purpose, and how much incremental demand will that produce?

My own sense is that longer-term rates will affect mortgage costs for consumers, both new buyers and those refinancing, and for commercial real estate owners, both new projects and refinancing. That's where the long rates will have the most effect, but only if short-term rates also fall, and that's uncertain, according to the study that was presented. Are other financed consumer purchases'namely, autos and other durables'cheaper? And furthermore, consumer revolving credit'credit cards and equivalent store charge cards'is very sticky at high rates in order to absorb credit costs and fraud costs. Most ordinary business credit is at short tenors'

that is, revolving credit that is typically priced around one year and term loans in the five- to eight-year range. So the best chance for lower longer-term rates to stimulate sustained activity is consumer spending from lower mortgage costs due to refinancing, with some cash flow that is freed up going into increased savings. And I ask, what's the recent response from the point of view of refinancing to lower rates, which have been declining since the first of the year or since about April, per Brian Sack's exhibit 3? I don't know what the credit aggregates have done, but I think if we look at that, we could get a sense of what the response is to lower rates; some of that is certainly contained by the fact that many mortgage holders are underwater and therefore not pursuing refinance.

Regarding interest on reserves, I'm skeptical that reducing interest on reserves alone will do much to stimulate more economic activity. Bankers don't perceive a business tradeoff between 25 basis points on reserves and 300 to 400 basis points average yield on a loan, and for what it's worth, bankers tell us that dropping interest on reserves will not incentivize them to make loans they wouldn't otherwise make. One banker did suggest that eliminating interest on reserves would cause some layoffs. Also, I think there's a question related to the FDIC assessment. Because of the FDIC assessment, interest on reserves at 10 basis points would imply a net tax on large domestic banks, and if we were to go so far as LSAP 3, that would increase the tax if implemented. So the question I have is, have we engaged the FDIC at all on their continued policy of applying this assessment, because it does affect, at least in some scenarios, monetary policy? I'm also concerned, although I heard President Rosengren argue the opposite, that there would be disruption of short-term funding markets. I think this is something of an unknown. So I ask, why should we take the risk of doing that?

One final comment on the targeting of unemployment within a framework as portrayed in paragraphs 2 and 4. As I said, I'm unconvinced but not closed minded on the subject, but I'm concerned that labor markets today are very confusing. There is much we do not understand, and an explicit number will be taken as a harder commitment than perhaps we can back up with our understanding of how labor markets are in fact working. Those are my comments. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Let me just mention one point. A number of people have mentioned the role of the projections, the SEP. I'm just raising this for consideration. Would it make sense to make reference to the SEP in a statement? For example, you could say, 'As indicated in the most recent Summary of Economic Projections, the Committee judges that inflation between 1.7 and 2,' et cetera. Does that help at all, Charlie? You don't have to answer now if you're not prepared, but that would be one way to refer to information that's already been out there, that I've already talked about'just something to put on the table. We'll put the pressure on President Williams to take us to lunch. [Laughter] President Williams.

MR. WILLIAMS. Well, thank you, Mr. Chairman. I would just start off with a comment about interest rates and lowering interest rates and the effect on spending. Nine months from now I'm going to have my 50th birthday, and I've been promised a midlife-crisis sports car. So I assure you that if interest rates are lower, I will spend more on that. [Laughter]

MR. BULLARD. You have a conflict of interest.

MR. WILLIAMS. If there is a silver lining to our current predicament, it's been that these events provide a laboratory for research that has increased our understanding of the effectiveness of monetary policy at the zero bound. Based on this research'and we've actually

reviewed probably about a dozen papers'I think it's pretty clear that these types of programs, both LSAPs and maturity extension, are effective policy tools that could help lower longer-term interest rates at the margin. And I'll just comment that the staff memo that we saw today shows that either of these policy options would lower 10-year Treasuries between 10 and 25 basis points initially, and that's roughly equivalent to a 75 to 100 basis point cut in the fed funds rate. I actually view that as a very sizable policy action to the extent that these are equivalent, and I'm going to come back to that in a second. I'd also just say that obviously these policies aren't cure-alls, but I still think we should use them as appropriate given the constraints we face at the short end of the yield curve. I'd add that in the future, we'll likely need to broaden the set of securities that we purchase for the very reasons that President Kocherlakota and President Fisher mentioned. I think we'll need to consider going back to mortgage-backed securities'I know that's not a popular idea'so that we can make larger ongoing purchases without cornering the market for longer-term Treasuries. Moreover, research has shown that our past MBS purchases have had broad effects on private borrowing rates, making MBS purchases a potentially more potent tool than Treasury purchases. And, as Brian mentioned earlier today, the MBS'OAS spread relative to Treasuries has spiked upward again. That's, again, I think, an argument for at least contemplating broadening to that class of securities.

In terms of reducing the interest rate paid on excess reserves, I think that would be another way for us to provide a bit more monetary policy accommodation. It would also lessen somewhat'I'm just repeating the comments that I think have already been made'the confusing appearance that we are paying banks not to lend money while we're trying to ease policy in every other possible way. Cutting the excess reserves rate would push down short-term rates a bit. I realize that's a small change. I do think it would send markets a signal to lower their

expected path of policy going forward, which would help reduce interest rates all along the yield curve'again, though, only modestly. And regarding President Rosengren's comment about how markets would respond or how much disruption you'd get, I also heard the same kind of thing'that money funds are really a part of a suite of services that are provided. So I would be surprised if lowering the interest on reserves to 10 basis points would cause a highly disruptive reduction in the money fund market.

Turning to monetary policy communication, I think that more transparency is desirable. Paragraph 2 of alternative A is a noble effort to communicate our long-run policy goals succinctly, and it's one that I support. I'm also sympathetic to the goal of providing conditional forward guidance, as in paragraph 4. I think this is very difficult to do, though, based on the wide variety of views in this room. And my main concern is that this approach will prove to be very challenging in terms of reaching consensus on these thresholds. It's very difficult to satisfactorily distill our policy strategy down to just two numbers, especially during a time of extraordinary volatility and uncertainty. Moreover, this approach focuses exclusively on the date of liftoff from low rates and provides no further information on the intended slope of rate increases after liftoff, which is equally or even more important for thinking about longer-term borrowing costs. I do want to add that I think it's essential that, if paragraph 2 makes reference to an inflation rate of 2'', there is a reference, such as in paragraph 2, to our longer-run goal of

2 percent. I think having just the 2'' percent number obviously would be potentially confusing. So I am sympathetic to this approach. It's very difficult to do in practice. Luckily, I

think there is a better way forward. I'm now not going to be the first person to mention this, but I will tilt at this windmill myself. I think that it would be a better approach if we were to include our individual projections about the appropriate path of monetary policy in the SEP. Like

Governor Tarullo, I see many advantages to this approach, but unlike Governor Tarullo, I will strongly advocate for it. Releasing our funds rate projections would accomplish everything that paragraph 4 in alternative A tries to do and, I think, much more. So let me emphasize a few advantages of this policy. First and foremost, releasing our funds rate projections in the SEP would clearly communicate to the public the most likely point at which we see the policy rate lifting off from the zero bound. That could be mid-2013 or later or earlier, as the evolving data warrant. Second, the range of our funds rate forecast would appropriately convey the disagreement and uncertainty we face about the exact liftoff point. Third, as our output, unemployment, and inflation forecasts evolve, so too would our forecast for monetary policy. This would give the public a genuine picture of the state-contingent nature of policy without any of the oversimplifications inherent in the simple thresholds of paragraph 4. Fourth, the steepness of our funds rate path after liftoff would provide very useful information to the markets that is not currently conveyed by paragraph 2 or 4, and again, as emphasized in the memo, the pace of tightening after liftoff can be just as important for influencing longer-term interest rates as the timing. Fifth and perhaps most important'and I really think this is the most important idea'is that having funds rate projections in the SEP, or at least having them internally, would help our policy discussions at this table. It would give us a better understanding of the range of views on the Committee and could help us better frame the debate about policy and the outlook. It might even help us find greater points of agreement regarding the future course of policy. To summarize, I support the use of forward guidance in principle, but I think we can do much better by publicly releasing our policy projections in the SEP or at least having them internally as part of our discussion. This would importantly communicate the most likely path of policy and the

uncertainty and state contingency of that path, and again, it would shape the public's expectations about policy after the liftoff point, which could be just as important. Thank you.

CHAIRMAN BERNANKE. I think I need to mention a very ticklish governance issue that you raised, though. The interest rate is set, of course, by the FOMC, not by everyone around the table equally. Would you somehow identify the FOMC projections vis-''-vis those nonvoting, for example, in a given year? That's just a question for discussion.

MR. WILLIAMS. My view was that, just as the SEP has done, it would represent all the participants and be consistent with the forecasts of the participants.

CHAIRMAN BERNANKE. Okay. Lunchtime. Why don't we go bring our lunch back to the table, let's say at 1:35'that will give us half an hour, and then we'll commence again even if people are still eating at that time. Thank you.

[Luncheon recess]

CHAIRMAN BERNANKE. Okay. Why don't we recommence with our go-round. President Pianalto, you're next on the list.

MS. PIANALTO. Thank you, Mr. Chairman. I want to start by thanking the staff for the helpful background memos. I found them very beneficial. I am going to focus my comments around the questions that were circulated, starting with the potential efficacy of policy tools. In my view, the efficacy of balance sheet tools depends in part on the problem that we are trying to solve. Our experience with the second LSAP program leads me to believe that when the problem is an elevated risk of deflation, these tools, particularly balance sheet expansion, can be helpful. Balance sheet expansion seems to be effective in boosting inflation expectations. When the problem is a deteriorating outlook for the economy, the efficacy of balance sheet tools is more uncertain and likely to be more limited. As the staff memo indicates, either asset

exchanges or purchases would have modest effects on bond yields. The associated effects on borrowing rates faced by consumers and businesses are likely to provide little further stimulus to the economy, in part because rates are already so low and in part because the effects of low rates are being hindered by other factors, including deleveraging by consumers and the uncertainty on the part of businesses.

Regarding reducing the rate of interest on excess reserves, in current circumstances, with short-term interest rates so low, the additional accommodation we could achieve by reducing the interest on excess reserves is likely to be pretty small. That said, it is generally a good idea to keep the interest rate on excess reserves close to the federal funds rate to limit the perceived subsidy to banks. So I can see some merit in the desire to reduce that subsidy, which seems to be a little large now. However, for the reasons laid out in the staff memo, I do worry about the potential for the reduction in the interest rate on excess reserves to disrupt markets for short-term funding.

Turning to the second set of questions, I support expanding our communication efforts more or less as laid out in the memo, but I would prefer to expand our communication efforts within the broader context of our existing economic projection process. I will comment on the specific questions. As I have indicated in previous meetings, I firmly believe that providing an explicit numerical objective for inflation would significantly improve our communications and, in turn, would improve the effectiveness of our policy. This is especially the case now as we face an uncertain inflation trend and with the unemployment rate still above 9 percent. In light of our dual mandate, it would also make sense to clarify our view of the longer-run equilibrium rate of unemployment, and I think the offered language does a good job of expressing the limitation of policy effects on unemployment.

I also believe that providing quantitative information on our reaction function could improve our communications. In particular, I think that coupling our Summary of Economic Projections with forward guidance based on economic conditions would allow the public to draw its own inferences on the likely timing that we would start to remove our policy accommodation. It would also lay out the conditions to which the Committee is likely to respond. For the reasons discussed in the background memo, using economic conditions would offer a number of advantages over using just a date, and in fact, it would eliminate the need for a date. When we are able to find a way to eliminate the date from the current forward guidance, including our federal funds rate forecast in our SEP could provide a viable alternative to the use of economic conditions in the forward guidance.

Finally, I think that some version of the draft language in alternative A could significantly improve our communications when coupled with information conveyed in the SEP. So, Mr. Chairman, I support the suggestion that you made earlier that we might want to make a reference to the SEP in our statement. The draft wording on the long-run objectives in alternative A, paragraph 2, seems effective as written. I think that the language elaborating on our forward guidance in alternative A, paragraph 4, could be effective with some modifications. First, as I just indicated, I would prefer to modify the language by dropping the date condition. Second, I would prefer a slightly different wording for the inflation condition. Specifically, I would prefer not to state that we are willing to allow inflation to rise to 2'' percent in the medium term, because I am concerned that that statement would take away some of our hard- won credibility on price stability. To me, it would be much better to use a condition of, for instance, 'as long as inflation is projected to remain near 2 percent in the medium term.' This keeps the focus on our long-term target, but it recognizes that inflation could at times run above

or below our target. Mr. Chairman, you would undoubtedly be asked what 'near 2 percent' means, which could easily be described as 'plus or minus '' percent on a four-quarter basis.' You could also acknowledge that the Committee would feel obligated to comment on circumstances where the inflation rate might go beyond these bounds. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. First Vice President George.

MS. GEORGE. Thank you, Mr. Chairman. Given that I've stepped into a conversation that's been going on for some time, I will keep my comments brief. On the balance sheet tools that are described by the staff, I think, as others have noted, that the benefits would be small at this stage in the deleveraging process and uncertain, but depending on the conditions under which we think those might be most useful, exploring those further would be warranted. That said, the asset purchases bear the largest longer-term cost and the conditions under which we might undertake those would be those we would need to think most carefully about.

I do not believe that reducing the interest on excess reserves would be especially effective at this point. I doubt it would stimulate bank lending, and I would be interested in knowing more about its impact on money markets, notwithstanding President Rosengren's reaction to that.

I would prefer to consider the communication alternatives, as have been outlined in these memos. I think maintaining a clear commitment to price stability is important, although it is not clear that markets or the public at this point doubt our commitment or even that they doubt our inflation objectives. The comments that have been made at this point about the use of an unemployment rate do require that we have good communications with the public and that they understand the context in which we would be talking about unemployment. I also have questions about providing more-explicit, quantitative information about the Committee's reaction function,

and in that regard, I would like to discuss further Governor Tarullo's memo and his comments about the importance of other variables in that reaction function, including financial stability concerns, asset bubbles, and financial imbalances. Finally, as I've discussed with our staff, I think exploring more the use of the SEP projections could have potential use for us in the broader context of our communications going forward. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS: Thank you, Mr. Chairman. Let me say at the outset that I generally agree with all of your opening comments on flexible inflation targeting. I think if we were very clear on exactly what that conveys, that would go a long way toward helping with the current situation.

The premise of this discussion today is, what should the Fed do if more monetary accommodation is called for but the fed funds rate is stuck at the zero lower bound? There are two key channels for transmitting more accommodation, and they've been discussed already at great length. The first is to use our balance sheet and work the portfolio-balance effects. The LSAPs, the MEP, and the RMEP all work that way. The second is to provide greater forward guidance on an accommodative monetary policy stance. We can do this by signaling a larger amount of monetary accommodation over a longer period of time. Strong accommodation would be to keep short-term policy rates at zero for an admittedly uncomfortably long period of time. This lowers real interest rates owing to higher inflationary expectations. I would say that given nominal rigidities in labor markets, higher inflation for a time likely would facilitate better matching and hiring as well.

But one of the big problems'and it's been alluded to by Presidents Bullard, Kocherlakota, and Plosser'is the time-consistency problem of promising to have more inflation

than what our perceived inflation objective is. Central bankers will withdraw accommodation prematurely because they don't like higher inflation, even modestly above a longer-run target. And of course, external criticism feeds this response, and it's very difficult to counterbalance those influences. Now, logically, these perceptions among the public make our current policy stance more restrictive because there's more of a probability attached to the possibility that we might raise rates prematurely. So an additional tool to provide added accommodation would be greater clarity of our forward intentions. Stating economic triggers for a state-contingent policy response can help us. Doing this in conjunction with a maturity extension program or asset purchases would strengthen the commitment to persistent accommodation. I have a different view than President Bullard on this. I think that that would actually be successful in helping display credibility.

The Board staff's analyses provide compelling evidence that further accommodation can be delivered with reasonable safeguards and acceptable risks, in my opinion. FRB/US and other Board models are the only reasonable macro models that are available to help us to sort through this at the moment. These models incorporate both sensible, modern macroeconomic analyses and empirically reasonable matches between the model and the data. Simplistic real business cycle or New Keynesian structures that can't explain basic features of quarterly or annual macro data can't be called upon for guidance here. Our Fed DSGE project is making good progress, but it's not far enough along to provide alternative answers in those frameworks, and we need to make decisions sooner than we're going to be making progress on those DSGE models.

President Bullard mentioned a New Keynesian model with search by Ravenna and Walsh. I confess not to have been familiar with this paper, and it's got a labor market and so that's good, but as macroeconomists, we tend not to be troubled by the fact that we don't have

labor markets in these models. Charlie and other early contributors to real business cycle theory didn't worry a lot about particular details; that's part of the art of it. When I asked the staff to look at this model, they summarized it this way: The Ravenna and Walsh model is not an empirically credible basis on which to base the actual conduct of monetary policy. I say this because the article's policy prescriptions are driven almost entirely by an empirically implausible factor. In particular, the model says essentially that the high levels of unemployment we currently see are due to workers having magically become much more powerful in their wage negotiations with employers. They're able to bid the wage up to a high level; they're thrown out of work; the unemployment rate is high'that's a key feature in the model's supply structure. It's not necessary to point out how ridiculous that sounds in the current period. We understand these factors about supply effects in these models, and I don't believe these influences are relevant for today's 9.1 percent unemployment rate. We talked about it in January, and I don't think we made a lot of progress here. The way to artfully interpret FRB/US and other models that may or may not have a complicated labor market is to think through those types of factors and whether or not they sound reasonable today. To me, they don't.

The analyses from FRB/US and company provide a wide variety of comforting risk assessments associated with a forward guidance that's based upon unemployment and inflation triggers. I won't repeat those presentations. I found them to provide strong support for these positions. The caveats are well known and can be taken into account, and Mr. Chairman, I thought that you were exactly on target when you opened up by saying that this is sort of like having in our statement something like, 'Well, it's going to be this way until the Red Sox win the pennant.' We could go further. We could do it and say 'until the Chicago Cubs win the World Series.' [Laughter]

CHAIRMAN BERNANKE. Incredible. [Laughter]

MR. EVANS. Well, we have the inflation trigger, which is the safeguard against that. So if structural unemployment is higher than most of us think and I'm wrong about the labor market assessment earlier, then strong monetary accommodation will lead to medium-term inflation pressures sooner than I expect. The role of the inflation trigger is to provide a good safeguard against this adverse outcome. If longer-term inflation expectations become unanchored, we will see evidence of this from financial market data and surveys. In addition, medium-term inflation will move up more quickly than I expect. Again, the role of the inflation trigger is to provide a good safeguard against this adverse outcome.

After reviewing the analyses, I continue to feel that a reasonable and aggressive set of triggers, if it was a decision today, would be 7 percent for unemployment and 3 percent for medium-term inflation. With an inflation objective of 2 percent, I think that 3 percent inflation is a reasonable statement of symmetric preferences around our objective. Having said this, I agree with President Kocherlakota that it's very important for the leadership of the Committee, if we were to go this route, to clearly communicate what our intentions are about inflation and inflation above our objective, what it means for flexible inflation targeting. Just using that phrase might not be enough. And in fact, I think that the concerns that President Bullard has about the worrisome zero inflation equilibrium would also be mitigated by the leadership speaking about intentions toward higher inflation because that would be a move away from that equilibrium.

Turning to the specific questions and just to finish up, let me reorder them according to my preferences. First, I think it would be most effective to continue providing some form of aggressive forward guidance. The use of 'mid-2013' was helpful in the context of wanting to provide more accommodation, which last meeting I did. Providing economic triggers like the

unemployment rate and medium-term inflation is the better way'by adding a more credible commitment. Level targeting might be best, although I think the benefits of aggressive triggers with inflation safeguards may be close to the benefits of level targeting. Second, announcing complementary purchases that aim to reduce long-maturity term premiums can provide powerful support to the forward guidance. I find the MEP approach to add acceptable accommodation at the outset; the reinvestment is a good addition, too, but these may not be enough. In the event that no meaningful progress is made in moving closer to hitting the triggers, adding further asset purchases would increase the level of accommodation. And with enough forward guidance, perhaps President Bullard's pace of purchases program would be appropriate at that later time. Third, I think that reducing IOER as much as is feasible would help a bit, too. It would be useful at the margin to provide disincentives for financial institutions that currently prefer cash over lending.

On the particular questions related to monetary policy communications, I support providing more-explicit, quantitative information about the Committee's longer-run objective for inflation and its projection of the level to which the unemployment rate will converge. And I can think of no reason to preclude discussions of the unemployment rate'or the output gap, if that was preferred'as they are critical objects for making monetary policy, and we need to be transparent. I approve of the general idea of providing information about the Committee's reaction function, like the economic and inflation triggers I discussed earlier and in August, and I find the language in alternative A, paragraphs 2 and 4, to be quite appealing. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Coming 11th in the order, I just note that President Kocherlakota's dictum has the corollary that you would expect those coming late in the order to speak less rather than more. I'll note as well that that's sometimes true, not always. [Laughter] But actually in this case, it will be true. I'm going to just work through the questions briefly and allude to points that many others have made that I agree with.

I think quantitative effects of balance sheet tools are very hard to assess. I applaud the staff's presentation of the term structure model, where assumptions of how things are put together are pretty transparent, but estimates on those models have their natural weaknesses. I think it's a great step forward, but they're obviously sensitive to modeling assumptions, and that's particularly true with implementations of the habitat model, which, on theoretical grounds, is a bit tenuous. And I'd note that one thing left out of the whole discussion is the question of whether there's habitat within a maturity class. This goes to President Fisher's point about the relationship between the 10-year Treasury and the 10-year corporate bond. There's nothing about habitat theory that rules out an imperfection in arbitrage across those two securities, which further loosens the connection that Treasuries have. Other assessments of effects of balance sheet tools rely on program announcements, and these are obviously contaminated by the effects of what our announcement says about the future of the economy'and so by the effect of downward revisions in private growth and inflation forecasts. I think those are hard to get a handle on as well.

To me'and this is a casual empiricism'last fall's policy initiative seems to have had only a small and relatively transitory effect on real economic activity, and in contrast, I think it probably had a more sizable and longer lasting effect on inflation. That colors my sense of what effect a maturity program or another LSAP would have.

I'm persuaded by President Rosengren's views that a reduction in the interest rate on reserves is unlikely to horribly gum up financial markets as we know them. We should view that as feasible and put it on the table, but I agree with President Lockhart that it doesn't look like it is likely to have gigantic effects. It doesn't look as though marginal changes in borrowing costs are going to have a notable effect on marginal willingness to spend now or invest now.

Quantitative information about a long-run inflation objective, I think, would be very useful. I'm still very much for an explicit numerical objective for inflation. I find myself very resistant to the idea of including explicit numbers about unemployment. I'm not convinced we can do justice in a sentence or two in the statement to the distinction between the role of our unemployment forecast and our inflation objective in monetary policymaking. We forecast a lot of things. Putting an unemployment rate forecast in the statement in very close proximity to a statement, first ever, of our jointly agreed inflation objective, even if it's identified the way we tried to in A(2), is inevitably going to lead to some confusion, and it's going to be hard to make that distinction. I don't think the idea of a dual mandate should prevent us from stating an objective for inflation alone without mentioning what we think unemployment is going to do in the same paragraph. As I've pointed out before, we in fact have three legislative goals, the third one being moderate long-term interest rates. We're actually doing quite well on that. [Laughter] I don't think we get enough credit for that. So why don't we factor that into our communication plans? But in any event, the economics and history are very clear that central banks are held responsible for inflation in a way they aren't and shouldn't be for unemployment because that's what central banks can directly control and can directly influence. And as you've said, Mr. Chairman, keeping inflation low and stable is the best contribution we can make to'and I'll add moderate long-term interest rates and'maximum employment.

About this trigger-strategy reaction function idea, I think including a reference to an unemployment rate there is a very bad idea for the reasons I've just described and for reasons that others, President Bullard and Governor Tarullo, have mentioned. But this problem about confusing it with the target is even more problematic in paragraph A(4) because we are directly linking it to our policy in a way we don't in paragraph A(2). As I said, I was stunned to see the discussion on CNBC this morning, where people were talking about the possible things we would do today, including this idea of setting numerical triggers, and they were referring to it as our unemployment target. Now, we could presumably push against that, but I think that's a signal of how hard we'd need to push and what kind of communication challenges we'd have. I could support contingency language on inflation and a reaction to that, but I'm persuaded that it would be better to explore other options and pursue those'like President Bullard's suggestion of an inflation forecast, like the idea many have suggested of including information on our projections for interest rates in the SEP.

Let me comment on something that you put on the table, Mr. Chairman, the idea of'I'm not quite sure what words you'd find satisfactory'temporarily tolerating a higher inflation rate. I think President Plosser is very articulate about these reasons, but I'll mention a couple of things in addition. This sets a precedent that will be with us for decades and be relevant to people's interpretation of our policymaking for decades to come. We've come to be viewed as wanting inflation to be 2 percent, but I think that to officially temporarily abandon that for a time is just going to make it harder for us to get back to the place where people think we're focused on

2 percent. I am persuaded that it's just going to be very hard for us to do this with credibility and to limit ourselves to just a percent or two if what we're really pursuing is unemployment. I understand this symmetry argument that inflation went down to 1 percent, and we didn't act as

though our hair were on fire, and so I guess we shouldn't at 3 percent. But there's a difference here because when inflation was 1 percent, we weren't trying to drive it further in order to reduce employment growth, and to use that as an argument for being willing to take actions to drive employment growth up when inflation is above 2 and it shows no sign of going down, I think, is a very different matter. So we should be very cautious about that. I don't see a way to pull that off, given where we are now. Those are my comments, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. This has been a pretty abstract conversation, and I think that bothers me a little bit because we actually have to make real decisions tomorrow about what we're going to do to support economic activity. This is hard because we're really searching for the best tools and framework consistent with making financial conditions more accommodative, and we're reaching the limits of that effort. At the same time, we also want to select those tools and frameworks that don't box us in, in terms of future action. I think that over the past few years, we've been a little bit too single-meeting-centric, and we need to think about how what we decide today affects our range of choices and options at the next meeting and the meeting after that. It's important that we make choices with respect to tools and framework that don't box us in going forward. We also have to recognize that anything we do, we're doing it in a very uncertain environment. If things evolve in a very different way than we anticipate, we have to make sure that our credibility is robust to those unanticipated developments. I think that is something we have to think about as well.

The staff has done a lot of great work, and there are a lot of alternatives on the table. They all have their warts, and that's reflected to some extent in the conversations around the table. In what follows, I'm going to advocate a few things, but I do have reservations about

almost all of the options to one degree or the other. I think that in a lot of ways we're trying to select the least-bad options in some ways to provide additional monetary policy stimulus. Just because they're not great doesn't mean we shouldn't do them, as long as the benefits exceed the costs.

Now, in a perfect world, I would prefer another sizable LSAP program for two reasons. First, I think we are more confident about how it works relative to the maturity extension program. We have some theory about how the MEP would work, but we haven't actually observed it in practice. We might see a greater disruption, for example, of market function than we anticipate. My understanding is that, as proposed, we would own as much as 70 percent of the outstanding CUSIPs in some of the longer-dated Treasury issues, and we really just don't know what that means in terms of market function. Also, the MEP would require us to sell short-dated securities. So it might increase yields in the short-dated sector by more than we anticipate. Second, I believe that, the staff memo notwithstanding, an LSAP of the size that the staff memo has proposed probably is going to be more powerful than the MEP. I was a little skeptical of the staff memo using the 10-year duration equivalence as our sole metric in weighing the MEP versus the LSAP. That implies that $1 of 30-year Treasury purchases is worth about the same as a little bit more than $2 of 10-year Treasury equivalents, and I'm just not sure that's right. I wouldn't be surprised at all if preferred habitat and other things could cause that relationship to not be quite that straightforward.

Another reason why I think the LSAP would be more powerful than an MEP program is that it's potentially open ended in terms of size. We can only do the MEP program once. Once we've done our duration extension, we're done, and the market knows that. The LSAP program would be more powerful because it would also change expectations about what might happen in

the future should the economy deteriorate more than what we expected. I worry somewhat about an MEP program because it might actually send a signal that we're done'this is the best thing we could come up with, this is all we've got, and we're done. And I think that would be very disturbing. If we do go forward with the MEP program, I'd certainly like to have some communications that strongly imply that the LSAP is not dead under all conditions. In other words, if things got bad enough, this could be brought back and put on the table. I think it's very important in our communications that we don't signal that we're out of ammunition.

Now, I said in a perfect world I would favor more LSAPs, but we don't live in a perfect world, as we all know. There are some really significant political constraints that make an LSAP a less-attractive option. If we were to do an LSAP, there would be a huge political uproar. Now, I don't really think that just because we get an uproar means that we shouldn't do a program. But if the uproar undercuts the efficacy of the policy, then you have to treat that as an environmental factor, and you have to view that as relevant in conducting policy in the real world. The attacks on LSAP policy'the claims that we're monetizing the public debt, the claims that we're playing politics'really would generate two bad consequences that we have to take into consideration: One, it would undercut the effectiveness of policy, and two, it would undermine our credibility. Let me just be very clear here. I'm not saying that we shouldn't do something because of political pressures. We should resist political pressures. We should do what we think is right, but if the political pressures mess up the policy, then we have to take that into consideration in the policy that we pursue. At the same time, I think we should probably be more aggressive in pushing back against these political pressures, because we can have some impact in changing people's perceptions about how damaging an LSAP would be or wouldn't be in the future.

If an LSAP is off the table for the time being, what would I propose? Well, the first thing I want to propose'I want to put this on the table now even though it's not part of the questions'is that I think we should invest the maturing agency MBS back into agency MBS. And the reason for that is Brian's chart 17 and handout, which showed that the mortgage basis between mortgages and Treasuries is now wider than it has been at any time in the past six years, except for the heart of the crisis. So we've really seen about a 45 basis point widening in the mortgage basis, and I think that if our goal is really to make financial conditions more accommodative, this is a very good way of doing that. The second benefit of doing that is that there will be a surprise to people, and so we've actually put this back on the table when people thought it was off the table. And I think it actually would tend to compress the mortgage basis by maybe more than the actual purchases because people would realize now that if the mortgage basis widens out, the Fed is likely to intervene, and that would make holding mortgage-backed securities less risky for private investors. The third benefit of reinvesting the maturing agency MBS into new agency MBS is that it would also mean the MEP program would be a little bit smaller at the margin. Some of the market disruption issues in terms of us owning 70 percent of long-dated Treasuries would be squeezed down a bit. My understanding is that we're anticipating over the next year that about $200 billion of mortgage-backed securities are going to mature. Obviously, it depends on the path of interest rates and a whole bunch of other things, but if that was the case, that would mean that rather than buying $600 billion of long-dated Treasuries under the MEP program, we'd be buying $400 billion. So I think you really would reduce considerably some of the market disruption issues that bother some people about the MEP.

What about interest rates on reserves? I've wrestled with this a lot, and I guess I think that at the end of the day, I'm 60'40 against rather than 60'40 for, but don't ask me precisely why, [laughter] because it's really hard. We all agree that it would have a very small benefit in terms of financial conditions, but what we have to weigh against that is the cost. And the fact is, it's very, very hard to assess what the cost is because I think what everyone is worried about with respect to reducing the IOER is that there's going to be a set of unintended consequences in terms of what happens to money market funds, what happens to the money market more generally, what happens to it if you have negative interest rates. We just don't have a very good way of dimensioning how significant those costs are. So it's a judgment call. If the sense of the Committee was the other way, I would go the other way, but I'm modestly against, just because I think that the benefits in terms of financial conditions are very tiny and I'm uncertain about what the costs are.

Question 2(a) was on explicit, quantitative information about the Committee's long-term objectives, like paragraph 2 of alternative A. I'm certainly willing to do this, but I personally think the benefits of doing it are actually very modest. I think that the SEP projections already show what our long-term outlook for unemployment and inflation is. The distribution is pretty tight. The market participants already interpret these projections as our objectives. So we could do it, and I don't have a real problem with doing it, but I just don't think that this idea that somehow this is a huge major advance in what the Committee is doing is accurate.

Regarding question 2(b), 'Do you approve of the general idea of providing more explicit, quantitative information about the Committee's reaction function?' I do, because I think providing more information about our reaction function will reduce uncertainty, and that will reduce risk premiums. It will enable market participants to more accurately map the implications

of incoming economic information in terms of the likely path of short-term rates. I think policy will then automatically adjust to incoming information in a countercyclical way, and that's a positive. We've been talking about these parameter values as triggers. I guess I view them a little differently. I view them more as an escape clause. If they are reached or other conditions fulfilled, then we might tighten monetary policy. I guess I don't view them as a trigger event. So I think that's something that we're going to have to settle if we go down this path as a Committee'exactly what do these parameters mean when they're reached? Are they triggers or are they escape clauses? We should include both inflation and unemployment rate parameters that might be viewed as necessary conditions for a rise in short-term rates, but I also think we should include the date at which we think those conditions might be satisfied. And keeping the date in there is important because if we just provide employment and inflation parameters market participants are still going to try to work out what that means in terms of a date. If we don't give them a date, they're still going to work out what the date is. And if they're going to work out the date, why not provide them with the date and give them more accurate information? At the end of the day, what they really care about is the path of future short-term rates, and therefore that date is very key in terms of determining their expectation. Now, in terms of keeping the date in, I don't see the date as standing by itself. I see it as the logical consequence of our projections of when the parameter values will be met. So the date is a follow-on from the parameter values. It's in there, but it's only in there because the parameter values are what drive it. Concerning the date, if we had it in there, I wouldn't be overly precise about adjusting it meeting to meeting. I don't think we want to say, 'It's August, and then it's September, and then it's back to August.' I would anticipate that, just as for the federal funds rate, we adjust in quarter-point increments, we might adjust this in quarterly or six-month increments.

The next question was on the language in paragraphs 2 and 4 of alternative A. I think there's some reluctance to proceed with paragraph 2 for a whole variety of reasons, but one of them is this notion that the Congress might need to be informed of actually pursuing an explicit inflation objective before proceeding with that. If you thought that was an issue, I think there's another way to go. A lot of people around the room thought that maybe we shouldn't go with an explicit inflation target and should rely more on the SEPs. In my mind, as an alternative, you could dispense with paragraph 2 altogether, and in paragraph 4 you could add a sentence after the parameter values that read something like this: 'Because the unemployment rate is projected to remain far above its long-run projections for the next few years, the Committee is willing to tolerate temporarily a move in inflation slightly above the rate it projects is likely in the long run in its central tendency SEP projections.' What that would be basically saying is explaining why the inflation parameter is 2'' percent rather than 2. It's not a target. It's just something that you're willing to tolerate for a short period of time because you're so far away from your employment objective. It makes it clear that the Committee is not changing its long-term goal for inflation. I think that is a potential alternative to paragraph 2 and it's something we can discuss further.

In terms of the SEP, just a few general thoughts. The SEPs can also be part of this whole process. Right now we have an SEP in which we write down our forecast, but the SEP could actually be used as part of this trigger mechanism development process. We could ask questions in the SEPs that said, 'When do you think your forecast is going to hit these parameter values?' And people could answer that question, and it would be interesting to see how people mapped the parameter values in terms of where they came out regarding dates. So maybe we should think about the SEPs as providing a somewhat richer mechanism for figuring out what

appropriate triggers are and what appropriate exit dates are. I have a lot of sympathy with people around the table who say the statement can only do so much. I think we've been asking an awful lot of our poor little FOMC statement over the past couple of years. And maybe we need to think about alternative ways to take a little bit of pressure off the statement. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I greatly appreciate the detailed staff analysis of policy options relating to our securities holdings and communications. I'll comment just briefly on the maturity extension program and IOER and devote most of my remarks to questions about clarifying our policy goals and reaction function.

Regarding the maturity extension program, I think the likely benefits outweigh the costs. Estimates of the program's effects on financial markets and the macroeconomy are subject to considerable uncertainty, but it seems plausible that the overall impact might be broadly similar to that of QE2, perhaps generating an additional 500,000 jobs or so over the next couple of years. Indeed, viewed as a form of jobs package, this program seems cost effective. Under the modal outlook, the program would have only negligible effects on the present value of our transfers to the U.S. Treasury, and under an alternative adverse scenario like that shown in the staff memo, the implied cost per job appears to still be under around $200,000, which seems quite low compared with many other proposals for stimulating employment. This is, as many have mentioned, a one-shot action, and certainly, if there were further deterioration in the outlook, I'm very open to considering further LSAPs to provide additional stimulus. I also agree with Vice Chairman Dudley that it makes sense to consider broadening our purchases or, alternatively, our reinvestment of runoff from our MBS portfolio back into further MBS purchases.

As for interest on reserves, I think cutting it to 10 basis points would provide a modest stimulus to bank lending and economic activity. I recognize that a reduction in IOER might induce more banks to charge an explicit fee on deposits and that the public reaction might be negative. That said, I agree with President Kocherlakota about this. Such a tax on money holdings provides stimulus to the economy by inducing some shift in private portfolios away from cash and into riskier assets, whereas he mentioned into spending. I'm concerned about the increasing volume of negative commentary that the $4 billion per year we're paying on reserves when prevailing money market rates are lower constitutes an unwarranted subsidy to banks. I do recognize, though, that a cut in IOER could have some adverse and unintended consequences for money market funds, the federal funds market, and other aspects of market functioning, perhaps making it an inadvisable time to make such an adjustment.

Let me turn next to the clarification of our longer-term goals, which is something I strongly support. As an old-timer, I intended to brag about participating in the FOMC's very first discussion of this topic back in 1995. In fact, I printed out my remarks here [laughter] from that meeting, two pages, and the seven subsequent discussions in which I've participated. I contemplated the idea of simply repeating what I'd said back then. Nevertheless, I used the FOMC Secretariat's handy web search tool, and I was astonished to discover that the sequence of discussions of this topic actually stretches back much further into the distant past. For example, here's an excerpt from a list of questions that the Committee discussed on a Monday afternoon in August 1983: 'Should ultimate economic goals be given clearer expression in conveying FOMC policy intentions to the public through, say, a specific numerical statement of objectives''

MR.TARULLO. What year was this, Janet?

MS. YELLEN. 1983'August 1983. ''or should expressions about ultimate economic goals continue to be limited to general qualitative statements?' That question sounded eerily familiar. [Laughter] So, too, did the answers. Preston Martin, who was the Federal Reserve Board's Vice Chairman at the time, specifically recommended the adoption of a 2 percent objective for consumer price inflation. In every Committee discussion, there's been widespread consensus on the benefits of adopting a numerical inflation objective, which, for the sake of time, I will not repeat at this point. As I look back on all those previous discussions, what's most striking to me is how frequently the Committee had reached the very threshold of consensus, only to become stymied by details that seem trivial in retrospect.

I think this is a good time to move forward. Indeed, there are a number of reasons why this may be a particularly propitious time to formalize the Committee's longer-run goals. From the standpoint of internal decisionmaking, all of us agree that monetary policy is fundamentally responsible for the longer-run inflation outlook and for ensuring that longer-run inflation expectations remain firmly anchored, whereas the longer-run outlook for economic growth and employment is largely determined by structural factors. We have reached a broad consensus that a PCE inflation rate of 2 percent would be fully consistent with our statutory mandate. Our longer-run unemployment projections generally lie in the range of 5 to 6 percent, and we all agree that those projections are intrinsically uncertain and subject to revision.

Moreover, I want to take a moment to dispel any notion that communicating an estimate of the longer-run sustainable unemployment rate is somehow inconsistent with flexible inflation targeting as practiced by other central banks around the world. For example, here's an excerpt from the Swedish central bank's October 2010 Monetary Policy Report: 'The Riksbank conducts a policy of flexible inflation targeting . . . with the aim of attaining an appropriate

balance between stabilising inflation around the inflation target and stabilising the real economy.' The Riksbank regularly publishes its estimates of the longer-run sustainable rates of output growth and unemployment, and its Monetary Policy Reports show how actual output and unemployment are expected to converge over time to those longer-term sustainable paths. In a paper delivered last week at Brookings, Lars Svensson noted that policymakers at the Riksbank scrutinize optimal control exercises and simple Taylor-style rules in much the same way that we do here at the Fed. Moreover, the Riksbank is by no means unique. The Bank of Canada, the Norges Bank, and the Reserve Bank of New Zealand each use similar language to describe the practice of flexible inflation targeting, and each central bank publishes estimates of the gap between actual resource utilization and its longer-run sustainable rate while noting that such estimates are uncertain and subject to revisions.

As for the Federal Reserve, information about our individual assessments of the mandate- consistent inflation rate and our longer-run projections for unemployment has been published regularly in the SEP since early 2009. Over the past year or so, the Chairman has addressed this topic in a number of highly visible speeches and congressional testimony and in his press briefings in April and June, and many of us around the table have highlighted these goals in speeches and media interviews. So I believe clarifying our longer-run goals in an FOMC meeting statement as proposed in paragraph 2 of alternative A would be seen as a helpful and only incremental step in the ongoing enhancement of our public communications.

Let me turn next to the idea of providing more-explicit, quantitative information about the Committee's reaction function as in paragraph 4 of alternative A. This is an approach I strongly support if it's coupled with an explicit numerical statement of our longer-run objectives as in paragraph 2 of alternative A. The use of such explicit, quantitative forward guidance could

be tremendously helpful in clarifying for markets and the public the connection between our economic outlook and the anticipated timing of policy firming. Absent the introduction of such conditional thresholds, I can imagine all but endless discussions in this Committee about whether to change the date for liftoff in our statement in light of ongoing changes in the economic outlook. In contrast, if we proceed to quantify the conditionality of the forward guidance, the need to specify calendar dates would diminish and perhaps disappear completely. Under a modal outlook like that of the staff, in which unemployment is declining only gradually and inflation remains below 2 percent, it seems reasonable that we would keep the funds rate targeted at its current setting until the unemployment rate drops below 7 percent. Of course, the evolution of aggregate demand would determine the timing of that outcome and hence the calendar date at which policy firming is likely to commence. For that very reason, spelling out the conditionality of our forward guidance would serve as an automatic stabilizer. Further deterioration in the outlook would cause investors to automatically push back the likely date of policy firming and thereby lead to more-accommodative financial conditions, while an unexpected strengthening in the outlook would have the converse effect.

As the staff memo indicates, such quantitative forward guidance might provide little or no stimulus if the medium-term inflation threshold were set at 2 percent. In contrast, the memo shows that a modestly higher inflation threshold of 2'' percent, coupled with an unemployment trigger of 7 percent, could provide meaningful policy stimulus by pushing back market expectations about the likely timing of policy firming. Moreover, such guidance could be helpful in clarifying that the anticipated path of policy would not necessarily shift in response to an uptick in core inflation or a transitory aggregate supply shock, at least as long as unemployment remains far above its long-run equilibrium rate. In my view, a modestly higher

rate of inflation over the medium term would be completely reasonable in the context of a policy strategy that fosters a somewhat more rapid reduction in the unemployment rate. Under such circumstances, a clear expression of the Committee's longer-run inflation goal would help ensure that inflation expectations remain firmly anchored.

Finally, I believe that the forward guidance in our meeting statement should be viewed as a complement to the SEP and not a substitute. While the SEP summarizes the individual projections of all meeting participants based on each participant's own assessment of the appropriate path of policy, our meeting statements are crafted through a consensus-building process that inevitably involves compromises among people with disparate views. Moreover, the SEP provides quantitative information about each participant's modal outlook, whereas our forward guidance is explicitly contingent on economic conditions, conveying some information about our reaction function.

By the way, I would note that some foreign central banks do produce multiple sets of projections conditioned on alternative scenarios roughly similar to the materials at the end of Tealbook, Book A. Nonetheless, including alternative scenarios in the SEP might not be appealing to everyone at this table, and in any case, such an initiative would require a substantial period of consultation and development. However, given the significant interest that I've heard expressed around the table in policy projections and adding them to the SEP, I believe my subcommittee would be more than willing to continue exploring this and potentially bring back further recommendations beyond what we circulated in August to this Committee.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I'd like to start by thanking the staff for making sure that I didn't waste another weekend in unproductive activity. [Laughter] Also, I noticed

that a number of the comments made by Vice Chairman Dudley are similar to my own, and I want to assure everyone that I did do my own work.

David Wessel observed in a Wall Street Journal article this week that 'Federal Reserve Chairman Ben Bernanke has demonstrated a straightforward approach to his job: If the Fed forecasts unemployment will be far above normal and inflation is heading below the Fed's target, then the central bank should do something'even if no tool seems potent enough to fix the economy.' I don't know how the Chairman feels about that characterization, but it pretty well describes the argument that has persuaded me so far to support QE1, QE2, and the '2013' guidance language in the August statement. I would add, however, one more factor to consider'that whatever we do should not have risks that outweigh its most optimistic positive benefit. This is the context in which I evaluated the alternative policy tools.

Turning first to the MEP and the LSAP'which I will call by their more popular names, the Twist and QE3'while I doubt that either is potent enough to fix the economy, I do think the risks are manageable. I prefer the Twist, as it is projected to have the same effect as QE3 without further increasing the size of our balance sheet. As to its efficacy, I'm pretty sure that if we're willing to buy enough of any security, we can affect its price. I'm less sure how much impact those lower rates will have on the economy. I'm especially concerned that the sectors of the economy most sensitive to long-term rates, the real estate sectors, are not responding normally. In particular, residential real estate is so burdened by the overhang of underwater homeowners, past-due mortgages, foreclosed properties, and tight credit conditions that recent declines in mortgage rates resulted in no pickup in purchase volume and only tepid refinance activity. Moreover, mortgage rates have not come down as much as they might have, because the current low-coupon securities seem to have a longer duration than existing higher-coupon

securities and there's less appetite for them. For this reason, and at the risk of causing President Lacker's head to spin around, I would wholeheartedly support Vice Chairman Dudley's suggestion that we should also consider purchasing MBS. At a minimum, we could reinvest maturing MBS into MBS rather than longer-term Treasuries and hopefully have a stronger effect on residential mortgage rates, which, in my opinion, would then strengthen the impact on the economy. This should also keep the percentage of total long-term Treasuries that we own lower than it otherwise might be. And given the evidence that the original Twist had a lesser effect on corporate rates, using the MBS could help ensure that this does impact the spread on mortgage rates. Even with minimal reaction in the mortgage market, the Board staff estimates that the lending'borrowing channel accounts for only about one-third of the projected effect on the economy, with two-thirds coming through stock market and exchange rate effects. So some benefits would be realized even given the weak mortgage market. And finally, because we've already engaged this tool, we've had some experience with it, and the market has had some experience with it. Thus, on balance, I can continue to support the use of this tool as the 'something to do' when conditions are such that we should do something.

With respect to lowering the IOER, however, I have not heard anyone argue that it would be very effective, and I think it does carry high risks of disrupting market functioning. Given the cost of FDIC insurance and the requirement to include all assets in the FDIC assessment base, I think the FDIC has already gotten our 15 basis points. And now that demand deposits have unlimited insurance coverage, in a negative-rate environment, substantial funds could flow into deposits and thus cause leverage ratios to bind. If this happens, I believe that a BONY-like charge for excess deposits could become the norm. I'll talk more about this in the next round, but banks are already reducing nondeposit funding and lowering deposit rates. I would point out

that because branches of foreign banks don't pay FDIC insurance, the effect on them is different. I understand the optics, but the differential between U.S. and foreign banks is not of our making. The only room that banks have left to offset the decline in asset yields if we lower the IOER would be to create negative rates on retail deposits through an FDIC charge. Most banks did actually charge for FDIC insurance when the insurance rate went to $0.23 after the S&L crisis' therefore, I assume that the system capacity still exists'although that did result in the Truth in Savings Act, so at least this time the banks will have to be truthful about the negative rates that they might post.

The potential for negative rates could also easily disrupt money market funds. I don't want anybody to infer that I'm a fan of money market funds, but I'm already worried about their exposure to Europe, and I believe that destabilizing them would have far more negative effects than any benefits I can see from reducing IOER. Several of you are skeptical about the willingness of banks and money market funds to deal with lower IOER. But if some markets can go to negative nominal rates and others cannot or do not, a large volume of money could move to the place where returns are not negative and change the economics there. And finally, if we lower the rate and market disruptions do develop, what would we do about it?

With regard to using explicit, quantitative guidance as a tool, I believe that this tool is likely to work much better in theory than in practice. I think the reason for this is that communication, by its very nature, is more difficult to control than an action, such as purchasing a security or changing a rate. Whatever we say is subject to evaluation, interpretation, and response by many different listeners. Many of you have spent a good part of your lives thinking about this, so the communications challenge seems simpler. But we also have to communicate with the same people who still believe that the Fed doesn't have an audit. I'm not saying that I

don't think we should discuss our preferences in speeches, testimony, and the Chairman's press conference. I just think that, however carefully phrased, asking the statement to carry the weight of this communication might be asking too much of it.

What I took from the memo is that to be effective as a monetary policy tool, communication would have to have two characteristics. First, it would have to communicate a future path for policy that is significantly different than what market participants currently expect, and second, it would have to be believed. In the memo's discussion of market reaction to the 'mid-2013' language, the text states that 'market participants generally appear to think that the Committee would raise the fed funds target before mid-2013 if necessary to prevent an increase in inflation to more than 2 percent over the subsequent couple of years, even if the unemployment rate were projected to remain well above policymakers' estimates of the longer- run equilibrium rate.' Truth be told, I thought that was exactly what we were trying to communicate in discussions about an inflation target of 2 percent. In that sense, we seem to have already communicated very well. So my first question is, how likely might we be to get broad agreement on a reaction function that is different from this? Governor Tarullo makes this point in his memo. The more specific and numerous the data points included in any communication, the more difficult it becomes to get broad agreement initially and to maintain that agreement as conditions evolve and voting composition changes. The less agreement we have, it seems to me, the less certainty markets would have about the ultimate follow-through. And we don't make our statements in a vacuum. While I believe in the independence of our actions, I firmly believe we would be wrong to take or refrain from taking any action because of the potential political reaction, but that doesn't mean that there won't be a political reaction. When there is such a reaction, I do think that the strength and tone of it could and would influence market perception

about the credibility of our statement. As an example of this, I would point to the widely held belief that blowback from QE2 makes the threshold for QE3 all the higher. I know the use of the 2013 date in the August statement is a less-than-satisfactory way of communicating, but it is now out there, and we should think very carefully about how and when we modify it and about how and when we might want to further modify whatever replaces it. Every time we change the language of the data points, we run the risk of more confusion.

Finally, before we jump straight to debating specific quantitative values, I think it's important that we make sure we're actually in agreement about frameworks, triggers, targets, and tools. Is the intent to change the 2 percent target for inflation or to clarify how it works? If we agree on the framework but not the specific values, then the option of communicating through the SEP makes sense to me. There's broad agreement on quantitative values that including those in the statement does make a stronger commitment. But the overall concept of the way we view our dual mandate needs to be well established before we start hanging values on it.

This is a time for everyone to make his or her own suggestions, so let me add mine. I think I would, once again, agree with Vice Chairman Dudley that we might ask a series of questions in the SEP phrased in the language of alternative A. For example, we define x, the inflation rate, and y, the unemployment rate, as they are outlined in alternative A, and then we ask each participant to write down his or her own preferences for x and y and publish those as part of the SEP. This would communicate the Committee's thinking in much the same way, but with perhaps richer texture than a potential 7'3 vote on individual numbers in the statement. Further, it leaves everyone free to discuss their own opinions without contradicting a statement. Also, as participants' perceptions, opinions, and forecasts change, or even as the participants

themselves change, markets would have a way to judge the Committee's likely reactions in almost real time.

I'll end where I started. The David Wessel quote and the assessment of the reaction to the 'mid-2013' language in the statement lead me to conclude that the market understands pretty well what's been going on in this room. Before we embark on a program to communicate a change, or even a refinement to that perception, we should be sure that we are broadly and fully committed to whatever change we plan to communicate, and we should create a communication framework that has flexibility to continually update markets on how our decision frameworks, targets, triggers, and forecasts are evolving. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. You're getting the lingo down really well. [Laughter] MS. DUKE. 'Credit constraint,' 'liquidity constraint''I've got those, too. CHAIRMAN BERNANKE. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I intentionally didn't draft up a statement because I knew I came toward the end and wanted to hear what others had to say. Also, I knew that if I drafted up a statement, I'd do what those of us at the end of the line always do, which is furiously scribble throughout everybody else's presentations to take account of what they've been saying. And I did want to pay attention today. So let me start with two introductory observations. One, as Richard said earlier, nothing that we've got on the table in a concrete fashion this afternoon is presenting us with a true contingency for something dramatic happening'the reemergence of really strong deflationary potential, the European crisis going hot, or even just a rapid deterioration of U.S. economic performance. And I do think it's important that we do some contingency planning along those lines, whether we call it something within the existing flexible inflation-targeting framework or some other framework. LSAPs,

obviously, could be that, but we've only really considered LSAPs in the abstract today and not in any particular fashion. A second and related observation echoes something Betsy said a moment ago, which is that even though the alternatives we're considering today for possible deployment in the relatively near term are within the current framework, it's worth paying some attention to the relationship of one potential action to another, including possibly shifting toward a different framework like nominal GDP or price targeting. With communication likely playing a more prominent role in any further stimulus efforts, and with the importance of communication for the credibility of the Committee on an ongoing basis no matter what our then-contemporary policy instincts, it's all the more important to be clear about our strategy.

With those two introductory observations, let me turn to the specifics that are on the table today. With respect to maturity extension, I absolutely agree with what everybody said. It's a limited step, and it's self-limiting in a sense because there's only so much that you can do. But Charlie Evans said something that I'm going to echo, not in precisely the way that Charlie stated it. Because I believe that anything we do in the communication realm is going to take some work'it's going to take some work through the Chairman socializing it publicly, through our working on it and figuring things out'it may be difficult in the next meeting or two at least to take any steps that some of us may be inclined to take to provide for monetary policy stimulus. And the maturity extension proposal is something that, precisely because it is self-contained, does provide us an opportunity to utilize it for that limited purpose as we prepare ourselves to either do something or at least have a framework within which we could do something with more persistence.

The only other thing I'd say is that it would be important for the efficacy of this measure that the Treasury debt program not undermine the efficacy of the MEP by shifting the duration

composition of the Treasury debt that's issued. I know that what they've been doing over the past year or year and a half has been in accordance with a plan that they had, and it wasn't opportunistic in responding to what we had done. But I don't think there's much question that to some degree, the shift in the composition of the debt that they issued did have the effect of reducing the effectiveness of our own LSAP programs.

Turning to communication, this is obviously a much bigger issue. I think it is pretty clear that we are going to need to do something'hopefully sooner rather than later'to help market actors and the public understand the implications of the mid-2013 date that we inserted in August into our statement of expectations for low rates. It's not in a strict sense necessary that whatever is done to provide clarification be part of a broader change in communication efforts'or even that it necessarily be consistent with such changes'but it would be desirable.

I also believe, as more than several of you have commented, that one way or another the SEP needs work. And I think it needs work, as John suggested, not only because it may help produce real discussion, conversation, and clarity in our deliberations, but also because it could serve as a complement to the statement and the minutes for communication and transparency purposes. I'm still genuinely undecided about the best way to proceed on the discrete issue in front of us, notwithstanding John's very persuasive take-up of some of the things I said in my heuristically intended memo of last week. It was an idea, not a proposal, and it's never quite the same thing to compare an idea with a specified proposal. So I think that before one selected between this and the reaction function approach, one would need to fully elaborate something so that you could poke holes in it as well. Having said that, and having listened to John today, I do believe it would be worth developing something specific that could be compared during the

intermeeting period with the reaction function language that is embodied in paragraphs 4 and possibly 2 of alternative A.

I don't want to rehearse everything I said in the memo last week. Just a couple more comments on the reaction function. When I was listening to Bill and Charlie and Janet'all of whom, I think, are proponents of this'I did pick up some differences, which I think we'll probably have to clarify. Charlie and Janet may not intend this, but I heard Bill to be thinking that the paragraph 4 language is more contingent in some respects than I think Janet and Charlie were projecting, so we'd surely need to clarify that. My own view is that it's going to be read closer to a rule, and the contingent element of it will probably drop some no matter what we try to do. I would also say that I heard Janet advocate inclusion of paragraph 2. And I think, Janet, if I'm not mistaken, you said you thought it was essential, actually, to have the paragraph 2 language, whereas Bill was suggesting maybe it would be better not to implicate that set of issues. That will also make a big difference in how those numbers are perceived, and so one would have to think through the consequences of both of those as well.

With respect to the forecast-based approach, like Janet, I spent some time recently'I don't know if it was over your weekend, Janet'looking at Scandinavian central banks and reading their monetary policy reports, which are, fortunately, in English, with very good grammar I might note as well. And I think this may be the starting point. The Norges Bank was my central bank of choice, having looked at a few of the alternatives. As I said in the memo, a forecast-based approach doesn't require as specific an ex ante agreement among FOMC members as a reaction function. But I think maybe even more important than that'and I think the Norges Bank experience shows this'is that because it allows us to indicate the path we expect interest rates to follow, it provides more transparency, allows for better planning by

market actors, and allows us regularly to incorporate what may become foreseeable about future developments, rather than relying on a quasi-rule with relatively fixed values. I also think, after reading the Norges Bank approach, that it's compatible with both flexible inflation targeting and price targeting. And so there's a certain suppleness to the approach that they've taken. A further advantage of it'which didn't occur to me as I was reading it this weekend but has in listening today'is its effort'it dates back at least to 1983'to deal with the recurring question of inflation targeting or targeting with a dual mandate that has consumed this Committee from time to time. What the Norges Bank does, of course, is to establish an operational target of

2.5percent, but it then sets forth the criteria for an appropriate interest rate path. By setting forth these criteria, it maintains the inflation target but also gives a lot of emphasis to output gap and other relevant performance features of the real economy. Those are transparent in the alternative paths that you see in the regular reports of the Executive Board of the Norges Bank. So I think there's a lot of potential here not only to help with transparency but also maybe to get around this issue that keeps coming up'because I'll say, Jeff, as I listened to you today, I felt as though' while you didn't mean to do this, and you certainly weren't doing it explicitly'you read the unemployment mandate out of what we do here. If we can never talk about it, and we can't suggest that it plays an active role, then I think we begin to approach the point at which it's not really having the impact on our deliberations that the Congress intended.

I equally understand why so many people are reluctant to attach a number to the

unemployment rate, and it seems to me that what's done by the Norges Bank doesn't provide a perfect answer, but it does help. It does give some clarity, and it gives some real meat to the notion that the path matters'how you're getting to the 2.5 percent matters. I also would say that Narayana mentioned duration in his introductory remarks. It does a bit of that as well, not as

specifically and as quantified as you would do, but I was interested in the fact that it begins its summary by saying, 'Based upon everything, we now''in this case''think interest rates should be rising over the next X quarters, absent unusual developments.' Of course, I'd drop a footnote here'their unemployment rate is 2.7 percent. So they're in a slightly different position.

MR. KOCHERLAKOTA. It's good to have oil, isn't it? [Laughter]

MR. TARULLO. Yes. But inflation is 1.4, which is the really remarkable thing. There are obviously disadvantages here as well. If we really did what the Norges Bank

does, or something like it, we'd have to make significant changes in our institutional practices' not only the nature of the SEP, but also consider how the Norges Bank conducts itself. As I understand it, they meet two weeks before they actually make their interest rate decisions, at which point they do the equivalent of thinking about the Tealbook projections and have a discussion of that. They must be one cohesive group, because the seven of them seem to come up with something thereafter, on the basis of which, two weeks later, they make the actual interest rate decision. And that might pose cultural or logistical challenges for us to do something like it. That's just one example of what might have to be done. So obviously, one way or another, some delay would be entailed in doing something really meaningful with the SEP. And this will convey a less precise reaction function, though again, this would assume that the reaction function is, in reality, quite firm.

The Chairman'in a question, I think, to John'asked about the delicate situation we have in that an entire group of 17 does our projections, but we only have, for right now, 5 plus 5 actually voting on interest rate policy. I guess, Mr. Chairman, I would say that I don't have a specific proposal here. But it does seem to me that both are relevant. If one is looking for

credibility, then the views and projections of the nonvoting members of the FOMC are quite relevant to providing credibility to markets at large, because even though Sandy and Jeff may not be voting now, they're going to be voting next year, or they're going to be voting the year after that. So their projections are also relevant. Thus, I might suggest a variant being two different projections if we couldn't come up with'as I suspect we couldn't'the consensus adoption (with modification) of the staff analysis that the Norges Bank seems to do.

Oh, one final point. I'm sorry. This is what happens with notes. Going back to the maturity extension point, I think John first mentioned today the idea of using MBS again, and then Bill and Janet spoke to it, and Betsy endorsed it as well. And I would weigh in there. I know that the earlier concern was that this looks like credit allocation, although I feel a little boxed in here: People don't want to do Treasury purchases because it looks like debt monetization; they don't want to do MBS purchases because it looks like credit allocation. If you conclude that you want to do purchases, you've got to purchase something. And it does seem, right now, for the reasons that Betsy and Bill identified, that we really could have more of an effect. As I'll mention later today or early tomorrow, since I think housing is right at the center of what is keeping us in this slog right now, anything that can be done to affect housing markets, even indirectly, would have a higher payoff. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you.

MR. LACKER. Mr. Chairman?

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. If I may respond to the good Governor Tarullo. The reason I keep mentioning our triple mandate is to note that we have read out the objective of moderate long- term interest rates precisely because the best contribution we can make to moderate long-term

interest rates is to keep the inflation rate low. That's despite the fact that the opposite is true in the short run'that we can, in the short run, raise interest rates by raising short-term interest rates to reduce inflation. So exactly the same logical relationship between moderate long-term interest rates and inflation exists with respect to unemployment and inflation'namely, fighting inflation may not reduce unemployment in the short run, but in the long run, we all recognize it would be our best contribution. The Congress can put anything they want in a mandate. It's up to us to construe it. They can ask us to pursue maximizing the postseason performance of the Boston Red Sox, but we'd have to construe what that meant.

MR. TARULLO. That's true, Jeff, and I understand what you're saying, but you made a point in part based on how the world would receive a statement endorsed by all or most members of the Committee that associated a number with unemployment. I would say you can make the converse argument. If the Committee were to come out now with an inflation target that made no reference to unemployment, that would be construed in a very meaningful fashion as well; personally, I think it would be construed as the embodiment of what some people in the world advocate anyway, which is an inflation-only mandate. So you're quite right to say the first statement is going to attract an enormous amount of attention, but it goes both ways. Omitting unemployment will have just as powerful a message as including something on unemployment.

MR. LACKER. I could just agree that there is that division. I think the division about this issue reflects different visions for how monetary policy affects inflation and unemployment. And if you think one is more accurate, you like that language; if putting inflation-only accords better with your vision of how monetary policy affects the two, you prefer that formulation; if you prefer a more symmetric approach, it's because your vision likely reflects a different view of how monetary policy interacts with the economy. I'm just reading it the way I see it.

MR. FISHER. Mr. Chairman, can I intercede here to ask Governor Raskin's views? CHAIRMAN BERNANKE. Why don't we do that first, and then we'll take the

remaining comments. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. First, here is my view regarding the efficacy of balance sheet tools. A maturity extension program, for example, can reduce duration risk, putting downward pressure on term premiums and thereby longer-term interest rates. I don't doubt that this channel works. To me, the fundamental question is not so much whether longer- term interest rates are sensitive to changes in the balance sheet, but to what degree economic activity is sensitive to changes in longer-term interest rates. I assume that when we ascertain the efficacy of policy tools tied to the balance sheet, this latter question is of primary importance. The ultimate value of balance sheet tools, after all, is whether they produce the desired effect, and only the desired effect, on economic growth, employment, and price stability.

At this point, I'm concerned that there are frictions inhibiting the transmission between longer-term interest rates and economic growth, so that determining the appropriate sizing of balance sheet actions and effectively communicating our policy decisions publicly have enhanced urgency. As I've noted before, the effectiveness of this Committee's actions has been affected adversely by the difficulty and slow pace of household balance sheet repair and restructuring. If times were normal, we would expect a smooth transmission to occur such that decreases in interest rates would encourage households to purchase houses, cars, and other consumer goods. Because of household balance sheet problems, this channel is likely severely attenuated.

Second, as we all know, there's an excess supply of housing, the elimination of which is not proving very sensitive to interest rates. In past expansions, residential construction has been

a vital component of recovery. This has not, obviously, been the case in this recovery, and I suspect that even if we could set 30-year rates at zero, we would still not see much new construction until the excess housing supply is eliminated. Third'and this is an additional factor clogging, so to speak, the transmission of low interest rates to greater economic growth' is the role played by the general lack of confidence and uncertainty plaguing households and businesses. Whether these are due to the threat posed by European sovereign debt and European banks or other sources, the lack of confidence and increase in perceived risk discourage households from undertaking substantial new spending and businesses from expanding payrolls, productive capacity, and inventory holdings, no matter how low interest rates are. Because of these factors, and there are others that we are all aware of, our monetary policy strategy has to be, it seems to me, less piecemeal and more coordinated. The challenge with balance sheet tools is that we run the risk of pushing on a string or not appropriately sizing our responses if we don't think through how we believe these clogs, or friction points, get addressed and how they constrain our need to respond going forward. I am fully aware that many, if not all, of these obstacles are not within the realm of monetary policy. But to my mind, that means it's our responsibility to clarify for others where these fixes need to happen in order to improve confidence, enhance the sensitivity of growth to interest rates, and make our policies potentially more effective.

All that said, I believe that policy tools tied to the Fed's balance sheet have been closely associated with declines in interest rates at the long end of the yield curve. And we have seen some discernible effects on things like credit conditions, confidence, relative asset prices, liquidity, and bank lending. Moreover, although I'm concerned that growth might not be as sensitive to interest rates as it has been historically, I don't think that the responsiveness is so

small as to make the policy useless. Rather, I think there is still room to bring down the longer end of the yield curve in such a way as to produce some shifts in economic growth. Just last week, shortly after mortgage rates had tumbled to the lowest levels in at least four decades, an increase in mortgage applications suggested at least some response from homebuyers.

I'll be brief on the subject of reducing IOER, except to note that while I take seriously the concerns expressed by some on the Committee regarding IOER, I wonder about the public perception of continuing to pay what is perceived as a high rate on reserves when rates on Treasury bills are close to zero. I find the perception problem among the American public exacerbated by the fact that many foreign branches currently hold unusually large reserves. Ultimately, we should gauge the effectiveness of this tool by the amount of growth it could produce as compared with our other tools and whether this amount of growth is worth pursuing in light of the probability of unintended consequences. The costs of this option, it seems to me, mostly relate to money market functioning, and those costs are worse the greater the decrease in IOER. Mitigating some of these costs is an option to not cut to zero. So if we decide not to pursue this avenue with a modest decrease in the IOER, I remain concerned with the appearance problems regarding the Committee's hesitation to use this tool.

As to the communication tools, I think they hold potential. I'm positively inclined to the proposal of providing more-explicit, quantitative information about the Committee's longer-run objective for inflation and its projection of the level to which the unemployment rate will converge over time. This will provide more-explicit, quantitative information about the Committee's reaction function and will serve to ground it with the communication regarding ''* and u*. My view is that we need to endeavor to improve public confidence'not, of course, by distorting our description of the true state of the economy, but by creating through our

communications the credible expectation that we have a series of maneuvers that will move the economy closer to the goals set in our statutory mandate. To the extent that businesses, the markets, households, and the public understand where we are heading, and assuming we can assure them we are credible, the greater will be our ability to nudge forward growth in the context of price stability. I think these communication tools are a way forward in improving mean expectations, which contribute to reductions in uncertainty and gains in confidence. As long as we can put in place words and actions that enhance their credibility, that they are in essence contracts we are establishing, to signal to economic agents that we are anticipating using other tools, as appropriate, to manage to these levels, then I would be favorably disposed. This task strikes me as exceedingly difficult, and yet the extraordinary nature of our times demands we try.

CHAIRMAN BERNANKE. Thank you. Do you have a comment, President Kocherlakota?

MR. KOCHERLAKOTA. I was going to make a very quick comment. Governor Tarullo pointed to the idea that we have to be careful about whether we're thinking about thresholds or triggers or rules when we put these numbers into the statement. In light of that, I would caution that if we do end up putting numbers in'which, as I've indicated, I'm not excited about'I think we want to be careful to choose numbers that we're not likely to change. I think there's a tendency to say we want to stick close to 2 percent not to scare people, and so we put in something like 2'' or 2'' or whatever. But you want to think down the path and consider that unemployment has remained very obdurate in the space of a great deal of stimulus. If we get to a point where our medium-term outlook for inflation is above 2'', closer to 3, and unemployment is still at 8'' or 9, what are we going to want to do? Admittedly, the way that it is crafted is all in

terms of thresholds, so it looks as though we have the flexibility, but the interpretation will matter as well.

CHAIRMAN BERNANKE. It falls to me to summarize. This was a very useful discussion, and I'm certainly glad we had a two-day meeting because'[laughter]'it's already past 2:15, and I think we would be in big trouble now. Just a couple of comments. I'm not going to try to summarize everything that was said. We will certainly''we' being mostly Bill English and his staff'be looking carefully at the transcript and trying to summarize from that.

On the balance sheet tools, I think most people preferred the maturity extension program to LSAPs at this juncture'with some notable exceptions, like President Bullard'on the grounds that we should perhaps reserve the big gun for later. However, people raised questions about the quantitative impact or the efficacy of that kind of tool, and observed that it's a one-shot tool'it can't be repeated. I think those are valid questions. I'll take the opportunity to editorialize. Some of the very small numbers on rate changes that were being cited are roughly consistent with a 25 to 50 basis point cut in the federal funds rate, which in normal times we think is a pretty significant action. I would also comment, again editorializing, that the channels of transmission are actually multifarious through many different ways in which interest rates affect asset prices and behavior. In the paper on the stock prices that President Fisher cited, the piece of research I did with Kenneth Kuttner, we found empirically that the biggest effect of interest rates on stock prices was through its effect on risk aversion and risk-taking, and we've been seeing big swings in risk-taking in asset markets. To the extent that we affect risk preferences and risk-taking, that would be one channel. But to come back to the thrust of the conversation, while not many people argued that these were positively harmful'except to the

extent that if they're ineffective, they would harm our credibility'the question that was raised was, how effective would they be?

One positive suggestion was made, which I think I'd like to just reiterate. A number of people'I think starting with the Vice Chairman'made the suggestion about reinvesting redeemed MBS back into MBS. If we did that, that would keep the MBS stock in our portfolio constant. It would not increase it, nor would it increase the size of the portfolio. But it might have the advantages, at least superficially, of addressing the increase in the spread between MBS and Treasuries and reducing the pressure on longer-term Treasury markets. I think that's an intriguing idea, and what I'd like to do is ask Brian and Bill to talk about this and, in the morning, give us your comments, if you would, about any risks or concerns you might have about that. And then, depending on how things go in the conversation tomorrow, I may ask the Committee if they see that as an improvement over alternatives. So let me just give you that fair warning.

On IOER, we had a pretty mixed view. On the one hand, people were concerned about the perception that we are subsidizing banks, especially foreign banks, and noted that cutting IOER would have at least a marginal impact on the cost of funds. On the other hand, a number of concerns were expressed about market functioning, and Seth's memo provided four or five different areas of possible concern. I'm wondering, Seth, whether you have reached the limit of human knowledge on this subject or whether looking at this a little further over the intermeeting period, for example, or the next few weeks would be useful. Tell me if that's not the case. Can we get more insight into some of these potential costs and risks?

MR. CARPENTER. Well, we can definitely do more thinking about it. I guess some of the issues are almost inherently unknowable until we get there. As in the discussions that the

Desk had with money funds and in those that President Rosengren had with money funds, you'll get potentially different answers from talking to different people. Is it primarily the cost that you are asking about?

CHAIRMAN BERNANKE. The way a lot of people put it is that there are unknowable impacts on market functioning, including money market mutual funds, bank deposits and interest on deposits, federal funds market, and so on. I don't know whether more progress can be made on this question or not, but perhaps you could give it some thought.

MR. CARPENTER. Yes. Let us think about it and then get back to you. CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. Just one idea that people have batted around, which I'm not sure is a good idea, but people have talked about an alternative of going slowly to a lower IOER to see what happens? Because I'm not sure it's a good idea, I'm not really supporting it. That's something that I don't think the staff has really looked at in detail. For example, an alternative is that you move it to 20 and you see what happens. And if nothing bad happens' [laughter]'you keep going.

CHAIRMAN BERNANKE. It's like, you drive the truck onto the bridge, and you' VICE CHAIRMAN DUDLEY. You walk onto the ice pond.

CHAIRMAN BERNANKE. I see. [Laughter]

MR. CARPENTER. After today's meeting wraps up, we'll have some discussion and get back to you tomorrow morning with our thoughts.

CHAIRMAN BERNANKE. Give us some sense of what further progress you think can be made.

We had the deepest and most interesting discussion on the communications issues. Clearly, there's a lot of interest around the table in increasing our transparency, establishing more information about our objectives, and giving more information about our reaction function. And in particular, we have the problem, or opportunity if you wish, to clarify the guidance that we gave at the last meeting. I think this is something that should remain very firmly on the table in the sense of something we should continue to work at closely. A lot of people suggested making more use of the SEP, the Summary of Economic Projections, and that's something we should certainly talk about. For example, the view was expressed that the subtle distinctions between an inflation target and the long-run unemployment rate could not be adequately expressed in a statement and needed other kinds of communication like the SEP, press conferences, speeches, et cetera. And I think that's worth discussing. The possibility was also raised of asking additional questions or getting forecasts of interest rates in the SEP. I do note that'and I think this was raised by at least a couple of people'the SEP is, in the end, the aggregation of our 17 or 19 opinions. It doesn't have the imprimatur of a Committee decision, and that's a bit of a problem that we'll have to take into account. But in terms of providing information to the public, I think it is a useful direction.

Governor Tarullo noted that our discussions today didn't really address the worst-case contingencies, which a number of people have brought up. And I would say that's by design because today we were talking about tools in the context of flexible inflation targeting. I think that in a flexible inflation-targeting framework, we would try to respond to prices primarily through lender-of-last-resort activities and liquidity provision. In terms of monetary policy stimulation, there may ultimately be some limits to how much stimulus we can provide if we're going to maintain inflation at the mandate-consistent level. So that's an issue to be talked about

further. In those 'break glass' situations, I think we would want to at least discuss seriously

some of the alternative frameworks that have been discussed and proposed. Again, as I

mentioned, we'll put that on the table for discussion at the next meeting. We certainly will talk

about the kinds of situations in which we might want to take more dramatic action.

Thank you for this very useful conversation. Coffee is ready. Why don't we take

20 minutes for coffee, and we'll come back for the economic go-round.

[Coffee break]

CHAIRMAN BERNANKE. We're finally to item 3 on the agenda.

MR. PLOSSER. Moving right along.

CHAIRMAN BERNANKE. The 'Economic and Financial Situation''Larry Slifman,

Steve Kamin.

MR. SLIFMAN.3 Thank you, Mr. Chairman. I will be using this single chart. I tricked Steve, and he doesn't have any. [Laughter] In putting together the projection this round, we faced two major issues. First, although the incoming spending data over the intermeeting period were largely in line with our expectations, much of the nonspending data that influence our projection came in well short of our expectations. So the question was, how aggressively should we respond to those data in revising the projection? Second, as we noted in the Tealbook, some of our statistical models based on high-frequency data suggest that the economy may be in the process of slipping into recession. Thus, with a weaker baseline forecast, our statistical filtering models pointing to a sizable probability of recession, and downside risks looming even larger than before, we faced the question, should we build a recession into the baseline forecast? In the remainder of my remarks, I'll talk about how we reacted to the news we received over the intermeeting period and then address the issue of why we think the most likely outcome is for a continued gradual recovery of economic activity.

The upper-left panel of the exhibit shows our GDP projection. The disappointing performance recently of many labor market indicators, the dramatic worsening of consumer and business sentiment, and the sharp drop in stock prices led us to revise down our forecast of real GDP growth in the second half of 2011 to an annual rate of 2'' percent, about '' percentage point less than in our previous projection. We also lowered our projection for economic growth in the medium term, largely in response to changes in financial conditions'in particular, the lower stock market and the

3The materials used by Mr. Slifman are appended to this transcript (appendix 3).

and we are anticipating that no major advanced-economy central bank will raise rates before 2013. Notably, Japan and Switzerland have been struggling to contain the effective tightening of financial conditions caused by their soaring currencies; Japan undertook a record intervention of $57 billion to weaken the yen in early August, while Switzerland arguably went even further, setting a ceiling on the Swiss franc's value in terms of euros.

In the EMEs, by contrast, inflation continues to run fairly high and output gaps have largely closed. However, EME inflation is likely to start moving back down as food prices soften, and prospects are that monetary tightening will slow in this region as well. Several Asian central banks have already refrained from tightening in recent months, citing the heightened risk from the global slowdown, and Brazil used the same rationale to explain a 50 basis point cut in the policy rate in late August.

Throughout most of the summer, concerns about Europe and global growth principally affected the United States through their effects on domestic stock and credit markets. During the intermeeting period, however, these concerns pushed the dollar up sharply, and the projected path of the broad real dollar is now some

3 percent higher than in the August Tealbook. Largely in response, we have revised down U.S. export growth over the forecast period to about 7'' percent, on average, and the average contribution of net exports to U.S. GDP growth, at about

''percentage point, is also a little weaker. Even so, trade should continue to represent a relative bright spot for the U.S. economy, thanks to still-solid growth in the EMEs, the fact that the broad real dollar remains low by historical standards, and the roughly 3 percent annual depreciation'chiefly against the EMEs'we are projecting for the next two years. That concludes my remarks. We'll be happy to take your questions.

CHAIRMAN BERNANKE. Thank you. Questions? Vice Chairman.

VICE CHAIRMAN DUDLEY. Larry, your view on the likelihood of recession was

independent of events in Europe'at least that's how I took it. So let's say, Steve, that you're

wrong and I'm wrong; Europe does not muddle through, and we get the worst case. How does

that, then, affect the view of the U.S.?

MR. SLIFMAN. Well, we explored that in one of the alternative simulations in the

Tealbook.

VICE CHAIRMAN DUDLEY. It didn't seem negative enough to me when I read it.

[Laughter]

MR. SLIFMAN. It could be even more negative. The one thing I would point out is that the factor models that I showed on the lower left have sentiment indicators as one of the many variables in those models. So to the extent that that sentiment currently is being held down, among other things, by the situation in Europe, then that would be captured by the factor models. But I think the more general point is that we did try to think about what would happen if things got a lot worse in Europe, and as we showed in the Tealbook, that would have adverse consequences. It would throw us into a recession.

VICE CHAIRMAN DUDLEY. I think what's hard to capture is that if something bad happens in Europe, it's not just a GDP feedback loop'it's a market feedback loop. And I think back in 2008, we underestimated how powerful that can be.

MR. SLIFMAN. Steve can talk more to it, but the alternative simulation incorporates some of that.

MR. KAMIN. Yes. Our simulation involves, for Europe, a very substantial increase, for example, in corporate credit spreads and a decline in consumer confidence there that reduces output in Europe some 8 percent below baseline, which is obviously very substantial. For the United States, we have also built in an increase in credit spreads, although smaller amounts, as well as some confidence effects, leading to a decline just in the level of GDP below baseline in the neighborhood of 4 or 5 percent. Now that, I will say, is probably the biggest negative effect we have ever built into an internationally based simulation in the Tealbook. But we can go further. [Laughter]

CHAIRMAN BERNANKE. Thank you. Other questions? President Fisher.

MR. FISHER. Real quickly, Steve. Also on the negative potential side'Turkey, Brazil, and China'our staff work indicates that there's substantial overheating, certainly in the first

two, and at risk in the third. Banking systems are highly fragile. Have you factored that into your discouraging scenarios?

MR. KAMIN. Well, we have certainly spent a lot of time thinking about that issue, particularly for China and Brazil, which are larger trading partners with us and figure more prominently in my thinking, though we do follow Turkey as well.

In China, for some time, there have been a number of property-market-related risks, both in terms of prices having risen very high and in terms of there being very substantial lending, which puts at risk not only some borrowers, but also lenders. In particular, a lot of state and local governments in China have been using off-balance sheet vehicles to try to channel funds to developers and others. It's sometimes like a substitute for fiscal policy for them. So that represents a concern. However, it is true that over the past half-year or so, property prices in China, based on our perhaps imperfect measurements, seem to have tailed off a bit and maybe even declined. And of course, the Chinese government and the PBOC are taking a lot of steps to try to rein in the lending. It's certainly something that's very much on our radar screens, and we're very aware it. But we don't see the overheating problem getting worse, at least as far as the property market in China is concerned.

We've also been following Brazil carefully for very much the same reason. There have been very many anecdotal reports of a bubbling property market in the country. Unfortunately, we don't have as good data on housing prices there, but there's no reason to disbelieve the anecdotes. And part of the problem is that Brazil ramped up credit growth a great deal during the financial crisis and hasn't really reversed that now. So we're watching that carefully. Thus far, we haven't seen evidence of a bust of that sort, and we have seen the GDP growth and the

economy slowing. We're looking forward to that tailing off again without a meltdown. But it's something we're following.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Yes. Just to follow up on this, I think the situation in Europe is quite concerning, given the pace at which they seem to be resolving their problems. And we can talk about a meltdown or implosion of Europe, but it seems to me that one of the things that might happen is an acceleration in the massive flight to quality that we have been seeing, with the consequences being, rather than a flight out of quality of the U.S. banks, a huge inflow of cash. How would we react to that, or what would the consequences of that be, short of rapid depreciation of the euro relative to the dollar and a huge inflow of cash from European institutions into the United States? How would that play out, and what would the consequences be for us, if any?

MR. KAMIN. Well, I will say a couple of words, and then maybe my domestic colleagues can add on. In some respects, the flight to safety could be a double-edged sword in the sense that on the one hand, most negatively for the United States, it would probably appreciate the dollar very substantially, and we've already seen a little bit of that happening. And that would be adverse for our net exports and represent a contractionary force through that channel. As well, the flight to quality would probably raise credit spreads for riskier borrowers in the States, and that would be adverse. On the other hand, of course, Treasury yields would fall more, but it's not clear how much more they would have to fall, so that plus would be mitigated. And then finally, there's an issue that we're already running into with the movement of money

market funds into banks, which is that the banks themselves are hitting their capital concerns. So I'll stop there.

MR. REIFSCHNEIDER. Right. In the scenario of a very severe European recession that we had in the Tealbook, all those effects that Steve just laid out were there. You were seeing Treasury yields fall appreciably, and that helped buffer things. However, the dollar was appreciating; that made things worse. And we assumed that risk spreads on private securities were going up, which also made things worse. Going back to Vice Chairman Dudley's question, the other recession scenario we had in the Tealbook featured some of the special things that might also occur in the event that Europe crashed. The other recession scenario assumed that the economy is extremely vulnerable at the moment to any sort of kick from anywhere. It could come from abroad; it could be domestic: But with any sort of kick, things could play out much worse than the models might usually suggest, because of the strains that households are under, because of the strains that the banking system is under, because people would be looking at monetary policy and saying, 'Well, what's the FOMC going to do to buffer this? Or, looking at fiscal policy'what's the federal government going to do to buffer this?' This isn't to say that all of those things will happen, but it is our view that if you did have a big kick to the economy' say, from Europe'there's a very strong risk that the negative effects, even aside from the channels that Steve outlined, would really ramp up because the economy is more vulnerable.

CHAIRMAN BERNANKE. Other questions? [No response] Okay. Seeing no questions, we're ready for our economic go-round, and I will start with President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. I am heartened by how many members are following the Red Sox. [Laughter]

MR. TARULLO. If not by the Red Sox themselves. [Laughter]

MR. ROSENGREN. But I must say that I am disheartened that the staff probability of a recession increasingly exceeds the probability of the Red Sox winning the pennant. [Laughter]

After the last meeting I was struck by how responsive the longer-term Treasury rates were to our announcement of maintaining very low rates through the middle of 2013. It highlighted the important role that forward guidance can play as we navigate this very difficult period. Unfortunately, the continuing debate in Europe on a way forward and a string of weak economic reports in the United States caused the 10-year Treasury to fall further. For much of the past month, the 10-year Treasury has been at 2 percent or a little bit less. Similarly, the

10-year rate in Germany has been below 2 percent, and the Japanese 10-year rate has been at

1 percent. This does not seem like an environment in which market participants are focused on inflation in the United States or other developed countries. My interpretation of this is that most market participants' worry index is ordered as follows: The highest concern is about another possible financial crisis, most likely triggered by European problems; the next-highest concern is for the very weak economic and labor market data we continue to receive; and a rather distant third is inflation. My own ordering is identical.

My biggest concern is that we will have at least a serious threat of a financial crisis this fall. I have talked previously about money market funds. However, it's not only the threat of investor runs that causes money market funds to have a significant impact on our short-term credit markets; even without a rapid withdrawal of investors, the money market funds have still dramatically reallocated funds away from some European banks. This move away from risk is a perfectly rational response for a lower-credit-risk investment. However, the consequence of money market funds' withdrawal from European banks has highlighted another key weakness in short-term credit markets'the reliance of European bank branches on short-term dollar funding

for long-term dollar assets. As money market funds and other investors have shrunk as a source of short-term dollar funding, the maturity of funding has shortened significantly, and in some cases, peripheral banks have been entirely shut out of short-term wholesale funding. The wholesale funding of dollar assets with increasingly short-term funds is all too reminiscent of the SIV problem experienced in 2007.

We need to make structural changes in our short-term credit markets so that U.S. dollar markets are no longer hostage to European credit risk. Structural changes in foreign branch wholesale funding could avoid some of these problems. My preference in the longer run would be to require full subsidiarization of all U.S. operations of foreign banks. But in the absence of that, we should be considering more-restrictive supervisory and regulatory oversight of branches to prevent their funding model from being destabilizing to the U.S. economy. However, we still have significant weakness among some of our largest institutions. Bank of America and Morgan Stanley both have credit default swap rates above 300. Should significant credit rating downgrades occur in the midst of a European crisis, I am concerned about how quickly their liquidity will disappear.

We've been taking unprecedented actions with monetary policy. I would strongly advocate that we consider whether the same sense of urgency is occurring around financial stability and bank supervision. The recent announcement on providing dollar funding was quite necessary, but we need to move more quickly to make sure these types of announcements are not needed. My worries about financial stability are ultimately grounded in my concern that financial disruptions will further weaken an already fragile real economy, moving us further from our dual-mandate goals.

Between the two goals, my biggest concern is the unemployment rate. The economy has been growing below potential, and I fear that even without a European crisis, the threat of a crisis and the underlying challenges in housing, state and local governments, and the labor market have sapped the confidence of consumers and businesses. In discussions with businesses, this concern is palpable. While Boston is doing better than many other parts of the country, businesses that have been hiring report being inundated by qualified applicants, from restaurants and grocery stores to biotech firms. They report that the only labor market problem is that if they identify a key potential hire, they cannot induce him or her to move, because the worker is concerned about losing the job if the new employer's prospects dim. This is quite consistent with the very low quit rate we continue to observe.

Turning to the inflation outlook, the Tealbook foresees an inflation rate below 2 percent in the medium term. We should not be content with an inflation rate expected to underrun

2 percent when the unemployment rate is so far from full employment. The pricing of corporate and Treasury securities seems quite consistent with very low inflation persisting. Finally, if one were to use DSGE models, which I do not find as compelling as some, inflation tends to be driven by unit labor costs, which continue to surprise on the downside. With labor market costs staying so low, inflation can become a problem only if firms are rapidly increasing their markup, an event quite unlikely given the poor growth rates we have been experiencing.

We face a very volatile fall, with confidence shaken and growth anemic. We should focus our policy attention on restoring both elements of the mandate in the medium term, a topic to be discussed tomorrow. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. It's been some time since I immediately followed in the go-round my friend and colleague from Boston. I'm tempted to lead off by quoting Monty Python: 'And now for something completely different.' [Laughter]

MR. KOCHERLAKOTA. But you won't. [Laughter]

MR. LACKER. Since our last meeting, the flow of data and reports from our Fifth District contacts have confirmed the view that the economy is experiencing an extended period of slow growth, one that's more persistent than can be accounted for by the temporary factors that many of us were emphasizing just a few months back. An array of factors appears to be impeding hiring and investment. We continue to hear about the difficulty of attracting skilled workers in certain regions of our District. We also hear continuing comments about the chilling effects of U.S. regulatory policy, as well as caustic complaints about the quality of U.S. political leadership. Some contacts have been able to cite compelling examples of regulatory changes that are inhibiting economic activity. Others, however, just see uncertainty about U.S. financial and fiscal and regulatory policy as having a general broad damping effect on confidence in future economic growth and on demand for their goods and services. And so I think it's difficult to disentangle how much tangible effect these things are having. More broadly, the uncertain status of European rescue schemes and the resulting financial strains seem to be depressing spirits and weighing down U.S. equity markets and sentiment measures.

Whatever the mix of causes, the slowdown is clearly apparent in the information we've received from our District contacts. Our survey indicators have retreated broadly since early in the year, with both our manufacturing and service-sector indexes now dipping into negative territory, as have many other Reserve Bank surveys. I do not see any evidence yet, though, of an outright contraction in activity, although it's certainly a little more possible than it was several

months ago. Like the Tealbook and many other forecasters, I think the most likely outcome is for economic growth to continue at a slow pace with some modest acceleration next year. Our surveys haven't gone deeply negative, as they do when the economy contracts. And while our anecdotal reports clearly reflect a general despondence, they still include a few bright spots.

Tourism and hospitality have been strong in a number of regions, for example. Several new manufacturing operations have been announced in various places.

I think the inflation outlook is going to play, or ought to play, a critical role in our policy deliberations at this meeting. When we initiated our second LSAP program a year ago, inflation and inflation expectations were low and threatening to fall further. The situation is quite different this time around. Headline inflation has run well ahead of our implicit target since the beginning of the year. Core inflation has increased since last year, is now running around

2'' percent, and, as yet, hasn't shown any signs of abating. The current Tealbook projects an immediate decline in inflation, but I don't find the case very convincing. Every Tealbook this year has forecast a decline in inflation during 2011, and inflation has surprised on the high side every single time. The Tealbook's disinflation forecast pays homage to that old chestnut 'the considerable amount of labor market slack.' It's really hard for me to take the simple Phillips curve logic very seriously anymore, especially in light of the behavior of inflation over the past year, when inflation surprised on the high side despite quite large slack the way it's conventionally measured. As I pointed out in March, we expected considerable slack to bring inflation down in late 2003 and early 2004 following what we thought was a temporary oil price surge. Instead, core inflation ratcheted up to about 2'' percent and stayed there for several years. I think it's quite plausible to think that that's what's happening again'a relatively persistent upward movement in core inflation despite a considerable amount of labor market slack.

President Bullard's memo, by the way, contains an excellent discussion of something that's relevant here. In our standard models, the slack that is relevant for inflation dynamics and policy is the difference between current employment and the efficient level of employment'that is, the level that would prevail if all prices were flexible. This is not the same as the gap between the current unemployment rate and what's called NAIRU, which, by construction, is an estimate of the level of employment that would prevail in the absence of shocks and if all prices were flexible. As President Bullard points out, the efficient level of employment fluctuates with shocks that hit the economy, and this makes intuitive sense'that current inflation dynamics and current policy shouldn't ignore the history of shocks we've received over time that have gotten us to where we are now. Thus, the amount of labor market slack in the United States could be rather low right now, and that accords with the idea that many people have advanced, and the intuition that many people sense, that there's little monetary policy can do to increase real activity right now.

The case for declining inflation also relies on the fading of transitory factors, such as the surge in energy and commodity prices. But there are transitory factors on the other side as well that are temporarily depressing inflation. For example, the lodging component, admittedly not a biggie of the CPI, fell at an annual rate of 19 percent last month; it seems poised to rebound going forward. More notably, owners' equivalent rent has been accelerating and appears likely to contribute to higher inflation, at least compared with earlier in the year. The point here is that there will always be transitory relative price changes, and you can always find some that are about to subside and some that are about to rise.

Popular accounts of the increase in inflation since 2010 also emphasize the run-up in energy and commodity prices, which is attributed to the pressure of rising global demand in the

presence of inelastic supply. I find it hard to rule out, however, the possibility'I'm not sure how strongly to take this'that our second LSAP played some role in this, partly through the decline in the dollar as the program was beginning, but partly as commodity prices responded more quickly and sharply to the monetary stimulus than the sticky goods and services prices. This is a common feature of standard models that allow for goods and services with different amounts of stickiness built into them. It's the flexible price goods whose prices respond to monetary stimulus more rapidly and more strongly. It's also easy to imagine portfolio rebalancing, shifting funds through a chain that drives funds into commodity markets. It's certainly difficult to quantify such a decomposition at this point, but as I said, it's difficult, I think, to rule out such effects.

What about the real side? Looking back over the past year, my sense is that our last LSAP program had only a small transitory effect on real activity. For a couple of months around the turn of the year, we saw some better-than-expected data on economic growth and spending. But on net, the growth outlook for 2011 and beyond has been marked down substantially since last fall. So looking back over the past year, my reading of our last LSAP program is that it had only a negligible and fleeting effect on real activity but instead showed up mainly in the form of higher inflation. That assessment, along with the significant difference in the inflation outlook from a year ago, is going to strongly shape my thinking about policy alternatives and whether we want more monetary stimulus at this point. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Lacker. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Business conditions in the Sixth District remain in positive territory, but anxiety levels have risen. Most firms report that they expect their businesses to post gains in the second half that are marginally better than the sluggish

growth in the first half. Forward expectations have deteriorated compared with the beginning of the year, but most firms are not yet preparing for an outright decline in business activity. There are still pockets of relatively strong activity. Tourism is doing well. Auto production has rebounded nicely. Freight traffic has moderated a little but is still strong. Port contacts report that export activity remains strong, and they have seen no significant drop-off in recent months.

During the intermeeting period, we mobilized our regional network to get a grassroots perspective on the labor market. The key takeaway from this effort is that the labor market situation is complicated. Firms are resistant to add to their payrolls. As reasons, most cite a combination of soft demand, uncertainty about the course of the economy, and uncertainty over regulatory and fiscal policy. Where jobs are available, structural or structural-like impediments seem to be at work. A number of contacts describe the hard and soft skill sets of applicants as substandard. Consequently, hires are made only if and when the right candidate presents himself or herself. Some workers are finding it difficult to reset expectations about wages and personal lifestyle. Some potential hires have to be wooed away from unemployment, which is preferred to some offers of work because of extended unemployment assistance. Despite earlier evidence casting doubt, firms of various stripes continue to say that 'house lock' is inhibiting relocation, which has complicated business expansion plans and contributed to persistent unemployment to some extent. Taken together, labor markets appear to be restrained by a host of both supply-side and demand-side negatives.

During the intermeeting period, my staff also conducted a formal survey of business inflationary conditions and sentiment. We noted a very modest rise in expected inflation over the coming year compared with readings a few months ago. While firms say their pricing power remains limited, they now do not see much room to offset cost pressures by productivity-

improvement measures. The firms in our survey see rising materials costs as having the greatest potential for upward cost pressure in spite of some recent stabilization. At the same time, the survey data indicate that potential for labor cost pressure has intensified a little in recent months. Overall, shifts in business inflationary sentiment since midyear have been modest and do not yet suggest an unanchoring of business cost expectations.

Turning to the national outlook, I have not adjusted my economic growth outlook from the August meeting. My baseline for growth is essentially the same as the Tealbook baseline, which is similar to the consensus of private forecasters. However, I have been surprised by and disappointed with recent inflation data and judge the inflation trend to be near the upper end of the desired long-term range. Given the unexpected persistence of elevated headline and core inflation readings, I'm incorporating into my outlook less assurance that inflationary pressures will subside as predicted in the Tealbook base case.

As regards the assessment of risks, I see the risk to my economic growth projection as elevated and weighted to the downside'no change in that assessment from the August meeting. I would add that the risk of financial system instability did intensify in recent weeks because of the European situation. In addition, the fact that I and others have repeatedly underforecasted actual inflation, combined with what I'm hearing about the declining ability of firms to offset further cost pressures, leads me to shift inflation risk to the upside. A final comment on the balance of risks. The recent behavior of prices has deviated from earlier projections and, in my view, made the Tealbook alternative scenario 'Greater Supply-Side Damage' more compelling. It seems to me to be an entirely plausible characterization of the economic environment we now face.

I want to take one more moment to try to summarize my sense of the economic context in which we will consider a range of policy actions today and tomorrow. The economy is growing modestly and, I expect, will grow slightly faster in the near term and medium term. Revisions of earlier numbers have evoked a downshifting of growth expectations, but not a forecast of outright deterioration of the economy. I am wrestling with the recognition that our forecasts have both overestimated growth and underestimated inflation, and this introduces a degree of ambiguity that is influencing my views about policy; I'll address that in the policy go-round tomorrow. Let me conclude with one parenthetical comment. The atmosphere in which the market and public are anticipating policy and in which we are making policy has deteriorated in the sense that the recognition of slow growth and persistent unemployment has spread and intensified. Since last July, we've seen the GDP revisions, the raising of the debt ceiling'a spectacle that dominated attention'the downgrade, a volatile equity market, a worsening situation in Europe, and a bad jobs report following earlier weak reports. In my opinion, all of this has contributed to a public psychology of impending crisis. While this may color how policy decisions will be perceived, I don't believe we should give it undue emphasis in crafting this meeting's decision. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Economic conditions in both the Third District and the nation remain weaker than they were earlier in the year. Not much, though, has really changed in terms of the outlook since our last meeting. The question is why, and how long will the slowdown last? We had thought earlier this year that the weakness would largely be temporary, but it is certainly turning out to be somewhat more persistent than we thought. Perhaps more relevant is that we have been hit by more shocks since the last meeting, including

Hurricanes Irene and Lee and the increased likelihood of disorderly resolution to the sovereign debt crisis in Europe. Many forecasters have revised down their forecasts for 2011, and some also for 2012, although by a lesser amount. However, there remain a few forecasters who are at this point predicting out and out recession.

In the Third District, manufacturing activity continued to contract in September after a sharper drop in August. The August drop was undoubtedly affected by the events in Europe and the debacle over the debt ceiling debate in the United States. The September numbers were clearly influenced by the hurricanes and the subsequent severe flooding in Pennsylvania and New Jersey. Thus, I find it very difficult at this point to get a very firm reading on manufacturing performance in the District, and I remain somewhat uncertain. However, both indexes for prices paid and for prices received bounced back higher than they had been after the bad August numbers. Labor markets continue to struggle, with little progress. But there appears to be a dichotomy in the labor market. My contacts report that the job postings for lower-skilled workers are finding a plethora of applicants who are either highly qualified or overqualified, or, on the other hand, not qualified at all, while firms looking to hire a more specialized skill are having great difficulty finding qualified workers. They have many job openings, and when they do hire, they tend to hire individuals from other firms rather than out of the unemployed.

Business leaders continually report to me, much like President Lacker, uncertainty, uncertainty, uncertainty'whether it be Europe, whether it be U.S. regulatory reform, whether it be tax policy, and the list goes on and on and on. They rarely complain to me about a lack of liquidity or that interest rates are too high for them to conduct their businesses as time goes on. The real estate sector shows few signs of life, as many people note. Sentiment remains subdued in the District. However, manufacturers do expect a pickup in activity over the next six months,

and that was a rebound from what we observed in the August survey. In other sectors, activity is expected to show very slight growth in the near term, and contacts report that they are concerned about the downward trend in consumer confidence. While their outlook is still positive, it is dripping with uncertainty. National conditions are similar to those in the District. While we are seeing weak activity, 12-month inflation rates continue to accelerate. It's a quite different situation than we faced in the fall of 2010 when we resumed asset purchases. At that time, real activity was weakening and inflation was falling.

To my mind, the big risk facing the U.S. economy is the potential for a large financial market shock stemming from Europe. The issue we should be focusing on is what we should do in the event that that should occur, and I agree with President Rosengren about the importance of us doing contingency planning and thinking about the consequences of that, should that crisis arise. This seems to be a much more salient question than how we might lower longer-term interest rates 10 or 15 or 20 basis points from their already historically low levels.

I don't think it makes much sense for us to try to fine-tune the real side of the economic recovery at this point. A large shock hit the economy, and with the benchmark revisions, we know it was even larger than we thought. The Fed responded in our role as lender of last resort to try to stem the financial instability and in our monetary policy role by reducing interest rates, easing credit conditions significantly. We have provided and continue to provide a historically large amount of liquidity and monetary accommodation. Interest rates are near record lows, and we've said they'll be so for a long time. If our purpose is to provide more certainty and confidence to the markets, we can best do that by stopping trying to tweak a little to no benefit. We undermine our own credibility and perhaps even the general public's confidence in us by giving the public the impression that we react to short-term events with little clear understanding

or communication of the underlying frameworks that are guiding us. I hope we can continue to develop a clear framework for our operations in our upcoming meetings. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. The news since our last meeting has been deeply discouraging. Job growth has been dismal for four straight months, and consumer sentiment has plunged to levels I'd hoped I'd never see again. Several of my business contacts report that their businesses and bookings took a nosedive in August. These are extremely worrisome developments, especially when the recovery is so vulnerable. Since our last meeting, I trimmed my GDP growth forecast for both 2011 and 2012 by about '' percentage point each, and compared with my forecast from last November when we undertook LSAP2, I have lowered my GDP growth forecast for both 2011 and 2012 by 2 full percentage points, to put some perspective on what the outlook looks like today relative to last November.

Yet even the U.S. data look good compared with the escalating crisis in Europe. Stresses in the European financial sector continue to mount, and by several measures, such as spreads and financial sector credit default swaps and market equity ratios, those strains are now comparable to what they were in September 2008. If European leaders do not find a credible and decisive solution very soon, I fear a full-blown financial crisis could erupt, and if this transpires, the damage to our financial system and the economy could be severe. As already discussed, such a dire scenario is laid out in the Tealbook's 'Very Severe Financial Stress in Europe' alternative scenario. My staff explored other plausible scenarios with different assumptions about how the crisis could evolve, but the message is clear throughout these. A massive European financial crisis could stall the recovery and drive inflation into negative territory. My business contacts

are very worried about the potential failure of one or more large European financial institutions. In fact, they tell me they are seeking shelter from the brewing storm already and have moved cash out of European banks. In fact, one contact told me that he is reducing his exposures to U.S. banks already.

Uncertainty in U.S. financial markets has soared to one of the highest levels in 50 years, exceeded only by the recent financial crisis and the 1987 stock market crash. We face an enormous uncertainty shock that could easily tip us into a recession. Based on his research on the effects of uncertainty, Stanford's Nick Bloom predicted back in June 2008 that the U.S. would fall into a recession, and he is now making that same prediction again. My staff examined the probability of a recession using various statistical models. Looking at U.S. data alone, they found that the probability of a recession in the next 12 months is only about 20 percent according to their models, but following up on Vice Chairman Dudley's question earlier, we actually did look at how adding European data changes those predictions. We included European economic indicators in our recession prediction models, and the probability of a U.S. recession when you include the European data increases to about 35 percent. This number echoes the most recent Blue Chip survey and the Wall Street Journal survey of forecasters from last week, both of which put the odds of a U.S. recession by the end of next year at about 1 in 3.

Even if we avoid a recession, the outlook for unemployment is bleak. Now, of course, it's important to distinguish between cyclical and structural unemployment, and recently my staff took a close look at the question of whether the large increase in the number of long-term unemployed workers signals a sizable increase in structural unemployment, an issue raised by President Lacker at our last meeting. According to one theory, the pool of unemployed workers now includes several million people with intrinsically very limited employment prospects'that

is, they are structurally unemployed. For these workers, the odds of getting a job again are slim to nil. A prediction of this theory is that the job-finding rate of the long-term unemployed should have fallen to very low levels by now and be essentially zero for those who are out of work for two years or longer. However, this prediction is at odds with the microeconomic evidence. Even the long-term unemployed are currently finding jobs at a rate greater than 10 percent per month, and this job-finding rate is about the same whether a worker has been unemployed for six months or for two years. Moreover, the rate at which the long-term unemployed are finding jobs has risen this year and is now higher than it was in 2009. So this evidence suggests that a sizable share of the long-term unemployed today are out of work because of a lack of demand rather than because they are unemployable.

More generally, the preponderance of evidence indicates a structural factor explains only a portion of the rise in unemployment over the past few years. As discussed at the January meeting and confirmed by subsequent data, careful empirical analysis of labor market conditions indicates that the effective natural rate of unemployment reached between 6 and 7 percent, and that's consistent with the Tealbook's estimates. Indeed, this analysis implies that the natural rate is now declining somewhat because of the diminishing effects of extended unemployment insurance benefits.

So let me finally turn to inflation. The first half of this year, the rate of inflation rose from very low levels recorded last year. In large part, this run-up was due to a spike in commodity and other import prices and the effects of supply chain disruptions. These transitory factors have now largely played out. The downshift in the outlook for the global economy is reducing pressures on commodity prices, and domestically the weak labor market translates into a lack of wage pressures. Throughout all of the upheaval, inflation expectations have remained

remarkably well anchored. Putting this together, the inflation outlook, to me, continues to seem relatively benign, with PCE inflation at around 1'' percent next year.

In summary, the outlook has darkened yet again. The risk of a recession is uncomfortably high, and the situation in Europe has become increasingly dangerous. Inflationary pressures are receding, and overall the economic outlook is in many ways, I think, much worse than it was this past fall. But I'll comment further on that tomorrow. Thank you.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, it may surprise many at this table that, like President Rosengren, I'm more concerned now about developments on the employment front than about those on the inflation front, and I'll reverse the order of comments. Unlike President Williams, I'm going to lead off with inflation and explain my views, talk about what I hear from the CEOs and my business contacts, and then mention an issue that I think is of great importance to us but one that we often do not talk about.

I will dispense with talking about Texas'because we have a presidential candidate who talks about it too much [laughter]'except to say that the data are a little fuzzy. We had

3'' million acres burn and an enormous amount of destruction in terms of homes and agriculture, and it's difficult to decipher the August data on events that took place during what is now the hottest summer on record in the history of the United States, surpassing that in 1934 in Oklahoma during the Dust Bowl. So I won't bore you with that.

With regard to inflation, I want to correct one thing that Eric mentioned, which is a concern that I also have. If you look at the growth of wage and salary increases on a four-quarter basis, it is quite limited at 1.5 percent. If you look at total compensation, which includes benefits, it's actually risen to 2.2 percent. Despite that, all of our indicators from the trimmed

mean PCE indicate that inflation is settling in around the 2 percent range. We have seen some pressure in core goods. We've also seen some in core services'one of the previous interlocutors mentioned owners' equivalent rent and rents'but if we look at the 178 items that we carefully track, we're seeing it settle in at about a 2 percent rate. And I do believe that the headline inflation rate, as you seemingly posit, is trending more in that direction than trending the other way, such as President Lockhart mentioned.

Not unimportantly, one has to consider what is the risk of deflation, and I note in that light that the fraction of components experiencing price declines within the 178 items that we carefully track for the trimmed mean PCE has fallen to a much more normal level in the past few months'certainly more normal than it was during the deflationary scare period of 2008 to 2010. It now averages closer to 30 percent, as opposed to the 40 percent level that it was running during that period. So I can see inflation coming in around 2 percent, trending toward that from its current headline rate, which is much higher, driven by core goods and OER, but I do not yet see signs that deflation is a significant threat.

My concern is about economic growth and employment, and if you surveyed all of the CEOs that I talk to'and I should note for the record that I've added a new one, Bunge, which is a significant agricultural producer'all of them pretty much are on the same note. If you look at the key ones that I like to look at, which are telephony, semiconductors'because of the nature of our society'rail movements, logistics, and air transportation, you're pretty much hearing the same response. Things have gotten awfully tepid. Volumes have dropped off. The past three weeks, in particular, the very large telephone companies and communications companies have seen things almost grind to a halt, and when I say 'grind to a halt,' I'm talking about year-over- year growth reduced nearly to zero. You see the same thing in the rails. Year-over-year

performance for the rail industry in 2010 was up roughly 10 percent; in the first half of this year, 5 to 6'' percent; and now, it's running between 0 and 1 percent. I won't use the profanity that was repeated almost as though they had decided to collect it at the Business Roundtable with regard to the issues of what is stymieing their activity. We've heard an awful lot about regulation and uncertainty about fiscal policy. I've talked about that in previous meetings, but there's no question that there are concerns about final sales and demand.

Now, with regard to job creation, President Rosengren mentioned something that I think we should consider, and that is, he talked about more-stringent supervisory activity over foreign branches and their activity in the United States. I believe that's what you said. I want to not dwell on that subject, but I want to dwell on another aspect of supervision and regulation. Something is wrong with the transmission mechanism. I believe we have created an enormous amount of liquidity. We see it in terms of excess bank reserves, half of which are domestic banks. We see it now in the over $2 trillion in liquidity that sits on corporate balance sheets in excess of working capital needs, and as I've noted before'and actually, before he left, Governor Warsh spoke about it'there's an enormous amount of liquidity that's floating through the nondepository financial system. My concern is that we haven't figured out how to engage that. Logic tells me that community banks and regional banks play a bigger role than we typically account for at this table. If small businesses are indeed the job creators or at least the job incubators, the question is, where do they get their credit? And I'm wondering, Mr. Chairman, if we think only about monetary policy qua monetary policy and don't think about how it is transmitted into what counts most at this juncture of great economic delicacy, job creation, then all the discussions we're having about monetary policy are for naught. As I've said publicly over and over and over again because I like the analogy'I hate to bore you with it again'we

certainly have filled up the gas tanks. Whether we've filled them enough or we've filled them too much is another issue, but somehow the business creators and the business incubators are not depressing the pedal and engaging the transmission mechanism.

I would like to suggest, and those who are involved in bank supervision might correct me, that we certainly spend as much time, if not more, on how we engage that transmission mechanism, particularly with small community banks'those are the ones that lend to small businesses and local businesses'and at least oversee our supervisory and regulatory activities so that we don't discourage them from transmitting what we've created and put into place. I'm willing to bet that we spend less time thinking about that, and I hope I'm wrong, than we do about capital ratios, too-big-to-fail, and the problems with systemic risk with the large banking institutions. But I just fail to see how we're going to take the liquidity we've created'and if you all decide to create more at this meeting or whatever the decision of the Committee is'and have it more effectively transmitted into what really counts, which is job creation. I'll argue tomorrow that I think many of the activities we've undertaken actually have been counterproductive on that front, but I raise this because I don't expect anybody else to do it. I'm more concerned about it than I am about inflation, and I want to put it on the table. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. Since our August meeting, I, too, have made further downward adjustments to my outlook for growth, and I have made upward adjustments to my near-term inflation outlook. However, I think the critical issues today are not so much differences in the point forecast but rather the overall likelihood of turning points in the level of output and in the inflation rate. In simple terms, the key questions are, are we headed

into recession, and have we turned the corner toward lower inflation again? Turning points are inherently hard to judge, but the answers to these questions will have major implications for policy beyond the current meeting. Past experiences indicate that if we believe a recession is likely, then we will want to act early and aggressively. Our flexibility to act early or more aggressively in this current environment depends on the extent to which the recent acceleration in inflation numbers has been reversed. It often takes months to definitively answer questions like these, but I will offer my current thoughts on both.

Overall, I agree with the Tealbook's assessment that the most likely scenario is for the economy to make it through this period of anemic growth without a recession. This forecast is easily supportable with hard data. But with such slow growth, there are many possible shocks that could easily push us back into recession. Of course, right now, the potential for a crisis in Europe looms large as a potential recession trigger for the United States. Also, like the Tealbook, I find myself concerned about changes in business and consumer sentiment, even while the hard data continue to show slow economic growth. As the 'Recession' scenario in the Tealbook shows, shifts in business and consumer attitudes can interact to produce a recession. So what can we infer from the recent business and consumer evidence?

On the business spending side, most of the data show slow growth, while sentiment indicators are more worrisome. In my discussion with Fourth District business leaders, many reported that their output and sales had slowed, but they are projecting flat demand for their products rather than a significant pullback. In this environment, they are not yet adjusting their production plans in response to weakening sentiment. Nonetheless, the same business executives are watching developments carefully and generally report that they are poised to quickly cut back if necessary. One interesting example came from a global capital goods producer headquartered

in my District. Because there is a long lead time for the firm's orders, this capital goods producer is still very highly profitable and busy filling existing orders. But it is also starting to plan for possible cutbacks in production based on a weakening economic growth profile here and abroad. It recognizes that today's consumer spending slowdown could produce a sharp pullback on capital spending in the quarters to come unless consumer demand recovers in the next few months. Responses like this are sufficiently common to make clear that, while the economy has not entered a sharp slowdown, it may also not be far from tipping into recession.

Compared with businesses, consumers look even more cautious during most of the recovery. On the positive side, as the Tealbook notes, the data clearly show declining consumer debt burdens, but these declines could be either the result of households' decisions to borrow less or a result of banks' decisions to cut back credit to riskier customers. Economists at my Bank have been examining credit bureau files of millions of consumers with widely differing levels of debt and differing levels of credit scores. Interestingly, both low- and high-risk individuals are cutting back their use of credit, the number of open accounts, and the application for new credit. Our analysis points to an ongoing pullback on the part of consumers rather than banks. Unfortunately, the data also reveal no significant recovery in credit, even among the high-credit- score borrowers. So it appears that today's consumers are still pulling back from borrowing, although not as rapidly as they were during the recession. In the long run, this household deleveraging will benefit the economy, but obviously in the short run, further deleveraging by consumers is likely to continue to hold back the pace of GDP growth.

With the pace of recovery so sluggish, recent inflation data continue to be a worry. A key question is whether the recent upward momentum in core inflation will die out. I think it will, but I wish I could be more confident. On the one hand, I continue to see significant factors

restraining inflation in the next year or two. Among them are low employment cost growth, continued productivity growth, and weakened international demand for commodities. Yet, on the other hand, in recent months I have been seeing more pressure in my preferred measures of the underlying inflation trend'namely, the median and trimmed mean CPIs. Both are close to 2 percent on a year-over-year basis but have been up much more sharply over the past three months. This pickup in measures of underlying inflation reflects acceleration in prices of many CPI components. In fact, in the latest release, almost two-thirds of the consumers' market basket saw price increases above 3 percent in the month of August. Given the inertia in prices, I am a little skeptical that disinflation is just around the corner, but it is likely to develop. Fortunately, financial market participants appear to have shrugged off the latest CPI data. In the latest estimates from the Cleveland Fed model, there continues to be a downward shift in inflation expectations. Most notably, in inflation expectations at the policy-relevant range of three years out, two years forward, we have seen a dip to just under 1'' percent. This is, again, reason to anticipate that inflation rates will come down.

Considering all of this evidence, I think the most likely scenario is that economic growth will gradually pick up while inflation rates will remain close to 2 percent. Of course, there is enough uncertainty in the air for this outlook to shift dramatically, as it did over the summer. At this point, I see the risks to growth as primarily to the downside, and the risk of a recession is significant. While inflation risks have gotten more complicated, I think the inflation risks remain balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. After reviewing the messages from my directors and business contacts, I think the best way to characterize their commentary is that the

U.S. economy is treading water at the moment. No one I speak with disagrees with the view that the economy is largely moving sideways relative to trend growth. As of now, none see their own businesses dropping off as if the economy were in recession. Manpower Employment Services noted that its July and August business was volatile'down and then up a bit. Most of Manpower's clients are experiencing flat or, at most, small increases in revenue, and some are making contingency plans to cut back on their workforces in case the economy deteriorates. Other contacts noted similar contingency planning. One of my region's best-performing large manufacturers with a globally diversified business line described the current situation by saying, 'The ice keeps getting thinner. We expect things will be fine unless the ice breaks.' It sounds like nice theater, but here's the scary part: The company has instructed all of its units to mock up plans for a 30 percent reduction in capital expenditure spending if it finds it needs to pull the trigger. To recount the recent fundamentals succinctly, developments in Europe and Washington, weak U.S. economic data, and the associated volatility and net declines in U.S. equity markets all have had negative effects on household and business confidence. Cyclically sensitive industries, like autos, are expressing substantial concern over the drop in consumer sentiment and the potential for a falloff in demand in the fourth quarter.

In financial markets, several contacts noted how things today feel eerily as they did in 2008 before Lehman went down, and one can hardly blame them, considering the risk to financial institutions in Europe, highlighted most recently by the funding stresses faced by the French banks over the past couple of weeks. One contact noted the widely held expectation that the U.S. economy is in for a long slog but no double dip. However, they are concerned that this forecast couldn't hold up to the financial contagion that would result from further significant stresses on some big European banks. Of course, substantial progress has been made. Since

2009, U.S. banks are better capitalized and have greater liquidity cushions, and the risks from excessive leverage have fallen in some sectors. For example, our financial contacts tell us that hedge funds have been reducing leverage for some time. Consequently, the recent equity market declines did not experience any amplification effect from forced sales to meet their debt obligations. Instead, recent equity sales likely reflected greater pessimism in general about the economic situation'greater economic risk, for sure, but less leverage risk. That's what our contacts suggest.

Finally, a different parallel to 2008 is the concern over inflation pressures. Like today's situation, back in 2008, there were substantial concerns over the risks of continued higher inflation. Indeed, my directors and I, in August 2008, voted for an increase in the discount rate in order to reduce those inflationary pressures. In my opinion, that turned out not to be the right move. Inflation concerns evaporated quickly with the economic downturn and commensurate with the decline in actual inflation. Today, with the currently weak business outlook, the pass- through of earlier high materials costs into prices is waning. At this point, let me take the opportunity'President Lacker made the comment about how output gaps and resource slack in our models depend importantly not just on how you would detrend these objects but also on a comparison with the efficient flex-price equilibrium. No?

MR. LACKER. No, you don't detrend them.

MR. EVANS. No, no. Exactly. That's what I'm saying. They do not rely on detrending.

MR. LACKER. Not 'just.'

MR. EVANS. They instead rely on comparisons with the flex-price equilibrium. MR. LACKER. Right.

MR. EVANS. Okay. Right. Our DSGE model obeys that type of definition'the Woodford definition. But here's the important thing. It sounds as though we don't quite know what we're doing when we talk about resource slack. That's not right. It fundamentally comes down to, what do you think are the sources of the shocks that hit the economy? In the flex-price equilibrium, it's going to depend on whether or not you think they are technology shocks, so that in the efficient equilibrium, output is a lot lower in a potential output'or flex-price equilibrium'sense or whether you think that demand is lower, and it's not the case that potential output is lower. So if you think that the most recent downturn and impediments to growth are due to technology shocks or higher wage bargaining on the part of workers that leads to higher wages and then to a higher unemployment rate, that would in fact lead to thinking that there's not as much resource slack and there would be more inflationary pressures. But if you take the view that they are demand shocks, as our Chicago DSGE model does in fact find, then there's a lot of resource slack'indeed, there's a ton of resource slack as they continue to update that model' and inflationary pressures are lowered. Again, it's a difference of opinion on what the driving forces are for the current period.

To sum up, here's my simple view on our current macro forecasting exercises. The economy is performing pretty poorly right now. There's no meaningful difference between today's world and one that has the NBER's 'bad housekeeping seal' of being labeled as in recession. One typical response during periods of economic weakness, like we face today, is to spend a lot of time trying to figure out whether or not the economy is falling into a recession. That effort just isn't necessary at this point. Whether growth is going negative or slightly positive is not the issue. Even a continuation of modest positive growth will leave us with large resource gaps, appropriately defined, for an unacceptable period of time. I continue to agree

with the Tealbook's assessment that substantial slack will result in inflation over the medium term coming in under my interpretation of our objective'namely, 2 percent. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. Overall, economic conditions in the Eighth District have improved slightly during the intermeeting period. District employment rose somewhat during the spring. Business contacts who have daily data on sales revenue and volumes generally indicated that business remained reasonably stable during August and may have improved somewhat in the early weeks of September. However, these contacts were intensely alert to the possibility of a looming slowdown. Some businesses saw signs that the upcoming holiday season may be weaker than last year, although it may be too early to make a judgment on that. In particular, should a recession not develop, many retailers may then have to scramble to provide a sufficient level of product for the fourth quarter. Because most of us are projecting slow growth with no recession, this might be a likely outcome as we go through the fall here. Businesses associated with agriculture are generally doing quite well. Businesses associated with information technology also tend to report continuing strong sales in a rapidly changing environment. Energy-related businesses continue to prosper and sometimes report that bottlenecks or technological problems have caused shortages in some areas of the business. However, in that area, much of the strongest activity is located in Asia. Looming cost containment in the health-care sector seems to suggest that this will not be an area of job creation over the next several years, even though it has been a source of strength in the past. District real estate continues to struggle, as it does elsewhere in the country. For instance, 90-day-plus delinquencies have increased slightly in recent months.

Based on the July 29 revisions to GDP over the past several years, I think the U.S. economy is at considerably more risk of a period of prolonged slow economic growth. As markets digested this report, they tended to mark down potential growth for the U.S. going forward and revalue U.S. corporate equities downward. The 'very slow growth' view may well turn out to be the correct one, if history is any guide to the pace of recovery following severe financial crises.

On inflation, I agree with several of the comments around the table so far. I've been dismayed that during the past year, measures of production and income surprised to the downside, yet inflation surprised to the upside. As I understand the forecast last fall, we were not likely to see this much inflation, even if the economy had grown at the projected rates of 3'' to 4 percent. This is lowering my confidence that we can accurately predict likely inflation outcomes going forward. Our models may not appropriately accommodate the effects of policies we have adopted since encountering the zero lower bound in December 2008.

As many of you noted'and I'll just mention'the European sovereign debt crisis

remains an acute risk to U.S. economic growth and global growth prospects. Our likely response should that crisis become more severe is an important preoccupation for this Committee. It seems to me that this crisis has the potential to deliver a powerful macroeconomic shock to global markets in the coming months.

I want to comment for just a minute on flexible inflation targeting. I'm very encouraged to find that many on the Committee spoke highly today concerning the virtues of flexible inflation targeting. I've been an advocate of this form of inflation targeting since I joined the Committee more than three years ago. The FRB St. Louis has sponsored numerous conferences on the merits and demerits of inflation targeting over the past two decades. If the proposal on the

table is to adopt flexible inflation targeting as practiced by some of the central banks that have led the effort in this area, then I am in full support of that. In fact, I would suggest that we simply adopt most of the practices of the flexible-inflation-targeting countries wholesale. The first step in that process means adopting a specific numerical inflation target. But in addition, as has been pointed out, the Committee would have to communicate more effectively by publishing something more like a Monetary Policy Report or an Inflation Report at a quarterly frequency. The United States has been a laggard in this area. It would substantially improve U.S. monetary policy to go in this direction, in my view.

I want to make some comments on communication as a one-time tool. We've been talking about the balance sheet policy or the lowering of the interest rate on reserves as being a one-time effect. I think communication challenges also have this one-time aspect. The exercises that illustrate the effects of communicating that monetary policy will remain at the zero bound for a longer-than-expected period also have a one-time flavor to them. In the experiments, the policymaker announces, with perfect credibility, that the policy of zero rates will last longer than currently anticipated. The experiment is to then trace out the effects of this announcement, assuming no further shocks to the economy. But especially considering the time scales involved'and you're talking about years here'further shocks will undoubtedly occur in the meantime as you're waiting to get to the period of extra time at the zero bound. Real-world policy has to be able to react to current economic developments in this situation. There is little guidance offered from the literature or in the simulations of the staff as to how the policymakers should react in this situation. In particular, a positive shock would move the desired date of takeoff sooner, but the policymaker cannot move the commitment in that direction without contradicting the original purpose of extending the horizon.

I want to make a last comment here on the paper by Ravenna and Walsh. President Evans said he did not like some of the assumptions in Ravenna and Walsh. I can appreciate that. One advantage of a DSGE model is that the assumptions are laid bare for examination; then we can debate what the appropriate framework is for analyzing a particular economic phenomenon. I do not think it is a good reaction to revert to a model in which such questions cannot be asked and to claim that that is a better model from which to take policy advice. In any event, my point was in part that we have a dearth of models on which to base policy opinions that have both monetary policy in them and a serious model of unemployment. If Ravenna and Walsh is discarded, then we have zero papers on the topic. Thank you.

CHAIRMAN BERNANKE. Thank you. First Vice President George.

MS. GEORGE. Thank you, Mr. Chairman. Since the last FOMC meeting, economic activity expanded modestly while inflationary pressures eased in the Tenth District. Mining and manufacturing job gains helped push the District's unemployment rate lower. Strong export demand, particularly for food and chemical products, supported manufacturing activity and boosted factory employment almost 4 percent above year-ago levels, roughly double the national rate. More District contacts reported labor shortages for high-skilled positions, but wage pressures were muted. Robust global demand for commodities underpinned the District's economic growth. The number of active drilling rigs in the District climbed in the intermeeting period, and contacts expect additional increases in coming months with the possibility of tight global energy supplies and higher prices. Smaller-than-expected crop production, record-high agricultural exports, and historically low inventories for grains are driving agricultural commodity prices and profits higher.

The surge in farm incomes is rapidly being capitalized into District farmland values, which continue to climb at an annual rate of 20 percent. In response to the run-up in prices, land brokers tell us that the number of scheduled farm auctions has increased in recent weeks. A typical financing arrangement for a farm purchase is 20 percent cash, 50 percent debt against the purchased farm, and 30 percent debt pledged against other owned assets, which typically are another farm. We continue to watch these developments, and especially the use of leverage in these transactions, very closely.

Still, District growth has not been immune to the economic weakness. Consumer spending slowed despite solid back-to-school shopping and auto sales, and weaker demand slowed the expansion at District factories. Contacts expected the growth in consumer spending and factory activity to slow further over the next few months.

Turning to the national outlook, the data have painted a mixed picture. The quarter opened with promise compared with the first half of the year, as some of the temporary factors that weighed on economic growth have dissipated. Unfortunately, the more recent releases have been less encouraging, and financial markets are unsettled. In terms of the most likely outcome, I expect that the economy will avoid recession and growth will gradually pick up over the next few years. Monetary policy is highly accommodative, and the passage of time should help repair household balance sheets and, eventually, the housing market. But I have marked down the strength of growth over the forecast horizon, as the labor market recovery is taking longer than previously anticipated and fiscal policy will be a larger drag. Furthermore, the downside risks to the growth outlook are considerable and have increased. The sovereign debt situation in Europe is very unstable, and a full-blown financial crisis would have the potential to spill over to the United States via interconnected financial markets. Near-term solutions to problems in our

housing market remain scarce, and the recent declines in consumer sentiment are reminiscent of 2008.

The inflation picture complicates our decisions. Price pressures are broad based, and inflation recently has been above 2 percent. With a gradually rebounding economy, a depreciating dollar, and stable inflation expectations, I do not expect that inflation will decline much below 2 percent over the next few years. While slow growth poses a downside risk to inflation in the short run, higher energy and commodity prices, along with an extended period of highly accommodative monetary policy, pose upside risks to inflation over a longer horizon.

In summary, I expect the recovery to continue, with economic growth gradually picking up the pace after a weak first half while inflation remains near 2 percent. However, the risks to the growth outlook have moved higher and seem skewed to the downside, given the events in Europe. Thank you.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I heard from a variety of business contacts in the Ninth District in the intermeeting period, and I would say the dominant word is 'caution.' There is hiring going on in the Ninth District. There is cap ex going on. But neither is proceeding at a rate necessary to spur significant economic growth. And as a result, the unemployment rate has remained relatively steady in the District over the past few months, albeit at a rate much lower than that of the national average.

Nationally, my outlook has deteriorated since August but remains slightly more optimistic in the near term than the Tealbook. And certainly I would say 'slightly.' I now expect the unemployment rate to fall to just over 8'' percent by the end of next year, and I expect real GDP growth to average 2.3 percent over the two-year period from the fourth quarter of 2010

to the fourth quarter of 2012'that is, through 2011 and 2012. My forecast for inflation has firmed slightly, and I now expect core inflation to average 2 percent per year over the two-year period from the end of 2010 to the end of 2012 under what I would consider optimal monetary policy. I would say, like President Lockhart, that I was quite sympathetic to, and found appealing in terms of my own views about the economy, the scenario described as 'Greater Supply-Side Damage' in the Tealbook. That means that on the real side, I'm expecting the recovery to continue but at a painfully slow pace. On the inflation side, under the assumption of no additional accommodation at this time, the evolution of prices is consistent with our dual mandate.

Let me talk about risks. I was asked to give a talk to the senior leadership conference in Chicago. And one of the things I talked about was the need to do contingency planning'not just private contingency planning, but also public contingency planning. And let me talk about what I mean by that. My baseline forecast, as I mentioned, is that inflation will run at 2 percent over the next several years. But I do see a lot of risks to that. In particular'as I'll talk about in a few minutes'I see risks that what I'm judging to be deterioration of the supply side is actually something that's occurring on the demand side. And that's going to lead to more disinflation than what I'm anticipating.

So what's one way we can deal with that through public contingency planning? Well, I think that translates into price-level targeting. There's been some talk about generating threes now to make up for ones we had in 2010 and in 2009. I think that's a rhetorical flourish. I see those ones as being totally sunk at this point. By promising threes now, we can't make those ones into twos. But it may be useful to promise to make up for future ones'if we had a one in

2012, to make up for that with threes further down the road. That kind of promise'that's what price-level targeting is all about'could help curb disinflationary pressures.

Now, contingency planning about Europe is much more delicate. But it's important for us, and it's an urgent problem for us, to have in mind what kinds of responses we would take. And I don't think those responses would take the form of monetary policy. Mr. Chairman, you said, I believe, that it would take some form of our lender-of-last-resort function. It's important for us to be clear about what we can do and what we are prepared to do. And establishing that clarity is very challenging because you don't want to create the very risk that you're trying to control. But at the same time, I think many market participants are likely confused about what Dodd'Frank has left intact for us and what it has not and about what we can and can't do without the approval of the Secretary of the Treasury. So trying to be clear about what we can and are prepared to do in the event of severe liquidity pressures due to a European crisis could be very important. Of course, the first thing is some kind of an internal discussion.

In terms of monetary policy, as always'and as we just heard in this cross-table discussion between President Evans and President Lacker'our decisions hinge on our judgments about the quantity of slack in the economy. I do think that President Evans's dichotomy in demand and supply was a little bit sharp compared with what we can discern. Speaking for myself, I would certainly agree that the initial shock that hit the economy in 2008 was clearly a demand shock, and any model that tried to say otherwise I would be quite suspicious of. But there have been ongoing shocks from that. If you just fed that initial shock into the model, you would have expected a relatively rapid recovery from that. And here I'm talking about the usual New Keynesian models. I think a series of ongoing shocks that we certainly aren't fully on top of has been hitting what's going on in the labor market.

What's important here is that in a lot of the models we write down, labor is just not as dynamic a decision as it is in real life. When firms hire workers, first of all, they don't think about that individual worker. They think about how it's going to affect a group of workers, and they think about that as being something that's going to be lasting over a longer period of time. Once you admit that possibility, you can start to think about taxes, regulation, and firing costs. When you talk to firms, they say that they learned how big firing costs were in 2008 and they do not want to go through firing again, so they're very reluctant to hire. Regarding mismatch, there's labor-biased technological change that has gone on over the past two years as well as a variety of forms of uncertainty, some of which are on the demand side, certainly, and some of which are on the real side. All of this is to say not that the supply-side shocks are clearly what are going on, but that it is much more confusing than simply saying that it's clearly a demand- side disturbance. That's why I've been pushing in past meetings, and continue to push, the idea that looking at inflation data, the behavior of inflation, is what helps us sort out across these things. And the increase in inflation since the end of 2010 is disturbing on that and points to more support for this 'Greater Supply-Side Damage' hypothesis than one would like.

I'll close by pointing out that by some measures, there's not that much slack in the

economy. I thought it was interesting to compare measures of slack now with those in mid-2004, during what was then considered a jobless recovery. I think we have a better perspective on what that can look like now. Capacity utilization right now is essentially the same as it was in June 2004; I'm talking about overall capacity utilization. The fraction of the labor force that has been unemployed for less than 15 weeks is only slightly higher now than it was in June 2004. And just as in 2011, the data available on PCE core inflation in mid-2004 showed a sharp increase to over 1'' percent. As many of you will recall, the Committee reduced accommodation

in mid-2004, whereas the Committee increased accommodation last month. Now, I've left out one huge difference in terms of measures of slack'a long-term unemployment rate, which is much higher now than it was in June 2004. So I think this comparison suggests that the Committee is currently attempting to use additional accommodation as a way to bring down the very high long-term unemployment rate. Unfortunately, I believe that it may take large amounts of inflation to reduce long-term unemployment by even a small amount. I'm not saying that that tradeoff is not a worthwhile one. It depends on your loss function, certainly. But I think if that's what we're trying to do, we should be clear to ourselves that's what we are doing, and we should be clear to ourselves that the relevant inflation costs may in fact be significant. And to return to my theme from earlier, I think we can retain our credibility only if we are also clear to the public about the potential inflationary costs involved in attempting to reduce long-term unemployment using monetary accommodation. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. As we've all, I think, noted around the table, the economic outlook continues to disappoint, with the near-term growth prospects weak and increasing downside risks to growth. At the same time, the inflation data indicate somewhat greater underlying inflation pressures at present. I'm much more worried about the former than I am about the latter.

In terms of the reasons why we don't have forward momentum, most of the reasons don't have that much to do with monetary policy. Monetary policy is a factor, but a lot of other things are going on. First, I think that the failure of Democrats and Republicans in Washington to play nice has actually been quite damaging to household and business confidence. Second, we're not getting the full benefits from lower longer-term rates in terms of refinancing because

homeowners have mortgages that are under water, and those mortgages are very difficult to refinance. High GSE fees are also an important factor. Third, as noted by many, the struggles in Europe to wrestle with the inherent contradictions of the euro-system model remain an important impediment to easier financial market conditions, and they pose the greatest downside risks to the growth outlook. Fourth, I think when the outlook does turn darker, this leads to a sharper pullback in confidence than before the financial crisis. Businesses and households that remember the dark days of 2008 and 2009 are quicker to react to indicators'for example, big declines in the equity market'that might foreshadow future weakness than they were in the past. Fifth, I hear a lot from businesses about how regulatory uncertainty is weighing on activity. I really have a lot of trouble judging how important this factor is, but clearly it's cited often, and we know what the sign is at least. It's in the negative direction. And then finally, I do think monetary policy has been a factor here because we've overstated the impetus of monetary policy to economic growth. We believe that monetary policy is more powerful in pushing the economy forward than it actually has been, and this is something that I raised in previous meetings. I think what's happening is that we're sitting here with what we believe is a very accommodative stance for a long period of time, but the accommodation is essentially wearing off in the sense that a given stance of monetary policy has less effect on financial conditions over time and the financial conditions have less effect on real economic activity over time. So you start needing increasing monetary policy accommodation to have the same impetus to economic growth.

On the inflation side, I think we do have to acknowledge that the underlying inflation rate has drifted up more than generally expected, with the core CPI now running 2 percent on a year- over-year basis, but we have to also recognize that 2 percent on the core CPI is not a really high inflation rate. We need to put that in context. I take considerably less signal from that than

developments on the activity side. First of all, some of the factors pushing up inflation are likely to prove temporary, tied to the rise in commodity prices passing through into other goods and services and the temporary supply disruption that we saw to motor vehicle production, which then fed into auto prices. Second, one of the things that is causing a rise in core inflation is the rise in rents, and it's hard to get really worried about the rise in rents as a start of an ongoing inflation problem, given that the overhang of unsold homes that's emerging from the foreclosure process continues to be very, very sizable. Third'and this is, I think, the most important thing for me'labor cost pressures remain very subdued. The average hourly earnings are 1.9 percent year over year. The employment cost index is about 2'' percent year over year, and inflation expectations are well anchored. I thought the recent GM settlement was a sign of lack of inflation pressure in the pipeline, as they basically signed for a bonus as opposed to ongoing wage increases. So I don't see much risk that the rise in core inflation will prove persistent. I'm pretty comfortable with the Tealbook forecast, which has core inflation gradually trending down over the next year or two. When precisely that happens, I don't know. If core inflation drifts up for a few more months, that wouldn't really change my mind about the longer-term outlook.

I think that, as everyone has noted, on the financial stability side, the biggest risks stem from Europe. The next few weeks, in particular, are going to be very problematic because it will take at least this long for the 17 European parliaments to enact what was agreed to on July 21, and we all have to be discouraged by how long it's taken'from July 21 to when this is actually enacted. In the meantime, no further broadening of the EFSF seems likely, which is important because we really do need that to backstop Italian and Spanish debt issuance. During this period, there's lots of scope for event risk, ranging from the Greek government not doing enough to get the blessing of the IMF and EU for further disbursements to difficulties in passing the legislation

in the parliaments of Europe. I think the Slovaks have said they're not going to pass it until everyone else has passed the legislation. If someone else takes the same posture, well, when does it actually get passed?

The intensifying funding pressures for European banks are an issue, and of course, there's the prospect of further sovereign and bank credit rating downgrades. Yesterday, for example, out of the blue, Italy was downgraded by S&P, and you certainly have to know that if there's going to be surprises on that front, they are all going to be in one direction. Last week was actually a good one among the past few weeks, but as we saw yesterday, these things can turn around on a dime. I wouldn't take any comfort from that.

In my view, in addition to the European governments demonstrating that they're willing to take the necessary steps to keep them on a sustainable fiscal path'the governments have to do the right thing'two other steps are really needed. First, there needs to be a more credible backstop for primary Italian and Spanish sovereign debt issuance. In other words, doing the right thing isn't enough. The market is going to demand your demonstrating that over a longer period of time. So you need something in the interim to get you over that gap. In my view, a credible backstop that caps debt service costs would help reassure market participants that the fiscal path was in fact sustainable. This also would be important because it would lessen jitters about the European banks, although more capital for the banks might still be needed, even with a fiscal sustainable path. The underlying problem, at least to my mind, is not bank capital but uncertainties about the long-run fiscal sustainability. You take that uncertainty away, and a lot of the bank issues become a much more manageable problem. I hope that once the parliaments approve the current set of proposals, the next step will be figuring out how to leverage the EFSF resources to create a credible backstop. The second problem is that the European leadership

needs to be clearer about how all of this is going to work over the medium term. Right now, we have the ECB buying sovereign debt, but what happens after that? A greater fiscal integration really does appear to be necessary, but there's no visibility on how that's going to come about.

In terms of the impact of all of this on the United States, I guess the good news to date, at least, is that beyond much lower bank share prices, U.S. banks have not been greatly affected. Their funding, unlike that of their European counterparts, is really holding up'we don't really see signs of any problems for the U.S. banks. And as noted by others, their capital levels and liquidity buffers are much greater than a few years ago. But I don't take a lot of comfort in that. If the EMU were really to rupture, the damage to the U.S. banks and the U.S. economy would be extraordinarily severe, almost regardless of what we do here to prepare ourselves. That's why I think the most important thing we can do is encourage the Europeans to recognize the danger and act proactively. We have been doing that in several ways. We have been encouraging the Europeans to extend the maturity of their dollar swap auctions. The 84-day operation was at least partly at our suggestion, and we've tried to make it very clear to the ECB that people in the United States are unclear about the ECB's willingness and ability to lend to European banks. So we've tried to encourage them to be more public about the capacity, the willingness, and the ability of the ECB to lend to backstop their institutions. Jean-Claude Trichet has pointed out more recently, I think, some pretty interesting numbers. The ECB currently is lending about '500 billion to European banks. The total collateral pledged to the ECB is '1'' trillion to

'2 trillion. Thus, there's plenty of capacity there, and the total collateral in the system that could be pledged to the ECB is '4 trillion to '5 trillion. So it's true that a few very unhealthy banks have run out of collateral, Greek banks and a few others, but most banks actually do have the capacity to borrow from the ECB. To remove the sense of uncertainty, at least a little bit, the

Europeans and we could point out to people that there's really not a problem with liquidity for European banks. The ECB has the capacity to provide them with liquidity in euros and in dollars.

I would not take any comfort in the fact that bilateral exposures to particular banks and countries look manageable. We always say, 'Well, how big is the U.S. exposure to Italy,' or 'How much is the U.S. exposure to German banks?' And on a bilateral basis, everything always looks pretty manageable. The 2008 experience, I think, underscores the fact that there are numerous contagion channels, and so bilateral measures of risk exposure provide really a lot of false comfort under these kinds of circumstances. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you.

MR. BULLARD. Mr. Chairman?

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Can I just ask one question of Vice Chairman Dudley? I thought the whisper on the EFSF was that, yes, they're going to expand it to '1 trillion, but they don't want to do that because it will take the pressure off the Spanish and Italian governments. Is that a reasonable assumption, or do you think that that's broken down some?

VICE CHAIRMAN DUDLEY. I'll give my answer, and then Steve can give his answer. My take on it is that getting it through the parliaments is so problematic that they don't want to add any noise to the process by talking about their need to upsize it or leverage it. I think they want to get it through the parliaments first with its expanded powers. And then once they have the expanded powers'it's like TARP in the United States. Once TARP got through, it got used for totally different things than what it was originally proposed for. [Laughter]

MR. TARULLO. Note the distinction though, Jim, in what Bill just said. There's a difference between what Bill just said and saying, 'Okay. We're going to come back and ask for another TARP now.' And I think that is a distinction in the minds of the Europeans.

VICE CHAIRMAN DUDLEY. My view is that after the parliament has passed the legislation, there may be fuller discussion about how to leverage the EFSF to maybe backstop Spanish and Italian debt, but there's a reluctance to put that on the table today because that could make it much more difficult to actually get it passed through all of these parliaments.

MR. KAMIN. If I could just add to that, I completely agree with everything you've said, including the fact that right now European leaders are focusing almost exclusively on getting the current changes to the EFSF passed. A couple of weeks ago, I had your idea in mind, and I hoped it were true, but every single European, including many ECB officials that I've talked to, has provided me with not the tiniest hint that they have in mind this expansion of the EFSF's capabilities and they're just keeping it secret. I just haven't gotten any information that would suggest that view.

CHAIRMAN BERNANKE. I can confirm that from some meetings of my own. So they're keeping the secret very, very tightly to the vest. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. The data we have received since August confirm that consumer spending is anemic. The labor market is deteriorating further, and growth in both emerging market and advanced foreign economies is slowing. We need a revival of confidence to spur recovery. Instead, pessimism has deepened among households and small businesses. Safe-haven flows have pushed Treasury yields toward historically low levels, while many other indicators of financial conditions have tightened over recent weeks. Since last March, when our meeting statement suggested that the economic recovery was on a firmer

footing, real PCE has advanced at an annual rate of only 0.4 percent, a truly glacial pace. Spending on core nondurables, a cyclical category that includes many discretionary items, has actually declined since March. Moreover, real spending on motor vehicles in August remains nearly 12 percent lower than in March, a reduction that seems consistent with cyclical factors and not just temporary supply chain disruptions.

While I still anticipate some pickup in the pace of economic growth over coming quarters, I have become increasingly concerned that the economy is near stall speed and could easily slip into recession. Indeed, commenting on the findings of the most recent Michigan survey, Richard Curtin, its longtime director, cautioned that in his view, 'a renewed downturn in consumer spending is as likely as not in the year ahead.' Curtin's assessment is substantially bleaker than that in the Tealbook, which projects real PCE growth of 2.3 percent in 2012. The survey's index of consumer expectations, which is a component of the index of leading indicators, fell in September to its lowest level since early 1980. The percentage of consumers expecting their finances to improve in the year ahead declined to 17 percent, and the fraction of households anticipating a decline in their inflation-adjusted income soared to 60 percent. These readings are the bleakest ever in the history of the Michigan survey.

The Tealbook projects that the recovery will gain some momentum in 2013. The driving force is an assumed diminution of the gloom that is now afflicting consumers and businesses. The lifting of gloom is sufficient to create a self-fulfilling prophecy of recovery, moving the economy from its current bad equilibrium to progressively better ones. As Tealbook A, puts it, 'The economy's . . . self-correcting mechanisms . . . will gain traction over the next two years, fostered by continued accommodative monetary policy.' Some other restorative mechanisms are also working to foster recovery. For example, over time, without sufficient investment, the

economy's capital stocks of housing and durable goods decline absolutely or in relation to a growing workforce or population, raising the return on such investments, and this should spur some revival in spending. Unfortunately, mechanisms of this type are exceptionally weak. The assumption that the gloom afflicting households will eventually lift seems reasonable since the degree of pessimism among households and businesses exceeds anything that appears to be warranted by such fundamentals as income, inflation, unemployment, and wealth. Most recessions are short-lived, and it seems logical that recovery from this downturn will likewise gather steam. But recessions are not all alike. Many occur when monetary policy is tightened to bring inflation down and end when the Fed puts its foot on the accelerator. Reinhart and Rogoff find that recessions following financial crises tend to be prolonged, but when they end, the impetus commonly comes from surging net exports induced by a currency depreciation. This recovery mechanism is operative to some extent, but insufficiently potent as an impetus for recovery. Fiscal policy has often been deployed in the past to get the economy going. At present, though, the scope for a fiscal response seems limited both here and abroad. Indeed, fiscal policy is projected to be a drag on economic growth in both the United States and Europe.

The fact that no meaningful policy response to continuing economic weakness has been forthcoming appears to be a further factor depressing confidence. For these reasons, I find it hard to rule out a scenario along the lines of the 'Recession' alternative simulation in the Tealbook, one in which the current malaise intensifies, triggering a further downturn, possibly followed by long-enduring weakness similar to Japan's 'lost decade' or the U.S. Great Depression. During the Depression, the loss of confidence was so deep and prolonged that it was not restored until World War II.

Among the many downside risks to the outlook, I particularly highlight the potential for a significant deterioration in financial conditions to restrict credit to the private sector. Since the August Tealbook closed, spreads on high-yield bonds have reached recession levels, CMBS spreads have similarly widened, CDS spreads on several large banking organizations have risen to levels close to those prevailing at the time of the Lehman default, and the stock prices of financial institutions have declined markedly. In addition, the trend we have been seeing of increased availability of credit and easing of terms in the SLOOS appears to have faltered, and our SCOOS survey points to a diminished appetite for risk-taking. Of course, European banks are facing significant strains in funding markets, and there is pronounced downside risk that increased stress in European financial markets will spill into our home markets.

Turning to inflation, I agree with the Tealbook forecast that inflation is poised to head downward over time as the pass-through of previous important commodity price increases is completed and production and inventories of motor vehicles are restored toward normal levels. Over time, I expect the extraordinary slack in the labor market to push wage growth and core inflation down. Financial markets appear to share this assessment, given that five-year inflation compensation has declined to about 1.6 percent, a reading identical to that registered a year ago just before we announced the inception of QE2. It's worth recalling that our Committee at that time was concerned about the risk of deflation. Board staff calculations from TIPS computed an implied probability of about 30 percent that the price level would decline by April 2015. That probability fell substantially after QE2 was announced, and it continued to decline through the spring, but it's been rising ever since and again stands around 30 percent. The implied probability of deflation has risen especially steeply since the August FOMC.

Monetary policy operates with lags, so our decisions need to be based not only on current conditions, but also on the outlook. I'd like, therefore, to conclude by comparing the outlook now and a year ago, when we launched QE2. Of course, there are various ways of performing such an exercise, but one instructive approach is to gauge the evolution of the outlook for 2012. As of October 2010, the Blue Chip consensus was that the unemployment rate would average

8.4percent in 2012, whereas the latest consensus forecast for 2012 is '' percentage point higher at 8.9 percent. Indeed, the Tealbook projection for unemployment in 2012 has been revised upward by the same amount since last October. In effect, professional forecasters and the staff each see a more sluggish pace of recovery and a higher trajectory for unemployment than they had anticipated a year ago. In contrast, the outlook for CPI inflation in 2012 is essentially unchanged. The latest Blue Chip consensus and the Tealbook forecast are each only

0.1percentage point higher than a year ago. In summary, a forward-looking perspective suggests that the likely progress toward our mandated objectives is even less satisfactory than we were expecting around the time that we initiated QE2. That deterioration in the outlook, in conjunction with downside risks that loom larger than a year ago, is a factor that inclines me toward additional monetary policy accommodation, a point that I will underscore in our policy go-round tomorrow.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. Credit metrics continue to improve, and charge- offs continue to drop. With the exception of residential real estate and construction loans, credit quality is now back to historic norms, indicating that the credit healing cycle is maturing.

In the last round, a number of you discussed the apparent preference of banks for cash over lending. I reject this notion, and I would further caution that if we could somehow through

monetary policy force banks to make loans to someone, anyone who was willing to borrow the money, then we would not likely be happy with the loans that they found to make. But I will agree with President Fisher that there are likely some adjustments that need to be made to our supervisory policy that would make it easier for community banks, in particular, to go back to lending to the small businesses that are in their communities. Governor Raskin and I are working through a subcommittee of the supervision committee here at the Board, and I would urge all of you to also work with your Community Depository Institutions Advisory Council for information on how we can do this.

But all of the work on supervisory matters won't offset the lack of loan demand. Every banker that I've spoken with right now cites their number one problem as nearly nonexistent demand for new loans, even as loan runoff accelerates. Problem loans are being sold off, charged off, and paid off. Banks have exited some business lines, and runoff in those lines is no longer being replaced. And what recent loan growth has been experienced has been in areas such as auto, where turnover is rapid. So portfolios are shrinking even as new production is too weak to offset the runoff. Those banks that are expanding loans admit that much of their growth comes from refinancing loans off the books of other banks, and as competition heats up, they find a need to watch out for their back door'that is, existing loans going to competitors'as well as to compete to bring new loans into the front door.

Almost every bank noted continued strong deposit growth, but deposits are a mixed blessing, as the need to invest funds from deposit growth adds to the pressure to find productive assets for the investment of funds from loan runoff and maturing securities. Right now, asset' liability management strategies seem focused on running down nondeposit liabilities and buying securities, primarily agency MBS. Interest margins are shrinking, and the potential for CD

rollovers to continue to lower interest cost is diminishing. On the positive side, the abundant liquidity has created a ready appetite for portfolios and businesses being shed by foreign banks. U.S. banks have snapped up businesses offered by RBC, HSBC, and ING and the CRE portfolios divested by the Irish banks. On the negative side, most banks are steadily working to reduce their expenses to offset weaker income. Expense reduction is taking the form of closing branches, reducing head counts, exiting products, and, in some cases, selling businesses.

The area where reduced capacity is the most stunning and the most worrisome to me is mortgage origination. The mortgage servicing business has become quite concentrated and is now faced with a number of challenges, such as the treatment of mortgage servicing rights in Basel III capital requirements, as yet unknown servicing standards, litigation risk, and subpar returns as the cost of servicing past-due loans continues to climb. Much of the profit in loan origination comes from the sale of servicing rights. So as the attractiveness of servicing declines, the servicers are less inclined to buy the production of others. Then the wider network of brokers and correspondent bank originators is finding fewer places to sell production, and they, in turn, are reluctant to maintain or add to capacity. And as capacity declines, originators use price to control the flow of volume, which might explain in part why the response to lower rates is less than might be expected.

Capital does not seem to be a problem for most banks, as asset quality improves, earnings turn positive, and balance sheet growth is sluggish to negative. But the drop in market cap as the financial sector has gone distinctly out of favor with investors is stunning. Our forecast of weak economic growth translates into even weaker loan and revenue growth for the banks. So it's hard to formulate a story about positive upside potential for bank investors, and the potential for downside surprises remains high. Even banks with limited exposure to Europe or mortgage

litigation will have trouble attracting investor interest. Three years ago, we worried about the financial system collapsing as a result of poor liquidity and steep losses on assets. Now, it seems more likely to gradually but steadily shrink down to wherever capital and expenses match revenue and asset generation prospects.

All in all, the outlook for banking is no longer scary, but it's certainly gloomy. However, to end on a more positive note, banks have the capital, the liquidity, and, importantly, the profit incentive to lend whenever demand picks up. Businesses, in general, have cash, cash flow, and credit availability to expand should confidence return or sales prospects look brighter. And households, notwithstanding the remaining problems with mortgages and home prices, appear to be under much less financial strain, as evidenced by low delinquency on other consumer debt and quite reasonable debt-to-income ratios. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. As I read the Tealbook last week, I was reminded of some of the wisdom of that eminent economic forecaster, Roseanne Roseannadanna [laughter], and more specifically, her repeated comment that 'it's always something'if it's not one thing, it's another.' And that's really the story that I think all of us have been facing with respect to economic growth over the past couple of years. There seems in the repeated narrative to be some problem or other, which should be temporary, and it should dissipate, and at that point growth should pick up.

As all of you know, I've had a somewhat different story over this period, thinking essentially that the baseline scenario was one of very tepid growth or a slog, as I've sometimes described it. The stories are now converging, but it's being further complicated by the fact that it's not a static story, that the changes that have taken place over the past couple of years in the

economy have changed the explanation that one can bring to bear. I think Janet alluded to this. You could have had the initial view'which was kind of my view'that we're in the Rogoff' Reinhart world, in which it was a financial-crisis-induced recession with a big change in asset values, resulting in a lot of debt work-off. And to some degree, it was going to take some time, and it was also going to take more stimulus to get the kind of kickback that you would expect in a recession. I still believe that's true, and it's true particularly with respect to housing, although as Sarah noted in her first go-round, the difficulty of the housing overhang being worked off purely through existing market mechanisms has been demonstrated. And it's been disappointing'to me, to all of us'that the political branches of government have been so alternately ineffective and uninterested in pursuing this with any great degree of attention.

At the same time, though, we have to acknowledge that there are changes, and not favorable ones, taking place in the economy. I do think that economic growth potential has declined some during this period. I am struck by the number of non-Fed economists with whom I've spoken'non-Fed economists who are not by instinct hawkishly inclined'who have made the observation that there does seem to be a reduction in growth potential. And to some degree, we would expect this based not only on the severity of the crisis, but also on the fact that if production lies fallow long enough and if at least some workers are out of the labor force long enough, their productive capacities and potential will have been diminished. I don't think, though, that that is the dominant explanation right now, particularly with respect to the labor market. John said much of what I would have said, so I won't repeat it.

With respect to difficulties in finding workers, though, and the difficulties that firms report in hiring the kinds of skilled workers they want, there is a reasonably well-documented phenomenon whereby during high-unemployment periods, firms actually take longer to hire

workers because their sense is that with all of these unemployed people out there, there must be somebody with exactly the right set of skills, and so their demands are actually higher for a lot of skilled workers. Whereas in a high-growth, low-unemployment period, the human resources mindset is, 'We're not going to get the perfect person because the perfect person already has nine job offers; therefore, we're just going to have to find somebody who's good, whom we can train, to whom we can add skills over time.' I think there may be a bit of that going on, but I've been asking staff for quite a while now if they can see any indication of localized, either on a geographic or sectoral basis, upward wage pressures, and they haven't been able to find any, and so I have none to report. I have no doubt that individual instances of such pressures do exist, but it's nothing that's coming through in any kind of statistical series that we have. Notwithstanding the Rogoff'Reinhart effect'the fact that there's surely some diminution in growth potential at least for the next few years'I think that the output gap story is still fundamentally a solid one. The question is, how much is it, and might we hit the point where structural factors are beginning to bite a little bit more quickly? Personally, I don't think we're there yet.

Because a number of people raised financial regulatory issues, let me just say a couple of things about that before I finish. And I'll separate between the big guys and the little guys, if I can do it that way. With respect to the big guys'separating between Europe and the United States, but it's, in some sense, for everyone'we have had a post-crisis reform agenda, which, in terms of development of the regulations and requirements, we're probably 50 percent, maybe a little bit more, of the way through. But in terms of the implementation, we're about 15 to

20 percent of the way through. If we were 100 percent of the way through both, I think we'd feel substantially better about European firms and somewhat better about U.S. firms, but the fact is, we're not. So the European firms have not raised the amount of capital that they needed to have.

The liquidity-coverage ratio requirements, which will do a lot to constrain overdependence upon wholesale funding, have not even been refined yet because it's not the easiest thing in the world to do that in a way that doesn't undermine a lot of operation of financial markets like the CP market, much less implement it. We're at the point now where we're getting, if not a crisis, at least a lot of stress, before we've had an opportunity to finish the post-last-crisis regulatory agenda. That raises concerns, and it gives me concern as well because banks, particularly European banks, are more vulnerable than I'd like them to be and than they should be were this agenda to have been fully implemented.

Having said that, in a period of high stress you can't generally accelerate the implementation of that reform agenda because you're essentially putting pro-cyclical demands on the financial institutions. So there's a limited amount in the short term that we can probably do to buttress the capacities of the institutions to absorb the shocks that may be coming. As Bill said, we have pushed our financial institutions, the big ones, to build capital through SCAP and through CCAR earlier this year, so they are in substantially better shape because of our concerns about potential downgrades of a few U.S. institutions. We also about a year ago pushed them to increase liquidity. If you look at the balance sheets, they are in way, way better shape than in 2007, much less 2008. But to refer to something else Bill said, if Europe implodes, all of what I've just said is not going to provide insulation from substantial effects. They would basically have to have 95 percent capital ratios in order to be fully insulated from the kind of effect that the breakup of the EMU, for example, might, if it were not properly cauterized, have on the world as a whole. I think that we in the Federal Reserve should be reinforced in our sense that we've been doing the right thing, even against some fairly strong pushback from large financial

institutions, on capital in particular, but we shouldn't believe that because of that, there's going to be some insulation if something truly cataclysmic happens in Europe.

On the smaller banks, Richard, I just refer to what Betsy said. It's largely a demand story for some of the same reasons big companies are sitting on so much cash. It's part self-insurance, but it's part just a lack of opportunity for projects into which they can put the cash. Having said that, though, I think you and your colleagues are actually in a better position than Betsy, Sarah, and I are to make the more granular assessment as to whether some supervisory practice at the community bank level is inadvertently giving the wrong kinds of messages, because there are hundreds, thousands of small banks being examined'I guess about a thousand, actually, by us' and we don't get the kind of detail and information about those routinely here, much less review it, that we do for the large institutions. So if you and your colleagues, working with Betsy and Sarah's subcommittee, have some ways to generalize that, that would be great. My suspicion is, though, this is going to be on the margin as well. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The good news is that the economy has not fallen off a cliff despite the confidence shock that was precipitated by the debt ceiling impasse, the downgrade of the U.S. sovereign rating, the worsening of the debt crisis in Europe, and financial market volatility that has occurred since the time of the August meeting. We have staggered through August without a financial collapse. That said, to me we look stuck. The recent unemployment report shows an economy with little momentum. Payrolls were flat in August, the workweek fell, and aggregate hours worked in the private sector have declined over the past few months.

Businesses are likely holding back on hiring because they are unsure when their

customers will fully return. Meanwhile, consumers are still coping with the sharp loss of wage growth and wealth, driven now by a triple whammy: low rates of disposable income growth, drops in home equity, and, now, hits in terms of volatility in the stock market. Consumers are also coping with an uncertain future. Indeed, discretionary consumer spending, a category that excludes housing, food, and health care and includes things like restaurant meals, entertainment, education, and most durable goods, is still down 1.2 percent more than three years after the business cycle peak. Going back decades, such spending has never remained weak for that long. Moreover, consumer spending is showing no signs of returning to the growth rates we saw during the recoveries of the 1980s and 1990s. In this environment, it seems quite likely that both firms and households will be easily frightened by any new adverse economic news, be it gas prices that are remaining stubbornly high or unease about policymakers' abilities to reach consensus on important issues.

At the same time, measures of inflation seem to me to indicate stability. The 12-month change in core PCE prices is around 1'' percent. Moreover, longer-run inflation expectations from the Michigan survey continue to hover in the same range they've occupied for some time, and inflation compensation from TIPS markets has fallen recently.

It appears that the ongoing weakness in the labor market is keeping inflation in check, and that there's not much risk of an unhinging of inflationary expectations that would feed into a dangerous wage'price spiral. That said, there remains the worry that persistently high unemployment could push up the structural unemployment rate in the long run, leading to a situation where the labor market outcomes that are consistent with price stability are much less satisfactory. At present, it's my view that we're probably a long way from that occurring. To be

sure, some estimates suggest an increase in the structural unemployment rate of up to

1 percentage point, and that has already happened. But most estimates still put the structural level far below the actual level of unemployment. However, if labor market conditions don't begin to improve sometime soon, structural unemployment could rise further. In particular, the unusually high share of long-term unemployed'with the share of those unemployed for

27 weeks and longer now at 43 percent, well above the 15 percent historical average'raises concerns that workers will at some point begin to find it difficult to reenter employment as their skills decay.

The possibility that the long-term unemployed will reduce our country's future growth potential is exacerbated the longer high long-term unemployment exists. From this perspective, the long path to recovery is relevant. In most recoveries, the ratio of residential investment to GDP jumps and provides a significant impetus to the recovery, but this has certainly not happened in this recovery, and I'm hard-pressed to see how it will happen anytime soon. As a result, I expect it will be quite some time before the unemployment rate comes down in any significant way. Thank you.

CHAIRMAN BERNANKE. Thank you very much. You're certainly fully employed. [Laughter] All right. We will recommence tomorrow morning at 9:00 a.m. A reception is available on the terrace, followed by an informal dinner. No business will be done. Thank you, all.

[Meeting recessed]

September 21 Session

CHAIRMAN BERNANKE. Good morning, everybody. Let me start this morning with the summary of the economic go-round that I heard yesterday.

Participants took note of continued slow economic growth and the increased probability of recession, which was put at about one-third by some models and forecasters. The reversal of some temporary factors that held back economic growth in the first half was positive, but financial stresses related to developments in Europe, and other factors, have offset much of the expected rebound. However, some of this slowdown may reflect supply-side damage and reduced potential as well as Reinhart'Rogoff effects related to the financial crisis. Going forward, risks to the recovery continue to appear to be to the downside as growth near stall speed makes the economy more vulnerable to shocks. Inflation has not yet come down by as much as expected. Core inflation has picked up, and there is some uncertainty about whether that increase is temporary or not. Most saw inflation as likely to move toward mandate-consistent levels in the medium term, with some seeing approximately balanced risks, but others now seeing risks to the upside. It was noted that, unfortunately, growth has come in below, and inflation above, forecasts made a year ago.

Households and small businesses are very pessimistic, with consumer sentiment at historically low levels. Households expect their real incomes to fall and their financial circumstances to worsen. Consumption growth is weak, with some categories of real consumer spending having declined since the spring. The labor market has deteriorated further, with workweeks and aggregate hours worked declining. Participants debated the extent to which persistent unemployment is structural or is becoming structural. Consumer debt has declined,

reflecting more reduced propensity to borrow than a restricted supply of credit. Housing markets remain dysfunctional, and some workers face the problem of house lock.

Businesses have become more anxious in response to increased recession risks and ongoing economic and political uncertainty, including uncertainty about U.S. fiscal policy, regulatory policy, and financial developments. Business sentiment and expectations of future activity are flat to down. Most firms see limited need to hire, and some find it difficult to attract workers with the specific skills that they need, although this may reflect greater pickiness on the part of employers. Some firms have contingency plans to cut employment and investment. Export demand for manufacturers and commodity producers remains healthy despite some signs of slowing in a global economy. High material costs remain a problem for some firms. Among key sectors, commodity-related sectors such as energy, agriculture, and mining, as well as tourism and some manufacturers, are doing well. Anecdotal reports, though, from communications, high-tech, and transportation firms are consistent with slowing growth. Fiscal drag is likely to be an increasing issue in both the United States and in Europe.

Financial conditions have continued to be strained'even reminiscent of 2008 in some dimensions. European sovereign debt and banking problems have the potential to worsen significantly, with potentially serious implications for the U.S. financial system and economy. Some large U.S. banks have seen further pressure on their stock prices and CDS, showing some potential vulnerability, though they are generally stronger than their European counterparts with respect to capital and liquidity. Money market mutual funds and other lenders are putting pressure on the dollar funding of European banks, which have a dangerous mismatch of short- term funding and long-term assets. More supervisory attention is needed in the U.S., both for financial stability purposes and to help unclog the monetary transmission mechanism. For most

U.S. banks, credit quality has continued to improve and banks are generally willing to lend. However, loan demand is perceived to be weak, and mortgage servicing is becoming unprofitable.

Some see inflation as likely to moderate from its current above-target levels, reflecting greater stability in commodity prices and a reversal of some factors affecting core inflation. Wages and salaries are growing slowly, although benefits are rising somewhat faster, and unit labor costs are flat. Inflation expectations remain well anchored, and measures of underlying inflation, such as trimmed mean inflation, remain around 2 percent. On the other hand, inflation has not yet fallen to the extent expected, reflecting the continued effects of high commodity prices, higher shelter costs, and perhaps some stickiness in core inflation. Uncertainty about the future course of inflation remains significant, given our inability to predict commodity prices and the difficulty of assessing slack, expectations, and other fundamental determinants of the inflation rate.

A number of people commented on the difficulty of assessing the effect of policy given, in particular, that some normal channels of transmission appear to be broken.

That is my summary. First, any comments or reactions? [No response] Let me now ask, as I have been doing this for quite a while, is this still helpful?

MR. FISHER. Yes.

VICE CHAIRMAN DUDLEY. Very much so.

CHAIRMAN BERNANKE. Okay. Good. Well, I'll continue to do it. It is good for me. It forces me to think about what everybody is saying. So my naptime was definitely constrained.

Let me just make a few comments of my own, building very much on the comments that we heard around the table. I don't have a great deal new to say. I think the most important

development over the summer is that financial instability looks to be rearing its ugly head once again. We are not yet, of course, at the level of 2008, but some of the same adverse feedback loop between the economy and financial conditions looks to be in operation. Others have discussed the European situation at some length already. Like others, my presumption has been that the European leaders will do whatever is necessary to preserve the euro and, more broadly, the European project. Even for Germany, which has in some sense the most to lose in terms of transfers and bailouts, the benefits of the euro, the single market, and close political cooperation have always seemed to me to significantly outweigh the direct fiscal costs of saving Europe. That has been my view until now. I have been following, though, very closely developments in Europe, and as I mentioned, I had the opportunity to attend two extended meetings last week, one at the G-7 and one in Basel, and I have become more concerned about the ability of Europeans to manage this. Their political and coordination problems are extraordinarily difficult, and I can only say'and I know this will be in the transcript in five years'but I think there is some lack of imagination in the policymaking that is going on now. There seems to be a very myopic focus now on getting the July 21 agreements ratified, which is in itself a difficult political task, but I think everybody recognizes that the July 21 agreements, particularly the size of the EFSF, will not be sufficient. Meanwhile, time is growing short. The Greek situation is becoming worse.

There is a focus on financial conditions, but the European macroeconomy is also slowing. On the one hand, they have had'even more so than we do'the stress from financial conditions, tightening credit conditions, falling stock prices, weaker banks, and so on. But they are also very much in the mode of monetary and fiscal tightness; whatever view you might have about the longer term, in the short term, it seems likely to be a negative for their cyclical recovery. It

seems clear that persuading taxpayers to approve transfers will be harder if unemployment is higher than if it is lower. On the politics, Jean-Claude Trichet has, on a number of occasions, drawn the comparison to the U.S. House vote on the TARP. Recall that there was a failed vote, the stock market expressed its displeasure, and the Congress went back and narrowly passed the TARP. He takes that as a point of argument, that Europe eventually will see the necessity of taking action and will do so, which may be true, but I reminded him that when this happened Lehman had already failed, and we already were seeing some of the implications of that for the financial system. Moreover, of course, the U.S. House is one house and one country, and in Europe we are dealing with 17 countries and a complex political environment.

Where we are is reminiscent of Henry Kissinger's comment that there is nobody to call in Europe. The only real effective Pan-European institution is the ECB, which has been doing, I think, on the whole, a pretty good job. It certainly has been helping to assure the short-term funding for banks, and Trichet himself has done a lot to try to develop a consensus in Europe and to keep reminding leaders of the importance of avoiding a financial calamity. In that respect, the fact that Trichet is retiring at the end of October is probably not a good thing. Mario Draghi is a very capable individual, but his influence and his room for operation will be no doubt more restricted than Trichet's was, if for no other reason than he is Italian and will have to demonstrate that he is comfortable with the German perspective. So it is a difficult situation. Of course, we are all monitoring it. There is not a lot that we can do directly other than to try to protect our own financial system, to try to help support dollar funding in Europe, and to think about what responses we would have in case of a blowup. Now, all of that being said, I think these are situations that we have to be very attentive to. But given the low likelihood that this will be completely and entirely resolved any time soon, we have to take into account the fact that we

should expect ongoing financial stress and periodic alarms and scares even if the situation doesn't get out of control.

My own assessment is that the instability in financial markets, increase in spreads, decline in stock prices, increased stock volatility'all of those things taken together are at least one important reason why the bounceback in the second half that we were anticipating has been weaker than we had hoped. Not only have financial conditions affected household wealth and the cost of credit by increasing spreads, for example, but they have led to increased risk aversion, both in markets, I think, and in the real economy, and have affected sentiment as well. So part of the reason I think sentiment dropped so sharply in the summer was because of stock market swings that suggested that we were perhaps near a new crisis situation.

In thinking about both the economy and about monetary policy, we should take into account the fact that monetary policy is only one input into a broader array of financial conditions, which in turn affect the state of the economy. Financial conditions have deteriorated. If you look at financial conditions indexes, for example, they show considerable tightening. In thinking about the impact of our policy on the economy, the risk of inflation, and so on, we ought to take that broader financial stress into account. We also should take into account the fact that the financial stress we are seeing is not localized to the United States. It is, of course, global, and countries all over the world'suggested, for example, by Brazil's recent cut in its policy rate'are seeing slowdowns both directly through financial factors, including capital outflows now from some emerging markets, as well as from slowing export demand from the advanced economies. One of the consequences of that is that seems to make a surge in commodity prices much less likely if emerging markets are going to grow more slowly. I'd note that copper prices, for example, are now at the lowest level of the year, and the lead story in the

Financial Times this morning was about how firms are delaying their deliveries of metals because they are concerned about demand. The Dallas Fed has led the research effort in the System talking about how global conditions affect U.S. inflation. I think here is a very clear and transparent example. And, again, to the extent that financial conditions remain stressed, and that affects global growth, that in turn will feed back into commodity price pressures in the U.S. economy.

A lot has already been said about the real economy in the U.S. I do continue to be concerned that momentum is slipping away, and that we are nearing stall speed. You can take several different views of stall speed. As I have said before, I put some credence in these sorts of two-state models, which suggest that there is a tipping point. But even if you don't accept that, clearly, if you are growing very slowly, as Governor Tarullo and others noted, you are quite vulnerable to new shocks, which are always possible. The high-frequency data have been pretty weak. In the labor market, for example, we noted the very weak jobs report this most recent month, even adjusted for the strike. But beyond the weak payrolls, as Governor Raskin mentioned, average workweeks and total hours worked actually fell. UI claims have popped up again by about 30,000 or so. Expected labor market conditions in both the Michigan and Conference Board surveys have deteriorated quite significantly. So there is a sense that in the labor market conditions are worsening. In consumption, Governor Yellen talked about some of the data. Core retail sales were flat in August. Auto sales have been up, but that is presumably only a temporary adjustment. Consumer confidence measures and expectations of future financial conditions, and so on, as I and others have noted, are very much weaker. In the household and labor market sectors, I think most of the indicators are suggestive of slowing and increased risk of recession in the near term.

On the production and investment side, I think the data are somewhat more mixed. We have seen, for example, the auto recovery, and industrial production, even outside of autos, has held up reasonably well. Net exports in July were pretty strong. Orders and shipments have been reasonably strong, and we are still seeing manufacturing activity driven both by continued equipment and software investment and by exports abroad. That being said, the forward-looking and survey indicators here also are not terribly encouraging. For example, the Fed regional surveys, the ISM, and so on, have generally shown more pessimism about the future on the part of businesses. Another important indicator, architectural billings, has dropped quite sharply, which is indicative of future construction.

Putting that all together, I think that we have reason to be concerned that the financial stress we are seeing is going to, at a minimum, keep economic growth at a very slow pace. And it is difficult to see what is going to help, unless financial conditions miraculously normalize. In particular, I wouldn't expect any help from fiscal policy; fiscal drag will be increasing. And in terms of pessimism, uncertainty, et cetera, the fact that we have a presidential election year is not likely to create a lot of calm and agreement in Washington. The point is that it is difficult to see where the strength is going to come from. That being said, if the past few years have taught us anything, it is that humility in our forecasting is always in order. The economy does seem to still be growing, and a few better numbers could improve sentiment. But at this point, I think the relatively weak forecast is the right one.

I agree that inflation is too high, but I do think that it will moderate. My expectation is that commodity prices are unlikely to spike, and they will probably continue to be relatively soft. To the extent that we continue to have financial stresses, the dollar tends to benefit, which is not good for exports but is good for import prices. We discussed inflation expectations. Looking at

the breakevens, I agree that a good part of the movement in the breakevens is due to idiosyncratic factors, but there are other indicators, such inflation in swaps, the Cleveland measure and things of that sort that suggest there has been some decline in inflation expectations. In any case, even in anticipation of possible action by the Fed, there obviously has not been any upside breakout in inflation expectations. There was also an interesting discussion around the table about the Phillips curve. I don't have a lot to add except to make just one very elementary observation, which was that the original Phillips curve in 1958 was a relationship between wages, not prices, and unemployment. I think it is pretty clear we have not yet seen any upward pressure on nominal wages, although, in full honesty, I have to agree that sometimes wages are not well measured and some of the effects can be lagged. But at least through that particular mechanism, there is not a lot of indication of price pressure.

To summarize the outlook, I think the weakness of the real side is a serious concern. We have ongoing financial stresses. We need to take that into account.

Let me make a couple of final comments on the discussion about the structure of the economy. Two observations. One that was made by a number of people is that the transmission channels for monetary policy have been in some cases attenuated, weakened, clogged, however you want to put it. I would note that that argument cuts both ways. I don't think it is literally the case that monetary policy is completely ineffective. I think we can see the effects on financial markets, which in turn must be affecting wealth, confidence, and some other determinants of spending and production. To the extent that transmission is weaker, that could be used to argue for more stimulus rather than less stimulus. But it does cut both ways.

Likewise, on the arguments about structural unemployment, it is true that as slack, as conventionally defined, declines, then the scope for monetary policy to have productive effects

on real output is restricted. But remember, our story is that the increase in structural unemployment is coming, in part, because of prolonged cyclical conditions that are affecting the long-term unemployed and are affecting manufacturing capacity. In other words, there are hysteresis-type effects. To the extent that you think that those are important, that might, in fact, cut both ways. It might be an argument for being more, rather than less, aggressive in monetary policy.

Those are my remarks. I would be happy to take any questions or comments, and then we can go to the policy round. [No response] Okay. Seeing none, let me turn now to Seth Carpenter to hear about any further work that could be done on the IOER, and then maybe from Brian and Bill English on the MBS issue.

MR. ENGLISH. I am going to roll that into my briefing. I will be starting off with a couple of paragraphs on that. But maybe Seth can say a few words on the IOER.

MR. CARPENTER. You asked if we had scope to do any more work on the costs and benefits. I feel that on the benefits side, we have as much knowledge as we are going to get. The economic effects are likely small; we know the sign, but the magnitude is very small. So then I think that it is the political economy subsidy issue that policymakers obviously will have to weigh, how important that is to you.

On the cost side, though, it is possible that we could do a bit more work, by talking to banks and money funds, to try to make more precise the mechanisms where we think disruptions would be, how big they might be, and what the probabilities are. We could talk to banks; we also could talk to the Treasury to understand its constraints about the bill-auction mechanism, per se. I suspect we could do a little bit more to try to clarify the costs and get back to you with a memo. Does that seem like a reasonable plan?

CHAIRMAN BERNANKE. You know, you face the difficulty of talking to outsiders without tipping a likely move. You need to think about whether it's possible to disguise that discussion in the context of a broader set of issues about market function, for example.

MR. CARPENTER. One possibility is to use the fact that since the spring, market rates have fallen pretty significantly, and talk about that as a pattern and ask what sort of effects they have seen, and then ask them to extrapolate on that if that trend were to continue.

CHAIRMAN BERNANKE. That sounds like a useful idea. President Lacker.

MR. LACKER. I would just suggest to the staff that it might be useful to supplement that with a more microeconomically focused investigation into who holds what, and what relevant margins of substitution, for which investors, link the IOER, the market funds rate, GC collateral RP rates, and short-term Treasury rates. Obviously, there are players that can't participate in all markets. Pair-wise, you can figure out where some participate and define what those margins of substitution are. I think this would help us understand how changing IOER would pass through to six-month bill rates, for example, and other relevant borrowing rates. In addition, I think it would be broadly informative to monetary policy operations.

MR. CARPENTER. Yes. That seems exactly right. And to the extent that we are worried about disruptions, we could also think about the opposite side of the market, who the ultimate borrowers are and to what degree they would be able to substitute.

MR. LACKER. Right, exactly. Same thing on the other side.

MR. CARPENTER. Absolutely.

CHAIRMAN BERNANKE. Okay. Thank you. Bill.

MR. ENGLISH.4 I will be referring to the handout labeled 'Material for FOMC Briefing on Monetary Policy Alternatives,' which contains the policy alternatives as well as the associated draft directives. Changes in the language since the Tealbook

4The materials used by Mr. English are appended to this transcript (appendix 4).

noting that the Committee was prepared to employ its policy tools as appropriate to promote a stronger economic recovery in a context of price stability.

Market participants would be quite surprised by the combination of actions under alternative A. Longer-term yields would likely drop sharply, although the decline might be tempered if the unexpectedly large easing move boosted inflation expectations. Equity prices would probably rise, and the foreign exchange value of the dollar fall.

Alternative C, page 6, would be appropriate if the Committee believed that monetary policy actions taken over the past year had already put in place sufficient support for the economic recovery and anticipated that additional accommodation was likely to boost inflation rather than spur additional economic growth. In particular, with core inflation having trended higher since the start of the year, and headline inflation over the past 12 months well above its levels of a year ago, some participants may think that the level of potential output has declined sufficiently relative to its pre-crisis trend that additional accommodation is likely to raise inflation further and so would risk unanchoring inflation expectations. Participants also may prefer to wait for more information on the likely rebound from the economic weakness in the first half of the year before committing to additional actions.

The statement under alternative C would be quite close to that issued following the August meeting. The first paragraph would be updated to reflect the recent data; the second paragraph would recognize the downside risks to the outlook but emphasize that the Committee continues to expect growth to pick up. The final paragraph would repeat the forward guidance from August. However, the final sentence of the statement would suggest that additional policy easing was not particularly likely and that the Committee stood ready to tighten policy before mid- 2013.

The adoption of alternative C would greatly surprise investors and would likely have outsized effects in financial markets.

The draft directives for the three alternatives are presented on pages 8 through 10 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you, Bill. Any questions? President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I wanted to make a comment

about the use of the date as opposed to my suggestion yesterday of using an announcement of

expected duration of our stay at the zero lower bound. Right now, if the Committee were to stay

with the mid-2013 date, in some sense the default is reducing accommodation from that, because

you are moving closer to the time when that date is going to take place. So the default stance is

that you are reducing accommodation. That is very different from when you choose to leave the fed funds rate the same. In that case, you are not reducing accommodation, you are keeping accommodation the same. If, instead, the Committee had said in August that they expected that conditions would warrant keeping the fed funds rate exceptionally low for two years, you could leave that statement in place, roll forward six weeks, and you would have the same level of accommodation in place.

Now, I have talked offline to some of you about this, and I agree with the general sentiment that we don't want to be making too many changes at one time. I'll take that as read. But I do think that, going forward, we are going to spend a long time at the zero lower bound. It is worthwhile to make this change'away from a date to a duration'to get away from the automatic tightening that is built into this.

MR. ENGLISH. To respond to that for a second, if everything played out exactly as the Committee expected, then that duration would have to be reduced by six weeks at every meeting. Right?

MR. KOCHERLAKOTA. That's correct.

MR. ENGLISH. It's a tradeoff. In which case are you going to be changing things? MR. KOCHERLAKOTA. But that's how raising the rate usually works, Bill, right? If

you look at a usual kind of monetary policy rule, you will set the rate according to current conditions. But if you are below trend and there is mean reversion, you are expecting conditions to improve, and as they do, you raise the rate accordingly. Even if you are on your forecast path under the usual fed funds rate in normal conditions, we would be raising the rate along that path, even if things just played out according to what we expected. So that's right. I'm trying to design a system at the zero lower bound that will work the way our fed funds rate movement will

usually work. I will talk more about this in my policy statement, where I think our not using this over the past 10 months has actually had a cost.

CHAIRMAN BERNANKE. I think the one thing everybody agrees on is that the mid- 2013 language needs further elaboration. And we will continue to work on that.

MR. KOCHERLAKOTA. Right, sure.

CHAIRMAN BERNANKE. That is certainly a useful suggestion. President Fisher. MR. FISHER. I wanted to ask simply a point of information. Is it true to say inflation

has moderated since earlier in the year? On a year-over-year basis? Now, we expect it to moderate, and the rest of the sentence is correct. But is that correct? I want to check.

MR. ENGLISH. I guess what I was looking at in writing that down was things like CPI inflation. The six-month change was up around 5 percent in the spring, and it's around

3.6percent in the latest numbers. Three-month changes were up around 6 percent in the spring, and now are around 2.6. So those measures have come down. The PCE numbers look about the same.

MR. FISHER. I was looking at the 12-month for core and the trimmed mean, et cetera. CHAIRMAN BERNANKE. The 12-month numbers have not come down mechanically

because some of the deflation-like numbers are being left out.

MR. FISHER. I would just be careful about that. That's our expectation, but I don't think that statement is correct because it depends on what time interval you measure, 12 months, 6 months. I would moderate it somehow were I to support alternative B.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I was going to support that. It has the look of cherry-picking the statistic you're looking at. We don't want to get caught shifting which one we are focusing on or appealing to from meeting to meeting.

CHAIRMAN BERNANKE. Well, except that in the August statement, which is the first page of the handout, we said, 'More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks.'

MR. LACKER. We set the precedent there to focus on less than 12 months of inflation, right? 'Are we going to stick to that?' is the question we need to ask ourselves.

CHAIRMAN BERNANKE. It's a fair question. We could say inflation appears to be moderating, which might be better given the commodity price behavior. Let's put that down as something for consideration if anyone wants to advocate that. President Evans.

MR. EVANS. I could be wrong, but this seems to be a relatively new development in our statement, right? Because we used to use the term 'underlying inflation,' and underlying inflation had a connotation of a little more ambiguity for good or bad, right? I mean, we have all cherry-picked at times, 'I've been saying 12 months. Now I'm going to roll into the 3-month window because that's what I think is more indicative of our pressures.' And when we took out the underlying measure concept, we bought into this other problem, which is that we really ought to be talking about inflation over the medium term, with the emphasis on forecasting. We ought to think more carefully about how to deal with this. I agree with that.

CHAIRMAN BERNANKE. Except that one suggestion that the Vice Chairman and others have championed is that the first paragraph ought to be sort of a retrospective of what we see has happened and that our forecast should be in a different part of the statement.

MR. EVANS. But 'underlying inflation' is helpful for that, and it's also more related.

CHAIRMAN BERNANKE. I don't want to go through that whole discussion again, but a very similar concept is 'medium-term projections of inflation,' which would be equivalent to 'underlying.'

MR. EVANS. Yes.

CHAIRMAN BERNANKE. I'm sorry. President Pianalto, did I skip you? Did you have a question?

MS. PIANALTO. I have a question, but not on this issue.

CHAIRMAN BERNANKE. Okay. Go ahead.

MS. PIANALTO. Bill, in your comments about reinvesting our MBS into Treasuries versus reinvestment into MBS, you made a comment that it reduces the effect of the program. I know we only put this possibility on the table yesterday, so you didn't have time to think about it further or talk to anybody, but what kind of market reaction will we get?

MR. ENGLISH. I'll look to Brian Sack in a second, and he may have a different sense, but mine is that markets don't know exactly how big the maturity extension program is going to be. They don't know exactly how we would be handling reinvestments and so on. My guess is they probably expect we would be reinvesting agency securities into longer-term Treasuries as well, but nonetheless, taken together, the package will look broadly similar to what markets are expecting. I don't think there will be a big disappointment. They will, I think, be surprised if the Committee decides to reinvest into MBS. That's something that I haven't been reading a lot about, and as I said in my remarks, we do think that would probably have some effect in the MBS'Treasury spread. Brian, do you have thoughts?

MR. SACK. I agree. The major surprise will clearly be on the MBS side. So I think you would see a sharp reaction of the MBS spreads to the announcement. In terms of how Treasury

yields would respond, as Bill suggested in his briefing, the effect would be modestly less than if the reinvestments went into longer-term Treasuries, but my guess is that, relative to market expectations, the maturity extension part of it will essentially meet expectations and won't prompt much of a backup in rates. I think that the program is a little bit bigger than most people assume, at $400 billion, and as I will talk about later, if you went with this proposal, we'd actually have a maturity distribution that's pretty skewed to the long end. Those two things suggest that the maturity extension piece will meet expectations on the Treasury side in terms of preventing a backup in rates.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. Could either of you continue on? What are the negatives of reinvesting the roll-offs in MBS, in your opinion? Bill?

MR. ENGLISH. As I said in my remarks, I think there are two. One is the Committee might be seen as allocating credit, and you've been nervous about that in the past.

MR. FISHER. We went through that before.

MR. ENGLISH. And the other is that when it comes time to exit, your portfolio of agency securities will be larger, and therefore the sales of them will take longer or will have to be more rapid. There will be some adjustment to be made at the end to unwind this and get back to a Treasury-only portfolio, which the Committee has been absolutely clear it wants to get to.

MR. FISHER. So we have a pretty clear concept of what the costs are. We also have a pretty clear concept of what the benefits would be. If that spread is widened, we do believe, as you just summarized, that it will impact mortgage-backed rates and help decrease that spread over 10-year Treasuries. Is that a correct summary?

MR. SACK. That's correct.

MR. FISHER. Thank you.

MR. SACK. A few more things to note. Past FOMC communications have left this door open, as Bill indicated in his briefing. At the same time, in terms of the longer-run strategy, the Committee has emphasized the move to a Treasury-only portfolio. So I think there will be some discussion of that and perhaps some confusion. The other thing is that there are broader housing initiatives in play at the moment, and don't be surprised if you took this step to see a discussion of this step in terms of how it interacts with those other initiatives.

MR. FISHER. If I may, Mr. Chairman, would it be considered, in your opinion, counterproductive to those other initiatives?

MR. SACK. No. In terms of effects, I think it would be very productive. I'm just making a few points about how this will be discussed and what the market commentary will be.

MR. FISHER. Yes, sir.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. To follow up on the mortgage-backed securities questions, if by reinvesting we're putting pressure on those rates, we're also putting pressure on Treasury rates that are often references for mortgages. Is it possible that our prepayment assumptions need to be adjusted so that the actual duration of the mortgage-backed securities portfolio will somewhat soften and, therefore we have a two-step duration concern? One is that we are changing our mix, and the second is we have to rethink what the prepayment assumption is. Is that possible, Brian?

MR. SACK. Yes. We have prepayment projections where we expect about $200 billion of principal payments on agency debt and agency MBS by the end of June of next year. That would be the amount under our current projections that we would be switching into mortgage purchases. If those purchases pushed down rates by more than we had assumed in the Tealbook,

that number could be higher and result in even more reinvestment in MBS. I don't think the size of the rate effects we're talking about will affect that too much. Another thing to note is that, at $200 billion, we're actually already pretty high relative to prepayment models produced by Wall Street. So there's a lot of uncertainty around that $200 billion number, and my guess is, under the current rate structure, the risks are toward being smaller than that than being bigger.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I have a couple of questions about the mortgage-backed securities thing. First, for the record, I think I know the answer to this question. In your staff presentation yesterday, I didn't recall any mention of dysfunction or dislocation in the mortgage-backed securities market. I take it you don't have any to report on, or if there are, I'd appreciate hearing that.

MR. SACK. No. We don't think there is dysfunction in the mortgage-backed securities market at this time.

MR. LACKER. So the staff's view is that, compared with not doing the MBS reinvestment, this would likely lower the MBS spread by some measure?

MR. ENGLISH. Likely.

MR. LACKER. So doesn't this mean that Treasury rates would be higher than they otherwise would be because we're taking less Treasury out of the market?

MR. ENGLISH. That's what I tried to say in my remarks, yes.

MR. LACKER. If we're able to reduce the MBS spread, there'd be some other borrowers in the economy that would face higher cost than otherwise, right?

Does the staff have a sense of the differential effect on spending? Is lowering mortgage rates going to result in enough spending to counteract the reduced spending on the part of the people for whom borrowing costs are going to go up because of this?

MR. ENGLISH. As I said in my remarks, the reason to do this would be the sense that the housing market is in particularly poor shape, and so providing assistance there is likely to be, at the margin, more useful, but I don't have any numerical exercises I can point to on that. We had about 18 hours to think about this. [Laughter]

MR. SACK. And we do think the upward pressure on Treasury yields relative to the other proposal will be limited. I was trying to explain in the answer to President Pianalto's question that even at $400 billion without the reinvestment piece added on, the maturity extension program is still sizable relative to market expectations and is probably skewed more toward longer-term securities than most market participants expect. I think those factors will help limit any upward pressure we see on Treasury yields. It is hard to judge exactly what is priced in. We should appreciate that there is some uncertainty about these market responses, particularly about how far out on the curve we're expected to go on the maturity extension program. In general, it's a fair assumption that the backup in Treasury yields will be quite modest.

MR. ENGLISH. I agree there isn't dysfunction in the MBS market, but the MBS' Treasury spread is pretty wide. It's gone up about 50 basis points in recent months. We think that's because with rates very low, the expected duration is probably longer than usual, so investors are a little chary of buying the MBS, and there's a lot of uncertainty about the duration. That spread has widened out, and this would be a way of taking a step to try to unwind some of that widening.

CHAIRMAN BERNANKE. Is some of it due to net supply'demand balance? Is there a change in the flows, Brian?

MR. SACK. Some of it is due to at least concerns about supply related to the discussion about government refinance programs. The point is that those programs could cause a large amount of refinancing of the higher coupon into the production coupon, and I think that is putting some upward pressure on the production coupon spread.

MR. LACKER. Bill, on the sources of uncertainty, do you think you know better than the market about those things?

MR. ENGLISH. No. It's simply risk that we could take out of the market. MR. LACKER. It's real risk. I mean, it's risk to us, too.

MR. ENGLISH. So it's duration risk.

MR. LACKER. Okay.

CHAIRMAN BERNANKE. A two-hander from the Vice Chairman.

VICE CHAIRMAN DUDLEY. What I hear the staff saying is that the effect on Treasury yields is quite small because, one, you're not moving that much money away from the Treasury market and, two, the program is still going to be as big or bigger than expectations. In addition, it will also have a pretty sizable effect on the mortgage basis because it is unanticipated. It's going to change the whole risk'reward perception of private investors in the mortgage market because they are going to realize that if the mortgage basis winds out dramatically, the Fed is now more likely to intervene, and that's going to change the dynamics in the mortgage market. Now, why would you do it in terms of who gets the benefit? Well, I think the marginal propensity to consumer of people who are refinancing is probably pretty high relative to other participants in the economy who might be affected by that couple of basis point backup in

Treasury bills. And, too, there's an ancillary, broader benefit to the extent that you can make housing markets slightly less distressed. While the benefits are obviously hard to quantify, if the housing sector is in a little bit better shape, that has a whole other set of benefits.

MR. LACKER. If I could respond, the stress in the housing market isn't among people who are going to be capable of refinancing at a slightly lower rate. These are people that have good credit now. The distress is somewhere else.

VICE CHAIRMAN DUDLEY. Assume you have a demand curve for mortgage rates, the demand will be slightly stronger for housing than it was before if mortgage rates are a little bit lower, and I think that has consequences for households.

CHAIRMAN BERNANKE. Can we save the substance for the go-round? [Laughter] CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. I have an empirical question. Pick your number of what you think this would do to mortgage rates or the mortgage spread'10, 15, 20 basis points. The question I want to ask is: Based on what's happened over the last three years, what's the empirical evidence about how that will change housing starts, sales of existing homes, or house prices? What's the empirical evidence we have as to the effect that that will have on the housing market measured by the things that we are interested in? Do we have any estimate for that? Maybe that's a question for Dave.

MR. REIFSCHNEIDER. There are two answers to that. One, if you take our models estimated over longer periods, housing is a pretty interest-sensitive sector. Second, over longer periods, if you look at the response of house prices to interest rates, there's not much evidence of a response. Now, looking at the past few years, it is very difficult to tease out the interest elasticity. It could be that the interest elasticity is extremely low at the moment, partly because

of the difficulties of people qualifying for mortgages with tighter standards and the smaller pool of people who have decent credit scores. However, the other way of looking at it is that there's a powerful interest-rate effect in play at the moment, but it's being swamped by concerns about continuing falling house prices and that sort of thing. The housing market has certainly been behaving very peculiarly in the last few years. Everyone agrees on that. None of the models can explain what's going on. Is it decreased interest sensitivity? Could be. Is it a very powerful dynamic on expected house price changes and things like that? Could be. Is it tighter underwriting standards and credit conditions that are independent of the interest sensitivity? Could be. I think some combination of those is at work, and I can't untangle them.

MR. PLOSSER. So it's likely that the players who are going to be able to take advantage of this maybe won't be the homeowners and the homebuyers. It's going to be the traders who are going to be trying to arbitrage whatever they think we're going to do between Treasuries and MBS and other things, and whether or not that's going to have the effect that we want on the real economy is questionable.

MR. ENGLISH. That seems too strong to me. I think it will contribute to lower mortgage rates and more refinancing, and that will matter. Who's doing the refinancing and exactly which households are benefiting is subject to question.

CHAIRMAN BERNANKE. Any other questions? President Lacker.

MR. LACKER. I just point out that if the Treasury yield difference is little or none, then we have this miraculous ability to reduce spreads everywhere, sector by sector, with no cost to anybody in the economy, and that can't be the case.

CHAIRMAN BERNANKE. It could be the case. Why can't it be the case? Suppose we could buy corporate bonds in large amounts. We would be effectively, through money creation,

financing credit extension. We'd be a new source of credit extension. I'm not saying that's a good way to allocate resources, but it would certainly affect spreads.

MR. LACKER. If you look at budget constraints and resource constraints, there's a certain amount of savings going on, and it's getting channeled to a certain amount of resources that are going to a certain amount of borrowers. From that point of view, if we increase the resources going to some borrowers, it has got to come from somebody.

CHAIRMAN BERNANKE. That's only with a total output being given. This is the basic error of the crowding out arguments that you've been hearing, which is that holding output constant, if you increase deficits, you're going to reduce investment. That's not true if output is, in turn, endogenous and responds to fiscal conditions. If output responds to monetary policy stimulus, that's going to affect income and saving.

I feel like we pretty much covered the issue here. [Laughter] Any further questions? [No response] If not, why don't we just go now into the go-round? And we'll start at the far west of the country with President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I support alternative B. As I mentioned yesterday, maturity extension is an effective policy tool that can help lower longer-term interest rates. I was going to comment on lowering the interest rate on reserves, but I understand we will get more memos on that between now and the next meeting. We will look forward to that memo and that discussion next time. I supported pursuing this particular policy of maturity extension at the last meeting, and I think the case for taking this step is, if anything, even stronger today, given the deterioration in the economy and even greater downside risks. I also support reinvesting principal payments from agency securities in agency MBS for the reasons discussed yesterday, also summarized by Bill English. Specifically, I see this as lowering spreads on MBS,

and I also think, importantly, it creates space for further Treasury purchases. As Vice Chairman Dudley said, there could be a very powerful signaling effect of this as well. This is the right step at this time.

Let me say a word about the appropriate stance of monetary policy, and how that has changed since last November. Governor Yellen made these very same points yesterday, so I will try to be very brief. Basically, we looked at where the forecast was in the November Tealbook from last year and compared that with the forecast as of the current Tealbook. Regarding monetary policy, I think it makes sense to be forward-looking and consider the forecasts, as opposed to where we are currently.

The November 2010 Tealbook forecast for the unemployment rate at the end of 2012 was

7.9percent. Today it is 8.7 percent. And the Tealbook forecast for core PCE inflation next year has climbed from 1 percent to 1.5 percent, an increase of '' percentage point. Obviously, there are factors telling you to have less monetary accommodation, and some saying that you should have more monetary accommodation, relative to our forecast from last November. But when I plug these forecast changes into a Taylor 1999 policy rule with coefficients of 1'' on inflation and minus 2 on the unemployment gap, it implies a reduction in the funds rate of 85 basis points. Based on this simple metric'which only incorporates the information about the change of our modal forecast'the change in the outlook argues for significantly more policy easing than we thought appropriate back in November based on the outlook that we had at that time. I think alternative B takes us a step in that direction.

Finally, I would like to comment on the need for more contingency planning. I completely agree with President Fisher's remarks yesterday, and also the remarks of others who followed on yours. I am very concerned that economic conditions could take a serious turn for

the worse, especially if the situation in Europe spins out of control. We need to think carefully now about what we will do if the worst-case scenario materializes. In that event, we would likely be employing unconventional policies and operating at the zero lower bound for many, many years, much as Japan has. In contemplating such a situation, I am sympathetic to President Bullard's point that we need to get away from one-shot, fixed-duration policies that we have used in the past, and move instead to a more systematic framework. In particular, we should plan now about how we would conduct and communicate asset purchase programs that are more open-ended and adaptable to changed circumstances. As I mentioned yesterday, I think we will clearly need to broaden the set of securities that we purchase to include mortgage-backed securities. Furthermore, I am increasingly worried that we could find ourselves in a situation where the yield curve is essentially flat at very low rates, and the economic situation is still not satisfactory. I think the traditional LSAP and communication policies may not be sufficient to achieve our macroeconomic goals. If you look at Japan and Switzerland, they both currently have 10-year government rates of around 1 percent. If we find ourselves in a situation like that'even after we have used all of our LSAP and communication policies'we really do need to think seriously about outside-the-box approaches to monetary policy, including the use of emergency-type programs or other approaches. We need to be doing that planning now rather than later. Thank you.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. In my comments, I will generally support alternative B and talk about alternative B. Let me start with paragraph 1, the last sentence. I, too, thought that the phrase, 'Inflation has moderated since earlier in the year as prices of energy and some commodities have declined from their peaks,' was a little bit strong. I think it has

been an improvement to eliminate the confusing references to underlying inflation, and I would take it that our basic measure of inflation, when we say 'inflation,' is PCE inflation measured from a year ago. I'm looking at page 23 of the data sheets here, which has all our data on consumer prices. This is what is presented to the Committee. There are six charts here, with a lot of upward sloping charts in 2011, so I think it might be a little bit strong to say this. I have a suggestion that I think more accurately will reflect your view, Mr. Chairman, which is that instead of using 'Inflation has moderated since earlier in the year,' we could say 'Inflation is expected to moderate as prices of energy and some commodities have declined.'

The new first part of the very last sentence in paragraph 1 would be 'Inflation is expected to moderate.' It would mean that, indeed, we think headline inflation is going to come down. Yes, it is kind of high right now if you look at these charts, but we think it is going to come down. That very much reflects the staff view and the view that you expressed earlier in your comments.

CHAIRMAN BERNANKE. Could I just explore that for just a second? The only objection is that we also say in the next paragraph, 'The Committee anticipates inflation will settle in coming quarters,' which is a little bit repetitive. What about something like the earlier suggestion, 'Inflation appears to be moderating;' is that better? It's more descriptive, rather than pure forecast.

MR. BULLARD. There are an awful lot of upward moving lines here. It is true that these three-month averages show little blips down, but that might be a little bit of a thin reed to hang your hat on.

CHAIRMAN BERNANKE. So, it 'appears''what is your view?

MR. BULLARD. 'Appears to have moderated.'

CHAIRMAN BERNANKE. 'Inflation appears to be moderating.' Does that help? MR. BULLARD. What is wrong with just 'expected to moderate'? I think that's fine. VICE CHAIRMAN DUDLEY. My critique of that is, I think it is very important that the

first paragraph be a statement of what we see, not a view about our forecast or our expectations. It should be a description of our view of reality. When you say 'is expected to,' then you are getting into something more forward-looking, and I am not in favor of that.

CHAIRMAN BERNANKE. Let's see. President Kocherlakota.

MR. KOCHERLAKOTA. One suggestion I would have is that the Committee actually specify exactly what inflation rates they had in mind when they say that inflation rates are moderating. I think it is certainly true of the three-month frequency. Maybe it is also true of the six-month frequency. If the Committee has a particular frequency in mind, then you can make reference to that.

MR. BULLARD. I don't mind the story that it is expected to moderate. I just don't want people to look at this picture and say, 'Well, what is the Committee thinking?' PCE inflation measured from a year ago is up close to 3 percent, and core inflation has also gone up quite a bit and is still on an upward slope. Just say 'is expected to moderate.'

CHAIRMAN BERNANKE. That's your proposal, and others can respond as we go around. Please continue.

MR. BULLARD. Moving on'. In paragraph 3, I want to make a few remarks on the attitude of the Committee since the onset of near-zero policy rates. As I said many times, I do not think it is desirable or necessary to have large, fixed total amounts in the statement. The Committee, in the past, would never contemplate announcing a bundle of interest rate moves to be executed over a fixed time period. Instead, the Committee would make an interest rate move

at a given meeting and offer a suggestion, a bias, or a continuation value about future moves, but reserving the right to review incoming data. This type of policy was later rationalized in a slew of economic research as being close to optimal in certain types of macroeconomic models. Even though that sort of policy was considered close to optimal, in the near-zero rate era we have thrown this idea out the window, and I think this is a mistake.

As many of you know, there is a substantial amount of stimulus fatigue in the U.S., which is feeding into unwarranted and unnecessary criticism of the Fed, which is in turn harming our credibility and our ability to carry out effective policy. What is happening, in my view, is that those less familiar with the intricacies of central banking simply seize on the $400 billion number and run with it. But this grand misunderstanding is completely unnecessary. The financial market participants who understand our duration program will have no difficulty discerning the Committee's intent and forming expectations appropriately. Any announcement effect will actually be exactly the same size because the rational expectations of markets will be exactly the same. I am arguing in favor of 3', then, instead of in favor of 3, and solely on the basis that you get rid of the big number in this statement.

Paragraph 4 is about the MBS. I am going to counsel against this for today. I'm not saying forever, but just for today. I do not think that the Committee has seen a very substantial analysis on this question, in particular, on what is the source of the increased spread in MBS markets and what would be our expected effects now going back into MBS markets after having once left them. I think we could get some more analysis on this'that would be one thing to do. I see this also as running against the Committee's widely agreed goal of returning to an all- Treasuries portfolio'which was part of the earlier discussion about MBS versus Treasuries' and this would be going in the opposite direction. I would want to be careful that we are

thinking about that before we make a commitment to do so. I counsel that we watch developments here carefully and consider this at a future meeting.

I do also think that regarding the heuristic argument that Vice Chairman Dudley just gave on refinancing, there are going to be distributional effects that are important. The people who don't have high income, are unemployed, or are under water in their house are not going to be able to take advantage of a low mortgage rate. That is already happening today, and that will continue to happen, so you are not really helping that group of people. You are helping the relatively high-income people whose value of their house hasn't fallen as substantially. It is not clear that is exactly the policy we want to pursue, although I would be open to hearing more about it. But for today, I think this needs a little more analysis. This is not an issue that has to be decided in the next 24 hours. We could probably wait a little bit on this.

Let me talk just a little bit about a few more issues, and then I will be done. On the risk to alternative B, I do think there are some risks in this announcement that will come out today. Longer-term rates could as easily rise as fall in the coming months, coming weeks even. Given the volatility in markets and the fact that yields are exceptionally low right now, I think this will probably stimulate an intense debate, about whether this is an effective program or not. We have to be prepared to carry that debate, and a good way to do that is to talk about the effects of the program in the run-up to this announcement, not in the aftermath of it. I also agree with President Williams that if the economy is as weak as many here think it may be, we may soon be forced to take more-aggressive action. I'm not exactly sure that we are really ready to do that, but we probably need even more intense contingency planning than we have done even at this meeting.

Let me comment on option A. I do not think these communications options are ready for prime time based on the discussion yesterday. However, I am encouraged by several outcomes of that discussion. I think that we may be able to use the SEP to help better communicate the Committee's intent going forward, and we may be able to revise and expand that process. That would be a great development. We should go ahead and adopt a flexible inflation-targeting program like the ones used in some of the leading countries on this issue. Some of the Nordic countries are good models, but there may be others. I think that would be a perfectly fine thing to do. We could adopt many of the practices that they have already implemented and tested. As the Chairman noted, we are essentially in a flexible inflation-targeting regime right now, but it is a bit of a clandestine one. We may as well get the full benefits of going ahead with the program. Thanks very much.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. Real growth has obviously been much weaker than we had hoped for, or that we view as desirable. But as I said yesterday, I think the inflation outlook is central to our policy decision today. A year ago inflation was running around 1 percent, and it looked as if it had the potential to continue falling. That made it very attractive to provide more stimulus to aid the real economy, and if that also increased inflation, it was for the good. I understand the rationale for intervention a year ago. But now inflation is 2.9 percent year over year, and 2.1 percent over the last three months. Core inflation is 2'' percent over the last three months and the three months before that, and survey measures of inflation are ticking up. I understand what is going on with TIPS yields, but it is a mixed picture on inflation expectations.

As I said yesterday, the balance of evidence suggests to me that our asset purchases initiated last November contributed to the rise in inflation, but had little or no effect on real growth. So my sense is that the alternatives'A or B'to the extent that they have material economic effects, are going to push up inflation and do very little for economic growth. And with inflation running above what everyone articulates as their preferred rate, I do not think we now want or need more monetary stimulus. Accordingly, I support alternative C.

I understand how raising inflation would reduce real rates and provide stimulus for the real economy. But I do not believe we could publicly acknowledge allowing inflation to rise and still keep inflation expectations from rising even further from time to time after that. I do not believe we would have an easy time reversing course and bringing inflation expectations down again without significant real costs. Even if I was wrong about that, and we could easily raise and lower inflation, we would have set a precedent that would permanently limit the credibility of our commitment to price stability, because always in the back of a market participant's mind would be the notion that in 2011 we raised inflation deliberately, and we could do it again. That will affect our conduct and our ability to meet our objectives for years to come. A strategy of tolerating a bit more inflation in an attempt to reduce unemployment bears, to me, more than a passing resemblance to the strategy pursued in the late 1960s and 1970s, and that was, obviously, such a dismal failure. I found it disturbing to have heard this notion entertained. I think it is agreed in hindsight that policymakers then placed excessive emphasis on unemployment, excessive blame on commodity price increases as opposed to their own policy errors, and excessive faith in the sluggishness of inflation expectations. Now, some of you no doubt view there as being a substantive distinction between the strategies we pursued then and the notion of

tolerating higher inflation, higher than it is now today. I would love to understand it, because I don't get the distinction at this point.

I fully appreciate that unemployment has been painfully high for an excruciatingly long time period, and that high unemployment is associated with substantial losses in well-being for many Americans, relative to an alternative world in which we came into today's meeting with a much lower unemployment rate. I understand the compelling urge to do something, even if there are legitimate doubts about how much of an effect monetary stimulus can have at the zero bound, which is the circumstance we find ourselves in. But if monetary stimulus is effective at the zero bound, what are those effects? Are they real, or are they on inflation? I don't think there is any question that we should be more confident that monetary stimulus is going to affect inflation than it is going to affect real growth. That comes from a reading of monetary economics going way back. It is the effect on real growth and the non-neutralities of monetary policy that are the really hard things in macroeconomics and that have divided us and divided the profession from time to time. I think inflation is one thing that we know monetary policy can affect if it affects anything.

As I said, I support alternative C. On the off-chance that the Committee gravitates to alternative B'[laughter]'I have a couple of observations to make. First, about the inflation language, I agree with Vice Chairman Dudley that we should keep forward-looking statements out of paragraph 1, and that the movements we made to doing that are sound. If we have something to say about what we expect inflation to do, let's keep that grouped in paragraph 2 with everything else about the future. 'Appears to be moderating' is a welcome addition to that. Under questioning, we can direct people to the three-month rate. At this point, I don't think we

want to enshrine the three-month rate in the statement. I'm a little hesitant to do that without thinking that through a little more.

Halting our transition to a Treasury-only portfolio is a terrible idea. My head has stopped spinning right now, but' [Laughter]

MR. PLOSSER. It's on fire. [Laughter]

MR. LACKER. This takes us into the realm of fine-tuning sectoral spreads, and it begs questions. What about small business lending? What about municipals? There are plenty of sectors where there is distress, urgency, and a need. People are going to ask, 'Well, you're helping out the housing market, why aren't you helping out our sector?' That's the reason we have stayed away from this stuff until the crisis, and we should keep on that track by getting out of the business of subsidizing housing. This perpetuates this really corrosive political economy in our country of tapping government resources to subsidize the housing market. I should think we would be a little averse to that, given the damage that caused in the last crisis.

About President Bullard's point on announcing $400 billion versus $45 billion, I think that is a cogent point. I will make the observation here about quantitative easing. We apparently are viewing, according to our Vice Chairman, quantitative easing as off the table because of the political backlash we got last year. That's my sense.

VICE CHAIRMAN DUDLEY. I would say that's too strong.

MR. LACKER. Too strong? Okay.

VICE CHAIRMAN DUDLEY. Not off the table. The bar is high.

MR. LACKER. The bar is high. Right. I have sour feelings about setting a higher bar. We have had two instances of naked political intimidation in the last week, and I think we all

gravitate toward the notion that we set policy the way we see it. I'd like to believe that we do that.

VICE CHAIRMAN DUDLEY. I was very clear yesterday that we have to set policy based on what we think is right. But if the politics wreck the efficacy of the policy tools, then we have to take that into consideration as an environmental factor. There is an important distinction between the two.

MR. LACKER. I wasn't sure I quite understood the extent to which the political backlash would affect the efficacy of the policy without affecting our subsequent actions?

VICE CHAIRMAN DUDLEY. If the policy caused people to think that LSAPs would lead to a big inflation problem or loss of confidence in the Fed's credibility, the policy would be less effective, and so we might decide that the cost-benefit analysis is no longer favorable. You're not not pursuing the policy because of the political pressure, you're not pursuing the policy because the political pressure is going to undermine how well the policy instrument works in practice. That's an important distinction, I think.

MR. LACKER. Would that work through beliefs about our future actions or not? VICE CHAIRMAN DUDLEY. I think it can work through a whole variety of ways. It

could affect inflation expectations; it could affect our future credibility. I think there are a lot of channels.

MR. LACKER. Those both seem like our future actions.

CHAIRMAN BERNANKE. There was some evidence that the reaction affected market expectations of the continuation policy, and that reduced the stimulus impact. Both internally and externally, assuming we do the maturity extension, I think we ought to note it has its own legitimate benefits. In particular, it does not create massive additional excess reserves, which

could create problems for our banking system. Second'and I think the evidence already suggests this in terms of what we are seeing in markets'because it doesn't increase high- powered money, it may have less effect on inflation expectations, which would be a positive from your perspective. I think it has some legitimate benefits, even aside from these calculations. Let me just assure everybody that we will do what we need to do, and political interference will not determine our policy actions.

MR. LACKER. I'm glad to hear that. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. If I might just say one word about the analytics between the 1970s and today. There is, of course, one very important distinction, which is that we are at the zero lower bound in the liquidity trap. You are familiar with the Krugman 1998 paper, which says in that particular case there may in fact be a permanent tradeoff'or at least a very long-lasting tradeoff'because only by increasing inflation expectations can you lower real rates at the zero bound. I'm sure you know that literature. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. It is a privilege to follow my esteemed colleague from Richmond. Here we provide the full range of options with just two commenters. [Laughter]

The economic outlook in the Tealbook clearly calls for action, and I would argue that the Tealbook outlook is on the optimistic side. As I look at the pricing of Greek debt and credit default swaps, I wonder whether the baseline forecast should include a Greek default. However, even with a more benign assessment of Europe, my forecast for both inflation and unemployment are consistent with significant action. My preference for this meeting would be to do three things. First, I would explicitly condition the forward guidance on economic outcomes, as President Evans has discussed recently, using language similar to what is in

alternative A. Second, I would reinvest principal payments of MBS back into MBS. I strongly support that. Third, I would do the Twist, but signal that should financial instability increase, or the economy deteriorate further, more-aggressive policy would be considered. In particular, if conditions were to worsen, we should be considering targeting intermediate Treasury rates consistent with our conditional language and expanding our balance sheet. While my preference is a combination of A and B, I can support alternative B with paragraph 3. I do hope that the forward guidance based on the SEP is considered for our next meeting. I actually agree with President Kocherlakota that it might be worthwhile considering whether using two years, rather than a calendar date, would be a more appropriate way of describing time.

I normally don't comment on language, but this time I feel I should. In paragraph 1, I think the criteria should be that it's factual and consistent. If we use three-month inflation rates, we are, in effect, going to be describing commodity prices and oil prices. That doesn't seem to be what we are trying to convey. For retrospective, I actually agree with President Evans that we should be using core or underlying inflation, so we don't overweight temporary supply shocks. Prospectively, we should be using total, because in the medium-term total and core are likely to be quite similar. Going forward, we could come up with an agreement that if we are going to characterize it, then we characterize it consistently in that fashion. In terms of paragraph 3 and

3', this is a one-time program, as we discussed yesterday. Talking about it in total makes much more sense than talking about it parsed in nine ways. In particular, when I look at the language at the bottom of paragraph 3, 'The Committee will regularly review the pace of its securities transactions and the overall size of the maturity extension program,' I would not use that language. I would go back to the August language that says, 'The Committee will regularly review the size and composition of its securities and is prepared to adjust those holdings as

appropriate.' I don't think that parsing an extension program into very small bits will be particularly effective. That language implies that we might consider doing that, and I don't think we should. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Inspired by Governor Tarullo's laudatory comments yesterday about the Norges Bank and the reference from my colleague on my left about the Scandinavians, I reached into my Norwegian mother's electronic photo album, and I want to read to you the sign that greets those that are brave enough to go to the northern-most Norwegian islands called Jan Mayen, where there is a weather station that tries to assess global warming. I'm going to speak a little Norse here. I will translate it later for the transcripts. But it says, 'Teori er n''r man forst''r alt men ingen ting virker. Praksis er n''r alt virker men ingen forst''r hvorfor.' And what that translates into'and here is the sign'it says, 'Theory is when you understand everything, but nothing works. Practice is when everything works, but nobody understands why.' It goes on at the bottom to say, 'At this station, theory and practice are united, so nothing works and nobody understands why.' [Laughter] Forgive me, the Congress of the United States.

Mr. Chairman, I cannot support alternative A. I agree with Mr. Lacker on his points about inflation. Governor Yellen went back to 1983 with her long experience. I go back to thinking about the briefings I gave for Bill Miller's transition from this wonderful independent body to the Treasury, and the memory that I tried to recall in my comments for Tom Hoenig about President Nixon, the Nixon'Burns era. I think it's extremely dangerous for us to embrace a 2'' percent inflation number. If you are not persuaded by President Lacker, I would urge everybody at this table to read former Chairman Volcker's op-ed in The New York Times. That is a dangerous course of action to embrace. We have to really think through it extremely

carefully. I believe President Rosengren and others have mentioned the importance of distinguishing between ceiling and target, but there is an ultra-sensitivity out there'particularly if you think in a historic context'of breaching the confidence that we hope to engender with regard to inflation.

There is very little that I can support in alternative B. I put forward my arguments yesterday in terms of the limited returns and the costs involved with duration extension or Operation Twist. I even quoted Mr. Swanson, who I think is a Swede by bloodline. He is sitting over there, and I don't want to put him in an uncomfortable spot. But in terms of the knock-on effects, as well as the direct effects, I think they are of limited utility, and the costs are quite great. I particularly am worried about the costs that we have imposed on those who have the least means, those who are out of work, those who are struggling to keep their jobs, and those who are aging, like me, and who are becoming more conservative with their portfolios, and therefore, shortening the duration of their exposure and doing what they are supposed to do. In other words, those who play by the rules have done what they are supposed to do, and are being penalized by our interest rate policy.

Of interest to me in the recent data that were released by the Census'and I know we are still looking at our triennial survey'was that the only income group between 2007 and 2010 that saw an increase in median income were those who are 65 and older. Those who are 65 and older are not going to take risk in equities. They are going to shorten their duration; they are going to focus on CDs. They are trying basically to preserve their savings but also are a source of purchasing power, since all other income demographics'whether it is age, race, or gender' have seen a declines in their income over the last three years. Every single one of them but citizens 65 and older.

I cannot see how lowering interest rates increases purchasing power. My logic chain is very simple. Final demand is horrid right now. How do we bump up final demand? We need to have more jobs. How do we create more jobs? We have to have more spending, more consumption. We also have to have more incentives. I don't believe inflating is an incentive; I believe inflating is a disincentive. And I believe in the basic principle of 'do no harm.'

I cannot support an extension, and I will not vote for alternative B as it is stated, nor alternative A. The one thing, which will surprise my colleague Mr. Lacker, that seems to make sense to me is to reinvest the proceeds as proposed by Vice Chairman Dudley from our mortgage-backed security roll-offs back into mortgage-backed securities. I mentioned yesterday that everything being contemplated at this table is most un-Bagehot-like. We are going to be purchasing more of, or extending the duration of, things that people are rushing into. If we do believe that we are in dire straits, then we should be purchasing things that people are rushing away from, or where the spreads are widening. By the way, Mr. Lacker, we are not allowed to buy municipals; we have already proceeded down the path of buying mortgage-backed securities. I think it is sensible in this case to help narrow that spread, which is widening, and I agree with Vice Chairman Dudley's argument on that front, and that is one thing that I can support.

I want to conclude with what I started with yesterday. We must plan for the most adverse outcomes. I articulated what they could be yesterday: a significant selloff in our own stock markets, which by different valuation methods'that at least I learned when I was in the business'is, if not richly priced, fairly priced, and therefore, has a lot of downside; the debacle that might ensue in Europe, despite their efforts to prevent it; or other exogenous shocks that could knock us for a huge loop. Right now, we have very little left in our holster. If you will

forgive the pun on your initials, Mr. Chairman, we are shooting BBs, not bullets. We should figure out what ammunition we have left, how we might best deploy it, and what more ammunition we need should those dire circumstances prevail. Therefore, I can only accept alternative C, and I will vote accordingly. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I usually begin my policy round statement declaring support for one of the alternatives, and that is usually alternative B, which is appropriate for a member of the quiet middle. Today, I am going to take a different approach. Because I am a nonvoter at this meeting, I am going to give myself permission to put some arguments on the table for the sake of devil's advocacy. As I stressed in the economy round, I would argue that the ambiguity of the moment should give pause, pointing to a preference for alternative C at this meeting. One might prefer alternative C not out of strong conviction that no action is called for, but out of preference for not acting quite yet. The case for holding off is included in the broader Tealbook case for alternative C, which Bill English just recited. I would add to that case, as devil's advocate, that an approach that might have the most positive impact in jolting the economy out of its apparent torpor is a binary one. By that I mean either do nothing or go all in, but avoid incremental half-measures.

Let me present three reasons for holding our fire at this meeting. First, the hard data and anecdotal reports suggest that the second half of the year will be better than the first half, even if not by a lot. The staff Tealbook forecast assumes that an alternative B is required to generate this outcome. I would argue that skepticism on this point is warranted. Even conceding that the very modest rate effects assumed by the staff will be realized from an alternative B policy, marginally lower longer-term rates won't stimulate much additional borrowing and business

activity producing job growth. Lower longer-term rates might stimulate some refinance activity by homeowners and commercial real estate owners, but short of some top-down program of comprehensive mortgage refinancing, the effect is likely to be marginal on real-side activity. Second, while acknowledging the sentiment that the Tealbook benchmark implies an uncomfortably slow decline of the unemployment rate, one could be just as uncomfortable with the persistent upward drift in core inflation measures. As the Tealbook shows in charts labeled 'Evolution of the Staff Forecast' on page 31, misses giving rise to upward revisions in unemployment forecasts have been matched by misses in upward revisions of core inflation forecasts. A benchmark forecast that has a fairly large drop in inflation premised on an unemployment rate projected to remain high, in my opinion, should be questioned. A third argument for holding fire is to let a little time pass to gain perspective on the circumstances the Committee is facing. Per this argument, sentiment is being weighed down by an unfortunate confluence of bad or troubling news that arrived in a very short span of time. By that I mean benchmark revisions, the debt ceiling spectacle, the S&P ratings downgrade, Europe, the jobs report, Hurricane Irene, and inflation numbers.

I would argue that, considering both the data and the reports from contacts, the economy is not presently on a slippery slope to recession. This view argues for giving ourselves a little more distance from the events of late July and early August before concluding that the economic landscape has changed so fundamentally that the economy cannot achieve escape velocity without further action on our part.

Turning to the action side of what they called a binary approach, I would argue this: If there is no progress toward firmer economic growth, and there is actual deterioration and/or it becomes clear that the European issues or the fiscal mess in this country are likely to suppress

economic activity going forward, stronger action than alternative B is needed, conditioned, of course, on no deterioration of the inflation outlook. It may be the case that a sequence of incremental policy steps ultimately accumulates to a big step. But if a jolt to the patient is what is needed, one big step may be preferable. So going all in'the expression I used earlier'could resemble President Bullard's proposal: an open-ended, quantitative easing commitment to be held in place until the Committee is satisfied that a sustainable recovery is firmly established or until we have to change course to meet our price stability mandate. Again, I am presenting these arguments in a devil's advocate vein, not in outright opposition to alternative B.

Switching to angel's advocacy, if that is a term, regarding alternative B, just a couple of comments. First, I favor 3' as being somewhat more flexible. Second, I am sympathetic to the mortgage-backed securities reinvestment proposal. I think it might make a difference. If I could wave a magic wand once to help demand, it would be to lower all mortgage payments in the country. Third, in response to President Bullard's suggestion, I agree that there is something slightly wrong with the description of inflation in paragraph 1. A simple fix would be to add the word 'somewhat,' 'inflation has moderated somewhat,' to try to capture a little bit of the ambiguity and slight disappointment we feel in the way inflation has evolved during the year. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I favor alternative C. I do not see alternative B as being consistent with our decisionmaking in November of 2010. Inflation, and the outlook for inflation, has risen since then. Unemployment, and the outlook for unemployment, has fallen. I should clarify what I mean by the term 'outlook' using it in a different sense from how Governor Yellen and President Williams have been using it. When I

think about what outlook is relevant for the course of monetary policy, I try to think about what horizon you might think monetary policy is going to be effective at. In November 2010, one might look ahead to the end of 2011'a one-year-ahead look'and see where unemployment is going to be and where inflation is going to be at that point. I won't remember the numbers off the top of my head, but my recollection is that in November 2010 we were thinking about unemployment being around 9 percent by the end of 2011 and that inflation would be running

1.3percent, or so, over the course of the year. Now, we come forward to September 2011 and, again, looking at what horizon do you think monetary policy is going to be effective at, that horizon is still one more year out. The right way to think about it is to consider our one-year- ahead outlook in November 2010 compared with our one-year-ahead outlook now. And once you do that kind of comparison, it is clear that the changes in economic conditions do not justify the addition of further accommodation, relative to November. One possibility is that our objectives for inflation and unemployment have changed, that we are willing to tolerate more inflation than we were in November of 2010. If that's true, then that change has to be communicated to the public. I detected heterogeneity of viewpoints even within this table about whether we are following what one might call a hard inflation-targeting framework or a flexible inflation-targeting framework. We have to be clear to the public about which framework we are actually using. I will come back to that toward the end of my remarks.

Two things have been difficult and have made the decisionmaking hard since last November. One is that I don't think we had a good tool for varying incremental amounts of accommodation as conditions changed. From November through March, conditions improved. In fact, I remember being asked, even in January by reporters, 'Look, things have gotten better. Shouldn't you actually stop the purchase program at this point, or curtail it early?' I don't think

any of us felt like we should do that, with possible exceptions. But, by and large, we didn't have an incremental tool for varying the level of accommodation as economic conditions varied. Let me talk about how my duration idea might have worked, my idea that the statement would include some expectation of how long we would stay at the zero lower bound over the last 10 months or so. In November 2010, I think we would have said something like, 'We expect to be at the zero lower bound for eight quarters.' Then, as conditions would have improved, in March I think that it would have been very reasonable to move that up to, say, five or six quarters. Certainly, we were talking a lot about exit among ourselves at that stage. We can quarrel about whether there would have been a consensus view, but let's take it as five to six quarters. From June to August, as things really worsened, you would have been able to do the natural thing, which is to add accommodation. The problem is that we didn't take accommodation away in the natural course of events as things improved.

The other issue is that I don't think unemployment and inflation are the triggers for this Committee. When I listen to people talk, I hear a lot of discussion about what is going on in terms of employment growth and what's going on in real GDP. I think real GDP growth and that performance is very important in the thinking of many people around the Committee. I say that only because I think it should give people pause about what you want to include in the statement as your triggers'be sure that those are the variables that we're conditioning decisionmaking on. I would certainly argue that for November 2010 through September 2011, those were not the variables that were critical in thinking about the conditioning decisionmaking. I think it was the poor performance of real GDP relative to expectations that was critical.

At the risk of being even more tedious, I will talk about why exactly I favor alternative C. Let me take the 1999 Taylor rule. This is generally regarded as a description of past behavior by

the Committee that led to relatively good outcomes, and it is also viewed, at least among the rules that John Taylor suggested, as being relatively accommodative. Take the output gap in that model and translate it to an unemployment gap, and here you have to make a choice about how that translation works. I am going to choose an Okun's law coefficient of 2, which serves to make the rules less accommodative, and I will use the staff's effective NAIRU of 6'' percent. I will use core inflation of 1.6 percent, which is measured over the past year, and unemployment is

9.1percent. If we plug that into the resulting Taylor rule, the right-hand side, it is going to say the fed funds rate should be negative 180 basis points, which sounds very low. The fed funds rate itself is between 0 and 25 basis points. Now the question is: how much accommodation is being provided by the cumulative effect of the LSAP? In November 2010, staff estimates were that the LSAP was providing about 200 basis points of accommodation. As President Williams has emphasized to us, this really depends on how long investors expect us to keep reinvesting the proceeds from the LSAP. It is worth noting that in November 2010 investors' modal forecast was that the exit process would take place less than two years later. I would say that, at this meeting at least, the LSAP is providing at least as much accommodation now as it did in November 2010. If you add this all up, you get a left-hand side of a fed funds rate of roughly minus 175 basis points. That means that alternative C is the alternative that is most consistent with the 1999 Taylor rule. This calculation I just offered is based on the staff's estimate of the NAIRU. I certainly think that the recent behavior of inflation and wages suggests that the NAIRU could be higher than 6'' percent, which would translate into a need for tighter policy.

The version of the Taylor rule that I am using has a particular inflation objective in it, which is to keep inflation at 2 percent. That is consistent with our communication of our current inflation objective. That is ultimately why I favor alternative C. It is the alternative that is most

consistent with our communication of our inflation objectives. Indeed, my baseline forecast is that further accommodation along the lines of alternative B is likely to lead inflation to average 2 percent over the next two years.

Let me pose a counterfactual. Suppose that over the past few months the Committee clearly communicated to the public its willingness to accept inflation higher than 2 percent, or even as high as 3 percent. Then I would say that my concerns about credibility would have been met. President Lacker has raised some very important issues about that communication and what it would mean for longer-term expectations. But if we have a flexible inflation-targeting framework, we should not be operating it clandestinely. I think there are good public policy reasons for that, and at heart, it limits our effectiveness. If we had clearly communicated our willingness to accept inflation higher than 2 percent, or even as high as 3 percent, my concerns about credibility would have been met, and I would have been willing to support additional accommodation at this meeting. But as it is, Mr. Chairman, I am going to be supporting alternative C.

CHAIRMAN BERNANKE. You said conditional on B, you thought inflation would be

what?

MR. KOCHERLAKOTA. I think it is going to average slightly above 2 percent over the next two years.

CHAIRMAN BERNANKE. I think there has been a miscommunication that I do need to address'just a couple of preliminary points. There is a pretty broad agreement that we are flexible inflation targeters, and President Bullard and others have made that acknowledgement. That is the only one that is consistent with the dual mandate so that means that we are looking at medium-term inflation and allowing for some flexibility in the short run.

Just a comment on the Taylor rule, which is on current variables, so a worsening in the outlook associated with financial distress would not appear in any way in that kind of model.

But let me address the thing that you have said a number of times, and I really don't understand. It's true that I have said in a number of speeches that our target is 2 percent or a bit less, by which I mean that if you look at the SEP, it reports that the central tendency of our Committee is 1.7 to 2.0 percent. What I'm saying, basically, is that the target is 1.85, let's say. What I have never said'and I don't think anybody around this table has ever said'is that we will not tolerate inflation above 2 percent. That is a very different proposition. Under a flexible inflation-targeting regime, with quadratic preferences or whatever weights you want to put in it, depending on the state of unemployment, there would be times when you would tolerate inflation a bit above the target. In particular, there is no inconsistency with having inflation a bit above 2 percent and having a ''* that is 1.85 percent. I understand that you have concerns, and you have every right to disagree. But on that one point, I really don't think that that is correct. The ECB has a somewhat different kind of approach where they seem to have a ceiling. But we have never expressed a ceiling approach to inflation. Rather, we have a target around which there is going to be some random variation and policy variation.

MR. KOCHERLAKOTA. Mr. Chairman, I think that this underscores the challenges of communicating with the public on this point. I think that the public perception of our framework is closer to the idea that we will not tolerate 2 percent. It would be very helpful to clarify' exactly as you have now with me'what our inflation target means and what it does not mean. In my view, the reactions to President Evans' recent remarks show that there is a sense in the general public and in the media that our medium-term targets really translate into something we have to meet on a year-by-year basis.

Those of us that are involved in the idea of monitoring cost recovery for the product office might be familiar with this example: In the product office, they are supposed to recover costs over a 10-year horizon. The way we implement that is by watching them closely on an annual basis to make sure they are doing cost recovery. With that, I think it will be very helpful'certainly for my own thinking about policy'for the general public to hear exactly this clear explanation you just gave to me about what the framework is. Thank you.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I do not support a change in policy at this juncture, and therefore, I support alternative C. As President Kocherlakota pointed out, inflation has moved up, not down, since our last meeting and since last fall, and the unemployment rate has not worsened. I think we should be cognizant of the risks of fueling a steady rise in inflation over the medium term, even while the unemployment rate remains elevated. Any action that we take now is likely to have only marginal impact on growth and employment, and yet it could make it more difficult for us to address future problems that arise in the financial markets or to combat deflation should it emerge. It does not make much sense for us to try to calibrate the speed of economic recovery, and the empirical evidence we have to date during this episode of the Great Recession suggests that we have very limited ability to do so in any event. As President Fisher said, we should be spending our time evaluating the emerging risks stemming from the continuation of the sovereign debt crisis in Europe and how we should respond should that situation devolve into a full-blown crisis.

I will also step out of my usual box and go into the realm of psych-ops that President Lockhart raised yesterday. We seriously have to ask ourselves as a Committee whether or not our incessant efforts to 'fix the economy''to little or no effect recently'is reassuring or

actually lowering confidence. I think the very negative outlook we painted for the economy in our August statement was too negative, and our actions in that statement came as a negative shock to consumer confidence. Confidence fell, and markets were surprised at how negative we were. I don't think that was a wise decision, and it likely contributed to falling confidence. The August language was also problematic for me because I think there are better ways to provide forward guidance than using calendar dates. Yet now that we have the language in the statement, and we have opted for a fix, it is hard to get it out, and we have to craft a way to get it out, as many of us have discussed. That suggests we should be very careful in changing language in our statement, because we tend to live with it for a while, even though we think we don't. It's hard.

Those concerns lead me to believe that alternative A, at this point, is a particularly dangerous road to go down. Once we have those numbers enshrined in the statement, it will be very difficult for us to change them. We have not given sufficient thought to the underlying mechanisms that give rise to those numbers. I don't think we have had sufficient debate on the underlying loss functions or rules that give rise to them. Proceeding with that from one meeting to the next'engaging in this very quickly'would be a mistake, and we would likely regret it because we would have trouble getting out of it. In a framework like alternative A, we also have to be concerned about our credibility. We put a target for 2'' percent inflation as a trigger or a 7 percent unemployment rate'whatever the numbers happen to be, and I'm thinking about inflation right now as an escape clause'that we would act. We would then have to ask ourselves very seriously, 'While we can all say that today, would we really act?' Today, year- over-year headline inflation is almost 3.8 percent on the CPI and 2.8 or 2.9 percent on the PCE. We are not acting. Why are we not acting? Because we are relying on a forecast that we are

confident that inflation will fall. But we have been saying inflation will fall and stay low ever since last fall. Forecasts haven't been very good. We have to be careful about those forecasts.

We don't have to go back to the 1970s'just look across the Atlantic at the Bank of England. For nearly two years now, inflation in the United Kingdom has risen from a very low level to 3 percent, and now inflation is 4.8 or 4.9 percent. This has occurred over a little less than a two-year period. They continually forecast that inflation is going to come down. Yes, it will come down next time; it will come down next quarter; it will come down the quarter after that. We keep looking for excuses as to why inflation may or may not be high, and looking at every excuse except monetary policy. I am worried that relying on forecasts and looking forward will make it very difficult for us to pull the trigger in such a strategy. We will have extreme biases toward excessive ease. The Bank of England is facing some severe challenges. Unemployment rates are running at around 8 percent, give or take a little bit from month to month, and inflation is pushing 5 percent. We do not want to find ourselves there, and yet I think it is entirely possible. There is a lot of slack in the U.K., but it hasn't prevented them from facing severe inflation problems.

Alternative B has its own set of problems. As I said, it is unlikely to be effective at improving real outcomes. It doesn't address what I believe are the real risks that this economy faces right now, and they are not risks within, they are the risks of a financial implosion in Europe. Alternative B is unlikely to be perceived by those outside the trading floors of Wall Street as anything but an ineffective measure for the real problems that Main Street faces. When we take actions that Main Street perceives as ineffective and plays to traders, we undermine our credibility. It leaves the impression that we are acting because we can, and doing what Wall Street expects, not because we must. I think we are entirely overreacting to short-term events. I

agree with President Lockhart's remarks about pausing, taking stock, and not feeling like we have to create responses to every intermeeting period's events. To react to short-term events is a dangerous way to conduct policy, and we should not do it that way. Our unemployment problem is a serious problem. It is a devastating problem for many millions of workers. But I think it is a medium- to longer-term problem that we face that is not easily repaired by short-term fixes and short-term tools. Those short-term tools, to the extent that we use them to no avail, will create longer-term problems for us down the road. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Why don't we take 15 minutes for coffee, and then we will come back. Thank you.

[Coffee break]

CHAIRMAN BERNANKE. Let's turn now to President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. This is a difficult decision in a highly uncertain economic environment, but today I support alternative B. Over the last several months the incoming data have made it clear to me that the slowing of the pace of the recovery has persistence. It isn't just a temporary response to supply disruptions and high commodity prices. In addition, the incoming data have significantly increased the downside risk to growth. While it is extremely difficult to forecast recessions, I think the deterioration in consumer and business sentiment and in the international economic conditions have left us on the cusp of a recession. I still project that the economy will avoid a downturn this year, but I think that a little extra accommodation would help lower the risk of a downturn.

My primary concern about providing more accommodation is the inflation risk. As I mentioned in yesterday's economic go-round, I think it is most likely that inflation will be at or below the rate consistent with price stability in the medium term, but with core inflation

measures coming in higher than expected for several months now, including in August, there is a risk of underestimating underlying price pressures. In judging the inflation risks, I do take some comfort from the stability of various measures of inflation expectations at rates that are consistent with price stability. I think this leaves us room to adjust policy in response to the increased risk of recession, but because the margin for error on the inflation outlook is not large, I would prefer that the maturity extension program be structured at a monthly pace as described in the language in alternative B(3'). This approach would give us more flexibility to alter the program if underlying inflation does not moderate.

I prefer to continue to reinvest maturing agency debt and MBS into Treasuries. We told the public that we wanted to return our portfolio to a Treasury-only portfolio. If we decide that this is an appropriate way to go, I would rather wait to do this at our November meeting because that is a meeting where you will have a press conference. It will give you an opportunity to talk about the change in our reinvestment strategy.

I also hope that at our November meeting we will be able to incorporate into our statement some of the elements of an enhanced communications strategy that we discussed yesterday. I would especially support including language along the lines of paragraph 2 in alternative A. I would leave the language in that the Committee discussed the range of policy tools. We announced that we changed this meeting to a two-day meeting in order to provide us time to discuss our alternative policy tools. And finally, in paragraph 1, I do prefer changing the language around the inflation situation to 'inflation appears to be moderating.' Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I want to thank President Lacker and others for their sobering comments about the 1970s. I don't think anybody here can conduct monetary policy without at least being concerned about any parallels to the 1970s and that difficult period in which the Fed didn't perform as ably as anyone would have hoped. That said, I believe that today, this period, will be as important for the United States as the 1930s were. The responsibilities of the Federal Reserve are as important today as they were in 1930s. This gives me great pause. The 1930s Fed has been vociferously criticized, and I don't think that this is a time for monetary policy in a business-as-usual mode. We have to think differently than that.

Normally, monetary policy can act within sS bands and achieve good outcomes with normal policy responses that are within these bands. Whenever policy is normally within these channels, you can follow a Taylor rule. You can follow the same type of policy process that President Bullard talks about in terms of having a bias for policy and a continuation basis. But times are very different now. In 2008 and 2009, we blew through those sS bands. At the zero lower bound, we did all kinds of additional liquidity programs like the TALF, QE1, and QE2.

Milton Friedman said that short-term interest rates of zero are a sign of restrictive monetary policy. That's what we're facing at the moment. There's an excess demand for safe assets. I think we have liquidity trap conditions, which are inhibiting the accommodative stance of policy that we'd like to say that we have but, in fact, we don't. Since most of the public, however, disagrees with this Friedman characterization'that our policy is restrictive today'we have a tough mountain to climb, but we should climb that mountain.

The effects of policy accommodation are currently held back by the time-consistency dilemma of conservative central bankers. I talked about this yesterday. Many around this table will earnestly talk about inflation risks and have the effect of damping the expectation that policy

can be truly accommodative into 2013 and beyond. For policy to be truly accommodative, I think we need a clear and transparent commitment to forward guidance. I commented yesterday about how the usefulness of economic markers related to the unemployment rate, with inflation safeguards, would help dramatically to achieve that type of clarity. Yes, I think we should have more clarification on the language that we introduced at our last meeting in terms of mid-2013. It wasn't totally satisfactory. I don't think anybody would disagree with that, but we need clarification of that in line with what our objectives really are.

Mr. Chairman, yesterday you spoke very well about flexible inflation targeting, but I think that details really matter there, and we have different views about how we think about flexible inflation targeting around this table. I don't think it's well understood. I agree with President Kocherlakota's suggestion that we need the leadership of the Committee to speak publicly about this. I think that you and the Vice Chairs should craft the most aggressive characterization of flexible inflation targeting as we can do. That's very important. I gave a speech recently where I used the colorful phrase that we should act as if our hair were on fire because of the fact that the unemployment rate was very high. I did that, in part, to clarify and amplify the key operating requirements that are part of flexible inflation targeting. I thought that was just a natural way to help describe what that really means because it's not out there enough.

Many times in the last two days we've made comments about how fragile our FOMC statement is and that it can't really bear the burden of including a few additional safeguards because the public won't understand it. I disagree with that at least in the following sense. I think that the Chairman, especially the Chairman, should craft a speech or testimony in which he describes exactly what we mean by these important policy options, and then they find their way into the statement in a way that is well understood by the public when they first see them. That's

how important changes in language have often been introduced, which suggests that, in fact, we could introduce those types of communication vehicles. It does require more than just introducing it to the statement. It requires a lot of additional work, but there's time to do that work within a short period of time.

The discussion at this meeting reinforces for me that our current policy development is a journey. I recognize that we won't get to the conclusion that I favor today, but we have to continue to make further progress today. I prefer, not surprisingly, alternative A with paragraphs 2 and 4. Frankly, if I had an ideal policy characterization of this, I would say that we could tolerate short-term deviations of inflation from our target up to 3 percent, and the unemployment rate threshold of 6'' percent would also be very reasonable, according to my reading of the policy memos. Whether or not we choose LSAPs or a maturity extension program is less critical to me. It's more about the commitment to having an accommodative policy. So I am fine with just doing the MEP as described in alternative B. I think we should expect to make progress toward hitting these thresholds, and if setbacks were to occur and progress wasn't made in a reasonable period of time, then we should respond with more policy accommodation. However, we've got inflation safeguards in the framework that I prefer. If medium-term inflation'it's a forecast, but that's how we have to think about inflation'were to go above 3 percent, then we would think about winding down that type of accommodation. If people don't like using the unemployment rate in there, there are other reasonable measures that could be put in there. We have talked about resource slack and about output gaps, but a lot of times one reason why we talk about unemployment is because people are nervous about saying the output gap because of the uncertainty. There's going to be uncertainty, but we have to be able to point

to something. If you don't like unemployment, we could use the employment-to-population ratio. I don't see why that can't be achieved.

I can accept that more discussion is required before we can entertain the types of actions like those we've discussed today. I look forward to additional discussions about policy frameworks, state contingent as they might be. I think that the state exists where we should undertake these. Alt B today can be acceptable to me. It's very important that as long as we make progress today toward more accommodation, I can support this. If the journey stops prematurely or aborts, I'm not sure I could support that given the extraordinary needs that the economy faces, and so I think November will be a very important discussion.

In terms of additional particulars, in alternative B the discussion about MBS purchases is fine. On the inflation in the first paragraph, you could go either way on this. It is true that this should be a factual discussion about developments of inflation, and sometimes it's just not how you would like it to be, but you have to acknowledge that, and you have to get that right in the second paragraph where you're talking about the forward-looking expectation for inflation. We have to make a choice there, but we're going to have to live with it. That's everything. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. First Vice President George.

MS. GEORGE. Thank you, Mr. Chairman. The economy appears to have lost some momentum in recent months, and labor market conditions certainly are weak. Furthermore, the downside risks to the growth outlook are considerable and have increased, especially with respect to the situation in Europe. Yet price pressures are broad-based, and inflation has been above 2 percent recently.

Regarding the policy options, my views are influenced by three factors. First, I do see the recovery as continuing, although at a lower level over the near term. Second, inflation is currently elevated and does not appear to be influenced solely by temporary factors. Third, current policy remains highly accommodative. Based on these factors, adopting additional accommodation at this time seems somewhat premature, although I do prefer that we keep the tools discussed under alternatives A and B on the table as we go forward. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I support alternative B. The economic outlook has deteriorated significantly since our August meeting and downside risks are looming ever larger. I've become increasingly concerned that the economy is near stall speed and could easily slip into recession. As I explained in the economic go-round, I see the modal outlook as decidedly worse than a year ago when we decided to adopt QE2. In particular, my outlook under current policy settings, like the Tealbook's, is for unemployment to stay horrifically high for years while inflation over the next two years declines below mandate-consistent levels. I can't see how such a forecast can be consistent with optimal policy under an inflation-targeting strategy if we interpret that as a forward-looking approach in which we choose policy to minimize a loss function, including deviations of inflation from target and deviations of unemployment from its long-run equilibrium level. In addition, we face downside risks that are exceptionally large at a time when policy is constrained by the zero bound. Therefore, I strongly support taking actions at this meeting to foster a stronger recovery, assuming they pass a cost- benefit test.

In my judgment, the maturity extension program, even though it is obviously not a panacea, is a cost-effective tool for providing some additional monetary accommodation. I

support Vice Chairman Dudley's suggestion that we roll over maturing MBS principal back into MBS rather than into Treasuries. I agree with the arguments he and others made for this strategy. Reducing the spread of MBS yields over Treasuries will have greater bang for the buck and would avoid a reduction in market liquidity that could result from our increasing dominance in the long end of the Treasury market.

Regarding specific language, I would prefer the first variant of paragraph B(3) because conveying our intent to complete the full program seems likely to provide the greatest extent of stimulus and would be consistent with our communications about the previous round of longer- term Treasury purchases. That said, I see good reasons for engaging in regular reviews of this program over coming months. In particular, if the strains in European financial markets intensify much further, it's quite plausible and perhaps likely that safe-haven flows would flatten the Treasury yield curve to the point where there might be little or no benefits to proceeding with our maturity transformation program. In light of such considerations, I'd be willing to support the second variant of paragraph B(3) if that language seems preferable to other members. Finally, I strongly support the bracketed language in paragraph B to underscore that the Committee is prepared to employ additional policy tools as appropriate. Indeed, as I noted yesterday, I believe that communications may be the most powerful tool that's still in our toolbox. I continue to see advantages to the approach in alternative A, but this is something we need to give further consideration to in the context of the larger discussion of our monetary policy framework in November. I also strongly agree that we need to consider out-of-the-box or blue-sky approaches should things deteriorate further, and that it's important to develop those tools now.

CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I want to particularly thank you for noting yesterday that I have learned to use the lingo of the FOMC, but I'm not yet able to plug my assumptions into a Taylor rule so I'm going to have to make up for that by expressing myself in terms of munitions metaphors.

When I look at the forecast, and particularly the inflation forecast, I could support alternative C. I'm concerned about the trajectory of the revisions to inflation and am mindful of the comments that President Kocherlakota has been making. But going back to the framework that I used in making business decisions, I also got used to asking: What is the worst possible outcome that could occur as a result of taking an action, and if that happened, would we be in a position to deal with it? When I looked at the estimate of the inflation effect in the forecast under the baseline and all the alternative simulations, only the 'Greater Supply-Side Damage with Higher Inflation Expectations' scenario breached 2 percent on total or core PCE, and that one peaked out at 2.6 percent, which didn't seem like an awful outcome. Further, if the forecast and the estimates of inflation that would be generated by this action were wrong and we did, indeed, get more inflation than we expect, I think we know what to do about it. It might be difficult to decide to do that, but we do know what to do about it. And at that point, we would also know that this balance sheet gun is truly out of bullets and that we wouldn't be able to use it anymore.

As to the 'keeping the powder dry' philosophy, I will admit that the experience of the last few years has made me more inclined to go ahead and shoot now. But even if I were inclined toward keeping powder dry, I'm not sure that this is the specific dry powder that would be helpful in a financial crisis that was precipitated by a European crisis. In that case, our balance sheet would be likely to grow again as a result of liquidity-providing actions, and I don't

think this would necessarily be the tool we would choose in that circumstance. However, if we're going to take this action, it's important to get the maximum effectiveness out of it. For this reason, I support the first paragraph 3 rather than 3'. We get the full stock effect immediately, and the reduction of uncertainty offsets the loss of flexibility. Second, it's important to aim precisely, and I support the reinvestment in mortgage-backed securities as a way to make this action, if only marginally, more effective in the housing market where I think the weakness is a significant impediment to recovery. Finally, President Bullard said that the Committee would not announce a series of interest rate moves in advance and that that is what the first characterization of paragraph 3 is, but that's exactly what we discussed yesterday in terms of the forward guidance'announcing a series of actions in advance. Again, I think 3 is more powerful. In paragraph 6, I have some discomfort with the bracketed language because it seems to leave us in the position of reloading, and I'm not sure exactly what sort of actions might be expected as a result of that language. Given my strong concerns about reducing the IOER, I would be really uncomfortable about setting up expectations for additional action that I'm not sure that we would be able to meet. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. Given that I have for some time believed that there was no real momentum in the economy or, more precisely, that the momentum that existed was provided only by fiscal and/or monetary stimulus measures at their peak of impact, I do believe we are still in a position where we need further stimulus. Like many people around the table, I would prefer that we had more of a structure within which we could provide that stimulus as appropriate, both timing and quantity. We don't right now, and certainly with respect to the communications options, it's going to take some time to develop it whether, as

Charlie Evans suggests, through public preparation before a move or through some change in the economic projections. In light of that, I would support alternative B. The maturity extension is, for the reasons many of you detailed yesterday, a program of limited efficacy, but as I suggested yesterday as well, the very limitations are, in some sense, appropriate given that we don't have a broader structure, and I don't think anybody is going to misunderstand this as the first step in some broader program.

On inflation, it is surely the case that inflation has been higher than many, if not most, of the people around this table expected. On that, I would say two things. One, I find the staff's explanation as to why the factors pushing up inflation are temporary more compelling than the explanation of factors as to why the relatively weak performance of the economy is temporary. And two, as many of you, most recently Janet, have suggested, if we're not willing to contemplate any increase in the potential inflation rate, even over a short term, notwithstanding a path toward the long-term rate, then it doesn't seem that we have a flexible inflation-targeting strategy anymore. We have a hard target, and I have never understood that to be the framework under which this Committee functioned.

With respect to specifics, I'm sure whatever language those of you with an intense interest in the inflation language come up with will be fine with me. For the reasons Betsy stated, I also would favor paragraph 3 rather than 3', but if there were a strong view among others for 3', I would not oppose it. Given what I said earlier, I am for the MBS rollover as well. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. Persistent weakness in labor markets, accompanied by the significant risk that sustained high unemployment could push up the

structural unemployment rate in the longer term, suggests to me that continued accommodation is warranted. However, in order to make a notable difference to the economy, a sizable action is needed in my view, well beyond the Twist described in alternative B. While I agree with the qualitative features of this plan'removing duration risk from the market without increasing the size of the balance sheet'it is unlikely that the magnitude we are considering by itself will deliver an impulse sufficient to get the economy out of the doldrums. The largest boost to economic growth I've seen for this action is '' percentage point, and even this modest number may end up being too high. At a 10-year yield of 2 percent, much of the impact on longer-term interest rates is now probably discounted, and while it's still early, I would be surprised if this move alone would have a significant positive impact on the economy. Nonetheless, at this juncture I think we need to do all we can to raise mean expectations of growth. From this perspective, I note that Committee participants with the help of staff have brought forward very interesting variations in the tools we have, and I believe that these variations could be useful in nudging the economy to greater growth.

Before briefly commenting on certain specific portions of alternative B, I want to say that contingency plans are important. We should do contingency planning. But we also have to do what we can to keep these contingencies from hurting us now, by creating the conditions now for stronger economic growth by inoculating, so to speak, the economy or partially insuring it from the impact of greater harm later on. For example, if the situation worsens in Europe and dollars become more of a safe haven leading to appreciation, clearly we would see our net exports declining, and, all else being equal, we would be led to weaker economic growth, which brings us back to where we are now and the ultimate challenges that we are looking at. Obviously I'm discounting here the effect of greater financial disruption. But I do want to make sure that we

don't use the necessary steps regarding contingency planning as just a way of kicking the can down the road in terms of what we can be doing now. In terms of that, I am heartened by a lot of the different suggestions that have been made. I think that Narayana's suggestion about moving from a date certain to duration has particular virtues in these times. It would be something, too, that would not require us to change language with the rapidity that we currently do, and that suggestion has potential.

In terms of 3' versus 3, I'm sensitive to Jim's concern regarding stimulus fatigue. Most of us remember that one reaction to QE2 was the fixation on the total program size, the notion that what was done in QE2 was government spending of a magnificent magnitude. If we're of the view that this level of analytical understanding in the public hasn't changed much, we may want to consider repositioning how we as individuals communicate this and how our press people present it. On the reference to housing in paragraph 4, I want to just remind us all that it is the failure of the housing market to bounce back that is a significant factor in holding back economic growth. While it may not be time to do this now, I would favor the slight enhancement in mortgage market conditions that is implied by paragraph 4 in alternative B. I don't think that there is really something to watch here or that we need to wait in terms of understanding what's going on in the housing market. But I do feel sensitive to the concerns that we may want to analyze more closely the effect regarding credit allocation and the real improvement that would come through such action. I want to say something about paragraph 6 and the bracketed language regarding the fact that 'the Committee discussed the range of policy tools available to promote a stronger economic recovery in the context of price stability' and note in deciding whether to include that language that it does appear to be the truth. [Laughter] Finally, I close by saying that in terms of the inflation language, I am moved by the current

structure that paragraph 1 continues to be where things are now, and that we put in paragraph 2 the Committee's views regarding what will happen to what we are seeing. I would be fine adding the language 'appearing to moderate.' Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. First, a couple of observations on the Taylor rule. I've never liked it, and I particularly don't like it in the current set of circumstances. The reason I don't like it in the current set of circumstances is that I think that it doesn't really work well because we know that the equilibrium real rate of interest is not anything close to 2 percent, which is assumed in the rule. We could actually solve backwards. We've seen the economy perform very, very poorly despite what's supposedly a very stimulative monetary policy. Well, why is that? Because the monetary policy hasn't been as stimulative as we thought, and that underscores one fundamental flaw of relying on the Taylor rule as your guide to policy.

A second problem with the Taylor rule is that we have an economic situation where the losses are very asymmetric. If we turn out weaker than we want or expect, there's a really good chance we're going to end up in a debt deflation, Japanese-style trap and we're not going to be able to get out. The losses on that side are very high relative to the losses if things turn out to be a little bit better than we expect, and if we get a little bit more inflation than we expect. In that environment, even if we thought that the Taylor rule was the right formulation, we should be following a policy easier than the Taylor rule because of this asymmetric loss function. That's about the big picture stuff. Let's get down to the statement.

First of all, I'm a little bit worried that the markets are going to take what we do today as us being done. In other words, we're doing the maturity extension program because the bar is

too high to do an LSAP, and so that's it. We want to lean against that expectation. In alternative B, paragraph 6, rather than have the phrase 'employ its tools as appropriate,' I would prefer to strengthen that a little bit to say 'to employ the full range of its tools as appropriate.' Keep it open ended, indicating that we could do more should things continue to go badly, which they very well might over the next six weeks. The second point is on paragraph 4. I do favor investing MBS into MBS. But I would flip the sentence order in paragraph 4. I would put the new policy action, 'To help support conditions in the mortgage market, the Committee will now reinvest'' and then I would follow with the second sentence, 'The Committee will maintain its existing policy...' This would give a little bit more prominence to the new policy action rather than the thing that you're maintaining. In terms of 3' versus 3, I have quite a bit of sympathy with what President Bullard has been saying on this, but I don't think it works in this particular case of the maturity extension program because you can do less, but you can't do more. You're limited at $400 billion by the nature of the constraints on our balance sheet. If we were ever to do an LSAP, I would be inclined to do 3' because there is some value to having something that you can stop earlier or you can keep going. But in the case of the maturity extension program, there is no option to keep going beyond nine months. So I think that 3' is actually weaker than 3, and I do not support it in this particular set of circumstances.

In terms of alt A, I would prefer to have more information that we could share with people about our reaction function. I don't think the date is really sufficient, but yesterday's conversation made it very clear there was no consensus on how exactly to do that. We should look at the SEP and try to discover what our ranges of views are on this subject, both in terms of what triggers would be interesting to us and whether any broad consensus would come out of

those numbers. We may find that there's no consensus and that this is a blind alley, but if there's a reasonable consensus, then maybe the SEP is something that can support this going forward.

And finally, I absolutely favor contingency planning in this environment. This is about as dark as the Committee has been regarding the downside risks that I can remember since maybe the dark days of the fall of 2008. The European situation, in particular, looms very large. We absolutely have to have contingency planning not just about our monetary policy stance, but also about what liquidity facilities we would deploy and in what manner. In other words, what's our program escalation should things go in the wrong direction for market functioning? Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much, and thanks, everyone, for comments. Arthur Burns once wrote a speech called 'The Anguish of Central Banking.' I can really relate to that. [Laughter] Many of you are taking strong positions for debating purposes, but I am sure all of you are introspective and appreciate how very important these decisions are and how difficult they are given how little we know and given the wide range of complex economic and political forces'and even natural forces from hurricanes to earthquakes'that are at play as we think about this. These are very, very difficult decisions, and I appreciate everyone's serious consideration.

I was very pleased that we made a good start on contingency planning. What it tells me, though, is that as difficult as the decisions are today, they conceivably could get a lot more difficult. For example, there are scenarios where deflation risk increases, and we look at LSAPs and have to figure out how we would manage that. There are scenarios where we would want to change our framework. I suspect that, barring a major change in the outlook in the next few

weeks, it's going to take us a bit of time to fully work through all of those options. I am, therefore, not sure what the next steps are likely to be and how quickly they will come.

That fact that it's difficult to judge how quickly and how aggressively we'll be able to move in the future is a consideration for me because I do think that the recovery is in some danger. Recession risks are increased. Financial volatility and financial stress are very important headwinds. At the same time, while acknowledging that inflation hasn't fallen as quickly as we expected, all the fundamentals suggest that, as best as we can tell'and of course, our forecasting is not particularly good'most of the pressures are toward stabilization or decline in inflation. Given that, I feel that we need some kind of bridge from now until the time when we either face some even more dangerous situation or choose to make fundamental changes in our framework or communication. For that reason, taking into account the very good arguments made'I was going to say on both sides, but there are probably about five or six different sides here [laughter]'I would propose to recommend alternative B to the Committee today. The idea is that we will provide some support for the economy and some reassurance that the Fed continues to be there. Clearly, it's not a panacea, as a number of people have pointed out, but I do think of it as a bridge toward whatever future action this Committee may find to be appropriate.

I favor the reinvestment into MBS. I note for those concerned about this reinvestment that all this does is maintain our current level of MBS. It doesn't increase either our balance sheet size or our holdings of MBS. It has the advantage, first of all, of focusing on a troubled sector'the housing sector. But we also talked a lot about market functioning the last two days, and by reducing the purchases of longer-term Treasuries, we'll actually reduce some of the pressures in the market functioning in the Treasury market. I think that's constructive. That's

my recommendation. I do want to reiterate what I said before about maturity extension. It is a different policy from the LSAP. It is not as powerful, and it is, of course, not repeatable, but its advantages include having fewer implications for excess reserves, for the size of the balance sheet, for our exit, and for inflation expectations. In those respects, it's a policy worth considering.

In terms of the language, in the first paragraph we've had two suggestions on inflation. One is 'inflation has moderated somewhat since earlier in the year.' The other is 'inflation appears to be moderating.' I don't feel strongly about that. Does anyone have a comment? President Lacker.

MR. LACKER. Would 'appears to have moderated' be more consistent with Dudley's dictum regarding the first paragraph?

CHAIRMAN BERNANKE. That's fine with me. Is that okay?

VICE CHAIRMAN DUDLEY. That's fine with me.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Just an observation. In some respects, the moderation of fuel and energy prices is what's really driving the moderation of overall inflation at this point.

CHAIRMAN BERNANKE. And that's what it says in the sentence here, too. MR. PLOSSER. Fuel and energy prices have moderated, period.

CHAIRMAN BERNANKE. Right, but we count those. 'Appears to have moderated,' is that fine? All right. Any objection? Okay. 'Inflation appears to have moderated.'

I'm going to come back to 3 versus 3' because I would like to hear the Committee's view on that decision. First, on paragraph 4, does anyone have a reaction to the Vice Chairman's suggestion of reordering those two sentences? Any particular concerns?

MS. YELLEN. Good idea.

CHAIRMAN BERNANKE. If we did that, it would be, 'to help support conditions in mortgage markets, the Committee will now reinvest . . . in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy rolling over maturing Treasury securities at auction.' Have you got that?

I have a compromise suggestion on paragraph 6. On the one hand, as Governor Raskin very appropriately pointed out, we did discuss the range of policy tools. The statement should correlate to some extent with the events of the meeting. On the other hand, I think that 'the full range of its tools' is a little aggressive. I would propose that, as a number of people have suggested, we go back to the language of August, which is identical to this without the brackets. 'Discussed the range of policy tools' is a reasonable step. I don't think it promises any additional action in the near term. Is that okay?

MS. DUKE. 'These' rather than 'its.'

MR. ENGLISH. Yes, change 'these' to 'its' to make it work with the brackets. You could go back to 'these' if you want to use exactly the language in there.

CHAIRMAN BERNANKE. Let's make 'these' into 'its.' In other words, let's just take paragraph 6 as it stands without the brackets, which is essentially the August language.

Now the somewhat substantive decision is 3 versus 3', and we will come back to a couple of issues there in a minute. Paragraph 3 gives the full amount, but it does note that there will be review of the program in light of incoming information. Paragraph 3', which is more along the lines that President Bullard has advocated, gives a monthly rate. Perhaps it's a bit more contingent. We will have the same last sentence in either case, which will be some kind of regular review. I'd be inclined to take a straw poll on this decision unless there's anyone who

wants to make a comment. Anyone? [No response] How many are in favor of 3, which gives the $400 billion total number? [Show of hands] One, two, three, four, five, six, seven. How many are in favor of 3'? [Show of hands] One, two, three, four, five, six.

MR. TARULLO. Some of these people are voting against alternative B.

CHAIRMAN BERNANKE. What?

VICE CHAIRMAN DUDLEY. It should be a vote for B.

MR. TARULLO. Yes, and Richard didn't vote.

CHAIRMAN BERNANKE. No, that's fine.

MR. KOCHERLAKOTA. I voted, but I thought it was a straw poll.

CHAIRMAN BERNANKE. That's all right. Your wisdom is still welcome even if you don't agree with all of what we're doing here. [Laughter] Did we have seven to six? I see a mild majority for 3.

Finally, but in order to maintain the review aspect, President Rosengren, you wanted to change the last sentence there, 'regular review' back to what was in August? Is that right?

MR. ROSENGREN. That's correct.

CHAIRMAN BERNANKE. The last sentence of paragraph 3 now says, 'The Committee will regularly review the pace of its securities transactions and the overall size of the maturity extension program in light of incoming information.' What we had in August was, 'The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate,' a simpler statement. Any preferences? Jim, do you have a preference? Narayana?

MR. KOCHERLAKOTA. I like Eric's suggestion.

MR. BULLARD. I'm happy with it, too.

CHAIRMAN BERNANKE. Are you okay? I hope this is not too complicated. Let's change the last sentence of 3 to the analogous sentence from August. Are there other comments, suggestions? President Lacker.

MR. LACKER. This removes the phrase 'maturity extension program.'

CHAIRMAN BERNANKE. Yes, it does.

MR. LACKER. We're going to have to figure how to communicate our name for this program.

CHAIRMAN BERNANKE. It's the MEP, clearly. You know how much attention they paid to LSAP, right? [Laughter]

MR. ENGLISH. It's going to be 'Operation Twist' no matter what you say. [Laughter] CHAIRMAN BERNANKE. I understand that.

MR. LOCKHART. But not 'quantitative easing.' [Laughter]

CHAIRMAN BERNANKE. We should have done statement A, which has both the MEP and the communications, so that we could have 'Twist and Shout.' [Laughter] Never mind. It wasn't my idea. Further comments?

In a moment we'll take a vote. Let me say that at the end of the vote, Brian, you're going to talk just a little bit about implementation?

MR. SACK. Sure.

CHAIRMAN BERNANKE. Following that, after the end of meeting announcements, we'll have lunch, and Linda, I believe, will give us a congressional update.

MS. ROBERTSON. I'm prepared to do so.

CHAIRMAN BERNANKE. She is prepared to do so. Please, are you able to give the statement?

MS. DANKER. We'll see. I'm starting with alternative B that was handed out. The first

paragraph is the way it was except the second-to-last sentence starts, 'Inflation appears to have moderated since earlier in the year,' and then continues as it was.

Paragraph 2, unchanged.

Paragraph 3'we're keeping paragraph 3, dropping paragraph 3', and the final sentence

of paragraph 3 is being removed and replaced with the analogous sentence from the August statement that starts, 'The Committee will regularly review the size and composition of its securities holdings,' and so on.

Then paragraph 4 will begin with the sentence that starts, 'To help support conditions in

mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.' Then, 'In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auctions.'

Paragraph 5 stands as is, and paragraph 6 stands as is minus the brackets.

CHAIRMAN BERNANKE. Okay.

MS. DANKER. Keeping what was in the brackets, just to clarify.

CHAIRMAN BERNANKE. Thank you. Brian, do you want to take a couple of

minutes?

MR. SACK.5 I will offer a brief description of how the Desk plans to implement the Committee's decisions regarding the SOMA portfolio.

Following recent practices, the Desk intends to release a statement with operational details on these initiatives at the same time as the release of the FOMC statement. A draft of the Desk statement is provided in the handout for your reference.

Let me begin with the $400 billion maturity extension program.

The Desk plans to distribute the purchases from this program across five sectors based on the approximate weights shown in the table contained in the statement. This distribution has been designed to extend the average maturity of the SOMA portfolio. For that reason, it allocates a much larger share of the purchases to longer maturities, including those beyond 10 years, than in previous asset purchase programs. Of course, this distribution could be altered if market conditions warrant.

In terms of selling assets, the Desk plans to conduct regular operations to sell Treasury securities with remaining maturities of three months to three years. Securities with less than three months to maturity will not be sold to provide the markets and the Treasury with greater certainty about the maturity profile of SOMA holdings. These operations will be structured to receive bids across a range of securities and to accept them based on their attractiveness to market prices. We will be selling roughly three quarters of the SOMA holdings in the eligible maturity range.

At this point, the Desk anticipates conducting 14 purchase operations and 6 sale operations per month. A schedule of both purchase and sale operations to be conducted over the following calendar month will be released on or around the last business day of each month. A schedule of operations expected to take place in October will be released on Friday, September 30.

Let me now turn to the agency MBS reinvestment program.

Principal payments from holdings of agency debt and agency MBS will be reinvested in agency MBS through purchases conducted in the secondary market. Based on current projections, the Desk anticipates that reinvestments will total about $200 billion by the end of June, thus resulting in an average monthly pace of purchases of $20 to $25 billion over that period. However, I should note that the prepayment rate on the MBS portfolio is quite uncertain in the current environment, and hence the actual pace of purchases could deviate meaningfully from our projection.

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

The Desk intends to conduct these purchases internally, rather than relying on an external investment manager. Recall that we had established this capability by the end of the earlier asset purchase program. We would expect to be active on most trading days, and purchase operations would be conducted through a competitive bidding process over an external trading platform. We will continue to rely on external firms for middle-office support and custodial services.

In terms of other operational details, we anticipate that the purchases will be

concentrated in newly issued agency MBS, as these securities have greater liquidity and are more closely tied to primary mortgage rates, although the Desk may purchase other agency MBS if market conditions warrant. We also would like the flexibility to use dollar roll transactions to facilitate the settlement of our transactions. The settlement conventions for agency MBS and dollar rolls mean that the SOMA balance may fluctuate around $2.6 trillion.

Purchases of MBS securities will begin on October 3, 2011, and the current practice of reinvesting principal payments from agency debt and agency MBS in Treasury securities will be halted at that point. The Desk will continue to publish on the eighth business day of each month the planned amount of reinvestment purchases for the next month, but we will no longer be including a calendar for the reinvestment operations since we will be purchasing on most trading days in the secondary market. Thank you.

CHAIRMAN BERNANKE. Thank you. Any questions for Brian? President Lacker.

MR. LACKER. This is a question more generally about what conversations we've had

with the U.S. Treasury and what we've gleaned from those about their debt management. Are

they going to react? Do they pledge not to offset us? What do we know?

MR. SACK. We speak to Treasury regularly about debt management issues, and not

surprisingly, we've been discussing that in the context of a maturity extension program in recent

weeks. My understanding is that Treasury has no intention of reacting to our program in terms

of shifting its issuance any time soon into longer-term securities because we're conducting the

maturity extension program. You should keep in mind, though, that they are on a course right

now that is extending the average maturity of their debt, and they've been doing that for some

time, consistent with the recommendation of their borrowing committee. The weighted-average

maturity of their debt will continue to extend, but that pace isn't going to accelerate just because we're doing the maturity extension program.

MR. LACKER. They're going to continue extending the maturity of what they issue while we're trying to reduce the maturity of what's in the hands of the public.

MR. SACK. That's right, but let me make a few more comments on that. The additional maturity extension that's going to be realized is already under way based on debt management decisions they've made to date, and my sense is that they've maybe reached the point at which they are ready to start to pull back from that objective. Yes, we will continue to see a lengthening of the weighted-average maturity given past decisions, but I think we'll see that lengthening begin to slow and at some point stabilize.

MR. LACKER. How does the magnitude of what you expect to be subsequent extension of the maturity of what's in the hands of the public due to their issuance compare with what we're doing with the maturity extension program?

MR. SACK. I believe the effects of the further extension that we expect would actually be larger than the effects of the maturity extension program that has been proposed today. A few things to note. One, that's already priced into the market. The weighted-average maturity of Treasury debt today is 62 months. As far as we can tell, the market expectation is that that's going to reach 70 months'another 8 months of extension'but we believe that's fully expected and priced into the market. Second, it doesn't seem that Treasury is intent on purposefully pushing beyond what's in the markets and, if anything, seems to be shifting perhaps in the other direction. And, third, we can think of these effects as being in place and then think about the FOMC's programs as trying to affect financial conditions around what would have been realized under Treasury's path.

MR. ENGLISH. That is what we did in the memo that was distributed to the Committee. We built in assumptions about what Treasury was up to, and looked at our program at the margin.

MR. LACKER. Right. You're telling me that there's a fair amount of uncertainty about what they're going to do.

SEVERAL. No. Not really.

MR. LACKER. Go to 70 or not?

MR. SACK. They've been clear that they will not be changing their strategy in response to our program. There's no ambiguity about that.

MR. LACKER. But you don't know what their strategy is?

MR. SACK. Their strategy is that they realize the weighted-average maturity will continue to lengthen, but that they're going to start, over time, to make adjustments that should cause that lengthening to slow and eventually to stop. They have not given a precise number of what their weighted-average maturity target is. I'm not sure if they have one at this point, and they're engaged in a very active discussion of these issues with their own borrowing advisory committee. I'm not sure. I don't think it's precisely settled in their mind exactly where they want to end up, but it is my understanding that they do not want to continue to lengthen indefinitely.

MR. LACKER. This contrasts notably with the first Operation Twist in which cooperation was fairly clear with the Treasury. We understood what they were doing with their portfolio and what we were doing with ours.

MR. FISHER. But, Mr. Chairman, this is a very delicate issue, and I think you're going to have to figure out if there's a way to do it when you put out the Frequently Asked Questions

on September 26. There may have been virtues back in 1961 to doing it hand-in-glove. There could also be drawbacks to being perceived as doing it hand-in-glove now. You're going to have to carefully vet this wherever you vet these things to make sure that we don't look like we're setting this up.

CHAIRMAN BERNANKE. We have been very clear: We don't want to involve the Treasury in monetary policy decisions or monetary policy execution.

MR. FISHER. Yes, but I would address this in the Frequently Asked Questions that we provide.

CHAIRMAN BERNANKE. There was a Financial Times story, which I believe made the point that should the Federal Reserve undertake any kind of maturity extension program, the Treasury would not react to that. That's the appropriate thing we've asked them to do, and I've received assurances to that effect as well. Any other questions? [No response]

First, let me note that we'll have a special topic in January called 'The Role of Financial Conditions in Economic Recovery: Lending and Leverage,' which was a very popular winner among the FOMC participants and certainly is a topical issue. I want to thank the Federal Reserve Bank of San Francisco for agreeing to lead the preparations for that special topic. The next meeting is another two-day meeting, fortunately, Tuesday and Wednesday, November 1'2. Lunch is available, and for those who can stay, Linda Robertson will be providing a presentation. President Lockhart.

MR. LOCKHART. Mr. Chairman, there was such a call for contingency planning that November seems, at least under certain circumstances, pretty far away. Is there any thought in your mind as to how we can address that between meetings?

CHAIRMAN BERNANKE. You should help me, Bill. My understanding is that we expect to get the framework memos out exceptionally early in the intermeeting period.

MR. ENGLISH. We're aiming to do so, but we wanted to do so this past intermeeting period, too. Yes, we will try our hardest to get the material out in early October so that there will be plenty of time for people to think about it.

CHAIRMAN BERNANKE. If there are Reserve Bank contributions that would like to be made, please be in touch with Bill, and we'll try to coordinate additional materials.

MR. LOCKHART. The process sounds like react to memos and circulate views and essentially do it all that way between now and November.

CHAIRMAN BERNANKE. What else would you suggest?

MR. LOCKHART. Well, we may be overtaken by events. You never know.

VICE CHAIRMAN DUDLEY. Are you proposing a videoconference or something like

that?

MR. LOCKHART. Yes. Something like a videoconference where we can have a spontaneous exchange of views as opposed to the formality of reacting to a memo and circulating that and then reacting to someone else's reaction, and so forth.

CHAIRMAN BERNANKE. We're certainly prepared to do that, either assuming we get early preparations or if the situation changes in a significant way. Governor Tarullo.

MR. TARULLO. Mr. Chairman, to draw a distinction, I think you've been referring to more conventional monetary policy contingencies. I believe that staff at the Board and the New York Fed have already been thinking about liquidity facility contingencies.

CHAIRMAN BERNANKE. Oh, yes.

MS. YELLEN. Is that what you were thinking of, liquidity and the like?

MR. LOCKHART. I really wasn't, in my mind, making a distinction. I'm just noting there's such a call, and November may be too late in some respects.

CHAIRMAN BERNANKE. Well, on the purely financial stability side, we have an ongoing LISCC, an Office of Financial Stability, and other coordination occurring on an operational daily basis.

MR. PLOSSER. Would it be inappropriate for the Board to have a meeting or a conference call so that we are filled in on what the Board staff is thinking in terms of the liquidity provisions and other things that might arise during such a time?

CHAIRMAN BERNANKE. Certainly, but again, the LISCC, for example, is a Systemwide committee, which in principle can report.

MR. LACKER. Not every Reserve Bank is on it.

CHAIRMAN BERNANKE. Not every Reserve Bank? Your point is taken. I don't know if Nellie is here. We will try to make sure that there is some kind of call at an appropriate time, particularly if there are any important developments.

MR. FISHER. Mr. Chairman, without giving offense, which I'm sure I will, I do think it's important that we all be on board with this, but we also have to be extremely mindful that none of this leaks out to the public, and that's what worries me.

CHAIRMAN BERNANKE. What?

MR. FISHER. If any of this contingency planning leaks to the public.

CHAIRMAN BERNANKE. Yes.

MR. FISHER. Again, I remind myself and everybody else that we have to watch this very, very carefully as we share what alternatives are being developed.

CHAIRMAN BERNANKE. There will be some minutes. That's inevitable.

MR. FISHER. We need to think about that then because we could scare the heck out of

people.

CHAIRMAN BERNANKE. Again, the liquidity issues or the financial stability issues don't have to take place in this particular context.

MR. FISHER. And we did it well during the crisis, and there was almost no leakage. So I just want to remind folks. I think it's critical.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I want to thank Governor Tarullo for sharing with us that the Board and New York staff are working on liquidity.

CHAIRMAN BERNANKE. We will have a full interaction with the System and make sure that everybody is kept abreast. The meeting is adjourned. Thank you.

END OF MEETING

Meeting of the Federal Open Market Committee on

November 1'2, 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, November 1, 2011, at 10:30 a.m. and continued on Wednesday, November 2, 2011, at 8:30 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

Christine Cumming, Jeffrey M. Lacker, Dennis P. Lockhart, Sandra Pianalto, and John C. Williams, Alternate Members of the Federal Open Market Committee

James Bullard, Esther L. George, 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 W. Wilcox, Economist

James A. Clouse, Thomas A. Connors, Steven B. Kamin, Loretta J. Mester, Simon Potter, David Reifschneider, Harvey Rosenblum, Lawrence Slifman, Daniel G. Sullivan, 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

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

Transcript of the Federal Open Market Committee Meeting on

November 1'2, 2011

November 1 Session

CHAIRMAN BERNANKE. Good morning, everybody. This is a joint FOMC'Board meeting. I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you. We welcome you, Esther George, in your new capacity as President of the Federal Reserve Bank of Kansas City. Welcome again.

MS. GEORGE. Thank you.

CHAIRMAN BERNANKE. Before launching into our official business, President Fisher needs to describe an intra'Reserve Bank transaction. President Fisher.

MR. FISHER. Yes, thank you, Mr. Chairman. Unlike some operators on Wall Street, we at the Federal Open Market Committee do pay our debts in full. [Laughter] I have a debt that I need to pay back to the gentleman on my left. [Laughter] I am tempted to claw his eyes out and scratch his legs during the meeting, but instead, being honorable, this is the bet. [Laughter]

MR. BULLARD. Let the record show'

MR. FISHER. This is beer. This is the elixir of working men and women, and I never resist giving some facts. Beer is the third-most consumed liquid product in the world after water and beer. It goes back to at least the Neolithic Period, 9,500 B.C. There was a goddess of beer that the Sumerians have called Ninkasi. And there is a famous prayer that is called 'The Hymn to Ninkasi.' I evoked it so many times during the sixth game, but I found out that Ninkasi, whoever she was, gave way to the god of Bud. There it is, Shiner Bock, the best of Texas beers. I would have brought you a Lone Star, but real men and women don't drink light beer. [Laughter]

Mr. Chairman, thank you for giving us this opportunity. I won't tell you how I snuck it

into this room. I never want to go through that security procedure again. [Laughter] But you

won, congratulations.

MR. BULLARD. Thank you, sir. And a great World Series it was.

MR. FISHER. It was a terrible World Series. [Laughter]

MR. TARULLO. What were you going to pay up if he won?

MR. BULLARD. A six-pack of the local brew.

MR. WILCOX. Bud Light. [Laughter]

MR. BULLARD. Bud Light, Busch.

CHAIRMAN BERNANKE. Okay. Meeting is adjourned. [Laughter]

Let's turn to item 1 on the agenda. The retirement of Dave Stockton opens up a vacancy.

We propose to select David Wilcox as economist for the FOMC, and Larry Slifman as associate

economist, effective until the organizational meeting in January 2012. No objections? [No

response] All right. Thank you very much.

Let's turn now to item 2 on monetary policy frameworks. Let me begin the discussion by

turning to Michael Kiley, who will lead the staff presentation.

MR. KILEY.1 Thank you. Early last month, Committee participants received a memo on 'Alternative Monetary Policy Frameworks' that I coauthored with Chris Erceg and David Lopez-Salido. The memo discussed several policy strategies that the Committee might wish to adopt that could potentially provide additional stimulus or protection against especially undesirable outcomes.

As highlighted in the box at the top of your first exhibit, these commitment strategies are broadly consistent with flexible inflation targeting'that is, with a policy framework that combines commitment to a medium-run inflation objective with the flexibility to respond to economic shocks as needed to moderate deviations of employment from its 'full employment' level. In our analysis, we assumed that the Committee aims to achieve an inflation rate of 2 percent, consistent with the majority of longer-run projections from the Summary of Economic Projections (SEP)

1The materials used by Mr. Kiley are appended to this transcript (appendix 1).

Nominal income targeting also achieved improvements in inflation and unemployment in simulations of dynamic stochastic general equilibrium models (such as SIGMA and EDO, two staff models) and in a small model based on research by economists throughout the Federal Reserve System. In contrast, price-level targeting performed poorly in the FRB/US model and the small model. Finally, price-level targeting performed well in the EDO model. This model is perhaps most similar to that used in some recent research that suggests price-level targeting can be a good strategy. As a result, our analysis confirms the support for price-level targeting provided by some research while highlighting that this result is sensitive to assumptions regarding the structure of the economy.

Moving to your final exhibit, Committee participants received a set of questions related to these issues on October 25; for your convenience, these questions are reproduced here.

CHAIRMAN BERNANKE. Thank you very much. The floor is open for questions. Let

me start with a quick one. In the nominal GDP targeting on exhibit 2 we show a gradual

approach to the target. How quickly do you assume that actual nominal GDP approaches the

trend level, and how do you communicate that to the public?

MR. KILEY. In all of the cases, whether it is nominal GDP targeting or the inertial

Taylor rule approach, policy is actually governed by a rule, not by a pure targeting approach. So,

there is no specific objective for how quickly nominal income approaches its target.

We assumed that the policy strategy would be highly inertial so that policy adjustments

would be very slow. We did that because the policy literature suggests that in many models,

highly inertial policies are a really good idea. Those strategies imply that nominal income hits

the target, depending on which model, late this decade or under some of the models even later.

In the FRB/US model, nominal income would hit the target around, say, 2018 and overshoot. In

the EDO model, it hits around the same time, and there is no nominal GDP overshooting. It

essentially hits that level. In the small model we considered, because inflation is so inertial, it

could take even longer, and nominal GDP wouldn't hit the target over the next 5 to 10 years.

The answer to the question depends upon the model and the specific degree to which the nominal income targeting is inertial.

CHAIRMAN BERNANKE. How do you communicate how aggressively you are going to respond to the gap?

MR. KILEY. One way to communicate that would be by laying out a simple policy rule, and that obviously was what we did in all of the models and is one thing that is robust across models. It doesn't depend on when nominal income achieves target. Showing how you would change policy in response to nominal income doesn't depend on a specific model's rate at which the nominal income gap closes, but, rather, depends on your model. Then, one could explain that in terms of your baseline outlook for nominal income or'

CHAIRMAN BERNANKE. All right. Thank you. Other questions? President Lacker. MR. LACKER. Yes, thank you, Mr. Chairman. I wanted to ask about the optimal policy

under discretion. You say that you assume the Committee aims for a target of 2 percent. I am wondering, does the policymaker choose what inflation rate we desire in the long run? Or do you hold that constant?

MR. KILEY. It is a period-by-period choice for the policy rate, given a long-run objective. The policymaker is trying to choose where inflation and unemployment will go on a period-by-period basis. They don't reconsider the 2 percent inflation objective. That is hardwired into a policymaker's DNA.

MR. LACKER. In a sense, there is some commitment.

MR. KILEY. That is right.

MR. LACKER. Thus the quotes around 'discretion.' So the Taylor rule is not time- consistent, and it describes what we do pretty well, right? Is that true?

MR. KILEY. Any simple instrument rule will not be the optimal discretionary policy. There would be an incentive to deviate from it.

MR. LACKER. Right. The extent to which the Taylor rule captures how we behave now, is it your judgment that we behave with some greater level of commitment than is embodied in your optimal policy with discretion?

MR. KILEY. As I noted, we would view the historical approach of the Committee as one consistent with constrained discretion. Clearly the Committee doesn't adjust policy willy-nilly and doesn't reconsider on a meeting-by-meeting basis every aspect of its strategy. Definitely, there are commitments.

Indeed, under the discretion case, as you noted, we take a number of commitments off the table and assume that, for example, an inflation objective of 2 percent is hardwired in the policymaker's DNA. In addition, policy communications have given guidance regarding the outlook for the federal funds rate, for example, and I am sure the Committee and the public view those as conditional commitments. It would be false to suggest that the policy approach involves zero commitments. The optimal discretionary case here involves a number of commitments as well, and the extent to which there could be gains from further commitment is consistent with the story that we have told in illustrating commitment versus discretion.

MR. LACKER. I have one other question, Mr. Chairman, if I could. You have an objective function that you carry across these scenarios and across models that has the policymaker minimizing this weighted sum. On the unemployment side, it is the deviation of unemployment from a u* that is fixed, that is a constant. Am I right about that, or is it the Tealbook's NAIRU?

MR. KILEY. There are the modest movements in the Tealbook's natural rate.

MR. LACKER. Is it the natural rate that is adjusted for the extended unemployment benefits?

MR. KILEY. It is. That is not particularly important, because that is only an adjustment in the next year.

MR. LACKER. In the model EDO, you start from preferences, endowments, and technologies, and, principally, you could derive the right loss function, right? And it wouldn't have the same property that the u* is some fixed, smooth thing. Am I right about that?

MR. KILEY. Yes, that's correct.

MR. LACKER. There is this dichotomy here, right? The change in the unemployment insurance, the richness of those'it is a kind of a shock, right? You guys take that on board for NAIRU, but you don't take on board any of the other shocks that have hit the economy in the past few years. Have you guys thought about that dichotomy, that contrast?

MR. REIFSCHNEIDER. Before this recession we thought the NAIRU was 4'' percent. Now we think, leaving aside the effects of extended unemployment benefits, things like that, it is 6 percent. When you ratchet that up, that is a very persistent hit to labor market functioning, relative to what we thought.

We have also gone back and taken a look at what it was prior to the recession. I don't think it was quite as low as 4'' percent. But we have assumed that'through very persistent reduced attachment to the labor force, through duration of employment, through long duration of employment hurting people's skills, things like that'there are persistent fallout effects, supply- side effects. As Mike said, those effects are taken into account in these analyses.

MR. LACKER. That results in a figure that is really smooth, and the vision you'd get out of EDO is that every quarter's TFP shock should affect the natural rate. There is still a bit of a bucket of left-out shocks there. Thank you.

MR. KILEY. That is technically true. In much of the literature actually incorporating unemployment in models like EDO'in practice, that is not the result that comes out. The natural rate of unemployment is often very smooth. In addition, it is important to be consistent across all the implications of a model if one wants to push the story that far. For example, in EDO, given the definition of the natural rate of unemployment that you are suggesting, that would be higher. It is also the case that there is a natural rate of interest that should be accounted for in a model like that, and that is actually much, much lower because of the effect on financial frictions estimated by that model. If you take both of those factors into account, you would want policy to be even easier than in a model like FRB/US. One shouldn't cherry-pick a particular implication of a model. One needs to walk through the analysis very consistently, and it is not always what one thinks.

MR. LACKER. Perfectly fair.

CHAIRMAN BERNANKE. Governor Raskin.

MS. RASKIN. Yes. Thank you, Mr. Chairman. One question, Michael, from an operational perspective on the nominal income targeting, and that has to do with whether the activity component of nominal income is known in a timely way and as a reliable data point sufficient to permit adjustment.

MR. KILEY. One could have different opinions on that. At the current juncture, I think the answer is clearly yes, the data are timely enough. Over the period that we are considering these strategies, nominal income would provide a reliable enough signal, because we are not

talking about whether the federal funds rate should be up or down 25 basis points this quarter, and then adjusted next quarter. We are looking at a situation in which, in our estimation, a plausible nominal income gap is about 7 percent. The measurement error or the degree of revision in nominal income is just not that high, but there are revisions.

It is certainly possible that when the economy is back closer to steady-state conditions that that type of a consideration would be important from meeting to meeting. I think that's something that one wants to consider when one is thinking about whether or not an intermediate target like nominal income is appropriate for the next 5 to 10 years or is appropriate forevermore.

And the answer to that question is that it doesn't have to be the same. Right now we are in extraordinary times. One of the problems with nominal income targeting'that we are not exactly sure about the level of nominal income this quarter'is actually not that important right now, even though 10 years from now I hope that that is a really important consideration.

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. I have a question. It seems like the way you have presented it implies that the nominal GDP targeting implied a lower trigger or a lower threshold for exit. Do you need the actual framework of nominal GDP targeting to generate these outcomes? Or could you just actually have the lower trigger threshold? And would that be sufficient? I mean, how does the staff view the articulation of the framework vis-''-vis how that maps into the trigger? I am not sure I am being clear.

MR. KILEY. I am not sure that there is a uniform step. The way that I would think about it is that certainly within a given model, or a given view of the world, specifying a trigger and an outlook for the funds rate is the same as saying that you want a target for nominal GDP. But as I noted earlier when we were talking about the rate at which nominal GDP might

approach its target, those implications are not robust necessarily across different views of the world; whereas reference to a set of goals'and those could be unemployment goals and inflation goals, those could be nominal income, those could be something else'may be more consistent across frameworks.

The way that I would view it is that there is some distinction between simply saying the funds rate is going to be a certain value for the next X quarters and a framework, because the framework provides information to individuals who have a different view. And over time they will learn whether their view is confirmed or disputed by the data and presumably update their expectations.

VICE CHAIRMAN DUDLEY. I am trying to get at a point'how much of the benefit do you get by having the trigger values out there versus the framework out there? I am trying to understand how you parse those two things.

MR. KILEY. Certainly, under the baseline outlook you get some of the benefit from the trigger and some of the benefit from the overall framework. And then, in the shocks, when things turn out different than you expect, the triggers don't necessarily tell you what is going to happen in all cases, because they may involve differences in policy in periods after the trigger has happened. The framework provides some of the benefit.

In the simulations, or in the forward-guidance memo, triggers that signal additional policy accommodation are helpful at the current time, if one wants to improve outcomes for resource utilization. But there appear to be some gains from moving beyond that.

VICE CHAIRMAN DUDLEY. Thank you.

MR. WILCOX. It would be difficult to analyze that question, in principle, in your models, because the agents in your models understand exactly what the framework is. I think

what Michael is saying is that communication clarity is key to the difference between a trigger strategy and a nominal income-targeting strategy, and communication isn't an issue that is salient in the model.

MR. KILEY. Yes, that is the hard part.

CHAIRMAN BERNANKE. On the other hand, nominal income targeting is only an approximation of the optimal path, so a lot depends on the quality of the approximation as well.

MR. KILEY. Right. And certainly, across different models is a less-good approximation. We had one example of nominal income targeting a specific rule, changing those parameters slightly. It is not going to be quite as good an approximation of the optimal policy rule.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Thanks for the great memo, and thanks for the great presentation, Michael. I had two quick questions. One is, in exhibit 3, when I look at PCE prices under nominal income targeting, the graph ends in 2018, and we are still above 3 percent. How long do we stay above 2 percent in that simulation?

MR. KILEY. This is a huge shock, so the economy takes a long time to get back to steady state.

MR. KOCHERLAKOTA. Yes, I agree with that.

MR. KILEY. It doesn't actually take that long to get back to 2 percent. This is sort of the peak, and it starts coming down and will be going back closely to 2 percent in the several years after that. But the economy won't settle down. It will undershoot, and then it will come back up, because the economy under this particular policy strategy, which is just focusing on nominal income, will be oscillating in toward that steady state for a while under the FRB/US

model. That is not necessarily true in all the models. But as I noted, part of the success of that strategy in this scenario is this willingness to have inflation go to 3 percent.

MR. KOCHERLAKOTA. I agree, yes.

MR. KILEY. We certainly did simulations in which, when you see that, you just back off and want to give up on nominal income targeting. That trims the gains and puts it closer to the Taylor-type strategy.

MR. KOCHERLAKOTA. Thanks. That was useful. This is not my second question. It is more of a follow-up. I think that this gets back to something that President Lacker was asking about discretion. One thing that might be interesting to know is the size of the losses that are being forgone by a discretionary FOMC as we go along these scenarios. If you are in 2017, and the inflation rate is at 3 percent and unemployment is down under 4, what is that FOMC thinking about how much they are forgoing in terms of the losses? I think that would help us understand how credible these kinds of plans are. I don't know if I was making sense or not.

MR. KILEY. Yes.

MR. KOCHERLAKOTA. My second question is, what is the size of our shortfall, in terms of nominal GDP, right now? The staff has an estimate of potential, and I think the shortfall right now is being calculated relative to that notion of potential GDP, and that comes to be about 7 percent in the current quarter relative to where we were starting in December '07 or something like that, fourth quarter '07. Many outside observers would say that the gap is actually 4 percentage points bigger than that because they are using some kind of trend line from December '07 to be their guidepost.

The challenge right now is, how do we start to communicate about our nuanced measures of potential GDP to the public relative to just drawing the straight trend line, which I think is

more what people are used to? I will speak for myself. When I try to communicate to the public about how deep this episode has been, I use the trend line. For one thing, I think potential GDP is Class II FOMC information, so I am not able to talk about it. [Laughter] But more seriously, it is a challenge for us to say that we are going to do nominal income targeting, but, by the way, we don't view ourselves as responsible for 4 percentage points of what you think of as a shortfall. It is a communication issue that might be hard.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. And thank you, Michael, for the presentation and the analysis. I love this kind of stuff; I am a big fan.

I have a couple of comments. One is, when we talk about price-level targeting, I thought it got a little jumbled, because I guess you are talking about what I would call strict price-level targeting. When I think back to the original Svensson paper on this, he took this objective that had the output gap and inflation in it, and he replaced inflation with price-level targeting. The output gap was still there, so to me, when we went to the price-level-targeting argument, it was all there, and so there wasn't anything that indicated that price-level targeting means that you are going to ignore the real side of the economy. There wasn't anything like that. To have price- level targeting get a bad name from this memo, which is what is happening, I think is a little unfair to the approach. The price level was supposed to substitute for the commitment that wasn't there when you had the inflation rates there. That was a pretty good insight and has been verified in subsequent models.

You can go to nominal income targeting instead, but you could also go to flexible price- level targeting. What is the difference between those two is really the question. What is the

difference between flexible price-level targeting, as I would see it originally envisioned by Svensson, and nominal income targeting?

MR. KILEY. Nominal income targeting is just one example of flexible price-level targeting. Because there are an infinite number of examples of flexible price-level targeting, we picked the polar cases that are easy, round numbers; we picked 0 on the output gap, strict price- level targeting, and 1 on the output gap, nominal income targeting. But you are absolutely right that flexible price-level targeting is the best thing to do in some models, and we just chose to focus on the one case. People have some empirical papers that have considered flexible price- level targeting. For example, the one by Gorodnichenko and Shapiro, let's say they have a coefficient of 1 plus some inertia on the price level, and then an even bigger coefficient on the output gap than 1. They would be even more aggressive than nominal income targeting. So one, of course, could have a smaller coefficient on the output gap, and performance would be sensitive to those assumptions. But one would move from 'price-level targeting performed poorly' in a couple of the models we considered to 'nominal income targeting performed reasonably well' in those models. One would move in that direction as one became more flexible in price-level targeting and put some weight on the output gap.

MR. BULLARD. Okay. Thank you. One thing about this memo that I thought was not addressed'from the perspective of this Committee'is, what are we really worried about? We are worried that you are playing with fire, and you might replay a really bad scenario in which inflation goes up a lot, and you really get into a lot of trouble.

What would it take in this kind of framework to get into that kind of hot water? The answer might be there is no scenario under which that can happen, but the '70s did happen. I think you have to have something in the model that goes too far and really generates a lot of

problems. Otherwise, the question would be, why don't you just commit to zero rates out to 2030, if it is all beneficial?

MR. KILEY. I agree. That is a really hard question, and certainly things can go wrong. It is hard to know what those are. I think if one committed to interest rates of some fixed path until 2030, things would be very likely to go wrong. That is why we talk about strategies that would be conditional on economic outcomes.

In terms of what could trigger a repeat of the 1970s, obviously, I don't know. It is notable that nominal income targeting was proposed in the late 1970s by people like Jim Tobin and James Meade, precisely because inflation was a problem. Then, a subsequent analysis by people in the 1980s'Marty Feldstein, Greg Mankiw, many people'showed it is a good strategy in response to those kind of shocks. The idea, actually, was to prevent that kind of outcome.

MR. BULLARD. I just have one more comment, which President Lacker has already brought up, which is, how fair is it to characterize what the Committee does now as a discretionary policy? In some sense, if you have a Taylor rule, maybe it is a simple Taylor rule, maybe it is not the optimal one, but you can pick the coefficients to be as good as they can be for that particular Taylor rule. That will probably get you pretty close to the optimal outcome. You are committing to the rule, you always behave like the rule, so in a sense there is a lot of commitment already there. How much can you really improve on that, as opposed to the literature, which says that you are always choosing the discretionary solution at every point in time?

MR. KILEY. There is one important aspect of commitment that isn't captured by the Taylor rule. In all of our baselines, the Committee is committed to following some reasonable strategy. The baseline is always a simple rule'the outcome-based rule or something like that.

The types of commitment strategies that Dave and Chris and I were talking about move beyond that simple rule, because they involve some commitment to undo undesirable movements in the price level. So one is willing to have inflation run at 2'' percent for a while, for example, if unemployment is very high, to a degree that is greater than embedded in something like a Taylor rule. That is an insight in the policy literature that can be a good idea, and that is behavior inconsistent with simple policy rules that involve inflation. That price-level-type aspect of nominal income targeting or the optimal commitment strategy or price-level targeting does move beyond the types of commitments that the Committee has, for the most part, been willing to make in the past.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I have two less deep, more mundane questions about the charts that I'd like to see if I understand. Under nominal GDP targeting, nominal GDP is the sum of real GDP plus the GDP deflator, and yet you're talking about what's going on with the PCE price index. If you're really targeting nominal GDP, you're targeting the GDP deflator implicitly, right? How in your calculation do you make that translation, and how do you think about that, again, as another communication device about what we're doing? That's the first question.

MR. KILEY. First, I'll give you technically what we did. This is a question very similar to the question Governor Raskin asked in terms of its implications at the current juncture. What we did mechanically is not be particularly concerned about any trend differences in GDP prices

and core PCE prices, and we set the target for 2 percent for GDP prices, and that's slightly different than a target for 2 percent for core PCE prices or for overall PCE prices.

During normal times'when we are there, 5 to 10 years from now'that would be really important if one's very concerned about 2 versus 2.2 percent. If the gap in nominal income is 7 percent, 2 or 2.2 percent just doesn't matter. It's not important for the types of simulations we're doing right now, but it is important for behavior potentially at other times.

MR. PLOSSER. The second question is sort of related to this. A lot of the level targeting, whether it be price-level targeting or nominal GDP'level targeting, can be quite sensitive to where the path begins, whether you start at December '07 or whether you start at December 2000 or 2003 or what have you. When we think about targeting the level for anything, the sensitivity perhaps to that initial condition, how do we think about choosing what the right initial condition was? Certainly, December 2007 was the peak of the housing bubble and perhaps some other things that you might want to think about. And yet if you go back earlier, as President Lacker has talked about, the inflation rates of 2005 and 2006 were high. I'm thinking about the sensitivity and how we would think about implementing a policy and choosing the right initial condition to measure what you think, in fact, the gap is.

MR. KILEY. It's a hard question. The approach we took was simply: I'm on the staff with the Board, and I think our estimate of the output gap is pretty reasonable. [Laughter] Taking a view in which it happened to be the case that the output gap was pretty close to zero before the recession started in our estimation now, and we said, let's take that as the initial condition because it might be something that one would want to communicate'that we've seen a bad few years and want to make up for those bad few years'and we came up with a reasonable number.

Other people would go back to that same date and just write through a trend line, and they would have an even bigger gap'not the 7 percent we had, but a 10 or 11 percent gap' because they wouldn't be accounting for the unfortunate decline in potential that we've seen in that period. Or you could start from today and say, 'the gap is zero, but we're going to follow this strategy in the future,' and that would have very different implications.

CHAIRMAN BERNANKE. Any other questions? [No response] Well, we're about ready for a go-round and discussion. I'd like to make a couple of framing comments.

First of all, let me thank the staff, for I think we can all agree that their work has been extraordinarily helpful, really first rate, and it helped me think about this quite a bit. Thanks very much for that work done under pressure of time.

One might think that a discussion of policy frameworks is a little bit arcane, academic, and off point, but actually, it's right at the center of what we're doing now. We're in a situation where the effects of our policy depend at least as much on what people think we're going to do in the future as they do on what we do today, and consequently, the framework that we are using and that we communicate'and the communication is incredibly important'has very real effects on the efficacy of our policy. This is very much part of the contingency planning effort that I promised a couple of meetings ago both in the sense of trying to think about our current framework and thinking about where we might go if things turn much to the worse.

There's probably a narrow way and a broad way to think about this discussion. The narrow way is to note that I think it's not too controversial to describe our behavior as conforming to a version of flexible inflation targeting, which attempts to achieve a broad definition of price stability over the forecast horizon, but in the short term allows some flexibility for stabilization of the real economy.

Where we deviate to some extent from international practice on inflation targeting is that we haven't done everything that some central banks have done in terms of communication, including specifying a numerical objective, providing a comprehensive, collective forecast, providing guidance or even forecasts of future rates, et cetera. One way to think about this discussion is, what additional steps do we want to take, if any, recognizing that we do have a rather different institutional situation here than in many other countries'a large Committee, a dual mandate, et cetera? But another way of thinking about this discussion is an issue that we've talked about many times before, that we want to take further steps to solidify and clarify our flexible inflation-targeting approach, and if so, how could we communicate that?

It's useful'and one of the things I thought that the memo did very well'to show us that there really is a broader issue here, which roughly speaking is the difference between discretionary and commitment-based policy, particularly in a situation where we're at the zero bound and conventional signaling by moving interest rates is not available. To the extent that we can show a committed policy'that we can clarify our future policies will correspond to the optimal path under commitment, similar and analogous to the path that is presented every meeting in the Tealbook'the better results we'll get.

In some sense the broader question is not just about flexible inflation targeting. The broader question is, can we provide a communications framework that will allow us both to convey and to commit to a policy path that will deliver potentially better outcomes on both inflation and growth than the policy framework we have now? I think that's an open question. There are a lot of practical issues that come into play, a lot of special issues related to what model you believe in, and so on, but I would urge us all to think about this in that context, and as much as possible, to divorce it from the current conjuncture and ask the question that if we're

going to adopt some changes in communication, what would serve this Committee well for a period of time.

Before opening the floor, let me restate the questions that were circulated so they'll be in everybody's mind. Narrowly, to the extent that we're looking at a flexible inflation targeting framework, would it make sense to adopt a numerical objective? That would be one way to clarify our goals. In doing so, of course, we would have to make very clear how that relates to our dual mandate and why it's consistent with our dual mandate. The counter argument is that doing that convincingly is a communications challenge in itself, and that's one issue to address.

More broadly, again, beyond the flexible inflation-targeting framework is the question of how we can make better, clearer commitments to future policy, and a number of different approaches have been suggested. We talked at the last meeting about conditional commitments, and we showed a few possible examples in the alternative A1 in the statements. Would it be helpful to specify some conditions under which we change policy, specifying those well in advance? That is one way to try to approximate an optimal policy in terms of commitment.

An alternative way, as the discussion just illustrated, is by specifying intermediate targets. Intermediate targets are an old concept in monetary policy. It's been always used in the sense of a guidepost or a second pillar, a way of providing additional information about policy. But in the current context, as the memo shows, it could be that pursuing a particular intermediate target might be a reasonable approximation to the first-best policy under commitment, and that's an empirical question, in part.

I'm sure many of you have seen some of the commentary on, for example, nominal GDP targets. Christina Romer made the point over the weekend that one potential advantage of something like a nominal GDP target is that it could be viewed as a regime change, and to the

extent that it reflects a real change in how the Fed is doing business, it might have a more dramatic effect on expectations than something more incremental. That being said, of course, big changes are also dangerous, and that's something we need to keep in mind.

Now, a fourth question. So'first, inflation targeting; second, conditional commitment; third, intermediate targets. A fourth question'there was a lot of discussion last time about the economic projections; can we use those better? I think we've made a lot of progress on that front. In particular, we have a proposal to look at projections of our policy rate. In what way could that be complementary to an improved communication strategy?

Finally, let's not forget, it's important as we talk about these things to keep in mind process. Is there a way that we can put this all together in a way that will satisfy the appropriate consultation and discussion within the Committee but also allow us to bring this to the public in a way that will be better understood and better accepted? In particular, a specific suggestion that's been made is that we use the approach we did with our principles of exit strategy, which we published in June in the minutes. Would it be possible, if we do adopt some changes in our communication strategy, to agree on a set of principles that would be sufficiently broad to encompass Committee support, that we could then put out through the minutes or some other mechanism? I think there's a whole bunch of interesting questions here, and this is very central to our current policy decisions. We don't have to resolve all of these questions today, but I do think that this is a valuable investment in time, and I look forward to your comments.

Beginning the go-round, I see President Evans is first on the list.

MR. EVANS. Thank you, Mr. Chairman. I'm not sure I was prepared for every one of those questions, but I certainly appreciate them. Before I simply answer the routine questions, I'd like to put some of this material in context. My first reaction to the outstanding staff memos

is extremely positive. As President Bullard said, I'm a big fan. I thought that was a great presentation, great answers to the questions.

I'm happy to see that there are policy approaches available to us that should produce economic outcomes that are vastly preferred to our current outlook, and as you just mentioned, Mr. Chairman, it's easy to see why there's a growing clamor among an impressive variety of outside experts calling for more aggressive action, like Christy Romer, Mike Woodford, Ken Rogoff, the staff at Goldman Sachs, et cetera.

Outsiders have an easier time advocating these prescriptions. For us insiders, details matter for the implementation. But before we can even consider technical details, I think the first major issue to grapple with is this: Has our current policy framework limited our effectiveness because it's not properly understood by the Committee in its fullness or by the public, or because we disagree on the particulars of our framework? I personally think this is a concern. I mentioned this back in August when I said I thought that there were cracks emerging in our policy framework. I won't belabor this issue. I've given two speeches on the dual mandate and my interpretation of its implications for our policymaking.

I don't believe we all agree on what flexible inflation targeting means and we simply disagree over many details of our policy objectives. Last week President Kocherlakota offered an informative and welcome memo on the dual mandate. I disagree with his preferences, but I welcome the information revelation on these fundamental issues.

Here's my first takeaway message. Our standard policy framework'one that glosses over the details of what we mean by flexible inflation targeting within our dual mandate responsibilities'usually works when the real economy and inflation pressures are within 1 or

maybe 2 percentage points of our goals. But when our policy differences burst into the open, as they have given today's extreme economic circumstances, this ambiguity is not constructive.

My second message is that today we need to adopt a more explicit framework. Even a complete articulation of our standard approach is unlikely to address the full range of relevant risk that the economy and monetary policy currently face. This is of enormous importance.

To highlight the potential value of these alternative policy frameworks, I want to focus a bit on risk-management considerations related to our current economic problems. Since the spring and summer of 2010, it has become more and more apparent that our macroeconomic problems are much larger than we had been planning for. There are essentially two story lines that are used to account for the aberrantly slow growth and high unemployment following the Great Recession, and I'd like to pick up on one of the themes that President Bullard was mentioning in terms of how we could get into trouble with some of these approaches.

The first story line I refer to as the 'structural impediments' scenario. In this scenario, the Great Recession was accompanied by an acute period of structural change, labor mismatch, job-killing uncertainties, and excessive regulatory burdens. As best I can tell, this scenario consists of lots of conjectures about economic outcomes and potential equilibriums. I would like to be able to point to macro simulation evidence from empirically relevant general equilibrium models studied by research economists that support this scenario, but I'm not aware of these studies. I don't know where to look, and I'd be happy for anybody to add in a literature list. The links to the relevant economic literature are unclear to me, at least. Nevertheless, in this story line, the role for additional monetary accommodation is modest, at best. We are up against a supply constraint that monetary policy can't fix. In this scenario, we should be guarding against a repeat of the 1970s. We should thus revert to what I refer to as 'business as usual' monetary

policies. Accordingly, it's probably time to begin considering removing excess accommodation before inflation rises above target and inflation expectations become unhinged.

The second story line I referred to as the 'liquidity trap' scenario. In this scenario, short- term risk-free rates are zero. Actual real rates are modestly negative, but the real natural rate of interest is strikingly negative. This is due to an abundance of risk aversion, extreme patience, and deleveraging, and these attitudes are unlikely to disappear any time soon. In this scenario, we're in the aftermath of an enormous Reinhart'Rogoff financial crisis, and the resulting drags on demand are exceedingly large and persistent. The clear and present danger here is that we repeat the experiences of the U.S. in the 1930s or Japan over the past 20 years. Liquidity traps have been studied in general equilibrium models by Paul Krugman, Gauti Eggertson, and Mike Woodford, and also recently by Iv''n Werning in a continuous-time framework. The conclusions from this literature indicate that there are monetary policy prescriptions that can vastly improve outcomes in such an event.

I think the evidence strongly favors the liquidity trap scenario. That's my opinion. But rather than putting all of our eggs in one theoretical basket, let's consider the case where we don't know which scenario is really the one we face today. This leads me to think more about a robust risk-management approach to the dilemma that these two scenarios present. If both are possible, but we don't know which one we face, how can we avoid risking a repeat of either the 1970s or the 1930s? Because I put high weight on liquidity trap theories, put me down as being sympathetic to nominal GDP targeting. I was actually not supposed to say that [laughter], but anyway I edited that out. The problem is that policies that are optimal for the liquidity trap scenario would generate high inflation if the structural impediment scenario actually was true. I think that's what President Bullard was alluding to. Conversely, policies that are optimal for the

structural impediment scenario would leave the economy mired in depression and deflation if applied during a liquidity trap scenario.

Fortunately, even amidst these two extreme scenarios, there is a middle-ground policy approach. A relatively robust policy approach would be to sharpen forward guidance in two directions. First, ensure state-contingent accommodative policies as long as unemployment is somewhat above its natural rate. But second, include an additional safeguard that policy will pull back if inflation rises above a threshold that would signal the economy is running into supply constraints, such as those in the structural impediment scenario.

In my opinion, the inflation safeguard threshold needs to be substantially above our inflation objective, and I've said in public perhaps 3 percent. Ken Rogoff has suggested

4 percent, 4 to 6 percent, he even said, and, frankly, Governor Bernanke suggested to Japan also a very large number when he was offering advice.

This guidance is consistent with the most recent liquidity trap research by MIT Professor Iv''n Werning, which shows that improved economic performance during a liquidity trap requires allowing inflation to run higher than the inflation target. In addition, establishing credible expectations of these events likely requires overshooting the efficient output level and creating an output boom, reversing the resource gap once the natural rate of interest returns to positive territory, and there were many simulations that had those characteristics that Michael was talking about. Under this trigger threshold policy, if the liquidity trap scenario is indeed true, then the massive degree of resource slack in the economy means such an output boom could perhaps be achieved without putting excessive pressure on productive resources. On the negative side, if the structural impediment scenario was instead true, inflation will rise more quickly and without any real-side improvements. In such an adverse situation, the inflation safeguard triggers an exit

from non-evident excessive policy accommodation before inflation expectations become unhinged.

Accordingly, under either scenario, liquidity trap or structural impediments, this policy keeps long-term inflation expectations firm. In my opinion, applying this trigger threshold risk- management approach to our current economic situation is really just an embodiment of what I see as our broader flexible inflation-targeting framework. The benefits of this policy draw me to the structure in alternative A1 with the paragraph 4' option in the Tealbook. However, as I mentioned before, I prefer a 3 percent medium-term inflation trigger instead of the 2'' percent one mentioned there.

According to the logic of the liquidity trap theory, we risk being mired for an unacceptably long period in recession-like circumstances unless we are willing to voluntarily embrace and commit to a higher inflation rate than our medium-term objective, at least for a time. It is against central bankers' DNA to discuss and acknowledge this, but we should not risk an outcome like the U.S. in the 1930s or Japan today. Three percent just isn't such a big number that we should resist it the way the 1930s Fed adhered to the gold standard.

Now, to quickly wrap up with regard to the specific questions posed to the Committee, I agree that the flexible inflation-targeting framework described in the memo is consistent with the Federal Reserve's dual mandate. I also think we should enunciate such a framework, and that it would be helpful for the Committee to be explicit in articulating these principles.

To reach a consensus statement, of course, we need to agree on an explicit numerical target for our inflation objective, and also what that target means operationally. After all, we should be confident that our choice of inflation target and operating procedure are jointly consistent with an exceedingly low probability of hitting the zero lower bound over the next

20 years. We've hit it twice in the past 10 years, in my opinion. I answered the second question extensively. Yes, I think the Committee's best choice is to announce and commit to the optimal policy path under commitment.

Finally, I believe that nominal income targeting is a close cousin to the economic thresholds policies. It is simply bigger and less prescriptive regarding the composition of growth and inflation. I expect that additional forward guidance combined with further asset purchases would either increase growth or generate inflation, or both, but just in case, a bigger communications bazooka is needed. I would prepare the groundwork for introducing nominal income targeting if it's needed. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Evans. Since you took my name in vain, I do feel constrained to mention'

MR. EVANS. No, I thought it was good. [Laughter]

CHAIRMAN BERNANKE. But I do think I need to clarify that those comments were directed at the country that actually was suffering significant deflation, and so it was failing on both the price stability and the economic growth.

MR. EVANS. Yes, I think you're right. I understand that, and in fact, I spent a little more time reading Friedman and Schwartz and The Great Contraction, and at the end of that lovely chapter, they had this section on why monetary policy was so inept. And I remember back to the lovely Milton Friedman celebration of his 90th birthday party where you gave a speech where'with Milton Friedman in the front row, attentive as always after a very long night before and that morning and afternoon'you assured him that the Federal Reserve had, indeed, caused mischief in the '30s, and that we wouldn't do it again.

I looked at that chapter, and I totally agree with you that you have been faithful to that. During the contraction, there were policies that should have been taken that were not, that could have prevented deflation and the Depression. I agree with that. I think we could do more, though. That's all I'm saying. Thank you.

CHAIRMAN BERNANKE. A two-handed intervention, President Kocherlakota. MR. KOCHERLAKOTA. Yes. Thank you, Mr. Chairman. The dialogue that you and

President Evans just had is relevant when we think about the Eggertson and Woodford model and the Werning model. I have to admit I understand the Werning model a little better, but in those models, basically, price-level targeting works extremely well, except for the presence of the zero lower bound. It means in some settings that you're not able to keep prices growing at 2 percent or constant. If you're ever in a situation where you're meeting your price-stability mandate in the Werning model, if you're doing well on that and hitting 2 percent, 2 percent, 2 percent, you do not have a problem in that model. That's also true in Eggertson and Woodford.

I think it's important to make this distinction that you just made between that and Japan and the U.S. in the '30s, that those were situations where you could easily point to problems on the price-stability mandate and see that the central bank is not behaving optimally. I think it's more challenging in our current environment where, as you expect in Minneapolis, we've done extremely well on our price-stability mandate'over the past four or five years, we've done very well on it. There are some differences of opinion about how well we're going to be doing going forward, but even there the differences of opinion are relatively minor compared to what we saw in Japan.

I think when we look at these New Keynesian models'they're very hard to bring support for the kind of commitment policies that President Evans has in mind because we're just not that far away from our price-stability mandate.

CHAIRMAN BERNANKE. Well, obviously this will be taken up in some length. [Laughter] President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. President Evans was quite eloquent and expansive. [Laughter] I have a great deal of sympathy with his views. I'll take a different strategy and use a little more brevity in my remarks.

In terms of question 1, flexible inflation targeting can be consistent with the dual mandate, but being clear about exactly what is meant is critical. Some use the term to place a heavy weight on inflation and a small but nonzero weight on employment. Others use it to imply a lexicographic preference between inflation and unemployment, that is, as long as we are below the inflation target, we have the flexibility to address large output gaps. I would be opposed to either of these interpretations of flexible inflation targeting. What I would support is a quadratic loss function with roughly equal weights on inflation and unemployment as in the optimal policy simulations in the Tealbook, Book B. Were we close to the inflation target but far from our estimate of full employment, we would be accommodative to reduce the quadratic loss function. Were we close to full employment but well above our inflation target, we would have more restrictive policy to return to our inflation target and reduce our loss function.

In terms of question 2, our current approach of using calendar dates to signal the first increase in the funds rate is potentially problematic if we are not willing to adjust it to changing circumstances. For example, significantly greater downside risks or worse-than-expected economic outcomes after the date is set, so that economic conditions are no longer consistent

with the original calendar date. I would prefer to announce our intent to remain at the zero bound until we hit specific economic triggers, such as an unemployment rate at or below

7 percent and an inflation rate of 3 percent or higher. Of course, we would not view such triggers as absolute and independent of all other economic conditions. For example, a forecast of exceptionally strong or weak growth as we approached a trigger might force us to take action earlier or later. I would strongly support moving to conditional commitments, such as the example in option A.

In terms of question 3, I would support considering moving to nominal GDP targeting if it is necessary to forcefully convey a change in regime. It would be most appropriate if we want to signal a regime change that requires more aggressive policies moving forward. I view nominal GDP targeting as preferable to price-level targeting because it is easier to communicate, performs better in simulations, and does not emphasize just one element of the dual mandate. An announcement that nominal GDP targeting was necessary to get much stronger growth in output is understandable to the public and could be effective if it was conveyed in conjunction with more aggressive actions.

In terms of question 4, we need to be clear what we're trying to communicate. If we're trying to communicate why we were taking policy actions, then enforcing a common interest rate path across all participants, such as an assumption of no change in interest rates or the interest rate path embedded in the futures market, may be appropriate. If our policy differs from the assumptions, we would show that our forecast with those assumptions is not consistent with our goals and use that communication to justify a different policy than what was used in the forecast. A potential problem is that it may be difficult to make clear at times why our forecast deviates substantially from what we expect. A second potential problem is that an interest rate path alone

may not be sufficient for describing policy over the next several years, given the prominence that balance sheet policies have played. If instead we are trying to communicate our best forecast for important economic variables, I would prefer to use optimal policy as we do now, even though we might disagree on how we get there. Of the two, my guess is the general public is primarily interested in our best forecast. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. I also want to thank the staff for their excellent set of memos. They are fascinating and interesting, and I appreciate the discussion and insights they provided. I will structure my comments around the questions that were posed.

I view flexible inflation targeting, which combines an explicit commitment to a medium- run inflation objective with the flexibility to respond to shocks to support economic stability, as fully consistent with the dual mandate. The dual mandate objectives, price stability and maximum employment, I believe are generally complementary to one another. Price stability is both a goal and a means through which monetary policy can contribute to the employment objective. Thus, I see no fundamental inconsistency with us having an explicit numerical inflation objective and a dual mandate. Indeed, by having accurate inflation expectations, the explicit inflation objective gives us more flexibility to act to help mitigate the effects of shocks on real activity.

I am an enthusiastic supporter of monetary policy transparency in viewing communications with the public about our framework as a further useful step in clarifying our policy decisionmaking process. The exit statement that we developed earlier in the year was quite consistent with the earlier steps we have taken toward increased transparency. It would be very helpful if we tried to formulate a consensus statement on the Committee's monetary policy

framework. I suggest that the subcommittee on communications chaired by Governor Yellen be charged with the task of creating a first draft of such a principles document, which could then be circulated for review and comments. You will recall that the ad hoc committee on which I served earlier in the year drafted a document on an explicit numerical inflation objective within the context of the dual mandate, which we thought was broadly consistent with the description that the Chairman just gave on flexible inflation targeting. So some progress has already been made on this initiative, and I think we can build on that foundation and hopefully find a consensus.

As long as we are on communication, I would like to make another suggestion. It is no secret that I favor a more rules-based approach to policy as both a disciplining device on our own actions as well as an effective communication tool to the public and the markets. While we are a long way from agreeing on what an appropriate rule might be, I think we can make progress down this path by being clear regarding what the variables are that would appear in such a rule. We started down this path when we added to our statement in November 2009 that we considered inflation, inflation expectations, and resource utilization as key factors that would influence our policy decisions. That was a good start, but we didn't do much with it. Indeed, some might even perceive that the changes in forward guidance we made in August/September as being at odds with the information in those conditioning variables. What would be helpful is if we could structure a discussion in this Committee on how we might better articulate the arguments of such a policy function, and then attempt to describe our decisions on an ongoing basis in the context of how those variables evolve over time, and thus describing how our decisions evolve over time in a mutually consistent manner. We wouldn't have to pin down the precise reaction function, but we would want to couch our decisions in terms of how those key

policy variables evolve. This could prove to be a useful communication device going forward, and in fact, aid our own internal deliberations.

Let me turn now to questions 2 and 4. I am much less enthusiastic about the alternative frameworks'advanced forward guidance, price-level targeting, or nominal GDP targeting'as discussed in the staff memo. While these frameworks do have logic to them in the context of some types of models, the benefits of these strategies are highly speculative and very risky from my perspective.

Let me elaborate briefly. As I discussed in our last meeting, I do not support the idea of providing policy thresholds or triggers as in alternative A1. I am very supportive of taking a systematic approach to policymaking, and there is a long literature on the benefits of robust rules for policymaking. However, the triggers tell us little about the Committee's reaction function. The proposed language doesn't provide any information to help the public infer the path of interest rates after such triggers are met, or what policies will do if inflation moves somewhat above the threshold when the employment rate remains above its threshold. More justification for the specific thresholds, in fact, requires assumptions about loss functions of the Committee and an underlying policy rule, neither of which the Committee has discussed in depth.

In my view, the best way to do forward guidance at this point is to publish our policy paths in the SEP, and I very much hope that we will begin that process in January. Increased transparency about how FOMC participants expect policy to change in light of changes in economic conditions and the outlook can help the public form expectations about inflation and future policy. Providing information on FOMC participants' appropriate policy paths, with their economic projections, emphasizes that policy is contingent on the evolution of economic conditions. I believe the results of the trial run of the projections, which we will discuss

tomorrow, will support this. It isn't a panacea. It isn't a solution. We still will have potential inconsistency problems, because we aren't revealing how to match up individual forecasts with particular policy variables. Still, I think in the name of transparency and information and coherence, it is the right direction to move.

The staff memo notes that, in principle, the best choice is to announce and commit to an optimal policy path under commitment. I understand why this looks desirable, but is such a policy choice actually feasible for the Committee? What is the commitment device? There will be great temptations to engage in time-inconsistent policies later on, as President Bullard emphasized in his memo. This underlies the extreme uncertainty associated with the projected benefits of such approaches that are outlined in the staff memo, since they very much depend on the credibility of this Committee's commitment to future actions. Even here I am putting aside the fact that optimal results are based on a particular loss function, as President Kocherlakota pointed out in his memo, and on a particular Taylor rule implementation. And as I just said, neither of those has been discussed at great length in this group.

Announcing the policy that we will follow in the future via forward guidance, without commitment to a time-consistent framework, is a weak commitment device at best. Indeed, some of the alternatives on the table at this meeting already suggest changing our forward guidance after just two meetings. In August, we indicated that we thought the outlook would warrant keeping the funds rate at zero until mid-2013. We reiterated that in September. Now, alternative A1 suggests that we extend that period to 2014, even though the outlook has actually improved somewhat since August and September'but not much. We don't seem to be acting with much commitment, even in our own language. It is even harder to believe that we have enough commitment or credibility to follow on a policy path when we discover that it may not be

optimal at some point in the future. And thus, if we deviate, we risk our credibility. Making commitments that we or the markets don't believe we can or will deliver on will not provide the intended benefits demonstrated in the memo that the staff suggests. And Michael Kiley made that point in his observations. Without the commitment and the credibility, we don't get the benefits.

Similarly, for both nominal GDP targeting and price-level targeting, the question is, do we have enough credibility and commitment to deliver on it? I, frankly, am very dubious that we would behave in a time-consistent manner with price-level targeting. Do we really believe that we would drive inflation down to 1 percent again to make up for overshooting in order to hit our price-level path? I don't believe we would. I don't think the public will believe it either. Some might, therefore, argue, although I wouldn't, that what we need to do then is commit to a higher level of inflation'4 percent or some higher number'so that we don't have to go too low to offset our overshooting. Well, that is certainly an interesting argument. I don't subscribe to it, but that would be an important conversation to have in weighing the costs and benefits of a commitment to a permanently higher inflation rate. But that discussion needs to weigh the long- term costs and benefits and not just exploit short-term expediencies driven by the problems at the zero lower bound. That would be a much more long-run discussion of trading off. The question I think we must ask ourselves, then, is, what framework gives us the best chance of meeting the level of commitment that is assumed in that chosen framework? I think that flexible inflation targeting is likely to be the best that we can deliver on. But there are other potential problems with some of these frameworks. As I asked the staff, both frameworks depend on some initial condition, and the degree of undershooting and the target we have depend critically on where that starting point occurs.

Michael also discussed the issue of measurement error as a concern, particularly with nominal GDP targeting. The level formulation'that is, targeting a particular level of nominal GDP'is worse, in my view, than nominal GDP growth targeting. If we underestimate or overestimate the appropriate level of potential output and misestimate the so-called gap that needs to be closed, we could make serious policy errors, and those would accumulate over time. Even a growth-rate target relies on some estimate of potential growth, which is subject to significant measurement error and changes over time. Again, if we overestimate potential growth, a nominal GDP growth target would lead us astray into being too accommodative, and if we underestimate potential growth, we would be too tight. To avoid this, we still need to focus on what is happening to inflation. To me, there seems to be little gain over a flexible inflation targeting regime. It also means that when our estimate of potential growth changes, as the staff does, we would need to change our target. This poses serious communications problems at best and risks credibility and the benefit of any commitment derived from specifying that framework.

Finally, it seems to me that switching to a new framework at this time could easily be viewed by some as an opportunistic way to inflate the economy. In an inflation environment where fiscal deficits loom large and well-respected economists are advocating inflating our way out of the problems, changing our framework now risks appearing opportunistic, and that will undermine our credibility over the long term and undermine the credibility we would need to actually deliver on the commitments that those frameworks would call for. Undermining our commitment by appearing opportunistic, by changing our framework, could be undermining the very benefits that we seek to have. Thus, I would strongly prefer that we concentrate on better explaining and strengthening our flexible inflation targeting framework that the Committee has been working toward for the past two decades. This includes an explicit numerical objective,

explaining why it is consistent with the dual mandate, and publishing our policy paths with the SEP. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I am going to organize my remarks around the questions. The first one is about flexible inflation targeting. In the question, it says 'the central bank pursues an explicit inflation objective, maintains the flexibility to stabilize economic activity, and seeks to communicate forecasts and policy plans as clearly as possible.' When you define it that way, flexible inflation targeting is a big tent. The main reason we are not in the tent right now is that we don't have an explicit inflation objective. It is an implicit one, and that could be easily remedied. In fact, I would be in favor of doing that. You asked about that, Mr. Chairman. I have long been on record as favoring adopting a numerical objective and communicating forecasts and policy plans as clearly as possible. When that is constructive, we should do that. I am in favor of that as well. I am willing to support describing our policy framework in terms of flexible inflation targeting. Now, under that definition, it is an awfully big tent. I am sure that some of us worry that it would include the possibility of taking stabilizing economic activity too far. I'm sure some of us worry that it would not take stabilizing economic activity far enough. That is, by way of supporting President Evans's observations, about the reality that we have different visions around here. But when you are evaluating these frameworks, I think it is legitimate to evaluate them from the point of view of what they do for our credibility, and in particular, the credibility of our commitment to price stability. The same thing is true with these frameworks. My general observation is that they could cause us trouble if they are viewed as opportunistic maneuvers to give us the license to raise inflation more. It is going to be critical to formulate things very carefully.

The second question asks about the staff's memo on alternative frameworks. With all due respect to the obviously huge amount of work and thought that went into the staff's memo, for me, it doesn't provide the kind of quantitative work that I would want to see if we are evaluating a change in framework. I think a framework is something we adopt once and for all, a relatively permanent change in how we approach policy. That means we are going to use it to guide policymaking over the course of many years and several business cycles, hopefully small ones, but several business cycles ahead.

What kind of analysis would you want there? You would want to know how the strategy is going to do in a range of circumstances in the future. What the staff did was give us a quantitative analysis of the first few years of the transition dynamics from where we are now to our new regime, starting from where we are today. There is some mention of how average inflation is higher in the alternative frameworks, but there isn't any quantitative information about the performance over a complete business cycle or how it does on average, the unconditional moments of performance under different frameworks. I think we ought to ask about the variability of the average level over the long haul of inflation, output, consumption, household welfare, things like that, if we are going to switch policies. That perspective could well lead to a different ranking of alternative frameworks than one based purely on the short-run transition dynamics'a fairly general point. I am not asking for anything unusual. This is the standard way we have in economics of evaluating alternative policy rules, assessing their average behavior over time.

I mentioned earlier this question about how you calculate optimal policy rules. The staff has invariably had one argument of a loss function: the deviation of output or unemployment from a smooth statistical trend that represents the natural rate, a concept like NAIRU. We have

talked about this many times. President Bullard had a very cogent memo on this several months ago. We know that is wrong if there are shocks to the economy. And it is wrong in the sense that in the standard models we have, you have got household welfare right there. You can derive what the right loss function is for the policymaker to use. When you do that, you don't get anything like NAIRU going into the loss function. You evaluate unemployment and output against something that varies with the shocks to the economy. The shocks affect what is feasible and what is desirable in the short run, and it is the natural and intuitive thing that you would expect to get. Monetary policy, if you do it right in those models, maximizes household welfare over time, and that translates into attempting to stabilize activity around the level that would be most desirable, taking into account all of the shocks we know have hit the economy. Sure, models differ, implementing this can give very different results, but I am struck by the absence of u*, even in the DSGE memos. The first thing I want to know about every one of those models is: What is u* in the current quarter? We don't get that out of the DSGE models, and that ought to be a standard part of the reporting from those frameworks.

The third comment on the second question is that, for me, the practical difficulties of implementing any of these alternative frameworks are prohibitive. Commitments are simple in models. They are very easy to achieve. Even complicated and very conditional commitment is something we all recognize. They are essentially completely credible by assumption, no matter how complicated. Real life'as we have learned doing policy over the years'is very complicated. The process of communicating what we intend and getting enough of the people understanding it and acting accordingly can be time-consuming and fraught with risks, given the inflation fight of the early '80s, an obvious example, and going from the '80s to the '90s, another example, where it took some time to get inflation down from about 5 percent to 2 percent. The

public's inflation expectations seem pretty well anchored where they are now around 2 percent. I'm not sure it would be easy to dial those up and down on a year-to-year basis. I think that is what is at stake here.

Changing inflation expectations, even if we could do that, just doing it once sets a precedent that is going to color interpretation of our commitments for decades, because we will have set the precedent that, yes, we say we want the inflation rate to be 2 percent. 'They did that back in the '90s and the '00s, but then they changed it on us. They raised their target to 2'' for a year or two, and so they could do that again.' Forever after, there is going to be a little extra variability in inflation expectations, a little less precision on the public's part in their understanding, and a little less commitment and credibility on our part, just by setting the precedent, even if we could. To be fair, the staff's memo acknowledges these difficulties, and these are all in the realm of the kind of learning that has to go on when you make a choice to adopt a new framework'you have to go down the path of convincing people you've got a new framework and getting them on board with acting accordingly.

The second question also asks about numerical triggers for inflation or unemployment. President Evans was passionate about that. I said at the last meeting I think they are a bad idea. I don't think it is going to be easy to avoid having them translated for us by the media to the public as the Fed's inflation and employment targets. It is hard for me to see how we are going to avoid the use of the word 'target' in the media relative to these things. If the issue is convincing people that we are willing to tolerate inflation of around 3 percent, inflation averaged 3 percent for four years between '04 and '07. We have done a great job of demonstrating our willingness to tolerate 3 percent inflation. We had 4 percent inflation for half a year earlier this

year. I don't think it's that much of a problem for us, that people don't think we are going to let headline inflation go above 2 percent.

The third question is about price-level or nominal income targeting'a lot of the same things apply. Adopting either of these proposals would be relatively complicated to explain to the kind of people that attend our speeches. It may be easy for a Goldman Sachs economist to understand, but I think about the people I talk to'it just seems hard. I often run these things by my 'brother-in-law' test. You know, my brother-in-law sitting in front of his PC with the retirement planning software, and it prompts him for the inflation rate he would like to assume for the next 10 or 15 years. I should warn you, I actually don't talk to him about this'that would be a violation of our communications policy. [Laughter] But I try to imagine'it is pretty easy with this guy'and nominal income targeting doesn't fare very well. To put in an assumption for the inflation rate, he needs to forecast real GDP, and he is going to call me. A framework where he has to call me flunks the test. [Laughter]

MR. FISHER. How smart is your brother-in-law?

MR. LACKER. He's a doctor. I won't say anything more. [Laughter]

Price path targeting does a bit better, except for the times when the price level is well below the target path, and then you'd have to do logarithms. Again, he would call me. [Laughter] I think it would be really hard for him to figure out what number to put in that software, and that is a test for simplicity and clarity that I am attracted to.

The fourth question: What should we do? I found the document we drafted earlier this year compelling. It explains the relationship between unemployment and inflation'as best we can forge a consensus on it within this group'and does a very good job of embodying that consensus about the relationship. Recasting that document as an explanation of the Federal

Reserve's flexible inflation-targeting framework seems like an ideal approach. Using that as a vehicle for slipping into the public domain our commitment to a numerical inflation objective seems to me like the best approach going forward. Let me leave it at that. Thank you.

CHAIRMAN BERNANKE. You could tell your brother-in-law what his revenue is going to be in his practice under nominal GDP targeting. [Laughter]

There actually was a good complementarity between your remarks and President Evans's, and you talked about the uncertainty of the NAIRU over time.

MR. LACKER. Yes.

CHAIRMAN BERNANKE. President Evans's approach, if I understood it, was to try to find something that was robust to uncertainty over that particular'

MR. LACKER. Yes, I think robustness has a lot to recommend it.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I, too, would like to compliment the staff on the fine work they did in advance of the meeting. I see this discussion of alternative frameworks'and I hope I am not getting ahead of the discussion'as boiling down to two questions. The first is: Should the Committee shore up its existing framework to be more effective? To that, I would answer yes. The second question is: In light of the extraordinary circumstances of the economy, should the Committee shake things up, go beyond the existing framework, and go in another direction? To that question, at the moment at least, I would answer no. I don't think the cost-benefit or the risk-reward tradeoffs justify such a move. I do see that clarification and reaffirmation of the Committee's basic framework and strategy, and an explicit inflation target, could serve to make the existing and future policy elements more effective. It will serve to reassure the public that there is coherence to the Committee's approach

and remove some uncertainty at a time when uncertainty is a major negative factor weighing on the economy.

Now let me turn to the questions posed by the staff, and I will paraphrase these questions. Is a flexible inflation-targeting framework consistent with the dual mandate? Yes, I think flexible inflation targeting, with flexibility around the price-stability mandate, allows for balancing the two objectives in the short term when required while still encompassing the belief that the two mandates are complementary over the longer term.

Should we enunciate it as our working framework, perhaps in a way similar to the exit strategy statement? I think it would be constructive to clarify our working framework in a general sense, and the method used in communication of the exit strategy seems like a reasonable approach. Also, the consensus-building process that preceded the addendum to the minutes I thought was quite effective. I also think it would be useful to provide more specifics about certain operational definitions relating to an inflation objective. We might put more definition around what is meant by short term, medium term, and long term. For example, we might state that over a long-term horizon of five years or longer, the Committee believes an average year- over-year growth rate of 2 percent, as measured by the overall PCE index, is consistent with the price-stability mandate.

We might then state that over a medium-term horizon of three to five years, the Committee seeks to maintain an average year-over-year growth and overall inflation in a range 'and this is for example only'of 1 to 3 percent. This range reflects the intent to keep overall inflation reasonably close to the long-term target while maintaining the flexibility to respond to economic conditions and shocks as required by the other half of the dual mandate. In the short run'a period of up to three years, and a horizon captured by the Committee's SEP'the

Committee, we might say, aims to closely monitor underlying inflation trends and inflation expectations. In such a scheme, there is a cascading from explicit long-term objective to performance within a range in the medium term to monitoring underlying inflation expectations in the short term.

Should the Committee announce conditional commitments? If so, how to communicate them? It is difficult to argue against the principle of credible commitment to an optimal policy path. That said, I view an explicit threshold for the unemployment rate as potentially problematic. Our understanding of participation trends, the equilibrium rate of unemployment, the lag in unemployment relative to GDP growth, and any number of other recent labor market developments suggest to me that an explicit threshold for unemployment is risky. I am also concerned about combining a real-time threshold for unemployment with an inflation threshold based on forecast, because the realization of an unemployment rate result is immediately verifiable, while an inflation forecast is inherently speculative. I am concerned that the public would interpret such conditionality as a de facto subordination of the inflation objective to an unemployment threshold. I am more comfortable with the communication method used in paragraph 4' in this meeting's proposals, which treats the interest rate, inflation, and unemployment rate conditionality symmetrically'an approach indicating the Committee's expectations of conditions that will prevail prior to commencing exit. If the Committee decides to be more activist, I think we need a nominal anchor to reassure the public that we have not lost sight of, and are not jettisoning, the inflation or price-stability objective. The public wants to know how much tolerance we will admit around the 2 percent inflation objective.

What about price-level targeting or nominal income targeting? Although both of these options have merit, both entail serious communications challenges, as the staff memos have

pointed out. My concern is that a shift to either option, but particularly nominal income targeting, would be viewed as a significant change of the Committee's approach. This might introduce more uncertainty about monetary policy and its intent at a time when we should be trying to reduce uncertainty.

Finally, a more general question: What steps should the Committee take to provide more information to the public about the expected course of policy? I continue to favor inclusion of implied policy paths in the quarterly SEPs. If the Committee decides to move in the direction of explicit employment and inflation thresholds in the statement, then a more complete rethinking of the SEPs seems necessary. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I apologize if I'm not completely coherent here. I've been enjoying some of the fruits of the Cardinal victory. [Laughter]

As you know, I laid out a number of comments on the Erceg, Kiley, and Lopez-Salido memo, which was excellent, in my communication to the FOMC on October 27. I will review and amplify some of those comments here.

In general, I think we're moving in the right direction in giving serious consideration to these approaches to policy and to the DSGE models from which they are derived. However, some of the difficulties seem to me to be very vexing and could lead to very different outcomes from those envisioned in the memo. As the authors emphasize, policy moves like the ones being described here put credibility front and center. These are pure expectations plays in which the Committee promises to behave differently not today but several years in the future. If the private sector believes this promise, a boom occurs today. However, the future Committee will have clear incentives to renege on the promise since at that point, according to the model, all will be

going well. Both output and inflation will be relatively high. Today's private sector seeing this will not believe the initial promise. As a consequence nothing happens at all. The policy move falls flat. This is actually my main concern. You go through a lot of gyrations here; you make the announcement and nothing happens at all. Could there be partial credibility for the promise? The memo argues that perhaps if you made the promise, the private sector will put a 50'50 chance on it coming true. I don't think this is the right way to think about this.

The Committee has repeatedly reassured financial markets over several decades that interest rates will be raised at an appropriate time in order to keep inflation low and stable. You'd be coming into a couple decades of that environment and saying that you are now departing from that policy, rather opportunistically as has been emphasized here, and you are not doing anything different today, but you will do something different five years in the future or several years in the future. This would surely not be believed, initially. Credibility would have to be earned through action. It would be very similar to Chairman Volcker coming in when inflation is running very high and deciding to change the policy framework. Initially, he is not believed. He has to earn credibility for that change in policy. The same thing would have to happen here. Credibility would have to be earned. The way the memo does it, which just assumes you could make a credible announcement and get something to happen today, is a little farfetched, but possibly you could earn credibility.

Now, how would you be able to earn credibility? I think we have pretty good ideas about how this would work. The private sector initially holds a belief that the Committee will never deviate from its implicit Taylor-type rule. Let's just suppose that's a good description of the behavior of the Committee and the belief of the private sector. The private sector will begin to adjust its perception of the Committee when the Committee takes actions that deviate from the

prescriptions of that rule. It's at that point that they'll start to believe that maybe something different is going on with the Committee. That change occurs when the Taylor-type rules suggest raising the policy rate, but the Committee doesn't raise the rate and instead leaves the rate near zero. I could imagine some scenario in the future where we're looking at the Tealbook and there's a whole bunch of Taylor rules in there. They're all saying we're supposed to be at a higher interest rate, but the Committee stays at zero. At that point you would get a boom and a change in private-sector behavior, because they would at that point learn that the Committee actually had changed behavior from what was previously believed to be dominating the thinking. But unfortunately, that sort of event in the scenario we're talking about here only occurs several years in the future when Taylor rules are saying we're supposed to be raising rates and we're not raising rates. The boom occurs, but only several years in the future'not today. In short, learning about the policy by the private sector would dramatically alter the timing of the effects. In some ways it defeats the purpose of the announcement.

In part because of these considerations, I've repeatedly favored balance sheet policies as a way to ease policy by creating expectations of higher inflation. With balance sheet policies, clear action is being taken today, which in my view, can influence and has influenced private- sector expectations of Committee behavior.

I agree with President Evans. The question is how to get the expected inflation that the Committee so desires higher. The question is how to make that happen. One way would be to make this promise out there in the future. I'm arguing that that would fall flat. I'm saying that the additional commitment strategy wouldn't be effective, and therefore, you're probably better off with balance sheet policy. That's as much as I have to say on time consistency.

As you all know, I remain concerned that we are not putting enough weight on the possibility that committing to near zero rates for a very long time will simply produce zero rates for decades. The memo contemplates very long times at a policy rate of zero. It really begins to sound like we would be creating the worst outcome of all and the importing of the Japanese situation to the U.S. We should be thinking about the tradeoff between possibly creating a replication of the Japanese situation in the U.S. versus the relatively minor and uncertain benefits of promising longer and longer times at a policy rate of zero in the hopes that that would raise inflation expectations today. In short, and there is a literature on this, it's going to be Schmitt- Groh'' and Uribe, not Eggertson'Woodford that's the relevant framework here. Eggertson' Woodford does not deal effectively with this issue. According to Benhabib et al., commitment to low nominal interest rates actually creates the problem.

As I discuss in my memo, I did not find the results on price-level targeting very convincing. This should be close to the fully optimal policy in models of this type. Partly I agree, based on the earlier comment, that this is because this is a form of strict price-level targeting, which isn't what I think of as typically discussed in the literature. The whole idea behind price-level targeting is that it changes the policymaker objective function in a way that helps substitute for the missing ability to commit what Peter Howitt once called the 'Zen archer' approach to policy. I'm not quite sure what that meant, but it sounded neat. [Laughter] The policymaker maximizes an objective that's a little bit different from the one that the household would maximize in order to get part of the commitment that the household doesn't have, and so you get a little bit better policy through that.

The notion that nominal income targeting respects the dual mandate while price-level targeting does not seems an odd way to describe the state of affairs to me. The literature is

talking about models with micro foundations. Households live in the model. They have utility functions defined over consumption and labor supply. A fully optimal policy maximizes the utility of these households. As President Lacker was saying, you've got the households there' ask them what they want. Ask them what the optimal policy is. Why come in with other objectives that we're imposing from the outside unless you don't believe your model, in which case I say go build your model the way you want to build it and get to a different objective. We cannot do any better than this, maximizing the utility of the households in the model, and household labor supply is very much part of the story. So it is very much about maximum employment if you want to talk in those terms.

For both nominal income targeting and price-level targeting, the starting point for drawing the baseline path is important, as several people have stressed. Many of us have described the past decade as a housing bubble that burst. I think it is inappropriate to project that bubble out into the indefinite future and then claim that it's up to monetary policy to reestablish the unsustainable path the economy was once on. Fundamental potential output growth was probably somewhat lower than it appears during the past decade. Embracing this view would give a more realistic description of the likely outcomes the FOMC would be able to achieve through an appropriate policy.

So as a bottom line, let me give several brief answers to the questions that were listed on the exam. Flexible inflation targeting, yes, I'm very much in favor of it. I think we should name an inflation target to get started. Lots of countries have done this. We're a laggard on this issue, and we should go ahead and do that. I would not give the extreme interpretations that President Rosengren alluded to earlier where you put just a minimal weight. You should put an appropriate weight on the real side of the economy when you do this.

The thresholds are intriguing, but I don't see them popping out as an optimal policy response in any of the models I'm aware of. I'd be willing to look at ones where they do, and I've argued in previous memos that unemployment as a threshold is problematic. It has behaved badly as a variable in the G-7 over the past couple of decades and especially in Europe. It wanders around, and we don't have good theories of why that happened. We know that other policies affect the level of unemployment'other labor market policies. I'm not against thinking about unemployment. I'm against tying monetary policy explicitly, numerically to the level of the unemployment rate because that would possibly throw monetary policy off for a very long time if that rate doesn't behave in the nice, cyclical fashion that we think that it should and instead wanders off into uncharted territory.

On price-level targeting or nominal income targeting, I'd be worried that if you went this way, not too much would happen. It would fall flat, and that's why I'm advocating a balance sheet policy instead. That being said, they're actually not too different from Taylor-type policy rules. In some ways it's hard to see why you get much of an announcement effect at all because it would be hard for the private sector to distinguish between existing policy and the new policy. But my main concern is that if you try to make these commitments out there in the future, it doesn't look credible to me, and it's going to fall flat. I would do balance sheet policy instead. You're taking clear actions today that markets understand very well.

On the issue of should we publish more information, I would again advocate that we're struggling too much with trying to condense a lot of information about our views about the U.S. economy into terse statements that just have a few words or a few numbers. I think the way to get around that is to go ahead and publish the Tealbook or some version of the Tealbook that you thought was appropriate, perhaps a quarterly report on the state of the U.S. economy. If you did

it that way, you could have a long document that could put in lots of information and contain many of the subtleties. You could comment on a lot of the issues that are facing the economy in a way that you can't in shorter statements. I'd be an advocate of thinking about going in that direction, and that will clear up many of our issues about communication. Other countries have done this, and I think it would be a sensible way to go. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you.

MR. EVANS. Could I ask a clarifying question?

CHAIRMAN BERNANKE. Sure.

MR. EVANS. President Bullard, you often had mentioned the Benhabib'Schmitt-Groh'' paper'and I have to admit that the half-life of my understanding of those analyses is usually less than a full meeting length when I ask my staff about that'but I thought that that relied on a Taylor-rule monetary policy, doesn't it ?

MR. BULLARD. The problem in the model is that you're fully committed to the Taylor- type policy rules.

MR. EVANS. But we've been running balance sheet policies and we're also at the zero lower bound, so obviously we're still running that type of policy. Isn't that the kind of thing that would tend to break that equilibrium?

MR. BULLARD. Well, I guess in the memos there is a'

MR. EVANS. I mean, usually there's some threshold.

MR. BULLARD. 'certain type of policy rule. If that policy rule is going to tell you that you'll never move off zero until certain conditions are met, then the public starts to think, okay, you're never going to meet those conditions, so you're going to stay at zero. One of the conditions is that inflation is near target, but because of the Fisher relation, inflation expectations

are low, and so you're just permanently below the target. That's what happened in Japan, where they've had mild deflation for 15 years.

CHAIRMAN BERNANKE. Let me inject here. I don't want to get into a deep discussion of this.

MR. EVANS. I didn't want to get into too much.

CHAIRMAN BERNANKE. I think, President Bullard, that some of us are confused about the dynamics and the inflation-expectation formation process that supports that equilibrium. In other words, it's obviously an equilibrium, but is it one that would naturally occur? Rather than ask you to answer that here, maybe you could help us with some comments.

MR. BULLARD. I can give you a stock answer in one sentence.

CHAIRMAN BERNANKE. Okay.

MR. BULLARD. It's fair to say'I wrote it down in my model'that the one equilibrium is the one that's the natural one to focus on, but you've got a country that's stuck at the other equilibrium. Your theory has to tell you why you're going to be at one equilibrium versus the other.

CHAIRMAN BERNANKE. Maybe because policy wasn't easy enough in the first place, and they got caught.

MS. YELLEN. Exactly.

MR. BULLARD. Well, they were at zero. We've been at zero for a long time. CHAIRMAN BERNANKE. Okay. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I'll echo the many thanks that have gone to the staff for the memos, particularly the Erceg et al. memo that formed the basis of this conversation, but I see I'm going to be drawing on the other memos as well. Very

impressive work over a very short period of time. With that said, I think there is room for considerably more analysis before we decide on a framework that is designed to govern Federal Reserve actions for the next 8 to 10 years and possibly beyond. Any monetary policy rule has two linked components, which are the initial level of accommodation it is providing and then a description of how that accommodation changes over time and responds to changes in conditions.

Now, the initial level of accommodation that's being provided by a given rule is a little arbitrary. Several people have already mentioned this, but I'll chime in as well. If we target a price-level path that began in the fourth quarter of 2008, we'll get a different amount of initial accommodation than if we target a price-level path that begins in the fourth quarter of 2007. I don't think of the initial amount of accommodation as really being a definitive property of price- level targeting or any rule. What really is defining a rule is how that accommodation varies in response to how conditions change.

I'm going to separate two questions in what I'm going to say before I go on. I'll talk at some length about these two questions before I go on to the four questions that were posed by the staff. The first question I'm going to talk about is, what is the current level of accommodation that we want to provide? And then, second, what kind of rule should govern how that accommodation varies in response to changes in conditions? It's very important to do this separation because there are several Committee members who feel very strongly that the current level of accommodation is unduly low, and the state of economy is such that this probably needs to be corrected rapidly. It would be untoward to address this perceived need for an urgent increase in our current level of accommodation by changing our framework. Rather, we should be able to figure out how to augment the current level accommodation while retaining the ability

to be appropriately deliberate in our decisionmaking about a framework designed to govern the next decade of monetary policy. I'm going to try to sketch one way to answer these two separate questions'current level of accommodation and then evolution'and then I'll come back to the four questions, Mr. Chairman, at the end.

How might we choose an appropriate level of current accommodation? The first thing we need to do is decide on a loss function, and it's our job to provide guidance to staff on this important issue, that is, us as principals, as policymakers around the Committee. In a memo I circulated last week, I talked about how we might go about structuring this conversation. With that loss function in hand, we can compute optimal time paths for asset holdings and short-term interest rates under the staff's modal forecast. Now, note that in the policy problems solved on page 3 of the Tealbook, Book B'there are all these nice pictures about what the optimal policy looks like'the staff fixes what's going on with asset purchases. They don't optimize over asset purchases. Those are just treated as given, and they optimize over the path of the fed funds rate.

What I want to do is start to think about optimizing where the paths include both tools. This might sound like a complicated problem, but we can immediately translate into a simpler one. The Reifschneider et al. memo provides the way to do that. It builds on earlier research by Fed System economists to map that time path of Fed asset holdings into a time path of downward adjustments to the fed funds rate.

Choosing a path of asset holdings and a path of short-term interest rates is similar to choosing a path of LSAP-adjusted path of interest rates, and this is a very important point. If there were no constraints in the size of the balance sheet, then this LSAP-adjusted path of interest rates could become arbitrarily negative. If we're willing to have as big a balance sheet as we want, then we can make those LSAP-adjusted interest rates as low as we want. The policy

problem then becomes equivalent to the unconstrained optimal problem on page 3 of Tealbook, Book B. It's as good as we can do. There is no tension in this problem in terms of the commitment problems that the staff was pointing to. That kind of reverse time-consistency problem does not emerge there. There's no commitment versus discretion issue if we're solving that unconstrained problem.

If we were to go in that direction, though, the balance sheet moves are fairly exaggerated. If you look at the unconstrained optimal policy path on page 3, Tealbook, Book B, it suggests the appropriate path of LSAP-adjusted interest rates involves cutting them in the near term by

300 basis points. The FOMC could achieve this cut by announcing its intention to buy something like $3 trillion of longer-term assets. Both of these numbers are quite rough. They'd have to be filled in with more work. This solution hinges on using a loss function that puts equal weight on deviations; loss functions that I've suggested in my memo would presumably imply a smaller cut in the LSAP-adjusted rate.

This is all about if you're willing to do $3 trillion of purchases. If you're not willing to do that, that means there are costs or constraints associated with balance sheet policies that aren't incorporated into the Reifschneider et al. memo and not really formally incorporated into the staff's technical analysis of our policies. For example, the Committee might decide it never wants to have a balance sheet larger than $3 trillion. This constraint will translate into a negative lower bound in the LSAP-adjusted interest rate, and then you get to solve a constrained optimal policy problem on LSAP-adjusted interest rates with this lower bound.

How would this solution work? You can guess the solution. It's going to look like the balance sheet being expanded up to its maximal level and then the short-term interest rate being kept equal to zero for some period of time. I would see the Committee implementing this

appropriate level of current accommodation by buying more assets and then announcing an anticipated duration for the zero interest rate policy.

What I'm trying to sketch here is that we can follow a systematic way to identify an appropriate current level of accommodation without a major change in our policy framework. Without constraints on the balance sheet, then we can make appropriate adjustments to the current level of accommodation through asset purchases alone. With constraints on the size of the balance sheet, that's what leads us into the need for making these long-term stays at the zero lower bound. That's all about choosing the current level of accommodation.

There's a separate but certainly linked question of how that accommodation should change over time in response to changes in the state of the economy. I think it's a good thing for us to have a determination of how we want that accommodation to change over time. Given that the zero lower bound is binding, it may well involve making a commitment. One of the reasons you're trying to build a rule'as people talk about the Taylor rule'is to try to buy into commitment. One of the nice things about the rules that the staff sketches is that it gives us a way to try to buy into the necessary commitment to have those rules be implemented down the road.

A good rule should satisfy four related criteria. One is consistency'its prescribed evolution of accommodation under the staff's modal forecast. It should provide a good approximation to the solution to the optimal control problems that I've discussed above. You want your rule to match up with what you want to be doing, given what you expect to happen. I think that's a relatively easy extension to what the staff has done.

What's a little harder, and this gets to some of the stuff that President Lacker was talking about, is that we need to have some notion of expected loss. There's a good start on this in the

Erceg et al. memo on scenario analysis, but really we need a full Monte Carlo simulation under the assumption the Committee is using that rule. We want this notion of the distribution of outcomes'how likely it is we're going to go above 2 percent, for how long, those kinds of questions'and the expected loss under whatever our loss function is.

Third, we really need to think about the robustness of a given rule. What's the worst-case macroeconomic scenario for a given rule? How bad are things under that worst-case scenario? And then think about comparing rules under that basis. Then, credibility matters. A proposed rule may well imply that some macroeconomic outcomes will lead to high rates of inflation coexisting with low rates of unemployment for several years at a time. Is such a rule truly credible or will future Committees simply abandon the rule at that point? Rules are rhetorical devices to try to convince future Committees to do things that are against their own interest, and so we want to see how much they have to buy into to do that.

The memo that we have is a great starting point for these kinds of assessments of

consistency, expected loss, robustness, and credibility, but there's a lot more to be done. That's why I think it's very important to separate these two issues, Mr. Chairman, of what we want to do today in terms of providing an appropriate level of accommodation, and what kind of rule we want to adopt for the evolution of that accommodation.

Let me try to answer the four questions. Flexible inflation targeting, it's a big tent. It's pretty hard to see how anyone could say no to it, but I will. [Laughter] I'm certainly on board with that description of our operating framework, but the word 'flexible' is going to require some definition and some clarity. President Lockhart offered some suggestions, but President Lockhart's words (I didn't catch everything he said, unfortunately) for example, talking about

2 percent averaging over five years'we explicitly don't mean that. We explicitly want the ability not to have that.

We have to be very clear. It probably would be useful to be clear among ourselves, first of all, about what we mean. What I've been talking about over the past couple of meetings is the need for us to be clear about how much inflation we're willing to tolerate and over what time horizon. Some of the staff simulations suggest we're willing to tolerate up to 3 percent for several years at a time. We have to be clear among ourselves and with the public that that's what our policies include.

President Evans made a good point about risk management and about his proposed triggers. I thought the implied dialogue between President Evans and President Rosengren is really interesting about whether these triggers should be evolving over time or fixed in time. Those are the kinds of things that it would be useful to get sorted out. We should be thinking about accommodation right now as an anticipation of time we are spending at the zero lower bound, plus the size of the balance sheet. Those are our two tools to adjust.

Then there's an issue of a rule about how those things would evolve over time in response to changes in conditions, and there's more work to be done on that. There's a fourth question, but I think I already answered it by answering the first question.

Thank you, Mr. Chairman, and I appreciate people's patience in listening to me for so long, but like several others have mentioned, this is great stuff, and I'm very excited to be able to talk about it.

CHAIRMAN BERNANKE. Okay. Thank you very much. I understand lunch is ready. I propose that we take half an hour and begin again at 1:15'with trays, if necessary. Thank you.

[Lunch recess]

CHAIRMAN BERNANKE. Thank you very much for your promptness. Let's recommence with our discussion of the frameworks, and I will turn to President George.

MS. GEORGE. Thank you, Mr. Chairman. I appreciate the Board staff's analysis of these alternative policy frameworks, as others have noted. Looking at ways to strengthen our framework and strategies for the longer term certainly is worthwhile, given the importance of our credibility to effective monetary policy.

I do support efforts that strive to make monetary policy transparent, credible, and clearly communicated. But in reading the alternatives and how they are interpreted in the Tealbook, transparency appears to be equated to additional stimulus when, in fact, the two strike me as separate concepts. In my view, adopting new strategies to achieve additional stimulus in the near term is unlikely to accelerate the broad and necessary process of deleveraging and rebalancing now under way in the economy without risking the low and stable inflation we have worked to achieve, sometimes at great cost, over the past 30 years.

Looking ahead to the long-term application of these alternative frameworks, I also see potential practical problems with their implementation, even though they appear to work well in simulations. In particular, the communication challenges associated with changing our policy framework now would be tremendous, raising the possibility of increasing rather than decreasing uncertainty in what are already uncertain times.

Let me turn briefly to my comments on the specific questions raised. While the general concept of flexible inflation targeting seems innocuous, there are a number of definitional issues I find that are unresolved. How would the explicit inflation objective be defined? What inflation rate, what horizon, what numerical value? And specifying an inflation target also raises the

question of how the Committee would define 'maximum employment''the other component of the dual mandate.

Second, the concept of optimal policy under commitment depends on a model, which immediately leads to questions about how different models reflect reality, and thus, produce different optimal policies. Some have noted how different preferences can contribute as well. For instance, I differ from the authors and would argue that inflation of 2'' percent over several years is more costly than inflation of 1'' percent, because of the risk of longer-term inflation expectations becoming unhinged. Commitment is elusive, because we cannot bind ourselves, or our successors, to carry through on any forward guidance we provide today. As economic circumstances change, the temptation to deviate in the future from today's promises will be significant.

Regarding strategies for price-level or nominal income targeting, I am concerned with basing policy decisions on only one or two variables. The financial crisis reminded us that policy decisions should be based on a range of data that can inform us about the state of the economy and the outlook. While our primary objectives are inflation and employment, financial stability is both important and consistent with our long-run mandate. A narrower focus on inflation and employment in the medium term could lead to a costly miss of our financial stability objective in the longer term.

Finally, I would be interested in exploring the idea of augmenting the SEP to include more information about our expected policy paths. Adding such information to the SEP has the potential to enhance transparency and provide more flexibility, in my view, than incorporating specific funds rate projections associated with unemployment and inflation triggers. Since the

public is beginning to be more familiar with the SEP, the communications challenges may be easier to overcome. Thank you.

CHAIRMAN BERNANKE. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I also want to thank the staff for the excellent work they did on this important issue. I am going to focus my comments on the questions.

My answer to all parts of the first question is yes. I view flexible inflation targeting as consistent with our dual mandate, and I think that we should enunciate this framework. As I have indicated in past meetings, I think that adopting an explicit numerical objective for inflation would enhance our accountability, our transparency, and our communications. We can and should go farther than simply saying the Committee seeks price stability, and we should define numerically what price stability means.

I would also be comfortable with indicating that the Committee estimates an unemployment rate of, say, around 6 percent to be consistent with maximum employment, as long as we make it clear that monetary policy does not determine what rate of unemployment is consistent with full employment. It would be helpful to try to formulate a consensus statement on the Committee's monetary policy framework as we did with our exit strategy.

Moving to the second set of questions, broadly, I see some form of conditional commitment as having value for improving our communications by providing more information on the policy reaction function. In principle, I think we could help the public to better understand how the Committee is likely to respond by using the SEP to provide the economic conditions underlying our forward guidance.

Paragraph 4' in policy alternative A1 strikes me as presenting an approach that could be helpful. I think it would be more difficult to go further, as paragraph 4' does, to set policy thresholds, because simple thresholds cannot capture the range of factors we will want to consider in determining the future course of policy.

Moving to question 3, of the options considered, I agree with the Board staff assessment that targeting the level of nominal income appears to work well in some challenging scenarios. But I would reserve a change in our operating procedure for an extreme event, such as a significant risk of deflation or another recession. Should we face such prospects, I think that nominal income targeting would be our best option for providing significantly more policy accommodation while making clear our commitment to both components of our dual mandate.

Finally, in response to question 4, as I have already suggested with my responses to the other questions, to improve our communication and effectiveness of policy, I would favor enunciating our flexible inflation-targeting framework and adopting an explicit numerical objective for inflation. I would also favor providing forward guidance more clearly linked to our SEP. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. Successful communication of our policy framework is especially important as we navigate uncharted waters of unconventional policies. A critical goal of our communication, to me, is to maintain well-anchored inflation expectations. During the past few years, the anchoring of inflation expectations has paid huge dividends. It stemmed what could have turned into a sustained deflationary dynamic, and it also provided monetary policy with greater maneuvering room for extraordinary accommodation with less

danger of high inflation. To further reinforce the anchoring of inflation expectations, I strongly favor publicly stating an explicit inflation objective in the context of our dual mandate.

I should say that I am one of the latter participants to go in this round, so many of my further comments are going to echo comments of other participants. In particular, I noticed that some of my comments are very closely aligned with President Rosengren, and some of my other comments are very closely aligned with President Plosser. I am not sure how often that sentence is uttered. [Laughter]

MR. PLOSSER. We will watch this with great interest. [Laughter]

MR. WILLIAMS. I, too, think it would be useful to make a general statement of the Committee's policy framework that we all agree on, and to publish that in the minutes, as was done with the exit strategy. I actually think flexible inflation targeting is a good framework for thinking about that. It is a big tent, as many people have already mentioned, but with this group you may need to have a big tent like that, and so that is a good approach. As President Plosser earlier said, the work that was done by the ad hoc group on putting together a one-pager about the framework around a numerical inflation objective is a good place to start on that. I will add that inflation targeting has proven to be a very highly successful strategy that has been used in many countries.

I do think we have to be careful in how we publicly describe our current policy framework if we were to describe it as flexible inflation targeting. The problem, which has already been mentioned by a number of people'and this is where President Rosengren's comments and mine overlap'is that flexible inflation targeting is a very elastic term. It means different things to different people. For example, some inflation-targeting central banks have a hierarchical mandate in which price stability is the prime goal. That is not how I interpret our

dual mandate or our framework. Explicitly identifying ourselves as an inflexible inflation targeter could be misperceived as tipping the balance of our dual mandate strongly toward price stability. This could complicate already daunting communications challenges, and it could be seen as inconsistent with the mandate given to us by Congress. If we were to publicly describe our framework as flexible inflation targeting, which I do support in principle, it is important that we do so along the lines that Lars Svensson has done, and that is as a balanced approach, with a significant weight on both parts of the dual mandate.

With regard to communicating the optimal policy under commitment, such an approach is attractive for the reasons that were laid out in the staff memos. Unfortunately, for similar reasons that President Bullard mentioned, I think it is an unrealistic benchmark. In the jargon of academics, our commitment technology is very limited. It is simply impossible for us to set a predetermined course of policy that will bind future Committees.

Another comment I will make on the staff presentations, which were really helpful, is that the differences in the outcomes under the different policies that they look at'nominal income targeting or inertial Taylor rule or optimal policy'depend critically on the expectations of events that are many years in the future, another point that President Bullard and others have made. For example, if you look at exhibit 2 from Mike Kiley's presentation, it is striking that the inertial Taylor rule and the nominal income-targeting rules actually yield essentially the same unemployment paths, as I see it, up until 2017, yet the inflation rates starting from 2012 are very different. I have dabbled in the dark arts of large-scale macro models, so I have some understanding of how these models work. Events way out in the future can really feed back into the present in a very strong way, and there is a lot of uncertainty about how strong the feedback effects are of events five, six, seven years in the future on the actual inflation and unemployment

rates today. I am not sure if, in reality, the simulations may exaggerate the benefits of differences in policy regimes. As President Bullard said, these simulations assume rational expectations, and that everybody instantly knows the change in the policy regime. In practice, I think there would be some learning and adjustment that would again reduce the differences in the policy alternatives.

Instead of thinking of optimal control as being the approach that we should be concentrating on, we should aim to communicate as clearly as possible our current reaction function. Policy thresholds could help in this communication. Alternatively, as Governor Tarullo and I argued last time, and a number of participants have already mentioned, we could include our individual projections about the appropriate path of monetary policy in the published SEP. Then, as our forecasts for economic activity, inflation, and the funds rate evolve, the public would get a clear picture of the state-contingent nature of our policy reaction function. Although I have not yet studied the results that we were sent this weekend from the trial run of the SEP, my reading of the SEP answers is that these are consistent with what I think of as a pretty clear view of where policy is expected to evolve, with a liftoff apparently in early 2014 or so, with a range of views on that. That range of views in the SEP about when liftoff is and what the policy will look like going forward is consistent with the range of views on inflation and economic activity. That would benefit transparency, and it would be consistent with our policy framework and communication.

Finally, I don't believe this is now the time to switch to a price-level or nominal income target. In theory, these approaches can work very well. President Lacker, and I think President Kocherlakota, brought up the issue that you should be really evaluating policy frameworks in an unconditional stance, thinking about how they perform on average. I and many other people

have actually looked at that issue in different models and under different assumptions. The way I would summarize is that a very good monetary policy rule'a well-calibrated Taylor rule, or an optimal control policy, or a nominal income-targeting policy, or a flexible price-level targeting policy'all of these do really well if they are well designed. They do roughly equivalently well in normal conditions. Looking at that question doesn't give you an answer about which framework you want. You really do have to think about the communications issues and also the unusual circumstances that we are in today. At this time, switching horses in the middle of the stream could confuse more than clarify, and ultimately could backfire. In particular, nominal income targeting seems to muddy the waters. Investors care separately about prices and about quantities. And, importantly, we care separately about prices and about quantities. Looking at only nominal income, which mashes together prices and quantities, seems to me at this time to be counterproductive and could undermine the anchoring of inflation expectations. Thanks.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I am going to start and conclude where President Williams concluded. That is, I don't think now is the time, but I do think it is a subject we are studying.

First, I want to thank the staff for their good work. I also want to thank them for their honesty. I thought section 4 about the risks of our models at least, and the faulty potential of our models, was frank and honest. I do want to have submitted for the record a particularly pungent sentence, which says, 'Given that the strategies we consider lack historical precedent, and even the tools used to implement the strategies are relatively unconventional, there is considerable risk that our model results may prove faulty in some respect.' Indeed, any policy outside the range of historical experience, ranging from the strategies considered here to balance sheet adjustments and macroprudential regulation, could have unintended consequences for economic welfare, for

better or for worse. Your section 4 expands upon that somewhat. I thank you for the good work that you have put together.

I am in favor of at least more discipline, if not a rule. I think we have been a little bit spastic in the way we have developed policy, a little bit reactionary, and we have sent signals to the marketplace, which then seem to be built into expectations. I would like to see a little bit more discipline as we go through time.

I am in favor of the exercise. I boil it down to two simple principles: We have to be realistic, and we have to be credible. What I mean by realistic is that we know that we have more influence on inflation as a monetary phenomenon than we do on employment. What I mean by credible is that shifting horses, whether we do it midstream or whenever we do it, cannot be viewed as a weakening of our commitment to price stability, and cannot be viewed as, in particular, a weakening of our commitment to long-term price stability.

I thought President George's comments were interesting. To me, the key variable is to identify a longer-term inflation target. I am in favor of doing that. President George pointed out some issues around that'which target do we pick, under what conditions, and so on'but talking about having one is a worthwhile exercise.

Then, I would want to understand better within this Committee what the bands of tolerance are around that target if we are going to talk about flexible inflation targeting. Once we have achieved that understanding, then I think we need to explain to the public that as long as we have a dual mandate we have to deal with both inflation and unemployment variables. And as long as we have that mandate, then it may be desirable, if we decide that is the case at this table'once we have agreed on a long-term inflation target, and our tolerance bands around it'

that we may have to deviate occasionally from our target on maybe the high or the low side in order to deal with our employment mandate.

This is something that we should take some time to consider. I started this meeting by giving President Bullard a six-pack of Shiner Bock beer.

MR. BULLARD. Three left.

MR. FISHER. There are only two left, actually. [Laughter] Shiner Bock beer, by the way, Mr. Chairman, was picked because the Shiner brewery was founded in 1913, fitting for the Federal Reserve. But if you look at the way beer is made, out of hops and grains, the standard formula has been in place since the year 1541 under a ruler of Bavaria named Henry IV. Now, there have been improvements made to beer, but I think it is something that you would have to proceed with extremely slowly.

I am not suggesting we take another 500-and-some-odd years to change our rule or our discipline, but I do think that we need to vet the thoughts that have been circling around this table. Reference has been made to Ms. Romer. I thought that was an interesting article. However, I must tell you that all I got out of it was, 'Be bold.' That was what her message was. I wasn't convinced by her argumentation. I have listened very carefully to Ken Rogoff, who is on our advisory committee at the Dallas Fed and our Globalization and Monetary Policy Institute. I respect him enormously. And then, I observed the pushback that came from another person I respect enormously named Paul Volcker. I understand that Tobin made the arguments in the 1970s, but I also understand that no other central bank has attempted what we are talking about. You had a slight variation of price-level targeting in 1930 by the Swedes. We love to evoke the Scandinavians at this table. But it was not held for very long, and it was a variation of

price-level targeting. To my knowledge, no central bank has adopted nominal income targeting. It is true that Tobin made the argument in 1970. It is true that Martin Feldstein agreed with it.

I did have Professor Feldstein down the other day to the Dallas Fed. He is completely against it presently. Why? Because he doesn't think we are quite credible yet in having anchored'and this is his own personal view'our commitment to long-term price stability. I come back to long-term price stability. To me, that is the key variable. The flexibility around it is something that we need to define, and then we need to socialize it. Despite the interest that has been shown by Goldman Sachs and Christy Romer and others, I think we need to socialize it further. I would say at a minimum I would take the theoretical work that has been done, and some of the studies that we are doing, and at least get these out into academia and into a more serious discussion, so that we can evaluate these alternative policy rules and see what kind of criticisms come forward.

Mr. Chairman, in short, I am in favor of trying to achieve greater discipline. I would like to come up with a rule that is more modernized. I am willing to change the formula to the beer that we brew, but we should take our time. I would like to suggest that we look at a time horizon that doesn't have to be infinite. I would be against changing this horse in midstream now, as President Williams mentioned. But I would at least like to have these questions discussed and vetted and thought through'including the risks that I mentioned at the very beginning'over the course of the next several months, if not half a year. I think it is a worthwhile exercise. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. I thought the staff work was excellent and thank them for all their efforts.

I am not convinced our current framework is obviously inferior to some of the alternative frameworks that have been proposed. I think market participants do know what our long-term inflation objectives are. If you look at the SEP's long-term inflation, it is in a very narrow range. I think market participants have a pretty good understanding that we have something close to a quadratic loss function. All you have to do is compare and contrast how we have reacted to the inflation and unemployment news in the U.S. compared to Europe, and you see quite a bit different path.

What we should be focusing on is not so much frameworks but providing more insight to the public about what our reaction function is. My emphasis would be on reducing the uncertainty about how we would likely react under a wide range of circumstances. By doing that, we can accomplish two things. One, we can reduce uncertainty about how monetary policy is likely to evolve, which should have favorable implications for risk premiums, therefore, making financial conditions more accommodative. And, two, it would help markets to think along better with us, so it may enable market participants to better anticipate our future actions. That means prices could adjust more rapidly to the receipt of new information on the economy or political developments that might affect the outlook.

Now, having said that, I want to provide more information about our reaction function. I don't think that is a very simple task. Not only are there 17 different reaction functions around the table, but it is also difficult to reduce those reaction functions into a simple two- or three- parameter mapping. For example, specifying what the unemployment rate and the inflation rate forecast is likely to be as a precondition for exit, is probably too simplistic for most of us; other parameters might also be important, for instance, speed limits'how fast the unemployment rate

is falling or inflation is rising'or the risk around the central forecast'if there is a very big skew in the outlook.

Despite this, I think we can do more to overcome some of these problems. First, we can provide greater detail about our individual forecasts, and we could aggregate this detail into consistent central tendency projections with respect to the inflation rate, unemployment rate, and the path of the federal funds rate.

Second, we can explore in greater detail the degree of agreement within the Committee about what parameter values would be important in their view in influencing when exit might be likely. If the dispersion turns out to be relatively narrow, then we could actually move down this path, hopefully over the next couple of meetings. In this respect, in terms of the trigger values, I would much prefer escape clauses rather than triggers, because it gives us a little bit more flexibility. It allows a little bit more nuance. The fact that you only have two parameters with escape clauses is implicitly saying that those aren't the only things that are important to you. In my mind, expressing parameters with respect to inflation and unemployment is quite a bit superior to a date. For one thing, we are probably going to move the parameters around a lot less frequently than we want to move around a date. I have a lot less uncertainty about what my parameter values on unemployment and inflation are likely to be than I do about the date. I have no idea when we are actually going to exit. I have a point forecast, but there is a wide range around that. Conversely, I have a relatively narrow range around the parameter values of unemployment and inflation that might trigger an exit.

In terms of the types of foreign commitments discussed in the staff memo, I am skeptical that there are significant benefits, because I don't know how we can tie our hands credibly'a point that many others have made'and I don't think the model assumptions about how market

participants form their expectations is necessarily correct, coming to the point about your brother-in-law.

Finally, I worry that making binding commitments might be viewed as potentially reckless in a world where the outlook is highly uncertain. If people thought we were making binding commitments and then we got a very bad draw relative to our modal forecast, we would then be committed to generating something that could be potentially a very unpleasant outcome. Market participants would price that in immediately as a potential risk.

In terms of the alternative frameworks, I have some skepticism about a nominal GDP targeting regime. It is very difficult to explain, and it seems to bless outcomes in terms of growth and inflation combinations that we might not be happy with. It seems to suggest that

5 percent real GDP growth and 0 percent inflation is equivalent to 0 percent real GDP growth and 5 percent inflation. The former would be terrific, and the latter would be pretty horrible. Explaining that in the context of nominal GDP target would be very difficult.

In terms of price-level targeting, I see some value in environments in which deflation expectations are a problem. The PLT could be helpful in those particular circumstances in anchoring inflation expectations. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I, too, want to thank the staff. I greatly appreciate their thorough analysis of alternative policy frameworks.

Let me turn to the questions. On the first question, I think that a flexible inflation- targeting framework would be fully consistent with our dual mandate. As I noted at our September meeting, I've been a long-time advocate of establishing a specific numerical inflation objective as a means of facilitating our internal decisionmaking and augmenting transparency

and accountability to the public. Under current circumstances, a clear long-run inflation goal would help ensure that transitory supply shocks don't shift inflation expectations, and it would underscore our determination to minimize the risks of deflation. A consensus statement about our policy framework could be an ideal means of enunciating an explicit inflation goal because such a statement of principles could emphasize our commitment to both parts of our dual mandate. The statement could specifically indicate our judgment that the mandate-consistent inflation rate is 2 percent, while noting that our estimates of the longer-run sustainable unemployment rate are regularly conveyed through the SEP. In my view, it would be also essential to clarify that the time horizon over which inflation is expected to converge to the longer-run goal would depend on economic conditions and would reflect the Committee's judgments about the path of policy that most effectively promotes both parts of our dual mandate.

Turning to the second question, a long and distinguished literature shows that central banks can foster better macroeconomic outcomes by making conditional commitments about the future path of policy rather than by following a discretionary approach of re-optimizing at every meeting. I think commitment strategies are particularly beneficial when the current setting of the policy rate is constrained by the zero lower bound, because the central bank can provide extra accommodation by promising a shallower interest rate trajectory than would be implied under a purely discretionary approach.

The conditionality is a crucial element of commitment strategies because an

unconditional commitment could result in very poor, even disastrous outcomes under some circumstances. In theory, the ideal Ramsey planner would formulate and communicate a complete set of state-contingent commitments. He would spell out exactly how the path of

policy would unfold under every conceivable scenario. In reality, of course, the idea of a policy committee agreeing to a myriad of policy paths and seeking to communicate all of that information to the public is completely impractical.

The staff memo mainly focuses on one approach to addressing this problem'namely, the use of simple rules that specify how the central bank will respond to observable economic variables. In my view, such rules can serve as very useful benchmarks for assessing the stance of monetary policy and for helping the public understand how policy may evolve under alternative scenarios. But it would be highly inadvisable to make a binding commitment to follow one particular rule, because there are surely contingencies under which any given rule might perform quite poorly. I, therefore, consider it preferable to take a more pragmatic approach, one that involves communicating our modal expectations about the path of policy and conveying the conditionality of that path by specifying thresholds for key economic variables, in effect, the approach illustrated in the final variant for paragraph 4' in alternative A1. And here I agree completely with President Evans and others, and I agree exactly with his analysis of why this type of approach would be robust and beneficial. As an alternative, the Committee could indicate its modal expectations for policy and the associated paths of economic variables as is proposed in 4', the second variant of paragraph 4 in alternative A1. But this approach would seem to me to be at least somewhat less effective in communicating conditionality.

Turning to the third question, I'll devote most of my comments to nominal income targeting. There is a significant body of research that highlights the extent to which this framework can facilitate the stability of prices and the real economy, and a number of prominent economists who have recently been urging the Fed to consider adopting it as a means to respond more forcefully to current economic circumstances.

The staff memo shows that nominal income targeting could be quite helpful in promoting our dual objectives under the modal outlook in a range of alternatives. Nonetheless, as I've contemplated the possibility of a nominal income target, I've become increasingly convinced that there would be enormous practical challenges in implementing this framework, and that may help explain why no other central bank has ever followed such an approach. Let me highlight a few specific concerns.

First, as is noted in the staff memo, it would not be appropriate for the target path to be permanently fixed. Rather, it would need to be revised whenever there were significant changes in the estimated level or growth rate of potential output. Importantly, such revisions would need to be retrospective as well as prospective. For example, last August's NIPA re-benchmarking led to a substantial revision of the estimated path of potential output that would have required a corresponding change in the target path. I can easily imagine the public confusion on such occasions. People would complain the Federal Reserve is changing the goal posts.

Second, the target path by itself doesn't provide a full description of this framework. Rather, the central bank must also specify and communicate the rule it will follow in bringing nominal income back to that target path. That choice may have non-trivial implications for the stabilization performance of the framework. For example, it might seem intuitive to follow a rule that prescribes monotonic convergence back to the target path, but such a rule would generate macro outcomes that are much less appealing than those obtained in the staff memo, which uses a rule that implies substantial overshooting. Nevertheless, I suspect it would be much more difficult to explain the overshooting rule to the public, and of course, the whole rationale for this approach could be undermined if wage and price setters and financial market investors didn't fully understand it.

A third pitfall of nominal income targeting'this is something that Presidents Williams and Kocherlakota have been commenting on'is that the strategy may involve a very long process of convergence to the balanced growth path, not just 5 or 6 or 8 years, as described in many of our SEP narratives, but perhaps stretching out as long as 15 or 20. For example, in the FRB/US simulation of the recession scenario with policy remaining highly accommodative through 2018, the unemployment rate, as Mike noted, drops to close to 3 percent. Inflation peaks around 2'' percent, and nominal income overshoots its target path by around 2 percentage points. At that point, though, monetary policy can't just shift back to being neutral. Rather, to bring nominal income back to target, the stance of policy gradually becomes contractionary. By 2024, the economy is in mild recession with unemployment rising back up to 6 percent and inflation running around 1'' for a few years until the path finally settles down around 2030.

In effect, the strategy succeeds in dampening the near-term consequences of the recession shock by providing a clear and credible commitment to a policy path stretching out over nearly two decades. From an aesthetic viewpoint, the dynamic elegance of this policy is breathtaking. [Laughter] I spent the weekend contemplating potential analogies, deciding that the best comparison would be to an Olympic figure skater who leaps in the air for a triple Salchow. We all hold our breath until she lands gracefully to complete the rest of her performance. However, we should remember that the figure skater's routine is one she's practiced hundreds of times [laughter] until she could execute it as flawlessly as possible. Even if she has an awkward landing, the worst case is that there's no gold medal, but surely no champion skater would introduce a routine for the very first time right in the middle of an Olympic performance. And like the practical complexities of nominal income targeting, it would only be prudent to develop, implement, and carefully communicate this approach over a course of a number of years. This is

the approach that's been taken by the Bank of Canada, which has spent the past half-decade exploring alternative monetary policy frameworks in close consultation with the public and the Canadian parliament. In the near term, however, we might consider making more frequent references in our monetary policy communications to the level of nominal income and its relevance in guiding our thinking, in effect, turning it into a second pillar of policy.

More broadly, the conditional commitments may be the most potent tool in our toolbox at this stage, but we need to be mindful of the intrinsic limits on our ability to make credible promises over time horizons that extend beyond several years. We need to follow a pragmatic approach for promoting the stability of economic activity and inflation, recognizing the limits of our understanding of the structure and evolution of the economy and of our ability to anticipate or plan for all possible contingencies. This inclines me, as I said, toward enhancing our forward guidance, ideally along the lines that President Evans has articulated or, alternatively, through an approach that would involve our projections.

On the final question about projections, I do strongly favor publishing information on policy projections in the SEP. Our subcommittee will be happy to work with staff to develop specific approaches to circulate to the Committee for your consideration if the Committee wants to go in this direction, and I certainly think that it's something that we should carefully consider. I look forward to working on that.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I, too, want to thank the staff for the quality of thought and work that went into the memos and for the time they spent with me answering my questions. I also want to apologize to that same staff because my comments are going to take the intellectual level of this discussion down a number of notches, but I'll remind you that the

intended audience for any communication that we might make includes a lot more people like me than it does people like you. [Laughter]

I am in no position to question the theory, the assumptions, the thought, the quantitative analysis, the simulations, or the academic literature that underpin the framework memos. As I thought about these over the weekend, I was reminded of a story that I first heard when I was in college, and maybe some of you heard it as well. It's the story of the physicist and the economist who were stranded at sea with nothing but a single can of beans to eat, and the physicist took the can of beans and applied precisely the right amount of force at exactly the right location and still couldn't open the can of beans, despite having used the heat of the sun and the coldness of the water to soften up the metal. So he asked the economist if he thought he could open the can of beans, and the economist looked at it and said thoughtfully, 'Assume we had a can opener.' So I focused on two aspects of execution, credibility and clarity, because all of the expected results depend critically on the assumption of a can opener'that is, absolute credibility and clarity.

The Federal Reserve already enjoys a high degree of credibility stemming from its demonstrated commitment to containing inflation. This credibility comes not so much from what we say, but from what we have done for many years, and the public has learned our ways. For the most part, the public still trusts us to control inflation, and those who pay the most attention to what we say have come to understand that we will control it at a level of 2 percent or a bit less. If we're going to convince the public that we're going to act differently in the future, especially far into the future, we will first need unanimous or near unanimous agreement and steadfast conviction that it's the right course for us to follow, and we would need to speak with one voice to communicate clearly how we were changing and why. Without near unanimity and one voice, the public could focus on the potential for the rotation of voters to change the path or

the potential for the two open seats and the upcoming term endings on the Board to bring about a philosophical change or, in the worst case for credibility, the political debate could become fixated on effecting such a change through legislation or personnel changes.

Finally, in order to protect the hard-won credibility that we already have, we must be absolutely clear about our intentions and our reasoning, and one carefully worded and unanimously supported statement is a start, but it has to be reinforced through repetition and explanation. As an example, there's already much confusion in the public about the difference between guarding against deflation and inflating our way to growth. To return to the questions we were asked to address, I'm supportive of an effort to create a document that addresses our framework as long as it addresses both parts of our dual mandate. I'm not opposed to making a clear statement about our objectives or even an explicit inflation target as long as we also articulate the way that the employment level influences our decisions. It would be helpful if we could also articulate the way that asset purchases fit into our strategy and how the size of our balance sheet interacts with the federal funds rate and our policy objectives.

Moving on to the question about using policy thresholds to explain our strategy, I used the fed funds rate in the alternative simulations to help me with my fed funds projections in this round, my understanding being that these are fed funds rates that most closely correspond with the historical behavior of the Committee if each of these scenarios were to unfold. But when I tried to find the common thresholds in those simulations, I couldn't do it, which underlined, for me at least, the need to think carefully about how we express ourselves. In August we started down the path of using a date for forward guidance. Then in September, with no one especially pleased with the idea of using a date, we discussed several alternative ways of providing guidance. Before we change this again, I hope we'll work very hard to forge agreement on the

language, such as date, time, or threshold; the vehicle, such as statement, SEP, or separate document; the frequency with which we plan to adjust it; and whether we do it as a commitment or a forecast.

As to changing frameworks altogether, such as a move to targeting nominal income or a price level, I found the discussion of risk in the memo quite persuasive and would hope that we could keep these weapons in reserve unless we see a recession scenario in which a dramatic change might better justify the risks. In the meantime, it could help with clarity if we could work to educate the public about why we might make this choice.

Here's what I would most like to see us do: Rather than each trying to convince the others that his or her approach is the best, maybe we could think about what it is that we all do agree on. If President Williams agreed with both President Plosser and President Rosengren, that proves that this is possible, [laughter] and then we could work to explain that to the world. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. I'll begin where Esther began, with the observation that people's preferences with respect to things we call framework or quasi- constitutional changes are almost always connected to substantive policy preferences. I very much think that's the case here, and so in part that leads me to want to bypass a lot of this discussion in order to focus on the question of what should we be doing given the fact that we have somewhat differing analyses of where the economy is. I think that leads to more need for communication, but it pushes me away from a preference for structural or quasi-constitutional changes because of my observation that writing constitutions or frameworks tends to become more complicated precisely because there's a different set of debates going on underneath, which

are substantive policy debates. And, while I wouldn't foreclose any of that, having listened to most of the conversation already today, it doesn't strike me that there's been an enormous amount of convergence thus far around any new framework.

The second introductory observation I'd make is that the more I've read in the intermeeting period about the way other central banks do everything, do inflation targeting and economic projections and the monetary policymaking in general, the more I have been impressed with the'how shall I put this neutrally?'peculiarity of the Federal Reserve System. Thus the tentative conclusion that much of what may work in other countries, in other monetary policy committees in other systems, may not work particularly well precisely because of the different institutional characteristics that the Federal Reserve System has.

Turning to the questions that the staff put in front of us, I'm going to change the order somewhat and start with the framework question. To Richard, I would say that the possibility of unanticipated negative consequences is a sobering one to be sure, but one always has to balance that with what the costs of the status quo are, and that's where we get to substantive issues again. My own view, which won't come as a surprise to anyone, is I am deeply distressed with the status quo. I fear, as an increasing number of people do, that we are sliding into a period of stagnation, which will become ever more difficult to extract ourselves from. As an ex ante matter, I wouldn't dismiss something just because there probably will be negative unanticipated consequences. However, I think Janet and a number of others have pointed to anticipated negative consequences, which could be associated with some of the framework changes, and add to that the communications difficulties that a number of you have pointed out, and it seems to me'again, like many, though not everybody here'that these things are worthy of continual consideration in the event that the economy deteriorates further or, regrettably more likely

perhaps today than a few days ago, we get a major external shock sometime in the not-too- distant future.

I'm going to pair the threshold proposal with the SEP because I think they are both about communications. As everybody knows from the last meeting, John and I were trying to push forward onto the table the use of the modified SEP as a surrogate for the use of the thresholds, and I continue to think that bears consideration, but I'm going to place two qualifications on my own predisposition.

First, I read the results of our initial foray here as posing more of a communication problem than I had anticipated, and I am of the provisional conclusion that aggregating the

17 individual results is not going to do the trick. We may want to think about some alternatives, again, taking into account the peculiar institutional characteristics of the Fed for this purpose, the fact that we are a very large group compared with other central banks that have this kind of exercise. The academics with whom I've spoken about these sorts of exercises all point to the value of the discussion whereby the monetary policy committee critiques, and comes eventually to some consensus, on the projected path of interest rates. I have a vivid imagination, but I have had difficulty conjuring up the scenario in which the 17 people around this table come to a consensus view on a projected path of interest rates. But it seems at least plausible that if staff could construct three scenarios'one, relatively higher inflation; two, their baseline scenario; three, relatively lower inflation'we might have the opportunity to get most members of the Committee signing onto the proposition that if this, in fact, is the way that the economy evolves over the next eight quarters or whatever the projection period would be, then the anticipated federal funds rate path associated with that movement in the economy would be appropriate. I don't know if that's possible either, but it seems to me worth thinking about.

The second problem, which somebody alluded to earlier, and I did note this in my memo last time, is that at present we've got the big balance sheet in addition to the zero interest rates. As many of us have said many times, beginning to draw down the balance sheet would be the equivalent of a tightening move and thus would be relevant to market actors and somehow that would be need to be factored in.

Moving now to the flexible inflation approach, Jeff is absolutely right. You state the proposition broadly enough, everybody can agree with it, and that allows everybody to tweak the particular clauses or phrases in the formulation in order to make it fit their policy predisposition. As I've said before on this Committee, I was substantially more open-minded on stating an explicit inflation target when I walked in here two years and nine months ago than I am now, and the reason for that gets back to Esther's observation. I think to a considerable extent, it reflects, and would be perceived publicly as reflecting, a fairly strong, substantive preference for an inflation target over the other side of the dual mandate.

I have listened to some of us around the table who basically say that if you do price stability well, you will promote maximum employment, which to me is very close to reading half the dual mandate out of the statute. It is a coherent view of the world, but it's not either what the statute says or my view of the world, and thus I have some substantial resistance to it. There are some environments in which the establishment of an explicit inflation target, along with the kind of explanations of unemployment or maximum employment or output gaps that people have mentioned, could be perceived as a balanced embodiment of the dual mandate. I don't think that this is one of them. Although I'm not closed-minded on the proposition, I have to say that there's a substantial hurdle that I feel has to be overcome before I would be comfortable with it.

My last comment would be that one way to potentially make me comfortable with an inflation target'contrary to what Esther said, as opposed to agreeing with her'is if it were put in place as part of an exercise that was actually accommodative. That is, if the inflation target were put in place and the rest of the explanation of the dual mandate made an effort to communicate as clearly and credibly as we could a medium-term inflation target, while at the same time taking the kind of substantive policy accommodation steps which I think are needed, then it would be a different story. But as Esther's comment reflects and as I've heard others speak, it seems to me that a lot of people want actually to pull those apart because, quite legitimately, they have a substantive policy preference for not taking further accommodative action and, thus, don't want to tie those two things together. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin. I'm sorry. President Kocherlakota.

MR. KOCHERLAKOTA. Just a quick gloss on what Governor Tarullo said about the SEP paths of the target funds rates. There was a lot of heterogeneity. I was struck by that.

I will say for myself, the question was about what I viewed as the optimal path of the fed funds rate. The question was not about asking me to forecast what the fed funds rate was going to be'what the likely outcomes of these Committee deliberations would be. My guess is that President Evans and I might come much closer on that calculation than we would if we were asked to be in charge of setting the fed funds rate.

CHAIRMAN BERNANKE. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. First, I think flexible inflation targeting can be consistent with the dual mandate. Unlike the Committee's current approach of constrained discretion, flexible inflation targeting is more optimal if it involves conditional commitments

referencing both parts of the dual mandate and indicating how policy rates will be adjusted going forward. Constrained discretion, on the other hand, means that the Committee proceeds on a meeting-to-meeting basis and remains unwilling to promise future accommodation via communication. With this current approach, the Federal Reserve will not meet its employment goal for a long time and may be at risk of undershooting its inflation goal as well. Moreover, the continued use of constrained discretion means that the funds rate begins to increase in 2014 even though unemployment is well above the natural rate and inflation is below 2 percent. I respond to question 1 by believing a framework of flexible inflation targeting can be structured to be better aligned with the dual mandate and more likely to lead to optimal results that are better achieved with commitment strategies that reference both employment and inflation. In terms of articulating a framework, I see no downside and can imagine developing a statement on the policy framework similar to that used for the exit strategy statement.

The staff memo on alternative frameworks describes the superiority of commitment strategies. The memo makes clear that there are risks in such strategies, most notably risks related to the possibility that the commitment strategies would perform less well if their credibility were significantly questioned, and that there are challenges in the use of such strategies, most notably the challenge of communication. Even the most stimulative policies considered do not imply significant overshooting of inflation above a possible long-run goal of 2 percent. I believe that the commitment strategies are superior, but only with a strong caveat. That caveat is the imperative of a well-developed and well-tested and multifaceted communication strategy. Unfortunately, to date we have not put enough effort into framing such a communication strategy, and the results have been negative and troubling to this institution and

to the Committee. The launch of the second LSAP, for example, was met with a barrage of mostly uninformed negativity, which may have undermined its effectiveness.

Paragraph 4 in alternative A1 presents three strategies with increasing commitment and accommodative value. The first option is the least transparent, contains the lowest commitment, and accordingly, would provide the least accommodation. The third option is the most transparent, contains the greatest commitment, and accordingly, I would expect it to provide the most accommodation. The latter two options could bring about a noticeably faster fall in unemployment than under the baseline outlook while keeping inflation in the neighborhood of 2 percent. Whichever of these options is chosen, there should be a corresponding communication program set forth for the Committee to discuss and debate. In addition to this enhanced forward guidance, which looks more like the third option for paragraph 4 in alternative A1 and less like the first option for paragraph 4 in alternative A1, the staff memo describes two other commitment strategies: price-level targeting and nominal income targeting. Both of these strategies are shown by staff to be more optimal under various models, including FRB/US, than the Committee's existing strategy. I appreciate how critical credibility is to the execution and success of these commitment strategies and appreciate the scale and creativity that would be involved in the crafting of a comprehensive communication strategy.

Again, I don't view the communication challenge as insurmountable. Rather, I would venture to say that communication thought of as a strategy is a challenge that needs more serious debate and piloting. From this perspective, I believe the communication challenge to be just as intense for our current framework and choice of policy actions. There's continued risk to the credibility of the Federal Reserve in a decision to continue to engage in constrained discretion

because we have not described to the public why we are choosing to engage in what we have decided is a suboptimal strategy.

Model simulations suggest that nominal income targeting could provide considerable stimulus under the modal outlook and would perform well in a severe downturn or in response to an unexpected sustained rise in inflationary pressures. Accordingly, if the credibility challenges could be overcome with a meaningfully robust and comprehensive communication program, I would view us as remiss in meeting the dual mandate if we were not to consider it.

Finally, I should attempt to be concrete about what I think a communication plan includes. At the very least, we need to be able to explain the expected transmission of the action. I was stunned when talking to a group of bankers after one of them said to me, 'Please stop. Just stop. What can we do to get you all to just cease?' This kind of question makes it obvious that our actions are not completely understood and suggests that we focus resources on a communication plan both through the SEP and through a coordinated strategy that can explain how our policy actions are expected to work and how they may fall short. Thank you.

CHAIRMAN BERNANKE. Thank you very much, and thank you all for your thoughtful comments. Let me make a couple of suggestions and summary remarks. First, on the intermediate targets like nominal GDP and price-level targeting, I didn't hear much enthusiasm for any near-term adoption, although I think there was at least some interest in continuing to think about these issues perhaps in the context of a significant change in the environment.

Just for interest, I do raise one point, which is that a number of people have mentioned Christy Romer's piece, and she talked about the 1979 regime change. I actually think that's the wrong example. As President Bullard pointed out, when Chairman Volcker changed the policy regime, in fact, it took a long time for people to appreciate it and understand it, and one

implication of that is there was a long recession and real interest rates remained very high, and so on. But there are other examples, like 1933, when Roosevelt took the U.S. off the gold standard, and prices and asset prices changed almost overnight. There are other examples like the end of hyperinflations, and so on. There's something sometimes about regime changes that has remarkable effects on an economy. I'm not saying that we know how to predict that, but that's something that we haven't really understood or really explored in this conversation. That being said, I think that there was a lot of agreement that there are a lot of practical issues associated with implementing such an intermediate target, including both the very long horizons over which they have to operate and the issues of communication and credibility.

There was considerably more support for two specific things. First would be formulating some statement of principles in the same mode as the exit strategy principles, to try to formalize a bit more our flexible inflation-targeting framework. One element of that would be a numerical inflation objective, but I think it was made clear that other important elements would be a clear explanation of how this framework is consistent with the dual mandate: in particular, why it is that we have a number for inflation and not for unemployment, how those two things differ, how we think about the horizon under which we take various actions, and so on. I would ask the subcommittee, if Governor Yellen is willing, to begin a process of trying to put together such a document. The work that President Plosser and his group did, and President Plosser is a member of the subcommittee, is obviously a starting point for that, and'we're not making any commitment, to coin a phrase [laughter]'we should see what kind of agreement we can get on such a statement. Incidentally, I thought a useful addendum to the Plosser et al. document was a set of Frequently Asked Questions, which might be a useful thing to work on as well in order to explore and illuminate some of the issues.

The other thing for which I heard reasonable support was for further implementation and use of the SEP as a means of policy guidance. In particular, we'll hear today a report on the trial run on the policy projections, and I would propose'contingent on the discussion that follows that presentation, if people are willing'to again ask the subcommittee with a lot of staff support to try to develop some possible presentation approaches, some mock-up SEPs, and so on for our consideration to see if we find that a useful mechanism.

If we can do these things, let me suggest a very ambitious way of putting this all together, and of course, which can always be extended. If we were able to get an agreed upon statement of principles on the framework by the next meeting, by mid-December, and if we were also able to get to some agreement about the use of our policy rate projections, then we could review those issues at the December meeting. If we were comfortable with where we were at that point, we could then have a plan to consider at least ratifying these items as part of a communications package perhaps as early as our January organizational meeting. If we were to agree to do that, then we could try to prepare the ground for that in various ways. One thing, for example, would be that I could give a speech a couple of weeks before the January meeting and outline some of the ideas that are being discussed, and that would give us a chance to get some public feedback on the ideas, and we could also do some consultation. But it seems to me possible, if things go well, that we might consider trying to put together a package by the end of January. Two weeks after that or so is my Humphrey'Hawkins testimony, which would be another opportunity to explain this.

I think some of these things are better as part of a package of communications ideas rather than a discrete change in one aspect of our communications. Again, this is just a proposal.

I'll give people a chance to react after I finish these remarks, but there's no commitment being made until we see how things go and how comfortable people are.

I have one other set of comments, which has to do with the discussions we had on conditional commitments. There was a lot of interesting discussion on that issue. I will say for myself that I think this is something we should keep on the table. First of all, forward guidance is not something we're contemplating; we're well into the forward-guidance game. In fact, that was something that was part of my predecessor's legacy''a considerable period' and 'measured pace,' you remember all those things. We have, for better or worse, given an estimate of the date at which policy will begin to tighten, and it would be very desirable for us to think about ways to improve our forward guidance, particularly in light of the fact that we're at the zero lower bound and communication is an important part potentially, at least, of our toolkit.

Forward guidance is also, again, one way, and President Evans made a couple of good points. One is that many of the properties of the optimal control path that the staff discussed, or at least some of them, could be replicated by an appropriately calibrated forward guidance, where there was a commitment or just a forecast. There's that advantage, and then President Evans also made the point that by having triggers or escape clauses, you can protect yourself against uncertainty about the underlying source of the problem. His example was if we don't know whether the problem is a collapse of potential output or a collapse of aggregate demand, if we have sufficient conditionality, we are protected against both approaches. Again, that's something we ought to consider.

I do think that some of the discussion helps us address some of the concerns that people have. Let me mention a few things. In our discussion of the strategies at the last meeting, one of the concerns people had was that the public would misinterpret a trigger or an escape clause as a

target. Obviously, if we put this in the context of a broader communications strategy, that would reduce that risk considerably. Another concern that was raised was that we certainly can't estimate the natural rate of unemployment, even if it's not time-varying, with any accuracy. And if it's time-varying, that makes it even more difficult. But I would point out that the kind of language we have in the statement A includes both an unemployment trigger, but also an inflation trigger, and that would be a protection against a mistake in terms of where the unemployment rate should be. Yet another concern about these conditional commitments is that they involve very long time frames. President Bullard made the very good point that we should be at least combining with, or maybe just focusing on, asset purchases as being a more active type of policy action that would be more likely to affect expectations. I make the point that if our optimal policy involves a commitment which is very long in terms of the interest rate, we could at least consider combining that with asset purchases as a way of bringing that rate closer to the present.

So there are some issues here that we need to discuss, but some of them may be at least addressable. Now, having said that, I recognize there are lots of different ways to do this. The alternative statement A gave three different types of language. It could go into the statement, but some people have talked about the use of the SEP, and there are a variety of modifications that could be contemplated. I put this out there as something I will ask the staff'and Reserve Bank presidents might want to ask their own staffs'to look at, and we should try to make some progress on this over the next couple of meetings.

Any comments or reactions, particularly on the plan to try to get something together by January? Again, this will be contingent on it working. I should say that these framework changes are constitutional-type changes, and I'm certainly going to be looking for a very broad

agreement before we make any of these changes. [No response] Let's turn next then to item 3

on our agenda, financial developments and open market operations; and we'll turn to Brian Sack.

MR. SACK.2 Thank you. The exhibits are coming, but I wanted to say a few words before actually getting to the handout. Frankly, after hearing about what's taken place in financial markets over the past couple of days, you may actually need a drink. [Laughter] So I think the innovation of beer at the FOMC meeting is a good one. [Laughter].

Movements in markets yesterday and today have been dramatic. Let me give you a few numbers: The S&P 500 index is off about 5 percent, European stocks are off about 8 percent, some U.S. financial companies, such as Morgan Stanley, have their equity prices off 15 to 20 percent, and the 10-year Treasury yield has plummeted about 30 basis points. My point is that, once again, the world appears to be shifting under our feet pretty dramatically.

One consequence of this volatility is that it actually makes it quite hard to prepare a briefing that is timely. I think you will find that my prepared briefing provides very accurate and insightful information about financial market movements through last Friday [laughter], but I will do my best to modify accordingly. You're going to notice some tension here and there.

The story from my briefing, and that was presented in the Tealbook, is that financial market participants had generally become more optimistic about the outlook over the intermeeting period in response to the perception of progress toward a comprehensive policy solution in Europe and generally better-than-expected economic data. This improved sentiment had lifted the prices of most risky assets and had caused interest rates to rise. However, I had planned to note that the financial environment remains volatile, and that it is uncertain whether this enthusiasm would last. The sharp downturn in markets that we saw yesterday and so far today has brought that point forward with an exclamation point.

Let me turn to the exhibits. As shown in the upper-left panel of your first exhibit, Treasury yields had increased significantly over the intermeeting period, with yields at intermediate maturities moving up 25 to 40 basis points through last Friday. As suggested by the news index shown to the right, the incoming economic data has generally been better than expectations, supporting the upward movement in yields. In addition, developments in Europe have been an important driver of market movements, with perceived improvements in the policy outlook usually associated with increases in Treasury yields. However, taking into account the sizable decline so far this week, Treasury yields are now only modestly higher, on net, over the intermeeting period.

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

The path of MF Global serves as an example of the vulnerability of firms that are heavily reliant on short-term wholesale funding. As shown in the bottom-right panel, the firm had a narrow equity buffer, and its liability structure was relatively unstable. Indeed, the firm had little longer-term unsecured debt and, since it was not a bank, no retail deposits. Instead, the firm had 61 percent of its liabilities in the form of repo transactions and other trading liabilities. This structure left the firm very susceptible to a liquidity run in response to any emerging questions about its capital adequacy. Of course, this is the same issue that I noted earlier in the discussion of investor concerns about Morgan Stanley and Goldman Sachs. However, as can be seen in the table, Morgan Stanley has a much larger share of long-term debt as well as some retail deposits. The table also shows the figures for JP Morgan to offer a comparison to an institution with a larger banking operation.

The problems experienced by MF Global raised risks to the Federal Reserve through our counterparty relationship with the firm. Our potential exposures were associated with MF Global's participation in our securities lending operations, in our operations in Treasury securities, and in our operations in agency mortgage-backed securities. The Desk began to exclude MF Global from some operations last Wednesday and from all operations last Thursday. Yesterday, the Federal Reserve Bank of New York announced that it had terminated its primary dealer relationship with MF Global.

Heading into the market open yesterday, our only exposure to the firm was from seven unsettled MBS purchase transactions. These transactions, which totaled about $950 million, were due to settle as far out as mid-January. To limit the risk to the Federal Reserve from these transactions, on Friday we established a special arrangement for the firm to post collateral to us on a daily basis. Based on yesterday's events, we exercised our legal authority to terminate the seven trades, and we conducted trades with other counterparties to reestablish the same positions, using the collateral that had been posted by MF Global to cover the additional expense of those replacement trades. Given these steps, we do not expect to realize any losses from our counterparty exposures to MF Global. Thank you.

CHAIRMAN BERNANKE. Thank you very much. Questions? I'm sorry. President

Lacker, do you have a question?

MR. LACKER. Thank you. I have two questions. Brian, as this chart shows, we've

been buying a lot more nominals than TIPS, and under the same theory that lengthening our

maturity of our portfolio twists the curve, that would also affect the breakeven spreads. Do you

think that's happening? And do you have a quantitative estimate of how much?

MR. SACK. It could be happening. We don't have a good quantitative estimate. The reason we include TIPS is we don't want to distort the decomposition of nominal rates into their breakeven and real components. We want to have some presence in that market, and, of course, when we calibrate the pace of purchases or the allocation of our purchases, we look at a variety of measures to try to judge how much we could buy without causing market strains.

Here I'm showing gross public issuance. When you compare it to gross issuance, it looks quite small, but I think we did have some concerns that going too fast could disrupt the markets, since this is a less liquid market anyway and there are a lot of buy-and-hold investors. Having said all that, it's possible we undershot, and indeed there were some commentaries by market participants, such as Barclay's, talking about our programs actually putting downward pressure on breakeven inflation rates.

MR. LACKER. You gave us an estimate of the effect on the 10-year yield, but it would be nice to have an estimate of this as well.

The second question is about Treasury debt issuance plans. Is there anything you can tell us about what you know about their plans for next year and the extent to which they may be contemplating or may have embarked on a path that would to some extent offset what we've done?

MR. SACK. I believe they have not made debt management decisions in response to the effects of our program that would undo our program. They are certainly not looking at rates and opportunistically saying, 'Given what the Fed has done to the yield curve, we want to move further out in our issuance.' Having said that, they were already on a course that was lengthening the average duration of their issuance, and I think that lengthening will continue over the near term. At one of the recent meetings, we talked about Treasury expecting to be on a

path toward a weighted-average maturity of about 70 months, the market having anticipated that, and I think the discussion at Treasury essentially is not whether to go beyond 70, but whether to stop at 70 or stop somewhat below that.

VICE CHAIRMAN DUDLEY. It's fair to say that we don't think Treasury has adjusted their behavior in response to our behavior. It sounds like that's the key point.

MR. SACK. They're also considering a debt management innovation that would probably reduce the amount of duration that they issue. They've asked the TBAC to consider the appeal of floating-rate securities, which of course would allow the Treasury to reduce rollover risk while not introducing duration into the market. If that were a product that they brought on line and used in any size, that would actually help in terms of keeping duration out of the market.

MR. LACKER. Thank you.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I have a quick question, Brian. In terms of table 18, what would Goldman Sachs look like if we looked at their liability structure?

MR. SACK. I initially had Goldman Sachs on the table. I am contemplating whether to dig through my notes. It looks a lot like Morgan Stanley. I can send you the details. The point is, both Morgan Stanley and Goldman Sachs look different from institutions with larger banking operations in the sense that they both have some retail deposits but much less in the banking operation, and hence they rely more intensively on repo financing. The point of this table is to say that was true for MF Global as well, but of course to a much more extreme degree.

MR. KOCHERLAKOTA. So, long-term unsecured debt would look roughly the same, you think, for Goldman Sachs in terms of percentage?

MR. SACK. I think it would be in the same ballpark now that the figures show.

MR. KOCHERLAKOTA. Thank you.

VICE CHAIRMAN DUDLEY. Deposits would probably be a little less. Their bank is probably a little smaller.

MR. KOCHERLAKOTA. Thanks.

MR. PLOSSER. Mr. Chairman?

CHAIRMAN BERNANKE. I'm sorry. President Plosser.

MR. PLOSSER. I want to follow up with a question that Brian may not be able to answer, but I'm just curious. If I looked at JPMorgan three years ago, before the crisis, roughly what percentage would they have had in repo and trading liabilities'just ballpark? Twice this or 50 percent more or about the same?

MR. SACK. I will have to check on that.

VICE CHAIRMAN DUDLEY. I would guess more, because remember, they bought Washington Mutual, which had a lot of core deposits. The repo books have generally come down over the past couple of years. I would guess more, but I don't think it's so significant that you'd think they were in a very different position.

MR. PLOSSER. Okay. That's kind of where I was.

CHAIRMAN BERNANKE. All right. Let me go to President Fisher.

MR. FISHER. First, I want to congratulate you on handling MF Global the way you handled it. I have a question about that, and I have two other questions. But on this front, any other trip bars that might ensue from MF's failure that you're monitoring in terms of its impact on the system'not the Federal Reserve System, but on the fixed-income markets and on financial stability?

MR. SACK. Yes, there are several areas we're monitoring. MF Global, of course, had essentially a large brokerage unit into futures markets. One area we're watching is whether their customers will experience any period of disruption and confusion about their ability to change positions. There could potentially be odd short-term dynamics for futures markets.

The second area is questions about whether the customers' assets are truly fully there at the institution, and if there were problems in that regard, you could see a loss in confidence in other types of custodial arrangements or intermediaries.

And the third area is whether there would be any consequences for repo financing, not necessarily direct consequences associated with the unwinding of MF Global's positions, but broader concerns about whether repo funding for less liquid assets is as stable as the market had assumed.

I'm sure there are others, but those are three areas that we're watching. Not having the benefit of seeing markets today, but through yesterday, it looked like the markets were not overly concerned with any of those systemic consequences, but that's what we'll continue to monitor.

CHAIRMAN BERNANKE. Vice Chairman, you wanted to add to that?

VICE CHAIRMAN DUDLEY. Yes, just a few things. This is the first significantly sized FCM, futures commission merchant, that's failed in a way that they didn't actually port the customer accounts off smoothly to some other entity. There's a little bit more uncertainty here because it has never happened like this before. In the past, there has always been a smooth transfer of accounts.

The second thing I would say is that it underscores how fast liquidity can dry up for a firm. This is another firm that, while I wouldn't say they were fine a week ago, they didn't look like they were headed to collapse, and a week later they're dead. That is going to reinforce

people's anxiety about firms that are wholesale funded without any obvious lender-of-last-resort support from the central bank. I think as long as other firms stay out of trouble, it's not an issue, but if they get into trouble, people may actually pull back faster as a consequence.

And the third thing, of course, is that this was triggered in part by, as Brian mentioned, European sovereign debt exposure. To the extent that things in Europe deteriorate, other firms are viewed as having exposure to Europe, and that's another aspect of this. But so far we would say, and I think Brian and I would both agree, that the selloff in the market today really has very little to do with MF Global.

MR. FISHER. I would add a fourth factor, which is humility versus arrogance and balanced risk. The principals involved here were extremely arrogant, taking the positions that they had, and were imbalanced in terms of their judiciousness of risks, and I think the markets are well aware of that.

The second area of inquiry I have, Brian, if you look at your chart 1 and chart 8, is with regard to the way Treasuries have moved and the initial way that corporate bond spreads moved'remember those spreads are relative to an increase in the yields as shown in chart 1. Can you separate out for me the Operation Twist impact versus the impact of Europe in terms of influencing the way yields have moved? The question really deals with the efficacy of Operation Twist'and mind you, we're just starting this process'and trying to separate out the seesaw effect and the whipsaw effect of what's happening in Europe.

MR. SACK. Are you specifically raising the question of whether Operation Twist passed through to the private borrowing rates? Or do you'

MR. FISHER. What I care about is whether it passed through to private borrowing rates. That's my priority'how it impacts the market for private debt. Because chart 1 doesn't indicate

what one might have expected, but I care more about what happens in terms of private debt. That should be our objective'affecting the real economy. I am curious as to your judgment at this stage, and mind you, it is initial. And then, how are you able to separate out the seesaw effect we have gotten from the standpoint of enthusiasm over Europe and then sudden disappointment on the details?

MR. SACK. My assessment would be that Operation Twist put downward pressure on Treasury yields, as I said in the briefing. All else being equal, the majority of that would have passed through to private borrowing rates'maybe not the entirety of it, but the large majority of it.

What actually happened on the FOMC announcement was that private borrowing rates did not go down for lower-quality issuers, that spreads widened immediately. But I would interpret that spread widening as more of a reaction to the concerns about the economy and the pessimism that was in the FOMC statement that apparently surprised market participants, rather than a lack of pass-through from the Twist action itself.

It wasn't that Twist only affects Treasuries and nothing else. We do think that arbitrage, all else being equal, would have pulled down the private borrowing rates. You see that in the reaction of the 30-year swap rate. The 30-year swap rate, in terms of credit risk, is somewhat complicated. It does have a credit risk premium in it related to the LIBOR that it is referenced to. It is not the credit risk of lending to a firm for 30 years, but it is essentially the credit risk of promising to lend to a bank that will be in the LIBOR panel for those 30 years. That means it has a much smaller credit risk component than corporate yields. You can look at this and basically, from the relative movement of swaps and Treasuries, assess whether Treasury yield

movements pass through to private rates, all else being equal, and then add on top of that the effects on credit quality.

In terms of assessed credit quality, for sure it has been a seesaw. The market repriced to much wider credit spreads through early October associated with pessimism about the economy and concerns about risks emanating from Europe. It is the same pattern we saw with the financials and their CDS spreads, and so on. Then, as sentiment improved'which was the old theme of the briefing, as Europe seemed a little better and the data came in'that is really what led to a substantial narrowing of the corporate bond spreads. But my guess is, as we seesaw here, if this pessimism we have seen in the past two days persists, we will again start to see some upward pressure on corporate yield spreads.

MR. FISHER. Thank you. And then, one last quick question. Do we know why the Norwegians liquidated their MBS portfolio entirely on Friday?

MR. SACK. No, I don't. We didn't run down that story.

MR. FISHER. It might be interesting to get as much as we can. They are running a $500 billion plus sovereign fund. They do interact with the central bank. I haven't seen an explanation yet as to why they would liquidate their entire MBS portfolio. If you can just follow up, I would be very grateful.

MR. SACK. Yes, that would be very easy for us to ask about. We just haven't done it

yet.

MR. FISHER. Thank you.

MR. EVANS. I thought you spoke Norwegian.

MR. FISHER. They didn't explain it in Norwegian or English. [Laughter] CHAIRMAN BERNANKE. Governor Duke.

MS. DUKE. My question goes back to the impact on customers of MF Global, and this question may not make sense because I wasn't sure I understood the article I read just before I came in here. But it was something about either clearinghouses or exchanges freezing customer transactions, customers of MF. And then, I was remembering how some of the people who came through here were really unhappy in the Lehman bankruptcy about their collateral getting tied up in pieces. Is there anything in moving derivatives to central counterparties that we should be aware of in connection with this?

MR. SACK. That is related to one of the three broad concerns I talked about: Would there be uncertainty about the client's ability to change positions? Would there be confusion about what the status of their assets was or not? And as Vice Chairman Dudley mentioned, without the quick transfer of the client accounts, it leaves this uncertainty. I don't know enough about the legal arrangements to answer the questions you raise. But how long that will take and how transparent it will be in terms of when the customers will be able to reaccess their positions is one of the big areas of uncertainty here.

VICE CHAIRMAN DUDLEY. SIPC is on the case now as a trustee, so they are trying to manage these accounts. But I think there is definitely some freezing of assets and people not being able to execute this stuff.

MR. TARULLO. It's CFTC rules, though, right?

VICE CHAIRMAN DUDLEY. FTC rules on it for the FCM. And they were not a big firm, about $40 billion or $45 billion in assets, but they were very big in the commodities space.

MS. DUKE. Is there anything in that that would cause potential customers of, say, Morgan Stanley not to want to be customers of Morgan Stanley for just that reason?

VICE CHAIRMAN DUDLEY. I think this is probably viewed as a pretty idiosyncratic case. But, like I said before'wholesale funding model, dependence on repo, exposure to Europe'our base case is that the contagion channel should be small, but there is some risk. Brian, would you agree with that?

MR. SACK. Right, exactly. You have these relationships not only at FCMs but also through prime brokers, and so on. When we saw some of the pressure on the financials, such as Morgan Stanley, through early October, there was a lot of focus on the prime-brokerage relationships. We talked to some hedge funds who were actually trying to figure out how to hedge those exposures, so generally, that is a piece of the story about stress at any institution.

VICE CHAIRMAN DUDLEY. If you feel we are going in the right direction rather than seeming to go in the wrong direction in terms of market sentiment, you would probably be less nervous about this.

MR. TARULLO. But, Bill, when you said it was idiosyncratic, did you mean idiosyncratic to the underlying problems at MF Global?

VICE CHAIRMAN DUDLEY. Yes.

MR. TARULLO. But in answer to Betsy's question, were another firm that was a commodities merchant to get in trouble, there is no reason to expect that the exchange treatment of collateral would be different for them than it was in this case, right?

VICE CHAIRMAN DUDLEY. What was unusual in this case was the fact that in the segregation of the customer accounts there was a shortfall, and that is gumming up the works, in a different way than you would expect in a normal case.

MR. TARULLO. Are those the same accounts, or was the action on the Chicago Mercantile independent of the private customers' accounts?

VICE CHAIRMAN DUDLEY. I don't know. I think there was a press report about the CME saying that they were aware of problems with the customer'

MR. TARULLO. So maybe it is related.

VICE CHAIRMAN DUDLEY. 'segregated assets, but I don't have any details on that. MR. TARULLO. If it is related, then it is purely idiosyncratic. If it's not related, then it

gets to the way they conduct themselves.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Just to continue on the question of MF Global, a couple of weeks ago, as you see on chart 12, there was'and I hesitate to call it a 'run' 'but certainly a lot of pressure on Morgan Stanley and Goldman Sachs, which has eased. Then, we get the first casualty with MF Global. My broad question, Brian, is: Are you more or less concerned about financial instability now than two weeks ago? How is that trending?

MR. SACK. At best slightly more comfortable, but actually probably about the same. As I noted, what happened a few weeks ago with Morgan Stanley and Goldman Sachs was the same dynamic. Taking Morgan Stanley as an example, based on their discussions about the firm's exposures, I think market participants weren't convinced that the firm actually had problematic exposures, but what they were convinced about was the fact that if the market got too concerned, they could put Morgan Stanley out of business because of their reliance on short- term funding markets. I think that contributed a lot to the jitters that emerged in early October, and it is the same dynamic that ultimately brought down MF Global. But I do want to emphasize that MF Global is a very different case than a Morgan Stanley, in terms of the aggressiveness' relative to its size'of how MF Global was positioned.

MR. LOCKHART. But their reliance on short-term funding is a lot different, too.

VICE CHAIRMAN DUDLEY. Yes. Morgan Stanley, we believe, has a very large liquidity cushion. The MF Global experience showed you that whatever liquidity cushion you have can run off a lot faster than you expect. Morgan Stanley is starting with a much better balance sheet than MF Global was, and they have been actually earning money. One of the precipitating events for MF Global was that they took a very large loss in the most recent quarter. That was really what started this thing spinning last Tuesday.

MR. LOCKHART. Do you see any dynamic of predatory market players essentially gaining any victory with this one and moving on to the next most vulnerable?

MR. SACK. No.

MR. LOCKHART. No, we don't see anything like that?

VICE CHAIRMAN DUDLEY. I don't think this was about people shorting the CDS and driving down the stock price. This is all about the fundamentals of the company; that would be my opinion.

CHAIRMAN BERNANKE. I've got President Bullard and President Lacker.

MR. BULLARD. Thank you, Mr. Chairman. On MF Global'it became a primary dealer this year, is that correct?

MR. SACK. Right.

MR. BULLARD. Are we happy with our expanded criteria for primary dealers? And does this give you any pause about that new, more expansive definition?

MR. SACK. The new primary dealer policy just increases the transparency about the requirements. There was no reduction in the requirements to be a primary dealer. When we look at the primary dealers as candidates, there is an extensive review. It covers quality of management, the quality of their systems, their financial health, and so on. But we are at a

disadvantage. We are not a supervisor of this firm. There is a credit review. They passed the credit review. But that doesn't guarantee that they can't go downhill. As we see in the market price and everything, they went downhill very quickly and very unexpectedly.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. Yes, a question about MF Global, and then I want to follow up on a question from President Fisher. MF Global is insolvent, I take it? Is that our best information?

VICE CHAIRMAN DUDLEY. I don't think we know whether they are insolvent or not. We know they can't meet their obligations, but that doesn't mean when they are all liquidated that the value of the assets couldn't be a lot greater than the value of the liabilities. We don't know that. The fact is that their long-term debt, which they have a small piece of, is trading at about, last time I saw, in the 35 to 45 percent per dollar range, which suggests that the market thinks that they are most likely to be insolvent. But we are not going to know for a while.

MR. LACKER. Okay. Do you view how it has played out as inefficient ex post? VICE CHAIRMAN DUDLEY. It was inefficient in the sense that there was not an

orderly bankruptcy process. It would be much better if there had been a way to move the customer accounts to new firms, so that they didn't get trapped. It was messier than optimal. Is it systemic or not? Fingers crossed, we hope not.

MR. LACKER. About Richard Fisher's question about corporate debt spreads'this actually came up at the last meeting. We are operating under this habitat theory, and there is this question: Is 10-year corporate debt in the same habitat as 10-year Treasuries? Or is it in a separate habitat, and its yield doesn't move? And the data look like it is in a separate habitat, but you are saying that there was some offsetting move and some expectation.

MR. SACK. Right, that's what I'm saying. Equity prices went down sharply on the FOMC announcement. If the story were just a preferred habitat, so that Operation Twist only affected Treasuries and didn't affect corporates and that explained the widening of spreads, that alone wouldn't cause a big decline in equity prices. Clearly the market read the FOMC statement as more pessimistic than expected and repriced equities and corporate bonds accordingly.

MR. LACKER. The question I want to ask is about 2-year versus 10-year corporates. Do you view the impediments between those two markets as similar to the impediments between 2-year Treasuries and 10-year Treasuries? Or are they in the same habitat? And, in particular, does the fact that a corporation can operate in its own debt make it different from Treasuries? And would that short-circuit the effect you want to have on the shape of the yield curve in the Treasury market?

MR. SACK. I would argue that what we have seen from the experiences with the Federal Reserve policies is that there clearly is preferred habitat across the Treasury curve, across maturities. I would imagine that, to a large degree, you would see some of that preferred habitat pass through on the corporate side as well. I wouldn't view corporates as a single asset class where duration doesn't matter. Are you asking if the degree of market segmentation is greater in Treasuries than in corporates across maturities? That is a bit harder.

MR. LACKER. The intuition in habitat theory is the costliness or riskiness of arbitrage. A corporation can scoop up its own debt pretty easily.

MR. SACK. Right. Maybe I'm missing the connection there, but'

MR. REIFSCHNEIDER. Another way of saying it is in the Treasury market we expected there to be a twisting of the yield curve; we weren't particularly surprised that the two-year

yields went up a little bit and then the longer-term yields came down. Ceteris paribus, we would

have expected to see a similar effect in the corporate bond market for the same reasons. I don't

know if they did, but if two-year corporates did go up, that wouldn't be at odds with what we

expected. Whereas, we would have expected 10-year corporates that have'

MR. SACK. I'm not sure what the corporate arbitrage is here. I don't think there is an

incentive for them to equalize their corporate yields across the yield curve or something, if that's

what you mean.

CHAIRMAN BERNANKE. I wonder if there is a constituency for taking a vote on

domestic open market operations. [Laughter] Without objection. It is 3:15. Let's take

20 minutes for coffee. Thank you.

[Coffee break]

CHAIRMAN BERNANKE. Why don't we recommence. The next item on the agenda is

the economic situation, and I will call on David Wilcox.

MR. WILCOX. 3 Thank you, Mr. Chairman. I'll be referring to the first exhibit in the package called 'Forecast Summary.'

A long time ago, when I was sitting at the breakfast table this morning [laughter], I was reminded once again of the value of a supportive home environment. One of my daughters attempted to bolster my confidence by helpfully observing, 'Just keep in mind, Dad, that they're much more likely to remember you today for whether you're wearing a good tie and whether you've got any good jokes to tell. At least Mom has picked out a good tie for you.' [Laughter]

In a departure from recent practice, the outlook for real activity that we provided you in the Tealbook last week was not a marked downgrade of its immediate predecessor. Indeed, as Bob Tetlow discussed in his briefing for the Board yesterday, most of the spending indicators that became available during the intermeeting period surprised us to the upside. The favorable news included better-than-expected retail sales in September and a stronger report on orders and shipments of capital goods in August, and even some surprising further signs of life in the nonresidential construction sector.

3The materials used by Mr. Wilcox are appended to this transcript (appendix 3).

Amid diminishing inflation pressures and economic growth that is too slow to significantly erode resource slack, several major central banks announced further stimulus measures during the intermeeting period. The Bank of England expanded its asset purchase program by ''75 billion (or 5 percent of GDP), while the Bank of Japan expanded its program by ''5 trillion (or 1 percent of GDP). The ECB held its policy rate constant at 1'' percent but announced additional purchases of covered bonds and brought back auctions of one-year money. In the EMEs, the pace of monetary tightening has clearly diminished in the face of concerns about weak global growth' notably, Brazil lowered its policy rate by another 50 basis points over the intermeeting period, even as 12-month inflation breached 7 percent.

Against the background of weak foreign economic growth, exports grew at only a 4 percent pace during the second and third quarters. Import growth has been running even slower, however, so net exports made a small positive contribution to U.S. GDP growth of about a quarter of a percentage point. During the next two years, we expect export growth to step up to an average of nearly 7 percent, in part as foreign growth firms; the dollar also supports export growth, as even after rising a bit over the summer, it remains well below its values in recent years. In consequence, the contribution of net exports to U.S. GDP growth rises slightly next year, but this contribution dwindles in 2013 as the pickup in the U.S. economy leads to faster imports.

Deborah will now continue our presentation.

MS. LEONARD.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 2014 and over the longer run. As shown, you now see real GDP growth'the top panel'to be appreciably slower this year than its pace in 2010 and then to pick up gradually through the end of the forecast period. The unemployment rate'shown in the second panel'declines slowly over the next three years, yet remains notably higher than your estimates of its longer-run, mandate-consistent level. With regard to inflation'the bottom two panels'the central tendency of your projections for PCE inflation indicates a sizable, but transitory, increase this year before settling back down next year and remaining at levels roughly consistent with, or slightly below, your estimates of its longer-run, mandate-consistent level. Your projections of core inflation generally remain at or somewhat under 2 percent over the forecast period.

Exhibit 2 reports summary statistics regarding your projections for 2011. Your previous projections, collected in June, are shown in italics, and the current and June Tealbook projections are included as memo items. The central tendency of your current projections for real GDP growth this year, shown in the first column in the top panel, is 1.6 to 1.7 percent, down more than 1 percentage point from your projections in June. As shown in the middle column, you now judge there to have been

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

growth (shown in the upper-right panel) to be weighted to the downside, while a larger majority than in June see the risks to the unemployment rate as weighted to the upside. Many of you continue to view the risks to inflation (shown in the two bottom-right panels) to be broadly balanced, while the number indicating upside risks fell and those indicating downside risks increased.

As the communications subcommittee recommended, the staff plans to include this exhibit showing histograms of the responses regarding uncertainty and risks in the SEP that will be published with the minutes of this meeting in three weeks. The information contained in this exhibit previously had only been described in the SEP text.

This concludes my presentation. Loretta Mester will now provide a summary of the projections you submitted for the trial run.

MS. MESTER.5 I will be referring to the exhibits in 'Material for Briefing on Trial-Run Policy Projections.'

As part of its exploration into various approaches for enhancing the Committee's communications, the subcommittee on communications asked FOMC participants to provide information on their individual assessments of appropriate monetary policy.

More specifically, participants were asked to provide projections for the average level of the federal funds rate target in the fourth quarter of each calendar year through the forecast horizon of 2014 and over the longer run. These projections correspond to the appropriate policy that participants incorporated into their November SEP submissions. Participants who see the first policy firming occurring after 2014 were asked to provide their assessments of the likely year of liftoff, as well as their economic projections for that year.

I have divided the handout's exhibits into those similar to the ones seen in the standard SEP release (these are exhibits 1 and 2) and those that might be useful for internal discussions (these are exhibits 3 and 4).

As shown in exhibit 1, participants' funds rate projections have a central tendency of 13 to 67 basis points in the fourth quarter of 2012. Beyond 2012, differences in views about the timing and pace of tightening can be seen in the widening of both the central tendency and the range of projections. By the end of 2014, the central tendency for the funds rate is 13 to 250 basis points. Thus, participants agree that by the end of the forecast period, the policy rate will remain considerably below its projected longer-run value, whose central tendency is 400 to 450 basis points. The longer-run projections represent the value of the funds rate to which the economy will converge over time in the absence of further shocks. This longer-run value depends on both the longer-run inflation rate, which the central bank can determine, and the equilibrium real interest rate, which it cannot.

5The materials used by Ms. Mester are appended to this transcript (appendix 5).

As indicated, in the year prior to their first rate increase (the middle bar in each forecast panel), the central tendency of participants' projections is for economic growth to pick up from the current level of around 1'' percent to between 2'' and 3'' percent; for the unemployment rate to decline from around 9 percent this year to between 7'' and 9 percent; and for total PCE inflation to decline from around

2'' percent this year to a range of 1'' to 2'' percent.

Then in the year of liftoff (the third bar in each forecast panel), participants generally anticipate a slight acceleration in GDP and that the unemployment rate will continue to move down'but the central tendency is fairly wide at 6'' to 8 percent. The central tendency of the inflation projection in the year of liftoff is about 1'' to 2'' percent.

Of course, while the central tendencies and ranges give summary information, they don't reveal the connections between an individual participant's policy assessment and his or her economic projections. The bottom panel of exhibit 4 displays some of that information in a set of scatter plots of pairs of variables from each individual forecaster in his or her year of liftoff. It is important to note that forecasters can have similar views of the economic conditions needed to spur liftoff, but their views on the timing of when those conditions will be reached can differ substantially. I've highlighted two points in the first scatter plot as an example. Each of these two forecasters sees growth around 3 percent and the unemployment rate around 8 percent when the fed funds rate moves away from the zero bound, but one thinks this will happen in 2012 and the other thinks it won't occur until 2014.

As seen in the first plot, several participants are projecting that the first rise in the funds rate will need to occur before the unemployment rate falls to 7'' percent and with growth at 3'' percent or less. As shown in the bottom-right plot, all participants anticipate that liftoff will need to occur even though inflation is under 3 percent and the unemployment rate is at or above 6'' percent.

These exhibits and those distributed on Monday are meant to illustrate how information about participants' policy expectations might facilitate the Committee's internal deliberations. If it would be helpful, the staff could collect and present this information on an ongoing basis and assist in exploring approaches for disseminating such information to the public through the SEP. Thank you.

CHAIRMAN BERNANKE. Thank you very much. These are some interesting ideas on

how to present the information on projections.

It's been our practice four times a year to have a briefing on financial stability. Given

that we had a videoconference a couple of weeks ago and given how full the agenda is, we've

decided not to have that briefing. But Nellie Liang is here and Pat Parkinson is here, and if

anyone has any further questions relating to financial stability or wants to make any comments or raise any issues, I hope you will feel free to do that. We're ready for questions for the staff. President Kocherlakota.

MR. KOCHERLAKOTA. Yes. Thank you, Mr. Chairman. I have a brief question related to our discussion of nominal income targeting. Looking not just at the change in real GDP in the year of liftoff'it might be interesting to look at the cumulative output gap of real GDP or nominal GDP at the time of liftoff. So maybe we're at minus 7 percent now'just thinking about putting in the Tealbook estimates of potential GDP and then thinking about how the forecasts of real GDP have evolved relative to that. I don't know if I'm making sense.

MS. MESTER. Yes, you are. One thing is in the handout that we distributed on Monday'we did deviations from the long run'an individual's forecast of long run. You can at least see how far away they are from where they think the long-run gap is. But I would direct you to look at those, and maybe that'll give you some insight.

The other thing we thought about doing is amending the one chart that is basically 'Year of Liftoff' in levels. You could imagine doing changes and then doing a central tendency and the range of that. But derivatives of derivatives of derivatives get to me, although I read your memo, and you have a third derivative in your loss function. [Laughter]

MR. KOCHERLAKOTA. A lot of functions have a third derivative. [Laughter] CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. Just a point for David and the international side'to tie them together. In talking to the oil companies'which include Exxon; it has pretty good information'what they note is that gasoline'diesel demand is off 2 percent year to date. But what has occurred is that with the slowdown in European growth, there is less refinery output, meaning less exports to the

East Coast of the United States. As a result, they haven't seen the decrease in motor gas prices that they had expected. So there is this odd phenomenon. It is an international market. It's marked off of Brent, by the way, not off of WTI. But it's a refinery concept. The slowdown in Europe is actually affecting supply in the United States, even though demand has come up somewhat. The same is true for av gas'that, in the parlance of business, the crack spread has just not narrowed. The question is, when will it happen? But the pressures are moving in that direction from a demand standpoint. I wanted to make that point.

On food prices, the entire structure seems to be supported by Chinese demand. Soybean oil, for example, which is the most important'10 years ago, they imported 5 million tons; this year, they'll import 60 million tons. I mention that because, if you look at the headline PCE number, Mr. Chairman, of that 2 percent, 1.7 percent was either gasoline or food'1.4 was gas and 0.3 was food'and the rest, the core, of course, was flat, in keeping with what the trimmed mean was forecasting, as I've said, at a six-month run rate.

For what it's worth, I think you need to take note of that phenomenon. The international side is definitely impacting, in both gas and food, what is happening here in the United States. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. I have a question for Steve. I want to clarify something you said. When you were talking about the bank capital issue in Europe, you said 'asked to raise.' I'm not sure I would characterize it quite that way'in the sense that it's a shortfall based on a 9 percent capital ratio, but they're not really forced to raise it; they're just supposed to get to a 9 percent capital ratio.

MR. KAMIN. Oh, right. What I thought I said'but I might have erred in my reading' was that they are required to raise it one way or another.

VICE CHAIRMAN DUDLEY. Okay.

MR. KAMIN. Their first option will be to go to the private markets.

VICE CHAIRMAN DUDLEY. They're not really raising.

MR. TARULLO. They can cut assets, too.

VICE CHAIRMAN DUDLEY. All they have to do is get to the right ratio at the end of the day. They could shrink to get to that ratio; they can change the risk-weighted assets. I just wanted to clarify that.

MR. KAMIN. Thank you'that's correct. In their statements and in their discussion, they are very eager that that target not be achieved through deleveraging.

VICE CHAIRMAN DUDLEY. But that's a loose EBA instruction.

MR. KAMIN. Exactly. That is, indeed, a loose instruction. And so they're trying not to have that be the case. They have talked about restricting dividends and things like that in order to achieve that, but thank you for that clarification.

CHAIRMAN BERNANKE. President Rosengren.

MR. ROSENGREN. My question is for Steve, but it's a financial stability question, which is: You highlighted the 50 percent voluntary write-down, and the CDSs presumably are not going to be triggered; I wonder if you have any views on what that means for the CDS market going forward? If you thought you were being hedged against sovereign debt default, then not only for Greece but also for all your sovereign debt, all of a sudden it looks as though that hedge isn't a very good hedge. And if you think that sovereigns could play that game not only for sovereigns but also possibly for bank debt if the bank was large relative to the size of the

country, you start wondering whether that contract any longer has viability. But all of a sudden then, do you want to hold sovereign debt if you can't hedge it? So it starts having implications for the yields going forward. So I was wondering if you have views on that. Then I think this is really a question for another time, maybe, that the financial stability people could pick up on. But given how often the CDSs are cited, I wonder if you have any views on that'or Nellie or anybody else.

MR. KAMIN. I'll just start by saying that's an excellent point, and it's something that people have raised as an issue. It is interesting that those same concerns came up after the July agreement by Europeans to impose a haircut of only 20 percent on private creditors. And in the event, that concern seems to have been shrugged off, but it's come up again with this much larger haircut. One could imagine a situation after this, especially if it goes through, where indeed the role of CDSs could diminish.

MR. SACK. My sense is that it's not being shrugged off as easily this time. There is a lot of discussion about this, and it's a serious potential problem. You see it in the prices. The CDS spreads have come in much more or have come in even in cases where the cash spreads have not, so I think you're already starting to see some slippage in the prices. And if they are no longer effective as a hedging instrument, it would have the implications that you raised.

CHAIRMAN BERNANKE. Are there any other staff who want to comment?

MS. LIANG. I don't think I'm going to add too much to that. That is an issue that was raised very quickly, and so that is something we're reviewing to see if there's any measurable effect on the cash spreads and the CDS. But as Steve pointed out, in July and last year, when they talked about extending maturities, it appeared to get shrugged off, though the effects on

CDS values were a big concern at the time. This time we're starting to see a little bit of an effect, but it's a hard question to answer. We'll try to come back with something.

CHAIRMAN BERNANKE. Other questions? President Plosser.

MR. PLOSSER. I want to turn to the trial run. I want to make a comment and maybe even ask a question here. One of the things I find interesting about this is the difference in part between exhibit 1 and exhibit 2. As Loretta pointed out, if you look at exhibit 1, it looks as though there are huge spreads about what people expect. I think it's important we remember two things about that. One is that this is appropriate policy and not a forecast. I think that's important to understand what we're doing. But also, as she pointed out in exhibit 2, the modal forecasts here reveal a somewhat different story than you'd get by just looking at the first chart. And the modal forecasts are much closer to what the Committee has been signaling through its forms of forward guidance.

I think the other thing that's important to remember about this is that the value of this, as I see it, is not just as a snapshot in time, but it's also to watch how this exercise would evolve every quarter as the economy evolved, and therefore how this shape would evolve. And that's part of the information, rather than a point in time. It's the evolution of that that would be very revealing, I think, over time. So from my perspective, this could be a very valuable exercise for the Committee to undertake.

CHAIRMAN BERNANKE. First time anybody ever estimated a Taylor rule on panel data. [Laughter] Any other questions? Governor Tarullo.

MR. TARULLO. I think I drew a somewhat different inference than Charlie did, because I found myself focused on panel B in exhibit 4, which had quite a bit of variance. If at some

level the most relevant piece of information for markets is when the Fed will begin to exit'if I looked at that, I'm not sure I would be too confident in drawing any conclusions. Go ahead.

MR. PLOSSER. I think the question might then be to look at that in the same sort of bar chart'in other words, looking at the modal numbers on that chart rather than just the spread and central tendency.

MR. LACKER. Which chart are you talking about?

MR. TARULLO. I'm talking about the lower right-hand column of panel B. MR. PLOSSER. Oh, I'm sorry. I misunderstood. I thought you were looking at

panel A.

CHAIRMAN BERNANKE. Exhibit 4.B'PCE inflation versus unemployment rate. MR. TARULLO. Very last page, very last panel, very last graph.

MR. LACKER. It would be hard to pick a consensus trigger out of that or a threshold. Is that what you take from this?

MR. TARULLO. Yes. That returns me to the question I had earlier, which was whether, if there were three kinds of scenarios, there would be more convergence. And this graph at least suggests that there might not be a whole lot more convergence.

MR. LACKER. You can make them into three clumps.

MR. TARULLO. Maybe that's right.

MR. LACKER. Maybe not. I don't know.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. Yes, I wanted to build on something I had said earlier after Governor Tarullo's earlier remarks. Frankly, when I speak about the economy, I'm not sure people are all that interested in what I would do with the fed

funds rate if I were in charge'they want to know what I expect this Committee to do. And when we use the SEP, I'm not sure we want to be thinking about it as conveying the full richness of all of our views about the economy, as opposed to trying to use it to convey what we think is going to be happening to policy tools.

I think it's right to condition our long-run forecasts on optimal monetary policy. That gives the people the right idea of what the long-run target is. Conditioning our forecast for the fed funds rate and for inflation and unemployment on that'I don't think that's going to convey the right kind of information to markets. Markets want to know where we think those variables are going to go and how we think policy is going to respond to that and what we think policy will be, as opposed to under what we think optimal policy should be.

MR. TARULLO. Narayana, there's insight in that observation. How, in practical terms, then, do you think one gets from the manifestation of everybody's individual inclinations, which this graph shows, on the one hand, to something resembling more of a consensus, which, I read into your remarks, you would expect to actually be way less divergent.

MR. KOCHERLAKOTA. I would be interested to see a different trial run where we make a forecast predicated on what we think the Committee will do, what the evolution of inflation, unemployment, and real GDP will be, on the one hand, and what the evolution of the fed funds rate will be, on the other hand. And we'll see'maybe I'm wrong. Maybe there won't be more convergence on that, but my suspicion is that there would be a lot more convergence.

CHAIRMAN BERNANKE. This is important information, though'what people's preferences are.

MR. TARULLO. Yes, I was going to ask you about that.

MR. KOCHERLAKOTA. It's very reasonable for us internally to have that information. I will say for myself, I don't think it's as important for the public. I'm all in favor of transparency, but I have many vehicles to inform the public of my personal preferences over these variables. I'm not sure that seeing them in this bar chart form is all that valuable. It's valuable for us to know'panel 4.B is really useful for us to know in our own internal dialogue. But it doesn't necessarily mean that's going to be what we should share with the public.

CHAIRMAN BERNANKE. Pages 3 and 4 were intended for internal use.

MR. KOCHERLAKOTA. And that's very valuable, but when we go out and talk about what we want to share with the public, what's going to be useful in terms of shaping policy, I think it's more about trying to tell the people what we think the Committee is going to be doing, as opposed to what we would do if we were in charge of the Committee.

CHAIRMAN BERNANKE. I'm not sure I agree with that. President Williams. MR. WILLIAMS. No, I'll pass.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I just wanted to follow up on that. There is literature that looks at the forecasts by the group here. They treat them as unconditional forecasts, and they look at whether it's accurate or not. They forget all about the 'appropriate policy' assumption, and so I think there are a lot of subtle issues here. If you think the Committee is off on the wrong path, you might forecast that inflation is going to go way down or way up'way far away from target, for instance. And do you want that?

Other central banks have wrestled with this. They've done the projection based on the market expectation, which is a reasonable compromise. Or they've allowed the staff forecast to

go out and have let the principals just comment on the staff forecast. So I'm not sure'this is a difficult issue, I think.

CHAIRMAN BERNANKE. Anyone else? [No response] Okay. We're ready for our go-round, and let's start with President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I'll do my best to ensure that we complete this meeting by nine o'clock tonight. [Laughter]

In our recent round of board meetings and contacts, the majority of directors and business contacts in the Sixth District described activity as expanding at a slow pace. While most reports were a bit more upbeat than before the last FOMC, a plurality of directors and their contacts stated that they had revised down expectations for their firms' performance. Two directors representing the country's second-largest retailer and largest airline expressed pessimism about the business outlook, citing continuing uncertainty and weak confidence emanating particularly from the political process. Overall, I would characterize what we heard over the past two weeks as falling in a range from 'still somewhat pessimistic' to 'very cautiously optimistic.' In our questioning of directors and other contacts, we asked about intentions to hire or reduce staffing in the coming months. Although we heard some rumblings about reducing employment, the modal response was no near-term intention either to hire beyond replacement requirements or seasonal needs or to downsize staffing. Most firms seem to be holding steady as regards staffing.

In our formal survey of business inflation sentiment'this time, it involved

164 respondents'we detected less pressure on input costs than earlier in the year. Also, no significant wage pressures were noted. However, the vast majority of respondents noted that they intended to pass on at least some of any cost increase to their customers. Businesses in the

transportation sector noted that they have faced little resistance to surcharges to cover fuel cost increases.

Turning to my sense of the outlook, Atlanta's forecast is very similar to the Tealbook's through 2013. In the last year of the forecast horizon'2014'we depart from the Tealbook's trajectory and project flatter growth, reflecting the weight of fiscal drag, continued deleveraging, and restrained consumer confidence. Our forecast has unemployment above the Tealbook's 2014 projection and above the 6'' to 7 percent projections suggested in version A1 of the Tealbook draft statements. At the same time, our inflation forecast stays in the neighborhood of 2 percent over the forecast horizon, while the Tealbook numbers stay south of 2 percent. Therefore, we have assumed less slack in the economy than the Board staff.

To be more specific, I have a strong sense that the labor market involves much more in the way of inchoate rigidities, inefficiencies, and behavioral impediments than fully appreciated. Now, admittedly, I am basing this sense on a lot of anecdotal input, but here is some of what we're picking up. With respect to the relatively slow pace at which reported job openings are being filled, we are in fact told that some vacancies are so-called purple squirrel openings: If a purple squirrel shows up, the company will hire; otherwise, the company waits. [Laughter] My sense is that this employer attitude will change if confidence increases and demand picks up. But we are also consistently told of many skills mismatches. These mismatches are related to hard skills in specific industries and job types, but we hear much more broadly of issues related to soft skills, such as basic work habits, attitudes, and expectations. I frequently hear of jobs going unfilled because a large number of applicants have difficulty passing basic requirements like drug tests or simply demonstrating the requisite work ethic. As an example, one contact in the staffing industry told us that during their pretesting process, a majority'actually, 60 percent

of applicants'failed to answer '0' to the question of how many days a week it's acceptable to miss work. [Laughter] Now, I am not suggesting that these are necessarily new phenomena. But for a variety of reasons, employers seem to be paying much more attention to the quality of prospective hires than pre-recession. We also hear that job requirements have been updated to combine a wider spectrum of performance competencies, such as those that are required for receipt of the ACT's National Career Readiness Certificate.

There is anecdotal evidence of structural shifts. Companies of various sizes in various industries report moving to increase their permanent part-time workforce, typically as a way to manage uncertainties about health-care expenses and requirements. Now, I stress that these are anecdotal accounts, and the effects are difficult to quantify. But combining these and other inputs with the somewhat confusing participation data suggests to me that a great deal is going on in labor markets that we don't fully grasp. And I am not quite ready to argue that all this means the structural rate of unemployment is permanently higher, but I am inclined to think that clear progress in the labor market will lag economic growth more than usual. Further, I am somewhat skeptical of the capacity of monetary policy measures to speed up the process.

Let me conclude with comments on the balance of risks. I see risks to growth to the downside. Financial market volatility, slow jobs growth, and weak confidence make the economy vulnerable to any number of adverse shocks. Regarding inflation, I judge the risks to be broadly balanced, reflecting some ambivalence on the question of the amount of slack in the economy. It is possible that the high unemployment rate reflects more slack than I have assumed in my inflation outlook. But as my earlier recitation of anecdotal input suggests, the labor market could be struggling under the weight of forces that have raised the natural rate of unemployment for at least some time. I also think there is a chance that the influence of

commodity prices and other pressures on core inflation numbers could play out over a longer period than I have assumed, and inflationary sentiment could be adversely affected as a result. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. The markets seem to have initially taken some solace in the Europeans having an outline of actions with no details and in U.S. economic data consistent with growth that does not improve the employment situation. That such diminished expectations can generate a market rally is hardly encouraging. As Brian highlighted, it is even less encouraging that a referendum in a small country can offset much of those gains. This highlights the fragile financial condition as we try to make our own forecast.

My forecast, like that in the Tealbook, provides little to celebrate'positive but weak growth given the sizable output gap, positive but weak employment growth that leaves us far from full employment, and inflation that remains below 2 percent. By mid-2013, I expect we will still have an unemployment rate above 8 percent and an inflation rate well below 2 percent. The Tealbook has a similar forecast. If these forecasts are right, we will be missing on both elements of the mandate two years from now.

Financial market participants remain concerned. Liquidity in many markets is sporadic at best. Financial institutions, worried about their own liquidity risk, are not supporting markets to the same degree, making financial market participants less willing to take positions that may be difficult to exit. My own interpretation is that in many markets, European and American institutions that have been dependent on wholesale financing are pulling back from activities, resulting in marketmakers less willing to make markets.

While there has been some increased refinancing activity, and the newly announced HARP changes are positive, both the movement in mortgage rates and the fiscal willingness to encourage refinancing remain too timid to have much macroeconomic effect. Our econometric equations imply that we are well below the level of construction implied by fundamentals at this time. And buyer concern about future prices and the tightness of credit conditions make a very gradual return to normal in housing the most likely outcome.

My business contacts indicate widespread caution. Given the possibility that deficit discussions remain dysfunctional and European brinkmanship remains the negotiating tool of choice, businesses would prefer to defer hiring and investment decisions until there is more clarity in the outlook.

Given the weak performance we have experienced and the weakness in our forecast, our incremental policy is not the best approach. Critics of Japanese policymakers focus on a slow, deliberate approach that led to very suboptimal outcomes, with 20 years of slow growth and inflation below targets. If we do not start seeing more-robust improvement, then the likely fiscal austerity and continued downside risk from Europe put such improvement at significant risk. We will need to decide whether incremental policies are likely to return us to either element of our mandate in the medium term. Thank you.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. The Ninth District economy continues to perform better than the nation as a whole. The overall unemployment rate in the Ninth District is under 7 percent. Per capita income has risen slightly faster for the past two years than in the nation as a whole. That said, the rate of progress within the District has still been painfully slow. The unemployment rate in Wisconsin, Minnesota, and South Dakota in

September 2011 is essentially no different from a year earlier, although, as I mentioned, markedly better than in the nation as a whole. The unemployment rate in Montana has actually risen over the past year. Nor do I see any impulses for big changes in the near term. Ninth District business respondents remain cautious, although I will not be able to achieve the level of nuance that President Lockhart was able to obtain; their level of cautiousness is perhaps a shade lower than in the fall of 2010, and it's certainly a couple of shades lower than in the fall of 2009. So the economy is improving, but the pace of recovery is distressingly slow.

My outlook for the real economy is consistent with what's happening in the Ninth District and is, consequently, not all that different from the Tealbook. The good news is that the near-term downside risk'this sentence is out of date. I was about to say that the near-term downside risk from Europe has receded some in the intermeeting period. I wrote this on Saturday. [Laughter] I apologize. But my outlook, nevertheless, remains subdued. I expect that real GDP will grow at 2.6 percent in 2012 and only slightly faster in 2013. This is too slow to make rapid inroads into unemployment, and I'm anticipating that unemployment will be around 8'' percent at the end of 2012 and around 8.1 percent by the end of 2013.

Where I differ from the Tealbook is in my forecast for inflation. Core inflation has stabilized in the past couple of months. Nonetheless, I am expecting that core inflation will remain at or above 2 percent over the next two or three years. Obviously, the difference in my forecast for inflation is predicated on a different view of slack. There are, I think, reasons to believe that slack is large. As captured in the Tealbook, detrended real GDP in the third quarter of 2011 is over 10 percent lower than in the fourth quarter of 2007. The employment'population ratio remains well below its December 2007 level. But there are also reasons to think that slack is smaller than these observations might suggest. Detrended real GDP and the employment'

population ratio have been disturbingly steady over the past two years despite variations in monetary policy and fiscal policy. And a theoretical statistician looking at the recent data on detrended real GDP or on the employment'population ratio would not be led to the obvious conclusion that further stimulus would lead these time series to turn north.

As I mentioned at our last meeting, I think the comparisons with June 2004 are informative. The capacity utilization rate is about the same as in June 2004. The short-term unemployment rate, the fraction of the labor force that has been unemployed for less than

15 weeks, is only slightly higher than in June 2004. Along the same lines, I believe that it is instructive to compare the matching efficiency of the labor market in mid-2004 with what it is today. If you look at the vacancy'unemployment ratio in August 2011, it is about half of what it was in mid-2004 during the midst of a jobless recovery. Typical estimates of the elasticity of the matching function are usually around a half. So this fall of the vacancy'unemployment ratio of 50 percent from mid-2004 to mid-2011 should have resulted in a fall of the job-finding rate of about 30 percent. And in fact, the steady-state job-finding rate is more than 50 percent lower than in mid-2004. The matching function seems to have shifted in this sense, so that it is now considerably harder for good matches to form than in June 2004. If this shift had not taken place, the unemployment rate would be just 6.1 percent'only slightly higher than it was in June 2004.

None of these observations can be viewed as being more than suggestive. My point is certainly not that I know for sure that slack is as low as in June 2004. But we need to keep in mind that the events of the past four years may well have had significant adverse effects on the supply side. This hypothesis is consistent with the uptick in core inflation that we have observed over the past year. And those effects will worsen the tradeoff between unemployment and

inflation that we face in formulating policy, in the sense that any given level of unemployment will lead to higher inflation. Thank you, Mr. Chairman. That's all I have to say.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. After all of the bad economic news throughout much of this year, it's refreshing to have intermeeting data that surprise to the upside, albeit relative to very modest expectations. The inflation data have also been encouraging, with core inflation trending lower.

A key question for the outlook and monetary policy that we have actually been discussing for a few years now is to what extent the modest growth we are seeing reflects a slowdown in the growth rate of potential output. My trusty staff has reexamined this issue using a variety of methods. The bottom line of their analysis is that the underlying growth rate of potential output since the start of the crisis appears to be slower than we previously thought and still assumed in the Tealbook. Specifically, we estimate that potential output will grow about 1.9 percent per year, on average, over 2011 to 2014, and this slower rate of potential output growth primarily reflects slower labor productivity growth owing to both a lower estimate of trend total factor productivity growth and the subdued pace of capital accumulation by businesses. This finding of slower potential growth obtains both from a careful bottom-up approach, similar to that employed by the Board staff, and a top-down Kalman-filter approach to estimating potential output. Looking further ahead, we estimate the long-run growth of potential output to be

2.2 percent. That's 0.3 percentage point lower than in the Tealbook.

As a result of this revision to our estimate of potential output, the level of potential at the end of 2014 looks to be about 5'' percent lower than what we expected on the eve of the Great Recession. So this gets back to President Kocherlakota's point about, if you were to extend a

line from late 2007, where that would be. But nonetheless, actual output remains well below even that reduced level of potential. And our estimate of the current output gap is around

5 percent. That's about 1 percentage point smaller than in the Tealbook.

The key factors underlying this large output gap are on the labor side. For example, despite the steady growth in the working-age population, hours worked today are more than 5'' percent lower than in the fourth quarter of 2007. My staff's analysis, along with the analyses of many other economists in the System, consistently finds that this shortfall is primarily cyclical, not structural.

My near-term outlook has real GDP growth of about 2.3 percent next year'and careful study of the tables we got shows that that is the slowest rate of growth projected for next year among the participants'and about 3 percent in 2013. I think, again, this slower rate of potential growth that we are assuming actually explains the fact that my forecast is somewhat lower than typical. With output increasing somewhat faster than potential over the next two years, I expect the unemployment rate to end this year at about 8.7 percent and to be 8 percent at the end of 2013, which is roughly comparable to the Tealbook.

I think it's important also to note something that Dave Stockton'David Wilcox'I don't know how I did that'[laughter]'something that David Wilcox pointed out earlier'several hours ago. And that is, in our forecast, similar to the Tealbook, more than half of the decline in the unemployment rate over the next two years is met with a decline in the natural rate of unemployment. So the closing of the gap is actually quite modest.

Another question that we've been grappling with is, if the unemployment gap is so large, why haven't wages fallen more over the past few years? This question was taken up by several leading economists at a recent symposium on U.S. wage dynamics hosted by my staff at the San

Francisco Fed. Although the participants came from different traditions and used varied approaches, a number of common themes surfaced. There was general agreement that wage growth has been firmer than expected during the recent recession and recovery. Still, none of the participants concluded that this signaled an absence of slack. Instead, the participants pointed to an upward shift in the skill composition of those employed as an explanation for the resilience of real wage growth. They also cited downward nominal wage rigidities, which are more likely to be binding in a low-inflation environment, as a potential explanation of the relative strength in wage growth.

This situation is likely to continue, and my business contacts report little or no upward pressure on wages. Similarly, I see no pressure for an acceleration in prices. Commodity price pressures have come down, and inflation expectations remain well anchored. Furthermore, the recent readings on core PCE inflation have come down from somewhat elevated levels seen earlier this year, as expected. Over the past three months, core PCE inflation is about

1'' percent, and over the past 12 months, core prices increased 1.6 percent. Looking forward, I expect PCE inflation to be around 1'' percent both next year and in 2013.

Let me turn to the risks to the outlook. I regard the risks to my inflation forecast as broadly balanced, which clearly puts me in the minority, with about equal risk of inflation running at 1 percent or at 2 percent next year. Despite the sizable swings in commodity prices and the worst recession in decades, inflation expectations have remained remarkably well anchored, and core inflation has been stable through this period. I will mention a paper that Dave Reifschneider and two of his colleagues here at the Board did, looking at what were the surprises of the past few years in terms of output, unemployment, and inflation. What was probably one of the most striking results is how stable inflation has behaved over the past few

years relative to a variety of DSGE or empirical models or FRB/US. The big surprise, in some sense, is that inflation has been so stable despite all of the shocks that we've had. For that reason, I view the inflation risk as broadly balanced but the uncertainty as not larger than history.

The risks to the outlook for economic activity appear to be larger than average and skewed to the downside. For example, our outlook assumes further improvements in credit conditions and consumer and business confidence. Instead, the recent subpar growth and elevated financial market volatility have, if anything, increased uncertainty. U.S. fiscal policy also remains a source of downside risk, and progress in Europe on solving several difficult problems, notably bank recapitalization and debt sustainability, has been halting at best. And this was written on the weekend.

The recent uncertainty appears to be particularly pernicious in character. It's not just unusually large shocks to our models that I worry about, but it's also the stuff that isn't even in our models'so Knightian uncertainty. And I have to say that purple squirrels were not in our model, so that's just one aspect of that. Let me see if I can read this: It's not just the known unknowns but also the unknown unknowns that seem to have persisted at a high level. For example, the risks of a full-blown financial crisis in Europe are not well captured by our models, and I have a hard time formulating precise risks to our economy in that scenario.

Finally, Governor Raskin and I are just back from a trip to both China and Japan, but I'll comment on what we heard in Japan that made me especially drawn to the Tealbook 'Lost Decade' alternative simulation. In fact, many of the people we talked to in Japan predicted that the U.S. would soon, or within a few years, be talking about a lost decade for the U.S. In this scenario, 'persistently sluggish growth . . . has a corrosive effect on the supply side of the economy.' Governor Raskin and I encountered people, as I said, who warned that these risks

were developing for the U.S. And based on their own agonizing experience, they stressed the difficulties of pulling an economy out of a protracted slump. The large downward revisions to U.S. potential that I mentioned earlier reinforce such concerns.

In summary, the outlook is one of sluggish growth and frustratingly slow progress on reducing unemployment. Inflation looks to be trending to levels somewhat below my preferred long-run goal of 2 percent.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. My assessment of the economic outlook has not changed meaningfully over the past few meetings. I do not see any evidence that the U.S. economy is poised to achieve escape velocity anytime soon. We've experienced periods when the balance of the incoming data had been negative. More recently, the news has been somewhat better. I made it a point not to overreact to the weaker monthly data we saw this summer, and so I'm not overreacting to the more positive numbers we've seen of late. The best-case outlook seems to be simply muddling along. The recent, more positive data are still only indicative of an economy that's just treading water. The 2'' percent growth rates we're looking at over the near term are just not enough to make meaningful headway into the substantial resource gaps we see in the economy today.

Commentary from my business contacts continues to support this assessment. Indeed, there really wasn't that much new in their reports this round. Overall, most say things are moving sideways at this time. They just don't see the demand in place to justify expanding workforces or capacity. Many of my contacts said they were demanding contingency plans from their staffs to slash expenditures 5 to 30 percent if needed, and I continue to hear many say they are making plans to promptly cut spending at the first sign of a downturn in demand. These are

hardly the plans of business leaders who are contemplating an acceleration in their activities. I expect more of the same. The ups and downs in the national data did show through in our contacts' commentaries about the automotive industry. The OEMs and their suppliers are expecting continuing modest improvement in auto sales and production, but they don't see things taking off, either.

Everyone continues to be concerned about Europe. This report seems stale. The reports from my staff, who talk to people in the Chicago markets'the report seemed stale on Friday, but it seems a little fresh today. Prior to last week's announcement, the financial-sector contacts said that uncertainty and caution were freezing up some markets. That said, there was little evidence of panic. Our contacts also said that they would view any European debt package with some skepticism. They seem to be on target with that one. They question the Europeans' ability to execute whatever immediate plans they come up with, as well as the prospects for a longer-term resolution given the impediments to growth in the region.

Turning to the macro outlook for the U.S., our growth forecast is similar to the Tealbook's. We also think that the reductions the Board staff has made to potential output are plausible, and these reductions are not small. They cut nearly 3 percent from the level you would get by simply extrapolating forward a modest 2'' percent growth trend from the beginning of the recession'not as much as the 5'' percent growth that President Williams was talking about. But even with this substantial reduction in potential, we're still looking at large output gaps and growth forecasts that leave resource utilization at very low levels throughout the projection period.

To sum up, all of the incoming data and anecdotal reports point to an economy that's just sputtering along. We're generating growth, but it falls far short of the pace we need given the

size of the resource gaps that must be closed. With regard to the two scenarios I discussed this morning, in my opinion, the U.S. economy is entangled in a liquidity trap with amplification from a large Reinhart'Rogoff financial crisis. We could be staring at a lost decade, the way President Williams was suggesting from his comments on Japan. Even if this is only an exaggerated risk'I don't think it is'if we fail to take further actions, owing to credibility risks, we end up with about as much credibility as the Bank of Japan has, I worry. Like President Rosengren, I worry about too slow, incremental policies. I think we need to continue to add more accommodation. There are alternatives in the Tealbook, A1 and A2, and I'm uncomfortable with stasis. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Let me ask you, President Evans and President Williams' I'm a little confused: If potential output is 5 percent lower, how can the output gap still be comparably large?

MR. WILLIAMS. This was a comparison'I should have spelled this out a little more carefully'of what our forecast or view of potential output was in 2007, before the recession. Basically, it was that trend line and seeing how much the decline in the level of potential output in the end of 2004 is relative to that in 2007. It's not just in the past six weeks.

CHAIRMAN BERNANKE. So what is your potential output relative to the Tealbook? MR. WILLIAMS. It's 1 percent because our output gap is 5 percent. The Tealbook, I

think, is 6 percent in Q3. So it's just a 1 percentage point difference. CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I was listening to President Evans. My summary of the economy is not that we're sputtering, but we're loping along rather than galloping, to use a

Texan term. And I'll basically say that things are not that much different, but they're slightly improved.

With regard to my own District, we continue to create private-sector jobs. We created 204,000 private-sector jobs year to date, and lost 41,000 government jobs. Twenty-three thousand of those were lost in September alone, and yet we still have net job creation. I find it interesting that there is a disparity between the private sector and the public sector, with the private-sector job creation growing at a pretty steady 3 percent, but clearly we have an offset from the public sector.

In the District, conditions in housing are improving. We have increased home sales, lower inventories. Prices, however, are flat, somewhat stagnant. Our construction job growth has been weak this year, but we're seeing significant investment in multifamily units and very robust demand translating into the price of rentals. Overall, price pressures are moderate in our District; wage pressures remain subdued.

All three of our indexes'which we're constantly working to perfect'in terms of

manufacturing services and retail, continue to point to continued economic growth in the next six months. So from a District standpoint, we're not quite in the parallel universe that President Kocherlakota's District is, but it's pretty much the same story. We just have a higher unemployment rate, but things are proceeding progressively.

From the standpoint of my business contacts and broader anecdotal evidence, the general claim is that business is slightly better than what we read in the press. For example, one of my business contacts is a large trucking company. In fact, it's the largest trucking company not located in my District, which runs 16,000 trucks'the largest in the country. They surveyed their customers. Eighty-five percent of their customers feel good about the fourth quarter and feel

better about it than they did'that is, they expect better growth in the fourth quarter than they did in the third, which I found different from almost every other economic forecast I have heard. One of the key worries that seems to be vexing for the private sector, particularly retailers, is a fear of understocking'that is, running under inventoried for the year-end season; based on last year's experience, there's no question people are running extremely tight inventories. The real issue is whether you'll see a pop at year-end or not. In terms of looking at rail activity, trucking activity, there appears to be a little bit of a pickup to hedge that risk, but it's not very strong.

From the standpoint of overall cap-ex, the best way it was described to me is, people are still finding that there is a benefit to the cheap money that we provided and abundant liquidity, but the use of it is hampered by the constant concerns we hear at this table about fiscal policy and regulation. And cap-ex is being deployed but 'with a string.'

From the standpoint of inflation, I said earlier that the trimmed mean is still running at a

2.1percent six-month run rate given that the BEA upward adjusted the last two to 2.1'but fairly constant. We expect the headline PCE to trend in that direction.

Without exception, in every sector for the CEOs that I speak with, this money is being used, and the conditions in the economy are being used, to drive additional productivity investment. Whether you talk to the telecoms, or you talk to the manufacturers, or you talk to almost any sector, given the uncertainty that surrounds fiscal and regulatory policy, there is an effort to make sure that risk is reduced by driving productivity significantly through technology investment'not a good picture for unemployment; maybe a good picture for inflation. I remain concerned as to the efficacy of policy as it treats unemployment, and I still, despite my hawkish reputation, am less concerned about immediate inflationary pressures.

I am concerned, however'and I mentioned this last time'about the effect that low interest rates are having on pensions. I asked our staff to analyze the Fed's own pension system. I referenced that last point. The data reveal that the pension discount rate within the System has fallen 100 basis points since the beginning of the year, and this would mean that we would have to reserve another 9 percent. I'm not sure whether that would apply through the rest of the economy. I heard cases, in terms of my anecdotal go-round with my CEOs, from an extra reserve of $1.7 billion to several hundred million dollars, but there's no question that anybody who has a tail end of a defined-benefit program is going to have to recalculate the expense ratio that they've imputed.

In terms of the insurance industry, I think this is something that we need to at least be aware of. Insurance is the most basic savings product that most ordinary Americans do utilize. I'm hearing increasing reports again that the profitability of the life insurance industry'I'm not talking about the demonized health insurance industry'is coming under increasing pressure and may result in a different sort of product that they are able to offer and disappointing returns to those who use that as a method of long-term savings and also protection.

Finally, with regard to the banks, they continue to report about margin suppression. I heard a new term. It's a bit earthy, but I'm a Texan. The new term in local and community banking is 'cashtration,' meaning that they are being squeezed by too many deposits'it's worse than being squeezed'and not enough demand for loans. The margins continue to flatten, and basically, in the words of Jamie Dimon, they're being crushed.

Let me make one last comment. I really don't see a need for change in policy at this juncture. If anything, the conditions are slightly better than they were the last time we met, and

I'll talk more about that in the next round. So, Mr. Chairman, that is the extent of my report. Thank you.

CHAIRMAN BERNANKE. Okay. Thank you. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. For the first time since last March, I've been encouraged by some of the economic news that we got during the intermeeting period. That news has lessened the odds of another recession, but with so many indicators still weak, the bit of good news we received hasn't been sufficient to change my baseline outlook beyond this year, and I'll explain the basis of this assessment.

Like the Tealbook, since our last meeting I have edged up my forecast for GDP growth in 2011 but otherwise left my growth forecast essentially unchanged. From the fourth quarter of this year onward, I expect GDP to grow at a moderate rate of about 2'' percent through the end of next year and about 2'' percent in 2013 and 2014. With this growth profile, unemployment will decline slowly by roughly '' percentage point per year, leaving it at 7'' percent at the end of 2014.

In my judgment, there was enough strength in the third-quarter figures to make the risk of recession lower than I feared at the time of our last meeting. I have also been somewhat encouraged by reports from my business contacts that bankers have become more optimistic and are a little more willing to lend. As one example, a builder of commercial properties reported that he is now starting to see a renewed willingness on the part of bankers to extend loans for the value of a project rather than the cost, allowing the borrower to take away cash, which then can be invested in other projects.

Despite this good news, a range of concerns lead me to believe that the pace of recovery is likely to remain slow over the next few years, with risks to my outlook that are still higher than

historical norms. Some of those concerns include, first, that the economy continues to see considerable headwinds, including the ongoing woes of the housing sector, consumer deleveraging, and cutbacks in state and local government spending. A second concern is that, based on the most recent purchasing managers survey, Europe now seems likely to be headed for recession. And third, the overall stress in financial markets seems likely to remain elevated until the European situation is fully resolved. This stress is going to continue to impair credit market functioning and hold back growth. I am also concerned that the continued high level of uncertainty, which others have mentioned, is holding back the pace of recovery by restraining business spending. Virtually every CEO I talk with has said that uncertainty is preventing some projects from going forward. Among the uncertainties they mention are weak sales outlooks, the direction of health-care requirements, the broader regulatory environment, and future tax rates. That said, even though uncertainty is limiting the expansion of capacity, it doesn't seem to be detracting from earnings and profits. Many companies in my District are reporting record earnings and profits, apparently because they have figured out how to manage their business to stay profitable in this environment.

Turning to the inflation outlook, I have made little change to my forecast of inflation. I continue to expect core inflation of about 2 percent from 2011 through 2014. As pressures from energy prices continue to dissipate, the rate of headline inflation should slow to the core rate by the end of next year. As others have mentioned, I saw some good news in the September CPI and PCE releases. The headline rate of inflation continued to drift downward. Surprisingly, the core CPI inflation rate dipped below 1 percent on an annualized basis, but the decline in core CPI inflation is probably overstating the slowing of the underlying trend. The core CPI was pulled down by significant reversals of apparel and auto prices, which finally dipped in September after

rising unusually sharply for much of the year, and these were likely relative price movements that don't tell us much about the underlying inflation rate. Consistent with this reasoning, the Cleveland Fed's median trimmed-mean and sticky price measures of underlying price trends didn't slow nearly as sharply as the core CPI did.

Still, I think the most likely outcome is for a gradual decline in inflation to about

2 percent, reflecting several forces. Critically, inflation expectations remain low and stable. The inflation expectations model that we maintain at the Cleveland Fed shows that inflation expectations over the next few years are still below 2 percent. The other important forces giving me some confidence in my inflation forecast are for continued slow growth of labor costs and reduced pressures from commodity prices.

Putting all of this together, while there was important good news in the economic

information received since the last meeting, the news hasn't been sufficient to materially change my outlook for the economy. I continue to think that the most likely outcome is for slow growth and inflation stable at about 2 percent. While the risks to the economy now seem somewhat lower than they did a meeting ago, they remain considerable, particularly with respect to the European crisis. So I still see that the risks to growth are primarily to the downside, while the risks to unemployment are primarily to the upside, and the risks to inflation still seem balanced to me. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President George.

MS. GEORGE. Thank you, Mr. Chairman. Economic activity in the Tenth District has continued to expand moderately, and contacts generally expect similar or perhaps slightly faster growth ahead. Manufacturing activity picked up in September and October. Inflationary

pressures have eased a bit and are expected to be moderate in coming months as the effects of higher commodity prices recede.

Recent job growth in the District as a whole has been similar to that in the nation, but the rate of growth continues to vary widely across District states. Energy and agriculture states have expanded rapidly, while other District states have shown little growth, if any. Many contacts express difficulties finding skilled workers, but wage pressures remain muted.

Energy drilling continues to boost economic activity in many areas of the District. Oil production remains highly profitable, and natural gas firms continue to have easy access to cheap capital. Continued rapid expansion of oil production in the central United States has put more pressure on pipelines and maintained the sizable spread between U.S. and world oil prices. This has caused some firms to ship oil by rail or even truck to coastal refineries rather than through pipelines to the hub in Cushing, Oklahoma.

Land values in the District continue to grow rapidly, particularly in northern parts of the region. Non-irrigated farmland values in the third quarter were up nearly 40 percent from a year ago in Nebraska, about 20 percent in Kansas, and over 10 percent in the rest of the District. Over the past five years, land values have increased over 100 percent in Nebraska and almost

80 percent in the District as a whole. Moreover, institutional investors are showing increasing interest in making these land purchases.

With respect to the national economy, recent data suggest that the near-term outlook has improved and the risk of the U.S. economy tipping back into recession has receded. Third- quarter real GDP growth came in stronger than I expected in September, as the temporary factors weighing on growth dissipated.

Over the medium term, my views are largely unchanged from September. I expect that the economy will maintain the momentum evident in the third quarter and will gradually move to a growth rate that will lead to modest reductions in the unemployment rate. Factors supporting growth include pent-up consumer and business demand, exports, and monetary policy that is highly accommodative. Nevertheless, several factors will weigh on growth over the next few years, including uncertainty, ongoing deleveraging, an anemic housing market, and an increasing drag from fiscal policy. In addition, the extended period of highly accommodative monetary policy could lead to a buildup of financial imbalances that could threaten the longer-run stability of the economy.

On a more positive note, the near-term outlook for inflation has improved. Inflation is likely to recede over the next several quarters to 2 percent or less. With a gradually rebounding economy, a depreciating dollar, and inflation expectations that appear to be well anchored, there is little risk that inflation will fall much below 2 percent over the medium term. In fact, the extended period of highly accommodative monetary policy, combined with our long-term fiscal imbalance and the possibility of a rebound in commodity prices, poses significant upside risk to inflation.

In summary, I expect that the recovery will continue at a moderate pace, with inflation remaining near 2 percent. While the risks to output growth have become somewhat more balanced, the risks to inflation remain to the upside. Thank you.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. The Eighth District economy continues to expand at a modest pace. The Eighth District unemployment rate based on 16 metropolitan

statistical areas is somewhat lower than the national rate, at 8.7 percent. Payroll employment in the District was approximately flat during the most recent reporting period.

Large firms in the District remain optimistic and plan to expand in some cases. Profitability remains strong. Cash holdings are high. Many large firms have a strong presence in Asia, and in almost every case, the growth strategy is based on Asian demand. In this sense, the European sovereign debt crisis is not upsetting business planning or entering corporate thinking as anything more than a general risk factor, and Asian growth is still considered mostly unassailable at this juncture.

District agriculture continues to do well. Relatively high prices, even with higher input prices, mean farm income will likely remain strong this year. As an indicator, some farm equipment dealers are reportedly sold out through the spring of 2012.

Commercial real estate conditions are variable across the District. Residential real estate continues to be lackluster in many areas. Banks continue to report very weak loan demand.

The national economy now appears to have avoided the recession scare that gripped financial markets during the August time frame, even though the level of global financial stress remains high. If a recession was developing during the September'October time frame, the hard data would have been considerably worse than they were. My sense is that market expectations outran actual economic developments. As it stands, I expect moderate growth during the remainder of 2011, with reasonably good prospects for improved growth during 2012, provided that significant financial stress can be mitigated.

The types of risk events that occurred during the past several months have apparently not been of a variety that might cause households and businesses to pull back spending sharply and set off a recessionary event. For households, the European sovereign debt crisis is worrying but

too distant to cause immediate changes in spending patterns. For large businesses, the EU crisis is, again, very worrying, but much of their growth strategy is in Asia so that both growth and profitability remain on track for them. For both businesses and households, the debt ceiling debate only confirmed the political realities in the U.S. concerning the difficulty of dealing with medium- and longer-term fiscal issues. Despite the contentiousness of the debate, there was no real news about the U.S. fiscal situation.

The July 29 revisions to GDP, as we have noted here on several occasions, were indeed significant and did lead to legitimate worry of a further slowdown or outright recession. But the Q3 hard data did not confirm this view, so now I think we're in a position to expect reasonable but not stellar growth going forward.

In the meantime, headline and core inflation have not subsided to the extent that one might have predicted based on the estimated size of the output gap. One reasonable interpretation is that the output gap is not nearly as large as suggested by conventional analysis. Reverse engineering the output gap using the method of Laubach and Williams'our colleague just to my left here'for instance, suggests that movements in core inflation are indicating a gap of about 2 to 3 percent, much smaller than suggested by other metrics. This makes a lot of sense if one is willing to attribute some of the growth in the past decade not to fundamental factors but to an unsustainable bubble in housing and real estate more generally. Indeed, this fits with our rhetoric about the past decade very well. I think this hypothesis bears careful watching during the coming quarters and years. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. The incoming data since the last meeting have generally confirmed my previous views about the outlook. Growth picked up a bit after

having slowed in the first half in response to several temporary factors. I was particularly pleased by the strong growth in final demand in Q3. I think 3.6 percent was more than a lot of economists expected.

Certainly, some of the rebound represented the passing of the effect of energy price increases and supply chain disruptions that held down spending earlier in the year. I'm struck, though, by the disconnect between household and business spending and the general despondence expressed on surveys and in conversations with our contacts. Given the news and commentary on the debt ceiling negotiations and European debt crisis beginning at the start of August, I might not have been surprised if falling confidence had led to a general free fall in spending in August and September, but instead, both retail sales and business fixed investment made decent advances last quarter. Consumers and firms seem to be expanding their spending based more on their individual economic fundamentals than on broader, more media-driven worries. Having said that, these fundamentals are by no means ebullient, and there still seem to be serious impediments to a more robust pace of economic expansion. I've talked before about what seems to me to be restraining the recovery, and I don't have much to add. I was impressed with President Lockhart's account.

The only thing I will add is that we continue to hear new anecdotal reports related to these impediments, and I'm going to share two with you. One is from an employment agency in West Virginia saying that unquestionably the biggest problem in hiring skilled and unskilled workers was the inability to pass a drug test. Other firms in the area have reported the same thing. We've gotten some reports, not quite as prevalent, outside of West Virginia. Many say that the problem has gotten worse recently. I asked someone to look into this to try to get a sense of whether this has become a bigger problem recently. Apparently the big increase in the

prevalence among firms of drug screening was in the late 1980s and early 1990s in response to new, low-cost screening tests and some new federal regulations that were related to safety. So it doesn't look as if we've had a technology shock or rapid decline in the cost of drug screening or anything like that. Now, illicit drug use, though, is more prevalent among the unemployed. Of those who are unemployed or not working, 17.3 percent are drug users, compared with

7.9percent of full-time workers. So forget the worries about full-time workers. The increased incidence of unemployment by itself would increase the frequency of bad drug tests. One suspects that usage increases the longer one is unemployed. You also expect the other causality'that usage would cause a lower exit rate from unemployment, but I'm not aware of any data on that, so I can't really say I've been able to document that. There also may be a regional component to this. Industries in which screening is more prevalent are mining, utilities, and transportation, and they're much more prevalent in the West Virginia economy. That might be why it's more of a problem in West Virginia. Now, usage doesn't appear to be higher than the national norm in West Virginia'we checked that. But we do hear widespread reports about hard drug use, OxyContin and methamphetamine, in Appalachia and other rural parts of our District'in particular, Appalachia. And there could be a demographic angle to this. Some of our contacts say that drug use is more of a problem with the younger generation, versus alcohol being the predominant problem among older workers. Obviously, demographic characteristics associated with higher drug use are also associated with higher unemployment. Drug abuse and the hardship involved in unemployment aren't really laughing matters; it's hard to pin this down quantitatively, but it strikes me that there could be something meaningful there as a contributor to impediments to labor market functioning.

I'll pass on just one other comment, and this is from a business owner who notably'it became quite obvious in our advisory council discussion; he's a member of one of our advisory councils'is a staunch Democrat. We asked at the very end of the council, 'What's your number one worry about your business going forward?' And he said, 'Obamacare.' He has a brewery and a 56-employee restaurant, and he said he was thinking of 'playing games,' as he put it, to get his employees down under the 50 mark, where a bunch of things kick in. We've heard similar concerns from others in our District, and this could be a widespread concern, obviously, among small businesses.

So those are my two anecdotes of the meeting. I realize anecdotes are murky as evidence. You have to look for an accumulation of these things, see if there's a tenor to them. But we're struggling to understand what's impeding growth, and what you can torture out of the macrodata is fairly limited at times, so I think it's useful to buttress our understanding with these, judiciously interpreted. My best guess is that no one single problem is holding things back. It's a combination of a bunch of things that people have mentioned at many of our recent meetings.

My growth projection is relatively guarded, like the Tealbook's. I think growth is most likely to rise, but only gradually over the next few years. I wrote down 3'' percent for 2014, but without much conviction. I put significant probability on a soggier path. I think growth could well average more like 2'' percent for the next few years.

I'm less pessimistic on inflation, but I don't see a lot of evidence of a decline anytime soon. Headline inflation numbers remain high. The PCE figure for September was 2.9 percent year over year and 3.3 percent over the previous months. It's true that the core index was flat for September, but that was largely due, as President Pianalto said, to volatile components, like apparel and autos, that were high earlier in the year. I think it's too soon to say we're seeing a

downward trend in core inflation in the data so far. Futures markets prices for Brent crude indicate only modest reversal of the run-up in prices that started in late 2010. As a result, I see little chance that a decline in energy prices is going to help us out by dragging down the headline inflation numbers and maybe passing through to core. I expect core and headline inflation to run around 2 percent, maybe even a little bit higher, going forward. I think that's an inflation outlook that, according to our SEP responses, most of us would be pretty happy with. I, of course, put down 1'' percent for my SEP response under appropriate policy. So I'm one of those people with diverging forecasts and SEP responses.

All in all, the outlook for the real economy is disappointing, to be sure, but I remain in the camp that ailments are largely beyond the power of monetary policy to correct. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Well, it sounds as though your drug use anecdote could argue either way. It could argue for more stimulus to get more people off the streets, right?

MR. LACKER. Get them off the street?

CHAIRMAN BERNANKE. Well, off their drug use.

MR. LACKER. I think a lot of people use in their homes.

CHAIRMAN BERNANKE. Okay. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Economic activity in the Third District has picked up a bit since our last meeting. And although downside risks remain, I think tail risks have lessened somewhat, and the risk of recession has diminished. But events in Europe today' you never know. Wait until tomorrow; something else will happen.

Our Business Outlook Survey of regional manufacturing showed a rebound into positive territory in October after two months of negative readings. The general activity index actually

rose from minus 30 in August, to minus 17 in September, to plus 8 in October. I think that's a remarkable swing in the period of three months, and part of that is related to what I mentioned here last time'that in October, the survey week was the week of the S&P downgrade of the U.S. debt, and the week of the September survey was the week of the hurricanes and floods in New Jersey and western Pennsylvania, which had a dampening effect, so to speak, on the outlook. But consistent with this improvement in general activity, both shipments and orders turned up as well. Employment readings remain positive, although weaker than they were earlier in the year'there's no question about that. We did ask a special question on our October survey about employment. The good news is that far more firms reported they had increased employment this year than had cut staffing: Indeed, nearly half'46 percent'had increased employment, and less than 25 percent had decreased employment. Less-good news was that most of that occurred in temporary employment.

Contacts with directors and the business community echoed many of President Lockhart's comments about jobs and challenges. It's not just mismatch; it's also the problems that'whether it be drug testing, which is a very common theme I hear. The other common theme I heard is work ethic. An employer in the Third District who owns, I think, 60-some-odd McDonald's restaurants in southeastern Pennsylvania and New Jersey says passing drug tests, passing literacy tests, and work ethic are the primary problems he has in hiring people, as far as he's concerned. It's also true in the city. I have an anecdote from my wife, who attended a meeting in the city of Philadelphia of a group that was engaged in trying to encourage both the city and businesses in Philadelphia to hire more people. Unemployment in Philadelphia is quite high, obviously, and our mayor, Mayor Nutter, in responding to this group, said, interestingly, 'We have over 1,000 job openings in the city of Philadelphia, and the problem is not that there

are not people hiring. One report is that we can't find enough people who understand that literacy, work ethic,''again''and drug testing are a big impediment to this city actually hiring people.' He made a very impassioned plea about that, and of course, it turned into a discussion of education and other things. So I think that's not an uncommon thing to hear these days among employers.

On the other hand, employers who are hiring high-skilled workers'engineers, technicians, and computer people'are clamoring for employees. One person told me that when they hire an engineer, they rarely hire him or her out of the unemployment pool; they're actually hiring the engineer from other firms, and that seems to be a very common theme as well.

Nevertheless, the weak indicators of employment in our manufacturing survey are consistent with weakness in labor markets overall. Payroll employment in our three-state region dropped over 1 percent on an annualized basis in the past three months, compared with nearly a 1 percent increase in the nation. In our District, state and local government downsizing has played a big role in the reductions in overall jobs.

Residential real estate markets remain weak. Market delinquencies and new foreclosures continued to improve in the second quarter, but coping with the growing inventories of foreclosures remains a serious problem, especially in New Jersey. According to RealtyTrac, the foreclosure process for loans foreclosed on during the third quarter averaged 974 days in New Jersey, compared with 336 days nationally. The long process time in New Jersey stems from the superior court decision in December 2010 to review bank foreclosure practices, and that was not lifted until mid-August. In the meantime, most banks stopped filing new foreclosures in New Jersey, and so we have an unusually high level of foreclosure, which will continue to burden house prices, particularly in New Jersey, because of this process. In contrast to the residential

sector, commercial real estate markets seem to have steadied somewhat and even improved slightly in the region. Indeed, in some submarkets of commercial real estate, rents have risen and vacancy rates have come down.

Retail sales in the region were mixed over the past few months. Our contacts expressed hopeful optimism for strong holiday sales but weren't sufficiently convinced to commit much to building inventories. Car dealers appear to be more optimistic. With supply surges, they have been able to raise prices and sell cars without promotions. I also have a contact at a very large New York retailer, and she reports to me that at this large store, retail sales have been surprisingly good'which is consistent with the data we got'and that they continue to be good going into October. And they are actually looking for a reasonably positive holiday season. That suggestion is consistent with other traffic on transportation that's been referred to. I have a director of a company that both builds and leases railroad cars nationwide. They report that the demand for railroad cars is very high and leases are high, and they're raising prices on a fairly steady basis.

The outlook is for continued modest recovery in our District. It's nothing to get excited about. They expect slow recovery in activity over the next six months but are not predicting a recession. Contacts there say that they are waiting for more substantive and persistent signs of growth before taking on any more risk.

On balance, the national economy appears to be weathering the heightened level of real and financial uncertainty unleashed by the growing fiscal problems in both Europe and the U.S. The data over the intermeeting period have come in somewhat more positive and are consistent with our forecast that growth will strengthen after the temporary factors holding back the economy in the first half of the year. So far, the economy, I think, is showing more resilience in

the second half than many anticipated. Third-quarter GDP, as many have mentioned, was quite good relative to the dire expectations of August and early September. Labor market indicators have stabilized rather than deteriorated as some had feared. Consumer confidence remains low, but retail sales have been somewhat stronger than expected. And production and investments continue to grow.

Overall, recession risks have receded considerably since our last meeting, but as we know, the risk and uncertainties remain high. News from Europe has been the dominant driver of financial markets over the intermeeting period, swamping the effect of Operation Twist, in my mind, and more-positive underlying data on the domestic economy. The European fiscal situation remains precarious, but some positive steps have been taken. However, it remains to be seen, as has been reported, whether it will all hang together in some form or not. In the U.S., the 'supercommittee' deadline looms large on our fiscal policy, and the outcome of that will also likely affect consumer and business confidence in the coming months. We'll need to see whether that is positive or negative.

Nonetheless, my modal forecast is that the economy is poised to grow just slightly above trend, maybe, from 2012 through 2014. That suggests a growth rate of about 3 percent. With a moderate pace of growth over that horizon, labor market recovery is going to be gradual, and it's going to be painfully slow and unsatisfactory to many people. The unemployment rate will move down but very, very slowly.

I anticipate that headline inflation will pull back a little bit, with about a 2'' percent increase in 2012, and then focus around 2 percent from 2013 through 2014. But in my view, that's predicated on a somewhat tighter monetary policy than is in the Tealbook forecast. In

order to keep expectations of inflation well anchored, the Committee will likely need to commence policy tightening before mid-2013. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. The way I would characterize the outlook is, we got a little bounce that we were hoping for. The positive of that is that the sharp drop we saw in household and business confidence does not seem to have led to a pullback in hiring or spending, but I think we shouldn't get overimpressed by 2'' percent growth in the third quarter. Some of the bounce was due to temporary factors such as autos, and the increase in consumption was accompanied by a pretty big drop in the household saving rate, which may indicate that there is actually some stress on household balance sheets. And finally, some significant obstacles to growth remain.

In my mind, there are three key determinants of the outlook over the next few quarters. The first one is Europe, and we saw earlier how powerful the contagion was back to the U.S., especially in terms of those financial intermediaries, like Morgan Stanley, that have very limited access to the Fed's lender-of-last resort function. If Europe goes badly, then there is a real risk to the U.S. financial system; and then, by extension, to financial conditions; and then to the real economy. So although the bilateral exposures don't look so great, the actual consequence would be quite severe. On Europe, I agree with Steve's characterization that there is lots of assembly required, probably a few missing parts, and no real assurance that it's going to work in practice.

A couple of things I would note. The first thing about the Greek restructuring that's really quite interesting is that even with a 50 percent haircut, full participation of all of the private-sector participants, optimistic assumptions on growth, and the fiscal austerity package being implemented, they still end up with a debt-to-GDP ratio of 120 percent in 2020. Now, the

reason why this is happening is that as more and more Greek debt gets socialized into official hands like the ECB and the IMF, the haircuts to the private sector have very diminished consequences to the total Greek debt burden. So I think that really raises a question: Is

50 percent restructuring enough, or is this the first in a series of Greek restructurings? Or is Greece ultimately going to default?

The second issue associated with the Greek restructuring that's noteworthy is, it's not clear that this is being done in a way that actually makes other sovereign debt look more attractive. You could argue that it makes it look less attractive because, one, you now have the precedent of restructuring in place, and, two, as we discussed earlier, if the CDS are not triggered, then you no longer have a way of hedging your sovereign debt. So I think in some ways, this actually makes the rest of the European debt look a little bit less attractive. If you can subordinate the Greek debt holders, the more that the ECB buys of Irish, Portuguese, Spanish, and Italian debt, you're essentially de facto subordinating those holders as well. And I think at some point, they're going to catch on to that.

The second thing I would say about Greece'we talked about this before: the bank recapitalization. They have a '106 billion shortfall. But press reports indicate that very little of this is expected to be met by new investor equity. In fact, most of it's going to be done by retained earnings, changing business model, and deleveraging. I think one of the real key questions is, how does that deleveraging hurt economic growth'and then does that feedback make it more difficult to make progress in terms of fiscal consolidation?

Lastly, there are two more issues with Europe'the next one is, does the EFSF actually have enough capacity to do all the things that they need to do? The reason we have this

20 percent first-loss piece is that the EFSF has only '440 billion of capacity, and a lot of that

capacity is already spoken for in terms of Greece, Ireland, and Portugal. So you have a pretty Rube Goldberg type of machine, and nobody really knows if investors are actually going to have much appetite for this debt that has a 20 percent first-loss piece. And then the final thing, the thing I think was probably the most disappointing regarding the European announcement' there's really no vision yet at all about where Europe is headed over the medium to longer run. What's the exit strategy of all of these programs? How are they going to enforce conditionality in terms of fiscal consolidation on an ongoing basis? How do these countries reenter the market and actually issue debt to private investors two, three, four years down the road? I'm pretty pessimistic about what's actually going to transpire in Europe. So that's issue number one.

Issue number two is housing, and I think there are a lot of problems there. Obviously, the first problem is the high loan to value. Mortgage holders are locked into high-coupon mortgages, and that's basically impeding the power of monetary policy to actually support the housing sector and household consumer spending. The second problem is the slow pace of foreclosures that you highlighted, which is bad in itself, but it also creates a greater incentive to default because if you already know it's'what was it, 397 days until the foreclosure actually is ended?

MR. PLOSSER. In New Jersey, it was 900 days.

VICE CHAIRMAN DUDLEY. Sorry'900 days. You can live in the house for a long time rent free before they actually catch up with you. Also, you have the problem of getting the Real Estate Owned once it's foreclosed back into the market. We have a very peculiar situation right now where rents are rising despite the fact that we have a glut of unsold homes. And that's a really peculiar situation. Now, the good news, of course, is that the Administration is taking another stab at helping high-loan-to-value households refinance. But as I read it, the program

seems pretty limited in scope, and the terms are not as generous as they could be. Also, the Administration program is focused just on that one aspect of housing.

I view housing as really essential because if you stabilized housing and housing prices did stop falling, not only would that be good for the housing sector itself in terms of provoking more demand for housing, but I think it would also be very important for household wealth and household confidence. So it could actually have pretty significant effects for consumer spending. But I don't think we're there yet.

The last issue is fiscal policy. There are two real issues here. First, fiscal policy, in the absence of policy action, is going to be turned sharply restrictive at the start of 2012. I think we're understating the potential significance of that. Second, we have policy dysfunction in Washington, and that's also important because it has an independent effect on household and business confidence. In this respect, the outcome of the supercommittee deliberations is important, not just for what they do or don't do in terms of long-term fiscal consolidation'but also, if they do something tangible, it will actually be good for household and business confidence, and if they don't, it won't, because then we'll just be on hold through the next election.

My view is that we're going to see moderate growth over the near term. But until these three issues'Europe, housing, and fiscal'are addressed in a way that takes them off the table, I view the risk as very much tilted to the downside. Now, if all of them were addressed positively, I could actually see the economy surprising on the upside. And the reason for that is, a lot of people are on the sidelines, holding back, because they're uncertain about the outlook. When I talk to businesses, especially small businesses, I actually hear a lot of people say, 'I'm okay, but I'm not doing anything right now.' So if we could just take care of these three problems, we

could actually have a pretty good outlook. But unfortunately, there's not a lot of power in this room to do much about it. My own view is, we should be highlighting these three issues, and, especially on housing and fiscal, we should be pressing the Washington policymakers, both publicly and privately, to do something about these things. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. Three working hypotheses have guided my thinking about the economic outlook. All three received support from the data during the intermeeting period. The first is that growth during the first half of 2011 was significantly depressed by transitory factors: sharp increases in the prices of imports and commodities and disruptions in global automotive supply chains. That hypothesis is consistent with the recent rebound in the spending data.

The second hypothesis is that those transitory factors also boosted consumer inflation. Thus, with well-anchored inflation expectations and subdued growth in compensation, I expected that as those transitory factors waned, inflation would subside to levels at or below the mandate- consistent rate. This hypothesis has also been confirmed by recent readings on consumer prices. In fact, the prices of core goods have been practically flat, rising at an annualized rate of only 0.2 percent over the three months ending in September, compared with a rate of about

3'' percent over the prior three-month period. Meanwhile, services prices have been rising steadily at a 2 percent pace over the past year. The latest three-month reading on core PCE inflation is now back down to 1'' percent and seems likely to decline a bit further going forward.

My third hypothesis is that economic growth has only limited upside potential due to the persistent headwinds that are restraining aggregate demand. Because the odds are so low that the recovery will gather any real head of steam, unemployment seems likely to linger at dismally

high levels for many years to come. Incoming data suggest that spending in the third quarter was somewhat stronger than I had anticipated, and the composition of growth may foreshadow slightly stronger growth in the fourth quarter as well. That said, nothing in the data dissuades me from the view that growth will gain momentum only gradually, and that view is also evident in the Tealbook and in the consensus outlook of professional forecasters. The key factors holding back spending are well described in the Tealbook and include unusual pessimism among households about their future income and financial prospects, declines in the values of homes and financial assets, still-elevated debt levels, and reduced access of households, particularly those under water on their mortgages, to credit.

The daily readings on consumer sentiment from the Gallup and Rasmussen surveys did point to some improvement over the past few days in the wake of Europe's announcement of measures to address its financial crisis and the attendant rebound in the stock market. I'll report tomorrow morning on how things look. But even with that slight rebound, consumer sentiment has simply reverted to exceptionally low levels that were seen in late July.

Other drags on the recovery include persistent dysfunction in the housing and residential mortgage markets and budget pressures that are restraining spending at the federal and state and local levels. Moreover, incoming information points to a more significant slowdown in European growth, a development that's having spillover effects on the global economy and is likely to damp the U.S. economic outlook.

Turning to risks to the outlook, I still see those risks as weighted to the downside, although there's slightly more balance than in our last meeting. Incoming data diminish the odds that the economy is about to slip into recession. But the odds still remain very high, in my view, that there will be negative spillovers from the European debt and banking crises, and I consider

this the number one risk affecting the outlook. European developments could still derail our recovery, and I think this is a scenario that's very well illustrated by an alternative simulation in the Tealbook.

My long-standing concerns about the ability and willingness of European policymakers to address their sovereign debt and banking issues effectively were reinforced 10 days ago, when I attended the meetings of the G-20 governors and ministers and their deputies in Paris. I had a chance to see, up close and personal, that the key players were still very far from having nailed down crucial elements of the deal only days before their self-appointed deadline. Glimpsing how the sausage was made was not at all reassuring. Of course, like many others around the world, I did breathe a huge sigh of relief when the euro-area leaders announced agreement last Thursday on a comprehensive package of measures to address Greece's unsustainable debt situation and the vulnerabilities of European banks and sovereigns, and presented a road map for stronger coordination and constraints on fiscal policy. But I'm not at all surprised to see a turnaround in market sentiment, and I fully expect that the road ahead will be long and will involve lots of scary turns and steep cliffs along the way. As Brian noted, of course, spreads on the debt of most peripheral countries barely budged, even after the agreement was announced, and at this point, spreads on Italian debt have reached new highs.

Here I'm going to pick up on some themes that Bill and Steve mentioned, but in my view, there are a number of reasons why substantial downside risks are likely to continue not for months but for years to come. In the first place, Greece, Ireland, Spain, Portugal, and Italy have all committed to further deficit reduction, and the adjustments called for by Greece and Ireland are exceptionally large. Fiscal contraction on this grand scale, at a time when economic activity in Europe is already weakening, will further undermine growth. From the perspective of

markets, this creates severe implementation risk. And as Bill and Steve noted, if you just take the case of Greece, even with a 50 percent haircut, the troika plan to stabilize Greece's debt-to- GDP ratio near 120 percent involves very tough fiscal targets, which are quite likely to be missed if growth falls only slightly short of the pace assumed in the analysis. Historically, large fiscal adjustments have typically occurred in situations where higher real export growth, reflecting a depreciation of the country's real exchange rate, could compensate at least partially for fiscal drag. No mechanism other than slow growth of wages and prices, along with structural adjustments that tend to be difficult and slow, is available here to restore competitiveness.

A second concern of mine'and Bill mentioned this'is the potential for a European credit crunch. The funding pressures currently afflicting European banks have already caused them to restrict credit and to delever, and these pressures may intensify as growth slows, as European banks experience pressures on their earnings and higher losses on their nonsovereign assets, and as banks struggle to meet the higher capital standards called for by European leaders and banking authorities. The leaders' statement, as Steve and Bill noted, does stress the importance of ensuring that capital raising not cause excessive deleveraging, but there is no mechanism in place to prevent banks from shedding assets. Moreover, even with more capital, European banks remain highly vulnerable to further sovereign debt problems given their enormous exposures. So the soundness of the banking system can be assured only if the sovereign debt issues are decisively addressed. Negative feedbacks between economic performance, the health of the banking sector, and the default risk of sovereigns that stand behind their banking systems create the potential for vicious downward spirals.

A third concern is that no matter how clever the arrangements to leverage the EFSF, without substantial participation by the European Central Bank, the underlying funding may

simply be insufficient to cover a new Greek package, to backstop bank recapitalization, and to offer credit enhancements sufficient to ring-fence Italy and Spain, given the enormous borrowing needs of those countries over the next two years. To me, it's highly questionable whether investors, including banks, will be willing to buy Italian and Spanish debt at yields that don't threaten debt sustainability.

And finally, with respect to European politics, as the European leaders' statement emphasized, progress on fiscal integration in Europe is necessary to the success of the euro, but exceptionally difficult politically. And the governments, as we can see in Greece and Italy, already seem close to the breaking point.

In summary, my modal outlook is that the European leaders will succeed in addressing these challenges, but only over a painful and protracted period. In the meantime, we'll need to monitor European developments closely and stay alert to the associated risk to financial stability and economic growth.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I used the 'Extended Tealbook Baseline' forecast in my projections, but unlike the Tealbook and most of you, I see the risks to growth as balanced'sort of. [Laughter] I can't discount the potential for a really bad shock coming from Europe. If rumors that someone has a plan to make a plan can brighten markets considerably, then all of the nasty realities that are sure to unfold over time can't be good for Europe or for us. In fact, even without actual spillover from actual crisis conditions, the headlines so far have been enough to swamp or at least mask the effects of our own policy actions. So that's the obvious downside.

But beyond the risks coming from Europe, I think there's a good case to be made for the 'Faster Snapback' scenario. Admittedly, the faster snapback results have gotten progressively less snappy over recent months, but I think there are elements of balance sheet repair, confidence, and credit conditions that can be viewed optimistically. Beginning with balance sheet repair, business balance sheets might be in the best shape ever. Debt has been reduced or refinanced at ever-lower rates. Companies are awash in cash. Continuing and growing cash mergers and stock repurchases signal that production-related uses of cash are not yet attractive, but provide evidence of the temptation to employ that cash opportunistically. And banks that have seen growth in C&I lending report that the borrowers are still keeping high cash balances rather than using their own cash before tapping bank lending. Finally, commercial deposits at banks continue to grow at an astonishing pace.

Even household balance sheets are in better shape than they appear. With the exception of mortgage debt, consumer debt has been reduced significantly. Admittedly, much of the reduction has come through charge-off and bankruptcy, but that's exactly the point of bankruptcy'a fresh start. And even though overall debt to income is still high, much of that debt is in mortgages with long amortization schedules. So the burden of debt, the monthly payments compared with net income, is at levels not seen since 1994. Delinquency rates on auto and credit card debt are at the bottoms of their historical ranges, indicating that those who still have credit are carrying it pretty comfortably. For mortgages, despite repeated calls for principal write-downs, I don't see that happening in any meaningful way, but foreclosure represents an absolute write-down of principal in the same way that charge-offs and bankruptcy wiped out other consumer debt. Mortgage modifications have leveled off at low but steady rates, and re- default rates on modified loans are improving. Rates of transition into delinquency status are

also improving, and the size of the foreclosure pipeline is beginning to gradually decline as foreclosures in nonjudicial states have resumed and foreclosures in judicial states begin to trickle through. Policy focus has finally moved from an emphasis on loan modifications to dealing with the impact on housing values and neighborhood stabilization issues that result from large numbers of distress sales. Lower mortgage rates, combined with an easing of credit standards for refinance and purchase mortgages and responsible REO disposition, could actually speed the final completion of household balance sheet repair. I'm optimistic that there are policy paths that could accomplish this.

Finally, financial institution balance sheets are the mirror image of those of businesses and households. Loans are down and deposits are up, leading to loan-to-deposit rates that are lower than they've been in decades. Deposits have been used to pay off wholesale funding, and all measures of liquidity look strong. Problem assets are steadily coming down, and those that remain seem more heavily weighted toward long-term workouts than losses waiting to happen. Capital levels are strong, and with credit losses posing less of a threat to capital, most banks returning to positive earnings, and a regulatory lid on payouts of capital, this capital strength seems more real than it did in 2008.

Turning, then, to sentiment, it's true that measures of business and consumer sentiment turned sharply negative, but it's not as clear that the change in sentiment led to equally sharp changes in behavior. A number of bankers I spoke with noted that from their perspective and the perspectives expressed by their customers if they hadn't listened to the news or read a newspaper, they wouldn't have noticed that anything had changed. Incoming business financials still show strong or at least improving results. Businesses are cautious about investing and hiring but are not necessarily pulling back. Business customers report already being fully prepared for

weaker or even double-dip conditions. And finally, consumer credit and debit transaction data didn't show any change that would correspond to the drop in confidence. It seems to me entirely plausible that consumers and businesses that hunkered down in the face of the Great Recession have not yet unhunkered and that they are still ready for the worst. If it comes, if pessimistic forecasts are correct, it won't really change anything in their behavior. On the other hand, if there were somehow to be some sustained good results, such as strength in sales or improvement in consumer income, I think that could translate into some positive change in behavior, and as we've all experienced in the past few weeks, the good news doesn't have to be all that good to surprise you if your expectations are low enough.

Let me turn now to the final headwind that I can envision dissipating more quickly and creating the condition for a faster snapback, and that's credit conditions. The number one financial problem faced by banks is a declining net margin. Many of them blame this on us and the low level of rates, but I believe it's due to the mix of assets on the balance sheet' specifically, the dearth of good lending opportunities. Competition is fierce for C&I loans. Banks are chasing them with rates, terms, and calling officers. When they find a good credit, they're willing to hold a much bigger piece of it. Appetite for commercial real estate loans now follows the fundamentals, vacancies and rent levels, which will in turn follow the economy. More banks are entering the auto finance business, where competition is also strong. Credit card solicitations are picking up, even though the Credit Card Act has likely changed credit terms permanently in this space. Banks are holding onto more of their mortgage production, even though most of them are not willing to offer the full spectrum of credit eligible for GSEs or the FHA. And credit is still tight for small businesses, especially those that have struggled over the past few years. But there's room for policy to improve credit conditions in both small business

and mortgage. Indeed, we have 'blue sky' groups here at the Board thinking about both of these, and if we can figure out a way to improve conditions in these two markets, then I think we could cause this headwind to dissipate more rapidly.

So while I recognize that the economy is vulnerable to shocks and that there are many potential shocks, including the looming potential in Europe, I think we're closer than we might realize to completing the debt burden cycle. And there are some possible policy actions that could speed us closer to some potential positive shocks as well. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO: Thank you, Mr. Chairman. I'm going to jettison most of the notes that I had prepared because someone has said most of these things'though not with the literary allusions that were included in my notes'and I want to address instead labor market issues.

I think it's worthwhile looking at the data rather than just relying on anecdotes, and as we think about what's happened in the labor market over the past few years, it's important to draw a distinction between what has happened in the past few years, presumably as a result of the recession and its aftermath, on the one hand, and the very real long-term problems that we've got in the labor market in this country, on the other hand. Basically, we've got to look at the delta, and I think once we try to look at the delta rather than to absolute numbers or anecdotes that can be drawn from one source or another, the picture becomes rather more clear.

There are a variety of hypotheses about why structural problems may be greater and greater as the result of the recession. One that has been alluded to today is, we had a bunch of bubble sectors where there was a lot of lost employment, and so one would expect that people in those sectors would have difficulty becoming reemployed. In the mid-'70s, we had a very serious recession with a lot of lost employment in the Midwest in manufacturing. There were

concerns then about whether there was going to be increased structural unemployment, but a retrospective look suggests that that was not the case. There are always some sectors in a serious recession that suffer significantly, and at least to date in the experience since World War II, we haven't seen a particular impact on long-term structural unemployment increases. Something may be different this time, but we've got to point to whatever it is that's different this time than in the mid-'70s or early '80s.

Second, we have the concern that because there's been long-term unemployment of an unusual and, indeed, unprecedented'since the data series was developed'nature, it seems logical to infer that there's going to be more structural unemployment there, that people are going to have more trouble getting back to work. I think at some point, that is going to become a phenomenon, but again, the data to date suggest or allow us to conclude, perhaps a tad counterintuitively, that the probability of reemployment declined in about the same amounts for the short-term unemployed and the long-term unemployed and has since risen in about the same amounts for the short-term unemployed and the long-term unemployed. So, to date at least, this hasn't happened.

Third, we've got a Beveridge curve phenomenon, which I refer to as shorthand for a lot of the points about vacancies and mismatch and the like. Economists at the Federal Reserve Banks of Cleveland and San Francisco have done a very nice job of going back pre'data series, pre'JOLTS series to try to construct from other data approximate Beveridge curves that, again, cover the two serious post'World War II recessions. And just as we saw this time, the Beveridge curves get pushed out, and each time, the Beveridge curve comes back. There's still debate apparently among the labor economists, including the very good labor economists at the Cleveland and San Francisco Feds, as to exactly why that was, but it does seem as though, when

you have an awful lot of unemployment growing pretty quickly, there's a generalized disruption in labor markets, which makes employers more likely to wait longer to fill vacancies, in particular. It may turn out, Dennis, that the purple squirrel phenomenon is more widespread than people think, because there does seem to be some sense that standards for hiring go up during periods of high unemployment since employers are saying, 'Gee, there must be somebody good out there somewhere.'

Finally, to the phenomena of a lack of literacy and of drug use, these are not new phenomena. These are not deltas from the recession. We had these problems 25 years ago when I was working on the Senate Labor and Human Resources Committee. I spent time in the city of Philadelphia with a school-to-work program, in which the greatest problem identified was the failure of individuals to understand they had to show up to work every day. We had that problem 25 years ago, 20 years ago, 10 years ago; we have it today; and we're going to have it 5 years from now. It is a real problem for the productive potential of the country. It is not an argument for the proposition that structural unemployment has increased during and as a result of the recession. I do believe that structural unemployment has increased some, and I was actually a bit surprised when we went through all the data, that the data don't suggest it has increased even more so far.

The last point I would make, which I think is very important and gets to what John was referring to earlier, is that at some point, all of this becomes a self-fulfilling prophesy. If there is no aggregate demand, if there isn't increased employment, if the productive facilities in both the manufacturing and service sectors that are lying fallow now do not get back into use, the productive capacity of the country and structural unemployment will go in the wrong direction. We are fortunate in that it doesn't seem as though we are there yet, but it also strikes me that the

tipping point may not be that far away. And I think we can't continue to come here as we have for the past two years, straining to see green shoots coming out of the ground'saying, 'Oh, the signs of spring are now here''and therefore to say we need not take any more action, only to see another snowfall the next month. I hope Betsy is right. I hope that the underlying structural conditions are getting closer to the point where there's more self-sustaining momentum in the economy, but even if there is some of that, it's not going to move us very far or very fast in the face of an awful lot of cyclical unemployment.

What we should do about it'I guess I'm supposed to save that for tomorrow, so I will. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. The economy remains mired in the worst slump since that of the 1930s. While recent readings on retail sales, capital goods orders and shipments, and nonresidential construction have turned up, important indicators of near-term economic activity remain downbeat. Business surveys point to continued caution, conditions in the labor market have not brightened, and gains in industrial production, excluding the motor vehicle supply chain, remain sluggish. These disappointing indicators likely reflect the fact that the factors that have been restraining the pace of the recovery are still in place. The large overhang of vacant housing units remains, credit availability remains impaired, and risk premiums remain elevated. In the interest of time, I won't comment on the European situation or the housing situation or the fiscal situation. I also won't comment on drug use among non' purple squirrels. Instead, I just want to talk for a minute about consumer sentiment, which is another factor likely continuing to hold back the recovery.

Confidence measures are at historic lows, and recent measures of confidence remain exceedingly low, probably due to households' concerns about low future income and wealth, which tend to depress consumption. Despite last week's report showing a 0.5 percent increase in real consumer spending in September, a welcome surprise for sure, I'm not optimistic that households are ready to be an engine of growth for this economy. For one thing, the September increase was not accompanied by rising incomes. Rather, real disposable income edged down in September and has increased only very modestly over the past 12 months. The resulting downdrift in the saving rate to around 4 percent in the third quarter might be interpreted as a sign that households are feeling optimistic again, but the lousy consumer sentiment numbers and the lack of any improvement in home equity values suggest that this is very unlikely to be the case and that consumer spending will be subdued going forward.

The lack of any meaningful increase in real incomes for the vast majority of households suggests that many are feeling pretty strapped, even those who have jobs and are not under water. This is evident in the spreading discourse about income inequality in the country, which the Chairman has been asked about. Many of us are receiving personally addressed letters to our homes from protesters, and I have the one that I received just yesterday. Page 1 reads, 'End the Fed.' This is typical because I do get one a day, and this is Occupy Muskegon. Many of the Reserve Bank presidents, too, I know, are dealing with Occupy Wall Street protesters in their cities and at their Banks. Regardless of how any of us feel about the merits of the 99'1 critique, we have to acknowledge that this is not only a cost of a lack of aggregate demand, a cost of long- term unemployment, but also an additional factor that is affecting social cohesion, dignity, and American optimism.

In sum, the pace of consumer spending is up, but the low level of sentiment, volatility in the stock market, and tepid gains in employment and income projected for the coming years continue to weigh on consumer spending and thus on overall economic activity. It's hard to see what string of events will eventually break this cycle, and as a consequence, I continue to expect the pace of the recovery to be subpar. Thank you.

CHAIRMAN BERNANKE. Thank you very much. Thank you, all, for a long but productive day. We have a reception upstairs, followed by an optional dinner, for those who are interested in staying around, and we will recommence in the morning at 8:30.

[Meeting recessed]

November 2 Session

CHAIRMAN BERNANKE. Good morning, everybody. Let me start with a summary of the discussion I heard yesterday. I had more time than usual, so it's a little bit longer than usual. [Laughter] You may want to pull out a pillow or something.

Participants took note of somewhat better data over the intermeeting period, reflecting in part the reversal of temporary factors that had depressed GDP growth in the first half. Final demand in the third quarter was stronger than expected, and near-term recession risks appear to have declined. There are some positive factors that may continue to support growth, including pent-up demand, accommodative monetary policy, and balance sheet repair by both households and businesses. However, most participants saw near-term growth as likely to be slow to moderate, held back by continued problems in the labor and housing markets, low confidence, financial market volatility, and fiscal restraint. With relatively modest economic growth will come only a very slow decline in unemployment. The downside risks to growth appear to have become somewhat less severe since the last meeting, but that assessment depends very much on European developments. Potential output may also be lower than had been thought, and the risk of a lost decade has risen. Inflation will moderate with commodity prices, although core inflation has come down more slowly than expected. Most participants expect inflation to moderate to 2 percent or below in the medium run, with many seeing the risks as approximately balanced.

Households remain very pessimistic and expect little to no improvement in their financial conditions. Income growth has also been tepid, reflecting in part the relatively slow pace of employment growth. Notwithstanding these factors, consumer spending has recently been stronger, and there is scattered optimism about holiday sales. However, some of the strength in

spending reflected lower saving rates, casting doubt on its sustainability. Some indicators of labor market performance have been slightly better, but the job situation remains very difficult. There was an extensive discussion of the degree to which unemployment reflects structural factors. Employers complain about unqualified applicants, including those lacking basic skills, and some will hire only so-called purple squirrels. [Laughter] Skilled workers are in high demand. Reverse engineering slack from core inflation suggests that the gap is lower than estimated by the Tealbook. On the other hand, many of the problems regarding the workforce are of long standing, and the Beveridge curve estimates for earlier recessions show that the pattern of vacancies and unemployment this time is not so unusual. Long-term unemployment may ultimately lead to more structural unemployment, but we may not yet have reached that point.

The housing market remains lackluster in most areas, except for some improvement in multifamily construction. Foreclosures remain a serious problem, and there are long delays to resolution. Mortgage eligibility conditions remain tight, notwithstanding some government initiatives, and LTVs are high in many cases, both of which are impeding purchases and refinancing. However, attention to factors affecting the housing market, such as REO management, refinancing by high-LTV borrowers, and neighborhood stabilization, could help this situation.

Reports on businesses are mixed. Some firms are pessimistic and cautious about the outlook. There are continued complaints about economic and political uncertainty, including uncertainty about fiscal policy, regulatory policy, demand, and the European situation. Hiring plans are on hold, or firms are looking to use temporary or part-time workers. Capital investment to increase productivity continues, however, benefiting from low interest rates. Input

cost pressures have abated somewhat, and wage costs are low. Profits and balance sheets are healthy. Autos are seeing modest improvement in sales and production, agriculture and energy are doing well, and there were some positive anecdotes from retailers and transportation firms. Asian demand remains strong, though Europe is slowing. Low interest rates are increasing pension contributions.

Fiscal policy is becoming more restrictive, with state and local governments continuing to shed jobs. Much attention will be paid to the report of the congressional supercommittee; its importance is not just the substantive outcome, but also the demonstration of whether the government can work.

Financial conditions remain quite volatile. The recent actions taken by European leaders to address their banking and sovereign debt problems were initially well received. However, whether their actions will be successful in ending the crisis remains uncertain, as many details of the plans remain to be worked out and there are questions about whether the resources being devoted will be sufficient to provide adequate firewalls for major debtors. Sovereign spreads continue to rise, and it is questionable whether European banks can raise private capital. U.S. banks are doing relatively better, with improved capital and earnings, better asset quality, and high deposits. However, loan demand is weak, and competition for good borrowers is keeping net interest margins low. Liquidity has worsened in some markets, including wholesale funding markets. Farmland prices continue to rise with agricultural prices.

Finally, inflation appears likely to moderate as commodity price declines are passed through to the retail level. Core inflation is also slowing, though possibly more slowly than expected. Growth in wages and benefits remains subdued, although wage data are affected by skill composition and nominal downward rigidity. Inflation expectations are well anchored at

low levels. Measures of inflation trends, such as the trimmed mean or median, suggest relative stability. On the other hand, if slack is lower than believed, downward pressure on core inflation will be limited. Moreover, there is some ongoing pass-through of input costs, such as fuel surcharges. Overall, most saw the risks to inflation as roughly balanced.

Let me stop there and see if there are any comments, omissions. [No response] Okay. If not, let me make a few comments, always from the disadvantage of having to follow many good discussions.

I led off my discussion last time with a review of the European situation, and many of you have talked about it. I'm not going to go into much detail. I think there's a lot of agreement that the latest plan at least addresses the right issues, notably the Greek sustainability, the banking system, and the firewalls for the major debtors.

There's also been some attention to the longer-term solutions: How will they ultimately achieve a degree of fiscal integration that will prevent similar problems from happening in the future? I think the consensus around the table, and what appears to be in the markets, though, is that there's considerable question about the details and the firepower behind the plans that have been put forward. I can add one small observation, which is that there's a fundamental misconception in the way they're thinking about this, particularly with reference to the ECB. The function of a lender of last resort is to provide unlimited firepower, unlimited lending against collateral, and that's what the ECB is doing for the banking system by lending against sovereign debt. What's happening now, though, is that the ECB is purchasing sovereign debt, which is evidently a fiscal action and probably not appropriate for the central bank given the credit risk associated with those obligations, but political opinion is preventing it from doing what it would naturally do, which would be to lend to a bank or some facility that was using the

sovereign debt as collateral. The ECB is effectively the only institution that can provide unlimited firepower and therefore can be a completely persuasive lender of last resort, and so I think that until that intellectual confusion is sorted out, it's not clear that this is going to work. Moreover, it's going to get harder and harder, of course, because Europe is slowing, and that's not an accident. Austerity, tighter monetary policy, a credit crunch, financial volatility'all of those things are obviously not going to be good for European growth, and that makes the fiscal issues worse and worse. This is a very troubling situation, and I can only feel that while this is partly political, it's also partly a question of appropriate conception of the problem and the solution.

We are innocent bystanders, but we are very severely affected by what's happening there. In my dreams, I'd like to know what the U.S. economy could do if financial markets were in a more placid state. Given the kind of volatility we're seeing, though, that's obviously a very negative factor. So we'll continue, obviously, to watch. The G-20 meeting is coming up. I'm sure that the U.S. and other countries will press the Europeans for further action, but this is, in some sense, the key issue for us.

Turning to the U.S. economy, I think the evidence is that the near-term performance has been a little better than expected. Notably, we saw, as people have noted, good final demand in the third quarter. Consumption was relatively strong. Total nonresidential investment, including structures, grew 16 percent at an annual rate. That was fairly strong. We had good final demand, less inventory billed than expected. All that is positive for the fourth quarter. Beyond that, the September consumption reading was quite strong, putting consumption above the average of the third quarter already. The ambiguities associated with the measurement of auto production suggest that there will be less payback in autos in the fourth quarter. For a number of

technical reasons, I think the fourth quarter is likely to be a decent headline number again. So that is good.

In the longer term, I think we continue to have legitimate concerns about sustainability of the recovery. I'd note a couple of points. One is the point that was emphasized in the Tealbook about the striking discrepancy between the recent relatively stronger economic news and the continued weakness in sentiment. I think there's a very interesting question here, which research might be able to address at some point'that is, to the extent that sentiment has information in it, is it because sentiment is what economists would call a sunspot, a random thing that relates to how Lindsay Lohan is doing or something like that, which then in turn affects the economy? Or is it reflective of the fact that consumers and businesses have much more micro information, and that's being aggregated in some way through sentiment indicators, which is not showing up in the macrodata? It's not clear.

I would note again that consumer sentiment remains very low, and there are indications now that business sentiment has also weakened. President Plosser noted that the Philly FRB business outlook improved a little bit last month but is still well below where it was earlier in the year. We've seen very big declines in, say, the Business Roundtable CEO survey. We've seen analysts' expectations for capital-goods-producing firms drop quite considerably. So there is clearly a sentiment issue in business as well as in the household sector. Sentiment is like the stock market'it predicts about nine out of every five recessions. So I don't think we should overstate that, but it does remain a concern.

Another issue related to sustainability has to do with income and saving. This point was made by a couple of people. I have some sympathy for Governor Duke's view that balance sheet deleveraging factors may be running their course to some extent or may be less powerful than we

thought. We have a discussion of that planned for January, as I recall. But one indicator of that is the fact that household saving rates remain quite low, which would not be what you would expect if they were making massive efforts to rebuild their balance sheets. Instead, it feels more like consumption is being constrained by income rather than by balance sheet considerations. Notably, the September saving rate was 3'' percent. Obviously, these numbers are frequently revised, but nevertheless, we've seen relatively low saving rates, and we've seen very weak income growth. In particular, for one illustration, the NBER, in picking its business cycle dates, uses two indicators of aggregate activity. One is employment; the other is something called real income less government transfers, which is a broad measure of income being generated in the economy. That measure of real income less government transfers is basically flat since the second quarter. It declined from the second to third quarters, and if the payroll tax cut extension is not passed, then we'll see further pressure on that indicator. So the sustainability of household spending depends on continued generation of income.

That brings us, of course, to labor markets. I thought we had a very good discussion of what's going on in labor markets. It's obviously important to think about these things at the microlevel. I think I would express caution about overinterpreting anecdotes on this issue. We talked about some of the social issues that have affected labor supply. I was just checking the Statistical Abstract before I came in here, though, and if you check, you'll see that drug use, crime, and a number of other similar social dysfunctions surprisingly have declined in the past couple of years and certainly are on a downward trend over a longer period. So it may be that what's happening there is that rather than those things causing unemployment, unemployment is causing those behaviors, in which case that would actually be an argument for expansion rather than for nonresponse. In terms of the sectoral components, Governor Tarullo gave some

interesting observations on that. I would note that the unemployment increases are very broadly distributed between men and women, between college graduates and high school graduates, which makes it difficult to pin this on, say, construction, if women or college graduates are having the same proportional increases in unemployment as high-school-educated men, for example. So I think there are still some very open issues there. I guess the last observation I would make is the historical observation that between 1939 and 1941, after a decade of high unemployment rates and all of the social implications of that, in a society that was much less educated than we have today, unemployment dropped from 17 percent to whatever it was, 1 or

2 percent, in the war. Clearly, there is capacity for reemployment. That's, of course, an extreme situation, but sometimes demand can generate more jobs.

Again, to summarize, it looks to me as though'forecasting, of course, is always difficult'the near-term numbers ought to continue to be moderately acceptable. But I think, particularly given the uncertainties in the financial markets, there should be a very wide confidence band around our forecast for growth in 2012.

A couple of words on inflation. Generally speaking, there was a lot of agreement that inflation is under pretty good control for the moment, although perhaps not coming down as quickly as some expected. I would note, again, the absence of wage pressure. The ECI just came out for the third quarter, and the employment cost index showed total labor costs on a quarter-on-quarter basis of 0.3 percent, which was the lowest in some time. And I thought that was interesting in that among the costs included in that number are pension costs, and we had some discussion about the effects of low rates on pension underfunding and the like. It is true that pension contributions are up, according to the ECI, 9 percent on a 12-month basis. So there

has been some increase in pension funding. But if you think about that as part of the total wage bill, you're still not getting any significant increases in the cost of labor.

I would end this by offering a hypothesis I've proposed before, which is a suggestion that we do need to think about the Phillips curve in an international context, as President Fisher and the Dallas Fed have talked about before. In particular, there's an awful lot of correlation between growth rates across the world. That, in turn, drives globally traded commodities, and so moderate growth in the U.S., to the extent that it feeds through, via a variety of mechanisms, into growth in the emerging world, for example, tends to lead to higher commodity prices. It's interesting that the investment interest in commodity prices was sparked a few years ago by some papers that suggested that commodity prices were pretty uncorrelated with stock prices. That seems hardly to be the case anymore. Commodity prices have become a very sensitive indicator of global growth expectations, the result being that even if growth in the U.S. remains subpar, increases in growth expectations or even monetary policy ease can generate some inflation pressure indirectly through this global commodity price nexus. So that, I think, probably explains part of the reason why inflation has been less sensitive to domestic slack than our traditional models would suggest and why there's more sensitivity to global conditions than is traditionally the case. The effect of that is going to make inflation more volatile and more difficult to predict, more linked to global conditions, and that's going to complicate our lives going forward as we seek to manage both inflation and inflation expectations.

But again, near term, we've seen a little bit better data, and that's good, but going forward, I think we still face very significant uncertainties, not least those in the financial markets. Any final observations or comments on the outlook? [No response] If not, let me turn to Bill English to introduce the monetary policy go-round.

MR. ENGLISH.6 Thank you, Mr. Chairman. I'll be referring to the handout labeled 'Material for FOMC Briefing on Monetary Policy Alternatives,' which was distributed earlier. The handout contains the policy alternatives as well as the associated draft directives. There's only one change, which is shown in blue in alternative B, from what you saw in the Tealbook; I'll come to that in a minute. Including the various toggle switches, the staff provided a total of nine statement options in the Tealbook this round'I'm told by the Secretariat staff that this is easily our new all-time record. So staff productivity is high at least. [Laughter] To help guide you through the options, I've reproduced the summary table that was included in the Tealbook on the first page of your handout.

Turning first to alternative B, on page 7, the Committee may see the somewhat stronger-than-expected economic data received over the period as having reduced the odds of a new recession but may continue to view the still-modest underlying pace of economic growth and the continued downside risks as warranting the accommodation provided at your previous two meetings. If so, members may wish to adopt a statement like alternative B, which contains no new policy action and uses language similar to that of the September statement.

The first paragraph of the statement for alternative B would be updated to reflect the recent economic data. The second paragraph would note the expected 'moderate pace of economic growth over coming quarters' and might indicate 'downside risks to the economic outlook' rather than 'significant downside risks to the economic outlook.' Dropping the word 'significant' might seem appropriate if you see the economy as more likely to be on a sustainable track than was the case in September and think that the European leadership, on balance, has made progress in addressing their banking and fiscal strains. The third paragraph would indicate that the Committee was continuing the maturity extension program (MEP) announced in September and maintaining the existing reinvestment policies.

In the fourth paragraph, the statement offers two options for the forward guidance. On the one hand, the Committee could retain the reference to 'exceptionally low levels for the federal funds rate at least through mid-2013' from the September statement. On the other hand, some participants might feel that a better way to communicate the Committee's expectations would be to indicate that the federal funds rate was expected to remain exceptionally low 'for the next six to seven quarters.' The latter approach might be seen as desirable because leaving those words unchanged from one meeting to the next would, all else being equal, maintain a constant degree of monetary accommodation. However, if the economy evolves about as expected, the Committee would need over time to reduce incrementally the number of quarters specified in the statement, while a fixed date such as 'mid-2013' could remain unchanged in that case.

The statement would end by indicating that the Committee 'is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.'

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

including the MEP, poses an unacceptably large risk to the stability of inflation expectations.

Much of the statement under alternative C would be close to the draft for alternative B. However, the first paragraph of alternative C would suggest greater confidence about the recent improvement in economic growth and less confidence about the moderation in inflation. The outlook for unemployment in the second paragraph would be slightly more upbeat, and the reference to downside risks would be dropped.

In paragraph 3, the statement would note that 'in light of the recent improvement in the economic outlook,' the Committee decided to reduce the size of the MEP to $200 billion of purchases and sales, and that the MEP would be completed by the end of March 2012. In paragraph 4, the statement would shorten the period during which the Committee expected economic conditions to warrant an exceptionally low federal funds rate by about two quarters, by indicating that the period runs either 'at least through 2012' or 'at least for the next four quarters.'

The adoption of alternative C would greatly surprise investors and would likely have outsized effects in financial markets.

The draft directives for the four alternatives are presented on pages 12 through 16 of your handout. Thank you, Mr. Chairman. That completes my prepared remarks.

CHAIRMAN BERNANKE. Thank you. Are there questions for Bill? President Fisher.

MR. FISHER. Mr. Chairman, can I ask Brian a question? Yesterday in his presentation,

he said that it was our description of the economy that you felt was a little harsher than markets

expected. I'm interpolating your words. The operative word here is 'significant.' Is that what

you were referring to in terms of statement B as it's drafted?

MR. SACK. I think that's what received a lot of attention in markets. Just to be clear, I

had thought the first two paragraphs of that statement were essentially marking to market in a

way that was pretty obvious. But market participants actually took a more negative signal from

it than I had anticipated.

MR. FISHER. Well, have they digested that word 'significant' by now in your opinion?

MR. SACK. Yes, I would imagine their expectation is that that clause would be

repeated. We didn't ask that explicitly, but certainly given the volatility in markets and the

uncertainties that they see, I think they wouldn't be surprised to have that sentence repeated with the word 'significant.'

MR. FISHER. Thank you. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Any other questions for Bill? [No response] All right. Let's begin our go-round with President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. I support alternative B. I also favor maintaining the 'at least through mid-2013' forward guidance and including the word 'significant' in describing the downside risks. I think that's accurate. In my view, appropriate policy entails liftoff of the funds rate from its current level around mid-2014. This is similar to the median of market participants' expectations, so I don't see a compelling need at this time to try to move market expectations by changing our policy guidance.

In thinking about the appropriate stance of monetary policy, I find it useful to consider a variety of simple estimated and calibrated monetary policy rules. I'm less swayed by the optimal control simulations, which are highly sensitive to the model and underlying forecasts, and I don't think they're as reliable a guide for policy. But currently, with considerable slack, slow growth, and fairly low inflation, the central tendency of these policy rules is completely consistent with the current very accommodative stance of monetary policy. Furthermore, the central tendency of these policy rules doesn't predict lifting off from the zero lower bound until around mid-2014.

Of course, simple rules are only partial guides to our policy decisions, and there are three key reasons why we may want to adjust the prescriptions from these rules. First, because of the zero lower bound, we haven't been able to follow the prescriptions of the policy rules into negative territory. So there's no reason to think that we should follow them regarding the policy liftoff. Indeed, much research, including work I've done with Dave Reifschneider, suggests that

policy should stay at zero longer than standard policy rules would suggest following an episode at the zero bound. A policy rule based on our analysis suggests liftoff in early 2015. Furthermore, the normal channels of monetary transmission remain unusually clogged. Many businesses and households are unable to take on new debt or want to shed existing debt, muting the effects of monetary policy stimulus. If this reduced effectiveness persists, additional policy accommodation is needed, and liftoff should be delayed relative to the simple rules' prescription. However, working in the opposite direction, the simple rules ignore the sizable additional accommodation from our unconventional monetary policies. The additional stimulus from lower term premiums and longer-term yields suggests that our short-term policy could lift off somewhat earlier than the simple rules suggest.

I view these and other arguments that deviate from the policy rules as roughly canceling out. So I remain fairly comfortable with the rules-based prescription of a mid-2014 liftoff as a modal forecast. Importantly, I foresee a relatively modest pace of increases after liftoff, with the funds rate ending 2014 at only 75 basis points.

Finally, there are significant downside risks to the outlook for the economy, as we discussed yesterday, and I therefore recognize that the date of liftoff could be significantly later than mid-2014. And obviously, depending on the actual evolution of the forecast for economic activity and inflation, we may need to change our policy guidance and use further large-scale asset purchases or lower the reserve rates as needed, but right now I see alternative B as appropriate.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I wasn't ready, but here we go. I am willing to support alternative B. I proposed the language of 'for the next six to seven

quarters' in alternative B. So let me explain why I did that. In the frameworks go-round, I described a rule, which I could alternatively describe as a reaction function, as a mapping from changes in economic conditions to the changes in the level of accommodation. And when I did that, I didn't mention calendar time. That's because reaction functions really should be intrinsically dateless. They should work exactly the same in 2011 as in 2012. This formulation of a dateless rule-based approach to policy argues in favor of our communicating our level of accommodation in a way that is just as dateless. And I believe that we should make it easy for the public to understand how the level of accommodation is evolving over time, and that would mean we should describe our policy stance in a dateless fashion so that it is readily comparable from one meeting to the next or, indeed, from one year to the next.

Now, I'll talk about the impact on the public, and then I'll talk about the impact on our own thinking. This issue is not an academic one to the public. I read several news stories that predicted the Fed would leave its policy statement unchanged and concluded from that that the Fed is also leaving its policy stance unchanged. This inference is a logical one, but it is actually incorrect given the current form of the statement, which would involve actually, the Fed reducing the level of accommodation in place by leaving the date 'mid-2013' in place with the passage of six to seven weeks.

I'll come back to this point about using the duration as opposed to a date as our lever of changing accommodation now, because I want to talk about something I feel is very important. We talk a lot about policy uncertainty, and I believe that we are right now, unfortunately, a source of that policy uncertainty. What I mean by that is that I think that we really have to be more systematic in our thinking about how to build a reaction function. This is not just about what triggers to pick or anything like that, which is really more about what level of

accommodation we want in place today'an important question and one that we should be thinking about all the time'but we also want to be thinking about how that level of accommodation is going to be changing over time in response to changes in conditions. For example, suppose next year, a year from now, unemployment is at 9 percent and inflation is running around 1.6 percent. What are we going to do in those circumstances? I'm including only inflation and unemployment, but basically my idea is, the outlook is remaining the same as now. We're in a sort of stasis, which is not my modal forecast by any means, but it's certainly, I think, a relatively likely outcome. Taking a dateless reaction function approach to thinking about policy would argue for doing the same, having the same level of accommodation. It wouldn't mean having this year, 'mid-2013,' in there, of course, but it would mean arguing for the same level of accommodation in terms of how long we're going to be to liftoff.

Some of my concerns about Committee decisionmaking over the past two meetings have been that I don't think this discipline of dateless decisionmaking has carried through, and it's not a hawkish or a dovish comment. It's basically, if you want to add accommodation a year from now when the conditions are the same as today, you should be asking yourself, why didn't you put that accommodation in place now when actually there is a year that will go by in which you could be helping people with it? So it's really about consistency, and failure to be consistent over time adds to policy uncertainty in the current environment. It's very important for us to be more structured and more deliberate in our thinking about how we're going to react to changes in conditions. Now, I'm merely channeling the words that President Bullard has uttered on many occasions. So I'm probably scooping some of the things he's'yes. But even though that's true, that doesn't mean that what I'm saying isn't right. [Laughter]

Having said all of that, it's not going to be true at all times that you would never, ever deviate from your reaction function. It's not as though you want to commit to something and leave it there and go home for the rest of all time. Governor Raskin has offered some real reasons that right now we might be thinking that maybe we should change our reaction function. Why is that? Well, maybe monetary policy is not as effective as it once was. Maybe we're more worried about unemployment because we might be more on the verge of triggering more social unrest than we thought a year ago. So there might be reasons to change, but we should have in place the structure from which to change before we change. We should have in place a structured, disciplined approach to thinking about reacting to change in the economy. We might come to that point and say, 'Look. The way we'd been thinking about monetary policy a year ago wasn't right. It's just not as effective as we thought it was.' Or we might get to that point a year from now when unemployment is still at 9, and we could have much more Depression-like civil unrest. We might have a different way of weighting inflation and unemployment at that point. These will be good reasons to be revisiting the situation. But I think it's important for us to have something to deviate from and so to have a reaction function in place.

Those are words for the future. Right now, as I said, Mr. Chairman, I'm happy to support'willing to support, I should say'alternative B.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. Yesterday I discussed the Boston forecast and talked about inflation being at 1'' percent, roughly where the Tealbook was, by mid-2013. Both the Boston forecast and the Board forecast come from a particular econometric tradition, so I thought it was noteworthy to at least look at the memos on DSGE models. And interestingly, from all four of those banks, they came up with roughly the same estimate that both

the Tealbook and the Boston Fed forecast, which was roughly 1'' percent. In fact, I think 1'' is a high rather than a low for both those four banks and those coming from a different econometric tradition.

What that would seem to say is that there is some flexibility, if we are going to have an inflation rate below 2 percent two to three years out, to do more accommodation in order to get a better result on the unemployment rate. The reason you wouldn't do that is, one, you might think that we couldn't affect the interest rate, or, two, if we did affect interest rates, it would have no impact. Brian yesterday showed the percent of Treasuries that we're buying, and showed that in a number of issues, we're buying a very significant amount. I have no doubt that if we're willing to buy a very significant amount, we have the ability to move down both Treasury rates and mortgage-backed securities rates. It's a question of will, not whether we can do it or not. It isn't a question of whether we can move those interest rates.

So then the question is, if we can move those interest rates, what is the likelihood it would have any impact? Some analysts have argued that pushing long rates down through quantitative easing would have no effect. No effect is a very restrictive assumption, but it has been cited by a wide number of analysts. That assumption means that housing is unresponsive to lower rates; that consumption, including autos and durables, is unresponsive to interest rates; that exchange rates in the foreign sector are unresponsive despite the complaints by many of our foreign trading partners about the quantitative easing; and that investment is unresponsive to lower rates.

I asked the people who do our model to test the assumption of whether the interest responsiveness of each of these components is really zero. Not surprisingly, my prior was that they wouldn't find that zero was the right answer. And when they did that, they did find that in

housing, the coefficient was much lower, but they didn't find that the coefficient was 0'which is, housing is responsive; it's not as responsive as it would be without all of the various headwinds. But in those other sectors, they couldn't reject the assumption that in the past several years, interest rates have affected those sectors in the same way that they did prior to the past several years. So it is interesting that it does seem, from at least the econometric analysis done at the Boston Fed, that in using the model that we use for the forecast, we actually do find that if we chose to push interest rates lower, it would have an impact on the economy, contrary to what at least some analysts have argued.

When I look at alternative B, which maintains the exceptionally low rates 'at least through mid-2013,' our forecast implies that the language in alternative A would actually be more appropriate. Should we leave policy unchanged when both elements of the mandate are missed in the medium term? We're not at full employment, and we're lower than 2 percent for the inflation rate. My preference would be to use this meeting to clearly communicate that rates will remain exceptionally low until unemployment is 7 percent or the inflation rate exceeds 2'' percent in the medium term. At our next meeting, if the outlook once again envisions unacceptable progress toward our primary goals, we need to consider taking more forceful action.

Were we to have a shock from a large bank failure here or abroad, a European crisis, or the inability to reach agreement on our debt problems, aggressive monetary actions, perhaps coupled with a move to nominal GDP targeting to signal a regime change, would clearly be appropriate. But even our baseline forecast implies a lost decade for many people in the workforce. We should consider soon whether more vigorous policies are necessary. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. Today I support further actions by the Committee to provide additional significant monetary accommodation. I am not arguing that economic conditions have deteriorated further and thus require this additional action. I am arguing that the progression of adding stimulus needs to continue. In my assessment, there are significant benefits to credibly solidifying expectations that policy will continue to be extraordinarily accommodative as long as conditions warrant. I spoke about the risk- management benefits at length yesterday, and I hope that the record properly reflects those comments here as well in the interest of time.

As I've stated here and in public, I interpret our dual-mandate responsibilities to be closely associated with minimizing a quadratic policy loss function, which puts equal weights on price stability and maximum employment as captured by unemployment deviations from a pretty conservative and time-varying natural rate. Given such a loss function, the staff analysis shows clear value in strengthening our forward guidance. I agree with President Rosengren very much.

There are also considerations not captured by the staff analysis that I think add to the case for further accommodation. Some of this came up yesterday. The longer we go with very high unemployment and output far below its potential, the more we risk actually eroding that potential. President Williams mentioned the supply effects the Japanese perceive. Some of the reductions that we have already made to our estimates of potential are due to decreased capital deepening that is actually a fallout of weak demand suppressing capital investment.

Mr. Chairman, your speeches have highlighted the corrosive effects of long-term unemployment, and Governor Tarullo did a great job of explaining how we may be on the cusp

of finally significantly raising the natural rate of unemployment. I think those considerations add some urgency to this situation.

In favoring more policy accommodation in the form of certain variations of alternative A, I expect that I will be outside the consensus policy decision today. Since July 2010, I've advocated aggressive forms of additional policy accommodation. I argued for state-contingent price-level targeting in the fall of 2010. I was pleased to support QE2 as a further substantial step along the way, and I hoped that that would be enough. In August of this year, I argued for a version of the trigger threshold strategy similar to the language in alt A1, paragraph 4'. Yesterday's discussion clearly indicates that, at least for now, I'm outside of the Committee's consensus regarding such policy clarifications of our 'mid-2013' forward guidance'that is, if in fact there is a consensus regarding interpreting and clarifying 'mid-2013.' We're going to have to deal with that soon. It's not really optional.

In any event, it's my judgment that we need another substantial step toward additional accommodation in order to solidify expectations. Accordingly, I favor alternative A1, with a variation of paragraph 4' included. I think that our exceptionally low range for the federal funds rate will be appropriate, at least as long as the unemployment rate exceeds 7 percent or unless medium-term PCE inflation exceeds 3 percent and longer-term inflation expectations become unanchored. Just to be clear, my preferred strategy for delivering additional accommodation in the most credible fashion would be to pursue additional asset purchases regularly at subsequent meetings until the outlook for hitting either of these thresholds increased commensurately with these additional actions.

As I said, Mr. Chairman, on the basis of yesterday's commentaries, I expect that my policy position is simply too far outside the consensus, and I cannot support alternative B today. Thank you.

VICE CHAIRMAN DUDLEY. Can I ask a clarifying question?

CHAIRMAN BERNANKE. Vice Chairman.

VICE CHAIRMAN DUDLEY. President Evans, in buying more assets, do you have a preference in terms of what you would buy?

MR. EVANS. I would clearly support MBS. I think that that would be very helpful for the housing market. And I also would say that if a consensus was to emerge'which I am not anticipating'that some sort of asset purchasing today could be adopted, then I could be prepared to support that.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I'm going to support alternative B. I do not support alternative A2 because I don't favor additional asset purchases at this time. But I do have to express some sympathy for alternative A1, with its policy thrust of pushing the funds rate guidance further out to 2014.

My own forecast projects a funds rate near zero at least through mid-2014. Considering the language options for paragraph 4 of alternative A1, I am sympathetic to the first option because, as I said, it reflects my forecast. I'm also sympathetic to the second option for paragraph 4 because, in my view, it makes sense to move in the direction of policy conditionality in terms of projected economic outcomes, versus guidance based only on a calendar date. I am less sympathetic to the third option in paragraph 4 because I think its introduction of an explicit unemployment threshold could prove to be a step too far. For reasons that I expressed yesterday,

I am concerned that the unemployment problem is multifaceted, not well understood, and quite possibly not as responsive as we might hope to a sustained accommodative monetary policy stance. I am reluctant to connect the path of policy so concretely to what might show itself as time passes to be a problematic number that is taken as a trigger. Despite my sympathy for alternative A1, paragraphs 4 and 4', I lean to alternative B at this meeting. I would prefer a 'stay the course' approach for the time being. The economy is improving, and I think we would be prudent to take a breather and see how the European and congressional fiscal stories play out and the economy evolves.

I think it would be best to avoid the impression of a policy change, and the easiest way to do that is to stick with our previous language. I say this because I do not really think the presumption of a very low funds rate through mid-2014 is a change from the consensus view that has prevailed since August. Because alternative A1, with the first paragraph 4 option, does reflect this reality, I do not strongly object to it in substance but advise against it at this meeting as a matter of tactics. If the Committee goes in that direction, I would hope we might convey that pushing the horizon of the current funds rate policy to mid-2014 is more an extension and continuation of the August policy decision than a change in the implied degree of stimulus relative to September. This could perhaps be done through the Chairman's comments on the SEP.

As regards the language of alternative B, I prefer no change at this meeting. As I already implied, I do not object strenuously to the change that comes off a date and allows a rolling approach. It does suggest an extension, as I said, which is consistent with my forecast, but that may be too narrow a point. It's early enough, it seems to me, to treat this tactically at this

meeting. So all things considered, I prefer the existing 'mid-2013' language. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Did you want to say anything about 'significant'? Were your comments meant to encompass that or not?

MR. LOCKHART. The dropping of 'significant' is okay with me, I think, at this time because of the slight improvement in the economy.

CHAIRMAN BERNANKE. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. I support alternative B today. Since our last meeting, we received some good news on the economy that signals a reduced chance of recession. But as I said yesterday, the news hasn't been sufficient to change my view of the most likely path of the economy, which is for slow growth in the 2'' to 2'' percent range through 2014. We also had a bit of good news on inflation, although not enough to be certain that we are seeing a reduction in the underlying trend of prices. Nonetheless, I continue, as I said yesterday, to expect inflation of about 2 percent for the next few years. With my outlook little changed since we eased policy at our last meeting, it makes sense to me to keep policy unchanged at this meeting.

As we move forward, I think the course of policy is going to be highly dependent on how the considerable risks to the outlook play out. While the risks don't look as dire today as they did at our last meeting, they may yet pose some challenges for policy. For example, we could easily face circumstances in which risks to price stability prevent us from easing in response to a faltering recovery or circumstances in which rising inflation prevents us from maintaining the current degree of policy accommodation in response to a still-weak recovery.

In terms of the language, I wouldn't change the 'mid-2013' date at this meeting. In paragraphs 1 and 2 of alternative B, we are making comments that show somewhat improved economic conditions, and we didn't really change our economic outlook very much since our last meeting. Drawing on yesterday's discussion of policy frameworks, though, I would prefer to use the SEP to clarify the forward guidance in alternative B by referring to our forecast for unemployment and inflation in mid-2013. Adding some form of the language in the last sentence in paragraph 4' in alternative A1, I think, could help the public better understand our reaction function.

Mr. Chairman, because you're going to have a press conference after this meeting, I would encourage you to use that opportunity to draw the public's attention to what we expect economic conditions are going to be in 2013, if we don't use that language in our statement today. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. Mr. Chairman, I support alternative B, with maintaining the language 'through mid-2013.' Mr. Evans may be surprised that I agree with him completely'that the longer we go with high unemployment, the more we undermine potential. I just don't believe that our monetary accommodation has been all that useful in assisting the reduction of joblessness, given the uncertainty that is posed by the fiscal and regulatory morass that we see on Capitol Hill. And I believe we're pushing on a string on that front.

I have been outspoken on this publicly and within this room. I did not support the

extension to mid-2013. I voted against it. I still'despite, I think, Brian's very good briefings' view Operation Twist as incomplete. I suspect it was good for the rich. As a former trader, having learned very well to operate on 'buying on the rumor and selling on the news,' I think we

did end up enriching certain swift and capable money operators. It's not clear to me that in the end it will benefit the cost of business borrowing. I do believe very firmly that we have significant liquidity in the economy.

I found all the interventions yesterday to be quite brilliant, but I was particularly struck by Governor Duke's, in terms of some of the improvements that have been made regarding balance sheets and the potential that exists out there. I wouldn't say that I want to completely embrace the 'Tigger' scenario, nor am I willing to embrace the 'Eeyore' scenario, but I found that to be a sobering assessment in contrast to what everybody else was talking about at the table, and it's something we should bear in mind.

I continue to believe that we should harbor our ammunition. We have few bullets left. I referred to them in the last meeting'in reference to your initials, Mr. Chairman'as BBs. But whatever we have left we need to use under dire circumstances. I am still of the belief that we could see an S&P 500 trading at 600 under very easy circumstances if we have the horrific scenario that some fear obtained in Europe and just because of the nature of the skittishness of markets.

I continue to worry about the impact of what we have wrought on those who played by the rules, saved their money, and are being hurt by low interest rates. I do believe this is not constructive from the standpoint of the 6,000-plus community banks we have in this country in terms of squeezing their profitability.

I do believe that this has a negative impact related to the resetting of pension fund liabilities, which takes away from investment that might otherwise go into job-creating capital, and I worry about the consequence of our low-interest-rate policy.

These are costs that are involved. There are certainly benefits that accrue. But I don't think one of the benefits is that we impact the too-high unemployment levels in this country if we just act as a substitute for fiscal policy.

We'll have more information by December in terms of knowing what the supercommittee is likely to do, and in my book, as long as we provide accommodative monetary policy, we give them an excuse not to act. It is time for them to act, and I would urge you, in your press briefing, to underscore what you have said publicly'and Mr. Dudley, the Vice Chairman of this Committee, mentioned yesterday'that we should stress regarding the need for fiscal policy to get its act together.

Mr. Chairman, I would support statement B. With regard to the word 'significant,' I am somewhat indifferent. I would prefer not to use it, but if the Desk tells us that it's been digested by the market, then I could swallow it. I didn't think it was in blue, by the way'I thought it was in purple, Mr. Lockhart, just to satisfy you. And I would suggest that those who are seeing purple squirrels may be taking the drugs that Mr. Lockhart and Mr. Lacker have been talking about. [Laughter] So that's it, Mr. Chairman. I support statement B as drafted, with 'through mid-2013.' Thank you.

CHAIRMAN BERNANKE. Thank you. President George.

MS. GEORGE. Thank you, Mr. Chairman. My preference is to take no further action at this meeting. Since September, the moderate recovery has continued, and although far from robust, GDP growth has been resilient, and the third-quarter reading came in slightly better than I had previously expected, thanks to strong business investment.

While I understand the desire to do something to address high unemployment, I don't think our current problems can fundamentally be solved with monetary policy alone.

Deleveraging and rebalancing take time to achieve, and monetary policy has only a limited ability to speed these processes without risking low and stable inflation, which we have worked hard to achieve. Moreover, we normally believe it takes some time for monetary policy decisions to affect economic activity. The Committee has taken action at each of the past two meetings, partly in response to a deteriorating outlook and downside risk, but conditions have not worsened, and in fact have improved a bit, since then.

So I favor no further action. I would like to leave the language unchanged and to eliminate the word 'significant' from 'downside.'

CHAIRMAN BERNANKE. Okay. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I'll be brief. I support alternative B. The data have been somewhat stronger than expected. The recession scare that was around during the August time frame has been mitigated, at least for now.

It's true that sentiment is down at both the household level and the firm level. I consider this a headline phenomenon for right now. There is very real risk to the U.S. from Europe, but it's only a risk at this point, and it's not enough to change household behavior or business behavior for a couple of reasons. The households, I think, see themselves as too far removed from Europe to actually change behavior, despite the fact that they're reporting bad feelings. For the large businesses, they're also worried about developments in Europe, but they are also profitable and cash rich. Their business growth strategies are not centered in Europe but in Asia, and Asian growth is projected to continue unabated. These are two good reasons to think that the sentiment numbers are not affecting actual household and business behavior in the U.S. at this point, and so I think that that helps explain why we're not getting significant downturn based on sentiment alone.

The Committee has taken easing actions at the August and September meetings, strengthening the commitment to maintain the policy rate near zero and undertaking Operation Twist. Both of these are operating today. Given the improved hard data on the economy, I counsel patience at this point.

I also counsel against the use of the word 'significant' in paragraph 2 of alternative B. The tradition of central bankers is to be appropriately fair but understated to avoid frightening the financial markets. It's a serious problem. They think that we know something that they don't know, and we have to be very careful about sending any signals of that nature. I think it's fine as originally written: 'Moreover, there are downside risks to the economic outlook, including strains in global financial markets.' Certainly there are. Everyone knows what we're talking about. Putting 'significant' in there may otherwise create more problems than it solves. So I would use the original wording in paragraph 2.

If the Committee wishes to ease aggressively at future meetings, I suggest that asset purchases are the most potent tool available to the Committee. Partly based on the discussion yesterday, I would recommend the incremental balance sheet policies, such as those described in the excellent memo of October 24 by Dave Reifschneider, John Roberts, and Jae Sim. We haven't discussed that memo very much at this meeting, but I thought it was very good, and I recommend that we take a look at it. I've also described my own views on this issue in previous discussions with the Committee. An incremental approach would have a great advantage of allowing the Committee to make decisions in a manner analogous to interest rate decisions in ordinary times. Also, the open-ended nature of this approach potentially promises substantial additional easing while still giving the Committee the ability to pause or reverse the policy as the macroeconomic situation changes. I counsel purchasing Treasuries versus MBS.

Other methods of easing did not strike me as being nearly as effective as they are sometimes portrayed, partly for the reasons I outlined yesterday. The trigger strategy approach seems questionable to me. I do not see why this is a good way to commit to longer periods of zero rates relative to other methods of committing to longer periods of zero rates. I do not think much would happen initially if we took this approach, and it might complicate our strategies down the line if either or both of the thresholds were violated. Furthermore, trying to tie monetary policy directly to unemployment strikes me as very questionable given the state of knowledge of hysteresis in unemployment as experienced in Europe in recent decades. It's not that we shouldn't think about unemployment'we should think about unemployment. The question is, should you tie the policy lever directly to a number that we probably don't understand as well as we would like to understand? Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. KOCHERLAKOTA. Mr. Chairman? Sorry.

CHAIRMAN BERNANKE. President Kocherlakota.

MR. KOCHERLAKOTA. I want to clarify something in my own mind. The word 'significant' was in the September FOMC statement, right?

CHAIRMAN BERNANKE. Right.

MR. KOCHERLAKOTA. So taking it out is a change from the September FOMC statement.

CHAIRMAN BERNANKE. That's correct.

MR. KOCHERLAKOTA. Okay. Just to be clear.

CHAIRMAN BERNANKE. The sentence is reoriented a little bit so that it's not quite so obvious, but yes, it is in fact the case, and the September statement is, of course, at the beginning of your handout.

MR. KOCHERLAKOTA. Thanks.

CHAIRMAN BERNANKE. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. This Committee has been aggressive and creative at fulfilling its dual mandate. Over the past three and a half years, we have reduced the policy rate from 5'' percent to 0, where it's been now for three years. We have purchased nearly $2 trillion worth of assets on our balance sheet, including MBS. We have targeted spreads. We have targeted risk premiums. We have targeted assets for moving their prices around. It is hard for me to imagine that this Committee could be accused of not making every effort in its power to fulfill our dual mandate.

The fact of the matter is that we are all frustrated and disappointed that unemployment rates remain stubbornly high, and we're all deeply concerned about that. I think we have to keep in mind, though, that policy actions by this Committee are not free. They carry costs as well as benefits, and it is our duty to keep evaluating those costs and benefits of our actions. And I think, as President Lockhart said yesterday and repeated today, it is troubling that despite our best efforts and very aggressive efforts, the labor market hasn't responded in ways that we normally think it might. That should give us some pause regarding how we think about proceeding going forward.

In thinking about the costs of aggressive action, we need to be concerned that it's about the future'it's not about today. Low interest rates for three years and longer'President Bullard has expressed concerns about that. But distorting interest rates, twisting curves, and

targeting asset prices of different classes of assets risk creating distortions, inefficiencies, and potentially, bubbles down the road that we have no control over or no ability to foresee with great foresight. That is a risk that we must take as real. President Hoenig for all of last year cautioned us about those risks'the unknowns that they may carry with them and therefore the risks for the future. As President Fisher just said, low interest rates punish savers as another form of distortion.

Our policy actions also have risks for the future as well in undermining our own

credibility. I've raised this point before. We continue to take actions in an environment where our actions will not help the unemployment rate or will have very de minimis effects on the unemployment rate. We undermine our credibility as an institution, and when we need that credibility, perhaps in the exit, we may suffer from it.

And finally, of course, there is the potential risk of inflation down the road. Inflation may not be in our future in the near term or even maybe in the medium term, but we put ourselves in a position where managing that future inflation could be extremely difficult. And undermining our credibility by taking actions that don't work makes managing that inflation exit that much more difficult. So these are real costs to our actions today, and we have to place judgments on how to balance those future costs that are not knowable completely. But we have to make judgments about those.

I am worried that we continue to take actions in ways that have no real coherence to them. I fully support our conversations yesterday about inflation targeting. I put myself in the camp of President Kocherlakota'his discussions about systematic policy'and even President Williams with respect to thinking about more systematic ways of guiding our policy decisions. I made a suggestion yesterday that this Committee work over time in developing what the

arguments of that systematic policy ought to be and using those arguments to explain to the public what our actions are in terms of how those arguments evolve. So I'm very much in favor of that approach, and I'm very much in favor of not only inflation targeting in articulating our framework, but also using that framework and potentially the SEPs as a way to provide more information, more transparency about forward guidance, as opposed to using the calendar. Those would all be steps forward. I was encouraged by our conversation yesterday about that, and I think those steps will help us mitigate some of the risks that I pointed to'the risks of our policies down the road.

To me, the economy looks, if anything, slightly better, as many people have said, than it did in August and September when we undertook those actions. The dire prognoses of a lot of people that we were about to fall off a cliff have not come to pass. That's not to say they might not at some future date, but clearly, there's a little more confidence, I think, that that will not happen at least in the near term.

From my perspective, given our actions in the past two meetings, I am hard pressed to figure out a justification for further accommodation at this point. I do not believe the maturity extension program is very effective. I didn't think it was going to be effective. I was opposed to it, and I was opposed to the dates. However, the progress we made yesterday and the prospects that we can strengthen our framework, improve the way we do forward guidance, and push toward a more systematic approach to policy give me hope that we can manage our way through this.

At this meeting, Mr. Chairman, I'm willing to go along with alternative B. I would prefer that the word 'significant' be dropped. I don't feel terribly strongly about that. Obviously, there's a part of me that very much would like to see alternative C, but I am hopeful that some of

the conversations and progress we made yesterday can translate into a way that will make our policymaking better and more transparent and help us avoid the kinds of risks that I see of our policies undertaken in the future. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I'm willing to support following through on our maturity extension program, which I opposed at the last meeting, but I'm willing to support that.

As I said in the economic go-round, I think the forecast for inflation'people's around this table and my own'is good, one that I'm very pleased with. The risks around inflation are heightened. If you look at a picture of inflation over the past several years, you'll notice the significant increase in volatility this past decade over the decade before, and I think that volatility is likely to be with us for some time. It is possible that the broader inflation trend could moderate a bit, as in the Tealbook and many of your forecasts, but I worry that a forecast of moderating inflation relies overly much on the effect of slack, whose downward effect on inflation has disappointed us several times in the recent past. I think inflation could accelerate, and it could do so rapidly. I don't see that on the horizon right away, but it's well within the realm of possibility. I'd note the continuing buildup of bank balances and the huge amount of reserves, and I'd question whether two-year Treasuries are any less effective as inflationary tinder than bank balances. So it's conceivable that with the spark of a commodity price increase or an oil price increase of a substantial magnitude, we could get a broader acceleration of inflation.

Growth is certainly extremely disappointing, but as I've said and many others have said around here, it's a fairly nonmonetary phenomenon. I think the natural rate, thinking in those

terms, is fairly high and fairly close to the unemployment rate we have. Further stimulus on our part could well affect growth, but I can't see it affecting growth without also pushing inflation up. It's one thing, when inflation is running below where we'd like it to average, to be willing to run that risk for the sake of stimulating employment, but it's entirely different when inflation is where we want it. And it's one thing to tolerate shocks that temporarily push headline inflation well above where we'd like it, in a situation where we have good reason to believe that that effect will reverse shortly and we'll get back down to where we want it; it's quite another thing to attempt to deliberately engineer an increase in inflation trends. I just don't think that our ability to manage the movement upward in inflation and a controlled movement downward warrants as much confidence as I'd require to get over the hump to support that. It would be a terribly risky maneuver to attempt.

Looking forward, I think the more stimulus we provide, the quicker we're going to have to be ready to take it out. The deeper we get into this, the quicker we're going to have to move to take it out. So I worry that we'll face a situation with rising inflation and terribly disappointing growth still, or growth picking up but still disappointing on the labor market side'a dilemma that will be tough for this Committee to grapple with, that will really expose a lot of differences of opinion in this Committee.

On the statements, I think 'significant downside risks' was a mistake, in hindsight. I believe that markets already thought there were significant downside risks, they read our statement as gloomier than they already were, and they read it as gloomier than we really were. So I'd favor dropping the word 'significant.' I realize that the past few days' events in Europe may make that a discordant, dissonant move; therefore, I could support leaving it in as well. Thank you very much, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Lacker. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. We've taken a number of important steps to ease monetary policy in recent meetings. Even so, absent further accommodation, the outlook is unacceptably weak. Under current policy settings, the Tealbook forecast and the Committee's central tendency projections show unemployment remaining exceptionally high for years to come and inflation running below the 2 percent level that most Committee members consider consistent with our dual mandate. A central bank that practices flexible inflation targeting would be looking for ways to provide further accommodation.

In my view, it would be feasible to foster a more satisfactory recovery, without pushing inflation above 2'' percent, by using communication strategies like those illustrated in alternative A1'namely, strategies that would convey the Committee's intention to exit from the zero lower bound at a somewhat later date, and to firm policy at a somewhat more gradual pace, than financial markets currently anticipate. Such a strategy is embedded in the projection that I submitted for this meeting, and hence my forecasts for both of the dual objectives are more appealing than in the extended Tealbook baseline. In particular, my preferred policy path is associated with a faster pace of economic growth over the next few years, a significantly lower rate of unemployment by late 2014, and a trajectory for inflation that stays very close to its mandate-consistent rate. Among the specific variants of paragraph 4 in alternative A1, the thresholds in version 4' are very appealing to me as a way of conveying quantitative information about the conditionality of forward guidance, and I agree with the comments and discussion that President Evans has given of why this is a good approach. The formulation in version 4' based on projections, however, could also be workable.

Nonetheless, as we have discussed, it makes eminent sense to make adjustments to our forward guidance in the context of a clear expression of our overarching goals and strategy. I'm hopeful that we can reach a broad consensus on a statement of principles over the next couple of months. I look forward to working with the subcommittee on communications to find a formulation that fully respects our dual mandate. I also hope we'll be able to move forward with incorporating policy projections into the SEP. As a matter of fact, I became even more persuaded of the merits of publishing our funds rate projections as I filled out my survey for this round and discovered that my rosy economic forecasts could easily be misinterpreted in the absence of information on my judgment about appropriate policy.

Regarding alternative A2, I'm also open to additional LSAPs, especially as a complement to providing additional accommodation through our forward guidance. I would be particularly supportive of MBS purchases to help foster recovery in the housing sector, especially since dysfunction in mortgage markets is attenuating the effectiveness of monetary policy accommodation. A pickup in the housing sector could make a substantial contribution to the recovery if starts were to rebound toward more normal levels. Moreover, house prices have significant effects on spending via wealth, cash flow, and collateral effects, and a stronger housing market would also improve the health of the banking system. So initiatives along these lines certainly deserve further consideration.

In summary, rather than changing our forward guidance or engaging in further LSAPs at the current meeting, I'm supportive of adopting alternative B today. With respect to the specific language, I strongly prefer to stick with the current wording of 'at least through mid-2013' rather than substituting the phrase 'for the next six to seven quarters.' The phrase 'at least' conveys that policy firming might not commence until significantly later than mid-2013, and this

phrasing has already been helpful in guiding financial markets, as Brian noted in his briefing yesterday. The Desk survey suggests that investors now see liftoff as most likely in early 2014. Moreover, from the standpoint of effective communications, I consider it preferable to formulate our forward guidance in terms that can be reiterated at each meeting as long as there isn't any substantial change in the economic outlook. In effect, we should lay out the anticipated path of policy as clearly as possible based on our economic forecast, and we should follow that path unless there's a good reason to change it. Finally, on the language concerning 'significant,' I could, frankly, go either way on this. The current language, the language that was incorporated initially in B, seemed acceptable to me based on the data suggesting less risk of inflation and the fact that there has been some progress on Europe, but I could certainly live also with including 'significant,' especially if, as Brian says, it's been digested by markets at this point.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. I support alternative B with the language 'at least through mid-2013,' not because I think that's optimal, but because, as I said yesterday, if we made a change to it this time, it might be considered, given all the discussion about communication in the intermeeting period, our final choice, and I don't think we've made a final choice. In making a final choice, I could support one that referenced time, such as the six to seven quarters. I could support one that was formulated as a prime or a double prime as long as we all agreed that that's how we were going to do it going forward. I do have some preference for referring it to the projections, the SEP, in some way and tying it to those.

With regard to the word 'significant,' I think the risks are significant, and taking that word out, it seems to me, would be a standing down from that position. So I would prefer to leave it in.

As to additional asset purchases, and specifically MBS, I would very much be in favor of weighting any purchases we were going to do toward MBS, but that goes only part of the way. That affects the spread between Treasuries and the MBS securities. It's not as effective at this point in affecting the spread between Treasuries and the rates that are actually offered to homeowners, and paying more attention to that piece also makes sense. We have within this System probably the largest collection'certainly of economic research resources that are available to the government, and I think making our assets available as technical assistance to parts of the government that can actually make changes that will improve the housing market and the ability of borrowers to access the low rates that we're working on is something that we can do. And certainly, anywhere that our regulatory supervisory policies can be supportive, that's an important thing to do as well. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. A week and a half ago, I gave a speech in which I suggested that additional purchases of mortgage-backed securities should be put back on the top of our agenda. I carefully phrased that speech and that particular suggestion so as to say that if things did not improve over the next couple of months, I thought we should consider it. I qualified the formulation, really out of respect for the decisionmaking process of the Committee. In fact, I think that there is a good case to be made right now for additional MBS purchases.

Before I get to that reasoning, though, I wanted to say a couple of things about the general environment in which we're making this decision today. First, we're not just talking about unemployment here. Had it been a circumstance in which the economy was growing 3'' percent a year but unemployment was remaining stubbornly high, it would have been one thing. But that is not the circumstance that we confront. We have now had a several-year

pattern of growth that has little spurts and then reverts back to a very tepid pace. So the failure to create more jobs seems quite logically tied to the performance of the economy as a whole. Of course, there are some uncertainties about exactly how some sectors of the labor market would or would not react to improved growth. But if one looks at the data, the importance of aggregate demand and of cyclical unemployment as explanatory variables is as strong as virtually anything that we look at in this Committee. So I do think it's a red herring to talk about structural unemployment or drug problems or something of the sort when we're talking about what impact may be had by further monetary stimulus. I appreciate Jeff's formulation, which was basically saying, 'Yes, of course there's room for more stimulus.' But Jeff assesses the risks of inflation versus the stimulus, and I think that's a legitimate conversation. I would come out on the other side, but it does seem to me that's the conversation we should be having.

I think the case is actually quite strong, and it's quite strong right now. Why MBS? Well, people have already mentioned several of the reasons. The spreads are obviously one of those reasons and the fact that we're getting to the point where there may be some impact on market functioning of further Treasury purchases. But I would also point to something that has been reflected in a number of your comments over the past couple of days'that the suboptimal, subexpected performance of the economy over the past few years, with the very disappointing trajectory of the recovery, seems in retrospect pretty obviously tied to debt overhang, the Reinhart'Rogoff kinds of factors that people have been citing for a while now. And the housing sector is clearly at the center of all of that. As Betsy was indicating, in other areas there's been a good bit of working down of debt. Housing is what has continued to be dysfunctional. That's where the debt is; that's where the failure of markets to clear is. Again, as Betsy was just mentioning, that's where prices and quantities don't quite seem to be in the kind of equilibrium

that we would expect. So I think action we would take in the housing area with MBS purchases would not only be efficacious in the way that all large-scale, long-term asset purchases would be, but could also have a particular impact on the major impediment to the kind of recovery that would more resemble past recoveries out of recessions.

I know that a lot of people, myself included, are frustrated with the failure of the political branches of government to take appropriate action to provide more clarity and stimulus for the economy. But this is an instance in which there could be some synergy. Some modest steps have already been taken to make refinancing more readily available. If we were to act by announcing a large-scale asset purchase, I think both the public sector and the banks themselves would see more opportunities again to leverage what we were doing to have a greater economic impact.

So the case is actually quite strong, and thus I'm very much tempted to join President Evans in dissenting from alternative B, because I think alternative B does not accurately reflect the state of the economy. Having said that, I believe there are a couple of reasons not to move right now. One is the point that Narayana and John made earlier, and which Bill Dudley has made, I think, on a number of occasions in the past several meetings'that we do need to get the communications and the framework and the sense that we think in terms of multiple meetings (and not just one meeting) more clear than we have. And there are some reasonable grounds for arguing that an action by us today, whether it was A1 or A2, would once again be difficult for markets and other observers fully to comprehend. They wouldn't quite know how it was that we were making decisions and why.

Second, and someone alluded to this earlier also, I do think that the risks of a significant adverse event in Europe are as high as they have been since May 2010. The risks are not just significant'whatever the adjective above 'significant' is, that's the one we should have.

MR. KOCHERLAKOTA. 'Very significant.'

PARTICIPANT. 'Humongous.' [Laughter]

MR. TARULLO. 'Humongous''that's the one that belongs in the statement as an actual reflection of reality. Because of the increased possibility of something seriously adverse happening, it might be prudent to withhold for now a significant additional policy initiative, which is what I might otherwise favor, and then to assess the state of our communications, the state of the economy, and the state of Europe over the next couple of meetings.

So with considerable reluctance, I can support alternative B today. Mr. Chairman, one probably shouldn't make one's support or nonsupport based on any single word, except maybe the insertion or omission of 'not' in certain places. [Laughter] But I do think that omitting 'significant,' given that it's in the statement now and given what I regard as the increase in financial risk since the last meeting, would be a mistake. Thanks.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. Some of the incoming data indicate that the downside risks have receded somewhat. But unemployment is still projected to decline only gradually, and inflation is still projected to settle at or below mandate-consistent levels. The economy is still in dire straits, with sentiment highly pessimistic. Again, I am not optimistic that households, many of which have lower levels of disposable income, are yet ready to be an engine of growth for this economy. We have not fallen off the cliff, but the margin of safety is not wide. Downside risk is significant.

First, I think that early cessation of the maturity extension program, as suggested in alternative C, would be premature. It also would challenge the credibility of the Committee to reverse a decision so quickly when economic indicators have not materially changed. In my view, early cessation of the maturity extension program requires more-definitive data confirming that the recovery has strengthened and that unemployment has begun to decline.

I'm instinctively drawn to alternative A1 because, with the federal funds rate constrained by the zero lower bound and with elevated downside risks to output, stronger forward guidance seems prudent. But stronger forward guidance of any type requires a communication strategy in order to be effective. In order to maximize the benefits of accommodation promised by such stronger forward guidance, I'd like to understand what communication efforts would accompany such an action. Once these communication plans are developed and considered, the option in alternative A1 will be more credible to the public. Until then, staying the course, as in alternative B, seems appropriate. But I am drawn to the need to update our reaction function in paragraph 4 by reflecting the 'six to seven quarters' language, which I think is more commensurate with at least my economic outlook. I'm sensitive to President Kocherlakota's argument that keeping the 'through mid-2013' language reduces the level of accommodation. So I look forward to the work of the subcommittee on communications to create for the full Committee's consideration a framework for enhanced forward guidance. Thank you.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you. First, I want to talk a little bit about the 'significant' point. I feel really strongly that it has to stay in, because if you take it out, you're basically saying that you now think the downside risks are insignificant. Does anyone around the room think that the downside risks are now insignificant? I agree that we were surprised by

the reaction of the markets last time to putting 'significant' in. But it's very different keeping it in as opposed to taking it out. If you're taking it out, you're trying to make a statement that you think the risks have really declined significantly.

I just don't see any evidence that the downside risks have declined significantly'in fact, at all. The European situation is probably at the worst place that it's been. It's also completely inconsistent with what we're saying in the SEPs. If you look at the SEP results, uncertainty about GDP growth went up compared with June; downside risks to GDP growth are the same as June'11 versus 6. If you look at the risks to unemployment, they have gone up since June. So how do you reconcile taking 'significant' out here, and then you have all of this uncertainty that you're going to discuss in the SEP results? I just don't see the benefit. I think it could be really embarrassing for the Committee if you take it out, Europe falls apart, and people go back and say, 'Well, what were you thinking? Didn't you see what was going on in Europe as you were going into the meeting?'

Now, in terms of other things, obviously I'm going to support alternative B. I prefer to stick with the date rather than move to the quarters. I understand the argument for the quarters, but we're on a trajectory here where we're hoping'at least some of us around the table are hoping'that by January we can arrive at a framework where we actually specify triggers or thresholds. And in that case, the thresholds will be the key thing, and then the date will follow from that. I don't think it really makes sense to go to quarters and then go to this new thing' you're going in a zigzag pattern. So I don't really oppose the idea of the quarters conceptually, but I don't think it really fits in, in terms of the trajectory of how we might like to move through the meetings.

MR. KOCHERLAKOTA. Could I just say one thing to that, Bill? For this meeting, I understand the arguments for staying the same as we were, and I appreciate that. But even if you're thinking about alternative A1 down the road, in December or January, we will have to communicate information about timing in some way. And I think saying something about the duration, as opposed to a date, would be a better way, even in that context. So I don't think of them as being inconsistent. That's all I would say.

VICE CHAIRMAN DUDLEY. Okay. Well, let me continue. The other thing I want to talk about is, we need to really think clearly through what our escalation options are in the near term, because there are significant downside risks. So I think we could actually not have the luxury of getting all the way to January to pursue the thresholds approach. Regarding the near- term escalation option, there are really two things that I would favor if we had to go down this path. One is that I much prefer MBS over Treasuries at this point, subject to the capacity constraints in terms of how much we can do without disrupting market function. And the reason why I favor MBS over Treasuries is, it's easier to make the case that this is more directly tied to one of the key issues that we're facing, which is housing. It's easier to tie it more directly to private-sector financial market conditions, and it also would have less political noise associated with it. I don't think that we should pay that much attention to the political noise per se, but the political noise can make policies less effective. So to the extent that there's less political noise of doing MBS versus Treasuries, I think it is significant in terms of the efficacy of the policy choice.

Regarding where we're heading over the next couple of meetings, I very much hope that we can get to the point where we can actually turn the date into thresholds, with the date actually following from the thresholds rather than just standing out there in space. As I said yesterday,

I'm very uncertain about what the date is. I'm considerably less uncertain about the thresholds, so I think the thresholds are, in some way, a better metric to give the markets. The second thing with thresholds is that they give the market the ability to update its view of how long policy is going to stay accommodative dynamically as it gets new information and the outlook changes. So that's something that I'm hoping we can work toward. Obviously, I think it's going to be difficult.

The second thing I think we need to think about'and this is something that we talked about; we got a briefing from the staff at the videoconference'was that we may need to think about bringing back a better liquidity backstop for our financial system if Europe really gets into great difficulty. The very rapid failure of MF Global underscores the fact that the broker'dealers in the United States do not have a credible lender-of-last-resort backstop. And so it's very possible that we may have to do something very quickly on the liquidity front to backstop the financial system. One thing I think that it's very important for us to stress in our public remarks is that despite the Dodd'Frank Act, we still have both the ability and the will to perform our lender-of-last-resort function, because I think there's a little bit of confusion in the market about whether we would actually be willing to act. Obviously, we didn't have a discussion at that videoconference, but my reading of the body language is that there's quite a bit of support on the Committee that lender of last resort is a legitimate central banking function. I think we should make it clear to people where the Committee stands on that in our public commentary. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much. Thank you, all, for your comments. We are still at a difficult juncture. There is certainly a case, I think, for further action. The best way to say it is that our medium-term forecasts have inflation below target or at target and

unemployment well above what most people consider to be the long-run equilibrium level. And I think it's pretty straightforward to show that that can't be a feature of optimal policy. That said'well, there are responses to that, of course. One can argue that the actions that we could take at this stage are ineffective or have unintended side effects. So it's a complex debate and one that's been going on in this room for some time.

For this meeting, I would propose that we not take new action, and that's based more on trying to get our framework clarified than on a clear decision on the need for or efficacy of further action. We took important actions at each of the past two meetings. Both of these, I think, were well grounded in theory. But President Kocherlakota and others have a point that there was some ad hoc feel to those actions, and probably their impact is somewhat less than it could have been if they had been better cast in the context of a framework and better prepared for the markets.

For those who are advocating more expansionary policy, I would just point out that our toolkit is not infinite, that our capacity is not infinite, and that we'll be more effective if we can use the ammunition we have left in the most focused way. And the best way to do that is to have a strong communication program that will help people understand what we're doing, why we're doing it, and help guide expectations in both the markets and the public.

So I would propose not to take new action today. I leave aside the question of whether new action is justified. I see a case for new action. But whatever we choose to do, it'll be more effective if we are able to provide a more coherent framework for communication. Again, I think that we should not introduce yet additional policy actions today. We have several things already in play. Therefore, I do support alternative B, which most people around the table were comfortable with. I think the majority of people in that statement were in favor of retaining the

'through mid-2013' language. Whatever the merits may be of the alternative, there's a case for waiting until we get to a new communication strategy before making changes, and then we can consider how to incorporate different considerations into that. So I propose that. 'Significant' is'I got a very divided response on that. Bill.

MR. ENGLISH. I'm sorry, but I wanted to suggest one possibility because the response was so divided, which was to use exactly the words from last time rather than changing the structure of the sentence. It might be that the market would be less likely to notice and think about the word 'significant' if it's in the context of exactly the same words as used before.

CHAIRMAN BERNANKE. I think that's right. I would say the two options are, in alternative B, either striking the bracketed word 'significant' and leaving the sentence as it is: 'Moreover, downside risks to the economic outlook remain, including strains in global financial markets''I think the case for doing that is, first, there's this mysterious overinterpretation of the word in the markets, and we're not quite sure what all that means. But more substantively, even though Europe remains very troubled, there has been at least a little reduction in downside risk in the near-term U.S. economic data. The case on the other side is that we have already used this language. And as the Vice Chairman and Governor Tarullo and others point out, we are facing downside risks that could be significant or worse from European developments. Frankly, I'm willing to go either way. I think if we do retain 'significant,' we ought to go back just to the language of September, so there's no need to change.

PARTICIPANT. I agree with that.

CHAIRMAN BERNANKE. President Lacker.

MR. LACKER. I found Vice Chairman Dudley compelling, so I agree we should leave it in. Going back to the old language makes sense.

CHAIRMAN BERNANKE. President Bullard.

MR. BULLARD. Yes, I agree'we could just keep it the way it was. Let me just say, though, that as a matter of style, you always want to be understated as a central bank. People are imputing that we have some really detailed knowledge about what's going to happen or that we have a special crystal ball, and they're imputing the probability of disaster to be higher than it otherwise is.

MR. LACKER. You could say 'somewhat significant.' [Laughter]

MR. BULLARD. I'm happy to leave the sentence the way it is, but let me just say, the Wall Street Journal is a master of understatement. They have the small headlines. It says, 'Nixon Resigns; Ford Takes the Oath of Office.' They don't blare it at you the way the other newspapers do. I think that's the style that we should have in describing the situation.

MR. FISHER. So you would caution against 'humongous'?

MR. BULLARD. I would caution against 'humongous.'

CHAIRMAN BERNANKE. Now, on the other side of that, 'significant' is not exactly a word that would blow most people away. [Laughter] It is significant, certainly.

MR. LACKER. 'Notable'?

CHAIRMAN BERNANKE. 'Significant.' [Laughter] I'm not suggesting any change. All right. President Plosser.

MR. PLOSSER. Just a comment. It's fine to leave as in the original sentence. However, in listening to what people said about 'significant,' in some sense, the significant risk domestically, as you point out, has actually mitigated somewhat. What is really true about the risk is what's going to happen in Europe. Being more specific'that is the source of the significant risk, rather than being something else'would be clearer in some way about what

we're saying. So that's just a thought, maybe, for the future. Or maybe instead of saying 'including global financial,' we could say 'particularly from global financial markets.' But I don't want to gum up the works.

VICE CHAIRMAN DUDLEY. I think this is a really great question. You really don't want to point fingers.

MR. FISHER. It's implicit in what we're saying.

CHAIRMAN BERNANKE. Right, I guess. President Pianalto.

MS. PIANALTO. Just a question, though. When you say we're going to keep it the same as the last meeting, does that mean the word 'remain' comes out?

CHAIRMAN BERNANKE. No. Replace the sentence that currently has the word 'significant' in it with'

MS. PIANALTO. The exact same statement from last'

CHAIRMAN BERNANKE. Exact same: 'Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.'

MS. PIANALTO. So 'remain' comes out.

CHAIRMAN BERNANKE. Yes, it's exactly identical to the last'in September. All right. I think I'm getting agreement. President Lockhart agrees. Okay, good. So we're ready to take a vote.

MS. DANKER. Okay. This vote covers alternative B as in the handout, with the substitution of the 'Moreover' sentence from the September statement: 'Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.' And in paragraph 4, it retains 'through mid-2013.' It encompasses the associated directive as well.

CHAIRMAN BERNANKE. Okay. Thank you very much. A few announcements.

First, I do have a press conference at 2:15. It will be the usual format. It'll be screened in the Special Library, if anybody has nothing better to do. [Laughter] As has been the case, I will focus on our projections and talk about our policy stance in the context of those projections. I'm going to say that we discussed communications frameworks today. I will say we didn't come to any conclusions. I was thinking of saying that there was a sense that there was no need for a fundamental change in framework, that we were looking within the context of our current framework to try to find ways to better explain our policy expectations and outlook. Any concern about that? [No response] Okay. So that's at 2:15.

Coffee is available for those who would like to have some coffee, and there will be lunch served in the anteroom at 11:30. The next meeting is on December 13. Thank you.

END OF MEETING

Conference Call of the Federal Open Market Committee on

November 28, 2011

A conference call of the Federal Open Market Committee was held on Monday, November 28, 2011, at 11:00 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

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, Esther L. George, 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

James A. Clouse, Steven B. Kamin, Loretta J. Mester, Daniel G. Sullivan, 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 Wascher, Deputy Director, Division of Research and Statistics, Board of Governors

Andrew T. Levin, Special Advisor to the Board, Office of Board Members, Board of Governors

Transcript of the Federal Open Market Committee Conference Call on

November 28, 2011

CHAIRMAN BERNANKE. Good morning, everybody. Thank you for joining us on this call. As you know, our main topic today is Europe and our swaps agreements. I thought I would take a minute at the beginning, though, to talk about FOMC confidentiality issues very briefly. As you know, on Wednesday, there was an article in the Wall Street Journal on the question of access to Fed officials. As is often the case, there was more innuendo than fact, but there were a couple of points. One, it was noted that I myself meet with various economists and consultants periodically in an effort to get outside points of view and to hear what they're thinking and so on. And second, it mentioned that until earlier this year, the staff of the New York Fed had been providing information on the staff forecast to the Bank's Economic Advisory Panel.

Let me comment briefly on responses to those issues. First of all, on my personal calendar, the article did reflect a point that the Chairman, like other members of the Committee, does need to have access to outside perspectives and information, which of course is why we have not only a Board, but also panels, advisory councils, and the like. The article also published a long quote from Michelle making the very valid point that people who meet with me sometimes have an incentive to claim inside information, even if none such exists. And finally, I'd like to note that my meetings are always in compliance with our policy. In particular, I always have a staff member there taking notes, and of course I'd never disclose information that I don't disclose in public. So I do believe that our meetings have been in full compliance with the policies that we passed over the summer. That said, the article illustrates that there is a reputational risk here, and so just for your information, we have canceled all similar meetings of

this sort for the near term, and we're going to look at whether there are any good alternative ways to get outside information, input, that don't have that particular risk. We're taking that seriously and trying to figure out a solution.

Second, on the New York staff forecast, this was something that had been going on for some time but was discontinued in June after the new policy on external communication was adopted. So it was in response to that policy that this practice was discontinued. And, in addition, you may be aware that the past forecasts were posted on the web last week in conjunction with an article by Simon Potter of the New York Fed on the ability of the Fed to forecast the recession, which of course was not very good, and the forecasts were put there as an illustration of some of the problems and issues that had come up. Now, that said, when the reporter was researching her story and the items relating the forecast materials were shown to us, I asked Bill English and Scott Alvarez, pursuant to our policies, to take a look at it and see if there was anything in there that did raise issues concerning our policies, as is required by our approach. Now, at this point, I think it's rather moot. But it is worthwhile for us to look at this episode briefly because we all deal with the problem of forecasts, have boards and councils, meet with outside individuals, and talk about the outlook in various ways. So I think it would be beneficial for us to make use of this to try to clarify for ourselves how best to use staff forecasting information. After Scott and Bill finish their look at this particular episode, I think we should maybe have a brief discussion at some point about how we treat forecasts and that kind of information'in dealing with our boards, for example.

Finally, a third issue came up, which was not in the article in any way'it was not referred to'but I got requests from an FOMC participant to look once again at the issue of the dealer survey, which, as you know, we put out before each meeting to the dealers, confidentially

asking them for their views on likely Fed policies, along with issues relating to the economy and so on. And there's been a concern raised in meetings that the dealer survey'which, again, was not mentioned in the article but nevertheless raises similar concerns'might provide or appear to provide preferential information to the recipients of the survey. Now, I raised this with Vice Chairman Dudley and Brian Sack, and from their perspective, it's perfectly fine to go ahead and start releasing the survey in real time, which we can do as early as Friday for the December meeting. The alternative would be to have some kind of Committee process, which I think none of us are particularly excited about but which I'm willing to do if there's a strong desire for it. In a moment I'll ask for comment, but the proposal is just to start releasing it, and of course we'll look carefully at it to make sure that it doesn't have any implied preferential information in it. We'll start that on Friday.

So those are just a few reactions. Vice Chairman Dudley wants to comment, and then I'll be happy to take any questions or comments on this particular issue. Bill.

VICE CHAIRMAN DUDLEY. To clarify on the release of the primary dealer survey, we're talking about releasing just the questions, not the actual results of the survey.

CHAIRMAN BERNANKE. I think that's okay, but others can comment. Does anyone have any reactions they'd like to share? [No response] Okay. Seeing none, why don't we turn to the business of the meeting. I think the best way to do this would be to turn first to Brian Sack, who will give us, as background, some markets updates, and then Steve Kamin here at the Board will talk about what's happening in Europe as they try to address the ongoing crisis. I'll say a few words about calls and contacts that I've had, and then we'll open up the discussion of the particular proposal. So let me turn it over to Brian Sack for an update on markets. Brian.

Such concerns may be more pressing when markets are as volatile as they have been of late, and it seems likely that this volatility will continue as investors have to contend with a wide range of possible policy outcomes in Europe.

Moreover, the U.S. financial sector is still in the process of recovering from the events of recent years and adjusting to a changed environment. A notable risk in this regard is that at least one rating agency is likely to take near-term actions to downgrade U.S. financial firms, reflecting a systematic review of its government support assumptions for these firms.

Lastly, it should be noted that CDS rates and longer-term debt spreads for U.S. financial firms have moved up again, reaching very elevated levels. Indeed, as of last Friday, five-year CDS rates were more than 500 basis points for Morgan Stanley and more than 400 basis points for Bank of America and Goldman Sachs. These rates imply that it will be difficult, or at least quite costly, for these firms to roll over their longer-term debt as it matures.

Overall, even though most U.S. financial firms have ample liquidity today and are not experiencing notable difficulties with short-term funding, the financial sector continues to face a range of risks going forward, and it could quickly come under significant pressure in response to a disorderly outcome in Europe. Steve Kamin will now continue the presentation.

MR. KAMIN.1 As Brian has discussed, the attempt by European leaders in late October to promote a comprehensive solution to the euro-area financial crisis has largely failed, and the crisis is deepening and threatening to spill over from the European periphery to the core. In Greece, the government collapsed two weeks ago and was replaced by a temporary caretaker government headed by former ECB Vice President Lucas Papademos. Greece's main opposition party has generally signed on to the fiscal reforms Greece has agreed to with the IMF and EU, but in order to repay its creditors and finance its deficit over the coming couple of years, Greece is negotiating a new '130 billion program with the IMF and EU, and this new loan is contingent on Greece's private-sector creditors voluntarily writing down the face value of their claims on Greece's government by 50 percent. However, the discussions between the Greek government and its private-sector creditors on this debt restructuring have been fractious, putting the new loan package in jeopardy and adding to speculation that Greece may soon default and possibly withdraw from the euro area.

If the European leaders had succeeded in putting the financial backstops in place to protect Italy, Spain, and other governments from contagion, the Greek situation would be just a sideshow with limited potential to destabilize broader markets. However, efforts to strengthen the euro-area financial backstop have been stymied. The October plan was to leverage the remaining '270 billion in uncommitted resources of the EFSF with private-sector funds to achieve over '1 trillion in

1The materials used by Mr. Kamin are appended to this transcript (appendix 1).

foreign currency swap lines are not needed today, but they would be established as part of a broad network of bilateral swap lines intended to address potential future funding needs and to support market confidence by demonstrating cooperation among the major central banks. Before the initial drawing on these new swap lines, the Foreign Currency Subcommittee would consult with the Federal Open Market Committee if possible under the circumstances then prevailing. These new arrangements would also expire in February 2013.

Both for the dollar swap lines and for the new lines providing other currencies, we propose that the Chairman establish the interest rates by agreement with the foreign central banks and in consultation with the Foreign Currency Subcommittee. He would keep the Federal Open Market Committee informed, and the rates agreed would be consistent with the principles discussed with the Committee. In this regard, we have reached tentative agreement with our foreign counterparties on a reduction in the cost of borrowing through the existing dollar swap lines of 50 basis points'from 100 basis points over OIS to 50 basis points over OIS. The reduction in borrowing costs should help reduce banks' aversion to using the swap facilities, thus strengthening their liquidity positions and reducing the pace of their deleveraging and associated impacts on credit conditions. These actions, if approved, will be described in a coordinated announcement by the Federal Reserve and our five central bank counterparties'the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Japan, and the Bank of Canada. That announcement is likely to be made Wednesday morning. That concludes my remarks.

CHAIRMAN BERNANKE. Thank you very much. Are there questions for Brian or

Steve? President Fisher.

MR. FISHER. Steve, can you bring us up to date on what is likely to occur in the G-7 in

terms of addressing solvency issues? That's the first of many questions I have, but it seems to

me that we have to have a backdrop. And I'm curious as to what you expect'or what we

expect, Mr. Chairman'to come out of these discussions, in addition to our committing to

addressing liquidity needs. That's question number one. What do we know that is not in the

press?

MR. TARULLO. Nothing.

MR. KAMIN. Yes. On question number two, I do not believe we know that much that's

not in the press, but perhaps the Chairman can add to that. On the issue of solvency, a couple of

things. First, clearly, the G-7 is engaged on this, and they have had talks recently. But

ultimately the role of the non-European members of the G-7 is really going to be to advise and perhaps pressure the European leaders on steps that need to be taken. They are addressing both the liquidity and the solvency issues, and those do need to be addressed jointly. The liquidity issue is quite obvious, which is that the possibility of a self-fulfilling prophecy of an investor run leading to default looms very large, and so you do need some backstops. At the same time, particularly the European leaders are keenly aware that there are solvency issues involved. They are very reluctant to put liquidity rescue measures in place if they cannot be assured that Italy, Spain, and other peripheral countries will put in place the fiscal reforms needed to guarantee solvency and sustainability. In that regard, the most obvious option now on the table is basically that any rescue measures be done in conjunction with an IMF program to enforce the conditionality needed to provide comfort to the European leaders.

CHAIRMAN BERNANKE. President Fisher, before we begin our general discussion in just a minute, I can talk about some calls I've had. On solvency, just to reiterate what Steve said, the clearest case of insolvency is Greece, which is being addressed in various ways. Arguably, for example, the increase in the German interest rate is not a solvency issue; it's a concern about the stability of the euro and about self-fulfilling panics. So I think there is arguably, for many if not most of the countries other than Greece, a significant element of panic or liquidity issue, as opposed to a solvency issue. But again, to reiterate what Steve said, the Europeans are very focused'some would say too focused'on the moral-hazard solvency issues and are addressing that from a number of different fronts.

MR. FISHER. Brian, am I correct that two-year Greek debt is trading over 100 percent? MR. SACK. Yes, 120 percent.

MR. FISHER. Thank you. Mr. Chairman, as I understand this'obviously, there's a code among central bankers. These don't seem to be extraordinary. I'm curious as to whether' we'll have a discussion in just a minute'part of this package is that we're going to reduce the domestic discount rate as well. In other words, what lies herein is extending swap arrangements, which we've all, for the most part, agreed to, and adding the new dimension of providing liquidity in Canadian dollars, British pounds, Japanese yen, euros, and Swiss francs if requested by the appropriate Reserve Bank'I presume that means Richmond, largely, or New York for B of A, and then the other big institutions, but it might include others. The suggestion here, as stated in the current intention, is that we reduce the rate on existing lines to OIS plus 50. OIS is, what, 12 basis points? So that would be less than the 75 we charge domestic institutions to borrow. Implicit in this is that we would reduce the domestic discount rate. Or can we justify' even though they are central banks'lending money to foreigners'to use the term that our overseers might use'at a cheaper rate than we lend to our highest-quality domestic banks? Is that our intention?

CHAIRMAN BERNANKE. That's our current intention. I was hoping to address that, though, before we begin our substantive round. Would you allow me to do that?

MR. FISHER. Yes, sir'of course.

CHAIRMAN BERNANKE. I'll come back to it.

MR. FISHER. And then the last thing is'and maybe this is a point you wish to address'in terms of adhering to Bagehot principles, not just regarding the rate we charge, but also regarding the collateral that is accepted, that this is an intra'central bank facility. But to take an extreme example, if during the course of time we decide to roll it over between now and

February 1, 2013, and the euro is no longer the euro that we know, I'm curious as to how this is actually secured. How would they pay us back?

MR. KAMIN. On that issue, a couple of points are worth making. First of all, in our bilateral agreement with the ECB, basically, they would be beholden, as per the contract, to return dollars to us in any event, even if the collateral that we were holding'the euros'no longer had the standing that they did beforehand. So, first, from a legal perspective, we are still owed the dollars. Second, presumably, the euro would still be exchangeable for the currencies that would succeed the euro if it came to that. So, in that instance, too, there will be value. And finally'and I think this is important'right now, we've got two different tenors of swaps, the one week and the three month. Certainly, the one-week swaps are short enough so that we could foresee an event and not lend any of those. Even the three-month swaps seem to have a sufficiently short time frame that if it looked as though the demise of the euro area were imminent, we could basically not participate in those swaps. So I think we have a reasonable amount of comfort on all of those fronts that the demise of the euro area, while no longer as unthinkable as it once was, probably does not pose a threat to the safety of these swaps.

MR. FISHER. Thank you very much. I have other questions, Mr. Chairman, but I'll defer them until we get into the discussion. Thank you.

CHAIRMAN BERNANKE. Okay. Any other questions for Brian or Steve? President Lacker.

MR. LACKER. Will these be sterilized?

CHAIRMAN BERNANKE. That had not been our plan. But if they become large, I think we would have to consider that. Up to now, of course, it's been essentially irrelevant because the draws have been tiny. And frankly, I don't expect large draws. I think this is

viewed as a backstop rather than as a major source of funding. But if they became large, we would have to consider that, yes. President Fisher.

MR. FISHER. Do we have in mind, Mr. Chairman, a limit in terms of the expansion of our balance sheet?

CHAIRMAN BERNANKE. Well, as I said, this is technically an unlimited swap line, as we have had since 2008. Of course, we do have to agree to each individual draw. Is that correct, Scott?

MR. ALVAREZ. Yes.

CHAIRMAN BERNANKE. If they became excessively large, we could either restrict them or sterilize them. So, no, I wouldn't anticipate that our balance sheet would grow meaningfully because of this, but that would be a decision for the FOMC to undertake.

MR. FISHER. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Okay. Other questions for Steve or Brian? [No response] Well, let me add just a few points. President Fisher asked whether we had information that was not in the newspapers. I would say that the answer in some technical sense is no, but we have a lot more, call it soft, information, which comes from extensive discussions with European policymakers and other policymakers. I had the pleasure of taking two G-7 calls beginning at 7:00 a.m. on Thanksgiving morning. There were two calls. The first was with both the G-7 central bank governors and the finance ministers, and the tone of these discussions remains, I think, fairly discouraging. A generous interpretation from the finance ministers' perspective is that they are approaching this on two fronts. One the one hand, they're taking a longer-run perspective'they're trying to address moral hazard issues, structural reform, building their fiscal union, and moving toward a long-term solution, which obviously is an important

component of an overall solution'at the same time that they are taking short-run steps, like leveraging the EFSF, capitalizing the banks, imposing near-term austerity measures, and allowing the ECB to buy government debt. I think the concern people are recognizing is that the process is too slow and that the short-run measures on this trajectory are not going to be adequate. So there is, obviously, a lot of concern. There are very important political constraints. The ECB, in particular, is in a very delicate position. They have been quite frank with me that although they talk about legalities, they view their main constraints as political. Essentially, what will the Germans allow the ECB to do? Their position is quite delicate in that respect, and frankly, I think it's kind of perverse that their strategy is to actually buy for their balance sheet Greek debt, as opposed to lending to some vehicle or to the European Investment Bank or some other bank to indirectly finance government debt. But that's where their arguments about monetary policy have led them. So the main inside information I would share with you is that there's considerable concern and a lot of pessimism among the policymakers in Europe.

I think it's also important to note'and I'm hearing this more on calls'the growing concern about the European economy. As Steve mentioned, the indicators have deteriorated in just the past few weeks. Draghi noted the risk of a mild recession in his first press conference recently, but on conference calls, he's pointed a number of times to a burgeoning credit crunch. That is, the banks are deleveraging very sharply, and that's beginning to have palpable effects on economic activity in Europe. So it's a stress situation. I believe that this would be the thrust of what Brian was saying'that while short-term funding markets for banks and financial institutions in the U.S. remain reasonably stable, the movements in stock prices and swap and CDS spreads for U.S. financial institutions suggest that we are at some risk of having the stress imported here.

The second call I had immediately consecutive to that was with the G-7 central bankers, and there I would just want to convey to you the sense that it's really important for central banks globally to work together, to be seen to be coordinating and cooperating. It was felt that cooperation in this particular matter would be another example that would be reassuring to markets in general. In particular, there was very strong support across all of the central banks for taking additional steps on the swaps. The proposal that has come from the group collectively' this was not really the Fed's initiative; it was partly our initiative, but it was a collective decision'has three parts. One is to extend the swap lines. Of course, we could do that later, but as part of a package, it seems to make sense. And the February 1, 2013, expiration would take us over the year-end. The second element of the proposed package that we discussed in our call was creating a complete network of swaps'every bilateral pair. Until now, it's been U.S. versus other counterparties; this would create a full, dense network of swaps between all bilateral pairs of the G-7 currencies. In particular, that would mean that we would be signing up for the option, of course'which we don't have to use and probably wouldn't use'of reciprocal swaps, where we could access pounds or euros or yen if we so needed. I don't anticipate we would need that, but it does provide yet another element. The third element, as you know, would be to reduce the swap rate to 50 basis points plus OIS. As was mentioned by Brian, the swap line rate has just recently gone in the money at its current rate. We're not seeing any activity. It's obvious that there is a significant stigma issue, and if the stigma is strong enough, then essentially the backstop is ineffective. It doesn't have any impact on market confidence. So there was a view that by reducing the swap rate, making it more economical, we would reduce the perceived stigma, and even if it were not heavily used'and I don't anticipate it to be heavily

used'it would have a stabilizing effect, or at least a positive effect, on European funding markets and then indirectly on U.S. credit markets as well.

President Fisher asked about the primary credit rate, and he's correct that on this proposal, the rate on swaps would be a little bit below the primary credit rate. I discussed this with the Board, and I would have to say that our view is not strongly one way or the other. I think that we could certainly take it up again. Clearly, there is some risk, as President Fisher suggested, that we would be criticized for lending to 'foreigners' at a lower rate than to U.S. banks. There are a couple of arguments in the other direction, though, which I want to note. The first is that we've been trying over time'and Dallas is one of the Federal Reserve Banks that has pressed this'to normalize the spread between the funds rate and the primary credit rate. And when we, in fact, moved up the primary credit rate to 75 basis points, it was actually quite a communications challenge and led to some market swings. So, barring any need in terms of domestic market conditions to cut the primary credit rate, it seems as though if we did that' besides possibly signaling more concern than we have'we would then be in a situation where we would have to again, in the future, move up the rate, and we would be further than ever from a more normal spread between the funds rate and the discount window rate. So that's one observation, not necessarily dispositive. The other point, though, on the question of lending to European banks: One advantage of keeping the primary credit rate where it is now is that it would be very clear that we would want European banks to borrow from the ECB with those additional credit guarantees rather than from our discount window. And that's something we can do with moral suasion, but this provides a market incentive for them to borrow from the ECB rather than from us. I think that's a good thing for us as well. So those were the reasons that the Board'again, informally'seemed to have a mild preference for not cutting the PCR. But

552 U.S.C. (b)(4)

552 U.S.C. (b)(4)

552 U.S.C. (b)(4)

again, this is something that we can certainly revisit, particularly if there's a reaction that is negative. But I guess my sense right now is that the benefits of leaving the PCR where it is are slightly greater than the costs.

You've now heard the proposal. I'm happy to now open the floor. We don't have to have a formal go-round, but, of course, anyone who has questions, comments, or reactions is more than welcome to speak. This is, of course, a meeting, and so your expressing your views on policy is obviously perfectly appropriate. Who would like to start? President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. I really have an FYI that leads to a question. I take it from remarks earlier about the idea of a network of bilateral swap arrangements that you would draw the line with the G-7 currencies. , who's the governor of the central bank, and in a private discussion, he made an appeal. Even though they have quite ample reserves at the moment, he made an appeal for a swap line because they are concerned about the turbulence that could come out of Europe that would affect hot money flows back and forth into 552 U.S.C. (b)(4). So that's the FYI.

Maybe the Board has already heard officially from or some other country, but I wanted to mention that. The question, really, is the following: Is the current thinking that we would draw the line with simply G-7 countries?

CHAIRMAN BERNANKE. Well, we have a lot of interest from emerging market economies in swap lines. As you know, we were up to 14 counterparties during the crisis. would very much like to have a swap line with us. Obviously, today we're talking about the G-7. My own sense is that, first of all, there should be a higher bar to going to the emerging market counterparties, in part because of greater counterparty risk. Second, the concerns they have are still prospective rather than actual

for the most part. Obviously, if we reached a very destructive situation, we would have to look at that again. However, at this point in time, I am not planning to propose any further expansion. But, of course, again, this is an FOMC decision, and if conditions warrant and the FOMC wants to address it, that's fine. But there's no current plan in place to go beyond the G-7. Other questions? President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I guess I'd advise against this. I think that, basically, theatrics are important in a situation like this, and coordinated central bank action would more or less send a panic signal without doing very much to actually help the situation. We had the 100 basis point policy in place all the way through 2008 and 2009. It actually worked quite well in that instance and did a lot to chase borrowers out to the market once conditions returned to a more normal status. I like the 100 basis point penalty that we had before, and given that it is battle tested, I don't really see a good reason to change it here. I also think the 50 basis point backstop would be unlikely to address any stigma issues. If there are stigma issues, there's stigma. And, as you point out, 100 basis points is already in the money right now, and it doesn't seem to me that things would change that much if we moved that to 50 basis points. We're going to be under a lot of pressure and a lot of criticism that we're somehow bailing out the Europeans. That's a very dangerous situation for the organization. Also, I think that in Europe, the recent discussions of enforcing fiscal austerity at the EU level are the first serious signs I've seen of some kind of significant reform that would actually address the problem instead of piling debt on top of existing debt problems. So I'd be very reluctant to take the pressure off the politicians in Europe on that process, however mild that might be, because we're a long way away and this is relatively minor policy on that.

On the extension, I would prefer to extend in some kind of regularly scheduled meeting, preferably the January meeting. Then you could review swap lines every year in January and not review them in the heat of the crisis when you're actually sending a signal in conjunction with the review of the swap lines. I think we've often been reviewing these in the heat of the moment, and I'd prefer to review them at regularly scheduled times that do not contribute to the problem. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Just a quick comment. I think there are a number of efforts under way to address moral hazard and fiscal reform issues. The market situation is one that might not comfortably await a regular meeting. We've also had these discussions with the foreign central banks, and they all believe that this would be a positive for markets and a positive for perception of cooperation and coordination. But again, that's a judgment you have to make. Other comments? President Rosengren.

MR. ROSENGREN. I'm strongly supportive of this action. I do think the financial markets are badly disrupted, and it does make sense to address it in a coordinated effort. I do have two questions. One is whether we have communicated with the other central banks about the moral suasion issue'that there is an expectation that banks would be borrowing in their home country when there is access to a swap line. Has that communication occurred, and do we have a reason to believe that that moral suasion will be effective? Because I would have a mild preference for actually having the rate at which both domestic and foreign banks borrow be the same if we thought that moral suasion would be effective. My second question is on disclosure. One part is whether or not we would be disclosing who's tapping the lines by central bank in our own releases. And the second part is whether any other central banks have different disclosure requirements'in terms of banks borrowing from their central banks or in terms of them

borrowing from us. Have we thought through all of the disclosure issues? Because when we think of stigma, disclosure is an important component of stigma, and given the Dodd'Frank requirements for providing more information, I'd be curious about how we were thinking about those disclosure issues across countries. Thank you.

CHAIRMAN BERNANKE. Yes'I'd be happy to get any help that's needed'but let me just say that on the moral suasion issue, we've been very clear, not only in the context of the swaps, but also more generally, that the discount window is a very short-term facility, and that we expect the Europeans and their regulators and their finance ministries to make sure that European banks' issues are being addressed by Europeans and not by the Federal Reserve. We've gotten a few troubled cases out of the window, as you know, and I don't believe we currently have any significant lending to European banks. So, yes, we've been very clear throughout that we don't want the discount window to be used as a first resort for European banks.

On disclosure, if I understand correctly from our previous practice, we would disclose regularly the amounts drawn by each counterparty'that is, each central bank. We would not know necessarily to whom they were lending, and I don't know about each of the five counterparties, but as far as I know, none of them disclose to whom they lend, although sometimes it's either obvious to figure out or becomes known. But, no, we would certainly not be doing that, because our counterparties are the individual central banks.

MR. ALVAREZ. If I could add something there, Mr. Chairman. However, if we do the reciprocal lines, and, for example, we then do transactions in yen with domestic banks, that would be considered open market operations. We would disclose those eight quarters after the transactions occurred.

CHAIRMAN BERNANKE. This is an interesting question'I should have asked you this before: If we got yen, could we lend yen through the discount window, or would it be only an OMO type of thing?

MR. ALVAREZ. That's a question of first impression. Because the System has never lent any currency other than dollars, we're looking into that. We clearly can do open market operations with anyone in the market. If we consider it that way, then we would buy and sell the yen, and we would treat that as open market operations for the Dodd'Frank Act. That would involve eight-quarter disclosure.

CHAIRMAN BERNANKE. Thank you. President Fisher.

MR. FISHER. To get back to Eric's question of disclosure, I'm trying to understand this. If someone draws down one of these swap lines'I'm talking about the dollar lines'we'd book it as a loan to a central bank. Is that correct?

CHAIRMAN BERNANKE. Yes.

MR. FISHER. Once it is lent out, then, from that central bank'

MR. ALVAREZ. It's not a loan. It's a swap.

CHAIRMAN BERNANKE. But the counterparty is the central bank.

MR. ALVAREZ. Correct.

MR. FISHER. Right. Once that central bank lends it out, does it shift to a loan to depository institutions, or does it stay as a swap?

CHAIRMAN BERNANKE. It stays as a swap.

MR. ALVAREZ. It stays the same.

MR. FISHER. So we have no way of knowing, to answer President Rosengren's question, where this ultimately ends up. It's not disclosed. Is that correct?

CHAIRMAN BERNANKE. It's not disclosed. We could inquire, of course, but our counterparty is the central bank. And they're the ones who are responsible to us.

MR. FISHER. Okay. Thank you.

CHAIRMAN BERNANKE. Vice Chairman Dudley.

VICE CHAIRMAN DUDLEY. I strongly support this. I think creating a more effective backstop for dollar liquidity is important. The way that it's being proposed will signal international policy coordination; we've seen historically through the crisis that international policy coordination is perceived by the market very favorably. And cutting the rate will encourage somewhat more usage, which will help destigmatize the facility. A destigmatized facility is a more effective backstop than one that's heavily stigmatized. I think the outcome we're trying to seek here is that by having a more effective dollar backstop, we'll have less forced deleveraging by European banks of their dollar books of assets How fast they deleverage those books of assets has real consequences for the United States' economy. That's really the connection in terms of what's in it for us; I think there really is something in it for us, and we shouldn't lose sight of that.

CHAIRMAN BERNANKE. I would commend to the group an article by my ex- colleague at Princeton, Hyun Shin, which looks at the transmission of credit from U.S. dollar sources and other dollar sources through the European banking system. Much of that dollar funding flows back into the United States. This, in fact, is addressing a funding problem of a credit source, which in turn affects U.S. borrowers. So there is a connection that we can point to. Other questions or comments? President Fisher.

MR. FISHER. Mr. Chairman, I'm torn on this issue. There is a code among central bankers. I think Vice Chairman Dudley is correct from the standpoint that we're most effective

when we work together. We've learned this from our own history. I think we have a communications problem here, which I would ask you to address. You made the correct point that we'and you used the term 'we''are trying and have been making efforts to normalize rates. And you're right'Dallas and one other Bank have been rather aggressive on that front. I'm very worried about what's going on in Europe. It's a political mare's nest, and the sovereignty issues are horrifically vexing. I'm also quite concerned about where the European banking system is'the false stress tests that they put together before and now the real effort'I know we're having an influence on them'to make sure that they get their capital ratios organized. Obviously, we know how they're doing it. They'd like to issue tier 1 equity, but that's not easy in these markets. They're cutting back, therefore, on their risk-weighted assets and on their lending. The Commerzbank call to the analysts this past week had very clear instructions and a revelation that they've instructed their bankers to lend only to Poland and to Germany, and they're just cutting out other activities. So we know some deleveraging is taking place. Shriveling up of other credits, including dollar-based credits, is happening, and I think Vice Chairman Dudley is absolutely correct. We all understand this. It comes back to bite us on the rear end.

What I'm most concerned about here is the reaction to our lending to others at less than we lend to the highest-quality community, regional, and large banks in this country. I wouldn't understate or underestimate how that might reverberate negatively against us. I'm a little concerned that we've agreed to OIS plus 50 basis points. If it were OIS plus whatever equates to 75, assuming OIS is 12, I'd be more comfortable. And that just gives me pause. I don't think that just issuing this statement, which does not refer to the OIS plus 50, is problematic. I do think it becomes problematic in terms of the execution and, again, in the minds of those on both

sides of the aisle in the Congress. There is a tradeoff here. We do want to normalize rates, but we've been presented with a very difficult circumstance that poses risk to us. And I think we need to noodle that through before we make a decision. Again, I've been probably the most aggressive advocate for normalizing rates. We've pulled back from that recently, but just because of the circumstance. I don't think we could easily answer those questions unless we deal with our highest-quality domestic credits. I think it would be very, very difficult, particularly with the community banks, the regional banks'which are high quality, from which we demand substantial and measurable collateral to make a loan'to say that we're trusting other institutions. Again, they're our brethren. These are central bankers. We understand the code. But it presents a huge communications problem, and the question is whether we should take action or just try to deal with it through communications. And I'd leave that up to the rest of the group to decide, but I wouldn't understate it. I think the optics are not very good, particularly when we're under the microscope'or certainly the magnifying glass. That's my biggest concern, Mr. Chairman. I'm torn on whether or not I can support this, unless we have a clear understanding of how we're going to deal with that. It might be through a press conference on your part. It might be through other efforts to communicate. But it's a hard sell. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Let me make a couple of comments. Others on the Board can speak to this if they wish. As I said, while there was not a strong preference in this regard, there was the advantage of pushing European banks away from our window toward the foreign central banks, which, by the way, because they are our counterparties, you could argue that, from a credit risk perspective, they're actually better risks than banks. But I suppose that's a different question. I would say two other things, if I could. One is that'and President Bullard raised this

as well'while deliberation is certainly important, we are in a very serious situation, one that is changing quickly. I don't think we're in a mode, of course, where we should be panicking or anything like that. But obviously, I think speed is useful and preemption is useful. I hesitate to make this argument, but I will anyway: I personally negotiated some of these ideas with my counterparts in the other central banks. And I do need to have a little bit of flexibility, I hope, to represent the Federal Reserve's point of view in international discussions. Now, obviously, if you're opposed to this action, by all means, you should vote against it. But if you're close to the edge, I would ask that to be an additional consideration. It's very difficult for me to consult continually with the FOMC at the same time that we're having calls and discussions and meetings with our foreign counterparties. But to go back to your main point, President Fisher, rather than defend this to the death, if in fact we do run into problems, the Board can consider making a change. We can do it in a few hours if we have to.

MR. FISHER. I think, Mr. Chairman, first of all, that nobody wants to undermine you, and I certainly personally never wish to undermine you. And I do think you have to have the leeway you discussed. I do find more convincing the explanation you gave us earlier, which is, we're not lending through the discount window. And we've had criticism of lending to foreign borrowers through the discount window, so we're not changing there. We're lending to another central bank and within the fraternity and sorority of central banks around the world. All I'm suggesting is that we really think through how this will be communicated, because we know'or at least I'm willing to surmise'that there will be tough questions asked, and we just have to be clear. And that goes beyond what the statement said. So the question is whether there is a vehicle for you to do that. I'm not against the proposal; I have concerns about the proposal. Its effectiveness will be dependent on how we communicate it. I'm just raising that flag and asking

us to think this through, as to how we get it done so we don't end up pulling the rug out from underneath you or from the purpose of the exercise. That's my point.

CHAIRMAN BERNANKE. I appreciate that. I agree'communication is a big part of this. President Bullard was next on my list.

MR. BULLARD. Thank you, Mr. Chairman. On expected usage, I understood Vice Chairman Dudley to argue that usage would probably be up substantially because of the deleveraging in Europe, but I understood you to say that you didn't think these swap lines would be used that much. So I think we should try to get some clarity on where we really think usage is likely to go. I'd also say that under the 100 basis point policy, we didn't seem to have any trouble getting people to use the facility during 2008 and 2009. So I'm wondering what's changed this time. And I'm a little concerned that at 50 basis points, if the dollar funding remains in the money, then you could end up with the addicted banking system in Europe that wants the dollar funding over the long term, and then we don't really get out of the swap lines the way we did in 2008 and 2009. The 100 basis point policy was very useful from that point of view, and you got those banks to seek other sources during that time.

As far as the signaling goes, I disagree with the way the other central banks see this. They want to send a united signal, which I would interpret mostly as they want to get the Fed on board, but I don't think that this is the way to go in this crisis. What you've got are governments that are counting on central banks to bail them out, and you need to keep pressure on those governments to get the fiscal austerity that they need. They've borrowed way too much, and they're certainly hoping that central banks will somehow bail them out, so we're sending exactly the wrong signal. I can believe other central banks want to do it, but I don't think it's a good idea, and I don't think it's a good way to manage a crisis. Again, I would prefer to review swap

lines at regular junctures, not at particular moments of intense turmoil in markets. That's a better way to go, and then you get rid of the signaling problem of a panic mode and a signal that the central banks are all coming to the governments' rescue. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. On the exit problem, the fact is, of course, that all of the loans are for finite periods, and we can stop lending anytime we want, or we can raise the rate anytime we want. So I don't think that is a real issue.

I don't know how much the swap borrowing would increase. Maybe Vice Chairman Dudley has a thought. My thinking on why it would not be so large is that if it does create more assurance, it will ease the flow of private money, because of the backstop feature, so that the funding can take place through private channels. But I obviously don't know for sure. Vice Chairman Dudley, you have a two-handed response to that?

VICE CHAIRMAN DUDLEY. Yes. I think you're absolutely right'we don't know for sure. We want some increase in usage because if we didn't get an increase in usage, it would just show us that the swap lines were still very stigmatized. So we want some increase in usage, which would serve to destigmatize the swaps, make them more effective as a backstop, and therefore keep more private-sector players in the game. I think you'd see some increase in usage. How much depends on how well we actually are destigmatizing the facility so it serves as an effective backstop. I don't know if it would be substantial or small. All we can say is that reducing the rate from 100 basis points to 50 basis points does two things: One, it increases the economics of using the swap facilities to a degree; and, two, it allows people who had been staying out to now say, 'Oh, it's now okay to use this facility.' If you have a number of people use it rather than just two or three, then the facility becomes destigmatized, and so it becomes more effective as a backstop. That's how I see it.

CHAIRMAN BERNANKE. Thanks. President Evans.

MR. EVANS. Thank you, Mr. Chairman. I support this resolution today. I think that it's a relatively small action given everything that's going on. As Vice Chairman Dudley just mentioned, I'm not sure if this will solve the stigma problem, but we can find out. Showing coordination with the other G-7 central banks is helpful in the current situation. Having listened to the discussion from President Fisher and President Rosengren, I am a little nervous about the discount rate alignment. It might be worth thinking through more carefully whether or not reducing the discount rate to 50 basis points would be a good idea to align it with the overall borrowing incentives associated with this swap. Trying to avoid any appearance that we're attempting to skirt disclosure requirements might be helpful, but that's for the Board to decide, obviously. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you. President Fisher, I had a lot of the same concerns about what this said in terms of the difference in the borrowing rates to our banks versus the foreign central banks. But here is the reason I've come out on the side of doing nothing with the primary credit rate at this point. First of all, I think there would certainly be some risk that in communicating the reduction in the primary credit rate, you could get some speculation as to what U.S. banks we were reducing it for and what the reason'changes in financial conditions in U.S. banks'for that was. To the extent that it actually did encourage usage of our discount window at the same time, there's always the speculation as to who's in there using that rate. Also, we will be reporting to the Congress who was using the discount window. All of that seemed to me to raise a lot of questions that might actually be more harmful to U.S. banks than not. Finally, if you haven't lowered it yet, you can always lower it. And if there does get to be a very public

criticism about the difference in the rates, then you can very specifically respond to that criticism by changing the rate, and it seems to me that the communication challenge is a little bit easier then. Thank you.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you, Mr. Chairman. I'm going to respectfully recommend that we don't pursue this course for many of the same reasons that President Bullard expressed. I can understand how funding can suddenly dry up for a financial institution, as in the case of

MF Global. I can understand how funding pressures can emerge for a broad set of market participants. But I don't see us in a situation where there's a deficiency of liquidity supply. Just look at our balance sheet. There's plenty of liquidity in dollars available in the marketplace. What I think we see is a deficiency in the willingness to lend to particular institutions, largely for the reason that they're viewed as riskier. What we know both from public sources and from supervisory sources suggests that that reluctance in the marketplace lines up pretty well with differences in the riskiness of those counterparties. I don't see any evidence that it doesn't reflect a difference in concerns about creditworthiness. And so this doesn't seem like a matter of market efficiency or functioning. It seems as though intervention here would be distributional. More broadly, I think some financial strains are consistent with a well-functioning set of markets. MF Global is a great example of that. I don't think that's a case where we should have intervened, and I don't see MF Global's demise as a failure of market functioning, apart from the fraud they committed relative to the use of funds. More central bank credit is always going to be seen as positive for markets. So I don't think the fact that markets would view this as positive is an argument for doing this. A farm bill is always positive for agricultural land prices, but it's not an argument that you want an infinitely large farm bill.

My predecessors have a long history of dissenting on foreign exchange operations. The reasoning is that, like other central bank credit actions, they essentially involve fiscal policy, they're distributional, and they're essentially end runs around constitutional appropriations policy, and that entangles us in political controversy. I think that, as I said, applies to virtually all central bank credit extension. That's why we've declared, as a Committee, our intention to get back to a Treasury-only balance sheet as soon as we can. And I'd argue that this dynamic has contributed to the hostile political environment that we currently face. More broadly, an expansion of central bank swap lines is going to send the message of an implied backstop commitment that I think is too large. It's counterproductive. It will contribute to financial instability rather than reduce it.

So I remain respectfully opposed to additional swap arrangements to support our provision of liquidity in foreign currencies. I agree with those who highlight the political risk that would be associated, I think, with offering these central bank swaps on terms that are more advantageous than those we offer at the discount window to domestic borrowers. I would urge you, Mr. Chairman, if we go down this road, to consult with your colleagues and ask them if a straight 75 basis points would be acceptable, rather than 50 over OIS. Thank you,

Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. I have Governor Raskin next.

MS. RASKIN. Thank you, Mr. Chairman. I have a couple of operational issues that are suggested by the text that I thought would be worth getting some clarification on. First of all, I was wondering whether we know the timing of other central bank announcements, if we were to go forward with this.

CHAIRMAN BERNANKE. All six banks will announce simultaneously before markets open on Wednesday.

MS. RASKIN. Thank you. Second, in terms of the process that is suggested in the second paragraph of the resolution, there is a sentence in it that indicates that the 'requests for drawings on the foreign currency swap lines and distribution of the proceeds to U.S. financial institutions shall be initiated by the appropriate Reserve Bank and approved by the Chairman in consultation with the Foreign Currency Subcommittee.' One question I have on that process is really about the statement of approval by the Chairman, and the question is whether that is an 'approved or denied,' or is the implication that it would be, in essence, 'approved'?

CHAIRMAN BERNANKE. Scott, will you help?

MR. ALVAREZ. I think this would give the Chairman the latitude, after consulting with the subcommittee and informing the full Committee, to deny draws or approve draws.

MS. RASKIN. So it's 'approved or denied'?

MR. ALVAREZ. Yes.

MS. RASKIN. Okay. And in that same sentence, the idea about 'distribution of the proceeds to U.S. financial institutions''to come back to the earlier part of the conversation regarding transparency, would the distribution of proceeds to U.S. financial institutions be disclosed?

MR. ALVAREZ. Yes. Remember, there are two directions that these swaps would work in. There are the swaps with the foreign central bank that they disseminate through their mechanisms and their countries. The disclosure of that would all be done by the foreign central bank, if at all'not by us. We do disclose that we've had the swap with the foreign central bank and how much draw there has been by that foreign central bank. But the clause you're referring

to is the reciprocal side of the line. So if we were to allow an institution in the United States to draw down yen that we had taken from a swap line, for example, then we would consider that an open market operation, the sale of foreign exchange in the open market. We would have to disclose that eight quarters after the transaction had occurred. We would make a disclosure of our counterparty and the amount and the rate, but it would be done in the future.

MS. RASKIN. Thank you.

CHAIRMAN BERNANKE. Other questions, comments? President Lacker has two

hands.

MR. LACKER. Yes, I'd like to follow up on this point. It says 'initiated by the appropriate Reserve Bank.' That seems to parallel the discount window and the way it works, and that Reserve Bank is essentially in charge of lending to an institution in its District. But this is an open market operation? Would this be administered through New York? And, more broadly, should we go down this path? Do you have in mind any protocol for deciding on an individual institution in a given District outside New York? What if the Reserve Bank doesn't initiate it?

MR. ALVAREZ. I'll leave the policy issue to others, but on the operational side, the thought was that because each financial institution'bank, in particular'has accounts at its local Reserve Bank, it made sense for banks in particular to deal with the Reserve Bank where they had an account and then for the Reserve Bank'say, Richmond'to obtain the currency from the SOMA. That was an easier operational method than having banks deal directly with New York, which wouldn't have the account set up for the bank. So they're OMO transactions, but we would be dealing with counterparties beyond the primary dealers, which are normally who we do the OMO transactions with.

MR. LACKER. Would this just be with banks, or could it be with any affiliates?

MR. ALVAREZ. It could be done with any financial institution, the way the resolution is worded. So that would include affiliates as well.

CHAIRMAN BERNANKE. I think it's important that we get these details straight, but I would hope we don't get too far down this line because this is a pretty hypothetical situation. President Fisher.

MR. FISHER. Mr. Chairman, the way the statement is written, there's no mention of the rate we would charge. It does say that 'the Chairman shall establish the rates on the swap arrangements by mutual agreement with the foreign central banks and in consultation with the Foreign Currency Subcommittee,' and that you'll keep us informed. I assume that paragraph applies to both sets of swap arrangements'the dollar swaps and the foreign currency swaps'is that correct?

MR. ENGLISH. Yes, that's right.

MR. FISHER. Okay. And that it'll be 'consistent with principles discussed with and guidance provided by the Committee.' Again, my guidance, for what it's worth, as an individual on the Committee and as a voter, is that we not lend at less than what we lend to high-quality U.S. banks. You will have the freedom under this, in consultation with the Foreign Currency Subcommittee, to make that decision. I want to be extremely careful here in terms of not undermining authority. You're primus inter pares; you're the Chairman. But I do think it is inadvisable for us to lend'despite the counterarguments, which are helpful and should be articulated'at less than we lend to our domestic counterparts; I have real trouble supporting that. I guess'and please don't take offense'I don't like the process with which this has been developed. I think we should have had this discussion at some point to highlight what these

obstacles are. Obviously, you know us all well. You're making the best judgment possible, and you are the central bank in the eyes of our counterparts. But that is a very tough one for me to swallow as an individual member of this Committee. And then the second thing, which President Rosengren and President Evans mentioned, is the transparency issue. I'm sure we're going to get questions. We have to be prepared to deal with that. Again, when we release the statement, we're not going to state the rate, as I understand it. We are going to say that you will establish the rate in consultation.

MR. ENGLISH. No, I think there's a distinction that you need to make between the resolution that the Committee will pass and the statement that will be released Wednesday morning before the opening of business, which is being negotiated.

CHAIRMAN BERNANKE. Right. There will be a press release.

MR. FISHER. So you're asking us to agree, then, on the 50 basis points'is that correct? And we would make that public?

CHAIRMAN BERNANKE. Well, technically, you're agreeing to delegate it to me, in consultation with the Foreign Currency Subcommittee. But I'm informing you that it would be my intention, along with the other five central banks, to agree to a rate of 50 basis points plus OIS.

MR. FISHER. Would we record minutes of this meeting, where you had some concerns expressed about lending at less than we would have lent to the domestic banks?

CHAIRMAN BERNANKE. Of course. This is a formal meeting, and it'll have minutes and transcripts.

MR. FISHER. Well, again, I'm worried about putting you in an uncomfortable position. There is a principle here that I'm worried about as well, and then there is the reactive aspect of

this, which I'm concerned about. If I may just put my cards on the table, in answer to Governor Duke's question, I think it would be a mistake to cut the rate to domestic banks to 50 basis points and do it simultaneously. I believe we would then panic the markets. So, Governor Duke, I agree with you. I think it would send a bad signal. I wouldn't close that door, depending on what happens in terms of economic developments. Where I come down personally is that we should not have agreed to 50 basis points. We should have agreed to 75 or 12 basis points less than that, wherever OIS is. But this is a dilemma because, again, we don't want to undermine our standing, and certainly we don't want to undermine your standing. So I'm just being utterly frank here. I think that's the biggest problem with this proposal'the 50 basis points. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Vice Chairman Dudley.

VICE CHAIRMAN DUDLEY. I just wanted to make the very simple point that we think it's highly unlikely that we'd ever be lending foreign currencies to U.S. depository institutions or other financial institutions. So all of this discussion about how these bilateral swap lines would actually work in practice is, as you said, hypothetical'extremely hypothetical. My understanding of why the bilateral swap lines are even on the table is that this is just something that the other central banks would like to see to signal the greatest degree of international policy coordination, as opposed to a need that we think we actually are, under any reasonable scenario, likely to ever have.

CHAIRMAN BERNANKE. Thank you. Any other questions or comments? [No response] All right. Well, I thank you for the discussion. The reservations are noted. I appreciate, Richard, the points you made. We are somewhat reactive of necessity. The world is changing quickly, and we are trying to coordinate with five other central banks, which makes it

more difficult to do things with a long lead time. My view is that this is a helpful step, not a major step. But I am quite concerned about market developments in general, and I think we should be prepared to have another meeting should that be necessary. As I said before, my concern is that it's even worse than political. I think the Europeans just do not, in some sense, get it, to use the vernacular. I don't believe they understand quite how dangerous the situation is that they're involved in. They are, of course, in a situation where politicians are making the decisions, and they have many concerns other than the ideal economic outcome.

If there are no further comments, given that there were some concerns, I think we

probably should take a roll call vote on this. Debbie.

MS. DANKER. Okay. This vote is on the resolution that was sent around this morning.

[Laughter]

CHAIRMAN BERNANKE. By the way, President Lacker is voting in place of President

Plosser, who was unable to join us today.

CHAIRMAN BERNANKE. All right. Thank you, again, and we will do our best to keep you well informed. And, if not sooner, we will see you in a couple of weeks. Thank you.

Meeting of the Federal Open Market Committee

December 13, 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, December 13, 2011, at 8:30 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

Christine Cumming, Jeffrey M. Lacker, Dennis P. Lockhart, Sandra Pianalto, and John C. Williams, Alternate Members of the Federal Open Market Committee

James Bullard, Esther L. George, 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

Steven B. Kamin, Economist

David W. Wilcox, Economist

Thomas A. Connors, Loretta J. Mester, Simon Potter, David Reifschneider, Harvey Rosenblum, and Lawrence Slifman, Associate Economists

Brian Sack, Manager, System Open Market Account

Jennifer J. Johnson, Secretary of the Board, Office of the Secretary, Board of Governors

Robert deV. Frierson, Deputy Secretary, Office of the Secretary, Board of Governors

Maryann F. Hunter, Deputy Director, Division of Banking Supervision and Regulation, Board of Governors; William Wascher, Deputy Director, Division of Research and Statistics, Board of Governors

Transcript of the Federal Open Market Committee Meeting on

December 13, 2011

CHAIRMAN BERNANKE. Good morning, everybody. This is a joint meeting of the FOMC and the Board. I need a motion to close the meeting.

MS. YELLEN. So moved.

CHAIRMAN BERNANKE. Thank you very much. I'd like to start with a few brief comments on FOMC information security. As you probably know, there have been a few issues recently, and as our rules require, I've asked Bill English and Scott Alvarez to look into them, and when we have some resolution, I'll certainly be reporting back to the full Committee.

I also wanted, though, to mention today some press reports on the timing of our communications initiatives. It appears that at least one report had information about the agenda, in particular, that we would be discussing those matters today and providing public information in January. The substance of our discussions today on interest rate projections and on principles, inflation targets, and those sorts of issues, are well known. They were in the minutes, and they were discussed by a number of people in speeches, and so on, but it does complicate the work of the subcommittee and of this Committee if the expectations of the public are for delivery of certain outcomes at certain dates. My own sense is that there was not really any reason to intentionally leak this information, but I want to take the opportunity once again to remind people that reporters are very good at piecing together little bits of information from many sources. When they come to you and say, 'Well, I've heard that X,' it's a little hard for each of us in dealing with that. Let me take note of that and ask people, as always, to be careful in their interactions.

Let me turn now to item 1 on the agenda. With the retirement of Nathan Sheets, we need to appoint a new FOMC Economist. There is a proposal that Steve Kamin replace Nathan until

January when we'll have our annual organizational meeting. Is there any objection? [No

response] Seeing none, thank you. Our second item is 'Financial Developments and Open

Market Operations,' and I'll turn, as usual, to Brian Sack.

MR. SACK.1 Financial markets have remained volatile, with investors heavily focused on the policy steps taken to address the European sovereign debt crisis and the associated pressures on bank funding.

Market sentiment had improved notably in advance of last week's summit of European Union leaders, as investors hoped for considerable progress toward establishing mechanisms that would ensure fiscal discipline by European governments and strengthen the support available to those governments if needed. Many market participants thought that those steps would open the door to more aggressive purchases of European sovereign bonds in the secondary market by the European Central Bank. These expectations contributed to a sharp narrowing of the spreads on Spanish, Italian, and French debt, as shown in the upper-left panel of your first exhibit.

However, market expectations apparently got a bit ahead of reality. Important policy steps were in fact agreed to at the EU summit, as Steve Kamin will review. However, they do not put to rest the risks associated with sovereign debt, and many uncertainties remain about the implementation and enforceability of the steps taken. Moreover, comments by ECB President Draghi ahead of the summit were seen as backing away from more aggressive bond purchases, and ECB officials gave no indication after the summit of a shift in that posture. In response to these developments, the spreads on those debt securities again turned higher in recent days, reversing much of the earlier declines.

Needless to say, market participants see the situation surrounding European sovereign debt as very uncertain, resulting in remarkable volatility in these securities and very poor liquidity at times. This is not the type of environment that is conducive to attracting private capital back to the market, which is of great concern considering that Italy and Spain have financing needs in excess of '500 billion next year. These tensions are further exacerbated by the decision by S&P to place the long-term credit ratings of 15 euro-zone countries and the EFSF on negative credit watch. Moody's yesterday also indicated that it would review the sovereign ratings of euro-area countries.

In contrast to the uncertainties surrounding the support of sovereign debt, central banks took clear and decisive steps regarding the provision of liquidity to the financial sector. The ECB announced that it would extend its fixed-rate, full- allotment operations in euros to a horizon of three years, and it made several adjustments that will help loosen the constraints that some banks are facing on the

1The materials used by Mr. Sack are appended to this transcript (appendix 1).

MR. LACKER. On exhibit 2, chart 12, the middle option is 'Provide SOMA Guidance.' Because I'm not familiar with that from past Committee discussions, I'm assuming you put it in there to reduce the information content of the questions you posed to market participants.

MR. SACK. What we've done with that question to reduce the information content that this question could present, is to ask about this entire range of possibilities on both the easing side and the tightening side. And we ask about probabilities for this meeting one year ahead and two years ahead on both sides. We wanted to present a full range of possibilities that has been discussed in the public.

MR. LACKER. Is 'Provide SOMA Guidance' the wording that you gave them or is there something more fulsome? I'm not quite sure what it means.

MR. SACK. Well, what it is intended to mean is to provide explicit guidance on the path of the SOMA portfolio. To some extent, the Committee has already done this in that its exit principles have laid out sequencing of portfolio adjustments relative to the adjustment in the funds rate.

MR. LACKER. Guidance would have something to do with timing, right?

MR. SACK. Right. The exact question is 'provide guidance over the period over which the SOMA will remain at the current level.' But that's in the wording of this question for a number of surveys now.

MR. LACKER. I think the measures you've taken to reduce implicit signaling are worthwhile, very good. I applaud you on that.

CHAIRMAN BERNANKE. President Fisher.

MR. FISHER. First, Brian, you have all of our sympathy for the hard work you've done all year and the excellent work you've done all year. I have four questions if I may quickly ask

them, and maybe we could answer some of them outside of this meeting. If my memory is correct, in terms of the 20-plus-year maturity allotment in the maturity extension program, roughly 29 percent of our allocated purchases would be in that area. A lot of holders of those instruments are basically matching liabilities, are buyers and holders, and my question is: Do you still feel comfortable with that 29 percent allotment in terms of a portion of the market? Or have you thought about readjusting that? Are we reaching any constraints? Then I have three other questions after this, if I may.

MR. SACK. We are comfortable with the performance so far. That was an area of the yield curve that we were somewhat worried about as we structured the maturity extension program. Of course, the reason we ended up proposing such a large allotment that far out was to get the duration effects within the maturity extension program. Given the limits of that program, you have to shift your purchases farther out to get the effects. But we did have some concerns because the liquidity of the bond sector is not as good as the rest of the curve, and as you saw, in asset purchase programs where we had the flexibility essentially to choose wherever on the curve we want to operate, we tended to focus more in the 2 to 10-ish sector in part because of the greater liquidity. Having said all that, I think we're comfortable with the performance so far. There are no obvious problems being created by our purchases. We're seeing some worsening of liquidity out there in recent weeks, but we attribute that more to year-end effects, so we'll continue to watch that.

MR. FISHER. The second question has to do with inventories being maintained by dealers in the corporate sector. If my information is correct, they're pretty near historic lows, and I'm wondering'again, being an advocate of stricter capital standards'if that's a legitimate excuse, because I hear some of that, or is it something else at work in the marketplace?

MR. SACK. You're right. Inventories have fallen a lot, and that's part of a story that market participants have been telling about liquidity being very poor in corporate bonds. Some of that has likely had to do with the large shifts in investors' risk preferences and at times with concerns about all types of risk assets. Again, in part it may have to do with approaching year- end. It's something we can continue to watch, but, yes, liquidity hasn't been great in corporate bonds.

MR. FISHER. It has been trending down in terms of dealer inventories.

MR. SACK. That's correct.

MR. FISHER. And then last, you talk about mortgage-backeds in your presentation. We own roughly 15 percent of all agency mortgage-backed securities and about 20 percent of the fixed-rate conventional pass-throughs? Is that correct, presently?

MR. SACK. You're asking about how much of the total stock of pass-throughs' MR. FISHER. I'm wondering what the capacity is if we were to expand and how much

space there is for us to do so, because the fixed-income markets are not divided into these neat compartments. We often think about them that way, but that's not the way they actually operate. I'm trying to get a sense of were we to come forward with a proposal to expand the portfolio there, how much resistance or how much impact do we have in the marketplace, not simply the MBS portfolio, but all fixed-income activities, particularly given the inventory levels that are being maintained by dealers.

MR. SACK. Right. Alternative A in the Tealbook has an asset purchase program of $500 billion focused in mortgage-backed securities. We made a judgment that that was within the capacity of the Desk, in terms of the flow and the stock that we'd end up taking out under that program. If the Committee were interested in scaling up the program meaningfully above

that, we'd have to explore just how far we think we could go, but at a minimum it would certainly require extending the duration of that program so that it's executed over a longer period.

MR. FISHER. So the two numbers here, that would probably push us to 25 or 35 percent. Is that the rough ballpark?

MR. SACK. The $500 billion?

MR. FISHER. Yes.

MR. SACK. Probably not quite to 30 percent, but we could check the number and let you know.

MR. FISHER. The last question is: What is a 'fully convincing resolution' of the European crisis? [Laughter]

MR. SACK. We struggled with this. I will admit that's not an overly precise question. [Laughter] We wanted to at least try to calibrate some of the effects of Europe in the baseline forecast, and it was actually hard to write a question to do that. We wrote it in terms of measuring how things would improve if there were a policy solution, but of course, we couldn't be overly precise by what we meant by a policy solution. Take that question for what it's worth.

MR. FISHER. Or the ECB is going to hire Brian away because he has the answer and he's not sharing it.

MR. SACK. We gave some sense of the calibration of these effects, but we're all realizing it's not a very precise question.

MR. FISHER. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Other questions for Brian? Yes, President Plosser.

MR. PLOSSER. To follow up on Richard's question, one of the things that strikes me

about the dealer survey questions'particularly this one about how is GDP going to be affected

by the European play-out'is it's not clear to me that the dealers themselves are the right

population to be surveying on the answer to that question. There are other groups, other

economists, and other types of groups in the financial markets and outside the financial markets

that might have something useful to say in response to that. The question I'm asking is: Have

you given any thought to expanding the survey to different groups that might be a little outside

the dealer network, if you will, to broaden the perspective on the types of answers you might get

to at least some of these questions?

MR. SACK. We have primarily been interested in using the survey to get the views of

financial market participants. At times we've gone beyond the primary dealers to include a

number of buy-side firms who would have views, but again, still in a set of respondents closely

associated with financial markets. I'd like to view the purpose of this survey as really trying to

gauge the expectations incorporated into asset prices. That doesn't mean there are not other

groups beyond financial market participants who have very informed views about these issues,

but I wouldn't leave it to the Desk to explore those.

CHAIRMAN BERNANKE. Okay. Let's turn to item 3, 'Economic and Financial

Situation.' Steve, will you be leading off?

MR. KAMIN. In a classic sequence from the comic strip 'Peanuts,' Lucy urges Charlie Brown to run and kick the football, promising that this time, she won't pull it away at the last second. As we wrote down the Tealbook forecast of the global economy last week, we were faced with our own Charlie Brown moment: Would European leaders finally deliver on their promise to alleviate the region's fiscal and financial strains or would their efforts once again fall short, dooming the markets so eagerly running up in advance of last Friday's summit to another unseemly pratfall? With the experience of the failed summit programs of July and October still fresh in our minds, we assumed that the Friday summit announcement would indeed fall short. We were not disappointed.

from positive '' percentage point in October. And this markdown would be even larger, had we not lowered the forecast of U.S. import growth in light of the downward revisions to U.S. economic activity. David will now continue our presentation.

MR. WILCOX.2 Over the intermeeting period, the indicators that we use to gauge the near-term pace of spending were, on balance, reasonably encouraging. Retail sales in October and light motor vehicle sales in November were stronger than we expected, and even the incoming news on nonresidential construction was a bit more upbeat than we anticipated. However, real business outlays on equipment and software appear to have slowed sharply in the current quarter'about in line with our October Tealbook forecast'and forward-looking indicators suggest that investment spending will remain tepid in the near term. Meanwhile, residential construction remains moribund, with few if any signs on the horizon of recovery, while federal defense purchases came in lower than expected. I would also note that the data that have been published since the Tealbook closed, including this morning's retail sales, have been, on net, consistent with our expectations, and leave our GDP forecast for the fourth quarter unchanged from the Tealbook at 3'' percent.

Our thinking in putting together the forecast was also informed by the substantially weaker news about aggregate income that the BEA published. Based on data from the quarterly census of employment and wages (which are received with a lag), the BEA revised down its estimate of second-quarter labor compensation by $40 billion. This resulted in a significant downward revision to real disposable personal income, and left second-quarter real gross domestic income, or GDI, roughly flat. Moreover, the BEA carried forward the weaker trajectory for income into the third quarter. And although'as I will discuss in a moment'the most recent labor- market report was a little stronger than we had expected in some respects, it did not point to a larger increase in wage income than we had anticipated.

Taken at face value, the lower level of personal income would point to somewhat weaker growth in consumer spending going forward. We wrestled at length with whether and if so, to what extent, we should buy into that message from the income data. In the end, displaying our own attempt at Solomonic wisdom, we split the difference, taking consumption down somewhat in response to the lower level of income but not as much as we would have done if we knew that consumption and income were measured without error. In effect, we've left some room for the possibility that households knew perfectly well what they were doing when they went out and spent at a respectable rate during the second half of this year, and that the current estimate of income will ultimately be revised up. But this judgment on our part admittedly represents a downside risk to our forecast.

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

Similarly, the path for headline PCE inflation in the December Tealbook is little changed from October. Headline price inflation has stepped down as the recent decline in core inflation was reinforced by a deceleration in consumer food and energy prices. We expect the deceleration in food prices to extend into this quarter and the next as lower crop prices continue to feed into retail prices. Likewise, we expect previous declines in imported oil prices to push down retail energy prices through the end of this year. In 2012 and 2013, energy prices are projected to decline slightly, leaving headline inflation a touch below the core in both years.

In previous briefings, we have shown results from a Markov-switching model that generates estimates of the probability that economic activity is moving into a so-called stall state'a slow-growth period that historical evidence indicates is often a way station along the path to a recession. This model combines data on real gross domestic income'which, according to Board staff research, provides another useful indicator of the real-time state of the economy'along with data on real GDP and the unemployment rate. As always, I would caution that one can generate a range of different results based on seemingly slight changes in the specification of the model, and that the model has generated false alarms in the past. That said, the lower-right panel presents updated probabilities from one of the specifications. As you can see, the estimated stall probability has risen sharply in recent quarters, and is markedly higher than the value we estimated around the time of the October Tealbook. Mainly, these higher probabilities reflect the downward surprises in second- and third-quarter real GDI. It is sobering to observe that, viewed through the lens of this particular specification, the rise in the estimated stall probability occurred even before the outlook for Europe took a turn for the worse. I'd be pleased to take your questions now.

CHAIRMAN BERNANKE. Thank you. Questions for our colleagues? Vice Chairman.

VICE CHAIRMAN DUDLEY. Two questions. If you looked at the estimated stall

probability and put down your forecast for Q4, what would it look like? That's question number

one. Question number two is the saving rate'if you look at the personal saving rate, it has

declined a lot, but if you look at other measures like flow of funds, they don't show

commensurate kind of declines.

MR. WILCOX. The stall probability would come down some, not a lot, because we've

only got growth proceeding about in line with its potential in the near term.

VICE CHAIRMAN DUDLEY. GDI in the fourth quarter should be quite a bit better I

would guess because you have inflation coming down. You have okay employment growth.

MR. WILCOX. Yes, but going forward over the next couple of years, we've got the economy expanding only slightly above its potential rate. Those probabilities will stay probably not as elevated as this, but I would suspect pretty high.

With regard to the personal saving rate, it is down. As I mentioned in my text, we have discounted that to some extent. Once we have all the data in hand and they've been benchmarked using tax returns and other sources of information that would become available only with considerable hindsight, that lower level of income would cause us to take down consumption spending by more than we did at the moment. We haven't unmoored ourselves entirely from the personal saving rate. There is measurement uncertainty as you suggest; the personal saving rate from the flow of funds accounts is higher. Discrepancies between the flow of funds account and the national income account are commonplace and can often be quite sizable. But we were loath to buy into a rigid view in reaction to those lower income numbers for a variety of reasons encompassing both model uncertainty and a recognition that the data with respect to both consumption and investment are imperfect and subject to considerable subsequent revision. We went part way, but not all the way.

VICE CHAIRMAN DUDLEY. Okay. Thank you.

CHAIRMAN BERNANKE. President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. David, I think you just answered my question, but I noted in yesterday's Wall Street Journal two comments in an article; one, that the Federal Reserve, using a different set of data, said last week that the saving rate rose markedly in the third quarter to 7.4 percent, and the second comment was that Fed data suggest that income may be rising faster than preliminary reports from the Commerce Department. I think you just

answered that, but can you summarize what your bottom line is in trying to sort out these indicators?

MR. WILCOX. The source of those other estimates is the flow of funds accounts, and historically we've keyed our projection more off the internally consistent framework provided by the national income accounts. But we're trying to be sensitive to the fact that we're operating in a world where none of these concepts is measured with precision. It will be years until these numbers are benchmarked and settled down. Moreover, different model specifications give us different guidance about how strongly we should react to surprises in income, and for all of those reasons we were reluctant to apply a rule-of-thumb kind of marginal propensity to consume to that decrement in income.

CHAIRMAN BERNANKE. David, are there valuation adjustments in the flow of the funds that could account for some of the difference or is it conceptually consistent?

MR. WILCOX. In principle, Larry Slifman or Michael, either one or both of you, can answer'two former chiefs of the Flow of Funds Section here. In principle, one can adjust the flow of funds data to a conceptually similar basis to the national income accounts.

MR. PALUMBO. The conceptual differences are fairly small. Both of the measures are missing lots of important pieces of data. The flow of funds accounts are missing a tremendous amount of data for the third quarter. The quarterly variation in the flow of funds saving rate is even more residually derived than the national income accounts saving rate. We don't take very much signal from the quarterly pattern at all. Nonetheless, as you suggested, over longer periods of time, they move generally together. They tell similar rather than dissimilar stories. I haven't looked at a detailed parsing from the most recent data to see what was going on in the third quarter.

One of the things that is conceptually different in the saving rates is the way that the accounting of liabilities on the household balance sheet works into flow of funds saving versus the expenditure-based measure in the NIPAs. It's possible that is still driving a wedge that's making the flow of funds saving rate higher. Essentially, households are still having a large amount of debt charged off their balance sheets; that could show up as a saving concept in the flow of funds accounts, but not necessarily so in the national income accounts. But I don't think that's a third-quarter source of difference. In general, we don't put a lot of signal content on the quarterly frequency flow of funds data, especially on these early vintages where there's a lot of missing information. It's something that I generally pay only a little bit of attention to.

MR. WILCOX. Michael, to the Chairman's question, using flow of funds accounts, one can construct a measure of personal saving that strips out capital gains on equity.

MR. PALUMBO. Actually, the headline measures of the saving rates from the flow of funds accounts do not have a capital gains component in them. The only real conceptual difference is with regard to net investment in consumer durable goods, and we even show a number in the table that takes out our estimate of that bit. The other thing that can be an issue' as I think I suggested'was how the charge-offs end up being a form of saving in the flow of funds accounts. I don't think that has a counterpart in the national income accounts, but the capital gains'depending on what they are reporting, and I think they are reporting the flow of funds saving basis'is not in there.

CHAIRMAN BERNANKE. Okay. Thank you. President Plosser.

MR. PLOSSER. I want to follow on this same theme with a little different take.

Particularly on the real gross domestic income side, one of the observations that we have is that certainly over the past four months'and actually longer than that'there have been substantial

revisions upward to the establishment survey employment numbers, like 250,000 jobs relative to the initial estimates. I think the establishment survey goes into calculating initial estimates of wage income, and so forth, that go into the NIPA accounts. Is there a role for the fact that those revisions have been so large in recent months? Does that feed into gross domestic income in a way that might be consistent with the fact that we are underestimating consumption, or have been? They seem to be moving in the same direction. Is there any separate linkage there into the forecast that we might be concerned about?

MR. WASCHER. That's right, there have been upward revisions to the establishment survey employment numbers, and those are used to construct the initial estimates of wage and salary income in the NIPA. For example, for the third quarter'and then for our estimate for the fourth quarter because we have data through October'we would use those to construct our estimates of personal income. It is also the case that BEA later gets estimates from the unemployment insurance tax system on basically a universe count of wages and salaries in the economy. That is the big downward revision that David referred to in Q2. There is some possibility'and this is one of the reasons we discounted some of the income surprise in making our forecast for consumption'that we will see an upward revision to Q3. The statistical analysis suggests that there is some negative correlation in the revisions, so it does seem possible that we will see an upward revision to income in Q3. Again, that is one of the reasons we did not take full signal from the downward revision to personal income.

MR. PLOSSER. I have a second question. Thank you.

MR. WILCOX. Can I summarize? The Q2 number for compensation is a pretty good number, because that is based on a universe count of employers. In Q3, the BEA has folded in everything we know, including the upward revisions to employment and all of that. We have

done the best that we can to translate all the latest information about those upward revisions in jobs numbers into the income numbers that we built into this forecast. Now, what the future may hold, of course, is anybody's guess. We have given you our guess, but we have tried to take into account all of the information.

MR. PLOSSER. It was the serial correlation part of it that I was asking about?

MR. WILCOX. Yes. I am not aware that we think there is any statistical inefficiency in the estimation procedure that the agency is bringing to bear.

MR. PLOSSER. A slightly different question. I really appreciate your discussion about Europe. Who knows whether the sovereigns will be Lucy and pull the ball away from the ECB once again. We will have to wait and see. But having said all of that, Dave, you mentioned exports, and you talked a little bit about the asset price changes and the heightened uncertainty. I would like to see if you can give me a little more quantitative measure of each of those. For example, if U.S. exports to Europe fell, your standard error of the consequence of that is probably small relative to perhaps some of the other variables that you are mentioning. Now, I want to see if I can get you to break down a little bit for me: You've marked down the forecast pretty substantially, and surprisingly a lot compared with what I anticipated. I'm trying to get a handle on what is the most important channel quantitatively and the magnitude of it. Can you elaborate a little bit on that?

MR. WILCOX. Yes. You asked me if I could break down, and I may proceed to do so. [Laughter]

MR. PLOSSER. You have such great anticipation. [Laughter]

MR. WILCOX. I'm going to air our dirty laundry. I'm going to give you a sense of precision here that will be misleading because around all of these estimates, I am just going to

give your our best guesses. We had to put a guess around all of these numbers. We guessed that the bulk of the downward weight on the GDP projection will occur in 2012. Four-tenths was what we put down as a total on the growth of GDP, and then an additional negative two-tenths in 2013, so some spillover. Even though the situation is improving, the all-clear signal hasn't been given. Now, the bulk of that is occurring through the dollar effects and the weaker activity abroad. The dollar is taking off a couple of tenths worth each year, and weaker activity abroad is taking off another tenth. Those two effects combined are worth minus three-tenths in each year. Then as a placeholder, we took another divot, the tenth of 1 percentage point for uncertainty and risk aversion in 2012. Then, we had that coming back, and so we added back in one-tenth in 2013.

MR. PLOSSER. So if you took the potential appreciation of dollar'

MR. WILCOX. But it then switches'we have already seen a substantial part.

MR. PLOSSER. No. But if you look at your standard error estimates associated with that forecast, how big is the standard error'what did you say, of two-tenths?

MR. WILCOX. Yes, at least.

MR. KAMIN. Are you talking about the uncertainty about what the dollar is going to do or the uncertainty in terms of the mapping from the change in the dollar?

MR. PLOSSER. The uncertainty of the mapping.

MR. KAMIN. Yes. We have different models, but looking at our partial equilibrium model of trade, we estimate models that link U.S. exports to foreign activity and the real exchange rate. Those models have performed relatively well in the past, but the standard error, we will have to admit, is reasonably large. It is also reasonably large in the neighborhood of large turning points in the economy. That is most relevant right now to the elasticity of our

exports with respect to foreign output, but it is probably also present in terms of the responsiveness to the dollar. Now, to amplify on that slightly, in the development of our export forecast, we decided that the standard elasticity of our exports with respect to foreign GDP basically ends up being in the neighborhood of 1 percent, although it might be a little bit larger than that because we observe that around deep recessions in the global economy trade usually falls by even more than the long-run elasticity. We have a little bit of that built in, but not too much. All told, yes, the uncertainty is fairly large.

MR. PLOSSER. Probably substantially bigger than your point estimate, right? MR. KAMIN. You mean bigger than the contribution of net exports?

MR. PLOSSER. Yes.

MR. KAMIN. Possibly in that neighborhood, I would have to look into that. But in terms of our point estimate for exports, our export growth is going to be 5 to 6 percent. The uncertainty is not going to be larger than that.

MR. WILCOX. I would venture a slightly stronger statement: In partial equilibrium, do we think a stronger dollar is better for or worse for our trade position? I don't profess a lot of uncertainty about that.

MR. KAMIN. No, I certainly don't profess any uncertainty about the direction. CHAIRMAN BERNANKE. Okay. A little certainty. President Fisher.

MR. FISHER. A comment, Mr. Chairman, and a question. First, the comment is how different the conversation is at this table now than under the previous regime. It was noteworthy that Steve led off the presentation, and coming full circle to the conversation we have just had.

It is wonderful that we think in globalized terms. In thinking in globalized terms, Steve, going back to your presentation, obviously, we are concerned about Europe presently, but we are

also seeing significant price declines the past two months in Chinese real estate'actually plunging sales. We're monitoring the employment in that sector informally through one of our contacts, and we are also seeing people laid off significantly in terms of the brokers. As you know, shadow banking has a huge role in the Chinese system. Most of that shadow banking, we think'we don't know'has gone into real estate. I am not going to ask for a breakdown. We can't afford to have both of you break down at the same time. But do we at least have a sense of how much impact that might have on the Chinese economy, are we monitoring it, and might it come back to bite us in some way, shape, or form?

MR. KAMIN. We are certainly monitoring that situation pretty closely, and I have to say that there are some different factors in play in terms of our thinking about the outlook for Chinese GDP growth. First, just to get this clear, we have long predicted the so-called soft landing for the Chinese economy, right? And we have frequently been surprised on the upside as GDP growth continues to be greater than we were penciling in. It's against that background that I think we have to look at future developments.

The evidence on credit creation is a little bit on the mixed side in the sense that if you just look at the standard measures of bank loan growth to China, they have certainly softened a bit from the previous year, but they are still running at around 15 to 16 percent, which is a healthy pace. At the same time, there are some broader measures of loan growth that include some of the off-balance-sheet types of items, and that seems to have slowed down a little more. That seems to be consistent with the story that, earlier on, Chinese authorities clamped down on this loan growth, and they also introduced macroprudential measures like lower loan-to-value ratios that also clamped down. We are seeing some evidence of that, in that the property market in China seems to have been taken off the boil a bit. The property prices have flattened out in recent

months. There are some mixed signals, but all told, it does look like there is some slowing in the property market.

Most recently over the intermeeting period, the Chinese authorities lowered their reserve requirement a notch, so that is like indicating that maybe they think that the tightening cycle has gone far enough. Putting all of those things together, we are looking at some slowdown in Chinese growth to a more sustainable 8'' percent pace. Personally, I wouldn't be surprised if China surprised us again on the upside. That said, the combination of those slowing credit aggregates, plus the decline in manufacturing PMIs and the other evidence you point to, does support the view that growth is sliding.

MR. FISHER. But you wouldn't foresee a housing price collapse. You don't think they would allow it.

MR. KAMIN. First of all, we almost never end up correctly calling that event. I think it would be premature at this point to develop much certainty about that very adverse scenario, aside from the fact that all we have seen so far is some flattening of prices in recent months. Property prices in China, as measured by the 70-city survey, are still 4 percent above their year- earlier level. It is also true that the market in China is a little bit different than in the United States, in the sense that a lot less of the residential market is financed by heavy leverage or loans and a lot more of it by cash. Furthermore, in the context of a very rapidly growing economy, a little excess capacity is less worrisome than it is in a more slowly growing economy. Right now, we are not calling for a property crash that could lead to more adverse consequences. But that is certainly an important risk to the outlook in China, and if it weren't for the Europe situation, that could be getting close to the top of the list.

MR. FISHER. Thank you.

CHAIRMAN BERNANKE. The last name I have on my list is President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. I have several questions here. I am going to proceed from the simplest to the most complex. The simplest one is: For real GDP we don't have a confidence bound, is that intentional or is that a misprint?

MR. WILCOX. That's intentional. I showed four-quarter percent changes for real GDP, and I showed one-quarter percent changes for both measures of inflation. And on the fly, we couldn't construct the confidence intervals correctly for the four-quarter changes. In previous editions of this, I have shown quarterly GDP growth. Because of our fiscal assumptions, there is some unseemly and distracting quarterly variation that I thought wasn't, frankly, very informative. We smoothed through that at the cost of losing our confidence interval.

MR. BULLARD. I see. So you are hiding an unseemly'[Laughter]

MR. WILCOX. I am hiding the unseemly variation in the baseline forecast because I think that is wholly irrelevant for your policy decision.

MR. BULLARD. Part of the story that you told is that some of the inflation developments earlier this year were temporary. You said that some of the energy and food price movements fed through to the core prices. In the past, we have always told the story that when those kinds of prices go up, they do not feed through to the core, and so this is not something that we need to worry about. Is this a change in the view of the staff about the pass-through to core inflation when energy prices, in particular, go up?

MR. WILCOX. I don't think that's right. Our story has been that the energy price pass- through has been small, but the import price pass-through is something that survived relatively well through the past 20 years or so of data. We had a pretty significant surge in the area of, what, 7 or 8 percent in import prices in the first half'

MR. BULLARD. 'non-energy import prices'

MR. WILCOX. Yes, core import prices.

MR. KAMIN. Yes, exactly. It was 8 percent in the first quarter and 7 percent in the second.

MR. WILCOX. That was a very significant factor, we think, in driving up core goods prices in the first half of the year. I don't think that is a change in our story.

MR. BULLARD. Well, those are core prices, so it's not really pass-through from energy to core. They're import core, that's what you're saying.

MR. WILCOX. Right, we think import prices contributed about three-tenths to core inflation this year, and energy prices contributed only about one-tenth or so. By far, the much bigger influence was on the import price side.

MR. BULLARD. And that is going to moderate?

MR. WILCOX. Yes, it already has. We think we have already seen that in core goods inflation and in motor vehicle prices, for example, in particular, which represents the unwinding of some of the supply chain disruptions that took place after the Japan earthquake.

MR. BULLARD. We were talking earlier about foreign real GDP growth, and I would like to hear more about the role of the dollar in that kind of calculation. We said foreign real GDP would decelerate from a high rate to a somewhat lower rate. Is that a PPP calculation? Is that a current exchange rate calculation? How much difference would it make if the various exchange rates go in different directions from the ones that you have talked about?

MR. KAMIN. The foreign GDP forecast that we make is based on using the real foreign GDP aggregate values for each of the economies of our trading partners. That is not converted to dollars, that is just real euros, real Canadian dollars, et cetera. For every one of our trading

partners, we have a projection of what their real GDP is and their real GDP growth. Then, we take those growth rates, and we basically aggregate them up, weighting by their shares in U.S. trade. In that way, that calculation is purely separate from any consideration of exchange rates, except insofar as the trade weights that we use are based on the current dollar value of our trade with them. We have a more or less exchange-rate-free measure of foreign GDP growth, and that has a particular effect on our projection for U.S. exports. Then, separately, we have a measure in our models for the value of the U.S. dollar converted into real terms using our and their CPIs, and that represents basically the trade competitiveness channel. We have both of those measures in our model.

MR. BULLARD. Thank you. And, finally, on these regime-switching models on page 1 of the handout, the bottom right has an estimated stall probability of about 50 percent right now. My sense of this is that there are a lot of regime-switching models that try to estimate recession probabilities. All of the ones I have seen have much lower probabilities than this one. Of all the models that you could present to the Committee, you have chosen the one that has the very highest probability. What is it about this model that says that it is a better model than the

10 others that are out there that have been published and have established track records? MR. WILCOX. I completely agree with you. The different specifications, as I had

mentioned in my text, can deliver different results. It's simply not the case that this is the specification that delivers the highest probability.

MR. BULLARD. I'm sure you can construct one.

MR. WILCOX. We can deliver to you a probability of 100 percent. I would make two claims on behalf of this specification. One is it puts quite a bit of weight on GDI, and we have a pretty solid body of research done by staff members now that points to the signal value of GDI in

helping to home in on the underlying state of real activity, and some preliminary work suggesting that GDI is more helpful in that regard than early estimates of GDP. They are both, after all, attempting to measure the same underlying concept, and so it's an empirical question as to which might be more informative, and this body of work suggests that a pretty good case can be made on behalf of GDI. The second claim I'd make on behalf of this model is that it is the same specification that generates the red line. So the simple message I'm telling you is that there is a middle-of-the-road specification of these models that keys off the much weaker trajectory for GDI in the second and third quarters and arrives at a conclusion that the underlying thrust of the pace of activity remains quite tenuous.

MR. BULLARD. Thank you.

CHAIRMAN BERNANKE. Thank you. Why don't we turn now to our economic go- round, and I have first on the list President Lockhart.

MR. LOCKHART. Thank you, Mr. Chairman. Since the November meeting, the data have mostly surprised positively to the upside, and the economic environment feels better, but despite somewhat better-than-expected incoming data'and I would add the tone of reports from Sixth District directors and contacts'I have not changed my outlook from the November FOMC submission.

As regards to directors and contacts, they're saying that business is good, but they also don't seem to be buying it yet as a trend. My baseline, which is broadly in line with the Tealbook through 2012, sees GDP growth next year at around 2.7 percent, inflation contained at or below the Committee's 2 percent objective, and unemployment continuing to decline slowly, notwithstanding the recent sharp fall in the household survey. In short, a pretty much mainstream outlook of moderate expansion.

The key restraining factors that are materially influencing this outlook are three in my mind. First, the situation in Europe constitutes both a factor incorporated into my forecast for the real economy in the near term and a downside risk. I think the discussion in the Tealbook does a nice job of distinguishing among the export channel, the asset price channel, and the financial linkages channel. The export channel effect seems to be already largely baked into the outlook. The asset price channel effect and the prospect of severe financial market disruption propagated through financial linkages are more contingencies in my mind and, therefore, part of the balance of risks equations.

Second, we continue to hear the repeating theme of uncertainty and its companion theme, weak business and consumer confidence, as a restraining force on the recovery. Whether or not the times are actually more uncertain than in the past, our contacts clearly think they are. To gauge the current uncertainty mental map, if you will, in our District, we polled our 44 directors and other District contacts during the intermeeting period on the question of sources of uncertainty influencing business decisions. Two uncertainties dominated: economic performance, defined as the sustainability of demand; and economic policy, and this being mostly nonmonetary matters such as regulation and taxes. Other unknowns, such as global economic and financial conditions (you can read that as Europe), credit availability, and health care costs seem to be considerably smaller influences on current decisionmaking. I think it's realistic to conclude that the uncertainties that are contributing to a conservative approach to investment in fixed capital and labor are likely to be part of the economic picture for quite a while.

A third factor is the lattice, you might call it, of recognized conditions and structural elements that are or likely will be drags on growth in employment. These include housing sector

factors like home prices, construction activity, and continuing foreclosures; fiscal drag; labor market dysfunction; weak income growth; and PCE growth, drawing on a saving rate that may not be sustainable.

Because of the tenuous character of the current situation, I give more-than-normal attention to the downside alternatives laid out in the Tealbook. The 'European Crisis with Severe Spillovers' scenario continues to be plausible. I am less concerned about the 'Homegrown Recession' scenario absent a shock from Europe. The 'Further Disinflation' scenario cannot be dismissed, given the apparent global slowdown and the current limitation on the potency of monetary policy. I perceive downside risk to the economic growth outlook. For now, I'm holding to the view that the risks to the inflation outlook are balanced. The 'Further Disinflation' scenario frames the downside. On the upside, I'm taking into account my District's most recent business inflation survey that reveals a growing concern about price pressure from labor costs.

To summarize, momentum in the economy seems to be building, but the outlook is really very cautiously positive. There are a number of restraining forces already detailed. I see downside risk to economic growth and the inflation risks as roughly balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Plosser.

MR. PLOSSER. Thank you, Mr. Chairman. Overall, the economic conditions in the Third District and the nation have improved somewhat over the intermeeting period. Preliminary anecdotal reports on activity from our business contacts since late November have been somewhat encouraging. Several private-sector forecasters revised up their forecasts for fourth- quarter GDP growth in light of the better-than-expected data.

Manufacturing activity in the Third District continued to expand in November and December. Our business outlook survey rebounded into positive territory in October after two months of negative readings and remained positive in November and now December. The December readings, which remain confidential until Thursday morning, will come out, and they indicate a further pickup in the general activity index from the November reading of 3.6 to 10.3 in December. The market expectation is for a number like 5, and it's going to be 10.3. The new orders index showed a significant increase. Shipments remain positive as well. Expectations for future activity, which rebounded significantly in November, increased again in December, suggesting that business sentiment is turning somewhat more positive.

District labor market conditions improved in October, our most recent data for the District. Employment in our three states grew modestly in October, though at a rate somewhat slower than the nation, but the unemployment rates moved down in our three states to an average of 8.5 percent. In Pennsylvania, the unemployment rate is 8.1; Delaware, 7.9; and only New Jersey, which has a rate of 9.1, exceeds the national average at this point. Thus, while there are signs of improvement, I expect we'll be in a pattern of two steps forward and one step back in the labor market for some time to come.

On the national level, I was encouraged by the relatively strong November employment report, in particular, the string of upward revisions we've seen in the payroll survey over the past several months. Since July, the upward revisions alone have added 240,000 jobs to payroll employment. Indeed, analysis of the nonfarm payroll employment revisions by staff at Philadelphia's Research Department and the Real-Time Data Research Center has found that over the period from 1964 through September of 2011 initial estimates of job gains are biased downward by nearly 18,000 jobs. That is, over the entire sample, the average revision from the

initial estimate to the estimate that the BLS releases two months later is 18,000. Moreover, there appears to be a statistically significant positive bias over the most recent expansionary period. In particular, from the period July 2009 to September 2011, the average revision to the initial estimate of job gains is 36,000 jobs per month. This may be a sign that we're underestimating the personal income data, too, as I was asking Dave earlier. We probably should take this possibility into account in our future forecasts. This might explain why consumer spending seems to have held up better than many of us have expected, given the weak labor markets.

My outlook for the national economy really hasn't changed much over the intermeeting period. I was a bit more positive than the staff in the last meeting. As I said earlier, I was somewhat surprised by the further markdown in the Tealbook forecast. The more positive data suggests to me continued moderate and gradually improving labor market conditions over the forecast horizon.

Although I don't see inflation as much of a risk in the near term, my inflation outlook is less sanguine than the Tealbook's is for some time. I believe there are risks of higher inflation in the medium term. Inflation has come down in recent months as oil prices have fallen, but recently, oil prices are back up again, suggesting we may see upward pressure on inflation once again. The price index in our business outlook survey is coming out on Thursday, and those price indexes are up as well in December. The prices paid index jumped from 23 to 34, and the prices received index jumped from 2.6 to 12. I think this Committee is going to have to be vigilant in this environment to keep inflation expectations anchored.

The European fiscal situation looms large, as we've been discussing, as a risk into this roughly benign outlook, but it isn't clear to me how the European situation will play out. Financial market ramifications are also highly uncertain. One risk, of course, is that we could

have a so-called Lehman-style event where investors pull away from all counterparties and the markets freeze up. However, it could be that if the situation in Europe worsens, we see a rapid flight to U.S. Treasuries as a safe haven. This might impose some disruptions, including an appreciation of the dollar as we've been talking about, which would dampen net exports, but that probably would be quite a different problem than what we saw and experienced in 2008.

So far, U.S. financial institutions have been able to access short-term funding markets on mostly normal terms, and large borrowers in Europe appear to continue to have access to bank funding. Indeed, one very large U.S. bank with a strong presence in Europe reports that while European banks are pulling out of some syndicated loans, it has been relatively easy to find U.S. banks or non-European foreign banks to replace that lost funding. Smaller European borrowers may have increased problems in securing funding, as European banks continue to try to increase their capital ratios. However, this may actually increase opportunities for U.S. banks operating in Europe as they try to increase market share by knocking on doors and taking customers away. We certainly have to remain vigilant to developments in Europe, there's no question about that. That said, I don't see a need for us to move preemptively to stave off problems, and the recent actions taken in Europe give me more hope that the European situation will actually muddle through and stabilize, and we'll be able to avoid the most dire outcomes suggested in the Tealbook's alternative simulation.

My modal forecast for the U.S. is that the economy will continue to grow at a modest pace with some acceleration to somewhat or slightly above-trend growth in 2012 through 2014. With the moderate pace of growth over the horizon, labor market conditions will gradually improve. I anticipate that inflation will fall and be around our 2 percent goal over the near term, but that forecast is predicated on inflation expectations remaining well anchored, which will

likely mean that the Committee will need to commence policy tightening well before mid-2013. I remain concerned that we have taken steps that actually create substantial risks of higher inflation in the medium term if things don't go just right for us. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Williams.

MR. WILLIAMS. Thank you, Mr. Chairman. The U.S. economic data since our last meeting have been encouraging. Car sales and auto production are up. Holiday sales are running above expectations, and consumer sentiment, although still depressed, has rebounded. The labor market continues to improve, and the unemployment rate has declined. While the recent U.S. data have brought us some holiday cheer, I'm afraid that Europe is playing the role of the Grinch who stole Christmas. [Laughter] The euro area is tumbling again into recession, and the European debt crisis lurches on.

These events cast a pall on the otherwise upbeat news we have on the U.S. economy. As David Wilcox mentioned, real GDP growth looks to be around 3'' percent this quarter, and I wish such a pace of growth could be sustained next year and further on, but there are a number of reasons to doubt that. For one, it's important to remember that some of the recent strength in spending and output is a rebound from very weak growth in the first half of the year. It's helpful to me to look at the four-quarter growth rate, and even with a strong Q4, we're still looking at

1.7percent growth in 2011, Q4 over Q4. It's also important to remember that much of fourth- quarter growth is coming from inventories and net exports, neither of which are likely to contribute so much to growth going forward. As we've already discussed at some length, income measures continue to disappoint. GDI grew at an annual rate of less than '' percent in the third quarter, and the recent personal income data suggest ongoing weakness. In particular,

labor compensation has been tepid, and consumer expectations of future income growth remain extraordinarily pessimistic.

All in all, I expect real GDP growth to be 2'' percent next year, consistent with the Tealbook. The risks to this forecast remain tilted to the downside. The Tealbook and my forecast assume that the payroll tax cut will be extended for 2012. Should that not occur, disposable income would come under further pressure. GDP growth in my forecast would end up being close to trend in 2012.

And like everyone, I'm very concerned about the situation in Europe, which could spin out of control at any moment. But even if Europe doesn't blow up, we still face a number of significant headwinds, and one of those is uncertainty, as President Lockhart commented, and I hear very much the same remarks from my directors and business contacts. By almost any metric, uncertainty is elevated. Businesses are uncertain about the economic environment and about the direction of economic policy'again, exactly consistent with President Lockhart's comments. Households are uncertain about job prospects and future incomes, and the looming crisis in Europe only adds to the prevailing angst. I repeatedly hear from my contacts that these uncertainties are prompting them to postpone large capital investments and delay more permanent payroll expansion. As one of my contacts put it, uncertainty is causing firms to step back from the playing field.

But a key question for monetary policy is whether this rise in uncertainty should be viewed primarily as a shock to demand, which monetary policy should lean against, or a shock to supply, which monetary policy should not respond to. To address this issue, my staff examined the quantitative effects of uncertainty on the U.S. economy using a standard vector autoregression, or VAR, framework and several measures of uncertainty taken from the research

literature that I think are related to what we hear from our business contacts. We included in the analysis the VIX, an index of policy and regulatory uncertainty that's been taken from recent research literature, and responses from the Michigan consumer survey about factors that consumers or households themselves say are restraining their buying.

If uncertainty shocks primarily affect supply, then one would expect both unemployment and inflation to rise following an adverse shock to uncertainty. However, if these shocks primarily affect demand, then unemployment should rise but inflation fall in response to an adverse shock. According to our analysis, over the past 30 or so years, uncertainty shocks of the type that we currently face and we talked about, have acted on the economy like adverse aggregate demand shocks. That is, in these models, following a shock to uncertainty, expenditures on consumer durables and investment, short-term interest rates, and inflation all fall, while unemployment and corporate bond spreads rise. This basic finding holds across all types of uncertainty that I've already mentioned, including financial market, policy and regulatory, income, and demand uncertainty.

The second headwind is tight credit. Although we've seen improvements in credit conditions, especially for households, small business lending remains an area of weakness. As noted in the Tealbook, much of this weakness reflects a lack of demand associated with weak growth in the economy and a small pool of qualified borrowers. The supply issues, including supervisory pressures, have also been part of the story. Now, the good news is that our CDIAC members say that broad supervisory pressures have eased this year and are no longer affecting the lending decisions of healthy banks. The bad news is that a large number of community banks are not that healthy. My staff examined the community bank data and confirmed that small business lending of banks with CAMELS ratings of '3' or worse continues to decline, and

because many small businesses rely on banks with which they have long-standing relationships, finding alternative sources of funding may be difficult. This suggests that a carryover from the financial crisis continues to impinge on the availability of credit to many small businesses.

Now let me turn to inflation. Inflation pressures seen earlier this year have clearly abated. Indeed, recent data are coming in below expectations. Six-month annualized changes in overall, core, and trimmed mean PCE prices are now all below 2 percent and heading lower. Compensation growth is still soft, and labor cost pressures are basically nonexistent. My forecast for inflation hasn't changed since our last meeting. I continue to expect PCE inflation to be about 1'' percent both next year and 2013.

In summary, after a rough first half, the economy has for now returned to a moderate growth path, which will nonetheless deliver frustratingly slow progress on unemployment. Inflation is low, and inflation expectations are well anchored. If, however, Europe's troubles deepen, our recovery could be derailed and deflationary pressures could reemerge. Thank you.

CHAIRMAN BERNANKE. Thank you. President Rosengren.

MR. ROSENGREN. Thank you, Mr. Chairman. The data this fall have been somewhat more positive than I expected, in part because of the diminished expectations created by the weak data we received over the summer. Like the Tealbook, I see an extended period of only moderate growth that is insufficient to significantly reduce the unemployment rate or prevent the PCE inflation rate from undershooting 2 percent inflation over the medium term.

The discussions with businesses in my district are quite consistent with this forecast. Most businesses are seeing moderate current sales and hoping to see modest increases over next year. However, along with uncertainty about the durability of the domestic private recovery, the uncertainty in Washington and Europe makes them acutely aware of the downside risks to their

outlook, and they are delaying investment and employment decisions until the outlook is clearer. The modest hiring by small businesses and the weak small business lending noted in the Tealbook are consistent with my discussions with community bankers and small businesses. I am increasingly hearing that to make risky small business loans in this environment will take a more energized effort by the Small Business Administration. Businesses are not reporting wage or price pressures, and most businesses have reported overwhelming applications when business expansion requires hiring additional workers, despite New England performing better than the rest of the country.

I find very few academics or financial market participants who expect the European situation to be a problem only in the near term. An academic from a prestigious economics program highlighted that there is an internal office pool on when the first country leaves the euro. And there is no money on 'never,' though I would note that it is difficult to see just when 'never' would pay off. [Laughter]

Financial market participants are reporting increased attention to counterparty risk. They are particularly reducing their exposure to French banks and are taking a hard look at U.S. broker'dealer organizations with elevated CDS spreads, including Jefferies and Morgan Stanley. While the Tealbook discusses some of the European linkages to the U.S., I would add a few more that are hard to capture in standard models, should things progress unfavorably. First, I am concerned that the broker'dealer model of financing might not survive a severe European shock. This is one reason why a company like Goldman Sachs has such an elevated CDS spread. Were a crisis to occur, financial institutions would quickly abandon counterparties with risky funding strategies. As we saw in the earlier crisis, even secured lenders run from troubled counterparties. This poses a significant risk to any firm that has a large broker'dealer.

Second, I have spent time at previous meetings discussing risks with funding structures that are not supported by domestic capital, such as money market funds, non-2a-7 funds that operate like money market funds, and foreign branches. All of these structures would be severely challenged in a crisis.

Third, I want to amplify on something that was mentioned only briefly in the Tealbook. The asset-backed commercial paper market is stressed. This market has declined dramatically from levels before the crisis to a market that is now a little over $320 billion. Nevertheless, it has been an important market for securitizing short-term commercial paper. It is also a market that has had a significant European presence. European banks have sponsored a surprising number of conduits and often provide liquidity support. Liquidity support entails serving as an alternative funding source in the event a conduit is unable to issue new asset-backed commercial paper'a constraint that many conduits associated with European banks are currently facing. Consistent with this concern, asset-backed commercial paper maturities have declined and rates have risen. This is another example of a financing structure that might not survive a European crisis and could cause a tightening in U.S. markets.

The baseline outlook is sobering, but increasingly the more severe European outcome is becoming part of the baseline forecast rather than a stress scenario. The Tealbook highlights that we will likely miss on both elements of the mandate. Should Europe worsen, as in the alternative scenarios, disinflation or deflation is quite possible, implying that we very significantly miss on both objectives. Now is the critical time, both to shore up our financial institutions, but also to promote as much growth in the economy as possible. Thank you.

CHAIRMAN BERNANKE. Thank you. President Bullard.

MR. BULLARD. Thank you, Mr. Chairman. By the way, Happy Birthday, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you very much.

MR. BULLARD. I hope you are having a fun day.

CHAIRMAN BERNANKE. I wouldn't want to be anywhere else. [Laughter]

MR. BULLARD. The Eighth District economy continues to expand at a modest pace according to many District contacts. Retail sales seem to have been reasonably robust during the first portion of the holiday season. I was impressed that even smaller stores in relatively remote locations report an unexpected upswing in sales. Retail contacts have expressed a fair amount of optimism for the season as a whole. Larger retailers also seem to be doing well, but expressed more caution in interpreting the data collected so far. While major retailers are up this year, some are down or flat as opposed to last year at this point when all major retailers were experiencing increased sales on a year-over-year basis. Still, cautious optimism prevails among this group as well. Transportation industry contacts seem to, likewise, feel that the business associated with the holiday season is brisk, although perhaps not showing the large gains experienced in 2010. Some slowdown from Asia has been noted, although an important fraction of that may be due to year-over-year comparisons. Capital spending plans for 2012 remain on track. District land prices are up substantially from last year. Farmers are using land as collateral to buy new equipment. Demand for new equipment remains very strong.

Turning to the national economy, I found the Tealbook overly pessimistic on the prospects for the U.S. It is more downbeat than most private-sector forecasts. Certainly, the risks from Europe are real and substantial, but those are still overweighted in my view. I do not expect clear resolution in Europe, but I think the probability of outright meltdown is low. The

EU will ultimately stand behind its financial system, and the banks in particular. They will nationalize banks if necessary, but will not do so unless forced to. On the question of outright debt default by European nations, markets have already factored in a significant probability of debt restructuring for some countries, and I don't think it would be a surprise to see some restructuring going forward as this event plays out. I do not think that either of the scenarios that were mentioned by the staff, either that a major bank fails in Europe or that a major debt restructuring surprises markets in a way that causes global markets to freeze up, are that likely. I admit that there is some probability there, and it is an uncertain situation, but I still think the probability of outright meltdown is low.

The much more likely scenario is a long period of tumbling along and trying to create better policy responses than have been put together so far. Accordingly, a reasonable forecast would call for above-trend growth in the U.S. next year, noting the downside risk given the situation in Europe. But above-trend growth need not be rapid growth. The Tealbook has marked down the estimate of potential growth, but not nearly far enough, in my view, given the recent experience in the United States. I will call your attention, in particular, to the figure in the middle of page 22 in the Tealbook A, 'Potential and Actual Real GDP.' Because you don't have it in front of you, I will describe it for you. It has a potential growth line that goes through the peak of 2007:Q4 and extends the trend that existed at that time out into the indefinite future, and it has actual real GDP growth falling below that trend and remaining below that trend out to the end of the forecast period. I think that this is an unreasonable interpretation of the U.S. data. It is unreasonable to interpret the peak of the housing bubble as an economy just at potential, and that everything that has happened since then is a falling off from that level of output. In

particular, it was a housing bubble. Surely this means that there was some notion of an artificial element to the growth that occurred, especially in the 2006 to 2007 time frame.

Instead, we should interpret the peak of the housing bubble as well above trend growth and, therefore, mark down our estimates of potential growth going forward to more reasonable levels. This is what will happen over the coming years if growth remains as slow as it is projected to be around this table. Economists' estimates of potential growth will be slowly ratcheted down until they better conform with reality and move through the middle of the black line in this picture instead of always above the black line in this picture.

In the meantime, both unemployment and inflation during the last year have moved in ways that seem inconsistent with the notion of an output gap as large as suggested by the Tealbook estimates. As the Tealbook notes, while unemployment remains very high, it has come down more rapidly than expected in the past year. One benchmark for thinking about this is the behavior of unemployment following the most recent two recessions in the United States. I would not look at earlier recessions. Those occurred 30 or more years ago'too long to provide meaningful comparisons given the extensive changes in the labor market in the past three decades. What happened after the 1990'91 recession and the 2001 recession regarding unemployment? Both of these were viewed as jobless recoveries at the time and still are today. In both cases, essentially no progress at all was made on unemployment during the first two and a half years following the end of the recession. That is, the unemployment rate two and a half years after the end of the recession was essentially the same'within one-tenth of 1 percentage point'as the unemployment rate at the end of the recession.

We are currently two and a half years past the end of the 2008'09 recession. Unemployment has dropped almost a full percentage point despite what we perceive to be a very

large output gap. This should not be happening, according to conventional models, especially given the experience following the 1990'91 and 2001 recessions, which indicated major structural change in the labor market relative to the earlier era.

Inflation over the last year tells a similar story. Last year at this time inflation readings were low and appeared to be falling further. Market measures of expected inflation were also low and projected inflation to remain low. Our asset purchase program changed expectations and sent actual inflation higher. Both core and headline inflation today are running at higher rates year over year, closer to target or above our implicit inflation target in some cases. Again, this should not have happened according to conventional models based on a very large output gap.

I conclude that we should consider revising our estimates of potential growth downward more aggressively. The overly generous gap measures are distorting our view of the economy and what is most likely to happen going forward. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Evans.

MR. EVANS. Thank you, Mr. Chairman. There have been several notable developments since our last meeting, but they have not fundamentally changed the basic outlook. First, economic growth over the next few years still seems unlikely to be strong enough to make sufficient progress on reducing resource gaps. And, second, inflation seems most likely to run below 2 percent, what most of us would consider price stability. If monetary policy were as extraordinarily overaccommodative as some say, inflation and inflation expectations should be much, much higher, especially in the aftermath of the large relative price shocks earlier this year.

Let me repeat the familiar list of headwinds. Households are deleveraging. Median income has fallen 7 percent in the past 10 years, and on top of this decline, future income

prospects are poor. Overall net wealth has greatly diminished since the financial downturn. State and local governments have tightened their budgets dramatically, so that public-sector employment has fallen substantially. And, of course, the housing market continues to struggle with excess supply and the weight of the foreclosure crisis.

Put this all together and it is clear to me that the American consumer will not be the engine of growth for the U.S. economy, much less the global economy. In this context, some of the recent developments in labor markets have been a little surprising. I hope that the significant drop in the unemployment rate is a harbinger of further good news, but there are serious reasons to doubt that. Half of the decline in the unemployment rate last month was due to a drop in labor force participation to a level even further below its long-run trend. Consequently, overall labor market slack probably didn't fall by as much as a four-tenths drop in the unemployment rate would normally indicate. I can't argue with the Tealbook's assessment that the labor data are consistent with a lower potential GDP than we previously estimated. I wouldn't go nearly as far as President Bullard was just suggesting. But even after accounting for these adjustments, there still appears to be a massive output gap.

Next, consider the darkening economic clouds that are settling in over Europe. Twenty years after the Maastricht Treaty, Europe has apparently decided to address their imbalances crisis with Maastricht, version 2.0. Stronger and arguably more enforceable fiscal guidelines with penalties for recalcitrants will lead to greater austerity and a deeper recession in Europe. They have announced no fiscal transfers from the strong to the weak economies. In the United States, a variety of automatic fiscal stabilizers dampen the blows that individual states take during downturns. And there appears to be no credible mechanism to redress the trade imbalances that exist among the euro countries. Germany has a large trade surplus, and the

periphery countries have trade deficits. These trade imbalances are far more important, at least for Spain and Italy. Without some other adjustment mechanism, the only way for the deficit countries to improve their competitiveness is through wage cuts, which are not likely to happen without a significant recession. This was the same challenge countries faced while on the gold standard in the 1930s. Without better prospects for economic growth in Spain and Italy, this is unlikely to end well for Europe or the United States. After considering all of these issues and more, we see the U.S. output gap and the unemployment rate staying high through at least 2014, like the Tealbook does.

Meanwhile, price pressures continue to decline pretty much as most forecasts anticipated they would. The oil and commodity price increases that caused the jump in relative prices earlier this year have run their course, and in many cases are reversing, given the weaker outlook for global growth. In line with this, several of my contacts noted that their input costs were running below the forecast they had made earlier in the year. Contacts also had little concern with labor costs. While there are a few hot occupations'I often hear that certain kinds of engineers are in great demand'firms do not foresee big wage increases for the vast majority of their workers. We even hear scattered reports of nominal wage cuts, including for some in the public sector. This seems consistent with the recent average hourly earnings and ECI data, which have come in pretty soft lately. Given these developments and inflation expectations that remain at the bottom of their recent ranges, I expect inflation to come in below 2 percent over the forecast horizon.

When I put together our economic growth and inflation projections, I don't see much that has changed for me with regard to the big picture. And in fact, listening to some of the commentary and the questions about the Tealbook, I was reminded that the modal complaint about the FOMC forecast during this entire time has been that we were overly optimistic, and we

appear to be willing to repeat more of that, at least as I interpreted the questioning. I agree with President Williams's analysis that it seems that uncertainty is more due to demand than supply, although I had not reviewed that evidence. That was nice to see. I think we are still left with work to do on the policy front to improve growth prospects in the U.S. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you, President Evans. President Pianalto.

MS. PIANALTO. Thank you, Mr. Chairman. The economic data have continued to come in a little better than I was anticipating, but the environment for growth next year still looks very challenging with critical risks for both the international and domestic outlooks. Under the circumstances, I left the basic contour of my forecast for GDP growth unchanged, but I did lower my projections for output and inflation. That leaves me with an outlook fairly similar to the Tealbook. I have real GDP growth for 2012 at 2'' percent and growth for 2013 at 3 percent.

Like others, I was surprised by the large dip in the November unemployment rate. While some of this dip was driven by a decrease in labor force participation, some portion also reflected a meaningful gain in employment, as measured by the household survey. As David mentioned in his remarks, compared with the payroll survey, the household survey has been showing stronger employment gains for the past few months. We have seen many episodes in which the payroll and household estimates deviate from one another for a while, so I am not placing too much stock in the household survey just yet. What is more important is that even at the stronger pace of employment growth that is embodied in the household numbers, it would still take a long time to recover the jobs lost during the recession and even longer to get the employment level up high enough to absorb the expansion of population over the past few years.

A number of headwinds are still holding back the pace of recovery, as others have mentioned. And while I have commented on this issue before, and Presidents Lockhart and Williams have already noted, my business contacts do continue to emphasize that in the current environment uncertainty is importantly affecting their decisions. They suspect that a large decline in European economic growth would directly affect demand for some U.S. products. More worrisome, however, is their concern that a European crisis could shatter U.S. consumer and business confidence at a time when many people thought we had finally come safely off the bottom. In addition, uncertainty over health care reform, tax policy, and energy policy are causing businesses, especially hospitals and energy companies, to hold back on spending initiatives.

Small businesses are obviously feeling the effects as well. The Tealbook had a nice summary of small business hiring patterns, which suggests that tight financing conditions are hampering hiring at small businesses and new businesses. Our research at the Cleveland Fed clearly shows that declines in real estate valuations have made it more difficult for borrowers to meet collateral requirements. But in more recent work that is being done by my staff using the NFIB data, they found that increases in measures of economic policy uncertainty predict reductions in the expansion plans of small businesses, and we are currently in an environment of heightened policy uncertainty.

Turning to the inflation outlook, I have adjusted down my PCE inflation projections. I now expect both core and headline inflation to dip below 2 percent in the first half of next year. Behind these projections are softer incoming inflation data for a broad range of goods, commodity prices that are no longer trending higher, and ongoing restraints in labor compensation. The latest GDP release revised labor compensation sharply lower. It is now

evident that compensation growth has remained quite low in recent months, even while labor productivity growth has recovered. Such an environment, combined with competitive product markets, should keep inflation low. We may need to start paying attention to how much inflation slows. For now, inflation expectations appear to be stable and remain below 2 percent for more than a decade.

In summary, the economy is still making gradual progress, but it is fraught with fragility. Europe's crisis keeps extending further and further, both in terms of the calendar and the map of Europe. As Europe's problems continue, our own situation looks more worrisome. For that reason, I judge the risks to growth to be primarily to the downside, while the risks to inflation remain balanced. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. It's 10:30. I understand that coffee is ready, so why don't we take a 20-minute break? Thank you.

[Coffee break]

CHAIRMAN BERNANKE. Why don't we recommence? I will start with President

Fisher.

MR. FISHER. Thank you, Mr. Chairman. I want to make sure Mr. Rosengren can hear me because he was complaining earlier. I'm not sure he wants to hear me. [Laughter] Our District has been very fortunate this year. We had decent job creation: 242,000 private-sector jobs were created; after subtracting government, a total of 186,000 jobs were created. We grew at a 2 percent rate in 2011. Our regional indicator suggests that our economy has slowed moderately in the Eleventh District since our last meeting, mainly due to weakening in the government sector'in particular to school teachers where we've had a contraction'and in our manufacturing sector. About one-fourth of our manufactures go to exports. Weakening of

foreign demand and a strengthening of what we calculate as the 'Texas dollar,' which is the dollar weighted by whom we export to and import from, has had a net damping effect on exports.

I'm going to spend my comments time, Mr. Chairman, not signaling any direction in policy, but rather reporting what I'm hearing from my corporate contacts. Again, for what it's worth, I did a particularly deep dive this time with the broader group of CEOs, big and small, public and private, and I thought I would report on that to the Committee.

My CEO interlocutors report slightly improved final demand since our previous meeting in almost all sectors. The one exception would be home furnishing, which remains a laggard. Indeed, according to the major credit and debit card processors I visit with, ex auto and ex gas' we all know that auto, as reported earlier, has been fairly robust'sales paid by credit and debit cards were up 7.4 percent year over year in November. That's the highest year-over-year gain in five years. October was up 5.3 percent, September was up 7.1 percent. Ten of the 11 sectors that the credit card industry tracks performed positively in November, and my soundings with the CEOs of the truckers and the rails, the air carriers and express shippers'and this is not just in my District, this is nationwide'all reported improved volumes in the U.S. in November and during the intermeeting period.

That said, there is, as others have noted, some anxiety about the Christmas season and the future. Most consumer-oriented companies I talked to'including theme parks and entertainment, and broadcasters (the latter basing their projections on ad bookings)'believe that Christmas will be weaker than originally projected. Nevertheless, among retailers there is some anxiety about stocking. Confirming this, the largest express delivery company now reports a backlog in trans-Pacific shipments for inventory replenishment. The largest trucking firms remark that inventories are very lean and restocking is taking place.

As to pricing, consumers are staying, in the words of one of my interlocutors, 'very surgical.' They are value driven on most needed goods. They're resisting the price increases that branded products continue to push. I find one of the more interesting examples from one of the largest food distributors is that there has been a substitution of tuna for beef, given high beef prices, in order to provide protein, and it's a marked and measurable one. Many of my interlocutors now expect price rollbacks in 2012. On the agriculture price front, the large producers feel that the bubble was pricked in September, and given the yields expected from expanded crop planting relative to projected demands, expect the price relief of the past three months 'you can see it on every commodity chart'to continue well on into 2012. That fits with what Mr. Wilcox was telling us earlier in his briefing.

As to nonnecessities, electronics are the stuff of great consumer demand. Apple is reported to have accounted for 10 percent of the nation's sales volume for the four days surrounding Black Friday. The telephonic companies report consumer sales running 8 to

9 percent year over year relative to the previous holiday season. Wal-Mart sold 1'' million televisions in a 24-hour period on Black Friday. Electronics still seem to be leading the consumption sector.

Capital is widely available and attractively priced. Customers are paying on time. My contacts confirm that cash flow is at a record high both in absolute terms and as a percentage of GDP. It's 47.4 percent, if memory serves. That's a function of very strong profits and increasing depreciation, including the bonus depreciation that has helped so much.

My small, nonpublic contacts confirm what the NFIB data show'and incidentally, there are two good reports out by Dunkelberg this morning'which is that they're not worried about access to funding. Smaller businesses, while the big guys remain concerned about their cost of

doing business, are 'sickened' by the political process. I should add here in my most Jesse Jacksonian rhetoric, 'The bile applies to both sides of the aisle.' They're happy with neither side. They remain focused on achieving greater productivity. They're hiring selectively and sparsely, but with a slightly improving pace. They're hoarding cash, partly to hedge against possible tax, health care, and other cost increases, including pension funding. They're generally refraining, but not totally, from cap-ex that would ordinarily result from the high profits and cash flow numbers we're seeing, until the rules are clarified. In the meantime, they're still using their cash to buy back stock, enhance their dividend payouts, and improve their debt structures.

One surprising thing was that the homebuilders report that land prices in areas where housing is feasible across the United States, not just in the Eleventh Federal Reserve District, may be beginning to creep up, indicating a possible turn in the housing market, however faint.

Emphasis is on the possible, though some are looking to build again, and when I asked where the financing was coming from, the ready answer was from hedge funds and other nonbank sources.

The CEOs that I speak with that operate internationally report a slowing in Chinese growth, but not in Chinese operating costs, which are still running on the order of 15 to 20 percent when labor, other government-imposed costs, and renminbi factors are taken into account.

The credit card companies importantly, or at least interestingly to me, report a very marked slowdown in demand growth in Brazil and Mexico. As to Europe, the best comparison I got actually came from one of our staffers, Mark Wynne, who reminded us that the Catholic Church has a saint named Saint Willibrord who is the patron saint of convulsions, and there's actually a procession in western Luxembourg where they proceed every year, and they take two steps forward and one step back, and I think this is the pace at which we seem to be proceeding

with Europe. All of my contacts are concerned, but can't quantify the impact that Europe is likely to have, and they are reporting a compression in European sales. One suggestion'I'm sure it was tongue-in-cheek'is that Greece leave the EU and join the SEC football conference. That would increase their revenues [laughter] and help them balance their budget. Thank you, Mr. Chairman.

MR. PLOSSER. They couldn't afford a coach. [Laughter]

MR. FISHER. That's right, or to pay the college players what we pay them. One other thing, Mr. Chairman, that I would like to work in here, and we could talk about this at another time, but I remain deeply concerned that we could have a significant correction in stock markets. If you go back to the pre-Greenspan years, and you look at the 10 bubbles that later were burst, it typically takes 14 years to recover the old trend. Quickly looking at those 10 episodes, if that were to occur presently'and we have surely been of assistance, through your administration and through Chairman Greenspan's administration, in moving quickly enough to have an impact on equity markets'my personal calculations are that we could easily go back to 800 on the S&P. There are very few money managers who have lived through any one of those 10 periods, which means mistakes can be made, perhaps tripped off by an exogenous shock, which may occur from China while we're looking at Europe or may occur from Europe, whatever it may be. Again, I'm very concerned that we don't have overt, at least at this table, contingency plans for such a sharp reversal. If we had the S&P correct to 800, it would undermine enormously the achievements that we have made through our emergency programs, and if we were to observe the typical

14-year pattern to full recovery, then we would be presented with significant challenges. I don't think that tinkering with our communications policy is sufficient to prepare us for that possible

tail risk adverse scenario, and I'd like to have deeper conversations about that at another point. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President George.

MS. GEORGE. Thank you, Mr. Chairman. The Tenth District economy continues to expand at a moderate pace. Growth in manufacturing slowed in November, but is expected to move higher over the next six months. Drilling activity is responding to higher oil prices and farm incomes are strong. Real hourly wages in the District were below year-ago levels, and contacts expect only limited wage pressures in the months ahead.

Over the past few months, employment growth has picked up in the Tenth District with growth strongest in states with large exposures to energy production and agriculture. Employment growth is also returning to other areas, such as Kansas and New Mexico, where growth was minimal earlier this year. Strong farm incomes have bolstered farm investments and farmland sales in recent months. While farmers remain the primary purchasers of farmland, business contacts indicate that institutional investors have lowered their return expectations for farmland from 5 percent to 4 percent, which could foster more investor purchases in the future. With farmland values soaring and loan-to-value ratios holding steady, purchasers of farmland are taking on considerable debt.

In the national economy, recent data suggest economic conditions have improved as temporary factors weighing on growth have dissipated. The decline in inventory investment in the third quarter suggests businesses will need to ramp up production going forward. Conditions in the labor market have been improving over the past three months as the pace of growth in total hours has increased, and corporate profits are near record levels as a share of GDP, which should support investment spending.

Over the medium term, my views are largely unchanged from November. I expect the economy will continue to build momentum with growth gradually increasing to a pace that should produce further reductions in the unemployment rate. Factors supporting growth include pent-up consumer demand, business investment to expand production, and highly accommodative monetary policy. Several factors, however, pose headwinds and downside risk for economic activity over the next few years. The European debt crisis, reduced federal spending, and an impaired housing market will limit growth, with further worsening of the European crisis posing significant downside risk.

Inflation has been affected by a number of temporary factors that boosted inflation in the first half of this year and which are now pushing it lower. After these pressures unwind, I expect inflation will be somewhat below 2 percent in the near term, before rising toward 2 percent as the recovery strengthens. In summary, I expect the recovery to continue, with growth rebounding from the soft patch in the first half of this year. Risks to growth remain to the downside, while longer-term risks to inflation remain to the upside. Thank you.

CHAIRMAN BERNANKE. Thank you. President Kocherlakota.

MR. KOCHERLAKOTA. Thank you, Mr. Chairman. I want to spend my time talking about the appropriate metric for the maximum employment mandate. The draft consensus statement that we'll be discussing later seems imprecise on this point, aiming at employment in some places and unemployment in others, and I think our own internal dialogue shares that imprecision. In my remarks, I will suggest that the unemployment rate as opposed to the employment-to-population ratio is the better of the two metrics.

Let me give you some background about why this discussion matters. The unemployment rate peaked in October of 2009 at over 10 percent. It has fallen back to

8.6percent, and my forecast is that the unemployment rate will continue to fall to around 8.3 percent by the end of 2012 and to 7.8 percent by the end of 2013. But the recovery in the employment-to-population ratio has been, and I believe it will continue to be, considerably less dynamic. The employment-to-population ratio is right now 58'' percent, close to its July 2011 nadir of 58.1 percent and well below its December 2007 level of 62.7 percent. My forecast for the employment-to-population ratio is that it will remain around its current value through 2013. This discrepancy poses an important question for us in terms of determining the appropriate level of monetary policy accommodation: Does the employment-to-population ratio, EPOP, or the unemployment rate provide the more useful metric for tracking deviations in what we mean by maximum employment? To help shed some light on this question, I'm going to turn to some research that is specific to the Ninth District.

The Minnesota Department of Employment and Economic Development, DEED, conducts an unusual and valuable semiannual survey of firms. As an aside, if you want to look up DEED later in Google, you don't type in 'Department of Employment and Economic Development.' What you type in is 'positively minnesota,' their website. The Department of Employment and Economic Development in Minnesota is a very cheery group. The survey that they conduct is an unusual and invaluable semiannual survey of firms, and it asks a range of questions about the vacancies being posted by those firms. We acquired the underlying data from DEED earlier this year, and one of our economists, Sam Schulhofer-Wohl has spent a lot of this past year analyzing them.

Basically, they're surveying firms about the kind of vacancies they are posting. One main finding is that once one controls for occupation and establishment effects, wage offers have grown at around 2 percent per year since 2007, as well as over the preceding five years. The

recession seemed to have little impact on the wage offer being made. By contrast, the number and composition of vacancies did change greatly over the past four years. In terms of numbers, vacancies fell in half from the fourth quarter of 2007 to the fourth quarter of 2009, and as of the fourth quarter of 2011, the number of vacancies still remained somewhat below its pre-recession levels. The unemployment rate in Minnesota behaved somewhat similarly. It rose from 5 percent in 2007 to a peak of 8'' percent in mid-2009, and it has fallen back to 6.4 percent as of October of 2011. The composition of vacancies also responded to cyclical forces. During the recession, the composition of vacancies shifted toward lower-wage positions. However, even by late 2010, the composition of vacancies had returned to something similar to the 2007 mix between high- and low-wage positions.

All I've been talking about is since 2007. If you go back all the way to 2001, the data also offer some perspective on the impact of structural forces in the Minnesota labor market. From 2001 through 2007, the number of vacancies remained roughly constant, but the composition of vacancies steadily shifted toward higher-wage positions. In the face of these changes in the composition of labor demand, the Minnesota unemployment rate remained low. It was between 4 and 5 percent in 2007 and 2006. But Minnesota experienced a steady decline in EPOP, in its employment-to-population ratio, from 2000 through 2009.

I've thrown a lot of numbers at you. Let me summarize what I think we've learned from these Minnesota data. The recession generated a transitory decline in labor demand, which had little effect on wages. Instead the decline in labor demand generated an increase in the Minnesota unemployment rate that is only gradually unwinding. But the recession also took place against the backdrop of longer-term structural changes in the Minnesota labor market. Since 2001, firms have systematically been looking for more highly skilled workers. These

structural changes did not show up in the unemployment rate, but were associated with a steady decline in the employment-to-population ratio.

What are the takeaways for monetary policy? Obviously this is one data set from one state, but from that one data set from that one state, I would say you can take away the following lessons. The unemployment rate is highly responsive to cyclical labor market conditions, while it seems much less responsive to structural labor market changes. In contrast, the employment- to-population ratio seems to respond not only to cyclical conditions, but also to longer-term trends in the composition of labor demand that are clearly outside the scope of monetary policy. My conclusion is that monetary policy should respond to the unemployment rate and the outlook for the unemployment rate, and not to the employment-to-population ratio and its outlook. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. President Lacker.

MR. LACKER. Thank you very much, Mr. Chairman. Over the past couple of months, incoming data have been consistent with the gradual improvement in U.S. growth that we had expected for the second half of the year. At the same time, deteriorating conditions in Europe have damped the outlook for future growth in the U.S.

Recent reports from our Fifth District contacts are certainly consistent with gradually improving activity now. We have heard of several positive developments in manufacturing, for example. Two new tire plants have been announced for South Carolina, and the resolution of the NLRB complaint against Boeing has removed a cloud over a project that is expected to add significantly to employment in the Charleston region. Machine tool orders for the Southeast are said to be up substantially over the past year. A director from central Maryland reports gains in activities there. And the West Virginia energy sector continues to boom. Reports from retailers

in our District have improved quite noticeably in the past couple of months. At a gathering a week and a half ago, a number of retailers were quite positive about holiday season sales based on early results they had seen through the Thanksgiving weekend.

On the less positive side of the ledger, housing remains depressed pretty much throughout the District. Uncertainty about the magnitude and distribution of federal spending cuts continues to weigh on business and commercial real estate in the D.C. area. And we have heard that revenues at K Street lobbying firms are down significantly due to the end of earmarks, although one could argue this actually belongs on the positive side of the ledger.

On balance, I would say that our anecdotal reports line up pretty well with the national data that show a pickup in growth since the first half of the year. Overall, the tone of reports is noticeably less gloomy than in August, and for what it's worth, we have even heard a couple of references to green shoots. I have to explain to people, though, that that is likely to jinx the recovery. [Laughter] We shouldn't do that.

Inflation indicators from the Fifth District are somewhat mixed. Measures of current price trends from our surveys have generally ticked back up in the past two months, as have our wage trend measures. Expected price trends have come down in the past few months, but they are still at or above the levels we generally saw from 2006 to 2008.

At the national level, the Tealbook marks down 2012 growth by '' percent, essentially due to the deteriorating outlook in European growth. I have no reason to question the staff's revision; it seems sensible to me. Such a forecast certainly gives one pause regarding downside risk. This would not be the first time a contraction in one major trading area turned into a broader downturn in global growth.

Perhaps more noteworthy is the downward revision of '' percent to the Tealbook's projection for growth in 2013. I am not sure I fully understand the reasons behind the staff's revision, but 2'' percent for that year would not at all surprise me. Indeed, it seemed reasonably plausible back in the late spring, before the recent weakening in Europe. Growth at that rate would be consistent with the shift in our assessment that has taken place over the course of this year, toward the notion that there are more-persistent impediments to growth.

Another feature of the Tealbook projection is the imminent convergence of inflation to around 1'' percent. Granted, we have seen very low inflation readings for the past couple of months, and commodity and energy price trends appear to be quite favorable. But on a 12-month basis, we are still much closer to 3 percent than to 2 percent.

When we see several months of inflation above average, we are usually very careful to give balanced consideration to the hypothesis that it is a transitory bulge in inflation versus the hypothesis that it is a harbinger of a permanent acceleration. When we see below-average inflation we need to be equally balanced. The current slowdown in inflation could just be transitory, as was the acceleration we saw a year earlier. Thank you very much.

CHAIRMAN BERNANKE. Thank you. Vice Chairman.

VICE CHAIRMAN DUDLEY. Thank you, Mr. Chairman. I certainly agree with the consensus around the table that the near-term activity data show more forward momentum in the economy. For us, it looks like real GDP will grow around 3'' percent or a little bit more at an annualized rate in the fourth quarter.

However, I still would be quite cautious about the implications of this for growth in 2012 and beyond. Two things that I want to highlight. First, we still have not made much progress in terms of the housing sector. To the extent that households and lenders fear that home prices will

fall further, this fear affects both the demand for housing and the supply of housing credit, and this constrains activity and reinforces the downward pressures on housing prices. If this dynamic could be broken, it would be a very positive development, which would make me more confident in the outlook. If households and lenders had a more optimistic view about the trajectory of home prices, this would increase housing demand and the supply of credit, and that would stimulate residential investment. Moreover, if we actually could see rising home prices, that rise would support household confidence and wealth, and also provide support to consumer spending. I have been making the case publicly for a number of actions that could be taken to help support the housing market. The Administration's proposals to reinvigorate the HUD program are one element of that, but there is much more that should be done and could be done to support the housing sector, and I would encourage all of us to make those points, because that is something that the Congress and the Administration could actually make further progress on.

The second thing I want to talk about is Europe. I think the considerable risks of Europe are worth highlighting. The good news, of course, that Steve talked about was that the European authorities have continued to move in the direction that reinforces the commitment to fiscal discipline and should provide greater resources to backstop sovereign debt issuance as these countries take steps to get on a sustainable path and restore their credibility. Steve highlighted all the number of steps that have been taken in that respect. However, I still have much doubt whether this will be sufficient. First, it is unclear whether the backstop for private debt issuance by such countries as Spain and Italy is sufficiently strong to encourage private investors to roll over their maturing debts, let alone take on new debt. You simply may not be able to put the toothpaste back in the tube now that investors understand how risky their sovereign debt holdings are. It's not just a question of the risk of default; it is also how volatile the market is,

where Italian and Spanish bonds can move 2 to 3 points in a day up or down. Even if they now have much more of this debt than they want, how do you induce these investors to continue to roll over their holdings as they mature?

The second issue, of course, is the ECB's role. To the extent that the ECB does not provide a solid backstop, this also sends a negative signal. Either the ECB is implicitly voting thumbs down to what has now been negotiated, or the ECB is simply unwilling to provide such a backstop regardless of the credibility of the fiscal commitments. Either way, it is a negative. There is no credible backstop. What is needed is a sufficiently credible backstop that reduces the perceived risk of investment in sovereign debt, thereby encouraging private investors to roll over their debt. To the extent that there is a less solid backstop, this is actually likely to lead to exit by the private sector. And it is important to note that this has a perverse impact in that as the holdings by the ECB and IMF climb, private holders perceive themselves as being increasingly subordinated relative to the ECB and IMF, and that perception sets off a very bad dynamic. The more the ECB purchases, it actually makes the existing stock held by the private investor perceived as more risky.

Third, there are other risks that we can face down the road. First, the fiscal austerity will cause the economies to underperform, causing the countries to fall short of their budgetary targets. Second, the poor performance will lead to further credit rating downgrades that will undermine the efficacy of institutional structures like the EFSF. Or, the political process will ultimately not support round after round of fiscal austerity.

Europe has not committed to move to a fiscal compact in which fiscal resources are pooled and obligations are mutual. There is no proposal for a path to a euro bond. Instead, the so-called compact is simply an agreement to do what was not done before'keep each individual

country's fiscal house in order in the future. This agreement means that the core issue'the inherent shortcomings of a currency union with 17 independent sovereign countries without fiscal integration'has not been addressed. As I see it, European economic performance at best will be very poor and will restrain our exports. That's the upside. At worst, the European Union will come undone. In this case, obviously, the consequences for the U.S. and U.S. financial institutions will be very severe, even though the direct sovereign debt exposure of major U.S. financial institutions to Europe is pretty modest.

Up to now, the consequences of the crisis on U.S. economic activity appear to have been quite muted. Although European banks are actively deleveraging, there is little evidence that this is significantly constraining credit in the United States. And although U.S. bank shares have fallen and CDS spreads have risen as the crisis has intensified, funding for the major U.S. banks and their broker'dealer subsidiaries has held up surprisingly well to this point. The credit rating downgrades by S&P, which brought down the short-term ratings for a number of major U.S. bank holding companies to A2, has only had a very minor impact on these companies' funding or on their liquidity buffers, at least to date. But even here, I wouldn't take too much positive signal from this. Wholesale funding can be very fickle. The risk here is exacerbated by the fact that we do not have a good lender-of-last-resort regime in place to support the major broker' dealers of U.S. firms either here or with respect to their large U.K. operations.

Finally, a few comments about the swaps. I think lowering the swap rate was a good decision. We saw a significant pickup in usage for the 84-day auction. That sent two messages: one, that there actually was a real need for dollar funding by these European institutions; and, two, the fact that there was pretty broad participation should be effective in destigmatizing those auction facilities. That should make the swaps a more effective backstop. The negative of the

swap decision is that swaps have now gotten the attention of the Congress, and there are really two concerns about the swaps: one is the lack of transparency and who the ECB is actually lending to; and, two is the concern that somehow we are taking on a lot of risk.

We should defend the swap program as very much an appropriate lender-of-last-resort function of a central bank. We should explain to people what this swap program does in terms of mitigating the degree of deleveraging that the European banks have to undertake, and that by mitigating that deleveraging, there is really a positive consequence in terms of less strain on the supply of credit to households and businesses. We haven't really gotten our message out about why we did this, why it was effective, and why this swap program is in the U.S.'s interest. This program isn't just a freebie for the Europeans. Thank you.

CHAIRMAN BERNANKE. Thank you. Governor Yellen.

MS. YELLEN. Thank you, Mr. Chairman. I think it is worth recalling that this FOMC meeting marks the third anniversary of the Committee's historic decision to lower the federal funds rate to zero. In announcing that decision, our December 2008 meeting statement indicated that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate 'for some time.' That phrase, and its successor''an extended period''were generally interpreted as suggesting a likely duration of around three to six meetings. But here we are in December 2011, and not only is the funds rate still pinned at zero, but modal market expectations are that monetary policy will remain constrained by the zero lower bound for several more years. Moreover, professional forecasters, like most of us around the table, anticipate that the economy will not be back on its balanced growth path for quite a long time to come. Can there be much doubt that historians will look back on this period as the lost decade?

As we engage in our usual festivities this month, we might also keep in mind the devastating economic circumstances that continue to confront so many people around the country. For example, a record 46 million Americans can give thanks to the supplemental nutritional assistance program for the meals on their holiday tables this season. Indeed, the numbers of individuals receiving food stamps has risen month after month and is now more than 30 percent higher than in June 2009 when the NBER officially declared that the recession was over.

In sifting through the latest data, I was struck by the complex combination of recent developments. In particular, unexpectedly strong readings on consumer spending and vehicles sales were accompanied by a disappointingly large shortfall in income, and the surprisingly large decline in unemployment was coupled with only modest growth in output and payroll employment. In the end, I reached the same conclusion as the Tealbook'namely, that the incoming data confirm the fundamental picture of an economy that is recovering only gradually at best. In effect, under current policy settings, the U.S. economy continues to face an exceptionally prolonged period of unacceptably high unemployment and a duration of unemployment spells that is simply unprecedented. The longer this situation persists, the more likely it is that individuals who are unable to obtain work will be permanently scarred'a development that is not only tragic for them and their families, but will also lower the potential of our economy.

While there are certainly some upside risks to the Tealbook's outlook for a very slow recovery, it is evidently quite hard to identify any scenario under current monetary policy in which growth would be sufficiently robust to bring unemployment down to normal levels within the next several years. In fact, no such alternative simulation appeared in the Tealbook. Even in

the scenarios labeled 'Faster European Recovery' and 'Faster Snapback,' unemployment falls only to the vicinity of 7 percent at the end of 2014. Unfortunately, the drags afflicting aggregate demand from fiscal policy, housing, and a weakening global economy and stronger dollar are just too large to support robust growth.

In my view, the risks to growth continue to be weighted to the downside. Most notably, while the Europeans may have made some progress in cementing stronger long-run fiscal discipline, they have done little to address the deterioration in the European economic outlook or to resolve the uncertainties that have caused market participants to shed sovereign debt and lose confidence in European banking institutions. Barring further major policy initiatives, those uncertainties are likely to afflict the forecast for many months, if not years, to come. We can by no means rule out an intensification of spillovers to our own financial markets and a further appreciation of the dollar that could undermine the prospects of U.S. export growth. At the same time unemployment is forecast to fall far short of its maximum sustainable level and inflation now appears likely to drift substantially below the 2 percent level most of us consider consistent with the Fed's dual mandate. Incoming data clearly confirm that inflation has subsided. Moreover, in light of the considerable slack in the labor market, subdued trends in compensation and unit labor costs, and downward pressure on import prices, the Tealbook forecasts that inflation is likely to run at around 1'' to 1'' percent over the next several years. Fortunately, long-term inflation expectations remain stable. However, as with the balance of risks to the growth outlook, I also see the risk to inflation as weighted to the downside.

With inflation expected to remain below mandate-consistent rates, and unemployment expected to deviate very substantially from my estimate of its longer-run normal level, I consider

the case for providing additional accommodation to be very strong, as I will discuss in the policy round.

CHAIRMAN BERNANKE. Thank you. Governor Duke.

MS. DUKE. Thank you, Mr. Chairman. Now I think I finally understand what it must have been like to be a European central banker in 2008. No wonder they kept calling you and urging you to act. I would imagine that in those dark days, they were the ones having to consider the possible spillover from our financial crisis to their financial markets, the threat to their financial institutions, the reduction in global demand from the loss of our consumer spending. And now I see how frustrating it must have been not to be able to forecast how and when it might be resolved, much less to have a hand in resolving it, but to know that what we did would impact their economy more than what they did.

I confess to being somewhat surprised and disappointed to see the downgrade in the Tealbook baseline forecast, driven in large part by increasing pessimism over the situation in Europe, even while domestic data came in a bit stronger than expected. Given that my comments at the last meeting were the most optimistic, and maybe even the only optimistic view at the table, I went back to those observations to see if I wanted to back up on them a bit. But I don't. I do think that the balance sheets of households, businesses, and financial institutions continue to strengthen, and all of my conversations with bankers confirmed a continuation of the same banking conditions.

With the exception of residential mortgage lending, I don't think spending is being held back by debt burdens or credit availability. In fact, banks are actually seeing some increases in commercial lending, including commercial real estate. And even though European lenders are pulling back in business and commercial real estate lending, those holes are apparently being

filled seamlessly by other banks, mostly from the U.S. but some from Japan and Canada. Even in the mortgage banks, I believe there are things that can be done. New policies that are being introduced are gaining acceptance that can improve the last area of severe credit problems.

Indeed, stronger retail sales, a pickup in auto lending and auto sales, indicators of robust early holiday spending'including significant growth in credit and debit card transaction volumes'signs of improvement in employment data, and better readings on consumer confidence all lead me to believe that it is possible that some pent-up demand from consumers might finally be showing up just as catch-up business capital expenditures start to fade.

My outlook for 2012 and 2013 is for slightly better performance than the baseline in the Tealbook, closer to the 'Faster Snapback' or 'Faster European Recovery' scenarios. I do recognize the risk to this outlook from the situation in Europe. If that goes badly, my forecast doesn't matter. I understand that lower readings on personal disposable income and the saving rate do not support continued improvement in consumer spending.

The Congress could certainly fail to extend the payroll tax cuts, extended unemployment, the Medicare doc fix, spending bills, or gridlock again on something else critical that I can't even think of right now. I've assumed achingly slow but still measurable progress in the resolution of housing and mortgage foreclosure issues that may not materialize. The most daunting risk for me is that my assessment is noticeably brighter than that of all the trained economists and complex models we use. [Laughter] However, even in the most optimistic scenario, inflation barely touches 2 percent. So none of my optimism about the outlook makes me reluctant to take action that could firm the momentum that I see developing. In fact, I think it is important to support strengthening where we can find it, so that it can finally break through if we ever catch a break. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Tarullo.

MR. TARULLO. Thank you, Mr. Chairman. First, with President Bullard's permission and based on a conversation we had during the break, I want to clarify one comment that Jim made earlier about the divergence of the staff forecast from private forecasts. I heard Jim mistakenly'and maybe others did too'to be referring to forecasts for U.S. growth, but I think actually Jim was referring to forecasts for European growth where the staff is somewhat more pessimistic than private forecasters.

MR. BULLARD. Yes, and I apologize for not being clear enough on that.

MR. TARULLO. That is the case'I think Steve and others and I have taken a somewhat gloomier view than private forecasters, but what's important to note is that everybody has moved toward the gloomier side. I notice the Blue Chip forecast for each of the past couple of months has gone down, and their consensus is now in slightly negative territory as well. This just indicates that, as several of you have already pointed out, euro zone problems have gone from being a dark threatening cloud on the horizon to still being a dark threatening cloud on the horizon, but now almost certain to be a drag on U.S. growth in any reasonable baseline projection. An interesting question, of course, is whether in the absence of this impact from Europe, the U.S. recovery would continue to pick up pace. My own sense is that, just as has been the case a couple of times already in the post-crisis period, the marginally better-than- expected data over the intermeeting period would likely have proven to be just another short stretch of dry pavement before we hit the mud again, rather than the beginning of an open road.

I think the aggregate demand shortfall is still the story, with no particularly good reason to think that there's going to be much progress in creating the additional demand required to move the economy more quickly toward filling the output gap. I want to say a couple of things,

some of which I can dispense with because John summarized very well some of the reasons to expect that this is a short stretch of dry pavement rather than the beginning of a nice, wide, open road.

But more generally, it's useful to recall again the origins of the circumstances in which we find ourselves. It is a financially induced recession based on the bursting of asset bubbles with an enormous amount of wealth lost. Board staff has been doing a lot of work on housing policies and the housing market. One of the striking numbers that jumps out of the work they've been doing is that there's been $7 trillion in home equity lost since the peak of the housing market about five years ago. Seven trillion dollars is obviously disproportionately in the hands of consumers since most home equity is in the hands of the homeowners themselves. That has clearly affected their own calculus of their wealth and their ability to take on further debt, and indeed, their thinking about saving rates and spending in the future. That loss really has not in any way, shape, or form begun to get worked off yet. Even if we're dealing with retail debt, even if we're beginning to deal with the dysfunction of the housing market itself, there is that enormous loss of home equity, which is not going to be replaced under the most optimistic of scenarios for years to come.

Similarly, there's a lot of sunk capital, if I can put it that way, sitting basically fallow throughout the United States, whether it's in factories that are not being fully utilized or in shopping malls that are sitting half or fully vacant at this point. This is the nature of a recession following a period of overleverage and burst asset bubbles. There's not a propensity to invest, to increase supply, or to invest in more productive capacity until people are convinced, investors are convinced, producers are convinced that there's going to be more demand, and I really do think that continues to be the story.

In terms of the labor market and what it can tell us about whether there's an output gap or whether we're on a more recovery-oriented path, it's hard to use any past postwar recession as a model for comparison with what's going on now because none of those was a financially induced recession. Jim referred to the two more recent recessions, which were not only not financially induced, but also shallow. The two more severe recessions obviously were further ago, in the early '80s and the mid-'70s.

It's difficult to conclude very much from the comparative performance of the labor market post this recession compared with the earlier two shallow recessions for a couple of reasons. One, precisely because those recessions were shallow, there were not large numbers of layoffs. We saw a striking, almost frightening hemorrhage of jobs in late 2008 and early 2009, whereas in those earlier recessions, because they were shallower, the employment adjustment occurred more through attrition, which took time, and indeed continued into the recovery period. That is related to a second distinguishing factor, which was that those earlier recessions followed long periods of expansion during which it's reasonable to think that a fair number of productive inefficiencies got baked into the labor market, and thus it was easier for companies to increase production in the post-recession period without increasing employment. Here, like in the earlier severe recessions, we had a cascade of layoffs, and thus one would expect some rebound and some reduction of the unemployment rate'because the layoffs had been so dramatic'in order to increase production at all, and I think that's what we've seen. The jury is still out on exactly where we are with labor markets, but I don't think that comparison of this experience with any past recessions suggests that somehow we're performing better here.

This leads to my final observation, which is that the critical issue is whether, after five years in which we've averaged less than 1 percent growth per year and with many reasons to

believe we will at best slog along for some time to come, we're approaching the point at which future potential growth may be adversely affected by this continuing period of lower economic growth and outright recession.

In the labor market, which I've looked at more closely than any other part of the economy, I don't think we're there yet, but we're certainly much closer than we've probably ever come before in the United States, at least in the postwar period. I'll close with a slight gloss on Narayana's very interesting observations earlier about the better use of unemployment as a way of doing monetary policy. Narayana makes very good points, which would probably hold up when the data were generalized, though maybe not in quite the same magnitudes. The one thing I would say, Narayana, which I don't think you'd disagree with, is that particularly because there are some underlying structural problems in the economy, an extended period of high unemployment and subpar economic performance could increase those structural problems and thereby make the unemployment rate look somewhat better than it might actually look otherwise just because of people dropping out of the labor market. With that qualification, I agree with what Narayana said earlier. Thank you, Mr. Chairman.

CHAIRMAN BERNANKE. Thank you. Governor Raskin.

MS. RASKIN. Thank you, Mr. Chairman. Some of the news we've received over the past several weeks has been pretty good. Consumers are buying motor vehicles and other goods at a faster clip than we had expected, and consumer sentiment moved up off its recent lows. In addition, the unemployment rate dropped and new claims for unemployment insurance have been edging down. However, I'm not convinced that we've actually seen much sustainable improvement in these two areas, and that's what I'd like to focus on right now. I should also say that we've seen zero improvement in the housing market, but I won't discuss that today. A lot

has been said about Europe, and I won't add anything to that discussion even though the situation is critical to our country's growth prospects.

In the labor market, all indicators other than the unemployment rate are pointing to only modest, if any, improvement. Job gains have been disappointing. Unemployment insurance claims are only creeping lower, and hiring plans are pretty stagnant this year. Even the unemployment rate declines don't look that great. Of the '' percentage point decline in the unemployment rate over the past year, about '' percentage point of it may be due to people dropping out of the labor force when their unemployment benefits run out, and probably some others are dropping out due to discouragement.

The rest of the improvement is pretty paltry for a recovery. Two and a half years into the recovery, there are still 24 million underemployed people. I think the decline in the unemployment rate exaggerates the improvement in underlying conditions, and I wouldn't be surprised if the rate moves back up a bit in December. At the current pace of improvement, it will be years before the labor market can be described in positive terms, and by that time we might well have started to see a loss of skills and networks among the unemployed and underemployed, which could cause a long-run erosion of the economy's productive potential, an outcome that we should all want to avoid.

Turning to consumer spending, while I'd like to believe the surprisingly strong consumption recently is going to continue, it just doesn't seem sustainable given all the other information. Real disposable personal income declined in both the second and third quarters' not much recovery there. The latest data on services from the quarterly services survey were also pretty weak in the third quarter. Consumer sentiment is still below the levels from last spring. While it's encouraging that sentiment has moved up from the panicky levels of the late

summer, it still remains at levels we usually see in recessions, and frankly, if the extremely low numbers we saw in September were associated with households' concerns about policymaker paralysis, the current debate about the payroll tax cut and the failure of the supercommittee is not likely to help.

One piece of the sentiment data that seems especially downbeat is households' expectations of their own income expectations. These figures have not budged from their lows at the 2008 trough. If households don't think incomes are going to improve, it's hard to see why they would begin to spend in earnest. Moreover, many households are still adapting to the

$7 trillion decline in household wealth, particularly the sharp drop in real estate wealth that occurred over the past several years. Consumers probably are still trying to rebuild their nest eggs and replenish their retirement accounts, and that will likely continue to curtail their spending in the quarters ahead. With all of this pessimism weighing on households, I don't believe that the recent sharp drop in the saving rate, which now stands at 3'' percent, is really sustainable. Rather, I expect household spending to be pretty unimpressive going forward. I'll stop there.