(from an interoffice email)

Karim:
Quite a long one http://www.frbsf.org/news/speeches/2007/1203.html, but here goes, with selected excerpts, headings my own.

If you don’t want to read the rest, one word describes it, DOVISH…if she was voting next week, she’d vote for 50bps.

Warren:
Agreed. Though the heightened inflation risks at the end do add some balance. This is far different from the Bernanke and Kohn speeches, and seems this is what they would have said if they held the same opinion.

Conditions are worse from 10/31/07
When the shock first hit, I expected the reverberations to subside gradually, especially in view of the easing in the stance of policy, so that by now there would have been a noticeable improvement in financial conditions. Indeed, though the reverberations have ebbed at times over the last four and a half months, since the October meeting market conditions have deteriorated again, and indications of heightened risk-aversion continue to abound both here and abroad.Mortgages in particularAlthough borrowing rates for low-risk conforming mortgages have decreased, other mortgage rates have risen, even for some borrowers with high credit ratings. In particular, fixed rates on jumbo mortgages are up on net since mid-July. Subprime mortgages remain difficult to get at any rate.Moreover, many markets for securitized assets, especially private-label mortgage-backed securities, continue to experience outright illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all. This illiquidity remains an enormous problem not only for companies that specialize in originating mortgages and then bundling them to sell as securities, but also for financial institutions holding such securities and for sponsors, including banks, of structured investment vehicles—these are entities that relied heavily on asset-backed commercial paper to fund portfolios of securitized assets.

To assess how financial conditions relevant to aggregate demand have changed since the shock first hit, we must consider not only credit markets but also the markets for equity and foreign exchange. These markets have hardly been immune to recent financial turbulence. Broad equity indices have been very volatile, and, on the whole, they have declined noticeably since mid-July, representing a restraint on spending.

Econ Outlook weaker than expected for longer; She’s not mincing words in this section

The fourth quarter is sizing up to show only very meager growth. The current weakness probably reflects some payback for the strength earlier this year—in other words, just some quarter-to-quarter volatility due to business inventories and exports. But it may also reflect some impact of the financial turmoil on economic activity. If so, a more prolonged period of sluggishness in demand seems more likely.

First, the on-going strains in mortgage finance markets seem to have intensified an already steep downturn in housing.

This weakness in house construction and prices is one of the factors that has led me to include a “rough patch” in my forecast for some time. More recently, however, the prospects for housing have actually worsened somewhat, as financial strains have intensified and housing demand appears to have fallen further.

Moreover, we face a risk that the problems in the housing market could spill over to personal consumption expenditures in a bigger way than has thus far been evident in the data. This is a significant risk since personal consumption accounts for about 70 percent of real GDP. These spillovers could occur through several channels. For example, with house prices falling, homeowners’ total wealth declines, and that could lead to a pullback in spending. At the same time, the fall in house prices may constrain consumer spending by changing the value of mortgage equity; less equity, for example, reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing. Furthermore, in the new environment of higher rates and tighter terms on mortgages, we may see other negative impacts on consumer spending. The reduced availability of high loan-to-value ratio and piggyback loans may drive some would-be homeowners to pull back on consumption in order to save for a sizable down payment. In addition, credit-constrained consumers with adjustable-rate mortgages seem likely to curtail spending, as interest rates reset at higher levels and they find themselves with less disposable income.

Moreover, there are significant downside risks to this projection. Recent data on personal consumption expenditures and retail sales are not that encouraging. They have begun to show a significant deceleration—more than was expected—and consumer confidence has plummeted. Reinforcing these concerns, I have begun to hear a pattern of negative comments and stories from my business contacts, including members of our Head Office and Branch Boards of Directors. It is far too early to tell if we are in for a sustained period of sluggish growth in consumption spending, but recent developments do raise this possibility as a serious risk to the forecast.

Net Exports to weaken along with decoupling

I anticipate ongoing strength in net exports, but perhaps somewhat less than in recent years, since foreign activity may be somewhat weaker going forward. Some countries are experiencing direct negative impacts from the ongoing turmoil in financial markets. Others are likely to suffer indirect impacts from any slowdown in the U.S. For example, most Asian economies are now enjoying exceptionally buoyant conditions. But the U.S. and Asian economies are not decoupled, and a slowdown here is likely to produce ripple effects lowering growth there through trade linkages.

Now for the bright side-

I don’t want to give the impression that all of the available recent data have been weak or overemphasize the downside risks. There are some significant areas of strength. In particular, labor markets have been fairly robust in recent months. As I mentioned before, the growth of jobs is an important element in generating the expansion of personal income needed to support consumption spending, which is a key factor for the overall health of the economy. In addition, business investment in equipment and software also has been fairly strong, although here too, recent data suggest some deceleration. Despite the hike in borrowing costs for higher-risk corporate borrowers and the illiquidity in markets for collateralized loan obligations, it appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil.

If we cut aggressively, we might grow at trend

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms.

Core PCE likely to slow further but still some upside risks

Turning to inflation, signs of improvement in underlying inflationary pressures are evident in recent data. Over the past twelve months, the price index for the measure of consumer inflation on which the FOMC bases its forecasts—personal consumption expenditures excluding food and energy, or the core PCE price index—has increased by 1.9 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent.

It seems most likely that core PCE price inflation will edge down to around 1¾ percent over the next few years under appropriate policy and the gap between total and core PCE inflation will diminish substantially. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. This view is predicated on continued well-anchored inflation expectations. It also assumes the emergence of a slight amount of slack in the labor market, as well as the ebbing of the upward effects of movements in energy and commodity prices. However, we do still face some inflation risks, mainly due to faster increases in unit labor costs, the depreciation of the dollar, and the continuing upside surprises in energy prices. Moreover, labor markets have continued to surprise on the strong side. All of these factors will need to be watched carefully going forward.

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