FOMC Minutes

September 20, 2006

A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors

of the Federal Reserve System in Washington, D.C., on Tuesday, September 20, 2006 at 8:30 a.m.

Present:

Mr. Bernanke, Chairman

Mr. Geithner, Vice Chairman

Ms. Bies

Mr. Guynn

Mr. Kohn

Mr. Kroszner

Mr. Lacker

Mr. Mishkin

Ms. Pianalto

Mr. Warsh

Ms. Yellen

Ms. Cumming, Mr. Hoenig, Ms. Minehan, and Messrs. Moskow and Poole, Alternate

Members of the Federal Open Market Committee

Messrs. Fisher, Plosser, and Stern, Presidents of the Federal Reserve Banks of Dallas,

Philadelphia, and Minneapolis, respectively

Mr. Reinhart, Secretary and Economist

Ms. Danker, Deputy Secretary

Ms. Smith, Assistant Secretary

Mr. Skidmore, Assistant Secretary

Mr. Alvarez, General Counsel

Mr. Baxter, Deputy General Counsel

Ms. Johnson, Economist

Mr. Stockton, Economist

Messrs. Connors, Eisenbeis, Kamin, Madigan, Sniderman, Struckmeyer, Tracy,

Weinberg, and Wilcox, Associate Economists

Mr. Kos, Manager, System Open Market Account

Messrs. English and Slifman, Associate Directors, Divisions of Monetary Affairs and

Research and Statistics, respectively, Board of Governors

Mr. Reifschneider, Deputy Associate Director, Division of Research and Statistics,

Board of Governors

Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors

Mr. Gross, Special Assistant to the Board, Office of Board Members, Board of

Governors

Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors

Mr. Durham, Section Chief, Division of Monetary Affairs, Board of Governors

Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of

Governors

Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of

Governors

Mr. Lyon, First Vice President, Federal Reserve Bank of Minneapolis

Messrs. Fuhrer and Rosenblum, Executive Vice Presidents, Federal Reserve Banks of

Boston and Dallas, respectively

Mr. Evans, Ms. Mester, Messrs. Rasche, Rolnick, Rudebusch, and Sellon, Senior

Vice Presidents, Federal Reserve Banks of Chicago, Philadelphia, St. Louis,

Minneapolis, San Francisco, and Kansas City, respectively

Ms. Mosser, Vice President, Federal Reserve Bank of New York

The Manager of the System Open Market Account reported on recent developments in

foreign exchange markets. There were no open market operations in foreign currencies for

the System's account in the period since the previous meeting. The Manager also reported on

developments in domestic financial markets and on System open market transactions in

government securities and federal agency obligations during the period since the previous

meeting. By unanimous vote, the Committee ratified these transactions.

The information reviewed at the meeting suggested that economic activity continued to

decelerate in recent months. Consumer and business spending held up well, and payroll

employment continued to rise moderately in July and August. However, a contraction in

homebuilding was damping the economic expansion. Core consumer price inflation eased

somewhat but nonetheless remained higher than it was in 2005. Total consumer price

inflation moderated in August, reflecting a substantial slowing of the increase in energy

prices.

Nonfarm payrolls rose in August at a pace similar to that recorded over the previous four

months. Employment gains were widespread in the service sector, and the construction

industry also added jobs, particularly in nonresidential building. However, employment in

retail trade and manufacturing fell again in August. Average hours of production or

nonsupervisory workers edged lower. The unemployment rate ticked back down to 4.7

percent in August, but it remained within the narrow band that prevailed since the beginning

of the year.

Industrial production rose in July but edged down in August. Manufacturing output was

unchanged in August, as a small increase in the production of motor vehicles and parts was

offset by a slight net decline in other sectors. Output of construction supplies, for example,

dropped a little. In the high-technology sector, the production of computers rose tepidly

through the summer, while output of communications equipment turned down in August after

increasing markedly during the first half of the year. Semiconductor production remained

sluggish through August.

Consumer spending appeared to be rising at a moderate pace in recent months. Spending on

cars and light trucks increased somewhat in July after a lackluster pace in the second quarter

but apparently weakened in August. Consumer spending on goods excluding motor vehicles

increased modestly during the four months ending in July. Despite the sharp net increase in

energy prices, real disposable income rose further, with solid gains in June and July.

Increases in household wealth earlier in the year continued to boost consumer spending.

However, consumer borrowing costs had risen since the beginning of the year with the

increase in short-term interest rates. Recent readings on consumer sentiment were mixed. The

personal saving rate fell further in July.

Residential construction activity continued to contract in recent months. Single-family starts

fell further in July and August to a level well below the peak in the third quarter of 2005.

Construction in the multifamily sector also fell back. Sales of both new and existing singlefamily homes fell in July and were significantly below the peaks of last summer. A range of

indicators suggested that housing market activity was likely to slow further in the near term.

Pending home sales dropped noticeably in July, and mortgage rates had increased since the

beginning of the year. Available measures suggested that prices of existing homes increased

through the second quarter at a much lower rate than the one observed during the same

period last year.

After strong increases in the first half of 2006, real spending on equipment and software

remained robust into the summer against a backdrop of rising business output, plentiful

corporate cash reserves, positive sentiment among executives, and falling relative prices for

high-tech equipment. Orders and shipments of communications equipment leveled off in

recent months after climbing earlier this year. Real computer spending remained sluggish in

July. Business purchases of light vehicles picked up in August after a weak performance in

July, and sales of medium and heavy trucks remained brisk. Available data indicated that

aircraft purchases remained flat. Real spending on equipment outside the high-tech and

transportation sectors appeared to be increasing moderately in the current quarter.

Book-value data for the manufacturing and trade sectors suggested that inventory

accumulation slowed only modestly in July from a brisk pace in the second quarter. Outside

the motor vehicle sector, inventories appeared to be well aligned with demand, and surveys

indicated that firms continued to be generally comfortable with their level of inventories.

Both imports and exports increased in the second quarter, but imports increased and exports

decreased in July, widening the U.S. trade deficit. The growth of imports was heavily

concentrated in oil, reflecting higher petroleum prices, and in non-oil industrial supplies and

capital goods. Imports of services fell slightly. Exports of capital goods and industrial

supplies declined after considerable gains in June, but exports of telecommunications

equipment and automotive products were strong. Exports of services were unchanged in July.

Economic activity in the advanced foreign economies decelerated in the second quarter but

remained strong. A fall in net exports held back expansion in Japan and Canada, while strong

domestic demand boosted growth in the United Kingdom and the euro area. Incoming data

suggested that overall GDP growth in these countries for the current quarter was dropping a

bit from the second-quarter pace. Recent economic indicators from the emerging-market

economies generally pointed to robust, but moderating, growth.

The overall price index for personal consumption expenditures rose relatively steeply in July

and was estimated to have increased further in August, bringing the advance over the

twelve-month period above the year-earlier rise. After July, though, crude oil and gasoline

prices dropped back significantly, and with inventories of natural gas remaining near

seasonal highs, natural gas prices fell from their spike earlier this summer. Core consumer

prices increased at a somewhat more subdued pace over July and August, but despite the

recent moderation, the twelve-month change in core prices remained above the increase over

the comparable period twelve months earlier. The producer price index for core intermediate

materials rose significantly in July and August. Substantial upward revisions to wages and

salaries boosted compensation per hour in the first quarter. The increase likely owed in part

to the exercise of stock options and cash bonuses; other data that did not include such forms

of compensation pointed to more moderate increases. Hourly compensation rose further in

the second quarter and recorded an increase of about 7-3/4 percent from four quarters earlier.

After more favorable readings in June and July, survey measures of households' inflation

expectations turned back up in August, but preliminary September readings suggested a

decline.

At its August meeting, the Federal Open Market Committee (FOMC) decided to maintain its

target for the federal funds rate at 5-1/4 percent. The Committee's accompanying statement

indicated that economic growth had moderated from its quite strong pace earlier in the year,

partly reflecting a gradual cooling of the housing market and the lagged effects of increases

in interest rates and energy prices. Readings on core inflation had been elevated in recent

months, and the high levels of resource utilization and of the prices of energy and other

commodities had the potential to sustain inflation pressures. However, inflation pressures

seemed likely to moderate over time, reflecting contained inflation expectations and the

cumulative effects of monetary policy actions, as well as reduced impetus from higher energy

and materials costs. Nonetheless, the Committee judged that some inflation risks remained.

The extent and timing of any additional firming that may be needed to address these risks

would depend on the evolution of the outlook for both inflation and economic growth, as

implied by incoming information.

Investors had largely anticipated the FOMC's decision at its August meeting to maintain the

federal funds rate at its current level, and short-term rates dropped only a bit in response.

Subsequently, data on inflation that were weaker than expected, substantial declines in oil

prices, and the release of the minutes of the August FOMC meeting led investors to revise

down their expectations for the future path of the federal funds rate. Over the intermeeting

period, yields on short- and intermediate-term nominal Treasury securities fell, while yields

on inflation-indexed Treasury securities of comparable maturity increased somewhat,

pushing inflation compensation considerably lower at those horizons. Nominal forward rates

further out the yield curve fell about the same amount as real forward rates, implying little

change in far-forward inflation compensation. Spreads of yields on investment- and

speculative-grade corporate bonds over those on Treasury securities were about unchanged.

Major stock price indexes posted solid gains. The foreign exchange value of the dollar

against other major currencies was little changed, on net, over the intermeeting period.

Debt of the domestic nonfinancial sectors in the third quarter was estimated to be rising at

about the same pace as in second quarter. Business-sector debt was increasing briskly, as the

expansion of business loans remained robust. In the household sector, debt expanded in the

second quarter at a rate slightly below that in the first quarter, as mortgage debt decelerated

somewhat. M2 growth remained modest in August, consistent with moderating growth of

nominal income and lagged increases in opportunity cost.

The staff forecast prepared for this meeting indicated that real GDP growth would continue

to slow into the second half of 2006 before strengthening gradually thereafter. By 2008,

output was projected to be expanding at a pace about equal to the staff's forecast of potential

output growth. The staff, however, had again reduced its projection for potential GDP

growth, and the projected slow pace of growth over the next several quarters was thus

consistent with an opening of only a small gap in resource utilization. In the near term, the

cooling of the housing market and lower motor vehicle production were expected to hold

growth back. At the same time, though, significantly lower energy prices, sustained increases

in labor income, and favorable labor market conditions were anticipated to support expansion

through the end of the year. Further ahead, the lagged effects of the previous tightening of

monetary policy and waning stimulus from household wealth and fiscal policy were

anticipated to restrain growth, but the drag from the downturn in residential construction was

expected to abate. Core consumer price inflation was projected to drop back somewhat later

this year and next, reflecting the emergence of slack in the economy and lower energy costs.

In their discussion of the economic situation and outlook, meeting participants noted that the

pace of the expansion appeared to be continuing to moderate in the third quarter. In

particular, activity in the housing market seemed to be cooling considerably, which would

contribute to relatively subdued growth over the balance of the year. Growth was likely to

strengthen next year as the housing correction abated, with activity also encouraged by the

recent decline in energy prices and still-supportive financial conditions. In the view of many

participants, economic expansion would probably track close to the rate of growth of the

economy's potential next year and in 2008. Many participants also noted that core inflation

had been running at an undesirably high rate. Although most participants expected core

inflation to decline gradually, substantial uncertainty attended this outlook.

In their discussion of major sectors of the economy, meeting participants focused especially

on developments in the housing market. Although the situation varied somewhat across the

nation, housing activity was continuing to contract in most regions. Home sales had slowed

considerably, and anecdotal reports suggested that more buyers were canceling contracts for

purchases. Participants noted that inventories of unsold homes had climbed sharply in many

areas and that builders were taking a number of measures to reduce inventories. Both permits

for new construction and housing starts had declined significantly. Available measures of

home prices suggested that appreciation had slowed considerably but prices in most areas

were not falling, although some sellers were reported to be providing various inducements to

potential purchasers that reduced effective prices.

Thus far, the drop in housing market activity appeared not to have spilled over significantly

to other sectors of the economy. Indeed, consumer expenditures appeared to have been

expanding moderately over the previous few months, buoyed by increases in employment,

personal income, and household wealth. Contacts in some Districts reported that retail sales

had picked up a little most recently. Meeting participants noted that consumer spending going

forward would be supported by the higher levels of personal income indicated by recent

revisions to the national income and product accounts, by further gains in employment, and

by the decline in consumer energy prices over recent months. However, considerable

uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector

and the degree to which the slowing in housing activity and the deceleration in home prices

would affect consumption and other expenditures going forward.

Business investment spending generally was seen as expanding at a reasonably good pace.

Meeting participants noted broad strength in manufacturing of capital goods. Nonresidential

construction activity continued to strengthen, and in the process was absorbing some of the

resources that were no longer employed in homebuilding. Although some survey evidence

suggested that some firms were trimming capital spending plans, participants reported that

their business contacts generally were quite positive about the economic outlook and the

strength of demand for their products. In this environment, investment spending would likely

continue to be supported by expansion of overall output, strong balance sheets and profits,

and the ready availability of funding from financial markets and institutions.

Participants noted that the financial condition of federal and state governments continued to

improve. Inflows of tax revenues remained strong, consistent with expanding personal

incomes, sales, and business profits.

Economic activity abroad appeared to be slowing a little from the unusually rapid rate of the

first half of the year, but still expanding at a reasonably good pace overall. Foreign economic

growth was expected to continue, albeit perhaps at a somewhat slower pace than expected by

some outside forecasters, contributing to increases in U.S. exports.

Participants took note of the jump in labor compensation in the first half of the year, but

commented that the increase likely reflected in part the exercise of stock options.

Nonetheless, some participants viewed the recent increase in overall compensation as

pointing to upside risks to inflation. Participants reported steady gains in employment in

various regions, roughly in line with expansion of the labor force. Many business contacts

continued to experience shortages of labor and accelerating wages, particularly for certain

types of professionals and skilled workers and, in some areas, unskilled workers.

One participant highlighted that, in the staff forecast, labor force growth would begin to slow

over the next few years as more members of the baby-boom generation retired. Even if

resource utilization rates were unchanged, slower growth of the labor force would mean that

increases in employment would be significantly lower, on average, than those registered in

recent years. In that case, the slower growth of the labor force and employment implied that

the expansion of potential GDP could be somewhat lower than it had been earlier this decade.

Some participants commented, however, that they viewed potential output growth, as well as

expansion of actual output, as likely to remain solid over the next several years.

Many meeting participants emphasized that they continued to be quite concerned about the

outlook for inflation. Recent rates of core inflation, if they persisted, were seen as higher than

consistent with price stability, and participants underscored the importance of ensuring a

moderation in inflation. To be sure, very recent data on inflation suggested some

improvement from the situation in the late spring, partly reflecting slower increases in

owners' equivalent rent. Also, the considerably lower level of energy prices of recent weeks,

if sustained, would help reduce overall inflation and damp increases in core prices.

Moreover, businesses would meet more resistance to attempts to pass through cost increases

in the less robust economic circumstances that were likely to prevail at least for a time.

However, energy prices remained quite sensitive to a wide range of forces, including

geopolitical developments, and might well rebound. To date, the available evidence indicated

that inflation expectations remained contained--indeed, expectations of price increases for the

next few years had fallen some as energy prices declined. Nonetheless, several participants

worried that inflation expectations could rise and the Federal Reserve's willingness to carry

through on its intention to seek price stability could be called into question if cost and price

pressures mounted or even if there was no moderation in core inflation. Looking forward,

most participants thought that the most likely outcome was a reduction in inflation pressures,

but the anticipated decline was only gradual and the uncertainties around that forecast were

skewed toward higher rather than lower inflation rates.

In the Committee's discussion of monetary policy for the intermeeting period, nearly all

members favored keeping the target federal funds rate at 5-1/4 percent at this meeting.

Members generally expected economic activity to expand at a pace below the rate of growth

of potential output in the near term before strengthening some over time. Moreover, given the

uncertainties in forecasting, significantly more sluggish performance than anticipated could

not be entirely ruled out. Although the uncertainties were substantial, core inflation seemed

most likely to ebb gradually from its elevated level, in part owing to the waning effects of

past increases in energy prices. The anticipated expansion of economic activity at a pace

slightly below the rate of growth of the economy's potential would likely also play a role by

easing pressures on resources. Members noted that certain developments of late--appreciable

declines in energy prices, some softer indicators of economic activity, and slightly lower

readings on core inflation--pointed to a modestly better inflation outlook and hence made the

policy decision today somewhat less difficult than it was in August, when it was seen as a

particularly close call.

In view of the most recent information on the economy, members agreed that it was

appropriate for the post-meeting statement to characterize economic growth as apparently

continuing to moderate. However, in view of still-high energy and other commodity prices

and elevated rates of resource utilization as well as recent indications of a possible

acceleration in labor costs, members continued to see a substantial risk that inflation would

not decline as anticipated by the Committee. Consequently, the Committee agreed that the

statement should again cite such risks to inflation and explicitly reference the possibility of

additional policy firming.

At the conclusion of the discussion, the Committee voted to authorize and direct the Federal

Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the

System Account in accordance with the following domestic policy directive:

"The Federal Open Market Committee seeks monetary and financial conditions

that will foster price stability and promote sustainable growth in output. To

further its long-run objectives, the Committee in the immediate future seeks

conditions in reserve markets consistent with maintaining the federal funds rate

at an average of around 5-1/4 percent."

The vote encompassed approval of the text below for inclusion in the statement to be

released at 2:15 p.m.:

"Nonetheless, the Committee judges that some inflation risks remain. The extent

and timing of any additional firming that may be needed to address these risks

will depend on the evolution of the outlook for both inflation and economic

growth, as implied by incoming information."

Votes for this action: Messrs. Bernanke and Geithner, Ms. Bies, Messrs. Guynn, Kohn,

Kroszner, and Mishkin, Ms. Pianalto, Mr. Warsh, and Ms.Yellen.

Votes against this action: Mr. Lacker.

Mr. Lacker dissented because he believed that further tightening was needed to bring

inflation down more rapidly than would be the case if the policy rate were kept unchanged.

Recent data indicated that inflation remained above levels consistent with price stability.

Moreover, the upswing in compensation and unit labor costs in the first half of the year

indicated that inflation risks were tilted to the upside. Although real growth was likely to be

moderate in coming quarters, in his view it was unlikely to be slow enough to bring core

inflation down.

The meeting adjourned at 1:20 p.m.

Notation Vote

By notation vote completed on August 28, 2006, the Committee unanimously approved the

minutes of the FOMC meeting held on August 8, 2006.

Vincent R. Reinhart

Secretary

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Last update: October 11, 2006, 2:00 PM