FOMC Minutes

December 12, 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, December 12, 2006 at 8:30 a.m.

Present:

Mr. Bernanke, Chairman

Mr. Geithner, Vice Chairman

Ms. Bies

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

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, Weinberg,

and Wilcox, Associate Economists

Mr. Kos, Manager, System Open Market Account

Messrs. Clouse and English, Associate Directors, Division of Monetary Affairs,

Board of Governors

Ms. Liang and Mr. Slifman, Associate Directors, Division of Research and Statistics,

Board of Governors

Messrs. Gagnon and Wascher, Deputy Associate Directors, Divisions of International

Finance and Research and Statistics, respectively, Board of Governors

Mr. Dale, Senior Adviser, Division of Monetary Affairs, Board of Governors

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

Governors

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

Governors

Mr. Driscoll, Economist, Division of Monetary Affairs, Board of Governors

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

Governors

Mr. Rasdall, First Vice President, Federal Reserve Bank of Kansas City

Mr. Rosenblum, Executive Vice President, Federal Reserve Bank of Dallas

Mr. Hakkio, Mses. Mester and Perelmuter, and Messrs. Rasche, Rolnick, and

Williams, Senior Vice Presidents, Federal Reserve Banks of Kansas City,

Philadelphia, New York, St. Louis, Minneapolis, and San Francisco, respectively

Messrs. Kahn and Sullivan, Vice Presidents, Federal Reserve Banks of New York and

Chicago, respectively

Mr. Olivei, Senior Economist, Federal Reserve Bank of Boston

The Manager of the System Open Market Account (SOMA) 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 December meeting suggested that economic activity was

increasing at a subdued rate during the second half of the year. The contraction in

homebuilding was continuing to restrain overall activity, and a step-down in motor vehicle

output held down industrial production. In contrast, consumer spending and business

investment were increasing at a moderate rate, and payroll employment expanded solidly

through November. Additional sharp declines in energy prices reduced total consumer price

inflation in October, but the twelve-month change in core prices remained above its

year-earlier level.

Indicators from the labor market were generally strong through November. Nonfarm payrolls

increased at a solid pace, while revisions to previous estimates showed a larger gain, on

balance, over the preceding two months. Employment in manufacturing and construction

industries fell in November, but hiring continued to be brisk in the professional and

nonbusiness service industries. Aggregate weekly hours of private production or

nonsupervisory workers edged up. The unemployment rate had fallen to 4.4 percent in

October but ticked back up to 4.5 percent in November, remaining below the average of 4.7

percent during the first three quarters of the year.

Industrial production (IP) declined in September but rose slightly in October. In October,

total industrial production was boosted by a weather-related rebound in electricity generation,

while output in the mining sector posted a sizable gain as crude oil extraction in Alaska

returned to full production following pipeline repairs. Manufacturing output fell in both

months, partly because of cutbacks in motor vehicle production as vehicle makers pared

elevated inventories in light trucks. Although less pronounced than in the motor vehicle

sector, the recent softness in factory output was also apparent in a number of other sectors. A

notable exception was production in high-tech industries, which posted another solid increase

in October, reflecting a pickup in computer output and a rise in semiconductor production

attributable to the rollout of a new generation of microprocessors.

The National Income and Product Accounts for the third quarter incorporated an estimate by

the Bureau of Economic Analysis (BEA) that gross output of new motor vehicles increased at

a rapid pace in the third quarter, a sharp contrast to a drop in the IP index for motor vehicles

(including parts production) for that same period. Much of that difference could be attributed

to the BEA's method of inferring motor vehicle output from separate data on sales, net

international trade, and changes in inventories rather than measuring output directly using

data on production. In addition, a large drop in the producer price index for light trucks in the

third quarter resulted in a jump in the BEA's implied unit values of light trucks in inventory.

In the staff's view, these measurement issues likely caused an overstatement of the rate of

increase in real GDP in the third quarter, and the gradual unwinding of those effects would

probably lead to an understatement of real GDP growth over the next several quarters.

Real consumer spending increased strongly in October after a more modest gain in

September. Although purchases of motor vehicles weakened in October, outlays on a broad

range of other categories of goods, including gasoline, food, and apparel, rose briskly.

Spurred by sharp declines in consumer energy prices, real disposable income also increased

rapidly in September and October. Despite the further deceleration in house prices, the ratio

of household wealth to disposable income remained well above its historical average, buoyed

by robust gains in the stock market. Readings on consumer sentiment edged down in

November and early December but stayed above levels seen in the summer.

Residential construction activity continued to be very weak. Single-family housing starts

dropped substantially in October after a slight increase in September, while new permit

issuance fell to nearly its lowest level in the past ten years. Construction in the much-smaller

multifamily sector continued to fluctuate within a range that had prevailed for the past

several years. Inventories of unsold homes remained high in October but were a bit lower

than those in preceding months. Sales of new and existing homes showed tentative signs of

stabilizing, although at levels well below their mid-2005 peaks. Price appreciation of existing

homes continued to slow in the third quarter, and some price measures showed outright

declines.

Real spending on equipment and software continued to increase at a solid pace in the third

quarter, supported by strong corporate cash positions and a low cost of capital. Early

indicators for the fourth quarter, including survey measures of business conditions, suggested

a slowdown in spending, in part reflecting the deceleration in business output. Business

purchases of motor vehicles were likely to continue to be boosted by an increase in spending

in advance of the upcoming change in regulations on truck engines from the Environmental

Protection Agency. Although spending on high-tech capital goods and software expanded at

a robust pace in the third quarter, data on new orders and shipments in October pointed to

more moderate growth in the fourth quarter. Growth of nonresidential construction spending

appeared to have slowed from a rapid rate earlier in the year, responding in part to still-high

vacancy rates in the office and industrial categories. The number of natural gas and

petroleum drilling rigs in operation had moved down, on balance, since September in

response to the moderation in energy prices.

Unit stocks of light motor vehicles dropped in the third quarter. Outside the motor vehicle

sector, real nonfarm inventories edged up, and the ratio of book-value inventories to sales for

both the manufacturing and trade sectors rose in September to levels last seen in mid-2005.

Inventory imbalances appeared more widespread than a few months earlier, although

business surveys through November indicated that a large majority of firms perceived that

their customers' inventories remained at comfortable levels.

The U.S. international trade deficit declined in September from a record level in August. The

narrowing primarily reflected a sharp falloff in the value of imported oil, although non-oil

imports, including industrial supplies, capital goods, and automotive products, also declined.

Export growth in September was led by aircraft and industrial supplies, while exports of

automotive products, consumer goods, and semiconductors fell. The trade deficit shrank a bit

further in October.

Economic activity in the advanced foreign economies rose at a moderate rate in the third

quarter. The expansion in real activity in the euro area, although slower than the staff had

expected, was supported by strong domestic demand. Canada's real GDP growth was

dragged down by weakness in inventories and government spending, while slumping private

consumption weighed on growth in Japan. The U.K. economy, buoyed by strong investment,

continued to expand solidly. Recent economic indicators for the developing economies were

somewhat mixed but suggested generally brisk growth in the third quarter.

The overall price index for personal consumption expenditures fell in September and

October, reflecting sharp declines in energy prices in both months; the declines left the

change in that index over the twelve months ending in October substantially lower than over

the preceding twelve-month period. In contrast, the change in the core price index for

personal consumption expenditures over the twelve months ending in October was still

somewhat higher than it was a year earlier, largely reflecting an acceleration in shelter costs

over that period. The producer price index for core intermediate materials was flat in

October. Increases in average hourly earnings had been moderate in recent months, and

compensation per hour in the nonfarm business sector appeared to have risen at a subdued

rate in the third quarter. The estimated increase in hourly compensation for the second

quarter had been revised down substantially; hourly compensation was now estimated to

have declined in the second quarter following the sharp gain recorded in the first quarter.

This uneven pattern suggested that the surge in hourly compensation in the first quarter had

largely been driven by transitory factors. Hourly compensation of private industry workers,

as measured by the employment cost index, increased at a somewhat faster rate in the three

months ending in September than it had in preceding quarters.

At its October 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 slowed over the course of the year, partly reflecting a

cooling of the housing market. Going forward, the economy seemed likely to expand at a

moderate pace. Readings on core inflation had been elevated, and the high level of resource

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

seemed likely to moderate over time, reflecting reduced impetus from energy prices,

contained inflation expectations, and the cumulative effects of monetary policy actions and

other factors restraining aggregate demand. Nonetheless, the Committee judged that some

inflation risks remained. The extent and timing of any additional firming that might 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 October meeting to leave the

target federal funds rate unchanged and to make only modest changes in the accompanying

policy statement. As a result, the announcement of the decision elicited little market reaction,

as did the subsequent publication of the minutes of the meeting. However, somewhat weakerthan-anticipated economic data over the intermeeting period apparently led to some softening

of investors' perception of the economic outlook. As a result, the likely pace and extent of

policy easing expected by investors increased, and yields on nominal and inflation-indexed

Treasury coupon securities fell. Inflation compensation measures were little changed.

Spreads of investment-grade corporate bond yields over those of comparable-maturity

Treasury securities remained about unchanged, while those on speculative-grade corporate

bonds rose a bit. Broad equity indexes showed solid gains. The foreign exchange value of the

dollar against other major currencies fell, on net, over the intermeeting period, with

pronounced declines against the euro and sterling.

Debt of the domestic nonfinancial sectors in the third quarter expanded at around its secondquarter pace. Business debt rose slightly more slowly than in the second quarter, in part

reflecting reduced borrowing in the bond and commercial paper markets. In the household

sector, mortgage debt increased at its lowest pace since the late 1990s, reflecting the

continued deceleration in house prices. M2 rose more strongly in October and November

than it had in preceding months.

The staff forecast prepared for this meeting indicated that growth in economic activity had

slowed to a pace below that of the economy's long-run potential in the second half of 2006,

partly as a result of the ongoing adjustment of the housing sector. The rate of increase in real

GDP was expected to pick up gradually as the drag from the contraction in residential

construction diminished, returning towards the end of 2007 to a rate close to the staff's

estimate of potential output growth. Core inflation was anticipated to edge down in 2007 and

2008 in response to a waning of the effects of higher energy and import prices, a step-down

in rent increases, and the emergence of a small amount of slack in the economy.

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

their assessments of the medium-term prospects for economic growth and inflation were little

changed from the previous meeting. Incoming indicators of near-term activity had been

mixed, with some spending and production data pointing to a more subdued picture than that

suggested by the still-solid labor market data. Many participants judged that economic

activity in the second half of this year was probably a touch softer than had been expected at

the time of the October meeting. But looking over the next year or so, participants continued

to expect the economy to expand at a rate close to or a little below the economy's long-run

sustainable pace. The ongoing adjustment of the housing market was likely to damp

economic growth in the near term, but this effect was expected to dissipate, and spending in

other categories looked set to expand at a reasonably good pace. Although readings on core

inflation had improved modestly since the spring, price pressures were not yet viewed as

convincingly on a downward trend. Most participants expected core inflation to moderate

slowly over time, but stressed that the risks to the inflation outlook remained to the upside.

In their discussion of the major sectors of the economy, participants noted that developments

in the housing market continued to weigh heavily on economic activity. Housing starts and

permits for new construction had dropped sharply in October, and contacts in the building

sector reported that construction firms were continuing to cancel options on land purchases.

However, there were some indications that home sales might be starting to stabilize, aided by

a marked slowing in the rate of increase of house prices and a decline in mortgage rates in

recent months. Several participants also noted that a range of non-price incentives and

concessions were being offered by construction firms to bolster sales. But even if home

purchases had begun to level off, residential investment was likely to fall further in coming

quarters as homebuilders sought to reduce their backlogs of unsold homes.

Thus far, the adjustment of activity and prices in the housing market did not appear to have

spilled over significantly to consumer spending, which had expanded at a steady pace in

recent months, buoyed by continued gains in employment and by a decline in energy prices.

Retailers in most Districts expected good sales over the holiday season, although some

contacts at package delivery and trucking firms reported that activity was less busy than

usual for this time of year. Participants noted the downward revision to the BEA's estimate of

personal income in the second quarter of this year, but nonetheless continued to anticipate

consumer expenditures to expand at a steady pace going forward. Growth in consumer

spending was expected to be supported by favorable financial conditions and solid gains in

income from employment, outweighing any damping effect of sluggish increases in housing

wealth. Still, considerable uncertainty regarding the ultimate extent of the housing market

correction meant that spillovers to consumption could become more evident, especially if

house prices were to decline significantly.

Business investment appeared to have decelerated recently, and surveys and orders data

pointed to a relatively slow rise in equipment and software spending over the next few

quarters. Incoming data on construction activity and employment also suggested that,

following very rapid growth earlier in the year, increases in nonresidential construction

spending could be moderating considerably. However, the weaker cast of some of these data

contrasted with the sense of optimism among business contacts. Moreover, several

participants noted that contacts within the construction sector had reported that commercial

real estate activity remained robust, encouraged by lower vacancy rates, some firming in

rents, and accommodative financial conditions. Looking further ahead, meeting participants

expected investment to expand at a solid pace, supported by strong corporate balance sheets

and profits and by the ready availability of funding from financial markets and institutions,

factors that were expected to be offset only partially by restraint from slower growth in final

sales.

Recent data suggested that aggregate demand in the rest of the world was likely to continue

to expand at a somewhat faster rate than in the United States. Participants noted that the

strength of global demand and the recent decline in the foreign exchange value of the dollar

should help to support increases in U.S. exports.

The slowing in the pace of economic expansion in recent quarters evidenced by the business

spending data was also apparent in measures of industrial production. Much of the slowing in

production had been concentrated in the motor vehicle sector--as producers had cut

assemblies in order to reduce high inventory levels--and in construction-related sectors. But,

more recently, inventories had increased in a number of other sectors, and manufacturing

production had been trimmed in response. Further adjustments remained possible, suggesting

an additional source of downside risk to economic growth in the near term. In contrast,

indicators of activity in the services sector implied continued brisk growth.

Participants noted that recent indicators provided mixed signals about the strength of

near-term activity. Solid gains in employment over recent quarters stood in contrast to the

softer pace of economic expansion suggested by the spending and production data. That

difference most likely reflected lags between movements in activity and employment,

implying that growth in employment would probably slow over the next quarter or so.

Participants suggested that other forces might be at work as well. The growth of structural

labor productivity could be weaker than currently thought, helping to reconcile the steady

growth in employment with more subdued advances in spending and output. Moreover, the

recent pace of activity may have been stronger than that indicated by the spending and

production data. With regard to this possibility, it was noted that gross domestic income had

grown substantially more quickly than measured GDP over the past year.

Incoming data and reports from businesses suggested that the labor market remained tight.

The unemployment rate had moved slightly lower on balance over recent months, and many

business contacts reported difficulties in recruiting suitably qualified workers, especially for

certain types of professional and skilled positions. The downward revision to the estimated

increases in labor compensation and unit labor costs earlier in the year had eased some

participants' concerns about the extent of the pressures on labor resources. Nonetheless, the

possibility that the tightness of the labor market could lead to sustained upward pressure on

nominal labor costs was viewed as an upside risk to the expected moderation in inflation.

All meeting participants remained concerned about the outlook for inflation. Although

readings on core inflation had improved modestly since the spring, nearly all participants

viewed core inflation as uncomfortably high and stressed the importance of further

moderation. Participants expected core inflation to edge lower over time, in part as the

pass-through of higher prices for energy and other commodities ran its course and as the

moderate growth in aggregate demand likely led to a modest easing of pressures on

resources. Some participants also highlighted the impact that movements in the prices of

individual components of the price index, such as owners' equivalent rent and medical costs,

could have on near-term readings on core inflation. More generally, participants stressed

there was considerable uncertainty as to the probable pace and extent of the moderation in

core inflation and that the risks around this desired downward path remained to the upside.

Moreover, participants expressed concern that a failure of inflation to moderate as expected

could entail significant costs if an upward drift in inflation expectations ensued.

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. The

outlook for economic growth and inflation was thought to have changed relatively little since

the previous meeting. Nearly all members felt that maintaining the current target for now was

most likely to foster moderate economic growth and a gradual ebbing of core inflation from

its elevated levels. Several members judged that the subdued tone of some incoming

indicators meant that the downside risks to economic growth in the near term had increased a

little and become a bit more broadly based than previously thought. Nonetheless, all

members agreed that the risk that inflation would fail to moderate as desired remained the

predominant concern.

In light of the data received over the intermeeting period, members felt that the statement

should characterize the cooling in the housing market as substantial and should note that

recent indicators had been mixed. The Committee thought that the statement should reiterate

that the economy seemed likely to expand at a moderate pace, while also recognizing the

possibility that measured GDP growth could be somewhat uneven in coming quarters.

Members agreed that the statement should continue to convey that inflation risks remained of

greatest concern and that additional policy firming was possible. One member did not favor

language that referenced only the possibility of additional policy firming and believed that,

although the risks to inflation remained the predominant concern, the statement should

emphasize that policy could be adjusted in either direction depending on the evolution of the

outlook for inflation and economic growth.

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. Kohn, Kroszner,

and Mishkin, Ms. Pianalto, Messrs. Poole and Warsh, and Ms. Yellen.

Votes against this action:Mr. Lacker

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

that core inflation declines to an acceptable rate in coming quarters.

Meeting participants briefly reviewed some issues regarding communications and the next

steps in their continuing discussion of the topic. At the next FOMC meeting, confirmed for

January 30-31, 2007, the Committee intended to consider the role that economic projections

and forecasts can play in communicating information.

The meeting adjourned at 1:35 p.m.

Notation Vote

By notation vote completed on November 14, 2006, the Committee unanimously approved

the minutes of the FOMC meeting held on October 24-25, 2006.

Vincent R. Reinhart

Secretary

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