Despite the positive readings on recent economic performance outside the housing sector, my forecast calls for below trend, slower GDP growth in the fourth quarter of 2007 and first half of next year. This forecast anticipates further weakness in housing in the near term and the likelihood that declines in housing wealth will contribute to a weakening of the pace of consumer spending.  

In addition to growth, I'm keeping a close watch on prices. Readings on inflation have improved this year, and I believe that inflation will most likely continue to moderate as measured by so-called core inflation indices. But there are some inflationary risks. In particular, recent increases in energy and commodity prices, among other factors, could put renewed upward pressure on headline inflationthe inflation you and I encounter in the marketplace.

The FOMC noted on October 31 that "economic growth was solid in the third quarter, and strains in financial markets have eased somewhat." However, the committee added "the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction." The committee believed its October 31 policy action, combined with its action taken in September, "should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time."

As discussed a moment ago, my view of the economy is consistent with the FOMC statement, and I supported last week's policy action. In part, my position was based on the notion of insurance against downside risks to the general economy given the unusually high level of uncertainty.

If I were to use one word to characterize our current economic circumstances, that word would be "uncertain." Much of this uncertainty relates to the potential depth, length, and impact of the housing downturn and potential flow-back to Main Street from the turbulence we have seen on Wall Street.

In my view, the most likely story line is one involving a moderate slowdown in economic activity over the coming quarters, with a return to growth near trend by late 2008 as the housing sector begins to recover. Underpinning this story is the view that our modern market economy has a keen ability to self-correct as opportunistic capital moves into depressed markets. Markets correct. And market solutions are preferable. This transition already is happening in the market for subprime mortgages. In this story, financial markets may endure some more weeks or months of volatility, but I believe they will find a restructured state of "normality," involving improved risk management practices, reduced leverage, and greater transparency.

An appropriate public policy posture is to be supportive of market solutions in the financial markets.

There are also important reasons to be concerned about the outlook for inflation.  Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased.  These changes most likely will put upward pressure on overall inflation in the short run.  Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods.  If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well. 

Looking ahead, two considerations suggest that conditions for subprime borrowers have the potential to get worse before they get better. First, all indications are that housing activity is continuing to weaken. Incoming data in recent weeks show that sales and new residential construction have declined further. In such an environment, house prices in the aggregate are likely to remain sluggish for some time. Second, the bulk of resets is yet to come: On average, in each quarter from now until the end of next year, monthly payments for more than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset. That number is up from roughly 200,000 per quarter during the first half of 2007. Delinquencies and foreclosures are therefore likely to continue to rise for a number of quarters.

The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time.

Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

In voting to ease policy, I carefully considered the effect of that decision

To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. Under one scenario, the effects on overall growth will be fairly isolated to declines in residential construction similar to our experience in 2006 and early 2007. However, there is a less benign possibility. Housing demand and prices could weaken a good deal more than we expect either because a new shock hits the sector or because we have underestimated the weakness already in train. A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth. I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against.

if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook. Indeed, not all of the risks to the economic outlook are on the downside.

[O]ur baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy. Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

With regard to inflation, we do not see any large movement one way or the other from current levels of core price inflation. Here the risks seem two-sided. With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers. However, weaker economic activity would tend to mitigate the potential for this. ... At present, my outlook is for core PCE inflation to be in the range of 1-1/2 to 2 percent in 2008-09. Relative to our outlook six months ago, this is a favorable development.

The strains in financial markets that were so evident and worrisome in mid-September appear to have lessened somewhat. During the past few weeks, as market participants have gained a better understanding of their financial positions and the positions of others, financial markets have become more stable. The Federal Open Market Committee meets again on October 30^th and 31^st, and we will once more assess developments and act as needed to foster price stability and maximum sustainable economic growth.

The recent problems in financial and credit markets reflect a pulling back from what I would call surrogate securitization, whereby investors were willing to buy debt that had been assigned high credit ratings by the credit rating agencies, regardless of the underlying assets used in the securitization. In other words, investors basically delegated due diligence to the rating agencies. Utilizing ratings to help evaluate the riskiness of securities is a normal part of the securitization process. But when new securities arise, investors may need to exercise more caution as rating agencies themselves learn about the appropriate risk to attach to the new instruments.

To better understand the subprime issue, the Federal Reserve Bank of Boston has been studying publicly-available information from the Registries of Deeds in New England states, which allows us to study the patterns of mortgages issued on a given house over time. ... A first finding is that recent foreclosures have been disproportionately related to multi-family dwellings... This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position. Second, the Banks research shows that the duration of a subprime mortgages is on average quite short for a sample of subprime mortgages used to purchase a home between 1999 and 2004, two-thirds have prepaid within two years and almost 90 percent have prepaid within three years. Prepayment will occur if the home is refinanced or if it is sold. While some of those sales may have been under difficult circumstances, it is plausible that many borrowers who purchased homes with subprime products did benefit from the appreciation of home prices in New England that occurred over the last decade.