Debt of the domestic nonfinancial sectors in the third quarter expanded at around its second-quarter 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: