Regional President Speech

Remarks by Cathy E. Minehan to Hong Kong Institute of Bankers October 24, 1995 Remarks by Cathy E. Minehan to the Hong Kong Institute of Bankers October 24, 1995 Good Afternoon. I'd like to thank Andrew Sheng for inviting me to speak before you today. This is my first visit to Hong Kong but I feel right at home. The harbor surrounds us, as it does in Boston, and I'm speaking to a luncheon meeting of bankers, a normal task for me to say the least. Usually I encourage questions at the end of my presentations, largely because from the tenor of the comments I get feedback on how the audience believes their businesses, and the New England economy are faring. I hope you will be as forthcoming as they usually are after I finish as I look forward to learning as much from you as you might from my comments. I want to touch on two related areas this afternoon. First, I'd like to share some perspectives on the U.S. economy and monetary policy, both where we've been and the near-term prospects as I see them. Second, I want to focus on some broad trends that link us globally and the issues that concern me as a central banker as I ponder these trends. For two or three months now I've been characterizing the U.S. economy in terms of the old children's story of Goldilocks: it's not too hot, it's not too cold, it's just about right. To understand this perspective, let me take you back to the end of 1993 when the long period of monetary accommodation after the 1991-92 recession began to come to an end. At that point, interest rates were at or near 30-year lows. Consumers were spending increasing amounts on new houses, 2 consumer durables to fill those houses, and new cars for those new two-car garages. Businesses were investing in high technology and other capital items in record amounts, while the growth of our trading partners began to pick up. Real GDP in fourth quarter 1993 grew at a 6.3 percent pace, unemployment was slowly declining and U.S. financial markets, especially bond markets, were caught up in the belief that interest rates could only go one direction--down. With 20/20 hindsight, it's clear that markets had gotten a bit ahead of themselves. More importantly, it became clear that the economy was close to full employment and that growth was too strong to avoid increases in the rate of change in inflation. Monetary policy during 1993 had focused on countering the headwinds that slowed growth in the recovery; by the end of the year, however, the need to change policy to resist the force of new tail winds driving the economy forward began to be clear. The first step toward tighter policy was small, but it was enough to shock the markets into instant retreat. At the long end of the yield curve, bond rates jumped about 200 basis points over the spring months reflecting the changed emphasis of monetary policy and market moves away from bonds. Over the year, and into 1995, the Fed tightened policy a total of seven times seeking to move the stance of policy away from its stimulative position in response to the growing worry of incipient inflation. As first quarter came to a close, I think it became clear the economy was slowing down, partly in response to monetary policy; 3 growth in first quarter was at a rate about half that of the ,, fourth quarter of 1994, and it slowed even further in the second quarter. In recognition of this, policy eased slightly amidst fears the long-awaited slowdown would lead into a recession. It didn't. Over the course of the summer sources of growth gradually appeared. The consumer continued to be a stable, if not spectacular, source of growth; the overhang of accumulated inventories that had slowed second quarter diminished; housing began a rebound, and, last but certainly not least, business investment especially in technology continued at a slower, but still double digit pace. Inflation as measured by the consumer price index remained well-behaved, with slow growth in wages and a continuing reduction in benefit costs, caused in large part, by market forces within the health care field. We don't have third quarter GDP data as yet, but our expectation is that it will be 2 percent or slightly better; unemployment has remained low at 5.6 percent and with year- over year inflation growth at less than three percent, we have, I think, a practical definition of that form of U.S. economic nirvana known as the "soft landing.'' Or, in other words, an economy that is "just about right." Looking beyond the immediate present, we at the Boston Fed agree with most analysts of the U.S. economic scene. We believe the third and fourth quarters will be stronger than the second; that 1995 as a whole will have real GDP growth about at 4 potential, or perhaps a tad slower; that unemployment will remain low, below 6 percent, and that inflation will continue to be restrained at 3 percent, give or take a tenth. Again, an economy "just about right" over the near-term. How to keep the economy on this course occupies no small amount of my time and that of my colleagues on the U.S. Federal Open Market Committee. At this point, I am watching each week's incoming data with great interest. And I'm also quite sensitive to the fact that we remain at or near full employment. At this point, surges in economic growth could be very costly in terms of the forward progress we've made toward achieving a reasonable definition of price stability. I for one would choose to defend that hard-won territory fairly vigorously. For a central bank, and indeed, for a government economic policy in general, this kind of economic present and future can only be viewed as positive. And such a view is not confined to the U.S. alone. As I look around the world, certainly there are pockets of problems--some of them severe--but, in general, the macroeconomic trends are reasonable. Decent rates of real growth, clear progress against inflation, a recognition of, and a commitment to solve, the twin problems of domestic budget and foreign trade deficits. All these areas of progress augur well, and reflect, to a greater or lesser degree, not just cyclical upturn, but more importantly, sustained patterns of solid economic progress in the face of series of worldwide trends. Let 5 me turn now to describe at least a few of these as a way of introducing my own central bank worries. While there are undoubtedly several major trends underway, let me address only three: the growth and pervasiveness of technology, the global integration of markets, and consolidation within the financial services industry, broadly defined. As we all are aware, not a day, week, month, or year goes by that we are not constantly confronted with the fact that technology is not only an increasingly vital input to everything we do, but also increasing massively in power while decreasing markedly in cost. What was simply not possible to do 10 years ago, now can be done in minutes, if not seconds, adding sizeably to productivity at the individual and firm level. Technology, in particular telecommunications, links us together in ways unimaginable even 5 years ago, and creates the necessary foundation for the global integration of markets. Moreover, technology has broadened the range of available modern financial instruments--derivatives as an example--that can help the financial services industry to minimize and redistribute sources of risk. And last, but certainly not least, technology has allowed the expansion and proliferation of payment clearance and settlement systems that provide the needed assurance of liquidity and financial stability to global markets. Not long ago, U.S. pension and mutual funds largely invested in domestic securities. Today, a growing fraction of the money handled by these funds is invested abroad, a change made 6 attractive by differential rates of return but made possible by technology. Information on foreign investments is readily available with on-line news services; trading in worldwide markets can be accomplished around the clock, and worldwide both securities and funds settlement increasingly take place electronically and in rapidly growing volumes and values. What this has meant is that businesses and economies not only must compete for customers and funding locally, but must also stand up to foreign competition that can, with increasing ease, supply products formerly made only locally and attract previously secure sources of investment. Global integration has also, I think, brought home with a vengeance the need for all countries to shape policies in ways that are credible to foreign investors. This has meant attention to achieving long-run economic goals of low inflation and high rates of savings, and in most countries this has meant attention to deficit reduction. In this regard, it's interesting, if not ironic, to note that the emerging market countries seem to have a better handle on deficit control than do many of the G-7. Finally, the realities of ever-changing technology and global integration have spawned the need for increasing consolidation in the financial services industry. No longer can any one type of financial services provider lay sole claim to a product--technology has created commodity-like products and services with low profit margins. Global integration has increased competition. This combination has driven home the 7 reality of the need for efficiency. Hence, the drive to larger and larger entities, in which the baseline costs of both technology and global reach can be spread over a large volume base. With their global base, these institutions seek to diversify geographic risk and deal profitably with global businesses needing support in many markets. Now all three of these trends--technology, global integration, and financial consolidation--hold great promise for increasing both the size of the world's economic pie, and broad based increases in living standards. And combined with the basically solid worldwide economic outlook I described earlier, the potential is great indeed. So why, you may well ask, do I worry? To some extent, worry is part of the genetic makeup of a central banker. We're paid to worry. But to an even greater extent, I worry because the dark sides of these three trends - the sides I haven't really reflected on as yet - and, more importantly, how those dark sides work together, can create real risks going forward. And risk is something that wakes a central banker up in the middle of the night. What are these risks? Let me focus on just three. First, amidst the growing complexity of a highly technological and globally integrated financial world, against a background of rapidly growing volumes and values, it's all too easy to forget the basics: the simple, unalterable financial truths that, if 8 neglected, come home to roost just as they did 100 years ago. When we look at any of the financial debacles of recent times Drexel, Kidder Peabody, Orange County, Barings, to name just a few - it's not the complex nature of derivatives or foreign exchange markets that has been the heart of the problem, it's lack of attention to basic fundamentals. High rewards are the result of higher risks; internal controls do matter (in fact, if you're going to pay the trader $1 million a year, then maybe you ought to think about paying the auditor a similar amount); leverage can be overdone, and most importantly, never, never invest in anything the logic of which you can't explain to your mother. It seems to me that the 80s should have been a wake up call to the senior management of banks, securities firms, and other financial services providers that if bad things can happen, they will, and that the premium should be on old-fashioned conservative management. However, so far in the 90s, we have little evidence of that. Second, with the benefits of increasing technical capabilities and a smaller world comes the increasing potential for bouts of financial instability. One has only to consider the phenomenon of the swift and violent "run-on-a-country" such as happened to Mexico 9 to realize the dark side of the combination of technology and highly sophisticated global investors. It is true that in each of the several cases in which global financial instability has threatened, so far, anyway, financial markets and institutions have shown remarkable resiliency. The world as a whole has managed to dodge the bullet, even though those most directly involved have paid dearly. But that may not continue to be the case. There is always the danger, however remote, that one of these disturbances could be bigger in size, have its effects in more countries, bring gridlock to national and international payments systems, and happen faster than ever before. For the world as a whole or for any nation or financial institutions, the only way to be insulated from the potential for crisis is to practice financial discipline. Conservative national macro-economic policies maximize the attractiveness of a country for stable foreign direct investment. Increased international regulatory cooperation can anticipate the global weak link before the crisis. And increased investment and coordinated central bank attention to the payment and settlement systems that underpin global markets is a necessity. These things are all occurring but one wonders if progress is fast enough to avoid the next problem. 10 Finally, there is no doubt that increasing the ; level of private savings and diminishing public dissaving is a critical economic priority in every developed country. High domestic savings rates reduce dependence on foreign savings, in effect reducing vulnerability to the dark aspects of technology and global integration. Promoting high savings rates means keeping inflation low, providing attractive savings vehicles - for example, pension reforms - and addressing chronic government budget deficits. In this regard the G-7 countries must redouble their efforts at deficit reduction, since such deficits collectively are a huge drain on savings and ongoing sources of congestion and pressure in global capital markets. However, in the global rush to better balance government income statements, it's important not to forget that governments exist for a reason. They exist to address the fact that the invisible hand simply cannot do the job by itself. There are needs, whether in the area of national security or providing the elements of a social safety net, that only governments can and should provide. Reconciling this inherent role of government with the need for fiscal discipline is a challenge of some dimension. I have the uneasy thought that just as countries all over the world are making headway in deficit reduction, the very public ( I 11 investments in human and physical infrastructure that are needed to cope with the challenges of technology, integration, and industry consolidation may have difficulty being funded. How, for example, will our public education systems turn out the highly skilled workers needed for the more technologically intense industries and services of the present and future? A real worry is that just when we need them the most, the funding for these so-called public goods will dry up, with all that implies about the potential for a permanent underclass and social instability. In closing, U.S. and worldwide economic health is encouraging both presently, and in the immediate future. But beneath the surface are problems that must be faced sooner or later. I have touched on only a few, and while I recognize that the probability of serious difficulty is low, to assume these issues will, if unattended, simply go away, is both myopic and dangerous. We as central bankers, and the financial community in general, have to take proactive steps to ensure these worries never materialize. These steps include following sound, conservative macro-economic policies, emphasizing basic financial controls, and ensuring enough investment can be made in the human and physical infrastructure to sustain growth in this challenging and ever-changing world. Thank you.

Cathy E. Minehan (1995, October 23). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19951024_cathy_e_minehan

@misc{wtfs_regional_speeche_19951024_cathy_e_minehan,
  author = {Cathy E. Minehan},
  title = {Regional President Speech},
  year = {1995},
  month = {Oct},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19951024_cathy_e_minehan},
  note = {Retrieved via When the Fed Speaks corpus}
}