Congressional Testimony

FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1989 HEARING BEFORE THK COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED FIRST CONGRESS FIRST SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 FEBRUARY 21, 1989 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1989 For sale by the Superintendent of Documents, Congressional Sales Office U.S. Government Printing Office, Washington, DC 20402 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS DONALD W. RIEGLE, JR., Michigan, Chairman ALAN CRANSTON, California JAKE GARN, Utah PAUL S. SARBANES. Maryland JOHN HEINZ, Pennsylvania CHRISTOPHER J. DODD, Connecticut ALFONSE M. D'AMATO, New York ALAN J. DIXON, Illinois PHIL GRAMM, Texas JIM SASSER, Tennessee CHRISTOPHER S. BOND, Missouri TERRY SANFORD, North Carolina CONNIE MACK, Florida RICHARD C. SHELBY, Alabama WILLIAM V. ROTH, JR., Delaware BOB GRAHAM, Florida NANCY LANDON KASSEBAUM, Kansas TIMOTHY E. WIRTH, Colorado LARRY PRESSLER, South Dakota JOHN F. KERRY, Massachusetts RICHARD H. BRYAN, Nevada KEVIN C. GOTTLIEB, Skiff Director LAMAR SMITH, Republican Staff Director and Economist STEVEN B. HARRIS, General Counsel PATRICK A. MDLLOY, Senior Counsel and International Affairs Adviser RICHARD S. CAKNEIA, Senior Counsel JOHN C, DUGAN. Republican General Counsel GARCIA, Assistant Director, General Government Division, GAO Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS FEBRUARY 21, 1989 Page Opening statement of Chairman Riegle 1 Opening remarks of Senator D'Amato 3 Prepared statement of Senator D'Amato 3 Opening statement of Senator Gramro 4 Opening statement of Senator Heinz 5 Opening statement of Senator Sasser 5 Prepared statement of Senator Graham 68 WITNESS Alan Greenspan, Chairman, Board of Governors, Federal Reserve System 34 Monetary Policy Report to Congress 7 Prepared statement 39 Economic and monetary developments in 1988 40 Economic prospects and monetary policy for 1989 44 Monetary policy and long-run economic growth 47 Financial developments and monetary policy 52 Conclusion 55 Response to written questions of Chairman Riegle 82 Response to written questions of Senator Sarbanes 90 (in) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1989 TUESDAY, FEBRUARY 21, 1989 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The committee met at 10 a.m. in room SD-538, Dirksen Senate Office Building, Senator Donald W. Riegle (chairman of the com- mittee) presiding. Present: Senators Riegle, Graham, Wirth, Heinz, D'Amato, Gramm, Mack, Kassebaum, and Pressler. OPENING STATEMENT OF CHAIRMAN RIEGLE The CHAIRMAN. The committee will come to order. Let me invite those who are in the room to find seats as best they can. Let me just say at the outset that we have a number of commit- tee hearings that are on this morning at precisely this hour. We have Budget Director Barman up one floor in this building testify- ing before the Budget Committee. There are several members of this committee, including myself and others who are here today, on the Budget Committee. So there necessarily will be members coming and going, attend- ing different hearings. The Intelligence Committee and the Appropriations Committee are meeting at this hour, and several others as well in the course of the morning, and we will accommodate members as best we can. I know, Senator D'Amato, you need to leave, I think, quite quick- ly, and so I am going to just make a brief opening comment. Then I will yield to you so that you can make your comment and then excuse yourself. Let me start by welcoming the Chairman of the Federal Reserve, Alan Greenspan, before us this morning. This is the first of two ap- pearances that you will make before this committee this week. You will be back 2 days from now to discuss in detail your thoughts on the FSLIC savings and loan issue, and we very much look forward to that discussion and your input will be very important to us. For the most part, I think we ought to leave that issue aside today. There may be some questions that arise about how interest rates and monetary policy may affect the savings and loan issue. I think that is an appropriate question if somebody wants to raise it, but generally I would hope that we could set aside a discussion of (1) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the savings and loan FSLIC issue in any detail until you return and we can get into it at that time. Our topic today, of course, is monetary policy. I want to say at the outset, Chairman Greenspan, that I appreciate the leadership that you have shown at the Fed in your time there. Certainly the turbulent period surrounding the market break back in 1987 was a severe test of the system and all the key players, and I think your leadership during that time was a very important, positive element that helped us work through that period. I appreciate that leadership, and I believe my view is quite widely shared on this committee and through the Senate as a whole. That particular crisis is now nearly a year and a half behind us, and other economic problems are of more immediate concern. The business cycle is certainly mature at this point. We have entered the seventh year of expansion, and I think it has become harder to steer a prudent course between inflation on the one hand and a re- cession or slowdown on the other. The Federal budget deficits and the trade deficit continue to trouble the economy and create prob- lems for us. Obviously, there are some very difficult judgments to make, It seems to me that the Fed at the present time is facing a rather classic policy conflict. On the one hand, there are those who argue for tighter money to avoid an outbreak of inflation and to preserve the value of financial assets. On the other hand, there are those who argue for easier money and lower interest rates in an effort to stimulate growth and to try to increase tax receipts without raising tax rates. I am struck by the fact—and I will ask you about this later if you don't choose to comment on it directly that your own economic growth and interest rate forecasts are different than those that are in the Bush administration budget proposals. Those are significant matters because depending upon which set of estimates are right, obviously, we face a very different set of ef- fects and policy outcomes, and so I think we have to discuss today precisely what the Fed targets are based on and why you see them the way you do. For example, with respect to growth forecasts, the administra- tion is forecasting 3.3 percent in 1989 and 3.2 percent in 1990, and with respect to interest rates the administration is projecting right now in the first quarter of 1989, 90-day Treasury bills at 8.3 per- cent, second quarter dropping to 7.8 percent, then dropping to 7.2 percent, in the fourth quarter dropping to 6,6 percent. Hie average for 1989 being at 7.4 percent, the average for 1990, next year, being 5.5 percent. That is a pretty remarkable drop in interest rates. It would be nice if that occurs, but I would be very interested in seeing how you and your colleagues within the Fed forecast the interest rate pattern over that same period of time. In a moment we will get into discussion of your outlook for growth, employment, exchange rates, the trade deficit, and infla- tion. We want, in addition, your assessment of the health of the economy, to hear not only the good news but also where you think the risks He and the steps you think we need to take. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I want to just make one other point before yielding to Senator D'Amato, and that is this, I have the strong view as the new chair- man of this committee that this committee ought to act, as should the Congress as a whole when revisions are needed in banking laws and the financial structure laws of the country. It will be the intent of this committee to do that, to act and to act promptly and decisively, We have got a savings and loan problem in front of us that is an immediate problem that has to be dealt with, but it would be my expectation that we will move on into other areas that need atten- tion and act on those, and I would hope that the Fed would not feel that it has to step into the vacuum because of an absence of con- gressional action. I would hope that we would be able to move affirmatively within the Congress, and I think that Is the way it should be done. I think we will all be more comfortable with that, and so I hope that we can follow through in that fashion. With that, let me now yield to Senator D'Amato. OPENING REMARKS OF SENATOR D'AMATO Senator D'AMATO. Thank you, Mr. Chairman. Mr. Chairman, in the interest of time—and I do have two other committee hearings—I am going to ask that my statement be in- cluded in the record as if read in its entirety. I would take a moment to observe that notwithstanding the doom prognosticators—and we do have those—that the old quote from Mark Twain I think applies to our current U.S. economy. "Rumors of its demise are greatly exaggerated." And with that, Mr. Chairman, let me congratulate you for hold- ing this hearing and also welcome Chairman Greenspan, who is doing an outstanding job. The CHAIRMAN. Thank you very much, Senator. We will make your statement a part of the record. OPENING STATEMENT OF SENATOR D'AMATO Senator D'AMATO. I welcome Chairman Greenspan and take this opportunity to observe that another 6 months of sustained econom- ic growth has passed since the last Fed report on monetary policy, The last time we convened here there was again talk of the im- pending recession. In fact, for a few years now, the doomsayers have been predicting an end to good economic times and many economists are still predicting a recession in the next 2 years. Not- withstanding the many problems that we face today, the old quote from Mark Twain applies to the current U.S. economy: rumors of its demise are greatly exaggerated. I realize that the Fed is ever vigilant against inflation and that this is a proper concern. Therefore, I commend the Fed for its ef- forts toward adjusting economic growth as the economy shows signs of reaching full employment and maximum industrial utiliza- tion. I also note the Fed's apparent success in establishing a mone- tary policy that has slowed growth without choking off the robust economy which has created jobs and increases opportunity for all Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Americans. We cannot overstate the significance of this current economic expansion. In the past 8 years, 19 million new jobs have been created, a 17 percent increase in civilian employment. Furthermore, this expan- sion has been felt in the communities in which increased job oppor- tunity is so much a part of the American dream: employment among blacks has grown by 30 percent and Hispanic employment has grown by 45 percent during the sustained period of growth in the 1980's. The strong economy of the past 7 years shows that the business cycle does not need to swing widely from periods of growth to peri- ods of recession; that is, there is no strict rule that says that reces- sion is the inevitable conclusion of a period of economic growth. It appears that the Fed, and the American free market, are proving that the economy can be managed at a state of high capacity with- out bringing on dangerous levels of inflation. In short, I see no need to accept the inevitability of a recession if we allow the marketplace and wise government policy to work to- gether in taming the business cycle. Therefore, I commend Chair- man Greenspan and the Fed for their commitment to fighting in- flation. I also encourage your continued sensitive use of the tools at your disposal so that the U.S. economy can continue to provide genuine opportunity and the hope of prosperity to every American. Thank you, Mr. Chairman. The CHAIRMAN. Senator Kassebaum. Senator KASSEBAUM. I have no opening statement, Mr. Chair- man. I welcome Chairman Greenspan as well. The CHAIRMAN. Senator Gramm. OPENING STATEMENT OF SENATOR GRAMM Senator GRAMM. Thank you, Mr. Chairman. Chairman Greenspan, I welcome you back before the committee. I thank you for all of your good work. Mr. Chairman, I think one of the things we have to look at in terms of assessing the various projections that are made of the future is what those projections are based on. One of the things that I will be questioning Chairman Greenspan about later today really comes down to that. Are the assumptions made by CBO and OMB realistic if you assume, as they do, that the deficit will be reduced by $55 billion? That would mean that $55 billion less would be absorbed by the Government out of the private sector, if we meet the Gramm- Rudman targets, meaning that money could go into the private sector to build new homes, new farms, new factories, and generate new economic growth. Are the assumptions of the two budget pro- jections realistic if you assume that the outcome of the budget debate will be such a reduction in the deficit? Second, I will be asking the Chairman, specifically does it make a difference from your point of view in terms of trying to promote economic growth, trying to control price increases so that we don't repeat a cycle that we paid such a high price to break, does it make a difference whether we deal with the deficit by raising taxes or by controlling spending? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Are the two approaches to deficit reduction created equally in terms of their economic impact, or is one superior to the other from the point of view of the economic impact in trying to create growth without inflation? I think those are the questions that we have to deal with here, and, Mr. Chairman, I look forward to participating in the hearing. Like you, I have got to run upstairs to the Budget Committee. Thank goodness we are here doing all this important work lest it might not get done. The CHAIRMAN, Well, try not to be gone too long. Senator Heinz. OPENING STATEMENT OF SENATOR HEINZ Senator HEINZ. Mr. Chairman, I simply want to join in welcom- ing Alan Greenspan back to this committee and to commend him for the usual excellent job he has done. One of the questions that I will want Chairman Greenspan to ad- dress is the question not only as posed by Phil Gramm about the effect of lowering the budget deficit and how it will help make the economic assumptions or projections in the President's budget come true, but also how those projections can come true unless we address the issues that affect real growth in the U.S. economy. I refer to labor productivity, the competence and technological ability of management and, most importantly, the cost of capital as it affects production of products in this country. It seems to me that we really need to focus on the three main inputs that drive real productivity. Some of them are very hard to influence. Labor productivity is influenced by educational levels and, I suppose, by incentives or morale or motivation. It certainly is true in the Japanese model. The competence or ability of man- agement is pretty hard to influence in the short term. I will be in- terested in Chairman Greenspan's comments about what we can do in improving the access to, and lowering of, the cost of capital as an important element in the equation. The CHAIRMAN. Thank you very much, Senator Heinz. Before we hear from Chairman Greenspan, I have a statement from Senator Sasser to be inserted in the record. STATEMENT OF SENATOR JIM SASSER Senator SASSER. Mr. Chairman, today we hear from the distin- guished chairman of the Federal Reserve on the conduct of mone- tary policy—a critical issue at this time. Interest rates are rising and this does not bode well for the econ- omy. Every percentage point increase in interest rates will add $11 billion to the deficit. Moreover, a dampening of the economy, that will surely follow higher rates, could make the deficit virtually im- possible to deal with. We need to closely examine our interest rate policy. Short term interest rates have increased by 2.5 percentage points—or 50 per- cent—since June of 1988. We know that there are basically two factors that can influence interest rates like this: Inflationary expectations of investors or monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis However, surveys of expectations of investors indicate that most investors believe that inflation will increase only modestly in the months ahead. There is little upward pressure on rates from the markets themselves. Hence, it appears that a very restrictive monetary policy is the driving force behind the interest rate rise. We know what has happened in the past when the fed has been overly restrictive. So we want to hear the Fed's evidence on infla- tion as well as their projections as to where the economy is going. Most of all, we want to know if the economy can grow at a rate that will fulfill the assumptions in the President's budget. Thank you, Mr. Chairman. The CHAIRMAN. Let me now just indicate that the monetary policy report that you are submitting this morning, Dr. Greenspan, is required by law under the Full Employment and Balanced Growth Act of 1978. This is a very important transmittal document, and we will make the full document a part of the record. [The complete document follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis For use at 10:00 a.m., E.S.T. Tuesday February 21, 1989 Board of Governors of the Federal Reserve System :«.B!f!ffil Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 21, 1989 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 21, 1989 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES. The Board of Governors is pleased to subrnil its Monetary Policy Report to trie Congress pursuant to (fie Full Employment and Balanced Growth Act of 1978. Sincerely, Alan Greenspan, Chairman Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table of Contents Page Section 1: Monetary Policy and the Economic Outlook for 1989 1 Section 2: The Performance of the Economy in 1988 5 Section 3: Monetary Policy and Financial Developments during 1988 10 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Section 1; Monetary Policy and the Economic Outlook for 1989 Overall, 1988 was another year of progress for the inflation required restrain! on the growth of domestic U.S. economy, marked by further substantial increases demand. in output and employment and by a significant improve- The shift by the Federal Reserve toward restraint ment in the balance of trade. The dramatic stock was reflected in a tightening of the reserve market market break of October 1987 did seem to affect real conditions that began in late March and continued, in activity for a time, but the underlying strength of the several steps, into 1989. short-term market interest economy soon showed through, and, apart from iosses rates moved up during this period, influenced both by of farm output caused by the drought, growth pro- the System's tightening and the strength of the econ- ceeded at a relatively strong pace throughout 1988, omy, and the discount rate was raised in August, to its Moreover, the sizable employment gains in January of current level of 6 Vi percent. Growth of M2 moderated this year suggest that the economy entered 1989 with after the spring and ended the year just below the considerable forward momentum. middle of the 1988 target range. The growth of M3 also Inflation has remained in check into the seventh year ebbed over the last two quarters, as the needs of banks of the expansion. Even so, developments during 1988 and thrifts to fund credit expansion slackened. were a little worrying, as, for a second year, increases At present, short-term interest rates are about 2'A in prices were somewhat larger than in earlier years of percentage points higher than they were early last the expansion. Part of the pressure on prices in 1988 spring. Long-term interest rates, by contrast, have came in the food area and reflected the influence of the changed little, on net, over that same period; although drought. However, with labor markets tightening, these rates turned up in the spring of 1988, they leveled there also was a quickening in the rise of wages and off over the summer and edged down in the fall, even as total hourly compensation, which affected prices more short-term rates were continuing 10 rise. This behavior generally. of bond yields seems to have reflected a lowering of Federal Reserve policy mirrored the changing eco- market expectations of long-run inflation. nomic circumstances of 1988, Early in the year, as in late 1987, the Federal Reserve soughtto fim it repercus- Monetary Policy for 1989 sions from the plunge in stock prices and, in particular, to guard against the possibility of a significant contrac- The commitment by the Federal Reserve to contain tion in business activity. Pressures on the reserve inflationary pressures is reflected in the FOMC's deci- positions of depository institutions were eased a bit sions to lower the ranges for monetary and credit further in early 1988, and interest rates edged down for expansion this year. The Committee has set a range of a time, extending the declines thai had begun in 3 to 7 percent for M2 growth during 1989 and a range October of 1987, Growth of M2 and M3 was fairly of 3Vi to IVi percent for M3, reaffirming the target rapid during this period, nearly reaching the upper ranges established tentatively in June 1988. These bounds of the annual target ranges established by the ranges were reduced from those for 1988—a full Federal Open Market Committee (FOMC). percentage point for M2 and one-half percentage point As it became clear in the spring that the economy still for M3 - signalling the Committee's determination to was strong, the focus of Federal Reserve policy shifted. resist any upward tendencies in inflation in the coming For much of the year, there was heightened concern year and to promote progress toward price stability about the potential for increased inflation, largely over the long run. The monitoring range for growth of reflecting rapid growth of spending and a continued domestic nonfinancial debt for 1989 was set at 6W> to tightening of labor and product markets. A sharp 10 'fi percent, which also is lower than that of last year. upswing in real net exports of goods and services that In recognitionof the degree fo which the relationship had begun in 1987 continued into 1988, and while this between monetary aggregates and economic perfor- upturn was a welcome and necessary part of (he mance has varied in this decade, the Committee re- adjustment of the U.S. economy towards better bal- tained the four percentage point spread between the ance in itr, external accounts, it also intensified the upper and lower ends of the growth ranges that it demands on U.S. producers at a time when the utiliza- adopted in 1988. Despite the deregulation of deposit tion of domestic labor and capital already was quite interest rates, M2 velocity has remained very sensitive high. Accommodating the improvement in our exter- to changes in market interest rates over periods as long nal position while limiting the risk of heightened as a year or more. Depository institutions have been Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 Ranges of Growth lor Monetary and Credit Aggregates Percent change, fount! quarter to fourth quarter 1967 1988 1989 M2 S'/ztoSVz 4 to 8 310 7 M3 Slfe to 8V? 4to0 3Va to 7Vs Debt 8 to 11 7W11 6^1010^ slow to adjust some of their offering races, causing buyouts and other corporate restructurings, and busi- substantial changes over the short- and intermediate- ness borrowing is likely to be especially sizable in the term in the relative allractiveness to savers of deposits eavly part of this year, owing to the recent heavy versus market instruments. In these circumstances, it volume of such activity. The federal government, once is difficult to specify in advance a narrow range for the again, will be placing heavy demands on credit mar- appropriate growth of M2 and the other aggregates in kets, financing its continuing deficit. the coming year; such growth will depend on the forces affecting the economy and prices and. on the response of depositor)' institutions to any changes in market inter- Economic Projections est rates, both of which, are subject to a substantial In general, the Committee members, including the degreeof uncertainty. Moreover, in 1989, the behavior nonvoting Reserve Bank presidents, anticipate that of M2 and M3 also could be influenced fay the resolu- real GNP will grow moderately in 1989, that prices tion of problems in the thrift industry, depending, in will rise at a pace similar to, or perhaps slightly above, pan, on how pricing practices of these institutions that of 1988, and that the unemployment rate will change, on. the reactions of retail and wholesale depos- remain near its recent level—the lowest in a decade and itors in these institutions, and on the extent of any a half. On balance, the FOMC members anticipate a restraints on the growth of assets of savings and loan little less real growth and a somewhar higher rate of associations. inflation than does the Administration, but the differ- M2 and M3 are now around the lower ends of their ences are not large. 1989 ranges. This slow growth and the accompanying Members of the Committee believe that the progress rise in velocity reflect the continuing effects of recent of the economy in 1989 will be determined in large increases in market interest rates. In light of the slow measure by developments on the inflation front. Al- adjustment of deposit rates, velocity could continue to though special factors, such as the drought, contrib- increase, with growth in these monetary aggregates in uted to price increases last year, there also have been the lower halves of their ranges. Given the uncertain- troubling indications—most notably in recent wage liet about the relation of movements in the aggregates trends—that inflationary pressures have become more to prices and output, the Committee agreed that in widespread and, potentially, more deeply rooted. implementing policy, they would need to assess, in Given the tightening actions taken by the Federal addition to the behavior of money, indicators of infla- Reserve over the past year and the policy of continued tionary pressures and economic growth, as well as restraint on aggregate demand expressed in the mone- developments in financial and foreign exchange tary targets for 1989, the members of the Committee markets. anticipate that, if there is any further acceleration of The Committee will continue to monitor the growth prices from the 1988 pace, it will be quite limited. The of domestic debt in 1989. The expansion of debt of majority of the Committee members expect mat the nonfinancial sectors may slow a little from the 854 consumer price index will rise about 4% to 5 percent percent pace of 1988, although it is expected once this year. This would be a slightly larger increase than again to exceed the pace of growth in nominal income. in 1988, and thus would represent something of a The growth of debt could be importantly affected by setback relative to Ac Committee's disinflationary corporate financial behavior. The expansion of private objective. However, in light of the tautness of markets debt has been boosted in recent years by the substitu- and the current momentum of wages and prices, these tion of debt for equity in connection with leveraged members viewed such a projection as realistic in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 Economic Projections for 1989 FOHC Members and Other FRB Presidents 1988 Actual Range Centra) Tendency Percent change, fourth quarto? to fourth quarter Nominal GNP 7,0 5V2 to 8Vz 61/2 to 7</2 Real GNP 2.7 1 1/2 to 3'A 2'A to 3 Consumer price Index 4.3 4V2 to 5 Average level in the fourth quarter, percent Unemployment rate 5.3 5 to 6 5V4 to 51/2 context of aprudeni effort to restore price stability over ouipu!, the central-tendency forecast is for consider- time. It should be noted, however, thai some members ably slower growth of real output than last year's gain, expect a rise in prices (hat is significantly below the excluding drought losses, of more than 3 percent. centra] -tendency range; in their view this far more Although the economy clearly has entered 1989 on a desirable outcome could flow from the dollar's recent strong note—even discounting the transitory influence firmness, which will damp the pressures from rising of unusually mild weather in many parts of the coun- import prices, and from the recognition by business try - the members feel that growth soon will move to a and labor that restraint is needed to preserve gains in lower trajectory, owing both lo the general influence of international competitiveness. monetary restraint and to a number of sector-specific A particular uncertainty in the inflation outlook for trends. In the business sector, the boom in capital 1989 centers on the prospects for food prices. FOMC outlays that was evident in the first half of 1988 has members generally assumed that a return to more since abated, and surveys of plans for 1989 point to normal weather conditions this year, together with an moderate gains in overall plant and equipment spend- increase in acres planted, would lead to a sharp re- ing. Government purchases are expected to be held bound in crop production, in which case food prices down by budgetary constraints; defense purchases, in might help to temper overall inflation. However, be- particular, have been trending lower under the influ- cause stocks of some key agricultural commodities ence of cutbacks in real spending authority. Recent have been reduced to low levels, there also is risk that increases in mortgage rates likely portend some slack- another year of drought could generate strong upward ening in the pace of homebuilding, arid the growth of pressures on prices. In the energy area, consumer consumption expenditures also should begin to taper prices could rise sharply early this year, responding to off from the rapid pace of 1988, as a slowing of the runup in oil prices around the end of 1988; none- expansion elsewhere in the economy damps the growth theless, world oil supplies still iook ample, and mem- of real disposable income. bers of the Committee are assuming that energy prices With regard to the external sector, real net exports of will increase only moderately over 1989 as a whole. goods and services declined over the second half of With respect to real GNP, the central tendency 1988, but most members of the Committee expect forecast of the Committee members is for a rise of some improvement in the months ahead. However, about 2Vi to 3 percent in 1989, about the same as in substantial further progress in external adjustment will 1988. However, this forecast incorporates a working require a continuing commitment on the part of U.S. assumption that increased farm output will add around firms to capitalize on the enhanced competitiveness two-thirds of a percentage point to the growth of resulting from the depreciation of the dollar since GNP—similar to the amount that the drought pared 1985. That commitment must take the form not only of from 1988's growth- Excluding this swing in farm continued cost control and price restraint, bui also of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 more intense efforts at marketing abroad and invest- steadfastly at movement toward price stability is one ment in new capacity where constraints are visible. critical ingredient. Bui also crucial is action to bring Failure on these counts would almost certainly leave about further progress toward balance in the federal the U.S. economy considerably less well off over ihe budget. The Committee has assumed that Gramm-Rud- long haul. maa-Holtings targets will be adhered to in the fiscal Government policy can do much to encourage busi- 1990 budget process, but the creation of an environ- nesses to make the longer-range commitments needed ment favorable for economic growth with stable prices to bring about better balance in the economy and to requires that fiscal policies be put in place to produce foster longer-run growth. A monetary policy directed the prescribed budget results in the out-years as well. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 Section 2: The Performance of the Economy in 1968 The U.S. economy completed a sixth year of expan- business and health services. However, oil drilling, sion in 1988. Real GNP rose about 2 M percent over the which had turned up in 1987 when oil prices were course of the year, the number of jobs increased more rising, experienced renewed weakness in 1988, inten- than 3 'A million, and the unemployment rate remained sifying economic stresses in some parts of the country. on a downward course, closing the year at 5.3 percent, its lowest level in 14 years. Progress also was made toward restoring external balance, as the merchandise The External Sector trade deficit fell sharply. The U.S. external accounts showed considerable The year began on a note of uncertainty. The sharp improvement during 1988. On a balance of payments break in the stock market in the fall of 1987 had raised basis, the deficit on merchandise trade fell from an concern that the economy might falter, and some signs annual rate of $ 165 billion in the fourth quarter of 1987 of weakness did emerge around (he start of 1988. By to around $120 billion in the second quarter of 1988 early spring, however, it became clear that the expan- and, on average, remained at that lower level in the sion still had considerable vigor, coming in particular second half of the year. Over the four quarters of last from rising exports ant) a boom in capital spending. year, the value of exports rose more than 20 percent; Households, meanwhile, adjusted fairly readily to the adjusted for inflation, the increase was around 15 loss of stock market wealth, and consumer spending percent. Much of the strength in exports, which was rose at a strong pace throughout the year. Toward the concentrated in the first half of the year, appeared lo be end of the year, net exports and capital spending associated with an improvement in the price competi- softened, but there was enough impetus from other tiveness of U.S. products, resulting from an earlier sectors to keep real GNP on a firm upward course. depreciation of the dollar, as well as with efforts at cost The rate of inflation, which had picked up in 1987, control and increases in productivity among domestic remained somewhat higher in 1988 than in earlier producers. Demand for exports also was supported by years. The step-up in inflation in 1987 had resulted surprisingly strong economic growth in other indus- mainly from a rebound in the price of oil and the trial countries. The growth in real export volume was passthrough of higher prices for imports. This pasl spread over most categories of trade; gains were year, by contrast, extra price pressures reflected the particularly large for capital goods (especially comput- impact of drought on the price of food arid, more ers and computer pans), automotive products, and generally, a widespread pickup in labor costs in the consumer goods. The volume of agricultural exports domestic economy. for 1988 was up 9 percent from that of 1987, despile declines in the second half of the year; the value of The rise in real GNP last year would have exceeded these exports was boosted further by the drought- 3 percent, but for a severe drought—one of the worst of induced rise in crop prices. this century-that caused huge losses of farm output. These losses accounted for most of the slowdown in The value of merchandise imports, other than oil, GNP growth that occurred after the first quarter of rose about 7 percent during 1988. The volume of 1988. Fortunately, inventories of farm products had. non-oil imports increased about 2 percent. This rise been sizable coming into 1988, and a drawdown of was concentrated mainly in the capital goods area; stocks helped to buffer households and others from the volume was down for other major categories of im- disruption to output. Within the farm sector, the drought ports. The prices of imported industrial supplies (ex- strained the finances of some producers, but the finan- cluding oil) rose signifkandy in 1988; smaller in- cial condition of many others was not seriously af- creases were recorded forconsumer goods, automotive fected, and the sector as a whole remains stronger products, and various machinery categories. How- fundamentally than in the first half of die 1980s, when ever, price declines for oil and computers held the the boom of the previous decade was unwinding. overall increase in import prices below that of 1987; on In most of the nonfarm economy, the growth of a fixed-weight basis, the rise in non-oil import prices activity was robust in 1988. Production in the manufac- during 1988 was 7 W percent. The value of oil imports turing sector increased 5 percent, nearly matching the declined last year, as an increase in physical volume previous year's gain, and factory employment rose was more than offset by the decline in price. sharply. Employment also continued to grow rapidly in For the first three quarters of 1988, the current retail and wholesale trade and among the providers of account showed a cumulative deficit of $102 billion, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 Real GNP Percent change from and of previous period, annual rate 1983 1984 1985 1986 1987 1988 Industrial Production Index 1977. 100 160 Jan. 140 120 100 80 1983 1984 1985 1986 1987 1988 Implicit Price Deflator for GNP Percent change from end of previous period, annual rate 1983 1984 1985 1986 1987 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 Foreign Exchange Value of the U.S. Dollar * fmtex, March 1973-100 175 150 125 100 75 1983 1984 19B5 1986 1987 1988 U.S. Real Merchandise Trade Annual rate, billions of 1982 dollars 600 500 Imports 400 Exports 300 200 100 1983 1984 1985 1986 1987 1988 U.S. Current Account Annual rate, billions of dollars 50 50 !00 150 200 1983 1384 1985 1986 1987 1988 " Index oi weighted average foreign encftange value ol U.S. dollar in terms of Currencies ot olher G-10 countries plus Switzerland Weights are 1972-76311*31 traded each ol (he 10 counties. " Average ot first three quarters ol 1988. at an annual rats. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 which was balanced by recorded net capital inflows of The Household Sector $88 billion anda statistical discrepancy of $14 billion. Foreign official assets in the United States increased At the stan of 1988, concern about the possible effect $28 billion on net (this rise included about $30 billion, of the stock market break on the real economy centered on net, of official purchases of U.S. government on the household sector. The drop in share values had securities). Net inflows through banks were $21 bil- pared roughly half a trillion dollars from household lion. Excluding banking flows, assets held in the wealth, and the degree to which spending would be cut United States by private foreigners increased $68 in response to this loss of wealth was not clear. billion on net; purchasesof U.S. government securities In the event, the loss of wealth may indeed have left were sizable fin contrast to net sales in 1987), and an imprint on consumer demand. The personal saving direct investment by foreigners in the United States rate did rise after the crash and, over the next year, remained near record levels. Excluding bank flows, averaged about a percentage point higher than in the the assets held abroad by private U.S. residents in- year preceding the crash. But, with exports and capital creased $26 billion. These recorded capital flows investment booming, the growth of jobs and real during the first three quarters of 1988, plus the likely incomes remained strong in 1988, and the uncertainties net inflows in the fourth quarter, brought the recorded spawned by the crash soon gave way to renewed U.S. net indebtedness to foreigners to almost $500 optimism among households. Thus, after the initial, billion at the end of 1988. one-time jump in the saving rate, real consumption The foreign exchange value of the U.S. dollar, expenditures grew at about the same pace as the trend which had fallen sharply from early 1985 through the in after-ax income; Ihe rise over the year was about end of 1987, has shown wide fluctuations in the 3 W percent. subsequent period. Measured against the other G-10 Consumer spending for big-ticket items was brisk in currencies, the dollar currently is up somewhat, on net, 1988. The unit sales of domestically produced automo- from its end-of-1987 low. However, it has declined biles moved up a bit from the 1987 pace, and the sales in real (price-adjusted) terms against (he currencies of light trucks and vans, which have more than doubled of our major trading partners among the develop- since the expansion began in 1983, reached another ing countries, especially South Korea, Mexico, and new high. Adjusted for inflation, total consumer spend- Brazil. ing for motor vehicles increased 6W percent over the four quarters of the year. Among the household dur- From mid-April to late August of last year, the dollar ables, real outlays for furniture and appliances, which rose sharply, on average, against the currencies of the had slowed in 1987, moved up 7V4 percent during other industrial countries, reflecting the influences of 1988, renewing the strength that had been evident over Federal Reserve monetary tightening and monthly me 1983-86 period. trade reports that brightened (he market's assessment of the outlook for U.S. external adjustment. When Real residential investment fell slightly in the first measured against a weighted average of the oiher G-10 half of 1988, but turned up in the second half and, by currencies, the appreciation during that period was the fourth quarter, wasalitdeabove the level of a year more than 15 percent. After holding steady through earlier. Starts of multifamily housing units, which had September, the dollar then declined sharply in October slumped in 1987, felt further in the first quarter of and November; market perceptions appeared to shift 1988, but then flattened out over the remainder of the during that period toward a view that monetary re- year; vacancy rates for multifamily dwellings remain straint in other countries had increased relative to that high in many areas and are likely to hold down new in the United States, and incoming trade data suggested construction of these units for some time. ID the a stalling of the adjustment process. Since November, single-family sector, starts edged down through the the dollar has again risen, partly in response to further first three quarters of 1988, but rebounded toward tightening actions by the Federal Reserve. year-end to the highest levels since the fall of 1981. By historical standards, these swings in single-family Measured against the G-IO currencies, the dollar starts during 1988 were relatively mild; indeed, from a currendy is about 7 percent above its December 1987 longer-term perspective, the past six years have been level. If adjustment is made for changes in relative an unusually stable period in the single-family market, prices, the resulting real appreciation is somewhat in sharp contrast to the boom and bust cycles of the greater, as inflation in Ac United States has exceeded 1970s and early 1980s. Total housing starts, of course, the weighted average of inflation rates of the other have fallen sharply since 1986 because of the steep major industrial countries. decline in construction of multifamily units. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 The Business Sector little over the course of 1988 and was near the lower end of the range in which it has been since the business Virtually all indicators of business activity exhibited expansion began. slrengtb in 19B8. Business sales, in nominal terms, rose 9 percent over the year. Hiring was brisk in most The Government Sector sectors, and operating rates rose further; in the indus- trial sector, capacity utilization at the end of 1988 was Budgetary constraints have led to a slowing of at its highest level since 1979. Corporate profits re- government purchases, both at the federal level and mained healthy. among state and local governments. The federal gov- A surge in business equipment spending that had ernment's purchases of goods and services — the part of begun in 1987 extended through the first half of 1988, federal spending that adds directry to the gross national when outlays grew, in real terms, at an annual rale of product—fell 4 percent in real terms from the fourth about 20 percent. The surge was led by sizable invest* quarter of 1987 to me fourth quarter of 1988. Roughly ment in high-technology items - computers, communi- half of the decline reflected a drought-induced reduc- cation equipment, and the like-but outlays for other tion in the farm inventories owned or financed by the types of equipment also were strong. After midyear, Commodity Credit Corporation (CCC), a reduction the rise in equipment spending slowed, and some that is counted as a negative federal purchase. Exclud- weakness became evident toward the end of the year. ing this inventory swing, federal purchases were down However, most reports from the field suggest that the 2 percent over the year-the first decline since 1976. underlying trend in equipment spending still is pointing Over the eight years that preceded 1988, real federal firmly upward. purchases, other than those of the CCC, had risen at an Business spending for new construction declined in average pace of nearly 5 percent, considerably faster 1988, reversing the moderate increase of the previous than the growth of real GNP. The downturn in 1988 year. Commercial Construction, the biggest item in the reflected cuts in the defense area; other non-CCC total, continued to be restrained in 1988 by the big federal purchases rose somewhat over the year. overhang of vacancies that grew out of the building On a budget basis, total federal outlays, which are boom of the mid-1980s. Gas and oil drilling, following almost three times as great as federal purchases alone, the lead of oil prices, fell back a little from the pace of continued to rise in fiscal year 1988, but at a somewhat late 1987, but remained above the lows of 1986. slower rate than in most previous years. There were Construction of buildings for industrial use was lillle further increases in entitlements, greater demands on changed over 1988; although capacity utilization is deposit insurance agencies, and increases in net inter- high in manufacturing, many producers also appear to est payments. Meanwhile, the growth of federal re- be limiting their needs for additional space by shifting ceipts slowed in 1988 from the rapid pace of the toward technologies that use more compact equip- previous year. Receipts from social security taxes rose ment, by economizing on inventories, or by conserv- more than 10 percent —owing in part to a rate increase ing on space in other ways. in January of 1988. However, growth in receipts from Inventory investment, which had been sizable in late personal income taxes slowed, as increases in employ- 1987, moderated in 1988, and, with sales on an upward ment and nominal incomes were offset by final reduc- trajectory, stock overhangs were not a problem for tions in income tax rates legislated under the 1986 tax most businesses. In manufacturing, stocks grew more reforms. The federal budget deficit in fiscal year 1988 rapidly in 1988 than they have in recent years, but was $155 billion, slightly above the level of the previ- much of the accumulation was in industries in which ous year. orders and shipments also were generally strong; the The real purchases of goods and services by stale ratio of inventories to sales for all of manufacturing and local governments rose 3 percent over the four moved down during the year from the already low quarters of 1988, a little more than in 1987, but less levels of late 1987. In retail trade, concern about a than the average rate of growth over the preceding possible overhang of the stocks of nondurables eased a three years. Spending for construction, which had bit during the year, as the ratio of stocks to sales in that risen rapidly in the mid-1980s, was little changed sector edged gradually lower from aFebruary high. By during 1988 as a whole, although some pickup was contrast, auto dealers' stocks rose sharply in the fourth evident in the fourth quarter. Employment in the state quarter, and auto manufacturers have enhanced sales and local sector continued to rise during 1988, re- incentives and moved to a lower assembly rate in an flecting, in part, the increased demands for teachers effort to pare inventories, For all of manufacturing and and other school workers associated with growth in the trade combined, the ratio of inventories to sales varied number of elementary students. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 Real Income and Consumption Percent change from end of previous period, annual rate . •- P|jReal Disposable Persona) Income r~lRea! Personal Consumption Expenditures 1983 1984 1985 1966 1987 1988 Personal Saving Rale Percent of disposable income 10 1983 1984 1985 1986 1987 1988 Private Housing Starts Annual rate, millions of units, quarterly average 2.5 1.5 Single-family' 0.5 1983 1984 1985 19SS 1987 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 Real Business Fixed Investment Percent change from end of previous period, annual rate 40 ||§j Structures 30 I ] Producers' Durable Equipment 20 10 + 0 10 20 1983 1984 1985 1986 1987 1988 Changes in Real Business Inventories Annual rate, billions of 1982 dollars 90 Total Nonfarm 60 30 LJii + 0 30 60 1983 1984 1985 1986 1987 1988 After-tax Profit Share of Gross Domestic Product * Percent 10 Nonlinancial Corporations 1983 1984 1985 1986 1987 1988 * Ratio Of profits from domestic operations with inventory valuation and capital consumption adjustments to gross domestic product of nonfinancial corporate sector. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 The Labor Markets average rate of increase during the previous fit, years. The rise in the number of jobs during 1988 was somewhat above that of 19&7 and brought the total increase in payroll employment since late 1982 to Price Developments about 18% million. Virtually all pans of the economy shared in last year's gain. The number of jobs in The broader measures of prices—including the GNP manufacturing increased 400,000; employment in con- price measures, the producer price index, and the struction was up 300,000, Close to a million new jobs consumer price index—all indicate that inflation was in were created in retail and wholesale trade, and 1.3 arangeof4lo4Wpercentin 1988- ExceptfortheCPI, million were added in services. Except for a brief which had moved up into this range in 1987, these slowdown in the summer, the growth of jobs was measures showed some acceleration last year, and all strong throughout the year. of them—including the CPI—rose more rapidly than in the first four years of the expansion. In contrast to The continued rise in employment last year led to a 1987, when the indexes were boosted by a rebound in tightening of labor markets and called attention to energy prices and rising prices for imports, the infla- limits on the potential growth of the supply of labor and tionary pressures this past year were augmented by of output. Growth of the working-age population has larger increases in labor costs in the U .S. economy and slowed in the 1980s, and the increase during 1988 was the drought's influence on agricultural prices. the smallest annual rise in more than two decades. This slowing of papula- tioft growth in the 1980s has led, in The drought's effects appeared quickly at the retail turn, to a more moderate rate of growth in the labor level in the summer, as price increases picked up for a force, even as the rale of labor force participation, wide variety of consumer foods. By late autumn, especially for adult women, has continued to rise. A however, the impact of the drought on food prices big boost to output during the expansion has come from began to dissipate, and inflation in the food sector putting unemployed workers back on the job; now, returned to a more moderate path. The increase in however, with the unemployment rate at less than 5 'A consumer food prices over the year as a whole was 5 'A percent, the labor force is more fully utilized than at percent—about 2 percentage points above the average any time in the last decade and a half. of the preceding five years. Prices in 1989 will be sensitive to weather developments over the spring and The tightening of labor markets in 1988 was associ- summer. In the past, major droughts in the United ated with a pickup in the rise of wages and labor cosis. Slates have been one-year events, often separated in The employment cost index for wages and salaries in lime by several good growing seasons, and most the private nonfarm sector increased a bit more than 4 agricultural observers have been assuming that farm percent over the year—almost a percentage point more output will rebound in 1989, thereby restraining the than in 1987. The pickup was most pronounced among prices of farm crops. Currently, however, dry condi- white collar workers and in the service-producing tions still prevail in some important growing regions, industries, where unemployment rates currently are and crop prices could rise abruptly if moisture supplies the lowest. The cosl of benefits provided to employees are deficient in coming months. rose 6% percent over the year, nearly twice the in- crease of 1987; the rise reflected both the hike in the Energy prices were little changed at the consumer payroll tax at the start of 1988 and asurge in the cost of level during 1988 after a sharp rise in 1987—a pattern health benefits. Total compensation per hour—wages that resulted mainly from the continued gyrations in and salaries plus benefits—rose nearly 5 percent over world oil markets. The price of oil, which had risen the four quarters of 1988, after two years in which the sharply in 1987, moved lower for much of 1988, as the annual increases had been in the neighborhood of 3W efforts of OPEC to restrain production unraveled. In percent. late 1988, a new agreement by OPEC to [unit produc- Productivity gains slackened somewhat in 1988. tion, coupled with higher-than-expected oil consump- The rise in output per hour in the nonfarm business tion and production shortfalls in non-OPEC countries, sector over the four quarters of the year was only 0.7 caused prices to rise sharply once again; however, percent—about half apercentage point below the aver- despite these fluctuations, prices have not made any age over this decade. This slippage in productivity sustained departure from the range in which they growth in 1988, combined with the faster rate of generally have been since the summer of 1986. increase in hourly compensation, resulted in a 4 per- Price increases for goods and services other than cent rise in unit labor costs in the notifarm business food and energy were larger in 1988 than in 1987. The sector over the four quarters of 1988—well above the pickup, while fairly moderate, was widespread and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 Nonfarm Payroll Employment Net change, millions of persons, Q4 to Q4 ^U Total — f^C] Manufacturing 1983 1984 1985 1966 19fl7 1983 Civilian Unemployment Rate Quarterly average, percent 12 10 1983 1984 1985 1986 1987 1988 Employment Cost Index * 12-month percent change Total Compensation 1983 1984 1985 1986 1987 1988 ' Employment cost index (or private industry, excluding (arm and household wortiera. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 GNP Fixed-weighted Prices Percent change from end of previous period, annual rate 1 I I I 1983 1984 1985 1986 1987 1988 Producer Prices Percent change from end of previous period, annual rate I I I I I 1983 1984 1985 1986 1987 1988 Consumer Prices * Percent change from end of previous period, annual rate Digitized for FRASER 1983 1984 1985 1986 1987 1988 http://fraser.stlouisfed.org/ * Consumer Price Index for all urban consumers. Federal Reserve Bank of St. Louis 23 Consumer Food Prices * Percent change from end of previous period, annual rate 1983 1984 1985 1986 1987 1988 Consumer Energy Prices * Percent change from end of previous period, annual rate 15 15 30 1983 1984 1985 1986 1987 1988 Consumer Prices Excluding Food and Energy * Percent change from end of previous period, annual rate [|p| Services Less Energy | | Commodities Less Food and Energy Digitized for FRASER 1983 1984 1985 1986 1987 1988 http://fraser.stlouisfed.org/ * Consumer Price Index for all urban consumers. Federal Reserve Bank of St. Louis 24 probably reflected, in large part, the past year's accel- after steep increases during 1987; by most measures, eralion in hourly compensation and unit labor costs in however, the year-to-year rate of rise in these prices the domestic economy. By contrast, the pressures from has remained somewhat above that of inflation in rising import prices appeared to be a bit less pro- general. The producer prices of intermediate inputs, nounced than in 1987. Even so, higher prices for excluding food and energy, rose more than 7 percent imports probably were an influence in some areas; the during 1988, reflecting the high levels of capacity retail prices of apparel, for example, rose nearly 5 utilization in a number of industries, as well as the percent for the second year in A row. The price tightening of labormarkets. increases for industrial commodities slowed in 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Section 3: Monetary Policy and Financial Developments Ourfng 1988 During 1988, Federal Reserve policy continued to inflation and in the context of rapid growth in M2 and be characterized by a flexible approach lo monetary M3, the Federal Reserve firmed reserve conditions targeting, with System actions responding to emerging further in a series of steps beginning in March and conditions in the economy and in financial markets, as culminating in early August with a one-half percentage well as to growth of (he monetary aggregates. This point hike in the discount rate. These moves brought approach has been necessitated by the short-run vari- about substantial increases in short-term interest rales, ability in the relation of these aggregates to economic but were accompanied by only small increases in performance, owing primarily to their sizable response Treasury bond yields, as investors viewed Federal to changing interesi rates, in addition to spending. In Reserve actions as heading off a long-term acceleration the early months of last year, monetary policy was of inflation. The upturn in short-term interest rates, eased in light of incoming data suggesting a weakening coupled with more optimistic expectations of future in the economic expansion and the possibility of further inflation, helped boost the foreign exchange value of financial market disruptions. Subsequent information, the dollar during this period. however, suggested a growing threat of inflationary In view of the policy restraint already in place, pressures, as Ihe economic expansion remained strong which was being reflected in slowing growth in the and margins of available labor and productive capacity monetary aggregates, and some signs that economic dwindled. To head off a potential acceleration of growth may have been moderating, the Committee inflation, the Committee tightened reserve conditions postponed any further action over the late summer and in a series of steps beginning in the spring and extend- early fall, awaiting further in forma lion on the courseof ing into 1989. The monetary aggregates were running the economy. During October and November, the close to the upper ends of their growth ranges prior io foreign exchange value of the dollar declined, partly in the tightening actions, but subsequently slowed, and response to a rise in foreign interest rates relative 10 they closed the year in the middle portions of their U.S. market interest rates and to investor concern over ranges. the lack of progress in reducing the U .S. federal budget deficit and the slowing improvement in the U.S. trade Implementation of Monetary Policy deficit. During the early months of last year, the Federal In late fall, incoming data suggested that previous Open Market Committee sought lo counter any eco- monetary restraint had not been sufficient to relieve the nomic weakness that could result from the slock mar- potential for higher inflation and the Committee re- ket break and lo ensure the smooth functioning of sumed tightening reserve conditions in a series of domestic financial markets. Indicators of aggregate moves beginning in November and extending into the demand suggested that there was a risk of weakness in new year. As a result of these measures, short-term the economy that warranted some easing of monetary market interest rates rose. In contrast, bond yields policy. In addition, special emphasis was placed on continued to fluctuate narrowly, signalling the market's monitoring domestic financial markets for signs of any continued confidence lhat inflationary pressures would new distress and on being alert to the need lo alter the be contained. This confidence together with the firming provision of reserves quickly in response to any trou- of policy contributed to a strengthening of die foreign ble. Against this backdrop, reserve conditions were exchange value of the dollar. eased slightly in early February, contributing to reduc- tions in short- and long-term interes! rates. Behavior of Money and Credit Throughout the spring, incoming economic data suggested that the economy had overcome the effects of M2 expanded 5.3 percent last year, jusl below the lower equity prices on confidence and spending. This middle of its 4-ro-8 percent target range. Although information indicated (hat the economy was expanding demands for M2 were supported by strong growth in at a rate that threatened progress toward long-run price income and spending, they were reduced by increases Stability. Bond yields increased during this period, as in its opportunity cost— that is, the difference between indications of economic strength contradicted the ear- market interest rates and the yields on M2-type instru- lier market forecasts of a general slowdown and raised ments. Early in the year, opportunity costs had de- concerns about an uptrend in inflation. Based on evi- clined in response to decreases in market interest rates dence of a greater potential for higher wage and price relative lo deposit rates in late 1987 and early 1988, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 Short-Term Interest Rates Monthly 3-morrth Treasury Bill Cwipw* Equivalent I I Long-Term Interest Rates Percent Monthly 1980 1931 1902 1d63 1984 1965 1986 1967 1966 ObaanradOfii are monthly average* <* daily "Jala, last obawvation IB lor Decantoer 1988, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 leading to strong growth in M2 and a decline in its such as bank borrowings from overseas branches. In velocity —the ratio of nominal GNP to M2—during the contrast, as in recent years, the heavy use of Federal first quarter. But as market interest rales moved up- Home Loan Bank advances by thrift institutions— ward after March and deposit rates lagged behind, its which are nol included in M3—has had a moderating velocity subsequently reversed, rising 1,7 perceni for effect on M3 growth. all of 1988. The response of offering rates was espe- At 4,3 percent, M1 growth last year was down more cially sluggish in the last part of 1988. One reason for than 2 percentage points from 1987. Growlh of interest- this may have been regulatory pressure on thrifts and bearing checking accounts moderated while demand the closing of many insolvent institutions, which often deposits continued running off. As in recent years, the had been overly aggressive in pricing deposits. The growth of Ml displayed great sensitivity to changes in extent (o which thrifts were offering higher rates than market rates of interest. Households shifted savings banks on small time deposits was greatly reduced, and balances between NOW accounts and those M2 com- partly as a consequence, growth of retail deposits was ponents, such as small time deposits, whose yields much stronger at banks than at thrifts. responded to increases in market rates much more The composition of the growth of the components of quickly than those on NOW accounts. Because substi- M2 also responded fo changes in deposit rates and tutions of this type are internalized within M2, M2 has market interest rates. Yields on liquid deposits— displayed less sensitivity to interest rates than has Ml interest-bearing checking deposits, savings deposits, in this decade. Demand deposits, the other highly and money market deposit accounts—changed very interest sensitive component of M1, again declined in little over the year. During the first half of 1988, liquid 1988 partly reflecting increases in their opportunity costs and declines in compensating balances. The retail deposits expanded at a strong pace, largely amount of such balances that businesses musi hold in re fleeting increases in their relative attractiveness stem- these noninterest bearing accounts to compensate banks ming from declines in market interest rates and, to a for services falls when interest rates rise. lesser extent, in rates on small time deposits. Their growth slowed markedly over the last half of 1988, The debt of domestic nonfinancial sectors expanded following (he reversal in the pattern of imerest rate nearly 834 percent during 1988, down from 9 percent movements. Growlh in small denomination time depos- in 1987, placing it near the midpoint of the Commit- its was particularly robust throughout 1988. Expansion tee's 7-to-11 percent monitoring range. Although debt in the early months of the year may have resulted, in expansion was well below the pace of the mid-1980s, it part, from shifts in household investment preferences still exceeded nominal GNP growth. Federal debt grew away from stocks toward the safety of these savings marginally faster last year than in 1987. Expansion in instruments. Later, rising yields on small time deposits nonfederal debt moderated, as slate and local govern- relative to those on more liquid deposits led households ments trimmed debt issuance, and as households ex- to shift funds from liquid to small denomination time panded their mortgage debt at a less robust pace in deposit accounts. response to higher mortgage rates. Growth of business debt picked up a bit from its 1987 pace, with short-term M3 grew 6.2 percent fast year, placing it slightly debt growing faster than long-term debt. Corporate above the midpoint of its 4-to-8 percent target range. borrowing was particularly strong, reflecting in- This increase from a 5.8 percent growth in 1987 creased external financing needs for capital invest- reflected a modest pickup in the issuance of managed ments and for mergers, buyouts, and stock repurchases. liabilities in M3 to fund credit expansion at banks and thrift institutions, M3 followed a trajectory near the upper end of its target range in the first half of 1988, but Other Financial Developments moderated thereafter, in association with slowing credit growth at depository institutions. For the year, large Although the economy continued to grow at a strong time deposits and other managed liabilities included in pace last year and the financial markets recovered from M3 but not in M2 grew rapidly, as inflows into M2-type their skittishness following the stock market break of deposits were insufficient foe banks and thrifts to 1987, financial developments in certain markets and finance their desired pace of asset expansion. This was sectors warranted the attention of policymakers. Of particularly true in the second half of the year when M2 particular note were the worsening condition of the growth moderated. To some extent, M3 growth last thrift industry, the need to achieve sounder capitaliza- year also was bolstered compared with 1987 by a tion Of commercial banking organizations, and the greater reliance by banks on managed liabilities in- rising indebtedness of businesses involved in restruc- cluded in M3 than on nonmoney stock instruments, turing activity. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 Ranges and Actual Money Growth M2 Billions ol dollars Rate of Growth 3200 1987 Q4 to 1968 Q4 5-3 Percent 4% 3000 J I O N D J F M A M J J A S O ND 1967 1988 M3 Billions of dollars Rate Of Growth 1987 CM to 1988 Q4 6.2 Percent 4% — O N DJ F U A M J J A S O ND 1987 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 Ranges and Actual Growth of Money and Debt Debt Billions of dollars 9-wo Rate of Growth 9200 1987Q4to1988Q4 8.7 Percent 9000 8800 8600 8400 8200 I I I 8000 O N D J F M A M J J A S O NO 1987 1988 M1 Billions ot do liars 900 Rate of Growth 1987 04 to 1988 Q4 850 4.3 Percent 800 750 J I I I I I I I I 700 O N D J F M A M J J A S O ND 1987 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 Velocity of Money and Debt (Quarterly) M1 _ . M2 Ratio scale 1-2 1961 1970 1979 1988 i961 1970 1979 M3 Debt Ratio scale Ratio scale 0.8 1961 1970 1988 1961 1970 1979 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 Growth of Money and Debt1 (Percentage changes) Debtof domestic nontlnanclal M1 M2 M3 sectors Founn quarter to fourth quarter 1979 7.7 8.2 10.4 12.3 1980 7.4 9.0 9.6 9.6 1981 5.2(2.5)3 9.3 12.3 10.0 1982 8.7 9,1 9.9 9.0 1983 10.2 12.1 9.8 11.3 1984 5.3 7.7 10.5 14.2 1985 12.0 (13.0)3 8.9 7.7 13.2 1986 1S.6 9.3 9.1 13.3 1987 6.4 4.2 5.7 9.8 1988 4,3 5.3 6.2 8.7 Quarterly growth rates < annual rates) 1988 Q1 3.2 6,2 6.8 8.2 Q2 6.4 6.9 7.2 8.7 Q3 5.2 3.8 5.5 8.6 Q4 4.4 3.8 4.9 8.4 1. M1, M2, and M3 incorporate effects of benchmark 3. M1 figure in parentheses is the annualized growth and seasonal adjustment revisions made in Febru- rate from th« second to the fourth quarter of 1985. ary 1989 2. M1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 As the year wore on, the dimensions of the problems emphasis on equity capital, take into account the facing the thrift industry became clearer. Although off-balance sheet activities of banks, and provide a industry losses eased in the third quarter from their more uniform regulatory treatment of banks based in record levels in the first half of 1988, this development different countries. appears largely to have reflected FSLIC assistance As in 1987, banks lent considerable sums 10 finance transactions during the third quarter, rather than a mergers and leveraged buyouts. Although banks have significant underlying improvement in earnings. reported that these loans have had a lower rate of loss Despite the turmoil in the thrift industry, there has than all other business loans combined, and although been no noticeable disruption of mortgage activity. In LBO borrowers typically obtain some insurance against pan, the development of a deep secondary mortgage higher loan rates, concern remains about bank expo- market has separated the origination of loans from the sure to losses in the event of an adverse turn in. business need to fund them. For this reason, the base of mort- conditions. For this reason, the Federal Reserve is gage credit has been broadened in recent years, making closely monitoring developments in this area and has the provision of mortgages far less dependent on the just revised its bank examination guidelines to ensure condition of any one type of financial institution or on that member bank loans used to finance buyouts and the regional supply of loanable funds. During the other highly levered corporate restructurings meet 1980s, the share of home mortgage credit held in prudent credit standards. securitized form has increased from about 10 percent Leveraged buyouts and other mergers and restruc- to more than one-third. The spread between interest turings led to a record pace of net equity retirements by rates on fixed-rate mortgages, which have an average nonfinancial corporations in 1988. Despite the large life of roughly.ten years, and yields on ten-year volume of this activity in recent years, the overall Treasury notes did not change appreciably over 1988, corporate debt-to-equity ratio is not out of line with which also implies that the mortgage markets contin- observations since the early 1970s, reflecting in- ued functioning well despite the problems of many creased market valuation of equities since the eaily savings and loan associations. 1980s. Much of the recent financial restructuring has In contrast to the thrift industry, preliminary data been a response to fundamental economic factors; it indicate that U.S. commercial bank profits were rea- may impose a discipline on corporate management, sonably strong in 1988, even after abstracting from the whkh in turn can stimulate efforts to improve produc- one-time jump in fourth quarter earnings associated tivity. Nevertheless, heavy commitments of cash flow with the resumption of Brazilian debt payments. More- to service debt reduce a firm's ability to cope with over, most large money-center banks with a significant stresses or industry-specific shocks. To some extent, amount of loans to developing countries have contin- the substitution of debt for equity is motivated by ued to build capital, which provides a cushion against simple tax-saving considerations, such as the full de- default losses. Giving added impetus to efforts to raise duction for interest payments and the double taxation equity was the agreement by bank supervisory author- of dividends. For these reasons, reforming the corpo- ities of major industrial countries to set more stringent, rate tax system should be a component of public policy risk-based standards of capital adequacy. These stan- in addressing this difficult issue. dards, to be fully phased in by 1992, place a greater Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 The Share of Residential Mortgage Debt Held as Securities Percent 35 Quarterly through 19S8O3 30 25 20 15 10 1980 1981 1982 1983 1984 1985 1986 1987 1988 The Spread Between Primary Home Mortgage and 10-year Treasury Bond Rates Percent Monthly liiimimi 1980 1982 1984 1986 1988 Debt to Equity Ratios of Nonfinancial Corporations* Percent 120 Quarterly through 1988Q4 100 Debt/Equity 80 60 M 20 1960 1964 1968 1972 1976 1980 1984 1988 'Debt and equity are at martot value. In computing nel worth, tangible assets ate valued at replacement cost or market value while finanaal assets are valued at cost. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 The CHAIRMAN. I would be very pleased now to have you give us your oral summary. STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. GREENSPAN. Thank you, Mr. Chairman. I also ask that my full testimony be included as part of the record as well. I will try to shorten it to a certain extent. Last year was a challenging one for monetary policy. Early in the year, uncertainties remained about the impact of the October 1987 worldwide stock market break on the economic expansion and financial system. Given these risks, the Federal Reserve increased the availability of bank reserves slightly further and monitored fi- nancial and economic indicators closely for any signs that the eco- nomic expansion was faltering. Gradually, however, it became clear that the economic expansion remained well on track and that the balance of risks was shifting in the direction of higher inflation. Consequently, the Federal Open Market Committee applied increased restraints to reserve positions in a aeries of steps beginning in the spring of 1988 and extending to the current period. In addition, the discount rate was raised from 6 to 6.5 percent in August. The policy restraint led to an appreciable rise in short-term market interest rates and a moderation of money growth beginning in the spring of 1988. M2 and M3 finished the year around the middle of their 4-to-8 percent annual target ranges. Despite tightening money markets, longer term interest rates have been remarkably stable. Moreover, the stock market recov- ered relatively steadily over the year and into 1989, and the dollar has been fairly stable since late 1987. The optimism of domestic and foreign investors evident in finan- cial markets reflected expectations that inflation would not intensi- fy appreciably as well as the solid performance of the economy and prospects for its continuation. Our GNP expanded by around 3.25 percent in 1988, adjusted for crop losses caused by the drought. This increase helped push the unemployment rate below 5.5 percent, its lowest level since the mid-1970's. Employment gains in 1987 and 1988 were strong in nearly every major sector of the American economy, including manufacturing. Although in 1988 farmers suffered one of their worst crop losses in this century, the situation in agriculture re- mains fundamentally much improved from that earlier in the 1980s. However, last year's economic performance had some disappoint- ing features. The Federal budget deficit remained high and our na- tional saving low. This contributed to continued large current ac- count and trade deficits. In addition, overall inflation in the area of 4 to 4.5 percent during 1988 was a little above the general range in which it had fluctuated in the mid-1980's. The drought boosted food prices, adding somewhat to inflation last year, but this was largely offset by a leveling off of energy prices. Prices of other consumer goods and services accelerated a bit. This acceleration is troubling, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 especially with inflation already at a level that would be unsatis- factory if it persisted. Although the ster>up in consumer inflation to date has been rather small, some signs have emerged of greater acceleration in the broad measures of costs of production. Wage gains accelerated toward the end of last year. Moreover, benefits took an unusually large jump in 1988, adding to business costs, and prices of materi- als also rose at a faster pace. On the whole, the economic expansion remains vigorous and un- usually well-balanced after more than 6 years. But with the econo- my running close to its potential, the risks seem to be on the side of a further strengthening of price pressures. In these circum- stances, the Federal Reserve remains more inclined to act in the direction of restraint than toward stimulus. The determination to resist any pickup in inflation in 1989 and especially to move over time toward price stability shaped the com- mittee's decisions with respect to monetary and credit ranges for 1989. The FOMC lowered the range for M2 by a full percentage point to 3 to 7 percent and reduced the range for M3 by one-half of a percentage point to 3.5 to 7.5 percent. The committee also low- ered the monitoring range for domestic nonfinancial sector debt by one-half of a percentage point to a range of 6.5 to 10.5 percentage points. These were the ranges adopted on a tentative basis last June. We decided to retain the wider, 4-percentage-point ranges that were adopted in 1988. The potential for sizable and somewhat un- predictable movements in velocity requires fairly broad ranges in order to have reasonable assurance that the targets are consistent with satisfactory economic performance. In view of the rather loose relationship of the aggregates to GNP and prices that have developed in the 1980's, the committee agreed to continue its current approach to the implementation of policy, which involves monitoring a variety of economic and financial indi- cators, including growth of money and debt. In this regard, appropriate growth of M2 and M3 relative to their ranges will be determined in part by developments during the year. The Federal Reserve expects its policy in 1989 to support contin- ued economic expansion while putting in place conditions for a gradual easing in the rate of inflation over time. However, the wage and price process may have developed some momentum. The central tendency of forecasts made by members of the Federal Re- serve Board and presidents of Federal Reserve Banks is for infla- tion to rise slightly in 1989. But let me stress that the current rate of inflation, let alone an increase, is not acceptable, and our poli- cies are designed to reduce inflation in coming years. This restraint will involve containing pressures on our produc- tive resources, and, thus, some slowing in the underlying rate of growth of real GNP is likely in 1989. The central tendency of GNP growth forecasts for this year of Board members and Reserve Bank presidents is between 2.5 and 3 percent; abstracting from the ex- pected rebound from last year's drought losses, real GNP is project- ed to grow at closer to a 2 percent rate. With demands for labor growing more in line with expansion of the labor force, the unem- ployment rate is expected to remain near its recent level over 1989. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 Maximum sustainable economic growth over time is the Federal Reserve's ultimate objective. The primary role of monetary policy in the pursuit of this goal is to foster price stability. Price stability contributes to economic efficiency in part by reducing the uncer- tainties that tend to inhibit investment. Also, it directs resources to productive economic activity that otherwise would tend to be di- verted to mitigating the financial effects of inflation. Price stability—indeed, even preventing inflation from accelerat- ing—requires that aggregate demand be in line with potential ag- gregate supply. In the long run, that balance depends crucially on monetary policy. Inflation cannot persist without a supporting ex- pansion in money and credit; conversely, price stability requires moderate growth in money—at rates below those prevailing in recent years. In the short run, demands can fall short of or run ahead of avail- able resources. Monetary policy can assist hi bringing about a better match between demand and potential supply and thereby contribute to aggregate price stability. When the economy is operating below capacity, bringing demand in line with supply can involve real GNP growth that is faster for a time than its long-run potential. But when the economy is operat- ing essentially at capacity, monetary policy cannot force demand to expand more rapidly than potential supply without adverse conse- quences. Such an attempt will result in accelerating prices and wages, as producers bid for scarcer, and at the margin less produc- tive, labor and capital. Over time it would result in little, if any, additional output. As a result of robust expansion in the last few years, the U.S. economy has absorbed much of its unused labor and capital re- sources. No one can say precisely which level of resource utilization marks the dividing line between accelerating and decelerating prices. However, the evidence—in the form of direct measures of prices and wages—is clear that we are now in the vicinity of that line. Thus, policies that foster more economic growth, if such growth is to be sustainable over the long run, should focus on aggregate supply. The United States could increase growth of supply by step- ping up the pace of capital accumulation. Government policies can contribute to a higher rate of investment. Tax policies can help by ensuring that returns from capital are not taxed excessively or un- predictably. And fiscal policy can help boost the national saving rate through a reduction in government dissaving. Congress should follow the Gramm-Rudman-Hollings timetable and then seek a budgetary surplus by the mid-1990's, in my judgment. An improving Federal budget position should have a variety of favorable effects. It can pave the way for a reduction in our exter- nal imbalance by freeing resources currently absorbed by domestic demand. By putting downward pressure on real interest rates, it can encourage domestic business capital formation and make hous- ing more affordable. It can encourage households and businesses to focus more on the long run in economic planning. Monetary policy also has a role to play in encouraging capital formation and economic growth over time, by providing a stable price environment. Although the relationship between growth of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 money and the economy can vary from year to year, over the long haul there is a close relationship between money and prices. The historical evidence suggests that price stability ultimately will re- quire a somewhat slower M2 growth than we have experienced in recent years. The Federal Reserve recognizes that monetary policy over the coming year will be carried out against the backdrop of a financial system facing certain difficulties. The thrift and FSLIC situation is perhaps most pressing. The Administration has proposed an exten- sive, workable plan for dealing with this matter. There appears to have been little, if any, effect of the S&L problem on mortgage availability in housing—thanks in part to financial innovation in the form of the mortgage-backed securities market. However, with- out quick and effective action the situation could deteriorate. Developments in the corporate sector warrant close scrutiny as well. As you know, corporate equity continues to be retired at a startling rate in conjunction with LBO's and other mergers and re- structurings and has involved issuance of a correspondingly large amount of debt. Although these restructurings often may improve economic efficiency, the higher leverage leaves these firms and po- tentially their creditors more vulnerable to financial difficulties in the event of a downturn. The Federal Reserve and other Federal regulators are instructing bank examiners to review especially carefully loans to highly leveraged firms in order to maintain a safe and sound banking system, The international economy also will command the continuing at- tention of policymakers around the world. Among the industrial countries, greater concern about rising inflation followed the sub- stantial economic growth recorded last year. Meanwhile, the proc- ess of adjustment of international imbalances appeared to have slowed somewhat in the second half of last year, and many develop- ing countries continued to face serious problems of achieving sus- tained economic growth, fostering development, and servicing large external debts. Some have argued that these financial stresses, taken together, could hamstring the Federal Reserve's anti-inflationary policy. Cer- tainly we have to take account of the effects of our actions on all sectors of the domestic and international economy and on financial markets; at the same time we recognize that monetary policy is not the instrument to deal with structural financial stresses and imbal- ances here and abroad—and that attempts to do so may even worsen these problems. Lowering interest rates in the short run through more rapid money growth against countervailing market pressures would quickly raise inflationary expectations, leading sooner to higher, not lower, interest rates. Instead, the structural financial problems require the prompt ap- plication of microeconomically oriented solutions within the super- visory, regulatory, and legal framework. Imbalances in the world economy require the continued, patient application of responsible macroeconomic policies in the United States and in other industri- al countries, as well as further progress in economic reforms by the developing countries. For its part, the Federal Reserve will continue to seek monetary conditions that will reduce inflation. Our major trading partners Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 are following consistent policies in their own economies. Together, these policies should bring about a more stable financial environ- ment and promote long-run worldwide economic growth. Relatively stable long-term nominal interest rates and flattening yield curves around the industrial world are strong evidence that savers and investors are in accord with this view. Monetary policy, at least for the moment, appears on track in the United States. The task is to keep it on track while making necessary adjustments to fiscal policy and reforms to the regulation of financial institu- tions. In this way, we can ensure vigorous and balanced economic conditions over the long run. Thank you very much. [The complete prepared statement of Alan Greenspan follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 Statement by Alan Greenspan Chairman, Board of Governors of the Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate February 21, 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Mr. Chairman and members of the Committee, I appreciate this opportunity to discuss with you recent monetary policy and our plans for the future. You have received our formal report to the Congress. This morning, I would like to summarize the important points of that report and to place monetary policy in the context of the overall economic and financial situation. gcgnpmic, and_ jipjie_^a_ryJ3gyej.op_ment3 in 1966 Last year was a challenging one for monetary policy. Early in the year, uncertainties remained about the impact of the October 1987 worldwide stock market break on the economic expansion and financial system. Given these risks, the Federal Reserve increased the availability of bank reserves slightly further, adding to the easing put in place immediately following October 19; at the same time we monitored financial and economic indicators closely for any signs that the economic expansion was faltering. Gradually, however, it became clear that the economic expansion remained well on track and that market confidence was on the mend. Spending was robust, and dwindling margins of unused resources aa employment and output registered sizable gains indicated that the balance of risks was shifting in the direction of higher inflation. Consequently, the FOMC applied increased restraint to reserve positions in a series of steps beginning in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 spring of 1988 and extending to the current period. In addition, the discount rate was raised from 6 to 6-1/2 percent in August. The policy restraint led to an appreciable rise in short-term market interest rates beginning in the spring of 1988. Growth of money moderated over the year as rates on deposits lagged the rise in market interest rates. M2 and M3, which were near the upper ends of their target ranges early in the year, slowed considerably in subsequent months and finished the year around the middle of their 4 to 8 percent annual target ranges. Growth of Ml also was restrained by higher interest rates, slowing to about 4 percent, while the monetary base grew only a bit less rapidly than in 1987, as currency continued to expand at a strong pace. Thus, in both 1987 and 1988, most money measures grew appreciably more slowly than they had in many years. This more moderate pace of monetary expansion has been a necessary aspect of a monetary policy designed to contain inflation and promote price stability and economic growth over timQ, Despite tightening money markets, longer-term interest rates have been remarkably stable. Yields on Treasury bonds, for example, remained in a fairly narrow range around 9 percent for moat of the year and have continued in that range so far in 1989. Moreover, the stock market recovered relatively steadily over the year and into Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 1989. The performance of the bond and stock markets in the face of rising short-term rates seemed to stem from expectations of continued relatively balanced economic expansion in the United States with inflation pressures not likely to intensify. U.S. investments looked attractive under these circumstances, and the dollar's average value against major foreign currencies recovered from the late 1987 plunge and was relatively stable over the course of the year. The optimism of domestic and foreign investors evident in financial markets reflected the solid performance of the economy and prospects for its continuation. Our GNP expanded by around 3-1/4 percent in 1988, adjusted for crop losses caused by the drought. Over the year, payroll employment rose by 3.7 million. Since the economic expansion began in late 1982, employment in the United States has increased by more than 17 million people, pushing the unemployment rate below 5-1/2 percent, its lowest level since the mid-1970s. Employment gains in 1987 and 1988 were strong in nearly every major sector of the American economy, including manufacturing, construction, trade, and services. Although in 1988 farmers suffered one of their worst crop losses in this century, the situation in agriculture remains fundamentally much improved from that earlier in the 1980s. Industrial production in manufacturing rose 5-1/2 percent, bringing average capacity utilization to the highest level Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 since the late 1970s. Some industries that had been hit especially hard by the recession of 1981-82 and by the erosion of international competitiveness owing to the rise in the value of the dollar now are considerably improved. Quite a few firms in those industries are operating essentially flat out and experiencing notable profit improvement. However, last year's economic performance had some disappointing features. The federal budget deficit remained high and our national saving low. This contributed to a continued large current account and trade deficit. By keeping pressure on interest rates, the low rate of saving also was a factor behind the performance of business fixed investment last year. Investment slowed from 1987, especially in the second half of the year, even in the face of relatively rapid expansion of production and high levels of capacity utilization. In addition, overall inflation, in the area of 4 to 4-1/2 percent, during 1988 was a little above the general range in which it had fluctuated in the mid 1980a. The drought boosted food prices, adding somewhat to inflation last year, but this was largely offset by a leveling off of energy prices. Prices of other consumer goods and services accelerated a bit. This acceleration is troubling, especially with inflation already at a level that would be unsatisfactory if it persisted. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 Although the step-up in consumer inflation to date hag been rather small, some signs have emerged of greater acceleration in broad measures of costs of production. Wage gains accelerated toward the end of last year. Moreover, benefits took an unusually large jump in 1988, boosted in part by a sharp rise in health insurance coats and a hike in social security taxes—both of which add to business costs as directly as do wages. Overall, the employment cost index, a comprehensive measure of hourly wage and benefit rates, rose 5 percent in 1988, up significantly from 1987. Materials inputs also were adding to costs; the producer price index for intermediate materials and supplies excluding food and energy rose about 7 percent over the past year. Economic^Prospects and jtonetary^ Policy for^ 1969 On the whole, the economic expansion remains vigorous and unusually well balanced after more than six years. There are few of the tell-tale distortions, such as widespread inventory overhangs or constricted profit margins, that typically have signaled the last phases of expansions. But with the economy running close to its potential, the risks seem to be on the side of a further strengthening of price pressures. In these circumstances, the Federal Reserve remains more inclined to act in the direction of restraint than toward stimulus. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 The determination to resist any pickup in inflation in 1989 and especially to move over time toward price stability shaped the Committee's decisions with respect to monetary and credit ranges for 1989. The Committee agreed that, particularly in this environment, progress toward these objectives likely will require continuing restraint on growth in money and credit. To this end, the Committee lowered the range for M2 by a full percentage point to 3 to 7 percent and reduced the range for M3 by 1/2 percentage point to 3-1/2 to 7-1/2 percent. The Committee also lowered the monitoring range for domestic nonfinancial sector debt by 1/2 percentage point to 6-1/2 to 10-1/2 percentage point. These were the ranges adopted on a tentative basis last June. We decided to retain the wider, 4-percentage-point ranges that were adopted in 1988. The relationship of the monetary aggregates to economic performance has been quite variable in the 1980s. The relatively high interest elasticity of the aggregates, even after deregulation, makes them very sensitive to changes in money market conditions, which in turn can respond to developments in the real economy or prices. The resulting potential for sizable movements in velocity requires broader ranges in order to have reasonable assurance that the targets are consistent with satisfactory economic performance. Considerable uncertainties regarding the effects on the monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 aggregates of the resolution of the thrift institution difficulties also argue for relatively wide ranges this year. Depending on the pace of asset growth of thrifts and changes in their deposit pricing policies, the composition and growth of their liabilities could vary substantially from past patterns. For the same reasons, the Committee agreed to continue its current approach to the implementation of policy, which involves monitoring a variety of economic and financial indicators, including growth of money and debt. In this regard, appropriate growth of M2 and M3 relative to their ranges will be determined in part by developments during the year. At present, it appears that the velocities of M2 and MS are likely to rise this year, in response to the market interest rate increasea to date and unusually sluggish adjustment of deposit rates. The Federal Reserve expects its policy in 1989 to support continued economic expansion while putting in place conditions for a gradual easing in the rate of inflation over time. However, the wage and price process may have developed some momentum. The central tendency of forecasts made by members of the Federal Reserve Board and presidents of Federal Reserve Banks is for inflation to rise slightly in 1989. But let me stress that the current rate of inflation, let alone an increase, is not acceptable, and our policies are designed to reduce inflation in coming years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 This restraint will involve containing pressures on our productive resources and, thus, some glowing in the underlying rate of growth of real GNP is likely in 1989. The central tendency of GNP forecasts for this year of Board members and Reserve BanJc presidents is 2-1/2 to 3 percent; abstracting from the expected rebound from last year's drought losses, real GNP is projected to grow at closer to a 2 percent rate. Net exports are expected to continue to improve in 1989 as we make further progress on reducing our external imbalances, but this implies the need for restraint on domestic demand to contain pressures on our productive resources. With demands for labor growing more in line with expansion of the labor force, the unemployment rate is expected to remain near its recent level over 1989. Monetary Policy and _Long^r_un_Ecgnomic Growth Maximum sustainable economic groirth over time is the Federal Reserve's ultimate objective. The primary role of monetary policy in the pursuit of this goal is to foster price stability. For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decisions. Price stability contributes to economic efficiency in part by reducing the uncertainties that tend to inhibit investment. Also, it directs resources to productive Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 economic activity that otherwise would tend to be diverted to mitigating the financial effects of inflation. Price stability—indeed, even preventing inflation from accelerating—requires that aggregate demand be in line with potential aggregate supply. In the long run, that balance depends crucially on monetary policy. Inflation cannot persist without a supporting expansion in money and credit; conversely, price stability requires moderate growth in money—at rates below those prevailing in recent years. In the short run, demands can fall short of, or run ahead of, available resources, with implications for wage and price pressures and the appropriate stance of monetary policy. By altering reserve conditions and the money supply, and thus interest and exchange rates and wealth positions, monetary policy can assist in bringing about a better match between demand and potential supply and thereby contribute to aggregate price stability. When the economy is operating below capacity, bringing demand in line witfc supply can involve real GNP growth that is faster for a time than its long-run potential. For example, in the mid-1980s, the U.S. economy was recovering from a deep recession; with utilization of labor and capital not nearly complete, we were able to bring these resources back into the production process at a pace that substantially exceeded their underlying growth rates. In those circumstances, it is not surprising that growth of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -10- real GNP was relatively rapid while inflation performance was reasonably good. But when the economy is operating essentially at capacity, monetary policy cannot force demand to expand more rapidly than potential supply without adverse consequences. Such an attempt will result in accelerating prices and wages, as producers bid for scarcer, and at the margin less productive, labor and capital. Over time it would result in little if any additional output. As a result of robust expansion in the last few years, the U.S. economy has absorbed much of its unused labor and capital resources. No one can say precisely which level of resource utilization marfca the dividing line between accelerating and decelerating prices. However, the evidence—in the form of direct measures of prices and wages--is clear that we are now in the vicinity of that line. Thus, policies that foster more economic growth, if such growth is to be sustainable over the long run, should focus on aggregate supply. Aggregate supply depends on the size of the labor force and its productivity. Growth of the labor force basically is a function of increases in population and of individuals' decisions with regard to participation in the labor force. Labor productivity depends partly on the quantity and quality of capital and the overall efficiency in combining labor and capital in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 -ii- production process. Given projections of likely labor force expansion and capital accumulation, most estimates of growth in long-run potential real GNP fall in a range below the average growth rates of real nonfarm GNP experienced over the last couple of years. Faster growth in real GNP would be possible for a time if we could use more of our labor and plant capacity without putting pressure on wages and prices. Monetary policy is not a useful tool to accomplish this. But microeconomic policies may well be, such as policies designed to improve the match between labor demands and supplies. Conversely, we must be careful to avoid approaches to our national needs that would add unduly to business costs or increase rigidities in labor and product markets. Perhaps moat important over the long run, as the composition of production in the U.S. economy continues to evolve, we must intensify our efforts to educate our labor force to be productive in the increasingly high-technology world marketplace. In addition, the United States could improve its longer-run growth prospects by stepping up the pace of capital accumulation. Government policies can contribute to a higher rate of investment. Tax policies can help by ensuring that returns from capital are not taxed excessively or unpredictably. And fiscal policy can help boost the national saving rate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 -12- Ideally, increased national saving would involve some improvement in the private saving rate. Household saving is abysmally low in the United States, and business saving hasn't risen enough to offset that. However, it is not clear that past government policies have been very effective in boosting private saving. Probably the most direct and sure way of increasing saving is by a reduction in government dissaving. Congress should follow the Gramm- Rudman-Hollings timetable and then seek a budgetary surplus by the mid-1990s. An improving federal budget position should have a variety of favorable effects. It can pave the way for a reduction in our external imbalance by freeing resources currently absorbed by domestic demand. By putting downward pressure on real interest rates, it can encourage domestic business capital formation and make housing more affordable. It can encourage households and businesses to focus more on the long run in economic planning. Monetary policy also has a role to play in encouraging capital formation and economic growth over time, by providing a stable price environment. Although the relationship between growth of money and the economy can vary from year to year, over the long haul there is a close relationship between money and prices. Recently, the Board's staff has done some interesting research on this subject. This worJc indicates that future changes in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 -13- rate of inflation have been fairly reliably linked to the difference between the prevailing price level and its equilibrium level. That equilibrium level is calculated at the current level of M2, assuming that real GNP is at its potential and velocity is at its long-run average. As you can see from the chart, inflation apparently tends to accelerate with a lag when actual prices are below the equilibrium value associated with current M2, and to decelerate when above it. This research suggests that despite relatively moderate expansion of M2 in recent years, the equilibrium value still is a little above the current price level, reinforcing the notion that the present risks are on the side of a pickup of inflation. This work also confirms that price stability ultimately will require somewhat slower M2 growth than we have experienced in recent years. Finaneia 1 Developments and Mongta_rv_Pgl_icy The Federal Reserve recognizes that monetary policy over the coming year will be carried out against the backdrop of a financial system facing certain difficulties. The thrift and FSLIC situation is perhaps most pressing. The administration has proposed an extensive, workable plan for closing insolvent institutions, improving the regulation and supervision of S&Ls, and strengthening the deposit insurance funds. On Thursday, I will be presenting more detailed testimony on this topic before this committee. For Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 -14- now, let me simply encourage you and your colleagues to take the necessary legislative steps to resolve this situation promptly. There appears to have been little, if any, effect of the S4L problem on mortgage availability and housing--thanks in part to financial innovation in the form of the mortgage-backed securities market. However, without quick and effective action the situation could deteriorate. Developments in the corporate sector warrant close scrutiny as well. The stock market has been recovering over the past 15 months, with few signs as yet of speculative excesses. However, as you know, corporate equity continues to be retired at a startling rate in conjunction with LBOs and other mergers and restructurings and has involved issuance of a correspondingly large amount of debt. As I have noted in recent congressional testimony, this phenomenon is complex, having both positive and negative dimensions. These restructurings often have added economic value through improved efficiency—an important consideration given the increasingly competitive nature of world markets. But the higher leverage leaves these firms, and potentially their creditors, more vulnerable to financial difficulties in event of a downturn. The Federal Reserve and other federal regulators are instructing bank examiners to review especially carefully loans to highly leveraged firms in order to maintain a safe and sound banking system. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 -15- The international economy also will command the continuing attention of policymakers around the world. Among the industrial countries, greater concern about rising inflation followed the substantial economic growth recorded last year. Meanwhile, the process of adjustment of international imbalances appeared to have slowed somewhat in the second half of last year, and many developing countries continued to face serious problems of achieving sustained economic growth, fostering development, and servicing large external debts. Some have argued that these financial stresses, taken together, could hamstring the Federal Reserve's anti- inflationary policy. Certainly we have to take account of the effects of our actions on all sectors of the domestic and international economy and on financial markets; at the same time we recognize that monetary policy is not the instrument to deal with structural financial stresses and imbalances here and abroad—and that attempts to do so may even worsen these problems. Backing away from policy adjustments needed to contain inflation will not solve the thrift problem, make the debt burden of heavily leveraged firms lighter, speed the process of international adjustment, or contribute to a fundamental solution of the economic problems of the developing countries. In fact, the thrift industry's problems, as well as the external debt problems of the developing countries, were exacerbated by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 -16- the inflation of the 1970s. Attempting to lower interest rates in the short run through more rapid money growth against countervailing market pressures would quickly raise inflationary expectations, leading soon to higher, not lower, interest rates. Instead, the structural financial problems require the prompt application of microeconomically oriented solutions within the supervisory, regulatory, and legal framework. Imbalances in the world economy require the continued, patient application of responsible macroeconomic policies in the United States and in other industrial countries, as well as further progress in economic reforms by the developing countries. Conclusion For its part, the Federal Reserve will continue to seek monetary conditions that will reduce inflation. Our major trading partners are following consistent policies in their own economies. Together, these policies should bring about a more stable financial environment and promote long- run worldwide economic growth. Relatively stable long-term nominal interest rates and flattening yield curves around the industrial world are strong evidence that savers and investors are in accord with this view. Monetary policy, at least for the moment, appears on track in the United States. The task is to keep it on track while making necessary adjustments to fiscal policy and reforms to the regulation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 -17- of financial institutions. In this way we can ensure vigorous and balanced economic conditions over the long run, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 Inflation Indicator Based on M2 Ratio seal* ISO 100 Current price level (P) /,••' Long-run equilibrium price level .. given current M2 (P *) ''' 50 I M I M I I I I I I t I I ) I ! I I M IJJ III I I 1 Percent 1956 1B64 1972 1860 1088 The current price level (P, the solid line In the top panel) la the Im- plicit QNP deflator, which IB set to 100 In 1982. The long-run equilibrium price level given currant M2 (P*, the dashed line In the top panel), Is calculated as P* - (M2 x V'VQ*. where V Is an estimate of the long-run value of the QNP velocity of M2—the mean of V2 from 1966:Q1 to 1966:04—and Q* la • Federal Reserve Board staff measure of potential real GNP. The verticil lines mark the quarters when the difference between the currant price level (P) and the long-run equilibrium price level (P*} switches sign, and thus when Inflation, with a lag, tends to begin accelerating or decelerating. Inflation (bottom panel) Is the percentage change In the Implicit QNP deflator from four quarters earlier. For more detail*, see Jeffrey Mailman, Richard D. Porter, and David H. Small, U2 Per Unit of Potent/a/ QNP 99 a Price-Level Anchor, staff Studies (Board of Governors of the Federal Reserve System, forthcoming). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 The CHAIRMAN. Thank you very much, Chairman Greenspan. We have had Senators Mack and Wirth join us. I gather neither wish to make an opening statement at this time. Let me now begin the question period. In your official forecast of 1989 real GNP growth on page 3 of your document, you indicate that the central tendency of projections by you and the other Federal Reserve Governors and bank presidents is a growth rate somewhere between 2.5 and 3 percent. I note that among other forecasters, CBO is projecting 2.9 percent, and the blue chip private forecasters' consensus is 2.7 percent. So those two would fall within the range of what you describe as the central tendency. I am concerned, however, about the fact that the administration for the purpose of building its economic forecasts and budget plan is assuming 1989 growth of 3.3 percent. That is well above and out- side the central tendency range that you have indicated that you believe is the most likely. Can you give us any understanding as to what accounts for the difference here? I assume you have talked with the administration. They obvious- ly see it one way and you and others see it a different way. Can you shed any light on that difference? Mr. GREENSPAN. Yes. First, Mr. Chairman, let me indicate that the differences between forecasts are not large in the context of the type of errors that we make as forecasters. There are differences. Their productivity numbers are stronger than ours. Their GNP is somewhat stronger. I would say that ours is somewhat more probable than theirs, al- though we could have chosen a forecast closer to theirs. I think I would be doing the process of economic forecasting a disservice if I indicated that I know for sure that it is not a reasonable forecast to assume a growth rate higher than 3 percent. If somebody said we will grow 4 or 5 percent this year, I would say that is most unlike- ly. But, frankly, Mr. Chairman, I don't think that the techniques that we have to forecast are sufficiently refined to argue strongly that the administration's forecast is outside the range of reason- ableness. The CHAIRMAN. You make a strong case for reducing the Federal deficit, and I agree with you 100 percent on that issue. But if it turns out that growth falls short of the administration's forecast, then the deficit goes higher. Obviously, that starts to work its way back through creating pressures on interest rates and other things, and so getting the best estimate that we can make is critical to building a budget for this year. Mr. GREENSPAN. I understand that, Mr. Chairman, but there is a very difficult problem that we have in this process because what an administration does when it brings forward a budget is to assume that the Congress will enact expeditiously that budget line by line exactly as it has proposed. If that process actually occurred, I think there is significant justi- fication on the part of the administration to assume they would have a somewhat stronger economy because, under those condi- tions, inflation expectations would fall rather significantly, as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 would long-term interest rates, and it is quite likely that capital in- vestment would accelerate above the path which it currently is on and certainly above the path which we project. It is a very difficult problem which you have. It is a chicken and egg problem, and it is a process which, when I was on the other side as Chairman of the Council of Economic Advisers, I had diffi- culties with. The CHAIRMAN. Let me leave that one for the moment with just this comment. Obviously, it matters on how realistic the budget proposal is to start with. If it is unrealistic in a major dimension and is so seen by most experts and observers, then the growth rate that would flow from that also becomes not very realistic. You don't do an interest rate forecast, and I understand why, but I think it is very important to get your judgment on the interest rate forecast that is also among the key economic assumptions that underlie the budget we are about to construct. I read you before the 90-day Treasury bill projections running as follows—for 1989, first quarter, 8.3 percent; second quarter, 7.8 per- cent; third quarter, 7.2 percent; fourth quarter, 6.6 percent; and the first quarter of 1990 being at 6 percent and then the average for the full year 1990 being 5.5 percent. Those are awfully low rates, I think, relative to what we are seeing today, and it would be a very startling change over a short period of time from where we find ourselves literally this minute—are those realistic? Mr. GREENSPAN. Mr. Chairman, as I said before, implicit in the administration's forecast, as I understand it, is the expectation of a fairly expeditious passage of the budget. I think they are correct to assume a significant decline in interest rates if that occurs. In other words, it is consistent with the approach which they are taking. I cannot comment on any of the individual numbers, but I have a considerable amount of sympathy for their overall notion that interest rates will fall significantly in that environment. The CHAIRMAN. Let me just ask you this. Then my time will be up for this question period. The 90-day bill rate at the moment is at what percentage figure? Mr. GREENSPAN. It is 8.5 percent on a discounted basis. The CHAIRMAN. Roughly 8.5 percent on a discounted basis, and we are now finishing the first quarter. The estimate is by the fourth quarter we are going to be down to 6.6 percent. We are going to have a full 2 percentage point drop. Is that realistic? Mr. GREENSPAN. Mr. Chairman, I don't feel I can comment very specifically on individual interest rates. I would just like to reiter- ate what I said previously—namely, the key to the interest rate outlook in the administration's forecast is rightfully targeted on the deficit. I don't think that they or we know exactly whether it is too much or too little, and I would just as soon not get involved in trying to fine-tune the forecast. The CHAIRMAN. Can you just tell me the last time that the 90- day T-bill was at 6 percent, going back in time? [Pause.] Mr. GREENSPAN. Preliminarily—we will check it—it has to go back to the late 1970'a. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 The CHAIRMAN, So it has been a full decade since we have had a 90-day bill rate as low as 6 percent, which we are now projected to meet within 1 year under the administration plan. I think that is a startling projection and one that we ought to take a closer look at. With that, let me yield to Senator Kassebaum. Mr. GREENSPAN. I am sorry, Mr. Chairman. May I just have a moment? It looks as though it temporarily got down to that level in the fall of 1986. The CHAIRMAN. I take it for a very short period of time? Mr. GREENSPAN. Actually, it carried through a good part of 1987. Unfortunately, I am reading from a chart. The CHAIRMAN. At 6 percent? Mr. GREENSPAN, Yes. The CHAIRMAN. But you don't infer that that necessarily means that in the period of a year's time we are going to be back to 6 percent? Mr. GREENSPAN. I had just as soon not respond to that. The CHAIRMAN. I can understand why. [Laughter.] Senator Kassebaum, Senator KASSEBAUM. Chairman Greenspan, do you sometimes feel like the Oracle at Delphi? The markets of the world are hang- ing on every comment you make here or testimony? I would like to ask you—you stressed a number of times in your statement the effect of wage and price increases. I would like to ask if you think any increase in the minimum wage would have an effect on the inflationary situation. Mr. GREENSPAN. I don't think there is any question that increas- ing the minimum wage does have an effect on the overall wage structure, and to that extent it is something which, other things equal, would contribute to inflationary forces. The decision the Congress has to make is whether or not the ad- vantages received from that override what is clearly an element which does exacerbate the underlying cost structure of American business. Senator KASSEBAUM. You mentioned three or four times at least in here that this is one of the main pressures building on inflation, and at some point I would guess then you would take that into con- sideration on what you would do with interest rates. Mr. GREENSPAN. I wouldn't say that we, as an organization, would specifically focus on the minimum wage and take action as a consequence of that, The issue is essentially why the underlying materials price in- creases were not reflected in comparable increases in final goods prices in the Consumers Price Index or even into the Producers Price Index, until recently. The reason is largely that unit labor costs, that is, the cost of labor per unit of output, were remarkably well-behaved. These costs have taken somewhat of a turn in a worrisome direc- tion now, and that is the reason we are particularly sensitive to the pattern of wage movements as they are a crucial element in the underlying cost structure of American business. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 Senator KASSEBAUM, Do you see it having any effect on GNP growth if the minimum wage were to be increased? Mr. GREENSPAN. I frankly would say that within the ranges which I have heard the minimum wage discussed the effect is modest. I mean, all economists will argue, I think quite correctly, that the effect of an increase in the minimum wage is to increase unemployment somewhat. That does mean that it probably slows GNP some, but I don't think the effect is large. Senator KASSEBAUM. You spoke, too, several times to the task of the Federal Reserve is just simply stability, and right at the end you were talking about keeping on track and reforms to the regula- tion of financial institutions. I would like to have you comment a bit further on that. Do you have some specific reforms, given your comment earlier about highly leveraged firms and the impact of that on the stability of the economy at this point, going beyond just the FSLIC problem? Mr. GREENSPAN. I was referring to the implications of depository institution changes. I was addressing not only the FSLIC problem, but also review of Glass-Steagall issues, as I am sure this commit- tee and the House Banking Committee will understand. Clearly the difficulties that we have with respect to debt resulting from the issue of LBO's, in my judgment, does require a longer run view of the balance of incentives to take on debt relative to equity. It is not the LBO issue per se which pushed me in this direction. I think this is something which has been clearly on the agenda for quite a long period of time, and I believe at some point it would be appropriate for the Congress to address that question. Senator KASSEBAUM. Do you think the value of the dollar should go any lower? Mr. GREENSPAN. I think the group of seven, the seven major in- dustrial countries, have done an extraordinarily good job, in my judgment, in keeping the dollar and most major exchange rates rel- atively stable for well over a year, and I think if we can continue that process we can contribute to economic growth not only in the United States but in the world as a whole. Senator KASSEBAUM. And you have confidence that if we do that the pressures won't be such that we will see a further decline? Mr. GREENSPAN. I think that we certainly are seeking continued stability in the dollar, and I expect that to continue. Senator KASSEBAUM. Thank you. The CHAIRMAN. Senator Wirth. Senator WIRTH. Thank you, Mr. Chairman. Mr. Greenspan, thank you very much for being here again. We appreciate your good judgment and stability at the helm of this ex- traordinarily important institution. Let me ask you just a little bit so I can understand in layman's language what looks to me is going on. You are concerned about a slowly increasing set of inflationary pressures. As a consequence, what you are doing is slowly calibrat- ing the interest rates to try to dampen that down, is that right? Mr, GREENSPAN. That is correct as a historical statement. Senator WIRTH. Historical as opposed to contemporary? How does that relate to your current acts? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 Mr. GREENSPAN. Well, I would say, as I indicated in my testimo- ny, it is up to the current period. I just didn't want to imply a fore- cast. Senator WIRTH. I have got it. Let me go on. If in fact we are slowly but surely edging up in interest rates for the purposes of damping down inflation, the question then has to be asked, what the impact of increased interest rates could be on the other problems that we are trying to deal with. This committee, as you know, is consumed with the S&L crisis and how we deal with that. It is consumed with the LBO issue and all of the controversy surrounding that, and also the Third World debt problem. Now, is it fair to say that increased interest rates are going to make it more difficult for us to resolve the S&L problem? I am not criticizing it in any way, let me say. I am just trying to understand what the ledger sheet looks like, what the balance sheet looks like. Mr. GREENSPAN. The ledger sheet says that the higher the inter- est rates at any particular time, the more costly the resolutions of these various problems are. One of the reasons why we embarked upon this type of policy is that we are seeking to suppress inflation so that it does not create a major acceleration in interest rates. It is the judgment of the committee—and I think it is a very good judgment—that our only alternative, when confronted with the type of economy we saw in 1988, was to try to suppress inflationary pressures and keep the in- terest rate increases relatively moderate. The alternative, to aban- don that particular policy goal, would result in inflationary expec- tations rapidly embodied in long-term interest rates, driving mort- gage interest rates and other interest rates up very substantially. I would suspect—and obviously it is a difficult type of retrospec- tive analysis to make—that had we not embarked on a tightening process throughout 1988 that interest rates today would be higher, certainly higher in the long end of the market, probably even higher in the short end, and that costs of the resolution of the vari- ous problems that we face would be substantially higher. Senator WIRTH. The assumption is that you all can calibrate in- terest rates carefully enough so that you can slowly edge them up without throwing real crisis into the S&L's beyond where we are today or cause some of the fragility of various leveraged buyouts to get real problems because of increased interest rates. That is really the assumption, and that is the balancing act that you all are in, correct? Mr. GREENSPAN. Yes. It is what we are endeavoring to do. It is not easy. Senator WIRTH. That is the point that I am making, however. Let me ask the question. Is there historic evidence to suggest that you can calibrate that carefully? Mr. GREENSPAN. We certainly have in the Federal Reserve an ex- traordinary information and analytical capability. We have never confronted a situation that is exactly comparable to what we are in at this particular stage. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Senator WIRTH. Expand on that a little bit, will you, that we have never been in a situation like this? Mr. GREENSPAN. We are in the sixth year of a major economic expansion with a crisis in the thrift industry which we have never seen. It is the largest financial problem that we have seen in the post-World War II period. We have a rather significant rise in the ratio of debt to equity, which is not only LBO's, and it has been going on for quite a long period of time. It is an economic environment which, coupled with the very large trade and central government deficits, creates a set of cir- cumstances that precludes us from looking at some historical period and saying this situation looks exactly like 1920, and then evaluate how it came out. What we have to do is try to bring together what conceptual in- sights we have about these relationships, the extraordinary detail that we are able to draw on the economy from our 12 Federal Re- serve Banks and other sources, and what I must say is a very quite remarkable, capable Federal Reserve staff, in order to try to devise those sets of policies which maximize our capability for bringing most of these problems to a successful landing. Senator WIRTH. My time has expired. I have great respect for the staff and what they are trying to do. What we have really identified here is really a high wire act that you are on at this point Mr. GREENSPAN. It is. Senator WIRTH [continuing]. And that our economy essentially is on. We have never been in a situation that is potentially as un- friendly as this economic situation? Mr. GREENSPAN, All I will say, Senator, is that we are acutely aware of all of the various elements that are impinging on what policies we take, and hopefully we will choose the right policies. Senator WIRTH. We all hope so, too. Thank you very much, Mr. Greenspan. The CHAIRMAN. Senator Gramm. Senator GRAMM. Thank you, Mr. Chairman. Chairman Greenspan, if you were a member of the United States Senate and you were deeply concerned about rising interest rates but you weren't on any open market committee and you weren't setting monetary policy, what would you do? Mr. GREENSPAN. That is an easy one, Senator. Senator GRAMM. I knew it was an easy one. That is why I asked it. Mr. GREENSPAN. As I have said many times before, and as I said at the beginning of this testimony, in fact, I think that a signifi- cant cut in the Federal budget deficit is essential to resolve the type of problems which Senator Wirth and I have just been discuss- ing. It is clear to me that many of the problems that we are confront- ed with can be assisted in an extraordinarily positive way by a very expeditious and significant cut in the deficit. I am not one of those who believes that the process of cutting the deficit can be overdone. I don't believe that there is too large a cut that can be done, and I trust that the Congress will move with the administra- tion in that direction. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 Senator GBAMM. Let me ask you a question, and I am not trying to inject you into the very difficult policy decision that Congress has to make. That is a policy decision as to whether we want to control the growth of spending and limit the growth rate of spend- ing to less than 3 percent above the level we spent last year, to achieve the deficit reduction targets by controlling spending, or whether we want to raise taxes so that government spending can grow by 7, 8, or 9 percent. Let me just ask you from the point of view of looking at the econ- omy, leaving aside any political factors. Just simply looking at what would be best in terms of maximizing our chances of sustain- ing the economic recovery, what would minimize the impact of rising—or minimize the chances that interest rates would go up enough to choke off the recovery? Given the two choices between controlling spending and raising taxes, simply from the point of view of trying to sustain a recovery that has created 19 million new jobs, which of those two approach- es to deficit reduction is preferable? Mr. GREENSPAN. Senator, I believe I have said to this committee before, and I will certainly repeat it, that if the purpose is to get the deficit down you will have far greater success by focusing solely on the expenditure side. Second, I would share your view that freeing private resources is more apt to create significant economic growth than endeavoring to close the deficit gap through increasing taxes. Senator GRAMM. So let me go back and again pose the question and see if I can get you just to focus on it. You said it, but I want to hear it in terms of the question. From the point of view of sustaining recovery and creating jobs, forgetting all the politics of the decision, would we be better off to control spending or raise taxes? Mr. GREENSPAN. Control spending. Senator GRAMM. Let me ask you a second question. As I look at the credit market, one of the reasons it seems to me that deficit reduction is so critical this year is that we are getting ready to go out and borrow $50 billion as part of the savings-and- loan recapitalization program. So, if we meet the Gramm-Rudman- Hollings targets and reduce projected borrowing by $55 billion, in essence what we are doing is we are simply offsetting what is al- ready occurring in dealing with the savings-and-loan problem. Do you see it that way? Mr. GREENSPAN. Not exactly, Senator, because I think that the markets already understand the size of savings-and-loan borrowing requirements. Senator GRAMM. You're saying that is already reflected in cur- rent rates? Mr. GREENSPAN. As best we can judge. It's already in the market. Senator GRAMM. So that if we came in with a $55 billion deficit reduction package to the extent that that is not already in the market, that would have an impact? Mr. GREENSPAN. Yes. Senator GRAMM. As you look at the various projections that are made by CBO and OMB, how realistic is it to think that we might Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 actually stabilize interest rates and bring rates down by the end of the year if we pass a dramatic deficit reduction action? Mr. GREENSPAN. I think it's very realistic. Senator GRAMM. So, you are in essence saying when we vote on the budget, to the extent that we're voting for lower deficits we are voting for lower interest rates? Mr. GREENSPAN. To the extent that the markets believe that what the Congress is doing is credible. That is an essential element in this whole equation. Then inflation expectations will fall be- cause I think that the market has only very marginally discounted a significant decline in the budget deficit at this stage. Senator GRAMM. Finally, do you think that we should do it quickly to get the full impact? Mr. GREENSPAN. Yes, Senator, I do. Senator GRAMM. Thank you, Mr. Chairman. The CHAIRMAN. Mr. Greenspan, I want just to ask you one ques- tion as a follow-up to something Senator Gramm said before yield- ing to Senator Heinz. That is this: He took you over two of the jumps. I don't know if he took you over the last jump, and I would like to take you over the last jump. And that is, if it turns out that we are not able, the administra- tion and the Congress together, to come up with enough deficit spending cuts to really get the deficit down to the targets because of a number of factors—the savings-and-loan problem, the drug war problem, the President's new initiatives on education and so forth—and if the only way to get to the Gramm-Rudman targets is with some revenue increase, would you favor that? Or do you think that has to be avoided at all costs even if it means missing the Gramm-Rudman targets? Mr. GREENSPAN. Well, Mr. Chairman, I have said previously that if the negotiations fail, that I would favor going, as the law re- quires, to a sequester. The presumption that the Congress will fail in its negotiations on this issue, I am not at this stage ready to make. The CHAIRMAN. So, your answer is: Go the sequester route, but talk of increased revenue of any sort is really so counterproductive, as you would see it, that you don't want to even entertain the thought of it? Mr. GREENSPAN. I would say at this particular stage without making judgments about the structure of the negotiations and where we are moving, that short of an agreement between the ad- ministration and the Congress I would find a sequester the next de- sirable step to take if we fail to get the most desirable outcome, which would be an agreement. The CHAIRMAN. Let me pass the ball to Senator Heinz. Senator HEINZ. Thank you very much, Mr. Chairman. Chairman Greenspan, you are one of the best witnesses that ever comes before this committee. It's hard to disagree with your con- tention that if we don't have effective anti-inflation policies, that this will cause interest rates to rise. Obviously, we want to avoid an increase in interest rates beyond where they are, and indeed we would all like, I think, to find a way, a set of policies, that will allow interest rates to decline. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 I say that particularly because as measured by the Federal funds rate, I think we are probably at a historic high for the cost of those funds, which was as of last Friday 9.31 percent. That is probably as high a premium over inflation as there has ever been. That is about a 5 percent, if you will, real interest rate. Is that, to your knowledge, a historic high for the Federal funds rate since World War II? Mr. GREENSPAN. First of all, let me just say this. The real inter- est rate is, of course, much lower than the market quote on the Federal funds rate, in the sense that that is the nominal interest rate. What reducing the deficit would essentially do is to bring real interest rates down. That is essentially what is crucially and importantly required. Senator HEINZ. I understand that. I just wanted to get a charac- terization of the current Federal funds rate as to whether it is, if your definition of a real interest rate is the nominal interest rate less inflation Mr. GREENSPAN. Inflation expectations. Senator HEINZ. Isn't that so-called real interest rate at an all- time high, when you're looking at the Federal funds rate? Mr. GREENSPAN. It was higher in the earlier part of the 1980's, depending on how one calculates it. The more important real inter- est rate in the context of economic activity is the long-term real interest rate, and that also was higher, as best we can judge, in the early part of the 1980's. It has come down some, but it is clearly still well above its average over a long period. Senator HEINZ. Why, if the only time we can remember having a real interest rate as high as the early 1980's as we were going into a major recession, is our best previous experience with that, how is it that you feel confident that a similarly high real interest rate will not precipitate another significant recession? Mr. GREENSPAN. First of all, Senator, the real long-term interest rate is still well below what it was in the early part of the decade. Even though that rate, for mortgages and other long-term instru- ments, has come up somewhat during the past year, it really has not come up a great deal, and as a consequence, both homebuilding and capital investment remain rather strong. In that context, what we are seeing is an economy which is still rather robust. Senator HEINZ. It seems to me that you can't argue this question both ways. If in fact the Federal funds rate, as you are saying, or other snorter-term interest rates are of relatively little conse- quence to the health of the economy, I don't understand how you can be successful in pursuing your strategy of demand manage- ment. On the other hand, if you say that the more meaningful rates are the 30-year T-bonds, which have been in the range of about 9 percent for the last IVa years and probably longer it seems to me that the market has been saying with great consistency that Fed's fears about inflation are ill-founded. How do you explain that? Mr. GREENSPAN. I am not quite sure what the sequence is. Senator HEINZ. The sequence in the latter part of the question is: if the market is a good predictor of inflation, if people are unwill- ing to lend their money for 30 years without adequate compensa- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 tion for inflation and if the return to those people has been for the last year and a half roughly around or even below 9 percent and the only time it has moved up is as the Fed fund rate has moved up, how do you account for your fears of inflation if the market is saying those fears are overstated? Mr. GREENSPAN. I think what the market is saying, if one inter- prets it in that respect, is that over the long term inflation expecta- tions—meaning average expected inflation over a 10-, 20-, or 30- year period—have come down some, but that says very little about the short run, meaning 2 or 3 years. You are raising a very interesting question: how do we in fact contain excess economic growth if what we do is deal in the short end of the market? The answer is that long-term real rates have come up in the past year as we have tightened. Short-term real rates clearly have come UP- To answer your earlier question, the real; that is, inflation ad- justed, 3-month Treasury bill rate in the early 1980's got up to about 7 percent. It fell all the way back down to about 2 percent, and is now back up to 4 percent. But it is clear that the 4 percent is high enough in real terms to suppress inventory excess, which is a very crucial element in keep- ing the economy on a relatively stable path. It is also true that we have not had a dramatic rise in long-term real rates. We have had some, but not a sharp one. What that is saying is that the rate is moving up to a level which is restraining. In other words, we are getting a level of rates which has slowed down the rate of growth in capital investment. My impression is that if real rates were significantly lower, we would have a much stronger current capital investment environ- ment. The basic thrust of Federal Reserve policy is to try to keep a sense of stability in the markets and to try to take a posture with respect to rates and with respect to the growth in money and credit aggregates, which is perceived by the markets to be noninflation- ary over the long term. Senator HEINZ. Mr. Chairman, I want to thank Chairman Green- span for delving into what is one of the great ciracular questions of his job, which is: how do you keep the economy growing, interest rates low, and keep demand down so inflation is low. I don't envy him his job. I would only observe that the increase in long rates that has ac- companied the tightening by the Fed over the last 3 or 4 months obviously will make it harder for this country to engage in produc- tive investment. That will make it harder for us to grow and reduce the budget deficit through growth. It will make it harder for us to build the capacity to displace imports. I think it is a very difficult and troubling question. I am not here to judge whether your policy is a little high or a little low. But I do worry enormously about the consequences of your having to pursue, perhaps for very good reason, a policy that at the present time would be, by your own admission, working against our ability to improve our productivity and international competitiveness. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Mr. GREENSPAN. If I may just say very quickly, Senator, that is the reason \vhy we have argued BO strenuously for quick action on the budget question because the simplest way to bring real long- term interest rates down is by bringing the budget deficit down sig- nificantly. Senator HEINZ. Are you trying to make us an offer we can't refuse? Mr. GREENSPAN. Sure enough. The CHAIRMAN. Thank you. That was a very useful exchange, and I think it bodes well for the record. Senator Graham. Senator GRAHAM. Mr. Chairman, I have an opening statement that I would like to file for the record. The CHAIRMAN. Without objection. OPENING STATEMENT OF SENATOR BOB GRAHAM Senator GRAHAM. Mr. Chairman, it is a pleasure to have Chair- man Greenspan report to us today on the conduct of monetary policy. As Chairman Greenspan has stated in the past, monetary policy alone cannot provide the answers to our economic problems. We need complementary fiscal and trade policies, and we need to coordinate these policies with the approaches of the administration, our trading partners and the Congress. Chairman Greenspan, it has been said that the Federal Reserve finds itself between a rock and a hard place when a discussion of interest rates takes place. Some people, such as yourself, are con- cerned about inflation moving up; others are concerned about a slow-down in the country's economic growth. Raising interest rates keeps inflation under control. However, the administration is pre- dicting lower interest rates to help reduce the budget deficit. As The Economist quotes, "Mr. Greenspan, having to run America's monetary policy between the rock of an intractable budget and the hard place of market skepticism, often has an equally tricky job persuading his Fed colleagues to unite." Higher interest rates impact our savings and loan problem as well as the Latin American debt crisis. The Fed in the past has been successful in lowering interest rates as well as inflation. This has helped reduce the crushing interest burden on the debtor coun- tries. If interest rates rise, these debtor countries are put in a more tenuous position. As to the savings and loans, higher interest rates also adversely impact them, as they try to compete against institu- tions paying higher interest rates for funds. Mr. Greenspan, it is a difficult time. We look forward to your comments this morning. Thank you, Mr. Chairman. Senator GRAHAM. Mr. Chairman, when you appeared on July 13, we talked a bit about the question of U.S. policy as it relates to Third World debt. I believe I characterized your statement at that time as basically advocating a continuation of the policy that was then in place. The new administration has indicated a willingness to reopen the issue and has indicated that there might be some revision to that policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 From your perspective, what do you recommend now should be any new directions in the United States leadership relative to Third World debt and Latin American debt? Mr. GREENSPAN. Senator, as a result of the President's request to review that policy—that is, his own review under the leadership of the Secretary of the Treasury—we at the Federal Reserve are obvi- ously participating to the greatest extent that we can. I cannot at this stage indicate how the review is going to come out. I think it is clearly going to continue to emphasize the necessity of the sound economic policies on the part of the debtor nations, international economic cooperation, the appropriate means of fi- nancing, and presumably will have some focus on the issue of debt reduction. The specific details will be presumably announced within a rea- sonably short period of time. Senator GRAHAM. One of the criticisms of the debtor nations has been that the United States regulatory policy relative to its com- mercial banks has been less forthcoming than has been the case in some of the major European creditor countries. Do you think that is a fair characterization? Mr. GREENSPAN. It's a very complex question because regulations are difficult to fully understand with respect to their implications in all regards. I suspect not because I don't think that we see any material problems emerging from our regulatory structure. As far as the resolution of the LDC debt problem is concerned, it's not that there are not problems. We just do not believe that there are regulatory changes which are going to make a large dif- ference. Senator GRAHAM. The review of policy that is under way which may lead to revision, what do you think should be the standards by which U.S. policy relative to Third World debt should be evaluated over the next 5 years? What would be the conditions within this country, within other creditor countries, and within the debtor countries, in 1994 that would lead you to say we have been success- ful in the policy directions set and in our pursuit of those direc- tions? Mr. GREENSPAN. I would say first, Senator, that the economic policies of the debtor nations brought them back to access to the financial markets on a voluntary basis. It's clear that a number of countries could, at this stage, float in the Euro bond markets, but they would be at interest rates which would be so high that the debtor countries would have difficulty servicing the debts. So, the first criterion of success would be the ability of nations in debt to be able to get into the markets for long-term or intermedi- ate-term borrowing at rates which they could readily service. Second, what I would see required as a corollary to that is a res- toration of the normal borrowing-lending relationships between the debtor nations and the international commercial banking system. If you get one, you will clearly get the second. That will create a situation in which the large block of loans on the books of the international commercial banking system would be a good deal more valuable than they are today. Finally, what we would want to see would be that some of the debtor nations which have done better than others, that have been, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 in a sense, contaminated by the whole process—such as Colombia, for example—find that their productive efforts get fully appreciat- ed in the marketplace. Senator GRAHAM. Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much. Senator Mack? Senator MACK. Thank you, Mr. Chairman. It's good to see you again this morning. I am delighted to have the opportunity to raise some points with you. I wanted to follow up on the suggestion that if we were to sub- stantially or significantly reduce the size of the deficit, there would be the possibility of a fairly significant reduction in interest rates. You indicated, I guess, that that would be helpful the earlier that could be done, but if we didn't do it earlier, your kind of second suggestion—or maybe that was said for you—is that a se- quester would be helpful. I guess I am wondering, if we went through this whole process and didn't come to an agreement between the executive and the legislative branch as to what kind of deficit reduction plans should be put together and a sequester went into place, would that be suf- ficient to allow for the possibility of significant reductions in inter- est rates? Mr. GREENSPAN. First of all, I think that we have to distinguish between the processes which the markets will perceive as perma- nent change and those which they may not. Clearly, an agreement between the administration and the Con- gress will carry forward not only into the fiscal 1990 budget, but also, because of the follow-on effects of any agreement, into the 1991 and the 1992 budgets. I am not clear to what extent a sequester will create that type of effect. It will clearly be positive. Senator MACK. Let me just kind of throw out a couple of thoughts here. One thing it would do, it obviously creates a lower baseline for the following year, which would be an advantage. Mr. GREENSPAN. That's correct. Senator MACK. No. 2, it would be a statement on the part of the Congress that we were willing to allow the sequester to go into effect rather than to relax the Gramm-Rudman targets, which I would think, if those two things would occur, would be a fairly sig- nificant signal to the markets. Mr. GREENSPAN. I don't think there is any question that if the Gramm-Rudman targets were relaxed as a means of resolving the impasse that the markets would view that rather negatively. Senator MACK. Let me see if I can follow on with that, A little bit earlier, you implied—or I think specifically said—that from your viewpoint that the markets had already taken into con- sideration the cost of the FSLIC problem. What do you think the markets have done with respect to what they think we are going to do with respect to the deficit? Mr. GREENSPAN. It's a difficult question to answer. My impres- sion is that there is a dubiousness out there which is very difficult to measure. That is the reason I say that should the deficit be re- duced materially—and when I say reduced, I don't mean only for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 fiscal 1990, I mean projected forward—a goodly part would be un- anticipated and would affect real interest rates. The problem I think we ought to focus on, however, is to distin- guish between the Gramm-Rudman targets on the one hand and the actual outcomes on the other, because the targets are for essen- tially the beginning of the fiscal year. Obviously, if one says that the target of $100 billion is met, that is not the same thing as saying that we have guaranteed that the deficit after the fact in fiscal year 1990 will be $100 billion. As I have said in other committee hearings, my impression is that if the market knew for a fact that the actual as distinct from the targeted deficit would end up somewhere between $110 billion and $120 billion after the fact, as of the close of business on Sep- tember 30, 1990, then I think the market would take it as a signifi- cant improvement. And I think that interest rates would fall from current levels as a result. Senator MACK. Let me take you to another area. I, from your testimony, drew the implication that we need to be addressing capital formation in this country. I would just like for you to respond as to what impact, if any, you think would result from a reduction in the capital gains rate, as has been proposed. Mr. GREENSPAN. I have always been in favor of a lower capital gains tax rate. It would enhance capital investment, especially in the small business sector of our economy. I would not, however, be supportive of the cut if it became part of a deal to unwind what I think were very important benefits in the Tax Reform Act of 1986—namely, the significant lowering of the marginal tax rates for all taxpayers. That to me was a very major event, and I would not like to see us unwind what was then an important bipartisan compromise. Senator MACK. Let me just, if I could, restate what I think I heard you say. In other words, you would not accept, let's say, a compromise which said, well, we will lower the capital gains rate but we are going to offset that lowering by raising marginal rates to compensate for what everyone agreed to was going to be the loss of revenues as a result, which is a debatable point. So, you would not make that trade? Mr. GREENSPAN. That is correct, Senator. I would not. Senator MACK. But you do believe that the capital gains rate would assist in capital formation, lowering of the capital gains rate? Mr. GREENSPAN. Yes, I do. Senator MACK. Thank you, Mr. Chairman. The CHAIRMAN. Senator Pressler? Senator PRESSLER. Thank you very much. Welcome to the hearing. Following up on Senator Mack's question about capital gains, I have been trying to figure this situation out. I believe the Presi- dent's economists say that lowering the capital gains tax rate would actually increase revenue to the government, while I think the Congressional Budget Office is about to suggest or has suggest- ed that it would decrease revenues to the government. Let me say that I am not arguing the point here. But what is your judgment of that question? Am I correct, are there different Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 respected economists who have reached different conclusions on that? Mr. GREENSPAN. Yes. Estimating the revenue effects of the change in the capital gains tax rate is one of the most difficult pro- cedures that economists have to deal with so far as economic policy is concerned. The reason is that very small changes in the degree of what we call the "lock-in" of capital gains—people not selling assets—has very large effects on revenues. So, it is perfectly conceivable that two equally competent tax rev- enue analysts can evaluate the President's proposal with rather dramatically different results. There is no question that the Treas- ury Department's estimates are credible. The assumptions are not outlandish. The problem basically is that it is very difficult to make those types of judgments. So, I think it's a difficult call. Senator PRESSLER. As a general rule for this discussion in lay- man's terms, they say that if capital gains taxes are higher, rich people put their monies into art, antiques, and things like that, but if they are lower, they will put them into job-creating business ac- tivities. Is that a true statement? Mr. GREENSPAN. I think it's difficult to say. As I understand the President's proposal, he is eliminating artifacts and the like in his proposal and is essentially focusing on areas that will spur capital investment. The impact of changes in the capital gains tax rate has been argued at extraordinarily great lengths for years. With respect to just the type of question you raised, Senator, I just want to say the battle has not been won by any side, of which I am aware, and is likely to continue for quite a long period of time. Senator PRESSLER. So, you don t have a clear position on the cap- ital gains tax issue. You would like to see it lower, but you wouldn't want to see us tackle that, opening up the tax question again? In general, your recommendation is to leave it alone? Mr. GREENSPAN. No, I would like to see it lowered, but not if it causes an offsetting rise in the marginal tax rates for individuals. Senator PRESSLER. Moving to another area—and again, you've covered this somewhat—but I want to focus in. I had 16 town meet- ings in my State last week, and I was trying to explain this but was unable to do so with certainty. Aren't the savings-and-loan bonds that are proposed to be issued—$50 billion of obligations or however we're going to handle it—part of our national debt? And I agree with you, I consider the deficit the number one domestic problem, and trust my voting record reflects that. But, from your point of view, isn't the adding of that debt in the aggregate whether it's off budget or on budget or however it's han- dled, isn't that essentially adding to the national debt, which is doing just exactly what you don't want to see us do? Mr. GREENSPAN. There is a difference, Senator. And I think that the crucial question is more the one of getting the deficit down than being overly concerned about the level of outstanding public debt either on budget or off budget because it is essentially the net claim on savings that is directly related to the deficit and which is Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 the crucial reason why the budget deficit is so corrosive a force in the economy. The difference between that and a one-shot solution to the sav- ings-and-loan problem is that whatever it costs, it is nonrepetitive. By that I mean that it does not affect either revenues or expendi- tures over the long run, or affect the budget deficit materially in the year, say, 2000, whereas anything that is done with respect to changing the structure and trend of receipts or expenditures in the regular budget will affect the long-term budget. Savings-and-loan financing, irrespective of how it's done, is a one- shot effect and does not materially affect the long-term outlook for the budget deficit. Senator PRESSLER. I couldn't agree with you more concerning the budget deficit. And we all must work together on it. But at some point someone, a respected national economist such as yourself who has the pulpit, so to speak, is going to have to outline where those cuts are going to be taken. The President gave his State of the Union Address, and in terms of an opportunity for leadership in this area, do you feel the Presi- dent sufficiently addressed the budget cut issue in that speech? Mr. GREENSPAN. Considering he was in office for so short a period of time, I thought that the Office of Management and Budget put together a rather substantial budget. Whether it is ade- quate for the purposes of the negotiations that you are currently involved in is really not for me to say. All I can tell you is, having seen how much work was put in, it was rather impressive. The issue of whether it is adequate, I think, will be determined very shortly. Senator PRESSLER. Mr. Chairman, might I ask one more question here? The CHAIRMAN. Please do. Senator PRESSLER. Are agriculture and small business more sen- sitive to interest rate changes? Are some sectors of the economy more sensitive? I get the feeling, listening to my small businessmen and women, that they are extremely sensitive to interest rate changes. Would you consider that sector to be more or less sensi- tive to interest rate changes? Mr. GREENSPAN. I think it's a mixed bag. It depends on the nature of the leverage. It depends on the nature of the alternative means of financing. I think interest rates affect both big and small business and farmers. I think they affect everybody, but the effect depends on the degree of leverage in any individual firm or industry. I would not want to argue that it's a significantly greater factor in small busi- ness or agriculture, with the exception that specific aspects of debt in agriculture and some small businesses do make them more sen- sitive, but it is not basically because they are small businesses. The cost of capital to small business for both equity and debt is higher than for larger, basically seasoned businesses. But the cost of cap- ital is a bigger issue for small business in general. I wouldn't say interest rates per se necessarily are. Senator PRESSLER. In my town meetings last week, in 16 South Dakota towns, I would say that somehow keeping interest rates down was almost a bigger issue than the farm bill or anything else. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 I know it's tied to the deficit and I know it's tied to a lot of things, but an increase in interest rates is really on people's minds out there. The people I talked to were mostly farmers, small businessmen, people who come to public meetings. So, I am very interested in what you have to say and what you and your colleagues do. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Pressler. I just want to make an observation on your second-to-last ques- tion and the Chairman's response in terms of where the cuts might be made. And I think the new administration was very ambiguous in that area, and I think Senator Pressler's question is exactly right. When you said they haven't been here very long, in a sense they haven't. But George has been here for the last 8 years. So, in fair- ness, with respect to the problem of deficits and cuts, he is not a stranger to this issue. I am concerned because I think there is a side step going on here generally, because of the difficulty of reconciling all of the particu- lar problems. One of the things that you have mentioned today and will talk about 2 days from now when you come back is paying for the sav- ings-and-loan problem. If we were direct about it, if it's been dis- counted by the markets, which I thought I earlier heard you say then why shouldn't we finance it at the lowest possible cost to the taxpayer? Why shouldn't we go out and raise the amount of money we need with a direct kind of borrowing that gets the interest rate costs down to the lowest level? Mr. GREENSPAN. Mr. Chairman, may I address that on Thursday because it requires a much broader answer than I think we would want to discuss today? The CHAIRMAN. We can take it over at that time. But I don't think that we should put contradictory ideas on the table today and not make some effort to reconcile them. We shouldn't say on the one hand that we want to reduce the deficit and be honest about the numbers and on the other hand use an off-budget means of financing, particularly if we have to pay a premium interest cost for doing so. Mr. GREENSPAN. The reason I would prefer to hold until Thurs- day is that I think I would like Secretary Brady to make his pres- entation on the full details of his program before I discuss some of the details. The CHAIRMAN. I won't press that issue now. Let me go back to something else you said earlier. You were citing the unique buildup of circumstances that you find today— the crisis in the thrift industry, the significant rise in the ratio of debt to equity out in our private sector, the large continuing trade and Federal Government deficits, the fact that the expansion has gone on for historically now a very long period of time, and you have created in that description a set of elements that are unique and that really pose some dangers to us if we don't deal with them directly. I think you clearly felt that way and made that impression. And I am inclined to agree with you. I think that as we look at these Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 things—the LBO's and everything else—we are in an unprecedent- ed situation and the time to act is now. We are at the beginning of a new administration. There is a new Congress. We should all step up to the responsibility of acting. And presumably we can put a strategy in place which starts to adjust us through this whole set of problems. I say all that by way of getting to this question: You have lived a long time in the world of national and interna- tional finance. When you add those issues together in terms of the kind of threat or risk they present to us if left unresolved, how se- rious a mixture of problems is this? I think that Congress needs to understand and the public needs to understand exactly the dimension of the risk. How urgent is it that we act on these things? Do these in combi- nation constitute something that would be an 8 on a scale of 1 to 10 in term of the overall urgency and risk that they present to us? Or are you talking about something that is down in the 5 range or the 3 range? Where are we exactly? Mr. GREENSPAN. The truth of the matter is, Mr. Chairman, that The CHAIRMAN. In your judgment. Mr. GREENSPAN. No one really knows, and can't know. We are dealing with degrees of complexity that anyone who gives you a de- finitive answer to that question is expressing a degree of ignorance, not insight. It's clear that if one evaluates the various risks and if there is enough of a concern that the risks could be large, then it very sig- nificantly skews policy toward reducing the budget deficit and making certain that inflation does not accelerate and create very significant additional imbalances in the system. I think the reason I addressed the issue or the question that Sen- ator Wirth raised earlier in the way I did is that what we have got is a rather complex structure of problems. What we cannot impose on them is a renewal of inflation and expect that they will some- how be resolved. They won't. That we know with a high degree of assurance. How these elements in the financial structure—the debt ques- tion, the trade deficit, the thrift issues—how they all will come out is difficult to say. But we do have the capability of resolving them all. It is not a l-shot-in-20. We've got a much higher probability than that. We can resolve the LDC issue. The CHAIRMAN. If I may just interrupt there. I agree with you that we can solve them. But I am really asking you to reflect on a different question. And that is, suppose we do not resolve them. They are very difficult to resolve. If you feel it's important not to let this buildup of situations just run on and just drift along without some very serious resolution of these problems, that we may be facing risks of a dimension that we have not seen in a long period of time, now is a good time to let everybody know it. Mr. GREENSPAN. What I don't want to convey to you is more than I know. I am not saying in effect that we have to resolve the budget deficit issue within the next 6 weeks or 2 weeks or 2 years. I don't know the answer to that. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 What I do know, however, is that the longer we wait to resolve it, the greater the risks to the system. What I am saying is that because of the size of the problem what could happen if we fail to address these problems appropriately is of such an order of magni- tude that we should not hesitate to resolve the budget deficit prob- lem. The CHAIRMAN. What are those risks? Mr. GREENSPAN. Well, let's assume we do not resolve the budget deficit question, I would say we'd have a significant acceleration of inflation in this country and a very considerable set of imbalances which would lead to a major contraction. The question which I cannot answer—does that mean we have to resolve it immediately? I don't think so. I do think we have a little time, but I don't think we have time to procrastinate and hope it will all go away, because I don't believe it will go away. I must say I am somewhat optimistic, knowing the players, that it will get resolved. But I am saying that we cannot take the chance of not resolving this problem. The CHAIRMAN. When you said a little time, I gather you're thinking in terms of months and not years? Mr. GREENSPAN. I mean I cannot say to you that if this thing drags on and we eventually resolve it some time early next year, that that is too late. I frankly don't know. I would feel uncomfort- able about doing that. But I don't know enough, nor does anybody have the knowledge, to make that judgment. The CHAIRMAN. I am not asking for precision, because, as you say, none of us has it. You know, you are a person with very highly respected professional judgment. You are probably in as good a po- sition to make an overall professional judgment as any person we might ask. So, I think given that, I think it's fair to ask about the degree of risk we run here if we should not step up to these things and resolve them in some rather decisive way. Mr. GREENSPAN. I would say the degree of risk of allowing this whole process to fester is unacceptable. The CHAIRMAN, Senator Pressler? Senator PRESSLER. I just wanted to get in there because I agree with you that it is such a severe problem, but I see us going through the same cycle up here as we have gone through—and I have been here for 14 years—somehow, and I say this in the back- ground of just having returned from going all over my State. Somehow we need a presidential speech on where to make the cuts or what to do about this budget deficit. We need some kind of national position by people such as yourself because each Member of Congress, I can give a speech in my hometown and 100 people will listen to me—and I have a plan, which I won't go into here— but the point is that by the time we get through—but I would like to embrace a presidential plan or something of that sort. But we really haven't had that explained to the American people. Everybody tells Congress, "You've got to cut the budget." We all agree. Everybody agrees we've got to have a balanced budget. We all agree. But we haven't really. Somewhere I think we are crying out for a national focus of somebody who can explain this thing, rally support nationwide and so forth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 It seems that everybody is kind of passing the buck to everybody else. That is what is the tragedy of the current situation as far as I can see it. Is my analysis correct, or would you disagree with that? Mr. GREENSPAN. I am a good deal more optimistic than you, Sen- ator. I think that this country, when it comes to the necessity to do something, has historically done it. While I can abstractly discuss the various outcomes if we don't do anything, I frankly and honest- ly don't believe it's going to come out that way. I do think that we understand what has to be done, and it's not that great a change. Some less developed countries have undergone types of adjustments that are far greater than any that we have to make, so I can't honestly tell you that I think we won't resolve all the problems because I really believe that we will. I think there will be a good deal of political negotiation and fric- tion, but in the end I am reasonably certain that we will all come together with the appropriate policy. The CHAIRMAN. Senator Pressler, you are next in order, and then I am going to go to Senator Graham. Senator PRESSLER. I don't have any further questions. The CHAIRMAN. Senator Graham? Senator GRAHAM. I would just like to add to the comments made by the Chairman and Senator Pressler. I agree the President has an opportunity and, I think, a national responsibility to be specific as to where he thinks our Federal fiscal policy should go. For example, there is tremendous concern among Americans in the age group 25 to 40 as to whether some of the basic support system such as Social Security and Medicare are credible for them. I believe that part of solving the budget deficit is to give some degree of assurance to Americans as to basic Federal financial com- mitment to programs on which people are basing a substantial amount of their lifetime planning. Early in President Reagan's administration there was a lot of discussion about the issue of new Federalism, a sorting out of do- mestic responsibilities among levels of Government. I think there was a great deal of wisdom in that effort, which is sort of dissipated. I believe those are two areas in which presiden- tial leadership on more than just that we need to reduce the budget but also what are some longer-term objectives in reducing the budget would be very positive and would help to build a nation- al coalition behind the tough decisions that the Chairman has indi- cated we will have to make. If I could move to another subject that we have already discussed somewhat, and that is the capital gains issue. On page 11 of your statement there is a paragraph which indi- cates your basic support for capital gains reduction. And I appreci- ate the further amplification that you have given. Assuming that the overall budget issue is such that that is a matter that could be seriously considered, what would be your rec- ommendation as to the shape of a capital gains policy? Mr. GREENSPAN. I thought the President's proposal was a sensi- ble proposal. In other words, it was a good way of structuring the proposal. I think if it were enacted, it would have a positive effect. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 There are different ways in which one can alter the capital gains tax, but I thought that proposal was a sensible one. Senator GRAHAM. Let me ask, would you favor a longer holding period than the 6 months which was applicable when we last had capital gains; and if so, would you favor a tiered holding period where greater tax benefits accrued to longer periods of ownership? Mr. GREENSPAN. It depends on the rate, Senator. In general I would have some sympathy for that sort of a proposal. Senator GRAHAM. Do you have any suggestions as to what the re- lationship of rate to holding period might be, or how do you go about thinking through reaching the numerical answer? Mr. GREENSPAN. Senator, years ago I studied the issue in great detail, and had very specific conclusions with respect to that ques- tion. But I have not been in touch with the numbers in the last several years to a degree to which I would feel comfortable in giving you such a response. Senator GRAHAM. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Graham. Just a few other things to cover, Chairman Greenspan, today. We have been talking about meeting the Gramm-Rudman-Hol- lings targets. There are some of us who feel that is an honest disci- pline. There are some of us who feel it is an inherently dishonest accounting discipline, the way we do it. For the fiscal year we are now doing the budget for, we are going to borrow $68 billion from Social Security. The regular general Government is going to borrow $68 billion out of Social Security, give the Social Security fund a series of IpU's, and we're going to spend the money on the day-to-day oper- ations of government. Some of it goes to the Defense Department, Some of it goes to the FBI. Some of it goes to the drug war and so forth. And it will be spent. The general government will, in effect, owe the Social Security that money that it has borrowed and will have to pay it back some time in the future. As I track this through in my own mind, it seems to me what is happening here is that individuals who are paying into their Social Security taxes each day, as I do and you do, are finding out that the money they are putting in that is supposed to be there to pay their retirement benefits in the future is being borrowed, taken over into the general area of government, being spent every day as part of the way to make the deficit look lower than it really is, and in the future that money is all going to have to be replaced. It has got to come from somewhere. It has got to be taken from the gener- al government and sent back over to Social Security to pay those benefits in the future when it is time for people to receive them. Now, the actual operating deficit of the budget is about $250 bil- lion at the present time if you take out the Social Security surplus and the other trust fund surpluses. How can we continue to do that? We say one thing in terms of what the deficit figure is, but in cold point of fact the real operat- ing deficit is about $100 billion larger. Do the financial markets of the world just take this in stride, this accounting trick? Are they comfortable with it? Can we just do this indefinitely? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 Mr. GREENSPAN. I think what the financial markets do is to rec- ognize that there really is a single Federal Government deficit, what we call the unified budget deficit, and that the issue of vari- ous trust funds are merely assumed to be consolidated in the system and essentially involve intragovernmental transfers. If we wished to create a significant amount of saving and there- fore real investment which generated an increased degree of pro- ductivity, which therefore supported the fund from which in real terms Social Security beneficiaries were paid off, then I think we would have to deal with the Social Security trust fund as though it were a separate organization investing in private instruments and in a sense independent of, as you put it, the operating budget. When one looks at the question of the overall government, both Social Security and all other, the crucial issue of total U.S. savings, must be seen in terms of the unified deficit because if the total budget, unified budget, goes into surplus because the Social Securi- ty surplus is larger than the operating deficit, that creates an in- crease in total domestic saving for the United States, which is in my judgment crucial to the long-term problem. The CHAIRMAN. Let me ask you this. That is, precisely what the Social Security fund is supposed to be. It is supposed to be a savings fund; that is, you put the money aside, you invest it pre- sumably in earning assets, and so the capital is safe. The earnings build up, and the money is there to pay benefits in the future. You collect that tax for a dedicated purpose. But what we are doing now is to take that money and spend it on the daily operations of government. I don't really understand how you can justify that. Would you be untroubled if, when the Social Security surpluses get up to, say, $200 billion a year, that we take it all and spend it on the daily operations of government and feel that somehow or another we are not putting ourselves in a terrific problem for the future? Mr. GREENSPAN. Actually, in a certain sense, Mr. Chairman, the problem is even worse than that because to the extent that special issues are issued by the Treasury to the Social Security Adminis- tration, interest is paid on that. That interest becomes a very large number. My recollection is that by the turn of the century, by the late 1990's or the early 2000's, the intragovernmental interest pay- ment from the Treasury to the Social Security trust fund is about 1 percent of the GNP, which is a very large number, the equivalent of $50 billion today. That means that the outlays for the non-Social Security part of the budget must include those interest payments to the Social Se- curity trust fund and a substantial part of the very large surplus that is building in the Social Security trust fund reflects the build- up of intragovernmental interest payments. When we see in our calculations that, on the one hand, Social Security annual surpluses are going up like that and non-Social Se- curity deficits are going up like that, both are very significantly af- fected by the same factor, which when we consolidate the accounts into the unified budget wash out as intragovernmental transfers and we never see it. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 The CHAIRMAN. Don't you think the time has come for us to stop using the Social Security surpluses as a way to make the deficit look smaller than it really is? Shouldn't we get down to the hard job of dealing with the true in-flows and out-flows of the general government? Mr. GREENSPAN, I don't disagree that would be useful to do that, but there is an important distinction in that the unified budget does have a certain meaning, and I think it is a useful concept be- cause even if you segregate Social Security and were you to invest the proceeds hi private instruments, combining the two is the measure of what the government is doing. The CHAIRMAN. I don't argue with that. But the cold fact of the matter is that we are running a much bigger operating deficit today than anybody wants to admit. You talk about the size of the interest claims in the future being enormous, and they will be. But the interest payments are exceed- ed by the principal. We are actually increasing the principal each day. You are nodding in the affirmative, and I want to make sure that that shows up on the record. This is a brand new development. Before the last 2 or 3 years we were not running these large surpluses in the Social Security fund. What has happened here, it seems to me, is that we are engaging in an accounting trick. We are going over and borrowing it, and we are using it to make it appear as if we are reaching these Gramm- Rudman targets on an operating basis when in fact we are not. We are off by about $100 billion. I really think it is dishonest. I think it is one of the issues that we ought to be facing right now in the first half of 1989, and I see a side step—I don't say by you going on because we have got a com- fortable way to make it appear that we are hitting the Gramm- Rudman-Hollings targets when in fact we are not, not without, in a sense, looting the Social Security reserves and spending them each day on other purposes. It is very frustrating to see that because when you throw that back in on top of your list—a crisis in the thrift industry, the sig- nificant rise in ratio of debt to equity, the large trade and central budget deficit—and I am just quoting from your comments as I wrote them down when you made them earlier—it seems to me that the time to be very hardboiled about it is right now. It seems to me that you made a case here in an understated way today that this pile-up of difficulties has taken us to a level of risk that we haven't seen maybe since the 1930's. We don't face them honestly and start to resolve them quite quickly, not tomorrow morning but on an accelerated tune frame. That is my interpretation of what I think I hear you saying today. Mr. GREENSPAN. I am concerned, Mr. Chairman, but as I said earlier, I have enough confidence in the way our system functions to believe we will resolve these difficult questions as we have re- solved questions in the past, and I think the willingness of the Con- gress to address those issues as expeditiously as apparently it is and with the seriousness of purpose which I infer from the attitude of the President and the key members relative to this whole proc- ess, the thrift problems and budget deficit problems to take two Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 major issues, I must say gives me a degree of confidence that we will come out in a manner which will be the type of resolution which will make restoration of balance in the system something which is quite achievable. The CHAIRMAN. We are going to work to accomplish that in every way we can. I want to raise one other thing, then yield to Senator Graham, and that is this. The Finance Minister of West Germany is quoted by Reuters on the 16th of February as saying that "The U.S. Federal Reserve now estimates U.S. 1989 inflation at 6 percent rather than 5 percent," and he went on to note that inflation was pressing upon other countries. In Britain it was 7 percent. In Italy it was approaching 6 percent. In fact, he was noting an increasing in inflationary pres- sures in West Germany. Where does that figure of 6 percent that he cites as being attrib- utable to our Federal Reserve come from? Mr. GREENSPAN, I frankly don't know, Mr. Chairman. It is possi- ble that I may have inadvertently misspoke in conversations with him, or one of my colleagues may have. It is not an official figure, nor is it any figure that we have internally in our staff operations. So it is likely that I or one of my colleagues misspoke and didn't get corrected in the process of what our internal forecast structure is. That is not a forecast. The CHAIRMAN. So there is no spoken or unspoken expectation within the Fed that inflation will be 6 percent this year and that is being conveyed to foreign finance minister? Mr. GREENSPAN. It certainly has not been conveyed in any sense that I am aware of other than by somebody misspeaking because it is not factually the case. The CHAIRMAN. So that is not the internal view of the Federal Reserve in terms of the inflation expectations? Mr. GREENSPAN, It is not, sir. The CHAIRMAN. Thank you. Senator Graham. Senator GRAHAM. Mr. Chairman, I have no further questions. I appreciate the excellent testimony of the Chairman and hope that in the near future you will get some political support to match the monetary leadership that you have given. The CHAIRMAN. Chairman Greenspan, we thank you very much. You have been very patient and forthcoming as always. We appre- ciate your testimony. The committee stands in recess. [Whereupon, at 12:15 p.m., the committee was recessed, to recon- vene at 10:00 a.m., Wednesday, February 22, 1989.] [Response to written questions of Chairman Riegle follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 Chairman Greenspan subsequently submitted the following in response to written questions from Chairman Riegle in connection with the hearing held on February 21, 1989: Question 1: The economic assumptions submitted with the budget this year show a decline in inflation over the next 5 years to a 1.8 percent rate, while economic growth averages 3 to 3.5 percent. The Fed's central tendency inflation projection for next year is 4.5 to 5 percent. Is it likely that inflation can be reduced 3 percentage points so painlessly? Answer: One might argue that this long-run scenario is optimistic, but there certainly are circumstances in which it could be realized. Two key considerations are (1) whether we can achieve growth in labor productivity more in line with the experience earlier in the post World War II period, and (2) whether we can maintain policies that provide people with some assurance that the government will remain committed to restoring price stability over time. Question 2: You have stated that current inflation rates cannot be acceptable indefinitely. What is an acceptable rate, and how soon do you expect to reach it? Answer: I have emphasized the importance of reducing the rate of inflation to a level at which it no longer has economic significance — that is, one so low that people no longer feel the need to make any allowance for inflation in their decisions about purchasing real or financial assets. I'm not sure what, in terms of our conventional price indexes, that translates into quantitatively, but I think we must at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 this point take as our working assumption that it is a number approximating zero. As to a timetable, it is clear that we can't achieve price stability overnight without undue wrenching of the economy; however, if we do not have at least a rough sense that we want to achieve this objective within several years, it will lose operational significance and have little, if any, of the favorable expectational effect that it might otherwise have. Q.3. In response to a question from Senator Heinz, you expressed some confidence that long-term real interest rates have risen over the past year in response to your increases in short-term rates. Long-term real rates can be computed in many ways. How ace the rates you use computed/ and can you give us the estimates for the past decade? Long-term real interest rates are difficult to determine precisely because long-term inflation expectations are not directly observable. Using survey data of market participants' long-tera inflation expectations, long-term real interest rates appear to have risen over the past year as expectations of long-term inflation rates have dropped while nominal long-term interest rates have been about stable. Table 1 shows the results of a survey published by Drexel Burnham Lambert, which gathers responses from financial market participants to questions concerning expected inflation rates for the next 12 months, 5 years, and 10 years; the chart in the lower panel shows recent 10-year real interest rates based on the responses to this survey and average monthly 10-year Treasury note rates. As shown in the table, expected 10-year inflation rates have declined from 5.3 percent in January of 1988 to 4.7 percent in February of 1989 {the last Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 available survey). The chart shows that long-term real interest rates have risen since 1986 but currently are not as high as they were in the early 1980s and in 1984. Another technique sometimes used to proxy inflation expectations is to assume such expectations are formed by extrapolating past inflation rates. Table 2 uses both 12- and 20-quarter moving averages of past inflation rates (using the PCE deflator) as prozies for expected future inflation rates to estimate long-term real interest rates. Using this proxy, real interest rates are unchanged or up slightly from early 1988, and are appreciably above their levels of the first half of 1987, though they have declined from the peaks reached in the last half of 1987. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 available survey). The chart shows that long-term real interest rates have risen since 1986 but currently are not as high as they were in the early 1980s and in 1984. Another technique sometimes us«d to proxy inflation expectations is to assume such expectations are formed by extrapolating past inflation rates. Table 2 uses both 12- and 20-quarter moving averages of past inflation rates (using the PCE deflator) as proxies for expected future inflation rates to estimate long-term real interest rates. Using this proxy, real interest rates are unchanged or up slightly from early J988, and are appreciably above their levels of the first half of 1961, though they have declined from the peaks reached in the last half of 1987. Question 4: You stated that the unified budget is the best measure of the federal government's impact on national savings, and that you believe we should generally have a unified budget surplus to increase national savings. Would you agree that the surplus should be bigger during periods when the Social Security trust fund is growing — that we ought to be saving more when our workforce is bulging with baby boomers who expect to receive large benefits in the future? Answer: I have stressed the importance of a consolidated measure of the federal government's budget position because that is the appropriate index of the sector's absorption of, or contribution to, national saving. What we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 should be seeking is to increase the overall level of national saving, so that we can finance added capital formaticn. By raising saving and investment, we can enhance our productive potential in the years ahead, and thereby make it possible for workers in future years to meet, without great sacrifice of their own living standard, the Social Security commitments made to the baby boomers. pugstion 5: Typically, inverted yield curves have been followed by business recessions. Why will the relationship between the yield curve and the economy be different this time? Answer: Over the past year, short-term interest rates have risen sharply while long-term Treasury interest rates have been stable. As a result, the Treasury yield curve has flattened considerably and is inverted between maturities of two years and thirty years. This downward sloping portion of the yield curve implies that market participants expect interest rates, including long-term rates, to decline in the future. Although the last four recessions were all preceded by inverted yield curves, there are reasons to believe that circumstances differ today, compared to those episodes of inverted Treasury yield curves, the recent flattening has been modest in both duration and magnitude. Indeed, three-month Treasury bill rates are still below longer-term rates. The federal funds rate (on a 365-day basis) has been above the thirty-year Treasury bond rate only since the beginning of this year, and the spread has only recently widened to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 85 basis points, which is a smaller spread than observed before any recession since the 1950's. In addition, past recessions followed inversions of the yield curve by up to two years; thus, it is likely that recent movements in nominal interest rates are not a reliable predictor of economic activity, especially in the near term. Indeed, the more recent changes in the slope of the yield curve may reflect only downward revisions to longer-term inflationary expectations not predictions of a recession. Further, new financial instruments, markets, and techniques have broadened the choices available to savers, spenders, and intermediaries for structuring their assets and liabilities. The consequences of these innovations have been to reduce the effects of liguidity constraints in financial markets and, thus, to elevate rate movements as a transmission channel for monetary policy and other influences in the economy; these developments also imply that historical associations among interest rates may be subject to change, making predictions based solely on the slope of the yield curve uncertain. Attachments (2) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table 1 Inflation Kzp*ct»tions IHoey Survey) Survey Next First Second 10-year Date 12 months 5 vears 5 vears averaae — -' — -•— ^annual rater percent" —" — ~ — 1986: Q3 3.5 4.8 5.5 5.1 Q4 3.6 4.7 5.5 5.1 1967: January 3.8 4.9 5.4 5..1 March 4,,0 5.2 5.8 5.,5 May 4.7 5.3 5.4 5..3 June 4.6 5.2 5.3 5..3 August 4..9 5-4 5.7 5,.5 September 4.7 5.3 5.6 5..4 November 4.1 5.0 5.3 5..1 1988: January 4.5 5.2 5.5 5..3 March 4,3 5.0 5.3 5,.2 April 4.7 5.1 5.0 5..1 June 5.1 5.1 4.9 5..0 August 5..3 5-1 4.8 4..9 October 4.9 4.7 4.9 4..8 November 4..8 4.6 4.7 4,.7 December 5.0 4.6 4.6 4,.6 1969: February 5..3 4.7 4.7 4,.7 ESTIMATED REAL INTEREST RATE 10-year Treasury bond yield less 10-year average Inflation expectation (Hoey survey). McnfMy 1979 I860 1982 1964 Monthly obMtvMkHW tor furv*ymonthf;lMobMmrton b February IBtot. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 Table 2 REAL AND MGMZNAI. IKT1REST RATES (Long-term Treasury bond, in percent) Real rate - Real rate 3 Nominal (Alternative A) (Alternative Bl bond cate 1979:Q1 2.2 1.9 9-0 Q2 1.8 1.9 9.1 Q3 1.3 1.8 9.0 Q4 2.1 2.8 10.1 1980 :Q1 3.2 4.2 11.7 Q2 2.0 2.8 10.5 Q3 2.0 3.1 10.9 04 2.9 4.2 12.1 1961 :Q1 2.9 4.3 12.5 Q2 3.8 4.9 13.3 Q3 4.8 5.7 14.1 Q4 4.6 5.4 13.8 1982:Q1 5.0 5.6 14.0 Q2 5.0 5.4 13.5 Q3 4.7 4.6 12.8 Q4 3.1 2.7 10.8 1983:Q1 3.8 2.8 10.7 Q2 4.2 3.0 10.6 Q3 5.7 4.2 11.6 Q4 6.3 4.4 11.7 1984:Q1 7.1 5.0 12.0 Q2 8.6 6.4 13.1 Q3 8.4 6.3 12.7 Q4 1.1 5.7 11.7 1985-.Q1 7.8 6.0 11.6 Q2 7.2 5.7 11.0 Q3 T.O 5.6 10.6 Q4 6.5 5.4 10.0 1986:Ql 5.4 4.6 8.8 Q2 4.4 3.6 7.5 03 4.3 3.7 7.4 Q* 4.5 4.0 •J.5 1987:Q1 4.3 3.9 7.5 02 5.2 4.9 8.5 Q3 5.6 5.5 9.1 Q4 5.7 5.7 9.2 198B-.Q1 5.2 5.1 8.6 02 5.4 5.5 9.1 Q3 5.4 5.6 9.2 Q4 5.2 5.3 9.0 1. All interest rate and inflation readings are quarterly averages. 2. Alternative & IB expected inflation measured by a 12-quarter moving average of past inflation (PCE deflator). 3. Alternative B is expected inflation measured by a 20-quarter moving average of past inflation (PCE deflator). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 Chairman Greenspan subsequently submitted the following in response to a written question from Senator Sarbanes in connection with the hearing held on February 21, 1989: Question 1: The Federal Reserve's Monetary Policy Report to Congress is made pursuant to the Full Employment and Balanced Growth Act of 1978, 12 U.S.C. 225(a). Last year's trade bill, the Omnibus Trade and Competitiveness Act of 1988, 22 U.S.C. 5306, amended the 1978 Act to read as follows: "In furtherance of the purposes of the Full Employment and Balanced Growth Act of 1978, the Board of Governors of the Federal Reserve System shall transmit to the Congress, not later than February 20 and July 20 of each year, independent written reports setting forth (1) a review and analysis of recent developments affecting economic trends in the nation, including an analysis of_ the impact of the exchange^rate of the dollar on those trends'^. The language that was added to the Act is underlined. The February 21 Monetary Policy Report's section on "The External Sector" does include some analysis of the effect of the exchange rate on the U.S. external accounts such as the trade and the current account. However, the Congress also intended that the analysis of the exchange rate extend to the effects on other economic trends central to the purposes of the Humphrey-Hawkins legislation - growth, inflation, employment, income, and investment. Please comment on the impact of the exchange rate on these measures of economic performance. More specifically, from mid-1986 to mid-1988, improvement in the real trade balance contributed positively to overall GNp growth and stimulated increases in investment and employment in goods industries. The real trade balance worsened in the last two quarters of 1988. What role did the exchange rate play in the recent deterioration and in the earlier improvement? How important is the trend in the real trade balance to overall growth, investment, and employment? The report notes some acceleration of domestic inflation. How much of the recent acceleration of inflation do you trace to movements in the exchange rate? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Answer : In describing the recent pcrf ormatice of the U.S. economy, the February 21 Monetary Policy Report to Congress noted that the gain in U.S. price competitiveness resulting from the earlier depreciation of the dollar, efforts at controlling costs, and increases in productivity accounted for much of the strong growth in exports during the first half of 1988. While net exports weakened somewhat toward the end of the year, there was enough impetus from other sectors to keep real GNP on a firm upward course. The report also noted that the direct effect of rising import prices on domestic inflation was less pronounced in 1988 than it had been in 1987, although higher import prices probably influenced pressures on domestic prices in some areas. Several more specific questions asked about the relationships among exchange rates, net exports, growth and inflation: Ef£ect_ of Exchange Rates _on Real Met Exports,, During 1986-88. The depreciation of the dollar through 1987 (along with improved U.S. domestic price, cost, and productivity performance) probably accounted for much of the overall improvement in net exports between mid-1986 and mid-1988. However, the very rapid pace of expansion of exports during the first half of 1988 was considerably faster than most analysts and models had anticipated. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 The substantial slowing of the growth of both exports and net exports after mid-1988 could have reflected a number of factors. Earlier movements in exchange rates probably continued to have a significant net positive effect on the real trade balance, despite the rise in the dollar around mid-year. Most empirical models suggest that changes in exchange rates continue to affect trade flows for at least two to three years, and the rise in the dollar during 1988 was small relative to the decline over the preceding two years and came relatively late in the period. Nevertheless, it is generally believed that the effects of exchange rate changes do tend to diminish over time. The slowing of U.S. external adjustment since mid-1988 may have reflected, at least to a small degree, a decline in this positive effect. Other factors that could have contributed to the modest widening of the real trade balance include: (1) the slowing of domestic demand in certain foreign markets towards the end of 1988, (2) emerging capacity constraints in several U.S. manufacturing sectors, and (3) timing factors, such as the bunching of orders for agricultural commodities by the Soviet Union and China into the first half of 1988, a pickup in imports late in the year from certain Asian countries facing a removal of GSP privileges at the end of 1988, and a surge in imports of petroleum as oil prices bottomed out. These and other timing factors probably accounted for much of the shift in the pace of external adjustment between the first half and the second half of 1988. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 Effect of Real Met Exports on Growth, Investment, and Employment - Between mid-1986 and mid-1988, the increase in real net exports accounted directly for about 20 percent of the total increase in GNP. However, the importance of the expansion of exports alone as an "exogenous** stimulus to output and employment during this period was probably greater than this 20 percent figure suggests. The growth in exports undoubtedly had "multiplier" effects on domestic consumption and investment (particularly on investment in the manufactur- ing sector). On the other hand, the effects of the expansion in exports on the real trade balance was partly offset by an induced increase in imports. If GNP had grown 20 percent less than it did from mid-1986 to mid-1988 (that is, if GNP growth had been about 3/4 percentage point per year lower than it was), then as a very rough estimate, the unemployment rate by mid-1988 might have been as much as 3/4 percentage point higher than it was. EjfecV of ^Exchange Rates on the Increase in Inflation. Movements in dollar exchange rates probably contributed no more than 1/4 percentage point to the pickup in inflation during 1988 through their direct impact on import prices. Only about half to three-fourths of the movement in exchange rates, on average, normally is passed through to import prices, and some of the effects of the dollar's earlier depreciation were offset by the appreciation during 1988. The full effects of the dollar on the pickup in inflation may be somewhat greater when one factors in the indirect effects Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 through the stimulus of real net exports to aggregate demand, and through reduced pressures on U.S. prices and wages arising front reduced competition from foreign goods. o Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1989, February 20). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19890221_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_19890221_chair_federal_reserves_first_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1989},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19890221_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}