Congressional Testimony

FEDERAL RESERVE'S SEMIANNUAL REPORT ON MONETARY POLICY-1994 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND UPBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED THIRD CONGRESS SECOND SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 JULY 20, 1994 Printed for the use of the Committee on Banking, Housing, and Urban Affairs 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 PAUL S. SARBANES, Maryland ALFONSE M. D'AMATO, New York CHRISTOPHER J. DODO, Connecticut PHIL GRAMM, Texas JIM SASSER. Tennessee CHRISTOPHER S. BOND, Missouri RICHARD C. SHELBY, Alabama CONNIE MACK, Florida JOHN F, KERRY, Massachusetts LAUGH FAIRCLOTH, North Carolina RICHARD H. BRYAN, Nevada ROBERT F. BENNETT, Utah BARBARA BOXER, California WILLIAM V. ROTH, JR., Delaware BEN NIGHTHORSE CAMPBELL, Colorado PETE V. DOMENICI, New Mexico CAROL MOSELEY-BRAL'N, Illinois PATTY MURRAY, Washington STEVfiN B. HARKIS, Staff Director and Chief Counsel HOWARD A. MKN'ELL, Republican Staff Director PATRICK J. LAWLER, Chief Economist WAYNE A. ABEKNATHY, Republican Economist EDWAHD M. MALAN, Editor an Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS WEDNESDAY, JULY 20, 1994 Page Opening statement of Chairman Riegle 1 Opening statements, comments, or prepared statements of; Senator Gramm 2 Senator Sarbanes 3 Senator Roth 6 Senator Sasser 7 Senator Faircloth 9 Senator Moseley-Rraun 10 Senator Bond 12 Senator Murray 13 Senator D'Amato 13 Senator Mack 14 Senator Bennett 14 Senator Domenici 15 Senator Boxer 17 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem, Washington, DC 18 Prepared statement 51 Response to written questions of: Senator Riegle 57 Senator Sarbanes 58 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to Congress 67 Analysis by James Tobin entitled, "Can't the Anti-Inflationary Monetary Pol- icy Raise Long-Run Real Growth?" 96 Chart showing unit labor costs for nonfarm business entitled, "Labor Costs at 29-Year Low" 99 Chart showing changes in inflation entitled, "Inflation Back to Early 1960s' Rate" 100 Chart showing change in the Consumer Price Index entitled, "Inflation Low and Tallin/ 101 (HI) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SEMIANNUAL REPORT ON MONETARY POLICY—1994 WEDNESDAY, JULY 20, 1994 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:10 a.m., in room SD-538 of the Dirk- sen Senate Office Building, Senator Donald W. Riegle, Jr. (Chair- man of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN DONALD W. RIEGLE, JR. The CHAIRMAN. The Committee will come to order. Let me welcome all those in attendance this morning, particu- larly our witness today, Federal Reserve Chairman, Alan Green- span, who is here to discuss with us the Federal Reserve's semi- annual monetary report which has just been released as this hear- ing begins this morning. As we know from reviewing the current statistics, recent eco- nomic growth has continued to be vigorous recently. We have added 1.4 million new jobs in just the past 4 months, and it ap- pears that the economy is finally on the verge of completing its re- covery from the recession that started about 4 years ago. During those 4 years, however, of what I think can fairly be called sub-par national economic performance, we have lost about $700 billion of goods and services that we could have produced over that time, but for the recessionary condition. Obviously, that is a very serious loss and one that we cannot afford to repeat any time soon. The Chairman has told us, in the past, one of the things that de- layed this recovery was the need for many households and firms to improve and to rebuild their balance sheets. Of course that has, in large measure, been accomplished, as we have previously reviewed. I think it's fair to say that it's the turn for those who were unem- ployed by the recession to get a chance to not only be employed, but stay employed long enough so that there's an opportunity to re- build those personal and family balance sheets as well, going out in time. We need to make sure that the economy keeps growing, at least, at a moderate rate. I think it is natural and appropriate that, with the recovery nearly complete, the Fed be concerned about the possibility of the economy overshooting to the point that inflation were to start to ac- celerate again, but the inflation data that were reported last week remained low and the risks do not appear to lie all in one direction in that area. (1) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis In fact, we already see signs that the economy is slowing down, probably, at least in part, due to the recent Fed tightening. We see recent retail sales have been weak. We see inventories of unsold goods are rising and consumer confidence has been falling again. These are signs that are current, signs that tell us, I think, impor- tant things about what the direction may be here. Higher interest rates have also significantly reduced new home sales from that which we saw late last year, and this morning, housing starts were reported to be down by a surprising 10 percent in June. I think monetary policy decisions over the coming months must not lose sight of the danger that the economy could slow to the point that it slips into another recession. I don't think any thought- ful policymaker would want to see that happen, and I don't pre- sume or believe that to be the view of the Fed. The Fed did raise short-term interest rates by I1/* percentage points earlier this year. When we met after those two moves, Mr. Chairman, you got a variety of reactions and opinions from this Committee, and from others. My own view was, having taken those steps, I hoped that the Fed would perhaps pause at this point and see what that policy impact would be. I think we're now beginning to see that. There are obviously lags in what happens in the real economy, but it would be my view that it would be wise if the Fed could continue that pause until we have an even clearer picture of how the economy is responding. Two areas of particular concern, lately, have been long-term in- terest rates and the foreign sector of our economy. Yesterday, the monthly trade deficit—now get this—the monthly trade deficit was reported at nearly $10 billion. That's essentially a 30-day period of time. That's an enormous monthly deficit, and we've seen a very disturbing pattern month after month in the foreign trade deficit. I think that's a problem that has persisted for a long time, but is very worrisome at these levels. The dollar has also fallen significantly over the past 3 months. Tomorrow, we will be hearing from Treasury Under Secretary Summers about Treasury's views on that. After years of selling large quantities of our long-term debt to foreigners, we appear now to be paying some price for that. They are not buying our long-term debt now, and that must be having some effect on helping to affect our interest rate picture, and not in a positive way. We're very interested to hear your views today on the economy's prospects and on your policy plans for the future, Mr. Chairman. Let me now go down the table for brief opening comments from Members. Senator Gramm. OPENING STATEMENT OF SENATOR PHIL GRAMM Senator GRAMM. Thank you, Mr. Chairman. Chairman Green- span, we're glad to have you back before the Committee. I'd like to raise a few concerns, and I hope in your prepared text or as we get into questions you can address them. I'm concerned about the decline in the value of the dollar. The dollar is the world currency. A decline in the value of the dollar Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis raises the cost of holding the dollar as a world currency and creates the potential that we could have a flight out of the dollar if the trend continues. I don't have any doubt in my mind that it has had an impact on your ability to conduct domestic monetary policy. A relevant question is, why is it happening? I think you can make a case that there's a general lack of con- fidence in American leadership and in American foreign policy, and I don't discount that as a factor. When people are expressing their opinions with their money and how they invest it, instead of their mouths, I think we ought to take their views seriously. I think when they're doing that, they're looking at some of these long-term trends that we're not addressing. There has been great jubilation that the deficit has gone down slightly. It's gone down because the S&L bail-out turned out not to be as expensive as we had thought. It has gone down because inter- est rates are low and we are trie largest debtor in the world and we are great beneficiaries, in the Federal budget, of lower interest rates. The deficit also has gone down because the economy has recov- ered, but I think the thing that is very ominous on the horizon is that the deficit pattern looks like a hockey stick. It goes down very slightly for 3 years and then it goes up like a rocket, even if the economy stays strong. Why? Because nothing has been done about the long-term spending patterns of the Federal Government. Finally, I have to believe that the health care debate and the prospects of the adoption of the largest entitlement program in American and world history has got to be having an impact on world financial markets. As I look at the President's health care plan, and as I look at similar plans, at best they're underfunded by 25 percent over the first 5 years of their life. They're generally underfunded by 50 per- cent or more over the second 5 years. What you're looking at is tak- ing a deficit picture that is already bleak and doubling how bleak it is. I can't help but believe that people who are using the dollar on the world financial market, looking at this picture, looking at the specter of a massive, new, long-term, explosive spending program on health care, and looking at what collectivized medicine has done to the spending patterns of other countries, I can't help but believe that that's a factor. I'd like to get your views on it. I thank you, Mr. Chairman. The CHAIRMAN. Thank you. Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANKS. Thank you very much, Mr. Chairman. I'm pleased to join with you in welcoming Chairman Greenspan to the Committee this morning for the mid-year Humphrey-Hawk ins tes- timony. Chairman Greenspan, just before your last appearance here on May 27, 1994, the Federal Reserve had hiked interest rates for the fourth consecutive month. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis In total, the four hikes raised the Federal funds rate from 3.0 percent to 4Vi percent. At that hearing, a number of Members urged the Fed to refrain from further hikes until they could survey the damage from the hikes already in place. Fortunately, the Fed has refrained from such further hikes and I think the economic news since May has clearly justified such re- straint. In fact, my own position is that the actions you took even earlier were counterproductive to the economy. Let me just quickly review some of the things that are happening. Underlying demand rose modestly in the second quarter. Consumer spending, almost 70 percent of total spending in the economy, appears to have grown by less than 1 percent in the sec- ond quarter. GDP probably rose faster, somewhat faster, in the second quar- ter, but apparently due largely to rapid build-up of inventories. There's been a sharp jump in inventories. This bodes poorly for GDP grown in the second half of the year, obviously. That's taking place, apparently, at the retail and wholesale level and, in effect, people were putting in orders that have come in and now they can't get the goods out of the store because of slackening demand. Other key cyclical indicators such as new orders for durable goods and housing construction, in the index of leading indicators, have all been flat for the last couple of months. Chairman Riegle mentioned the housing starts figure in his opening statement, down 10 percent this month. The Fed, in my view, has engineered a slowdown in the economy despite the absence of an inflation problem. The domestic economy is generating less inflation than it has in three decades. In the last 12 months, consumer prices rose just 2V2 percent. Producer prices were unchanged. This chart shows you the move- ment in consumer prices and, of course, what you have is the best performance since the early 1960's on consumer prices. Except for 1986, when oil prices collapsed—you have to go back to 1965, almost 30 years ago, to find a year with a CPI as low as it's been over the past year. A broader-based measure from the GDP accounts, the deflator for final sales to domestic purchasers, has risen only 1.7 percent in the last year—1.7 percent. That's the lowest rate in 30 years. In 30 years. Those indices, I think, indicate that there's not an inflation prob- lem pressing us. We've got the best inflation performance in 30 years. The economy remains far from overheating. Capacity utiliza- tion in manufacturing has not risen over the last 3 months. Even reported levels are overstated, according to some experts, including, I think, some experts at the Federal Reserve. Moreover, the industries with higher utilization rates generally face intense international competition with substantial unused ca- pacity abroad, I think, a factor that's often overlooked when we ad- dress the question of an inflation danger. As we globalize the econ- omy, the presence of this competition from abroad and excess ca- pacity elsewhere, of course, serves to act as a damper on price movements in this country. The only clear sign of recent economy strength comes from the job market. After such a long period of jobless recovery, I find it Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis entirely welcome that more than 1V-2 million jobs have been added to payrolls in the last 6 months and that the employment rate has declined to 6 percent. These improvements in the labor market are long overdue, but there's no evidence that they are having any impact on inflation. In fact, the most recent data show a deceleration in hourly wages and compensation costs—something you obviously wouldn't expect in an overheated labor market. In addition, unit labor costs, which take into account productivity gains, increased only Vioths of 1 percent in the last year, a record unmatched in 29 years. Again, just as we were showing on the in- flation front, looking at this performance on unit labor costs, we're getting the best performance since the early 1960's. Another commonly used indicator of labor market pressures, the index of help-wanted advertising, remains at levels associated with a slack job market. One of the best signs that we still have ample slack in the labor market is the dearth of people coming into the labor force. After every other recession in the last three decades, strong job growth drew large numbers of new workers into the labor force as jobs became plentiful, but employment growth in this expansion has been too feeble to attract new workers. In fact, we still have a smaller fraction of the working age population em- ployed now than before the 1990 recession began. The Fed, in its monetary policy report to Congress, which you're giving us this morning, says on page 13, and I quote you: Survey data reveal that many individuals still perceive jobs as hard to find, which may limit their desire to search for employment. That's the very point that I'm trying to make in this statement. I'd like to make this observation. High unemployment has social, as well as economic, costs, because the burden of unemployment is not evenly distributed. Historically, a 1-percent reduction in the unemployment rate raises employment, jobs, among blacks at dou- ble the rate as for whites. Conversely, when overall unemployment rises, blacks suffer unemployment losses at double the rate of whites. This means that the burden of a slow growth, high unem- ployment policy falls twice as heavily on the minority community. Jim Hoagland, in a recent article in The Washington Post, makes these points, that I think are extremely important, with a verve and a pungency and I'm going to quote him: Ono man's job is another man's basis point tn the brave new economic world of the centra) hankers. Being unemployed may bo bad for you, but cheer up. It cools inflation and should be good for the markets. That is part of the unspoken, and un- speakable, philosophy that lies behind the manipulation of interest rates in the world's leading industrial economics in recent months. Because of the central bank- ers' abiding and unbalanced fear of inflation, declining unemployment rates have be- come a hair-trigger for raising interest rates. The bankers and fund managers resemble old generals refighting the last war after the battlefield has changed. They build a Maginot Line of high, long-term in- terest rates instead of adapting monetary policy to a world in which the greater bar- riers to economic renewal arc unemployment and lack of public investment in pro- ductive enterprises. He closes with this observation: Growth is measured in jobs, as well as stock and bond prices. Ixiw inflation rates purchased by high unemployment will turn out to have been a dubious bargain. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis In summary, in my view, the economy is not growing too rapidly. While the labor market is improving, there's no basis for alarm that we will soon run out of available workers. To slam on the monetary brakes before we can restore employment conditions to their pre-recession levels would be a cruel mistake. Mr. Chairman, it's turned out I'm getting a lot of communica- tions from across the country and I just want to share a few of those with the Committee and the Chairman here this morning, be- cause it gives you some perception of how this is being seen by oth- ers. This says: Alan Greenspan's car. This is Alan Greenspan. The speedometer says: Inflation. The posted notice on the car dash- board says: This vehicle stops at the slightest provocation. [Laughter.] As my colleague, Senator Sasser, points out, here's this huge brake pedal and you've got both feet on it, Mr. Chairman. L Laughter.] Senator GRAMM. We've certainly raised the intellectual level of this debate. [Laughter.] Senator SARBANES. This one is—these two people are talking and this one says, "Say, isn't that Alan Greenspan's house?" [ Laugh ter.l This is the final one I want to share, Mr. Chairman, and I appre- ciate your indulgence. Here you are, Mr. Chairman, carrying your briefcase. The Fed. This says: Now hiring. This says: Men at work. The caption is: A terrible day in the neighborhood for Mr. Green- span. This is the sign we want all over the country. I look forward to hearing the Chairman's testimony. Thank you, Mr. Chairman. The CHAIRMAN. Mr. Roth, by order of the arrival, you're next. OPENING STATEMENT OF SENATOR WILLIAM V. ROTH, JR. Senator ROTH. Thank you, Mr. Chairman. It's always a pleasure to welcome Chairman Greenspan before this Committee. Mr. Chairman, traditionally, the Federal Reserve is considered responsible for monetary policy, and the Administration and Con- gress for fiscal policy. Since both monetary and fiscal policy can affect the economy, re- sponsibility for specific economic developments is muddled between the central bank and elected officials. According to the new Woodward book entitled, "The Agenda," this muddle has become clarified in recent years. Woodward de- scribed the Federal Reserve as working closely with Administration officials in designing fiscal policy. As you know, Mr. Chairman, in the Woodward book, you're portrayed as having ghostwritten the Clinton budget package. To the extent that the Woodward book is accurate, it would ap- pear that the Federal Reserve has become part and parcel of Ad- ministration economic policy. In this context, Federal Reserve ac- tions, whether producing lower or higher interest rates at any par- ticular time, must be viewed as a result of Administration policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Moreover, in light of Woodward's book, efforts to attack Federal Reserve policies for undermining the Clinton program appear to be less than fully informed. Mr. Chairman, the Woodward book raises, I think, some serious issues about the institutional relationship between the Federal Re- serve Board and the Administration, The close collaboration be- tween the Federal Reserve and Administration officials, if accurate, raises concerns that Federal Reserve independence might have been compromised. Mr. Chairman, I would appreciate it if you could address the con- cerns at an appropriate point in this hearing. Thank you, Mr. Chairman. The CHAIRMAN. Senator Sasser. OPENING STATEMENT OF SENATOR JIM SASSER Senator SASSER. Thank you, Mr. Chairman. I, too, want to wel- come the Chairman of the Federal Reserve, Alan Greenspan, before the Committee. Dr. Greenspan, as you are aware, I have strongly disagreed with the Federal Reserve's monetary policy over the past 6 months, and my views of disagreement are perhaps even stronger today than they were at the outset. I realize that economists can read the numbers in different ways, however, I am still at a loss to find evi- dence of an overheating economy. As Senator Sarbanes indicated a moment ago on his chart, labor costs and real hourly wages have gone up only G/ioths of 1 percent over the past year. If you add in the cost of fringe benefits, that puts it up to Vioths of 1 percent, but real increases in productivity have been at 2.6 percent, while fringes and wages are going up at a figure one-third of that. There is no evidence, nor clear footprint of inflation here. If it were here, I think this is where we would find it. The Federal Reserve may have scored well on Wall Street with its policy over the past few months, but, frankly, I think it has the American economy on the verge of reeling. Make no mistake about it, as the Fed pushes interest rates up, it is pushing down further the hopes of working men and women in this country. It's threatening to choke off the economic recovery that we worked so very hard to produce. If you look at this chart, the rise in the cost of 30-year mortgage rates for homes have caused many Americans, particularly young couples, to mortgage their dreams of home ownership. We can see why here. On February 4, 1994, mortgage rates stood at 6.9 percent. July 15, 1994, 30-year conventional mortgage rates stood at 8.7 percent. Merrill Lynch reports that mortgage applications in early July fell to their lowest level in 18 months. In fact, the Commerce De- partment reported this morning, as the Chairman indicated, that June housing starts fell by almost 10 percent—9.8 percent—and May housing starts were revised downward. This June level of housing starts is below average starts for the decade of the 1960's, 1970's, and 1980's, even though the popu- lation has been growing during that period of time. How does this impact down where the rubber meets the road? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A homebuilder in Knoxville, TN, told me recently that his busi- ness has been cut in half from just 6 months ago. He tells me that his colleagues in the homebuilding business are now contemplating lay-offs this summer in the eastern part of Tennessee, and they place the blame squarely at the doorstep of the Federal Reserve. The Mortgage Bankers Association estimates that 200,000 rent- ers who would have purchased a house this year have been pushed out of the market because of higher interest rates. Let's just take a moment and see how that's occurring. A couple who received, back in January, a $100,000 mortgage at a 7 percent interest rate paid $665-a-month in principal and inter- est. If that same couple had waited until May to try to buy a house, after the Fed pushed the rates up, they would have been paying 8.6 percent, and the monthly payments, instead of $665, would have been $778. On Wall Street, $113 difference in house payments or mortgage payments may not be a lot of money, but if you're a working man and woman, a working couple trying to get off the renters' tread- mill, that $113-a-month may very well be the difference between continuing to rent and buying your own home and starting to ac- quire some equity in that home, I ask, for what? Inflation is not a problem. I'm reminded of that television commercial where the two elderly ladies were asking, "Where's the beef?" My question here is, "Where's the inflation?" Over the past 12 months, consumer prices have risen only 2.6 percent. This is down from 2.9 percent in the preceding year. Sen- ator Sarbanes said, with the exception of 1986, when oil prices col- lapsed, this is the best inflation level since the mid-1960's. Evidence against inflation keeps mounting. Wholesale prices haven't changed at all over the last 12 months. Labor costs in- creased only %oths of 1 percent in the past year. As the charts used by Senator Sarbanes so graphically illustrate, it's the slowest rate of increase in labor costs in over a decade. The Wall Street Journal headline from this past Monday indi- cates: "Economy Shows Additional Signs of Slowdown." Inventories are piling up. Industrial output is moderating. Consumers are re- trenching. We also see that automobile sales, which had been going up for the past 2 years, are now starting to move down very sharply as a result of interest rates having their effect. As auto sales start falling, as housing starts continue to decline, I think we run a very, very real risk of choking off this economic recovery. Dr. Greenspan, you said last week before the Entitlement Com- mission, of which I'm a member and which I think Senator Moseley-Braun is also a member, and 1 quote: The U.S. economy has recently been experiencing the ideal combination of rising activity, falling unemployment, and slowing inflation. I must say to you that I'm most pleased with the performance of the economy over the past 18 months. I believe it's a direct re- sult of the historic deficit reduction package that we passed last year. I'm deeply concerned, though, that the Fed considers today's situation "ideal." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 My question is, "Ideal for whom?" Many working men and women have suffered with stagnant wages now for many, many years. They've seen their standard of living either decline or just remain stagnant, even though both man and wife are working as hard as they can. It was my hope, and it is still my hope, that we can expand this recovery to once again start enhancing the quality of life of the working men and women of this country. Let me make one additional point that I know is very important to you, Dr. Greenspan. It's about this country's fiscal condition. It's a matter about which we're all deeply concerned. I want to direct your attention to the OMB's mid-session review for fiscal year 1995. We clearly see the effect of higher interest rates on the out-year deficits. Higher interest rates since February have increased spending on net interest by more than $100 billion from 1994 through 1999. If interest rates had remained at the levels forecast in February, out-year deficits would have declined by about $15-billion-a-year. Let me conclude, Mr. Chairman, by saying that I still, as you can see, strongly disagree with the Fed's policy of seeing what I per- ceive to be a shadow of inflation where there is none. I think this policy of trying to deal with inflation where none exists is causing real Americans to lose confidence. It's causing real citizens to feel a pinch, and I think our people are getting hurt. Mr. Chairman, thank you. The CHAIRMAN. Thank you, Senator Sasser. Senator Faircloth. OPENING STATEMENT OF SENATOR LAUGH FAIRCLOTH Senator FAIRCLOTH. Thank you, Mr. Chairman. Good morning and welcome, Mr. Greenspan. I applaud your leadership and the di- rection you've been taking. In 45 years in the private sector, I've learned one thing. That is, markets don't lie. If the politicians and economists are telling you one thing, and the markets are telling you another, you've got to believe the market. The dollar has been falling not just against the yen, but a whole basket of currencies, and no matter what the politicians say, the market is telling us one of two things. First, there are too many dollars in circulation. In that case, the market is telling those who criticize your concern about inflation they are just plain wrong. There are too many dollars out there. Second, and more disturbing, the market is telling us that the dollar is losing value because it is better to invest your money some place other than in the United States' economy. It's telling us that pretty decisively. That doesn't say bad things about you or the Federal Reserve. It says bad things about the President and this Congress, as well as past Presidents and Congresses who have run up this debt. We need to cut Federal spending and quit talking about cutting it, but cut it and stop penalizing people who work for a living. Stop subsidizing people who don't work for a living. If we don't get the rate of savings and investment up in this country, we're going to face sn economic catastrophe that no Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 amount of testifying by any Federal Reserve Chairman, whoever he might be, can fix. Again, I applaud the direction you've taken and keep it up. Thank you. The CHAIRMAN. Senator Moseley-Braun. OPENING STATEMENT OF SENATOR CAROL MOSELEY-BRAUN Senator MOSELEY-BRAUN. Thank you, Mr. Chairman. Mr. Chairman, the subject of today's hearing, the semiannual monetary policy report of the Board of Governors of the Federal Re- serve System, may be seen by many Americans as not having much to do with their daily lives. After all, we will be discussing a num- ber of rather technical economic policy issues and using a lot of big numbers. However, all of my colleagues here today, and of course our dis- tinguished witness, know that this Committee hearing is really about issues that are central to the lives of every American, People who have jobs want to know whether they will keep them or lose them. People who are looking for work want to know whether there will be new jobs out there to find. I want to congratulate Senator Sarbanes on his excellent state- ment and description of that issue and the sense, out in the coun- try, of the importance of what it is we'll be doing here. All of us want to know how much things will cost. Will prices go up? And if so, by how much? The economic statistics provide the beginning of the answers to those questions. Inflation is low at 2.7 percent, and staying low. Economic growth is strong, now over 3.2 percent. Unemployment is down, down to 6 percent last month and job creation is up, with over 3.8 million new jobs created in the last 18 months. The real good news, however, is what those numbers mean to in- dividual Americans around this country. They mean greater secu- rity for working Americans, greater opportunities for Americans seeking work, and real bargains for American consumers. That good news, for real people, is due, in no small part, to the fact that the Federal Reserve and the rest of the Government are no longer working at cross-purposes. For the last 18 months, the Federal Reserve has not been put into the position of having to try to use monetary policy to make up for the failure of the legislative and executive branches of Government to deal with fiscal policy is- sues. Last year, the President proposed and Congress passed a very tough economic package. That legislation was designed to help re- duce Federal budget deficits to an estimated $220 billion this year and $167 billion next year. That legislation worked with monetary policy to lower interest rates, to increase economic growth, and to create jobs and opportunities. The result is that we have made real progress over the last 18 months. The issue, now, is how to ensure that we stay on that path of strong, noninflationary, economic growth. As Senator Sarbanes mentioned, I serve on the Commission on Entitlement and Tax Reform, which is a group that is also very much concerned about America's future. We had an opportunity at a Commission meeting to listen to the Chairman last week, I think Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 it was, on some of the entitlement issues that were being discussed. I'm sure the Chairman would agree that the work of the Commis- sion has enormous relevance to the subject matter before us today. Therefore, Chairman Greenspan, I hope that your statement today will touch on the relationship between entitlement reform and monetary policy, and what all this means to Americans who contribute to Social Security and who may need Medicare at some point in their lives. How does this affect real people? I want to conclude by noting the obvious, which is that the Fed- eral Reserve has enormous influence over the economic future of our country and over the economic future of virtually every Amer- ican. Americans all need to know whether the Fed will act to raise in- terest rates and slow down the economy. They want to know whether Government policies will change the economies in ways that will, for example, make it r/iore difficult for many of them to afford the mortgage they need to buy a home. Most Americans do not know, in detail, how the Federal Reserve actions affect their jobs or job prospects, or the prices of what they will buy. What's really important to them, however, is that the de- cisions behind those actions take them into account. Again, I want to associate myself with Senator Sarbanes1 state- ment, that this is about real people, flesh and blood. These are not just sterile numbers on an economist's worksheet. They need to know that the Federal Reserve and all of us here in Washington listen to the millions and millions of ordinary Amer- icans who have made this such a great country, and that our ac- tions are based on what we have learned from them. Senator Sarbanes' pictures did paint a thousand words, and I was delighted that it added a little humor to this hearing, but it really touched on the enormous importance of what it is that you have to say. Last week, Chairman Greenspan, just in passing and almost as a joke, I said, "You breathe hard and the markets change." Do you recollect that? Then, of course, this morning in the papers, the Dow has been off 7 points just on the eve of waiting to hear what you're §oing to breathe to us this morning. The markets are holding their reath. Your testimony is going to be of critical importance in setting the tone for a lot of private sector decisions that will affect our econ- omy. I would just suggest to you to be mindful of the fact that we are all in this together, that what is good for working people here in the United States, particularly in this global economy, is good for working people all over the world. Frankly, finding what is good for the most people and achieving that greatest good is the essence of the challenge of public service. That really is what we're all in this for. It's not a partisan issue. It's not a theoretical issue. It is a real, practical, and immediate issue and I very much look forward to your testimony this morning. The CHAIRMAN. Thank you. Senator Bond. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 OPENING STATEMENT OF SENATOR CHRISTOPHER S. BOND Senator BOND. Thank you very much, Mr. Chairman. Mr. Chairman, I want to welcome you here, and in hopes that you will be able to testify before the market closes today, I will break with practice and attempt to keep my remarks under 5 min- utes. [Laughter.] I do look forward to hearing your remarks, and I apologize for not being here when you last testified. I was gone on that Friday because it was a day when we were not in session on the Floor. However, I understand that there was much discussion and sharp criticism, so I decided to look around for sources that were not per- haps using the Fed as a political whipping boy to see what judg- ments were being made about the Fed's action in other arenas. I noticed that in the May 18, 1994, Wall Street Journal, the headlines were: "Fed's Strong Rate Moves Spark Rally." It said: Ending weeks of suspense, the Federal Reserve boosted interest rates and ignited a feverish rally in stocks and bonds. Both increases were at the high end of expecta- tions. The effect was instantaneous. It seems to me, as I believe Senator Faircloth and Senator Gramm have indicated, that when people are voting with their dol- lars, investing in the prospect of whether the economy will get bet- ter or worse, the increase in stocks and bonds suggests that people who vote for real, with their money rather than with political rhet- oric, were saying that the Fed had followed the right course. I also had a good opportunity to visit with an economist nomi- nated to serve on the Federal Reserve and was told that, as an out- side observer, the economist believed the course of action of the Federal Reserve, in recent months, had been quite appropriate. Since we decided to refer to the editorial pages of newspapers to judge the Fed's actions, I have before me a May 31, 1994, editorial from the Washington Post, headed felicitously, "Senator Sarbanes and Mr. Greenspan." In that editorial, the Washington Post, which I sometimes don't agree with economically, said Senator SASSER. Neither do I, Senator Bond. Senator BOND. The Washington Post said: Mr. Greenspan said that the whole concept of a trade-off between jobs and infla- tion is wrong, a theory popular in the 1960's that has been wholly discredited by much painful experience since then. The evidence shows, he argued, that low inflation brings higher growth and rising productivity, which means more jobs and better incomes. Mr, Greenspan is right about that. The recent record leaves little doubt. Mr. Chairman, that's why we look forward with interest to your comments on monetary policy with respect to the condition of the economy. I would agree that there are factors which threaten the economic recovery. Job growth and consumer confidence may be down, but I happen to believe much of that has been the reflection of the impact of the heavy tax burdens that were imposed on the American people in the April 15th tax season. There were also the prospects, as my colleague from Texas has said, of heavy mandates on business which also costs jobs. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 The dollar has fallen, which is of concern here. I believe the un- certainty in the world about U.S. international policy and a lack of leadership is foremost among the reasons for the weak dollar. Anyhow, we enjoy these spirited discussions. If nothing else, they should prove, if they have not already conclusively proven this morning, that monetary policy is better left in the hands of you and the Federal Reserve than in the hands of Congress. The CHAIRMAN. Senator Murray. OPENING STATEMENT OF SENATOR PATTY MURRAY Senator MURRAY. Thank you, Mr. Chairman. In the interest of getting to your testimony, let me just say that I am interested in your views on the falling dollar abroad and how you feel it's going to impact on our economy. I look forward to your comments on that. I commend Senator Moseley-Braun for her statement and for re- minding all of us that it's the people out there who are worrying about whether or not they can buy a house, pay a mortgage, have a job and a quality of life that we have to remember when we dis- cuss these issues. Thank you, Mr. Chairman. The CHAIRMAN. Thank you. Senator D'Amato. OPENING STATEMENT OF SENATOR ALFONSE M. D'AMATO Senator D'AMATO. Mr. Chairman, I find some of our opening re- marks today, laying all of the problems of the economy on Mr. Greenspan, to be difficult to really fathom or to put some real cre- dence in. I've had my own differences with the Chairman and, as a matter of fact, as I look around, it seems to me that I was the only person who voted not to reconfirm on this Committee. It was about 19 to 1. Again, I have had my own differences. Reasonable people can disagree, so most of you disagreed with me. [Laughter.! Having said that, for God's sake, I have to tell you maybe I'm only one, but I disagree completely with this nonsensical attack on the Chairman of the Fed, who I think was recommended by Presi- dent Clinton this last time. Isn't that true? Am I mistaken? I thought so. He's been embraced by the President. [Laughter.] They went to the speeches together, yes. Now, look. We're the people who authorize and appropriate the money. We're the people who either get cost containment and enti- tlements under control or we don't. To come and lacerate him up and down is unfair. If you want to talk about the policy, as it relates to a specific instance, that's fair, but I don't think it is fair to jump up and down and to lay all of the problems that may exist in the economy on the Chairman of the Fed. I'd like to hear from him. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 The CHAIRMAN. Thank you. Senator Mack. OPENING STATEMENT OF SENATOR CONNIE MACK Senator MACK. Thank you, Mr. Chairman. Just two points. I believe that the past will show, if individuals truly are concerned about job creation and the stability of families and their futures, they are better off with a Federal Reserve that is committed to long-term price stability. If that is a policy that is followed, that is a policy that will create the highest levels of long- term growth. The second point I would make is that the effort, which has been pretty obvious, frankly, since this Congress began, and this Com- mittee has been holding hearings with respect to monetary policy, that my colleagues on the other side of the aisle, I don't believe, have learned from the past. It appears that they want to return to the days of Jimmy Carter and stagflation; that is, restrictive fiscal policy in the sense of high- er tax rates and jawboning for an accommodating policy on the part of the Federal Reserve, which creates the worst of all worlds. Again, the bottom line is people really concerned about moms and dads back home, as opposed to some re-election, I'd suggest, should stick with a policy of long-term price stability. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Mack. Senator Bennett. OPENING STATEMENT OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you, Mr. Chairman, I have a number of things I could say. In the interest of time, I will not, other than to go to one source in an effort to put some balance in the conversation we've had, which qualifies, I think, for being somewhat disinterested. Indeed, it's so disinterested, it's not even an American source. This is the Economist magazine, and the comments that they have in their current issue with respect to the debate that we're having here. Those who are saying there is no indication of inflation, I would hope would listen to this. I shan't read the entire thing. I've edited it in the interest of time, but I find this of some interest. Quoting, then: It is significant that the American currency has not appreciated strongly in the past year or so. The likeliest reason for that failure to rise is American monetary policy. Although the economy has been growing since early 1992, and strongly so since early 1993, monetary policy was not tightened until February this year, widely criticized as premature. That raising of interest rates was in fact pretty late, and although rates have since been raised further, policy remains loose. Inflation is now subdued, but in 1995 and 1996, it is likely to revive unless inter- est rates are raised sharply. Oil and other commodity prices are climbing. The price of gold, singled out in February by Mr. Greenspan as a warning .sign for inflation, is on its way up. And the Feds resolve is in doubt because the political demands of the Presidential election cycle will increasingly make themselves felt because two new Fed governors appointed by Bill Clinton, Alan Blinder and Janet Yellen, seem soft on inflation, because Mr. Greenspan himself has to be reconfirmed or replaced within 2 years, and because the Clinton Administration's trade policy toward Japan Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 seems to favor a weaker dollar against the yen, which can be achieved only by the Fed dragging its feet on interest rates. Market panics of the sort seen in the past week are not necessarily harmful. They are messengers rather than murderers. The best outcome would be if these market panics forced Mr. Greenspan and his political patrons at the White House to forget about Japanese trade, to become sanguine about growth, and to clamp down hard on inflation. There are, indeed, Mr. Chairman, responsible voices that take issue with those who say that inflation is not a problem. I look forward to the testimony of the Chairman. The CHAIRMAN. Senator Domenici. OPENING STATEMENT OF SENATOR PETE V. DOMENICI Senator DOMENICI, Thank you very much, Mr. Chairman. I will say to you right off, Mr. Chairman, I think the best thing you could do today is loudly and clearly reaffirm your policy. I'm certain that's the best for working men and women in the United States. Senator Sarbanes, I didn't know you were going to use some comic strips. Had I known, I would have brought a Superman car- toon and I would have labeled it, Alan Greenspan. I'll tell you that for sure. Senator GRAMM. It would be a good likeness. [Laughter.] Senator DOMENICI. I don't know how we'd do the exact carica- ture, but it's the body, right? [Laughter.] Anyhow, Mr. Chairman, let me congratulate you on what you've done for the working men and women of the United States. The worst policy for American working men and women is inflation. The worst policy for the economy is inflation. Any policy that succumbs to inflation, or even invites it in the name of growth, in this Senator's opinion, takes money right out of the pockets of the working men and women. It produces less jobs overall, less productivity overall. I believe the United States has a lot to be thankful for, that once we got through the stagflation of the Carter Administration, and through the tightening of money policy in the first 2 years of Ron- ald Reagan in order to get inflation down, that we have had people like you controlling the supply of money and, to the extent possible, having some positive effect on interest rates. I believe you did exactly the right thing in starting to be more accommodative when you were and to start to be concerned about inflation when you did. Frankly, there's no doubt in my mind that you are making some very new, positive steps, taking some new positive steps in your analysis of the American economy and your response. Heretofore, it would appear, since the Second World War, we let an economy grow robust. Inflation began to perk up and get strong, and then we have a recession. I believe what you have tried to do is prolong the recovery in the U.S. economy which started in 1990, and you're trying desperately against very difficult odds of those who would like you to have the lowest interest rates around. What you have done is hope that this economic recovery may go on 2 or 3 years longer than it would have otherwise. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 I will ask you that question after a while, but that's what I un- derstand to be concerned about the future, as you adjust interest rates within your control at the appropriate time. Last of all, I would like to say that I believe the policy you've adopted and the policy we're living under now of low inflation has caused this recovery, this recovery in the United States, to be a very different one. I don't agree at all that the package of so-called deficit reduction, adopted by the U.S. Congress at the request of the President, has had much to do with this recovery. As a matter of fact, I am con- vinced this is a productivity-led recovery, so much more than prior recoveries that it bodes very, very well for the future. On average, heretofore, our recoveries have been vested with about 50-percent productivity, as I understand it, if you figure out the positive movement. This one, according to the best economists I can find, is over 90-percent driven by increases in productivity. Great. That's how you keep inflation. That's how you increase real wages to our working men and women, and that's what's hap- pening in the United States. I don't believe it's thanks to a $43 billion tax increase that's in effect this year, or to $250 to $300 billion in tax increases over the next 5 years under the Clinton plan. I don't think that has any- thing to do with it. If anything, it will drag it down, not cause it to go, to be as strong as it would otherwise be. The facts are there. Interest rates started down in 1990. They went down until February when you made some adjustments. That is because you wanted this economy to recover with low inflation and to build into it the maximum productivity increases for the fu- ture. I think all of that has happened. The one dark spot on the Amer- ican economy is what's happening to the American dollar. Hope- fully, today, you will explain to us what it is. My own assessment is the sooner, after a hearing like this, you disavow any intention of following the advice of Senators who want more growth and are fearful of your approaches to noninflation and price stability, the sooner you can say, I'm not going to do that, Senator Sarbanes. Thank you very much. The better off the Amer- ican economy is and the better off the dollar is. I don't think there's any question about that. Frankly, the one bleak spot, and I repeat, is the American dollar, and I think it has nothing whatsoever to do with what you are doing, but rather with what the President isn't doing. I think it is an absolute vote of no confidence in the way the President is conducting trade policy and foreign policy, and we'd better fix that, but I don't think we can fix that by telling you what to do. Thank you very much. The CHAIRMAN. Senator Boxer, you will be the 14th Senator today, and I think it's an indication of the keen interest, to say the least, that everyone has. We've had 14 different States now, in a sense, represented and speaking here through their Senators. Of course, you represent the largest State in the country, so it's appropriate that you close these comments and then we'll hear the report. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 Senator Boxer from California. OPENING STATEMENT OF SENATOR BARBARA BOXER Senator BOXER. Thank you very much, Mr. Chairman. Before my colleague leaves, I just would like to say to him that I think it is a very important forum that we have here today. I would encour- age Senators, whether they agree with interest rate policy or not, to speak up. That's what this country is about. It's about building consensus. It's about giving our views. I think we would be far worse if we made the Federal Reserve even more, if you will, a cloister than some think it already is. I think it's important to have Mr. Greenspan here, and it's im- portant for us to state the way we feel. He's going to listen to us, weigh the views, and make his decisions, as is the rest of the Fed. I'm not an individual who believes that Congress ought to set in- terest rates. [Pause. I I'm not a Senator who thinks that interest rates ought to be set by politicians. I think that would be a grave mistake. I do feel, however, it's very important that we express our views on this economy and this recovery. Let me state that I just happen to believe, if we were sitting here and the economy was not doing well, if the figures weren't good, that my Republican colleagues would not be blaming you for that. They praise you for what is happening out there. If things were bad, I think you're in a pretty good spot with them. I have to say, after serving in Congress for the many years that I have, most of the time on the other side of the Capitol, that this is the first time in many years that I've seen the kind of recovery that we have going on. Now, in California, we're lagging. We're lagging because we get the brunt of the change from, if you will, the stress on military spending, the shift away from that. We're going to bounce back very strongly because much of our economy depends on trade. Trade is very important. We are on the Pacific Rim. This President understands that. He doesn't look back. He looks ahead and realizes it's the global marketplace that is important for us. In time, California is going to be stronger than it ever was, be- cause it's not going to be dependent on Big Brother, which I think is very, very important. I guess my message to you, Mr. Greenspan, is please be mindful that some of our States are still struggling a bit, and we are inter- est rate dependent. As a matter of fact, we are very interest rate dependent, in construction and in other areas. We look to your leadership. We like the way things are going. We don't want to choke off an economic recovery that, in our State, is really nascent. I hope you will take all of our comments in the right spirit. We feel we speak for many, many people. We urge you, please, espe- cially for my State, to realize that we can't go back to the high in- terest rates or we will not join in with the rest of the Nation. I thank you very much, Mr. Chairman. The CHAIRMAN. Thank you very much. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 Chairman Greenspan, we'll make the full monetary policy report a part of the record. We'd like to have your comments at this time. OPENING STATEMENT OF ALAN GREENSPAN, CHAIRMAN BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, DC Chairman GREENSPAN. Thank you very much, Mr. Chairman. I request that the complete testimony be included for the record. The CHAIRMAN. Without objection, it is so ordered. Chairman GREENSPAN. I will excerpt from it. Mr. Chairman and Members of the Committee, I very much ap- preciate this opportunity to discuss with you recent economic devel- opments and the Federal Reserve's conduct of monetary policy. The favorable performance of the economy continued in the first half of 1994. Economic growth was strong, unemployment fell ap- preciably, and inflation remained subdued. To sustain the expan- sion, the Federal Reserve adjusted monetary policy over recent months so as to contain potential inflationary pressures. Our actions this year can be understood by reference to policy over the previous several years. Through that period, the Federal Reserve moved toward and then maintained for a considerable time a purposefully accommodative stance of policy. During 1993, that stance was associated with low levels of real short-term interest rates—around zero. We judged that low interest rates would be necessary for a time to overcome the effects of a number of factors that were restraining the economic expansion, including heavy debt burdens of households and businesses and tighter credit policies of many lenders. By early this year, however, it became clear that many of these impediments had diminished and that the economy had consequently gained considerable momentum. In these circumstances, it was no longer appropriate to maintain an accommodative policy. Indeed, history strongly suggests that maintenance of real short-term rates at levels prevailing last year ultimately would have fueled inflationary pressures. Accordingly, the Federal Open Market Committee, at its meeting in early February, decided to move away from its accommodative posture by tightening reserve market conditions. Given the level of real short-term rates and the evident momentum in the economy, it seemed likely that a substantial cumulative adjustment of policy would be needed. However, Committee members recognized that fi- nancial markets were not fully prepared for this action. Many were concerned that a marked shift in the stance of policy, while nec- essary, could precipitate an exaggerated reaction in financial mar- kets. With this in mind, we initially tightened reserve conditions only slightly, just enough to raise the Federal funds rate a quarter of a percentage point. The financial markets did, indeed, react sharp- ly, with substantial increases in longer-term interest rates and de- clines in stock prices. Markets remained unsettled for several months, and we continued to move cautiously in March and April in the process of moving away from our accommodative stance. By raid-May, however, a considerable portion of the adjustment in portfolios to the new rate environment appeared to have taken place. With financial markets evidently better prepared to absorb Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 a larger move, the Federal Reserve could substantially complete the removal of the degree of monetary accommodation that pre- vailed throughout 1993. The Board raised the discount rate Vi per- centage point, a move that was fully passed through to reserve market conditions by the Federal Open Market Committee. Partly to minimize any market confusion about the extent of and rationale for our moves, the Federal Reserve has announced each action and, in relevant instances, provided an explanation. At its meeting in early July, the FOMC faced considerable uncertainty about the pace of expansion and pressures on prices going forward, and it made no further adjustment in its policy stance. Nonetheless, it is an open question whether our actions to date have been sufficient to head off inflationary pressures and thus maintain favorable trends in the economy. Labor demand has been quite strong, pointing to robust growth in production and incomes. To be sure, some hints of moderation in the growth of domestic final demand have appeared, and the recent indications of accel- erating inventory accumulation may suggest an unwanted backing up of stocks. Conversely, the inventory accumulation may reflect pressures on firms who had brought inventories down to sub-opti- mal levels and now need to replenish them. In the latter case, stock-building may continue at an above-normal rate, supporting production for quite some time. Moreover, the improving economic conditions of our trading partners should add impetus to aggregate demand from the external sector. How these forces balance out in the coming months could be crit- ical in determining whether inflation will remain in check, for the amount of slack in the economy, while difficult to judge, appears to have become relatively small. An increase of inflation would come at considerable cost. We would lose hard-won ground in the fight against inflation expecta- tions—ground that would be difficult to recapture later. Our long- run economic performance would be impaired by the inefficiencies associated with higher inflation if it persisted. Harsher policy ac- tions would eventually be necessary to reverse the upsurge in infla- tionary instabilities. We are determined to prevent such an out- come, and currently are monitoring economic and financial data carefully to assess whether additional adjustments are appropriate. The economic figures that have formed the backdrop of our policy actions so far this year confirm that a rapid expansion has been in progress. Following growth at an annual rate of 7 percent in the fourth quarter of last year, real gross domestic product rose at nearly a 3V2 percent rate in the first quarter. A conceptually equiv- alent measure of aggregate output—gross domestic income—exhib- ited even larger gains in the fourth and first quarters. At this stage, available data leave some uncertainty regarding the pace of economic activity over the past 3 months. Nonetheless, the evi- dence in hand makes it reasonably clear that growth remained ap- preciably above its longer-run trend. The robust expansion over the first half of 1994 has been reflected in substantial increases in em- ployment. The accumulating evidence of stronger-than-expected economic growth here and abroad, combined with changing expectations of policy actions by the Federal Reserve as well as other central Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 banks, prompted considerable increases in long-term interest rates in occasionally volatile markets over the first half of the year. The recent weakness in bond prices was not limited to the Unit- ed States, but was accompanied by a surge in foreign interest rates as well. Rising foreign interest rates, concerns in markets about the pros- pects for reduced trade tensions and about U.S. inflation contrib- uted to considerable activity directed at rebalancing international investment portfolios. One effect of this activity appears to have been a substantial decline of the foreign exchange value of the dol- lar on net over the past 6 months. Foreign exchange rates are key prices in the American economy, with significant implications for the volumes of exports and imports as well as for the prices of im- ports and domestically-produced items that compete with imports. The foreign exchange value of the dollar also can provide useful in- sights into inflation expectations. If we conduct an appropriate monetary policy—and appropriate economic policies more gen- erally—we shall achieve our goals of solid economic growth and price stability, and such economic results will ensure that dollar- denominated assets remain attractive to global investors, which is essential to the dollar's continuing role as the world's principal re- serve currency. Rising interest rates and considerable volatility in financial mar- kets do not seem to have slowed overall credit flows this year. At about a 5V4 percent annual rate through May, domestic non- financial sector debt has increased within its 4-to-8 percent mon- itoring range. Expansion of M2, however, has been quite slow this year, leaving this aggregate near the lower end of its l-to-5 percent annual range. M3 actually has edged down, and thus is just below its 0- to-4 percent range for 1994. The weakness in the broader aggre- gates has not been reflected in the growth of income again this year, representing a continuation of the substantial increases in ve- locity that we have experienced over the past few years. In reviewing its ranges for money growth in 1994, the FOMC noted that further increases in velocity of M2 and M3 were likely. As a result, growth of both aggregates near the lower bounds of their 1994 ranges is considered to be consistent with achieving our objectives for economic performance, and the ranges were left un- changed. The Committee also decided, on a provisional basis, to carry for- ward the current ranges for the monetary aggregates to 1995. Regarding domestic nonfinancial sector debt, we made no adjust- ment to this year's monitoring range, but elected to set a provi- sional monitoring range for 1995 of 3 to 7 percent, a percentage point lower than this year's. A lower range would conform with some deceleration in nominal income, in the process of containing inflation and ultimately making progress toward price stability. We expect that expansion of money and credit within the ranges we have established will be consistent with the continuation of good economic performance. With appropriate monetary policies, the Board members and Reserve Bank presidents see the economy settling into more moderate rates of growth over the next six quar- ters and inflation remaining relatively subdued. Specifically, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 central tendencies of our forecasts are for real GDP to expand 3 to 3V4 percent over 1994 and 2V2 to 23/4 percent next year. The consumer price index is projected to increase 2:iA to 3 percent this year. In 1995, inflation may be about the same as in 1994, or slightly higher. The unemployment rate is expected to remain close to its recent level. Mr. Chairman, you also asked for the economic projections for 1996. Senator SASSKK. Mr. Chairman, this may be a good point at which to interrupt. We have a vote underway. Chairman Riegle should be returning very, very shortly. I'll ask you to suspend and the Committee will stand in temporary recess, subject to the call of the Chair. Thank you. f Recess, j The CHAIRMAN. Let me invite all those who are standing to find seats so that we can resume. I want to thank the Chairman for his patience. I think just as we prepare to resume here, it's very important that—I was reading your statement on the way over as you were delivering it, or deliv- ering a summary of it. I tried to follow where I think you probably are in your delivery, and I want you to go ahead and finish. I know you had not done so. Before you resume, though, I just want to say I think the early aspect of our hearing this morning, where we have 14 Senators from around the country, both parties in a sense exercising our oversight as a Banking Committee with respect to monetary policy, is that we have always had, I think, a good cooperative relation- ship, certainly with you and with the Federal Reserve generally. I think sometimes the nature and the way our democracy works—people don't necessarily learn about it in textbooks or in classrooms the way they should. The only way we have a check and balance in our system is exactly the way were operating today, as you, of course, clearly know, understand, and subscribe to, as do we. Why don't you go ahead and finish the delivery of your state- ment, and then we'll go to questions. Chairman GREENSPAN. Indeed, Mr. Chairman, I think that we have been quite cognizant of the need for the Federal Reserve to try to make clear to Congress not only what we are doing, but why we are doing it. We recognize that if we are to maintain the degree of independ- ence that we think is necessary for a central bank in this country, that the issue of accountability is in the forefront of our notions. You cannot have an independent central banking institution with- out adequate accountability to the electorate. We fully recognize that and this type of forum is, as far as my issues are concerned, the ideal way in which we can try to communicate as best we can what it is we're doing. I must say, Mr. Chairman, continuing my testimony, that you, in a letter to me, asked for economic projections for 1996, and in this context, obviously, I fully appreciate your purpose in requesting this information. However, my colleagues and I don't think we can best communicate our policy intentions through additional numeri- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 cal forecasts. Rather, we believe our intentions are best conveyed in terms of our declared objective of fostering as much growth of output and employment as can be achieved without placing desta- bilizing inflationary pressures on productive resources. There is considerable uncertainty about what that goal implies for the ex- pansion of GDP and rates of unemployment. That said, it may be useful to note that the assumptions underly- ing the medium-term projections provided to you by the Adminis- tration and the Congressional Budget Office are within the main- stream of thinking among academics and private business econo- mists. These projections do not attempt to anticipate cyclical move- ments, but instead represent estimates of the likely performance of the economy in the neighborhood of its potential. The Administration, for example, projected in its most recent forecast that the economy will expand at a 2V2 percent rate in the second half of the 1990's and unemployment will average 6.1 per- cent. These projections are consistent with common estimates of the economy's potential growth rate and fall within the range of typical estimates of the so-called "natural rate" of unemployment. Uncertainties around these estimates arise because identifying economic relationships is always difficult, partly owing to limita- tions of the data. More fundamentally, all policymakers recognize that notions of potential GDP growth and the natural rate of un- employment are considerable simplifications, useful in conceptual models, but subject to a variety of real-world complications. Our economy is a complex, dynamic system, comprising countless and diverse households, firms, services, products, and prices, inter- acting in a multitude of markets. Estimates of macroeconomic rela- tionships, as best we can make them, are useful starting points for analysis, but they are just starting points. Given questions about the aggregate relationships, policymakers need to look below the surface, in markets themselves, for evidence of tightness that might indicate whether inflationary pressures are indeed building. If the economy were nearing capacity, we would expect to see certain patterns in the statistical and anecdotal information with increasing frequency and intensity. Reports of shortages of skilled labor, strikes, and instances of difficulties in finding workers in specific regions, for example, all would be more likely. Businesses would have difficulty obtaining certain materials or pay higher prices for them. In recent months, we have seen some of these signs. There are reports of shortages of some types of labor—construction workers and truck drivers, for instance. Indexes of vendor performance have deteriorated considerably, and manufacturers are paying higher prices for materials used in their production processes. As yet, these sorts of indications do not seem to be widespread across the economy. Nonetheless, we shall need to be particularly alert to these emerging signs in considering further adjustments to policy in the period ahead. In light of the uncertainties about aggregate measures of our eco- nomic potential, the Federal Reserve cannot rely heavily on any one estimate of either the natural rate of unemployment or poten- tial GDP growth. Most important, we have no intention of setting Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 artificial limits on employment or growth. Indeed, the Federal Re- serve would be pleased to see more rapid output growth and lower unemployment than projected by forecasters such as the CBO and the Administration, provided they were sustainable and consistent with approaching price stability. A more significant issue for economic policymakers than the pre- cise values of such estimates is what can be done to maximize sus- tainable employment and economic growth. We need, for example, to give careful attention to the problem of unemployment, as noted The CHAIRMAN. Mr. Chairman, excuse me. Let me just stop you, if I may. I'd rather take this in context, if you'll permit me. If you back up to the paragraph on page 14 that you just deliv- ered, you chose to not read the final sentence in that paragraph— "I should note, however, . . ." I think it would be well for you, assuming that is in fact still part of the text, to read that into the record, because I think it's an im- portant caveat that we'll want to come back to. Chairman GREKNSPAN. Yes. I appreciate that. Because we had such a very long statement, we excerpted a number of things which I think are important. I agree with you. This is an important sentence. The CHAIRMAN. I understand. Chairman GREENSPAN. I said in the written testimony, I should note, however, that most Federal Reserve policymakers would not regard the inflation projections of these other forecasters, which generally do not foresee further progress toward price stability over the medium term, as a desired outcome. The CHAIRMAN. Why don't you continue? We'll come back to that at a later time. Chairman GREENSPAN. Let me just repeat what I had said subse- quent to that. A more significant issue for economic policymakers than the pre- cise values of such estimates is what can be done to maximize sus- tainable employment and economic growth. We need, for example, to give careful attention to the problem of unemployment, as noted by the G—7 leaders at their recent summit. We could raise output and living standards around the world and at the same time ease many social problems if more people were working. We ought to be encouraging measures that increase the flexibil- ity of our work force and Tabor markets. Improving education and training and facilitating better and more rapid matching of workers with jobs are essential elements in making more effective use of the U.S. labor force. Congress and the Administration also can continue to contribute to the growth of our economy's capital and productivity through a sound fiscal policy. The extension of the spending caps in last year's budget agreement was a significant step in putting fiscal pol- icy on a more sustainable, long-run path. However, we should not lose sight of the fact that under current law, the deficit, as a percent of GDP, will begin to expand again as we move into the next century, with unacceptable consequences for financial stability and economic growth. Mr. Chairman, as I Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 have testified before this Committee last year, only by reducing the growth in spending is ultimate balance achievable. The Federal Reserve also, as I have indicated previously, can contribute to the achievement of our overriding goal—maximum sustainable economic growth—by pursuing and ultimately achiev- ing a stable price level. There is some evidence to suggest that the stronger trend of pro- ductivity growth we have witnessed over the recent past is due, at least partly, to the beneficial effects of low rates of inflation. Our Nation has made considerable progress in putting the econ- omy on a sound footing in the past few years. To preserve and ex- tend these advances, our monetary and fiscal policies will need to remain disciplined and focused on our long-term objectives. It would be foolish to squander our recent gains for near-term bene- fits that would prove ephemeral. Indeed, by fostering progress to- ward price stability, achieving lower Federal budget deficits, and encouraging competitive markets both here and abroad, we will help ensure the continued viability of our Nation's economy now and for many years into the future. Thank you, Mr. Chairman. The CHAIRMAN. Thank you very much, Mr. Chairman. I'll yield to Senator Sarbanes to let him start the questioning period. Senator SARBANES. Thank you very much, Mr. Chairman. First of all, in light of a lot of the comments that were made in the opening statements, I just want to repeat this quote from the Jim Hoagland article: One man's job is another man's basis point in the brave new economic world of the central bankers. Being unemployed may be bad for you, but cheer up. It cools inflation and should be good for the markets. That is part of the unspoken, and un- speakable, philosophy that lies behind the manipulation of interest rates. He goes on later to say: Growth is measured in jobs, as well as stock and bond prices. Low inflation rates purchased by high unemployment will turn out to have been a dubious bargain, I'm really searching to find out. The president of your Federal Reserve Bank in San Francisco is on the Open Market Committee, is he not? Chairman GREENSPAN. He is. Senator SARBANES. Mr. Parry. Is that it? Chairman GREENSPAN. That's correct. Senator SARBANES. As I understand it, his view is that the natu- ral rate of unemployment is at 6Va percent. I think he's made such a statement. I've been searching in my own mind for some way, if that's the view, to get him within the 6V2 percent of those that are unemployed. It's very easy if you're employed to have a very high natural rate of unemployment for the economy. Mr. Chairman, I want to pick up on your closing paragraph, the next-to-last closing paragraph. There is some evidence to suggest that the stronger trend of pro- ductivity growth we've witnessed over the recent past is due, at least partly, to the beneficial effects of low rates of inflation. What evidence are you relying upon? Chairman GREENSPAN. I'm relying on two different types of evi- dence in this regard. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 First, there is an extraordinarily large amount of anecdotal evi- dence in the marketplace, not only in this most recent period, but in my recollections over the years as an economic consultant, that when inflation is low, and there is considerable inability to pass through price increases, there is a considerable tendency on the part of American business to reduce costs. This is Senator SARBANES. Is this the Rudebusch-Wilcox study? Chairman GREENSPAN. No. Senator SARBANES. Is that part of what you're relying upon? Chairman GREENSPAN. No. I will get to that in a minute. Senator SARBANES. Could we Chairman GREENSPAN. There's two different types. There's econo- metric evidence and there is anecdotal evidence. Senator SARBANES. All right. I understand the anecdotal point. Is the econometric evidence the Rudebusch-Wilcox paper? Is that what you would rely upon? Chairman GREENSPAN. In part, yes. Senator SARHANES. I want to really question you on that. Chairman GREENSPAN. May I just suggest Senator SARBANES. In an article in the New York Times—"New Fuel for the Fed's Rate Fire"—and I just want to quote what Barry Bosworth said about this. Bosworth, an economist at Brookings, said, "Earlier academic re- search had failed to document any clear link to productivity for in- flation rates below 20 percent." He suggested that, in arguing for the existence of the link at much lower levels, "Mr. Greenspan might be looking for a politically palatable explanation for the central bank's interest rate increases this spring." "I think it's a bit of throwing everything at the fan and seeing what sticks," Mr. Bosworth said. This is an interesting assertion you're putting forth. We asked the Fed, after you made the statement at the May 27th hearing, about this Fed study. Of course, the logic of this argument is, you could shut off an expansion whenever you start getting a little bit of inflation and assert you're going to be raising productivity and therefore, long-term potential growth. We shared that Fed paper with several prominent economists across the country and macroeconomists at the CBO, the Senate Banking, our own staff, and the JEC. They uniformly find the paper technically well done, but unpersuasive, even on its own terms, for the purposes for which you have used it and the purposes with which the press, some of the press, have interpreted it. Mr. Chairman, I want to submit for the record a very careful analysis, and I think a very thoughtful analysis, by Jim Tobin, the Nobel Prize winner, distinguished professor of economics at Yale, headed, "Can't the Anti-Inflationary Monetary Policy Raise Long- Run Real Growth?" He says, "Chairman Greenspan has advanced, as an argument for giving high priority to inflation reduction and monetary policy, the hypothesis that lower inflation will lead to higher productivity growth." To support this conjecture, the Board of Governors made available the staff paper—Productivity in Inflation—Evidence and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 Interpretations—by Rudebusch and Wilcox. The authors are first- class professional economists. Their paper is a conscientious survey of relevant theory and empirical research, and they add some ex- ploratory modeling and calculations of their own. They are appropriately cautious, concluding that the evidence on the Greenspan hypothesis is, at this stage, mixed and uncertain. Clearly, the paper offers no guidance to monetary policy. He then goes on to have an extended discussion of this, and he points out—and asks the question—that the relevant question is whether there is any correlation that the central bank can exploit? Can we expect a reduction in inflation engineered by monetary pol- icy to raise productivity growth? The qualification, engineered by monetary policy, is of basic im- portance. Of course, it is easy to think of numerous scenarios, shocks, and circumstances in which lower inflation and higher pro- ductivity growth are associated, but unless monetary policy is di- rectly or indirectly an important and independent one of the sources, those observed correlations are nothing central banks can exploit. This analysis then goes on, and I think with a great deal of thought, which, of course, one would expect from Jim Tobin, to ana- lyze this assertion. He concludes as follows: Productivity is a real phenomenon and its long-run growth is likely to be affected by real factors, notably, investments of all kinds in future technologies and human skills. So far as Government's macro-policies are concerned, its fiscal policies are crucial, as Chairman Greenspan often points out. This is not just a matter of public deficits and debts, but also public in- vestments in future-oriented activities. Monetary policy can help by keeping the economy growing along its full employment potential GDP path. By itself, the Fed cannot expect to accelerate productivity, surely not by tightening policy in order to lower the trend rate of inflation. I'm going to submit this for the record. I see my time is up. I ex- pect we're going to have further discussion, dialog, and debate about this assertion. I notice it's also been strongly criticized by Alan Sinai in a Leh- man Brothers newsletter—Lower Inflation Equals Higher Produc- tivity Growth? The research, summarized in a paper by Rudebusch and Wilcox, is, in fact, quite inconclusive. The paper itself proves much less than is suggested by the articles reporting it, which I think is an accurate statement. The articles reporting it have picked it up and exaggerated in a way that I think is certainly not warranted. I dont think it was intended by the authors. It may well not have been intended by you, as a matter of fact. Chairman GREENSPAN. Mr. Chairman, let me just say that I have raised this issue on several occasions, and I've said that the evidence on this is fragmentary and suggestive and by no means conclusive. Let me tell you what I think the status of the research on this question is, and let me do so, first, by quoting the conclusion on page 20 in the Rudebusch-Wilcox paper which I believe you have. It says: Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 This paper has presented a plethora of evidence on the correlation between pro- ductivity and inflation. That evidence consistently points to a negative correlation between inflation and the growth of productivity over the post-Korean War period in the United States. Moreover, this correlation is remarkably robust across meas- ures of productivity (average labor productivity, total factory productivity), sectors of the economy (whether it's nonfarm business or manufacturing), and measures of inflation (whether the CP!, the implicit deflator, or quasi-fixed weight price indexes are used). In addition, it withstands straightforward methods of controlling for the oil shocks of the 1970's. Evidence that the relationship exists is very difficult to undercut. There is a very serious question with respect to the direction of causation of the particular correlation, and that is the crucial issue. The underlying data that were produced here by Rudebusch and Wilcox tries a wide variety of evaluations. They get positive rela- tionships on what is called the range of causation techniques for determining which of two variables is causing which. It concludes that the evidence that productivity causes low infla- tion is easily rejected, whereas the reverse is not, and in certain formulations, is quite statistically significant. I, myself, do not think that this relationship is fully confirmed at this stage. I do not think enough work and perhaps enough data are available to draw the types of conclusions which I suspect are probably true, but are not factually verifiable at this stage, nor would I argue, as a consequence, that they are or should be the basis of monetary policy. Senator SARBANKS. Mr. Chairman Chairman GREENSPAN. Just let me say one final word. The CHAIRMAN. Please. Chairman GREENSPAN. I disagree with the general notion that what I am trying to do is to combine a whole series of arguments of why inflation is a danger to the economy and the reduction of inflation a positive value. I do believe that, but the presumption that I would put before this Committee or, in fact, anyone else, a long laundry list of ideas to buttress views which are not otherwise defensible, I must say I find objectionable. Senator SARBANES. Mr. Chairman, maybe we should consider, if the time of the Committee permits, a hearing in which we could bring in Rudebusch and Wilcox, Jim Tobin, and some of these other very distinguished economists to discuss these asserts, so we have a chance to go into Chairman GREENSPAN. I'm not making assertions. I am making statements about the evidence that is there. Remember, there are two ways to approach obtaining informa- tion from which one learns about the overall state of the world. One is a very powerful tool, econometric techniques, which have been evolved in the post-World War II period and have been very useful in data analysis. But you cannot take that whole set of tech- niques as the whole means by which one concludes what relation- ships are true or false. All I'm suggesting is that the reason I originally began to be aware that there may be—and I underline the words, may be—a relationship here comes not from the econometric evidence, but rather from an extraordinarily widespread view on the part of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 American businessmen that, in periods of low inflation, they do tend to focus on reducing costs inordinately. If that statement is true, then the proposition that low inflation contributes to higher productivity growth would be proved. Now I will never argue that anecdotal evidence is conclusive in itself. It is suggestive, as indeed some of the statistical evidence is suggestive. I would not wish to argue that that proposition is proved to my satisfaction or anyone else's. There are others in the academic profession who think there's something there. My suspicion is that there is something there, but I cannot say to you, at this particular time, that I think it is sci- entifically proved and, having not been proved, it should not be a vehicle for monetary policy. The CHAIRMAN. I think we have to leave it at that, at this point, because we're going to run out of time and we've got to cover other ground. Senator SARBANES. Could we take under advisement the idea of bringing the authors of the study in, and also some distinguished economists to comment about the study? The CHAIRMAN. Yes. I think it would be a good idea. I think the discussion here is an important one. Chairman GREENSPAN. It's a very important issue. The CHAIRMAN. Yes. I think that, in a sense, is a supporting ar- gument for what you've just said. Let's try to set up such a near- ing. Senator Roth. Senator ROTH. Mr. Chairman, as I mentioned in my opening statement, Bob Woodward, in the book, "The Agenda," states in considerable detail that, in effect, you were the ghostwriter of Clintonomics. It describes you, I think, as a senior advisor to Clinton, a rela- tionship that started even before the inauguration. The book sug- gests that Federal Reserve policy is part of Clintonomics, not op- posed to it. My concern and question is the problem of independence of the Federal Reserve. I have to say that, as far as I know, there's been no major denial of the statements in "The Agenda" either by the Federal Reserve, the White House, or elsewhere. I would be interested in what role you played in developing the so-called Clintonomics. Was it appropriate? To what extent should the Federal Reserve become involved in fiscal policy? How does it impact upon the independence of the institution? Chairman GREENSPAN. Senator, it is quite appropriate for the Federal Reserve to be involved in what the fiscal policy of this country is, because the financing requirement of the budget deficit is a very important variable with which we have to deal in main- taining stable financial systems and noninfiationary growth. As you know, we deal quite extensively with the Treasury De- partment in trying to coordinate policies to the extent that they overlap, and indeed, they overlap to a considerable extent. I have very frequent meetings with the Secretary of the Treas- ury, and his other colleagues, in an endeavor to make certain that there is a consistent financial policy for the United States. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 With respect to the Woodward book, I do not recall that it basi- cally says that I ghost wrote what the President came out with. What, in fact, occurred, was that he invited me to Little Rock, prior to the inauguration, to discuss affairs generally. So far as fiscal pol- icy was concerned, I did spend a considerable amount of time ex- pressing my concerns about the long-term budget problems, and in- deed, probably replicated very closely precisely the type of testi- mony I presented before this Committee shortly thereafter. I never discussed any of the details involved in any budget pro- gram other than those which I discussed before this Committee. There was never any discussion of a tit-for-tat between monetary policy and fiscal policy and, indeed, as I recall some of the excerpts in the book, that was very explicitly stated. I do not think it is inappropriate for the central bank to be dis- cussing general issues with respect to financing in financial mar- kets. I do think it would be inappropriate to discuss the specific as- pects of how that financing occurs. I raised with him at the time, I raised with this Committee, and I've been raising ever since, the concern I have that after the defense budget flattens out later in this decade, we begin to get a rate of growth in total spending which exceeds the rate of growth in the tax base. That is economically unstable. That is, unless the rate of growth in spending is eventually brought down to the rate of growth in the tax base, you have a destabilizing, inflationary increase in budget deficits that would occur in the years beyond 1999 or the year 2000. I commented last Friday that this is a view which is becoming increasingly general. I think the American people are beginning to become aware that there is something wrong with the long-term budget outlook. All of the individuals with whom I have discussed this in the Ad- ministration agree that something has to be done in this regard. It's very crucially important that the central bank, which is so heavily involved in the issue of financing these deficits, try to, when we see that there is some fundamental issues involved which require addressing, make those views available to Congress and to the Administration. That is what I did, what I hope I will continue to do. The pre- sumption that somehow, in a 2]/2 hour conversation, I convinced the President-elect about what his policies should be, I find a little bit far out. I appreciate the implication of being the extraordinarily impor- tant element within how events occur. It just is not true. It's not credible in any sense of which I'm aware. In that regard, I thought the Woodward book exaggerated my role to an extraordinary ex- tent. Senator ROTH. I would just point out that you said you weren't aware of the word "ghostwriter." On page 135, it says: The Chairman of the Federal Reserve was in some ways a ghostwriter of the Clin- ton plan. On page 98, it says: Greenspan was careful not to give the impression of making an overt deal with Bentsen. Greenspan will be supportive within limits, but those limits are great. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 My principal concern is the question of independence. Chairman GREENSPAN. Let me say this, Senator. I think Wood- ward is an excellent reporter, and that book, in many ways, is ex- traordinary. I happen to disagree with his conclusions on this. It's not that I say he is factually incorrect in what he is reporting, but I do disagree with his conclusions as to what the dynamics basi- cally were. The one thing that is crucially important is that in no way was the independence of the Federal Reserve then, or since, com- promised. Indeed, there are quotes in that book which indicate there is a very significant limit about what we as a central bank would do relative to what might happen with respect to various dif- ferent types of economic policy. Senator ROTH. It is interesting that last year the Administration, and spokesmen for the Administration, of course, wanted to take credit for the low interest rates. As I listen to some of my colleagues this year, they want to blame you for the high interest rates, or the higher interest rates. It seems to me, if you want to take credit one time, you have to take credit both times. Let me turn to another matter. There's been a lot of talk about The CHAIRMAN. Senator Roth, I'll give you time to pursue that, but I think with the light having gone on, we perhaps shouldn't in- troduce still another topic here. I don't want to be arbitrary in any way on this. Senator ROTH. I'll wait until my next turn. The CHAIRMAN. Let me just, as a follow-up, say that there's also been a very serious rumor to the effect that you actually play ten- nis with Lloyd Bentsen. Is that true? [Laughter.] Chairman GREENSPAN. Some rumors in this town are correct. [Laughter.] The CHAIRMAN. I see. Senator ROTH. I would just say, Mr. Chairman, I think the ques- tion of Federal Reserve independence is a very important matter. Chairman GREENSPAN. Absolutely. Senator ROTH. I do think a serious question arises when fiscal policy becomes somewhat intertwined with monetary policy. If the Federal Reserve has had a role in developing the fiscal policy, that is significant information. Chairman GREENSPAN. I think the only role that I had, I hope I had, was to indicate the long-term problems that I thought would occur to this country if we failed to address our long-term fiscal problems. I emphasized that in great detail, and I hope I made some com- munication dent in the process. The CHAIRMAN. I'm tweaking my good friend from Delaware a bit, but I assume your independence is not compromised when you're in these tennis games with the Secretary of the Treasury. Senator MACK. It depends on the score. [Laughter.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 The CHAIRMAN. There's no problem there, is there, in terms of undercutting the Fed? [Laughter.] My recollection is that you used to do these very same things with the Bush Administration from time to time. Chairman GREENSPAN. It is essential that the central bank, be- cause we've got extraordinary resources to do economic research and to evaluate the economy, try to communicate what we think is happening to other aspects of the Government because there's a single Government here. The CHAIRMAN. But the point is, you were pre-existing Chair- man. My recollection is, and I think you even made reference to it here before, you did exactly the same thing with the past Presi- dent. This isn't a new practice, on your part, to sit down from time to time and talk with the President, insofar as I know. Chairman GREENSPAN. That is correct. The CHAIRMAN. Senator Mack has asked to make a comment. Senator MACK. Just a quick comment with respect to the inde- pendence thing. Everybody understands the significance and the importance of the independence. I certainly don't mind, though, if the Chairman has the ability to influence the President with respect to deficit re- duction, as long as the President doesn't have the ability to influ- ence the Chairman. [Laughter.] The CHAIRMAN. Let me ask you about the dollar. It's certainly been weak during the past few months, as everyone who follows it knows. On balance, do you think the dollar's fall, has that been bad or good for the economy? Chairman GREENSPAN. I would say it's bad for the economy. I would say when you have an economy like the United States, which is so intricately involved on a global basis with the world fi- nancial markets and, indeed, as I indicated in my prepared re- marks, the dollar is the principal reserve currency, any evidences of weakness in that currency are neither good for the international financial system, nor good for the American economy because of what they say about what is going on in the American system. The CHAIRMAN. Right. But the last time you were here, which is not all that many weeks ago, you were very frank in saying, and I was encouraged by you saying, that you thought the economy, in terms of its fundamentals, might be on the strongest footing it's been on in decades, that as you look at the picture, you really feel quite confident about where we are now in terms of the path we've come and the outlook ahead. I don't have your exact comment, but you were, I thought, very direct in saying that. Would that be a fair characterization of what you said? Chairman GREENSPAN. Yes, basically. I cant quote myself ex- actly, but, to the extent that you can forecast in the short-run or intermediate period, when I was here the last time, what I stipu- lated was that it was very difficult for me to envisage, granted all the qualifications, a better period for the intermediate period, 6 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 months, 9 months out, than I have seen in a very long period of time. Obviously, that doesn't refer to the broader, very long-term is- sues such as the Federal budget deficit and income distribution problems that we've got or structural difficulties. The CHAIRMAN, Right. Chairman GREENSPAN. But in talking about sheer balance in the economy, yes. The CHAIRMAN. I thought your assessment was balanced, thoughtful, and supported by a lot of analytical information, but when I try to put that beside this sharp fall in the dollar, which you say is not good for the economy, I'm trying to square these two things because, normally, if your view is correct, then why are the markets behaving as they are? I'm wondering if market forces, in some way or another, are not just reacting to economic forces that you would see. That, to me, seems to be a contradiction and I'm wondering what your analysis is? Isn't it something of a contradiction to see those two things at the same time? Chairman GREENSPAN. No, not necessarily, because remember that at root, it's the potential rate of return on assets denominated in different currencies which will determine where the exchange rates move. If you get any judgments that the potential real rate of return in an economy relative to other countries has declined, you will get types of adjustments. There are numbers of concerns about why currencies go up or down. I don't want to get into too much detail on this particular issue because Under Secretary Summers will be here tomorrow and I think The CHAIRMAN. Let me ask you this question. Has the weak dol- lar started to affect monetary policy decisions? Chairman GREENSPAN. It has certainly been an issue which we have been aware of because, to the extent it is a symptom of poten- tial inflationary forces beginning to emerge in our domestic econ- omy, it has to be something which we are focusing upon. The CHAIRMAN. But you've not indicated to us that you see any- thing out there that's of any great concern to you in terms of infla- tionary expectations. We've gone over that ground, unless your view has changed since you were here the last time. Chairman GREENSPAN. No, my view hasn't changed. There's a difference in the timeframe of all of this. As I said 6 months ago, and I'm saying now, the actual evidence of inflation at this particular stage is quite contained. It may not be as contained as we would like it over the longer run, but it is clearly contained and the data have been improving, especially in the last 6 or 9 months. The difficulty, however, is that we are dealing with a situation in which past history suggests that as the economy begins to move up and credit demands begin to emerge, the tinder for inflationary pressures is potentially there. It is important for us to recognize that what we are dealing with is a monetary policy whose consequences are four to six quarters away. Therefore, it's inadequate, basically, to come to the conclu- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 sion that inflation now, or in the immediate past, is contained and therefore monetary policy need not be concerned about that. We see inflation premiums emerging in a number of financial markets. To the extent that they are not going up, they clearly haven't gone down. That is true, as I indicated here a number of months ago, with the price of gold, which has been relatively stable and has not gone down. It's been true of inflation premiums in long-term bonds which have not gone down, and a number of other indications. What the exchange rate is relevant to, in this regard, is another indication, not that there is inflation right now, but that there is a longer-term inflation expectation which should be of concern to us here in the United States, and that, indeed, is, of course, a cru- cial issue with respect to our deliberations relevant to policy. The CHAIRMAN. I want to pursue this, but I don't want to tres- pass on my own time here, except to just make this comment, and then I'm going to yield to Senator Mack, who I think is next in the order. That is, I've asked to get the text of what you said the last time you were here, which is not all that long ago, with respect to infla- tionary tinder. That was the phrase that was used then. I think I'm hearing you say something different today than I heard you say the last time. Because you may be saying the same thing in different words, I don't want to misinterpret what you're saying. The clear message you gave us the last time is that you felt the strategy had worked quite well to contain inflationary pressures. The Fed had made the monetary policy adjustments to subtract some of that overcompensation that had been in the picture before- hand with lower than normal interest rates, and you felt that we were on a pretty solid path. The data you saw looked good and so forth. If you're giving a different statement today, with respect to so- called inflationary tinder out sometime in the future, that's a very important statement. If you're not saying that, if you're saying your level of confidence is as strong as it was when you were here the last time, then that answers my question. I want to be able to understand whether I'm getting a different signal today. Chairman GREENSPAN. I do not intend to give a different signal. My views of May 27, 1994, as I recall, have not fundamentally changed, nor do I believe the Committee's has in these weeks. I think the valuation of the economy is pretty much on track and has not materially changed since the last time I was here. The CHAIRMAN. There was no new inflation specter since May 27th? Chairman GREENSPAN. No. The track that we perceived the econ- omy was on, our concerns about the plusses and minuses in the economy, our concerns about inflationary instabilities, plus and minus, are, as best as I can judge, very little changed from what they were back then. In other words, what has occurred since then is pretty much what we expected would materialize. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 The CHAIRMAN. That's good. What I don't want to go out of here is the notion that there's some new inflation scare, and that's not what you're saying. I think that s, in effect, what you're saying here, that you don't see a new inflation scare that you didn't see on May 27th. Chairman GREENSPAN. The problems that would confront this economy and the difficulties we would have if inflation reignited are important and something which we should be very closely mon- itoring. I would have made precisely that same statement on May 27th. The CHAIRMAN. Very good. Senator Mack. Senator MACK, Thank you, Mr. Chairman. Mr. Chairman, I'll maybe just follow up with some of that ques- tioning, because your statement seemed to imply that, really, no further change in interest rates is necessary. Then I wonder, given your comment with respect to what has happened in terms of the importance of the value of the dollar, that since May 27th, and I don't have the exact number, but it seems to me that around May 27th the dollar was probably 105, and today is about 98 or 99. Chairman GREENSPAN. It's about 5 percent lower. Senator MACK. All right. That indicates to me that you're not overly concerned about what's happened with the dollar. Chairman GREENSPAN. No, I disagree with that. Looking basi- cally at the overall financial system, I would be quite concerned about a dollar which did not show significant strength. I would amend my remarks only in a general way, that a number of things have gone on in the last number of weeks. The one that has worried me most clearly is the weakness in the dollar, and that is an important signal, insofar as I'm concerned, that inflationary pressures, as viewed out in the world, are clearly not coming down. There are other factors which have been contributing toward sta- bility. It's a mix. You can never say you learned nothing over a 6- or 8-week period, or something of that nature, but I cannot say that the economy has fundamentally veered from where I would have expected it to be moving, with the sole exception, which I will grant, that the dollar is weaker than I would have expected. Senator MACK. A moment ago you also said, in reference to the dollar, and this will be close, I hope, something to the effect of what they are saying about what is going on in the American econ- omy. I think you were referring, basically, to the markets seeing prob- lems in the American economy. I wonder if you might expand on what you think those concerns are. Chairman GREENSPAN. Obviously, to the extent that people are eschewing investments in dollar-denominated assets, that should be a concern to us. There are vast numbers of things which affect the rates of return on dollar-denominated assets vis-a-vis other as- sets, and we should be very considerably concerned about that. Not the least of which is that we are the principal reserve currency in the world, and that is an important position to be maintained. Senator MACK. The question I was really trying to get at is, what do you think it is that's going on in the markets? What are the pur- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 chasers and sellers of the American dollar seeing in our economy that makes them want to leave the dollar? Chairman GREENSPAN. May I suggest you put that to Under Sec- retary Summers tomorrow, because it is a very complex issue and I want to stay away from areas which he should be covering. There's no point in having two voices when it's difficult enough to get one clear voice. Senator MACK. I don't really accept the explanation, but I will grant you your request and just move on. Chairman GREENSPAN. I thank you, Senator. Senator MACK. I just want to touch, again, on the general policy of the Fed. There are some who are saying—most of what you heard here today, basically, don't tighten further, probably remain where you are, but there are some out in the markets that think because of the growth of bank reserves in 1991, 1992, and 1993, that if you don't move more aggressively, that, in fact, we will see higher levels of inflation in 1995 and 1996. I'm just interested in your reaction to their concerns. Chairman GREENSPAN. We obviously have looked at this data in very considerable detail. There has been, as you know, an extraordinarily subdued growth in the various different monetary aggregates over the last several years. They signaled a significant weakness in the economy which never emerged, never happened. Senator MACK. Say that again. Chairman GREENSPAN. The weakness in M2 and M3 signaled a significant weakness in the economy which never happened. In other words, the economy did not do what the slowdown in M2 his- torically would have suggested it should do. The result was that we began to look at other measures of mone- tary aggregates, the so-called monetary base, reserve balances, and the like. The argument that we've had a very substantial increase in the monetary base over the early part of the 1990's, up until about 8 or 9 months ago, is correct. Technically, there's a problem with that in that a very substantial part of the increase reflects the extraordinarily large amount of U.S. currency issuance which goes abroad. That currency is included in the monetary base and signifi- cantly exaggerates the degree of domestic liquidity that is implied. Perhaps more importantly, however, we have had great difficulty in using the monetary base as a good indicator of where the econ- omy is going because, historically, its relationship to future eco- nomic events is nowhere near as good as M2. That's the reason that we would not use it. Having said all of that, the effects of our interest rate increases have slowed the growth of the reserve base and the expansion, as I indicated to you in a letter the other day, Senator. The Federal Reserve balance sheet shows a significant increase in currency on the liability side, and there are assets on the asset side which sup- port that. That currency, very largely, is going abroad and is not a domestic liquidity question. As best we can judge, that currency does not come back and create domestic inflation in the United States. Senator MACK. Is it available to come back? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 Chairman GREENSPAN. Sure it is. It's American currency and it's spendable in the United States. The only difference is that there have been vast amounts of American currency which have become part of the monetary financial systems of a lot of countries out there. Senator MACK. So, again, your conclusion, with respect to this high level of growth in reserves, is much of it is driven by currency that goes overseas and should not be of concern. Chairman GREENSPAN. No. Actually, the reserve balances have been going down in the last 6 or 8 months. I guess the best way to describe it is that it's the expansion of the Federal Reserve's balance sheet which gives a number of people concern. There's nothing else that's expanding now. The money supply is flat. The rate of growth in domestic nonfinancial debt is modest. The reserve balances are modest. The only thing that's really growing significantly is the currency, and that is substan- tially, as best as we can judge, going abroad. Senator MACK. Is that unusual? Why is that happening? Chairman GREENSPAN. It is quite unusual. In fact, what I find really quite fascinating is the extraordinary extent of the desire to use American currency abroad. It's a very substantial part of the increase that we have experienced in the last decade or so. Is it unusual? It's unprecedented, but it's also true, I might add, from evidence that we have seen, for the Deutschmark and other currencies. As the globalization of this world financial system has moved apace, the amount of currencies which are used as second cur- rencies in a large number of countries has really mushroomed to an extraordinary extent. Senator MACK. I guess the last question I would ask along that line is would that indicate there's a greater demand for the dollar? Wouldn't that push the price of the dollar up? Chairman GREENSPAN. If that were the only thing involved, if currency were the only thing involved, the answer is very clearly, yes. The most interesting aspect about it is, remember, this is zero- interest liabilities of the United States. We are, in effect, selling debt to the external world at zero interest. Were that the sole evi- dence of demand for the American dollar, clearly, we'd have a stronger exchange rate than we do, but it's a negligible part of the total outstanding claims in dollars against financial institutions and the United States. Senator MACK. Thank you, Mr. Chairman. The CHAIRMAN. Very interesting. The Chairman of the Budget Committee, Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. The hour is late and I'll try to be brief and abide by the lights. Dr. Greenspan, the weakness in the second quarter spending and the build-up of inventory which is, I'm advised, the largest since 1989, was followed with V/z percent real growth—negligible growth. That means, as I read it, production and hiring are now going to slow down. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 My question to you is, "Have we already seen most of the re- straining effect of these recent interest rate increases, or is there more to come?" Are interest-sensitive sectors, like housing, autos, and business investment, likely to weaken in the coming months? When will we know how big an effect these past interest rate increases have had on the economy? Chairman GRKKNSPAN. Senator, first of all, let me just say that this morning I found the housing figures a little surprising in the sense that while single-family starts went down modestly, pretty much as we would have expected, there was a really sharp drop in multifamily starts. The permits data, however, did not decline, and from what I can judge, just looking cursorily at the data, there seems to have been a significant increase in unused permits. I don't know whether or not this is reflecting delays or what, but while I think there is clearly weakness in residential construction, the data this morning may have a technical problem of multifamily starts figures being highly unstable. I don't know that, but there's nothing in the data, having looked at it in some detail as best I could before I got here, that suggests to me there's anything particularly new going on. With respect to the inventory data, as you know, it is wholly in the area of wholesale and retail trade. There's very little evidence of any accumulation going on in the manufacturing area. We're not certain whether that inventory is domestic or foreign goods. We do know that there's a significant amount in the trade area of imports which end up in inventories, and to the extent that they are excessive, their impact is not on domestic production and jobs, but on foreign shipments. Senator SASSER. If we're indeed correct that it's a build-up in for- eign inventory- Chairman GREENSPAN. Yes. We don't- Senator SASSER. If it's a build-up in domestic inventory, then you're going to have a negative effect on it. Chairman GREENSPAN. That is correct. One of the issues we are watching very closely, as a consequence, is that if these inventories are unwanted—I mean, they're basically unplanned—we should begin to see, indeed, we should already be seeing it in anecdotal evidence on new orders which should be receding. As best as we can judge, there is very little evidence that that is, in fact, the case. It may be premature. I'm not sure. We don't, at this stage, have evidence which suggests that inventory increase is causing a significant weakening in the economy, but clearly, it is very difficult to absorb a large number like that without some perhaps temporary adjustments in the process. Senator SASSER. Mr. Chairman, the objective data here would in- dicate that past interest rate increases are having a chilling effect on such things as auto sales, home sales, et cetera. We've got that delayed effect of interest rates moving through the economy. We haven't seen all of the economic effects yet of the fiscal contraction that Congress enacted last year in the deficit reduction package that we passed last August. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 Where are we going with regard to the interest rate increases, and how do they coordinate or collide with the fiscal contraction that we enacted last year as we tried to grow the economy? Chairman GREENSPAN. Senator, as I said last year and will re- peat today because I think it's still true, it's by no means clear to me that fiscal contraction is a negative for economic growth in this particular context because inflation premiums embodied in long- term interest rates are, from an historical point of view, quite high. Senator SASSEK. Five percent. Is it 5 percent real interest rate? Chairman GREENSPAN. It's not the real interest rate. Real inter- est rates are less than that. Senator SASSER. On real long-term rates, is it not 5 percent? Chairman GREENSPAN. I would say, probably, real long-term rates now, as best as we can estimate them, may be in the area of 4 percent. The important point that I would argue here is that when you have inflation The CHAIRMAN. Can I just understand? Excuse me for interrupt- ing, but are you saying, then, that you think the embedded infla- tion rate is 3Vz percent? I assume you're using a long rate of IVz percent. Chairman GREENSPAN. That's correct. In other words, using a number of different forecasts of a variety of different techniques, the long-term expected inflation rate from the University of Michi- gan survey and from other surveys, gives us something in the area of 3V2 percent, or something slightly higher than that. That is not the same thing as the true inflation premium em- bodied in long-term rates. We can only pick that up if we get in- dexed bonds, so we're using only a rough proxy. The point I'm trying to make here The CHAIRMAN. Excuse me. I just wanted to have that clarified. Chairman GREENSPAN. Yes. The point I'm trying to make here, Senator, is that so long as you have an inflation premium of the order of magnitude that we're talking about, you have a two-sided effect when you're getting involved in deficit reduction. One is the so-called fiscal drag, which you've indicated and which I agree with. The other is the offset resulting from the fact that longer-term interest rates would tend to be currently lower than they would otherwise be, which is a positive effect. I can conceive of situations where one of those two can be larger than the other and then reversed. I'm not saying that necessarily, in today's context, the effect of the fiscal drag is less than the infla- tion expectations, although I'm sure it was true last year when we first discussed that. It may still be true, and I have no reason to believe it is not still true. Senator SASSER. Mr. Chairman, the point I'm making is we real- ly don't know precisely what the effects of recent interest rate in- creases on the economy are, and I don't think we know precisely the effects of the fiscal contraction contained in last year's Budget Act. Given that scenario, and given the fact that we see a build-up in inventories, and given the fact that we see home sales going down and auto sales going down, which are generally the most sen- sitive forward indicators, taking all that into consideration, 1 agree Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 with your statement that there's no necessity now for any further increase in interest rates. Chairman GREENSPAN. I don't recall saying that, Senator. [Laughter.] Senator SASSER. I want to get you to say it here today, Mr. Chairman, if at all possible. I don't know that you said it explicitly, but I got the impression that was the thrust of your remarks. Chairman GREENSPAN. Senator, the truth of the matter is that we are looking at a complex economy which has had a rate of growth which has been extraordinary in the fourth quarter of last year and the first quarter of this year. We're not sure whether the gross domestic product appropriately picked up the full extent of the rate of growth. If we are simmering down the rate of growth to more long-term sustainable levels, that is all to the good. If you are arguing that we are getting some reduction in some areas which are interest sensitive, yes, of course we are. It's got to come from somewhere. We had a very dramatic increase in truck and car sales over the last couple of years. We're still pressing up against capacity in most of the auto and truck assembly lines. There are shortages of numbers of cars. Demand is still fairly solid. Residential construction is still better than it has been in a while, with the exception of the extraordinary period last fall when there was a huge acceleration that picked up some of the backlog of housing demand. We're trying to get an economy which is balanced over time and in which inflationary pressures are subdued. Have the effects of in- terest rate moves that we have done to date been fully channeled through the economy? I don't think completely because, obviously, we're talking about lags of 4 to 6 quarters. One of the concerns that I've had, which we've been discussing, is that we find our way into a n on inflationary stable environment so that this economy does not run into difficulty. I must say, one of the reasons why we have been concerned about the dollar's weakness is that it's a suggestion there may be more inflationary pressures than we had previously thought. It's not that we know for certain, but it clearly is one of those indications, as indeed the inflation premiums in long-term bonds are, which suggests that if we are complacent about this particular expansion we risk not setting it. As far as the Federal Reserve is concerned, we are acutely desir- ous of making certain that this economy sustain itself on a contin- ued, long-term growth path without inflationary instabilities which so characterized the period of the latter part of the 1960's and the 1970's. Senator SASSER. Dr. Greenspan, I can't let that pass. There's a big difference between the 1960's and 1970's. We were fighting a war in the last part of the 1960's. Chairman GREENSPAN. That's part of what the problem was. Senator SASSER. That was one of the largest wars this country has ever fought In the 1970's, we also had two very severe oil shocks that shook the economies of all the industrialized nations. To draw that contrast between what's occurring now is, in my opinion, not being accurate with this Committee. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Chairman GREENSPAN. Senator, I would argue with that point. I don't think I want to necessarily do it at the moment, but there are other countries who handled it somewhat differently and had somewhat different results. The question is you cannot merely presume that the oil shocks, in and of themselves, were wholly to blame for the instabilities that were engendered. Senator SASSER. There's no doubt they played a large part in it. Chairman GREENSPAN. I do not deny that. I grant you that. I'm merely stipulating, even without that, we had policies which, in my judgment, were not sufficiently stable to maintain a noninflation- ary environment. I might add, going back to the Vietnam War, one of the problems we had is that, in retrospect, and it was a very difficult judgment, we did not finance it in a manner which was n on inflationary. At least that was the judgment of many of the economists at that time, as I recall. Senator SASSER. I don't know of any war that's been financed in a way that was noninflationary. I know we had the last balanced budget in 1969. The CHAIRMAN. This is a discussion that could go on at much greater length. Senator Bond. Senator BOND, Thank you, Mr. Chairman. I think for my col- leagues to ask the Chairman of the Federal Reserve what he's going to do on monetary policy in the future and expect an answer is probably a triumph of hope over experience. I will get back to that after a while. Following up on that discus- sion, I seem to recall that the oil shocks came in 1973 and 1974. The hyperinflation that so badly afflicted this country came about as a result of fiscal and monetary policies of the Federal Govern- ment in the late 1970's. I believe it is imperative that we avoid a similar misguided set of policies that led us to the job-killing, growth-stifling inflation of the late 1970's. Are there lessons from the late 1970's that you would call our at- tention to? Chairman GREENSPAN. I hope there are, Senator. We did have an oil shock then as well. We also had an oil shock during the Gulf War a few years ago. I don't think that an oil shock can account for the inflationary instabilities that emerged as a consequence of policies we had that led us into the early part of the 1980's. Senator BOND. What were the policies of the late 1970's that sent inflation and interest rates out the roof? Chairman GREENSPAN. In retrospect, it was clear that monetary policy was looser than it should have been, that there was an emer- gence of deficits which began to get increasingly financed through the financial system. We didn't understand at that point, indeed, we didn't have ade- quate information to suggest what the potentials of that would be. We do now. In other words, we may not have been able, even with foreknowledge, to have changed a lot of the results that oc- curred, but we were dealing with a situation back then where the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 conventional wisdom was that inflation could not be engendered within the United States because of our institutions. It's only when that was clearly demonstrated to be false that the true underlying impact of excessive deficits and monetary ease were understood to have created the problems. I say that only in hindsight because I lived through that period and I will tell you, it wasn't that easy to forecast. It wasn't that obvious and it's only in retrospect that it is clear what the nature of the problems were. I hope that we've learned our lessons from that period. Senator DOMENICI. Will the Senator yield for an observation on that point? It will take me 30 seconds. Take it off of my time. We also have to account for the fact that we've had a very posi- tive influence on inflation in the last 24 months by a precipitous drop in oil prices. It's just starting back up, but this economy has had the deflationary plus from low oil prices, which may not be around for the entire next 5 to 10 years. Thank you. Senator BOND. Let me move on to dealing with the deficits. I believe I read in your testimony before the Entitlement Com- mission that entitlement spending was a very great threat to fu- ture economic growth. Could you give us, briefly, your judgment on what we should be doing with respect to entitlements and fiscal policy as we seek to maintain a stable economic growth? Chairman GREENSPAN. Senator, I didn't address entitlements, per se. I addressed in somewhat more detail what I said here at the end of my testimony; namely, that we are involved with a situ- ation in which expenditures are, under current law and policy, scheduled to rise at a pace faster than any reasonable estimate of the growth in the tax base, and that that, basically, has to be ad- dressed. I argue that this is part of a problem which really refers to the way in which resources in the private sector are allocated to the public sector, either through the Federal budget directly or off- budget through mandates such as environmental controls and the like. I emphasized Senator BOND. Is it your recommendation to us that we not try to close that gap by raising additional revenues, that we need to bring under control the spending and the mandated impact on the private sector of various directed programs? Chairman GREENSPAN. Senator, if you raise taxes to close the deficit, you only have a temporary effect because after that you still have expenditures which are rising faster than the tax base and you can't keep raising taxes because you'll essentially run up against counterproductive activities in the marketplace. I would put it this way: A necessary condition for getting the budget deficit down is to bring the rate of growth in spending to or below the growth in the tax base over the long run. Whatever else you do, and I've argued that taxes don't help in this regard, there is no alternative to coming to grips with the ex- penditure data. Senator BOND. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 The CHAIRMAN. Senator Bennett. Senator BENNETT. Thank you, Mr. Chairman. Mr. Chairman, I read in my opening statement some comments from the Economist, generally in support of what you've been doing. I did as much to support you against the brickbats you were receiving as anyone else. There s a comment in here that I would like to take as the beginning point of my questioning. The Economist says, as I quoted earlier, inflation is likely to re- vive and it cites oil and other commodity prices are climbing. The price of gold, singled out in February by Mr. Greenspan as a warn- ing sign for inflation, is on its way up. Could we talk about gold? Talk about the falling dollar. Yen, in comparison to the dollar, is more stable against gold than the dollar is because if you are buying gold with yen, you don't have the loss in purchasing power that you do if you re buying gold in dollars. Do you still believe that gold is a reliable indicator of inflation expectations? Chairman GREENSPAN. I do, Senator. It's a special monetary commodity which distinguishes itself from all other commodities because virtually all of the production of gold since the dawn of his- tory probably still exists, which means that new production or changes in production levels have much smaller effect on the stock of the commodity than a lot of other commodities. Since the substantial part of gold demand is for monetary use, what we're basically dealing with is a situation in which the supply doesn't change very much from one year to the next. The demand for monetary use does and, therefore, affects the general price of gold. It's that which effectively impacts—I should say, that is the es- sential reason why it tends to be an indicator of inflation expecta- tions, and in that regard, I would say that it really always has been, in one way or another. When we were on the gold standard, when the value of the dollar was fixed to gold, obviously, you could not see that phenomenon. It's only been in the last decade or two that we've had real market availability to understand what some of the relationships are, so it's going to take a long while to become fully aware of how useful this is. My own impression is it's quite useful. Senator BENNETT. Senator Sasser made a comment in closing in which he said we've financed every war with inflation. I'm reaching very deeply back into my childhood, but I'm told from the history books and my brief memory that we were on the gold standard during the Second World War and that Federal funds rates remained around 2 percent throughout the entire war; that is, the gold standard presumably helped us not finance that war by inflation. Is that correct? You're a little older than I am, but not that much. Chairman GREENSPAN. I think not. My recollection of that pe- riod, at least as I read about it because I was not involved at that point, was that we locked the interest rate. The Federal Reserve just fixed the interest rate and printed as many reserves as were required to keep it there. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 I don't believe we had any of the aspects of a gold standard at that point, except that there was a nominal fixed anchor to gold, but gold was not functioning as a monetary system. Therefore, I would not use that as an indication of what interest rates would be under a gold standard. I think that you'd have to go back to, probably, the pre-World War I period to get a better judgment as to where they were. The rates were quite low back then. Senator BENNETT. Yes. Gold, by tying to gold, we did produce long-term price stability to a degree weve not seen in the recent decades. Is that correct? Chairman GREENSPAN. That is correct, Senator. Senator BENNETT. What would happen if we were to try to tie to gold again, if the Federal Reserve were to decide to peg its pur- chases in the bond market, either selling bonds back into the sys- tem, into this banking system, or buying them back from the bank- ing system, in an effort to target the price of gold? What would happen? Chairman GREENSPAN. I'm not sure how that would target the price of gold, except through interest rates, because affecting the supply and demand for bonds and Treasury bills, for example, by our actions in the open market, would clearly affect interest rates, as, indeed, it does very directly. It would then only be through in- terest rates that you would get an effect on the gold price. When we were on the gold standard, what we had was the U.S. Treasury buying and selling gold at a fixed price. That's the way the gold standard was implemented. Senator BENNETT. Yes, I understand that. I'm wondering if, by interest rates, you cannot, in effect, target the price of gold and say we would prefer the price of gold to be around $350 an ounce, roughly 10 percent below where it is now, through the Fed's ability to control interest rates. Could the Fed have an impact on that without going back to the old system of having the Treasury physically buy and sell the metal? Chairman GREENSPAN. My own impression is that the fluctua- tions in interest rates that would occur in order to do that specific thing would be very high. I don't mean that the levels would necessarily be high. I'm saying the fluctuations would be quite high. If we're going to go back to a gold standard, I think you have to have the metal as a basic reserve within your system and to have the Treasury buy and sell gold at fixed prices. I'm not sure that you can implement an indirect gold standard, except by the original means that it was done. Senator BENNETT. I see. I see my light is on. Let me ask you one last quick question. If there is one country in the world that has the most integrity in its money, as far as other currencies are concerned, wouldn't that be the country that would have the lowest interest rates in the world? Chairman GREENSPAN. Probably. Senator BENNETT. Would some kind of gold standard lead to that sort of integrity? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 Chairman GREENSPAN. There's no question that when the dollar was tied to gold in the period from the 1880's through World War I, we did have quite low interest rates and stable long-term infla- tion expectations. Indeed, at the turn of the century, as I recall, we were able to sell 100-year bonds at very low interest rates. We most recently have been able to start selling some very long maturity bonds, but not at the interest rates we were able to back at the turn of the century. Senator BENNETT. Thank you. The CHAIRMAN. Senator Domenici. Senator DOMENICI. Thank you, Mr. Chairman. Mr. Chairman, I will heed your advice and if I can make it when Mr. Summers is here, I'll inquire as to why he thinks the dollar is falling vis-a-vis the Deutchmark and the Yen. Let me take this occasion to ask you something about deficit in the out-years, since we're about to engage in a debate on health care. I would like to start with a couple of premises and see if you agree. As we look in the American budget and at what we might cut, restrain, or reform on the spending side, so as to get the deficit under control, is it fair to assume that, as said by many, one impor- tant way to do it is to get health care costs under control? Chairman GREENSPAN. I would certainly say that the numbers we're beginning to see in the projections for the various different programs related to medical care do presuppose that, if we're going to get stabilized growth in spending, those numbers must slow their rate of growth so that the aggregate rate is brought, at least, to the level of the growth in the tax base. Senator DOMENICI. Let me just make this point. It seems that the Federal Government's health care expenditures were a part of everybody's game plan for getting the long-term defi- cit under control. I haven't seen a plan that didn't say it was. In fact, I'm going to put up a little, tiny diagram here and graph. I will tell you that in 1993, in February—can you see this line down here? Chairman GREENSPAN. Yes. Senator DOMENICI. OK. The President of the United States, in his vision of America, vision of change for America, put this in his budget. The difference here, all of this in orange was $307 billion that we would apply to the deficit over time because we would get health care costs under control. This one, right here, is the promise that this is one of the ways to get the deficit under control. As a matter of fact, what happens, to the best of our knowledge, is the Congressional Budget Office says, "Well, this reality, this promise is gone and the reality is that we're going to spend this much more on health care." You see the yellow part? So the promise versus the reality is this much more Federal spending for health care instead of reducing the cost of health care. The reason I bring this up is because it is assumed these days that we're going to pay for health care. Part of the payment is to assume that some or all of these savings will be applied to the defi- cit, and others will be increases in different taxes for health care itself. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 If I'm reading the Federal budget correctly, we have just essen- tially, at least for 10 years, and perhaps 20, taken off the table any ability of the U.S. Congress to reduce the deficit by getting health care costs under control because the promise is gone. I don't expect you to agree with me on that, but I would just ask you, if that's the case, do you know enough about the rest of the budget, since we aren't going to get much more out of defense? I assume you've already said that here, and you've used different words than I. You've said it's leveled off or something. We're not going to get any more there. The discretionary accounts of the Government aren't really very big, so where do you assume the deficit reduction is going to come from, or where could we get it, since it will be back up to $250 bil- lion—that is, the deficit—by 1999, instead of the $150 billion the President had indicated? I guess to make it relevant to the hearing, do you think any of this is escaping analysts around the world who look at the future of the American deficit? Maybe you could answer the second part first and then give me your thoughts on the rest. Chairman GKKKNSPAN. I've been concerned that the long-term budget outlook in this country after the turn of the century is the major problem that confronts us, along with our inability to save adequate amounts. I think we have collateral problems, with respect to the distribu- tion of income and a variety of other issues, which have to be ad- dressed. Focusing on this particular issue, which raises serious questions about the long-term stability of our fiscal posture, raises questions around the world as to what the longer-term value of the dollar would be. That's the reason why I think it's crucially important for us be- cause we are going to be, will have to be, as far as we at the Fed- eral Reserve are concerned, the principal reserve currency in the world for the indefinite future. If we allow the dollar to weaken as a reserve currency, we will have consequences not only in our domestic system, but I think we will have significant problems with the necessary responsibilities that we have as a world leader in financial markets and in the economy. We are the dominant economic force in the world, and that car- ries with it significant responsibilities. Senator DOMKNICI. I will just summarize for myself what I think is going to happen, Mr. Chairman. I say that to both Chairmen. I believe if we pass a health care plan that takes all of this re- source that was in the promise, spend it all on health care and more, that it's unavoidable, that the United States will be in a po- sition of doing only two things with reference to the burgeoning deficit which will start back up and go past $450 billion, for those who wonder if we're just whistling Dixie, about 4 years into the next century. That's not too far off, 10 years. We're talking about long-term interest rates. Two things. One is the pension programs of the United States will have to be totally overhauled, and the other is substantial new Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 taxes will have to be imposed on the American public, or the deficit will go unattended. Frankly, I think to rely on those two things as the way to get the deficit under control in the future is perilous, both politically and economically. I thought we'd use this occasion to at least raise this question as we begin to debate health care on the Floor. Thank you very much, Mr. Chairman. The CHAIRMAN. Let me just—we'll conclude here shortly, Mr. Chairman. I want to say in regard to the issue that Senator Domenici intro- duced, I serve on the Finance Committee as the Chairman of the Health Care Subcommittee for families and the uninsured and we spent a lot of time on this issue in that Committee. I've conducted, myself, over 45 hearings on health care over the last short number of years. It's a mind-numbing subject in terms of its complexity, but I can tell you this, and I tell you this as somebody with a background in economics and finance myself; that is, you pay these bills one way or the other. You've seen that situation, so have I. Good preventive health care at the end of the day saves us money. You can squander money on health care as well, and we do a certain amount of that, but if you deny health care on a preven- tive basis to keep people from getting sick or to get them well when they can get well, and instead wait and let the negative con- sequences play out, you're going to pay a lot more. You're going to pay more in dollars, more in heartache, and more in suffering. Even if you leave aside the heartache and suffering, which I don't believe we should do, the dollars work against you. The other side of the coin comes back to the gold standard dis- cussion with Senator Bennett, and that is this. The other industri- alized countries have all managed to do this. They've gotten some plan of comprehensive health care for people because they think it's sound economics over the long term. They seem to be doing all right with it. They've had their different ap- proaches to it and so forth, and we're lagging behind in that area. I don't think I would want the suggestion left on the record that some kind of a thoughtful, cost-effective, comprehensive health care plan that provides good preventive care for people, is somehow going to cost us more money or be wasteful. I think the most wasteful scheme is to let people get sick and then come along and spend the high-cost dollars to try to deal with it after the fact. Those of us who are lucky enough to be healthy or to have good health insurance, that's one thing, because we're in a protected cat- egory by those circumstances, but, in any event, I think it's time we find a way to deal with this problem, and I think once we do it and do it in some semi-competent way, we'll actually spend less money over time than we would otherwise spend. That's my observation. I just want to put that on the record to juxtapose what has been said. Two final questions, Mr. Chairman. They're both important. I went back and got out of the record what was said between us on May 27, 1994, not very long ago, because we had a rather long discussion on that. We'd gone back and forth as to whether or not Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 there were major inflation problems building up and so-called infla- tionary tinder, t-i-n-d-e-r. I'm going to read you a paragraph that I stated at the end of our discussion to try to summarize an exchange between ourselves, and then I want to read to you what you said in response. I said, in summary, at the end of our exchange, "I think in to- days discussion, if anybody will take the time to watch it on C- SPAN or to read what you have said, it's quite clear that you have not found, the Fed has not yet found this build-up of inflationary pressure. It's not happening in real time to any degree worth talk- ing about. I don't want to get stuck at any great length on it, but is that a fair statement?" I put that to you. Chairman Greenspan, you responded, "I think that's a fair state- ment. We want to make certain it continues." I then added, and I want you to hear your response to this as well. I said to you, "So you've adjusted your policy for other rea- sons; namely, the increase in interest rates, so if somebody is at- tributing to the Fed some secret knowledge that you have seen ahead of time a huge burst of inflation, that would be a false read- ing by them." You answered, 'That is correct, Mr. Chairman." What preceded that summary was your long explanation about how the Fed had, in effect, tilted monetary policy in a direction of having abnormally low interest rates to try to bring about this bal- ance sneet recovery that you laid out in very clear detail. I won't go back and read all of that here. Not very many weeks have passed, but I thought I detected ear- lier, and a couple of other colleagues that have just left tell me that they thought maybe they were hearing, something different from you today. People were around the press table reporting on this, and your words come right back around in a matter of minutes here, in terms of an impression as to what's being said. The headline today on the AP story that was put out at 12:47, which is just a little over an hour ago, starts out this way: Treas- ury bond prices were sharply lower around midday after Federal Keserve Chairman, Alan Greenspan, delivered a blunt warning about the dangers of inflation. Dropping down here, after a couple of your quotes, one gen- tleman, head of the market analysis at First Chicago Capital Mar- kets, is quoted as saying, "The view is he is coming out slightly more hawkish than he was expected to." He hears what he hears watching this and we all hear what we hear, but when we went through that exchange 20 minutes ago, I want to understand, again, whether or not I'm hearing something different today from you, whether your own assessment has changed from May 27th. In other words, has the inflation concern gotten larger or is it es- sentially the same as it was back when you testified in that period? Chairman GREENSPAN. Mr. Chairman, I'd say that there are two ways of looking at this. If you're asking me, do we see any specific, underlying, hard evidence that inflation is taking hold, as I said in my introductory remarks, we are looking at the various elements Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 to suggest where tightness would occur. We do see certain things, for example, in the deterioration of delivery schedules, which sug- gests some manufacturing tightness in certain types of goods. So, we do see some underlying cost pressures emerging, but we do not see any evidence of costs flowing through into final prices as yet. I said that back in May and I say that today. Are we seeing a possibility of a higher degree of inflation, or are we closer to potentially inflationary pressures now than we were back then? The answer is the economy has moved up. It's some- what stronger than we would have expected earlier in the year, al- though I'm not clear that it's particularly stronger than I expected it was in May. It is true the value of the dollar has fallen, and to that extent, obviously, that does affect import prices and, indirectly, other prices. One could say the decline in the dollar since then has had some increased inflationary possibilities. The CHAIRMAN. In terms of buying foreign goods. Chairman GREENSPAN. In terms of buying foreign goods and to the extent that the higher prices of foreign goods enable domestic manufacturers who are competing with them to move prices up some. If you ask me, have I seen any evidence that the weakness in the dollar has as yet gotten into the import price structure, the answer is, not yet. It's obviously too early. Does it necessarily mean that it is a major inflationary force? It depends on numerous other things. The reason why I hesitate to say that there's something starkly different from May 27th is that there are plusses and there are minuses, but I don't see that there is a materially different view of what we are looking at out there. I was concerned back then, as you may recall, saying that infla- tion is something which concerns us because the lead times are very considerable, and that actions we take today, meaning May 27th, won't affect fully the general level of the economy or inflation until well into 1995. I say that today. Are there more inflationary pressures today than before? I would say it's mixed. I would say the dollar clearly is signaling more inflationary pressures. The acceleration of inventories has worked in the other direction because, however one reads what those data are, they are of such an order of magnitude that they are working in the other direction. I say in my prepared remarks that it's essential we at the central bank be very cognizant about what is going on and make as good projections as we can make about the emerging forces because there is no alternative to making a forecast. You cannot, unfortunately, have a simple set of indicators which say, monetary policy gets tightened or loosened depending upon some objectively calibrated sets of current data. Regrettably, we don't have that luxury. We have to make a judgment the best that we can on what the risks are out there. We do know, as far as the central bank is concerned, that the balances in the economy, at this stage, are reasonably good and that there is a significant issue in monetary policy that we have to focus upon which basically is, what happens if we implement a policy and we are wrong? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 In that regard, there is a much higher risk that if we are unduly restrained, we have the capability of reversing that with, as far as I can see looking at the economy, very little permanent damage. If we fail to recognize emerging inflationary forces, remedying that will be far more difficult and far more of a problem for the long-term stability of the economy in 1995 and beyond. It's a very difficult balancing that we're trying to make here. I hope we do it well. We do it the best that we can, and we try to find, try to understand all of the forces that are impinging on us at this particular stage. I will just merely repeat what I said earlier. I don't see a signifi- cant change in the overall risks of inflation between late May and now. I was concerned about them back then. I said, and I repeat the same thing today, actual inflation, as measured now, is not evi- dent either in the published data or the anecdotal data. What we are concerned about is processes which history tells us create inflationary forces, and it is that which we're addressing today. It's that which we were addressing back in late May. The CHAIRMAN. I appreciate the thoughtfulness of both the policy that you've developed here and the time that you've taken to ex- plain it today, not just to this Committee, but to everyone else who wants to try to understand the thought process and what the policy is. I think if someone could have in their mind what you said the last time when, in effect, the Fed moved ahead of a burst of infla- tion—in other words, to adjust the monetary policy upward in terms of the rate adjustments that have been put in place—you said it was to try, given the lags that occur here, to get ahead of a potential problem, to try to take out the excessive monetary availability that had been there before. That's the general strategy that you outlined. YouVe done that and, as I understand it, it takes about 6 or 9 months for us to fully see the effects of those rate increases playing themselves out. A lot of other things are going on at the same time, but is that the normal time period lag that you generally see? Chairman GREENSPAN. I would say we would begin to see the ef- fects, but that it depends on how quickly you get responses in long- term rates and what types of adjustments take place. The normal full completion of the cycle is probably a year and a half, but you obviously see the effects building through time. The variability of that lag is also something of a concern. Some- times it speeds up, sometimes it slows down, but it is a significant lag. There's almost no evidence of shorter lags where the full im- pact of monetary policy is dissipated fairly quickly. The CHAIRMAN. You certainly, in some areas, get an immediate psychological effect. Chairman GREENSPAN. Indeed, we do. The CHAIRMAN. We saw that because, obviously, it was a change in direction, a change in Fed signals. I know there was some con- cern about some speculation in financial markets, and we've seen a wash-out of some speculation in the financial markets since inter- est rate direction has changed. Almost every analyst has noted that. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 Is it fair to assume that the policy changes we've already seen and the change in direction has, in effect, dealt with whatever fi- nancial speculation problem there may have been in the markets? Has that been washed out sufficiently in your view? Chairman GREENSPAN. I don't think we ever know fully. The real significant problem that had concerned us at the beginning of this year; that is, what seemed to be a track toward ever increasing capital gains and very little risk and very low margins of risk pre- miums, and the belief that there was no down side, clearly has changed. That was the major problem which worried us. We have no way of knowing whether the full adjustment is com- plete. We do know, from options data, that the degree of volatility in financial markets is still somewhat higher than it was back then, and I guess one would have to say that until we see the vola- tility come down to somewhat lower levels, the turmoil in the mar- kets probably is not fully dissipated. Unquestionably, the major part that concerned us, obviously, has been addressed. The CHAIRMAN. I thank you for your time today and for your pro- fessionalism. We've covered a lot of ground and it took us a while because of the opening statements and also because we had to ad- journ for a vote. We thank vou and we look forward to our next discussion. The Committee stands in recess. Chairman GREENSPAN. Thank you. [Whereupon, at 1:32 p.m., the Committee was adjourned.] [Prepared statement, response to written questions, Monetary Policy Report to Congress, and additional material supplied for the record follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, DC JULY 20, 1994 Mr. Chairman and Members of the Committee, I appreciate this opportunity to discuss with you recent economic developments and the Federal Reserve's conduct of monetary policy. The favorable performance of the economy continued in the first half of 1994. Eco- nomic growth was strong, unemployment fell appreciably, and inflation remained subdued. To sustain the expansion, the Federal Reserve adjusted monetary policy over recent months so as to contain potential inflationary pressures. Our actions this year can be understood by reference to policy over the previous several years. Through that period, the Federal Reserve moved toward and then maintained for a considerable time a purposefully accommodative stance of policy. During 1993, that stance was associated with low levels of real short-term interest rates—around zero. We judged that low interest rates would be necessary for a time to overcome the effects of a number of factors that were restraining the economic expansion, including heavy debt burdens of households and businesses and tighter credit policies of many lenders. By early this year, however, it became clear that many of these impediments had diminished and that the economy had consequently gained considerable momentum. In these circumstances, it was no longer appro- priate to maintain an accommodative policy. Indeed, history strongly suggests that maintenance of real short-term rates at levels prevailing last year ultimately would have fueled inflationary pressures. Accordingly, the Federal Open Market Committee, at its meeting in early Feb- ruary, decided to move away from its accommodative posture by tightening reserve market conditions. Given the level of real short-term rates and the evident momen- tum in the economy, it seemed likely that a substantial cumulative adjustment of policy would be needed. However, Committee members recognized that financial markets were not fully prepared for this action. About 5 years had passed since the previous episode of monetary firming, and a number of market participants in de- signing their investment strategies seemed to give little weight to the possibility that interest rates would rise; instead, many apparently extrapolated the then-re- cent, but highly unusual, extended period of low short-term interest rates, fairly steady capital gains on long-term investments, and relatively stable conditions in fi- nancial markets. Many Committee members were concerned that a marked shift in the stance of policy, while necessary, could precipitate an exaggerated reaction in financial markets. With this in mind, we initially tightened reserve conditions only slightly—just enough to raise the Federal funds rate 14 percentage point. And the financial mar- kets did, indeed, react sharply, with substantial increases in longer-term interest rates and declines in stock prices. Markets remained unsettled for several months, and we continued to move cautiously in March and April in the process of moving away from our accommodative stance. By mid-May, however, a considerable portion of the adjustment in portfolios to the new rate environment appeared to have taken place. With financial markets evidently better prepared to absorb a larger move, the Federal Reserve could substantially complete the removal of the degree of monetary accommodation that prevailed throughout 1993. The Board raised the discount rate Vz percentage point, a move that was fully passed through to reserve market condi- tions by the FOMC. Overall, the Federal funds rate increased IVi percentage points during the first half of the year, and real short-term rates likely rose a similar amount. Partly to minimize any market confusion about the extent of and rationale for our moves, the Federal Reserve has announced each action and, in relevant in- stances, provided an explanation. At its meeting in early July, the FOMC faced con- siderable uncertainty about the pace of expansion and pressures on prices going for- ward, and it made no further adjustment in its policy stance. Nonetheless, it is an open question whether our actions to date have been suffi- cient to head off inflationary pressures and thus maintain favorable trends in the economy. Labor demand has been quite strong, pointing to robust growth in produc- tion and incomes. To be sure, some hints of moderation in the growth of domestic final demand have appeared, and the recent indications of accelerating inventory ac- cumulation may suggest an unwanted backing up of stocks. Conversely, the inven- tory accumulation may reflect pressures on firms who had brought inventories down to sub-optimal levels and now need to replenish them. In the latter case, stock- building may continue at an abovc-normai rate, supporting production for quite Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 some time. Moreover, the improving economic conditions of our trading partners should add impetus to aggregate demand from the external sector. How these forces balance out in the coming months could be critical in determin- ing whether inflation will remain in check, for the amount of slack in the economy, while difficult to judge, appears to have become relatively small. Concerns that pro' ductive capacity could come under pressure and prices accelerate are already evi- dent in commodity and financial markets, including the foreign exchange market. An increase of inflation would come at considerable cost: We would lose hard-won ground in the fight against inflation expectations—ground that would be difficult to recapture later; our long-run economic performance would be impaired by the ineffi- ciencies associated with higher inflation if it persisted; and harsher policy actions would eventually be necessary to reverse the upsurge in inflationary instabilities. We are determined to prevent such an outcome, and currently are monitoring eco- nomic and financial data carefully to assess whether additional adjustments arc ap- propriate. The economic figures that have formed the backdrop for our policy actions so far this year confirm that a rapid expansion has been in progress. Following growth at an annual rate of 7 percent in the fourth quarter of last year, real gross domestic product rose at nearly a 3V'2 percent rate in the first quarter. A conceptually equiva- lent measure of aggregate output, gross domestic income, exhibited even larger gains in the fourth and first quarters. At this stage, available data leave some un- certainty regarding the pace of economic activity over the past 3 months. Nonethe- less, the evidence in hand makes it reasonably clear that growth remained appre- ciably above its longer-run trend. The robust expansion over the first half of 1994 has been reflected in substantial increases in employment. Since last December, nonfarm payrolls have risen by l3/4 million workers, bringing the gain in jobs since the expansion got underway to 5 million. Reflecting this hiring, the civilian unem- ployment rate has fallen to 6 percent. Although labor markets have tightened considerably in recent months, aggregate measures of wage and compensation rates have not yet evidenced persuasive signs of acceleration. Similarly, the increases in the consumer price index excluding food and energy, at about a 3 percent rate over the last 6 months, have remained near last years pace, while the overall CPI has risen at a reduced rate of about 2Vz per- cent. To be sure, price pressures have been manifest at earlier stages of processing: Costs of many commodities and materials have been climbing, in some cases reflect- ing the tightening of industrial capacity utilization, which is now at its highest level in 5 years. But these pressures have been offset by favorable trends in unit labor costs resulting from marked improvements in productivity—especially in manufac- turing—in recent years. The accumulating evidence of stronger-than-expected economic growth here and abroad, combined with changing expectations of policy actions by the Federal Re- serve as well as other central banks, prompted considerable increases in long-term interest rates in occasionally volatile markets over the first half of the year. Market participants concluded that, with aggregate demand stronger, higher real rates would be necessary to hold growth to a sustainable pace. Inflation expectations may also have been revised higher, as the performance of the economy seemed to make further near-term progress against inflation less likely and raised questions about whether price pressures might intensify. To a degree, the very volatility of markets probably augmented the backup in long-term interest rates. One of the effects of the extended market rallies of recent years was to promote a rather complacent view among investors about the risks of holding long-term assets. In response, they gradually increased the proportions of their portfolios devoted to stocks and bonds, driving up their prices still further and narrowing risk spreads. But when developments earlier this year surprised inves- tors and diminished their confidence in predicting future market conditions, they pulled back from long positions in securities until returns rose to compensate them for (.he additional price risk. The recent weakness in bond prices was not limited to the United States, but was accompanied by a surge in foreign interest rates. This surge was particularly in- formative; ordinarily one would expect that as interest rates go up in one country, they would not increase to the same extent in others because exchange rates also would be expected to adjust. The initial jump in foreign interest rates was a sign of the extraordinary increase in uncertainty as, evidently, investors attempted to re- duce their price-sensitive long positions by selling stocks and bonds regardless of currency denomination or economic conditions in the country of issuance. Roughly concurrently, moreover, signs that the slump in some foreign industrial economies was ending also were becoming apparent. As a result, market participants antici- pated stronger credit demands abroad and a reduced likelihood of further easing by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 some foreign central banks, and intermediate- and longer-term rates in many of our trading partners rose as much as or more than in the United States. Rising foreign interest rates, concerns in markets about the prospects for reduced trade tensions and about U.S. inflation contributed to considerable activity directed at rebalancing international investment portfolios. One effect of this activity ap- pears to have oeen a substantial decline of the foreign exchange value of the dollar on net over the past 6 months. Foreign exchange rates are key prices in the Amer- ican economy, with significant implications for the volumes of exports and imports as well as for the prices of imports and domestically-produced items that compete with imports. The foreign exchange value of the dollar also can provide useful in- sights into inflation expectations. If we conduct an appropriate monetary policy— and appropriate economic policies more generally—we shall achieve our goals of solid economic growth and price stability, and such economic results will ensure that dollar-denominated assets remain attractive to global investors, which is essen- tial to the dollar's continuing role as the world's principal reserve currency. Rising interest rates and considerable volatility in financial markets do not seem to have slowed overall credit flows this year. At about a 5'/i percent annual rate through May, domestic nonfinancial sector debt has increased within its 4-to-8 per- cent monitoring range. The composition of debt growth, however, has differed from the patterns of the previous few years. Expansion of Federal debt has slowed as the actions of Congress and the Administration as well as cyclical forces have narrowed the budget deficit considerably. The total debt of businesses, households, and State and local governments, by contrast, has risen this year at a brisker pace, though growth has remained quite moderate in comparison with the average experience of recent decades. The pickup this year indicates both that private borrowers have be- come less cautious about taking on debt and that lenders have become more com- fortable lending to them. Although household debt-income ratios remain high, debt- service burdens have fallen appreciably, partly reflecting the refinancing of mort- gages at lower interest rates. The lower debt burdens evidently have fostered a more favorable attitude toward credit among households, and consumer installment borrowing has accelerated, with strong growth of consumer loans at banks. Banks have been increasingly willing to extend credit, easing their terms and standards on business loans considerably. In addition, some firms have turned to banks for financing because of the turbulence in bond and stock markets this spring. Total bank lending has strengthened materially and, with continued acquisitions of secu- rities, total bank credit has picked up as well. Nonetheless, growth of the monetary aggregates remains damped, as banks have relied heavily on non-deposit sources of funds to finance loan growth. Expansion of M2 has been quite slow this year, leaving this aggregate near the lower end of its l-to-5 percent annual range. M3 actually has edged down, and thus is just below its O-to-4 percent range for 1994. The weakness in the broader aggre- gates has not been reflected in the growth of income again this year, representing a continuation of the substantial increases in velocity that we have experienced over the past few years. The factors behind this behavior, however, have changed some- what. The diversion of savings funds from deposits to bond and stock mutual funds, which sharply depressed money growth in past years, seerns to have slowed sub- stantially; the experience with capital losses this spring apparently has heightened some investors' appreciation of the risks of such instruments. On the other hand, rising short-term market interest rates, combined with the usual lag in the adjust- ment of deposit rates, have been a significant restraint on growth of the aggregates this year, in contrast to 1992 and 1993. The increases in market rates this year have exerted a particular drag on the nar- rower monetary aggregates, as well as on the closely related reserves and monetary base measures. Ml has expanded at only a 4 percent rate so far this year, compared with lO'/a percent increases in each of the previous 2 years. Mi's velocity has con- tinued to fluctuate sharply, limiting its usefulness in formulating and interpreting monetary policy. The growth of Ml this year would have been even lower were it not for continued heavy demands for U.S. currency abroad. Flows of currency over- seas have an even greater effect proportionately on the monetary base, which has grown rapidly this year despite declines in the reserves of depository institutions. In reviewing its ranges for money growth in 1994, the FOMC noted that further increases in velocity of M2 and M3 were likely. Although yields on deposits will probably continue to rise further in lagged response to increases in market rates, the wider rate disadvantage of deposits is likely to persist, and savers will continue to redirect flows into market instruments. As a result, growth of both aggregates near the lower bounds of their 1994 ranges is considered to be consistent with achieving our objectives for economic performance, and the ranges were left un- changed. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 The Committee also decided, on a provisional basis, to carry forward the current ranges for the monetary aggregates to 1995. We were not confident that we could predict with sufficient accuracy the money-income relationships that were likely to prevail next year to modify the ranges. Moreover, further permanent reductions of the monetary ranges did not seem necessary, as those ranges are already low enough to be consistent with the goal of price stability and maximum sustainable economic growth, assuming an eventual return to more stable velocity behavior. From that point of view, we felt that maintenance of the current monetary ranges would give the clearest indication of the long-run intentions of policy. Regarding domestic nonfinancial sector debt, we made no adjustment to this year's monitoring range, but elected to set a provisional monitoring range for 1995 of 3 to 7 percent, a percentage point lower than this year's. A lower range would conform with some deceleration in nominal income, in the process of containing in- flation and ultimately making progress toward price stability. The reduction is not intended to signal an increased emphasis on the debt measure, but it is supported by our view that rapid debt growth, if sustained, can eventually lead to significant imbalances that are inimical to stable, noninflationary growth. As usual, we shall review carefully all of the provisional ranges for 1995 in February. Given the rapid pace of financial change, considerable uncertainties continue to attend the relationships of all of the aggregates to the performance of the economy and inflation, and we do not expect in the near term to increase the weight accorded in policy formulation to these measures. However, the processes of porlfolio reallocation that have generated these recent shifts may be slowing. We snail con- tinue to monitor monetary growth, and financial flows more generally, for informa- tion about the course of the economy and prices in coming to decisions regarding adjustments to the stance of monetary policy. We expect that expansion of money and credit within the ranges we have estab- lished will be consistent with the continuation of good economic performance. With appropriate monetary policies, the Hoard members and Reserve Bank presidents sec the economy settling into more moderate rates of growth over the next six quarters and inflation remaining relatively subdued. Specifically, the central tendencies of our forecasts are for real GDP to expand 3 to 3l/4 percent over 1994 and 2Va to 23A percent next year. The consumer price index is projected to increase 23A to 3 percent this year. In 1995, inflation may be about the same as in 1994, or slightly higher; the recent depreciation in the dollar is likely to put upward pressure on inflation over the next year if it is not reversed. With the pace of hiring likely to about match that of labor force growth, the unemployment rate is expected to remain close to its recent level. Mr. Chairman, you also asked for economic projections for 1996. I fully appreciate your purpose in requesting this information, however, my colleagues and I don't think we can best communicate our policy intentions through additional numerical forecasts. Rather, we believe our intentions are best conveyed in terms of our de- clared objective of fostering as much growth of output and employment as can be achieved without placing destabilizing inflationary pressures on productive re- sources. There is considerable uncertainty about what that goal implies for the ex- pansion of GDP and rates of unemployment. That said, it may be useful to note that the assumptions underlying the medium- term orojections provided to you by the Administration and the Congressional Budg- et Office (CBO) are within the mainstream of thinking among academics and pri- vate business economists. These projections do not attempt to anticipate cyclical movements, but instead represent estimates of the likely performance of the econ- omy in the neighborhood of its potential. The Administration, for example, projected in its most recent forecast that the economy will expand at a 2.5 percent rate in the second half of the 1990's and unemployment will average 6.1 percent. These pro- jections are consistent with common estimates of the economy s potential growth rate and fall within the range of typical estimates of the so-called "natural rate" of unemployment. Uncertainties around these estimates arise because identifying economic relation- ships is always difficult, partly owing to limitations of the data. But more fun- damentally, all policymakers recognize that notions of potential GDP growth and the natural rate of unemployment are considerable simplifications, useful in concep- tual models, but subject to a variety of real-world complications. Our economy is a complex, dynamic system, comprising countless and diverse households, firms, serv- ices, products, and prices, interacting in a multitude of markets. Estimates of mac- roeconomic relationships, as best we can make them, are useful starting points for analysis—but they are just starting points. Given questions about the aggregate relationships, policymakers need to look below the surface, in markets themselves, for evidence of tightness that might indi- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 cate whether inflationary pressures are indeed building. One important source of such evidence is the reports we receive from our Reserve Banks through their exten- sive contacts in their communities. These reports are released to the public in the "beige book" and are updated—fmjuently on the basis of confidential information from individual firms and financial institutions—by the Reserve Bank officials at our meetings and through normal intermeeting communications. Another source of useful information is individual industries ana trade groups, which provide many timely indicators that are sensitive to supply-demand conditions in particular sec- tors. If the economy were nearing capacity, we would expect to see certain patterns in the statistical and anecdotal information with increasing frequency and intensity. Reports of shortages of skilled labor, strikes, and instances of difficulties in finding workers in specific regions all would be more likely. To attract additional workers, employers would presumably step up their use of want-ads and might begin to use nonstandard techniques, such as signing or recruiting bonuses. More firms might choose to bring on less skilled workers and train them on the job. All of these steps, in themselves, could add to costs and suggest developing inflationary imbalances. As firms experienced difficulty in expanding production to meet rising demand, we would also expect to see increasingly frequent signs of shortages of goods as well as labor. Businesses might have difficulty in obtaining certain materials. Vendor performance would deteriorate, and lead times on deliveries of new orders would in- crease. Pressures on supplies of materials and commodities would be reflected in ris- ing prices of these items. Of course, we would not expect to see these phenomena occur simultaneously throughout the economy—quite the contrary. And, to a degree, these symptoms occur in a few sectors even in noninflationary economies. But a noticeable step-up in their incidence could constitute evidence of an incipient inflationary process. In recent months, we have seen some of these signs. There are reports of short- ages of some types of labor—construction workers and truck drivers, for instance. Indexes of vendor performance have deteriorated considerably, and manufacturers are paying higher prices for materials used in their production processes. As yet, these sorts of indications do not seem to be widespread across the economy. None- theless, we shall need to be particularly alert to these emerging signs in considering further adjustments to policy in the period ahead. Financial flows may also impart useful warnings of price pressures. For example, persistent unsustainably low real interest rates might prompt very rapid credit growth, as expectations of price increases led households and firms to accelerate purchases of durable goods and equipment and finance these expenditures by step- ping up the pace of borrowing. Although consumer borrowing has accelerated consid- erably of late, overall debt growth has so far remained moderate. In light of the uncertainties about aggregate measures of our economic potential, the Federal Reserve cannot rely heavily on any one estimate of either the natural rate of unemployment or potential GDP growth. Most important, we have no inten- tion of setting artificial limits on employment or growth. Indeed, the Federal Re- serve would be pleased to see more rapid output growth and lower unemployment than projected by forecasters such as the CBO and the Administration—provided they were sustainable and consistent with approaching price stability. I should note, however, that most Federal Reserve policymakers would not regard the inflation projections of these other forecasters, which generally do not foresee further progress toward price stability over the medium term, as a desirable outcome. A more significant issue for economic policymakers than the precise values of such estimates is what can be done to maximize sustainable employment and economic growth. We need, for example, to give careful attention to the problem of unemploy- ment, as noted by the G-7 leaders at their recent summit. We could raise output and living standards around the world and at the same time ease many social prob- lems if more people were working. Here at home, nearly eight million Americans arc looking for work. At this stage of the business cycle—having experienced almost 40 months of expansion and particularly strong growth recently—most of this unem- ployment probably is not due to a shortfall in aggregate demand. Rather, a good deal of it is likely Trictional," reflecting the ordinary process of workers moving be- tween jobs, or "structural," resulting from longer-term mismatches between workers and available jobs. Monetary policy, which works mainly by influencing aggregate demand, is not suited to addressing such problems. But we ought to be encouraging other measures to increase the flexibility of our work force and labor markets. Im- proving education and training and facilitating better and more rapid matching of workers with jobs are essential elements in making more effective use of the U.S. labor force. Just as important, Congress should avoid enacting policies that create impediments to the efficient movement of individuals across regions, industries, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 occupations, or that unduly discourage the hiring of those seeking work. Competi- tive markets have shown a remarkable ability to create rising standards of living when left free to function. Congress and the Administration also can continue to contribute to the growth of our economy's capital and productivity through a sound Fiscal policy. The extension of the spending caps in last yearns budget agreement was a significant step in put- ting fiscal policy on a more sustainable, long-run path. Budget deficit reduction has proved to be particularly timely, by reducing the Government's claim on savings just as households and firms are seeking more capital to finance investments. But under current law, the deficit, as a percent of GDP, will begin to expand again as we move into the next century, with unacceptable consequences for financial stability and economic growth. The primary cause of this increase will be Federal outlays, which will almost surely again be rising at a pace that will exceed the growth of our tax base. Only by reducing the growth in spending is ultimate balance achievable. As I have emphasized many times, the Federal Reserve also can contribute to the achievement of our overriding goal—maximum sustainable economic growth—by pursuing and ultimately achieving a stable price level. Without the uncertainties en- gendered by inflation, households and firms are better able to plan for the future, And firms focus on maximizing profitability by holding down costs and increasing productivity rather than by using inflationary conditions to support price increases. There is some evidence to suggest that the stronger trend of productivity growth we have witnessed over the recent past is due, at least partly, to the beneficial effects of low rates of inflation. Our Nation has made considerable progress in putting the economy on a sound footing in the past few years. To preserve and extend these advances, our monetary and fiscal policies will need to remain disciplined and focused on our long-term ob- jectives; we would be foolish to squander our recent gains for near-term benefits that would prove ephemeral. Indeed, by fostering progress toward price stability, achieving lower Federal budget deficits, and encouraging competitive markets both here and abroad, we will help ensure the continued vitality of our Nation's economy now and for many years into the future. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 RESPONSE TO WRITTEN QUESTIONS OF SENATOR RIEGLE FROM ALAN GREENSPAN Q.I. The reported unemployment rate has declined from 6.7 per- cent in January to 6.0 percent in June, which you evidently think approximately represents full employment, but the survey on which that rate is based incongruously shows the labor force declining by half a million workers over the same period of rapid growth. Are you concerned that this new survey may be defective, and that the true rate may be higher? A.1. I don't believe there is any evidence that the new survey is "defective," but it is different and there is still considerable uncer- tainty about how to link the new survey results with the old. One problem in interpreting the recent data is that the limited experi- ence with the new survey has made it necessary to utilize seasonal adjustment factors derived from the old survey—and the changes in the survey may well alter the seasonal patterns. That said, I don't think we have a strong basis for assuming that the surprising reported decline in labor force participation means that the 6.0 percent unemployment rate for June is biased down- ward. Among other things, employment and labor force participa- tion tend to be positively correlated in the short run, making the unemployment rate a more stable number. There is no doubt that this relationship bears close watching in the months ahead; in- sights into why labor force growth is lagging could be important in judging the degree of labor market tautness, as your question sug- gests. Q.2. At earlier hearings, you expressed considerable optimism about the trend of productivity growth, suggesting that the econo- my's growth potential may now be higher than the 2Vz percent rate commonly cited, and which you referred to today. Does the evi- dence indicate that 2% percent is an at least equally plausible esti- mate? A.2. Presumably, the many analysts—including those in the Ad- ministration and the Congressional Budget Office—who have adopted the 2Va percent assumption viewed that number as more likely than the 23/4 percent alternative you offer, but the potential output growth rate is difficult to pin down, both analytically and empirically, and the "standard error" of any estimate must be at least a quarter point. As I've stressed repeatedly, we in the Federal Reserve have not wedded ourselves to a particular figure in fram- ing our monetary policies. Q.3. In your testimony, you noted "continued heavy demands for U.S. currency abroad." How do you measure that? A.3. Information on current outflows of U.S. currency abroad is generally obtained on an informal basis by cash officers at Federal Reserve offices from a small number of commercial banks who are active in this business. Typically, only a few of the 37 Federal Re- serve offices are involved in handling large orders for currency that these commercial banks ship abroad. In addition to this information, Board staff are developing meth- ods for refining such estimates of currency flows abroad. Each method is based on an empirical model in which foreign demands Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 and domestic demands are distinguished by important differences in their behavior. However, estimating currency flows is quite dif- ficult and any procedure or set of procedures is likely to be subject to a wide margin of error. Comprehensive direct measurements of cross-border currency flows are lacking; the United States places no restrictions on such flows and Customs' reports obtained from those carrying $10,000 or more in currency across borders do not appear to have been a reliable source for estimating aggregate currency flows. While development of the Board methods is still in progress, tentative estimates for recent years appear to be highly correlated with the information provided by cash officers. The combined esti- mates suggest that a sizable percentage of the rise in the currency component of Ml in the 1990's is attributable to foreign demands— certainly well over half of the average annual increase of about $25 billion so far in this decade. Q.4. Recently, a major BCCI figure entered into a plea agreement with the Justice Department on the basis of his cooperation in de- tailing BCCI's activities in this country. Is the Fed a participant in these cooperative discussions? Are they likely to result in any fu- ture activities by the Fed? A.4. Under the plea agreement recently accepted by the Federal District Court in Washington, DC, Swaleh Naqvi, a senior manager of the Bank of Credit and Commerce International, pleaded guilty to three criminal charges arising out of the operations of BCCI. Al- though the Federal Reserve was not a party to the plea agreement, Naqvi is obligated under the agreement to cooperate with the ongo- ing investigations of a number of law enforcement and regulatory agencies, including the Federal Reserve. As a result of the plea agreement, we expect that Naqvi would be available if needed by staff in reviewing recently-obtained BCCI documents that had been maintained in Abu Dhabi or if required to testify in any Federal Reserve enforcement proceedings. RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ALAN GREENSPAN Q.I. Ten years ago, the Federal Reserve joined the Treasury and State Departments in a report to Congress that rejected member- ship of the U.S. on the BIS Board. What has changed in the last decade to reverse the position of the Federal Reserve on this issue? A.1. The November 1984 report to Congress on the Federal Reserve relationship with the Bank for International Settlements (BIS) con- cluded that there was no urgent need to change the then-current relationship with the BIS. The report noted, however, that "(T)his matter obviously deserves to be reviewed periodically in light of evolving developments in the international monetary and financial system." Since the 1984 report, a number of circumstances in the inter- national monetary and financial system, in international political developments, and in the evolution of the BIS have changed. As a result, technical and policy reservations about the Federal Re- serve's joining the BIS Board have substantially diminished in re- cent years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 The BIS itself has undergone significant changes over the past 10 years. It has become involved in a wider range of central bank- ing activities, providing the Federal Reserve with an increasingly valuable means of collecting information, sharing insights, develop- ing analysis, and potentially influencing the policies of other central banks. For a number of years the BIS has been working cooperatively with, rather than as a competitor of, the International Monetary Fund (IMF). For example, it has mobilized supplementary re- sources for the IMF, and it is working closely with the IMF in co- ordinating the technical assistance that is being provided to the central banks of Eastern European countries and of the countries of the former Soviet Union. With regard to the reservation that the BIS had a European ori- entation, in recent years the BIS has broadened its reach beyond Europe and has included representatives of central banks from Latin America and East Asia in some of its meetings. Also, to re- flect its more global character, the BIS Board of Directors in July 1994 elected the governors of the central banks of Canada and Japan to join the Board, which for many years had been con- stituted only by representatives of West European central banks. The end of the Cold War removed another reservation that the Federal Reserve had about being on the BIS Board and becoming involved in the BIS's financial operations for central banks, name- ly, that the BIS performed banking and agent functions for some countries that at that time were part of the East Bloc. In the Cold War environment, the United States at times expressed dis- approval of such financial relationships with these countries. With the end of the Cold War, this factor is no longer relevant in consid- ering whether the Federal Reserve should exercise its right to be represented on the BIS Board. In fact, Federal Reserve representa- tion could help to facilitate the integration of East European coun- tries (and over time the countries of the former Soviet Union) into the global economy. For example, the BIS organizes semiannual meetings of coordinators of central bank technical assistance to Eastern Europe and to the former Soviet Union and serves as a clearinghouse for information on technical assistance related to central banking being provided to these countries. In earlier considerations of whether the Federal Reserve should assume its seat on the BIS Board a number of technical and legal issues were raised, including the issue of the appropriate U.S. rep- resentation on the Board, which might have required amending the BIS statutes, something that some members of the BIS Board did not favor. The BIS Board has now welcomed Federal Reserve par- ticipation, and thus it has been easier to deal with these technical issues (including amending the BIS statutes) in order to facilitate Federal Reserve membership. Given these developments, the Federal Reserve Board has con- cluded that its previous reservations about joining the BIS's Board of Directors are no longer as powerful, and that the positive bene- fits of being represented on the BIS Board in helping to achieve the Federal Reserve's objectives have been enhanced. The United States is an active member in other international and regional fi- nancial organizations, and its non-membership status on the BIS Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 Board of Directors was becoming an increasingly questionable anomaly.1 The Federal Reserve's anomalous position was further underscored by the fact that the Federal Reserve is a member of the Group of Ten (G-10),2 and with Canada and Japan joining the BIS Board of Directors the United States would have been the only G-10 country not represented on the BIS Board. Thus, the Federal Reserve Board concluded that the time had ar- rived for the Federal Reserve to become an insider rather than an outsider at the BIS. By being represented on the BIS Board, the Federal Reserve will be able to play an active role in shaping the future of the BIS and to further international monetary coopera- tion. Q.2. The Federal Reserve System operates as an independent agen- cy of the United States Government. Are there precedents for the United States Government to be represented on an international policymaking body exclusively by an independent agency? If so, what were the arrangements for consultation with, or direction from, either the Administration or Congress? What is the legal au- thority pursuant to which the Federal Reserve can take Board seats at the BIS? A.2. The BIS is not a policymaking institution except with respect to its own affairs. The principal focus of the Board of Directors of the BIS is on the formulation of broad operating principles of the management of the institution. The BIS is an organization of central banks that was established in 1930 with the express pur- pose of promoting cooperation among central banks and providing additional facilities for financial operations. Accordingly, the in- volvement of other independent agencies in international policy- making bodies does not provide useful precedent here. As to the legal authority of the Federal Reserve to assume its seat on the BIS Board, although there is no express provision in the Federal Reserve Act authorizing the Federal Reserve Board or the Chairman to participate on the BIS Board, there is implicit au- thority under the Federal Reserve Act to take up the U.S. ex officio director seat. This implicit authority derives from the conclusion that partici- pation on the BIS Board is a highly efficient means of accomplish- ing the Federal Reserve Board's statutory duties. The effective dis- charge by the Federal Reserve Board of its statutory duties—to conduct monetary policy and foreign exchange operations, super- vise banking organizations, monitor and control systemic risk, and exercise special supervision over all relationships and transactions of Federal Reserve Banks with foreign banks and bankers—re- quires the Board to consult extensively with its foreign counter- parts and have access to a broad range of information on inter- national monetary, financial, and market developments. The Fed- JThe United States is a founding member of the International Monetary Fund (IMP"), the International Bank for Reconstruction and Development, the Organization for Economic Co- operation and Development (OECD), the Inter-American Development Bank, the Asian Develop- ment Bank, the African Development Bank, and the European Bank for Reconstruction and De- velopment. The Federal Reserve is a collaborating (associate) member of the Center for Latin American Studies (CEMLA), the Chairman of the Federal Reserve Board is Alternate Governor of the IMF, and Federal Reserve officials participate actively in meetings of the OECD. 2The G-10 consists of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, United Kingdom, and the United States. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 eral Reserve Board's association with the BIS is a major and effi- cient means by which the Federal Reserve Board satisfies these international consultative and information gathering needs, and the Federal Reserve Board's participation on the BIS Board should further international monetary cooperation, help promote inter- national financial stability, and provide the Federal Reserve Board with opportunities to maintain and broaden its sources of informa- tion and insights, as well as its contacts and relations with central banks worldwide. The legal advisor at the State Department agreed with the Fed- eral Reserve view that there are no legal impediments to the Fed- eral Reserve taking its U.S. seat on the BIS Board. Q.3. Private interests control six of the nine votes of the boards that select regional bank presidents. Is there precedent for the United States Government to be represented on an international policymaking body by a person selected from a board the majority of which is selected by private interests? If so, what were the ar- rangements for consultation with, or direction from, either the Ad- ministration or Congress? A.3. As noted in the above response to question 2, the BIS is a pol- icymaking body in only a very limited sense. Nonetheless, in the course of consultations with the Administration and Congress, I in- dicated that I expected to be authorized to appoint the president of the Federal Reserve Bank of New York to the seat of the ap- pointed U.S. director. The Members of Congress that were con- sulted raised no objection to this intended appointment. The Treas- ury and State Departments also were informed of this intention and raised no objection. Directors on the BIS Board are not permitted, according to the BIS statutes, to be officials or members of governments other than central bankers. The appointed director is supposed to represent "finance, industry, or commerce." Accordingly, the Federal Reserve Board has chosen to appoint the president of the Federal Reserve Bank of New York to this seat instead of appointing a U.S. individ- ual who is wholly in the private sector or, alternatively, not filling the second U.S. seat on the BIS Board. The decision to appoint President McDonough is particularly appropriate in light of the Federal Reserve Bank of New York's role in the Federal Reserve System. Q.4. When did the Federal Reserve begin discussions with the BIS about revising the BIS rules to permit the Federal Reserve to take two seats on its Board? What was the chronology of those discus- sions? At what point in those discussions did you first raise the question of taking the BIS seats with the Administration? To what extent have you consulted with Congress about taking the two seats? A.4. The question of whether or not the Federal Reserve should ex- ercise its right to take up the ex officio seat for the central bank of the United States on the BIS's Board of Directors has a long his- tory dating back to the establishment of the BIS in 1930. (This right also entitles the ex officio director to appoint a second U.S. director.) In the course of that history, the Federal Reserve has had Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 numerous contacts with the BIS, various Administrations, and Congress. By the 1970's, the Federal Reserve Board had reached an infor- mal consensus that the BIS had become a sufficiently important international monetary institution for the Federal Reserve to seek to be a full participant in its deliberations and that representation on the BIS Board of Directors would enable the Federal Reserve to contribute to the evolution and policies of that organization. During 1976-78, Federal Reserve officials initiated discussions with BIS officials regarding the possibility of the Federal Reserve joining the BIS Board of Directors. At that time, Chairman Arthur F. Burns initiated consultations on the BIS membership issue with the Administration and with key congressional leaders. However, with the departure of Arthur Burns as Chairman of the Federal Reserve Board, interest in being represented on the BIS Board of Directors waned, and no action was taken. Discussions with the BIS regarding the Federal Reserve being represented on the BIS's Board of Directors resumed informally in September 1993 and more seriously in January 1994 when the BIS management, contemplating a possible geographic broadening of representation on its Board of Directors, raised the issue with the Federal Reserve, including the probable need to revise the BIS statutes to clarify the status of the Chairman of the Board of Gov- ernors of the Federal Reserve System to represent the central bank of the United States on the BIS Board. After examining the BIS membership issue in some detail, the Federal Reserve Board reached a tentative consensus to pursue this matter further. I per- sonally raised this subject with Secretary Bentsen in March and with Secretary Christopher in early May. (In the case of the Treas- ury Department, staff-level contacts followed my initial conversa- tion with the Secretary. In the case of the State Department, staff- level contacts preceded my meeting with the Secretary.) Both Sec- retaries subsequently wrote to express their support for the Fed- eral Reserve Board to avail itself of its right to be represented on the Board of Directors of the BIS. (Copies of these letters are at- tached.) Following further Federal Reserve Board discussion of the BIS membership issue and endorsement by the Board to pursue this matter, in early June, I contacted key Members of Congress (in- cluding the Chairmen and Ranking Minority Members of the Sen- ate Committee on Banking, Housing, and Urban Affairs and the Senate Committee on Foreign Relations, as well as the Chairmen and Ranking Minority Members of the House Committee on Bank- ing, Finance, and Uroan Affairs and the House Committee on For- eign Affairs, and the Chairman of the Subcommittee on Economic Growth and Credit Formation of the House Committee on Banking, Finance, and Urban Affairs) to inform them of the Federal Reserve Board's reconsideration of its relationship with the BIS and to seek their views. I sent letters to these individuals, which included a background note on the Federal Reserve's relationship with the BIS, requesting appointments to discuss this matter personally, and I met with most of the individuals. These consultations proved valuable; it enabled me to explain the considerations leading to the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Federal Reserve Board's decision to be represented on the BIS Board and to respond to questions. The almost universal response by the Members of Congress with whom I met was favorable and supportive of the Federal Reserve Board's decision. Q.5. In your consultations with the Administration and Congress, did you discuss whether an independent agency should represent the U.S. Government on a policymaking body? If so, what views were expressed on that question? A.5. Discussion of this issue was raised implicitly with the Admin- istration as evidenced by the Federal Reserve Board's agreement to inform and consult with the Departments of State and Treasury in the future, as appropriate, about matters before the BIS Board. This also was the case, generally, with consultations with Con- gress. However, Congressman Kanjorski specifically asked about the Federal Reserve's independence and the executive branch's dis- charge of its constitutional responsibilities. In response to his con- cerns, I expressed the view that the consultations that the Federal Reserve Board has agreed to with the Departments of State and Treasury should more than adequately protect the executive branch in the discharge of its constitutional responsibilities without undermining the independence of the Federal Reserve. Q.6. In your consultations with the Administration and Congress, did you discuss whether a person selected by private interests such as the president of the Federal Reserve Bank of New York should represent the U.S. Government on a policymaking body? If so, what views were expressed on that question? A.6. As noted in the above response to question 3, the Federal Re- serve Board informed both Members of the Administration and Congress as to the Board's intent to appoint President McDonough to the appointed U.S. director seat on the BIS Board, and no objec- tions were raised. Because the BIS is a policymaking body in only a very limited sense, there was no general discussion of the propri- ety of having a Reserve Bank president represent the U.S. Govern- ment on a policymaking body. Q.7. In letters to Members of Congress, the Federal Reserve has justified taking the BIS Board seats, in part, on the grounds that it could take "a leadership role" in the area of financial supervision and regulation with several other agencies. In the United States, the Federal Reserve shares responsibility for financial supervision and regulation with other agencies. What arrangements have you made with these other agencies for making decisions on policy posi- tions, on programmatic initiatives, and on the votes to be cast on such matters by the two U.S. seats on the BIS Board? A.7. As noted above, the BIS is not a policymaking institution ex- cept with respect to its own affairs and in the formulation of broad operating principles for the management of the institution, includ- ing the staffing and support that the BIS provides to the subsidiary committees of the G-10 central bank governors that meet under the auspices of the BIS. These subsidiary committees do not make policy decisions; they are advisory or consultative bodies. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 The more direct and active leadership role at the BIS that the Federal Reserve will be able to play through representation on the BIS's Board should be viewed from this perspective. Such a leader- ship role encompasses the attention and support that the BIS gives not only in supporting the work of the Basle Committee on Bank- ing Supervision (on which officials from the Comptroller of the Cur- rency and the Federal Deposit Insurance Corporation (FDIC) are represented along with the Federal Reserve) but also to exploring a wide range of issues involving the functioning of international fi- nancial markets, monetary policy, and payment systems. The par- ticipation by officials from the Comptroller of the Currency and from the FDIC, along with those from the Federal Reserve, in the Basle Committee on Banking Supervision, allows the three U.S. bank supervision and regulation agencies to formulate a common U.S. position with regard to programmatic initiatives that arise in the context of this Committee's activities. It should also be noted in this context that the BIS statutes do not allow representation on the BIS Board of government entities other than central banks, and that central banks with considerably less involvement in finan- cial supervision and regulation than the Federal Reserve are rep- resented on the BIS Board of Directors. Q.8. What undertaking or commitment has the Federal Reserve made to the Administration and Congress to keep them fully in- formed of developments at the BIS? What arrangements have been made for consultations with or direction from the Administration or Congress? A.8. In my consultations with Secretaries Bentsen and Christopher regarding the BIS membership issue, I assured them that the Fed- eral Reserve would keep their Departments informed of develop- ments in the BIS that are relevant to executive branch policies. It is understood that Federal Reserve officials will consult these De- partments, where appropriate, on matters of significance, particu- larly on international monetary issues and on matters that are of foreign policy concern to the United States. (See attached letters from Secretaries Bentsen and Christopher.) Attachments Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 DEPARTMENT OF THE TREASURY WASHINGTON. D.C. May 25, 1994 The Honorable Alan Greenspan Chairman, Board of Governors Federal Reserve System 20th St. and Constitution Ave., H.W. Washington, D-C. 20551 Dear Alan: Some time ago you indicated to ate that the Board of Governors of the Federal Reserve System would like the Chairman ot the Board to take up the SX_a££i£ifi seat of the United States on the BIS Board of Directors. You also indicated that the President of the Federal Reserve Bank of New York would be appointed to assume the second U.S. seat on the BIS Board. You asked for Treasury's support for this initiative. As I said in our telephone conversation on April 21, Treasury supports the Federal Reserve's taking up the seat. Treasury's position is premised on the understanding that the Federal Reserve will keep Treasury informed of all BIS Board decisions relevant to Executive Branch policies, particularly on international monetary issues, and in this respect will consult with Treasury in advance on significant matters. Moreover, it is our understanding that, because of- past Congressional interest, the Federal Reserve Board will consult appropriately with Congress on this initiative. I would appreciate being Xept Informed of your progress concerning this matter. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 THE SECRETARY OF STATE WASHINGTON June 15, 1994 Dear Alan: During our meeting on May LQ we discussed the desire of the Board of Governors of the Federal Reserve System to nave the Chairman of the Board taJce up the ax ofTic^P seat of the United States on the Board of Directors of the Bank for International Settlements (BIS). You indicated your intention to appoint the President of the Federal Reserve Bank of New York to the second U.S. seat on the BIS Board, an arrangement to which the Prssident of the. Federal Reserve Bank of New York has concurred. You asked for Department of State support for this step. Our legal advisers tiave since agreed that there are no legal impediments to the Federal Reserve taking the U.S. seat on the BIS Board- We fully expect that active participation of the Federal Reserve on the BIS Board will serve U.S. foreign policy interests by adding this avenue of influence in international financial affairs. On that basis, Federal Reserve membership on the BIS Board oas the full support of the Department of State. Given that matters coming up in BIS Board meetings may be relevant to foreign policy concerns, your assurance that we shall be kept informed and consulted as appropriate is important to our support for this initiative. Your intention ^p consult with Congress before taking this step is also welcome. Hith beat regards. Sincerely, Warren Christooher The Honorable Alan Greenspan, Chairman r Board of Governors, Federal Reserve System, Washington, D.C. 20551 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 For use at 10:00 a.m., E.D.T. Wednesday July 20, 1994 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 July 20, 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, O.C., July 20. 1994 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board o( Governors is pleased lo submit Hs Monetary Policy Report to the Congress, pursuant to the Full Employment and Balanced Growth Act o( 1973. Sincerely, Alan Greenspan, Chairman Table of Contents Pane Section 1: Monetary Policy iind the Economic Outlook for 1994 and 1995 Section 2: The Performance of the Economy in 1994 Section 3: Monetary and Financial Developments in 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 Section 1: Monetary Policy and the Economic Outlook for 1994 and 1995 The favorable performance of the U.S. economy and the resulting higher rates of resource utilization. continued in Ihc first half of 1994. Economic activ- Looking ahead, retail energy prices likely will rise ity advanced at a brisk pace, building on the substan- over the summer, pushed up by the rebound in crude tial gains in lale 1993. and broad measures of infla- oil prices in receni months; in addition, the decline in tion moved still lower. Unemployment declined, and the dollar since the beginning of the year, if not indusfriaJ capacity utilization rose, substantially reduc- reversed, probably will exert some upward pressure ing ihe remaining slack in resource use. on prices. In this context, monetary policy has been directed The Federal Reserve's policy actions this year have ihis year at heading off a buildup of inflationary raised the federal funds rate to around 4'/4 percent, pressures that could jeopardize the continuation of the from 3 percent, and have boosted the discount rate to economic expansion. To do so. the Federal Reserve 3'/: percent, also from 3 percent. Other market inter- has had to move away from us highly accommodative est rates have risen 1 V-> to 1 Vt percentage points since poJicy stance of receni years. Thai stance had been the beginning of the year. Increases in intermediate- adopted 10 counteract unusual restraint on domestic and long-term rates have been unusually large relative spending associated in large pan with the efforts of to the adjustment of shon-term rates, reflecting both borrowers and lenders to strengthen their finan- stronger-than-amicipated economic growth and mar- cial condition. Data available in late 1993 and early ket expectations of greater inflationary pressures, as 1994 suggested that the restraint on spending had well as actual and expected tightening actions by ihe dissipated and thai the economic expansion had Federal Reserve to contain those pressures. On occa- become strong and self-sustaining. Against this back- sion, the declining value of the dollar also appeared to ground, the Federal Reserve has finned money market contribute to higher yields. Markets have been vola- conditions in four steps this year. tile at times this year as investors have adjusted to a changing economic and policy outlook. The uncertain Despite disruptions caused by severe winter storms, conditions encouraged investors to try to reduce their real gross domestic product (GDP) rose at an annual risk exposure, and the associated attempts to make rate of 31/: percent in the first quarter, and available large shifts in portfolios over short penods seemed to indicators point to another sizable gain in the second add to the upward pressure on long-term rates at quarter. Business fixed investment has continued to times. grow rapidly this year, as firms have sought to Despite the rise in U.S. interest rates, the dollar has improve efficiency by installing state-of-the-an equip- declined considerably this year, with its trade- ment; rising utilization rates have spurred interest in weighted foreign exchange value against the Group of expansion of capacity as well. Consumer outlays have Ten (G-10) countries falling about 8 percent. Rising trended higher this year, buoyed by the considerable long-term interest rates abroad, associated with gains in income and an increased willingness to bor- brighter prospects for economic growth, tended to row or use savings; lately, though, spending growth offset ihe effect on the dollar of higher U.S. rates. appears to have moderated somewhat. The rise in Moreover, other factors, including diminished hopes long-term interest rates that began last fall has for a prompt resolution of trade tensions with Japan damped the growth of housing activity this year, but and market concerns about future inflation in the the effect has been relatively mild, in pan because United States, fostered downward pressure on the homes remain quite affordable by the standards of the dollar. This pressure was especially intense in laie past two decades. In the labor market, ihe employ- April and early May and again in the second half of ment gains dunne the first half of this year were June and first half of July. The U.S. Treasury and the substantially more rapid than in 1993, and (he unem- Federal Reserve made subttamiaj dollar purchases on ployment rate has continued to move lower. three occasions dunng these penods to deal *ith Inflation generally was moderate during the first volatile trading condition-, and movements in the dol- half of 1994. Retail food and energy prices changed lar judged to be inconsistent wuh economic funda- little, on balance, over this period, holding the rise in mentals Other governments shared the concern of the consumer priL-e inde* (CP!) to 2V: percent at an U.S ofticiulh. jnd [he more receni operations uere annual rate. At the same time, prices for a wide range coordinated with the monetary authorities of a large of materials used in manufacturing and construction number of other countries, including the other mem- have been boosted considerably by strong demand ber-, of the Group of Seven iG-7). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 The strength of spending and a renewed willing- siock mutual funds were not a major factor in the rise ness to use and extend credit contributed tc a pickup in M2 velocity this year. Falling securities prices in borrowing by households and businesses in the created capital losses for bond and equity mutual second half of last year, and this trend extended into funds, prompting some fund holders to reevaluace the the first half of 1994. However, the composition of risks and prospective returns of such investments. borrowing has been affected by financial market con- Bond mutual funds experienced outflows this spring, ditions. Rising and more volatile long-term interest and a portion of the proceeds was directed lo less- rates have encouraged businesses to rely more heavily risky money market mutual, funds, thus elevating M2 on sources of snoner-ierm financing, such as finance for a time. Even with more subdued moves in securi- companies and bunks, and have prompted households ties prices since the late spring, many small investors to shift 10 adjustable rate mortgages. Banks, which have retained a mote cauiious view of the possible had been hampered by balance-sheet problems of risks and rewards of holding capital market instru- their own in tecem years, sought business and house- ments, and total inflows to bond and stock mutual hold loans more aggressively by continuing to ease funds have remained considerably weaker than in the credit standards and ihe nonpnce lerms of lending. past few yeais. The effect of these slower flows on Total commercial bank credit has increased consid- M2 has been offset by shifts into direct holdings of erably this year, and thrift institution credit, which market instruments, such as Treasury bills. As aeon- contracted sharply between 1989 and 1993, appears (o sequence, the sum of M2 and household holdings of have expanded a bit. In contrast to the strength of bond and stock mutual funds has decelerated sharply private borrowing, [he growth of federal government ihis year. debt has slowed this year, reflecting ihe subdued growth of expenditures and sharply higher tax re- Money and Debt Ranges ceipts associated with fiscal policy actions and ihe for 1994 and 1995 robust economy. As a result, the total debs of the domestic nonlinancial seciors expanded at about a At its July 1994 meeting, the Federal Open Mar- 5'A percent annual rate from the fourth quarter of ket Committee (FOMC) reviewed the annual ranges 1993 through May, close to us pace over ihe second for money growth for 1994 that it had established in half of lasi year and well within as monitoring range February. In light of the experience of the first half of of 4 to 8 percent. the year and the likelihood thai funds would con- tinue to be diverted from deposits to higher yielding Growth of ihe broad money aggregates has not kept market instruments, the Committee expected a sub- pace with that of nominal GDP again this year. M2 stantial increase in the level of M2 velocity over increased at about a IV* percent annual rate from the 1994. M3 velocity a!so was seen as likely to rise quite fourth quarter of last year through June, while M3 fell sharply, given the funding patterns of depository in- slightly, placing these aggregates around the lower stitutions, which had been favoring sources of funds bounds of (heir respective annual growth ranges. In not included in M3, such as capital and borrowing the uaual pattern, increases in rates on retail deposits from overseas offices. As a consequence, the Com- and on money market muiual funds have lagged the mitiee continued to expect [hat money growth within, me in market inieresi rates, inducing a redirection of though perhaps toward ihe lower end. of the ranges of savings from M2 into market instruments and boost- 1 to 5 percent for M2 and 0 to 4 percent for M3 ins Mi '•elocily. With returns on interest-paying would be consistent with its broader objective of fos- checking icconnts virtually unchanged, compensating tering financial conditions that would sustain eco- balance requirement for demand deposits reduced by nomic expansion and contain price pressures. It there- n.tina rates, and transactions balances also depressed fore voted to retain these ranges for 1994. With little by -several special influences. M I growth this year has information to suggest any new trends in velocity for >lov.ej to less than hilt" its rale of advance in 1993; 1995. the Committee chose simply to carry forward ihroueh June, this aygreyjie had expanded at about a the 1994 ranges for M2 and M3 as provisional ranges 4 percent jnnual rate since the fourth quarter of last for ihose aggregates in 1995. The Committee noted year. Ov-my to ihe anemic expansion of transaction;, that these ranges, especially that for M2. provided an de.pi)Mt.s. local re?er\ea fell sliahih o\er the tirst h;i!f indication of the loneer-run growth that might be of the year. Only continued strong demand for cur- expected in this aggregate with the attainment of rency, much of which reflected use abroad, hj.s jup- reasonable price stability and a return to the past ported grow th in M 1 and the monetary base. pattern of velocity fluctuating around a constani long-run level. Considerable uncertainty about the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 Ranges for Growth of Monetary and Credit Aggregates' Percent Aggregate 1993 1994 Provisional for 1995 M2 i to 5 1 to 5 1 to 5 M3 0 104 010 4 0 10 4 Debt2 4 to 8 4 to 8 3 to 7 1. Change from average tor fourth quarter oi preceding 2. Monitonng .'ange for QeOt of domestic nonfinaneial year to average tor lourm quarter at year indicated. sectors. behavior of velocity is iikeiy to persist, however, and quite close to those made in February. Most continue the FOMC will continue to moniior a broad range of to expect thai real GDP will rise 3 to 3'A percent over financial and economic indicators in addition to the the four quarters of this year. For 1995. the central monetary aggregates, when determining the appropri- tendency of the forecasts is a range of 21/: to 2Vt per- ate stance of policy. cent. The unemployment rate anticipated in the fourth quarter of 1994 has been revised down about '/: per- The Committee also decided !0 retain its current, centage point from that projected in February.1 The monitoring range of 4 10 8 percent for growth in the forecasts of the unemployment raie in the fourth debt aggregate during I994. With debt expanding at quarter of 1994 are now bunched between 6 and a rate close to that of nominal income, [he FOMC's 6'A percent: this range is also the central tendency of expectation for the growth in nominal GDP for the the projections for the fourth quarter of 1995. year suggested that the debt aggregate would finish the year comfortably within this range. In 1995. how- These forecasts envision the next several quarters ever, the Committee expected that macroeconomic as a period of transition to a more moderate expansion performance consistent with sustainable expansion accompanied by reasonably full use of available would involve some slowing in the growth of nominal resources. This transition already is evident in the spending and moderate growth in debt; indeed, rapid housing market and, perhaps, in consumer outlays as credit growth might suggest the possibility of a well. The resulting deceleration in private domestic borrow-and-spend psychology typical of strengthen- spending is, expected to be offset., in pan. by a smaller, ing inflation. Consequently, the Committee voted to decline in net exports than that registered over the set provisionally the 1995 monitoring range for debt past several quarters; this projection for the external growth at 3 to 7 percent, a reduction of 1 percentage sector largely reflects the expectation of stronger eco- poini. nomic expansion abroad. The Board members and Reserve Bank presidents Economic Projections for 1994 and 1995 generally expect the nse m the consumer pnce index over the four quarters of 1994 to end up in the range The members of the Board of Governors and the of 23A to 3 percent. So far this year, retail energy Reserve Bank presidents, all of whom participate in prices have been flat on balance and retail food prices the deliberations of the Federal Open Market Com- have moved up only a little, restraining the rise in the mittee, generally anticipate that the growth of real total CPI. However, given the runup in crude oil GDP will moderate during the second half of this year prices of late and the unlikely prospect ol" another and into 1995 from [he unsustainable pace jn recent large drop in the prices of fruits and vegetables, the quarters. Employment sains through the end ol" 1995 are expected roughly to balance the net flow or" indi- viduals into the labor force, leaving the unemploy- ment rate about unchanged from its a\era»e level in the second quarter of this year. Inflation is expected to (o the > pick up a little over the next year and one-halt". v. iht rev [o have boosied Ihc unemployment rate Irom Jjn The forecasts of the Board members and Reserve by roujfily '.': ptrccnuec poirl. Subsequent jna thai the upwjrtl -.hifl caused by [he nev. Mjr Bank presidents for economic growth in 1994 .ire cruller lhan omsirtallv ih»uEhl Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 Economic Projections for 1994 and 1995 FOMC Members and Other FRB Presidents Administration Central Range Tendency 1994 Percentage change, fourth quarter to fourth quarter Nominal GDP 5% to 6V*> 5'/z to 6 5.8 Real GDP 3 to 3'A 3 to 3V* 3.0 Consumer price index 2Va to 3'/a 2% to 3 2.9 Average level in the fourth quarter, percent Civilian unemployment rate 6 to 6V4 6 to 6V* 1995 Percentage change, fourth Quarter jo fourth quarter Nominal GDP 4V* to 6:/4 5 to 5Va 5.6 Real GDP 2'A to 2V, 2Vs to 2% 2-7 Consumer price index 2 to 4'A 23/4 lo 3Vz 3.2 Average level in the fourth quarter, percent Civilian unemployment rate to 6Va 6 to 6Y* 6.2 rate of infiatiort projected for the next year and one- Reserve can do us part to prolong and enhance this half is slightly higher rhan ihai posted recently. The favorable performance of the economy by continuing decline in ihe dollar to dare, if no( reversed, also could to set monetary policy m accord with the long-run exert some mild upward pressure on inflation. objective of pnce stability. An environment of stable pnces is a necessary condition foe attaining the maxi- The Administration recently released its mid->ear mum sustainable growth of productivity and living update 01' economic and budgetary projections. The standards. However, the outcome for the economy projections for nominal and real GDP growth, infla- also uill depend on government policy in other areas. tion, and unemployment for 1994 and 1995 fall within In this regard. Congress and the Administration can ihe ranges anticipated by Federal Reserve officials help ensure that the nation's economy reaches us full and are essentially consistent with the central ten- potential by working to keep the federal budaet deficit dency of those ranges. Thus, it would appear thai the on a downward course, by promoting an open world monetary ranges set by the FOMC are compatible trading system, and by adopting regulatory policies with the goals of the Administration. that preserve the flexibility of labor, product, and Both Federal Reserve policymakers and ;he financial markets and minimize the costs imposed on Administration anticipate lunher economic expansion the private sector. accompanied by relatively low inflation. The Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 Section 2: The Performance of the Economy in 1994 The economy entered 1994 with a considerable down retail energy prices. However, oil prices have amount of forward momentum. Severe winter since moved up considerably, which likely will boost weather disrupted activity, but real GDP still posted a retail energy prices over the summer. Prices also have solid gain in the first quarter, amounting to 3'A per- risen substantially for many industrial materials, but cent at an annual rate. As had been the case during these increases have not had a noticeable effect on the 1993, domestic private-sec tor spending was robust in prices of finished goods. the first quarter, with consumer purchases of motor vehicles and investment in business equipment both increasing at double-digit annual rates. At the same The Household Sector time, the ongoing cutbacks in defense spending Household balance sheets strengthened over 1992 depressed total purchases by the federal govern- and 1993. and the setback in stock and bond mar- ment, and ihe sluggish economic performance of kets this year has not made a major dent in the sec- some major foreign industrial countries held down the tor's financial position. In addition, real income has growth of U.S. exports. continued to trend up at a healthy pace. Averaging through the monthly ups and downs, consumer spend- ing appears to have posted a sizable advance over the Real GOP first half of 1994, wish most of the gain coming in the Percent change, annual <ate first quarter. Higher mortgage rates have cooled the growth in housing demand, but the level of activity remains strong. In the first quarter of 1994, real consumer spending rose at an annual rate of about SVt percent, building on the large increases registered during the second half of 1993. Real outlays for motor vehicles were particularly strong in the first quarter. Spending on other durable goods—which had advanced robustly TT during most of 1993—rose only slightly in the first quarter, while outlays for nondurable goods and ser- vices remained on a solid uptrend. The severe weather that gripped much of the country this winter left us mark on the monthly pattern of outlays, but appears to have had little effect on the level of consumer spend- ing for the first quarter as a whole. Outlays for furni- ture and appliances, clothing, and food ail lumbled in The data in hand for the second quarter suggest that January, but then rebounded smanly over the remain- real GDP increased substantially further. In the labor der of the first quarter. This pattern was reversed for market, gains in payroll employment and longer energy consumption, which soared in January and workweeks appreciably boosted total hours ".orked. then turned down. and [he civilian unemployment rate fell further. The The gro*[h of real consumer spending appears lo indicators of spending, while less robust on balance have slowed in the second quarter, with much ol the than those from the labor market, still point to a deceleration reflecting declines in two areas. First. sizable increase in economic activity. consumer outlays for motor vehicles softened in April Inflation (rends remained favorable over the first and May. and the level of spending probably did not half of this year, with the consumer price index iCPI) move up much, if at all, in June However, because rising at an annual rate of only 2V: percent over this vehicle sales in the second quarter were held down by period. Inflation has been damped by the healihy shortaaes of popular models, underlying consumer uptrend in productivity—which has offset much of demand has remained firmer ihan the receni spending the increase in compensation rates—and by the mini- data would suggest. Second, household use of elec- mal nse in non-oil import pricey In addition, the mcity and gas for ihe second quaner as a whole likely decline in crude oil prices through this spnng held will turn out to have been below (he weather-boosted Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Income and Consumption are assets that provide a flow of services for years to P*e«n cMngt, come. Household balance sheets have remained relatively [] Real Disposable Personal Income strong despite the lower prices in financial markets this year. The total value of household assets—which QReai Personal Consumption Expenditures includes housing and consumer durables as well as financial assets—rose moderately on balance over the year ended in the first quarter of 1994. Moreover, survey data indicate that households, in the aggregate, continue to view their current and expected financial n,m positions in a favorable light. This greater sense of financial security, and the attendant willingness to take on debt, helps explain the rapid growth of con- sumer credit sinctf the middle of last year. Other measures of household financial conditions also 1990 1992 1994 remain positive. Debt-service burdens, measured as ' Porcsni cnangt. I993:Q4 lo May 1994. it an annual rat*. a percent of disposable income, held about steady in the first quarter at a level well below the peak reached several years ago. Delinquency rates on con- sumer loans and home mortgages were little changed level of the first quarter. Apart from these iwo cate- in the first quarter, with most measures of delinquen- gories, real consumer outlays evidently posted a mod- cies holding near their lowest levels in a decade or erate increase in the second quarter. more. On a pre-tax basis, real income growth has been The market for single-family housing has softened brisk over the past year, buoyed by a considerable in recent months. Starts of single-family homes, gain in wages and salaries, a sharp increase in the net which strengthened over the course of 1993, plum- income of nonfarm proprietorships, and an upturn in meted in January and remained low in February. interest income. However, the higher personal income Much of this sharp decline can be attributed to ad- taxes imposed on upper-bracket taxpayers by the 1993 verse weather. With the return to more normal Budget Act have cut into the growth of disposable weather in the spring, starts did recover, but the income. All told, the average level of real disposable rebound was relatively weak, leaving the May level income in April and May was about 31/: percent below that in the fourth quarter of last year. Sales above the level during the same period in 1993. This of both new and existing homes in May also were rise in real income was slightly smaller than the down from their respective fourth-quarter levels. In advance in real consumer spending over the same time span. Private Housing Starts According to preliminary estimates (that are sub- ject to potentially large revisions), the personal saving Annual rale, millions ol units rate averaged a bit less than 4 percent during the first Quarterly average five months of this year—quite a low rate by histori- cal standards. The level was so low partly because of 1.5 a one-time charge against income to account for the wealth lost in the Los Angeles earthquake. In addi- tion, the higher taxes due on returns tiled this spring probably pushed down the amount of personal saving. Still, a good pan of the decline m the saving rate from the 5 percent level prevailing two years ago reflects a burst of spending on motor vehicles and other durable Single-family goods. Such a decline in the saving rate often accom- panies cyclical surges in outlays for consumer dura- bles, which are counted as consumption in the national accounts; in reality, much of ihe initial expen- 1988 1990 diture on durables is a form of saving, as these goods ' April-May avenge. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 addition, consumer attitudes toward homebuying have industrial Production deteriorated somewhat since late winter. lndtx1M7* 100 Nonetheless, the level of sales and building activity in the single-family market has remained fairly high. Even with the rise in mortgage rates, new homes 115 continue to be quite affordable by the standards of recent decades. A simple measure of aflbrdability is the monthly payment on a fixed-rate mortgage for a 110 new home with a given set of attributes, divided by average household income. By this measure, the cost burden of homeownership in the second quarter of this year was lower than at any time from mid-1973 10 105 early 1992. Moreover, in response to the rise in long- term rates, an increasing share of households have financed home purchases [his year with adjustable- 100 rate mortgages; the lower initial rates on ARMs allow 1990 1994 some households 10 obtain financing when they would be unable to qualify for a fixed-rale loan. As another support for housing demand, the strong labor market first quarter, about the same rate of advance recorded in recent quarters has lessened the perceived likeli- in 1993. Focusing on me industrial sector—for which hood of job loss, encouraging many households io output data are available on a more timely basis— assume the financial commitment of homeownership. production advanced at an annual rate of 5 percent over the first half of 1994, vmb the strongest gains Starts of multifamily housing units this year have registered early in the year. This pattern largely picked up from the extraordinarily low levels regis- reflects developments in the motor vehicle industry, tered from 1991 through 1993. This rise likely reflects where production rose sharply from last August to an improving balance between demand and supply in February of this year in response to strengthening some local markets. Lenders have shown a greater demand and dwindling inventories. Since February, willingness to fund multifamily projects, owing not assembly rates have moved lower on a seasonally only to the firming real estate market, but also to their adjusted basis, as capacity constraints have hindered own improved financial conditions; equity investors— the automakers from achieving their normal seasonal including real estate investment trusts—also have gains- Excluding motor vehicles and pans, industrial been participating more actively in this market. How- production continued to advance strongly in the sec- ever, for the nation as a whole, vacancy rates for ond quarter. multifamily rental units remain high, and rent increases have continued to be relatively small, sug- After rising sharply over 1993. ihe profits of U.S gesting that a major recovery in this sector is unlikely corporations from current operations fell back in the in the near term. first quarter of 1994. However, this decline in eco- nomic profits appears to have been due entirely to the effects of the Los Anseles earthquake and the severe The Business Sector weather last winter; these events greatly increased the volume of claims against insurance companies and Developments m the business sector remained also resulted in uninsured damage to plant and equip- favorable during the first half of 1994. Apart from ment. Abstracting from these losses, pre-tax eco- losses from the Los Angeles earthquake, earnings nomic profits in the first quarter rose slishilv from the have continued to be strong, and the repair of bal- ilready hi ah 1'oun.h-quaner kvel. Prolix of minhnan- ance sheets over the past few years has improved the cial corporations have been boosted by the strong access to credit for many businesses. Fixed invest- growth in sales and by continued tight control of ment has moved up further, supported bv wide- cost^. For financial corporations. domeMic profits spread effons to boost productmis iuraed over 1993 and remained high in thd first quar- Business output, excluding that in the tarn seaor. ter (after adjusting for the jump in insurance payouts I. continued to increase at a brisk pace in the first buoyed by (he relatively wide margin beiween their quarter. In real terms, the gross domestic product of cost of funds and the interest rales earned on their this sector rose at an annual rate of 4'/j percent in the assets Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 Before-tax Profit Share of sible for the skid in aciivity during January and Febru- Gross Domestic Product" ary. Construction spending ihen recovered during the spring, leaving the level in May about equal to lhai Nonlinancial Corporations registered in December of last year. The absence of growth, on net. over this period might suggest that the sector has lost some momentum, quite apart from the effects of weather. However, the monthly con- struction data are prone to large revisions, which limits the information conveyed by the initial esti- mates. Two leading indicators of private nonresiden- lial construction—permit issuance and contract awards—remained on a choppy uptrend through May. Real Business Fixed Investment Percenl change, annual rate 1988 1990 1992 1994 jj Structures •profits iron domestic operanons with inventory valuation ana JO caonal consumotion 3diustments divided Dy gross domestic [J Producers' Durable Equipment proaucl of nontinanoal cofporale sector i r - 15 Real outlays for business equipment continued to r rise rapidly in the lirst quarter, increasing about r~ i rfl Ir 17 percent at an annual rate. This was the eighth H U *— ' consecutive quarter with a double-digit advance. . Monthly daia through May on orders and shipments - 15 of business capital goods point to further sizable gains in real equipment purchases. i , , i The increase in equipment investment (his year has 1990 1992 1994 been quite broad, as firms have attempted to cut costs - Percent cnange. 1993:04 to I99t.0i. ai an annual raie and improve product quality through the use ot' more advanced technology. Real outlays for computers and Looking at the major components of nonresidential related devices climbed at an annual rate ot' 20 per- construction, some progress has been made in reduc- cent in the rirsi quarter, reachine a level more than ing the huee stock of unoccupied office space, and the double that of three years earlier. Businesses have plunge in pnces tor office properties appears to have invested heavily in computers to take advantage of abated. Nonetheless, the national vacancy rate re- the increasingly powerful equipment available at ever mains high by historical standards, and starts ot new lower prices. Outlays for industrial and other types of office buildings continue to be limited. In contrast, machinery, which turned up in [he middle of 1992, outlays for commercial structures other than offices continued to e\pand at a solid pace early thin >ear. moved up smartly last year. Financing for ihese Business spending for motor vehicles also rose sub- projects has become more readily available, and (he stantially in the rirsi quarter, led by .mother large proliferation of large-scale discount stores in subur- increase in purchases of trucks: these purchases likelv ban locations has been a major source of construction have been boJsiered by improvement in the vjfefy activity. In the industrial sidcior. utilization rates have and eltiaency of new models and by the increased risen considerably over the past year, but little sign demand lor shipping to support just-m-mne inventor, haj yet emerged 01 a significant rise in construction ot management. In contrast to this widespread strength ne^v plants. Public utilities, according to surveys taken in investment, domestic purchases of commercial jir- ihi.s spring, anticipate only a small nse in investment cratl dropped in the tirst quarter 10 a very low level, this year, in pan because ot the perceived difficulty in rejecting [he c.\ces.s capacity in the airline industry gaining approval for rate hikes and because ot new rules requiring utilities to purchase power generated b> other sources. Meanwhile, real investment in petroleum drilling structures- fell somewhat in the lirst Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 quarter to a level about unchanged from that of a year The Government Sector earlier. Federal purchases of goods and services—the part Nonfarm inventory investment picked up substan- of federal spending included in gross domestic pro- tially during the first five months of 1994 from the duct—fell at an annual rate of 5V» percent in real pace of late last year. Pan of the pickup reflected terms in the first quarter. Real federal purchases have efforts to replenish stocks at automotive dealers, been trending down since the first half of 1991. and which had been depleted during the third quarter of the level of outlays in the first quarter of this year 1993. In addition, the rate of inventory accumulation stood roughly 12 percent below the peak reached increased this year for producers of machinery, likely three years earlier. This decline has been driven in response to the robust orders for these goods. At by the ongoing reduction in military outlays. Real the wholesale level, stocks of machinery and other defense spending plunged at an annual rate of about durable goods increased considerably during the 15 percent in the first quarter, after declining more spring; the pace of siockbuilding in the retail sector than 9 percent over 1993. Real nondefense outlays spurred at about the same lime. jumped in the first quarter, more than reversing the drop in late 1993; however, given the appropriations Changes in Real Nonfarm Business Inventories for nondefense spending in the FY1994 budget, these Annual rate, billions ol 1987 dollars outlays are not likely to increase much further in the near term. Real Federal Purchases 20 Percent change, annual rate n_ _Q 1990 1992 1994 In the farm sector, output last year was depressed by floods in the Midwesi and by drought conditions further east. As a result, inventories of some major 1990 1992 1994 field crops—principally corn and soybeans—are • Percent enange, 1993:Q4 to 1994-Qi, 3| af, annual rale unusually low at present. This year, changes in gov- As measured in nominal terms in the unified bud- ernment subsidy programs encouraged farmers to get, total federal expenditures during the first eight increase iheir planted acreage, and favorable weather months of FY 1994—the penod from October through during the spring facilitated rapid planting. Although May—were only 2V: percent above the level during the harvest is still several months away, tield condi- the comparaDit pnrt of FY1993. Although the drop in tions appear to be reasonably good at present. defense spending has figured importantly in the over- Farmers hurt by bad weather last year suffered all restraint on outlays, other ['actors have contributed income losses, and their financial positions may have as well. First, substantial gains in income and the weakened in some instances Nonetheless, the finan- expiration of the emergency unemployment compen- cial condition of the farm sector as a whole appears to sation program have tempered the arowth of income be sound. Delinquency rates on farm loans at the end security payments. Second, net interest payments on of 1993 were quiie low compared with the experience ihe national debt have been about flat thus far in ol' the paM decade, and land values rose noticeably FYI994. as a further decline in the average interest last year across most of the farm belt. Reflecting these rate paid on federal debt has offset the effect of favorable conditions, investment in farm machinery increases in the slock of debt. In addition, form sub- has been relatively strong this year. sidy payments have fallen because of the nse in crop Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 prices. The main stimulus to federal outUyi still Although Ihe growth in Medicaid spending hu comes from spending on Medicare, Medicaid, and stowed markedly from the 30 percent jump during other health programs. Health-related outlays during 1991, the« outlays still rose !3 percent over the year the first eight months of FY1994 were up 10 percent ended in the first quarter. !n addition, stale and local from the same period in FY1993; this increase, governments remain under pressure to fight crime, to although considerable, is a bit less rapid than that repair aging infrastructure, and to meet die needs of a during 1993 and is much smaller than the increases growing school-age population. Boosted by higher registered from 1990 to 1992. spending on highways and schools, outlays for con- struction rose almost 7 percent in real terms over The growth of federal receipts was strong during the year ended in the first quarter. This rise occurred the first eight months of FYI994, with all major even (hough adverse weather depressed construction categories posting solid gains. The 9'/4 percent rise activity early this year, dragging down total state and in receipts over the comparable pan of FY1993 local purchases in the first quarter in real terms. Apart exceeded the increase in nominal GDP by a wide from transfer payments and construction spending, margin. Receipts from corporate income taxes have state and local outlays—mainly compensation for been especially robust, reflecting ihe upswing in cor- employees—have continued to grow at a relatively porate profits and various provisions of the 1993 slow pace. Budget Act. Receipts from individual income and social insurance taxes have also been boosted by the tax hikes in [he 1993 Act. In addition, revenues from Real Slate and Local Purchases excise taxes thus far in FY1994 are up markedly from Percent change, annual rale the year-earlier level, due in pan to the higher lax on transportation fuels that became effective last October. As a result of the slow growth in federal outlays and the robust rise in receipts, the federal budget n deficit narrowed during the first eight months of FY1994. The deficit, as measured in the unified bud- get, totaled $165 billion during this period, down from the 3212 billion deficit recorded over the same panofFYl993. In contrast to the improved budget picture at the federal level, the fiscal pressures facing state and local governments have not abated much. Ii is true that, for most states, receipts during the past year have 1990 1992 1994 ' Percent change, 1993:O4to 1994:Qi, at an annual raW. matched or exceeded projected levels, as economic growth turned out to be somewhat more buoyant than anticipated. Even so. as measured in the national The receipts of state and local governments moved income accounts, me deficit (net of social insurance up about 61/: percent in nominal terms over the year hindsl in slate and local operating and capital ended in the first quarter, also outpacing the growth in accounts hjs remained large. The S57 billion dehcit nominal GDP. As noted above, this outcome was during Lhe >ear ended in the tirst quarter of 1994 somewhat better than most Mates had anticipated. In amounted to 6'A percent of the sector's expenditures, response, tax cuts are now on the agenda in about about the same percentage js in the preceding three one-third of the states. However, most of these pro- years. posals are fairly narrow in scope and, in ihe aggre- gate, would have only a small effect on expected Sute jnd kical outlays have continued u> rise ai a revenues. lairly rapid puce, despite ihe efforts to curb spending. O\er the year ended in the rirsi ijuuner iif 1994. these The External Sector outlay-, increased 6''-" percent in nominal terms, about I percentage point I'aMer than the rise in nominal Since December 1993. the trade-weighted foreign GDP. Transfer payments to indiv iduals have remained exchange value of the dollar has declined about S per- [he J'astesi growing component of Male and local cent relative to the currencies of the other members of spending, reflecting large increases for Medicaid. the G-IO. In terms of the currencies of a wider group Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 Foreign Exchange Value o< the U.S. Dollar' Jobless rates remain very high in France and drifted ln<J«x. Marcn 1973= 100 somewhat higher in western Germany over the first half of this year. The unemployment rate in Japan is essentially unchanged from its level at the end of 1993: the number of job offers per applicant, a more sensitive indicator of labor market conditions in Japan, also has shown no improvement since the end of last year. In contrast, in both the United Kingdom and Canada, the unemployment rate has continued to edge down from the peaks reached in mid-1993. So far this year, growth in (he major developing countries appears to have slowed slightly, on balance, from its rapid pace in 1993. The growth of real output in China has moderated from its previously very strong—and unsustainable—pace in response to 1988 1990 1992 1994 tiehter macroeconomic policy, while real growth in ' Indei ol weighted average loreign eicManga ualue at US dollar the other Asian developing countries has remained m on t u 1 r 9 n 7 s 3 - o 7 l 6 c g u l r o re o n a c l i t e ra s d o e t o ot t n e « a ' c G n - o 1 f 0 m co e u 1 nr 0 n c a o s u n W tri e e i s g . fiO ara Oasad robust on average. Real output in Mexico has rebounded somewhat this year after the declines expe- rienced during the second halt' of" 1993. The rebound of major U.S. trading partners, the value of the dol- appears to have been due. in part, to tire somewhat lar has dropped roughly 4 percent since tost Decem- more expansionary fiscal policy in Mexico and to the ber, when adjusted for changes in consumer prices ratification of the North American Free Trade Agree- here and abroad. Taking a longer view, the exchange ment, which resolved uncertainty that had held down value ot" the dollar—adjusted for these price changes— investment activity during 1993. has held within a rather narrow range since the end of 1992. despite the decline this year. (See section 3 of After having surged in ihe fourth quarter of last this report for a further discussion of developments in year, real U.S. exports of goods and services fell back foreign exchange markets.; in the first quarter of this year, but remained about 4Vj percent above the year-earlier level. Preliminary Economic activity appears to be strengthening in data for Apnl indicate that real exports moved some- the major foreign industrial countries. In Canada and what above the first-quarter average. The uptrend the United Kingdom, where recovery has been under largely reflects a boom in sales of capital goods; for way for some rime, real GDP continues to expand ai a other goods, and for services as well, exports have fairly steady pace. Continental European countries, nsen only slightly over the past year. Looking across most of which were in recession dunng 1993, are showing signs of a turnaround. Real GDP rose moder- ately in western Germany in the first quarter, although indicators suggest that growth during the second quar- U S. Real Imports and Exports ter may have slowed somewhat, economic activity Annual rat*. Billions ot 1987 dollars continues to move back toward pre-recession levels. There is also some evidence of a turnaround in Japan: After no growth on net in 1993, real GDP moved up strongly m the first quarter: for the second quaner, the data point to continued, albeit slower, expansion. The level of real GDP remains substantially below potenrial in al! of (he major foreign industrial coun- tries, and inflation generally has continued to slow. In western Germany, the twelve-month change in the consumer price index was 3 percent in June, down from more than 31/: percent at the end of 199?. In Japan, consumer prices rose less than I percent over the year ended in June, an even more modest increase than that recorded over the (welve months of 1993. 1988 1990 1992 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 our major trading partners, exports to Canada and Net inflows of private capital into the United States Latin America remained on an upward path through picked up in the first quarter of 1994. Private foreign the firsi quarter Although exports 10 Asia dropped net purchases of U.S. securities were strong, as for- back in the first quarter, they also remain on a strong eign investors added to their holdings of US. govern- upward trend. Exports to continental Europe contin- ment securities, corporate bonds, and stocks. U.S. net ued to expand sluggishly through the tirsi quarter. purchases of foreign securities also remained very high in the first quarter. Banking offices in the United Real imports of goods and services posted another States reported substantial inflows, as foreign char- sizable increase in the first quarter, reflecting the tered banks, in particular, continued to substitute bor- strength in U.S. economic activity. Over the year rowing abroad for funding in the United States. For- ended in the first quarter, real imports jumped more eign branches of U.S. banks also became net providers than 11 percent, and the level of imports in April of funds to [heir U.S. offices. Direct investment stood somewhat above that in the first quarter. inflows and outflows were spurred by a revival of Imports of capital goods and industrial supplies have mergers and acquisitions. U.S. direct investment continued to be especially robust. Prices of non-oil abroad continued at near-record levels; foreign direct imports rose relatively little over the year ended in investment in the United States was also significant, .May. as inflation abroad generally remained subdued although far below the peaks reached in [he late and ihe dollar's foreign exchange value was linle 1980*." changed on net over this twelve-month penot] against [he currencies of the other G-10 countries. Labor Market Developments The nominal trade deficit on goods and .services widened to S97 billion (at an annual rate) in the first The labor market continued to strengthen in [he quarter, significantly larger than in any recent quarter, first ha[f of 199*1. Nonfarm payroll employment and then remained at about that level in April. Net increased at an average rate of about 285.000 pec investment income showed a small deficit in the first month during this period, up from the average quarter, somewhat weaker than (he average perfor- monthly gain of roughly 200.000 during 1993. These mance in 1993. The current account deficit widened increases brought [he total rise in payrolls to about 10 SI28 billion (at an annual rate) in the first quarter, 5 million since [he beginning of the current expan- compared with S1Q4 billion for a!l of 1993. sion in early 1991. The job gains this year have been spread across most major sectors of the economy. In manufacturing, U.S. Current Account employment turned up last October, and a choppy Annual rale, billions 0> dollars advance continued during the first half of 1994. The hiring has been concentrated in two \ndusiries that have experienced robust sales growth, machinery and Payroll Employment Net enange. millions o( jobs, annual rale - 50 ! Total Nonlarm 150 1986 1990 1992 1994 Recorded net capital inflows for the first quarter about balanced the current account deficit. Foreign official inflows slowed, particularly on [he pan of iome developing countries that had substantial accu- mulations of reserves in 1993. 1990 1992 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 moior vehicles: payrolls also have expanded in indus- Civilian Unemployment Rate" tries that supply materials and parts to these pro- ducers. In contrast, employment in defense-related industries has continued to drop this year. Meanwhile, construction employment was held down early in the year by the severe weather, but then moved up sharply in March and April and rose somewhai further in May and June. \ . Considerable employment growth also has taken place this year in ihe service-producing sector. Con- tinuing the pattern of recent years, employment in business services rose at a rapid clip in the first half of 1994. Employment in neaith services has remained on a fairly brisk uptrend, and job gains have been wide- spread in other service industries. Another area of strength has been wholesale and retail trade, where 1988 1990 1992 1994 the sizable employment gams recorded dunne 1993 ' Data after Decemoer 1993 are not consisieni witr earlier data Because ol major revisions 10 ihe survey Irom wmcn and again this year contrast with the absence of job (tie series is generalea growth on net over the preceding four years. In addition to boosting the pace of hiring, employ- civilian unemployment rate, and numerous other ers have continued to rely on a longer workweek to series. Nonetheless, the decline in [he unemployment increase aggregate labor input. Indeed, in April, the rate from 6.7 percent in January to 6 percent in June workweek of production or noniupervisory workers provides additional evidence of strong labor demand in manufacturing reached a record high for the post- this year. On a regional basis, unemployment rates World War JJ period; it has since edged off only have generally moved lower since January, and the slightly. Prior to this expansion, the typical pattern dispersion across regions also has narrowed; the had been for the workweek to nse as the recovery got declines since January have been largest in California underway, but then to drift back down with the even- and other states in ihe Pacific region and in New tual pickup in hiring. England. Firms also have shown an increased preference for The strength in hiring has not drawn many workers using temporary workers. In ihe employment data, into the civilian labor force. In fact, between January these workers appear on the payrolls of personnel and June, the labor force contracted a bit. pushing supply agencies (a component of business services), down the labor force participation rate—which mea- where employment growth continued to be extremely sures the percentage of the working age population fast in the first half of 1994. Although these agencies lhat is either employed or looking for work. The represent only about 2 percent of total payroll em- participation rate has changed little on net during ployment, they accounted for more than 15 percent of the current expansion, m contrast to the upswing the total rise in employment in 1993 and for nearly thai ijpitally occurs vnth a strengthening of labor that share so far this >ear, Manufacturing firms, in demand. Although the reasons for this departure from particular, have increased iheir use of temporary ihe usual pattern are not entirely clear, more voung workers. Both the growing employment of temporary •-vornen appear to be opting for activities outside the workers and 'he rise in the workweek may be moti- labor market, jnd survey data re\eal that mans indi- vated, in pan. by the oesire to avoid the rising costs of viduals still perceive jobs as hard to rind, vihieh mav health insurance and inter ("rinse benefits lor new limit (JiL'if desire to search for employment. permanent workers. Moreover, given the greater costs Output per hour in the nont'arm business seuor rose now associated with Minna and linns employees, such at an annual rjte ot I1'4 percent in the lirsi quarter, behavior may be a response to uncertainty about alter advancing at a far more rapid pace over the future -tafh'na needs. second hall of 199? Averaging through these move- In January, the introduction of the redesigned ments, labor productivity rose jbout 2"- percent over household survey, jjwnt' ivnh ihc incorporjiion ol ihe yi\w L'ndeJ in ihe first quarter o( IWJ.roughlv in population estimates from the 1990 Census, created a line with the increases during the first two >s.lars of the break in the household measure of employment, the current expansion. Most of the productivity ^am over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 Output p«r Hour employer costs for health insurance and workers' Psreaot change. Q4 to CM compensation. In contrast, wage increases have held fairly stable. The ECI for wages and salaries rose Nonfarm Business Sector almost 3 percent over the year ended in Match, a figure at about the midpoint of the twelve-month changes recorded over the past two years. Separate data through June on average hourly earnings of production or nonsupervisory workers also show no significant change in the rate of wage inflation. With the rise in labor compensation largely offset by improvements in productivity, unit labor costs in non- farm business rose only a little more than 'A percent over the year ended in the first quarter of 1994. Price Developments 19BB 1990 1992 1994 • Percent change. 1993:Q1 to 1994:Q1. Inflation slowed slightly further during the ftrat half of 1994. The CPI excluding food and energy—a measure of the underlying trend of inflation—rose this three-year period likefy reflects the normal cycli- 3 percent during this period, down a bit from the cal upswing that accompanies the strengthening 01 3'/j percent increases recorded in \992 and 1993. output after a recession. Nonetheless, there does "Core" inflation has not been this low for an appear to have been some speed-up in the trend rate extended period since the taily 1970s, when wage of productivity growth from the relatively slow pace and price controls were in place; apart from that in the 1970s and 1980s. episode, the cote inflation rate over a twelve-month The growth in labor compensation remained sub- span was last below 3 percent in 1966. Food prices dued early this year. The employment cost index have risen only slightly this year, and energy prices (ECI) for private industry—a measure that includes have been flat on net, holding the increase in the total both wages and benefits—rose 3'/j percent over the CPI over ihe first half of the year to 1~<h. percent at an year ended in March 1994, a shade below the increase annual rate. Price pressures have been evident in ihe registered over the preceding iweive months. The cost markets for raw materials, but these increases have of employee benefits decelerated quite a bit over the not had an obvious effect on inflation at the retail past year, due largely to more moderate increases in level. Employment Cost Index' Consumer Prices Excluding Food and Energy * Percent change, Dec. to Dec. PatceM chaogo, Osc. to Dec. Tola I Compensation 1988 1990 1992 1994 1988 1990 1992 1994 'EmpKJymem cost index tor private industry, excluding (arm ' Consumer pnca inde» lor all urOan consumers and Household workers '• PBTCBPI change. Decemoer 1993 to Juno 1994 '" Percent change. March 1993 to March 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 Consumer Prices * planting proceeded fairly smoothly this spring, and Percent change, Doc, to D«c. crops generally were in good condition as of mid- July. The CPI for energy was about unchanged on bal- ance over the first half of I994, but this measure has yet to reflect the rise in crude oil prices since March. As the year began, consumer energy prices were still on a downward path, owing to the persistent oversup- pjy of crude oil in world markets. Energy demand then soared when the frigid weather hit in January and February, depleting inventories of fuel oil, gasoline, and natural gas. In response, the CPI for energy jumped in February and rose slightly further in March, but most of this increase was reversed in Aprit and May. Quite apart from any effects of abnormal 1988 1990 1992 1994 weather, world oil markets nave tightened since 1 Consumer price index for aU urban consumers, March, boosting the price of crude oil by as much as " Pamenl change, December 1993 to June 1994. S6 per barrel. This increase appears to have resulted from the expectation of improved economic The news on food prices so far this year has been conditions—and hence stronger demand—in Western quiie favorable. After having risen at close to a 4 per- Europe and Japan, combined with flat OPEC produc- cent annual rate during the second half of last year, tion and supply disruptions in the North Sea and other the CPI for food edged up at an annual rate of less areas. Retail energy prices were little changed in than 1 percent over the first half of 1994. This moder- June, but the higher crude costs are likely to be passed ation largely reflects a decline in prices for fruits and through to the retail level over (he summer vegetables over the firsi few months of the year. which retraced much of the runup thai occurred over the second half of 1993, In addition, plentiful supplies Consumer Energy Prices* of beef and pork pushed down retail meal prices a bit Percent change. Dec. ID Dec. on balance over ihe first half of 1994. Prices for other foods—which represent about two-thirds of toial food in the CPI—increased ai an annual rate of 2V* percent during the first half of the year. Looking ahead, the path for retail food prices will depend heavily on the outcome of this year's harvest. As discussed above, Consumer Food Prices' Percent change. Dec. to Dee. 1988 1990 1992 1994 • Consumer price index lor all urban consumers " Percent change. December 199310 June 1994. The CPI for commodities excluding food and energy increased at an annual rale of 2'/; percent over the firsl half of 1994, a somewhat faster rise man n during ) 993. However, the increase last year was held down by a huge price drop for tobacco products. Excluding tobacco, as well as food and energy, goods 1988 1990 1992 1994 prices rose at an annual rate of 21/* percent during the ' Consumer pnce mde« lor all urban consumers. " Percenl change. December 199310 June 1994. first half of this year, about the same raie of advance Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 as in 1993. Price increases for most consumer com- In contrast, inflation pressures continue to be evi- modities have been modes! ihis year, due in part to Che dent in the markets for raw commodities. With Ihe very limited increases in the prices of imported goods. exception of steel scrap, prices of industrial metals The only major area in which prices have clearly have moved up from iheir lows last fall, in some cases accelerated is motor vehicles. Reflecting strong de- quite substantially. Lumber prices, which have swung mand and the weakness of the dollar vis-a-vis the yen, widely over the past few years, have been at relatively the CPI for new motor vehicles rose 43A percent over high levels for most of this year. Prices of other raw- the first half of 1994, up from ihe 3l/» percent increase materials have been firm as well. As a summary during 1993. measure of these movements, the PPI for crude mate- rials excluding food and energy rose about 7 percent Inflation for consumer services other than energy over (he year ended in June. However, crude materials has continued to trend lower. During the first half of constitute a relatively small pan of the value of fin- ihe year, ttie CPI for this aggregate rose at an annual ished goods, and price increases for these inputs usu- rate of 31/* percent, after increases of nearly 4 percent ally have a limited effect on ihe prices of finished in 1992 and J993 and 4'/- percent in [991. Shelter goods in the absence of more general cos! pressures. costs—which represent about half of non-energy services—have continued to rise at a relatively sub- Expectations of inflation appear to have changed dued rate, while price increases have slowed in a little on net since the end of 1993. According TO variety of oiher areas. Indeed, the CPI for medical the survey or" households conducted by (tie Survey care services rose only 5 percent over the year ended Research Center of the University of Michigan, ihe in June, the smallest twelve-month change in this mean expected increase in the CPI over the coming series in twenty years. Tuition costs, which posted year rose from 3% percent in the fourth quarter of increases of 8 to 9 percent annually foe several years, 1993 to 4V; percent in March and April; however, the have decelerated as well, rising 6Vt percent over the readings for May through early July dropped back to year ended in June. an average of about 4 percent. In the Conference Board survey of households, the expected rate of The producer price index for finished goods exclud- inflation over the coming year has held fairly steady ing food and energy, which covers domestically pro- at 4'/4 percent since last November. Expectations of duced consumer goods and capital equipment, rose inflation over longer periods also have not changed only '/: percent over the year ended in June 1994. As much on balance this year. In the University of Mich- with the CPI, this measure of inflation has been held igan survey, the expected rate of CPI inflation over down by the plunge in tobacco prices; excluding the next five to ten years jumped in Match. bu( has tobacco, the IV* percent rise over the past year was since retraced the increase. Finally, the June 1994 about the same as thai over the preceding twelve survey of professional forecasters conducted by the months. At earlier stages of processing, price Philadelphia Federal Receive Bank produced the increases have remained fairly small on balance. The same expectation of inflation aver Ov; coming ten PPI for intermediate materials excluding food and years—3.5 percent—as did ihe .survey taken last energy rose 2 percent over ihe year ended in June, December. after an increase of 1'/i percent over Ihe preceding year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 Section 3: Monetary and Financial Developments in 1994 Interest rates have increased substamially in 1994. concerns about higher inflation, and actual and antici- Short-term rates started the year at the unusually low pated tightening moves. In addition, a shift in the levels that prevailed throughout 1993. but they have financial setting, from one marked by yields that were subsequently risen in response to the Federal Re- stable or declining to one characterized by rising serve's monetary policy actions and market expecta- rates, was accompanied by greater market volatility tions about future actions. The Federal Reserve has and a revaluation of the risks and returns on long- moved away from its previously very accommoda- term securities. Investors seemed to become more tive policy posture in four steps, which lifted the fed- uncertain about the future path of interest rates, and eral funds rate a total of 1 '/4 percentage points. Other the resulting portfolio shifts and volatility have con- short-term rates increased commensurately, and banks tributed to the upward pressure on long-term yields. raised (heir prime lending rate, also by I V-> percent- Despite the rise in interest rates, overall borrowing age points. has remained fairly strong. The composition of pri- vate borrowing, however, has been affected by finan- Domestic Interest Rates cial market conditions. Businesses, in particular, have Short-Term reduced their issuance of long-term debt and stepped up their use of bank loans. Nonetheless, overall bank lending has increased only slighlly, as growth in real Monthly estate loans has slowed. The expansion of bank secu- rities holdings, after adjusting for certain accounting rule changes, has eased slightly, and bank credit growth has remained close to the pace recorded last year. Higher short-term market interest rales Federal Funds have also restrained the growth of the monetary 10 aggregates. Growth in the broader aggregates has slowed somewhat from last year, and MI has deceler- ated substantially. Since December 1993. the dollar has declined about Three-montfi Treasury Bill 10 percent against the German mark and about 11 per- Coupon Equivalent cent against the Japanese yen. although it has appreci- 1 I I 1 1 1 L_J 1 I L_l ated against the Canadian dollar. Over the same Long-Term period, stronger growth prospects abroad as well as portfolio adjustments by globally diversified investors have lifted long-term interest rates in the G-10 coun- tries about I'/: percentage points, similar to the rise in U.S. longer-term yields. By contrast, foreign short- term rates, which largely reflect the thrust of" mone- lary policy in individual countries, are about Home Mortgage unchanged on a trade-weighted basis: rates have Conventional 30-year Fined - declined substantially in Germany and a number of continental European countries, have changed liitle in Japan, and have risen more in Canada than in the United States. Dollar weakness against the yen and mark was intense from time to time and itemed to reflect, in part, difficulty in resolving trade tensions, changing expectations about macroeconomic develop- ment!) in Japan and Germany, and investor concerns 1982 1984 1986 1988 1990 1992 1994 that U.S. inflation prospects were no longer improving while inflation abroad seemed likely to continue to Longer-term interest rates have risen about ['A to move lower. On three occasions when conditions P/J percentage points. These rates have been boosted warranted, the U.S. Treasury and the Federal Reserve by stronger-than-expected economic growth, market intervened to buy dollars. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 U.S. and Foreign Interest Rates In February, when the Federal Open Market Com- 3-Month mittee gathered for its first meeting of the year, the available dam suggested that the economic expansion was solid and self-sustaining. Spending had picked up Monthly considerably, panly reflecting declines in long-term interest rates and the improved financial condition of Average Foreign' businesses and households. Short-term interest rates had been at historically low levels for some time, measured both absolutely and relative to inflation, and banks and other tenders had been loosening their terms and siandards for extending credit. In this envi- ronment, the Committee was concerned thai keeping policy so accommodative risked elevating demands on productive capacity to the point where inflation U.S. Large CD pressures might emerge. Even though current infla- tion readings were favorable, delaying a policy move until these indicators signaled an actual acceleration 'Multoaiatal uaas-wttghiw average ol comparaoto ban* ratas of prices would permit an inflationary process to m ifM oifier G-10 countries. become embedded in the economy. In that event, 10-Year larger and possibly disruptive actions eventually Petcent would be needed to bring inflation back under con- MonUily trol. Against this backdrop, the Committee decided to take steps toward eliminating the considerable degree of monetary accommodation that had prevailed for some time. When discussing how to implement this decision, Average Foreign * the FOMC considered the possible reaction of finan- cial markets. Market participants, while anticipating that interest rates would rise at some point, generally did not expect a tightening of policy at this meeting. The Committee was concerned mat the capital losses U.S. Treasury engendered by the finning action might unsettle many investors, who had not faced a policy firming in nearly five years and whose portfolio choices in some 1984 1986 1988 1990 1992 1994 'Multilateral traOa-wwgnisti average of comparaWe government QwilJ yield in me olfie' G-10 countries Spread of Thirty-year Treasury Bond Yield Over Three-month Treasury Bill Yield The Course of Policy and Interest Rates A! the beginning of 1994, financial markets had been characterized for several years by falling and then persistently low short-term interest rates, declin- ing long-term rales, and unusually wide spreads between long- and short-term yields. Moreover, the volatility of bond prices had been quite low by receni historical standards. In ihis environment investors had taken on riskier assets in pursuit of higher returns. For example, small investors had switched out of low-yielding, but low-risk, assets, such as deposits and money market mutual funds, and into such investments as bond and equity mutual fund shares. 1978 1982 1986 1990 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 Real Federal Funds Rate nomic and financial developments. Market partici- pants generally believed that the System's firming action was the first of a series, but they were unsure of the timing and cumulative magnitude r-f future policy steps. This heightened uncertainty, as well as the capital losses in the wake of the firming action, prompted market participants to reduce their risk ex- posure by attempting to shonen the maturities of their investments and by trimming the degree to which positions were leveraged. They sold !ong-(erm assets denominated not only in dollars but in other curren- cies as well. This rebalancing of portfolios contrib- uted to sharp rate swings and may have exacerbated the upward pressure on long-term interest rates, boch in (he United States and abroad. Bond Market Volatility' 1962 1970 1978 1986 1994 ' Real federal funds rale is me nominal tedaial tucvjs rale minus *w criange m the CPI lass food and energy Over the last lour (juarters. cases seemed nol (o anticipate ihe consequences of rising CMes. In these circumstances, ihe response lo 20 the policy action might be outsized, especially if a large adjustment were made. Consequently, the Com- mittee decided to iniiiate its move toward a less accommodative stance with a small step, although it thought that additional firming steps likely would be necessary in the months ahead. The FOMC instrucied the Domestic Trading Desk to increase slightly the 10 degree of pressure on reserve positions and autho- rized the Chairman to announce the action in order to avoid any misinterpretation of its action or purpose. The tightening of reserve conditions pushed up the 1984 1986 1988 1990 1992 1994 1 Expected volatility derived (ram prices of options on federal funds rale by about '/•> percentage point, to a Treasury bond futures. range around 3'A percent. When ihe Committee convened in mid-March, the Although Ihe structure of market inierest rates had evidence suggested that the expansion in economic built in a policy firming in the months ahead, the activity remained robust. There was a small risk that timing of the move caught many market participants the weakness and volatility in financial markets by surprise and. by itself, seemed to precipitate a might have significantly affected household and busi- substantial shift in expectations. When the move was ness confidence and spending. But. (he Committee followed by information indicating a much stronger believed that, on balance, its policy stance sail was path for U.S. economic activity than had been antici- overly accommodative and likely to promote infla- pated and by an associated heightening of concerns tionary pressures. The FOMC therefore decided to about inflationary pressures, short- and long-ietm continue the process begun in February to remove the interest rates moved sharply higher throughout the excess degree of monetary accommodation and, in remainder of the winter. International developments, light of recent financial market conditions, it chose to such as trade tensions, improving foreign economic take another small step. The resultant increase in prospects and rising long-term inierest rates, and a reserve pressures lifted the funds rate by '/i percent- declining value of the dollar, also may have played a age point, to about 31/; percent. role in elevating yields by raising investor concerns about price pressures in the United States and about Data released over the next several weeks indicated foreign investor appetite for dollar-denominated considerable strength in economic activity. Yields assets. Rates were volatile on occasion, owing to increased across the maturity spectrum, with long- shilling perceptions about the future course of eco- term rates rising especially sharply into early April Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 88 Selected Treasury Market Rates 30-year bond 10-year note 5-year nole 12/31 2/4 3/22 4/18 S/17 7/6 FOMC FOMC FOMC FOMC ' Dotted vertical lines indicate days on which a monetary policy move wai announced before sealing back- somewhat. On April 18, the circumstances, the Federal Reserve thought that con- FOMC reviewed the incoming daia, as well as the ditions warranted eliminating much of the remaining apparently more stable conditions in financial mar- degree of monetary stimulus. The Board of Gover- kets, during a telephone consultation. Following that nors, therefore, approved an increase in the discount review,. Committee members supported the Chair- rate to 3Vi percent, from 3 percent, and the FOMC man's decision to continue the process of reducing directed the Domestic Trading Desk to permit the the degree of monetary accommodation. Reserve entire W-percentage-point rise to show through to the pressures were tightened slightly further, and the fed- federal funds rate, which moved up to 4'A percent. eral funds rate again rose by '/« percentage point. These moves, along with the three earlier steps, were judged to have substantially removed the degree of Yields continued to increase, on balance, through monetary accommodation that had prevailed through- mid-May. Short-term rates were affected by expecta- out 1993. Still, the FOMC would have to monitor tions of additional firming actions, while long-term incoming financial and economic data carefully to rales were subject to countervailing forces. Incoming determine whether additional policy adjustments were data that showed signs of a possible cooling in the needed to accomplish its objective of maintaining pace of the economic expansion, favorable price favorable trends in inflation and thereby sustaining reports, and more stable trading conditions helped to the economic expansion. push bond yields down for a time. Later, however, a falling dollar, especially in late April and early May, Long-term interest rates dropped immediately fol- and the release of a stronger-than-ex peeled employ- lowing the May 17 policy moves, but. since thai time, ment report caused long-term yields to retrace some they have retraced the decline. Market participants of the earlier decline. initially interpreted the Federal Reserve's polic> announcement as signaling that it had completed its Despite the earlier firming actions, real short-term firming actions, at least for a while. In addition, rates were still fairly low at the time of the May investors apparently viewed the actions as reducing FOMC meeting. The economy continued to exhibit the degree and frequency of tightening that might be forward momentum and a considerable portion of the needed in the future Long-term yields, however, remaining margin of slack in resource utilization had began to move up in June, reflecting the further eroded. In financial markets, many of the more risk depreciation of the dollar, intermittent jumps in com- averse investors had made the initial portfolio adjust- modities prices, less sanguine inflation reports, and ments to a rising rate environment. Under these rising foreign long-term interest rates. 20 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 Al the time of the July FOMC meeting, data on and composition of borrowing by nonfinancial busi- employment and hours worked suggested that the nesses. The debt of such firms has expanded M a economy was still growing at a brisk rale, and there somewhat faster pace in 1994, after three years of remained a risk thai an inflationary process could very little growth, in pan reflecting u. shift away from begin to build. However, data on spending showed equity issuance as stock prices fell. Moreover, rising some signs of a moderation, and growth m money and and more volatile interest rates have played a role in credit had not picked up. In these circumstances, the discouraging businesses from issuing long-term debt Committee decided to maintain the existing degree of securities. Such issuance had been strong in WJ as reserve pressure and await additional information to businesses look advantage of relatively low interest judge the trajectory of the economy and prices and the rates to refinance high-taie longer-term debt and appropriateness of its policy stance. replace shorter-term debt, such us bank loans. In 1994, however, businesses have lurned more to banks Credit and Money Flows and finance companies to meet their financing needs. Since mid-1993, credit expansion has picked up as Interest rate developments have also affected bor- the economy has strengthened and the restraint rowing by households. The growth in household mort- exerted by financial restructuring has ebbed. Lower gage debt has slowed a bit from the pace recorded m debt-service burdens and improved balance sheets the second half of 1993. rellectins the rise in mon- have encouraged businesses and households to lake gage rates that began late in thai year. Higher rates on new debt, while stronger capital positions and have curbed refinancing, a practice that tended to more robust economic conditions apparently have boost mortgage debt growth as some borrowers took made banks and other lenders more willing to extend ihe opportunity to liquefy some of the capital in their credit. Growth of the debt of nonfederal nonfinan- homes. In contrast to the behavior of mortgage" debi. cial sectors (nonfinancial businesses, households, and consumec credit growth has remained brisk, reflecting state and local governments] picked up in the sec- strong demand for consumer durable goods and rela- ond half of 1993 and has increased a bit more this tively attractive rates on many consumer loans. Gen- year—-to a 5 percent annual rate. Total domestic non- erally, rates on such loans have risen much les.s than financial sector debt, which includes the debt of the market rates. Consumer credit at finance companies federal government, rose at a 5'A percent annual rate and at banks have both picked up in 1994. between the fourth quarter of last year and May, close to its pace over ihe second half of 1993 and a little Total loans at commercial banks have risen at about below the midpoint of its monitoring range of 4 to a 4'/4 percent annual rate, a bit above last year's pace. The faster growth of business and consumer loans has 8 percent. been offset by slower expansion of other types of Rising market interest rates and less hospitable loans, such as those for real estate. In addition, secu- capital market conditions have affected the growth rity loan-, have dropped off as the more subdued pace ot' debt issuance and the paring of dealer lone posi- Debt: Annual Monitoring Range and Actual Growth tions in a rising rate environment has reduced dealer Billions oI dollars financing needs. The expansion of bank lending in 1993 and 1944. following two years of virtually no growth, has te- 12QOO Hecied not only stronger loan demand, bui also an increased willingness on the pan ut' banks w make loans. This heighieneil desire ID extend credit stems 12600 from the improved financial conduum «t banks a-, well as their borrowers. In the early 1990s, bank*, had - 12400 been pressed by balance-sheet problem-, and ilw need 10 meet more stnngeni capital-as set ratio1-. B> early 1993. however, the capitalization ratios i>|' mam - 12200 banks were considerably stronger, and they have con- tinued to improve since then us banks issued si7able volumes of equity and retained a hiyh proportion of 12000 [heir record earnings. In mid-1995. Mime banks began to report an easing of their standards and term-- for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 Changes in Bank Lending Standards bottom of the G-to-4 percent growth range established For Business Loans * by the FOMC, and its velocity seems to be increasing Percent faster this year than in 1993. The weakness in M3 partly reflects an exodus of investors from institution- By Size ol Fim SaWing Loan only money market mutual funds, whose returns have lagged the rise in market rates. M3 has also been held \ Large back by declines in large time deposits. The runoff in this component has been concentrated at U.S. branches and agencies of foreign banks, which have stepped up their borrowings from affiliated foreign offices. Domestic banks have also boosted such bor- rowings. In December 1993. domestic banks, for the first time, borrowed more from their foreign affiliates Sma: than they lent to them. This net borrowed position has expanded considerably since that time. Apparently, weaker credit demands abroad have held down the costs of borrowing overseas relative to the costs of 1990 1991 1992 1993 1994 1 Percentage ol domestic loan oflicers lightening standards obtaining funds in the United Slates. less percentage easing sianOarO*. Source Federal Reserve sun/ays ot senior loan officer bank (ending pracncss. M3: Annual Range and Actual Growth Billions of dollars business loans and residential mortgages, and this easing has continued, albeit at a reduced rate, into the first two quarters of 1994. 4300 Measured growth in holdings of bank securities (his year has been affected by two accounting changes. One change affects how banks report, on their balance sheets, the fair market value of off- 4250 balance-sheet items. Banks are no longer permitted to net positions in these items across customers; this change has appreciably boosted the ''other securities" 4200 component, where these positions are booked. The other change in accounting rules requires banks to value at market prices those securities thai they do not plan jo bold 10 maturity. With the decline m securities O prices this year, the requirement ot "marking 10 mar- 1993 1994 ket" likely has restrained the measured growth of bank securities portfolios, although to an uncertain M2 growth has slowed a bit in 1994. and its veloc- extent. Abstracting from these special factors, growth ity appears to have registered another sizable increase. in bank securities holdings likefy has slowed slightly The major factor behind the rise in velocity this year funher in 1994. This slowing has been about offset by has been higher short-term market interest rates. In the pickup in loan growth, leaving underlying bank the usual pattern, the increases in rates paid on M2 credit growth close to the pace recorded last year. deposits und money market mutual funds have lagged Meanwhile, thrift institution credit has resumed behind (he rise in market rales, boosting the earnings expanding this year, albeit modestly, after declining forgone (opportunity costs) by holding the compo- over the past five years. Expansion at credit unions nents of M2 and thus inducing shifts out of the has been robust, while the contraction of the remain- aggregate. For example, noncompetitive bids at Trea- der of the thrift sector has slowed somewhat further. sury auctions have increased sharply this year, and Despite ihe expansion of depository credit, the some of the funds likely were drawn from the instru- broadest monetary aggregate. M3, has edged a bit ments included in M2, Moreover, the composition of lower since the fourth quarter of last year, as deposi- MZ has been affected by (he varying speed with tory institutions have chosen to fund growth in assets which rate^ on different components have adjusted to with nondcposil sources. In June. M3 was around the higher markei yields. Rates on money market mutual Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 M2 Velocity and M2 Opportunity Cost Rano scale Percenlage points, ratio scale 13 11 1.85 9 1.8 7 1.75 5 1.7 1.65 1.6 1.55 1.5 1978 1982 1986 1994 * Two-quarter moving average at 3-mantn Treasury tiiU rate less average rale paid an funds and retail certificates of deposit (CDs) have The depressing effect of higher interest rates on M2 moved up considerably since February, while rates on was offset for a lime by flows from bond and equity liquid deposits, such as savings and NOW accounis, (or long-term) mutual funds into money market have been virtually unchanged. Partly as a conse- mutual funds. Declining securkies prices and higher quence, money market mutual funds have risen, small volatility prompted households to reconsider their CDs have turned around, and the expansion of liquid investments in long-term mutual funds and encour- deposits has languished. From the fourth quarter of aged many to liquidate some o! their bond and 1993 through June, M2 expanded at a 1'/4 percent equity mutual fund holdings. Over the March-to-May annual rate, placing this aggregate around the lower period, households pulled more money out of bond bound of the l-to-5 percent growth range set by the funds than they invested. A portion of the proceeds FOMC. from the redemptions likely was placed in money market mutual funds, which grew quite rapidly. As changes in securities prices became more subdued in M2: Annual Range and Actual Growth late May, flows into long-term mutual funds began to Billions of dollars pick up, but they have remained weak by the stan- dards of recent years. Shifts from M2 into direct holdings of securities, such as Treasury bills, as well as the capital losses on long-term mutual funds, have 3650 damped the growth of a measure thai adds to MZ the net assets of mutual funds rioi held by insmuiional investors or in retirement accounts This series has 3600 grown at an estimated 1 percent pace this year, well below iti 5'/; percent advance in 1993. Its velocity therefore also has increased, after several years of rough stability. 3550 Ml growth has been restrained by wider opportu- nity costs as well as some special factors-. From the l ._—L .-L- 3500 fourth quarter of last year through June, MI expanded O N OJ F M A MJ J at about a 4 percent annual rate, lew than half of its 1993 1994 101/: percent rise in 1993. Ml velocity, which fell at a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 5 percent rate last year, appears to have increased this The dollar was supported initially by market expec- year. The growth in Ml has primarily stemmed from tations that it would rise over the near term as the the coniinued rapid rise in currency, as overseas U.S. economy strengthened and U.S. interest rates demand has remained robust and domestic demand rose, in contrast to expected developments abroad. has expanded with sales. In contrast, increases in Following the FOMC's firming action on February 4. transactions deposits have been quite weak. Growth the dollar rose only modestly and briefly, in pan of demand deposit, which pay no interest, has been because foreign long-term rates increased with U.S. reined in by higher market rates, the associated rise rates. In the weeks that followed, the dollar weak- in earnings credits on compensating balances, and a ened with respect to the yen, especially in mid- drop-off in mortgage refinancings, Refinancings boost February, when market participants became more liquid deposits—especially demand deposits— concerned about the sizable external surpluses in because they are accompanied by a temporary park- Japan in the wake of the lack of progress in the ing of funds in such an accouni; however, as the framework talks be!ween the United States and volume of refinancings declines, deposits return to Japan. The dollar also came under downward pres- more normal levels. Rate spreads have also depressed sure against the German mark, particularly in Febru- the growth of other checkable deposits, whose offer- ary and March. Continued strong growth in German ing rates have changed little since the beginning of M3, amid signs of economic revival, suggested that the year. In addition, growth has been restrained by a further sizable cuts in German and other European large bank's introduction of a program that sweeps rates were not as likely as had been previously excess balances out of NOW accounts and into money thought, and long-term rates in these countries market deposit accounts. (The program, therefore, has increased further. In early April, the dollar came no impact on M2.) The anemic expansion of transac- under renewed downward pressure in terms of the tions deposits has contributed to a decline in total yen. The resignation of Prime Minister Hosokawa reserves. This reserve measure has contracted at a rejuvenated concerns that progress on negotiations 1 Vi percent rate so far this year, a stark contrast with 10 open Japanese markets would stall and that plans its \2 percent expansion in 1993. The continued to stimulate the Japanese economy would not be strong demand for currency has propped up growth of implemented. the monetary base, whose growth has slowed only Market sentiment against the dollar became partic- slightly this year, to a 9'A percent rale. ularly strong in late April and early May, in some- limes disorderly markets. On April 28. with U.S. bond prices falling, the dollar approached its post-war low M1: Actual Growth Billions of dollars against ihe yen in thin trading and. on the following day, it started to lirop sharply against the mark as trading became more volatile. In response, the For- eign Trading Desk at the Federal Reserve Bank of New York entered the market and purchased dollars against both marks ($500 million) and yen ($200 mil- lion!. Treasury Secretary Bentsen confirmed the inter- 1160 vention and explained that it was prompted by disor- derly market conditions. The dollar briefly recovered, but resumed falling over the next several days. On May 4. the U.S. Treasury and the Federal Reserve joined other monetary authorities in substantial, coor- dinated intervention in support of the dollar. Secretary Bentsen again confirmed the intervention and said it 1100 was in response to exchange market developments O N DJ F M A MJ J that were inconsistent with economic fundamentals. 1993 1994 These actions stemmed the slide of the dollar and contributed to a partial recovery over the subsequent two weeks. Foreign Exchange Developments The dollar fluctuated in a narrow range following After starling the year wjih a firm lone, the dollar the May 17 policy actions by the Federal Reserve, but declined on balance from February through laie April. it later lost ground. The Federal Reserve's May policy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 S0tocted Dollar Exchange Rales selling pressure on the dollar may also have been CMcwnbW 1993=100 exacerbated by a rise in dollar-denominated commod- ity prices, which market participants viewed as indic- ative of a risk of higher U.S. inflation. With the dollar hovering around a postwar low against the yen on June 24, the United Slates led substantial coordinated intervention with the monetary authorities of the G-7 100 countries and a number of other countries. Secretary Benisen confirmed the intervention, citing shared con- cerns over recent developments in foreign exchange markets. Since that time, sentiment against the dollar has continued, with the dollar recording a new post- war low againsi the yen on July 12 before rebounding moderately in subsequent days. Federal Reserve Foreign Currency Weighted Average Foreign Exchange Value Transactions of the U.S. Dollar * QecenW 1993=100 The Federal Reserve has undertaken other foreign currency transactions in 1994 in addition to the inter- vention actions of April 29, May 4, and June 24. The FOMC has authorized a restructuring of the Sys- tem's portfolio of foreign currencies and has approved three reciprocal currency arrangements, also known as swap arrangements. At its December 1993 meeting, the FOMC autho- rized the Manager for Foreign Operations to sell all non-mark and non-yen foreign exchange reserves held by the Federal Reserve. The Manager sold these reserves, which were equivalent to $750 million, dor- ing the first few months of 1994, These holdings along with those of the Exchange Stabilization Fund Dae Jan Feb Mar Aor May Juna July of the U.S. Treasury were eliminated in light of the 1993 1994 practice of U.S. monetary authorities in recent years •Multilateral trade-weighted average at trie dollar against Itw currencies o' ttw OBIBT G-lO countries. to conduct intervention operations exclusively in marks and yen. actions were consistent wiih the view expressed in [he On March 24, the Committee approved a tempo- statement accompanying the May 4 intervention that rary increase to $3 billion, from $700 million, in ihe the U.S. Administration did not believe that the pcos- System's swap arrangement with the Bank of Mexico. pects for the U.S. economy wammied a weak dollar. The value of the Mexican peso against the dollar had However, in mid-June, the dollar declined against the been nearly stable during the initial weeks of the year, yen as market perceptions resurfaced [hat the United following ratification of the North American Free States was not concerned about a weak dollar- despite Trade Agreement by the United States in November. official statements to the contrary, and as an easing of The peso began lo weaken m late February, however, trade frictions with Japan appeared less likely fol- m response to disappointing economic new.s and polit- lowing the resignation of Prime Minister Haia on ical unrest in Mexico. The assassination of presiden- June 24. Downward pressure on the dollar in terms of tial candidate Luis Donaldo Colosio on March 23 the German mark intensified at this lime as additional further undermined the peso, which fell to the lower data confirmed that an economic recovery was under- intervention limit against the dollar set by the Bark of way in Germany. These data contributed to higher Mexico. Mexican authorities then intervened heavily long-term rates and reinforced views that Bundesbank to support the peso. At the request of the Mexican official rates were nol likely to be reduced further government and the Bank of Mexico, U.S. monetary following the substantial adjustment on May II, The authorities established a $6 billion temporary bilaierul Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 swap facility for the Bank of Mexico, which was split recognition of the increasing interdependence of the between the U.S. Treasury and the Federal Reserve. three economies. In connection with the formation of The swap was intended to help prevent any turmoil in the Group, the authorities of the three countries estab- Mexican markets, which could have spilled into US. lished a trilateral foreign exchange swap facility. The financial markets. In the evenl, no drawings were United States and Mexico put in place swap arrange- made on this facility. In late April, the peso moved ments for up to $6 billion, with the Treasury and the away from its lower intervention limit as the substan- Federal Reserve each participating up to $3 billion. tial increase in Mexican interest rates persuaded mar- The Federal Reserve and the Bank of Canada ket participants of the commitment of ihe Mexican reaffirmed their existing swap agreement of $2 billion government to maintain the value of the peso. and extended its maturity to December 1995. The Bank of Canada increased its swap line with the On April 26, the monetary authorities of the United Bank of Mexico to 1 billion Canadian dollars. These States. Canada, and Mexico announced the creation arrangements expand the pool of potential resources of the North American Financial Group to provide an available to the monetary authorities of each country opportunity for more regular consultation on eco- to maintain orderly exchange markets. The FOMC nomic and financial developments. Plans for Ihis approved the Federal Reserve's participation in these Group had been under way for several months in arrangements effective April 26. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 Growth of Money and D*bt Percent Domestic non financial Period M1 M2 M3 debt Annual1 1980 7.4 8.9 9.6 9.1 1981 5.4 (2.5)2 9.3 12.4 9.9 1982 8,8 9.2 9.9 9.6 1983 10,4 12.2 9.9 12.0 1984 5.5 8.1 10.9 14.0 1985 12.0 8.7 7.6 14.2 1986 15,5 9.3 8.9 13.4 1987 6.3 4.3 5.7 10.3 1988 4.3 5.3 6.3 9.0 1939 0.6 4.8 3.8 7.8 1990 4.2 4.0 1.7 6.6 1991 7.9 2.9 1.2 4.6 1992 14,3 1.9 0,5 5.0 1993 10.5 1.4 0.6 5.0 Semiannual (annual rale)2 1994 H1 5.44 Quarter (annual rate)* 1994 01 6.0 1.8 0.2 5,9 Q2 2.0 1.5 -0.3 4.74 1. From awraga lor iourth quartet oi preceding year to 4. Second quarter debt aggregate based on data through average lor fourth quarter of year indicated. May, 2. Figure in parentheses is adjusted for shifts to NOW 5. From average for preceding quarter to average for quar- accounts in 1981. ter indicated. 3. From average for lounh quarter of 1993 to average tor second quarter of 1994. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 CAM MRx-nriA*x(M noamunr rower uxn UMO-KM uu omm 7 Chairman ar««napan hea advanced, a* an aryuiHRC (or giving high DfiorUv to inflation reduction in mon«i;»ry policy, tho hypotneaia that low inflation will lead to higher productivity growth. To support thi» conjecture the of CXjvernory made available the staff papor "Productivity and inl-lationi Rvldencc and Interpretations" by Qlenn Hudcbueh and David Wileox. The authors are first-class professional economists. Thsir papor la a conacieniious survey of relevant tnoory and empirical research, and Ln«y add nomo exploratory modeling and calculations of their own. They are appropriately cautious, concluding chat tho evidence on the Greenspan hypothenin ia at thiu stage nixed and uncertain. Clearly the paper offers no guidance to monetary policy. AB tnifl staff paper points out, inferences of cauaation from statistical correlations are always tricky and treacherous. This ia true for both time usual regression* and crosH-national correlations. The problems could hardly be more acute than in the present context, because both productivity growth and inflation, aggregated ov«tr whole economies, are difficult to measure unambiguou»iy, and bacaue botn ma Influenced by a whole hoac of "third" Cactora, systematic and random, oil interconnected by a large number of dimly understood oquatione. I would atreaa, as th* Kudabuah-Hllcox paper do«a not. the monetary policy contnxt In which Chairman Greenspan relsea thia queation. The practical leeue in not whether inflauion and productivity growth are. on the whole, negatively correlated. It ia whether them la any correlation that the central bank can exploit, can wg expect a reduction in inflation enalpaerad hv > monetary aolicv co raise productivity growth? The qualification n^airmnrod bv inonftiiary jpjlcv is of banlc importance. 1C is eawy to think of numerous scenarios, shocks, and circumBtances in which lower inflation and higher productivity growth are associated. But unless rnonauftry policy ia, directly or indirectly, an important and independent one Of the sources, those observed correJatione are nothing central banks can exploit. T would acres* a]BO that, co naka aenne, the question concerns ]pya-rmi trcndn in pricea ana prtxJuctlvity. The insuo is not now transient cyclical deviations £ron I.rends are correlated, when these deviations are affected by monetary policy, but how the trends themueivea are related insofar as cliey are affectad by monetary policy. In the U.S. today the issue Bftems further circumscribed. Since the VolcXer Ped'fl unti-inflation crusade in 1979-82, which involved a deep recession, the inflation trend haa been below 5V and probably declining. Mould Fedoral Raserva action to reduce it lurcher, to two percent or «aro, be rawerdad by higher trend growtn In productivity? A *ero inflation policy has b«en advocated Dy aone inflation nawks in the Fed and outside it, who want to finish tho cruxode cut short in 1982-83 at 5*. Such action would involve •lowing down the growth of output and amploymonc relative to potential real OOP and lull employment labor force, aluwlng this growth to a greater degree than Lha Prri would do If Ita abjoct-ive were 9imply to avoid overshooting the HAIRI1 and thus to forestall a wage-prlca spiral. Such B policy would hive Bone obvious coetB In terns of future productivity growth. It vould aJow, at least tenporarily, naLional saving and investment. Capitol investment -- doneatic and foreign, private and public, physical and human, hlgn-tech and low-toch -- arc generally i-eqarded as the inatrunents of productivity gains, it IB hard to BBC how policies that clow them down, even temporarily, can ba qooo for productivity even if they succeed Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 in durably lowarlng inflation by a couple of points, Tho optimal price l*vel trend -- positive, r.ero, or negative •- IB an old iBBua in economics and la drawing renewed attention today. In tho discussion earlier in the century, u goon ceee for moderate stable positive trend JnClation was made by William Victory and Tiber Scitovsfcy, among otners. I mention two arguments h«re. on* stares with the observation that economically officiant chorigwtj in galaciy^ price* and wages, to a V tract resources Into progressive a actors avay from obsolescent sectors, aro easier and quieter when they can be mode without actual declines in dollar wages. with positive trend inflation thcoe adjustments can ha lude ay holding dollar •ayes In declining industries and occupations constant or by restricting their rlsee to sub-average amounts. For this reason, efficient adjustments in resource ollocuf.ion, crucial tn advances in overall productivity, will be aurnr end fa«ter with a clearly poaitlve price trand -- i .«. 31 LO St rather than o* co 21. The second argument cqncerno nominal internet ratsu. AL tines cyclical recoveries require that some real interest races, especially on safe Short-term assets, be temporarily negative. Hue »lnce *ero 13 tha floor on noninal .interest rates, negative real rateu cannot bo obtained if tha Inflation calling is also zero. Bvidenca that economics with hyper-inflation or inflation chronically in triple or double digits have lower productivity growth than economies averaging single-digit inflation is not overwhelming. But svan it' it, were leas ambiguous. it would not awoport uw asueixion that reducing loo inflation by one or two or three percentage points would have any significant affect on productivity. The groee cross-national scatter diagrams do not allow such flnfl ation. Yeer-to-year or cftjaruer- to- quarter tine aeries correlations of inflation and productivity growth are eleo of dubloua rolevanca if --as 1 think la eloar -- tftn main policy laftue involves trends rather chan cycles. For the O.S. 1SSO-73, there la no time serlos correlation anyway, in Lhat period average inflation was low and productivity growth high. When tha years after 1972 are added, the correlation becomes negative, essentially reflecting tha contrast of stagflation and ita aftermath 1973-83 with pre-1973 performance. Simultaneously «ith the rise in trend inflation, a sharp worldwide fall in trend productivity growth took plnco in tho early J970S, PorPaps It was reL&ted CO the energy crisis, but professional economieta spcclaliiing in the nubjact aro uncertain about the causes of the productivity slowdown. There is no convincing cose that it was. due to expansionary cnncral hank policies throughout the world. whether monetary policy, rattier than exogenous supply shocks, was roaponaible for stagflation in che 1970s la still a contested and contentious issue, Tn ne It aoecna pretty clear that, whatever over- accommodative mistake* had boan mado 1965-72, the two oil shocks triggered inflations that then obatcid only slowly during tho recessions that raaulted from the Fed's rosponues to ttvoso ahockB. In this BSOBB I>«d policy had aomeching to do with S shore-run negative correlation of inflation and productivity growth. Inflation- conscious counter-cyclical moneeary policy will generate tho appearanco of negative correlation betweon Inflation Rod productivity growth. inflations are high, thourjh slowly declining, during recessions, which alao generate taraporarily bad productivity stntlsuicu. The nw»t lively oxplanation ot evidence chat economies with relatively law inflation perform better in many dimensions, including productivity, is tnat all these dnalrable resultc are sywiptorno of genecully goad social. political, and aconumic health. Ttilu in Lurtx »«y rafletrt good fortune, ncrong traditions, social cohesion. ?ax example, a aoelety tn«e vnn agree on now the economic pie ia to be divided amonri its ciLirens, or on how questions of thie Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 kind ace co be dacided, is likely to t» IMS inflationary and more succassful In productivity growth and other aspects of national performance than • society that suf£«rs pexpecu*! internal conflict about, tha division of lnco*e and wealth. Likowi**, a «ocl*ty Jn vhJcti («nllie«. schools, ana ouher ineLltucions Bocinlite and educate th* young ie yoing to be nore nuccaisfui cnon a eociouy that fails in ihis banic humn task. productivity IB » real phononenon, and its long run growth i* liLaly to bo affocteri by roal factors •- notably IrweatTMneg o£ all kinds in future technologies and human akilla. so far as governnent' a nacro policies ar« concornad. Its fiscal policiea arc crucial, aa CtwJrncui Greanapart often points out. Thin is not just a matter o£ public deficits and debts, but also of public InvettnantB In future-oriented activicioe. Monetary policy can help by keeplnq the economy growing along ita full employment potential QDt> paen. But by itsolf the Fed cannot expect to accelerate productivity, surely noc by tightening policy in order 1.0 lower tha trend race at inflation. Jamee Tobin July 17, 199* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 Labor Costs at 29 -Year Low Unit Labor Costs, Nonfarm Business 14.0% 12.0% 10.0%- § 8.0%- ra 6.0%- .c O c i V O 4.0%- 2.0%- I 1994 Rate* I1 0.6% 1,1 IIIIII 0.0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 Source: Bureau ot Labor Statistics • 1994 rate is 1st Quarter ot 1993 to Isl Quarter ot 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Inflation Back to Early 1960s* Rate Four Quarter Change in Deflator for Final Sales to Domestic Purchasers 12.0% 10,0% 8.0% 6.0% o o 4.0% 2.0% 0.0% -2.0% 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 101 Inflation Low and Falling Change in Consumer Price Index 14.0%' 10.0%-J o o Q 8.0%- 0o) C x(:0 6.0%- O "c <u H 4.0%' 1994 Rate' I 2.5% 2.0%- 0.0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 Source: Bureau of Labor Statistics '1994 Rale: 12 months ending June 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1994, July 19). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19940720_chair_federal_reserves_semiannual_report_on

@misc{wtfs_testimony_19940720_chair_federal_reserves_semiannual_report_on,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1994},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19940720_chair_federal_reserves_semiannual_report_on},
  note = {Retrieved via When the Fed Speaks corpus}
}