Congressional Testimony

FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1996 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED FOURTH CONGRESS SECOND SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 FEBRUARY 21, 1996 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE WASHINGTON ; 1996 For sale by the U.S. Government Printing Office Superintendeni of Documents, Congressional Sales Office, Washington, DC 2IM02 ISBN 0-16-052727-9 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS ALFONSE M. D'AMATO, New York, Chairman PHIL GRAMM, Texas PAUL S. SARBANES, Maryland RICHARD C. SHELBY, Alabama CHRISTOPHER J. DODD, Connecticut CHRISTOPHER S. BOND, Missouri JOHN F. KERRY, Massachusetts CONNIE MACK, Florida RICHARD H. BRYAN, Nevada LAUCH FAIRCLOTH, North Carolina BARBARA BOXER, California ROBERT F. BENNETT, Utah CAROL MOSELEY-BRAUN, Illinois ROD GRAMS, Minnesota PATTY MURRAY, Washington PETE V. DOMENICI, New Mexico HOWARD A MENELL, Staff Director ROBERT J. GIUFFRA, JR., Chief Counsel PHILIP E. BECHTEL, Deputy Staff Director BRENT FRENZEL, Professional Staff Member STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel MARTY GRUENBERG, Democratic Senior Counsel PATRICK A. MULLOY, Democratic Chief International Counsel EDWARD M. MALAN, Editor Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C O N T E N TS WEDNESDAY, FEBRUARY 21, 1996 Page Opening statement of Chairman D'Amato 1 Prepared statement Opening statements, comments, or prepared statements of: Senator Sarbanes 2 Senator Mack 4 Senator Faircloth 4 Senator Gramm 5 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem 6 Prepared statement 31 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to Congress, February 20, 1996 37 (ill) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1996 WEDNESDAY, FEBRUARY 21, 1996 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:10 a.m. in room 538 of the Dirksen Senate Office Building, Senator Alfonse M. D'Amato (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN ALFONSE M. D'AMATO The CHAIRMAN. Good morning, Chairman Greenspan. It's good to see you. Chairman GREENSPAN. Thank you. Good morning. The CHAIRMAN. I'm pleased to welcome you here to discuss the Federal Reserve's semiannual monetary policy report. I have extended remarks that go for a number of fully type- written pages, but I want to save some time so that we can hear from you, Mr. Chairman. I'm going to ask that my remarks be placed in the record as if read in their entirety. I also want to commend you for your able stewardship because we have come through some very rough waters and notwithstand- ing our own inability, that being the Congress and the Executive, to do its business in a manner that would strengthen the economy, I think you've done admirably well. I think our failure to come to a budget accord has not helped the situation out, has created instability, and I say our failure because we have not been able to accomplish it. There are no miracles unless we get the deficits under control with a program that is realistic, not one that is manufactured, which is not one which is back-loaded with cuts in the last several years of a projected program to bring the deficit into balance, it seems to me that regardless of who sits in your chair, the job is never going to be done adequately and properly. I think sometimes we place too much attention at one end and fail to recognize that without there being the kind of action nec- essary to reduce the deficits and to get spending programs which are growing at a disproportionate rate, at a rate that cannot be practically sustained, that we're never going to really have the kind of success that we could have. So the responsibility, in great measure, large measure, rests with Congress and the White House. (1) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis That's my thought. I've asked that ray statement be included in the record as if read in its entirety. I want to congratulate you for operating under very difficult cir- cumstances. Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you, Mr. Chairman, and I join you in welcoming Alan Greenspan, the Chairman of the Board of Gov- ernors of the Federal Reserve before the Committee for the semi- annual report on monetary policy as required by the Full Employ- ment Balance Growth Act of 1978. Since the middle of last year, the middle of 1995, the Federal Open Market Committee has cut the benchmark Federal funds rate by 94 of a percentage point from the mid-year peak of 6 percent to a current level of 5.25 percent. While this has reversed somewhat the steep increase in interest rates that consumed the attention of the Federal Reserve through- out 1994 and into early 1995, I still regard this as unfinished busi- ness. At the beginning of February, Merrill Lynch, under the heading "Monetary Policy More Easing Ahead" had the following to say: Having met market expectation and eased monetary policy on January 31, we believe that the Fed still has several more rounds of easing to go. Even after the latest easing—I'm continuing to quote—we believe the monetary policy remains overly restrictive. At the moment, consumer spending is barely growing, the indus- trial sector is at a standstill, and despite lower mortgage rates, home sales are slipping. GDP grew by only around 1.5 percent during 1995 and we doubt that it is growing faster than at a 1-percent rate in the current order, and it could be weaker. That is well below anyone's estimate of U.S. non-inflationary growth potential. Meanwhile, the CPI rose just 2.5 percent during 1995 and indus- trial commodity prices declined. Now even with the latest interest rate cut, the real Federal funds rate is currently 2^4 percent, well above the historical average of 1.85 percent as this chart would demonstrate. This is the Fed funds, this is the 40-year average, 1.9 percent. The current is 2.8 percent. This is the prime rate for the 40-year average of 3.4 percent and is currently 5.8 percent. The gap between the Federal funds rate and the prime rate has expanded over recent times. It used to run at about 2 points, or less than 2 points. It's now running at about 3 points, almost in tandem. This is a 5.8 percent real prime rate. The 40-year average on the prime rate is 3.4 percent, and of course the prime rate is the rate at which the lending from the banks takes place, now much higher than the historical average. In fact, the real rates are not much lower than they were last year when the Fed completed its year-long tightening. Much of the % point decline in the Federal funds rate simply reflects a lower inflation. It was running last year at 3 to 3 V* points. Ifs now at 2.5 points, and that's about the change in the fund rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The decline actually just about matches two declines in inflation and the Federal funds rate. There's evidence that the rate cuts thus far are having little practical effect on the economic outlook. On February 10, the Blue Chip Economic Forecasters cut their consensus outlook for GDP by two-tenths of 1 point. They are now projecting 2 percent growth for this year. The recent survey of consumer expectations, done by the Univer- sity of Michigan Survey Research Center, released on February 9, found that the recent interest rate cuts will have little impact from the consumer's point of view. I quote them: The recent cuts are likely to have an even smaller impact on bolstering job and income prospects, the most important concern amongst consumers at the present time. While consumers do not expect an outright recession, there's ample evidence that they are becoming increasingly concerned that the recent slowdown in the pace of economic growth will persist during the year ahead. The survey also found that consumers expect the unemployment rate to rise this year. It would seem that with the economy on the soft side, 2 percent growth projected for this year and unemployment now at 5.8 per- cent, that we would be able to absorb stronger growth for monetary stimulus without an inflation problem. In fact, the University of Michigan's Survey of Consumers states, and I quote: Importantly, the data suggests that some further lowering of interest rates to stimulate demand would not cause consumers to abandon their resistance to price increases and product markets, nor escalate their demands for wage increases in labor markets. Yesterday marked, and I'll close with this observation, the 50th anniversary of President Truman signing the Employment Act of 1946. That committed the Federal Government, "To use all prac- ticable means for the purpose of creating and maintaining condi- tions which promote useful employment opportunities for those able, willing, and seeking to work." In fact, for 50 years, following this commitment, we have suc- ceeded in stabilizing the business cycle. I just want to close with this chart that shows the dramatic dif- ference between the downturns of the last half century before the Employment Act, and what's occurred since. This is the Depression of the 1930's. This was just at the end of the World War II period before the Employment Act, and this is what we've managed to do in the past 50 years. We've avoided these very wild fluctuations and have managed to sustain the economy almost completely in a positive growth mode. We've gone negative only on a couple of occasions, and then by very small margins. I think a concerted use of fiscal and monetary policy has enabled us to achieve that performance, and I'm very anxious that we con- tinue to do so. Thank you, Mr. Chairman. The CHAIRMAN. Senator Mack. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis OPENING STATEMENT OF SENATOR CONNIE MACK Senator MACK. Thank you, Mr. Chairman. Welcome, Chairman Greenspan. When you became Chairman of the Federal Reserve Board in Au- gust 1987, the price of gold was $461 per ounce, and 30-year Treas- ury bond yields were almost 9 percent. Today gold prices are down to $400 an ounce and 30-year Treasuries are under 6.5 percent. In my view, the reason gold prices and bond yields are down is because inflationary expectations are down. In the past 5 years, your oversight of monetary policy has kept inflation below 3 percent. Mr. Chairman, that is an extraordinary record. The numbers speak for themselves, and many Americans have benefited. With mortgage rates down, many people have purchased their first homes and even more have refinanced at lower rates. Your management of monetary policy toward price stability has yielded tremendous results, and you can be proud of that record. However, in recent months, with signs of weakness in the econ- omy, it has become commonplace to blame the Federal Reserve for slow growth. The President and other critics of the Federal Reserve Board refuse to look at the impact of fiscal policy on economic growth. Increases in taxes, regulation, and Government burdens during President Clinton's administration have slowed the potential growth in the economy. Job growth, income growth, and opportunity have all suffered as this recovery continues to under perform. Let's set the facts straight on growth. I will stand second to none in my support of policies which enhance economic growth. Let me be clear. Economic growth does not come from appointing easy money advocates to the Fed. If it did, counterfeiting would be legal. Real growth comes from entrepreneurial activity, savings and in- vestment. The way to increase these activities is to free the econ- omy from the handcuffs of Government. We must cut taxes, reduce spending, and slash regulation. For these reasons, I've introduced the Economic Growth and Price Stability Act. This bill is designed to maximize economic growth. The Federal Reserve can best maximize economic growth by keeping prices stable. Any attempt to use the Federal Reserve to boost growth always results in higher interest rates, more infla- tion, less employment and slower growth over the long run. I know you understand this, and I urge the President to renomi- nate you as quickly as possible. I'm looking forward to your testimony today. Thank you, Mr. Chairman. The CHAIRMAN. Senator Faircloth. OPENING STATEMENT OF SENATOR LAUCH FAIRCLOTH Senator FAIRCLOTH. Thank you, Mr. Chairman. Just very briefly, Mr. Chairman, I wanted to make the following point in reaction to the President's statement about Republican Senators blocking certain people from the Federal Reserve Board. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The President will soon make two and possibly three appoint- ments to the Federal Reserve Board. In making these appoint- ments, I hope he will remember his own phrase about the era of big Government is over, and that does mean, however, that the era of easy money has arrived. The Congress can appropriate money. Congress and the Treasury can borrow money. The Federal Reserve has the power to create money. This is an awesome power and it should be delegated care- fully. For this reason, I think the Senate has every right to be very cautious about who gets on the Board, and who may, in 8 or 12 years from now, become chairman. I want to compliment you on the job you've done. The CHAIRMAN. Senator Gramm. OPENING COMMENTS OF SENATOR PHIL GRAMM Senator GRAMM. Thank you, Mr. Chairman. Let me make a few remarks, building on the remarks of my col- leagues. No. 1, when I read about economic growth in the press, the atti- tude of many is almost as if we choose economic growth with no sacrifice, with no change in policy required. It's almost as if we could simply have someone somewhere, in the White House, the Congress, the Federal Reserve Board, on Wall Street, say, "well wouldn't it just be a great idea to have 4 percent economic growth?" In that light, if we could have growth by wishing it, I don't know what idiot decided we should have 1.5 percent economic growth, and all we need to do is have somebody decide that it would be bet- ter to have higher growth. It seems to me that it's very important that we knock that kind of thinking in the head and make it clear that if you want to have higher growth, you have to do the hard things that are necessary in order to have it. You have to have a stable monetary policy. You have to have low interest rates. You have to have something ap- proaching a balanced budget. You have to lift the regulatory bur- den. You have to reduce taxes to provide incentives, and that re- quires positive Government leadership. It means saying no in Washington so that people that make investment decisions can say yes. I see almost a total absence, to some extent in both parties, of any discussion of these realities. Let me also say one thing about inflation and interest rates. I think we all have to be very careful that we not take any action that would in any way convince the financial markets that we had lost our commitment to controlling inflation, because if we do, in- terest rates will spike, and the deficit is going to explode. The im- pact on the fiscal policy of the country of a weakened resolve to fight inflation would be cataclysmic. The final point I want to make I want to pose as a question. Obviously I have listened to you, Alan, for quite a few years, talk about the deficits. I know you understand they matter, and that, in the short run, there's something that we need to do about them. It seems to me that one of the things that many policymakers have Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 a hard time focusing on is just how seriously we should take the projections of what the deficit and what the Government will look like 20 years from now. I know that probably more than anyone else in the country you, as Chairman of the Federal Reserve Board, have taken a good, hard look at what happens 20 years from now if you take the cur- rent growth rate that is built into the Government, in what we have already committed to, and you project that out for 20 years, and you look at the kind of tax rate that that would call for. You understand the ability of the economy to sustain tax rates of that level. You have to reach a conclusion that that's a future that can't be, that that's a future that won't be. The question is, what's going to change it? One of the things that Fd like to get your views on in your testi- mony today is, just how seriously should we take that kind of anal- ysis, of looking at economic trends projected 20 years from now? Should that be something that we should be focused in on, that we should be trying to make decisions about today? Should our focus just be on the next 5 to 7 years? How seriously should we take that long-term problem? From my own point of view, I take it very seriously, because I think it shows that we have to make a fundamental decision as to what kind of country we want. I don't see much evidence that those decisions are being made. I'd like at least to get your thoughts about looking at some of these projections. The President has used generational accounting. I see a lot of problems with that. I think if you look at current services govern- ment, no new programs, just funding what we already have, when you look at a generation, 20 years, and you look at the kind of tax burden that would be required to fund that government, it looks to me as if that is a very severe problem. It is a problem that nobody appears to be addressing, and it seems to me it ought to be one of our concerns. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator. Alan, now we look forward to hearing from you. STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Thank you very much, Mr. Chairman. I have a rather long official presentation, and have taken the lib- erty of making major deletions but request, however, that the full transcript be included in the record. Mr. Chairman and Members of the Committee, it's always a pleasure to appear before you to present the Federal Reserve's semiannual report on monetary policy. The United States' economy performed reasonably well in 1995. One and three-quarter million jobs were added to payrolls over the year, and the unemployment rate was at the lowest sustained level in 5 years. Despite the relatively high level of resource utilization, inflation remained well contained with the consumer price index rising less than 3 percent—the fifth year running at 3 percent or Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis below. A reduction in inflation expectations, together with anticipa- tion of significant progress toward eliminating Federal budget defi- cits, was reflected in financial markets, where long-term interest rates dropped sharply and stock prices rose dramatically over the year. With inflation contained and inflation expectations dropping, the Federal Reserve was able to ease monetary conditions twice in the second half of the year. As we entered 1996, information becoming available raised addi- tional questions about the prospective pace of expansion. The situation was difficult to judge, but several indicators ap- peared to signal some softening in the economy. A number of fac- tors have prompted the recent tendency toward renewed weakness. Some are clearly quite transitory, related, for example, to bad weather or the Federal Government shutdown. Others may be somewhat more significant but still temporary. A constraint on Government spending while permanent budget authorizations are being negotiated is one. Another may be a temporary reduction in output in some industries as businesses have further adjusted in- ventories to disappointing sales. As I noted last July, the change in the pace of inventory investment when the economy shifts gears can be substantial. Inventory investment surged in 1994 and into the early months of 1995, but proceeded to fall markedly through- out the rest of the year. This has placed significant downward pres- sure on output, which should lift as inventory adjustments subside. But for the moment, the pressures remain, in the motor vehicle industry and elsewhere. Ultimately, of course, it is the path of final demand, after the temporary influences work themselves out, that determines the tra- jectory of the economy. There are some factors, such as high consumer debt levels, that may be working to restrain spending. But as I shall be detailing shortly, a number of fundamentals point to an economy basically on track for sustained growth, so any weakness is likely to be temporary. Nonetheless, the Committee decided in late January that the evi- dence suggested sufficient risk of subpar performance going for- ward to warrant another slight easing in the stance of monetary policy. Given the subdued trends in costs and wages, the odds that such a move would boost inflation pressures seemed low. In assessing the likely course of the economy and the appropriate stance of policy, one question is the significance, if any, of the age of the business expansion. Some analysts, viewing recent weak- ness, have observed that the expansion is approaching the start of its sixth year and is now one of the longer peacetime spans of growth in the past half century. Economic expansions, however, do not necessarily die of old age. Although the factors governing each individual business cycle are not always clear, expansions usually end because serious imbalances eventually develop. When aggregate demand exceeds the economy's potential, for ex- ample, inflationary pressures pick up. The inevitable increase in market interest rates, as inflation expectations rise and price pres- sures intensify, depresses final demand. Lagging demand in turn sets off an inventory correction that frequently triggers a downturn in the economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Capital expenditures by households and firms can also contribute significantly through the development of cycle-ending imbalances. The level of stocks of such real assets have effects on output very similar to those of business inventories. In typical cycles, capital expenditures tend to grow rapidly in the early stages of recovery. Pent-up demands coming out of a recession by consumers and busi- nesses are satisfied by rapid growth of spending on capital assets. There is a limit, however, on, say, how many cars people choose to own or how many square feet of floor space retailers need to service customers. Spending on such assets generally tends to grow more slowly after the pent-up demand is met. As with business inven- tories, downshifting of spending on consumer durables or business plant equipment may not occur smoothly. The dynamics of expanding output and rising profit expectations often create a degree of exuberance which, as in much of human nature, tends on occasion to excess—in this case, in the form of a temporary over-accumulation of assets. The ensuing correction and demand for such assets triggers production adjustments that can significantly mute growth for a time or even cause a downturn if the imbalances are large enough. The current extent of any asset overhang is difficult to deter- mine. Growth of demand for durables in some categories of capital goods evidently has slowed. But the available evidence does not suggest a degree of saturation in capital assets that would tip the economy into a downturn. Moreover, financial conditions are likely to be generally support- ive of spending. The low level of long-term interest rates should have an especially favorable effect. In addition, with the condition of most financial institutions strong, lenders are likely to remain willing to extend credit to firms and households on favorable terms. Against this background, the Federal Reserve policymakers ex- pect the most likely outcome for 1996 as a whole is further mod- erate growth. The unemployment rate is expected to remain around recent levels. The Federal Open Market Committee also anticipates a continu- ation of reasonably good inflation performance in 1996. The success during 1995 in keeping the increase in the consumer price index below 3 percent in the fifth year of an expansion illustrates that an extended period of growth with low inflation is possible. Keep- ing inflation from rising significantly during economic expansions will permit a gradual ratcheting down of inflation over the course of successive business cycles that will eventually result in the achievement of price stability. Determining whether further changes to the stance of monetary policy will be necessary in the months ahead to foster progress to- ward our goals will be a continuing challenge. In formulating mon- etary policy, while we have in mind a forecast of the most likely outcome, we must also evaluate the consequences of other possible developments. Thus, it is sometimes the case that we take out monetary policy "insurance" when we perceive an imbalance in the net costs or benefits of coming out on one side or the other of the most probable scenario. For example, in our most recent actions, we saw a decline in the FfHgral ftinda rate 3s not increasing infla- tionary risks unacceptably while addressing the downside risks to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the most likely forecast. In assessing the costs and benefits of ad- justments to the stance of policy, Members of the Committee recog- nize that policy affects the economy and inflation with a lag, and thus needs to be formulated with a focus on the future. Over the past year, we have kept firmly in mind our goals of containing in- flation in the near term, and moving over time toward price stabil- ity, and they will continue to guide us in the period ahead. Structural forces may be assisting us in this regard. Increases in producers' costs and output prices proved to be a little lower last year than many had anticipated. While it is too soon to draw any definitive conclusions, this experience provides some tentative evi- dence that basic on-going changes in the structure of the economy may be helping to hold down price increases. These changes stem from the introduction of new technologies in a wide variety of pro- duction processes throughout the economy. The more rapid advance of information and communications technology and the associated acceleration in the turnover of the capital stock are being mirrored in a brisk restructuring of firms. In line with their adoption of new organizational structures and technologies, many enterprises are finding that their needs for var- ious forms of labor are evolving just as quickly. Partly for that rea- son, most corporate restructurings have involved a significant num- ber of permanent dismissals. An important consequence of the layoffs and dismissals associ- ated with restructuring activity is a significant and widely reported increase in the sense of job insecurity. Concern about employment has been manifested in unusually low levels of indicators of labor unrest. Of particular relevance to the inflation outlook, a sense of job insecurity is having a pronounced effect in damping labor costs. For example, the increase in the employment cost index for com- pensation in the private sector, which includes both wage and sal- ary payments and benefit costs, slowed further in 1995 to 294 per- cent despite labor market conditions that by historical standards were fairly tight. The more rapid pace of technological change is also reducing business costs through other channels. Initially most important, the downsizing of products resulting from semiconductor tech- nologies together with the increasing proportion of national output accounted for by high-tech products has reduced costs of transport- ing the average unit of the gross domestic product. Quite simply, small products can be moved more quickly and at lower cost. More recently, dramatic advances in telecommunications tech- nologies have lowered the costs of production for a variety of prod- ucts by slashing further the information component of those costs. Increasingly, the physical distance between communications end- points is becoming less relevant in determining the difficulty and cost of transporting information. To be sure, advancing technology, with its profound implications for the nature of the economy, is nothing new and the pace of im- provement has never been even. But it is possible that we may be in the midst of a quickening of the process. Nonetheless, we dp have to be careful in projecting a further acceleration in the appli- cation of technology indefinitely into the future. Similarly, sup- pressed wage cost growth as a consequence of job insecurity can be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 carried only so far. While it is difficult to judge the timeframe of such adjustments, the risks to the cost and price inflation going forward are not entirely skewed to the downside, especially with the economy so recently operating at high levels of resource utiliza- tion. In light of the quickened pace of technological change, the ques- tion arises whether the United States' economy can expand more rapidly without adding to inflationary pressures. The Federal Re- serve would certainly welcome faster growth provided that it is sustainable. The particular rate of maximum sustainable growth in an econ- omy as complex and ever-changing as ours is difficult to pin down. Fortunately, the Federal Reserve does not need to have a firm judgment on such an estimate for persistent deviations of actual growth from that of capacity potential will soon send signals that a policy adjustment is needed. Should the Nation's true growth po- tential exceed actual growth, for example, the disparity and less- ened strain would be signaled in shorter lead times on the delivery of materials, declining overtime and ebbing inflationary pressures. Conversely, actual growth in excess of the economy's true poten- tial would soon result in tightened markets and other distortions which, as history amply demonstrates, would propel the economy into recession. The hypothesis that advancing technology has enhanced produc- tivity growth would be more persuasive if national data on produc- tivity increases showed a distinct improvement. To a degree, the lack of any marked pickup may be a shortcoming of the statistics rather than a refutation of the hypothesis. Faulty data could be arising in part because business purchases are increasingly con- centrated in items that are expensed but which market prices sug- gest should be capitalized. In addition, the output of services—and the productivity of labor in that sector—is particularly hard to measure. There is still a nagging inconsistency: The evidence of significant restructurings and improvements in technology and real costs with- in the business establishment does not seem to be rally reflected in our national productivity measures. It is possible that some of the frenetic pace of business restructuring is mere wheel spinning, changing production inputs without increasing output, rather than real increases in productivity. One cause of wheel spinning, if that is what it is, may be that it takes some time for firms to adapt in such a way that major new technology is translated into increased output. It may be that the full advantage of even the current gen- eration of information and communication equipment will be ex- ploited over a span of a few years, and only after a considerably updated stock of physical capital has been put in place. To be fully effective in achieving potential productivity improve- ments, technological innovations also require a considerable amount of human investment on the part of workers who have to deal with these devices on a day-by-day basis. On this score, we still may not have progressed very far. Many workers still possess only rudimentary skills in manipulating advanced information technology. In these circumstances, firms and employees alike need to recognize that obtaining the potential rewards of the new tech- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 nologies in the years ahead will require a renewed commitment to effective education and training, especially on-the-job training. Our Nation faces many important and difficult challenges in eco- nomic policy. Nonetheless, we have made significant and fun- damental gains in macroeconomic performance in recent years that enhance the prospects for maximum sustainable economic growth. Lower rates of inflation have brought a variety of benefits to the economy including lower long-term interest rates, a sense of greater economic stability, an improved environment for household and business planning, and more robust investment in capital ex- penditures. We have also made considerable progress on the fiscal front. Over the past 10 years, and especially since 1993, our elected polit- ical leaders, through sometimes prolonged and even painful nego- tiations, have been successful in reaching several agreements that have significantly narrowed the budget deficit. But more remains to be done. As I have emphasized many times, lower budget deficits are the surest and most direct way to increase national saving. Higher national saving would help to reduce real interest rates fur- ther, promoting more rapid accumulation of productive capital em- bodying recent technological advances. Lower inflation and reduced budget deficits will by no means solve all of the economic problems we face, but the achievement of price stability and Federal budget balance or surplus will provide the best possible macroeconomic climate in which the Nation can address other economic challenges. Thank you very much. The CHAIRMAN. Well thank you, Mr. Chairman. I was going to ask you to summarize, with some particularity, what would the impact be on the economy, if we ever could bring about a budget accord or balanced budget between the Congress and the President. But you summarized that. With particularity in regard to interest rates. We hear so much about interest rates and people clamor at you about interest rates. If we could put aside the political posturing, and get a balanced budget, that would be sustained by CBO as being achievable, one that is credible, what impact would that have on interest rates and inflation in your opinion? Chairman GREENSPAN. Mr. Chairman, as I've indicated many times in the past, the significant decline in long-term interest rates over the past year and a half, has been, to a very significant ex- tent, the result of the financial markets' perception that something real with respect to balanced budget programs would be initiated. There's been over the years a very significant degree of skep- ticism in the financial community that much of what has been passing as fiscal policy directed at budget balance has been smoke and mirrors. That clearly changed last year. With some reluctance, I perceived that the markets, or more exactly, the people within the markets, began to realize that perhaps something was changing, as indeed I think it has. The culture is very obviously changing and if for no other reason, one need only look at how effective the "paygo" issue in the budget process has become, even though a majority of the Congress could readily overthrow it. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 I also said, in response to similar questions, that in the event that the significant move toward budget balance fails, part of the decline that has occurred in anticipation of a successful outcome will probably be retraced, and part of the move upward in long- term interest rates over the last week or so has basically reflected some concern in that direction. If, however, further progress toward getting a credible program is made which the markets will perceive as real efforts in the direc- tion of budget balance, and which are not just hopeful statements of where we wish to be, but give the type of specificity and program changes which would be difficult to change in subsequent years, my suspicion is that we will find that long-term rates will fall signifi- cantly further. That clearly is the crucial statistic in the current environment which could be most positive to economic growth. We estimate that perhaps two-thirds or more of the overall interest rate effect on the economy comes from changes in longer-term rates because obvi- ously they impact mortgage rates and a number of rates in the pri- vate sector where capital investment is involved. So there's nothing that I could see which would be, in the short run, more important to galvanize economic growth than to come to an effective credible agreement on reaching budget balance within a reasonable period of time. The CHAIRMAN. Do you believe the marketplace is already begin- ning to sense that notwithstanding a change in attitude for the bet- ter, as it relates to more Members of the Congress on both sides seeing the importance of bringing about a balanced budget, do they sense that once again we may hit an impasse, and that this then would create some instability and also have an adverse impact in terms of higher interest rates long term? Chairman GREENSPAN. I think the answer to your question is generally yes. Nonetheless, I think that what still appears to be in place is the view within the market that commitments toward sig- nificant reductions in budget deficits are still on the table in the White House and in the Congress, and so we have not had, and I don't think we will have unless there is a dramatic reversal of this whole process, a really major rise in long-term interest rates be- cause of failure to come to grips with this particular issue. But I do think that the clear ebbing of the efforts and the rhetoric to solve this problem is beginning to have some marked effects as doubts are beginning to rise. I don't think they have risen to the level where they are as yet serious but they could. The CHAIRMAN. That would be unfortunate. Chairman GREENSPAN. Most certainly. The CHAIRMAN. If we lose this opportunity to continue to really bring about a goal of achieving it I think would be an absolute tragedy. Chairman GREENSPAN. I agree with that, Mr. Chairman. The CHAIRMAN. Senator Sarbanes. Senator SARBANES. Chairman Greenspan, I was intrigued to read the morning papers reporting on your testimony yesterday before the House Committee. One morning paper headlined your testimony as follows: Greenspan Calls Economy Soft, Hints At Rate Cut. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 The other one said: Greenspan Rattles Market As Hopes for Rate Cut Dim. One says that you're hinting at rate cut and the other one says, hopes for rate cut dim. I know you don't like to add clarity to situations. [Laughter.] Senator SARBANES. It seems to me for the Chairman of the Fed to get reported upon in this virtually contradictory manner is not a good thing for public understanding of the economy or where we are or what economic, what direction economic policy is moving. I'd ask you this morning to provide a little guidance in order to give us some sense about these contradictory reports. Chairman GREENSPAN. Well, Senator, I obviously will not clarify it to the point where everyone will be happy. Maybe I can do a lit- tle bit in that regard. The problem is that this is a very unusual type of period that we find ourselves. We're at the stage of a process which is one in which we have to be aware of the fact that, as I said in my pre- pared remarks, we are going through effectively a significant soft patch in the economy. The probabilities of our coming out and the economy doing reasonably well are, as they usually are, better than 50/50. I say that because I think we have to understand what is on the other side of this issue, namely the question of how do we view the probabilities of recession, for example. And how would we respond to that sort of thing. The difficulty that I have with this type of question is that with extremely rare exceptions, a recession defined as some breaking of the fabric of the economy so that you get cu- mulative downward erosion in economic activity, that sort of situa- tion almost at any point in time never has a more than 50 percent probability. As a consequence, you very rarely see people who have single line forecasts forecasting recessions except if they want to be seen as outliers, and usually most of the forecasts of recession turn out to be wrong. Nonetheless, there is always a situation underlying any particu- lar type of outlook, especially one such as now in which we are in a soft patch, when even though the probabilities of a recession don't seem likely, they do rise. That's invariably the case whenever you get a situation where you're in a soft economy. The reason I discussed the issue in some detail in my prepared remarks with respect to taking out "insurance" is that, as a prac- tical matter, monetary policy cannot and should not be directed at a single forecast. We do not have the capability, nor does anyone else, to be able to know with certainty precisely where the economy is going to be. What you have to do is to try to weigh the pluses and the minuses of particular policies which you could potentially make, and what the costs and benefits of those particular policies are. As I indicated earlier, since we did not perceive that there was a significant risk of reigniting inflationary pressures, we did move, on January 31, 1996, to recognize the fact that we are in a soft patch. Where the confusion arises is the fact that you cannot view mon- etary policymaking as a simple issue of deciding that the most Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 probable outcome is coining out of this soft patch into moderate growth with low inflation, although I think that is the most prob- able outcome. That is not the same statement as saying that you therefore, in the process of implementing monetary policy, or for- mulating it, I should say, completely disregard what the upsides and downsides of a potential outcome may be. Therefore it is con- ceivable, for example, that if we envisage that inflationary pres- sures are significantly subdued, it would not be inconsistent to move rates lower, as we did on January 31. Or, on the other side of the outlook, if we perceived that the economy were inordinately strong, and not capable of really being affected significantly by increased interest rates, but which could very well stem inflationary pressures, we would move. What's important to recognize is that it is a complex set of choices that we make. It's that process which we try to expound on without indicating, as we cannot, precisely where we may come out at any particular point because that can only be done by the official process which the Federal Open Market Committee has with re- spect to when we move, either by moving within a Committee meeting or by giving authority to the Chairman to move under cer- tain circumstances. Senator SAKBANES. I see my time's up, and I'll pursue it on the next round. The CHAIRMAN. Senator Mack. Senator MACK. Mr. Chairman, I'm going to, I want to ask an aca- demic question but I want to ask something else first. In 1995, real GDP expanded at less than 1.5 percent. In 1996, your forecast is for only 2 percent real growth. This would represent the slowest 2-year period of growth without a recession in the U.S. economy since 1956-57. In your opinion, why is growth so slow? Chairman GREENSPAN. Basically, it is slow because we have come out of the 1994 period when the economy was moving at a fairly impressive pace and pressing resources, as I indicated in my prepared remarks, and once you get up to where you're running up against capacity, there is clearly a tendency to start to back off to a certain extent. In the last numbers of months we were growing at clearly less than potential. One need only look at the operating rates, for exam- ple, in manufacturing to basically see that. That is part of the nor- mal rhythm of the business cycle and the expectation that one will be at some firm growth rate for any protracted period of time, whether it be high, low, or moderate, doesn't properly reflect the complexity that the economy of our country has. So it's not easy to answer very specifically unless you want to look at the details of what's causing it. As I indicated in my pre- pared remarks, the actual technical reason is that the rate of in- ventory investment has been falling very dramatically from an unsustainably high level in the latter part of 1994 and early 1995 to something very significantly less the last few months. Senator MACK. If we reduced the deficits, reduced taxes, and re- duced regulations, would we experience more growth in the econ- omy? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 Chairman GREENSPAN. I think over the longer run, the answer is yes because those factors do have positive impacts on the longer run. I would hesitate to argue its short-term impact because far more likely to affect the short-term economic outlook is the behavior of inventory investment, and, as I indicated in my prepared remarks, capital expenditures by both business and households. Senator MACK. But if you had smaller deficits moving toward a balance long-term interest rates lower Chairman GREENSPAN. That would sustain capital investment yes, certainly. Senator MACK. Which would, in essence, increase the level of growth? Chairman GREENSPAN. Yes. The only reason I hesitate to answer directly is in the short run, there are other forces which will be far more dynamic than that, but there's no question, Senator that maintaining direction of lower budget deficits and a return to lower long-term interest rates will galvanize housing and capital invest- ment in a manner which would sustain maximum long-term growth. Senator MACK. Let me go back to raising a question about mone- tary policy. And as I say, this may be kind of asked from an aca- demic perspective. Through the first three quarters of last year, the economy grew 4.2 percent, that is, 2.8 percent inflation plus 1.4 percent real growth. If somehow the United States was able to change its potential real growth rate to 4 percent, would monetary policy need to change? Chairman GREENSPAN. You mean with essentially zero inflation? Senator MACK. Right. Chairman GREENSPAN. The answer is no, because what we essen- tially finance over the long run, if you can put it that way in the amount of credit that we support, reflects the nominal gross domes- tic product. Senator MACK. Do you have any specific proposals that policy- makers could implement to boost potential real growth in the econ- omy? Chairman GREENSPAN. There is an interesting question first that we have to answer. And that's this nagging dilemma which exists about why, with this extraordinary acceleration that we've seen in technology, at this $ic growth acceleration means accel- eration of productivity growth. It's hard to envisage the state of technological change being more rapid than we see, and we have to ask ourselves why isn't it not reflecting itself in the data, even granting, as I point out in my re- marks, that we probably are not measuring it correctly. But still, it's not fully there no matter what. Professor David of Stanford, made an extraordinarily important insight into this process a number of years ago when examining the comparable dilemma, namely, that in the latter part of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 19th century, there was a major thrust forward because of the ad- vent of electric power, but it never really embodied itself in real economic growth until the 1920's. The reason essentially was that electric motors were put into buildings which were constructed for the purpose of implementing steam power production. As a con- sequence of that, you really didn't get the full synergies of electric motor use in the economy until we built whole new infrastructures in the 1920's, flat rather than the vertical buildings that had been the key type of factories we had in the 19th century. When that all came together, the measured productivity of this country all of a sudden took off. There are very similar relation- ships here with respect to trying to impose a silicon-based com- puter chip telecommunications technology on an infrastructure which was not put together for that purpose. As that changes, one would expect, and indeed I do, that there will be a marked acceleration in productivity. Pending that, we have to recognize that it may be a few years before it even starts to take off, because I don't know what state of this process we're in. We also have to be aware that you cannot have merely capital investment as your base for productivity gains. There is the whole question of what the so-called human capital is that interfaces with that process. What is terribly obvious, when you begin to look at the shortfalls of the skills that we have to implement this new technology, is that it's going to become terribly important to imple- ment a significant amount of education and especially on-the-job training to make certain that our work force has the skills that are required to implement this new high-level technology, because we already have the highest standard of living in the world. When one perceives of where we go as we move through the rest of this century into the next, it is a wholly different type of eco- nomic structure, one extraordinarily technologically high-skilled and one which, unless you have the appropriate trained people to handle those technologies, you will not get the synergisms and the type of growth rewards, so to speak, that we are all seeking. Senator MACK. Thank you. The CHAIRMAN. Senator Faircloth. Senator FAIRCLOTH. Thank you, Mr. Chairman. Chairman Greenspan, one of the issues that has been developed in this election, Presidential primaries, and it was also in the last election, is a feeling of a middle class discontent. You hear today that two incomes will not equal what one was several years ago. Companies are moving jobs overseas to lower paid workers. Large corporations are laying off workers. Now we've heard various political solutions put forth, such as flat tax, trade protection, tax incentives to keep jobs in the United States. My question is, what are your thoughts on the issue, and what is the answer to the fear of the middle class American that their standard of living is being weakened and continues to erode, they feel? Chairman GREENSPAN. Senator, to extend my remarks, one other aspect of this tremendous move toward high technology products has been the very evident increase in the premium for intellectual Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 skill, because the products that we're producing are ever increas- ingly conceptual as distinct from physical. The consequence of this has been that since the late 1970's, we've observed that the incomes earned by those who have college de- grees have been increasing relative to those who have high school degrees, and those who have high school degrees have had incomes rising at a pace faster than those who were high school dropouts, or I should say, falling less in certain cases. But the consequence of that has been a very significant dispersion of incomes in our economy and a not insignificant proportion of the work force, as a consequence, has actually experienced real declines in income. This has created a very considerable degree of frustration for a signifi- cant part of our work force. Superimposed on that is the problem that as a logically nec- essary result of having very high technology products increasingly becoming embodied in our capital stock, we are finding that the av- erage age of the equipment that people use is falling dramatically as we get newer and newer types of applications. The consequence is that rapid change in equipment is making people with any exist- ing level of skills highly insecure because what they are dealing with is changing all the time and they don't feel secure in their capacities. The example I like to use, which I think is a little bit extreme but nonetheless I think captures the problem, is if you have a skilled typist who types at an extremely rapid pace, but is con- fronted every 2 years with somebody coming by and changing the structure of the keyboard, all of a sudden, that skill that is in one's fingers just disappears and has to be relearned. If you keep chang- ing the capital stock, as we are, people who are highly skilled feel very insecure that those skills will not be usable 4 or 5 years down the road. This is the reason why I emphasize the fact that in order to han- dle this problem, it is not protectionism, it is not a lot of other things that we can do, but if our main purpose is to try to reduce the degree of anxiety which a very large number of people have in part because of the increasing job insecurity which I pointed out in my prepared remarks, what we have got to do is to make certain that they have a sense of where they are in the infrastructure which makes them feel confident that they can handle what they're doing. As a consequence, we are going inevitably to move toward a very substantial amount of education taking place within the business firm, and indeed that already occurs because a lot of firms require their people to go 2 nights a week, for example, to the company university to learn the types of things they need for what it is they are doing. To a greater or lesser degree, that's inevitably going to occur be- cause that's the only way our system will work. It's the only way in which the level of anxiety is going to be lowered, and if we find that we can improve the portability of certain aspects of our pay programs, then people will not feel all that insecure moving from one firm to another, provided that it's their skills that they're bringing forward in the sense that now, for example, physicians who go from one hospital to another, or people who are truck driv- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 ers go from one firm to another, it's their skill that gives them their security, not the particular job. If we can construct that sort of labor force interface with the business environment, I think we can successfully confront these issues. I'm not sure that a lot of other things that are suggested are going to resolve this. I'm not saying we're not going to have to do more, but unless we do something with respect to the education question, other things will not effectively work. Senator FAIRCLOTH. Thank you, Mr. Chairman. The CHAIRMAN. Senator Gramm. Senator GRAMM. Thank you, Mr. Chairman. I want to touch very briefly if I can, Alan, on a few issues. First of all, let's assume for a moment that you weren't the head of the Federal Reserve Board, and someone hired you and said, "I'm going to give you a bonus as an advisor to the Government. For every quarter percent you get the economy to grow above the current level, I'm going to give you $5 million. And I'm going to give you 10 years to implement this policy." Off the top of your head, forgetting all political considerations, tell me what kind of policies you think you would recommend? Chairman GREENSPAN. Well, the ones I just recommended are necessary first conditions—namely to take advantage of what ap- pears to be a potential acceleration of growth which is in the pipe- line but is not yet evident, and will eventually come on the scene. I hope it occurs within the 10 years so I get my bonus. But I would have had nothing to do with that. I generally believe, as I've said before this Committee on numer- ous occasions, that maintaining a degree of incentive for capital in- vestment and a degree of regulation which does not hobble those incentives are necessary conditions for economic growth. There are enumerable ways in which one could implement that but I think all of our history suggests that unless you do that, it is very difficult to create the types of incentives which improve pro- ductivity. As I said before, unless the policies that we're imple- menting improve productivity, they will not increase growth. Senator GRAMM. As you know, we have strong forces now in both political parties that are arguing for protectionism. Since our focus here is on economic growth, I'd like to give you an opportunity to comment on protectionism and its impact on economic growth. Chairman GREENSPAN. Protectionism has a number of negative effects, but one which is very relevant to this issue is it removes the level of competition in a domestic economy. Nobody likes competition. As I used to say before this Committee and other Committees, when I was in the private sector, I hated competition. I didn't like people who offered services The CHAIRMAN. I think some of us up here feel the same way. Chairman GREENSPAN. Yes. [Laughter.] Chairman GREENSPAN. But in the calm of the evening, I recog- nized that that made me work better, that I did things far more effectively and hearing the pound of my competitors' feet behind me, I did a lot better and my clients did a lot better. If you create protectionism around an industry, an economy, any- thing, you remove those pressures. I have no question that the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 removal of the competitive pressure will feel good. But I also sug- gest that it's the last thing that one would want to implement if the purpose is to improve productivity. Senator GRAMM. I'll give you a brief example. In 1992, I bought an American-made sport utility vehicle, and I already had a 1982 American-made sport utility vehicle which was a clunker the day I bought it. In those days, you didn't want to buy a car made on Monday, and you didn't want to buy a car made on Friday. We had all these guys on assembly lines who, in the words of that old country and western song, were having daydreams about night things in the middle of the afternoon. [Laughter.] By 1992, we were producing as many good trucks and cars as anybody in the world, given the price we were charging for them. But it's very interesting to note what happened when Bill Clinton reclassified sport utility vehicles as trucks. I went out and looked at the price of a new sport utility vehicle, like the one I bought, and it was slightly over $5,000 more expensive than the one I bought in 1992. What happened was that Detroit siezed the whole $5,000. I don't see any evidence that our market share changed, but the consumer is now paying $5,000 more for a sport utility vehicle. I haven't looked at the data, but I wouldn't be surprised that if you could separate that data out, it would turn out that virtually the whole $5,000 ended up being lost to the consumer. Let me get back to my first point, about this long-term deficit. Looking at the actuarial makeup of the country, looking at the problems with Social Security, looking at the explosive cost of Med- icare, how much does this worry you, looking off 20 years into the future? Chairman GREENSPAN. Quite a considerable amount, Senator. One thing we can be reasonably sure of 20 years ahead is the rough demographic distribution of our population. We know the age categories. And we can pretty much extend, as a consequence of that what, under current programs, various benefits would be and the like. It is conceivable that if, for whatever reason or by whatever means, we can significantly accelerate growth and therefore reve- nues to a number of these programs. The current services projec- tions which, as you well know and pointed out, look awful, but by 2020, may improve. That is really taking a very large chance on an event which we have really no realistic way to judge is going to happen. Therefore, it is essential that we address those issues now, rather than later, because the types of changes that we have to make now to bring a number of these benefit programs back in line under reasonable growth forecasts, reasonable meaning ones we're currently using in our types of projections, we could probably make with very little having to be changed say 1 or 2 years from now. In fact, it is probably quite likely that you could pass legislation today that would not come into effect for 10 years, and it's far easier to put legislation in place today with a 10-year lag so that people can adjust to the timeframe than it is to wait until 2 years Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 before you're running into really serious problems and enact legis- lation at that point. If it turns out, having done that, that we have managed to create a new beneficence and growth, which I think we would all be very much hoping will occur, it means that there are just more re- sources to deal with both in the public and the private sectors, and I don't consider that a negative which one has to be concerned about. Senator GRAMM. Well, if I may, Mr. Chairman, just at one figure, at 4 percent real growth rate The CHAIRMAN. If I might just intrude upon my friend, since I'm going to be next, I'm going to ask that we go to me. I'm going to yield to you, so that we just keep this moving. Senator GRAMM. Even a 4 percent real growth rate only elimi- nates half of the growth in the unfunded liability of Social Security. Even if you could achieve the growth rate we had from 1950 to 1966, which would be an incredible achievement to sustain over 25 years, we only solve half of the problem. Chairman GREENSPAN. Especially since the population has Senator GRAMM. That's right, you still don't really nail the prob- lem down. Even growth at a rate that would equal anything we've had over any extended period of time in the whole history of the country won't solve the problem. It makes it easier but it still doesn't eliminate excruciatingly difficult decisions. Chairman GREENSPAN. That's right. The CHAIRMAN. Let me ask you this because I was looking at some of the clips yesterday from your testimony at the House. I think it underscores the problem that some of us see. The fact that there are tremendous potentials, and you testified to it today, hopes and aspirations that the marketplace has factored in—we're getting spending, particularly long-term growth in these programs, very important programs, politically sensitive programs., Medicare, Medicaid, except for social programs that un- derscore the safety net that we're all concerned about under con- trol. Unless we do something to get the deficit under control for a period of time to deal with this spending explosion, kind of project out, and not just pass programs that are going to have implications of growth in the future and just look the other way, then we're going to have real serious problems. Now I can't help but believe that there was not an anticipation, a very strong anticipation on the part of many that Congress and the President, for the first time, were really going to do something about this deficit and not just smoke and mirrors. I looked at your statement yesterday, and I'm going to read it to you. I don't know if it's verbatim but it's in one of the newspapers, the New York Times: A failure by Congress and the White House to reach agreement this year on a credible deficit reduction plan would mean that some of last year's 2 percentage point decline in long-term interest rates "will have to be refunded." Then it goes on to say, "passage of a program by contrast would bring rates down quite a bit further, Mr. Greenspan predicted." Do you care to comment on that because, you see, I feel very strongly that we're in for an absolutely horrific awakening that the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 marketplace will react very, very negatively if we fail in coining to closure before this next election because the Wall Streeters, the economists, the people who make their living having followed this, they're going to say, if you fellows couldn't do this before an elec- tion, with the pressure of a Presidential election, by God, there's no way you're going to do it afterwards. Do you care to comment? Chairman GREENSPAN. First of all, let me just say that the New York Times report is correct. I hope you're mistaken about not being able to do it if you don't do it before the election, but I fear that you probably are correct. The CHAIRMAN. Well, I hope we can do it, I really do. There's a group of Republicans and Democrats who are working together to come up with a balanced budget program that's real, that's not smoke and mirrors, that's not made up of backloading cuts, which I find absolutely deplorable. Anybody who says they're going to—and I don't care whose pro- gram it comes in, whether it's a congressional program or one that comes from the Administration—that if you say you're going to really make all of your spending reductions in the last 2 years of a 7-year plan, that's just nonsense. That's not realistic. There is a group of Republicans and Democrats who have been meeting regularly and who are achieving some real accord. It would be my hope that absent the ability of the Administration, and that's the President, and the congressional leaders to come to closure, because this is a political year and it's very easy to posture and to frighten people and to tell them what dire repercussions would take place, that there would be some congressional leader- ship that would bring to the table ultimately the White House and congressional leaders to pass a real plan of deficit reduction that will lead to balancing the budget without smoke and mirrors. I think there is that opportunity, but if it doesn't take place, I share the concern that you expressed yesterday and today, that there will be some very real problems in the marketplace. Notwith- standing all of the technological changes that are taking place, we can look forward to long-term rates going up tremendously. I think they factored in, they have already counted on our doing something of significance. Chairman GREENSPAN. If I might just make one collateral com- ment, Mr. Chairman. As I said earlier, I think that there has nonetheless been a change in the culture. It's in the economics fraternity, it's in the Administration, it's in the Congress. I would find it unlikely that even under the worst scenarios, that we'll go back to some earlier process which was highly unacceptable by any standard. Nonetheless, to assume that we can just go through this process and have the existing negotiations unravel without market con- sequences is highly unrealistic. Indeed, as I indicated earlier, I think the backing up of long-term interest rates in the last week is to a large extent a reflection of that problem. The CHAIRMAN. Mr. Chairman, I hope that my colleagues and those who are concerned, and I think all of us are, Republicans, Democrats, liberals, conservatives, will hear your concern as one that will give us, give additional impetus for us doing the job. That Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 might mean, you know, that there has to be an accommodation on both sides. Maybe the tax cut, which I think is secondary, I really think is secondary to the business of balancing the budget and making spending cuts and reducing the rate of growth. Maybe people will be able to give and put aside partisanship and that means on both sides, to really do the business of the people. I am very concerned that there will be an additional backup. And indeed going into this economic downturn or softness could contrib- ute significantly to an economic downturn. That's my concern. Senator Sarbanes. Senator SARBANES. Chairman Greenspan, the Fed doubled the interest rates, the Federal fund rate between February 1994 and February 1995, from 3 to 6 percent, correct? Chairman GREENSPAN. Correct. Senator SARBANES. Then in July you took it down, and again in January, so it's now at 5.25 percent. Chairman GREENSPAN. Yes, sir. Senator SARBANES. Now, at 5.25 percent, the Federal funds rate remains 275 basis points above the inflation rate, correct? Chairman GREENSPAN. Approximately. It depends on where you envisage the inflation rate at this particular moment. Senator SARBANES. All right. Chairman GREENSPAN. But I grant you, you're general Senator SARBANES. But the long-term average is 175 basis points. In fact, when we had the hearing in the fall, back in Sep- tember, you in effect said that, indeed real rates were somewhat above long-term averages and probably above long-term equilibriums. It would be my own perception that that remains the case. Now, when the Fed took the rates down in July, it said inflation- ary pressures have receded enough to accommodate a modest ad- justment in monetary conditions, correct? Chairman GREENSPAN. Correct. Senator SARBANES. At that point, the inflation rate for the 12 months ending in May, which was the latest data available, was 3.2 percent. The inflation rate now is at 2.5 percent. There are indications that the economy is softening. In fact, you said yesterday to Chair- man Leach, that there is no question this is a soft economy, the Chairman—meaning you—said in response to Representative Leach. Now, and of course we've had the blue chip forecasters revise their forecast downwards now to 2 percent growth for the coming year. The point I want to pursue is whether the insurance policy now ought not to be on the side of growth, given where we are. I say this in light of this Wall Street Journal article about a month ago that said even the Fed's Greenspan is fallible when try- ing to predict a recession. In fact, working off of the minutes of the Fed for the 1990 period, it takes a long time to get those minutes, but in any event, I think there are several things we can stipulate with some degree of certainty. This is quoting you in August 21, 1990. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 Namely that those who argue that we are already in a recession are reasonably certain to be wrong. End of quote. Then in October and at the moment, it isn't raining, the economy has not yet slipped into recession. Of course we now know that the economy had gone into recession at that time. Now, given all of this, wouldn't it be wise to try to guard against the economy moving downward in the period ahead? Chairman GREENSPAN. Well, Senator, let me first put the sum- mer and fall of 1990 in a certain context. The problem that you have when you are looking at an economy is that the definition of what constitutes a recession, in my judgment, is faulty in the fol- lowing sense. If the economy had turned up in say October 1990, the fact that July was a temporary peak would have been lost in history. It is only in retrospect that where the actual absolute peak of a cycle was has any meaning. We have had, and invariably have in all cycles, several declines which have never turned into recession. I define a recession, as I indicated earlier, as essentially a significant structural change in the way the system is working, and it's a sense of a tearing of the fabric of relationships which induces a major implosion. Through September 1990 and in the early—I've forgotten exactly when you could really begin to see when things were happening— but surely through the end of September 1990, there was no evi- dence of a recession in the definitional form that I use it. The rea- son I say that is that at the moment, everyone is saying, well, we're not in a recession at the moment. If it turns out 2 weeks from now the economy turns into a reces- sion, everyone will be arguing that the recession began in Septem- ber last year. That has no meaning because if, as I expect, the economy picks up from here, as indeed the vast majority of forecasters believe, no one will remember that industrial production was at a peak in Sep- tember 1995. Senator SARBANES. But the point is that given that it's a slow economy, by your own statement, and given the performance on the inflation front which is much better than the performance last July when you first took rates down, isn't it advisable to guard against the slow economy? I don't want a repetition Chairman GREENSPAN, May I just Senator SARBANES. Let me make this point, at the February 1990 meeting of the Federal Open Market Committee, Roger Guffy, the president of the Kansas City Fed, said the following: And I'm quoting now from the transcript. The Committee hopes—this is the Open Market Committee—that there's some ex- ogenous event that causes a recession, and we won't get blamed for it, and yet re- capture the progress toward price stability. Now, you know, I hope an attitude of that sort is not present cur- rently on the Open Market Committee because I don't think we should have a recession, and you certainly ought not to be search- ing for an exogenous event in order to escape any responsibility for it. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 Chairman GREENSPAN. Well that's certainly not my view. Senator SARBANES. I wouldn't think so. Chairman GREENSPAN. Senator, you are merely expressing the reasons why, on January 31, we chose to move lower, I can't go be- yond that statement. The CHAIRMAN. Senator Mack. Senator MACK. Mr. Chairman, something caught my attention yesterday when the bond market reacted one way and the price of gold reacted the other to whatever statements were made yester- day. The price of gold fell I think about $5, and 30-year bond rates went up. Those seem to be contradictory signals. I mean is there some explanation, from your perspective, as to why that happened? Chairman GREENSPAN. Well, over the long run, there is a cor- relation, as you know, between the gold price and long-term inter- est rates to the extent that the gold price is a pretty good estimator of inflation expectations, as indeed is the long-term bond. But on a day-by-day basis, you cannot expect that these similar events will affect both. In the gold market, we've had a peculiar problem in re- cent weeks, which is difficult to segregate from the more fun- damental issues that are driving the price of gold, which is the fact that the so-called lease rate for gold shot up significantly and then came down again. And with the lag, the price of gold has sort of picked up part of that problem. That is clearly a technical market issue which probably tempo- rarily overrides the issue of changes in inflationary expectations. You often get that sort of problem, so you never quite disentangle why you seem to get contradictory signals. Senator MACK. Listening to the discussion that's taking place here today, I got the impression that most were saying that the market's reaction to the failure to get an agreement has something to do with the long-term interest rate going back up somewhere be- tween what, 20 and 25 basis points, I guess, over the last Chairman GREENSPAN. It's been more than that. Senator MACK. More than that? Chairman GREENSPAN. Yes. Senator MACK. How much more? Chairman GREENSPAN. It's up 40 basis points. Senator MACK. Forty basis points in the last 30 days? Chairman GREENSPAN. Oh, less than that. Senator MACK. OK. It would then not be—I mean, I suspect what you're saying, given the answer to that last question, that then gold prices will start back up as well? Chairman GREENSPAN. No. I can't forecast what they're going to do because I'm not quite sure where the adjusted level is, if I may put it that way, that is, adjusted for short-term technical factors. We're going to find out, my guess is, within a week or so how much of that is merely technical and how much is changed inflation ex- pectations, if any. But I, at this stage, would find it extremely dif- ficult to get a good sense of what part is what. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Senator MACK. I'm going to move off of that, though, and raise some questions about what I refer to as forward-looking indicators. We've had some discussions about this in the past. But I'd like to ask you about forward-looking indicators of mone- tary policy, inflation, and growth. Would you please discuss the forward-looking indicators that you believe are important and how you might assess any movement of them over future months? For example, bank reserves, yield spreads, commodity prices? Chairman GREENSPAN. Yes. Senator what we have found over the years is that to feel con- fident that we have a sense of how the economy is functioning and where its weak points and strengths are, is that we look at an ex- traordinarily wide range of different types of data which capture various different views of the so-called elephant, if you want to look at it that way. It is true that there are certain specific indicators which some- times seem to capture the overall, sometimes not. For example, the spread between 6-month commercial paper and 6-month Treasury bills was an indicator which seemed to have exceptionally powerful forecasting capability until it was actually applied to a specific event, which was the 1990-91 recession, and it failed. The term structure of interest rates, for example, seems to have some fore- casting capability. We often find yield spreads of different types very useful in judging the question of apparent risks in the system. We use all of them and what we find is that they all work some of the time but not all of the time. But if you have a large enough sample, you usually have a fairly good sense of the underlying forces that are moving the economy. It's hard to define in any particular case which are the more rel- evant ones and which are not. Obviously, if we're in a period where inventory liquidation is a critical phenomenon, we try to look at those elements which seem to capture those data before they are officially published, and we therefore will look at certain bank loan relationships which are used in part to finance inventories. Or we will look at individual inventory data for motor vehicles, or other products for which data are available in advance of these aggrega- tive numbers. What we will tend to do is to get samples and anecdotal evi- dences to determine whether in fact a particular phenomenon, such as a degree of inventory liquidation is accelerating or decelerating, and even though we may not know what the numbers are, we'll get a qualitative sense, which is enough for us to get a sense of what the economy is doing. We have a huge effort underway at all times, not only to process published data but very importantly to reach out for anecdotal information. Indeed, we talk to a lot of individual companies with respect to how their orders are doing, what they're expecting, their backlogs, and what their projects are. We have our 12 Federal Reserve Banks periodically reaching out into their particular communities and getting real time judgments on the part of businesses and others as to what's going on. We find that very useful. It gives us a real time qualitative view of what's happening well before we have specific statistical or financial indi- cators. So what we tend to do is to look at all of that. 24-528 96-3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 If we could find some specific number which, with an extremely high degree of accuracy, captured all of this, we wouldn't need to have the elaborate type of research business evaluation process that we go through. But we have not found any alternative to that process. The CHAIRMAN. Senator Faircloth. Senator FAIRCLOTH. Thank you, Mr. Chairman. Chairman Greenspan, I'll try to be real brief with my question, but it keeps coming back on an annual basis, I guess, because it does concern me as a 68-year-old man, and I've seen the transitions that I'm sure you have. By borrowing $5 trillion or whatever we owe today, have we not led the so-called middle class that we're asked about, the average American citizen, to expect a higher standard of living by this con- tinuous borrowing, to expect a higher standard of living than we can continue to maintain with the productivity of the country? And just, you know, and you and I have seen it, but so many young people and younger people have not. I don't want to return us to today's recession, but I remember when a deluxe automobile was the one that had two taillights and two sun visors, and everything else went down from that. Yet today, if you have a 16-year-old child that doesn't have a super sport with air-conditioning and every possible accessory, you're de- priving the child. These are just glaring examples of what we have grow. It used to be a house with one bathroom would certainly handle six people, and it cost $10,000. Chairman GREENSPAN. And it was inside. Senator FAIRCLOTH. That was inside, and one bathroom would adequately handle six people. Today, if you have six people, you need six bathrooms. Have we, because of borrowing $5 trillion, and I don't say it's bad, I mean, the expectations for vacations and all of the things are good, and I'm delighted that we have them, and my question is, can we continue to afford them without going deeper in debt? Chairman GREENSPAN. Well, Senator, what we have to do is to view debt both in the public and private sectors, and recognize that as our standards of living rise, and as we build up assets that in- variably occur from one generation to the other, we tend to finance various different types of purchases by borrowing. For example, as you well know, in Japan, you usually have to wait until you can save an adequate amount of money to buy a home, at least that's what used to be the case, and it was consid- ered inappropriate to borrow. It used to be that way in part in the United States. Now the mortgage market is an extraordinarily facile instrument to enable you to pay off from future earnings and have assets ear- lier. It's obvious that the extent to which one can move up the proc- ess, so to speak, really rests on your ability to borrow other people's savings and they're of course willing to lend them to you. And what debt is in the private sector basically is that process. The comparable feature in the Federal sector is when we sell our bonds abroad, and effectively borrow foreign savings to do much the same thing. There are clear limits to that. I think that a lot Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 of economists don't like the usual household analogy about the Fed- eral budget, and indeed there's some differences, but if we got fairly naive and required that everyone handle Federal finances the way we handle our household finances, it may be naive, but it would sure work, and it would solve a lot of the problems that our Chairman has been terribly concerned about in his remarks today. Senator FAIRCLOTH. I thank you. It concerns me maybe as having lived long enough to have seen just the vast difference in expectations, maybe I'm probably more sensitive to it than others, but you mentioned a downpayment, just as an aside. When I went in the automobile business, the remnant of the OPA, if anybody remembers that, said you had to have 50 percent of the money down to buy an automobile, and you were under some Federal charge not to sell a car unless the customer had 50 percent of the money or a trade-in. Chairman GREENSPAN. We ought to tell the next generation and beyond that that was the Office of Price Administration. Senator FAIRCLOTH. OPA, Office of Price Administration. Mr, Chairman, how important is it literally that we keep manu- facturing jobs in this country? Certainly no company can afford to pay American wages, 10 times or whatever, the wage rate in Asia or Mexico, or whatever the difference might be. We have seen this movement of manufacturing jobs, as you and I have discussed, the cut-and-sew industry just left the lofts of New York in the late 1950's and 1960's and moved south. The flat buildings that were designed for it, and today some of the most expensive garments and best in the country are made in little isolated communities that you would never expect them to be. Of course we took great pride in that we had gotten rid of the IG—International Garment Workers—or whatever, but we built these plants and the cut-and-sew came. Chairman GREENSPAN. That's IGWA, as I remember. Senator FAIRCLOTH. IGWA, International Garment Workers. Thanks. They came. Now we are seeing all but the highest end of these cut-and-sew simply move out to offshore. Now, we survived before they came and I assume we'll keep on surviving. New York didn't collapse when they left the garment dis- trict and moved south, and we'll keep going if they move to Mexico. So how do we address the problem and how serious a problem is it? Chairman GREENSPAN. The first question we have to ask our- selves, which may seem an extraordinarily odd way to answer your question, Senator, is what do we mean by manufacturing? The reason I say that—that's a rhetorical question—is that as we move toward this technologically-based type of economic system, what we are finding is that the proportion of fabricated goods, which is what historically has always been our definition of manu- facturing, has become increasingly more ideas and less physical bulk. In the 1930's, for example, we had radios which were as large as this desk and had vacuum tubes. Today, our little radios are this Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 size, they are far better, and they're all transistor operated. The difference between the two are concepts. It's the invention of the transistor and new insights on how to put materials together to do things. We are finding that the average weight of industrial output is falling dramatically relative to the real value that's being produced. As a consequence, if you actually weighed the number of tons of physical things that we turn out, I wouldn't be surprised to find that even though the real value of industrial output has gone up quite significantly in the last 40 or 50 years, the actual amount of tons has not gone up very much at all. The difference is ideas. It's the downsizing of products. There's far more valuable manufactur- ing but less bulk. The problem is that as we continue to project that, we find our- selves, for example, realizing that if we have a software product that is 98 percent conceptual, but we put it in a CD ROM, a manu- factured good, we're getting to the point where the distinction be- tween what is manufacturing and what is not is becoming ex- tremely fuzzy. My own impression is that 20 years from now, the so-called standard industrial classification, which we use, will probably no longer capture correctly what it is we produce. So that what we will term manufacturing 20 or 30 years from now is going to be quite different from what it is today, and it will be difficult to say whether a lot of jobs are factory jobs or non-factory jobs because the average factory is not going to look like a factory today, and certainly not the way it looked 30 years ago. So I don't think we ought to view the issue of jobs as high-paying factory jobs or low-paying service jobs. That distinction is rapidly becoming obsolete, and you have to look at where is the value- added in the economy—whether it's conceptual value-added or whether it's physical value-added—and not be terribly concerned whether it is a palpable physical good or whether it's a conceptual product for as a practical purpose, for the value that is produced, that is, meaning what it is that is conceived of as a value to human beings or to people as consumers, whether it's a physical thing or non-physical thing really doesn't matter all that much. The crucial issue is what is its value-added and its value to other people, which means what is our purchasing power. So I would very strongly argue that this question of distinguishing factory employment, manufacturing employment, and non-manufacturing employment is not a useful concept. Senator FAIRCLOTH. Thank you, sir. The CHAIRMAN. Mr. Chairman, I just think it's important to note something. First of all, let me make an observation. It's based anecdotally, et cetera, but I think the economy is hav- ing some problems. I also think that it is absolutely simplistic to say that those problems can be dealt with by the Reserve by simply lowering interest rates. Indeed, they may exacerbate the problem. Indeed, an economic downturn, and just simply dropping interest rates and somehow thinking that short-term rates by coming down are going to turn everything around is fallacious. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 The marketplace has become very sophisticated, right? I mean the same computers, studies, thoughts, and young people who are graduating are working in the marketplaces. They are giving ad- vice to their clients to large pools of money that are available, have the data, and they're going to respond accordingly. Your drop of interest rates on a short term is not going to be the answer. The Government cannot solve all these problems. But indeed Government can do something to help exacerbating some of the uncertainty, it would seem to me. With that as a background, I'd like to share with you, I don't know if you had an opportunity to read, I don't necessarily sub- scribe to everything, but certainly I do subscribe to some of the ob- servations made in today's Washington Post, February 21, 1996, by Robert J. Samuelson, Did you have an opportunity? Chairman GREENSPAN. Is that the same article that appeared in Newsweek this week? I think it may be. The CHAIRMAN. Very, very interesting. Let me just take the time to read the first paragraph. We are now witnessing—this is Mr. Samuelson—another out- break of one of the most destructive tendencies in American poli- tics, the practice of our leaders to promise phantom solutions to our economic problems. The latest object of the compulsion is job inse- curity. Yo, America. Government can't suppress it and its trying too hard could cripple the economy's job creating capacity, Mr. Samuelson goes on to say. This perpetual pandering to Americans' every anxiety is a politi- cal disease that ultimately feeds poplar cynicism. He goes on to say that, you know, here's government in Canada, it's running around saying, I'm going to create more jobs, I'm going to do this, I'm going to do that. You vote for me, and I've got the magic cure. What nonsense. And he does make, I think it's a very balanced argument, I think he does make some very astute observations. Let me go to that, where he talks about the role of Government and what it can do, the next to last paragraph. He says, politics should focus on what Government can do, not what it can't do. It can modestly help laid off workers, some im- provements in the social safety net. Then he goes on to quote the Kassebaum-Kennedy bill, legisla- tion that would help fired workers keep their health insurance. The White House has endorsed it, Congress should pass it. But sweeping measures to prevent job loss or protect laid-off workers are self-defeating. It's a fact. Maybe we've gotten so involved in our own rhetoric and the abil- ity to want to transform our rhetoric into getting elected that I think we have a disease up here that maybe you know those who are espousing these things actually have come to believe them. It's just really incredible. Then I go back to one last thing, which I think is worthwhile ending on. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 And that is, someone said this, and this is in the American Banker. "Lower budget deficits are the surest and most direct way to increase national savings. Higher national savings would help to reduce real interest rates further." You know who said that? Sure you do. Are you being modest? Chairman GREENSPAN. No. I agree with that. The CHAIRMAN. You agree with that. [Laughter.] The CHAIRMAN. That was a quote of Chairman Greenspan. [Laughter.] The CHAIRMAN. And on that note, I have to say two things. No. 1, Mr. Chairman, we thank you for coming in and speaking to us and sharing your thoughts. No. 2, I couldn't agree more with you, your observations, and some of those made by Mr. Samuelson. We had better get to the main task, which is to run and manage the assets that the people entrust to us in a better way and to be more candid with the American people. We haven't had the courage to do what's right. And to really come together and to put aside the political rhetoric that comes from both sides. I would hope that some of my colleagues who are working to- gether, Democrats and Republicans, will achieve some measure of success. I am hopeful, I really am, that they can come to a situation where they can put enough pressure by having a bill that can pass both in the House and the Senate with significant bipartisan sup- port that will bring the Administration to the table. If we can't do that, then I think we are in for some tough times over and above the normal business cycles that are without our control. We will be exacerbating the problem. Mr. Chairman, thank you for your participation. We stand in recess. [Whereupon, at 12:15 p.m., Wednesday, February 21, 1996, the Committee was adjourned, subject to call of the Chair.] [Prepared statement and additional material supplied for the record follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, DC FEBRUARY 21, 1996 I appreciate the opportunity to appear before this Committee to present the Fed- eral Reserve's semiannual report on monetary policy. The United States economy performed reasonably well in 1995. One-and-three- quarter million new jobs were added to payrolls over the year, and the unemploy- ment rate was at the lowest sustained level in 5 years. Despite the relatively high level of resource utilization, inflation remained well contained, with the consumer price index rising less than 3 percent—the fifth year running at 3 percent or below. A reduction in inflation expectations, together with anticipation of significant progress toward eliminating Federal budget deficits, was reflected in financial mar- kets, where long-term interest rates dropped sharply and stock prices rose dramati- cally over the year. This outcome was influenced in part by monetary policy actions taken by the Fed- eral Reserve in recent years. Responding to evidence that inflationary pressures were building, we progressively raised short-term interest rates over 1994 and early 1995. Rates nad been purposely held at quite low, stimulative levels in 1993. We moved in 1994 to levels more consistent with sustainable growth. Our intent was to be preemptive—to head off an incipient increase in inflationary pressures and to forestall the emergence of imbalances that so often in the past have undermined economic expansions. As we entered the spring of 1995, it became increasingly evident that our policy was likely to succeed. Although various price indexes were rising a bit more rapidly, there were indications that pressures would not continue to intensify, and might even reverse to a degree. Moderating overall demand growth left businesses with excess inventories. In response, firms initiated production cutbacks to prevent seri- ous inventory imbalances, and the growth of economic activity slowed substantially. With inflation pressures apparently receding, the previous degree of restraint in monetary policy was no longer deemed necessary, and the Federal Open Market Committee consequently implemented a small reduction in reserve market pres- sures last July. During the summer and early fall, aggregate demand growth strengthened. As a result, business stocks of raw materials and finished goods appeared somewhat bet- ter aligned with sales. In sum, the economy, as hoped, appeared to have moved onto a trajectory that could be maintained—one less steep than in 1994, when the rate of growth was clearly unsustainable, but one that nevertheless would imply contin- ued significant growth in employment and incomes. Importantly, the performance of the economy seemed to be consistent with main- taining low inflation. Despite the step-up in growth and the relatively high levels of resource utilization, measured inflation abated a little, and many of the signs that had been pointing toward greater price pressures gradually disappeared. Ex- pectations of both near- and longer-term inflation fell substantially over the second half of the year, as gauged by survey results as well as by the downward movements in longer-term interest rates. The fall in bond rates was also encouraged by improv- ing prospects for significant progress in reducing the Federal budget deficit. The de- clines in actual and expected inflation meant that maintaining the existing nominal Federal funds rate would raise real short-term interest rates, implying a slight ef- fective firming in the stance of monetary policy. Such a shift would have been par- ticularly inappropriate because economic growth near the end of the year seemed to be slowing, and some FOMC members were concerned about the risks of pro- longed sluggishness. Consequently, the Committee decided in December that a fur- ther reduction in the funds rate was warranted. Information becoming available in late December and January raised additional questions about the prospective pace of expansion. The situation was difficult to judge, partly because economic statistics were more sparse than usual, owing main- ly to the Government shutdowns. In addition, harsh weather in January disrupted both data flows and patterns of economic activity. But several indicators—including initial claims for unemployment insurance, purchasing managers surveys, and consumer confidence measures—appeared to signal some softening in the economy. Consonant with this pattern, some Reserve Bank Presidents reported that they seemed to be detecting anecdotal indications of weakness in the expansion within their districts with somewhat greater frequency than previously. Moreover, growth in several of our major trading partners seemed to be lagging, which could tend to moderate demand for exports. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 A number of factors have prompted the recent tendency toward renewed weak- ness. Some are clearly quite transitory—related, for example, to bad weather or the Federal Government shutdown. Others may be somewhat more significant, but still temporary. The constraint on Government spending while permanent budget au- thorizations are being negotiated is one. Another may be a temporary reduction in output in some industries as businesses have further adjusted inventories to dis- appointing sales. As I noted last July, the change in the pace of inventory invest- ment when the economy shifts gears can be substantial. Inventory investment surged in 1994 and into the early months of 1995, but proceeded to fall markedly throughout the rest of the year. This has placed significant downward pressure on output, which should lift as inventory adjustments subside. But for the moment, the pressures remain, in the motor vehicle industry and elsewhere. Ultimately, of course, it is the path of final demand after the temporary influences work themselves out that determines the trajectory of the economy. There are some factors, such as high consumer debt levels, that may be working to restrain spend- ing. But as I shall be detailing shortly, a number of fundamentals point to an econ- omy basically on track for sustained growth, so any weakness is likely to be tem- porary. Nonetheless, the Committee decided in late January that the evidence sug- gested sufficient risk of subpar performance going forward to warrant another slight easing of the stance of monetary policy. Given the subdued trends in costs and wages, the odds that such a move would boost inflation pressures seemed low. In assessing the likely course of the economy and the appropriate stance of policy, one question is the significance, if any, of the age of the business expansion. Some analysts, viewing recent weakness, have observed that the expansion is approaching the start of its sixth year and is now one of the longer peacetime spans of growth in the past half century. Economic expansions, however, do not necessarily die of old age. Although the factors governing each individual business cycle are not al- ways clear, expansions usually end because serious imbalances eventually develop. When aggregate demand exceeds the economy's potential, for example, inflation- ary pressures pick up. The inevitable increase in market interest rates, as inflation expectations rise and price pressures intensify, depresses final demand. Lagging de- mand in turn sets off an inventory correction that frequently triggers a downturn in the economy. As I noted, we acted in 1994 to forestall such a process. Monetary policy began to tighten in advance of the buildup of inflationary pressures and, at least to date, these pressures appear to have been held in check. Capital expenditures by households and firms can also contribute significantly to the development of cycle-ending imbalances. The level of stocks of such real assets have effects on output very similar to those of business inventories. In typical cycles, capital expenditures tend to grow rapidly in the early stages of recovery: Pent-up demands coming out of a recession by consumers and businesses are satisfied by rapid growth of spending on capital assets. There is a limit, however, on, say, how many cars people choose to own, or how many square feet of floor space retailers need to service customers. Spending on such assets generally tends to grow more slowly after the pent-up demand is met. As with business inventories, the downshifting of spending on consumer durable goods or business plant and equip- ment may not occur smoothly. The dynamics of expanding output and rising profit expectations often create a degree of exuberance which, as in much of human na- ture, tends on occasion to excess—in this case, in the form of a temporary over-accu- mulation of assets. The ensuing correction in demand for such assets triggers pro- duction adjustments that can significantly mute growth for a time or even cause a downturn if the imbalances are large enough. The current extent of any asset overhang is difficult to determine. The growth of demand for durables and some categories of capital goods evidently has slowed, but the available evidence does not suggest a degree of saturation in capital assets that would tip the economy into a downturn. Moreover, financial conditions are likely to be generally supportive of spending. The low level of long-term interest rates should have an especially favorable effect. Low rates increase the affordability of housing for consumers and foster investment in productive plant and equipment by businesses. The decline in interest rates also has contributed to a pronounced rise in stock prices. The spread of mutual fund in- vestments has meant that the ,gain in wealth as financial asset prices have risen has been shared by an ever-wider segment of households. These developments should tend to counter, in part, the depressing effects on spending of rising debt burdens. In addition, with the condition of most financial institutions strong, lend- ers are likely to remain willing to extend credit to firms and households on favor- able terms. We have seen some move by lenders toward tighter standards, but these actions are a modest correction after a marked swing toward ease and should not constrain the availability of funds to creditworthy borrowers. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 Against this backdrop, Federal Reserve policymakers expect the most likely out- come for 1996 as a whole is further moderate growth. On the new chain-weighted basis, the central tendency of the forecasts of Board members and Reserve Bank Presidents is for real gross domestic product to expand 2 to 2Vi percent on a fourthquarter to fourth-quarter basis, similar to the Administration's outlook. With output expanding roughly in line with standard estimates of the increase in the pro- ductive capacity of the economy, the unemployment rate is expected to remain around recent levels, as is also forecast by the Administration. The Federal Open Market Committee expects a continuation of reasonably good inflation performance in 1996. The success during 1995 in keeping the increase in the consumer price index below 3 percent in the fifth year of an expansion illus- trates that an extended period of growth with low inflation is possible. And most on the Committee anticipate consumer price inflation at or somewhat below 3 per- cent in 1996. Although well-known biases in the CPI, as well as the more favorable price performance of business equipment, which is not included in that index, indi- cate that the true rate of inflation for the whole economy would be significantly lower than 3 percent, the Committee recognized that its expectations for inflation do not imply that price stability has as yet been reached. Nonetheless, keeping infla- tion from rising significantly during economic expansions will permit a gradual ratcheting down of inflation over the course of successive business cycles that will eventually result in the achievement of price stability. To emphasize its continued commitment to price stability, the Committee chose to reaffirm the relatively low ranges for money growth in 1996 that it had selected on a provisional basis last July. These ranges are identical to those employed in 1995-—1 to 5 percent for M2 and 2 to 6 percent for M3. The Committee also reaffirmed the 3 to 7 percent range for debt. Patterns of money growth and velocity have been erratic in recent years, but should the monetary aggregates at some point re-establish their previous trend relationships with nominal income, average growth near the center of these ranges should be consistent with the eventual achievement of price stability. Determining whether further changes to the stance of monetary policy will be nec- essary in the months ahead to foster progress toward our goals will be a continuing challenge. In formulating monetary policy, while we have in mind a forecast of the most likely outcome, we must also evaluate the consequences of other possible devel- opments. Thus, it is sometimes the case that we take out monetary policy "insur- ance" when we perceive an imbalance in the net costs or benefits of coming out on one side or the other of the most probable scenario. For example, in our most recent actions, we saw a decline in the Federal funds rate as not increasing inflationary risks unacceptably, while addressing the down- side risks to the most likely forecast. In assessing the costs and benefits of adjust- ments to the stance of policy, Members of the Committee recognize that policy af- fects the economy and inflation with a lag and thus needs to be formulated with a focus on the future. Over the past year, we have kept firmly in mind our goals of containing inflation in the near term and moving over time toward price stability, and they will continue to guide us in the period ahead. Structural forces may be assisting us in this regard. Increases in producers' costs and in output prices proved to be a little lower last year than many had anticipated. While it is too soon to draw any definitive conclusions, this experience provides some tentative evidence that basic, ongoing changes in the structure of the economy may be helping to hold down price pressures. These changes stem from the introduc- tion of new technologies into a wide variety of production processes throughout the economy. Successive generations of these new technologies are being quickly em- bodied in the nation's capital stock and older technologies are, at a somewhat slower pace, being phased out. As a consequence, the nation's capital stock is turning over at an increasingly rapid pace, not primarily because of physical deterioration but reflecting technological and economic obsolescence. The more rapid advance of information and communications technology and the associated acceleration in the turnover of the capital stock are being mirrored in a brisk restructuring of firms. In line with their adoption of new organizational struc- tures and technologies, many enterprises are finding that their needs for various forms of labor are evolving just as quickly. In some cases, the job skills that were adequate only 5 years ago are no longer as relevant. Partly for that reason, most corporate restructurings have involved a significant number of permanent dismis- sals. The phenomenon of restructuring can be especially unfortunate for those workers directly caught up in the process. Many dedicated, long-term workers in all types of American businesses—including long established, stable, and profitable firms— have been let go. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 An important consequence of the layoffs and dismissals associated with restruc- turing activity is a significant and widely reported increase in the sense of job inse- curity. Concern about employment has been manifested in unusually low levels of indicators of labor unrest. Work stoppages, for example, were at a 50-year low last year. And contract negotiators for labor unions have sought to obtain greater job se- curity for their members through very long term labor contracts, including some with virtually unprecedented lengths of 5 or 6 years. Of particular relevance to the inflation outlook, the sense of job insecurity is hav- ing a pronounced effect in damping labor costs. For example, the increase in the em- ployment cost index for compensation in the private sector, which includes both wage and salary payments and benefit costs, slowed further in 1995, to 2% percent, despite labor market conditions that, by historical standards, were fairly tight. With productivity also expanding, the increase in unit labor costs was even Tower. In manufacturing, such costs have actually been falling in recent years. While the link between labor costs, which account for two-thirds of consolidated business sector costs, and prices is not rigid these very limited increases in labor expenses nonethe- less constitute a significant restraint on inflation. In addition to its effect on labor costs, the more rapid pace of technological change is reducing business costs through other channels. Initially most important, the downsizing of products resulting from semiconductor technologies, together with the increasing proportion of national output accounted for by high-tech products, has re- duced costs of transporting the average unit of GDP. Quite simply, small products can be moved more quickly and at lower cost. More recently, dramatic advances in telecommunications technologies have low- ered the costs of production for a variety of products by slashing further the infor- mation component of those costs. Increasingly, the physical distance between com- munications endpoints is becoming less relevant in determining the difficulty and cost of transporting information. Once fiber-optic and satellite technologies are in place, the added resource cost of another 200 or 2,000 miles is often quite trivial. As a consequence, the movement of inputs and outputs across geographic distance is progressively becoming a smaller component of overall business expenses, particu- larly as intellectual—and therefore immaterial—products become proportionately more important in the economy. This enables an average business firm to broaden markets and sales far beyond its original domicile. Accordingly, fixed costs are spread more widely. For the world market as a whole, the specialization of labor is enhanced to the benefit of standards of hying of all market participants. To be sure, advancing technology, with its profound implications for the nature of the economy, is nothing new, and the pace of improvement has never been even. But it is possible that we may be in the midst of a quickening of the process. It is possible that the rate at which earlier computer technologies are being applied to new production processes is still increasing. This would explain the recent decline in the growth of unit costs. Nonetheless, we have to be careful in projecting a fur- ther acceleration in the application of technology indefinitely into the future, as would be required for technological change to depress the rate of increase in unit business costs even more. Similarly, suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point in the future, the tradeoff of subdued wage growth for job security has to come to an end. While it is difficult to judge the time frame on such adjustments, the risks to cost and price inflation going forward are not entirely skewed to the downside, especially with the economy so recently operating at high levels of resource utilization. In light of the quickened pace of technological change, the question arises whether the U.S. economy can expand more rapidly on an ongoing basis than the 2 to 2^4 percent range for measured GDP forecasted for 1996 by Government agencies and most private forecasters without adding to inflationary pressures, which in turn would undermine growth. The Federal Reserve would certainly welcome faster growth—provided that it is sustainable. The particular rate of maximum sustainable growth in an economy as complex and ever-changing as ours is difficult to pin down. Fortunately, the Federal Reserve does not need to have a firm judgment on such an estimate, for persistent deviations of actual growth from that of capacity potential will soon send signals that a policy adjustment is needed. Should the nation's true growth potential exceed actual growth, for example, the disparity and lessened strain would be signaled in shorter lead times on the delivery of materials, declining overtime, and ebbing inflationary pressures. Conversely, actual growth in excess of the economy s true potential would soon result in tightened markets and other distortions which, as history amply dem- onstrates, would propel the economy into recession. Consequently, we must be cau- tious in reaching conclusions that growth in productivity and hence of potential out- put has as yet risen to match the evident step-up in technological advance. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 The hypothesis that advancing technology has enhanced productivity growth would be more persuasive if national data on productivity increases showed a dis- tinct improvement. To a degree, the lack of any marked pickup may be a short- coming of the statistics rather than a refutation of the hypothesis. Faulty data could be arising in part because business purchases are increasingly concentrated in items that are expensed but which market prices suggest should be capitalized. Growing disparities between book capital and its valuation in equity markets may in part reflect widening effects of this misclassification. If this problem is indeed growing, we may be underestimating the growth of our GDP and productivity. This classification problem compounds other difficulties with measuring output in the increasingly important service sector. The output of services—and the productiv- ity of labor in that sector—is particularly hard to measure. In part, the statisticians have simply thrown up their hands, gauging output in some service industries just in terms of labor input. By construction, such a procedure will miss improvements in productivity caused by other inputs. In manufacturing, where output is more tan- gible and therefore easier to assess, measured productivity has been rising briskly, suggesting that technological advances are indeed having some effect. Nonetheless, there is still a nagging inconsistency: The evidence of significant restructurings and improvements in technology and real costs within business es- tablishments does not seem to be fully reflected in our national productivity meas- urements. It is possible that some of the frenetic pace of business restructuring is mere wheel spinning—changing production inputs without increasing output—rath- er than real increases in productivity- One cause of the wheel spinning, if that is what it is, may be that it takes some time for firms to adapt in such a way that major new technology is translated into increased output. In an intriguing parallel, electric motors in the late 19th century were well-known as a technology, but were initially integrated into production systems that were de- signed for steam-driven power plants. It wasn't until the gradual conversion of pre- viously vertical factories into horizontal facilities, mainly in the 1920s, that firms were able to take full advantage of the synergies implicit in the electric dynamo, thus achieving dramatic productivity increases. Analogously, existing production systems today to some degree cannot be integrated easily with new information and communication technologies. Some existing equipment is not capable of control by computer, for example. Thus, it may be that the full advantage of even the current generation of information and communication equipment will be exploited over a span of quite a few years and only after a considerably updated stock of physical capital has been put in place. While the Federal Reserve does not need to establish targets-—and definitely not limits—for long-term growth, it is helpful in coming to shorter-run policy insights to have some judgments about the growth in potential GDP in the past and what it is likely to be in the future. Judgments of potential, quite naturally, are based on experience. Through the four quarters of 1994, for example, real GDP, pressed by strong demand, rose 3¥s percent. If that were the true rate of increase in the economy's long-run potential, then we would have expected no change in rates ol resource utilization. Instead, industrial capacity utilization rose nearly 3 percentage points and the unemployment rate dropped a percentage point. Moreover, we began to see signs of strains on facilities; deliveries of materials slowed appreciably and factory overtime rose sharply. These signs of developing pressures on capacity sug- gest that the growth rate in economic potential in 1994 was below 3V2 percent. Ir general, as we get close to presumed potential, we are required to step up our sur- veillance for inflationary pressures. Estimates of potential growth necessarily recognize that expansion in the econom; over time comes essentially from three factors—growth in population, increases ir labor force participation, and gains in average labor productivity. Of these factors the first two are determined basically by demographic and social factors and seen unlikely to change dramatically over the next few years. Thus, the source of an; significant pickup of output growth would need to be a more rapid pace of productiv ity growth. Here, the uncertainty of the pace of conversion of rapid technological ad vance into productivity gains is crucial to the determination. To be fully effective in achieving potential productivity improvements, techno logical innovations also require a considerable amount of human investment on th< part of workers who have to deal with these devices on a day-to-day basis. On thii score, we still may not have progressed very far. Many workers still possess onl; rudimentary skills in manipulating advanced information technology. In these cir cumstances, firms and employees alike need to recognize that obtaining the poten tial rewards of the new technologies in the years ahead will require a renewed com mitment to effective education and training, especially on-the-job training. This is especially the case if we are to prevent the disruptions to lives and the nation's ca Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 pacity to produce that arise from mismatches between jobs and workers. We need to improve the preparation for the job market our schools do, but even better schools are unlikely to be able to provide adequate skills to support a lifetime of work. In- deed, the need to ensure that our labor force has the ongoing education and training necessary to compete in an increasingly sophisticated world economy is a critical task for the years ahead. Our Nation faces many important and difficult challenges in economic policy. Nonetheless, we have made significant and fundamental gains in macroeconomic performance in recent years that enhance the prospects for maximum sustainable economic growth. Inflation, as measured by the consumer price index, has been gradually reduced from a peak of more than 13 percent in 1979 to 2Va percent last year. Lower rates of inflation have brought a variety of benefits to the economy, in- cluding lower long-term interest rates, a sense of greater economic stability, an im- proved environment for household and business planning, and more robust invest- ment in capital expenditures. The years ahead should see further progress against inflation and the eventual achievement.of price stability. We have also made considerable progress on the fiscal front. Over the past 10 years and especially since 1993, our elected political leaders, through sometimes prolonged and even painful negotiations, have been successful in reaching several agreements that have significantly narrowed the budget deficit. But more remains to be done. As I have emphasized many times, lower budget deficits are the surest and most direct way to increase national saving. Higher national saving would help to reduce real interest rates further, promoting more rapid accumulation of produc- tive capital embodying recent technological advances. Agreement is widely shared that attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the Nation's demographics in the first few decades of the next century. Lower inflation and reduced budget deficits will by no means solve all of the eco- nomic problems we face. But the achievement of price stability and Federal budget balance or surplus will provide the best possible macroeconomic climate in which the Nation can address other economic challenges. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 For use at 2:00 p.m., E.S.T. Tuesday „.. February 20,1996 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 February 20,1996 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C.. February 20, 1996 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the Full Employment ana Balanced Growth Act ot 1978. Sincerely. Alan Greenspan, Chairman \J Table of Contents Page Section 1: Monetary Policy and the Economic Outlook 1 Section 2: The Performance of the Economy 5 Section 3: Financial. Credit, and Monetary Developments Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 Section 1: Monetary Policy and the Economic Outlook The economy performed well in 1995. Moderate lower last year as the risks of rising inflation receded economic growth kept the unemployment rate ai a and as prospects for substantial progress in reducing relatively low level, and inflation, as measured by the the federal budget deficit seemed to improve. As of change in the consumer price index, was in a range mid-February, these rates were t*i to 2¥* percentage of 3 parent or less for the fifth straight year, the points below iheir levels at the beginning of 1995. first such occurrence in thirty years. This desirable Helped by lower interest rates and favorable earnings, combination of low inflation and tow unemploy- major equity price indexes rose 30 to 40 percent last ment provided further substantiation of a fundamental year and have moved still higher in early 1996. These point that the Board has made in past reports— financial developments reduced the cost to businesses namely, that there is no trade-off in the long run of financing investment and to households of buying between the monetary policy goats of maximum homes and consumer durables: households were also employment and stable prices set in the Federal aided by substantial additions to financial wealth from Reserve Act. Indeed, it is by fostering price stability rising bond and equity prices. that a central bank can mate its greatest contribu- The foreign exchange value of the US. dollar, tion to the efficient operation and overall ability of the measured in terms of the currencies of the other G-10 nation's economy to create jobs and advance living countries, fell about 5 percent, on net, during 1995. standards over time. The dollar appreciated substantially from the summer As economic prospects changed in 1995 and early on and has advanced further on balance in 1996 but 1996. the Federal Reserve found that promoting full not enough to offset a sharp decline that look place in employment and price stability required several the first four months of 1995. Interest rates fell in adjustments in its policy settings. Last February, most other foreign industrial countries, which also the economy still seemed to be pressing against its were experiencing slower economic growth, but by potential, and prices were tending to accelerate. To less than the decline in rates in the United States. reduce the risk that inflation might mount, with the Early in 1995. the dollar also was pulled down by tne attendant threat to continued economic expansion, the reactions to the crisis in Mexico, but the negative Federal Open Market Committee raised the federal influence on the dollar from this source appeared to funds rate an additional 1A percentage point, to 6 per- lessen as Mexican financial markets stabilized over cent. Inflation did. in fact, pick up in the first pan the balance of the year. Inflation rates in major indus- of 1995. but data released during the spring indi- trial countries held fairly steady in I99S at levels cated that price pressures were receding, and the somewhat lower than those prevailing in this country: Committee reduced the federal funds rate 'A per- thus, depreciation of the dollar in real terms against centage point at its July meeting. Through the remain- other G-10 currencies was less than the depreciation der of the year, inflation was even more favorable in nominal terms. Against the currencies of a broader than had been anticipated in July, and inflation group of U.S. trading partners, the dollar's real depre- expectations decreased. In addition, an apparent ciation in 1995 was even smaller. slowing of economic activity late in the year further Borrowing and spending in the United States was reduced the potential for inflationary pressures going facilitated not only by lower interest rates but also by forward. To forestall an undue increase in real interest favorable supply conditions in credit markets. Spreads rates as inflation slowed, and to guard against the between interest rates on securities issued by private possibility of unnecessary slack developing in the firms and those issued by the Treasury generally economy, the Committee eased reserve conditions in remained narrow, and banks continued to ease terms December and again at the end of January 1996. and qualifying standards on loans to businesses and reducing the federal funds rate by a total of Vi per- households through most of the year. Total debt of centage point. domestic nonfinancial sectors grew slightly more than Monetary policy easings since mid-1995 contrib- 5 percent last year, just above the midpoint of the uted to declines in short-term market interest rates, Committee's 3 percent to 7 percent monitoring range. which by mid-February were down 1 to 2 percentage Rapid growth of business spending on inventories and points from the highs reached early last year. fixed capital early in the year boosted the credit Intermediate- and Jong-term rates also moved sharply demands of firms, despite strong corporate profiis. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 Borrowing was also lifted by the financing of heavy The economy also has been stowed by production net retirements of equity shares in connection with adjustments in some industries in which efforts are mergers and share repurchase programs. Growth of being made to bring stocks into better alignment with household debt slowed a bit but remained brisk; con- sales. Inventory accumulation apparently slowed in sumer credit continued to grow quite rapidly. Federal the fourth quarter, and with financial conditions debt growth was relatively modesi for a second year. remaining broadly conducive to growth of private influenced by a lower deficit and constraints on nor- final sales, inventory problems of a degree that might mal seasonal borrowing at year-end owing to the prompt a sustained period of widespread production federal debt ceiling. Outstanding state and local gov- adjustments do not seem likely. In the household ernment debt ran off more rapidly than in 1994. sector, the accumulation of financial wealth brought on by the rise in the stock market has provided the Commercial banks and thrift institutions again wherewithal for increases in consumption greater than financed a large portion of the borrowing last yean would otherwise have been expected—countering the their share of total outstanding debt of nonfederal potential negative influences of mote burdensome sectors edged up in 1994 and 1995 after declining for levels of consumer debt. At the same time, reductions more than fifteen years. The growth in depository in mortgage interest rates have put the cost of financ- credit was funded primarily with deposits, boosting ing a house within reach of a greater number of the expansion of the broad monetary aggregates. M3 families and made it possible for a significant number grew 6 percent, at the upper end of its 2 percent to of households to ease their debt-service burdens by 6 percent annual range established by ihe Committee refinancing their homes at lower rates. In the business at midyear. Depositories relied heavily on large- sector, reductions in the cosi of financing investment denomination time deposits for funding, but retail in new capital are providing some offset to the slow- deposits also showed gains as declining market inter- ing tendencies that normally accompany a cyclical est rates made these deposits more attractive to retail moderation in the growth of aggregate output. In customers. M2 advanced 4'/4 percent, putting it in the addition, business investment in high-tech equipment upper portion of its 1 percent to 5 percent annual likely will continue to be boosted not only by the range. The expansion of M2 was the largest in six ready availability of finance but also by technological years, and its velocity was unchanged after increasing upgrades and ongoing steep declines in the effective during the previous three years. Nonetheless, growth price of real computing power. of the aggregate was erratic through the year, and die stability of its relationship to nominal spending In the US. external sector, growih of exports remains in doubt. Ml declined last year for the first strengthened after some sluggishness early in 1995. time since the beginning of the official series in 1959. Expansion of income abroad seems likely to pick up An increasing number of banks introduced retail this year, although the prospects still are subject to sweep accounts, which shift money from interest- some downside risk. Imports, meanwhile, have bearing checkable accounts to savings accounts in slowed from the very rapid pace seen earlier in the order to reduce banks' reserve requirements. Without expansion. On net. the underlying trends in exports these shifts. Ml would have risen in 1995. although and impons of goods and services appear to be essen- slowly. tially canceling out in terms of their combined contri- bution to growth of US. real GDP. Economic Projections for 1996 Against the backdrop of these developments, mem- bers of the Board of Governors and the Reserve Bank The relatively small amount of information that is Presidents, ail of whom participate in the delibera- available for 1996 indicates that the economy has tions of the Federal Open Market Committee, antici- started off slowly early [his year, but fundamental pate that the US. economy will grow moderately, condiiions appear to be more encouraging than with little change in underlying inflation trends. The recent data might seem to suggest. Bad weather in central tendency of the participants' forecasts of real a number of regions and the partial shutdown of GDP growth ranges from 2 percent to 2W percent, ihe federal government have been disruptive to the measured as the cumulative change in output from the economy this winter. These influences seem likely to final quarter of 1995 to the final quarter of 1996. leave only temporary impnnts on spending and The rise in activity is expected to be accompanied production, creating volatility in incoming data over by further expansion of job opportunities and little ine near term while having liitle effect on under- change, on net. in the civilian unemployment rate lying trends. over the four quarters of 1996. The central tendency Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Economic Projections for 1996 Percent Federal Reserve Governors and Reserve Bank Presidents Administration Central Indicator Range Tendency Change, fourth quarter to fourth quartet Nominal GDP 4-5 4V4-4V4 5.1 Real GDP2 2-2% 2.2 Consumer price index3 23/4-3 3.1 Average level, fourth quarter Civilian unemployment rate 5Vz-6 5.7" 1. Change Irom average lw fourth quarter ot 1995 to aver- 3. All urban consumers. age tor fourth quarter d 1996. 4. Annual average. 2. Chain-weighted of the unemployment raie forecasts for the fourth was in the first year or so of the current economic quarter of 1996 is a range of 5>/i percent 10 5W per- expansion, with the rate of increase holding apprecia- cent, compared with an average of 5.6 perceru in the bly below the average rate seen during the expansion final quarter of 1995. The Committee's forecasts of of the 1980s. Although the Federal Reserve's long- economic growth and unemployment are quite similar run goal of restoring price stability has not yet been to those of the Administratioa achieved, the capping of inflation and its diminution over recent business cycles is a clear indication of the The central tendency of the Governors' and Bank substantial progress that has been made to date. Presidents' forecasts of she rise in the consumer price index over the four quarters of 1996 is a range of 2Ki percent to 3 percem. a shade to the high side of the actual outcome of 1995. At this early point in Money and Debt Ranges for 1996 1996. wiih grain stocks exceptionally tight, there is some risk that food price increases at retail could be The Committee's intention to make further larger than those of recent years, especially if crop progress over rime toward price stability formed the production should remain subpar again this year: and. basis for the selection of the growth ranges for the even though recent upward pressures on energy prices monetary aggregates in 1996. In reaffirming the should diminish with the return of normal weather, ranges that were adopted on a provisional basis in another year of declining prices cannot be taken as a July, the Committee noted that it viewed them as given. Nonetheless, the experience with inflation at benchmarks for what would be expected under condi- high levels of resource utilization was favorable in tions of reasonable price stability and historical veloc- 1995. and with businesses still tightly focused on cost ity behavior. The Committee set the range for M2 at control and efficiency gain, broad tendencies toward 1 percent to 5 percent and the range for M3 at increased rates of price increase are not anticipated. 2 percent to 6 percent. The Administration forecast of inflation is higher than Given its expectations for inflation in 1996. the the forecasts of the Federal Reserve officials, but the Committee anticipates that nominal GDP will grow difference is not significant, given the uncertainties of somewhat faster this year than would be the case if forecasting. the economy already were at price stability. If veloci- Price increases like those being forecast for the ties of the aggregates were to exhibit roughly normal coming year would leave inflation no higher than it behavior this year and nominal income were to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 Ranges for Growth of Monetary and Debt Aggregates Percent Aggregate 1994 1995 1996 M2 1-5 1-5 1-5 MS 0-4 2-6' 2-6 4-8 3-7 3-7 Note. Chang* trom average 1or fourth quarter ot preced- 2. Monitoring range tor debt of domestic nonfinanCtal ing year to average (or fourth quarter of year indicated. eectore 1. Revised at July 1995 FOMC meeting. expand as anticipated by the Committee, M2 and M3 aggregates and nominal GDP that nave yet to be might grow near the upper ends of their ranges. In resolved assessing the possible outcomes, the Committee noted The Committee also reaffirmed the 3 percent to that considerable uncertainty remains about the use- 7 percent growth range for debt. Although there are fulness of the monetary aggregates in guiding the indications that lenders may no longer be easing pursuit of its macroeconomic objectives. Although terms and conditions for granting credit to businesses the monetary aggregates have been behaving more in and households, the Committee anticipated that credit line with historical patterns ihan was the case earlier supplies would remain ample and that debt would in the decade, the effects of financial innovation and grow at about the same pace as nominal GDP. Such deregulation over the years have raised questions increases would be consistent with containing infla- about the stability of the relationships between the tion and promoting sustainable growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 Section 2: The Performance of the Economy Measured in terms of the chain-type indexes thai The Household Sector are now being emphasized by the Buieau of Eco- Real personal consumption expenditures rose at an nomic Analysis, growth of real GDP averaged annual rate of about 2V* percent over the first three slightly less than IVi percent at an annual rate quaners of 1995 after having risen slightly more than over the firsi three quarters of 1995 after a gain of 3 percent over Ihe four quaners of 1994. Available 3V4 percent in 1994. The rise in aggregate output this data suggest thai growth of real outlays slowed past year was accompanied by an increase in payroll further in the fourth quarter. The reduced rate of rise employment of IV* million, and the unemployment in consumption spending this past year came against rate, after having fallen sharply in 1994, held fairiy the backdrop of moderate gains in employment and steady over the course of ] 995, keeping to a range of income. The financial wealth of households surged, about 5Vi percent to 53/* percent. Consumer prices, as but impetus to spending from this source evidently measured by the CPI for all items, rase 2V* percent was countered by other influences, such as increases over the four quarters of 1995, an increase that was in debt burdens among some households and an virtually the same as those of the two previous years. apparent rise, according to survey data, in consum- Growth of output during die past year was slowed ers' concerns about job security. in pan by the actions of businesses to reduce the pace Real consumer expenditures for durable goods of inventory accumulation afiera burst of stockpiling increased at an annual rate of 2V* percent over the in 1994. Final sales—a measure of current output first three quaners of 1995, a slower rate of rise than thai does not end up in inventories—rose at an aver- in other recent years. Consumer expenditures for age rate of 2 percent over the first three quarters of motor vehicles declined slightly, on net. over the first 1995 after an increase of 3 percent over the four three quarters after moving up nearly 20 percent over quarters of 1994. The slowing of final sales was largely a reflection of a downshifting in growth of the three previous years: in the fourth quaner. unit sales of cars and light trucks, a key indicator of real the real outlays of households and businesses, from elevated rales of increase in 1994 to rates that were outlays for vehicles, were down slightly from Iheir third-quaner pace. Incentive programs that provided more sustainable. Real government outlays for con- sumption and investment edged down slightly, on net, price concessions of one sort or another to buyers probably gave some lift to sales in 1995. However, during the firet three quarters of 1995. Increases in "pent-up" demand, which had helped to boost sales real exports and real imports of goods and services earlier in the expansion, probably was no longer an were smaller than those of 1994; their combined contribution to GDP growth in the first three quaners important factor. Recent sales data do not seem to point to any big shifts in demand for vehicles around was slightly negative. the turn of the year The average rate of sales of cars and light trucks in December and January was a touch above the average for 1995 as a whole. Change in Real GDP Percent annual rate Real outlays for durable goods other than motor vehicles continued to rise at a brisk pace in 1995. but not so rapidly as in other recent years. Spending for furniture and household equipment hit a temporary lull in the first part of 1995. but picked up again over the next two quaners. lifted in pan by a rebound in construction of new houses. Founti-quarter data on retail sales seem to point to a funher sizable increase in outlays for household durables: according to most anecdotal accounts, spending for home computers and other electronic gear, which has been surging in recent years, continued to move up rapidly through the latter pan of 1995. Consumer expenditures for nondurables increased 7990 1991 1992 1993 1994 1995 at an annual rate of atoul 1 Vy percent, in real terms. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 over the first three quarters of 1995, a little less than 1995. matching, almost exactly, the increases in each the average of the previous ten years and considerably of the two previous years. less than in 1994. The growth of real expenditures on After little change during 1994, the real value of apparel slowed sharply after three years of sizable household wealth surged in 1995. The value of assets advances. In the fourth quarter, real outlays for non- durables appear to have been lackluster. was boosted substantially by huge increases in the prices of stocks and bonds. Liabilities continued to Real expenditures for services—which account for rise fairly rapidly but at a rate well below the rate of more than half of total consumer outlays—increased increase in household assets; rapid growth of con- at an annual rate of about 23/* percent over the first sumer credit was again the most notable feature on three quarters of 1995. moderately faster than in either the liability side. Behind these aggregate measures of 1993 or 1994. After declining in 1994. outlays for household assets and liabilities was some wide varia- energy services increased sharply over the first three tion in the circumstances of individual households- quarters of 1995: The unusually mild weather of late Appreciation of share prices and the rally in the bond 1994 gave way, first, to more normal winter condi- market provided a substantial boost to the wealth of tions in early 1995 and. later on, to hot summer households holding large amounts of those assets. weather that lifted fuel requirements for cooling. However, households holding few such assets bene- Spending gains for other categories of services pro- fited little from the rally in securities prices, and some ceeded at an annual rate of about 2V« percent over the of these households began to experience greater finan- first three quarters of 1995, about die same rate of rise cial pressure in 1995. Debts taken on earlier proved to as in the two previous years. be difficult to repay in some instances, and a rising number of households saw their loans fall into delin- Real disposable persona! income rose at an average quency. Overall, however, the incidence of financial annual rate of about 2Vi percent over the first three stress among households appears to have been lim- quarters of 1995- a gain that was about inline with the ited, as sustained increases in persona! income helped previous year's increase. Monihly data through lo facilitate timely repayment of obligations. November suggest that growth of real income may have picked up a little in the fourth quarter Nominal Consumers maintained relatively upbeat percep- personal income appears to have increased slightly tions of current and future economic conditions dur- faster in 1995 ihan it did in 1994, and growth of ing 1995. The measure of consumer confidence that is nominal disposable income, which excludes income prepared by the Conference Board held fairly sieady taxes, apparently held close to its 1994 pace. Inflation at a high level. The index of consumer sentiment that continued to take only a moderate bile from increases is compiled by the University of Michigan Survey in nominal receipts: The chain-type price index for Research Center edged down a little, on net. from the personal consumption expenditures rose at an annual end of 1994 to the end of 1995. but its level also rate of 2lh percent over the first ihree quarters of remained relatively high. By contrast, some survey questions dealing specifically with perceptions of labor market conditions pointed to increased concerns Change in Real Income and Consumption about job prospects during the year; although employ- Percent, annual rale ment continued to rise in the aggregate, announce- ments of job cuts by some major corporations may Q Disposable personal income have rekindled consumers' anxieties about job secu- R Personal consumption expenditures rity. In January of this year, consumer assessments of labor market conditions softened further, and the broader indexes of sentiment also declined. The Janu- ary levels of the indexes were on the low side of their averages oi" the past couple of years but were well above levels that were reported through most of the first three years of the expansion. Consumers tended to save a slightly higher propor- tion of their income in 1995 than they had in 1994. Large increases in financial wealth usually cause households 10 spend a greater share of their current 1990 1991 1992 1993 1994 1995 income, thereby reducing the share of income that is Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 saved. However, rising debt burdens and increased fairly elevated levels. The average pace of sales of nervousness about job prospects would work in the existing homes over the first eleven months of 1995 opposite direction, and these influences may have was well above the average for the 1980s, even after offset the effect of increases in wealth. Some house- adjusting for increases in the stock of houses. Starts holds also may have started focusing more intently on and sales of new single-family dwellings in 1995 saving for retirement, especially in light of increased were about one-tenth higher than their averages for political debate about curbing the growth of entitle; the 1980s. So far in the 1990s, demographic influ- ments provided under government programs. None- ences have been less supportive of housing activity theless, the personal saving rate for all of 1995, while than in the 1980s, as the rate of household formation moving up a little, remained in a range that was has lagged—in part because many young adults have relatively low by historical standards. delayed setting up their own domiciles. However. offsetting impetus to demand has come from the Residential investment fell in the first half of 1995 improved affordability of housing, brought about in but turned up in the third quarter. Both the down- particular by declines in mortgage interest rates. swing in the first half and the subsequent rebound after midyear appear to have been shaped, at least in a Construction of multifamily units, after taking a rough way, by swings in mortgage interest rates. notable step toward recovery in 1994, rose only mod- Although housing activity had been slow to respond erately further in 1995. Over the first eleven months to increases in mortgage interest rates through much of 1995. starts of multifamily units amounted to of 1994. sizable declines in sales of new and existing 280.000 at an annual rate, compared with about homes started to show up toward the end of that year, 260.000 the previous year and a low of 162,000 in and by early 1995. permits and starts also were drop- 1993. Financing for the construction of new multifam- ping. However, the deciine in activity proved to be ily projects appeared to be readily available this past relatively short and mild. By March, mortgage inter- year. However, the national vacancy rate for multi- est rates already were down appreciably from the family rental units, while down from the peaks of a peaks of late 1994. and midway through the second few years ago. remained relatively high, and increases quarter, most indicators of housing activity were start- in rents were not of a magnitude to provide much ing to rebound. Sales of new homes surged to espe- incentive for the construction of new units. cially high levels during the summer, and permits and starts of single-family units rose appreciably. In the The Business Sector autumn, sales retreated from their midyear peaks. Starts also slipped back somewhat during the autumn, Most indicators of business activity remained but permits held firm. favorable in 1995. but strength was less widespread The intra-year swings in the various housing indi- than it had been in 1994. and growth overall was less cators left the annual totals for these indicators at robust. The output of all nonfarm businesses rose at an annual rate of slightly less than 2 percent over the Private Housing Starts first three quarters of 1995. after a gain of 4 percent in 1991—a pace that could not have been sustained Millions ol units, annual rale given already high operating levels. Inventory Quarterly average problems cropped up in some lines of manufactur- ing and trade in 1995 and prompted production adjustments. Scattered structural problems were 1.5 apparem as well, especially in pans of retail trade in which intense competition for market share caused financial losses and eventual bankruptcy for some enterprises. More generally, however, business profits remained high in 1995. as firms continued to emphasize strategies that have served them well 0-5 throughout the 1990s—most notably, tight control over costs and rapid adoption of new technologies, achieved by way of heavy investment in high-tech equipmera. 1989 1991 1993 1995 In total, real business fixed investment increased at Note. Data points for 199S:Q4 ate the averages (or October and November. an annual rate of 8 percent over the first three quarters Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 Change in Real Business Fixed Investment gain of about 4 percent in industrial capacity. How- PwoMit, annual rab ever, in a turnabout from ihe outcome of the previous D year, output of the industrial sector rose considerably Structures less rapidly than capacity: A gain of 1 >/i percent in Producers' durable 20 total industrial production over the four quarters of equipment 1995 was a sharp slowdown from a 1994 rise of more than 6Vi percent. Production of consumer goods fol- 10 lowed a choppy pattern during 1995 and rose less than Va percent over the year as a whole, the smallest annual increase of the current expansion. Ire output of business equipment advanced in e&h quaner. but a cumulative gain of 4Vi petcem for this category was smaller than the increases of other recent years. Pro- 10 duction of materials faltered temporarily in the sec- ond quarter, but production gains resumed thereafter. 20 leading to a rise of about 2V* percent over the four 1990 1991 1992 1993 1994 1995 quarters of ihe year. of 1995 after a gain of 10 percent in 1994. Growth in Industrial Production business spending for equipment continued to out- Index, 1987 - 100 pace the growth of investment in structures, even though the latter scored its largest gain of the past several years. On a quanerly basis, investment 125 remained very strong through the first quarter of 1995. After slowing sharply in the spring, it then 120 picked up somewhat in the third quarter. Fragmentary data for the fourth quarter suggest that investment in plant and equipment recorded a gain of at least mod- 115 erate size in that period. 110 Businesses continued to invest heavily in comput- ers in 1995. In real terms, these expenditures rose at an annual rate of nearly 30 percent over the first three 105 quarters of the year, an increase that was even more rapid than that of 1994. Excluding computers, real j t 100 investment outlays increased less rapidly, on balance, 1990 1991 1992 1993 1994 1995 1996 than in 1994. and growth after the first quaner was modest, on net. In the equipment category, outlays for With capacity expanding rapidly and production information-processing equipment other than comput- growth slowing, the rate of capacity utilization in ers moved up at an annual rate of about 13 percent in industry turned down sharply in 1995. backing away the first half of 1995 but fell back a little in ihe ihird from The high operating rates of late 1994. As of this quaner. Spending for industrial equipment followed past December, the utilization rate in manufacturing a roughly similar patiem. with a small third-quarter was about Vi percentage point above its long-term decline coming on the heels of large gains in the first averag;. In January of this year, utilization rates fell half of the year. Real outlays for transportation equip- noticeably: Vehicle producers reduced assembly rates ment declined in the second quaner but rebounded in last month, and winter storms temporarily shut down [he third. Real investmem in nonresideraial structures manufacturing operations more generally. moved up in each of the first three quarters of f 995. ai After rising rapidly during 1994. business inven- an annual rate of more than 6 percent, on average, tories continued to build at a substantial pace in after a gain of 3'/2 percent during 1994: the most the early part of 1995. By the end of the first quaner, recent year brought increased construction of most real inventories of nonfarm businesses were about types of nonresidential buildings. 5'/i percent above the level of a year earlier. Mean- In the industrial sector, elevated levels of invest- while, strength thai had been evident in final sales ment in equipment and structures in 1995 led to a during 1994 gave way to more subdued growth in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 Manufacturing Capacity UtHizatton Rate Business profit* rose further over the first three quarters of 199S. Economic profits of all US. corpora- lions increased at an annual rate of nearly 11 percent, a pace similar to that seen over the fonr quarters of 1994. The profits of corporations from their opera- tions in the rest of the world moved up sharply, on net, and earnings from domestic operations also con- tinued to advance. The strongest gains in domestic profits came at financial corporations and reflected, in part, an increased volume of lending by financial institutions, reduced premiums on deposit insurance at commercial banks, and rising profits of securities dealers. The economic profits earned by nonfinancial corporations from their domestic operations rose at an annual rate of about 316 percent over the first three quarters of 1995 after three years in which the annual 1988 1990 1992 1994 1996 increases were 15 percent or more. A moderation of output growth at nonfinancial corporations and a flat- tening of the rise in profits per unit of output both first quarter of 1995. and the ratio of inventories to worked lo reduce the rate of growth in nominal earn- sates rose. In the second and third quarters, growth of ings in 1995. Nonetheless, with unit costs also mov- inventories was roughly in line with growth of busi- ing up at a moderate pace, the share of the value of ness final sales; consequently, aggregate mveraory- nonfinanciaJ corporate output that ended up as profits sales ratios held fairly steady during this period. changed little, on net. in the first three quarters, hold- Although data on inventory change in the year's final ing in a range thai was relatively high in comparison quarter are riot yet complete, the available indicators to the average profit share over the past couple of suggest that significant imbalances probably were decades. present in only a few industries at year-end. Potential for wider inventory problems appears to have been contained through a combination of production Before-Tax Profit Share of GDP restraint late in 1995, caution in ordering merchandise Percent from abroad, and discounting by some retailers during the holiday shopping season. Wholesalers reduced Nonfinancial corporations their inventories in the final two months of 1995. and manufacturers' stocks rose only slightly: aggregate inventory-sales ratios moved down in both sectors. Change in Real Nonfarm Business Inventories Percent, annual rate 1989 1991 1993 1995 Note. Piolits from domestic operation* with inventory valua- tion and capital consumption adjustments, divided by gross domestic product o( nari inane ial corporate sector. The Government Sector At the federal level, combined real outlays for investment and consumption fell ai an annual rate of 1990 1991 1992 1993 1994 1995 about 4^4 percent over the first three quarters of 1995. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 dropping to a level aboul 13 percent below its annual ing budget resolutions has translated into sharp cuts in peak in 1990. Both investment and consumption were nondefense outlays. cut back over the firs three quarters of 1995. Outlays Federal receipts rose ~IVi percent in fiscal 1995. for defense continued 10 contract, and nondefense after having increased 9 percent in fiscal 1994. In expenditures turned down, reversing a moderate both years, categories of receipts that are most closely increase chat took place over the four quarters of related to the state of the economy showed sizable 1994. increases. With receipts moving up more rapidly than Federal outlays in the unified budget, which covers spending in fiscal 1995. the federal budget deficit fell items such as transfers and giants, as well as con- for a third consecutive year, lo $164 billion. Progress sumption and investment expenditures other than UK in reducing ire deficit in recent years has come from consumption of fixed capital, rose 3J/i percent in cyclical expansion of the economy, tax increases, nominal terms in fiscal 1995. matching almost exactly non-recurring factors such as the sale of spectrum ihe percentage rise of the previous fiscal year. Nomi- rights, and adherence to the budgetary restraints nal outlays for defense declined 3V4 percent in both embodied in the Budget Enforcement Act of 1990 and fiscal 1995 and fiscal 1994. Outlays for social security the Omnibus Budgetary Reconciliation Act of 1993. increased about 5 percent in both years. Spending for Medicare and Medicaid continued to rise at rates Federal Unified Budget Deficit appreciably faster than the growth of nominal GDP. Net interest payments jumped in fiscal 1995 after three years of relatively little change, but. working in Fiscal years the other direction, net outlays for deposit insurance were more negative than in 1994 (i.e., the margin between insurance premiums and the payout for - 300 losses increased). Proceeds from auctions of spectrum rights also helped to hold down expenditures: like the premiums for deposit insurance, these proceeds enter - 200 the budget as a negative outlay. In the first three months of fiscal 1996—i.e.. the three-month period ended in December—federal outlays were about - 100 1 percent lower in nominal terms man in the com- parable period of fiscal 1995. Nominal outlays for defense nave continued to trend down this fiscal year, and the spending restrain: embodied in recent continu- 1990 1991 1992 1993 1994 1995 Change in Real Federal Expenditures on Consumption and Investment The economic expansion also has helped to relieve budgetary pressures that many state and local govern- Percent. Q4 to Q4 ments were experiencing earlier in the 1990s. Exclud- ing social insurance funds, surpluses in the combined current accounts of state and Local governments were equal to about '/2 percent of nominal GDP in the first three quarters of 1995: this figure was more than double the average for 1991 and 1992. when budget- ary pressures were most severe. Even so, state and local fudgets reman ai the center of strongly competing pressures, with ine demand tor many of the services that typically are provided by these governments continuing to nse at a time when ihe public also is expressing desire for tax relief. Although states and localities have responded 10 lo these pressures in different ways, the aggregate 1990 7991 1992 1993 1994 1995 picture is one in which expenditures and revenues Note. Value for 1995 is measured from !994:Q4 to l995:Q3at an annual rale. have continued to rise faster than nominal GDP—but Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 by smaller margins than in the early pan of the 1990s. 1995 from die robust rates of 1994. In Canada, where In total, the current expenditures of state and local economic activity had been particularly vigorous governments, made up mainly of transfers and con- through the end of 1994, (he slowdown reflected sumption expenditures, were equal to about 12'A per- weaker U.S. growth and macroeconomic policies cent of nominal GDP in the first three quarters of intended to achieve improved fiscal balance and to 1995. up slightly from the percentages of the two prevent the reemergence of inflationary pressures. In previous years and about IV* percentage points higher Germany and the other European economies, appre- than the comparable figure for 1989. Total receipts of ciation of their currencies in terms of the dollar dur- state and local governments were equal to about ing the early months of the year and efforts to reduce 1 jy* percent of nominal GDP in the first three quar- public sector deficits contributed to the decline in the ters of 1995, up just a touch from the comparable rate of real output growth. In contrast, Japan showed percentages of the two previous years but about some tentative signs of recovery late in 1995 after 1 '/* percentage points higher than the percentage in almost no growth during the previous three years. 1989. With the expansion of real GDP slowing in the foreign G-10 countries at a time when some slack Change in Real State and Local Expenditures remained, inflation stayed low. The average rate of on Consumption and Investment consumer price inflation in these countries remained Percent. 04 to Q4 about 2 percent last year. essentially the same as in 1994 and somewhat less than in the United States. Economic growth in the major developing coun- tries slowed on average in 1995 from the strong pace recorded for 1994. The substantial contraction of eco- nomic aciiviry in Mexico had important effects on - 3 US. trade, but real output also slowed in other devel- oping countries, including Argentina. In response to - 2 the December 1994 collapse of the Mexican peso, the Mexican government adopted a set of policies intended to tighten monetary conditions, maintain wage restraint, and reduce government spending in order to mitigate the inflationary impact of die peso's devaluation and to achieve significant reduction in 1990 1991 1992 1993 1994 1995 the current account deficit in 1995. Through the third Note. Value for 1995 is measured from 1994:04 to 1995:03 at quarter, the Mexican current account was approxi- an annual rate. mately balanced; a deficit of about 520 billion had cumulated during the comparable three quarters of State and local outlays thai are included in GDP 1994. The merchandise trade balance improved to have been rising less rapidly than the current expendi- moderate surplus in 1995 from a substantial deficit tures of these jurisdictions, because GDP excludes in 1994. The improved trade performance in pan transfer payments, which have been growing faster reflected a severe contraction in aggregate demand. than other outlays. In real terms, combined state and Mexican real output fell sharply early in the year but local outlays for consumption and investment picked up toward the end of the year, for an annual increased at an annual rate of about 2Vy percent over decline of nearly 7 percent. the first three quarters of 1995. Real investment expenditures, which consist mainly of outlays for The newly industrializing economies in Asia—for construction, moved up at an annual rate of almost example. Malaysia. Korea, and Taiwan—continued to 7 percent. By contrast, consumption expenditures, grow rapidly during 1995. at about the same rate as in which are about four times the size of investment 1994, Although growth in mosr of these countries was outlays, rose only modesily in real terms—at an aver- driven by a strong expansion in internal demand, age annual rate of about l'/3 percent. especially in investment, most countries also bene- fited from very fast export growth. The marked accel- eration in exports was attributable at least in part to a The External Sector real depreciation of their currencies against the yen Growth of real GDP in the major foreign indus- and key European currencies during the eariy part of trial countries oiher ihan Japan slowed sharply in the year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 In the first eleven raotHhs of 1995 the nominal US. Cnange in Real Imports and Exports trade deficit in goods and services reached about of Goods and Services SllS billion at a seasonally adjusted annual rate, a Percent. CM to CM level slightly greater than the $106 billioa recorded for 1994. US. income growth in 1995 was similar to D Imports the average for our trading partners, but. as is typi- I Exports cally the case, comparable increases in income 15 seemed to bring forth an increase in U.S. demand for impons that was larger than the average increases in demand for our exports by the foreign countries with 10 which we trade. Effects of the dollar's depreciation during 1994 and early 1995 worked in the opposite direction, tending to boost exports and hold down imparts. Overall, the result of these offsetting tenden- cies was that the dollar value of exports grew some- what faster than the dollar value of imports through November. Nonetheless, with the level of imports exceeding the level of exports at the start of the year. 1989 1991 1993 1995 these growth rates translated into a slightly larger Note. ValuB»for1996a™maa«u*dliomlW»:Q*to199ftO3 at an annual rate. deficit. The current account deficit averaged about $160 billion at an annual rate during the first three quarters of 1995. Both the trade deficit and the deficit destination showed divergent patterns: Exports to on net investment income widened somewhat, result- Mexico dropped in response to the economic crisis in ing in an increase from the S15G billion current that country, but shipments to developing countries account deficit experienced in 1994. in Asia rose sharply. Exports to Western Europe. Canada, and Japan increased as well. U.S. Current Account Imports of goods and services increased at an Billions ol dollars, annual rate annual rate of about 6 percent in real terms during the first three quaners. a slower rate of advance than during 1994. Imports of computers and semiconduc- tors rose sharply, but imports of other machinery, consumer goods and industrial supplies slowed. Import prices increased about IVz percent in the 50 twelve months ending in December 1995. An end to the very rapid rise in world non-oil commodity prices •\oo and tow inflation abroad helped to restrain the rise in import prices. In the first three quaners of 1995, recorded n« 150 capital inflows irao the United States were substantial and nearly balanced the deficit in the US. current i i _ i _ i account. Sharp increases were reported in both for- 200 1989 1991 1993 1995 eign assets in the United States and US. assets abroad. Foreign official asset holdings in the United States Real exports of goods and services grew at an increased almost $100 billion through September. annual rate of about 5 percent over the first three These increases reflected both intervention by certain quaners of 1995. Agricultural exports remained at industrial countries to support the foreign exchange elevated levels, and the volume of computer exports value of the dollar and very substantial accumulation continued to rise sharply. Other merchandise exports of reserves by several developing countries in Asia expanded in real terms at a marginally slower rate and Uuin America, Private foreign assets in the than did the total: within this broad category, machin- United States also rase rapidly. Net purchases of US. ery and industrial supplies accounted for the largest Treasury securities by private foreigners totaled increases. Tabulation of the export data by country of S97 billion, an amount far exceeding previous Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 record*. Net purchase! of US. government agency omy. but gains there were more mixed than mote bonds and corporate bonds were also very large. of 1994. In manufacturing, employment fell about 160,000 over the twelve months ended in December, Direct investment inflows reached almost $50 bil- reversing almost half of the previous year's gala lion ill the first three quarters of 1995; this total was Losses were concentrated in industries that produce about equal to the inflow during all of 1994 and nondurables. A decline this past year in the number of almost matched the record pace of 1989. Mergers and jobs at apparel manufacturers was one of the largest acquisitions added substantially to the inflow of funds ever in that industry. Sizable reductions in employ- from foreign direct investors in the United States. ment also were reported by manufacturers of textiles, US. direct investment abroad was even larger than tobacco, leather products, and petroleum and coal. In foreign direct investment in the United States and also many of these industries, cyclical deceleration of the approached previous peak rates. US. net purchases of economy in 1995 compounded the effects of adjust- foreign stocks and bonds were up from 1994, but ments stemming from longer-run structural changes. below the 1993 peak rate. The bulk of the net U.S. In contrast to the widespread contraction in employ- purchases of foreign securities were from the indus- ment among producers of nondurables. employment trial countries; net purchases from emerging markets at the manufacturers of durable goods increased played a relatively small role. slightly during 1995. Hiring continued to expand briskly at firms that produce business equipment. Metal fabricators also sustained growth in employ- Labor Markets ment but at a slower pace than in 1994. The number The number of jobs on nonfann payrolls increased of jobs in transportion equipment declined, on net. IV* million over the twelve months ended in Decem- In most other sectors of the economy, employment ber 1995. After a sharp rise during 1994, gains in rose moderately last year. The number of jobs in employment slowed in the first pan of 1995. and the construction increased 140,000 over the twelve second quarter brought only a small increase. months ended in December, a rise of more than 3 per- Thereafter, increases picked up somewhat. Nearly cent. In the private service-producing sector, which 450,000 jobs were added in ihe final three months of now accounts for about three-fourths of all jobs in the the year, a gain of about 1 Vi percent at an annual rate. private sector, employment increased 1.7 million in In January of this year, with the weather keeping 1995 after having advanced 2.6 million in 1994. many workers at home during the reference week Establishments thai are involved in wholesale trade for the monthly survey of establishments, payroll continued to boost payrolls at a relatively brisk pace employment fell sharply. in 1995. Retailers also added to employment but at a As in 1994, increases in payroll employment in considerably slower rate than in 1994: within retail 1995 came mainly in the private sector of the econ- trade, employment at apparel outlets fell substantially last year, and payrolls at stores selling general mer- chandise dropped moderately after a large increase in 1994. Providers of health services added slightly more Net Change in Payroll Employment jobs than in other recent years. Ai firms that supply M«fons ol job* services to other businesses, employment growth was sizable again in 1995 but less rapid than in either Total nonfarm of the two previous years; in this category, providers of computer services expanded their job counts at an accelerated pace in 1995. but suppliers of personnel—a category that includes temporary help I, agencies—added jobs at a much slower raie than in other receru years. Results from the monthly survey of households showed the civilian unemployment rate holding in a narrow range throughout 1995. and the rate reported in December—5.6 percent of the labor force—was near the midpoint of that narrow range. In January of (his year, the unemployment rate ticked up to 1990 1991 1992 1993 1994 1995 5.8 percent. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 Civilian Unemployment Rate pan by faster rates of rise in hourly compensation and Percent unit labor costs. The current expansion, in contrast, has remained relatively free of increased inflation pressures working through the labor markets. The employment cost index for hourly compensation of workers in private nonfarm industries rose only 2.8 percent over the twelve months ended in Decem- ber, the smallest annual increase on record in a series that goes back to the start of the 1980s. Hourly wages \r*s~ increased 2.8 percent during the past year, the same Jan. relatively low rate of increase as in 1994. The cost of fringe benefits, prorated to an hourly basis, rose only 2.7 percent last year, the smallest annual rise on record. With many firms still undergoing restruc- turings and reorganizations, many of which have involved permanent job losses, workers probably have 1988 1990 1992 1994 1996 been more reluctant to press for wage increases than Hote. The break in data at January 1994 marks the introduc- they normally would have been during a period of tion ot • realigned survey; data from that poirt on are not dtoctly corrparaWe with the data of Mri«t period*. tight labor markets. Also, firms have been making unprecedented efforts to gain better control over the rate of rise in the cost of benefits provided to employ- The proportion of working-age persons choosing to ees, especially those related to health care. Although participate in the labor force edged down slightly, on some of these efforts may have only a one-time effect nei, over the course of 1995. It has changed little, on on the level of benefit costs, groundwork also seems balance, since the start of the 1990s. By contrast, to have been laid for slower growth of benefits over the two previous decades brought substantial net time than would otherwise have prevailed. increases in labor force participation, although longer- term trends during die two decades were interrupted at times by spells of cyclical sluggishness in the Change in Employment Cost Index economy. Two or three years ago. cyclical influences also seemed to be a plausible explanation for the Percent. Dec. to Dec. sluggishness of labor force participation in the current Hourly compensation business expansion. But, with the participation rate remaining sluggish as job opportunities have contin- ued to expand, the evidence is pointing increasingly toward a slower rate of rise in the trend of participa- tion. Slower growth of participation will tend to limit the growth of potential output, unless an offsetting rise is forthcoming in the trend of productivity growth. So far in the current expansion, measured increases in productivity seem to have followed a fairly typical cyclical pattern, with larger increases early in the expansion and smaller gains, on average. in subsequent years. Overall, however, this pattern has not yielded evidence of a significant pickup in the 1989 1991 1993 1995 longer-term trend of productivity growth. Not*, P rival* industry, excluding farm and household wortre The average unemployment rate for all of 1995 was about Vi percentage point below the average for 1994. Prices and it was only a little above the levels to which the unemployment rate fell in the latter stages of the long Early in 1995. inflation pressures that had started business expansion of the 1980s. The low unemploy- building in 1994 seemed to be gaining in intensity. ment rates reached back then proved to be unsustain- Indexes of spot commodity prices continued to surge able, as they eventually were accompanied by a sig- in the eariy pan of last year, and in the producer price nificant step-up in the rate of inflation, brought on in index, materials prices recorded some of the largest Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 monthly increases of the past decade and a half. Change in Consumer Prices Excluding Consumer prices also began to exhibit some upward Food and Energy pressure, with the index for items other than food and Parcent, 04 to 04 energy moving up fairiy rapidly over the first four months of ihe year The surge in inflation proved to be relatively short- lived, however. The spot prices of industrial com- modities turned down in the spring of the year and fell further, on net, after midyear. Price increases for intermediate materials slowed in the second and third quarters of 1995, and by the final quarter of the year these prices also were declining. Monthly increases in the core CPI slowed in May; thereafter, increases generally were small over the remainder of the year. The slowing of the economy after the start of the year appears to have cut short die buildup of inflationary pressures before they could have much effect on the 1989 1991 1993 1995 underlying processes of wage and price determina- Note. Consumer price index lor afl urban consumers. tion. In the end. the rise in the CPI excluding food and energy from the final quarter of 1994 to the final quarter of 1995 amounted to 3 percent, an increase year but not so rapidly as in the previous year. Price that differed little from those of the two previous increases for vehicles moderated. The, 1995 rise in the years. The increase in the total CPI in 1995 came in at CPI for services other than energy was 3V* percent; 2*4 percent, the fifth consecutive year in which it has although this increase exceeded the 1994 rise by a been in a range of 3 percent or less. slight amount, the results for both years were among the smallest increases for this category in the last three decades. Change in Consumer Prices Percent, O4 to O4 Trends in food prices and energy prices remained favorable to consumers in 1995. The rise in food prices from the final quarter of 1994 to the final quarter of 1995 was slightly more than 2V4 percent. almost exactly the same as the increases of the two previous years. The last yearly increase in food prices in excess of 3 percent came five years ago. in 1990. In the intervening years, production adjustments by fanners and weather problems of one son or another have caused temporary surges in the prices of some farm commodities, but these surges have not resulted in widespread pressures on food prices at the retail level. Moderate rates of increase in the costs of non- farm inputs that contribute heavily to value added have been an important anchor in the setting of food 1989 1991 1993 1995 prices at the consumer level. Also, if only by chance, Note- Consumer price index tor all urban consume™. years of poor crops—like thai of 1995. when grain and oilseed production plummeted—have tended lo In the aggregate, rates of price increase held fairly be interspersed with years of good crops, a pattern Mi-'acy for both goods and services this past year. The dial has prevented sustained upward pressures on CPI for commodities other than food and energy rose farm and food prices. In the energy area, prices at the lJ/4 perecm over the four quarters of 1995 after consumer level fell 1V' percent, on net, over the four increases of I1/: percent in both 1993 and 1994. The quarters of 1995. more than reversing a moderate last three-year period in which prices of these goods 1994 increase. Gasoline prices dropped neatly 5 per- rose by such small amounts came in the middle pan cent, on net. over the four quarters of the year, and oi the 1960s. Apparel prices continued 10 decline last consumer prices of natural gas also declined appre- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 ciably. However, some upward pressures developed anticipated price increases one year into Che future late in 1995 and early this year, largely in response to were sligndy lower than those of 1994, and survey unexpectedly cold temperatures thai boosted fuel responses about inflation prospects over the longer requirements for winter heating. term came down more substantially. Although the All told, the price developments of 1995 appear to responses regarding expected inflation still tended, on have left a favorable imprint on expectations of future balance, to run to the high side of actual rates of price rales of inflation, if results from various surveys of increase, the easing of inflation expectations this past consumers and forecasters are an accurate reflection year provided another encouraging sign thai inflation of the views held by the broader public. Monthly processes that helped to undermine other recent busi- responses lo the surveys tend to bounce around some- ness expansions are still in check- in the current what, but over 1995 as a whole, average readings of expansion. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 Section 3: Financial, Credit, and Monetary Developments In 1995 and early 1996. the Federal Reserve had Most market interest rates had peaked before the to adjust its policy stance several times to promote policy tightening last February. During the spring. credit market conditions supponive of sustained interest rales declined appreciably, as market partici- growth with low inflation. At the beginning of 1995, pants increasingly came to believe that no additional some risk icmained that inflation might rise. To policy restraint would be forthcoming, and. indeed, provide additional insurance against that develop- thai easing might be in the cards. Mounting evidence ment, the Federal Open Market Committee (FOMC) that the growth of spending had downshifted and tightened reserve conditions, raising the intended fed- price pressures were muted, along with greater hopes eral funds rate Vt percentage point, to 6 percent, that substantial progress would be made toward thereby extending the episode of policy finning that reducing the federal budget deficit, contributed to the had begun one year earlier. As time passed, it became change in altitudes and to the drop in interest rates, dear that these policy tightening* had been success- especially longer-term rates. On balance during 1995. ful in containing inflationary pressures, and the interest rates dropped 1 to 2Vi percentage points, System initialed V* point reductions in the federal with the largest declines registered on imermediate- funds rate in July and December of 1995 and Janu- and long-term securities. This year, short- and ary of 1996. intermediaie-tenn interest rates have fallen somewhat further, while long-term rates are unchanged to a little Domestic Interest Rates higher. Short-Term During the first pan of lasi year, expectations of lower U.S. interest rates relative to other G-10 coun- Monthly tries and other factors such as the crisis in Mexico contributed to a 10 percent depreciation of the trade- weighted exchange value of the dollar. By year-end, Federal Funds though, the dollar had retraced about half of these 10 tosses, and it has appreciated further on balance in 1996. The course of interest rales during the year influ- enced overall credit flows and their composition. The expansion of the total debt of domestic nonfinancial Three-month Treasury bill Coupon oqurvalonl basis sectors was relatively strong during the first half of the year but moderated later in 1995. For the year, I I I I i 1 I i 1 i i 1 i debl grew 5<A percent, a bit above the midpoint of its annual growth range. Initially, household and non- Long-Term financial business credit demands were concentrated in floating-rate or short-term debt instruments. As the yield curve flattened, credit demands shifted to fixed- Monthly raie. long-term debt instruments. Because depository institutions are important Home Mortgage sources of short-term and floating-rate credit to house- Primary Conventional 12 holds and businesses, depository assets grew rapidly early on and then backed off. The need to fund the increase in assets, along with declines in market inter- est rates relative 10 yields on recail deposits, led to the fastest growth in M2 and M3 since the late 1980s; M2 ended the year in the upper pan of its annual range, and M3 was at the upper end of its range. In contrast. Thirty-year Treasury bond Ml declined for the first time since the beginning of i i i i i i i i i 1 the official series in 1959. as many banks introduced 1984 1986 1988 1990 1992 1994 1996 retail sweep accounts that shifted deposits from Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 interest-bearing checking accounts to savings-type marked rise in materials prices during the last half of accounts in order to reduce reserve requirements. 1994, seemed indicative of emerging resource con- straints and building inflationary pressures. In these circumstances, the FOMC agreed on a ¥2 percentage The Course of Policy and Interest Rates point increase in the federal funds rate, and the Board The Federal Reserve entered 1995 having tightened of Governors approved an equal increase in the dis- policy appreciably during the previous year. Short- count rate. term interest rates had risen more than 2V4 percent- age points from the end of 1993, and long-term rates During the remainder of the winter and through the were up 2 percentage points. Policy tightening had spring, incoming data signaled that economic growth been necessitated by the threat of rising inflation was finally moderating. At first, it was unclear if the posed by unusually low real short-term interest rates slowdown was temporary or if it was a lasting shift earlier in the 1990s. Rates had been kept low to toward a sustainable rate of economic expansion in counter the effects of impediments to credit flows and the neighborhood of the economy's potential. Adding economic growth. But as these impediments were to the uncertainty was a pickup of consumer price reduced, the economy expanded at an unsustainable inflation and a pronounced weakening in the foreign pace and margins of underutilized labor and capital exchange value of the dollar. At the March meeting, began to erode. Ultimately, absent a firmer policy, the FOMC determined that it would be prudent to excessive demands on productive resources and await further information before taking any additional resulting higher inflation would have produced policy actions, but it alerted the Manager of the strains, threatening economic expansion. System Open Market Account that, if intermeeting action were to be required, the step would more likely In early February the policy actions taken in 1994 be to firm than to ease. did not appear to be sufficient to head off inflationary pressures. The growth of economic activity had not By the May meeting, substantial evidence had shown convincing signs of slowing to a more sustain- accumulated that the threat of rising inflation had able pace, and available information, including a lessened. Economic growth had slowed: although the The Discount Rate and Selected Market Interest Rates Percent Daily 12/31 2/4/94 122 4/18 S/17 7/6 8/16 9/27 11(151320 2/1/96 3/28 5/23 7/6 832 9G6 11/15)2/19101(96 Nate. Oatt*d vertical lines indicate days on which the Committee announced a monetary pofcy action. Asterisks indicate days on which the FOMC held scheduled meetings. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 adjustment to inventory imbalances thai had devel- a softening in spending after the third quarter, but the oped earlier in the year was contributing to the slow- extent of any slowing of spending and inflation was down, the underlying trajectory of final sales was still unclear. Although short-term rates remained above uncertain. The FOMC determined that the existing long-term averages on a real, inflation-adjusted basis, stance of policy was appropriate and expressed no substantial rallies in bond and stock markets were presumption as to the direction of potential poSicy thought \ikely to buoy spending. Against this back- action over the intermeeiing period, issuing a sym- drop, the FOMC voted to maintain the existing stance metric directive to the Account Manager. of monetary policy. Intermediate- and long-term interest rates had The generally positive news about inflation and fallen throughout the winter and spring, as evidence hopes for a budget agreement had helped propel the accumulated that the expansion of economic activity bond market higher throughout the fall. By the was slowing and that inflationary pressures were ebb- December meeting, intermediate- and long-term inter- ing. Furthermore, budget discussions in the Congress est rates were IV* to 2W percentage points below their seemed to foreshadow significant fiscal restraint over levels at the beginning of the year. The bond market the balance of the decade, putting additional down- rally, along with strong earnings reports, pushed ward pressure on these rates. Shon-tenn rates had equity prices higher during the year, and by mid- declined less, but in late spring, financial market December, equity price indexes were up about 35 per- participants had begun to anticipate an easing of cent from levels at the beginning of the year. Since monetary policy. By midyear, the three-month Trea- the last easing in July, inflation had been somewhat sury bill rate had declined about '/* percentage point more favorable than anticipated, and the expansion of from its level at the beginning of the year, while rates economic activity had moderated substantially after on securities with maturities greater [nan one year had posting a strong third quarter. With both inflation and dropped as much as 2 percentage points. inflation expectations more subdued than expected. Employment data released shortly after the May and with the slowing in economic growth suggesting FOMC meeting were surprisingly weak, and by the that price pressures would continue to be contained, July meeting it appeared that growth of aggregate the FOMC decided to reduce the intended federal output had sagged markedly during the second quar- funds rate an additional V* percentage point, bringing ter as businesses sought to keep inventories from it to 5'/4 percent. rising to undesirable levels. This deceleration of out- The data available at the time of the FOMC meet- put growth was accompanied by a softening of indus- ing in late January gave stronger evidence of slowing trial prices and a marked reduction in the pace at economic expansion. This development reduced which materials prices were rising. With ihe economy potential inflationary pressures going forward and growing more slowly than had been anticipated and raised questions about whether monetary policy might potential inflationary pressures receding, the FOMC unduly restrain the pace of expansion. The Committee voted to ease reserve pressures slightly with a '/* per- believed thai a further slight easing in monetary pol- centage point decline in the intended federal funds icy was consistent with keeping inflation contained rate. and fostering sustainable growth, given that price and Although financial market participants had antici- cost trends were already subdued. In these circum- pated a decline in the federal funds rate at some point, stances, the Committee lowered the intended federal bond and equity markets rallied strongly immediately funds rate '/* percentage point, to 5Vt percent, and the after the change in policy was announced. However, a Board approved an equivalent reduction in the dis- pickup in economic growth during the summer made count rate, to 5 percent. further reductions in the funds rate appear less likely, and interest rates backed up for a time. Partly as a consequence of the System actions in December and January, shon- and intermediate-term The- Committee did keep rates unchanged at the interest rates have fallen V* to Vt percentage poini August and September meetings. Although inflation since mid-December. However, on balance, longer- had improved, the slowdown had been anticipated to term rates are unchanged to a little higher. The a considerable extent. Moreover, uncertainties arioui absence of a firm agreement to reduce the federal federal budget policies and their effects on the econ- budget deficit, and some tentative signs most recently omy remained substantial. that the economy might not be so sluggish as some Ai the November meeting, the economic signals market participants had feared, have held up longer- were mixed. Anecdotal information tended to suggest term rales. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 Debt Annual Range and Actual Level Household Financial Condition BMon* of dofan N on financial 13000 J 1 1 1 1 1 1 1 1 1 L 12700 Q N O 4 F M A MJ J A S O ND 1980 1985 1990 1995 1994 1995 debt of proposals for changes in federal taxation that Credit and Money Plows would sharply reduce the tax advantages of holding municipal bonds. On balance in 1995. the debt of the domestic nonfinancial sectors grew at about the same pace as Household borrowing remained robust in 1995. in [he previous year, although within the year, debt moderating only a bit from 1994, and the ratio of growth was much stronger in the firs! half than in the household act* to disposable personal income rose second. Credit supplies remained plentiful: Banks further. Even so. the financial condition of this sector continued to be willing lenders, and in securities remained good on balance, although there were signs markets most inierest-rate spreads remained quite of deterioration. The rally in the domestic equity narrow. Debt burdens for households increased, tat markets supported household balance sheets by boost- except for a few types of consumer credit obliga- ing net worth sharply. In addition, delinquency rates tions, delinquency rates remained at low levels. Ris- on home mortgages and closed-end consumer loans ing equity prices bolstered the overall financiaJ condi- at banks, while rising, remained at low levels. tion of households. Other indicators, howevec. provided evidence thai some households were likely beginning to experience Federal debt rose 3% percent in 1995. slightly less increased financial pressures. For instance, delin- than in 1994. The federal government's demands for quency rates on credit card debt held by banks and on credit fell largely because the budget deficit shrank about 20 percent for the calendar year. Federal debi growth also slowed toward year-end as the Treasury Delinquency Rates on Household Loans drew down its cash balance to keep borrowing within Percent the S4.9 trillion debt ceiling. Stale and local government debt fell 5V4 percent— Closed-end consumer loans al banks more than in 1994. A few years earlier, municipalities had taken advantage of low long-term rates to pre- refund a substantial volume of issues, many of which were eligible to be called in 1995. As those securities were called, and with gross issuance light, ihe stock of municipal securities contracted tor a second con- secutive year. Despite ihe overall reduction in debt outsianding. the ratios of tax -exempt 10 taxable yields Auto loans at jumped in the flrsi half of the year and. for long-term finance companies debt, held at an elevated level during the remainder of Mortgages the year. This increase was associated with concerns I Li 1 l_l.t I 1_L.I LJ I IJ I I I I I I I I I I I about the effect on demands for tax-free municipal 1970 1975 1980 1985 1990 1995 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 anto loam booked a captive finance companies rose Distribution of Bank Assets sharply. Furthermore, the average household debt ser- by Capital Status vice burden—calculated as the share of disposable Percent of industry assets income needed to meet required payments on mort- gage and consumer debt—continued to rise last year. 1990:04 1995:Q3 Tins measure of debt burden has now reversed about one-half of the decline ii posted earlier in the decade. Under Capitalized 31.3 .5 The average debt service burden of nonfinancial Adequately Capitalized 38.6 2.9 corporations—the ratio of net interest payments to cash flow—also rose last year, but it remained well Well Capitalized 30.1 96.6 beneath the most recent peak reached in 1990. The increase in debt burden was in pan associated with Note. Adjusted for examiner ratings. the relatively strong growth of the debt of nonfinan- cial businesses. This sector's debt growth was espe- balance sheets. Banks funded a portion of the loan cially robust early in the year, when business fixed increase by reducing their securities holdings. investment picked up further and inventory accumula- although higher market prices of securities and off- tion was rapid. Debt issuance was also boosted by the balance sheet contracts left reported securities hold- rising wave of mergers, although a good number ings slightly higher for the year. In fact, bank security involved stock swaps. Financing needs fell back later holdings relative to the size of their balance sheets on as investment growth slowed and profits increased remained elevated and. together with banks' strong Funding patterns also shifted as bond yields fell, capital positions, indicated that late in the year banks and firms relied more heavily on longer-term debt were well positioned to continue accommodating Despite the increase in credit demands, interest rate the credit demands of households and businesses. spreads of investment-grade private securities over Although qualitative information suggested that banks comparable Treasuries widened only slightly and were no longer reducing the standards businesses remained narrow by historical standards, suggesting needed to meet to qualify for loans, some easing of that lenders continued to view balance sheets of non- credit terms continued, with interest-rate spreads on financial corporations as remaining healthy on the business loans narrowing further. Growth of real whole. Spreads on below-investment-grade debt rose estate loans held by banks slowed over the year as the more sharply but stayed well beneath levels reached share of fixed-rate mongages in total originations rose early in the decade. with the decline in long-term rates. Banks tend to securitize fixed-rate mortgages more than adjustable- Securities as a Percent of Bank Credit rate loans. Consumer loans on the books of banks began the year growing at very high rates: this growth decelerated throughout 1995 as the volume of securi- tization increased. In response to rising delinquency rates, some banks tightened terms and standards for consumer loans toward the end of 1995 and early 1996. 40 Total assets of thrift institutions are estimated to have risen slightly last year. Growth at healthy thrifts more than offset a substantial transfer of thrift assets 30 to commercial banks through mergers. The revival of growth in thrift assets, along with the strong showing of bank credit, helped to nudge up depository credit 20 as a share of domestic nonfinancia! debt for the sec- ond straight year after fifteen years of declines. Banks 1960 1965 1970 1975 1980 1985 1990 1995 and thrifts still account for more than one-third of all credit to nonfinancia] sectors. Commercial banks met a significant portion of the Banks and thrifts funded a large share of their asset increase in business credit demands last year, which. growth with deposits, and M3 grew 6 percent. The in turn, contributed to the rapid expansion of bank non-M2 portion of M3 was especially strong, in pan Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 M3: Actual Range and Actual Level market instruments were not the whole story for the Billon* at dollars growth of M2, however. As the yield curve flattened, the relative gains from holding longer-term assets with less certain price behavior fell and probably strengthened household demand for components of M2. Even so, M2 velocity was about unchanged after having increased for four years. Ml fell almost 2 percent in 1995. the first annual decline since the beginning of the Board's official series in 1959. Sweeps of deposits from reservable checking accounts, a component of Ml. to nonreserv- able money market deposit accounts were a major influence. Without these sweeps. Ml would have risen \ percent. By the end of last year, sweeps had spread to thirty-two bank holding companies, and the 4250 initial amounts swept by these programs totaled O N DJ F M A M J J A S O NO 1994 1995 $54 billion. The corresponding decline of more Ihan $5 billion in required reserves largely showed through as depository institutions substituted large time depos- its for nondeposit sources of funds. The shaip reduc- M1: Actual Level tion in deposit insurance premiums, which made large Billions of dollar* time deposits a more attractive source of funds, prob- ably contributed 10 this shift. Late in the year, branches and agencies of Japanese banks, facing some 1220 resistance in US. funding markets, ran off time depos- its while continuing to increase their funding from 1200 overseas offices. 1180 M2 rose as lower market interest rates and a flatter yield curve increased the relative attractiveness of 1160 retail deposits. As is typical, deposit interest rates. and to a lesser extent returns on money market mutual 1140 funds, adjusted slowly to declines in market rases last year. Falling interest rates for comparable maturity 1120 1100 M2: Actual Range and Actual Level O N O J F M A M J J A S O ND Billions ot dollars 1994 1995 to reserve balances maintained at Federal Reserve 3700 Banks. As banks continue to introduce retail sweep programs in the future, the aggregate level of required 3650 reserve balances will tend to fall further. Although it has not happened yet. one possible consequence of 3600 the declining required reserve balances is greater instabiliry in the aggregate demand for reserves and in 3550 overnight interest rates. In 1991. following the cut in reserve requirements at the end of 1990, unusually low levels of required reserve balances were associ- 3500 ated with greater variability in the federal funds rate, as banks' volatile clearing needs began to dominate 3450 O N D J F M A M J J A S O ND the demand for reserves, making daily reserve 1994 1995 demand more difficult to estimate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 The runoff in reserve balances held down [he Treasury and the Federal Reserve System in an growth of the monetary base to 4 percent in 1995. In effort to counter the pressure for dollar depreciation. addition, currency growth slowed, primarily owing to The release by the G-7 officials of the communique reduced shipments abroad. Foreign demand moder- from their meeting in late April supporting an orderly ated with the stabilization of financial conditions in reversal of the dollar's decline and the signing of a some countries where dollars circulate widely. Indeed. trade agreement between the United States and Japan reduced demands from abroad contributed to a rare at the end of June helped to stabilize the dollar, which decline in the currency component of Ml this past fluctuated narrowly until early August. The dollar summer, the first decrease since ire early 1960s. The then rebounded somewhat and remained within a demand for existing Federal Reserve notes also slack- narrow range through the end of the year. The recov- ened in anticipation of the introduction of a newly ery of the dollar stemmed, in part, from perceptions designed $100 bill that will be harder to counterfeit. that its earlier decline, particularly in terms ol" the yen. had been excessive in light of the underlying funda- Foreign Exchange Developments mentals. Moreover, weakness in the economies of The weighted-average foreign exchange value of some other major industrial countries began to the dollar in terms of the ocher G-10 currencies emerge, reducing prospective returns available declined about 5 percent on balance last year. The dollar fell sharply through April and reached a low U.S. and Foreign Interest Rates almost 10 percent below its value at the end of 1994. Three-month The downward pressure against the dollar was Percent sparked by indications of some slowing of the pace of US. real output growth, which contributed to expectations that further increases in US. interest Average foreign rates were unlikely, and by the acrimony surround- ing the ongoing trade dispute between the United 10 States and Japan. The crisis in Mexico also weighed on the dollar. On several occasions in March and early April the Trading Desk at the New York Fed- eral Reserve Bank, joined by some other central banks, intervened to buy dollars on behalf of the Weighted Average Foreign Exchange Value of the U.S. Dollar December 1993 « 100 Ten-year Daily Percent 100 12 Average foreign 90 U.S. Treasury SO NDJFMAMJJASONDJFMAMJJASONDJFM i i i i 1993 1994 1995 1996 Note. Index of weighted average foreign exchange value ol 1984 1986 1988 1990 1992 1994 1996 U.S. dollar in terms of currencies ol the other G-10 eouitries. Note. Average foreign rates are the trade-weighted average, Weights are based on 1972-76 global trade ol each ol the tor- for the other G-10 countries, of yields on instrumerts eorparable eign countries. to U.S. instruments shown. The data are monthly. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 abroad. At times from May through August, the Trad- and then partly recovered as economic indicators ing Desk again entered the market in conjunction with revealed significant softening in economic activity in other central banks to intervene in support of the Germany. Easing by the Bundesbank during the sec- dollar, reinforcing the view that US. authorities were ond half of the year reinforced the view that mark committal to a strong dollar. interest rates were not likely to rise and might fall further. The dollar depreciated slightly, on balance, in In all of the major foreign industrial countries, icrms of the Canadian dollar, despite periods of sell- long-term interest rates declined during 1995. nearlv ing pressure on the Canadian dollar during the year reversing the increases that had occurred during the related to Canada's fiscal situation and possible seces- previous year. On average, rates on foreign govern- sion by Quebec. ment issues with maturities of ten years fell about 150 basis points in the twelve months to December, Although the dollar did fall to a record low. below somewhat less than the decline that occurred in the 80 yen to the dollar in mid-April, by year-end the comparable US. rate. In Canada, where economic dollar had appreciated slightly in terms of the yen activity slowed sharply, the drop in long-term rates from its level at the end of 1994. So far this year, the nearly matched that in the United States, while in dollar has appreciated somewhat further against the Italy, where political uncertainty remained a concern yen. Resolution of the trade dispute and repeated throughout the year, rates fell only 100 basis points. episodes of exchange market intervention by the Bank During the first few weeks of this year, long-term of Japan, sometimes in conjunction with US. and rates abroad generally moved down somewhat more, foreign monetary authorities, contributed to the appre- but then most recently returned to their December ciation of the dollar in terms of the yen during the average levels. An important exception is Japan. second half of the year. However, the fundamental where rates have risen from their late-December lev- cause of the yen's decline during that period probably els, apparently reflecting market perceptions that the was the easing of monetary policy by the Bank of stage is set for a Japanese economic recovery. Shon- Japan that pushed shon-term rnarket interest rates to term market rates in the major foreign industrial coun- extremely low levels. tries were mixed, but on average raies moved down. In terms of the Mexican peso, the dollar appreci- On balance, the dollar depreciated about 8 percent ated sharply from the onset of the crisis in late December 1994 to March. The dollar subsequently in terms of the German mark during 1995 and by similar amounts in terms of most other currencies retraced some of those gains, and the peso-dollar rare fluctuated narrowly through the middle of the year. participating in the Exchange Rate Mechanism of the Uncertainty about the prospects for Mexican eco- European Union. After substantial depreciation against the mark early \n the year, the dollar stabilized nomic performance and macroeconoimc policy sparked renewed appreciation of the dollar in terms of the peso in November. Since November, data indicat- Foreign Exchange Value of the Dollar ing thai the decline in Mexican real economic activity in Terms of Selected Currencies may have ended, some intervention by the Bank of December 1993 - 100 Mexico in support of the peso, and a perception that the decline in the peso may have gone 100 far given Daily the underlying fundamentals have contributed to some rebound of the peso. During the year, the Mexican 100 authorities drew S3 billion on short-term swap lines with the Federal Reserve and Exchange Stabilization Fund (ESF) of the US. Treasury and S10.5 billion on a medium-term swap facility provided by the ESF. By the end of January 1996. the shon-ierm drawings had been entirely repaid. Adjusted for relative consumer price inflation, the 90 dollar was little changed, on balance, against a multilateral-trade-weighted average of the currencies of eight developing countries that are important US. NDJFMAMJJASONDJFMAMJJASONDJFM 70 trading partners. The dollar's 30 percent real appreci- 1993 1994 1995 1996 ation against the Mexican peso was aboui offset by Hole. Foreign currency units par dollar. real depreciations against the other seven currencies. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 Growth of Money and Debt Domestic Nonflnanclal Period M1 M2 M3 Debt Year1 1980 7.5 8.7 9.6 9.5 1981 5.4 (2.5) s 9.0 12.4 10.2 1982 8.8 8.8 9.7 9.8 1983 10.3 11.8 9.5 11.9 1984 5.4 8.1 10.8 14.6 1985 12.0 8.6 7.7 14.3 1986 15.5 92 9.0 13.3 1987 6.3 4.2 5.9 9.9 1988 4.3 5.7 6.3 9.0 1989 .5 5.2 4.0 7.8 1990 4.2 4.1 1.8 6.8 1991 7.9 3.1 12 4.6 1992 14.3 1.8 .6 4.7 1993 10.5 1.4 1.0 5.2 1994 2.4 .6 1.6 5.2 1995 -1.8 4.2 6.1 5.3 Quarter {annual rate)3 1995:01 -.1 1.4 4.8 5.3 Q2 -.5 4.3 6.7 7.0 Q3 -1.5 7.0 8.0 4.6 CM -5.1 4.0 4.4 3.9 1. From average for fourth quarter of preceding year to 3. From average for preceolng quarter to iav1erage for average for fourth quarter of year indicated quarter indicated. 2. Adjusted for shift* to NOW accounts in 1981, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1996, February 20). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19960221_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_19960221_chair_federal_reserves_first_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1996},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19960221_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}