Congressional Testimony

FEDERAL RESERVE'S SECOND 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 JULY 18, 1996 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE 36-984 CC WASHINGTON : 1997 For sale by the U.S. Government Printing Office Superintendent of Documents, Congressional Sates Office, Washington, DC 20402 ISBN 0-16-054031-3 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 SHEILA FRAHM, Kansas HOWARD A. MENELL, Staff Director ROBERT J. GIUFFRA, JR., Chief Counsel PHILIP E. BECHTEL, Deputy Staff Director HOLIDAE H. HAYES, Counsel PEGGY KUHN, Financial Economist STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel MARTIN J. GRUENBERG, Democratic Senior Counsel CHUCK MARR, Democratic Profession! Staff GEORGE E. WHITTLE, Editor (ID Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS THURSDAY, JULY 18, 1996 Page Opening statement of Chairman D'Amato 1 Opening statements, comments, or prepared statements of: Senator Sarbanes 2 Senator Shelby 6 Senator Dodd 6 Prepared statement 34 Senator Bond 8 Senator Kerry 9 Senator Mack 10 Senator Faircloth 11 Senator Moseley-Braun 12 Senator Bennett , 14 Senator Frahm 20 Prepared statement 35 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem, Washington, DC 14 Prepared statement 36 Introduction 36 Review of the First Half of 1996 36 The Recent Behavior of Inflation 37 The FOMC's Outlook for the Remainder of 1996 and 1997 38 The Pursuit of Price Stability 38 The Ranges for the Debt and Monetary Aggregates 39 Budgetary Policy 39 Conclusion 40 Response to written questions of: Senator D'Amato 41 Senator Mack 46 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Graph on Real Economic Growth submitted by Senator Sarbanes 47 National Association of Manufacturers [NAM] News Release 48 Monetary Policy Report to the Congress, July 18, 1996 50 (ill) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1996 THURSDAY, JULY 18, 1996 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 11:08 a.m., in room SH-216 of the Hart Senate Office Building, Senator Alfonse M. D'Amato (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN ALFONSE M. D'AMATO The CHAIRMAN. The Committee will come to order. Chairman Greenspan, it is good to welcome you here and I want to congratulate you on your confirmation for a third term. Mr. Chairman, never before have so many working middle-class Americans had so much invested in the marketplace through mu- tual funds, IRA's, and 401(k)'s. And as I said during the floor de- bate on your confirmation, you are the Michael Jordan of the world's central bankers. You have earned the respect of Wall Street and Main Street. During your tenure, the Federal Reserve has kept inflation down and our economy has been strong. Low-interest rates have allowed thousands of businesses to expand and millions of families to buy homes, but more needs to be done. While the Federal Reserve has done its job, the fate of our Na- tion's economic future remains in the hands of the Congress and the President. A stable monetary policy by itself is not enough to keep the American economy strong. This morning, when I reviewed a copy of your statement, I was struck by your admonition to us about the critical importance to our Nation's economic welfare, "Of continuing to reduce our Fed- eral budget deficit." That is a quote from Chairman Greenspan's statement. In your statement, you further indicate that last year the inter- est rates fell and the stock and bond markets rallied, in part, be- cause it appeared that Congress and the President were engaged, "In a positive dialogue on deficit reduction." You go on to say that this year the interest rates have started to rise in part because of, "The dying out of serious discussions that might lead to a biparti- san agreement to eliminate the budget deficit over time." Mr. Chairman, you recognize that the Congress and the Presi- dent must address, "The consequences for entitlement spending of the anticipated shift in the Nation's demographics in the first few decades of the next century." Unless we deal with the growing ex- (1) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis penditures on entitlements, we are just kidding the people, and the markets know that. I commend the Chairman for the skillful man- ner in which he puts forth this issue. I hope all of my colleagues in the Congress and the President heed your warning. Reducing the Federal budget deficit is of criti- cal importance to our Nation s economic welfare. Chairman Greenspan, you may be the Michael Jordan of the world's central bankers, but we recognize that you can't win the world championship of economic growth for the American people by yourself. Just as Michael Jordan could not win the NBA championship without Dennis Rodman, Scottie Pippen, and the rest of the team, you need the support of Congress and the President. Make no mis- take about it. The Congress and the President must take action. We must cut spending, balance the budget, and reduce the heavy tax burden on middle-class Americans. We owe it to our children and grandchildren to make the hard choices. We must put our eco- nomic house in order. I have a series of questions for Chairman Greenspan that are on the minds, I believe, of many Americans. Over the past few years, more and more middle-class Americans have invested their savings in the stock market. Mutual funds have begun to replace bank ac- counts. Over 160 million Americans now invest in the stock mar- ket. The savings of middle-class Americans have fueled a great bull market. Public confidence is obviously critical to the health of our economy and our stock market. During the past several weeks, investors have been on a roller coaster ride. Middle-class Americans are understandably nervous. They are concerned. Is the stock market strong? Is there a risk of another crash like October 1987, when the Dow plunged 500 points in a single day. The stock market shocks of the past few weeks may be a warning sign. Middle-class Americans are wondering— how strong is our economy? Is trouble on the horizon? Is inflation under control? Are wages stagnating? How safe is my job? I am particularly concerned about the cost to middle-class Ameri- cans of the Federal budget deficit. Would interest rates be lower if the Federal budget were balanced? Are high taxes slowing eco- nomic growth? The Committee recognizes that you will have to be, as is appro- priate, your usual circumspect self in your testimony. I suspect by the time you are done no one will know the answer to the question of the moment—whether the Fed will raise or lower interest rates. In these times of uncertainty and concern, it is important to calm investors and to calm the markets. Probably no one can calm the marketplace better than you, Chairman Greenspan. This morning I would hope that you will tell the American people what you can about the state of our economy and our markets. Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you very much, Mr. Chairman. I am pleased to welcome Alan Greenspan, the Chairman of the Board of Governors of the Federal Reserve System, before us once again this morning. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Mr. Chairman, I do not envy you your task here this morning. This thing is being hyped up out of all proportion. You have press people out there poised in their seats to dash from the room at the slightest suggestion that you've said something at the witness table that will enable them to throw something on the wire and, as they say, roil the markets. In fact, yesterday's Wall Street Journal in a lead-up to this hear- ing this morning, said: "With television cameras focused on his face, microphones picking up his every word, reporters for financial news wires armed with cellular phones reporting every nuance, and the stock market in extraordinary turmoil, Federal Reserve Chairman Alan Greenspan testifies before Congress tomorrow morning." "A misinterpreted phrase, an overly exuberant adverb, an unin- tended hint that interest rates may—or may not—be raised soon, and the Chairman could trigger the Greenspan crash of 1996." [Laughter.] "As one veteran of both Wall Street and Washington put it yes- terday, 'He's got three hours to blow smoke.'" [Laughter.] "So Mr. Greenspan likely will be even more cautious and ellip- tical than usual, if that is possible." [Laughter.] "He knows that at times of great uncertainty in financial mar- kets, the markets often attach unjustified significance to even in- consequential statements by public officials, let alone pronounce- ments from the Chairman of the Fed." The CHAIRMAN. Is that my quote there? Senator SARBANES. Yes, we have the Chairman's quote for later. The CHAIRMAN. It's pretty good, isn't it? Senator SARBANES. Yes, I don't want to leave Chairman D'Amato out of this recitation. The CHAIRMAN. Don't leave my quote out of there. Senator SARBANES. No, no, no. [Laughter.] "Mr. Greenspan's host, Senate Banking Committee Chairman Alfonse D'Amato, predicted yesterday that the Fed chief will say 'absolutely nothing^ about the Fed's interest-rate intentions. That's deliberate on his part. He will not give any signs or indications whatsoever to a lessening or a tightening of the interest rates.'" Now, with that kind of build-up, it is sort of a let-down for me to observe that this hearing comes at a time of great interest in the direction of the economy and of monetary policy. The financial markets have been more chaotic than usual lately, although I'm struck by a comment in an editorial in the Baltimore Sun not too long ago, which said: "Wall Street bulls, bears and strattlebugs do not run the U.S. economy, and a good thing, too. Right now brokerage houses and market tipsters are saying the Federal Reserve just has to raise short-term interest rates—prob- ably sooner rather than later. Why so? Because unemployment has fallen to a 6-year low. Because a whopping 239,000 jobs were added to non-farm payrolls in June. Because hourly non-farm wages jumped a record 9 cents an hour. Because the interest rate on 30- year Government bonds has risen above 7 percent." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis They then go on to point out that: "An increase in short-term in- terest rates could indeed slow economic growth from the red-hot 4 percent annual rate in the second quarter. But a fall-off might hap- pen anyway. The full-year growth rate could drop below the 2.5 percent level favored by anti-inflation hawks. There is no reason to panic. The Fed should stay on the sidelines, if circumstances per- mit, until after the election." And it goes on to say: "With corporate earnings up smartly, remember that what is bad news on Wall Street is often good news for the rest of the country." Now, I just want to make a few observations before we get to your statement and the opportunity to ask questions. First of all, on bringing down the deficit, I think it's very impor- tant to note that the deficit now has been brought from $290 billion in Fiscal 1992 to where the latest forecast is $117 billion for Fiscal 1996. As a percentage of the GDP, the deficit has come down from 4.9 percent in Fiscal 1992. We are now projecting 1.6 percent in Fiscal 1996. By any standard, I think a very substantial accomplishment. In fact, when you compare it with the other G-7 countries, we now find that the U.S. has the lowest budget deficit relative to GDP by a substantial margin of any of the G-7 countries. Here is the United States. This was at 2 percent and this was for Fiscal 1995. We are now moving to 1.6 percent, we think, for this year. Japan is at 3.1, Germany, 3.5, Canada, 4.2, France, 5.0, UK, 5.1, and Italy, 7.2, So the U.S. performance comparatively with these other major industrial countries is significantly better. Actu- ally, the best of the major industrial countries. The inflation picture remains benign. We're getting all these ad- jurations about inflation. There was a story yesterday in the paper out of the Bloomberg Business News which said, consumer price spiral eases. Consumer prices rise at slowest pace in months. And I know we can't operate off of a 1-month figure, but the people who flash the warning signs take a 1-month figure in order to do it. I am not saying the Fed. I am saying some of these commentators that we are talking about. So I just throw that latest figure into the pot for consideration. The core inflation rate is at a 30-year low. Here we are right here, the 1996 rate at 2.7 percent. It's been 3 percent or under for the past 3 years andnd that is really the best performance since the early 1960's. If you look at this performance, if you look at bringing down the deficit, it seems to me there's a lot to be said for letting the economy continue to move because it seems to be moving in quite a good way. In fact, the National Association of Manufacturers issued a state- ment last week which commended the Fed for not raising interest rates earlier this month and summarized why you ought not to raise interest rates at the next meeting in August. I am only bring- ing this in because of this stirring up that's now going on with all the Wall Street commentators saying, "Well, now the Fed's got to take up the rates." Now what the NAM said—and Mr. Chairman, I will ask that their entire statement be included in the record. The CHAIRMAN. So ordered. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Senator SARBANES. The NAM says Wall Street is wrong to push for higher rates. They criticize traders on Wall Street for calling on the Federal Reserve Board to raise interest rates in the wake of strong employment numbers. They praise the Fed for holding rates steady. The Federal Reserve made the right decision in not caving in to pressure from the markets to raise short-term rates. Despite the drop in the unemployment rate from 5.6 to 5.3 percent and a 9-cent jump in hourly earnings, there is no real justification for raising short-term rates now. They then go on to discuss movements in wages and benefits to analyze the labor market. They point out that since late 1994, the unemployment rate has fluctuated be tween 5.3 and 5.6 percent, and inflation has remained stable. The fact that inflation didn't accelerate supports the notion tha the NARU, the Natural Rate of Unemployment, is quite low. W> estimate that NARU is only 5.2 percent, which would explain why inflation has remained modest. And they go on then to examine the underlying inflation rate, the growth rate, which they expect to slow down in the second half of 1996. I emphasize this because 3 years ago one of the regional presi- dents of the Federal Reserve, one of the presidents of one of your regional banks, predicted that if unemployment were allowed to go below 6.8 percent, we would suffer rising inflation. 6.8 percent was his benchmark of the Natural Rate of Unemployment, and if the economy, through its active workings, pushed the rate down below that, we were going to have a big inflation problem. Fortunately, his advice was not followed. For almost 2 years now, we have enjoyed an unemployment rate a full percentage point below his feared 6.8 percent barrier and inflation has remained tamed. If we had followed that advice, millions more Americans would have been unemployed, underemployed, and less well paid. In fact, business executives now are reporting they do not have the power to raise prices that they had in the past. John Welch, the Chairman of General Electric, states in an article that ap- peared in the New York Times not too long ago. There is no infla- tion," Mr. Welch said, adding that, "GE's experience indicates that the economy remains weaker than recent statistics would suggest. There is no pricing power at all." And only recently, the Wall Street Journal had an article entitled, "Economists Not Worried About Inflation." The consensus forecast published by Blue Chip Indicators last week, suggests no need to raise rates. The consensus forecast calls for moderate growth to resume after last quarter's strong growth, even as that same consensus forecast expects no change in either short-term interest rates or inflation. So, Chairman Greenspan, we very much look forward to your tes- timony this morning and to the opportunity to ask you questions. It is not my intention to seek to provide any grist for the mill that would send people scurrying from the room to telephone their sto- ries. I don't think that's the purpose of these hearings. Actually, the Chairman has already dealt a bit of a blow to that because this story yesterday ended up saying: "The first headlines on Mr. Greenspan's testimony and the Fed's semi-annual report to Congress will move on financial news wires at 10 a.m. tomorrow. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The full text of the Chairman's prepared remarks will be posted on the Internet by the Fed around 10:10 a.m." Then they give all the Internet initials here, so that you can clue right into the Internet. We're setting this thing up. It's all being set up. Now Chairman D'Amato, of course, by delaying this morning's hearing because we were voting on the Senate Floor, the interven- tion of Senate business, so we had to delay it to 11 a.m., has al- ready, I guess, dealt a minor blow to this forecast. We look forward to hearing from you this morning. Thank you, Mr. Chairman. The CHAIRMAN. Senator Shelby. OPENING STATEMENT OF SENATOR RICHARD C. SHELBY Senator SHELBY. Mr. Chairman, thank you. Mr. Chairman, I look forward to hearing the testimony of Chair- man Greenspan, and I want to thank him for his timely appear- ance. I do, however, want to keep my remarks here short because I believe it is the Chairman that we have all come to hear and I know that the world is waiting. I would like to take this opportunity, however, to reiterate my conviction that monetary policy should strive for price stability and zero inflation. Inflation, as we all know, is a tax, plain and simple. Americans are taxed too much and should not have the purchasing power of their hard-earned dollars taken away from them that way, by inflation. Hard-working Americans deserve to bear the fruits of their labor and a strong independent bank, I believe, is essential to that goal. In addition, I want to reiterate, Mr. Chairman, that monetary policy should not be subject to the whims of the political cycle. It's in the best interest of all Americans that the Central Bank remain independent above most other things. Congress does not know what the rate of growth monetary aggre- gates should be or even the correct Federal funds rate. My guess is that no Member in the Senate, except maybe Senator Gramm, could even produce an ISLM model, much less recognize its impli- cations. That being said, Mr. Chairman, that's no one else I would rather have at the helm during a volatile time than our Chairman, Alan Greenspan, and I look forward to his testimony. The CHAIRMAN. Senator Dodd. OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD Senator DODD. Thank you, Mr. Chairman, and let me thank Chairman Greenspan as well for being here today. I, too, as Senator Sarbanes, was struck with the number of sto- ries that were going to focus on scrutinizing on the Chairman of the Federal Reserve. In fact, beyond just his words, I guess, now it is inflections and whether or not you are smiling or frowning, and maybe even the colors of your ties. There's, I think, sort of a new industry that Senator SARBANES. I think it is the same tie he wore last time, though. Senator DODD. I think it is. [Laughter.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Senator SARBANES. We can't read any significance into that. [Laughter.] Senator DODD. Well, I thought they said red would be the rates are going up. Blue, they're doing down. Polka dots, holding steady. [Laughter.] Senator MACK. No, the same tie means the same rate. Senator DODD. You see what's happened. There is a whole new cottage industry called Greenspan-ology that is developing here. [Laughter.] So just don't move. Just stay right there. Let me ask, Mr. Chairman, consent to include my remarks in the record full text. I want to note, in fact, staff has told me it was February 20, 1946, that we passed the Employment Act, 50 years ago. I want to certainly commend the Administration, as well as the Fed, for, while we haven't achieved the ideal stated in the Employment Act of 1946, it is certainly taken us a long way toward getting there. I think it is worthwhile to note the Act and what was expressed 50 years ago. It could have been written an hour ago, let alone 50 years ago. And that Act says: The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to use all practicable means . .. for the purpose of creating and maintaining . . . conditions under which there will be afforded use- ful employment opportunities, including self-employment, for those able, willing, and seeking to work . . . The Congress further declares and establishes as a national goal the fulfillment of the right to full opportunities for useful paid employment at fair rates of com- pensation for all individuals able, willing, and seeking to work. Fifty years ago, and still a pretty worthwhile stated set of goals and purposes. And while, as I said a moment ago, we were a long way from achieving the ultimate desires expressed in those words, the Administration and the Federal Reserve have taken us closer to that goal, I would argue, than we have been in a very long time. So I want to thank you, Mr. Chairman, for your work and the efforts that have been made in this regard. Let me just point out, as has been reference here by my colleague from Maryland with his very worthwhile charts this morning, there are very few single events that can affect the financial markets, ob- viously, and our individual wallets as much as interest rates and decisions by the Fed's Open Market. But as our attention focuses more and more narrowly upon this single, albeit, extremely impor- tant, economic decision, it becomes easy, I think, for too many peo- ple to lose perspective as to how well the overall economy is doing. The indisputable fact is that the economy is stronger and healthier now than it has been in nearly a generation. Yesterdays Wall Street Journal said that our hearing, "Will dwell on what is already obvious—the economy is growing with surprising strength, but with surprisingly little evidence of inflationary pressure." Indi- cator after indicator, from job growth to the shrinking deficit to in- creases in exports, all highlight the validity of the Wall Street Journal's observation. Now, again, this is not to say that this growth rate has been uni- form across the country, and I would be remiss if I didn't point out that my own State of Connecticut has lagged a bit behind for many reasons—the end of the Cold War, the decline in purchasing orders Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 of what has been a mainstay of our economy for almost 200 years in defense work. So we have still got a ways to go there. But no one has suggested that it's necessarily going to be totally even. But there is a growing expectation, even in my State, that the economic recovery is finally reaching them. Unemployment is down in every labor market and things seem to be getting better. But the increasing optimism about conditions, indeed, across the country is predicated upon the belief that the United States will enjoy a growth rate that is robust enough not only to sustain the gains made, but to create new jobs that will pay a living wage. The fact of the matter is that only a healthy rate of growth in the economy will translate into fundamental job security that is, of course, the cornerstone of our continued economic success. There's been a disturbing trend of late to focus on price stability as an end in and of itself, rather than as one of the principal tools of ensuring economic growth. Fighting inflation is an extremely im- portant task, but we cannot forget that it is a means, in my view, to an end, not an end in and of itself. In my opinion, this desire to focus solely on price stability is what makes the Fed's dual mis- sion so very important. When American families gather around the dinner table, you are not likely to hear a wife turning to her husband and saying, "What wonderful news—the growth rate is 2.8 percent, while the CPI is only at 2.1 or 2 percent." What you're much more likely to hear is, "Two people in my department were laid off yesterday." Or, ^No one at the plant has had a raise in 2 years." Or, "Our daughter just graduated from college, is she going to be able to find a job?" Those are the kinds of things people talk about around that table. If our actions here in Congress or over in the Fed, of course, don't translate into jobs that provide Americans with a living wage, then we might as well be debating the color of wallpaper in heaven, for all the relevance it will have to the average American family. Thus, the Deficit Reduction Act of 1993, which played a vital role in freeing the economy from the grips of a crushing budget deficit, is so important, not in and of itself, but for the role that it played in helping the economy create 10 million new jobs, almost all of them in the private sector. So, Mr. Chairman, I want to thank you for your work, but also to commend the Fed for what I think has been a very responsible participation under the leadership of Alan Greenspan over these past number of months. I am very, very interested in hearing his comments and thoughts today about where we are heading in the coming months of this year and beyond. So I thank you for being here. The CHAIRMAN. Senator Bond. OPENING STATEMENT OF SENATOR CHRISTOPHER S. BOND Senator BOND. Thank you very much, Chairman D>Amato. Chairman Greenspan, welcome. Congratulations on your confir- mation to a third term as the head of the Federal Reserve Board. As always, I look forward to hearing your views on monetary policies and your comments on fiscal policies, and to listening to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the spirited debates they always seem to inspire. I would hope that those debates would be after your testimony. Coming into the meeting today, I have already heard foreign cor- respondents in other languages transmitting their analysis, their pre-game predictions of what you're going to say. I would only say, having listened with a great deal of care to your testimony in these hearings during previous years, if they think they have divined the direction of the Fed from your wonder- fully elliptical comments, they are surely mistaken, and I would urge them to take a couple of aspirin and place a cold compress on their head, rather than making too many predictions. This hearing is particularly timely in light of the policy issues we are facing on the Floor of the Senate and the House. As a fiscal conservative, I think it's very important that we con- tinue our efforts to gain control over Government spending. It has been noted previously that the deficit has come down, in part by reason of the 1993 tax increases, in part by reason of Congressional restraint on appropriations, but mostly because of more favorable economic news. There are many of us who are increasingly concerned about the ticking timebomb of mandated future increases in spending, the en- titlement spending that we have not yet been able to gain support for dealing with on not only a bipartisan basis, but gaining support for a legislative/executive compromise. And the recent reports on Medicare and Social Security are particularly disturbing. We heard a few moments ago that our debt may be a low as a percentage of GDP. But we know looking into the future that we have built in mechanisms that threaten to drive that percentage up much higher in the future with potentially disastrous results if we cannot get a handle on some of those programs we've locked into automatic spending increases. I also continue to be concerned about Government regulation and its impact on economic growth. I would welcome any perspective you could give us on how the burden of regulation has affected the growth in the private sector and what we in Congress might re- sponsibly do to end that cycle. I really believe that our fiscal policies, rather than our monetary policies, are threatening international competitiveness. Although the dollar has rebounded against several currencies, it has fallen almost 30 percent against the yen in the last year and our foreign trade deficit remains well above the record lows of just 3 or 4 years ago. Chairman D'Amato, I thank you for calling this hearing. I look forward to hearing Chairman Greenspan's comments and to asking some questions. The CHAIRMAN. Senator Kerry. OPENING STATEMENT OF SENATOR JOHN F. KERRY Senator KERRY. Thank you very much, Mr. Chairman. Mr. Chairman, welcome, and also, congratulations on your re- appointment and reconfirmation. I will be very, very brief. I know we would like to get to your testimony. And yours is an overview of monetary policy and its ef- fect on the economy as a whole. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 Over the last months, we have had a tremendous amount of good news, in broad economic terms, as a number of my colleagues have mentioned. And in response, we have seen the stock market lose 160 points on Monday, which is sort of one of those continuing con- tradictions that a lot of Americans are asking themselves about. It's not dissimilar to what Senator Dodd said. We have had strong, robust economic growth, and I think a great deal of that credit goes to the policies you have pursued, coming out of the difficult period in the history of the banking industry. Your role in the resuscitation of the banks was significant. We have had record low levels of inflation and that also has precipitated drops in the market. There's been stronger job growth during the past 3 years than in any Republican Administration since the 1920's. More than 10 mil- lion jobs have been added to the economy in the past 3Va years. And the combined rate of unemployment, inflation, and mortgages is the lowest we have had in 30 years. The unemployment rate alone is now 5.3 percent, the lowest level in 6 years, and the rate is steady and the trend is prolonged. June was the 22nd consecutive month with that rate below 6 percent. And as you know, the economy has added some 1 million jobs to construction and manufacturing. We have had an unprecedented low level of inflation, something you have been particularly focused on to such an extent that some people question whether it's overly focused or focused to the exclu- sion of other concerns, something we'll undoubtedly discuss today. But that is an inflationary average that is lower than any other Administration since President Kennedy. And while the projected deficit this year is about one-third the size of its record high, $290 billion in 1992, and inflation is sub- dued, and interest rates are low, while all of this has been going on, we nevertheless, all of us, continually run into a perceptible, tangible tension in the marketplace and in the workplace and in our communities. Secretary Reich has called this phenomenon "eco- nomic insecurity." But it is the same thing. It is people, some of whom are holding 2 or 3 of those 10 million jobs in order to make ends meet. I feel this as I travel across Massachusetts. There's great anxiety at many different income levels about whether the job they have today will be there tomorrow or what they will be able to do to make ends meet. I would simply ask—I haven't seen your prepared comments. I hope that you would take time prior even to the questioning, but in the course of them, to address what I know you have been sen- sitive to and understand is there, which is this sense of anxiety. Perhaps you can help shed some light on it or some rationale for it. And I look forward to your testimony in that context. Thank you very much. The CHAIRMAN. Senator Mack. OPENING STATEMENT OF SENATOR CONNIE MACK Senator MACK. Thank you, Mr. Chairman. I too want to welcome you, Chairman Greenspan, and congratu- late you on your confirmation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 The vote on your nomination gave the Senate the opportunity for a very important debate on economic growth. The success of your reappointment reinforces the fact that you and the Fed are not to blame for the dismal economic growth rates we've seen over the past few years. In fact, the Fed has done a solid job in moving the economy toward price stability, which is a key component of long- term economic growth. Unfortunately, other components affecting the rate of growth which fall on the fiscal side of the policy equation have not been nearly as successful in recent years. We have learned the hard way that the President's harmful fiscal policy can render even the most beneficial monetary policy less effective. So what has this Administration's fiscal policy produced? Since Bill Clinton became President, GDP growth has averaged only 2.3 percent. Compare that to the robust 3.7 percent growth rate he inherited in 1992. During the entire decade before Presi- dent Clinton took office, annual economic growth averaged 3.2 per- cent. During the last five periods of economic expansion, growth averaged 4.4 percent. And economists are calling these recent growth rates which are closer to 2 percent than 3 percent a recov- ery? That's not economic growth. That's anemic growth. President Clinton's economic policies have robbed the American economy of its full potential. His policies of higher taxes, more Fed- eral spending, and increased regulation have created this low growth environment in which we find ourselves. Some people are calling it the Clinton Growth Gap or the Clinton Crunch. It's the difference between the growth America has experi- enced under the Clinton Administration and what we should expect given historical standards or historical trends. The Clinton Growth Gap has meant a lower standard of living for every man, woman, and child in America. The Clinton Growth Gap is why American families are feeling such anxiety today. The growth of Government is squeezing out the growth of the economy. We can change this. We need a real balanced budget, not empty promises. We need lower taxes, not political posturing. We need to lighten the regulatory burden and generally get Washington off the backs of hard-working Americans. The economy can grow faster, but not until we have responsible leadership that truly believes that the era of big Government is over. Thank you, Mr. Chairman. The CHAIRMAN. Senator Faircloth. OPENING STATEMENT OF SENATOR LAUCH FAIRCLOTH Senator FAIRCLOTH. Thank you, Mr. Chairman. And thank you, Chairman Greenspan. We appreciate you being with us today. This hearing, as you have heard many times, has taken on a lot more interest than normal because of the fluidity in the stock mar- ket. But the market has been going up and down for a long time. I believe it was Bernard Baruch or somebody that said, when ques- tioned what the market was going to do, it would go up or go down, one, and it usually does one or the other, and will continue to. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 The issues before us are pretty simple. We tend to make them complex. But we are worried about interest. We are worried about the market. What we need to be worried about and what we should be doing something about is cutting the spending of the Federal Government and balance the budget, and a balanced budget amendment. Inter- est rates will come down if we will simply do that. We don't have to take a lot more conversation. If we'll balance the budget, interest rates will come down. We need reduced regulations. We are piling them on at hundreds of thousands a week to impede the operation of the private sector. If we will simply reduce regulations, and give the private sector an opportunity to produce, that will unleash the competitive drive that will take care of inflation of itself. If we will stop increasing taxes and allow the American business community to retain more of its profits, plus its wage-earners and the people of this Nation to retain more of our profits and more of their hard-earned money and not bring it to Washington, then you will see positive earning reports all around the country. I think those three very simple things are what we are dealing with. We won't need more programs and more rules as to how the market needs to operate. I thank you for being with us. The CHAIRMAN. Senator Moseley-Braun. OPENING STATEMENT OF SENATOR CAROL MOSELEY-BRAUN Senator MoSELEY-BRAUN. Thank you, Mr. Chairman. I want to say that I am pleased to be here this morning and have the opportunity to hear from the Chairman of the Federal Reserve, Mr. Greenspan. Mr. Chairman, it is a truism that Government's ability to assist in creating an economic climate that fosters noninflationary eco- nomic growth and full employment is maximized when fiscal and monetary policy are working together, as has been the case since President Clinton was elected in 1992. Since that time, Federal deficits have declined from the $290 bil- lion level to about $116 billion, freeing more capital up for private investment. The rate of growth in Federal spending has declined dramatically, falling from a 6.7 percent annual rate in the 1980's to 3.8 percent over the last 3 years. As a percentage of our economy, total spending is today lower than in any year since 1979. That Federal fiscal restraint has played an important role in keeping inflation in check. Inflation has been held to 3 percent or less in each of the last 3 years. Chairman Greenspan himself commented that the 1993 economic plan was, "An unquestioned factor in contributing to the improve- ment in economic activity that occurred thereafter." He made the same point in January 1994, stating that, "The ac- tions taken to reduce the Federal budget deficit have been instru- mental in creating the basis for declining inflation expectation and easing pressures on long-term interest rates." These fiscal policies also help to produce an economy that has grown an average of 3.1 percent annually over the last 3 years. These fiscal policies helped create over 10 million new jobs in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 last 3Va years, and these fiscal policies have helped to lower the unemployment rate to its current level of about 5.3 percent. As a result of the efforts of this Administration, the Congress, and the Federal Reserve, the combined unemployment, inflation, and mortgage interest rates are now at their lowest level in more than 30 years. These may be dry economic statistics, Mr. Chairman, but they represent major economic good news for the American people. They represent new hope and opportunity. They represent higher levels of homeownership than at any time in the last 15 years. They rep- resent an increase in exports of $150 billion, a one-third jump, and that is creating literally millions of new jobs here at home. They represent increases in median-family income which had fallen in the 4 years preceding 1993. After-tax median-family in- come was $30,687 in 1992. It increased to $34,541 last year, a 12V 2 percent increase. The economic forecast for this year and beyond shows a continu- ation of that good news. The Blue Chip Economic Forecast is for real GDP growth of 2.6 percent this year, continued low unemploy- ment and low inflation. In fact, the CPI has gone up only 0.1 per- cent in each of the last 2 months. All of this good news does not mean our country still does not have a lot of work to do. I refuse to believe that an unemployment rate that exceeds 5 percent, not including discouraged workers who do not even show up in the statistic any more, constitutes full em- ployment. And despite the millions of new jobs our economy is cre- ating, I am troubled by the fact that 20 percent of the unemployed have been out of work for 26 weeks or more. That fact suggests that too many Americans are still having trouble finding the kind of good jobs they need to support and help their families. There are other problems as well. Income inequality is increasing in this country, which means that the benefits of economic growth are not reaching every American. Moreover, 50 percent of Americans have less than $1,000 in net financial assets, which means many American families will have a very hard time, indeed, in helping their children finance college. In the economy of the 21st century, however, a college education will be needed more than ever before. Finally, with less than $1,000 in net financial assets, all too many Americans do not have the savings they need to provide for their own retirement security. Our Government also faces challenges. Long-term budget trends are very troubling. Current budget trends could increase Federal spending from the current approximate 22 percent of GDP to over 37 percent of GDP. Social Security, according to one of the mem- bers of the bipartisan Commission on Entitlements and Tax Reform on which I serve has an unfunded liability of up to $8 trillion. It seems clear to me that we continue to face major challenges if our country is to make the investments in educating our children that the future demands, to ensure that every American has the opportunity to fully participate in our economy to the maximum ex- tent of their ability, and to ensure that as Americans approach re- tirement age, they can be confident that they will be able to enjoy a safe and secure retirement. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 While I believe we are making progress, there is still much un- finished work to be done. Education needs to be a higher priority. Retirement security demands more of our attention. All of us have an obligation to open the doors of economic opportunity to every American. I congratulate the Chairman of the Federal Reserve for his part in the economic successes that we have had to date. I look forward to continuing to working with him and from hearing from him this morning. I am tickled, actually, Mr. Chairman, when we look at headlines that say, "An Economy Waits for the Magic Words," that we have an opportunity to listen to our modern-day Merlin this morning and to get the cues on which way he sees the economy going. And so, I look forward to hearing from the Chairman. Thank you. The CHAIRMAN. Thank you, Senator. Senator Bennett. OPENING COMMENTS OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you, Mr. Chairman. Mr. Chairman of the deficits that have declined as a result of President Clinton's election in 1992, I thought they declined as a result of my election in 1992. [Laughter.] I'm a little surprised to see somebody else get the credit for that. [Laughter.] We, I think, have carried out our mandate, which is to com- pletely screw up the deadlines of all of the folks that were planning to flash around the world Mr. Greenspan's words. I won't contrib- ute to that any further. I will listen to what Mr. Greenspan has to say. The CHAIRMAN. Well, thank you, Senator. I think it was Senator Bennett who said before that, Chairman Greenspan, you are the first witness we have had before this Com- mittee in many, many months that we have not had to swear in. Senator BENNETT. In this room. The CHAIRMAN. In this room. Senator BENNETT. Yes. [Laughter.] The CHAIRMAN. It's a great, great pleasure. Never have so many people tuned in with such eager anticipation to hear your words, and we look forward to your testimony. Senator BENNETT. Mr. Chairman, I might say, I wish that some of those that we had sworn in had drawn this big a crowd. [Laughter.] OPENING STATEMENT OF ALAN GREENSPAN, CHAIRMAN BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Thank you very much, Mr. Chairman. I will be excerpting from my prepared remarks and request the full testimony be included for the record. The CHAIRMAN. So ordered. Chairman GREENSPAN. Before I take this opportunity to discuss the performance of the American economy and the conduct of mon- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 etary policy, I would first like to thank you, Mr. Chairman, and the other Members of this Committee for their support during my con- firmation process. I am grateful for the opportunity to serve the Nation in this capacity another term. Nineteen-ninety-six has been a good year for the American econ- omy. By all indications, spending and production were robust in the first half of this year. GDP increased at a 2Y4 percent annual rate in the first quarter. Partial data suggest a significantly strong- er increase in the second quarter as the economy, as expected, ac- celerated out of its soft patch around the turn of the year. Even though the U.S. economy is using its productive resources intensively, inflation has remained quiescent. The core inflation rate, measured by the Consumer Price Index less food and energy prices, at a 2.8 percent annual rate over the first 6 months of the year, is about a half a percentage point slower than the same pe- riod 1 year ago. I shall be discussing in greater detail later some possible reasons for this favorable inflation experience and offering some thoughts about how long it might last. Looking forward, there are a number of reasons to expect de- mands to moderate and economic activity to settle back toward a more sustainable pace in the months ahead. First, the bond markets have taken a turn toward restraint this year as they have responded to incoming data depicting an econ- omy that was stronger than had been anticipated. Second, the value of the dollar on foreign exchange markets has appreciated significantly on a trade-weighted basis against the cur- rencies of other industrial countries over the past year or so. Third, the support to economic growth provided by expenditures on durable goods, both for household consumption and business- fixed investment, is likely to wane in coming quarters. While these are all good reasons to anticipate that economic growth will moderate some, the timing and extent of that down- shift are uncertain. We have not, as yet, seen much effect of the rise in interest rates on, for example, the housing market. In many other aspects, financial market conditions remain quite supportive to domestic spending, and the economies of many foreign countries are showing signs of achieving more solid growth, which would help support our export sales. Moreover, and perhaps of most rel- evance, a desire to build inventories could add significantly to pro- duction in the near term. Data available for 1996 through May show that inventories were reduced relative to sales and are now fairly lean in many important industries. Although the use of just-in-time inventory and production sys- tems encourages purchasing managers to keep stocks lean, any evi- dence that deliveries of previously ordered goods are being delayed for extended periods would quickly alert companies to the need for higher safety stocks. Indeed, indications of some mounting delivery delays in June do raise warning flags in this regard. The reversal of earlier draw-downs in inventories, of course, could potentially impart an important boost to incomes and production as we enter the second half of the year. The economy is already producing at a high level—and some early signs of pressures on resources are emerging, especially in the labor market. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 There are, to be sure, legitimate questions about how much mar- gin in resource utilization currently exists. Historically, current lev- els of slack, measured in terms of either the unemployment rate or capacity utilization, have often been associated with a gradual strengthening of price and wage pressures. Yet, the recent evidence of such pressures is scant. I have already noted the lack of a dis- tinct trend in the growth rate of the so-called core CPI. Increases in more comprehensive, and perhaps more representative, chain- weighted measures of consumer prices, based on the national in- come and product accounts, actually have continued to edge lower. The same is true of a still broader measure of price change, the chain-weighted price index for gross domestic purchases, which cov- ers both consumers and businesses. Although nominal wage rates have accelerated recently, the rate of increase has been lagging sig- nificantly behind that predicted on the basis of historical relation- ships with unemployment and past inflation. And domestic profit margins have held up far later into this economic expansion than is the norm. Have we moved into a new environment where inflation imbal- ances no longer threaten the stability and growth of our economy in ways they once did? The simple answer, in our judgment, is no. But the issue is not a simple one. As we have discussed before, powerful forces have evolved in the past few years to help contain inflationary tendencies. An ever- increasing share of our Nation's workforce uses the tools of new technologies. Microchips embodied in physical capital make it work more efficiently, and sophisticated software adds to intellectual capital. The consequent waves of improvements in production tech- niques have quickly altered the economic viability of individual firms and sometimes even entire industries, as well as the market value of workers' skills. With such fast and changeable currents, it is not surprising that workers may be less willing to test the waters of job change. In- deed, voluntary job leaving to seek other employment appears to be quite subdued despite evidence of a tight labor market. Because workers are more worried about their own job security and their marketability if forced to change jobs, they are apparently accept- ing smaller increases in their compensation at any given level of labor market tightness. Moreover, a growing share of all output competes in an increasingly global marketplace, allowing fixed costs to be spread over ever broader markets, promoting greater specialization and efficiency and enhancing price competition. As I indicated in February, these forces, to the extent that they are operative, exert a transitory, not permanent, effect in reducing wage and price inflation. These trends leave the level of both wages and prices lower than historical relationships would predict. But at some point, greater job security will no longer be worth the further sacrifice of gains in real incomes. The growth of wages will then again be more responsive to tightness of labor markets, potentially putting pressure on profit margins and ultimately prices. Moreover, the reductions in unit costs that are a consequence of the ever expanding global reach of many companies must ulti- mately be bound by the limits of geography. To be sure, production and sales will continue to be diversified across geographic areas, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 but the world can only figuratively shrink so far. At some point, possibly well in the future, increasing returns from ever-greater globalization must also ebb. Perhaps reflecting these unusual influences, we have yet to see early signs in prices themselves of intensifying pressures, despite anecdotal and statistical evidence that the amount of operating slack in our economy has been at low levels by historic standards for some time. Among the encouraging indicators, industrial com- modity prices have remained roughly flat and the list of reported shortages of materials has been exceptionally small. This pattern is consistent with the view that American businesses, by and large, have felt comfortable that inflation has been subdued and offers lit- tle evidence of the advanced buying and expanded commitments that would come if businesses were expecting significant price pres- sures in the reasonably near future. Nonetheless, there are early indications that this episode of fa- vorable inflation developments, especially with regard to labor mar- kets, may be drawing to a close. The surprising strength in the employment cost index for wages and salaries in the first quarter raises the possibility that workers' willingness to surrender wage gains for job security may be lessening. Wage data since March have been somewhat difficult to read. Average hourly earnings clearly accelerated in the second quarter. However, in looking at those figures, one must be mindful that they can reflect not only changes in wage rates but also shifts in the composition of employ- ment. And in recent months, a significant part, although not all of the pickup, has been accounted for by a tendency for employment to shift to relatively high-pay industries, such as durable goods manufacturing. Whether such shifts also imply a correspondingly higher level of output per worker will determine whether unit labor costs also ac- celerated to impart upward pressure to price inflation. Increases in pay, of course, are not inflationary so long as they are matched by gains in productivity. Without question, we would applaud such trends, which increase standards of living. However, wage gains that increase unit costs and are eaten up by inflation help no one, and ultimately place economic growth in jeopardy. Clearly, in this environment, the Federal Reserve has had to be- come especially vigilant to incipient inflation pressures that could ultimately threaten the health of the expansion. The relatively good inflation performance of the past few years, as best we can judge, owes in part to transitional forces that are only temporarily dampening the wage-price inflation process. We cannot be con- fident that we can ascertain when that process will come to an end. This makes policy responses more difficult than usual, because, as always, the impact of policy will be felt with a significant lag. Of course, if the economy grows so strongly as to strain available resources, transitional forces notwithstanding, history persuasively indicates that imbalances will develop that will bring the expansion to a halt. The forecasts of the Governors of the Federal Reserve Board and Presidents of the Federal Reserve Banks for economic performance over the remainder of this year and next reflect the view that sus- tainable economic growth is likely in store. The growth rate of real Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 GDP is most commonly seen as between 2V2 and 294 percent over the four quarters of 1996, and 1% to 2Vi percent in 1997. Given the strong performance of real GDP in the last two quarters, this outcome implies slower growth in the second half of this year. Nonetheless, for the remainder of this year and the next in these projections, the unemployment rate remains in the range of the past IVz years. Inflation as measured by the four-quarter percent change in the Consumer Price Index is expected to be 3 to 3V* per- cent in 1996. The Governors and Bank Presidents, however, view the prospects for inflation to be more favorable going forward. The expected reversal of some of the recent run-up in energy prices would contribute to that result, but policymakers' forecasts also re- flect their determination to hold the line on inflation. The central tendency of their inflation forecasts for 1997 is 2% to 3 percent, re- turning to the range from 1991 through 1995. We at the Federal Reserve would welcome faster economic growth, provided that it is sustainable. As I emphasized last Feb- ruary, we do not have firm judgments on the specific level or growth rate of output that would engender economic strains. In- stead, we respond to evidence that those strains themselves are de- veloping. Whatever the long-run potential for sustainable growth, we believe that a necessary condition for achieving it is low infla- tion. As a consequence, the Federal Reserve remains committed to preventing a sustained pickup in inflation and ultimately achieving and preserving price stability. Price stability is an appropriate and desirable goal for policy, not only because it allows financial markets in the economy to work more efficiently, but also because it most likely raises productivity and living standards in the long run. Specifically, in an inflationary environment, business managers are distracted from their basic function of building profits through prudent investment and cost control. My own observation of business practices over the years suggests that the inability to pass cost increases through to higher prices provides a powerful incentive to firms to increase profit mar- gins through innovation and greater efficiency. This boosts produc- tivity and ultimately standards of living over time. Holding the line on inflation, thus, does not impose a speed limit on economic growth. On the contrary, it induces the private sector to focus more on efforts that yield faster long-term economic growth. In this context, we can readily understand why financial markets welcome sustained low inflation. Uncertainty about future inflation raises the risks associated with investing for that future. Lowering that uncertainty by keeping inflation down diminishes those risks, so that all commitments concerning future income become more valuable. During periods of low inflation, stock and bond prices tend to reflect the higher valuation that comes from harnessing our physical plant more efficiently to provide improved opportunities in the future, including higher wages and profits. What investors fear, what all Americans should fear are infla- tionary instabilities. They diminish our ability to provide the wherewithal for the standards of living of the next generation and the retirement incomes of our current workforce. The interests of investors as expressed in bond and stock markets do not conflict with those of average Americans—they coincide. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 In order to realize the benefits of low and declining inflation, Federal Reserve policy has, for some time now, been designed to act preemptively, as I indicated earlier, to look beyond current data readings and base action on its assessment of where the economy is headed. Policy restraint initiated in February 1994 followed from the judgment that unchanged policy would encourage subsequent inflationary imbalances that would ultimately cut short the eco- nomic expansion. The three easing steps in the past year were in- stituted when we anticipated that inflationary imbalances would be less threatening and that lower rates would be compatible with promoting sustainable economic expansion. Similarly, I am confident that the Federal Open Market Commit- tee would move to tighten reserve market conditions should the weight of incoming evidence persuasively suggest an ongoing inten- sification of inflation pressures that would jeopardize the durability of the economic expansion. Monetary policy is, of course, only one factor shaping the macro- economic environments. I thus would be remiss if I did not again emphasize the critical importance to our Nation's economic welfare of continuing to reduce our Federal budget deficit. We have made significant and welcome progress on this score in recent years. But unless further legislative steps are taken, that progress will be reversed. Inevitably, such changes will require ad- dressing the consequences for entitlement spending of the antici- pated shift in the Nation's demographics in the first few decades of the next century. Lower budget deficits are the surest and most direct way to increase national saving. Higher national saving would help to lower real interest rates, spurring spending on cap- ital goods so as to put cutting-edge technology in the hands of more American workers. With a greater volume of modern equipment at their disposal, American workers will be able to produce goods that compete even more effectively on world markets. Mr. Chairman, our economy is now in its sixth year of economic expansion. The staying power of the expansion has owed impor- tantly to the initial small size and rapid correction of emerging im- balances, reflected in part in the persistence of low inflation. To be sure, the economy is not free of problems. But as we address those problems, policymakers also need to recognize the limitations of our influence and the well-spring of our success. The good performance of the American economy in the most fun- damental sense rests on the actions of millions of people who have been given the scope to express themselves in free and open mar- kets. In this we are a model for the rest of the world, which has come to appreciate the power of market economies to provide for the public's long-term welfare. Thank you very much. The CHAIRMAN. Thank you very, very much, Mr. Chairman. I am going to ask all of our Members to observe the 5-minute limit because we have a number of Members here. I will raise one question then I want to yield to a Member who just arrived, Sen- ator Frahm, the balance of my time. Mr. Chairman, obviously, we have seen the turbulence in the stock market in the past several days. I would like you to comment, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 if you would, on the major factors that you believe contributed to this turbulence. Chairman GREENSPAN. The best way of looking at the stock mar- ket, Mr. Chairman, is to recognize that if we define it, as I believe we should, as the present value of discounted future expected earn- ings, then we can break down the issue of how to observe this into a few major components. The first is the expected growth rate in earnings over the longer term. The second is the riskless rate of interest usually proxied by, say, our 30-year long-term Treasury bond. And then finally there is what economists call the real equity premium in the market which reflects the additional risk elements associated with owning stocks relative to owning riskless bonds. Obviously, as expected earnings rise, stock prices go up. If the equity premium rises, stock prices go down. And if long-term inter- est rates fall, stock prices go up. What we have seen through this long-term period in which long- term interest rates have fallen, and long-term expected earnings have risen, is a very substantial upward adjustment in the market. What has happened in recent days is very clearly that there is a serious question in the marketplace whether the decline in long- term interest rates has come to a halt. Most recently, especially in the technology-related areas, there has been concern about whether the growth in earnings in that particular area, which invariably is projected on a very high slope, has been overestimated. And what we have seen is an adjustment process. This goes on all the time and the market continually adjusts, often in a some- what discontinuous manner, in part because we are dealing with human psychology on a number of these issues—namely, projec- tions into the future. So I think that the reason why the most recent volatility has caught our attention is we haven't had much of that in recent years and it is that which is unusual, not the most recent period. The CHAIRMAN. Thank you very much, Mr. Chairman. Senator Frahm. OPENING COMMENTS OF SENATOR SHEILA FRAHM Senator FRAHM. Thank you, Mr. Chairman. I will ask that my remarks be included in the record and not take the time for that. Chairman Greenspan, a pleasure to have you with our Commit- tee today. I have been looking forward to hearing from you. I know that we anticipate your words. I know that reference has been made to the color of your tie and whether or not we are going to reflect on that. Does the tie—do you decide what color each morning, or [Laughter.] Chairman GREENSPAN. This happens to be a relatively new tie— just to make the record clear. [Laughter.] Senator FRAHM. Well, you chose a good tie for this morning. I am glad you are with us. I think that we look to your words, certainly, not only in the Congress but across the Nation. I wonder what impact our actions have on some decisions that you make. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 The question I would like to ask, I know that last year, when we were able to pass the budget resolution in the Congress, the econ- omy seemed to brighten. Even though we lost some ground, per- haps, when the veto came of the entitlement reform for Fiscal Year 1996, without that entitlement reform, the balanced budget really won't be available, maybe in 100 years, let alone by 2002. In your opinion, how much longer do we have to achieve mean- ingful entitlement reform before the market begins to doubt our ability to even balance the budget, reacts, maybe panics, and pushes the economy into a tailspin? Chairman GREENSPAN. Senator, I wouldn't necessarily think that if there is emerging market doubt about our ability to come to grips with these entitlement programs, that that will quickly lead to a major breakdown. Nonetheless, I do think you're raising a very important question because there is some sense in the market, at least as I can judge it, which raises questions as to whether we will in fact come to grips with the entitlement programs in an appropriate timeframe that will enable us to glide to the levels of benefits over the next several decades that are sustainable and to a system which is in- ternally sound. It's obvious that if that is not done, there will be a major disruption in the system with significant consequences. I must say, however, that I have been somewhat encouraged in maybe the last 6 to 9 months because there has been a general willingness to at least recognize that the existing path which we are projecting into the 21st century is fundamentally nonsus- tainable. It is crucially important that an evaluation of what those various relationships are as we move out over the years is made prior to taking any action. There has to be a consensus about what the na- ture of the problem is before it is appropriate even for the Congress to come to grips with the issue. We are now finally getting into that first stage whereas, as you may recall previously, discussing Social Security was labeled the third rail of American politics. I think the electric power has been turned off and people are willing to take a look at it. Senator FRAHM. Thank you, Mr. Chairman. The CHAIRMAN. Senator Sarbanes. Senator SARBANES. Well, thank you very much, Mr. Chairman. I first want to make reference to a point that Senator Dodd made when he talked about the Employment Act of 1946 and that we were marking this year the 50th anniversary of the Act. And while I don't want to necessarily attribute all of this to the Act, I do want to note that this chart shows real economic growth, the annual change in real GDP, beginning in 1890 and coming forward into the 1990's. This is at the end of World War II. I think the very interesting thing about this chart is that we have essentially succeeded in moderating the very steep declines that took place in the economy over the previous half century. A little more than half a century, in which we would have very severe plunges with the kind of eco- nomic and social turmoil and dislocation that that brought about. That doesn't mean that there aren't fluctuations in the economy. Obviously, there are. But we have managed to keep them almost Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 completely above the positive growth level. There have been just a couple of occasions when it's dipped into negative growth. And I would submit that the use of fiscal and monetary policy over this time period has helped to contribute to that economic performance, very much to the benefit of our country and, indeed, to the world, since the U.S. economy is the single largest economy in the world. I just wanted to register that point, to follow up on Senator Dodd's references to the 50th anniversary of the Employment Act. Mr. Chairman, I was struck by your comments right at the close about the fact that monetary policy is only one factor that shapes the macro-economic environment. I think it is very clear from that, you would think that fiscal stimulus at this particular time, that is, the expansion of the budget deficit, would be an ill-advised measure. In fact, as I take it, you are still seeking further fiscal restraint in order to diminish the deficit even further. Is that cor- rect? Chairman GREENSPAN. That is correct, Senator. Senator SARBANES. So any measures that are put forward that, in effect, would contribute to the budget deficit in the guise of pro- moting growth, given the current circumstances of the economy, you would regard as ill-advised, I take it. Chairman GREENSPAN. I have argued in my testimony and I have argued at length in the past that bringing the deficit down— and, as a consequence, bringing real long-term interest rates down —is an element which contributes to economic growth, not con- tracts it. And as a consequence, we at the Fed are very strongly supportive of measures which increase economic growth. One of them is a balanced budget. Senator SARBANES. My recollection was that the last time you testified before us under the Humphrey-Hawkins, you indicated that the deficit reduction that the President and the Congress put together in 1993, that economic plan was an unquestioned factor in contributing to the improvement in economic activity that oc- curred thereafter. Chairman GREENSPAN. To be very specific, what I said is that reducing the deficit was a major contributor to bringing long-term interest rates down. I did add the caveat that I did not wish to respond to questions about the nature of either the expenditure side or the receipt side, only the issue of deficit reduction, because we don't want to get in- volved in the particular budget structure. But we do applaud deficit reduction, per se, because I think it's very clear from the data that that had a very important impact on reducing long-term interest rates and accelerating economic activity. Senator SARBANES. I understand you are not wanting to get in- volved in the budget structure. But if it netted out to in fact raise the deficit rather than lower it, you would regard that as not well advised, I take it. Chairman GREENSPAN. I would say that any initiatives which are taken to enhance economic growth, either from the expenditure side or from the tax side, should start first with the presumption that it will not increase the deficit. Senator SARBANES. All right. I have finally just sort of a throw- away question. Do you think that there's anything that we can do Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 that eliminates all this hyperactivity that seems to surround your appearances before the Committee? To some extent, I am getting concerned that traders in the mar- ket are sort of trying to move the markets in a way that will move the Federal Reserve and its policy not related to the basic trends that are going on in the economy. And I am increasingly interested in these criticisms being made of Wall Street by Main Street, by leading American businessmen. I quoted earlier from the statement of the National Association of Manufacturers and there are others, business leaders who have spoken out on their own separately. First of all, I would assume that the Fed is not going to allow people to play the market in order to move the Fed to sort of take policy measures that don't correspond with what the basic underly- ing economic trends are. Chairman GREENSPAN. I can assure you that is the case. Senator SARBANES. Do you have any idea of what we can do to dehype this situation? Chairman GREENSPAN. Well, Senator, the current period—mean- ing the weeks that are the early weeks of the third quarter—is a very crucial period for this particular business cycle. I suspect that the reason there is so much interest in this particular testimony is that there is a legitimate question of exactly where the economy is going. This is a very important period where events as they evolve can go in two significantly different directions. First of all, as I pointed out in my prepared testimony, it's our general forecast that we expect the economy is likely to slow down to a more sustainable pace. Nonetheless, the process of slowing down has to become evident within the period immediately ahead. If it does, then it confirms the general view that most forecasters are making about 1996 and 1997. But it really hasn't happened yet. We don't see any accelera- tion, but it is still too early to basically argue that the relative exu- berance that we saw in the spring and early summer has simmered down as yet. So there is a very legitimate concern at this particular point about where the economy is heading. And I don't think anybody knows for sure because there are certain times when we look out into the future and can recognize what the process is, but very small changes can unbalance the system and move it in a different direction. That's the reason why I said in my prepared remarks that we have moved to a level of heightened surveillance of what is going on because the period ahead is a relatively important one which will tell us to a substantial extent how the economy is likely to evolve, not only for the rest of this year, but well into 1997. I might also say, Senator, that the turmoil in the stock market is a reflection of exactly that phenomenon. So if people are terribly concerned about where we at the Fed stand, I think it's under- standable. If you're asking me how do we simmer down some of the interest, I wish I knew. The CHAIRMAN. Senator Shelby. Senator SHELBY. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 Chairman Greenspan, I believe you used the term, transitional forces or transitory forces earlier. And you also used the phrase, faster economic growth, if it is sustainable. What do you mean by faster economic growth if it is sustainable? Is that dealing with in- flation? Chairman GREENSPAN. Well, it is basically the type of economic growth which doesn't, as a consequence, create imbalances which ultimately tilt the economy down. Senator SHELBY. You also use and we all use price stability, how important is it to keep inflation in line? Chairman GREENSPAN. I think it is a necessary condition, as I have indicated previously, if our goal is maximum sustainable eco- nomic growth. I don't believe that it is realistically possible to maintain steady, long-term, solid economic growth with highly un- stable prices. Senator SHELBY. I agree with you. Would you agree that the pri- mary source of the GDP growth has been and continues to be con- sumption spending? Chairman GREENSPAN. It is largely because it includes a very large part of the GDP. So while Senator SHELBY. Is it over half of the GDP? Chairman GREENSPAN. Oh, yes. Senator SHELBY. Two-thirds, maybe? Chairman GREENSPAN. I think it's 60 percent, or thereabouts. Senator SHELBY. OK. Chairman GREENSPAN. But there are a lot of other elements that are fluctuating far more actively on occasion than consumption. In- ventories, for example, are a very crucial issue in business-fixed in- vestment. They do move around with some alacrity. So changes in consumption expenditures have a markedly less impact on changes in the GDP than they do on the level of the GDP. Senator SHELBY. Are you concerned that debt is growing three times faster than income, according to the Comptroller of the Cur- rency, and that consumer credit is now over $1.14 trillion? Are you concerned about such accelerated debt? Chairman GREENSPAN. We worry about it. Remember that most of the concerns about consumer debt really reflect basically credit card debt. It's not evident that we have any difficulties that I am aware of in the mortgage market, for example, or indeed, in other consumer debt areas. Senator SHELBY. How do you differentiate in your economic thoughts between the credit card debt, which is growing at a high rate, and the other debt, like mortgages on homes and buildings and so forth? Chairman GREENSPAN. What you try to do is to understand what, for example, the structure of American households' balance sheets look like and to understand how debt works its way into consumption expenditures. It's been my experience that the vast proportion of individuals are capable of making very sound judgments about how much debt they can carry. And as a consequence of that, when the economy is doing well, you very rarely see debt problems. Household debt problems are almost always problems of recession and unexpected declines in consumer incomes, where individuals who previously Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 had presumed they were able to meet their regular payment re- quirements find that all of a sudden they lose their jobs, their over- time goes down, or something happens, and they are put under very considerable stringency. Under those conditions, you can actually see the impact on retail sales and consumption expenditures generally, and that very obvi- ously is an element in exacerbating recessions. It is rarely, how- ever, a factor which engenders them. Senator SHELBY. Would the fact that credit card delinquencies are at a 15-year high, does that concern you some? A little bit? A great deal? Chairman GREENSPAN. Yes, it concerns me and my collea; some, not a great deal, because we do recognize that the rr cause of the rise is the extraordinary expansion that has occu in recent years in the issuances of credit cards of all varying tj The reason has been that a number of issuers have recognized - they can take some fairly large losses and still have very substan- tial profits at the interest rates at which people are willing to pay. I must say, it always surprises me what people are willing to pay on credit cards. But that's what the markets are saying. People are willing to do that, and what that has done is created a much larger credit card market. And part of it is the fact that losses are ex- pected to be larger, and indeed, they are. Having said all of that, I think we have observed some evidence in our senior loan officer surveys which we take periodically that banks are beginning to tighten up a little bit. And I must say, that makes me feel a little better. Senator SHELBY. Good. Mr. Chairman, last, are we seeing the be- ginning of what we call a bear market? Or is this recent downward trend in the stock market just a small correction before a lot more growth? Chairman GREENSPAN. Senator, I have spent the last 9 years in evading that question. Senator SHELBY. I know. You're good at it. [Laughter.] Chairman GREENSPAN. And I think I will, if you don't mind, con- tinue to do so. Senator SHELBY. And wait and see the events. Thank you, Mr. Chairman. The CHAIRMAN. Senator Dodd. Senator DODD. Thank you, Mr. Chairman. Just a couple of questions, if I can. First of all, let me take ad- vantage of your presence here today and ask you if you'll comment on the situation with SAIF, which is a great concern of mine. As you know, there's been a lot of attention paid over the last year or so to the increasing threats to the stability of this Savings Associa- tion Insurance Fund and the ability of SAIF-insured institutions to meet their obligations on these FICO bonds. There's no disagreement, I think, that something has to be done, at least those who are the regulators and others who are looking at it. The Chairman of this Committee has been tremendously helpful and forthright on this, and the Ranking Member, Senator Sarbanes, as well. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 We've had some problems in the other chamber to get something moving here and I don't know whether anything is going to happen or not. But I wonder if you might just comment on the problems that potentially face SAIF and what are the implications for the country if there is either new instability here or a possible default on these FICO bonds. Chairman GREENSPAN. Senator, as I am sure you know, I have testified at some length on these issues before Committees of the Congress for the last year or two. The major thrust of my com- ments is that we effectively are offering two types of insurance, one for thrifts and one for commercial banks; but they are fundamen- tally the same insurance; that is, they are the same product. If you price one higher than the other, which is effectively what we are doing now with the SAIF fund, people will, of necessity, find ways to move into BIF, the Bank Insurance Fund. And inevitably, the economics of the system will create an increasing problem for SAIF because, as you get the shift from SAIF to BIF and the FICO obligations remain unchanged, you clearly are running up against an impossible, unstable situation. I have argued that we have in front of us several different rec- ommendations and various different initiatives which will solve this problem. And all I can say is that the longer we wait, the more difficult it is going to be to solve. I would hope that all parties con- cerned will come together and get this resolved, recognizing fully that none of them are the ones that caused this problem. The savings and loans, the thrifts, generally, who are still oper- ating clearly were not the cause of the problem. They did not de- fault. And certainly, commercial banks are not at fault. What we are asking effectively is for individual institutions who were not the cause of a problem to effectively pay the cost of the savings and loan debacle, which has not been covered by taxpayer funds. That's not easy, and I understand and fully sympathize with the concerns that these people have raised. But one way or the other, unless we get it resolved fairly quickly, we are going to find that it's becoming increasingly more difficult, especially as we get into the next Congress. Senator DODD. Well, I hope those out there will listen to what you have just said carefully. Particularly I say, we all have inter- ests and there are banks and so forth that we try to help. But there is an ad on television, "You can pay me now or pay me later." And that seems to be what you are saying to us here. There was a time not long ago when we didn't listen to those words of pay now or pay later, and we paid an awful price for it. And I am not suggesting nor am I asking you to agree that we are talking about anything necessarily of the magnitude of that, but, nonetheless, your words of getting this done with the remaining few days that we have left in this Congress I think is terribly im- portant. Again, I know where the Chairman stands on this issue. He has been terrific on it. But he is only one person. This involves other people as well to step up to the plate and to help us get it done. So I am very hopeful that people will hear what you had to say here this morning and understand the implications that if we don't act, it gets a lot more difficult. No matter who runs this Congress Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 in 1997, the problem doesn't go away and the disparities are creat- ing some real problems. Last, and this sort of picks up on what Senator Sarbanes was raising with you, the question of how do you deal with trying to reduce the hype as such. I think most of us grew up at least in recent years of sort of fol- lowing the axiom that the markets were predicated on future activ- ity. So it's not uncommon that when markets do react in the way that we have seen in the last few days, that people jump and want to draw conclusions about where we are heading. My question to you, in a sense, is has that axiom sort of lost its value? As we look at what moves markets, whether it is over valu- ation or matters to do with the question of programmed trading and the like, are we looking at more of an insider operation in the sense of what causes markets, bargain-hunting, rather than the axiom that, as markets moved, you would get some sense of where things were headed. I was looking at some headlines of newspapers in responding to the unemployment rate. A headline of one major newspaper says— here it is—Unemployment Rate Drops to Lowest Level in 6 Years. This is a July paper. Clinton Hails Report. Some Economists See Inflation Threat. Almost the same day—Economists Not Worried About Inflation. June's Jump In Jobs and Earnings Are Shrugged Off. Two highly respected newspapers reacting to the same news, predicting exactly entirely different conclusions in a way. So I wonder if we are not still reacting in ways that had some validity a few years ago to a situation today that just doesn't hold up to the old axiom that as markets move, you get a predictor of future economic activity. Chairman GREENSPAN. I don't think so, Senator. Markets try to make judgments, if you can have such a concept of a market as other than individual people. And what you observe is about the best combination of analysts and researchers on values of compa- nies that you can possibly put together on Wall Street and, indeed, throughout the world. These are people who look very closely at what is going on in the economy. The reason why we see the type of evidence which you adduce is that there are differences of opinion. One of the reasons, for ex- ample, why the stock market fell the other day when there was a much higher increase in employment and a big increase in pre- sumed employment cost than many had expected is not that real economic growth is perceived to be negative by the stock market, but, as I point out in my prepared remarks, what the markets neg- atively respond to is fear of instability. I won't even raise the issue of inflationary instability, but instability per se is very detrimental to long-term values. And what that report did is create a very, very extraordinarily large amount of uncertainty on the part of some in- vestors. You don't need all of them to have that opinion. All you need is some. And if there are enough, they can create, as indeed they did, a very substantial decline in both bond and stock prices. I think that markets generally are no different than I remember them 20 or 30 years ago. They respond to the same evidence. They react the same. It is not the sort of inside Wall Street that is in- volved here. Programmed trading, if anything, is less now. Indeed, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 it's significantly less than it was a number of years ago. Ulti- mately, what determines the value of a stock is the viability of the corporation that it is involved with, not the supply and demand for the number of shares or who is investing and who is not investing. And as far as I can judge, there's been no real change in that as far as I remember, and I suspect there will not be. Senator DODD. Thank you very much. Thank you, Mr. Chairman. The CHAIRMAN. Chairman Greenspan, one thing becomes rather obvious and that is this great anxiety that is felt by so many Amer- icans. You alluded to it in your testimony. Americans are concerned about their economic well-being, about their future, about the fu- ture of jobs that they hold and what jobs will and won't be avail- able for themselves and for their children. For the first time in many generations, there is a feeling that future generations may not have the same living standard or an improvement in their living standard. How do we deal with that? What are the best policies that the Congress could enact, recogniz- ing our limits within the world economy. Our economy is now so interrelated to conditions in the rest of the world. What can we do as a Congress, as a Government, to deal with some of these anxi- eties? Chairman GREENSPAN. I don't think there is any way that Gov- ernment per se, by making speeches or statements, is going to alter anybody's view of their own internal anxiety. I think the anxiety comes from two different sources and actually, they look a lot alike. But I don't think they are. The first is what I was implying in my written remarks that the degree of technology has created an extraordinarily rapid change in the way we do business. A goodly part of the turnover that we see is probably near wheel- spinning in the sense that we don't see the extraordinary rises in productivity that one would observe to be commensurate with the degree of turmoil or what we often call creative destruction after Schumpeter's great insights. This induces a very substantial degree of job insecurity which relates to the fear of skill obsolescence. Things are changing so fast that people who used to be able to go to high school or college, graduate and find that their skills were adequate for a full life's work no longer see that any more, and that they are always acutely aware that their capabilities will no longer be adequate for the new high-tech world in which we are in- creasingly living. That is a major element for a very large part of the workforce from just under the middle class and upward. It clearly is more rel- evant to individuals who are closer to retirement than people get- ting out of school and, indeed, there is virtually none of that fear in our children. They seem to be able to basically deal with new technologies do all of that stuff in ways which are alien to a lot of the people who are parents and grandparents. The CHAIRMAN. That's because they can operate those computers with a lot greater dexterity and ability than we can. Chairman GREENSPAN. They are not afraid of it. And as a con- sequence, with the inexorable turn of the calendar, they are going Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 to move into the central structure and, presumably, a goodly part of that uncertainty will decline. There is another element, however, which is those who have ob- served that with the dispersion of incomes—which is part of the fact of this increased intellectual product—their real incomes are indeed either stagnant or falling, and they are projecting them still lower for the next generation. Those are really related but are two different types of elements of insecurity which I think plague our job market. The resolution of those, in my judgment, is to get an economy which can function in a highly viable form, get a type of capital as- sets in our production system which can really expand real incomes and increase productivity. And that, of course, implies, as I have indicated earlier, a low- inflation rate or stable prices which would be, to a substantial ex- tent, reinforced by balanced budgets and perceived balanced budg- ets out in the longer term. We have to look at our tax structure to make certain that incen- tives are there. We have to look at our educational system to make certain that our human capital has the capability of being at a level to deal with the ever increasingly high level of technology which we see. It is action, not words, that will make a difference here and Gov- ernment has a major role in seeing that it happens. But a goodly part of that major role is to reduce a lot of the supervision and reg- ulation that we see in so many different aspects of our life which, in my judgment, are not very helpful in reaching this goal. So I think that Government has an important role. Part of that is to know when it shouldn't be there. The CHAIRMAN. Well, I want to thank you very much, Mr. Chair- man, for your very candid, I think very cogent, observations. I also want to commend the women on our panel, Senators Moseley-Braun and Frahm. Senator Moseley-Braun testified with some very real specificity on the potential growth of entitlements as a percentage of our GDP. Notwithstanding the progress we have made and the fact that the percentage of debt to the GDP has gone down, there is a ticking timebomb that is growing underneath the surface of our current stability. You referred to it as a question of a third rail that we would be afraid to discuss and resolve. I think that Congress must deal with the entitlements and make the necessary reforms so that we can ensure the American public that these programs will be there. Our economy must be able to sustain them in a manner that will still permit capital formation. This type of reform is critically important. And I think there is a greater recognition by many of my colleagues, Democrats and Re- publicans, of the need to look at this issue. Now, obviously, this being the political season that it is and this year being particularly tumultuous with the election of a President, I think that discussion has been put on the back burner. But I would hope that once we get past this election, that we will be serious, very, very serious and very dedicated to dealing with the explosive growth in the entitlements that will otherwise over- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 whelm us and make the budget reduction efforts that we have achieved look insignificant. I think there is an anxiety out there and I think you put it so eloquently in your testimony which touched on the fact that people now are beginning to become somewhat concerned. Does the Con- gress through its political process really have the resolve to deal with the issues creating these anxieties? You have not made a judgment other than to say that you think there's a greater recognition now of the need to act. I would agree with you. But I think in the fullness of time, and I share this with my friend and colleague, Senator Sarbanes, that's going to be one of the great tests of our mettle, without attempting to say what we should or shouldn't do. And I would hope that in the absence of the political atmosphere that obviously exists when we come into an election cycle, that we would be able to deal with some of these problems so that we could minimize some of these long-term anxieties that otherwise are going to continue. But I want to thank you for your testimony. Senator Sarbanes. Senator SARBANES. Thank you very much, Mr. Chairman. I just have a couple points I want to clear up with Chairman Greenspan here at the end. Senator Shelby suggested that the growth that we were seeing was consumption-related. Of course, consumption is the largest part of the components that make up the GDP. But the figures, as I understand them, and in fact, I think this is from the Board of Governors of the Fed, there's been a very sharp growth in indus- trial capacity over the last 3 or 4 years. As I understand it, there has been a very significant increase in investment in new plant and equipment and presumably, the improved productivity which flows from such investment. Would that be correct? Chairman GREENSPAN. Yes, there is no question that gross in- vestment has gone up very substantially. But an increasing part of that is short-lived investment and, as a consequence, net invest- ment has gone up less. But still, it is unquestionably the case that there has been an acceleration in both and indeed, the industrial capacity numbers you're looking at there Senator SARBANES. Are net. Chairman GREENSPAN. —are a reflection of net, exactly. Senator SARBANES. Yes. Now the next question I wanted to ask— I just have this one and one other, Mr. Chairman—is I still remain concerned about the tendency I see now to take a figure that is re- ported, some economic statistic, whether it is the unemployment rate or inflation. You talked about inflation. Of course, it's your position, as I understand it, that the inflation rate is overstated in any event. So that when we talk about 2.7, it is not really 2.7. I think most people accept that it is somewhat less than that, but there's serious argument about how much less. But, nevertheless, you have the markets pouncing on these figures and sort of gyrating. For instance, the National Association of Manufacturers, NAM, in its statement on the growth figures said: *The panicky hysteria Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 in financial markets over the possibility that the economy might overheat is ironic because recent growth rates have actually been weak. In the first quarter, GDP grew by only 2.2 percent, and in 1995 the fourth quarter to fourth quarter gain in GDP was a paltry 1.3 percent. Claiming that these anemic growth rates represent overheating is not only wrong, it's completely irrational." This is not me talking. This is the NAM talking. They then ana- lyze the surge in the second quarter of 1996: "While April and May were strong, data for June suggests that consumer spending is slowing down." And then they say: "The growth rate should slow to about 2.4 percent in the second half." Which is what all the blue chip forecasts are saying. So, again, you have this pouncing on a figure. I have heard you testify before saying that's something the Fed strenuously tries to avoid doing. You try to look at a pattern and trend in analyzing where the economy is going. You can't simply take one month's fig- ures. In fact, the way a lot of it is reported, there were stories in the beginning, some then sought to correct it, that said, well, the Dow fell 160 points. And they then looked back to find when previously had the Dow fallen by those number of points, without putting right up front the fact that it fell 160 points in a market where the average is well over 5,000. So that the percentage fall compared with some earlier time, while the figure, the absolute number fig- ure might be the same or even somewhat larger, the percentage figure was much less. It seems to me somehow we have to try to do that education process so that we're not just gyrating around off of a single figure, often with an inadequate analysis. I think the Fed can contribute to that and I think in fact you've done so today by the statement that you've given to the Committee. I have just one final question. What progress are we making in getting the barons at the Federal Reserve, the staff, these very powerful senior staff people, so powerful, in fact, that one of the members of the Board of Governors at one point said, you know— no, I think a staff member said that he would not give up being a staff member in order to be a member of the Board because he had more power as a staff member. So I wonder what progress we are making in getting the barons to realize that the other six peo- ple on the Board are also policymakers and have a vote just like the Chairman? Chairman GREENSPAN. Senator, the article to which you are re- ferring describes a Federal Reserve System of which I am not fa- miliar. [Laughter.] I know of no staff member who believes that working at the Fed- eral Reserve is terrific, who would not like to be a Governor. I also know no staff member who doesn't recognize where all the power is, which is at the Governor level. I think that it is an interesting game that a lot of people like to play about the presumed power of the staff. But let me tell you where that power comes from, which I must say is one of the really extraordinary strengths of our System. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 There is a competition within the Federal Reserve for intellectual capability, analysis, and proficiency. And the people who are the best, those who are the most incisive analytically and who can con- vey their views in a manner which we Governors can understand, move up. And indeed, that's what should happen. What occurs, as I have said publicly on numerous occasions, I think one of the most extraordinary things about the Federal Re- serve Board, and I would even extend it to the Federal Reserve Banks as well, is that there exists a degree of dedication and capa- bility among the people who work in the organization which I must say I have never seen in all of my experience in the private sector and public sector. So the presumption that there are some barons who have capa- bilities of moving things about that Governors do not is false. To the extent that they succeed in, indeed, altering views of we Gov- ernors or the Presidents of the Federal Reserve Banks, it is on the basis of the rationality of their arguments. And that's what counts. If somebody has got an argument which overcomes one of the views that we on the Board of Governors, for example, have and an argument which we have inarticulately and perhaps inappropri- ately structured, and one of our staff comes up and says no, it is the other way around, that is a great advance in understanding. I hope that the Governors continue, as they have over the years, to listen to staff. I think we have benefited immensely. And the last thing that I would like to see happen is that the so-called "power" of those people get diminished. Senator SARBANES. Well, I am not questioning either the dedica- tion or the competency of the staff. I am quite prepared to concede that it is at very high standards and that the quality of the staff at the Fed is clearly a very important asset of the Fed and is and ought to be respected, I just want them to cut the other Governors in on the benefit of the information and the analysis which they have, the information that they have available to them and the analysis which they make. I have some concern about a story of this sort which says that four members of the Board of Governors had to meet with you in order to try to address this situation. They in fact, in turn, lavishly praised the competence of the staff, but obviously, they want to share more equitably, and I would as- sume at an earlier time in the fruits of the labors of the staff. And so I just hope that that problem can be addressed. Chairman GREENSPAN. Well, let me just tell you quickly what happens. If all of the Governors got all of the material that is generated by the staff, our 28-hour days would be inadequate to read it all. So it's a question of who gets what because we have subcommittees of the Board. And what the particular example to which you are alluding is a group of my colleagues wanted greater amounts of information relating to certain specific subjects. That happens on occasion and it is no big deal. We changed the routing lists and now I suspect that some of my Governor friends wish that we hadn't. But leave that aside. Senator SARBANES. Well, hopefully, that's improved the situation. It's obviously one we can visit. I was prompted to ask this question Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 by the comment in this article that says: "The criticism I have re- lates to the position that the Governors are left in, said one Gov- ernor who requested anonymity. Information flowing through the barons to the Governors is scanty. These are not people who work for me. They do not think their jobs are to inform." But the article then goes on to say, "But the Governors eventually got their infor- mation. Greenspan saw to it that the entire Board was put into the loop." I am pleased that took place. I hope it will continue to take place. Thank you very much, Mr. Chairman. The CHAIRMAN. Mr, Chairman, let me thank you. I think that you have been quite clear. I think you have been quite cogent in your presentation. We thank you for your stewardship. Next Thursday, we are going to meet again to look into the operation of the Federal Reserve Sys- tem. We look forward to your staff and yourself sharing with us what we can do and what you are doing because I know you are undertaking a number of initiatives. I think it is important that you share that information with the Committee and with the other Members of Congress. But suffice it to say, we are deeply appreciative of your testimony today and your continued stewardship because I think you have made a significant contribution to the growth in our economy hi a manner which will continue hopefully into the future. So we stand in recess and you certainly have our thanks. Chairman GREENSPAN. Thank you very much. Senator SARBANES. Good hearing, Mr. Chairman. [Whereupon, at 1:15 p.m., the hearing was recessed.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 PREPARED STATEMENT OF SENATOR CHRISTOPHER J. DODD Thank you Mr. Chairman. As I was reading some of the articles about today's hearing, I was struck by the amount of space devoted to explaining just how closely Mr. Greenspan's appearance here today will be watched. Not onlyliis actual words, but his inflections, the expression on his face—whether he's smiling or frowning— have become fertile ground for the cottage industry of Fed watchers who seek to di- vine the Chairman's intentions with respect to raising interest rates. As a matter of fact, I am surprised that this study of Greenspan-ology hasn't ex- tended to trying to match the color of his tie to interest rates: Red for a rise, blue for a drop, polka-dot for holding steady. There is, of course, serious purpose behind this intense scrutiny. There are few single events that can affect our financial markets and our individual wallets as much as the interest rate decisions of the Fed's Open Market Committee. But, as our attention focuses more and more narrowly upon this single, albeit extremely im- portant, economic decision, it becomes very easy to lose perspective as to how well the overall economy is doing. The indisputable fact is that the economy is stronger and healthier now than it has been in nearly a generation. Yesterday's Wall Street Journal said that our hear- ing, "Will dwell on what is already obvious. The economy is growing with surprising strength, but with surprisingly little evidence of inflationary pressure." Indicator after indicator, from job growth to the shrinking deficit to increases in exports, all highlight the validity of the Journal's observation. This is not to say, however, that this growth has been uniform across the Nation. In my own State of Connecticut, for example, we are only just beginning to see the stirrings of economic recovery. Connecticut has been hit with a number of tough eco- nomic blows over the past 8 to 10 years—from reductions in the defense industry to deterioration in many of our real estate markets—Connecticut was harder hit by the recession of the early 1990's and has been slower to recover from that recession than the rest of the Nation. But there is a growing expectation, not present in years past, that the economic recovery is finally reaching our State. Unemployment is down in every labor market in the State and new companies—export ana technology oriented—are slowly coming to fill the void left by downsizing in our traditional in- dustries. But the increasing optimism about conditions in Connecticut—indeed across the country—is predicated upon the belief that the United States will enjoy a growth rate that is robust enough not only to sustain the gains made so far, but to create new jobs that will pay a living wage. The fact of the matter is that only a healthy rate of growth in the economy will translate into the fundamental job security that is the cornerstone of our continued economic success. There has been a disturbing trend of late to focus on price stability as an end in and of itself, rather than as one of the principal tools for ensuring economic growth. Fighting inflation is an extremely important task, but we cannot forget that it is a means to an end. In my opinion, this desire to focus solely upon price stability is what makes the Fed's dual mission so important. When American families gather around the dinner table, you aren't likely to hear a wife turning to her husband and saying: "What wonderful news, the growth rate is 2.8 percent while the CPI is only 2 percent!" What you are much more likely to hear is, "Two people in my department were laid off today." Or, "No one at the plant has had a raise in 2 years." Or, "Our daughter Jane just graduated from college and can't find a job." If our actions here in Congress or over in the Fed don't translate into jobs that provide Americans with a living wage, we might as well be debating the color of the wallpaper in heaven for all the relevance it will have to the average American family. Thus the Deficit Reduction Act of 1993, which played a vital role in freeing the economy from the grips of a crushing budget deficit, is so important not in and of itself, but for the role it played in helping the economy create 10 million new jobs—almost all of them in the private sector. If the goal of full employment is lost as a mandated priority of the Federal Re- serve, the purpose for which inflation is fought could also be lost. Mr. Chairman, almost exactly 50 years ago Congress passed the Employment Act of 1946, and while times have certainly changed, the goals of that Act still ring true today: "The Congress hereby declares that it is the continuing policy and responsibil- ity of the Federal Government to use all practicable means . . . for the purpose of creating and maintaining . . . conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work . . . Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 "The Congress further declares and establishes as a national goal the fulfill- ment of the right to full opportunities for useful paid employment at fair rates of compensation for all individuals able, willing, and seeking to work." [Employ- ment Act of 1946; Section 2(a-b)] While we might stall be a long way from achieving that worthy—though elusive— goal, this Administration and the Federal Reserve have taken us closer to that goal than we've been in a very, very long time. PREPARED STATEMENT OF SENATOR SHEILA FRAHM Thank you, Mr. Chairman. It is a pleasure to be here this morning. I would first like to welcome Chairman Greenspan and congratulate him on his successful recon- firmation as Chairman of the Federal Reserve Board. 1 look forward to hearing from Mr. Greenspan with great interest and anticipation. Few individuals capture American's attention, from Wall Street to rural Main Street like the Chairman of the Federal Reserve. The Federal Reserve affects the lives of every American family. Its monetary policies certainly influence our behav- ior when we buy a new house or a new car; their policies very much affect farmers like myself when we try to obtain a new loan to purchase equipment or plant the next year's crops. Small businesses who often must secure loans in order to survive, are particularly susceptible to any fluctuation in the interest rates. The policy goals of the Federal Reserve are made more difficult when battling big Government spending. Ronald Reagan was fond of saying that, "Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it." This type of irre- sponsible behavior, coupled with unremitting spending drives up our interest rates, ultimately hurts ordinary Americans. Since winning back the Majority, Congress has attempted to limit Government spending and to reduce the tax burden on our citizens. While we in Congress are responsible for long-term growth and a higher rate of GDP growth, the Federal Reserve has been instrumental in keeping the economy relatively stable, providing confidence in the marketplace, and keeping inflation in check. For the past 3 years, Mr. Greenspan and the Federal Reserve have sustained an economy of peaks and valleys, with relatively low levels of unemployment and a sustainable growth rate. Accomplishing that has certainly not been an easy task, and Mr. Greenspan should be commended for the job he has done over the past several years. The Fed has had to deal with the misguided policies of the Clinton Administration. Under the Clinton Administration, America saw its largest tax increase in history. This in- crease raised gas prices and lowered Social Security take-home—costs that certainly do not affect the nch as much as the less fortunate members of our Nation. The Democrats tell us that the economy is doing better than ever. Some economic indicators seem to back that up, but the fact is that we need higher non-inflationary growth. When I meet with ordinary Americans back in Kansas, I can tell you that there is a definite feeling of insecurity out there. People are concerned about keep- ing their jobs. People are concerned that their lives will not be as comfortable as their parents, and that their children's lives will be worse than theirs. To alleviate these concerns, we must get the economy growing faster. Slow eco- nomic growth is America's No. 1 economic problem. Adding even a half of a percent- age point of growth a year would allow the economy to create jobs at a faster pace raising wages and living standards. We desperately need new pro-growth policies to raise wages, a real pay raise I might add, not the artificial Government induced pay raise that passed last week. Raising wages certainly brings in more tax revenue, making it easier to balance the Federal Budget. We need to secure the income of workers now and in the coming century. And the fact is that there is great uncertainty among the American people about our country's economic future; we owe it to these people to provide them with some level of security. Our role in Congress is to work with the Federal Reserve. However, Congress must take the initiative by limiting our spending. But more importantly, we must come up with a new tax system that incorporates deep tax cuts with tax policies that encourage growth, savings, and investment—in order to fully unleash Ameri- ca's potential. Thank you again for testifying. During this period of such market fragility, your candor is greatly appreciated. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 18, 1996 Introduction Before I take this opportunity to discuss the performance of the U.S. economy and the conduct of monetary policy, I would first like to thank the Chairman and the other Members of this Committee for their support during my confirmation process. I am grateful for the opportunity to serve the Nation in this capacity for another term. Review of the First Half of 1996 Nineteen-ninety-six has been a good year for the American economy. By all indica- tions, spending and production were robust in the first half of this year. The GDP increased at a 2V* percent annual rate in the first quarter. Partial data suggest a significantly stronger increase in the second quarter as the economy, as expected, accelerated out of its soft patch around the turn of the year. During the second quarter, industrial production rose at an annual rate of 5Va percent, and manufac- turers are currently running their plant and equipment at utilization rates that are a touch above their postwar averages. About 1.4 million workers have been added to nonfarm payrolls in the first 6 months of the year, and the unemployment rate fell to 5.3 percent in June. Even though the U.S. economy is using its productive resources intensively, infla- tion has remained quiescent. The core inflation rate, measured by the consumer price index less food and energy prices, at a 2.8 percent annual rate over the first 6 months of the year, is about Vz percentage point slower than the same period one year ago. While increases in energy prices hare boosted the overall CPI inflation rate to 3.5 percent thus far in 1996, a partial reversal of the jump in petroleum product prices observed in the first half appears to be in train. I shall be discussing in greater detail later some possible reasons for this favorable inflation experience and offering some thoughts about how long it might last. Economic activity thus far this year has turned out to be better than many ana- lysts expected. An important supporting factor, as I pointed out in February, was favorable conditions in financial markets in the latter part of 1995 and early 1996. Intermediate- and longer-term interest rates were low. Among the influences ac- counting for this were optimism about prospective budget-deficit reduction, small easings of the stance of monetary policy in the second half of 1995 and early 1996, and the possibility of a further moderation in credit demands owing to a potentially soft economy. Credit remained readily available, with banks and other lenders in financial markets generally pursuing credit opportunities aggressively. And a rising stock market reduced the cost of capital to businesses and bolstered household bal- ance sheets. Looking forward, there are a number of reasons to expect demands to moderate and economic activity to settle back toward a more sustainable pace in the months ahead. First, the bond markets have taken a turn toward restraint this year as they have responded to incoming data depicting an economy that was stronger than had been anticipated. Intermediate- and longer-term interest rates have risen from 1 to 1V4 percentage points since January. Second, the value of the dollar on the foreign exchange markets has appreciated significantly on a trade-weighted basis against the currencies of other industrial countries over the past year or so. This appreciation importantly reflects the market perception that the U.S. economy has been performing better than those of many of our major trading partners. The rise in the dollar helps to keep down price pres- sures, but it also tends to divert domestic demand toward imported goods and damp exports some. Third, the support to economic growth provided by expenditures on durable goods, both for household consumption and business-fixed investment, is likely to wane in coming quarters. Consumer spending in the past few years has been boosted as households have made up for the purchases of big-ticket items that they had de- ferred during the recession and the early, weaker phase of the recovery. Five years after the business-cycle trough, however, we should expect that this pent-up demand has been largely exhausted. Moreover, many households have built up sizable debt burdens in recent years, and coping with debt repayments could hold down their spending. The business sector has been adding considerably to capacity; opportuni- ties to invest profitably in new capital should be increasing less rapidly as final de- mand slows some. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 While these are all good reasons to anticipate that economic growth will moderate some, the timing and extent of that downshift are uncertain. We have not, as yet, seen much effect of the rise in interest rates on, for example, the housing market. In many other aspects, financial market conditions remain quite supportive to do- mestic spending, and the economies of many foreign countries are showing signs of achieving more solid growth, which should help support our export sales. Moreover, and perhaps of most relevance, a desire to build inventories could add significantly to production in the near term. Data available for 1996 through May show that in- ventories were reduced relative to sales and are now fairly lean in many important industries. Although the use of just-in-time inventory and production systems en- courages purchasing managers to keep stocks lean, any evidence that deliveries of previously ordered goods are being delayed for extended periods would quickly alert companies to the need for higher safety stocks. Indeed, indications of some mount- ing delivery delays in June do raise warning flags in this regard. The reversal of earlier draw-downs in inventories, of course, could potentially impart an important boost to incomes and production as we enter the second half of the year. The econ- omy is already producing at a high level—and some early signs of pressures on re- sources are emerging, especially in the labor market. The Recent Behavior of Inflation There are, to be sure, legitimate questions about how much margin in resource utilization currently exists. Historically, current levels of slack, measured in terms of either the unemployment rate or capacity utilization, have often been associated with a gradual strengthening of price and wage pressures. Yet, the recent evidence of such pressures is scant. I have already noted the lack of a distinct trend in the growth rate of the so-called core CPI. Increases in more comprehensive, and perhaps more representative, chain-weighted measures of consumer prices, based on the na- tional income and product accounts, actually have continued to edge lower. The same is true of a still broader measure of price change, the chain-weighted price index for gross domestic purchases, which covers both consumers and businesses. Although nominal wage rates have accelerated recently, the rate of increase has been lagging significantly behind that predicted on the basis of historical relation- ships with unemployment and past inflation. And domestic profit margins have held up far later into this economic expansion than is the norm. Have we moved into a new environment where inflation imbalances no longer threaten the stability and growth of our economy in ways they once did? The simple answer, in our judgment, is no. But the issue is not a simple one. As we have discussed before, powerful forces have evolved in the past few years to help contain inflationary tendencies. An ever-increasing share of our Nation's workforce uses the tools of new technologies. Microchips embodied in physical cap- ital make it work more efficiently, and sophisticated software adds to intellectual capital. The consequent waves of improvements in production techniques have quickly altered the economic viability of individual firms and sometimes even entire industries, as well as the market value of workers' skills. With such fast and changeable currents, it is not surprising that workers may be less willing to test the waters of job change. Indeed, voluntary job leaving to seek other employment appears to be quite subdued despite evidence of a tight labor market. Because work- ers are more worried about their own job security and their marketability if forced to change jobs, they are apparently accepting smaller increases in their compensa- tion at any given level of labor market tightness. Moreover, a growing share of all output competes in an increasingly global marketplace, allowing fixed costs to be spread over ever broader markets, promoting greater specialization and efficiency, and enhancing price competition. As I indicated in February, these forces, to the extent that they are operative, exert a transitory, not permanent, effect in reducing wage and price inflation. These trends leave the level of both wages and prices lower than historical relationships would predict. But, at some point, greater job security will no longer be worth the further sacrifice of gains in real wages. The growth of wages will then again be more responsive to tightness of labor markets, potentially putting pressure on profit mar- gins and ultimately prices. Moreover, the reductions in unit costs that are a con- sequence of the ever expanding global reach of many companies must ultimately be bound by the limits of geography. To be sure, production and sales will continue to be diversified across geographic areas, but the world can only figuratively shrink so far. At some point, possibly well into the future, increasing returns from ever- greater globalization must also ebb. Perhaps reflecting these unusual influences, we have yet to see early signs in prices themselves of intensifying pressures, despite anecdotal and statistical evi- dence that the amount of operating slack in our economy has been at low levels by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 historic standards for some time. Among the encouraging indicators, industrial com- modity prices have remained roughly flat and the list of reported shortages of mate- rials has been exceptionally small. This pattern is consistent with the view that American businesses, by and large, have felt comfortable that inflation has been subdued and offers little evidence of the advanced buying and expanded commit- ments that would come if businesses were expecting significant price pressures in the reasonably near future. Nonetheless, there are early indications that this episode of favorable inflation de- velopments, especially with regard to labor markets, may be drawing to a close. The surprising strength in the employment cost index for wages and salaries in the first quarter raises the possibility that workers' willingness to surrender wage gains for job security may be lessening. Wage data since March have been somewhat difficult to read. Average hourly earnings clearly accelerated in the second quarter. However, in looking at those figures, one must be mindful that they can reflect not only changes in wage rates out also shifts in the composition of employment. And in re- cent months, a significant part, although not all of the pickup, has been accounted for by & tendency for employment to shift to relatively high-pay industries, such as durable goods manufacturing. Whether such shifts also imply a correspondingly higher level of output per worker will determine whether unit labor costs also accel- erated to impart upward pressures to price inflation. Increases in pay, of course, are not inflationary so long as they are matched by gains in productivity. Without ques- tion, we would applaud such trends, which increase standards of living. However, wage gains that increase unit costs and are eaten up by inflation help no one, and ultimately place economic growth in jeopardy. Clearly, in this environment, the Federal Reserve has had to become especially vigilant to incipient inflation pressures that could ultimately threaten the health of the expansion. The relatively good inflation performance of the past few years, as best we can judge, owes hi part to transitional forces that are only temporarily dampening the wage-price inflation process. We cannot be confident that we can as- certain when that process will come to an end. This makes policy responses more difficult than usual, because, as always, the impact of policy will be felt with a significant lag. Of course, if the economy grows so strongly as to strain available resources, transitional forces notwithstanding, history persuasively indicates that imbalances will develop that will bring the expansion to a halt. The FOMC's Outlook for the Remainder of 1996 and 1997 The forecasts of the Governors of the Federal Reserve Board and Presidents of the Federal Reserve Banks for economic performance over the remainder of this year and the next reflect the view that sustainable economic growth is likely in store. The growth rate of real GDP is most commonly seen as between 2Va and 2% percent over the four quarters of 1996 and 1% to 2Yt percent in 1997. Given the strong performance of real GDP in the last two quarters, this outcome implies slower growth in the second half of this year. Nonetheless, for the remainder of this year and the next in these projections, the unemployment rate remains in the range of the past \Yz years. Inflation, as measured by the four-quarter percent change in the Consumer Price Index, is expected to be 3 to 3V-* percent in 1996. The Governors and Bank Presidents, however, view the prospects for inflation to be more favorable going forward. The expected reversal of some of the recent run-up in energy prices would contribute to that result, but policymakers' forecasts also reflect their deter- mination to hold the line on inflation. The central tendency of their inflation fore- casts for 1997 is 2% to 3 percent, returning to the range from 1991 to 1995. The Pursuit of Price Stability We at the Federal Reserve would welcome faster economic growth, provided that it were sustainable. As I emphasized last February, we do not have firm judgments on the specific level or growth rate of output that would engender economic strains. Instead, we respond to evidence that those strains themselves are developing. What- ever the long-run potential for sustainable growth, we believe that a necessary con- dition for achieving it is low inflation. And as a consequence, the Federal Reserve remains committed to preventing a sustained pickup in inflation and ultimately achieving and preserving price stability. Price stability is an appropriate and desirable goal for policy, not only because it allows financial markets and the economy to work most efficiently, but also because it most likely raises productivity and living standards in the long run. Specifically, in an inflationary environment, business managers are distracted from their basic function of building profits through prudent investment and cost control. My own observation of business practices over the years suggests that the inability to pass cost increases through to higher prices provides a powerful incentive to firms to in- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 crease profit margins through innovation and greater efficiency, which boosts pro- ductivity and ultimately standards of living over time. Holding the line on inflation, thus, does not impose a speed limit on economic growth. On the contrary, it induces the private sector to focus more on efforts that yield faster long-term economic growth. In this context, we can readily understand why financial markets welcome sus- tained low inflation. Uncertainty about future inflation raises the risks associated with investing for that future. Lowering that uncertainty by keeping inflation down diminishes those risks, so that all commitments concerning future income become more valuable. During periods of low inflation, stock and bond prices tend to reflect the higher valuation that comes from harnessing our physical plant more efficiently to provide improved opportunities in the future, including higher wages and profits. What investors fear, what all Americans should fear, are inflationary instabilities. They diminish our ability to provide the wherewithal for the standards of living of the next generation and the retirement incomes of our current work force. The inter- ests of investors as expressed in bond and stock markets do not conflict with those of average Americans—they coincide. In order to realize the benefits of low and declining inflation, the Federal Reserve policy has, for some time now, been designed to act preemptively—as I indicated earlier—to look beyond current data readings and base action on its assessment of where the economy is headed. Policy restraint initiated in February 1994 followed from the judgment that unchanged policy would encourage subsequent inflationary imbalances that would ultimately cut short the economic expansion. The three eas- ing steps in the past year were instituted when we anticipated that inflationary im- balances would be less threatening and that lower rates would be compatible with promoting sustainable economic expansion. Similarly, I am confident that the Fed- eral Open Market Committee would move to tighten reserve market conditions should the weight of incoming evidence persuasively suggest an oncoming inten- sification of inflation pressures that would jeopardize the durability of the economic expansion. The Ranges for the Debt and Monetary Aggregates The Committee selected provisional ranges for the monetary aggregates in 1997 that once again encompass the growth rates associated with conditions of approxi- mate price stability, provided that these aggregates act in accord with their histori- cal relationships with nominal income and interest rates. These ranges are identical to those endorsed for 1996—\ to 5 percent for M2 and 2 to 6 percent for M3. The Committee reaffirmed its range of 3 to 7 percent for the debt of the domestic non- financial sectors for this year and chose the same range provisionally for next year. The Committee's expectations for inflation and nominal GDP expansion in 1996 and 1997 suggest growth of the monetary aggregates at the upper ends of their bench- mark ranges as a distinct possibility this year and next, though debt should be in the middle portion of its range. The experience of the first part of the 1990's—when money growth diverged from historical relationships with income and interest rates—severely set back most ana- lysts' confidence in the usefulness of M2. Recently, there have been tentative signs that the historical relationship linking the velocity of M2—or the ratio of nominal GDP to the money stock—to the cost of holding M2 assets has reasserted itself. For now, though, the Committee is satisfied with watching these developments care- fully, waiting for more compelling evidence that M2 has some predictive content in forecasting current and prospective spending. Such evidence, however, at best will only accumulate gradually over time. Budgetary Policy Monetary policy is, of course, only one factor shaping the macroeconomic environ- ment. I thus would be remiss if I did not again emphasize the critical importance to our Nation's economic welfare of continuing to reduce our Federal budget deficit. We have made significant and welcome progress on this score in recent years. But unless further legislative steps are taken, that progress will be reversed. Inevitably, such changes will require addressing the consequences for entitlement spending of the anticipated shift in the Nation's demographics in the first few decades of the next century. Lower budget deficits are the surest and most direct way to increase national saving. Higher national saving would help to lower real interest rates, spurring spending on capital goods so as to put cutting-edge technology in the hands of more American workers. With a greater volume of modern equipment at their dis- posal, American workers will be able to produce goods that compete even more effec- tively on world markets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 The rally in capital markets last year that trimmed as much as 2 percentage points from longer-term Treasury yields was almost surely, in part, a response to the developing positive dialogue on deficit reduction. While the backup in intermediate- and longer-term market interest rates this year has mostly reflected the unexpected vigor of economic activity, market participants must also have been struck by the dying out of serious discussions that might lead to a bipartisan agree- ment to eliminate the budget deficit over time. Conclusion Mr. Chairman, our economy is now in its sixth year of economic expansion. The staying power of the expansion has owed importantly to the initial small size and rapid correction of emerging imbalances, reflected in part in the persistence of low inflation. To be sure, the economy is not free of problems. But as we address those prob- lems, policymakers also need to recognize the limitations of our influence and the wellspring of our success. The good performance of the American economy in the most fundamental sense rests on the actions of millions of people, who have been given the scope to express themselves in free and open markets. In this, we are a model for the rest of the world, which has come to appreciate the power of market economies to provide for the public's long-term welfare. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 RESPONSE TO WRITTEN QUESTIONS OF SENATOR D'AMATO FROM ALAN GREENSPAN Q.I. Information on inflation seem to be pointing in opposite direc- tions with the June average hourly earnings up significantly but the June CPI number up only one-tenth of a percent. What is your assessment on whether inflation is beginning to accelerate? Since the labor market is so tight, at what point will the American work- er stop worrying about job security and start looking for higher pay? A.1. Setting aside the effects of the run-up in oil prices earlier this year, measures of inflation to date have shown little or no tendency to pick up. However, it is apparent that labor markets have tight- ened considerably and that wages have accelerated somewhat. Given the importance of labor in the consolidated cost structure of the economy, this is a development that underscores the need for closer monitoring of the economy today, for signs of a possibly broadening inflation process. As I noted, there are indications that, whether or not they are looking for higher pay, workers have been getting it recently. And surveys of consumer sentiment suggest that perhaps households are feeling somewhat better of late about their economic situation. But I doubt that worries about job security will disappear entirely very soon, given the enormous flux in the economy and, especially, the rapid changes in technology. It seems to be clear that the accel- erated obsolescence of skills and knowledge associated with the on- going changes in the physical capital will continue to be perceived by workers as a threat to their job security. Q.2.a. Businesses looking to increase their markets overseas are concerned that any Federal Reserve action to raise interest rates will cause the dollar to strengthen against major currencies, fur- ther harming their competitiveness. What factors are likely to in- fluence the dollar's strength over the next year? A,2.a. In general, the most important factors affecting the dollar's strength in the short run are those that tend to be reflected in real long-term interest differentials between the United States and for- eign countries, notably relative monetary policy stances (and mar- ket anticipations of same), but also relative fiscal policy actions. Over the longer run such factors as current account balances, and the more structural forces behind these, such as savings propen- sities or productivity growth, are important. Also, at times, special factors such as political developments, e.g., the start of the next stage of European Monetary Union, may influence dollar exchange rates. For the near term, the attention of market participants seems mostly focused on whether U.S. growth is going to slow somewhat in the second half, whether inflation continues at its re- cent moderate pace, and whether European growth is going to re- cover from a period of slow-to-nonexistent growth; each of these has its implications for market anticipations of monetary policy actions, Despite the net appreciation of the dollar's weighted average ex- change value of 6 percent from its last low point in April 1995, the dollar is currently slightly below its average levels over the past 9 years and U.S. exporters remain extremely competitive, owing to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 very substantial gains in manufacturing productivity in recent years and to a high rate of product innovation. Q.2.b. To what extent are the central banks of other industrialized countries influencing the increasing strength of the dollar? A,2.b. There are two types of operations by foreign central banks that can influence dollar exchange rates. The first, and by far most important, is monetary policy actions. The second is (sterilized) for- eign exchange market intervention. Monetary policy easing actions in Europe and, especially, in Japan were important factors in the dollar's recovery from its 1995 lows. Intervention by major foreign central banks was a much less important factor. The only signifi- cant intervention in the second half of last year was by the Bank of Japan, which was trying to reinforce the effects of its monetary easing in reversing the precipitous rise of the yen against the dol- lar, which was widely viewed, including by United States officials, as contributing to the prolonged stagnation of the Japanese econ- omy. The Bank of Japan again intervened on a significant scale in February of this year when the yen suddenly surged against the dollar. Intervention purchases of dollars by several European cen- tral banks through July totaled an even larger amount; this inter- vention, as their currencies strengthened against the German mark, was by and large aimed at rebuilding reserve levels. Total intervention by fifteen major foreign central banks in 1996 through July amounted to purchases of $35 billion, not an extraordinary total for recent years. Q.3. In June, the Nation's unemployment rate dropped to its lowest level in 6 years—5.3 percent. Do you believe that the unemploy- ment rate masks under-employment and the number of people who have given up looking for jobs? A.3. Certainly, there are many workers not currently in positions that tap the full extent of their skills, and there are some individ- uals who have dropped out of the labor force entirely because they have become discouraged about the possibility of finding employ- ment acceptable to them. That said, however, there are widespread reports of difficulty in attracting qualified workers and signs of some bidding up of wages to attract labor. Q.4. Recent articles have linked you to a theory termed "opportun- istic disinflation." This theory, according to the Wall Street Jour- nal, calls for the Fed to guard against higher inflation in the late stages of a business cycle, which many would argue we are in now, but also suggests policymakers might tolerate a small rise in infla- tion as long as it remains within limits. Is the Federal Reserve practicing this theory of "opportunistic disinflation?" If so, please explain. A.4. The recent Wall Street Journal article referenced a theoretical paper by the Federal Reserve staff economists. The purpose of the paper was to fit one description of an approach to the Federal Re- serve policy—the so-called opportunistic approach—into a theoreti- cal framework. The approach to policy that the article described has not been adopted or agreed to by the Federal Open Market Committee, and the article was only one way of characterizing the approach. Even, those policymakers who consider themselves to be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 following an opportunistic approach might not agree with the de- scription of it in the paper. It is important to recognize that a num- ber of individuals participate in the monetary policymaking process and that there is considerable diversity among them in terms of their approach to policy; for that reason, it is not possible to state that monetary policy follows any one theory. Nonetheless, there is important commonality in policymakers' approaches: all FOMC members accept the importance of keeping inflation low, and all of their policy approaches, I believe, would involve firmly resisting any tendency for inflation to rise from current levels. Similarly, both approaches share the objective of making further progress over time toward price stability. Q.5. In recent testimony before this Committee, you spoke exten- sively about advances in technology and the failure of these changes to be fully reflected in productivity measures. What factors could speed the adjustment of our economy and its workers to fully benefit from improved technologies? A.5. This is a very interesting question, and one to which I can offer no certain answer. Education and training clearly are impor- tant, if our labor force is to fully exploit the technological opportu- nities. Because technology is often embodied in physical capital, we also should attempt to foster an environment conducive to invest- ment, and enhancing the pool of saving available for that purpose by reducing the Federal Government's deficit financing needs is an important step in this regard. Q.6.a. The FOMC has noted that the money supply measures may not be useful in guiding the Fed's macroeconomic objectives, partly because depository institutions hold a declining share of financial assets. What, if any, stable relationship still exists between the Fed's money supply measures and GDP growth? A-6.a. The relationship between money and nominal GDP growth has never been perfectly stable, but temporary changes in the rela- tionship of various measures of money to nominal GDP have his- torically been explained by other variables—most importantly, by changes in the opportunity cost of holding money, defined as the difference between market and deposit interest rates. However, in the early 1980's, the deregulation of deposit interest rates and the spread of NOW accounts undermined the use of transactions money, Ml, in monetary policy. During the 1980's, the broad mone- tary aggregate, M2, had the most reliable relationship to nominal GDP. However, in the early 1990's, the relationship of M2 to GDP was disrupted by a number of interacting developments, including greater availability and attractiveness of stock and bond mutual funds for households and the closure or merger of many troubled banks and thrift institutions. Over those years, M2 growth re- mained unusually weak, even as nominal GDP growth picked up after the recession. More recently, M2 growth seems to have returned to a more pre- dictable relationship to nominal GDP growth, although the level of M2 remains well below that predicted by the historical relation- ships (see chart). In light of the changes in the financial system, however, further evidence that a stable relationship will persist Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 will be needed before this aggregate can be given more weight in policymaking. Q.6.b. Is the Fed considering revamping the monetary aggregate measures in light of the changes in the financial services industry? A.6.b. Over the years, the Federal Reserve has from time to time adjusted the definitions of the aggregates in view of financial inno- vation and deregulation. The most recent complete overhaul was in 1980. Since then, we have analyzed, in addition to the standard monetary aggregates, a wide range of alternative monetary aggre- gates and indicators as part of our ongoing research in support of monetary policymaking. For example, alternative combinations of the components of the traditional monetary aggregates have been studied. One such recombination, which has received some atten- tion in the academic circles, is the aggregate called "money of zero maturity/' or MZM. MZM differs from M2 by excluding small time deposits and including institutional money ftmds. Federal Reserve studies of this aggregate suggest that, like Ml, it is too sensitive to interest rates to be a useful monetary target. In recent years, particular attention has been given to data on stock and bond mutual funds because of their increasing impor- tance in household portfolio choices. A number of Federal Reserve staff research papers have investigated alternative monetary aggre- gates that include household holdings of such mutual funds. In general, these studies have failed to uncover reliable relationships of these alternative aggregates with national income. Another recent research paper prepared by Federal Reserve staff noted that the evolution of the financial services industry since 1980 had diminished the degree of substitution between demand deposits and overnight wholesale liabilities of depositories (over- night RFs and Eurodollars). As a result of this work, a minor re- definition of M2 was undertaken in February 1996 to exclude the volatile overnight wholesale components. Although this change re- sulted in slightly less volatile weekly and monthly data on M2, it did not significantly alter the longer-term properties of M2 that are most relevant for monetary policymaking. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 M2 Velocity and Opportunity Cost - * -Bill 1979 1981 1983 19BE 1987 1989 1991 1993 1995 1997 1993 1994 1995 1996 Note W«Wy. through 8/7/96 Ratio Seals Harra Scale Psfcafitago Poinl [tan scale) I ( I 1979 1981 1983 19BS 19S7 1989 1991 ;993 1965 1997 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 RESPONSE TO WRITTEN QUESTION OF SENATOR MACK FROM ALAN GREENSPAN Q.I. Chairman Greenspan, I have heard you speak about the econ- omy in the past when you have implied that the non-inflationary growth rate of the economy is 2.5 percent. What needs to happen in order to increase the potential growth rate of the economy? A.1. As I have often said in testimony, owing to data inadequacies I am not sure what number I would put on the actual sustainable long-term growth rate of the American economy. But whatever the number, in a simple accounting, there are two major elements in potential growth: The expansion of our workforce and the increase in labor productivity. Labor force growth is largely determined by demographic trends, but it could be affected by the economic incen- tives to work outside the home. Labor productivity can be influ- enced by many factors that affect the allocative efficiency of the economy, including the regulatory environment, but clearly central is the process of capital deepening—the provision of more capital to leverage the available labor input. Reducing the Federal deficit is one way to help create financial conditions conducive to business investment and thus productivity growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 Real Economic Growth Annual Change in Real GDP or GNP 20.0% -15.0%-* 1690 1900 1910 1920 1930 1940 1950 1960 1970 1960 1990 Source: U.S. Department of Commerce Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 JIMSMMotional Association of Manufacturer* 96-148 NEWS CONTACTS: DAVID SHAPIRO (202) 637-3090 FOR IMMEDIATE RELEASE GORDON RICHARDS (202) 637-3078 NAM SAYS WALL STREET IS WRONG TO PUSH FOR HIGHER RATES WASHINGTON, D.C., July 9, 1996 — National Association of Manufacturers President 3cny lasinowski today criticized bond traders on Wall Street for calling on the Federal Reserve Board to raise interest rates in the wake of strong employment numbers. Jasinowskj, who has criticized the Fed in the past for keeping interest rates higher than necessary, today praised the Fed for holding rates steady. "The Federal Reserve made the right decision in not caving in to pressure from the bond markets to raise short-term rates. Despite tlie drop in the unemployment rate from 5.6 to 5.3 percent and the nine-cent jump in hourly earnings, there is no real justification for raising short-term rates now. Increasing rates would hurt U.S. sales overseas by raising the value of the dollar and would slow the domestic economy unnecessarily, affecting the job security and welfare of millions of Americans. "There are many reasons not to raise interest rates at this time. First, most of ihe measured rise in wages is due to temporary seasonal adjustment. Also, benefit costs have declined. Wages and benefits are almost perfect substitutes for each other. When benefits rose sharply in the early 1990s, this was paid foe by slower wage gains. With benefit costs under control, wages are rising to fill the gap. "There is little evidence that labor markets arc too tight, or thai wages are sei to explode. Since late 1994. the unemployment rate has fluctuated between 5.3 and 5.6 percent, and inflation has remained stable. The fact that inflation didn't accelerate supports the notion thai the NAIRU, or natural rate of unemployment, is quite low. We estimate that NAIRU is only 5.2 percent, which would explain why inflation has remained modest. Also, there is still an ample supply of skilled workers to fill the available jobs thanks to the availability of recent college graduates and older workers who were displaced during the restructurings of the early 1990s. "The second reason not to raise rates is that die uptick in growth in the second quarter is also likely to be temporary. While GDP will come in between 3.5 and 4 percent, this will be due largely to ihe inventory cycle in an auto industry still -MORE- J33> Pennsykamti Avenue, NW, Suite 1500-Nonti Tower. Washington. 0020004-1790 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 NAM SAYS NO REASON TO RAISE INTEREST RATES / Page 2 rebuilding stocks after the strike in the First quarter. "The panicky hysteria in financial markets over the possibility that the economy might overheat is ironic because recent growth rates have actually been weak. In the first quarter, GDP grew by only 2.2 percent, and in 1995 the fourth quarter to fourUi quarter gain in GDP was a paltry 1.3 percent. Claiming lhai these anemic growth rates represent overheating is not only wrong, it's completely irrational. "Third, the underlying inflation rate is not rising. The spike in prices in the first quarter was largely due to energy costs, which reflect low inventories and strong demand. In the first quarter, the GDP deflator increased by 2.4 percent — hardly a rapid rate of inflation — and would have advanced by only about 2 percent without the effect of energy. Further, once Iraqi oil comes into the world markets, energy prices will decline, and inflation should actually slow in the second half. In 1995, we saw something similar: the inflation rate spiked in the first half, but slowed in the second. "Fourth, after the surge in the second quarter, the growth rate should slow to about 2.4 percent in ihe second half. While April and May were strong, data for June suggests that consumer spending is slowing down. Higher long-term interest rates will slow credit-sensitive sectors such as consumer durables, construction and home buying. "Finally, the economy is not above its growth potential. In 1996, GDP should come in at about 27 percent on a fourth-quarter to fourth-quarter basis. Using inputs of labor, capital investment and advances in technology, we calculate that potential output for 1996 is 2.8 percent. While some analysts en (he bond markets have argued that potential is lower, this fails to consider the investment in new capital and technology since the early 1990s. As a general principle, monetary policy should allow GDP to grow at or near its potential. By implication, monetary policy should accommodate the current pick-up in activity. "The financial markets are wrong on the merits in clamoring for an interest rate increase. We hope the Federal Reserve will stick to its guns and repeat in August [he excellent decision they made in not raising rates in July," Jasinowski concluded. For additional information or to arrange an interview with Jerry Jasinowski, please contact David Shapiro at (202) 637-3090. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 For use at 19.06 BULL, E.D.T. Thursday July 16,1996 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 July 18,1996 Letter of Transmitta! BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C.. July 18,-1996 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES •> The'Board of Governors is pleased to submit Us Monetary Policy Report lo the Congress, pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Alan Greenspan, Chairman Table of Contents Page Section 1: Monetary Policy and the Economic Outlook 1 Section 2: Economic and Financial Developments in 1996 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 Section 1: Monetary Policy and the Economic Outlook The US. economy performed well in the firsi half reflecting importantly a deceleration of consumer of 1996. In early February, when the Federal Reserve spending. In addition, hesitant growth abroad and a prepared its last report oti monetary policy, there was strengthening in the foreign exchange value of the some concern about ihe strength and durability of the dollar relative to the levels prevailing at mid-1995 current economic expansion: The economy was were seen as limiting OK prospects for further growth operating at a relatively high level of resource utiliza- in exports. The slowdown in the growth of final tion, but it was not exhibiting a great deal of forward demand had given rise to inventory buildups in momentum. As the year has unfolded, however, eco- some industries; in turn, the production cutbacks nomic activity has proven quite robust. After rising undertaken in response to those buildups were hav- only fractionally in the fourth quarter of 1995. real ing a further damping effect on economic activity. gross domestic product posted a solid gain over the Meanwhile, data on prices and wages suggesied first half of 1996. providing a considerable lift to job that inflation performance continued to be fairly growth. Looking ahead, the members of the Federal satisfactory—indeed, better than many members of Open Market Committee (FOMC) anticipate that eco- the FOMC had expected as of midyear 1995. To nomic activity will grow more moderately, on aver- keep the stance of monetary policy from becoming age, in coming quarters and that the unemployment effectively more restrictive owing to the slowdown rate will remain around Hie level it has averaged over in inflation in the second half of last year, and to the past year and a half. promote sustainable growth, the Committee eased the stance of policy in December 1995 and again at the Although overall consumer price inflation was end of January 1996, bringing the federal funds rate boosted by higher energy prices during the first half down a half percentage point in total, to Sv* percent. of the year, the underlying trend of prices still appears to have been well contained. Over the past twelve Most participants in financial markets were months, the consumer price index excluding food and unsurprised by these policy adjustments, given the energy items has risen 2% percent—near the lower economic backdrop. Moreover, they anticipated that end of the narrow range that has prevailed since early there would be scope for additional easing steps in the 1994. Moreover, the deflator for personal consump- coming months. Thus, between mid-December and tion expenditures on items oiher than food and energy the end of January, interest rates on Treasury securi- derived from data reported in the rational income and ties generally moved lower, especially at short and product accounts has continued to show a slowing intermediate maturities, and stock price indexes trend. edged higher on balance. The dollar strengthened The combination of brisk growth and favorable slightly on net against the currencies of the other underlying inflation so far this year has. of course, G-10 countries, reflecting in part disappointing news been welcome. Nonetheless, mounting pressures on about the pace of activity in Europe and consequently resources are apparent in some segments of the larger declines in interest rates there than in the economy—most notably in the labor market—and United States. these pressures must be monitored closely. Allowing The underlying trends in the economy early in the inflationary forces to intensify would ultimately year were obscured to a degree by extraordinarily disrupt the growth process. The Federal Reserve adverse weather that affected a significant pan of (he recognizes that its contribution to promoting the country. Through the course of the next few months, optimal performance of the economy involves however, it became increasingly clear thai the econ- containing the rate of inflation and. over time, mov- omy had regained vitality. Consumer spending perked ing toward price stability. up after a lackluster holiday season, and was only temporarily depressed by the severe winter. Busi- Monetary Policy, Financial Markets, and ness demand for equipment proved quite strong, as did housing demand. The strengthening in sales the Economy over the First Half of 1996 facilitated businesses' efforts to control their inven- Information available around the turn of the year tories, and as that situation improved, industrial suggested (hat the economy had downshifted after production rebounded smartly. Overall employment posting a strong gain in the third quarter of 1995. The growth was brisk, and by June the unemployment rate growth of final demand appeared to have slowed. reached its lowest level in six years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 The Discount Rate and Selected Market Interest Rates Daily 12/20 2/1/95 11/15 12/19 1/31/96 1995 1996 Note. Dotted vertical lines indicate days on which Die Committee announced a monetary policy action. The ticks on the horizontal ajis indicate days on which the CommtteB held scheduled meetings. The last observation* are (CM July 16, 1996. Inflation during the first half of ihe year was gener- month bills has edged up only slightly. Despite the ally well behaved Energy prices surged, mainly in backup in bond yields, major stock-price indexes rose response to a runup in the world price of oil. and bad considerably further through the first half of the year, news about grain crops raised the prospect of higher most of those gains were erased in late June and the food prices down the road. However, price inflation first half of July, however, as company reports raised for consumer items other than food.and energy held questions about the pace of earnings growth. The rise steady or moved a bit lower. Labor costs presented a in bond yields has boosted the dollar in foreign mixed picture. The increase in total hourly compen- exchange markets; since mid-April, the dollar has sation over the first three months of the year, as generally traded against an average of the currencies measured by the employment cost index, was in line of the other major industrial countries about 4 per- with its recent moderate trend. However, within total cent above its level at the end of December. compensation, the wage and salary component of the During the first half of the year, credit remained ECI surged in the first quarter, and further signals of easily available to most household and business appli- wage acceleration came from a more rapid increase in cants. Interest-rate spreads on private debt over average hourly earnings in the second quarter. Treasury securities remained narrow. In response to Against the backdrop of stronger activity but (he rccens increase in delinquencies on credit-card subdued inflation trends, the Federal Reserve made accounts, many banks have tightened their standards no adjustments to its policy stance after January. With for approval of new accounts, but this appears to have economic activity more clearly on the upswing, how- only partially reversed a marked relaxation of such ever, and prospects for a breakthrough on the fed- standards earlier this decade, and banks overall eral budget seeming 10 fade, intermediate- and long- remain aggressive in the pursuit of new borrowers, lenn interest rates reversed course in February and especially business clients. The debt of all domestic trended up over subsequent morons. Since the end of nonfinancial sectors combined expanded at about a December, !he yield on ihe 30-year Treasury bond has 4Vi percent annual pace, placing this aggregate near increased about 1 percentage point, on net, while the the middle of its monitoring range. M2 and M3 are yield on the 5-year note has risen about 1V* percent- currently near the 5 and 6 percent upper boundaries age points over the same period. The rate on three- of their respective growth ranges, in line with the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 Economic Projections for 1996 and 1997 Federal Reserve Governors and Reserve Bank Presidents Administration Central Range Tendency 1996 Percent change. founh quarter Jo fourth quarter' Nominal GDP 43A to 53 StoSVi 5.0 Real GDP 2Yz to 3 21* tO 2% 2.6 Consumer price index-5 3 to 3V4 3 to 3'A 3,2 Average levsf in Ifie fourth quarter, percent Civilian unemployment rate 5'AtO 5% About SVs 1997 Percent change. fourth quarter to fourth quarter' Nominal GDP 4 to 5Vs 4V4 to 5 5.1 Real GOP 1 Vfe to 2 Vz 1V< to 2 % 2.3 Consumer price index2 2Y; to 3% 2% to 3 2.8 Average level in the founn quarter, percent Civilian unemployment rate 5ft to 6 SVfe to 5% 5.7 1. Change Irom average tor tourth quarter ol previous year 2. All uiban consumers. to average lot fourth quarter of year indicated FOMC's expectation as of last February. In comrasc on monetary policy. For 1997. the central tendency of to the experience of the early 1990s, growth in the the forecasts spans a range of 1 V< to 2V* percent. The monetary aggregates relative to nominal GDP has civilian unemployment rate, which averaged around been broadly in line wiih historical relationships, 5V] percent in the second quarter of 1996. is expected given the stmcture of interest raies. to stay near this level through the end of this year and perhaps to edge higher during 1997. Economic Projections for 1996 and 1997 Economic activity clearly retains considerable As noted previous!)1, the members of the Board of momentum. The trend in final demand is positive, and Governors and the Reserve Bank presidents, all of inventories appear to be well aligned with the cur- whom participate in the deliberations of the Federal rent pace of sales—perhaps even a bit lean. Accord- Open Market Committee, generally think it likely that ingly, the members of the FOMC recognize the pos- economic activity will return to a moderate growth sibility that growth could remain elevated a while. paih in the second half of 1996 and in 1997 after the wilh ihe potential for putting greater pressure on larger gains in the first half of this year. For 1996 as resources. Nonetheless, most members think thai a whole, this would result in an increase in real gross some slowing from the rapid growth pace recorded, domestic product in the range of 2W to 2V* percent, on average, in the first half is the most likely somewhat above the forecasts in the February repon outcome. Housing construction and other interest- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 Ranges for Growth of Monetary and Debt Aggregates Percent Aggregate 1995 1996 Provisional for 1997 M2 1 to 5 1 to 5 1 to 5 M3 2 to 6 2 to 6 2 tO 6 Debt1 3 to 7 3 to 7 3 to 7 Note. Change from average for fourth quarter of preeed- 1- Monitoring range k» debt ot domestic nonlinancial ing year to average for fourth quarter of year indicated. sectors. sensitive activity should be restrained to some degree The Committee's inflation projections incorporate by the rise in long-term interest rates over the past the technical improvements the Bureau of Labor several months. And. although some of the lagging Statistics is making to the CPI in 1996 and 1997; they economies abroad are expected, to perform better this are expected to shave a lirde from inflation in both year, there are still concerns about the solidity of thai years. The Committee also recognizes that the acceleration and the associated lift to US. exports. In remaining biases in the CPI are non-negligible and addition, growth in real business fixed investment may not be stable over time. Thus, it will continue to appears to be tapering off. although spending will monitor a variety of alternative measures of price likely remain buoyant, owing to the rapid caie of change as it attempts to gauge progress toward the product innovation and dramatic price declines in the long-run goal of price stability. computer area. Consumer spending is also expected The Administration has just released its midyear to grow less rapidly in coming quarters. Household update to its economic and budgetary projections. Its wealth has been boosted substantially by the runup forecasts for real growth and inflation in 1996 and in stock prices aver the past year and a half. bui. 1997 are broadly in line with the central tendencies of for many households, debt burdens have risen the forecasts of Federal Reserve policymakers. significantly in recent years and may represent a constraint on purchases of big-ticket items. Most members of the FOMC expect the rise in the Money and Debt Ranges consumer price index over the four quarters of 1996 tori996 and 1997 to be in the range of 3 to 3'/« percent, about At its meeting earlier this month, the Committee ¥4 percentage point higher than they predicted last reaffirmed the ranges for 1996 growth of money and winter. The projected increase in the CPI is also debt that it had established in February: l percent to somewhat larger than that recorded in 1995. How- 5 percent for M2.1 percent 10 6 percent for M3. and ever, that stepup would mainly reflect developments 3 percent to 7 percent for the debt of the domestic in the food and energy sectors, which are likely 10 add nonnnancial sectors. In addition, the Committee set to overall inflation in 1996 after having damped it in provisional growth ranges for 1997 at the same levels. 1995. Apart from these volatile sectors, inflation has remained in check so far this year despite high levels In setting the ranges for M2 and M3, the Commif- of resource utilization and reports that tightness in tee intended to communicate its expectation as to the some parts of the labor market is placing upward growth of these monetary aggregates that would pressure on wages. Assuming no further adverse result under conditions of approximaie price stabil- shocks to food and energy prices, and in the context ity, assuming that the aggregates exhibit the same of the Federal Reserve's intent to keep trend infla- trends relative to nominal spending that prevailed for tion well contained, the Committee believes that many years until the early 1990s and that seem to overall CPI inflation should recede. Accordingly, the have reemerged after an intervening period of marked central tendency of the FQMC's forecasts snows CPI deviation. Based on that reemergence and on Com- inflation dropping back to the range of 2V« to mittee members' expectations for the growth of 3 percent in 1997. nominal GDP in 1996 and 1997. the Committee Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 anticipates thai both M2 and M3 will probably tin- innovation stili occurring in the financial sector—and ish near the upper boundaries of their respective the attending uncertainty about che future beiuvior ol' ranges each year. The Committee expects the debt of the aggregates—the Committee will continue to rely the domestic nonnnancial sectors to remain near the on a wide range of other information in determining middle of its monitoring range in 1996 and 1997. In its policy stance, light of the rapid pace of technological change and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 Section 2: Economic and Financial Developments in 1996 Economic activity has increased substantially thus Change in Real Income and Consumption far this year. Reaf gross domestic product grew at an Percent annual rate annual rate of aboui 2'A percent in the first quarter of !996. and the available data poim to a much larger [] Disposable personal income increase in die second quarter. The increases in activ- 9 Personal consumption expenditures ity have been facilitated by generally supportive financial conditions: Although long-term interest rates have risen considerably on net since early 1996. imermediaries have continued to supply credit 10 most borrowers on favorable terms, and interesi-rate spreads on corporate securities over Treasury securi- ties have remained narrow. In the foreign exchange markets, ire dollar has appreciated on average against the currencies of trie other major industrial countries. Change in Real GDP 1991 1992 1993 1994 1995 1996 Percent, annual rate Outlays for durable goods have continued 10 be the strongest component of spending, emending (tie long- standing uptrend in the share of durables in lotal real consumption. Declining relative prices and the avail- ability of innovative products have continued 10 lift demand for home electronic equipment and software products. In addition, sales of light motor vehicles, bolstered by relatively generous incentives and per- haps by the cash freed up by the surge in mortgage refinancings last winter, averaged a tiealiMy 15 mil- lion unit annual rate in the first half of 1996. After a lackluster performance in 1995. real outlays for nondurable goods have also nsen this year, (he 1991 1992 1993 1994 1995 1996 average level of these expenditures in April and May was nearly 3 percent ai an annual rate above thai recorded in the fourth quarter. Meanwhile, spending Economic Developments on services has remained on a moderate uptrend, with short-run variauons reflecting the effects of weather The Household Sector on household energy use. After a sluggish performance in late J99.5. spend- Consumer spending has fjeen supported by brisk ing by households has picked up noticeably this year. gains in wage and salary income associated with Consumer expenditures increased about 3Vi percent the belter pace of hiring this year. However, other ai an annual rate in real terms in the first quarter and components of before-iax income, taken together, appear 10 have posted another sizable gain in the have risen less rapidly than they did in 1995. and second quarter. In addition, according to indexes such gains in after-tax income were restrained by larger- as those compiled by the Survey Research Center at than-usual tax bills (final payments less refunds) this the University of Michigan and the Conference spring. Accordingly, the level of the personal saving Board, consumer sentiment has generally been rate in May was somewhat below that recorded in late relatively upbeat. In the real estate market, sales of 1995. although fragmentary data suggest ihai saving new single-family dwellings have posted an average rose sharply in June. In any event, taking a longer level well above thai of last year, encouraging build- perspective, spending and income have grown at ers 10 boost housing starts. roughly similar rates over the past few years, and the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 saving rate has generally fluctuated in a fairly nar- the National Association of Homebuilders continued row band between 4 percent and 5 percent since to indicate solid demand through early July, and the 1993—a low level historically, Mortgage Bankers Association reported that loan applications for home purchases remained brisk The recent developments in financial markets may through midyear. have had an important influence on the spending deci- sions of individual households. In particular, house- Relative to the lows reached in early 1996. the rate holds holding large stock portfolios have enjoyed siz- on 30-year conventional fixed-rate home mortgages able increases in wealth over the past year and a half, has risen nearly 1 ¥* percentage points and has been which may be inducing them to consume greater frac- fluctuating around 8'A percent in recent weeks. How- tions of their incomes than they would otherwise. At ever, a number of factors seem to have cushioned the the same time, a growing number of households are effects of these higher mortgage rates. In particular, apparently finding it difficult to meet their debt- rates on adjustable-rate mortgages have risen only service obligations, judging from the appreciable rise about half as much as have those on 30-year fixed- in delinquency rates on consumer loans in recent rate loans. Also, house prices have firmed somewhat, yean. In addition, it is possible that job insecurity and which may have raised confidence in the investment longer-run concerns about retirement income have value of residential real estate and thus contributed to caused many households to raise their targets for ihe recent rise in the nomeownership rate, which is assei accumulation. However, the relative stability now at its highest level since the early 1980s, Prob- of the saving rale over the past tew years suggests ably more important in this regard, however, is the thai the net effect of these factors on overall trend in the affordability of housing. One simple consumption—at least to date—has been limited. measure of affordability is the monthly mortgage payment on a new home having a given set of Residential construction has. on the whole, been attributes, divided by average monthly household robust this year. Private housing starts averaged income. Despite the increase in mortgage rates this nearly 1.5 million units at an annual race through year, this measure suggests that the cash-flow burden June, a pace appreciably above that in 1995. In addi- of homeownership is still only modestly above the tion, the volume of shipments of mobile homes lows of the past thirty years. ("manufactured housing"); which has doubled over the past five years, now stands around 350,000 units Construction of multifamily housing averaged at an annual rate, the highest level since 1974. about 300.000 units at an annual rate in the first hall" of 1996. a rate somewhat above that in 1995 but a fairly low one historically. Market conditions vary Private Housing Starts geographically, but the rental vacancy rate for the Millions of units, annual rate nation as a whole seems to have tilted back up. after generally trending down between mid-1993 and mid- Quarterly average 1995. Also, the absorption rate, which measures the percentage of apartments that are rented within three Mull if amity 1.5 months of their completion, edged back down in 1995 after several years of increases. The Business Sector Developments in the business sector were quite favorable in the first half of 1996. After decelerat- 0.5 ing in 1995. real business fixed investment rose at a 12Vb percent annual rate in the first quarter of 1996, with sizable advances for both equipment and structures. And. although real investment appears to 1990 1992 1994 1996 have decelerated again in the second quarter, it prob- ably posted an appreciable gain. Over the past four In the single-family sector, starts and sales of new years, real investment has grown around 8 percent per homes were surprisingly firm in the face of severe year, on average, and now stands at a level that weather in early 1996. and they moved siill higher in implies quite substantial growth in the capital stock. the second quarter. Moreover, the regular survey of The updating of capital and the increase in capital per Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 worker are key to lifting productivity growth and liv- second quarter. In contrast, spending for commercial ing standards. structures other lhan office buildings, which has been rising briskly since 1992. continued to advance Outlays for producers' durable equipment rose at through the first quarter—although further gains may an annual rate of about 14 percent in real terms in the be limited by an emerging excess of retail space in first quarter, after a IVi percent rise over the course of some pans of the country and the recent leveling out 1995. As has been true throughout the expansion, of transactions pnces. Elsewhere, outlays for indus- much of the first-quarter growth was in real outlays trial construction, which had moved up over 1994 and for computers and other information-processing the first half of 1995, have been nearly flat over the equipment; such investment received particular past few quarters, while construction of hotels and impetus from extensive price-cutting in virtually all motels, which account for less than 10 percent of segments of the computer market and from a push structures outlays, has boomed. to acquire the state-of-the-art equipment needed to take full advantage of popular new software and Investment in nonfarm business inventories slowed opportunities for information transfer. However. dramatically in the fourth quarter of 1995 after run- incoming orders data and recent anecdotal reports ning at a fairly rapid pace over much of last year, and suggest that the growth in real computer outlays may it nearly ceased in the first quarter of 1996 as motor be slowing. Meanwhile, demand for other types of vehicle stocks plummeted. Automotive stocks had capital equipment, which had softened in 1995. risen appreciably over the second half of 1995. and firmed somewhat in the first quarter. some reduction was in train even before a March strike at General Motors curbed production; with the strike, dealer stocks were drawn down sharply. In Change in Real Business Fixed Investment addition, although firms outside motor vehicles appar- Parceni, annual rate ently made considerable progress in rectifying inven- tory imbalances in late 1995. many continued to restrain production in response to continued weak orders in early 1996: producers of household dura- bles and textiles are notable examples. Change in Real Nonfarm Business Inventories Percent, annual iale 1991 1992 1993 1994 1995 1996 In the nonresidential construction area, real invest- ll II ment continued to expand in the first quarter. How- ever, the monthly data suggest that outlays softened in the second quarter, an occurrence that is consistent with the downturn in contracts—a forward-looking indicator of construction outlays—since late 1995. 1991 1992 1993 1994 1995 1996 Trends within the construction sector have been divergent. In the office sector, the modest recovery that seemed to be under way appears to have waned Inventory investment evidently rebounded in the even though vacancy rates have continued to fall and second quarter, mainly because motor vehicle stocks Transactions prices have continued to rise. Outlays stabilized as sales and production returned to dropped noticeably in the founli quarter of 1995 and rough balance. Outside of motor vehicles, stocks the first quarter of 1996. and preliminary data sug- accumulated moderately, on balance, in April and gest that they remained at a fairly low level in the May. As of May, inventory-sales ratios for all major Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 sectors were noticeably below their levels in late the same pace as hnd been recorded, on average, over 1995: the decline in the ratio for retailers was espe- the preceding four years. If present trends continue, cially sleep. the fiscal 1996 deficit, when measured as j percent- age of nominal GDP, will be the smallest since (979. Economic profits of all U.S. corporations continued to surge in the first quaner. extending the steep climb Federal receipts in the first eight months of fiscal that began in the early 1990s. The strength in profits 1996 were 8 percent higher than in the same period a in recent quarters has been attributable in large pan to year earlier, the rise was considerably greater than robust earnings growth at domestic financial institu- that of nominal GDP. Boosted by the upswing m busi- tions and a rebound in profits at foreign subsidiaries ness profits, corporate taxes have been increasing at of U.S. corporations. In the domestic nonfinancial double-digit rates since fiscal 1993. and that path has corporate sector, the profit share—pre-tax profits extended into fiscal 1996. Individual income taxes divided by the sector's GDP—has been hovering have also risen sharply this yean little information is around 10 percent since mid-1994, after having risen available on the factors behind (he surge in individual appreciably over the preceding few years: its current payments, but it may have resulted, at least in pan. level is similar to the levels attained in the mid- from capital gains realizations associated with the 1980s but well below the highs of the 1960s and strong performance in financial markers Jasi year. 1970s. About half of the increase in the sector's profit In total, federal outlays in the first eight months of share since the early 1990s has reflected a reduction fiscal 1996 were 4 percent higher than during the cor- in net interes; expenses. responding period of fiscal 1995. Outlay growth was damped by the reductions in discretionary domestic Before-Tax Profit Share of GDP spending implied by this year's appropriations legistation. However, expenditures for "mandaiory" programs continued to rise rapidly, and net outlays for N on financial corporations deposit insurance were less negative than in 1995 (i.e.. insurance premiums and the proceeds from net 15 sales of thrift assets declined). In addition, net inter- est payments increased moderately, reflecting the growth in the stock of outstanding federal debt. 10 Federal expenditures on consumption and investment—[he pan of federal spending included directly in GDP—increased at an annual rare of about 6 percent in real terms in the first quaner of 1996 after declining about 13 percent in the fourth quaner i i MJ i jj i i 1111 i M i i i i i i i i i i i i i i i Change in Real Federal Expenditures 1966 1976 1986 1996 on Consumption and Investment Note. Profits from donwafb operatore wftfr inventory valua- tion and cap Hal coosumpbon adluatmants. <£vkfed by gross Percent, annual rale domestic product ot nonfinancial cotpoiate sector. Seasonally adjusted The Government Sector 1 AJttiough the nation continues to grapple with the HT ! prospect of growing federal budget deficits in the years ahead, the incoming news on the budget for fis- cal 1996 has been extremely favorable. The deficit in the unified budget over the first eight months of the fiscal year—the period from October to May—was only $109 billion. S27 billion less than during the 10 comparable period of fiscal. 1995. The improvement in the deficit primarily reflected exceptionally rapid I I 1 I I 15 growth in receipts; outlays continued to rise at about 1991 1992 1993 1994 1995 1996 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 of 1995. In pan. real spending rose in the firs! quaner Receipts of siaie and local governments rose about because the government shutdowns thai occurred dur- 4 percent in nominal terms over the year ending in the ing ihe budget crisis depressed real spending less in first quaner. about matching the rise in nominal GDP. the first quaner than in the fourth. Even so. given the The sector's own-source general receipts, which enacted appropriations, the first-quarter increase was comprise income, corporate, and indireci business almost surely a transitory spike. taxes, rose about 1 percentage point faster, with solid gains in all major components. Federal grams have The fiscal position of stales and localities has been changed little, on net. over the past four quarters. relatively stable in the aggregate over the past few years. As measured in [he national income and The External Sector product accounts, the surplus (net of social insur- ance funds) in the sector's operating accounts has The nominal trade deficit in goods and services fluctuated in the range of $30 billion to $40 billion widened from its low fourth-quaner level of S78 bil- (annual rate) since the beginning of 1994; it stood lion ai an annual rate to $97 billion in the first quaner around the middle of that range in the first quaner. On of 1996. slightly less tfian the deficit of 5105 billion the whole, these governments are in considerably bet- for 1995 as a whole. The current account deficit stood ter shape than they were in the early 1990s. Even so. at $142 billion (annual rate) in the first quarter, about the sector remains under pressure 10 balance rising the same as the figure for 1995 as a whole. In April, demand for services—especially in education, correc- the trade deficit increased from the average level for tions, and health care—against the public desire for the first quaner. tax relief. Real expenditures on consumption and gross investment—the pan of state and local spending U.S. Current Account included directly in GDP—declined somewhat in the Billions of dollars, annual rale first quarter of 1996. However, the decrease reflected primarily the effects of the unusually adverse winter weather, and spending appears to have rebounded in the second quaner. State and local employment posted a respectable gain, on net. over the first six months of the year. In addition, outlays for construc- tion rose about 3 '/i percent in real terms over the year ending in the first quarter, reflecting higher spending - 100 on highways and schools; monthly construction data through May suggest that spending rose substantially in the second quarter. - 150 Change in Real State and Local Expenditures 200 on Consumption and Investment 1991 1992 1993 1994 1995 1996 Percent annual rate Seasonally adjusted After expanding very slowly during the second half of 1995. the quantity of U.S. imports of goods and services rose about 10 percent at an annual rate in the first quaner. and preliminary data for April show anodicr sizable increase. The rebound in imports largely reflected the strengthening of U.S. economic activity. In addition, non-oil import prices have declined somewhat since last fall, after having risen sharply in late 1994 and early 1995. A turnaround in imported automotive vehicles, consumer goods, and non-oil industrial supplies, following more than six months of declines, accounted for most of the I I increase in imports during the first four months of 1991 1992 1993 1994 1995 1996 1996. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 Change in Real Imports and Exports expanded nearly 5 percent at an annual rate in the of Goods and Services first quaner, supported by a very sizable rebound in Percent, annual rate consumption as well as leap-year effects; strikes dur- ing the fourth quaner of iast year depressed eco- U Imports nomic activity and contributed to a decline in private I Exports consumption spending. Indicators for the second quarter suggest that output growth moderated from its first-quarter pace. In the United Kingdom, real GDP 10 grew at an annual rate of 1V4 percent during the first quarter., somewhat more slowly than during the second half of 1995. On the policy front, most Euro- pean countries are seeking to rein in their fiscal deficits dining 1996 and 1997, in pan to comply with the criterion in the Maastricht Treaty that countries participating in the third stage of the European Mone- tary Union, now scheduled to begin on January 1. 1999, not have excessive fiscal deficits. As a refer- 1991 1992 1993 1994 1995 1996 ence value, the treaty specifies that deficits greater than 3 percent of a country's GDP are excessive, but The quantity of U.S. exports of goods and ser- it also provides scope for accepting deficits above that vices expanded at a 2 percent annual rate during the level in some circumstances. firs quaner: it also appears lo have expanded at about this pace in April. The somewhai subdued pace of In Mexico, robust growth of real GDP in the first export growth so far this year reflects in pan a bunch- quarter extended the recovery in economic activity ing of shipments, particularly of machinery, that that began in the second half of 1995. Through June, resulted in an unusually strong increase in exports in the Mexican trade balance remained roughly stable at the fourth quarter of last year. the level reached toward the end of last year, after having improved markedly over the course of 1995, Trends in economic activity have vaned across the Argentina also appears to be emerging from the steep major foreign industrial countries so far in 1996. In declines in output experienced during the first half of Japan, economic recovery appears to have taken hold, 1995, while Chile continues to enjoy steady growth, although the underlying pace of real GDP growth is Activity in Brazil has begun to expand again in recent clearly less than the nearly 13 percent annual rate months, following a sharp contraction in mid-1995. reported for the first quarter the first-quarter growth rate was boosted in pan by a temporary surge in Economic growth in our major Asian trading government spending and measurement practices partners (other than Japan) appears to have picked i"? associated with the leap year.1 In Canada, growth again this year after slowing noticeably during die remained subdued in the first quarter as real GDP rose second half of 1995 from the extremely rapid rates only I1/* percent at an annual raw despite much recorded m 1994 and the first half of 1995. The recent stronger growth in domestic demand; indicators for pickup in activity was associated with an easing of the second quarter suggest some strengthening. monetary policy in some of these countries in the second half of last year and the early pan of this year. Economic performance so far this year in Europe In China, output appears to have expanded during the has been mixed. In Germany, real GDP declined first quarter at around the 10 percent annual rate another IVi percent at an annual rate in the first recorded in 1995. with a pickup in consumption quarter, largely because severe weather caused a spending compensating for weaker growth in the substantial contraction in construction spending: external sector. preliminary data suggest that construction activity rebounded in the second quarter wicft the return to Consumer price inflation generally stayed low in more normal weather. In contrast. French real GDP the major foreign industrial countries and declined or remained moderate elsewhere. In Japan, prices in the I. Although ihf statistical agencies in many countries uJte the second quarter, on average, were slightly above their number of working days in the quarter inlo accounr when tenon- year-earlier levels because of the effects of yen depre- ally adjusting data, (he naiisucil agencm in Japan, Franc*, and ciation on import prices: this upturn followed a year Italy among ihr G-IO countries do nol make working-day adjuiUwnis. of deflatioa In western Germany, inflation slowed Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 through June to only about IV* percent. Inflation in Civilian Unemployment Rate Italy remained higher than in the other major for- eign industrial countries out slowed to below 4 percent through June. In Canada, inflation also moved down funhci this year, to about 1V: percent in May. Inflation trends in Latin America have been mixed In Mexico, the twelve-month change in consumer prices diminished lo about 32 percent in June, compared with a reading of 52 percent for the twelve months ending in December 1995. Consumer price inflation has also declined further in Brazil and remained low in Argentina. In contrast, prices have picked up in Venezuela in response to the depre- ciation of its currency associated with the adoption of a program of macroeconomic stabilization. In Asia 1990 1992 1994 1996 inflation has decreased so far in 1996 in China and Note. The brwak in data «t January 1994 mart™ the introduc- remained moderate to low elsewhere. tion of a redesigned survay; data from thai point on an nM directly cort^Mrabte with the data ot earlier periods, Labor Market Developments Labor demand was strong over the first half of vices, growth in employment in business services 1996. Growth in nonfami payroll employment remained rapid, with large gains at computer and data exhibited considerable month-lo-month variability but processing firms as well as at temporary help agen- averaged a hefty 235.000 per month. In addition, the cies, and employment in health services trended up civilian unemployment rate remained low. holding in further. In addition, construction payrolls rose a brisk the narrow range around 5Vi percent that has 30,000 per month, on average—an annual rate of prevailed since late 1994.' about 7 percent Elsewhere, payrolls at wholesale and retail trade establishments continued to increase at about the same pace as that in 1995, and employ- Net Change in Payroll Employment ment in the finance, insurance, and real estate cate- Thousands of joba, average monthly change gory picked up after having been nearly flat over 1994 and 1995. Total nonfarm Developments in manufacturing were uneven but showed some improvement in the second quarter. As 400 1996 started, firms were still adjusting employment to I the slower path of output that had been evident since early 1995. and payrolls—especially at firms produc- 200 ing nondurable goods—were reduced further. In the past three months, manufacturing employment has held fairly steady, buoyed by the pickup in indus- trial activity, and the average factory workweek, which had contracted appreciably in 1995, trended up through June. 200 For the nonfami business sector as a whole, 1990 1992 1994 1996 productivity rose at an annual rate of about 2 percent in the first quarter of 1996, echoing the Employment gains were fairly broadly based over acceleration in output. However, productivity had the first half of the year. The services sector, which posted an outright decline in the fourth quarter of now accounts for nearly 30 percent of nonfarm 1995; all told, productivity rose about I percent over employment, continued to be a mainstay of job the year ending in the first quarter of 1996, in line growth, showing increases of nearly 120.000 per with the average pace this decade. In the manufactur- month, on average, over the first half. Within ser- ing sector, productivity rose 4!4 percent over the pasi Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Change in Output per Hour for the redesign of the household survey in 1994) has Percent. 04 to 04 changed little, on net. since 1989. after rising fairly steadily from (he mid-1960s to the laie 1980s. The Nonfarm business sector flattening reflects mainly a marked deceleration in women's participation, owing both to a leveling oft" in the perceniage of women who are in the labor force for at least part of a given year and slower growth in the average number of weeks they spend in the labor force that year. Moreover, with the average number of weeks these women spend in the labor force having risen to a level only slightly below the average for men. a significant rebound in participation does not seem very likely over the near term. The sluggish- ness in participation tends to restrain the growth of potential output unless it is offset by a better productivity performance or by faster growth in che 1990 1992 1994 1996 working-age population—neither of which has yet Note Value lot 1996 is measured from 1995:01 to 1996:Q1. been in evidence. Despite the tightness in labor markets in recent quarters, the broad trends in hourly compensation year, alihough the reported increase was probably appear to have heid fairly steady. The employment overstated because firms in this sector have been rely- cost index for private industry—a measure that ing increasingly on workers supplied by temporary includes wages and benefits—rose at an annual rate help firms, who are counted as service industry of about 3 percent over both the first three months of employees rather rhan as manufacturing employees in 1996 and over the twelve months ending in March: the establishment survey of the Bureau of Labor the ECl had also increased about 3 percent over the Stan sties. twelve months ending in March 1995. Compensa- Labor force participation has remained sluggish tion growth has continued to be damped by a marked this year. The participation rate, which measures the deceleration in employer-paid benefits—especially percentage of the working-age population that is payments for medical insurance, which have been either employed or looking for work, did retrace the restrained by the slowing in medical care costs, the dip thai occurred in late 1995. But. taking a longer switch in insurance arrangements from traditional perspective, the overall participation rate (adjusted indemnity plans to HMOs and other managed care plans, and changes in the provisions of health plans (including greater sharing of health care costs by Labor Force Participation Rate employees). On the whole, wages also seem to have been held in check, although the most recent data may be hinting at some acceleration. Ntxably. the wage and salary component of the ECI rose sharply in the first quarter, although the data are volatile and the 66 first-quarter figure likely overstates curreni wage trends, the twelve-month change in the series moved up to 3'/i percent, nearly Y2 percentage point larger than the increases in the preceding two yean. 63 Separate data on average hourly earnings of produc- tion or nonsupervisory workers also show a recent ac- celeration in wages: the twelve-month change in this series moved up to about 3Vi percent in June. Price Deveiapmeats 57 1971 1976 1981 1986 1991 1996 The underlying trend of prices has remained favor- ho N ld o t s e u . r v P e r y e . -1904 dita adjusted tor the redesign of the house- able this year—notably, the CPI excluding food and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 Change in Consumer Prices Excluding about 2% percent over the twelve months ending Food and Energy in June: excluding food and energy, the PPI rose Percent, Dec. to Dec I1/: percent, a bit less than over the preceding year. Consumer energy prices picked up around the rum of the year and rose at an annual rate of about 12 percent, on net. over the first six months of 1996. With crude oil stocks drained by Mrong worldwide demand for healing oil and weather-related supply disruptions in the North Sea and elsewhere, the spot price of Wesi Texas intermediate (WTI) soared from around S18 per barrel, on average, in the second half of 1995 to a high of around S25 per barrel in - 2 mid-April; the WTI price has since retraced much of thai runup. Reflecting the surge in crude oil prices, retail prices of refined petroleum products rose sharply through May. on balance. However. 1990 1992 1994 1996 they fell markedly in June, and private surveys of Note. Consigner price index fcx «H ufatm consumer*. Value for gasoline prices imply a further decrease in early 1996 a measured Irom December 1995 to Jun* 1996, at an July. •muaJ rale. Retail food prices rose at an annual rate of about 4 percent over the first six months of 1996. somewhat energy rose at an annual rale of 23/« percent over the above the pace of the preceding few years. At (he firsi six months of the year, near the lower end of farm level, prices of grains and other commodities the narrow range than has been evident since early rose to exceptionally high levels as adverse crop 1994. Developments in food and energy markets conditions in some pans of the country exacerbated boosted overall Inflation, however, and the total CP1 an already tight stock situation. For some rose at an annual rate of 3 1/2 percent over the first foods—notably, dairy products, cereals and bakery half: this pattern was the reverse of that seen in 1995, products, poultry, and pork—the pass-through tends when a small drop in energy prices, combined with to occur relatively rapidly, and retail prices of such only a modest increase in food prices, held the rise items have already risen appreciably. Beef prices fell in the total CPI to just 2Vi percent. Meanwhile, through May as producers sold off nerds in response the producer price index for finished goods rose to higher feed costs and poor range conditions; they turned around in June and will likely rise further over the next several quarters as the sell-off of breeding Change in Consumer Prices stock will eventually lead to tighter supplies. Percent. Dec. to Dec. Price increases for consumer goods other than food and energy slowed to l percent at an annual rate over the first half of 1996, after averaging about 1 Vi percent per year over the preceding three years. Increases in goods prices have been restrained in pan by the uptrend in the dollar since mid-1995, which has helped to damp import prices. In addition, with the operating rate in the manufacturing sector hav- ing fallen to about its long-term average, pressure from the materials side has been limited. Indeed, the - 2 PPI for intermediate materials (excluding food and energy) actually fell a bit over the past twelve months, after having risen 7Vi percent over the preceding year. Looking ahead, however, the latest 1990 1992 1994 1996 rcpon from the National Association of Purchasing Not*. Corwunw price Index lor all urban oon*umn. Value tot Managers suggests that vendor performance 1906 i» maMUred from Decerrtoer 1995 to Jun* 1986, at an annual rale. deteriorated markedly in June, a development that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 could portend some firming of prices of materials and Debt: Annual Range and Actual Level supplies over the near term. Billions o* doHars Prices of non-energy services rose 33/4 perceni at an Domestic nonfinancial sectors annual rate over the first half, about the same as the rise over 1995 as a whole. Airfares accelerated 14400 significantly in the first half. However, shelter costs increased less rapidly tlnin they had in 1995, and 14200 prices of medical care continued to decelerate: over the six months ending in June, the CPI for medical care services rose at an annual rate of only about 14000 3Vt percent, roughly l percentage point below the 1995 pace. Moreover, there is some evidence that the CPI may be understating the recent slowing in medi- 13800 cal care inflation, in pan because it does not fully capture the discounts negotiated between medical 13600 providers and insurers, including managed care plans. 0 N D The price measure used to deflate consumer 1995 1996 expenditures on medical care in the N1PA better reflects such factors; it rose Jess than 2 perceni over row spreads of interest rates on corporate securities the year ending in the first quarter of 1996. after hav- over those on Treasury securities. The debt of domes- ing risen 4Vj percent over the preceding year. tic nonfinancial sectors increased about 4% percent at Judging from the various surveys of consumers and an annual rate from the fourth quarter of 1995 forecasters, expectations of near-term CPI inflation through May of this year, a bit more slowly than last deteriorated slightly in the first half" of 1996. NocaWy. year but still sufficient to place the level of this aggre- although both the University of Michigan and the gate in the middle of its monitoring range for 1996. Conference Board had reported a noticeable drop in Thf Government Sector. Federal debt out- their one-year-ahead measures in the second half of standing increased about 4 percent at an annual rate 1995. that improvement was not sustained in 1996; over the first half of 1996. a shade below the aver- the recent monthly readings have bounced around, age rate of increase last year. The impasse over the but the June results from both surveys were similar to debt ceiling disrupted the timing and size of some those recorded, on average, in the first half of 1995. Treasury auctions but did not alter the longer-term In contrast, longer-run inflation expectations, which trajectory of federal debt. have presumably been less affected by the recent news in food and energy markets, have held fairly The pattern of net borrowing by state and local steady. Smoothing through the monthly data, the governments in the last several years has been heavily University of Michigan's measure of expected CPI influenced by their efforts to retire debt issued at inflation over the next five to ten years has not relatively high interest rates in the mid-1980s. They changed much since late 1994, and the survey of have pursued these efforts through a strategy of professional forecasters conducted by the Federal advance refunding: In the early 1990s, when bond Reserve Bank of Philadelphia during the second yields were seen as especially favorable, state and quarter of 1996 produced the same expectation for the local governments issued new debt, even before call ensuing ten years as that in the survey taken in the provisions on the older bonds could be exercised, and fourth quarter of 1995. placed the proceeds in escrow accounts. As it became possible to do so. the issuing governments began call- ing the older debt, using the contents of the escrow accounts to complete the transactions. Reflecting Financial Developments these retirements, the amount of state and local government debt outstanding declined about Credit 4 percent per year in 1994 and 1995. This process is Financial conditions in the first half of 1996 sup- still in train but evidently on a smaller scale: avail- ported the pickup in the growth of spending. For the able information suggests that state and local govern- most pan. lenders continued to pursue credit appli- ment debt outstanding declined only marginally dur- cants aggressively as reflected, for .example, in nar- ing the first half of this year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 The Household Sector. The pace of borrowing Delinquency Rates on Household Loans by households appears lo have moderated somewhat from (he elevated rates of 1994 and 1995. but it Quarterly remains substantial. In particular, consumer credit expanded at a 9Vi percent annual rate from the fourth quarter of 1995 through May of this year, down from l4'/i percent over the four quarters of 1995. Mort- gage debt actually expanded somewhat more rapidly during the first quarter than in 1995 (7V percent at an 4 annual rate versus 6Vi percent), and available indica- tors suggest that growth during the second quarter dropped back only to about lasi year's pace. The recent backup in mortgage rates, which only began in February, has had linte effect on borrowing thus far. and might even have increased it temporarily by accelerating transactions. I I I I I l_l I I I I I I I |_| I I 1980 1984 1983 1992 1996 The rapid growth in household, debt during the past •The laal data point is an average of the delinquency rate* lot few years has resulted in a sizable increase in the April and May 1996. estimated ratio of scheduled payments of principal and interest to disposable personal income. This first few years of the current economic expansion. measure of debt-servicing burden has trended up over The delinquency rate on auto loans at the finance the past two years, and as of the firs: quarter of 1996. companies affiliated with the major manufacturers was approaching—but still short of—the levels moved up sharply beginning about two years ago. and attained toward the end of the last business cycle since late last year has hovered around historically expansion. high levels. Anecdotal evidence suggests that the rise in both credit-card and auto-loan delinquency rates Household Debt Service Burden reflects a strategy to liberalize lending standards as Percent of dapoaabto penorwt income pan of an overall marketing effort. The auto loan delinquency rate has also been boosted a bit by the Quarterly increased prevalence of leasing. Lease customers tend to be better credit risks than the average conventional 17 borrower, and the shift toward leasing has had the effect of skimming the more financially secure car buyers and thus degrading somewhat the remaining pool of people financing their purchases through conventional loan contracts. The personal bankruptcy rate also surged to a new 15 high this year. The extent to which this develop- ment reflects mounting financial difficulties of house- holds is clouded, however, by changes in federal law i i i i (effective at the start of 1995) that may have increased the attractiveness of bankruptcy by increas- 1984 1986 1988 1990 1992 1994 1996 ing the value of assets that can be protected from Note. Debt Mrvice i* the »*n of required interatt and principal payments on houMhold-*actor mortgage and consumer debt liquidation in bankruptcy proceedings. The "cost" of bankruptcy to households also has been effectively lowered by the greater willingness of lenders to Several other recen; indicators suggest that some extend credit to riskier borrowers—even those with a households are experiencing financial strains. For previous bankruptcy on their records. example, the Consolidated Report of Condition and Income shows thai the delinquency rate on credit- Other indicators are less suggestive of a deteriora- card receivables at commercial banks has increased tion in the financial condition of households. For significantly in recent quarters, retracing about one- example, the delinquency rate for mortgage loans third of the improvement that took place during the sixty days or more past due at all lenders is near its Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 Household Net Worth traced to the behavior of the financing gap tor Percent of disposable personal income incorporated nonfinancial enterprises—the excess of their capital expenditures (including inventory invest- Four-quarter moving average ment) over their internally generated funds. During 500 1995. this gap narrowed quite substantially, reflect- ing strong profits and a marked reduction in inven- 475 tory investment. Available indications are that the gap has remained smalt this year. 450 External funding for business spending has been in plentiful supply thus far this year. One piece of 425 evidence on this point is that interest-rate spreads on invesimera-grade bonds have edged down slightly 400 since the beginning of the year. Additionally, spreads on high-yield bonds have declined markedly, and are as low as they have been in ai (east a decade. 1966 1972 1978 1984 1990 1996 Also, supply conditions for loans from banks to busi- nesses continue to look quite favorable. According to the Rderal Reserve's most recent survey of bank lowest level in two decades, white the rate on closed- lending officers, standards for approval of com- end consumer loans—despite having moved up over mercial and industrial loans were about unchanged the past eighteen months—remains low by historical from January to May of this year, and terms on such standards. Moreover, the aggregate balance sheet of loans were eased on net Surveys by the National the household sector clearly is in very good shape: Federation of Independent Business indicate that owing in large pan to the surge in equity prices over small businesses have not faced difficulty getting the past year and a half, the ratio of household net credit, and stories abound of new small-business worth to disposable personal income moved up into lending programs of banks. record territory recently. Gross offerings of long-term bonds by nonfinancial Apparently in response to the recent runup in corporations have been running about in line with last delinquency and charge-off rates on consumer loans. year's pace. However, the mix of issuers has shifted banks have selectively lightened their standards for somewhat, reflecting the changing structure of rates. consumer lending. These actions reversed steps taken Late last year and early this year, investment-grade earlier in the decade, when many card issuers corporations were issuing a hefty volume of bonds in increased the growth of their credit card receivables order to pay down commercial paper and to refinance by offering accounts to customers who previously existing long-term debt. As the rates on invesunent- would have been denied credit. The belief was thai grade bonds increased this year, issuance of such debt more sophisticated credit scoring techniques would dropped off. Rates on high-yield bonds moved up control risks adequately, but it appears that some less, however, and issuers of those bonds continued to "adverse selection" occurred and that the uptick in offer new debt at a rapid pace. delinquencies has been larger than at least some banks had planned. About 20 percent of the Gross issuance of equity shares by nonfinancial respondents in the Federal Reserve's most recent corporations has been exceedingly strong this year. survey of senior loan officers reported having Indeed, total offerings in each of (he three months of tightened standards for approving applications for the second quarter set successive monthly records. credit cards, and 10 percent reported tightening This activity has been fueled by initial public offer- standards for other consumer loans. Notwithstand- ings and other equity issuance by relatively young ing the recent tightening of standards, supply condi- companies. Share retirements by nonfinancial tions for loans from banks to consumers still appear corporations have aiso been very heavy. Announced accommodative. stock buybacks by such firms in both the first and second quarters ran at $28 billion per quarter—the The Business Sector. The debt of nonfinancial fastest pace since the late 1980s. On net. available businesses also appears to have expanded somewhat information suggests that nonfinancial corporations less rapidly during the first half of 1996 than it did retired even more equity during the first half of 1996 last year. In pan. the moderation in borrowing can be than they had in 1995. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Shan: retirements and merger activity have gener- M3; Annual Range and Actual Level ated much less issuance of dels recently than they did BiHiQns of dollars in the 1980s. Recent share repurchases have been undertaken mostly by companies seeking to return the excess cash on their balance sheets 10 stockholders. 4750 And recent mergers and acquisitions have mainly been accomplished through stock swaps between 4700 companies in similar lines of business, rather than the leveraged transactions commonplace in the 1980s. In 4650 line with the limited extent of debt financing, the mergers executed ihus far in 1996 have resulted in little fiet change in bond ratings—again in marked 4600 contrast to the experience of the 1980s. 4550 Depository Intermediation. The growth of credit provided by depository institutions slowed sharply in the fourth quarter of last year and first O N D J F M A MJ 4500 quarter of this year, and commercial bank credit—a 1995 1996 component of total depository credit for which more recent data are available—slowed further in the second quarter. The share of thrift institutions in total market mutual funds increased about 18 percent at an depository credit has continued to decline in recent annual rate over this period. This component of the quarters. This long-standing trend may have been money stock increased especially rapidly during [he given additional impetus last summer by the open- first three months of the year. Often, the yields on ing up of a differential between the premium rates these funds lag changes in short-term market inter- paid by banks and thrifts for their deposit insur- est rates, making them particularly attractive invest- ance: this differential has reduced the cost of funds ments when short-term market rates are declining, as for banks relative to ihe.cost of funds for thrift they were around the turn of the year when the Fed- institutions. eral Resewe eased policy, The reduction and subsequent elimination of the M2 increased 4J/4 percent at an annual rate between deposit insurance premium for financially sound the fourth quarter of 1995 and June of this year, leav- banks probably played a role in shifting bank fund- ing it near (he upper boundary of its growth range. ing toward deposits. During the first half of 1996. For many years before the early 1990s, die velocity of banks increased their deposit liabilities more rapidly M2 (defined as the ratio of nominal GDP to M2) than their nondeposit liabilities—a contrast from moved roughly in tandem with the opportunity cost of the preceding few years when banks relied disproportionately for their funding on nondeposit M2: Annual Range and Actual Level sources, including borrowing from their foreign offices. aiton* o* dollars The Monetary Aggregates The increased reliance on deposit sources of fund- 3750 ing by banks has helped support the growth of the broad money aggregates of late. Between the fourth quarter of last year and June of this year. M3 3700 expanded at an annual rate of about 6 percent, put- ting it at the upper boundary of its annual growth cone. As in 1995. the growth in M3 this year was led 3650 by those components not included in M2- In aggre- gate, ihese components increased atom 11 percent ai an annual rate between the fourth quarter of last year and June of this year, only moderately below the 1995 M A 3600 average pace of 14Vj percent. Insiliflion-only money- 1995 1996 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 M2 Velocity and the Opportunity Cost of Holding M2 Percentage points, ratio scale Quarterly 2.0 / 25 M2 velocity 1.9 10 1.8 i M2 opportunity cost 1.7 1.6 1980 1984 1988 1992 1996 Note. M2 opportunity cost is two-quarter moving average at three-month Treasury bill lass weighted average rate paid on M2 components. holding M2—that is. the interest earnings forgone by vices, however, it is impossible to know whether holding M2 assets rather .than market instruments the new parallel movement of velocity and the such as Treasury bills. This relationship implied thai opportunity cost will persist into the future. M2 tended to move in proportion to nominal GDP. Ml declined about P/-> percent at an annual rate except as it was influenced by changes in the op- during the first half of 1996. just as it had done over portunity cost of holding it. When the opportunity the four quarters of 1995. The recent sluggish cost rose, owners of M2 tended to economize on their behavior of Ml reflects the ongoing spread of so- holdings, driving up the velocity of M2. called sweep programs, under which idle reservable Beginning around the early 1990s, however, this deposits are "swept" into money-market-deposit historical relationship began to break down. Indeed, accounts (MMDAs). (An appendix provides addi- in 1991 and 1992. the velocity of M2 rose sharply tional information on sweep accounts.) Estimates even as the opportunity cost of holding M2 declined. based on initial amounts swept suggest that Ml A number of reasons for this development have been would have expanded at about a 7 percent annual rate adduced, including the unusually steeply sloped yield during the first half of 1996 in the absence of these curve and very low level of short-term interest rates. programs. Another factor contributing to the recent which helped to attract the public out of liquid bal- weakness in Ml has been the growth of currency, ances and into more readily available long-term which has been sluggish by the standards of the early mutual funds; the credit crunch ai banks and the 1990s. Foreign demand for currency apparently has resolution of troubled thrifts, which reduced the tailed off somewhat. In large pan. the slackening in aggressiveness with which these institutions sought net foreign demand owes to substantial reflows from retail deposits: and household balance-sheet Argentina and Mexico, where earlier worst-case fears restructuring, which entailed in pan repayment of about the stability of the financial system have not loans out of liquid money balances. The divergent been realized. Reflows from Western Europe and movement of the velocity of M2 and its opportunity Asia have also been significant, but net shipments to cost continued until the end ol" 1992. More recently, the former Soviel Union remain sizable. On the the variables have once again been moving essen- whole, demand for the new $100 bill has been tially in parallel. In light of the rapid ongoing pace of substantial, but this has noi had any detectable effect innovation and technological change in financial ser- on the stock of currency outstanding. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 The sluggish growih of currency lias held down rates overall continued to be relatively low by the expansion of the monetary base to only about standards of the past twenty years. 2 percent at an annual rate thus far this year. The The spread between interest rales on mvesiment- other restrain] on the growth or" the base has been the gratlc private bonds and those on com para Me - lumaround in the hehavior of required reserves. After maturity Treasury securities remained narrow during surging at double-digit rates in 1992 and 199,1. the h'rst half of the year. In particular, the average required reserves have been on a downward trend. spread on Baa-raied industrial bonds over 30-year and at an increasing rate. Thus far this year, required Treasury bonds continued to fluctuate near where it reserves have contracted about 7Y? percent at an has heen for ihe last several ycare and well telow the annual rate. The emergence of this trend is perhaps levels typical of the 1980s. The spread on invesimem- the most direci consequence of the spread of sweep grade utility bonds continued to drift upward, hut this programs. Absent such programs, required reserves appeared to reflect the market's increasing percep- probably would have increased about 10 percent over tion that some firms in that industry might become the some period, owing to strong growth in demand riskier as a result of deregulation and new compe- deposits. Continued spread of sweep programs could titive pressures. The rate spread on high-yield affeci the federal funds market, perhaps lending to bonds over the comparable Treasury noies narrowed greater volatility like that experienced in early 1991 sharply, reversing the upward dnft of 1995. and following the elimination of reserve requirements on returning this measure to the tow end of its range over non-transactions deposits. Thus far. such instabilities ihe last decade. The continuing low level of spreads have not been realized, but the Federal Reserve is on most investment-grade securities, as well as the monitoring the situation carefully. marked decline of the spread on high-yield securi- ties, appeared to reflect in pan market participants' Interest Rates, Equity Prices, increasing confidence in the durability of the eco- and Exchange Rates nomic expansion and consequent optimism about die Interest Rates. Interest rates on Treasury securi- creditworthiness of corporate borrowers. ties rose over the first half of 1996. with the most pronounced increases occurring for incermediate- lerm securities. Between the end of December 1995 Major Stock Price Indexes and the middle of July, the rate on three-month bills Index (December 29. 1995=100) increased somewhat less than '/* percentage point, the Daily rate on 5-year notes rose about 1 Vt percentage points, Nasdaq and die rate on 30-year bonds rose about 1 percent- 110 age point Despite these increases, nominal Treasury Selected Treasury Rates Monthly 15 Thirty-year 70 reaaury" 10 1995 1996 Note. Lasl observations ara lor JJy 16. 1996. Equity Prices. Share prices have fallen in rccem weeks, most notably those of "high-teen" compa- nies whose ability to maintain steep earnings tra- jectones has come into question. On net. though. 1965 1975 1985 1995 broad indexes of equity prices have held steady or moved up slightly since the end of 1995. As of 'The twenty-year Treasury bond rate is shown until the fits) iaauance of the thirty-year Treasury bond in Febiuaiy 1977. July 16. the S&P 500 composite index of stock prices Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 had increased 2 percent thus far this year, while the (lie long-term interest differential in favor of the dol- NASDAQ had returned ID its beginning-of-year level. lar. In addition, (be dollar was lifted to an extent Even ihis performance has heeu impressive, given against the yen by data early in the year showing that dial u occurred in the race of appreciable upward the Japanese external surpluses were narrowing. movement in long-term interest rates. Despite a weak output performance, long-ierm Exchange Rates. Since mid-Apnl. the weighted interest rates in Germany have risen about 50 basis average value of the dollar in terms of the other G-10 points, with much of that increase coming during the currencies has generally heen about 4 percent above firs! quarter. Lorie-rerm mteres! rates teve its level at the end of December, although die dollar has moved down somewhat in mid-July. When U.S. and Foreign Interest Rates compared with an index of currencies from a some- Three-month what broader group of U.S. trading partners, the dol- lar has appreciated 3 percent since December alter adjustment for changes in relative consumer prices. Monthly The dollar has risen on balance about 4 percent in terms of the German mark and about 6 percent in Average foreign terms of the Japanese yen. Exchange Value of the U.S. Dollar Index, March 1973= 100 Nominal 100 Ten-year 90 Monthly 80 Average foreign 1991 1992 1993 1994 1995 1996 Note. In terms of the currencies ot the other G-10 countries. Weights are baaed on 1973-76 global trade of aach ol the ten coortries. The dollar has been supported by perceptions of a U.S. Treasury disparity in the performance of the U.S. economy relative to thai of many of our major trading partners and the resulting expectations for the course of rela- 1984 1986 1986 1990 1992 1994 1996 tive interest rates. Specifically- while data suggest- Note Avarags (ensign rates are the global tracts-weighted ing robust growth in the United States caused inter- average, tor the other G-10 countries ot yields on instruments oorrparsbla to U.S. instruments shown. est rates to rise, questions remained about the strength of expansions in a number of other industrial countries, particularly in Europe. Average long-term fallen since the end of last year in some European (ten-year) interest rates in the other G-10 countries countries, such as France and Italy, where political have risen only slightly, about 20 basis points, since and economic policy uncertainties have been reduced. the end of December. With U.S. rates rising In Japan, long-term interest rates have risen atom substantially more than that, the appreciation of the 30 basis points, on balance. Shon-term market inter- dollar over this period is consistent, with the shift in est rates abroad are generally lower than they were at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 the end of last year. German short-term market rales Although private net purchases of U.S. Treasury arc down nearly 50 basis poinis while rales in France securities were small, there were large increases in arc down more than 100 basis points and [hose in the ihe pnvate holdings of US. government agency United Kingdom are down 70 basis points. Official bonds and US. corporate bonds, as US. corpora- lending rates have been reduced by the central banks tions issued heavily in the Eurobond market. In addi- in Germany. France, the United Kingdom, and several tion, direct invesimeni capital inflows surged in other European countries in 1996. In Japan, short- almost $30 dill ion in the first quarter, reflecting a term market interest rales remain near the histori- pickup in foreign acquisitions of U.S. firms. Together, cally low levels reached during the second half of these gross inflows totaled nearly S80 billion, roughly 1995 as the Bank of Japan's official rates have been twice the U.S. current account deficit for the quarter, unchanged. Slock markets in the foreign G-10 US. net purchases of foreign stocks and bonds were couniries have risen 3 10 15 percent since the end of also sizable in the first quarter, with net purchases of December, except in the United Kingdom, where foreign stocks from Japan particularly large. U.S. stock prices, on balance, are about unchanged. direct investment abroad slowed somewhat between the fourth quarter of 1995 and the tirsi quarter of The Mexican peso traded during the first half of 1996. but remained near the record pace for all of last 1996 in a range somewhat stronger than that which year. In April and May. private foreign interest in U.S. prevailed at the end of 1995. Mexican 28-day treasury securities conunued 10 be strong while US. investor bill (cetes) rates have declined from nearly interest in foreign stocks cooled somewhat from the 50 percent in December to around 30 percent as the strong first -quarter pace. rale of inflation has fallen. The economic positions of Mexican households and firms have improved since Foreign official holdings in the United States early 1995. but problems in the financial system increased about S52 billion in the first quarter of remain, as evidenced by increasing non-performing 1996. after a record SI 10 billion rise in 1995. These loans at banks. Stock prices have risen, on balance, increases reflected both intervention to support the about 5 percent in peso terms since December, foreign exchange value of the dollar by certain indus- buoyed by the interest rate declines and evidence of trial countries and substantial reserve accumulation recovery in the Mexican economy. by several developing couniries. Data for April and May indicated continued increases in official hold- The pace at which private foreigners acquired US. ings in the United States, but on a much more mod- assets increased markedly in ire first quarter. esi scale. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 Appendix: Sweeps of Retail Transaction Sweeps of Transaction Deposits Deposits into Savings Accounts* In January 1994. depository institutions began Billions of dollars implementing sweep programs for retail cusiomers.- Monthly In sucli programs, balances in houselrold transaction accounts (typically NOW accounts, hut also some averages Cumu- of initial lative demand deposits, both of which are included in Ml) amounts total are swept into savings deposits, which are pan of tlic non-Mi ponton ol" M2. Such sweeps shift deposits from reservable (transactions) accounts to nonreserv- 1994 afle (savings) accounts without impairing deposi- January 5.3 5.3 tors' ability to access the funds for transactions pur- February 2.2 7.5 poses. Depositories have an incentive to establish March 0.0 7.5 these programs because reserves held at the Federal Reserve earn no inwresi. Retail sweep programs April 0.0 7.5 reduce reported reserves, the monetary base, and Ml. May 0.0 7.5 They have no eftect on M2. since both transactions June 0.0 7.5 and savings accounts are in M2. July 0.0 7.5 Retail sweep programs have been established either August 0.0 7.5 as daily sweeps or as weekend sweeps. Under a daily September 1.5 9.0 sweep, a depositor's transaction balances above a October 0.6 9.6 target level are shifted each night into a special sav- November 0.3 9.9 ings account created for the purpose. II" debits December 0.0 9.9 threaten to reduce the remaining transaction account balances below zero, enough funds are transferred 1995 back from the savings account to reestablish the January 0.0 9.9 target level of transaction balances. Because only six February 0.0 9.9 transfers are allowed out of a savings account within a statement month, on the sixth transfer, the entire March 0.0 9.9 savings balance is returned to the transaction account. April 0.0 9.9 Alternatively, in a weekend sweep program, all May 5.0 14.9 affected transaction account balances arc swepi June 7.3 22.2 into the special purpose savings account over the July 0.6 22.8 weekend, and then returned on Monday. Some August 4.6 27.4 "weekend sweep" programs undertake sweeps on September 5.9 33.3 certain holidays as well. October 7.7 41.0 No information is available on the current amounts November 4.3 45.3 of transaction balances that are being swept into sav- December 9.2 54.5 ings accounts. The Federal Reserve has obtained data from depositories only on the initial amounts swept 7996 on the date each program was established. The table January 13.7 68.2 below, which is updated and made available to the February 7.0 752 public on an ongoing basis, shows that the initial amounts swept under programs implemented through March 6.4 81.6 May 1996 have cumulated to $98 billion. With a April 7.8 89.4 marginal reserve requirement of 10 percent on May 8.4 97.8 most of these balances, the cumulative reduction of required reserves attributable to the initial amounts 'Figures ore the estimated total of transaction account bal- swept has been nearly SIO billioa ance* ntttaNy swept into saving* accounts owing to the introduc- tion of now sweep programs Monthly totals are averages of dairy data 1. Sweep account* for biuineii customers of builti became Regular monthly update! of iratftal amounts swept may be wxiejpre»d in me nud-19'Oi. They involve sweeps of demand obtained by email by Mndng an email address along with deposiii mio RPs or other money mirkel iniinirncnls whose mini- a phone nxrttei\aaw«*p»_tib@Hib.gov. Those without access to mum sizes Kt loo \iftf 10 •ccommodMc households. email may request data by calling (202) 872-7577 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Growth of Money and Debt Percent Domestic nonfinancial Period M1 M2 M3 debt Annual' 1980 7.5 8.7 9.6 9.5 1981 5.4 (2.5)J 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 14.4 1986 15.5 9.2 9.0 13.3 1987 6.3 42 5.9 10.0 1988 4.3 5.7 6.3 8.8 1989 0.6 5.2 4.0 7.9 1990 4.1 4.1 1.8 6.8 1991 7.9 3.1 1.2 4.6 1992 14.3 1.8 0.6 4.7 1993 10.5 1,4 1.0 5.2 1994 2.4 0.6 1.6 52 1995 -1.8 4.0 5.9 5.6 Quarterly (annual rate)* 1995 Q1 -0.1 1.0 4.5 5.4 Q2 -0.5 3.8 6.3 7.1 Q3 -1.5 6.9 7.9 4.9 Q4 -5.1 4.1 4.5 4.7 1996 Q1 -2.7 5.9 72 4.7 Q2 -0.5 4.1 5.3 n.a. 1. From average for fourth quarter ot preceding year to 3. From average for precodng quarter to average lor average for fourth quarter of year indented. quarter indlcaled. 2. Adjusted for shifts to NOW accounts in 1981. o Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1996, July 17). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19960718_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_19960718_chair_federal_reserves_second_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1996},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19960718_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}