Congressional Testimony

FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1998 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED FIFTH 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 21, 1998 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1999 For sale by the U.S. Government Printing Office Superintendent of Documents, Congressional Sales Office, Washington, DC 20402 ISBN 0-16-058098-6 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND UBBAN AFFAIRS ALFONSE M. D'AMATO, New York, Chau-mun PHIL GRAMM. Texas PAUL S. SARBANES, Maryland RICHARD C. SHELBY. Alabama CHRISTOPHER J. DODDi Connection CONNIE MACK, Florida JOHN F. KERRY, Massachusetts LAUCH FAIRCLOTH, North Carolina RICHARD H. BRYAN, Nevada ROBERT F. BENNETT, Utah BARBARA BOXER, California ROD GRAMS, Minnesota CAROL MOSELEY-BRAUN, Illinois WAYNE ALLARD, Colorado TIM JOHNSON, South Dakota MICHAEL B. ENZI. Wyoming JACK REED, Rhode Island CHUCK HAGEL, Nebraska HOWARD A. MENELL, Staff Director STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel PHIUP E. BECHTBL, Chief Counsel PEGGY KTJHN, Financial Analyst LENDELL PORTERFIELD, Financial Economist MARTIN J. GRUENBERG, Democratic Senior Counsel GEORGE E. WHITTLE, Editor (ID Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis C O N T E N TS TUESDAY, JULY 21, 1998 Page Opening statement of Chairman D'Amato 1 Prepared statement 26 Opening statements, comments, or prepared statements of: Senator Boxer 1 Senator Reed 1 Senator Allard 7 Senator Sarbanes 10 Senator Kerry 14 Senator Grama 17 Senator Dodd 19 Senator Mack 26 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem, Washington, DC 2 Prepared statement 27 Introduction 27 Recent Developments 27 Economic Fundamentals: The Virtuous Cycle 29 Foreign Developments 31 The Economic Outlook 32 Ranges for Money and Credit Growth 34 Concluding Comments 34 Response to written questions of Senator Shelby 35 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Statement of David A Smith, Director of Public Policy, AFLr-CIO 39 Statement of Andrew L. Stern, International President, Service Employees International Union, AFL-CIO 40 Research by L. Slifman and C. Corrado, Board of Governors of the Federal Reserve System, entitled "Decomposition of Productivity and Unit Costs," November 18, 1996 42 Monetary Policy Report to the Congress, February 24, 1998 64 (III) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1998 TUESDAY, JULY 21, 1998 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:30 a.m., in room SD-106 of the Dirk- sen 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 is pleased to welcome Chairman Greenspan this morning to give the Federal Reserve's semiannual report to Congress on our Nation's economy. As many have noted on countless occasions, the Fed has done a remarkable job under Chairman Greenspan's tenure. Our economic expansion is in its eighth year, making it the third longest in the post-World War II period. I'm going to ask that the full text of my remarks be included in the record as if read in its entirety because we really are here to listen to Chairman Greenspan. I also might note that a number of pur colleagues are at a Fi- nance Committee markup which is taking place at the same time as this hearing. At some point, I'm going to have to leave to partici- pate in that markup. I would ask my colleagues, with respect to Chairman Greenspan and his time constraints, to see if we can't limit our remarks so that we can hear from the Chairman. Then, we will pose whatever questions we would like to put to him. With that, I will recognize Senator Boxer. OPENING COMMENT OF SENATOR BARBARA BOXER Senator BOXER. I'm anxious to hear from Chairman Greenspan. I will pass at this time. The CHAIRMAN. Senator Reed. OPENING COMMENT OF SENATOR JACK REED Senator REED. Mr. Chairman, I think we should proceed right to Chairman Greenspan. The CHAIRMAN. I thank my colleagues. Chairman Greenspan, I think this is the quickest you have ever gotten on. Before anyone else gets here, we would like to hear your remarks. [Laughter.] (i) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis OPENING STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. I have just been thinking over the last 20 times that I have been here, and I guess you are unquestionably correct; there's nothing even close. Anyway, thank you very much, Mr. Chairman. I have a rather extensive prepared statement from which I will be excerpting sig- nificantly. I request that the full text be included in the record. The CHAIRMAN. So ordered. Chairman GREENSPAN. I appreciate this opportunity to present the Federal Reserve's semiannual report on monetary policy. Overall, the performance of the U.S. economy continues to be im- pressive. Over the first part of the year, we experienced further gains in output and hi employment, subdued prices, and moderate long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor markets very tight and do- mestic final demand retaining considerable momentum, the risks of a pickup in inflation remain significant. Inventory investment, which was rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in Asian economies are now de- monstrably restraining demands for U.S. goods and services—and those troubles could intensify and could spread further. Weighing these forces, the Federal Open Market Committee chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it under- mines this extraordinary expansion. When I last appeared before your Committee on February 25, I noted that a key question for monetary policy was whether the con- sequences of the turmoil in Asia would be sufficient to check infla- tionary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. In the event, the contraction of output and incomes in a number of Asian economies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in the emerging market economies generally have remained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, prompted a sharp deterioration in the U.S. bal- ance of trade in the first quarter. Nonetheless, the American econ- omy proved to be unexpectedly robust in that period. Evidently, optimism about jobs, incomes, and profits, about high and rising wealth-to-income ratios, low financing costs, and falling prices for high-tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter. As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pres- sures mounted. The robust expansion of demand tightened labor markets fur- ther, giving additional impetus to the upward trend in labor costs. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Inflation was low—though, given the lags with which monetary pol- icy affects the economy and prices, we had to be mainly concerned not with conditions at the moment, but with those likely to prevail many months ahead. Although national income and product data for the second quar- ter have not yet been published, growth of U.S. output appears to have slowed sharply. Indeed, readings on the elements that make up the real GDP have led many analysts to anticipate a decline in that measure in the second quarter, after the first-quarter surge. It is worth noting that some of the other indicators of output, in- cluding worker hours and manufacturing production, show a some- what steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion. Labor markets became increasingly taut during the first half of the year, but, at least through the first quarter, the effects of tight labor markets and a rising wage bill on production costs were mod- erated by strong gains in productivity. Indeed, inflation stayed remarkably damped throughout the first quarter. The Consumer Price Index, as well as broader measures of prices, indicate that inflation moved down further, even as the economy strengthened. The most recent price data suggest that overall consumer price inflation moved up in the second quarter, but, even so, the increase remained moderate. In any event, it would be a mistake for monetary policymakers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the CPI, the Federal Reserve monitors a wide variety of aggregate price measures. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. So far this year, Mr. Chairman, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still farther increases in equity values, and the improve- ments in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, expansion of output, employment, and productivity- enhancing capital investment. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist have promoted stabil- ity in financial markets and fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership po- sitions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraor- dinary growth of profits to be extended into the distant future. In- deed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995, These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtu- ous cycle continues. Probably only a few percent of these largely unrealized capital gains have been transformed into the purchase of goods and serv- ices in consumer markets. But that increment to spending, com- bined with the sharp increase in equipment investment, which has stemmed from the low cost of both equity and debt relative to ex- pected profits on capital, has been instrumental in propelling the economy forward. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills. Government finances have been enhanced as well. In the Federal sector, taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by Congress and the Adminis- tration to put Federal finances on a sounder footing have added to national saving, relieving pressures on credit markets. Maintaining this disciplined budget stance would be most helpful in supporting a continuation of our current robust economic performance in the years ahead. The fact that economic performance has strengthened as infla- tion subsided should not have been surprising, given that risk pre- miums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions—eventually bringing those expansions to an end—have not played a significant role in this expansion. For one thing, increases in hourly compensation have been much slower to pick up than in most other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved be- yond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. A couple of years ago—almost at the same time that increases in total hourly compensation began trending up in nominal terms— evidence of a iong-awaited pickup in the growth of labor produc- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis tivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Signs of technological improvements are all around us, and the benefits are evident not only in high-tech industries but also in production processes that have long been part of our industrial economy. Those technological innovations and the rapidly declining cost of capital equipment that embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity. Evidently, plant managers who were involved in planning capital investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting these emerging new technologies. Notwithstanding a reasonably optimistic interpretation of the re- cent productivity numbers, it would not be very prudent to assume that even strongly rising productivity, by itself, can ensure a non- inflationary future. Certainly wage increases, per se, are not infla- tionary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually under- mine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity most likely also occur rather gradually. By contrast, the potential for an abrupt acceleration of nominal hourly compensation is surely greater. As I have noted in previous appearances before Congress, eco- nomic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of un- employed people available to work is drawn down. The annual in- crease in the working-age population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per hour. This gap between the growth in employment and that of the working-age population will inevitably close. What is crucial to sus- taining this unprecedented period of prosperity is that it close rea- sonably promptly, given already stretched labor resources, and that the labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy ac- tion remains an open question. While the United States has been benefiting from a virtuous eco- nomic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, as well as Canada and Western Europe, have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping U.S. economic and financial trends in the period ahead. With all that is at stake, it would be difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis effective policies to correct the structural problems underlying re- cent weaknesses and to promote sustainable economic growth be- fore patterns of reinforcing contraction become difficult to contain. Responses in countries that are currently experiencing difficul- ties have varied considerably. Some have reacted quickly and, in general terms, appropriately. In others, a variety of political consid- erations appear to have militated against prompt and effective ac- tion. As a consequence, the risks of further adverse developments in these economies remain substantial, and given the pervasive interconnections of virtually all economies and financial systems in the world today, the associated uncertainties for the United States and other developed economies remain substantial as well. In the current circumstances, we need to be aware that monetary policy tightening actions in the United States could have outsized effects on very sensitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must also be careful that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the U.S. economy. Our main objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-term interests of troubled finan- cial markets and economies abroad. The Federal Open Market Committee believes that conditions for continued growth with low inflation are in place here in the United States. As I noted previously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that re- gard, we see a slowing of aggregate demand as a necessary element in the mix. At this time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. With their incomes and wealth having been on a strong upward track, Amer- ican consumers remain upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets, increasingly confident workers might place escalating pressures on wages and costs, which would eventually feed through to prices. But a number of factors will likely serve to damp growth in ag- gregate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. The CHAIRMAN, Chairman Greenspan, we are in the process of completing a vote. That's why my colleagues left. I just want to call this to your attention. There are only 2V6 minutes remaining for the vote. I'm going to ask that we take a 5-minute recess so my colleagues can come back and hear this testimony and proceed with the hearing. We will recess for just 5 minutes. [Recess.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis OPENING COMMENTS OF SENATOR WAYNE ALLARD Senator ALLARD [presiding]. I call the hearing back to order. Chairman D'Amato just stepped on the elevator to go to vote. He asked if I would call the hearing back to order. Let's continue with the testimony. Chairman Greenspan, would you finish your testimony. Chairman GREENSPAN. Thank you, Senator. A number of factors will likely serve to damp growth in aggre- gate demand, helping to foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full effects of the crisis in East Asia on U.S. employment and income. Residential and business fixed "investment already have reached such high levels that any further gains approaching those experienced recently would imply very rapid growth of the stocks of housing and plant and equip- ment relative to income trends. Moreover, business investment will be damped if recent indications of a narrowing in domestic operat- ing profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less op- timistic view of earnings prospects. Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 to 3.25 percent over 1998 as a whole and 2 to 2.5 percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change very little from its current level, finishing next year in the neighborhood of 4.5 to 4.75 percent. Inflation performance will be affected by developments abroad as well as by those here at home. The extent and pace of the recovery of Asian economies currently experiencing a severe downturn will have important implications for prices of energy and other com- modities, the strength of the dollar, and competitive conditions on world product markets. On a more fundamental level, it is the balance of supply and de- mand in labor and product markets in the United States that will have the greatest effect on inflation rates here. As I noted pre- viously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time. In addition, a gradual upward tilt in benefit costs has become evident of late. Given that compensation costs are likely to acceler- ate at least a little further, productivity trends and profit margins will be key to determining price performance in the period ahead. We will be closely monitoring a variety of indicators to assess the degree to which productivity is on a stronger, long-run track, after what is likely to appear in the data as a weak second quarter. Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next IVa years. The central tendency of monetary policymakers' CPI inflation forecasts is for an increase of 1.75 to 2 percent during 1998 and 2 to 2.5 percent next year. As noted, the ebbing of the special factors reducing inflation over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflationary pressures. The Committee would need to resist very vigorously any tendency for an upward trend, which could become embedded in the inflationary process. The Committee recognizes that significant risks attend the out- look: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could then reduce the demand for U.S. goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively smoothly, the Committee believes that, given the current tightness in labor markets, the potential for accelerating inflation is probably much greater than the risk of pro- tracted, excessive weakness in the economy. In any case, the Committee will need to continue to observe the evolving circumstances closely, and adjust the stance of monetary policy as appropriate, in order to help establish conditions that are consistent with progress toward the Federal Reserve's goals of price stability and maximum sustainable economic growth. As I have stated in previous testimony, the recent economic per- formance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy. Although the rea- sons for this development are very complex, much of our success can be attributed in part to sound economic policy. Congress and the Administration have successfully balanced the budget and, in- deed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-term growth by seeking price sta- bility. These policies have helped to bring about a healthy macro- economic environment for productivity-boosting investment and for innovation, factors that have lifted living standards for most Amer- icans. The task before us is to maintain disciplined economic poli- cies and to thereby contribute to maintaining and extending these gains in the years ahead. Thank you, Mr. Chairman. I'm available for questions. Senator ALLARD. Chairman Greenspan, thank you for your testi- mony. I have a few questions, then I will yield to Senator Sarbanes from Maryland. There is some talk about what's happening in the Far East, and it seems to me that the Japanese economy certainly is important, and we need to be aware of what is taking place. If you were to be an advisor to the new Prime Minister, what kind of advice would you give him in order to strengthen the econ- omy of Japan? Chairman GREENSPAN. First, Senator, the issue is what's wrong with Japan? There are a number of things which are wrong, but by far the most significant is the fact that following the bursting of the bubble in the early 1990's, which precipitated a very sharp Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis decline in both real estate and equity values, essentially the collat- eral underlying borrowing in the banking system, a huge increase in nonperfonning loans was allowed to accelerate and fester in the banking system for a number of years, essentially unaddressed. This has created an erosion in the financial intermediary system which has created significant slow growth for a number of years, and now under pressures of continuing erosion in the banking sys- tem, a weakness has occurred which has now tilted the Japanese economy downward. It's clear that they need to do two things: The first is to address their banking situation expeditiously and in dramatic ways, which perhaps would even go against the prevailing culture of the way things are done in Japan. Second, having done that, what they need to do is to engage in more stimulative fiscal policies, specifi- cally reducing taxes. Senator ALLARD. Thank you. Now I would like to turn to our economy here, and ask you a question with regard to the Congressional Budget Office, who once again dramatically increased their estimates of the budget surplus over the next several years. I don't like to refer to them as surpluses when we have this big debt still hanging over us, but at least we have revenues that are continuing to exceed expenditures. What is the likelihood that this phenomenon the Congressional Budget Office has predicted will materialize, and what are the greatest threats to it not materializing? Chairman GREENSPAN. Senator, that is really the crucial ques- tion. As the experience of the last several years has indicated, the ability to forecast the trend of fiscal balances in the United States is not easy. And one of the reasons, of course, is because we're deal- ing with large receipts and outlays, and small changes in either of them, especially in opposite directions, can move the budget deficit, the budget balance, or surplus, in a very dramatic manner. What has occurred in the last couple of years is a really quite remarkable acceleration in personal income tax receipts which are not fully understood by analysts who have full data available to them. It is pretty clear that in 1996, the last annual set of data which we have in detail, a substantial amount of the so-called in- come tax receipt "surprises" of that year were attributable to an underestimate of the extent of realized capital gains and the taxes that were paid on them. There were also very substantial increased incomes which were engendered by the rise in stock prices. We have seen a substantial increase in stock options, in bonus payments, and a number of re- lated types of incomes, largely to upper-income individuals who are paying very large taxes on them. That has very markedly bolstered the receipt side of the budget. The key problem we have in projecting forward is how much of that to presume will continue, and how one answers that question can very dramatically alter the outlook. The most general forecasts which are being made largely by OMB and CBO, for example, tend to assume that a good part of the increased rates on a number of these different personal taxes will increase, and that productivity Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 acceleration, which seems to have been in the works, will continue into that period. If that occurs—and there are no other policy actions—obviously the surpluses will occur. It's important to recognize that a major force in the forecast is once you start on what is clearly a virtuous cycle of surpluses, you bring down the level of debt which brings down the interest cost of that debt, which makes the surplus even larger, which makes the debt even lower, and you get a fairly dra- matic reduction in aggregate debt, which has some very important and very positive consequences. But to answer the bottom line of your question, I think you have to realize that a number of these projections are very tentative and, indeed, can reverse just as dramatically as the estimates made 2 or 3 years ago have been reversed. Senator ALLARD. Thank you. I will now yield to the Senator from Maryland, Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you very much, Senator Allard. First of all, Chairman D'Amato and I have received a statement from the AFL-CIO to be entered into the record. If that's not yet been done, I would like to do that at this point, Mr. Chairman. Senator ALLARD. Without objection. Senator SARBANES. I would note that in that statement they say it is good news for America's workers that the Nation's unemploy- ment rate is edging closer to our historic full employment targets than at any other time since the Humphrey-Hawkins legislation was adopted in 1978. This, of course, would fit in with your obser- vation, Chairman Greenspan, about this being the—I forget exactly how you put it—strongest economy you have seen in 50 years. Is that what you stated? Chairman GREENSPAN. This is the strongest economy I have seen in nearly 50 years of watching the economy daily. It's really quite a remarkable exhibition by a complex economy such as ours. Senator SARBANES. I would like to make this observation: I can remember at the time Humphrey-Hawkins was passed and there- after, everyone saying, it is absolutely ridiculous; how can you have a 4 percent unemployment rate. Yet we're now down to 4.5 percent with still no significant inflation. That goal now seems a lot more realistic and credible than it did in the past when people were criti- cizing it Chairman Greenspan, I would like to ask you first about the IMF funding. It's asserted by some that the IMF has enough resources that they don't need a general quota reserve. The observation is made that they have about $45 billion, but my understanding is that $30-35 billion of that $45 billion has to be set aside by the IMF in order for it to be in a position to meet the right of member countries to make demand withdrawals of their re- serve deposits, so that the figure looks larger than it really is. Actually, the IMF has only $10-15 billion of usable resources in its general quota reserve and, in fact, reflected this squeeze in that the Russian package took only $2.8 billion out of the general quota reserve, and the balance came out of the general arrangements to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 borrow. This means the IMF now has only $7-12 billion of its own effectively loanable quota reserves. First of all, is this analysis correct, in your estimation, in terms of what's available to the IMF, which seems to me to be a disturb- ingly low amount? My understanding is that it's the lowest amount that they have ever had on hand. If the analysis is correct, what does that say in terms of the ur- gency for Congress to act on the IMF quota increase? Chairman GREENSPAN. Those numbers, Senator, are very close to the ones that we use. I would certainly agree with you that they're down to rock-bottom, and while I have considerable sympathy for a number of the arguments about how we should change some of our international financial institutions, that's an issue which I feel should be put aside while we confront a crisis which continues to mount. In my judgment, approving the quota is crucial to put the IMF in a position to address potential other crises which may arise in the short term. After the particular period of disruption has passed, I think it would be perfectly appropriate to go back and relook at the way the whole structure of how our financial institutions are positioned is working out, largely because we are in a different type of global fi- nancial system in the sense that, since the beginning of this dec- ade, the alterations in the types of markets that have evolved, and the types of products that have been constructed, have given us a new, very dynamic, productive, but, in a certain sense, somewhat worrisome set of relationships. In other words, money moves at paces which are far quicker than anything we had seen before, and we have to address our system and our structure in that context so that at that point, we would be well served to look at the IMF, its structure, and see whether it serves the purposes of a new global financial system. But not at this point. Senator SARBANES. Now, part of the total picture is not only the money the IMF has available to meet crises, but also the likelihood that crises will occur, or how fragile the current international situ- ation is. I'm struck by the fact that this statement from the AFL-CIO, as I mentioned earlier, is almost entirely devoted to the East Asian crisis, the financial crisis, and the impact of that potentially on the U.S. economy. I'm a little hard put to understand why what's going on in Asia seems to be being discounted to the extent it is in the workings of our own markets and economic thinking in this country. It's as though these very serious developments are taking place which any analyst will tell you have the potential for consequences of very far-reaching proportions, yet most people seem to be going blissfully along as though there's little danger that it will have any impact on us. Do you have any observations at all as to why that seems to be the case? I know you, Secretary Rubin, and others have been sounding the warning bells, but why is it that people seem not to be hearing these warnings? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 Chairman GREENSPAN. It's obviously difficult for me to judge, but I will comment on the fact that the initial impact of the Asian cri- sis has, in a certain sense, been to stabilize some of the hot spots in the American economy and, indeed, probably has contributed to stronger growth, lower inflation, and greater stability than would otherwise have been the case. It appears that the initial response to the Asian crisis has been positive, not adverse. The major concern that I have is that it obvi- ously cannot continue indefinitely. At some point, it ceases to be other than adverse. While the probability that it will markedly impact the United States is, as I have said in the past, quite small, the consequences of that occurring, even though the probability is small, would be of such a nature that we should not be taking the risk, even with the relatively small probability of an adverse event. Senator ALLARD. Thank you. I will now yield to the Chairman, who is back from voting. I think he may have a few questions for you. The CHAIRMAN. Thank you very much, Senator. Chairman Greenspan, let me follow up on something that Sen- ator Sarbanes raised, and that is the situation in Japan. We need to discuss just how serious that situation is, and how acute the problem is for their banks. We have many estimates on the amount of problem loans, and those estimates are quite significant. Some say that their problem loans are more than three times the size of the problem we had in the S&L crisis. Do we have sufficient transparency of data to get a legitimate estimate on the true size of the banking problem tak- ing place in Japan? Chairman GREENSPAN. The Japanese authorities I believe are in- creasingly becoming aware of the issue of the need to become far more transparent than they have, and they are now moving in that direction. The problem, however, is that with the real estate markets still essentially moribund, and the volume of transactions going on still quite small, it's very difficult to get values on real estate which is the major collateral underlying a lot of those loans. The ability to judge how poor a particular loan portfolio is is ac- tually even difficult for the banks themselves because they do not fully sense what the underlying value is of what they hold. One of the issues that we have argued strenuously with our Jap- anese colleagues is to try to sell properties into the real estate mar- kets which are currently in the hands of the Japanese government to do effectively what we did with the RTC, that is, galvanize the real estate market so you get real prices, you get real markets, and you can make far better judgments about the underlying collateral of the loans, which is a necessary condition for making a judgment of how bad they are. The numbers that the Japanese authorities are publishing are very large, and the size of the problem is unquestionably substan- tial. One needs only to look at the vast amounts of public funds— taxpayer funds—which they are bringing to bear to try to resolve this issue. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 The difficulty is large, and I think that's the reason why, as I said earlier, allowing the problem to fester as long as it has been allowed to fester has been a major mistake which has made it far more difficult to resolve than it would have been 5 or 6 years ago. The CHAIRMAN. Let's come closer to home and discuss the con- cern that you and others have expressed about the possibility that credit underwriting standards at our own institutions may be less stringent than advisable. What level of concern is that to you and to the Fed? Chairman GREENSPAN. Mr. Chairman, what our experience over the years clearly demonstrates is that it is in a period such as now that bad loans are made. The CHAIRMAN. You mean when things are booming? Chairman GREENSPAN. You do not have very much risk of creat- ing a poor loan portfolio at the bottom of the business cycle. No- body makes bad loans—they don't make any loans—but they surely don't make bad ones at the bottom of the business cycle. It's now when the loans which will ultimately run into trouble are being extended in a very competitive race, one bank against the other, to lower their loan rates and yield spreads. What we know is that—and there's almost no data—the loans being made today will have a nonperforming ratio to total loans much higher than currently exists. We don't know how much, but we do know that if history is any guide, now is the time to be cir- cumspect. On the basis of certain studies we have done, we have concluded that there has been less circumspection than seems to be appropriate for this time period. Some of my colleagues have raised the issue, both at the staff level and at the Governors level, and to state that we find the issue somewhat discomforting is to underemphasize the potential prob- lems that may emerge. The CHAIRMAN. Let me then follow up with one more question on that issue. What specifically are your examiners doing about these under- writing concerns? Are we trying to get ahead of this problem, rec- ognizing the difficulties that we have experienced in the past? Chairman GREENSPAN. Obviously, we can't induce people not to be foolish in certain loan practices, but we can bring to bear and try to indicate to loan officers and to the senior management of the Jb^nks that, in our judgment, on the basis of our experience and our evaluation, the practices have become somewhat looser than they should be. I don't want to say, because it's not true, that we have evidence at this particular point that there is a mounting degree of loan losses. On the contrary, if you look at the data, it is really quite remarkable how few losses there are and how few of the loans are in delayed payment. In fact, it's that very process which is creating some let down of people's guard, and it is precisely that concern which we are trying to effectively arouse concern about. The CHAIRMAN. I applaud your efforts in that area because we have experienced these problems in the past. I particularly com- mend you for calling this to our attention and to the attention of those in the banking industry. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 Bankers need to be concerned about the quality of new loans, as you have indicated. It's something that's so obvious that we tend not to think about it. Lower quality loans tend to be made when you have this great prosperity, not when you have a tightening of credit. Thank you very much, Chairman Greenspan. Chairman GREENSPAN. Thank you. Senator ALLARD. I now recognize Senator Kerry. OPENING STATEMENT OF SENATOR JOHN F. KERRY Senator KERRY. Thank you very much, Mr. Chairman. Chairman Greenspan, welcome. This is a remarkable document. You have stated in your last paragraph and reemphasized the degree to which this represents an extraordinary set of perceptions on your part in the years you have been watching. But as I read through the document, I was struck by the fact that, paragraph for paragraph, in each place where there was a sense of a cloud or potential transition, you seem to have an eco- nomic countervailing force addressing it. The market obviously is doing what it's supposed to do, and an extraordinary job at that. I wanted to ask you some questions about the virtuous cycle you describe and the notes you have made about the future. You particularly pointed to the working-age population increase, growing at about 1 percent per year, but I gather that the 2 per- cent a year rise in the number of people working, which is really quite fascinating, comes about principally because the productivity increases? Chairman GREENSPAN. No. Actually, because the number of peo- ple going into jobs is rising at 2 percent a year, and the working- age population, including immigration, is only rising 1 percent, we are getting those additional people from (1) reduced unemployment as counted officially, and (2) the significant number of people who are not in the labor force because they're not actively seeking jobs but who would nonetheless like to work. The combination of both of those groups of people who want jobs but don't have them has been going down gradually year by year, and in a sense we are dipping into a reservoir which ultimately is going to be probably at a minimal level, unless we close this gap between the increased working-age population and the rate of in- crease in the number of people working. Senator KERRY. That's precisely what I wanted to get to, because you say the gap between growth and employment and the working- age population will inevitably close, and that what is crucial to sus- taining this unprecedented period of prosperity and growth is that it close reasonably promptly, especially given the already stretched labor resources. Could you share with us what trend line you view as essential with respect to that? I mean, how reasonably promptly must you expect that to close in order to sustain this, and what are the dangers that you see in terms of that gap not closing? Chairman GREENSPAN. That's a good question, Senator, and it's not easy to answer. The reason I say that is that clearly the sooner Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 it can be closed, the better, because that will immediately relieve the increasing pressure on labor resources, although the market is still very taut at this particular time. If we continue for another year under these pressures, the risks go up. But I cannot say to you when, because we still have approxi- mately 10 million people who are in these two groups in a ratio to the population which is at the lowest level in the data series that goes back to 1970. Senator KERRY. Do you have a breakdown on the nature of that group, to what degree there are people within that group that are in fact employable versus conceivably chronically unemployable? Chairman GREENSPAN. Yes. Those data are published by the Bu- reau of Labor Statistics, and if I can shuffle through these papers I will give you Senator KERRY. But that breakdown, I assume you would agree, could considerably affect the rate at which that gap can close? Chairman GREENSPAN. Certainly. Senator KERRY. I would assume also that it may affect what we might need to do with respect to helping to keep it moving, i.e., transitional training, or even entry-level training? Chairman GREENSPAN. Yes. Absolutely. One of the characteristics that we are seeing in this particular recovery is that, because of the tightness of the labor markets, the value of on-the-job training and the remarkable expansion in com- munity colleges which have been giving courses to people, trying to upgrade their skills, is something which has had a major positive effect on our workforce and probably would not have occurred to the extent that it has if we didn't have the tightness in the labor market that we have. Incidentally, I have the breakdown of the two elements that we use for the working-age population, age 16 to 64. As of June, total unemployment was 6.1 million, and those not in the labor force but who nonetheless want a job was 4.5 million. We are somewhat over 10 million, and that number has been progressively falling for the last several years. Senator KERRY. I see the light is on. I would like to come back, if I could. Senator ALLARD. How many more questions do you have? Senator KERRY. Just a couple more. Senator ALLARD. Why don't you finish your two questions. In the meantime, I'm going to turn the Chair over to Senator Grams, the Senator from Minnesota. Senator KERRY. Chairman Greenspan, I appreciate your answers on that. The other questions I have deal with this virtuous cycle of our economy. You described the virtuous cycle, and I think I un- derstand the context to be that the evidence of accelerated produc- tivity raises the expectations of future corporate earnings, which in turn then fuels further increases in equity values, and ultimately the improvements in productivity reduce inflation. Now, the question is, is there a reality check in the expectations that you refer to as central to what is fueling this? Is there a point where the values may be exceeding the reality, where you may have an artificial bubble that somehow is riding the back of the tiger, so to speak? Do you sense that at all? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 Chairman GREENSPAN. Senator, there are two ways of respond- ing to that question. The first one is, as I indicated in my prepared remarks, a significant part of the rise in equity prices has resulted from the continuous increase in long-term expected earnings start- ing from evaluations of security analysts in early 1995, virtually continuously since. In other words, the analysts have raised their long-term expectations virtually month after month, and the cur- rent rate, which is well over 13 percent of an annual rate, is sug- gested indefinitely in the future and projects a very marked rise in profit margins and the share of profits in the national income. History tells us that is going to run into some difficulty sooner rather than later, which suggests that these 3- to 5-year projections of analysts are unrealistic, and that the real world will somehow converge and suggest that to them in no uncertain terms. Failing that, there is an ultimate element which you cannot go beyond, which essentially is the extent to which human beings dis- count the future, in the sense that the stock market value is bro- ken down into expected long-term earnings and the discount factor one applies to that to get a present value which is eifectively the stock price. That number has been falling quite consistently, which is essen- tially a combination of long-term interest rates, plus what we call the equity premium. That can go down just so far. At some point, we are discounting the hereafter, and the markets at that point will fail to move further. Which happens first I do not know. Senator KERRY. That will be interesting to find out. I hope we are not there when we do. You also point to the special relationship in the labor market itself, the pressure on wage-price increase and the productivity input that has reduced some of that pressure, as well as the good behavior of the consumer price component. My question is, is there a sooner-rather-than-later confrontation with that component of the good behavior on both sides because there's been a wearing out, if you will, of this experience of older and more traditional manufacturing and service-oriented industry workers, having used up their fear of the transition into the infor- mation market age, and with a huge influx of younger, more highly skilled, and much more expectant, demanding workers, there's a clash then of the two and you lose the good will of people being willing to take wage benefits in order to simply have a job? Is that a potential fly in the ointment? Chairman GREENSPAN. That is a very interesting view, Senator. There is unquestionably something in what you're saying. The only issue is how long it takes before that process occurs. We do observe that the job skill obsolescence, to which I refer in my prepared remarks, tends to be far more prominent among older segments in the workforce, people who have not been brought up with word processors, with complex computers, or with the tech- nologies which seem so obvious and sensible to somebody coming out of college today. It's being assuaged, however, in part by this fairly dramatic back-to-schopl attitude of numbers of workers. One of the most fascinating statistics that we have seen in the last several years is that the average age of people who are full- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 time undergraduate students in college has gone up 3 or 4 years. It suggests that the fear of this new technological world, which is inducing this shift toward job security relative to wage gains, is also creating a major impetus to go back to school. That's where the big expansion in, on the one hand, on-the-job training courses and, on the other, community colleges and other institutes which endeavor to increase skills, is coming from. For the moment, that crunch that you raised is partly being met by this shift in educational processes and in educational markets, which has presumably markedly increased the skills of many peo- ple in pur labor force and maybe forestalled this confrontation that you raise for a while. The truth of the matter is I don't know how we would know for sure when that was arising. Senator KERRY. I thank you very much, Chairman Greenspan. Mr. Chairman, thank, you for your courtesy. OPENING STATEMENT OF SENATOR ROD GRAMS Senator GRAMS [presiding]. Thank you. Mr. Greenspan, welcome. I have just a couple of quick questions, and I see we have been joined by Senator Dodd. I don't want to be the pessimist, but I want to look beyond this bubble of good economic news a little bit. Clearly, I think our short- term economic and fiscal outlook has improved in recent years, due to what you call the "delicate equilibrium" that has allowed the United States to enjoy fast economic growth, high employment, and low inflation. A recent estimate from the Congressional Budget Office shows that we may have as much as $1.5 trillion unified budget surplus and nearly $170 billion on budget surplus over the next decade, and I think you should share in a lot of that credit because of your very prudent monetary policy. However, many long-term imbalances are still hanging over our heads, and without addressing these future risks, I think steady growth is impossible. A major risk, I believe, is the imbalance between the Govern- ment's entitlement promises and the funds it will have available to pay for them, specifically, Social Security. Now, Chairman Greenspan, if we don't fix our Social Security problems such as the unfunded liabilities, and I don't know if you have a handle on those numbers, how much unfunded liability is out there Chairman GREENSPAN. It's about $9 trillion. Senator GRAMS. How much? Chairman GREENSPAN. About $9 trillion. Senator GRAMS. Unfunded liability for Social Security is about $9 trillion. "With that in mind, what will the consequences be for our economy in our long-term monetary policy, our interest rates, inflation, et cetera? Chairman GREENSPAN. Senator, one thing that's come out of a lot of these long-term projections of the budget is that over the very long run, given the types of commitments, as you put it, for entitle- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 ment programs, it's very difficult to close the gap between the long- term commitments and long-term revenues. What is crucial in this regard is to make sure that when we think in terms of retirement programs, we set aside the issue of what these types of projections are showing us, and remember that there is a fundamental question which has evolved here; namely, that when you have a significant increase in the proportion of your population which is retired, it means you're going to have to create a greater volume of goods to sustain both the working-age popu- lation and the retired population in the future, but it is produced by the working-age population by definition. Which is another way of saying, you need a significant increase in productivity. One aspect of running these very large unified budget surpluses is that they tend to create a fairly marked decline in the Federal budget debt, in long-term interest rates, and a fairly important in- crease in national savings, which will in turn ultimately feed into capital investment and the higher productivity which is required to sustain the retired population at anywhere near the real wage that those people had at their point of retirement. As a consequence of this, we should not be mesmerized into these very major mega-sized apparent surpluses because if we take out of them, as you put it, some amortized estimate of the unfunded liability for all of our entitlement programs, that surplus will then disappear. While I have argued in the past, and I would still argue today, that from the point of view of the budget that we would look at to analyze its direct immediate impact on the economy, the unified budget balance is the appropriate number, but to look at the com- mitments in the future, as to whether the intergenerational trans- fers are appropriately being funded, then we would have to look at something which excludes at least the Social Security budget to get a sense of what the longer-term outlook is. I do think in the debate which is inevitably going to occur as a consequence of these new numbers, and I must say it's the type of problem that is nice to have compared to what we were dealing with 10 years ago, we should recognize that one, as I indicated ear- lier, we have to be a little careful about the certainty we may have about whether these surpluses will rise at the levels which are being projected, but two, even if they do, what it is we wish to do with them. I would say that reducing the debt is a very high prior- ity that we should look toward as a major component of what we do with these surpluses. We should be cautious about new entitlement programs which, once in place, will eat up revenues at the pace that we have seen in the past, and it becomes very difficult to reverse. To the extent that people make judgments that it's very difficult to sit there with a huge surplus in the unified account, and that it will be spent if we don't do something with it, then I would say the second highest priority is to give it back to the taxpayer. But it's the type of problem, I must say, that is a pleasant type of problem to be confronted with. Senator GRAMS. But we should watch the spending levels? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 Chairman GREENSPAN. The one thing that can go wrong in this whole process is that we think we have a big bundle of cash, we commit it to the future, and find out that most of it isn't there. Senator GRAMS. I have another question, but I will now recognize Senator Dodd. OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD Senator DODD. Thank you very much. I appreciate, Chairman Greenspan, your presence today, and con- gratulations again on the tremendous job that you and the Fed are doing for our country. On the last question the Chairman raised, your concern here is to be careful of the deficit? Chairman GREENSPAN. Yes. Senator DODD. That's really the underlying issue. It's a question of, if we have revenues, trying to decide what to do with them— whether we should spend them or take them off the table through tax expenditures. The point is, we should be careful about assuming a surplus that we have today is going to be there for any length of time because of the fiscal responsibility that's underlying. Chairman GREENSPAN. Yes, sir. Senator DODD. Chairman Greenspan, if someone has raised this, please interrupt me. There's no point in having you repeat answers to questions that may have been raised by others. I apologize for not being here, but the Labor Committee held a hearing I briefly wanted to attend. I know you have spent some time, I gather, talking about Japan, and obviously that is important. I wonder if you might share with us some thoughts about China. We have been talking about Japan's difficulties and the Asian problems in general and how they are affecting us. I wonder if you might share with us, to the extent you feel is worthwhile, how the Asian economy is affecting China and to what extent, if at all, that places us in any longer-term risk? I believe it has been pointed out, at least I hope it has, how much we appreciate the fact that the Chinese have not devalued their currency and how important that has been to us. I was stunned by some of the trade numbers reported. Exports were down 1.2 percent in the first quarter. In the last quarter, they were actually up 8.3 percent. Imports were up 17.1 percent. In the last quarter, they had been 5.3 percent. I wonder if you might comment on that? Chairman GREENSPAN. Are you citing Chinese numbers at the moment, or ours? Senator DODD. Ours, Chairman GREENSPAN. Are you referring to our bilateral trade with China? Senator DODD. No, these figures were from global trade. Chairman GREENSPAN. Oh, our global ones. Senator DODD. I would go back to my question just about China specifically. Chairman GREENSPAN. Senator, the growth rate of the Chinese economy is slowing down. The official objective that they perceive Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 to be necessary to maintain economic reform and stable labor mar- kets is a growth rate of about 8 percent per year. The growth rate has slipped, so far, according to their official fig- ures just recently released, to 6,8 percent annual rate in the second quarter, and there are those who believe that the pressures from the economies contiguous to China are really creating problems. Obviously, their exports to a number of the so-called tigers—we used to call them tigers, I don't know what they would be called at this particular stage—are down quite appreciably, as they are to Japan. This has created internal financial problems among the state-owned enterprises where their earnings and cash flows have been under severe pressure. It has clearly been the case that as a consequence of the weaken- ing Asian situation and its impact on China, the full thrust of the reforms that have been underway are in some jeopardy, and when you are confronting a short-term crisis, you tend to push longer- term things somewhat aside. Nonetheless, there's no doubt that they see the great advantages of moving increasingly toward a market economy, and the benefits that they have folly perceived as a consequence. There's no evidence of which I'm aware that would suggest that they were in any way backing away from the longer-term thrust of their policies, but the current situation is giving them some con- cern, and I think rightfully so. But when you sit right in the middle of an East Asian economy that is undergoing fairly significant con- traction, that it would have little or no effect on China is obviously most unrealistic. Senator DODD. We speak of the impact of what's taking place in Japan on our own economy. We read about the difficulty with the IMF issues regarding Russia, but I think most people think about it in terms of an IMF-Russia issue. I'm not sure they think about it in broader terms. As Japan is to the United States, I suppose Russia is to Europe. Given the European exposure in Russia, to what extent does the Russian economic condition pose any longer-term problems viz-a- viz the European economy and, again, to what extent does that pose some longer-term risk for us? Chairman GREENSPAN. Remember that the Russian economy is far smaller than the Japanese economy, and that is an element of importance. The actual ties of Europe directly to Russia through the trade accounts are not all that large. There's not a great deal of trade. Indeed, one of the fascinating characteristics of the demise of the Soviet Union is the extent to which all of those inter-Soviet bloc states' trade virtually evaporated. Nonetheless, there are very significant financial ties. The Ger- man banks, for example, have fairly substantial commitments as indeed the German government, through the banks, has also. Dif- ficulties in Russia do spread through the financial system and, to a limited extent, through the product markets, but that can have a negative impact on Europe, and I think it's giving concern to a number of European analysts for exactly that reason. Senator DODD. I see the light is on, Mr. Chairman. I thank you. I have another question or two, but I will Senator GRAMS. Why don't you go ahead and finish. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 Senator DODD. Thank you very much. Again, if these issues have been raised, Chairman Greenspan, please interrupt me. You commented on the underwriting standards used by banks, and I gather that issue has been addressed. I was intrigued about the numbers affecting consumer personal consumption. The numbers were up, and I presume much of that is attributed to the increase in real disposable income in the first quarter. We are going to be asked to vote fairly soon on a bill on bank- ruptcy reform issues. I'm not asking you to comment on the bill, but I would like to hear your views on the subject. I think all of us are inclined to want to do something about it. There has been a tremendous increase. In just my State of Connecticut alone, over the last 3 or 4 years, as cited in an article in the paper the other day, the number of bankruptcies has went from 8,000 to approxi- mately 13,000. But I also want to make note of the fact that last year, banks sent out some 3 billion solicitations for credit cards, and many of them were pre-approved. It's a very competitive market, and a very lucrative one. I'm worried about this rise in consumer debt, and the extent to which we may be looking at personal consumption related to con- sumer obligations. Without commenting on the bill, are we in some danger here? I don't want to ask you to comment on a bill, but to what extent should we be looking at the issue of this explosion in plastic aa a potential threat to longer economic stability? Chairman GREENSPAN. We are acutely aware of it because this plastic, as you put it, is everywhere, except as a big number in our financial statistics. Actually, credit card debt, while growing fairly substantially, is still a relatively small component in our economic system. House- hold mortgage debt is huge compared to that debt. There's no doubt that there's been a fairly dramatic endeavor on the part of banks, finance companies, and other institutions actu- ally to cater to this market, because it's growing at a good clip. Despite the fact that there are substantial losses, by the very na- ture of the type of instrument, the interest rates which are charged more than capture the losses and create a reasonably good rate of return. It has turned out to be good for both consumers and for fi- nancial institutions. It is certainly the case that credit card delinquencies are much higher than mortgage delinquencies by a huge order of magnitude. But the delinquency rate has come down in the last 6 months. As I'm sure you are aware, the bankruptcy rate for other than businesses has pretty much flattened out in the last number of months, so we're not getting evidence that we see the situation de- teriorating, and there is an interrelationship between credit cards and this process. It's something which I think should be addressed. The fact that we have had this huge increase in bankruptcies in a period of quite remarkable economic expansion and of falling unemployment rates tells you that something needs some form of adjustment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 What that is, I don't feel sufficiently expert at, but I will tell you it sticks out like a sore thumb from the other economic statistics. Senator DODD. You speak of this unprecedented growth in our economy taking place across the country, and you raised this in re- sponse to some of Senator Kerry's questions, but I think in many of our inner cities and rural areas this has yet to take place. Some rural areas have been untouched by it, as we see from some of the farm state issues that have been raised. I'm concerned about this education gap. I have heard talk about this, and heard you address it briefly here today, but I have this great concern, even though many people are going back to school and continuing their education, I worry that, in certain sectors of our economy, that's not happening at all. I see this gap getting wider and wider each year. When Nesbit wrote his book on megatrends a number of years ago, he picked four States to look at; California and Florida, for ob- vious reasons a number of years ago, the demographic changes that were taking place; Colorado and Connecticut. In Connecticut, you are looking at a relatively small piece of ge- ography the size of San Diego County, where you have tremendous affluence, the highest per capita earnings in the country. Yet, the inner cities of Connecticut, Hartford, New Haven, and Bridgeport, for instance, rank in the top 30 of the poorest cities in America. In an area of 110 miles by 50 miles, you have incredible affluence and you have some real poverty, and we don't have much of a rural area in our State. It seems to me, while we do have a strong middle-class and the economy has improved tremendously over the last number of years, when I compare the schools in suburban communities of Connecti- cut to those in urban areas, I see tremendous disparities in terms of the opportunities. Disparities not on the level of intelligence, de- sires, and so forth, but there's a huge gap educationally that's oc- curring. I'm not going to get involved in an education discussion per se, but I am concerned about this. I don't know if you have any thoughts on this particular concern beyond the question of technology, moving people into an ongoing educational experience, which I think will help, but I'm concerned about something more endemic here, something at another level. Chairman GREENSPAN. I just wanted to reinforce your concerns. The evidence of this gap, this relationship between the degree of education and income, has increasingly been reinforced in the last decade or two. In other words, as the premium of having a college education over a high school diploma has continued to increase, and the premium of a high school diploma over a dropout has con- tinued to increase, you can see it in the labor market, you can see it in the whole process of the skill differentials becoming ever more pronounced. Since our economy is at the cutting edge of technology, where ideas matter, the proportion of the gross domestic product which is comprised of conceptual, as distinct from physical, is consistently increasing, which is going to make this problem even worse unless we can find a means to bring up those in the lower echelons of the society to educational levels that bring them into the mainstream. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 We have found, in todays environment, that a number of people who thought of themselves as not having the capacity to do the types of jobs which really pay well, have been proved wrong. When they have been pressed into action, when they have been given on- the-job training, when they have been, in a sense, prodded in some cases, to reach out for things that they didn't think they could do, they have, for the most part, found they could do them. It's really an issue here of how does one create incentives to en- courage people to reach out, because that's going to be the way in which we are going to solve a lot of these problems. If we can find means to encourage them, to improve the environment in a manner in which they feel encouraged to do it, I think we will find that that's where the solution lies. It is not in trying to get new types of schools with heavy equipment in them, because that, in itself, isn't going to do it. Senator DODD. Thank you, Mr. Chairman, I'm very grateful to you. Thank you. Senator GRAMS. Thank you, Senator. Mr. Greenspan, I appreciate your time. I don't want to keep you very long, but when one feels the power of the gavel, you don't let it go very quickly. [Laughter.] I just have a couple of quick questions. We talked a little bit about Social Security unfunded liabilities. As you are aware, there's going to be a great debate going on—it's already started—over the next couple of months at least, on how to reform our Social Security system, where do we go from here to make it solvent. One approach would be to let the Government invest part of the Social Security trust fund surplus into the financial market. Do you believe this would be the right direction to go? Chairman GREENSPAN. No. I think it would be very dangerous. The presumption that you can somehow have, and I assume this is what you are suggesting, the Social Security Administration in- vest in equities—I don't know of any way you can essentially insu- late Government decisionmakers from having access to what will amount to very large investments in American private industry. There are, without doubt, many Presidents, many Members of Congress, who would look at the thought of employing that type of leverage which the Government would then have, as an anathema. There are others who would not. I'm fearful we are taking on a po- sition here, at least in conjecture, that has very far-reaching poten- tial dangers for the free American economy and the free American society. It is a wholly different phenomenon of having private investment of pension funds in the market where individuals own the stock, vote the claims on management, and having Government do that. I know there are those who have views, beliefs that it can be insu- lated from the political process, and they go a long way to try to do that. I have been around long enough to realize that that's just not credible, not possible. Somewhere along the line, that breach will be broken, and I think it will be much to the detriment of the American society. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 Senator GRAMS. Just to be clear, you are not opposed to personal retirement accounts being established and allowing individuals to invest in the market alongside of having Government control those accounts? Chairman GREENSPAN. Even if you are an indexed fund, it is a slippery slope away from there. But I'm very strongly supportive of going to private funding where individuals control claims on the corporations. I just feel there's a slippery slope of extraordinary magnitude to move that power into a Government agency. Senator GRAMS. Finally, Chairman Greenspan, what if Congress, instead of trying to move to more of a personalized retirement ac- count, would decide to look at the old system and tinker around the edges and maybe raise payroll taxes to fix the Social Security prob- lem instead of pursuing reform? Would these taxes absolve the problems of Social Security in the long run? How would that tax again affect national savings and investment interest rates, et cetera? Chairman GREENSPAN. Senator, you have to look at it in two ways. You have to look at it in terms of whether or not you're cre- ating a pay-as-you-go Social Security system, or whether you are fully funding it. One of the reasons, I might add, as I have indicated many times before in Congress, why I'm inclined toward private accounts is I think it far more readily will move toward funding which I think is essential, as I indicated earlier, to create the savings which will create investment and production of the real goods that are re- quired for retirees. What is involved here is essentially to recognize that you can, if you want to, create a pay-as-you-go system, and it will work for the 75-year horizon which forecasters always create by jiggling with the tax side and the benefit side. That will keep the system going the way it's been going. The question, however, is that, with the significant demographic changes about to be created in the United States where the popu- lation is aging and proportionate retirement is increasing year by year, can we afford not to have far more funding, it may not even have to be full funding, but clearly, the more funding you have, the greater capacity you have to employ current savings for investment into assets—productive equipment—which produce the real goods that are required to finance retirees. A pay-as-you-go system does not do that. It's just a mere inter- generational transfer or a transfer from workers to retirees, and in and of itself, that does not provide the increased productivity which a full funding system would engender. Senator GRAMS. I think to keep the current system afloat, if I'm not mistaken, in the last several decades, Congress has now had to tinker 51 times with either raising Social Security tax, adjusting the income on which it's levied, or tinker with the benefits. That is what has put us in the situation we are in today. Would you say there would have to be even higher taxes, less benefits, and greater income levied against the system in order to maintain even the present pay-as-you-go? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Chairman GREENSPAN. The current projections of the Social Se- curity Administration indicate there's a gap which would have to be closed, either on the revenue side or on the benefit side. Senator GRAMS. Chairman Greenspan, I would like to thank you for your time and your patience. I appreciate you coming before this Committee. Thank you very much. The hearing is concluded. Thank you. (Whereupon, at 12:10 p.m., Tuesday, July 21, 1998, the hearing was adjourned.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 PREPARED STATEMENT OF SENATOR ALFONSE M. D'AMATO The Committee is pleased to welcome Chairman Greenspan this morning to give the Federal Reserve's semiannual report to Congress on our Nation's economy. As many have noted on countless occasions, the Fed has done a remarkable job under your tenure. Our economic expansion is in its eighth year, making it the third longest in the post-World War II period. More than 15 million new jobs have been created. Continued low interest rates have allowed thousands of businesses to ex- pand and millions of families to buy homes. Chairman Greenspan, one thing is now clear to this Senator and perhaps to my colleagues as well. You and your colleagues at the Federal Reserve have something in common with Mark McGwire, a very talented baseball player. Continuing to hit home runs at a blistering pace, Mark McGwire is almost certain to break Roger Maris* home run record. Chairman Greenspan, you, too, are now in the pursuit of a home run record. If you succeed in keeping the expansion going for just another 19 months, 107 months in total, you will set a new record for the longest economic postwar expansion. Should that happen—and we all hope it will—my colleagues and I will be pleased to designate you "The Great Inflation Slugger" and induct you into the Economics Hall of Fame which, coincidentally, would be located in a lovely city in New York State. In much the same way as Mark McGwire must face challenges nearly every night in hitting against very talented pitchers, the Federal Reserve will face challenges in the year ahead. Inflation remains under control, yet low prices on oil and other commodities are hurting the economies of countries who can't afford it. Unemploy- ment also remains low, yet there is still significant concern among workers about their long-term job security. In addition, you and other financial regulators have ex- pressed concern about the underwriting standards of commercial banks. Finally, I think we all have questions about the depth and extent of financial problems in sev- eral countries around the world. Chairman Greenspan, I know that you will touch on the significant factors which may affect our Nation's economy over the next year, in particular the risks posed by international events, as we attempt to remain on our prosperous economic path. I would note that we in Congress remain optimistic that this path can be sustained and we look forward to working with you to ensure that continued economic growth under stable prices remains our common goal. PREPARED STATEMENT OF SENATOR CONNIE MACK Thank you, Chairman Greenspan, for appearing before this Committee. As al- ways, I look forward to hearing your thoughtful insights on monetary policy and the economy. With continued turmoil in many foreign economies, it is comforting to know that the U.S. economy remains fundamentally sound and growing. It almost seems like the U.S. economy is the saving grace—helping to bolster many troubled economies around the world. It is clear that our Nation is experiencing a remarkable period of good economic times. Our currency is strong, and we are enjoying low inflation, favorable growth, and good employment opportunities. A great deal of our economic stability is the result of sound monetary policy that has kept inflation in check. Under your guidance, the Federal Reserve has done an excellentjob of focusing on stable prices, which is the key to good, strong economic growth. There is no doubt that your solid leadership has produced confidence and certainty in the U.S. economy. The focus OD sound fiscal policy has also been a positive factor in our economy. Under a Republican Congress, the deficit outlook has changed dramatically, from predicted deficits of more than $200 billion, all the way down to sizable surpluses. This, I believe, has helped to foster lower interest rates that act as a major tax cut— benefiting millions of American families and helping our economy remain strong. However, our current growth and positive fiscal statistics should not lure us into complacency—particularly with major economies around the world teetering on fi- nancial meltdown. It was not long ago that some questioned whether the United States could remain the world's leading economic power, and they were in awe of the "Asian economic miracle." Perhaps the overriding lesson to be learned from the current economic turmoil in many countries is the tremendous importance of a stable monetary policy. The Fed- eral Reserve must remain committed to price stability—and Congress should remain focused on preserving budget balance, reducing wasteful spending, and easing the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 tax burden. I will continue to work to reform the Humphrey-Hawkins Act and re- place it with legislation that focuses on price stability as the Fed's primary goal. Most importantly, pursuing sound monetary policy is not just for abstract eco- nomic reasons. The failure of many governments to keep their currencies stable means that the people in these countries end up suffering greatly. In Indonesia, for example, the value of the rupiah has dropped more than 80 percent, half the popu- lation has fallen into poverty, and 1,200 have died in related violence. We have to come up with better ways to identify and to prevent such economic crises—both in the near-term and in the future. I would be interested in hearing from Chairman Greenspan just how the Federal Reserve and other international in- stitutions might be improving their efforts to identify and to prevent crises before they become severe. Congress role should be to ensure that both the United States and the IMF promote pro-growth policies, including low tax rates, free markets, sound banking systems, and stable currencies. A strong America must continue to be a guiding light to countries around the world. Our country has an important role to play in promoting economic growth, not just at home but also abroad. Why? Because our Nation strongly believes in free- dom, justice, democracy, human rights, and capitalism—and we're the only nation committed to exporting these ideas and principles around the globe. I welcome Chairman Greenspan and look forward to hearing his analysis. PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 21,1998 Introduction Mr. Chairman and Members of the Committee, I appreciate this opportunity to present the Federal Reserve's semiannual report on monetary policy. Overall, the performance of the U.S. economy continues to be impressive. Over the first part of the year, we experienced further gains in output and employment, sub- dued prices, and moderate long-term interest rates. Important crosscurrents, how- ever, have been impacting the economy. With labor markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup hi inflation remain significant. But inventory investment, which was quite rapid late last year and early this year, appears to have slowed, perhaps appreciably. Moreover, the eco- nomic and financial troubles in Asian economies are now demonstrably restraining demands for U.S. goods and services—and those troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee chose to keep the stance of policy unchanged over the first half of 1998. However, should pres- sures on labor resources begin to show through more impressively in cost increases, policy action may need to counter any associated tendency for prices to accelerate before it undermines this extraordinary expansion. Recent Developments When I appeared before your Committee in February, I noted that a key question for monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check inflationary tendencies that might otherwise result from the strength of domestic spending and tightening labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization, particularly that of the labor force, had risen to a very high level. Although there were some signs pointing to stepped-up increases in productivity, the speed at which the demand for goods and services had been growing clearly exceeded the rate of expansion of the econ- omy's long-run potential to produce. Maintenance of such a pace would put even greater pressures on the economy's resources, threatening the balance and longevity of the expansion. However, it appeared very likely that the difficulties being encountered by Asian economies, by cutting into U.S. exports, would be a potentially important factor slowing the growth of aggregate demand in the United States. But uncertainties about the timing and dimensions of that development were considerable given the difficulties in assessing the extent of the problems in East Asia. In the event, the contraction of output and incomes in a number of Asian econo- mies has turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in emerging market economies generally have re- mained unsettled, portending further difficult adjustments. The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over 1997, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 prompted a sharp deterioration in the U.S. balance of trade in the first quarter. Nonetheless, the American economy proved to be unexpectedly robust in that period. The growth of real GDP not only failed to slow, it climbed even further, to about a 5Vfe percent annual rate in the first quarter, according to the current national in- come accounts. Domestic private demand for goods and services—including personal consumption expenditures, business investment, and residential expenditures—was exceptionally strong. Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to- income ratios, low financing costs, and falling prices for high-tech goods fed the ap- petites of households and businesses for consumer durables and capital equipment. In addition, inventory investment contributed significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced that of overall output by a wide margin during the first quarter, adding 134 percentage points to the annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys indicate that much of the stock building probably reflected firms' confidence in the prospects for continued growth. As evidence piled up that the economy continued to run hot during the winter, the Federal Reserve's concerns about inflationary pressures mounted. Domestic de- mand clearly had more underlying momentum than we had anticipated, supported in part by financial conditions that were quite accommodative. Credit remained easy for most borrowers to obtain; intermediate* and long-term interest rates were at rel- atively low levels; equity prices soared higher, despite some disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering longer-term U.S. interest rates—through stronger preferences for dollar investments and expectations of slower growth ahead—and by reducing com- modity prices, probably added to the positive forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The robust expan- sion of demand tightened labor markets further, giving additional impetus to the upward trend in labor costs. Inflation was low—though, given the lags with which monetary policy affects the economy and prices, we had to be mainly concerned not with conditions at the moment, but with those likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee elected in March to move to a state of heightened alert against inflation, but left the stance of policy unchanged. Although national income and product data for the second quarter have not yet been published, growth of U.S. output appears to have slowed sharply. The auto strike has brought General Motor's production essentially to a halt, probably reduc- ing real GDP in the second quarter by about Vi percentage point at an annual rate. The limited amount of available information on inventory investment suggests that stock building dropped markedly from its unsustainable pace of the first quarter. In addition to the slower pace of inventory building, Asian economies have contin- ued to deteriorate, further retarding our exports in recent months. Indeed, readings on the elements that make up the real GDP have led many ana- lysts to anticipate a decline in that measure in the second quarter, after the first- quarter surge. Given the upcoming revisions to the national income accounts, such assessments would have to be regarded as conjectural. It is worth noting in any case that other indicators of output, including worker hours and manufacturing produc- tion, show a somewhat steadier, though slowing, path over the first half of the year. And underlying trends in domestic final demand have remained strong, imparting impetus to the continuing economic expansion. During the first half of the year, measures of resource utilization diverged. Pres- sures on manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly reflecting the deceleration in the world demand for manufactured goods that resulted from the Asian economic difficulties. But labor markets, hi contrast, became increasingly taut during the first half. Total payroll jobs rose about ll/s million over the first 6 months of the year. The civilian unemployment rate dropped to a bit below \Vz percent in the second quar- ter, its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a rising wage bill on production costs were moderated by strong gains ia productivity. Indeed, inflation stayed remarkably damped during the first quarter. The Con- sumer Price Index, as well as broader measures of prices, indicate that inflation moved down further, even as the economy strengthened. Although the declining oil prices contributed to this development, pricing leverage in the goods-producing sec- tor more generally was held in check by reduced demand from Asia that, among Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain prices on many imports, and rising industrial capacity. Serv- ice price inflation, less influenced by international events, has remained steady at about a 3 percent rate since before the beginning of the crisis. Some elements in the goods price mix clearly were transitory. Indeed, the more recent price data suggest that overall consumer price inflation moved up in the sec- ond quarter. But, even so, the increase remained moderate. In any event, it would be a mistake for monetary policymakers to focus on any single index in gauging inflation pressures in the economy. Although much public attention is directed to the CPI, the Federal Reserve monitors a wide variety of ag- gregate price measures. Each is designed for a particular purpose and has its own strengths and •weaknesses. Price pressures appear especially absent in some of the measures in the national income accounts, which are available through the first quarter. The chain-weight price index for personal consumption expenditures ex- cluding food and energy, for example, rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some aspects of so-called substitution bias and that already published data can be revised to incorporate any and all new informa- tion and measurement techniques. Taken together, while the various price indexes show some differences, the basic message is that inflation to date has remained low. Economic Fundamentals: The Virtuous Cycle So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earn- ings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have pro- vided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment. The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably the decline in the rate of inflation to near price stability. In recent years, continued low product price inflation and expectations that it will persist nave promoted stability in financial markets and fostered perceptions that the de- gree of risk in the financial outlook has been moving ever lower. These perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit and equity capital have been readily available for many businesses, fostering strong investment. And low mortgage interest rates have allowed many households to purchase homes and to refinance outstanding debt. The reduction in debt servicing coats has contributed to an apparent stabilization of the financial strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer demand. To a considerable extent, investors seem to be expecting that low inflation and stronger productivity growth will allow the extraordinary growth of profits to be ex- tended into the distant future. Indeed, expectations of earnings growth over the longer term have been undergoing continual upward revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about $12Vfe trillion has been added to the value of house- hold assets since the end of 1994. Probably only a few percent of these largely unre- alized capital gains have been transformed into the purchase of goods and services in consumer markets. But that increment to spending, combined with the sharp increase in equipment investment, which has stemmed from the low cost of both eq- uity and debt relative to expected profits on capital, has been instrumental in pro- pelling the economy forward. The consequences for the American worker have been dramatic and, for the most part, highly favorable. A great many chronically underemployed people have been given the opportunity to work, and many others have been able to upgrade their skills as a result of work experience, extensive increases in on-the-job training, or increased enrollment in technical programs in community colleges and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work- force in significant numbers. Government finances have been enhanced as well. Widespread improvement has been evident in the financial positions of State and local governments. In the Fed- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 eral sector, the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on markedly higher corporate profits, have joined with restraint on spending to produce a unified budget surplus for the first time in nearly three decades. The important steps taken by Congress and the Administration to put Federal finances on a sounder footing have added to national savins, relieving pressures on credit markets. The paydown of debt associated with the Federal surplus has helped to hold down longer-terra interest rates, which in turn has encouraged capital formation and reduced debt burdens. Maintaining this disciplined budget stance would be moat helpful in supporting a continuation of our current robust economic performance in the years ahead. The fact that economic performance has strengthened as inflation subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital diminish as the economy approaches price stability. But the extent to which strong growth and high labor force utilization have been joined with low inflation over an extended period is, nevertheless, exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring inflation higher in many past business expansions—eventually bringing those ex- pansions to an end—have not played a significant role in the current expansion. For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be sure, wages have started to acceler- ate in the past couple of years as the labor market has become progressively tighter. In the first few years of the expansion, the subdued rate of rise in hourly compensa- tion seemed to be, in part, a reflection of greater concerns among workers about job security. We now seem to have moved beyond that phase of especially acute concern, though the flux of technology may still be leaving many workers with fears of job skill obsolescence and a willingness to trade wage gains for job security. In the past couple of years, of course, workers have not had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In contrast to the pattern that developed in several previous business expansions, when workers required sub- stantial increases in pay just to cover increases in the cost of living, consumer prices have been generally well-behaved in the current expansion. A couple of years ago—almost at the same time that increases in total hourly compensation began trending up in nominal terms—some evidence of a long-awaited pickup in the growth of labor productivity began to show through more strongly in the data; and this accelerated increase in output per hour has enabled firms to raise workers' real wages while holding the line on price increases. Gains in productivity usually vary with the strength of the economy, and the favorable results that we have observed during the past 2 years or so, when the economy has been growing more rapidly, almost certainly overstate the degree of structural improvement. But evidence continues to mount that the trend of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major technological improve- ments are all around us, and the benefits are evident not only in the high-tech in- dustries but also in production processes that have long been part of our industrial economy. Those technological innovations, as well as the rapidly declining cost of capital equipment which embodies them, in turn seem to be a major factor behind the re- cent enlarged gains in productivity. Evidently, plant managers who were involved in planning capita) investments anticipated that a significant increase in the real rates of return on facilities could be achieved by exploiting emerging technologies. If that had been a mistake on their part, one would have expected capital invest- ment to run up briefly and then start down again when the lower-than-anticipated rates of return developed. But we have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have been realized. Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a noninflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed productivity growth, thereby creating pressure for inflationary price increases that can eventually undermine economic growth and employment. Because the level of productivity is tied to an important degree to the stock of capital, which turns over only gradually, increases in the trend growth of productivity probably also occur rather gradually. By contrast, the potential for ab- rupt acceleration of nominal hourly compensation is surely greater. As I have noted in previous appearances before Congress, economic growth at rates experienced on average over the past several years would eventually run into constraints as the reservoir of unemployed people available to work is drawn down. The annual increase in the working-age population (from 16 to 64 years of age), in- cluding immigrants, has been approximately 1 percent a year in recent years. Yet employment, measured by the count of persons who are working rather than by the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of output per nour. The gap between employment growth and popu- lation growth, amounting to about 1.1 million persons a year on average since the end of 1995, has been made up, in part, by a decline in the number of individuals who are counted as unemployed—those persons who are actively seeking work—of approximately 650,000 a year, on average, over the past ZVz years. The remainder of the gap has reflected a rise in labor force participation that can be traced largely to a decline of almost 300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one. Presumably, many of the persons who once were in this group have more recently become active and successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the offi- cial unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record low reached in May for these data, which can be calculated back to 1970. Nonetheless, a strong signal of inflation pressures building because of compensa- tion increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among nonfinancial corporations (our most recent source of data on consolidated income statements), trends in costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total unit costs are still quite low. Still, the gap between the growth in employment and that of the working-age pop- ulation will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close reasonably promptly, given already stretched labor re- sources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without monetary policy action remains an open question. Foreign Developments While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been spiraling in quite the opposite direction. The United States, Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation and declining unemployment, but the economic performance in many developing and transition nations and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor in shaping U.S. economic and financial trends in the period ahead. With all that is at stake, it would be very difficult to overstate how crucial it is that the authorities in the relevant economies promptly implement effective policies to cor- rect the structural problems underlying recent weaknesses and to promote sustain- able economic growth before patterns of reinforcing contraction become difficult to contain. Conditions in Asia are of particular concern. Aggregate output of the Asian devel- oping economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia. Even the economies of the stalwart tigers—Hong Kong, Singapore, and Taiwan—have softened. Economic growth in China has also slowed, owing largely to the currency depreciations among its neighbors and the sharp de- clines in their demand for imports. Russia has also experienced some spillover from the Asian difficulties, but Rus- sia's problems are mostly home-grown. Large fiscal deficits stem from high effective marginal tax rates that encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an environment of heightened concern about all emerging markets. The Russian government has re- cently promulgated a set of new policy measures in connection with an expanded IMF support package in an effort to address these problems. In Latin America, conditions vary: Economies that are heavily dependent on ex- ports of oil and other commodities have suffered as prices of those items have fallen, and several countries in that region have received more intensive scrutiny in inter- national capital markets, but, on the whole, Latin American economies continue to perform reasonably well. Disappointingly, economic activity in Japan—a crucial engine of Asian economic growth—has now turned down after a long period of subpar growth. Gross domestic product fell at a SVt percent annual rate in the first quarter. More recently, con- fidence of households and businesses has continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling domestic demand for goods and services in that country has been even further constrained by a mounting credit crunch. Nonperforming loans have risen sharply as real estate values fell fol- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 lowing the bursting of the asset bubble in 1991. Problems in the banking sector, ex- acerbated by the broader Asian financial crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have engendered a pre- mium in the market for Japanese banks' borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in dollars or yen. In response to the weaken- ing economy and deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often volatile markets, against the dollar and major Euro- pean currencies. As you know, we have sought to be helpful in the Japanese government's efforts to stabilize their economy and financial system, reflecting our awareness of the im- portant role that Japanese financial and economic performance plays in the world economy, including tnat of the United States. We have consulted with the relevant Japanese authorities on methods for resolving difficulties in their banking system and have urged them to take effective measures to stimulate their economy. I be- lieve that the Japanese authorities recognize the urgency of the situation. That a number of foreign economies are currently experiencing difficulties is not surprising. Although many had previously realized a substantial measure of success in developing their economies, a number had leaned heavily on command-type sys- tems rather than relying primarily on market mechanisms. This characteristic has been evident not only in their industrial sectors but also in banking where govern- ment intervention is typically heavy, where long-standing personal and corporate re- lationships are the predominant factor in their financing arrangements, and where market-based credit assessments are the exception rather than the rule. Many re- cent events confirm that these sorts of structures are ill-suited to today's dynamic global economy, in which national economies must be capable of adapting flexibly and rapidly to changing conditions. Responses in countries currently experiencing difficulties have varied consider- ably. Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political considerations appear to have militated against prompt and ef- fective action. As a consequence, the risks of further adverse developments in these economies remain substantial. And given the pervasive interconnections of virtually all econo- mies and financial systems in the world today, the associated uncertainties for the United States and otner developed economies remain substantial as well. In the current circumstances, we need to be very much aware that monetary pol- icy tightening actions in the United States could have outsized effects on very sen- sitive financial markets in Asia, a development that could have substantial adverse repercussions on U.S. financial markets and, over time, on our own economy. But while we must take account of such foreign interactions, we must also be careful that our responses ultimately are consistent with a monetary policy aimed at opti- mal performance of the U.S. economy. Our objectives relate to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve the long-run interests of troubled financial markets and economies abroad. The Economic Outlook The Federal Open Market Committee believes that the conditions for continued growth with low inflation are in place here in the United States. As I noted pre- viously, an important issue for policy is how the imbalance of recent years between the demand for labor and the growth of the working-age population is resolved. In that regard, we see a slowing of the growth in aggregate demand as a necessary element in the mix. At thia time, some of the key factors that have supported strong final demand by domestic purchasers remain favorable. Although real short-term interest rates have risen as the Federal funds rate has been held unchanged while inflation expecta- tions have declined, the financial conditions that have fostered the strength in de- mand are still in place. With their incomes and wealth having been on a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated. These factors suggest some risk that the labor market could get even tighter. And even if it does not, under prevailing tight labor markets increasingly confident workers might place gradually escalating pressures on wages and costs, which would eventually feed through to prices. But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition to a much more sustainable rate of growth and reasonable balance in labor markets. We have yet to see the full ef- fects of the crisis in East Asia on U.S. employment and income. Residential and business fixed investment already have reached such high levels that further gains Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 approaching those experienced recently would imply rapid growth of the stocks of housing and plant and equipment relative to income trends. Moreover, business in- vestment will be damped if recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the expected rates of return on investment in plant and equipment. Reduced prospects for the return to capital would not only affect investment directly but could also affect consumption if stock prices adjust to a less optimistic view of earnings prospects. Of course, the demand for labor that is consistent with a particular rate of output growth also could be lowered if productivity growth were to increase more. And, on the supply side of the labor market, faster growth of the labor force could emerge as the result of increased immigration or delayed retirements. Nonetheless, it ap- pears most probable that the necessary slower absorption of labor into employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track of expansion that is capable of being sustained. Thus, members of the Board of Governors and presidents of the Federal Reserve Banks anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real GDP will rise 3 to 31/* percent over 1998 as a whole and 2 to 2J/2 percent in 1999. With the rise in the demand for workers coming into line with that of the labor force, the unemployment rate is expected to change Tittle from its current level, finishing next year in the neighborhood of 4Vz to 43A percent. Inflation performance will be affected by developments abroad as well as those here at home. The extent and pace of recovery of Asian economies currently experi- encing a severe downturn will have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on world product markets. Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign eco- nomic activity, should that occur, would add, at least temporarily, to price pressures in the United States. On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will have the greatest effect on infla- tion rates here. As I noted previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless, an accelerating trend in wages has been apparent for some time. In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of factors—including the strength of the economy and rising equity values, which have reduced the need for payments into unemployment trust funds and pen- sion plans, and the restructuring of the health care sector—have been working to keep benefit costs in check in this expansion. But, in the medical area at least, the most recent developments suggest that the favorable trend may have run its course. The slowing of price increases for medical services seems to have come to a halt, at least for a time, and, with the cost-saving shift to managed care having been largely completed, the potential for businesses to achieve any further savings in that regard appears to be rather limited at this point. There have been a few striking instances this past year of employers boosting outlays for health benefits by sub- stantial amounts. Given that compensation costs are likely to accelerate at least a little further, pro- ductivity trends and profit margins will be key to determining price performance in the period ahead. Whether the recent strong performance of productivity can be ex- tended remains to be seen. It does seem likely that productivity calculated for the entire economy using GDP data weakened in the second quarter. This development clearly owed, at least in some degree, to the deceleration of output in that period. In manufacturing, where our data are better measured, productivity appears still to have registered a solid increase. We will be closely monitoring a variety of indica- tors to assess how productivity is performing in the months ahead. Monetary policymakers see the most likely outcome as modestly higher inflation rates in the next 1V& years. The central tendency of monetary policymakers' CPI in- flation forecasts is for an increase of 1% to 2 percent during 1998 and 2 to 2Vz per- cent next year. Aa noted, the ebbing of the special factors reducing inflation over the past year or so, such as the decline in oil prices, will account for some of this uptick. But the Federal Open Market Committee will need to remain particularly alert to the possibility that more fundamental imbalances are increasing inflation- ary pressures. The Committee would need to resist vigorously any tendency for an upward trend, which could become embedded in the inflationary process. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 The Committee recognizes that significant risks attend the outlook: One is that the impending constraint from domestic labor markets could bind more abruptly than it has to date, intensifying inflation pressures. The other is the potential for further adverse developments abroad, which could reduce the demand for U.S. goods and services more sharply than anticipated and which would thereby ease pressures on labor markets. While we expect that the situation will develop rather smoothly, the Committee believes that, given the current tightness in labor markets, the po- tential for accelerating inflation is probably greater than the risk of protracted, ex- cessive weakness in the economy. In any case, it will need to continue to monitor evolving circumstances closely, and adjust the stance of monetary policy as appro- priate, in order to help establish conditions consistent with progress toward the Fed- eral Reserve's goals of price stability and maximum sustainable economic growth. Ranges for Money and Credit Growth Indeed, recognition of the benefits of low inflation and our commitment to the Federal Reserve's statutory objective of price stability were once again dominant in the Committee's semiannual review of the ranges for the monetary and debt aggre- gates. The FOMC noted that the behavior of the monetary aggregates had been somewhat more predictable over the past few years than it had been earlier in the 1990's. The rapid growth of M2 and M3 over the first half of the year, which lifted those measures above the upper ends of the target ranges established in February, was consistent with the unexpectedly strong advance in aggregate demand. How- ever, movements in velocity remain difficult to predict. The FOMC will continue to interpret the monetary ranges as benchmarks for the achievement of price stability under conditions of historically normal velocity behav- ior. Consistent with that interpretation, the Committee decided to retain the current ranges for the monetary aggregates for 1998, as well as the range for debt, and to carry them over on a provisional basis to next year. Although near-term prospects for velocity behavior are uncertain, the Committee recognizes that monetary growth does appear to provide some information about trends in the economy and inflation. Therefore, we will be carefully evaluating the aggregates, relative both to forecasts and to their ranges, in the context of other readings on other variables in our efforts to promote optimum macroeconomic conditions. Concluding Comments As I have stated in previous testimony, the recent economic performance, with its combination of strong growth and low inflation, is as impressive as any I have wit- nessed in my near half-century of daily observation of the American economy. Al- though the reasons for this development are complex, our success can be attributed in part to sound economic policy. Congress and the Administration have successfully balanced the budget and, indeed, achieved a near-term surplus, a development that tends to boost national saving and investment. The Federal Reserve has pursued monetary conditions consistent with maximum sustainable long-run growth by seek- ing price stability. These policies have helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted living standards for most Americans. The task before us is to maintain dis- ciplined economic policies and thereby contribute to maintaining and to extending these gains in the years ahead. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM ALAN GREENSPAN Q.I. Can you explain how and why the monetary aggregates like M2 and M3 have been growing so rapidly? Does the recent increase in the growth of M2 and M3 cause inflationary concerns? Why or why not? A.l. The monetary aggregates have been growing very rapidly so far this year. M2 has expanded at an 8V4 percent annual rate through September and M3 at a 10V4 percent annual rate. The fac- tors behind this development are not completely clear. Expansion of nominal income, which has been relatively low this year, does not explain the rapid growth. Nor do movements in short-term in- terest rates, which until recently have been relatively stable. Instead, it appears that factors relating to developments in the stock market have been playing a role. First, in light of the rapid rise in equity valuations which occurred through mid-July 1998, households may have been re-balancing their asset portfolios by steering more of their savings toward cash-type instruments, many of which are included in M2, such as money market mutual fund shares. More recently, the pronounced volatility in equity prices probably has led some households to reduce their equity positions in favor of the safety of money funds and, perhaps, other M2 in- struments. The rapid growth of M3 owes importantly to money market mutual funds, both the retail funds within M2 as well as the institution-only funds in the non-M2 component of M3. In addi- tion, M3 has been supported by strong advances in bank credit, which is funded partly with instruments included in M3. Interpreting these aggregates is not straightforward because of uncertainties about their relationships to spending. The velocity of M2—the ratio of income to money—varies considerably, and recent changes have been within the normal range of fluctuation. The ro- bust growth in M2 earlier in the year, to the extent that it did owe in part to the elevated level of equity prices, may have been provid- ing a signal consistent with other indicators that suggested that demand in the U.S. economy remained quite strong and inflation pressures were in danger of building. But the more recent strength in the monetary aggregates is reflective of the current volatility in financial markets; it seems to reflect a flight to liquidity rather than financial stimulus, and thus does not appear to be signaling oncoming inflationary pressures. Q.2. In the past, you have stated that productivity is tough to measure with regard to the service sector. In fact, most economists would agree that durable manufacturing productivity is a much more reliable indicator of productivity. It is my understanding that durable manufacturing productivity has increased at an annual rate of 5.6 percent over the last 7 years—the fastest of any recov- ery in the history of the data. Is that true? If so, is it possible we are experiencing record growth rates in the productivity of the service sector as well, but our measurements just do not record it as such? A.2. I agree that a number of difficult issues surround the meas- urement of productivity, but I disagree that "durable manufactur- ing" productivity is a more reliable indicator of productivity in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 economy as a whole. It is, in fact, true that for some firms in the durable goods sector we have very good physical product measures of output—for example, for motor vehicles and steel. However, for other firms, such as computer companies, the measurement of out- put can be quite difficult.1 In addition, durable manufacturing is a relatively small part of the total private sector. Rather than focus on durable manufacturing, I prefer to look at a broader measure of productivity. In particular research by the staff of the Federal Reserve, "Decomposition of Productivity and Unit Costs," November 1996 (included in Additional Material Sup- plied for the Record), it is suggested that the best measured broad sector of the economy is the nonfarm nonfinancial corporate sector. Typically, macro-economists look at productivity in the nonfarm business sector (line 1 of the table). However, the Board's research suggests that two important components of that aggregate are not well measured—the financial sector and, even more important, the nonfarm noncorporate sector (lines 3 and 7).2 As shown on line 7, output per hour in the nonfarm noncorporate sector, as derived from the published statistics, fell for more than two decades, begin- ning in the early 1970's. However, it seems unlikely that, in re- ality, the firms in this sector became less and less efficient, year in and year out. This suggests that this sector is not well measured and may distort productivity analyses that include this sector. Sectoral Labor Productivity (Percent change at annual rate over period indicated) 1959 to 1973 1973 to 1989 1989 to 1998:Q2 1. Nonfarm business sector 2.9 1.1 1.2 2. Nonfarm corporate 2.4 1.5 1.8 3. Financial 2.4 1.2 1.6 4. Nonfinancial 2.3 1,5 1.9 5. Manufacturing 3.3 2.7 3.0 6. Nonmanufacturing 1.4 .8 1.5 7. Nonfarm noncorporate 3.5 -.6 — 2 Source: Baaed on updated version of the data set described in "Decomposition of Productivity and Unit Costa." As can be seen on line 4 of the table, productivity of nonfarm nonfinancial corporations has been increasing at nearly a 2 percent annual rate since the peak of the last cyclical expansion in 1989— nearly half a percentage point faster than the average pace be- tween the cyclical peaks in 1973 and 1989. As shown on lines 5 and 6, productivity growth in the total manufacturing sector (durable plus nondurable goods-producing industries) continues to outpace 1 The issue is how to evaluate the output represented by this year's PC versus last year's PC. If, for example, the same number of "boxes" left a factory this year as last, we would not think that the output of the factory was unchanged since this year's PC is more powerful than last year's. Government statisticians do their best to estimate how much more output is represented by the extra power of this, year's PC, but these ar« only educated guesses. 2 The shares of the financial and nonfarm noncorporate sectors in total nonfarm business sec- tor productivity are roughly 5 percent and 25 percent, respectively. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 the growth of productivity in nonmarmfacturing corporations. The greatest amount of measured improvement in productivity perform- ance during the 1990's, however, has occurred at nonmanufactur- ing corporations. Q.3. The Producer Price Index and the price of commodities were dropping even before the East Asian currency crisis and the Gen- eral Motors strike. Why do you believe those indicators were de- creasing before these two events? Doesn't this suggest something else may be at work helping to hold inflation down? A.3. Following the 2.8 percent rise in 1996, the Producer Price Index (PPI) fell 1.2 percent in 1997 and another 0.9 percent in the first 8 months of 1998. As suggested in your question, these move- ments do reflect a complex set of influences, and Asian economic developments certainly have played a role. However, the supply- demand balance in individual markets has been important as well, and to better understand the underlying trends, it is useful to ex- amine the behavior of several key subindexes of the PPI. Buoyed by favorable harvests, food prices fell 0.8 percent in 1997 and have edged lower this year. These developments reflect the fa- vorable growing conditions in most parts of the country over the past 2 years as well as reduced demand for U.S. agricultural ex- ports as a result of the economic crises in Asia and Russia. Falling energy prices also have contributed to the declines in the PPI over the past 18 months. Energy prices fell 6.4 percent in 1997 and another 10.1 percent in the first 8 months of this year. This pattern largely reflects the sizable declines in crude oil prices over this period. Oil producers were slow to cut back their production in the face of an unusually mild winter in the Northern Hemi- sphere earlier this year and slumping demand from the economi- cally troubled Asian economies. Crude oil prices fell as a result, and these cost decreases quickly were passed through to the prices of refined petroleum products. Falling electricity charges associated with the deregulation of electricity markets in several States also have contributed to the decline in energy prices this year. Other than food and energy, producer prices were flat in 1997 and have edged up about 3/4 percent in the first 8 months of 1998. This favorable performance reflects a number of factors. First, in- creases in unit labor costs have remained quite low despite an up- tick in compensation costs because firms have been able to achieve rapid gains in labor productivity. Second, firms now find that they have very little leverage to raise prices. Todays marketplace is ex- tremely competitive, and the appreciation of the U.S. dollar on for- eign exchange markets—related in part to the Asian crisis—has heightened that competition. Third, unusually rapid declines in the prices of high-tech equipment (such as computers) also has been a restraining influence on PPI inflation this year. Q.4. The yield curve is inverted from the Federal funds rate out to the 10-year Treasury bond. Historically, that has suggested mon- etary policy is too tight. Is that the case today? If not, why? A.4. Although rates on most Treasury securities are less than or equal to the Federal funds rate, the yield curve is currently upward sloping from 3-month Treasury bills through 30-year bonds- Thus, it may be a misnomer to say that the yield curve is inverted. The Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 current configuration likely reflects several factors. Recent devel- opments, including slower growth in foreign economies, widening yield spreads on corporate debt, and tighter terms and standards on business lending, have substantially altered the outlook for the U.S. economy, lowering investors' expectations of economic growth and further reducing inflationary pressures. Thus, the lower rates on shorter-term Treasury securities relative to the Federal funds rate in part reflects the view in the market that the Federal Re- serve will ease monetary policy further in coming months to help counter these developments. In addition, Treasury securities, especially Treasury bills, have benefited strongly from safe-haven flows as investors continue to reduce risk exposure in light of turbulence in worldwide financial markets. Because of the high value they currently place on safety and liquidity, these investors are willing to hold Treasury securi- ties at yields well below levels that might be observed in more or- derly markets. Also, reductions in the supply of Treasury securities may also be keeping yields low. On net, there has been a paydown of nominal Treasury securities over the past year as the Federal budget has moved into surplus. The accuracy of the yield curve as a signal of the stance of mone- tary policy is unclear. It is true that each recession over the past several decades has been preceded by an inverted yield curve. How- ever, in these cases, the yield curve typically has become inverted as a result of sharp increases in short-term rates when monetary policy tightened to counter high and rising inflation. The inversion occurred as both short- and long-term rates rose, with the former increasing more than the latter. In contrast to this, the more recent inversion of the yield curve has been driven by a decline in long- term interest rates of more than 1V& percentage points over the past 12 months, importantly reflecting declining inflation expecta- tions, and, more recently, by the strong flight-to-quality demands for Treasury securities described previously. With few historical precedents for this pattern, the implications for future economic trends are difficult to discern. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 STATEMENT OF DAVID A. SMITH DIRECTOR OF PUBLIC POLICY, AFL-CIO JULY 21, 1998 The AFL-CIO appreciates the opportunity to submit this statement for the record of today's Humphrey-Hawkins hearing. All working Americans and their families have a high stake in the achievement of the Humphrey-Hawkins Act's full employ- ment targets. It is good news for America's workers that the Nation's unemployment rate is edging closer to our historic full employment targets than at any other time since this landmark legislation was adopted in 1978. While the reduction in the unemployment rate over the last few years has been gratifying, it is by no means guaranteed that this favorable trend will continue, or that the Humphrey-Hawkins target of a national unemployment rate no higher than 4 percent will actually be achieved. Much will depend on economic policy decisions, of which none will be more important than the monetary policy decisions of the Fed- eral Reserve's Open Market Committee. We urge Chairman Greenspan and his FOMC colleagues to use the tools of mone- tary policy in order to guide the economy toward its full employment potential. With inflation low and declining while unemployment has been decreasing, 4 percent un- employment should no longer be dismissed as an unrealistic goal. The most serious threat to reaching that goal is the shock waves set off by the severe financial and economic crisis which has enveloped much of East Asia, and which apparently is spreading to other parts of the world, including Russia. No serious observer would deny that the movement of a tidal wave of capital from East Asia and elsewhere to the relative safety, security, and high returns of U.S. financial markets has been a hallmark of the current financial crisis. In an effort to stem the outflow, defend their currencies, and satisfy the austerity conditions im- posed by the IMF, the countries hit hardest by the crisis have been forced to boost their domestic interest rates to astronomical and punishing levels. Meanwhile, the largest economy in Asia and the second largest in the world, Japan, is caught in a deepening economic crisis. In an effort to jump-start its stalled economy, Japan's central bank has cut interest rates to record lows. Low interest rates, however, have done little to stimulate Japan's economy; in part because a banking crisis has curtailed lending but also in part because capital has left the country in pursuit of higher returns on investment in the United States. The exit of capital has battered the yen, making Japanese exports hyper-competitive and stimulating the outflow of even more capital. The human costs of East Asia's financial crisis are staggering. In Indonesia, Thai- land, South Korea, and elsewhere bankruptcies and unemployment are mounting, and the worst is yet to come. Rudimentary or nonexistent social safety nets in these countries mean that the unemployed are left largely to their own devices, Beyond the human tragedy, the inadequate safety net worsens these economies' downward spiral, as the unemployed are forced to curtail their purchases when they lose their jobs. Deficit spending to mitigate the crisis is out of the question, partly as a result of IMF austerity conditions and partly because of the need to prevent further exodus of capital. One obvious step which the United States could and should take to ease Japan's and the East Asian economic crisis is to lower our interest rates in order to slow down the torrent of capital pouring into our financial markets. Lower U.S. interest rates in and of themselves will not resolve the crisis, but they would clearly ease it. Compared with the cost of IMF bailouts both to U.S. taxpayers and to the people of East Asia who are bearing the burden of economic austerity, lower U.S. interest rates are a dirt-cheap policy alternative. The crisis taking place in Japan and the rest of East Asia has already begun to have a negative impact on the U.S. economy. In May, the Nation's trade deficit in goods and services increased to $15.7 billion, an all-time monthly high. For the first 5 months of 1998, the U.S. trade deficit in goods with the Pacific Rim countries to- taled $59 billion, a 43 percent jump from the first 5 months of 1997. Much of the recent deterioration in the Nation's trade position is attributable to declining U.S. exports, brought about by the collapse of currencies and bank lending in Asian countries which, as a result, can no longer afford or finance the purchase of U.S.-made products. The declining exports and accelerating imports have begun to hit U.S. manufacturing employment, which has been weak for most of this year. In May and June, this weakness yielded to outright employment declines totaling 51,000 jobs. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Evidence is mounting, moreover, that the worsening of the Nation's trade position and the declines in manufacturing employment may already have triggered a very marked slowdown or even contraction in the U.S. economy. In view of the time lag between changes in monetary policy and their impact on the economy, it would be far better to lower U.S. interest rates now than to wait for the East Asian economic crisis and the weakness in the U.S. economy to worsen. There is little downside to lowering U.S. interest rates. Inflation remains tame, as the June figures for both the CPI and PPI attest. Now is the time to lower interest rates, to ease the East Asian economic crisis and keep the U.S. economy on course to, at long last, reaching the Humphrey-Hawkins Act's full employment goal. STATEMENT OF ANDREW L. STERN INTERNATIONAL PRESIDENT, SERVICE EMPLOYEES INTERNATIONAL UNION, AFL-CIO JULY 21, 1998 The 1.3 million members of the Service Employees International Union have a vital stake in the monetary policies of the Federal Reserve. SEIU's membership in- cludes workers in the public sector, health care, and the building service industry. The economic security of their families depends on a strong and growing economy. Our Future is At Stake Strong economic growth has eliminated the Federal budget deficit and boosted the budgets of State and local government. After years of cutbacks, these conditions make possible a debate about restoring the ability of our public sector to strengthen our economic future through increased investment in education, families, health care, and infrastructure. Decades of neglect have left unattended many social problems that threaten our economic well-being. Over 41 million Americans have no health insurance, a figure projected to increase to 50.4 million by 2004. According to the General Accounting Office, at least one-third of our schools—serving 14 million students—have one or more buildings in need of extensive repair. Only strong growth can generate the re- sources we need to become more competitive in the future. It's a Question of Fairness Low-wage workers have suffered significant wage losses over the past two dec- ades, partly as a result of the historically high real interest rates during that time which kept unemployment higher than the postwar norm. Low-wage workers are es- pecially vulnerable to labor market conditions. Since 1996, thanks to low unemploy- ment, and an increase in the minimum wage, low-wage workers have enjoyed real wage gains. These gains are important and must be sustained by keeping growth strong. Even with these gains, low-wage workers have not restored their wages to the level they enjoyed in 1989, the peak of the previous recovery. Low-wage workers are especially fortunate that job growth has been strong over the past 2 years. The 1996 welfare reform law introduced stiff work requirements that have pushed millions of former welfare recipients into the workforce. Nation- wide, welfare rolls are down by over one-third. Rising unemployment would put the recent wage gains and the success of welfare reform into jeopardy. While workers are benefiting from the strong economy, they still have a long way to go to regain their fair share of the economic pie. Working Families Are Still Digging Out of the Hole According to Bureau of Labor Statistics data analyzed by the Economic Policy Institute, the median worker's 1997 wage of $10,82 was 3.2 percent below what it was in 1989, the peak year of the previous economic expansion, after adjusting for inflation. Not that 1989 was such a great year—the 1997 median wage is 6.8 per- cent below what it was in 1973. Stagnant wages undermine the ability of workers to save for the future. In a Jan- uary poll conducted by Peter Hart Research for the AFL-CIO, only 41 percent of respondents said their family income was sufficient to put money aside in savings. Economic Danger Signals "We should not be complacent about the dangers posed by the Asian crisis. Indo- nesia's economy has shrunk by 80 percent in the past 2 years, Thailand's by 50 per- cent, and South Korea by 25 percent. Japan, the world's second largest economy and the only hope for pulling the region out of the doldrums, is now in its second reces- sion in 5 years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 Manufacturing employment has declined in the United States in June and May— prior to any impact of the General Motors strike. The strong dollar is adding to the woes of the manufacturing sector by making U.S. exports more expensive and im- ports cheaper. Lowering interest rates would slow the inflow of short-term capital which is driving up the dollar. The Federal Reserve Must Act Now Although the Federal Reserve has maintained a steady interest rate policy over the past year, this does not mean that the cost of borrowing is unchanged. Inflation has been declining steadily. As a result, in 1997, the benchmark Federal funds rate was at its highest level since 1989—on the eve of the last recession (in annualized, inflation-adjusted terms). The Federal Reserve should reverse its policy of allowing real interest rates to drift upward. Over the past two decades of determined inflation-fighting by the Fed, we have heard often about the need for preemptive action to forestall inflation. Today, we have clear signs of an impending economic slowdown. Now is the time for preemp- tive action by the Federal Reserve to prevent an increase in unemployment result- ing from slower growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 DECOMPOSITION OF PRODUCTIVITY AND UNIT COSTS L. Slifman and C. Corrado* Board of Governors of the Federal Reserve System November 18, 1996 * Associate Director, Division of Research and Statistics, and Chief, Industrial Output Section. Division of Research and Statistics. Other Federal Reserve staff contributors to this report were Mark Doms, Charles Fleischman, Gloria Fennell, Marc Fusaro, Fong Kiang, Elizabeth Vrankovich, and Beth Anne Wilson. The authors thank Robert Parker and Gerald Donahoe of the Bureau of Economic Analysis for providing unpublished income estimates, and Alan Greenspan, Alice Rivlin, David Stockton, P. A. Tinsley, and Ellen Dykes of the Federal Reserve Board as well as Edwin Dean (BLS), Michael Harper (BLS), Steven Landefeld (BEA), and Robert Parker (BEA) for helpful comments on an earlier draft. This paper does not necessarily reflect the views or opinions of the Board of Governors of the Federal Reserve System. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 DECOMPOSITION OF PRODUCTIVITY AND UNIT COSTS L. Slifrnan and C. Corrado Labor productivity (output per hour) in the private business sector is reported to have been rising at an annual rate of about 1-1/4 percent since 1973. At the same time, output per hour in the nonfinancial corporate sector is estimated to have been increasing at a 1-3/4 percent annual rate. Given that the nonfinancial corporate sector is about two-thirds of the aggregate, these statistics imply that output per hour elsewhere in private business has not increased, on average, for more than two decades. For the past fifteen years, productivity growth in manufacturing has been relatively robust. A BLS study concluded that all of the growth in private business multifactor productivity in the 1980s could be attributed to manufacturing.1 Moreover, the published Figures for private business and manufacturing labor productivity suggest that since the beginning of the 1990s output per hour in the nonmanufacturing sector of the economy has been disappointing. Because it seems unlikely that major sectors of the economy have, in reality, failed to become more efficient year in and year out, it would be useful to try to identify at a more disaggregated level those segments of the economy with persistently dismal measured productivity performance. Moreover, for purposes of current analysis, one would like to have the data at a quarterly frequency. This paper presents such a disaggregation. The decompositions are by legal form of organization, with gross industry breaks within the corporate sector, and by detailed industry. For expository convenience, we refer to the former as the "sectoral" decomposition and the latter as the "industry" decomposition. An accompanying dataset contains the complete set of sectoral and industry estimates of labor productivity as well as a decomposition of sectoral data on unit costs and profits. Decomposition of Productivity and Unit Costs by Sector The sectoral decomposition develops product and income accounts for subsectors of the domestic business sector in the national income and product accounts (NIPAs). The basic idea underlying the decomposition is that the Commerce Department's Bureau of Economic Analysis (BEA) publishes quarterly income and product for the domestic business sector and for most of the corporate business sector. The BEA also publishes annual income and product for farms and owner-occupied housing. After making a few interpolations (and extrapolations) of these annual data, as well as constructing an implicit deflator for the output of financial corporations, one can calculate a complete quarterly income and product account for the nonfarm business 'William Gullickson, "Multifactor Productivity in Manufacturing Industries/ Monthly Labor Review (October 1992); see especially page 29 and chart 2. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 -2- sector (as defined by BLS for official productivity estimates).1 An income and product account for the noncorporate sector can then be calculated as a residual. The nonfarm, nonfinancial corporate sector is further disaggregated into manufacturing and nonmanufacturing; this disaggrcgauon relies, in pan, on BEA's annual series on gross product originating by industry (see below). A complete description of all the series that are part of the sectoral decomposition appears in Appendix 1. What Does the Decomposition Comprise? The sectoral decomposition breaks the nonfamt business sector (less housing) into the following sectors: nonfarm corporate business, financial corporations, nonfarm nonfinancial corporations, manufacturing corporations, nonmanufacturing corporations (excluding farm and financial corporations), and nonfarm noncorporations. The nonfarm noncorporate sector consists primarily of sole proprietorships and partnerships, with nearly half of the sector's income generated by businesses in the services industry.1 In addition, nominal and real product for the total nonfarm business sector and for the nonfarm noncorporate business sector are recalculated on an "income basis" by subtracting the NIPA statistical discrepancy. Because the statistical discrepancy has swung from +$58 billion in 1993 to -$51 billion in 1996:Q2, the income-based measures of activity (and, hence, productivity) have been growing more rapidly than the output-based numbers in recent quarters. Each sector is decomposed into the following product and income components: nominal gross product; real gross product; consumption of fixed capital (with capital consumption adjustment); indirect business taxes, business transfers, and net subsidies; compensation; profits (with inventory valuation adjustment and capital consumption adjustment); net interest; proprietors' income; and rental income. When real sector product is divided by hours worked, the result is labor productivity, or output per hour.4 When nominal sector product and its income components are divided by real sector product, the result is a complete unit cost (and profit) accounting that adds up to the implicit deflator for the sector. The unit cost decomposition for each sector is presented in the accompanying dataset. interpolations, extrapolations, and data constructions are based primarily on published quarterly NIPA series and are described in Appendix 1. 'The services industry share reflects calculations based on unpublished BEA data on domestic income by industry and legal form of business. See table 4, line 15, column 3. 4Note that the manufacturing sectoral real product estimates presented here are value-added measures and thus differ from sectoral output as calculated by BLS. See William Gullickson, "Measurement of Productivity Growth in U.S. Manufacturing," Monthly Labor Review (July 1995), pp. 13-28. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 -3- Highlights of the Sectoral Decomposition Tables 1 and 2 summarize the results of the exercise. The upper portion of lable 1 shows the annuaHzed growth rate of real sector output over selected time periods and the next portion shows the corresponding growth rates of hours worked.5 The third and fourth sections show labor productivity (output per hour) and unit labor costs by sector. As can be seen in line 16, the official measure of labor productivity in the nonfarm business sector slowed from an annual growth rate of 2.8 percent in the 1960s and early 1970s to a 0.9 percent rate during the 1990s. Even when measured on an income basis (line 17), the recent performance (1.2 percent per year) has been disappointing compared with that in the 1960s. By sector, the decomposition suggests that the 1970s slowdown in measured productivity growth was concentrated in the corporate manufacturing and nonfarm noncorporate sectors (lines 2! and 23). Subsequently, output per hour in manufacturing recovered. But the level of output in the noncorporate sector, as implied by this decomposition, has continued to fall. Table 2 provides perspective on the relative size of each sector's domestic income, real output, and hours. As may be seen, the nonfarm noncorporate sector has accounted for just under one-fourth of nonfarm business activity in recent years. Accompanying the lackluster behavior of productivity in the nonfarm noncorporate sector has been rapid growth in unit labor costs compared with those in the corporate sector (table 1, line 31 vs. line 26). At the same time, as shown in chart 1, the return to the owners of nonfarm noncorporate businesses (that is, proprietors' income plus rental income) as a share of either nominal gross sector product or domestic income has been well maintained in recent years.6 Consequently, as illustrated by chart 2, since 1976 the implicit deflator for the nonfarm noncorporate sector has been rising much faster than the deflator for the nonfarm corporate sector -- 6.7 percent (annual rate) vs. 4 percent (annual rate). A Caveat A critical component of this decomposition is BEA's estimate of real nonfinancial corporate output. To calculate real nonfinancial corporate output, BEA deflates current-dollar nonfinancial corporate product using the implicit deflator for goods and structures, which may not accurately represent corporate product prices. For example, corporate product includes almost all of the output for services, such as purchased 'For the most part, the figures on hours worked are those used in the BLS measures of output per hour for nonfarm business, nonfinancial corporations, and manufacturing. See Appendix 1 for a complete description. ^he domestic income of a sector is equal to the sector's gross product originating minus the consumption of fixed capital, indirect business taxes, and business transfers, plus net subsidies. See table A-l, line 6. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 -4- intercity transportation, houseKold utilities, and motion pictures, as well as a portion of legal services. However, the quantity weights for the prices of these and other obviously excluded categories are relatively small for the nonfinancia! corporate sector as a whole (see table 4, column 2). In fact, as shown on chart 3, a nonfinancial corporate output price index constructed to reflect the two-digit industry composition of nonfinancial corporate product does not show a long-term trend that is significantly different from BEA's published deflator. The broad trends implied by the productivity and unit cost decompositions, which are based on the published estimates of real nonfinancial corporate product, would be little changed if current-dollar nonfinancial corporate product were deflated with the constructed price index. However, the chart does show the two deflators beginning to diverge in the 1990s, suggesting that in recent years the use of official statistics for the decomposition has caused a misallocation of a small portion of real product from the noncorporate sector to the nonmanufacturing corporate sector. Decomposition of Productivity by Industry The industry decomposition relies on one- and two-digit SIC industry output, employment, and hours data that are available as part of BEA's gross product by industry dataset.7 An important caveat associated with using these data for longer-run historical comparisons is that the SIC system was changed in 1987. BEA's recommendations have been followed in combining certain two-digit industries to create reasonably continuous time series.* In any event, with these data, output per hour measures were calculated for detailed industries and aggregated to a measure for the nonfarm business sector less housing.* Highlights of the Industry Decomposition Table 3 summarizes the results of this exercise. As can be seen by comparing lines 1 and 2, growth rates of the constructed aggregate and the official series are quite close, 7This decomposition is similar to analyses of output per hour by major industry presented in the 1988 Economic Report of the President, page 73, and in Zvi GriHches' introduction to the conference volume Output Measurement in the Service Sectors, University of Chicago Press, 1992, page 5. In addition to updating these earlier studies, this report presents productivity estimates at a more disaggregated level. 8See the August 1996 edition of the Survey of Current Business for a complete description of gross product by industry and BEA's recommendations for linking the data across the 1987 SIC change. 'Unlike the official BLS productivity series, the constructed aggregate includes output and hours from nonprofit institutions and paid private household workers. In addition, the constructed series excludes the entire government, and agriculture, forestry, and fishing industries rather than just excluding farm output and hours. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 -5- even though 25 percent of services industry domestic income is not in the business sector (table 5, column 3, line 15). Within the industry decomposition, the results are similar to those in the sectoral decomposition—that is, the level of measured output per hour in the services industry (line 16) has been falling continuously for the past two decades. Lines 17 to 28 provide additional detail and suggest that the disappointing reported productivity performance has been widespread across nearly all two-digit services industries. Questions Raised by the Decomposition As indicated above, the dataset shows that the profitability of noncorporate businesses, (proxied by proprietors' income plus rental income as a share of sector output) has been well maintained in the face of declining productivity over the past two decades. One question raised by the decomposition, then, is. Does such a confluence of events make economic sense? It seems unlikely that firms wiih declining long-term productivity would be able to avoid bankruptcy let alone maintain the rate of return to the owners. In theory, some firms could have low or declining measured output per hour and still be profitable, but it is hard to imagine this occurring on a widespread basis. To be sure, the noncorporate sector is not stagnant; it reflects many start-up businesses, the most successful of which eventually incorporate. But the confluence of events as described by this dataset requires the sector to have persistently harbored the economy's least efficient businesses since the mid-1970s, which seems inconsistent with the sector's continued profitability. In an accounting sense, these apparently incompatible productivity and profitability trends can be reconciled by relatively rapid increases in the prices of the noncorporate sector's output. Is there an economic explanation for the rapid rise over two decades in the relative price of output from the noncorporate sector? Factors such as widespread price inelastic demand, barriers to entry, including nontransferabie intellectual property rights, and so forth could possibly explain such trends. But it is hard to imagine the presence of these factors on a wide enough scale to account for a significant portion of the productivity slowdown in the noncorporate sector. Alternatively, the sector's measured trends in productivity, profitability, and prices may not reflect actual economic developments. Thus, another question raised by the decomposition is, Do these inconsistent trends signify problems with our economic statistics? One possible measurement problem is that nominal output could be understated. In particular, the invoices for some output may not be captured by the Commerce Department's statistical nets. But is the problem, if it exists, getting worse? The $100 billion swing in the statistical discrepancy since 1993 does raise the possibility that nominal output growth has been understated in recent years. Nevertheless, the income-based measures of output per hour presented on lines 17 and 23 of table 1 suggests that mismeasurement of nominal output is unlikely to account for much of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 -6- the dreary performance of productivity as indicated by published statistics over the past two decades. A more likely statistical explanation for the implausible productivity, profitability, and price trends in the noncorporate sector is that they reflect problems in measuring prices. Indeed, the decomposition of national accounts data presented here can be viewed as providing a macroeconomic perspective on the problems of price measurement that many other researchers have noted from a microstatistical perspective.10 It suggests that actual inflation in the economy is less than that shown by the published data, and, accordingly, actual growth of output and productivity is faster. What is the possible magnitude of the overstatement of inflation that emerges from this dataset? As a benchmark thought experiment for making a judgment on this issue, one could assume that instead of falling for the past two decades, productivity in all declining two-digit service-producing industries has been flat. Such a calculation suggests that over the past two decades aggregate productivity growth would have been nearly half a percentage point faster per year than indicated by the published data and, that for a given nominal output, inflation would have been lower by the same amount.11 This benchmark figure, which is derived independently, is within the range of estimates of CPI biases arising from the slow introduction of new products and deficiencies of quality adjustment that have been noted by many researchers (see footnote 10). Of course, one could argue that even the assumption of no productivity growth for these industries is unrealistic. Obviously, if one were to assume that productivity in these industries has actually been improving, aggregate output per hour would rise even faster and price inflation would be still lower. A Concluding Thought '"See, for example, the following studies: David E. Lebow, John M. Roberts, and David J. Stockton, "Monetary Policy and the Price Level," Federal Reserve Board, August 1994. J. Peterson, "Is the Growth of the CPI a Biased Measure of Changes in the Cost of Living?", Congressional Budget Office, 1994. Advisory Commission to Study the Consumer Price Index, "Toward a More Accurate Measure of the Cost of Living: Interim Report to the Senate Finance Committee," September 15, 1995. Mathew Shapiro and David W. Wilcox, "Mismeasurement in the Consumer Price Index: An Evaluation," NBER Working Paper 5590, May 1996. "Seventeen industries were adjusted. Four of these industries were in the transportation sector: local and interurban passenger transit; trucking and warehousing; water transportation; and transportation services. Two of the adjusted industries were in finance, insurance, and real estate: insurance carriers; and insurance agents, brokers, and services. The remaining eleven adjusted were in the services industry: hotels and other lodging places; personal business services; business services; auto repair services and parking; miscellaneous repair services; motion pictures; amusement and recreation services; health services; legal services; education services; and social services. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 -7- Many observers have questioned how the influence of relentless technological progress appears so prominently in statistics on manufacturing, but not in those for services. Some have long questioned the accuracy of the statistics themselves.12 Others suggest that the gains from new technologies take a long time to diffuse and that the productivity boost from information technology has yet to come.13 Yet others look more closely at structural developments such as "downsizing" and "outsourcing" and suggest that these need not stimulate aggregate growth or efficiency; instead, such developments could just reflect a reallocation of resources within the economy. Clearly, the basic trend toward automation in manufacturing and distribution will result in a productivity gain in the aggregate economy only if the laid-off workers find new jobs in which they are as productive as they were in their old jobs. If human capital is lost when production workers move from one industry to another following firm downsizing, aggregate labor productivity will not necessarily increase. However, many of the changes in manufacturing over the 1980s occurred as part of corporate restructuring that outsourced ancillary, labor-intensive, service activities of the basic enterprises. A related development is the increased tendency in the 1990s for manufacturers to purchase the services of temporary workers as labor on production lines. When a manufacturing or related enterprise decides to use temporary workers or to close down an ancillary activity (for example, a warehousing unit, a legal services department, or a research and development laboratory) and purchase the service on the market instead, value added in manufacturing is reduced and value added elsewhere in industry is increased. These changes reflect an alteration in the organization of production to meet a given pattern of final demand and do not necessarily result in an immediate increase in aggregate productive efficiency. Over time, however, contracting out ancillary activities means replacing own-account production by specialist production, which should eventually lead to an increase in productive efficiency for the economy as a whole. A final question, then, is How long does it take for these efficiency gains to occur, and when they do take place, will our economic statistics capture them? '^See, for example, Zvi Griliches, "Productivity, R&D and the Data Constraint," American Economic Review (March 1994), pp. 1-23 and the references therein. "Paul David, "The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox," American Economic Review. Papers and Proceedings (May 1990), and Nathan Rosenberg, "Uncertainty and Technological Change," unpublished paper prepared for a conference sponsored by the Federal Reserve Bank of Boston, June 5-7, 1996. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 Table 1 Sectoral Labor Productivity and Costs (Percent change at an annual rate over period indicated) 60:Q2to 60:O2 to 73:Q41o 80:Q1 to 90 O2 to 96:O2 73:O4 80:Q1 90;O2 96;Q2 HEAL OUTPUT 1 . Nonfarm business sector 3.3 45 3.0 2.9 2.1 2. Income-based 3.3 4.4 2.6 3.0 2.3 3. Nontarm corporate 3.9 4.7 3.8 3.5 2.9 4 Financial 35 3.2 7.4 1.7 3.2 S. Nonfinancial 3.9 48 3.6 3.7 2.8 6- Manufacturing 2.9 4.2 1.9 2.5 1.8 7. Nonmanufacturing 4.6 5.4 4.8 4.3 3.3 8 Nonfarm noncorporate 1.4 3.6 -1 5 1.0 0.4 HOURS WORKED 9. Nonfmrm business sector 1.6 1.6 1.8 1.7 1-1 10 Nontarm corporate 2.2 2.9 2.2 1.8 1.2 1 1 . Financial 2.5 32 3.2 2.2 0.4 12, Nonfinancial 2.2 2.9 2.1 1.8 13 13 Manufacturing 03 1.4 -0.1 -0.5 -0.4 14. Noo manufacturing 36 4.5 3.8 3.1 2.0 15. Nonfarm noncorporate 0.2 -1 1 0.5 1.5 0.9 LABOR PRODUCTIVITY 16 Nonfarm business sector 1,7 2.3 1.2 1.1 0.9 17. Income-based 1,7 28 0.9 1.2 1.2 18. Nonfarm corporate 1.7 1.8 1.6 1.7 1.6 19. Financial 1.0 -0.0 4.1 -0.5 2.8 20. Nonfinancial 1.7 1.9 1.5 1.8 1.5 21 . Manufacturing 2.6 2.8 2.0 3 1 2.3 22. Nonmanufactunng 1 0 0.9 1.0 1.2 1.2 23. Nonfarm noncorporate 1.2 4.8 -1 9 -0.5 -0.5 i UNIT LABOR COSTS 24. Nonfarm business sector 4.2 3.1 8.0 4.2 2.7 25. Income-based 4.2 3.1 S3 4.0 2.5 26 Nonfarm corporate 38 33 73 3.5 1.9 27. Financial 5.7 56 4.5 3.0 3.3 28. Nonfinancial 3.7 3.2 75 32 1.8 29. Manufacturing 3.1 2.4 78 22 1.6 30. Nonmanufacturing 4.2 ! 41 '' 74 38 1.9 31. Nonlarm noncorporate 4 J 10 110 6.2 5.0 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 -9- Table2 Sectoral Income, Real Output and Hours (Average percentage of total nonfarm business over period indicated) 196010 1960 to 197410 1979 to 199010 1995 1973 1979 1990 19Q5 DOMESTIC INCOME 1 . Nonfarm business sector 100.0 100.0 100.0 100-0 100.0 2. Nonlarm corporate 76.7 74.8 77.8 78.2 77.4 3. Financial 5.5 4.3 4.9 6.0 7.9 4. Nonfinancial 71.2 70.5 73.0 72.2 69.5 5. Manulactunng 29.9 34.6 31.4 266 230 6. Nonmanufacturing 41.4 35.9 4(6 45.6 •te.s 7. Nontarm noncorporate 23.3 252 22.2 21.8 22.6 FiEAL OUTPUT' 8. Nonfarm business sector 100.0 100.0 100.0 100.0 100.0 9. Nonfarm corporate 73.2 69.0 71.6 76.2 78.4 10. Financial 7.5 6.8 7.6 8.2 76 1 1 . Nonfinancial 65.6 62.0 64.1 6B.1 708 12. Manufacturing 24.4 26 1 244 23.6 22.4 13. Nonmanufacturing 41-1 35,6 39.7 446 48.4 14 Nonfarm noncorporate 28.4 34.3 303 24.1 21.6 HOURS 15. Nonfarm business sector 100.0 100.0 100.0 100.0 100.0 16. Nonfarm corporate 72.7 67.9 74.5 76.2 76.3 17. Financial 4.4 3.8 4.5 50 4,9 18. Nonfinancial 68.3 64.1 700 71.2 71.4 19 Manufacturing 28.2 32.7 29.5 25.1 21.7 20. Nonmanufacturing 40.1 31.4 40.5 46.1 49.8 21. Nontarm noncorporate 27.3 32,1 25.5 23.8 23.7 1. Figures for real output shares begin in 1961 and are relative lo the income-based measure of total nonfarm business output. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 -10- Table 3 Real Gross Product Originating per Hour, 1977-94 (Percent change at an annual rate over period indicated) 1977 to 1980to 1990 to Industry 1994 1990 1994 t Nonlarm business sector, excluding housing (BUS) 0.95 1.14 1.12 2 Nonagocuttural private industnes (axe. housing) 089 1.17 1.03 3 Mining 2.62 5.00 4.58 4 Construction -1.02 -0.68 0.77 5 Manufacturing Z.45 3.22 2.15 6 Durables 2. BO 3.56 3.07 7 Nondurables 1.99 2.73 0.96 S Transportation and utilities 1.51 1.29 2.58 9 Transportation O.S8 -0.05 234 10 Communications 4.53 4.02 5.20 1 1 Public utilities 0.65 1.21 2.80 12 Trade 2.06 2.49 2.37 13 Wholesale trade 3.30 3.34 5.42 14 Retail trade 1.29 2.04 0.60 15 Finance, ins . real estate (exc. housing) 0.16 0.10 0.88 16 Services -0.56 -0.50 -1.11 1 7 Hotels and lodging -1.53 -1.46 0.40 18 Personal services -0.87 -053 -0.71 19 Business and other services -0.42 -0.21 -1.12 20 Auto repair -1.26 -1.04 -1 87 21 Miscellaneous services -0.20 -1.22 -3.47 22 Motion pictures 1.65 1.68 1.0S 23 Amusement services 0.98 2.64 -4.75 24 Health services -1.84 -1.82 -2.50 25 Legal services -2.77 -2-58 -3.61 26 Education services 0.01 -0.53 0.23 27 Membership orgs. and social services -018 -0.14 0.45 28 Private households 2.16 3.70 2.07 Notes: Hours of all persons in these calculations differ from hours of aH persons as defined by the BUS because the calculations presented here include nonprofit institutions and private households. These calculations assume that self- employed workers in each industry work the same number of hours annually as full-time wage and salary employees Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 -11- Table 4 Distribution of Domestic Income across Private Nonagricultural Industries, by Legal Form of Organization, 1994' Sole Households Proprietorships and Nonprofit TOTAL Corporations and Partnerships Institutions 1 Tout 100.00 100.00 10000 100.00 2 Mining 1.01 1.13 0.98 0.00 3. Construction 5.98 5.69 io.se 0.00 4 Manufacturing 23.78 3043 5.26 0.23 5. Durables 13.76 17.73 2.49 0.02 6. Nondurabtes 10.02 12.69 2.77 0.20 7 Transportation and utilities 10.37 11.83 7.06 3.83 8 Transportation 4.59 5.04 324 3.22 9 Communications 2.97 3.45 221 028 10. Public utilities 2.80 3.35 1.60 0.32 11. Trad* 18,44 21.48 14.09 0.17 1 2. Wholesale trade 7.59 9.36 3.36 0.08 13. Retail trade 10.84 12.12 10.73 0.09 14. Finance, insurance, and real estate 11.06 10.00 15.69 11.30 15. Services 29.36 19.44 46.25 83.97 16. Hotels and lodging 1.03 0.94 1.98 0.08 1 7. Personal services 0.98 065 3.07 0.00 18. Motion pictures 0.54 10.42 1.41 0.00 1 9 Amusement 1.02 0.78 1.72 1.81 20. Business and other 937 9.15 14.12 2.56 21. Auto repair 0.92 0.73 2.35 0.00 22. Mucellaneous repair 0.39 0.34 0.87 0.00 23. Health services 9.39 469 11.17 46.51 24. Legal services 2.20 1.09 8.66 0.10 25. Education services 1.20 0.12 0.20 12.34 26 Social services 2.06 0.53 0.71 17.59 27. Pnvate households 0.26 0.00 0.00 2.95 1 These data are derived tram unpublished BEA estimates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 -12- Table 5 Distribution ot Domestic Income within Private Nonagncultural Industries. by Legal Form ol Organization, 19941 Sole Proprietorships Households and Corporaions and Partnerships Nonprofit Institutions 1 TOTAL 75.57 15.10 933 2. Mining 84.50 15.50 000 3. Construction 71.65 28.35 0.00 4. Manufacturing 96.40 352 008 5. Durables 97.10 2.88 0.02 6. Nondurables 9543 439 018 7. Transportation and utilities 85.95 10.82 324 8. Transportation 3262 11 22 6.16 9. Communications 87.34 11.82 084 10. Public utilities 89.93 908 099 11. Trade 87.78 12.14 0.08 12. Wholesale trade 92.88 7.03 0.10 13. Retail trade 84.21 15.72 007 14. Finance, insurance, and real estate1 41.91 13.86 5.76 15. Services 4988 25.03 25.10 16. Hotels and lodging 68.72 30.62 0.66 1 7. Personal services 50.24 49.76 0.00 18. Motion pictures! 58.72 41.28 0.00 19. Amusement 57.81 26.66 1553 20. Business and other 73.63 2395 2.42 21. Auto repair 59.49 40.51 0.00 22. Miscellaneous repair 64.67 35.33 0.00 23. Health services 37.63 18.90 43.47 24. Legal services 37.12 62.48 0 40 25. Education services 7.21 2.63 9016 26. Social services 19.49 5.45 | 75 06 27. Private households 0.00 0.00 100.00 1 These data are derived from unpublished BEA estimates. 2. Finance, insurance, and real estate add to less than 100 because of the omission of owner-occupied housing Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 -13- Chart 1 Nonfarm Noncorporate Sector Percent —.046 Return to Owners as a Share at Gross Sector Product I960 1364 1968 197! 1976 I960 1964 1908 1992 1996 Percent Return to Owners as a Share ol Domestic Income I960 1964 1368 1972 1978 1980 1984 19 1992 1996 NQIB Return 10 owners equals proprietors' income ptus rental income. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 -14- Chart2 Implicit Deflators 1961 . 100 1961 19M 1971 1976 1MI 19M 1991 19M Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 -15- Chart 3 Nonfinancial Corporations Price Indexes 1977 1MO 1083 IBM IBM 1BB2 1995 Mow: BEA's published deflator tor nonfinancial corporations ii ba*M on th* implicrt ctoflanx lor good* and structures. The coninuciaa pnca m*asur« it a Fisher indoi lhal wwghlt two-digii GPO industry deflator* by the corporate GPO lor each induairy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 -16- Appendix 1 Detailed Description of the Sectoral Decomposition Table A-l presents the I996:Q2 levels of the data used in the sectoral decomposition. Columns A through I contain the series of primary interest; columns J through Q contain the sectors needed to construct the series in the first nine columns. A description of the source data, accounting identity, or interpolation/exrapolation procedure used to construct each cell is given below. Column A Nonfarm Business Less Housing, Product-based Lines 1-11: Column J-Column O-Column P-Column Q. That is, the domestic business sector less the farm sector, owner-occupied housing, and the rental value of buildings and equipment owned by nonprofit institutions. The domestic business sector excludes output originating in private households, nonprofit institutions, and general government from total GDP. Line 12: BLS. Hours of all persons in the nonfarm business sector. Column B Nonfarm Business Less Housing, Income-based Line 1: Al - NIP A statistical discrepancy for gross domestic product (NTPA 1.9, line 15). Line 2: B1/(A1/A2) Line 3: A3 Line 4: A4-(NIPA 1.9, line 15) Line 5: A5-(NIPA 1.9, line 15) Lines 6-12: A6 through A12 Column C Nonfarm Corporate Business Lines 1-12: Column E+Column D Column P Financial Corporations Lines 1-12: Column K-Column L Colum.nJ;: Nonfarm Nonflnancial Corporations Lines 1-12: Column L-Column N Column^F Manufacturing Corporations Line 1: F4+F3 Line 2: Fl/(manufacturing deflator). The manufacturing deflator is the implicit gross product originating (GPO) deflator interpolated and extrapolated to the quarterly frequency using a deflator for nonfarm goods (calculated using NIPAs 1.3 and 1.4, lines 4 and 5, and NIPAs 1.7 and 1.8, line 6). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 -17- Line 3: NIPA 6.22C, line 11, interpolated and extrapolated by the capital consumption allowance for nonfmancial corporations. Line 4: F5+F6 Line 5: M5*(F6/M6). This assumes that indirect business taxes, etc., for manufacturing corporations are proportional to their income relative to the income of all manufacturing business (column M). Line 6: F7+F8+F9 Line 7: M7*0.98 Line 8: M8 Line 9: M9*0.97 (This ratio is based on unpublished BEA data by legal form of business.) Lines 10-11: Not applicable Line 12: BLS. Hours of all employees in manufacturing*0.98 The 0.98 estimate for the corporate share of manufacturing hours is based on data provided by BEA for the distribution of labor compensation by legal form of organization and industry. Column G Nonfarm Nonmanufacturing Corporations Lines 1-12: Column E-column F. Note, line 2 is adjusted to take account of the residual that emerges from chain weight aggregation. Column H Nonfarm Noncorporate Business Lines 1-12: Column A-coiumn D-column E. Note, line 2 is adjusted to take account of the residual that emerges from chain weight aggregation. Column I Nonfarm Noncorporate Business, Income-based Lines 1-12: Column B-column D-column E. Note, line 2 is adjusted to take account of the residual that emerges from chain weight aggregation. Column J Domestic Business Line 1: NIPA 1.7, line 2. Line 2: NIPA 1.8, line 2. Line 3: NIPA 1.9, line 6+line 11. Line 4: J1-J3. Line 5: NIPA 3.1, line 4+NIPA 1.9, line 14+NIPA 1.9, line 15-NIPA 3.2, line 25 Line 6: J4-J5. Line 7: NIPA 1.14, line 2 - NIPA 3.7B, line 38 - NIPA 1.7, line 7 - NIPA 1.15, line 49. (The last item, rest of world compensation, is linearly interpolated to the quarterly frequency.) Line 8: NIPA 1.16. line 9. Line 9: J6-J7-J8-J10-J11 Line 10: NIPA 1.14, line 9. Line 11: NIPA 1.14, line 17. Line 12: BLS. Hours of all persons in the business sector. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 -18- Column K Corporations Line 1: NIPA 1.16, line I Line 2: NIPA 1.16, line 36+(NlPA 1.16, line 18/fmancial deflator). The financial deflator is the implicit GPO deflator for banking, credit agencies other than banks, insurance carriers, and security and commodity brokers interpolated and extrapolated by the quarterly deflator for personal consumption expenditures on brokerage and bank service charges, services furnished without payment by financial intermediaries, and the expense of handling life insurance (NIPA 2.4, lines 61-64). Lines 3-9: NIPA 1.16, lines 2, 3, 4, 5, 6, 9, and 17. Lines 10-11: Not applicable. Line 12: L12 + (financial hours). The financial hours are calculated from 8LS data on hours paid in the finance, insurance and real estate industry, excluding hours in SIC 64, 65, and 67, reduced by 6 percent to adjust for hours worked vs. hours paid. (This series is similar to BEA's annual series on employee hours for SICs 60, 61, and 63.) Column L Nonfinancial Corporations Lines 1-9: NIPA 1.16, lines 19, 36, 20-24, 27, and 35. Lines 10-11 Not applicable. Line 12: BLS. Hours of all employees in the nonfinancial corporate sector. Column M Manufacturing Line 1: M3+M4 Line 2: Ml/(manufacturing deflator) (see F2). Line 3: NIPA 6.13C, line 7 + NIPA 6.22C, line 11, interpolated and extrapolated by the capital consumption allowance for nonfinancial corporations. Line 4: M5+M6 Line 5: GPO data. Indirect business taxes are interpolated and extrapolated by manufacturing shipments; business transfers and subsidies are interpolated to the quarterly frequency using a cubic spline. Line 6: M7+M8+M9+MIO Line 7: NIPA 2.1. line 5 + (NIPA 6.2C, line 13 - NTPA 6.3C, fine 13), interpolated and extrapolated by NIPA 1.16, line 26 (supplements for all nonfinancial corporations). Line 8: NIPA 6.16C, line 14 (adjusted to be consistent with latest GPO figures). Line 9: NIPA 6.15C, line 6, interpolated and extrapolated by NIPA 1.16, line 35. Line 10: NIPA 6.I2C, line 5, interpolated and extrapolated by manufacturing shipments. Line 11: Not applicable. Line 12: BLS. Hours of all persons in manufacturing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 -19- Column N Farm Corporations Line 1: N3+N4 Line 2: N1/(OI/O2) Line 3: Flow of funds table F. 104, line 4. Line 4: N5+N6. Line 5: O5*(N6/O6) This assumes that indirect business taxes and subsidies for farm corporations are proportional to their income relative to the income of all farm business(column O). Line 6: N7+N8+N9 Line 7: O7* (the corporate share of farm sector compensation obtained from unpublished BEA annual data interpolated to the quarterly frequency). O8 O9* (the corporate share of farm sector net interest obtained from unpublished BEA annual data interpolated to the quarterly frequency). Lines 10-11: Not applicable. Line 12: O12* (the corporate share of farm sector compensation (see N7)). Column 0 Farm Business Line 1: NTPA 1.7, line 6. Line 2: NIPA 1.8, line 6 Line 3: Flow of funds table F.104, line 3. Line 4: O1-O3. Line 5: NIPA 8.8, line 17-NIPA 8.8, line 18. Note: both series are interpolated to a quarterly frequency using a cubic spline. Line 6: O4-O5. Line 7: NIPA 8.8, line 20, interpolated to a quarterly pattern using the sector's total domestic income less net interest and proprietors' income (O6-O9-O10). O6-O7-O9-O10. NIPA 8.8, line 26, interpolated to a quarterly frequency using a cubic spline. Line 10: NIPA 1.14, line 10. Line 11: Not applicable. Line 12: J12-A12. (BLS hours of all persons for the business less nonfarm business sectors) Column P Owner-occupied Housing Line 1: NIPA 8.19, line 89, interpolated to a quarterly frequency using PCE space rent for owner-occupied nonfarm dwellings (NIPA 2.4, line 24). [Data beginning in 1995Q4 are the unpublished BEA estimates supplied to BLS.J Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 -20- Line 2: PI deflated by the implicit deflator for nonfarm housing product (NIPA 1.7, line 5/NIPA 1.8, line 5). [Data beginning in 1995Q4 are the unpublished BEA estimates supplied to BLS.J Line 3: NIPA 8.19, line 90, interpolated to a quarterly frequency using the consumption of fixed capital for the noncorporate sector (NIPA 1.9, line6-NIPA 1.14, line 33). Line 4: P1-P3. Line 5: P4-P6. Line 6: P9+P11 Lines 7-8: Not applicable. Line 9: NIPA 8.19, line 93, interpolated to a quarterly frequency using net interest for the noncorporate sector (NIPA 1.9, line 19-NIPA 1.16, line 17). Line 10: Not applicable. Line 11: NIPA 8.19, line 94, interpolated to a quarterly frequency using rental income of persons (NIPA 1.14, line 17). Line 12: Not applicable. Column Q Building and Equipment Serving Nonprofit Institutions Line 1: NIPA 8.19, b'ne 102, interpolated to a quarterly frequency using nonfarm business output less housing (NIPA 1.7, line 4). Note: this is the convention used by BLS. Line 2: Ql deflated by the implicit deflator for nonfarm business output less housing (NIPA 1.7, line 4/NIPA 1.8, line 4). Line 3: NIPA 8.19, 103, interpolated to a quarterly frequency using the consumption of fixed capital for the noncorporate sector (NIPA 1.9, line 6-NIPA 1.14, line 33). Line 4: Q1-Q3. Line 5: Q6-Q4. Line 6: Q9 Lines 7-8: Not applicable. Line 9: NIPA 8.19, line 105, interpolated to a quarterly frequency using net interest for the noncorporate sector (NIPA 1.9, line 19-NIPA 1.16, line 17). Lines 10-12: Not applicable. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 •21- Tabte A-1 Sectoral Decomposition of Gross Product and Income - 1996:Q2 Ngnlvin Mtg Nooitmi Nontann Bui. MM Bin. 1MB carponM C«pt. Non- corp»- Mon- Nan- Nofh houBofl. ArancM nunuUe- coporaw. corporM*. produel noorM corp*. umg pioduct ncorn* tuud tUMd A a C O E F O H 1 1 Qnm product nomral 5714.4 5771.9 4992.5 4MD 40BI.5 1242.2 2M83 11*1.9 1219.4 2 QranpnducL 192 S2M»1 S30»» 4M7.7 *».* Ml" 11»7B 2831.9 1018.9 1W5.4 3 Contoffa.dap 801.1 801 -• 4tt» 31.1 437.7 152* 289.1 132.9 132.9 4 NM dam product 5112.S 51701 40B3.7 452.9 300.8 I0».« 2541.2 1029.0 10*6.5 5 K9Tt8«r nra.-iub(. 429.0 4M.9 4S0.3 47.3 403.0 <e.8 3403 -21.3 382 « Dnnartt kiconn 4M3* 4U3< 3Ct3,3 4095 3227.8 102C.8 2201.0 1090.2 1050.2 7 Comp«MMMn 33209 3320.9 29M2 241.9 28W.3 •3D.« IMS. 7 3*2* 3V2J I Pro** mnVMCCA 574.7 574.7 574.7 1435 4312 1815 288.7 9 NMinWM asa.« 2S3.< 120.4 20.1 100J 34.8 8S.5 1332 ^^13^3.2 10 Pnop. income 409.4 449.4 W//M W//M 4M4 4«94 W^! '$m,f^»? 11 RonM Income S5.0 S5.0 89.0 89.0 12 HounrfpMon. 173.» 173.8 ^ ^^13*3^.5 *,i 129.3 394 80.9 404 40.4 OomMIc Corp- Hon- Uf). Firm FUMW buwwa oraH ooip*. (To-, OCCUpMl (Tout) ooipc. tanning (ToM) •PMp. of non- praik J K L M N O P O 1 GfQM pnKVet: nominM «334.« 4509.8 4011. « 12M.3 13.1 97.8 47«S 4*5 2 Gnaipraduci: tie 5*07.3 4iS»> 3*11,0 12414 11.1 828 429.1 42.9 3 Com. of iMd tav 7M.4 471.0 439.9 199.7 22 23.5 78.0 232 4 NMd»m. product MOtZ 40M.« 3*417 113M ; 109 74.1 398.5 23.0 9 IBTVBur Mm.-*!**. 552J 4W.3 403.0 «9.« •0.0 •0.1 114.4 9.4 « DornMcncom* 5095.4 3H4.3 323i.» W73.0 11.0 74.2 f////M 2*4.1 13.5 7 Compwtnllon 3334.9 294S.3 2703.4 •475 7.1 18.0 1 Pratt* *flVAi,CCA 577.3 5773 433* HI .5 2* 2.* W/M «^ 9 NMnMrMt 901.5 121.* 101.5 35.9 1.2 89 2245 ^» 13 $ .5 to Pino, incam* S194 3*3 45* g^Pg piiii; 11 ItenUltMom* 124.5^^^ ^^^ ^^S*^.5 ^^^ 12 Houn o( pcrtoni 178.S 135* ^^ 1J7 ^ .4 371 ^^ 2 ^ .1 ^^4^.7 ^^^^^^ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 For use at 10:00 a.m., E.D.T. Tuesday July 21,1998 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 21, 1998 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 21, 1998 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the Full Employment and Balanced Growth Act of 1978- Sincerely, Alan Greenspan, Chairman Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 Table of Contents Page Section 1: Monetary Policy and the Economic Outlook 1 Section 2: Economic and Financial Developments in 1998 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 Section 1: Monetary Policy and the Economic Outlook The U.S. economy posted significant further gains past few months created added pressures for reform, in the first half of 1998. The unemployment rate and they underscored the depth and scope of the dropped to its lowest level in nearly thirty years, and problems that must be addressed. inflation remained subdued. Real output rose appre- Despite the pronounced weakening of our trade ciably, on balance, although much of the advance balance, the already tight U.S. labor market has come apparently occurred early in the year. Household under further strain diis year owing to robust growth spending and business fixed investment, supported by of domestic demand. As a result, the outlook for the ongoing rise in equity prices and the continued inflation has taken on a greater degree of risk. low level of long-term interest rates, appear to have Consumer prices actually rose a bit less rapidly in the maintained considerable momentum this year. The first half of 1998 than they did in 1997, but transi- sizable advance in capital spending and the result- tory factors—the drop in oil prices, the runup in the ing additions to the capital stock should help bolster dollar, and weak economic activity in Asia—exerted labor productivity—the key to rising living standards. considerable downward pressure on domestic prices. Yel the news this year has not been uniformly These factors will not persist indefinitely. Meanwhile, good. The turmoil that erupted in some Asian che pool of individuals interested in working but who countries last year has generated major concerns are not already employed has continued to shrink. about the outlook for those economies and the The extraordinary tightness in labor markets has repercussions for other nations, including the United generated a rising trend of increases in wages and States. Several Asian countries have had sharp related costs, although faster productivity growth has contractions in economic activity, and others have damped the effect on business costs so far. experienced distinctly sub-par growth. Heightened In conducting monetary policy in the first half of uneasiness among international investors has induced 1998, the federal Open Market Committee (FOMC) portfolio shifts away from Asia and, to some extent, closely scrutinized incoming information for signs from other emerging market economics. that the strength of the economy and the taut labor These difficulties have created considerable market were likely to boost inflation and threaten the uncertainty and risk for the U.S. economy, but they durability of the expansion. However, despite slightly have also helped to contain potential inflationary larger increases in the CPI in some months, infla- pressures in the near term by reducing import prices tion remained moderate on the whole. Moreover, the and restraining aggregate demand. In particular, the Committee expected that aggregate demand would substantial rise in the foreign exchange value of the slow appreciably because of a rising trade deficit dollar has- boosted out real imports and—together and a considerable slackening in domestic spending. with the slower growth in Asia—depressed our real Although the Committee was acutely aware of the exports. At the same time, the runup in the dollar and uncertainties in the economic outlook, it believed slack economic conditions in Asia have helped that the deceleration in demand—and the associated produce a sharp drop in the dollar prices of oil and modest easing of pressures on resources—could wtll other commodities and have pushed down other be sufficient to limit any deterioration in underlying import prices. Shirts in preferences toward dollar- price performance. On balance, the FOMC chose to denominaied assets in combination with downward keep the intended federal funds rate at 5V4 percent. revisions to forecasts of inflation and demand have helped to reduce our interest rues; the lower inter- est rates have boosted household and business spend- Monetary Policy, Financial Markets, and ing, offsetting a portion of the damping of demand the Economy over the First Half of 1998 from the foreign sector. Output grew rapidly in the first quarter, with real The Asian crisis is likely to continue to restrain gross domestic product estimated to have risen U.S. economic activity in coming quarters. The size 5Vi percent at an annual rate. Business fixed invest- of the effect will depend in large part on how quickly ment soared after a weak fourth quarter, and con- the authorities in the Asian nations can put their sumption and housing expenditures expanded at a troubled financial systems on a sounder footing and strong clip. In addition, 'contrary to the expectations carry out other essential economic reforms. of many forecasters, inventory investment rose Deteriorating conditions in many countries during the substantially from its already hefty fourth-quarter Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Selected Interest Rates Daily Thfw-year Treasury i if t i ll I 7/3 8/20 *24 11/1312/17 215 3/25 5/20 7/2 #19 9OO 11/12 12/16 2/4 Ml S/19 7/1 1996 1997 1998 Hole. Dotted vertical line indicates the Oay on wtwch me Fed- po»cy action. The flates on trw horizontal axis are those or wnidi eral Open Marital Committee (FOMC) announced a monetary tne FOMC held meetings. Last observations are (or July 17, 1998. pace, with the rise contributing more than rates were also restrained to a significant extent by the 1'A percentage points to overall GDP growth. At the effects of the Asian crisis. Equity prices increased same time, the cumulative effect of the appreciation sharply in the firsi quarter, extending their remark- of the dollar and faster growth of demand here than able gains of the previous three years in spite of abroad resulted in a sharp drop in real net exports, disappointing news on corporate profits. Households with both rapid import growth and the first quarterly and firms borrowed at a vigorous pace in the first drop in exports in four years. Employment continued quarter, and growth in the debt of domestic to advance briskly, and the unemployment rate held nonfinanciaJ sectors picked up from the fourth quarter steady at 4'A percent. Hourly compensation acceler- of 1997, as did the growth of the monetary ated somewhat when measured on a year-over-year aggregates. basis, but impressive productivity growth once again At their March meeting, the members of the helped to restrain the increase in unit labor costs. The FOMC confronted unusual cross-currents in the eco- consumer price index rase only 'A percent at an nomic outlook. On the price side, the FOMC noted annual rate over the first three months of the year, as that, although the incoming data were quite favor- a sharp drop in energy prices offset price increases able, transitory factors were possibly masking under- elsewhere. lying tendencies toward higher inflation. Moreover, Falling long-term interest rates and rising equity the available data on household and business spend- prices over the previous year provided substantial ing confirmed the impressive strength of domestic impetus to household and business spending in the demand and highlighted the possibility that develop- first quarter. Interest rates dropped sharply further in ments in the external sector might not provide suffi- early January, and although they moved up a lirtle cient offset in coining quarters to avoid a build-up of over the remainder of the quarter, nominal yields on inflation pressures. At the same time, the FOMC long-term Treasury securities were among the low- noted the substantial uncertainty surrounding the est in decades. Interest rates continued to benefit from prospects for the Asian economies. Balancing these the improvement in the federal budget and the considerations, the FOMC kept its policy stance prospect of reduced federal borrowing in the future; unchanged but noted that recent information had Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 altered the inflation risks enough to make tightening precipitate an upturn in inflation over time. Yet the more likely than easing in the period ahead. FOMC believed that the growth of economic activ- ity would slow. It also judged that the risk of The second quarter brought both a marked further significant further deterioration in Asia, which could deterioration tn the outlook for Asia and some indica- disrupt global financial markets and impair eco- tions that the U.S. economy might be cooling. In. Asia, nomic activity in the United States, was rising evidence of steep output declines in several countries somewhat. was combined with mounting concern that eco- nomic and financial problems, in Japan were not likely to be resolved as quickly as many observers had Economic Projections for hoped or expected. One result was a further rise in the 1998 and 1999 exchange value of the dollar and a decline in long- The members of the Board of Governors and the term U.S. interest rates. Increasing investor concern Federal Reserve Bank Presidents, all of whom about emerging market economies raised risk spreads participate in the deliberations of the FOMC, expect on external debts in Asia. Russia, and Latin America. economic activity to expand moderately, on average. The higher value of the dollar and the depressed over the next year and a half. For 1998 as a whole, income in many Asian countries continued to take the central tendency of their forecasts for real GDP their toll on U.S. exports and to boost imports in growth spans a range of 3 percent to 3'/« percent For the second quarter. In addition, a marked slackening 1999. these forecasts center on a range of 2 percent 10 in the pace of inventory accumulation, which was 2'/4 percent. The civilian unemployment rate, which amplified by the effects of a strike in the motor vehi- averaged a bit less than 4l/S percent in the second cle industry, was reflected in a sharp slowing in quarter of 1998, is expected to stay near this level domestic demand. Nonetheless, the utilization of through the end of this year and to edge higher in labor resources remained very high: In the second 1999. With labor markets remaining tight and some of quarter, the unemployment rate averaged a bit less the special factors that helped restrain inflation in the than 4'/z percent, its lowest quarterly reading in first half of 1998 unlikely to be repeated, inflation is nearly thirty years. The twelve-month change in aver- anocipated to run somewhat higher in the second half age hourly earnings indicated that wages were ris- of 199S and in 1999. ing somewhat more rapidly than they had a year The economy is entering the second half of 1998 earlier. And the CPI rose faster in the second quarter with considerable strength in household spending and than in the first, mainly reflecting a smaller drop in business fixed investment Consumers are enjoying energy prices. expanding job opportunities, rising real incomes, and Financial conditions in the second quarter and into high levels of wealth, all of which are providing them July remained supportive of domestic spending. with the confidence and wherewithal to spend. These Yields on private securities declined, although less factors, in conjunction with low mortgage interest than Treasury yields, as quality spreads widened a bit rates, are also bolstering housing demand. Business Equity prices rose further in early April before fall- fixed investment appears robust as well: Financial ing back over the next two months in response conditions remain conducive to capital spending, and to renewed earnings disappointments. Prices then firms no doubt are continuing to seek out opportuni- rebounded substantially, with most major indexes hit- ties for productivity gains in an environment of rapid ting record highs in July, The growth of money and technological change, falling prices for high-wet credit slowed a little on balance from the first- equipment, and tight labor markets. quarter pace but remained buoyant. Banks and other Nonetheless, a number of factors are expected to lenders continued to compete vigorously, extending exert some restraint on the expansion of activity in credit on generally favorable terms as they responded the quarters ahead. The demand for U.S. exports will in part to the sustained healthy financial condition of continue to be depressed for a while by weak activ- most businesses and households. ity abroad, on average, and by the strong dollar, The FOMC left the intended federal funds rate which will also likely continue to boost imports. The unchanged at its May and June-July meetings. At the effects of these external sector developments on May meeting, the FOMC reiterated its earlier concern employment and income growth have yet to material- that the robust expansion of domestic final demand, ize fully. In addition, although financial conditions are supported by very positive financial conditions, had generally expected to be supportive, real outlays on raised labor market pressures to a point that might housing and business equipment have reached such Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 Economic Projections for 1998 and 1999 Percent Federal Reserve governors and Reserve Bank presidents Central Indicator Range tendency Administration 1998 Change, fourth quarter to fourth quarter* Nominal GDP 4>/4 to 5 Vi to 5 4.2 Real GDP 2V4 to 3</4 3 to 3V« 2.4 Consumer price index2 1 1/4 tO 2'/4 % to 2 1.6 Average level, fourth quarter Civilian unemployment rate 4'/4 to 4Va 4'A to 4V: 4.S 1999 Change, fourth quarter to fourth quarter1 Nominal GDP 4 to 5'/2 4% to 5 4.1 Real GDP 2 to 3 2 to 2'/z 2.0 Consumer price index2 1 Vi to 3 2 to 2Va 2.1 Average level, fourth quarter Civilian unemployment rate 4'A to 4% 4Va to 4% 5.0 1. Change from average lor fourtri quarter of previous year 2. All urOan consumers. to average for lourtri quarter of year indicated. high levels thai gains from here are expected to be labor market will remain tight, suggesting potential more moderate. ongoing pressures on available resources that would tend to raise inflation a bit. The FOMC will remain With the plunge in energy prices in early 1998 alert lo the possibility of underlying imbalances in the unlikely to be repeated, most FOMC participants economy that could generate a persisting pickup in expect the CP1 for all urban consumers to rise more inflation, which would threaten the economic rapidly in the second half of 1998 than it did in expansion. the first half, resulting in an increase in the CPI of IV* percent to 2 percent for 1998 as a whole. The As noted in past monetary policy reports, the pickup in the second half should be limited, how- Bureau of Labor Statistics is in the process of ever, by further decreases in non-oil import prices, implementing a series of technical adjustments to ample domestic manufacturing capacity, and low make the CPI a more accurate measure of price expected inflation. Looking ahead to next year, the change. These adjustments and the regular updating central tendency is for an increase in the CPI of of the market basket are estimated to have trimmed 2 percent to 2'A percent. Absent a further rise in the CPI inflation somewhat over 1995-98, and a dollar, the fall in non-oil import prices should have significant further adjustment is scheduled for 1999. run its course. Moreover, even with the expected edg- All told, the published figures for CPI inflation in ing higher of the unemployment rate next year, the 1999 are expected to be more than Vi percentage Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 Ranges for Growth of Monetary and Debt Aggregates Percent Aggregate 1997 1998 Provisional (or 1999 M2 1 to 5 1 to 5 1 to 5 M3 210 6 2 to 6 2 to 6 Debt 3 to 7 3 to 7 3 to 7 Note. Change dom average for fourth quarter of preced- ing year to average (or fourth quarter of year indicated. point lower than they would have been had the M2 and M3 behavior were disrupted, and the veloci- Bureau retained the methods and formutas in place in ties of both aggregates climbed well above the levels 1994. In any event, the FOMC will continue to moni- that were predicted by past relationships. However. tor a variety of price measures besides the CPI as it since 1994 the velocities of M2 and M3 have again attempts to gauge progress toward the long-run goal moved roughly in accord with their pre-1990 experi- of price stability. ence, although their levels remain elevated. Federal Reserve officials project somewhat faster The recent return to historical patterns does not growth in real GDP and slightly higher inflation imply that velocity will be fully predictable or even in 1998 than does the Administration. The that all movements in velocity can be completely Administration's projections for the growth in real explained in retrospect. Some shifts in velocity arise GDP and inflation in 1999 are around the lower end from household and business decisions to adjust their of the FOMC participants' central tendencies. portfolios for reasons that are not captured by simple measures of opportunity cost Some shifts in veloc- Money and Debt Ranges ity arise from decisions of depository institutions 10 for 1998 and 1999 create more or less credit or to fund credit creation in different ways. All these decisions are shaped by the At its mosi recent meeting, the FOMC reaffirmed rapid pace of innovation in financial institutions and the ranges for 1998 growth of money and debt that it instruments. Between 1994 and early 1997, M2 had established :n February: 1 percent to 5 percent for velocity drifted somewhat higher, probably owing to M2, 2 percent to 6 percent for M3, and 3 percent to some real location of household savings into bond and 7 percent for the debt of the domestic nonfmancial equity markets. But M2 velocity has declined over sectors. The FOMC set these same ranges for 1999 on the past year despite little change, in its traditionally a provisional basis. defined opportunity cost. One explanation may be that the flatter yield curve has reduced the return on Once again, the FOMC chose the growth ranges for longer-tern investments relative to the bank depos- the monetary aggregates as benchmarks for growth its and money market mutual funds in M2- Another under conditions of pnce stability and historical part of the story may be the booming stock market, velocity behavior. For several decades before 1990, which has reduced the share of households' finan- the velocities of M2 and M3 (defined as the ratios of cial assets represented by monetary assets and may nominal GDP to the aggregates) behaved in a fairly have encouraged households to rebalance their port- consistent way over periods of a year or more. M2 folios by increasing their M2 holdings. M3 velocity velocity showed little trend but varied positively from has dropped more sharply over the past year, with year to year with changes in a traditional measure of strong growth in large time deposits and in insti- M2 opportunity cost, defined as the interest forgone tutional money funds that are increasingly used by by holding M2 assets rather than short-term market businesses for cash management. instruments such as Treasury bills. M3 velocity moved down a bit over time. a& depository credit and If ihe velocities of M2 and M3 follow their aver- the associated elements in M3 tended to grow a shade age historical patterns over the remainder of 1998 and faster than GDP. In the early 1990s, these patterns of the growth of nominal GDP matches the cxpecta- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 lions of Federal Reserve policymakers, these aggre- In light of the apparent return of velocity changes gates will finish this year above the upper ends of to their pre-1990 behavior, some FOMC members their respective ranges. Part of this relatively rapid have been giving the aggregates greater weight in money growth reflects nominal GDP growth in excess assessing overall financial conditions and the thrust of that consistent with price stability and sustainable of monetary policy. However, velocity remains growth of real output; the rest represents a decline in somewhat unpredictable, and all Committee members velocity. Absent unusual changes in velocity in 1999, monitor a wide variety of other financial and eco- policymakers' expectations of nominal GDP growth nomic indicators to inform their policy delibera- imply that M2 and M3 will be in the upper ends of tions. The FOMC decided that the money and debt their price-stability growth ranges next year. The debt ranges are best used to emphasize the Committee's of the domestic nonfinancial sectors is expected to commitment to achieving price stability, so it again remain near the middle of its range this year and in set the ranges as benchmarks for growth under price 1999, stability and historical velocity behavior. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 Section 2: Economic and Financial Developments in 1998 The U.S. economy continued to perform well in The Household Sector the first half of the year. The economic difficulties Consumer Spending. The factors that fueled in Asia and the Strong dollar reduced the demand for the sizable increase in household expenditures m our exports and intensified the pressures on domes- 1997 continued to spur spending in the first half of tic producers from foreign competition. But these 1998: Growth in employment and real disposable effects were outweighed by robust domestic final income remained very strong, and households in the demand, owing in pan to supportive financial condi- aggregate enjoyed significant further gains in net tions, including a higher stock market, ample avail- worth. Reflecting these developments, sentiment ability of credit, and long-term interest rates that in indexes suggest that consumers continued to feel nominal terms were among the lowest in many years. extraordinarily upbeat about the current and prospec- Sharp swings in inventory investment were mirrored tive condition of the economy and theit own finan- in considerable uncvenness in the growth of real cial situations. GDP, which appears to have slowed markedly in the second quarter after having soared to nearly 5'/j percent at in annual rate in the first quarter. Change in Real Income and Consumption Nonetheless, over the first half as a whole, the rise in real output was large enough to support sizable gains Parcant, annual rate in employment and to push the unemployment rate Q Disposable personal income down to the range of 4W to 4'A percent, the lowest in decades. | Personal consumption expenditures The further tightening of labor markets in recent Q1 quarters has been reflected in a more discernible uptili to the trend tn hourly compensation. But price inflation remained subdued in the first half of the year- held down in pan by a sharp decline in energy prices and lower prices for non-oil imports. Intense competition in product markets, ample plant capac- ity, ongoing productivity gains, and damped infla- tion expectations also helped to restrain inflation pres- sures in the face of tight labor markets. 1993 1994 1995 1996 1997 1998 In total, real consumer outlays rose at an annual Change in Real GDP rate of 6 percent in the first quarter, and the avail- Pwcwrt. annual ratt able data point to another large increase in the second quarter. Increases in spending were broad-based, but outlays for durable goods were especially strong. O1 Declining prices and ongoing product innovation continued to stimulate demand for personal comput- ers and other home electronic equipment, In addi- tion, purchases of motor vehicles were sustained by a combination of solid fundamentals and attractive pricing. Indeed, since 1994, sales of light vehicles have been running at a brisk pace of 15 million units (annual rate), and, in the second quarter, a round of very attractive manufacturers' incentives helped lift sales to a pace of 16 million units. Spending on services also remained robust in the 1993 1994 1995 1996 1997 1998 first half of the year, with short-run variations reflect- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 ing in part the effects of weather on household energy starts over the first five months of the year—1 '/< mil- use; outlays on personal business services, includ- lion units at an annual rate—was 9 percent above the ing those related 10 financial transactions, and on pace for 1997 as a whole. Moreover, surveys by the recreation services continued to exhibit remarkable National Association of Homebuilders suggested that strength. In addition, real outlays for nondurable housing demand remained vigorous at midyear, and goods, which rose only moderately last year, grew die Mortgage Bankers Association reported thai loan about 6'/: percent at an annual rate in the first quarter, applications for home purchases have been around and they appear to have posted another sizable all-time highs of late. increase in the second quarter. The strong demand for homes has contributed to Real disposable income—that is, after-tax income some firming of house prices, which are now rising in adjusted for inflation—remained on a strong uptrend the neighborhood of 3 to 5 percent per year, accord- in early 1998: It rose about 4 percent at an annual rate ing to measures that control for shifts in the regional between the fourth quarter of 1997 and May 1998. composition of sales and attempt to minimize the This increase in part reflected a sharp rise in aggre- effects of changes in the mix of the structural features gate wages and salaries, which were boosted by siz- of houses sold. In nominal terms, these increases are able gains in both employment and real wage rates; well within the range of recent years: however, in real dividends and nonfarm proprietors' incomes also rose terms, they are among the largest since the mid- appreciably. However, growth in after-tax income 1980s—a development that should reinforce the (as measured in the national income and product investment motive for homeownership. Of course, accounts) was restrained by large increases in rising house prices may make purchasing homes more personal income tax payments—likely owing in pan difficult for some families. But. with income growth to taxes paid on realized capital gains; capital gains— strong and mortgage rates around 7 percent (thirty- whether realized or not—are not included in year conventional fixed-rate loans), homeownership is measured income. Reflecting the movements in as affordable as it has been at any time in the past spending and measured income, the personal saving thirty years. Moreover, innovative programs that relax rate fell from an already low level of about 4 per- the standards for mortgage qualification are helping cent in 1997 to 3Vi percent during the first-five low-income families to finance home purchases. months of 1998. Also, stock market gains have probably boosted demand among higher-income groups, especially in Residential Investment. Housing activity the trade-up and second-home segments of the continued to strengthen in the first half of 1998, espe- market cially in the single-family sector, where starts rose After having surged in the fourth quarter of 1997. noticeably and sites of both new and existing homes mulb'family starts settled back to about 325,000 units soared. Indeed, the average level of single-family (annual rate) over the first five months of 1998, a pace only slightly below that recorded over 1997 as a whole. Support for multifamily construction con- Private Housing Starts tinued to come from the overall strength of the econ- MMioos <X unto, annual ran omy, which undoubtedly has stimulated more Quarterly average individuals to form households, as well as from low interest rates and an ample supply of financing. In addition, real rents picked up over the past year, and 1.5 the apartment vacancy rate appears to be edging Singto-tenily down. Household Finane». Household net worth rose sharply in the first quarter, pushing the wealth-to- income ratio to another record high. Although the 0.5 flow of new personal saving was quite small, the revaluation of existing assets added considerably to wealth, with much of these capital gains accu- mulated on equities held either directly or indirectly 1968 1990 1992 1994 1996 1998 through mutual funds and retirement accounts. Of Now. Value* tor 1998X32 an Bw Mragt o4 April v*J May. course, these gains have been distributed quite Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 Household Net Worth Relative to home purchases suggest a further solid gain in mort- Disposable Personal Income gage debt in the second quarter. Home equity credit at banks increased only 2 percent at an annual rate from the fourth quarter of 1997 through June 1998 after having posted a I5'/: percent gain last year; this slowdown may reflect a diminished substitution of mortgage debt for consumer debt or simply the increase in mortgage refinancings, which allowed households to pay down more expensive home equity debt or to convert housing equity into cash in a more advantageous manner. Despite the further buildup of household indebted- ness, financial stress among households appears to have stabilized after several years of deterioration. In the aggregate, estimated required payments of loan principal and interest have held about steady rela- J_|_.l I iJ_J I I I 1 I I I I M I M 1 I-LJ I l_l I I M ll 1968 1978 1968 1998 tive to disposable personal income—albeit at a high level—since 1996. Over this period, the effect on debt bmdens of faster growth of debt than income has unevenly: The 1995 Survey of Consumer Finances been roughly offset by declining interest rates and the reported that 41 percent of U.S. families own equi- associated refinancing of higher interest-rate debt, as ties in some form, but that families with higher well as by a shift toward mortgage debt (which has wealth own a much larger share of total equities. a longer repayment period). Various measures of In the first quarter of this year, die runup in wealth, delinquency rates on consumer loans leveled off or together with low interest tales and high levels of declined in 1997, and delinquency rates on mort- confidence about future economic conditions, sup- gages have been at very low levels for several years. ported robust household spending and borrowing. The Personal bankruptcy filings reached a new record expansion of household debt, at an annual rate of high in the first quarter of 1998, but this represented 7V* percent, was above last year's pace and once only 6 percent more filings than four quarters earlier, again outstripped growth in disposable income. The which is the smallest such change in three years. consumer credit component of household debt grew 4Vi percent at an annual rate in the first quarter, a Household Debt-Service Burden pace roughly double that for the fourth quarter of last Percent of disposable personal income year but near the 1997 average. Preliminary data for April and May point to a somewhat smaller advance in the second quarter. 17 Mortgage debt increased S'/i percent at an annual rate in the first quarter, the same as its fourth- quarter advance and a little above its 1997 growth 16 rate. Fined-rate mortgage interest rates were 15 basis points lower in the first quarter than three months 15 earlier and 75 basis points lower than a year earlier, which encouraged both new home purchases and a surge of refinancing of existing mortgages. Within 14 total gross mortgage borrowing, the flattening of the yield curve made adjustable-rate mortgages less attractive relative to fixed-rate mortgages, and their I I I J I I ..1 I.I I _i I _L 13 1983 1988 1993 1998 share of originations reached the lowest point in Now. Debt service is the sum of estimated requrea interest recent years. Net borrowing can be boosted by and principal payments on consumer and household-se«or mort- refinancings if households "cash out" some housing gtgadebt. equity, but the magnitude of this effect is unclear. In any event, continued expansion of hank real estate These developments have apparently suggested lending and a high level of mortgage applications for to banks that they have sufficiently tightened terms Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 Delinquency Rates on Household Loans exceptional growth of investment since the early 1990s has been facilitated in pan by the increase in national saving associated with the elimination of the federal budget deficit It has resulted in considerable modernization and expansion of the nation's capital stock, which have been important in the improved performance of labor productivity over the past few yean and which should continue to lift productivity in the future. Moreover, rapid investment in the manufacturing sector in recent years has resulted in Q1 - large additions to productive capacity, which have helped keep factory operating rates from rising much above average historical levels in the face of appre- ciable increases in output. Real outlays for producers' durable equipment, 1 1988 1990 1992 1994 1996 1998 which have been rising more than 10 percent per year, on average, since the early 1990s, moved sharply Now. Data on credil-card delinquencies ate Irom the Cai Report: data on mortgage cWinqueneies are Irom the Mortgage higher in the first half of 1998. All major categories Bankers Assoowion. of equipment spending recorded sizable gains in the first quarter; but as has been true throughout the and standards on consumer loans. In the Federal expansion, outlays for computers rose especially Reserve's May Senior Loan Officer Opinion Survey rapidly. Real computer outlays received particular on Bank Lending Practices, relatively few banks, on impetus in early 1998 from extensive price-cutting. net, reported tightening standards on credit card or Purchases of communications equipment have also other consumer loans. Little change was reported in soared in recent quarters; the rise reflects intense the terms of consumer loans. pressures to add capacity to accommodate the growth of networking; the rapid pace of technological The Business Sector advance, especially in wireless communications; and regulatory changes. As for the second quarter, data Fixed Investment Real business fixed invest- on shipments, coupled with another steep decline in ment appears to have posted another hefty gain over computer prices, point to a further substantial increase the first half of 1998 as spending continued to be in real computer outlays. Spending on motor vehi- boosted by positive sales expectations in many indus- cles apparently continued to advance as well white tries; favorable financial conditions; and a perceived demand for other types of capital equipment appears opportunity, if not a necessity, for firms to install to have remained brisk. new technology in order to remain competitive. The In total, real outlays on nonresidential construc- Change in Real Business Fixed Investment tion flattened out in 1997 after four years of gains, Percent, annual rats and they remained sluggish in early 1998. Construc- tion of office buildings remained robust in die first half of this year, after having risen at double-digit rates in 1996 and 1997, and outlays for institutional buildings continued to trend up. However, expen- ditures for other types of structures were lackluster. Nonetheless, the economic fundamentals for the sec- tor as a whole remain quite favorable: Vacancy rates for office and retail space have continued to fall; real estate prices, though still well below the levels of the mid-1980s in real terms, have risen appreciably in recent quarters; and funding for new projects remains abundant Inventory Investment The pace of stockbuild- 1993 1994 1995 1996 1997 1998 ing by nonfarm businesses picked up markedly in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 1997 and is estimated [0 have approached $100 bil- lion (annual rate) in the first quarter of 1998—equal Percent of national income to an annual rate increase of 8'A percent in the level of inventories and accounting for more than I'/i percentage points of that quarter's growth in real GDP. The first-quarter accumulation was heavy almost across the board. Among other things, it included a large increase in slocks of petroleum as ihe unusually warm weather reduced demand for refined products and low prices provided an incentive for refiners and distributors lo accumulate stocks. How- ever, overall sales were also very strong, and with only a few exceptions—notably, semiconductors, chemicals, and textiles—stocks did not seem out of line with sales. In any event, fragmentary data for the second quarter point to a considerable slowing in -L. L 1.1 1 1- 1 I i i I i 1 inventory investment that is especially evident in the 1978 1983 1988 1993 1998 motor vehicle sector, where stocks were depleted by Nots. Corporate profits induce inventory vatuaucn anO capital the combination of strong sales and CM production consumption adjustments. shortfalls. In addition, petroleum stocks appear to have grown less rapidly than they did in the first quarter, and stockholding elsewhere slowed sharply Overall, a major portion of the increase in profits in April and May. between the 1980s and the 1990s represents a realign- ment of returns from debt-holders to equity-holders. Change in Real Nonfarm Business Inventories Although their level remains high, the growth of Percent, annual rate profits has slowed: Economic profits rose AVa per- cent at an annual rate in the first quarter compared with 9'A percent between the fourth quartet of 1996 and the fourth quarter of 1997. This slowdown may have resulted from various causes,, including rising employee compensation and the Asian financial crisis. Quantifying the effect of the Asian turmoil is difficult: Although only a small share of the profits of US- companies is earned in die directly affected Asian countries, the crisis has reduced the prices of U.S. imports and [hereby put downward pressure on domestic prices. Noofinancial businesses realized annualized eco- nomic profit growth of only !'/« percent in the firsi 1993 1994 1995 1996 1997 1998 quartet. Because capital expenditures (including inventory investment) grew much faster, the financ- Corporate Profits and Business Finance. ing gap—the excess of capital expenditures over Businesses have financed a good part of their invest- retained earnings—widened. As a result, these busi- ment this year through continued strong cash flow, nesses used less of their cash flow to retire out- but they have also increased their reliance on finan- standing equity and continued to borrow at the rapid cial markets. Economic profits (book profits after pace of the fourth quarter of 1997, with debt expand- inventory valuation and capital consumption adjust- ing at an annual rate of 9 percent in the first quarter of ments) have run at 12 percent of national income over 1998. Outstanding amounts of both bonds and com- the past year. *cH above the 1980s peak of roughly mercial paper rose especially sharply. The decline in 9 percent. However, the strength in profits has long-term interest rates around year-end encouraged resulted partly from the low kvel of nel interest pay- companies to lock in those yields, and gross bond ments, leaving total capital income at roughly the issuance reached a record high in the first quarter same share of national income as at the 1960s peak. of 1998. Borrowing by nonfinancial businesses Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 increased at a slightly slower but still rapid clip in the Net Interest Payments of Nonfinancial second quarter, with little change in outstanding com' Corporations Relative io Cash Row mercial paper but very strong net bond issuance and some rebound in bank loans. Despite persistent high borrowing, external fund- ing for businesses remained readily available on 22 favorable terms. The spreads between yields on investment-grade bonds and yields on Treasury bonds widened a little from low levels, with investors favor- 18 ing Treasury securities over corporate securities as a haven from Asian turmoil and, perhaps, with disap- pointing profits leading to some minor reassessment of the underlying risk of private obligations. The spreads on high-yield bonds also increased, in part 10 because of heavy issuance of these bonds this spring, but they remain narrow by ftistoricaJ standards. In the Federal Reserve's May survey on bank lending 1978 1983 1988 1993 1998 practices, banks reported negligible change in busi- ness loan standards; moreover, yield spreads on bank loans remained low for both large and small firms. payments to cash flow, dropped substantially between Surveys by the National Federation of Independent 1990 and 1996 and remains modest, despite edging Business suggest that small firms have been facing up in the first quarter of this year. In addition, most little difficulty in obtaining credit. measures of financial distress have shown favorable readings. The delinquency rate on commercial and Spreads Between Yields on industrial bank loans has stayed very low since 1995, Private and Treasury Securities preserving the dramatic decline that occurred in the first half of the decade. After moving up a little m Percent 1996 and 1997, business failures decreased in the first five months of 1998; the liabilities of failed busi- nesses as a share of total liabilities was less than one- quarter the value reached in the early 1990s. At the same time. Moody's upgraded significantly more debt than it downgraded, and the rate of junk bond defaults stayed close to its low 1997 level. High-yield bonds Net equity issuance was less negative in the first quarter of this year than in the fourth quarter of last year, but nonfinancial corporations still retired, on net. about S100 billion of equity at an annual rate. The wave of merger announcements this spring will likely generate strong share retirements over the remainder of the year. Gross equity issuance in the first half of 1988 1990 1992 1994 1996 1998 1998 was close to its pace of the past several years, the N o M w e . rr T il h l e L y s n p c re h a d M o as n t e h r i gh II - y I ie rW ld e x b o w nd if s t c t o h m at p a o r n e s a t h s e e v y e ie n l - d y e o a n r although investors seemed somewhat cautious about Treasury note- the spread on investment-grade bonds compares initial public offerings. tne y*d on Moody1* index at A-rated bonds with that on a ten- year Treasury note. The Government Sector The ready availability of credit has stemmed Federal Government The incoming news on importantly from the healthy financial condition of the federal budget continues to be very positive. Over many businesses, which have enjoyed an extended the twe[ve months ending in May J998. the untried period of economic expansion and robust profits. budget registered a surplus of $60 billion, compared The aggregate debt-service burden for nonfinancial with a deficit of S65 billion during the twelve months corporations, measured as the ratio of net interest ending in May 1997. Soaring receipts continued to be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 the main force driving the improvement in the budget, Federal receipts in the twelve months ending in but subdued growth m outlays also played a key role. May 1998 were 10 percent higher than in the same If the latest projections from OMB and CBO are real- period a year earlier—roughly twice the percentage ized, the unified budget for fiscal year 1998 as a increase for nominal GDP over ihe past year. whole will show a surplus of roughly $40 billion to Individual income tax receipts, whfch have been $65 billion. rising at double-digit rates since ihe mid-1990s. continued to do so over the past year as the surge in With the federal budget having shifted into surplus, capital gains realizations likely persisted and sizable the federal government is now augmenting, rather gains in real income raised the average tax rates on than drawing on. the pool of national saving. In many households (the individual income tax structure fact, the improvement in ihe government's budget being indexed for inflation but not for growth in real position over the past several years has been large incomes). In contrast to the ongoing strength in enough to generate a considerable rise in gross individual taxes, corporate tax payments increased domestic saving despite a decline in the private sav- only moderately over the past year, echoing the ing rate; ali told, gross saving by households, busi- deceleration in corporate profits. nesses, and governments increased from about 141/! percent of gross national product in the early Federal expenditures in the twelve months ending 1990s, when federal saving was at a cyclical low, to in May 1998 were only 1 'A percent higher in nominal more than 17 percent of GNP in recent quarters. terms than during the twelve months ending in May This increase in domes tic saving, along with 1997, with restraint evident in most categories. increased borrowing from abroad, has financed the Outlays for defense were about unchanged, as were surge in domestic investment in this expansion. those for itvcome security programs. In the latter Moreover, this year's budgetary surplus will con- category, outlays for low-income support fell as tinue to pay benefits in future years because it allows economic activity remained robust, welfare reform the government to reduce its outstanding debt, which capped outlays for family assistance, and enrollment implies smaller future interest payments and. all rates in other programs dropped. In me health area, else equal, makes it easier to keep the budget in spending on Medicaid picked up somewhat after a surplus. If, in fact, the budget outcome over the next period of extraordinarily small increases, whereas several years is as favorable as OMB and CBO now growth in spending for Medicare slowed, in pan anticipate under current policies, the reduction in because of the programmatic changes that were the outstanding debt could be substantial. legislated in 1997. And, with interest rates little changed and the stock of outstanding federal debt no longer rising, net interest payments stabilized. Saving and Investment Real federal outlays for consumption and gross Percent of nominal GNP investment, 'the pan of federal spending that is counted in GDP. fell about 2 percent between the first quarters of 1997 and 199%, The decrease was con- Gross domestic investment centrated in real defense spending, which fell about iy> percent, roughly the same as over the preced- 20 ing four quarters; real nondcfense spending was unchanged, on balance. In the first quarter, real fed- eral outlays fell at a 10 percent annual rate; the drop reflected a plunge in defense spending, which appears 16 to have been reversed in the second quaner. With debt held by the public close to $4 trillion, the government will continue to undertake substantial gross borrowing in order to redeem maturing securi- 12 ties. The government will also continue to adjust its 1961 1985 1989 1993 1997 issuance of short-term debt to accommodate seasonal Now. Gross saving consists of saving ol housefloKte. busi- swings in receipts and spending. The surplus during nesses, and governments. Grass domestic myesflneni«the sum ol gross pnvaW domestic investment and government invest- the first half of calendar year 1998—boosted by the ment. Th« gap between TOSS saving and gross domestic invest- huge inflow of individual income tax receipts— ment is equal to tti* sum d net toteign wwestmerrt and me MaSsS- cal discrepancy from trie national income and product accounts. enabled the Treasury to reduce its outstanding debt Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 Change in Real Federal Expenditures rent expenditures in the national income and product on Consumption and Investment accounts, held steady in the first quarter at around Percent. Q4 to Q4 $35 billion (annual rate), roughly where it has been since 1995. State governments, which have reaped the mam benefits of rising income taxes, have fared espe- cially well: Indeed, all of the forty-seven states whose fiscal years ended by June 30 appear to have achieved CM balance or to have run surpluses in their general funds budgets in fiscal year 1998. Real expenditures for consumption and gross investment by states and localities have been rising about 2 percent per year, on average, since the early 1990s, and the increase in spending for the first half of 1998 appears to have been a bit below that trend. These governments added jobs over the first half of the year at about the same rate as they did over 1997 12 as a whole. However, real construction oudays, which 1993 1994 1995 1996 1997 1998 Now. Value tor 1998:01 is a Quarterly percent change al an have been drifting down since early 1997, posted a annual rale. sizable decline in the first quarter, and monthly data suggest that spending dropped further in the spring. The weakness in construction spending over the past S57 billion while augmenting its cash balance year has cut across the major categories of construc- $40 billion. The reduction in debt included net tion and is puzzling in light of the sector's ongoing paydowns of coupon securities and bills. infrastructure needs and the good financial shape of most governments. Looking ahead to projected surpluses for coming years, the Treasury announced that it will no longer issue three-year notes and will auction five-year notes Change in Real State and Local Expenditures quarterly rather than monthly. Over the past several on Consumption and Investment years, the Treasury has accommodated the surpris- Percent, Q4 to CM ing improvement in federal finances by substantially reducing both bill and coupon issuance. The Treasury hopes that concentrating future coupon offerings in larger, less-frequent auctions will maintain the liquid- ity of these securities while still allowing for suffi- cient issuance of bills to maintain their liquidity as well. These changes are also intended to prevent — 2 further upcreep in the average maturity of the out- standing debt held by private investors, now stand- ing at sixty-five months. The Treasury continues to work on encouraging the market for inflation- indexed securities, issuing a thirty-year indexed bond in April to complement the existing five-year and ten- year indexed notes. 1993 1994 1995 1996 1997 1996 State and Local Governments. The fiscal Not». Value lor '998:01 is a quarterly peiOTOl crtange al an annual <*M position of state and local governments in the aggre- gate has also remained quite favorable. Strong growth of household income and consumer spending has State and local governments responded to the low continued to lift revenues, despite numerous small tax interest rates during the first half of the year by bor- cuts, and governments have continued to hold the line rowing at a rapid rate, both to refinance outstanding on expenditures. As a result, (be consolidated cur- debt and to fund new capital projects. Because debt rent account of the sector, as measured by the surplus retirements eased in the first quarter relative to (net Qf social insurance funds) of receipts over cur- the fourth quarter of 1997, net issuance increased Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 substantially. Meanwhile, credit quality of state and The quantity of imports of goods and services local debt continued to improve, with much more again grew vigorously in the first quarter. The annual debt upgraded than downgraded in the first half of the rate of expansion at 17 percent exceeded thai for 1997 year. and reflected the continued strength of US. eco- nomic activity and the effects of past dollar appre- ciation. Imports of consumer goods, automotive External Sector products, and machinery were particularly robust. Trade and the Current Account. The nominal Preliminary data for April and May suggest that real trade deficit on goods and services widened to import growth remained strong. Non-oil import prices $140 billion at an annual rate in ihe first quarter from fell sharply through the second quarter, reflecting the $114 billion in ihe fourth quarter of last year. The rise in the exchange value of the dollar over the past current account deficit for the first quarter reached year. S189 billion (annual late), 21A percent of GDP, compared with $155 billion for the year 1997. A Change in Real Imports and Exports larger deficit on nei investment income as well as the of Goods and Services widening of the deficit on trade in goods and ser- Pwcem, O* ID O4 vices contributed to the deterioration in the first quarter of the current account balance. In April and [J Imports May, (he trade deficit increased further. • Exports 20 U.S. Current Account Billions of dollars, annual rate 10 50 10 100 1993 1994 1995 1996 1997 1998 Note. Valua (or i99S:Qt « a quartet^ pwtsiii etange at an 150 annual raw. 200 The quantity of exports of goods and services declined at an annual rate of 1 percent in the first quarter, the first such absolute drop since trie first 250 quarter of 1994. The weakness of economic activity 1993 1994 1995 1996 1997 1996 in a number of our trading partners, with absolute Percent o( nominal GDP declines in several economies in Asia, and the strength of the dollar, which also partly resulted from the Asian financial crises, largely account for the abrupt halt in the growth of real exports after a - 2 10 percent rise last year. Declines were recorded for machinery, industrial supplies, and agricultural products. Exports to the emerging market economies in Asia, particularly Korea, as well as exports to Japan were down sharply while exports to western Europe and Canada rose moderately. Preliminary data for April and May suggest that real exports declined further. The Capital Account. Foreign direct invest- 1973 1978 1983 1988 1993 1998 ment in the United States and U.S. direct investment Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 abroad continued at near record levels in the first Unemployment Rate quarter of 1998, spurred by strong merger and acquisition activity across national borders. In the first quarter, the booming US. stock market continued to attract large foreign interest Net purchases by private foreigners were $29 billion, fol- lowing record net purchases of $66 billion in the year 1997. Foreign net purchases of U.S. corporate bonds remained substantial, and net purchases of U.S. government agency bonds reached a record $21 bil- lion. In contrast, net sales of U.S. Treasury securi- ties by private foreigners, particularly large net sales booked at a Caribbean financial center, were recorded in the first quarter U.S. net purchases of foreign stocks and bonds were modest. I I 1 LI I I 1 I II 1 I I I I I I I I 111 I I LJ_| 1 1 __ Foreign official assets in the United States 1966 1973 J978 1983 1988 1993 1998 increased $ 10 billion in the first quarter. However, the nei increase in the second quarter was limited by large dollar sales by Japan. of 1998. posting increases of 115,000 per month, on average. Within services, hiring remained brisk The Labor Market at computer and data-processing firms and at firms providing engineering and managerial services, but Employment and Labor Supply. Labor payrolls at temporary help agencies rose much less demand remained robust during the first half of 1998. rapidly than they had over the preceding few years— Growth in payroll employment averaged 243,000 per apparently in part reflecting difficulties in finding month, only a little less than in 1997 and well above workers, especially for highly skilled and technical the rate consistent with the growth in the working- positions. Sizable increases were also posted ai age population. The unemployment rate held steady wholesale and retail trade establishments and in the in the first quarter at 4V4 percent but dropped to the finance, insurance, and real estate category. Construc- range of 41/* percent to 4Vi percent in the second tion payrolls were bounced around by unusual winter quarter. weather but. on average, rose a brisk 21,000 per The services industry, which accounts for about month—about the same as in 1997. 30 percent of nonfarrn employment, continued to be In contrast to the robust gains elsewhere, the mainstay of employment growth over the first half manufacturing firms curbed their hiring in the first half of 1998 in the face of slower growth in factory output. After having risen a torrid 6'A percent in Change in Payroll Employment 1997, factory output increased at an annual rate of Thousands of Jobs, monthly average about 2V4 percent between the fourth quarter of last Total nonfarm year and May 1998; the deceleration reflected the effects of the Asian crisis as well as a downshift in motor vehicle assemblies and the completion of the 400 1996-97 ramp-up in aircraft production. In June, fac- tory output is estimated to have fallen SA percent; the GM strike accounted for the decline. The labor force participation rate—which measures the percentage of the working-age population that is either employed or looking for work—trended up mildly over the past couple of years and stood at 67.1 percent, on average, in the first half of 1998, slightly above the previous cyclical highs achieved in 200 late 1989 and early 1990. Participation among adult 1993 1994 1995 1996 199? 1998 women has picked up noticeably in recent years, after Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 having risen only slowly in the first half of the 1990s, Change in Employment Cost Index and participation among adult men. which had been Percent. Dec. to Dae. on a gradual downtrend through mid-decade, appears Hourly compensation to have leveled out. In contrast, participation rates for teenagers, for whom school enrollment rates have riser, have continued to sag after having dropped sharply in the early 1990s. Strong labor demand clearly contributed importantly to the rise in overall participation over the past several years, but the expansion of the earned income tax credit and changes in the welfare system probably provided added stimulus. Labor Force Participation Rate 1991 1993 1995 1997 Note, Data ate lor private industry, excluding farm and house- hold wotfcars. The valua lot S999-Q1 is nwasurM from Mar* 1997 toMaren 1998. 66 over the past year, implies a solid increase in real pay for many workers. 63 The acceleration in hourly compensation costs over the past year resulted mainly from faster growth of wages and salaries, which rose 4 percent over ihe 60 twelve months ending in March: this increase was about SA percentage point larger than the one recorded over the preceding twelve months. Separate data 57 on average hourly earnings of production or 1968 1973 1978 1983 1988 1993 1996 nonsupervisory workers also show an ongoing for N W ot B e . r e D de a s ta ig n M t o o f r m e e 1 9 tio 9 u 4 s e ha fio v W e b s e u e r n ve a y d . justed by me FRB stall acceleration of wages: The twelve-month change in this series was 4,1 percent in June, '/; percentage point above the reading for the preceding twelve months. Labor Costs and Productivity, Firms no doubt are continuing to rely heavily on targeted pay Benefits costs have generally remained subdued. increases and incentives like stock options and with the increase over the year ending in March bonuses to attract and retain workers. But the tight- amounting to only about 2V4 percent. According 10 ness of the labor market also appears to be exening the ECI, employer payments for health insurance some upward pressure on traditional measures of have picked up moderately in recent quarters after hourly compensation, which have exhibited a having been essentially flat over the previous couple somewhat more pronounced uptrend of late. Indeed, of years, and indications are that further increases The twelve-month change in the employment cost may be in the offing. Insurers whose profit margins index (ECI) for private industry workers picked up had been squeezed in recent years by pricing strate- to Vfi percent in March, compared with 3 percent gies designed to gain market share reportedly are rais- for the twelve months ending in March 1997 and ing premiums, and many managed care plans are add- 2V* percent for the twelve months ending in March ing innovations that, while offering greater flexibility 1996. Hourly compensation accelerated especially and protections to consumers, may boost costs. Addi- rapidly for employees of finance, insurance, and real tional upward pressure on premiums apparently has estate firms, some of whom received sizable bonuses come from higher spending on prescription drugs. and commissions. However, the acceleration was Among other major components of benefits, rising fairly widespread across industries and occupations equity prices have reduced the need for firms to and. given the relatively small rise in consumer prices pay into denned benefit plans, and costs for state Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 unemployment insurance and workers' compensa- Prices tion have fallen sharply. Price inflation remained quiescent in the first half Labor productivity in the nonfann business sector of this year. After having increased \V* percent in posted another sizable advance in the first quarter of 1997, the consumer price index (CPI) slowed lo a 1998. bringing the increase over the year ending in crawl in early 1998 as energy prices plummeted, and it the first quarter to an impressive 2 percent.1 Takjng a recorded a nse of only about I'/: percent at an annual slightly longer perspective, productivity has risen a rale over the first six months of the year. The increase bit more than IV4 percent per year, on average, over in the CPI excluding food and energy—the so- the past three years, after having risen less than called "core CPI"—picked up to 2'/i percent (annual 1 percent per year, on average, over the first half rate) over the first half of the year. However, this of the decade. At least in part, the recent strong pickup follows some unusually small increases in the productivity growth has likely been a cyclical response to the marked acceleration of output. But it Change in Consumer Prices is also possible that the high levels of business invest- ment over the past several years—and the associ- Percent. Dae. lo Dec. ated rise in the amount of capital per worker—are translating into a stronger underlying productivity trend. In aiklition, productivity apparently is being buoyed by the assimilation of new technologies into the workplace. In any event, the faster productivity growth of late is helping to offset the effects of higher hourly compensation on unit labor costs and prices, thereby allowing wages to rise in real terms. Change in Output per Hour Percent. 04 to Q4 0 1991 1993 1995 1997 Note. Consumer pnceinOex lor aU urban consumers. Value for 1998:H1 is the percent change from December 1997 to June 1993 al an annual rate. Change in Consumer Prices Excluding Food and Energy Percent. D«. to Dec. 1991 1993 1995 1997 Mole. Nonfann business sector. Value for 199B:Q1 is the percent change from 1997:Q1 Id 1993:O1. 1. According lo the published daw, productivity rose 1.1 pcicenl at an annual rale in (he first quarter. However, (best data arc distorted by inconsistencies in the measurement of hows associated with varying lengths of pay periods across months. Although (he Bureau of Labor Statistics tots already revised the monthly hours and earnings data 10 account for these inconsisteacie*. u will not update the productivity statistic! until August All else bang equal. adjusting the productivity data to reflect the Bureau's revisions to 1991 1993 1995 1997 hours would subuwoiily raise productivity growth in die first Note, Consumer pnce index tor at urtwrt consumers. VaftM tor quarter, but it would have little effect on (he change over the four 1998:H1 is me percent change from December 1997 to June quarters ending in Che first quarter. 1998 at an annual rate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 Alternative Measures of Price Change Percent 1996:O1 1997:Q1 to to Price measure 1997:O1 1998:Q1 Fixed weight Consumer price index 2,9 1.5 Excluding food and energy 2.5 2.3 Chain type Personal consumption expenditures 2.6 1.0 Excluding food and energy 2.3 1.4 Gross domestic product 2.2 1.4 Note. Changes are OaseO on quarterly averages. second lialf of 1997. and the twelve-month change The CPI for goods other lhan food and energy rose has held fairly steady at about 2'/4 percent since late at an annual rate of 1 percent over the first six months last summer. The chain pncc index for personal of 1998, only a bit above the meager '/i percent consumption expenditures on items other than food rise over 1997 as a whole. In the main, the step-up and en«gy rose only 1'A percent over the year end- reflected a turnaround in prices of used cars and ing in the first quarter of 1998—the most recent trucks, and prices of tobacco products and prescrip- information available; this measure typically rises less tion drugs also rose considerably faster than they rapidly than does the core CPI, in part because it is had in 1997. More generally, prices continued to be less affected by so-called "substitution bias." restrained by the effect of the strong dollar on prices of import-sensitive goods. For example, prices of new The reiativciy favorable price performance in the vehicles fell slightly over the first half of the year first half of 1998 reflected a number of factors ihaL while prices of other import-sensitive goods—such as taken together, continued to exert enough restraint apparel and audio-video equipment—were flat or to offset the upward pressures from strong aggre- down. In the producer price index, prices of capital gate demand and high levels of labor utilization. One equipment were little changed, on balance, over the was the drop in oil prices. In addition, non-oil import ftrsi half of 19981, they, too, were damped by the prices continued to fail, thus further lowering input competitive effects of falling import prices. costs for many domestic industries and limiting the ability of firms facing foreign competition to raise The CPI for n on-energy services increased prices for fear of losing sales to producers abroad. 3 percent over the first six months of 1998. about Prices of manufactured goods were also held in check ihe same as last year's pace. After having fallen by the sizable increase in domestic industrial capac- somewhat last year, airfares picked up in the first half ity in recent years and by devd-opments in Asia, of the year, and owner's Equivalent rent seems to be which, among other things, led to a considerable rising a bit faster than it did in 1997. In addition, softening of commodity prices. Moreover, the vari- increases in prices of medical services, which had ous surveys of consumers and forecasters suggest that slowed to about 3 percent per year in 1996-97, have inflation expectations stayed low—even declined been running somewhat higher so far this year. Price in some measures. For example, according to the changes for most other major categories of services Michigan survey, median one-year inflation expecta- were similar to or smaller than those recorded in tions dropped a bit furtHer this year, after having held 1997. fairly steady over 1996 and 1997, and inflation expectations for the Text five, to ten years edged down Energy prices fell sharply in early 1998 as the price from about 3 percent, on average, in 1996 and 1997 of crude oil came under severe downward pressure to 2V« percent in the second quarter of 1998. from weak demand in Asia, a decision by key OPEC Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 producers to increase output, and a relatively warm Debt Annual Range and Actual Level winter in the Northern Hemisphere. After averaging Trillions ot doHars about $20 per barrel in the fourth quarter of 1997, the Domestic nonftnancial sectors spot price of West Texas intermediate dropped to a monthly average of $15 per barrel in March, where it 15.8 more or less remained through the spring. Crude prices dropped sharply in June following reports of 15.6 high levels of inventories and revised estimates of 011 consumption in Asia but have since firmed in response to an agreement by major oil producers 10 15.4 restrict supply in the months ahead; they now stand at $I4¥i per barrel. Reflecting the decline in crude 15.2 prices, retail energy prices fell at an annual rate of 12 percent over the first half of the year, led by a 15.0 steep drop in gasoline prices. Developments in the agriculruraJ sector also helped 14,8 to restrain overall inflation in the first half of this year. 0 N D M AM Excluding ibe prices of fruits and vegetables— 1997 1998 which tend to be bounced around by short-term swings in the weather—food prices have been rising a the second. This slowdown was especially acute in scant 0.1 percent per month, on average, since late securities holdings, which had surged in both the 1997. Although farmers in some regions of the fourth quarter of 1997 and the first quarter of this country are experiencing more prolonged weather year. Responses Co the FederaJ Reserve's May survey problems, conditions in the major crop-producing on bank lending practices suggest that the earlier areas of the Midwest still look relatively favorable, runup in securities reflected the efforts of banks to and it appears that aggregate farm production will be boost returns on equity by increasing leverage; much sufficient to maintain ample supplies over the com- of the rise in securities holdings was concentrated at ing year, especially in the context of sluggish export banks that were constrained by recent mergers from demand. using their profits to repurchase shares. Loan growth also slowed in the second quarter, although the vari- ous loan categories behaved quite differently: Real Credit and the Monetary Aggregates estate lending expanded most slowly in May and Cmdit and Depository Intermediation. The June, whereas business lending rebounded in those total debt of US. households, governments, and months after stalling out in March and April. Out- nonftnancial businesses increased at an annual rate of standing loans at branches and agencies of foreign 5V* percent from the fourth quarter of 1997 through banks declined in the second quarter, and survey May of this year. Domestic nonfinancial debt now responses identified an actual or expected weaken- stands a little above the midpoint of the 3 percent ing in the capital position of the parent banks as the to 7 percent range established by the FOMC for primary impetus for a tightening of loan terms and 1998. Debt growth has picked up since 1997, as an standards. acceleration of private credit associated with strong The Report of Condition and Income (the Call domestic demand and readily available supply has Report) showed that banks' return on equity was more than offset reduced federal borrowing. Indeed, about unchanged in the first quarter, staying in the federal debt declined Ivi percent at an annual rate elevated range it has occupied since 1993. Call between the fourth quarter of 1997 and May 1998, Report data also indicated thai delinquency and whereas nonfederal debt increased 8'A percent charge-off rates on commercial and industrial loans annualized over the same period. The growth of non- and on real estate loans remain quite low, while federal debt has slowed only slightly over the past delinquency and charge-off rates on consumer loans several months. have leveled off after their previous rise. Indeed, bank Credit on the books of depository institutions rose profits have benefited importantly in recent years at roughly the same pace as total credit in the first half from a low level of provisioning for loan losses. of the year. Commercial bank credit advanced rapidly Nevertheless, bank supervisors have been concerned in the first quarter and at a more subdued rate in that intense competition and favorable economic 20 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 conditions might be leading banks to ease standards has not increased banking concentration m most local excessively. They reminded depositories thai credit markets. assessments should lake account of the possibility of less positive economic circumstances in (he future. The Monetary Aggregates. The broad mone- The trend toward consolidation in the banking tary aggregates grew more rapidly in the first half of industry continued in the first half of the year- Some 1998 than they did in 1997. although the pace of their of the announced mergers involve combinations of expansion has slowed noticeably in recent months. banks and nonbank financial institutions, such as M2 grew 7'/4 percent at an annual rate between the thrifts and insurance companies. Many of the merg- fourth quarter of last year and June of this year, ers were designed to capitalize on the economies of placing il well above the top of its 1 percent to scale and diversification of risk in nationwide bank- 5 percent growth range. When the FOMC established ing; other mergers were undertaken to expand the this range in February, it noted that annual ranges range of services offered to customers. Although represented benchmarks for money growth under some observers are concerned that consolidation conditions of stable prices ind velocity behavior in might raise banks' market power, greater national accordance with its pre-1990 historical experience. In concert ration in banking over the past several years fact, nominal spending and income have grown more Growth of Money and Debt Percent Domestic Period M1 M2 M3 nonfinanciai debt Annual1 1986 4.3 5.7 6.3 9.1 1989 0.5 SJ2. 4.0 7.5 1990 4.2 4.1 1.8 6.7 1991 7.9 3.1 1.2 4.S 1992 14.4 1.8 0.6 4.5 1993 10.6 1.3 1.1 4.9 1994 2.5 0.6 1.7 4.9 1995 -1.6 3.9 6.1 5.4 1996 -4.5 4.6 6.8 5.3 1997 -1.2 5.7 8.8 5.0 Quarterly (annual rate)' 1998 Q1 3.0 8.0 11.0 6.2 Q2 0.3 7.3 9.6 n.a. Year-to-date3 1998 0.9 7.3 9.8 5.8 1, Front average tor tooth quarter of preceding year to 3. Ficm average tor tourtti quarter of 1997 U average tor 2. From average tor preceding quarter to avenge tor quarter indicated. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 88 MZ: Annual Range and Actual Level and opportunity cost have again been moving roughly Trillions of dollars together, though not in Jockstep. Indeed, velocity has declined recently despite almost no change in the standard measure of opportunity cost The dip in 4.25 velocity may be partly attributable to the flatter yield curve, which has reduced the return on longer-term 4.20 investments relative to M2 assets—bank deposits and money market mutual funds. Money demand may 4.15 also be bolstered by the efforts of households to rebalance their portfolios in the face of a booming 4.10 stock market. By the end of 1997. households' mone- tary assets had ebbed to the smallest share of their 4.05 total financial assets in many years, and households may want to reduce the concentration of their assets 4.00 in relatively risky equities and increase their hold- ings of less volatile M2 assets. However, in spite of O N D J F M A M JJ 3-95 both the Ratter yield curve and the rebalancing 1997 1998 motive, flows into both bond mutual funds and stock mutual funds have been quite heavy this year. rapidly than is consistent with price stability and M2 increased 7V* percent at an annual rate in the sustainable real growth, and the velocity of M2 second quarter, compared with 8 percent in the first {defined as the ratio of nominal GDP to M2) has quarter. A buildup in household liquid accounts in fallen relative to the behavior predicted by the pre- preparation for individual income tax payments 1990 experience. substantially boosted money growth in April; the clearing of these payments depressed May growth by For several decades before 1990, M2 velocity a roughly equal amount. At an annual rate, M2 showed little overall trend but varied positively from increased about 6 percent on average over April and year-to-year with changes in M2 opportunity cost, May and about 5 percent in June, suggesting a larger which is generally defined as the interest forgone by deceleration than is shown by die quarterly average holding M2 assets rather than short-term market figures. instruments such as Treasury bills. The relationship was disturbed in the early 1990s by a sharp increase in velocity; however, since mid-1994, M2 velocity M3: Annual Range and Actual Level Trillions of doflare M2 Velocity and the Opportunity Cost of Holding M£ Ratio scale Percentage points, ratio seal* 5.6 2.0 5.5 5.4 10 5.3 1.7 5.2 o N D J M AM 1997 1998 1.6 1978 1983 I98S 1993 1998 M3 grew 9V* percent at an annual rate between the Note. M2 opportunity cost it a two-quirttr moving av*r»g* ol fourth quarter of last year and June, placing it far ttw mrw-monm Treasury M raw leu tna w«ghtM-av*r*g> nil pad on U2 comparnns. above the top of its 2 percent to 6 percent growth 22 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 range. As with M2- the FOMC chose the growth on only a two-week average basis. As a result, the range for M3 as a benchmark for growth under condi- Federal Reserve has generally been able to supply a tions of price stability and historical velocity quantity of reserves that is close to the quantity behavior. The components of M3 not included in M2 demanded at the federal funds rate intended by increased 17V*: percent at an annual rate over the firsl the FOMC. and banks have accommodated many half of the year, following an even faster runup in unanticipated imbalances in reserve supply by vary- 1997. Rapid expansion of large time deposits in the ing the quantity demanded across days. Banks also first quarter was driven importantly by strong credit hold reserve balances to avoid overdrafts after mak- growth at depository institutions. More recently, gains ing payments to other banks. But this precautionary in this category have diminished as bank credit demand is more variable and difficult to predict than growth has slowed. Holdings of institutional money requirement-related demand, and it cannot be market mutual funds climbed more than 20 percent in substituted across days. As required reserves drop, each of the past three years, and that strength has more banks will hold deposits at Che Federal Reserve mounted in 1998 as businesses' interest in outsourc- only to meet these day-to-day demands, reducing the ing their cash management evidently has intensified. potential for rate-smoothing behavior. Because in-house management often involves short- So far, however, the federal funds rate has not term assets that are not included in M3. the shift to become noticeably more volatile on a maintenance mutual funds boosts M3 growth. period average basis. This outcome has occurred Ml rose 1 percent at an annual rate between the partly because die Federal Reserve has responded to fourth quarter of 1997 and June of this year. Cur- the changing nature of reserve demand by conduct- rency expanded 6W percent annualized over that ing open market operations on more days than had period, a bit below its increase last year. Foreign been customary and by arranging more operations demand for US. currency apparently weakened with overnight maturity, thereby bringing the daily substantially in the first five months of the year, with reserve supply more closely in line with demand. At an especially large decline in shipments to Russia. the same time, banks have borrowed, more reserves at Deposits in Ml declined in the first half of the year me discount window and have improved the manage- owing to the conbnued introduction of "sweep" ment of their accounts at Reserve Banks. Between programs. Ml growth has been depressed for several 1995 and 1997, banks also significantly increased years by the spread of these programs, which sweep theii required clearing balances, which they pre- balances out of transactions accounts, which are commit to hold and which earn credits that can be subject to reserve requirements, and into savings applied to Federal Reserve priced services. Like accounts, which are not. Depositors are unaffected by required reserve balances, required clearing balances this arrangement because the funds are swept back are predictable by the Federal Reserve and can be when needed; banks benefit because they can reduce substituted across days within the two-week their holdings of reserves, which earn no interest. maintenance period. Going forward, the Federal New sweeps of other checkable deposits, have slowed Reserve1! recent decision to use lagged reserve sharply, but sweeps of demand deposits into savings accounting rather than contemporaneous reserve deposits—an activity Chat has become popular more accounting will increase somewhat the predictability recently—continue to spread. Because many banks of reserve demand by both banks and the Federal have already reduced their required reserves to Reserve. Still, further declines in required reserves minimal levels, the total flow of new sweep programs might increase funds-rate volatility. Moreover, one- is tapering off, although it remains considerable. third of the banks responding to the Federal Reserve's recent Senior Financial Officer Survey report thai The drop in transactions accounts in die first half of reserve management is more difficult today than the year caused required reserves to fall 33A percent at in the past. One way to diminish these problems an annual rate, a much slower decline than in 1997. would be to pay interest on reserve balances, which The monetary base grew 5Vi percent over the same would reduce banks' incentives to minimize those period, as the runoff in required reserves was more balances. than offset by the increased demand for currency. The substantial decline in required reserves over Financial Markets the past several years has raised concern that the fed- eral funds rate might become more volatile. Required Interest Rates. Yields on intermediate- and long- reserves are fairly predictable and must be maintained term Treasury securities moved in a fairly narrow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 Selected Nominal Treasury Rates economies. Lastly, diminished borrowing by the fed- Percent eral government has restrained interest rales by reducing the competition for private domestic sav- ing and for borrowed funds from abroad. Assessing the relative importance of some of these 15 factors might be aided, in principle, by comparing yields on nominal and inflation-indexed Treasury Thirty-year notes. Between the second quarters of 199? and 1998, bond 10 the nominal ten-year yield fell more than 1 percent- age point, whereas the inflation-indexed ten-year yield increased a bit. Unfortunately, the relatively recent introduction of inflation-indexed securities and the thinness of trading makes interpreting their yield levels and movements difficult In particular, light trading may lead investors to view these new securi- 1968 1978 1988 1998 ties as providing less liquidity than traditional Treasury notes, and investors may value liquidity Note. The twenty-year Treasury bond rate is shown until the firsl issuance ot the thirty-year Treasury Bond in FeOruary 1977 especially highly now in the face of uncertainty about developments in Asia. The yield curve for Treasury securities has recently band during the first half of 1998. centered a little been flatter than at any point since the beginning of below the levels that prevailed in the latter part of the decade. For example, the difference between the 1997. The thirty-year bond yield touched its lowest ten-year-note yield and the three-month-bill yield was value since the bond was introduced to the regular smaller in the first half of 1998 than in any otber half- auction calendar in 1977: it was also lower than any year period since early 1990. In that earlier episode, sustained yield on the twenty-year bond (the longest the yield curve had been flattened by a sharp runup maturity Treasury security before the issuance of the in short-term interest rates as the FcdeiaJ Reserve thirty-year bond) since 1968. Meanwhile, the aver- tried to check an upcieep in inflation. In the current age yield on five-year notes in the first half of the year episode, short rates have held fairly steady, while was the lowest since early 1994. long-term rates have declined significantly. Some of Several factors have contributed to die decline in the current flatness of the term structure probably intermediate- and long-ienn interest rates over the stems from the apparent reduction in term premiums past year. For one, developments in the U.S. econ- noted above. But the flat yield curve may also reflect omy and overseas reduced expected inflation and. the expectation that short-term real interest rates, perhaps, uncertainty about future inflation. Between which have been boosted by the decline in inflation the second quarter of 1997 and the second quarter of over the past year, will drop in the future. Support- 1998, the median long-term inflation expectation in ing that notion, the yield curve for inflation-indexed the Michigan SRC survey of households dropped debt has become inverted this year, as the return on Vt, percentage point, and the average expectation in the five-year indexed note has risen above the return the Philadelphia Federal Reserve's Survey of Profes- on the ten-year indexed note, which exceeds the sional Forecasters fell almost Vi percentage point. return on the new thirty-year indexed bond. Over the same period, the variance of long-term infla- tion expectations in the Michigan survey was halved. Equity Prices. Equity markets have remained This greater consensus of expectations suggests that ebullient this year. The SAP 500 composite index people may now place less weight on the possibility rose sharply in the first several months of 1998; it of a sharp acceleration in prices; a reduction in then fell back a little before moving up to a new perceived inflation risk would tend to reduce term record in July. The NASDAQ composite, NYSE premiums and thereby cut long-term interest rates. A composite, and Dow Jones Industrial Average fol- damping of expected growth in real demand here and lowed roughly similar patterns, and these indexes abroad, triggered importandy by the Asian financial now stand about 17 to 28 percent above their year- crisis, also has probably pulled rates lower, as has an end marks. Small capitalization stocks have not fared apparent shift in desired portfolios away from Asia so well this year, with the Russell 2000 index up and, to some extent, from other emerging market about a third as much on net. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Major Stock Price Indexes survey—is little changed since year-end. As a result, Index (December 31. 1996=100) the forward-earnings yield on stocks exceeds the real yield on bonds by one of the smallest amounts in many years. Apparently, investors share analysts' expectations of robust long-term earnings growth, or they are content with a much smaller equity premium than the historical average. International Developments Events in Asia, including in Japan, have continued to dominate developments in global asset markets so far in L998- During the first months of the year, many financial markets in Asia appeared to stabilize, and progress in implementing economic and financial reform programs was made in most of the countries J M M J S N J MM seriously affected by the crises. In early April, the 1997 1998 agreement between Korean banks and their external Now. Last observations ate lor July 17, 1998, bank creditors to stretch out short-term obligations was implemented, ending an interval of rollovers by creditors that was endorsed by the authorities in The increase in equity prices combined with the countries that had pledged to support the Korean recent slowdown in earnings growth has kepi many program. Indonesia reached a second revised agree- valuation measures well above their historical ranges. ment with the International Monetary Fund (IMF) in The ratio of prices in the S&P 500 to consensus April on a reform program, which was subsequently estimates of earnings over the coming twelve months derailed by political strife and the resignation of the reached a new high in Apn] and has retreated only president in late May; the change in political regime slightly from that point. At the same time, the real was followed by calm, and a new agreement was long-term bond yield—measured either by the ten- reached with the IMF management in law June and year indexed yield or by the difference between the approved by the IMF Executive Board on July 15. ten-year nominal Treasury yield and inflation expectations in the Philadelphia Federal Reserve's Dairy Value oi Foreign Currencies irxJsx of S/foreJon currencies (Jury 2, 1997^100) Equity Valuation and Long-Term Interest Rate Percent 90 S&P 500 earnings-price ratio 70 Tan-year real _ interest rate 50 30 10 J A S O N 0 M M 1997 1998 1978 1983 1988 1993 1998 Note. Last observations are tor Jury 17. 1996. Mole, l^ie earnings-price latio is Dased on the consensus estimate of earnings over the corning twelve months derived Irom tne forecasts collected uy I/B/E/S International. Inc. The real inter- After rising sharply during the final months of est rale is the yield on the ten-year Treasury now lees We wv 1997 through mid-January of 1998. the exchange year inflation expectations tiom the Philadelphia Federal Reserve Survey o> ProlessionaJ Forecasters. value of the dollar in terms of the currencies Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 of Korea. Indonesia. Thailand, and other ASEAN about the sustainafaility of current exchange rate poli- countries partly retraced those gains during Febru- cies in China and Hong Kong. ary. March, and April. Since then, however, market On June 17. the monetary authorities in the United pressures have again led to further sharp increases in States and Japan cooperated in foreign exchange the exchange value of the dollar in terms of the intervention purchases of yen for dollars. This Indonesian mpiah while the dollar has changed link intervention operation was the first by US. authori- against mosi of the other Asian emerging-market cur- ties since August 1995. In announcing the market rencies. Since the end of December, the dollar has intervention, Treasury Secretary Rubin cited Japanese declined, on balance, 24 percent against the Korean government plans to restore the health of their finan- won and nearly 14 percent against the Thai bant and cial system and to strengthen Japanese domestic has risen moderately in terms of the Taiwan dollar demand. He pointed to the stake of Asia and the and increased about 130 percent in terms of the international community as a whole in Japan's suc- Indonesian mpiah. cess. The yen rose somewhat following the exchange During the first weeks of the year, the dollar depre- market intervention and has since partially given back ciated in terms of the Japanese yen as improved thai gain. In the wake of the recent election, which prospects elsewhere in Asia and market uncertainly cost the LDP numerous seats in the upper house of regarding potential intervention by the Japanese the Diet and precipitated the resignation of Prime monetary authorities lent support to the yen. Indica- Minister Hashimoto, the yen changed little. On bal- tions that significant measures for economic stimulus ance, the dollar has appreciated about 7 percent in might be announced aiso put upward pressure on the terms of the yen since the end of December. yen. In February, the dollar resumed its appreciation with respect to the yen. The rise in the dollar was Equity prices in the Asian emerging-market only temporarily interrupted by sizable intervention economies have been volatile so far this year as well. purchases of dollars by Japanese authorities in April. These prices recovered somewhat in the first weeks of Upward pressure on the dollar relative to the yen the year in response to the market perception that the intensified in late May and June. Renewed signs of crisis was easing; after fluctuating narrowly, they cyclical weakness in the Japanese economy and lack began moving back down in March and April, reach- of market confidence in the announced programs for ing new lows ia June in Korea. Thailand, and Hong addressing the chronic problems within the financial Kong. On balance, these equity prices have moved sector contributed to pessimism toward the yen. down about 25 percent (Singapore and Malaysia) to Persistent weakness in the Japanese economy and up about 20 percent (Indonesia) since the end of last the yen, in turn, heightened concerns about prospects year. Equity prices in Japan also rose eariy in the year elsewhere in Asia; the lower yen adversely affected on improved optimism but then gave back those gains the competitiveness of goods produced in the Asian over time with the release of indicators suggesting emerging-market economies and raised questions additional weakness in the Japanese economy. Since the middle of June, Japanese equity prices have rebounded on the perception that significant fiscal U.S. Exchange Rates with Japan and Germany stimulus is now more likely. On balance, Japanese YerVS DM/S equity prices are up about 9 percent from their level at the end of last year. Japanese long-term interest Nominal rates continued through May on their downward 140 1.B trend that began in mid-1997, declining an addi- tional SO basis points during the first five months. 130 1.7 Since then, long-term interest rates have retraced more than half of that decline, in pan in response to 120 1.6 the announcement of the plan for financial restructur- ing and in part in response to the outcome of the 110 1.5 recent election, which heightened expectations of 100 1.4 additional fiscal stimulus. The Asian financial crises have resulted, in a sharp 90 1.3 drop in the pace of economic activity in the region. SO 1.2 Output declined precipitously in the first quarter 1993 1994 1995 1996 1997 1998 in those countries most affected, such as Korea, 26 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 U.S. and Foreign Interest Rates half of this year. In addition, officials have announced a package of steps directed at restoring the sound- Yield on Three-month Bank Liabilities Psrcwit ness of the financial sector including (1) introduc- tion of a bridge bank mechanism to facilitate the resolution of failed banks while permitting some of their borrowers to continue to receive credit. (2) measures to improve the disposal of bad bank loans, (3) enhanced transparency and disclosure by banks, and (4) strengthened bank supervision. These actions are intended to restore confidence in Japanese financial institutions and in the prospects for the . German interbank economy more broadly. *^^. Jun* In the other major industrial countries, economic developments so far this year have generally been Japanese CD favorable. The exchange value of the dollar in terms of the German mark has fluctuated narrowly and. on j i i i balance, is little changed since the end of Decem- YieW on Ten-year Government Securities ber. Market perceptions mat progress toward the sian of the final stage of European Monetary Union Peroem (EMU) is going smoothly and signs of momentum in the U.S. and German economies resulted in little pres- sure in either direction on the exchange rate. The dollar also fluctuated narrowly against the U.K. pound United States with little net change so far this year. Moves to tighten monetary conditions in the United Kingdom lent support to the pound, countering some tendency for weak external demand to depress the currency. The Canadian dollar rebounded following a tighten- ing of monetary conditions by the Bank of Canada on January 30. Since early March, however, it has tended to move down as market participants have come to believe that further upward shifts of official interest rates are unlikely and as weakness in global commodity markets, partly the result of reduced eco- 1993 1994 1995 1996 1997 1998 nomic activity in Asia, have weighed on the cur- rency. The exchange value of die U.S. dollar in terms Indonesia, and Malaysia, and slowed in other Asian of the Canadian dollar reached new highs in July economies, such as China and Taiwan, that have suf- and, on balance so far this year, has risen about fered a loss of competitiveness and reduced external 4 percent. demand as a consequence of the crises. Data for Long-term interest rates have declined and equity recent months suggest (hat additional slowing has prices have generally risen strongly in European occurred and that the risk of further spread and and Canadian markets this year. Despite signs deepening of cyclical weakness throughout the region of strengthening activity in Germany and other cannot be ruled out Depreciation of their respective continental European countries and continued healthy currencies has led to acceleration of domestic prices expansion in the United Kingdom and Canada, long- in several of these economies, particularly ia term rates have moved down since December; long Indonesia and Thailand. rates are about 60 basis points lower in Germany and Real GDP in Japan also fell sharply in the first less than half that amount lower in Canada. Shifts of quarter, and output indicators suggest a further international portfolios away from Asian assets and decline in the second quarter. Consumer price infla- toward those perceived to be safer have probably tion remains very low. Japanese authorities have contributed to rate declines in Continental Europe and announced a series of fiscal measures that are in the United States. Stock prices have also continued expected to boost domestic demand during the second to rise in Europe and Canada, Since December, ihe Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 gains have ranged from about 40 percent in Germany about 9 percent in terms of the dollar so far this year. and France lo about 10 percent in Canada. The Brazilian exchange rate regime of a controlled crawl and the Argentine regime of pegging the peso The pace of real economic activity improved to the dollar remain in place, and Brazilian short- somewhat in the first quarter in Germany and on term interest rales have been lowered from die very average in the eleven countries slated to proceed with high levels to which they were raised when the Asian currency union on January 1. 1999.2 Production and crisis intensified in laic 1997. Equity prices in these employment data for more recent months suggest three Latin American countries have been volatile, continued expansion. Business confidence has firmed rising early in the year and giving back those gains as progress toward EMU has continued. Domestic since April. On balance this year, equity prices have demand is becoming more buoyant in several of these declined about 10 percent in Mexico and Argentina countries, offsetting weakening of external demand and have risen about 8 percent in Brazil. arising from events in Asia. On average, inflation remains subdued wiihin the euro area. In the United Real output growth remains strong in Mexico and Kingdom and Canada, real output continues to Argentina, but the rate has slowed somewhat from expand at a relatively rapid rate. U.K. inflation last year's vigorous pace. In Brazil, economic activ- threatens ro exceed the government's target of ity has weakened more sharply, in pan in response to 2'/! percent, and the Bank of England raised its the tightening of monetary conditions that followed official lending rate 23 basis points in June in order to the outbreak of the Asian crisis. lessen price pressures. Consumer price inflation in Lower global oil prices have combined with a Canada remains very low. poorly functioning domestic tax system to trigger a Events in Asia have spilled over to affect develop- financial crisis in Russia. Russian officials have ments in Latin American countries. Declines in global reached agreement with IMF management on a oil prices have contributed to downward pressure on revised program that includes proposed increased the exchange value of die Mexican peso. The peso funds from the IMF and other sources. To help declined sharply in terms of the dollar at the start of finance this program, the General Arrangements to the year but then stabilized in February through May Borrow are being activated in light of the inadequacy as Asian markets partially recovered. It depreciated of IMF resources 10 meet actual or expected requests further in May and June, resulting in a net decline of for financing and a need to forestall impairment of die international monetary system. The General Arrangements to Borrow provide the IMF with 2. Those countries aie Austria. Belgium. Finland. France. supplementary lines of credit from the G-10 Inland. Italy. Germany, Luxembourg, the Netherlands, Portugal, sod Spam countries. 28 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1998, July 20). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19980721_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_19980721_chair_federal_reserves_second_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1998},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19980721_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}