Congressional Testimony

CONDUCT OF MONETARY POLICY Report of the Federal Reserve Board pursuant to the Full Emplujmint and Balanced Growth Act of 1978 PX.95-523 The State of the Economy HEARING BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED SIXTH CONGRESS FIRST SESSION FEBRUARY 24, 1999 Printed for the use of the Committee on Banking and Financial Services Serial No. 106-4 U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1999 For sale by the U.S. Governmeni Printing Office Superintendent of Documents, Congressional Sales Office, Washington, DC 20402 ISBN 0-16-058419-1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES JAMES A. LEACH, Iowa, Chairman BILL McCOLLUM, Florida, Vice Chairman MARGE ROUKEMA, New Jersey JOHN J. LAFALCE, New York DOUG K. BEREUTER, Nebraska BRUCE F. VENTO, Minnesota RICHARD H. BAKER, Louisiana BARNEY FRANK, Massachusetts RICK LAZIO, New York PAUL E. KANJORSKI, Pennsylvania SPENCER BACKUS III, Alabama MAXINE WATERS, California MICHAEL N. CASTLE, Delaware CAROLYN B. MALONEY^ New York . PETER T, KING, New York LUIS V. GUTERRE^iffirjoisV TOM CAMPBELL, California NYDIA M. VELAZQUEVNew'Yorn EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York JACK METCALF, Washington KEN BENTSEN, Texas ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut BOB BARR, Georgia DARLENE HOOLEY, Oregon SUE W. KELLY, New York JULIA M. CARSON, Indiana RON PAUL, Texas ROBERT A. WEYGAND, Rhode Island DAVE WELDON, Florida BRAD SHERMAN, California JIM RYUN, Kansas MAX SANDLIN, Texas MERRILL COOK, Utah GREGORY W. MEEKS, New York BOB RILEY, Alabama BARBARA LEE, California RICK HILL, Montana VIRGIL H. GOODE JR., Virginia STEVEN c. LATOURETTE, Ohio FRANK R. MASCARA, Pennsylvania DONALD A. MANZULLO, Illinois JAY INSLEE, Washington WALTER B. JONES JR., North Carolina JANICE D. SCHAKOWSKY, Illinois PAUL RYAN, Wisconsin DENNIS MOORE, Kansas DOUG OSE, California CHARLES A. GONZALEZ, Texas JOHN E. SWEENEY, New York STEPHANIE TUBES JONES, Ohio JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts LEE TERRY, Nebraska MARK GREEN, Wisconsin BERNARD SANDERS, Vermont PATRICK J. TOOMEY, Pennsylvania (ID Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS Hearing held on: February 24, 1999 1 Appendix: February 24, 1999 43 WITNESS WEDNESDAY, FEBRUARY 24, 1999 Greenspan, Hon. Alan, Chairman, Board of Governors, Federal Reserve System 6 APPENDIX Prepared statements: Leach, Hon. James A. 44 Ban-, Hon. Bob 46 Mascara, Hon. Frank R 48 Greenspan, Hon. Alan 50 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Greenspan, Hon. Alan: Monetary Policy Report to the Congress Pursuant to the Pull Employ- ment and Balanced Growth Act of 1978, dated February 23, 1999 81 Written response to questions from Hon. James A. Leach 69 Written response to questions from Hon. Barbara Lee 77 Written response to questions from Hon. Doug Ose 80 (III) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONDUCT OF MONETARY POLICY WEDNESDAY, FEBRUARY 24, 1999 U.S. HOUSE OP REPRESENTATIVES, COMMITTEE ON BANKING AND FINANCIAL SERVICES, Washington, DC. The committee met, pursuant to call, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding. Present: Chairman Leach; Representatives McCollum, Roukema, Bachus, Castle, Campbell, Royce, Manzullo, Ryan, Ose, Sweeney, Biggert, Terry, Toomey, LaFalce, Vento, Frank, Waters, C. Maloney of New York, Watt, Bentsen, J. Maloney of Connecticut, Lee, Goode, Mascara, Inslee, Jones, Capuano and Sanders. Chairman LEACH. The hearing will come to order. The committee meets today to receive the Semiannual Report of the Board of Governors of the Federal Reserve System on the Con- duct of Monetary Policy and the State of the Economy as mandated in the Full Employment and Balanced Growth Act of 1978. Chairman Greenspan, we welcome you back to the committee. It has long been my view that no committee has a greater oversight obligation than this committee, with its jurisdiction over the Fed- eral Reserve Board and its conduct of monetary policy. In order that all Members may have an opportunity to examine the Chairman, it is the intent of the Chair to allocate opening statements to the Chairman and Ranking Member of the full com- mittee, as well as the full Subcommittee on Domestic and Inter- national Monetary Policy. All other opening statements will be in- cluded for the record. In this regard, it has come to my attention that the semiannual report on the conduct of monetary policy and the state of the econ- omy is one of many such reports scheduled to terminate at the end of the year under a 1995 statute. I would like to assure Members of the committee that we are working closely with House leader- ship to rectify this issue on a timely basis. But whether or not there continues to be a legislative mandate for regular congres- sional review of the Fed's conduct of monetary policy, it would be the committee's intent to require the Chairman to report regularly on the state of economy and the Federal Reserve policies to sustain economic growth and promote the fullest credible employment of the American work force. The combination of a more disciplined fiscal policy promulgated by Congress and prudential stewardship of monetary policy by the Federal Reserve has produced the longest peacetime expansion in modern U.S. history. The facts speak for themselves. The unem- (l) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ployment rate is at a 29-year low, inflation is at a 33-year low, in- flationary pressures appear subdued, and the Federal budget sur- plus is growing. In this reinforcing cycle, low inflation and low real interest rates have produced real wage increases for the American people. It is a circumstance which has remarkably caused the ability of this Congress to deal with issues like Social Security to become much more manageable. In this context, let me just stress that as Chairman of the com- mittee of oversight over monetary policy, I take as the highest obli- gation the necessity of maintaining the independence of the Fed- eral Reserve System, which I consider to be the 20th Century's most innovative institutional addition to the science of government at the national level. Let me just request unanimous consent to put a fuller statement in the record and also ask unanimous consent for other Members to revise and extend their remarks and put fuller statements in the record. [The prepared statement of Hon. James A. Leach can be found on page 44 in the appendix.] Mr. LaFalce. Mr. LAFALCE. Thank you very much, Mr. Chairman. Chairman Greenspan, we are delighted to have you with us again today. When you have a job description, I am sure the very first few words will say, "Testify before Congress with some fre- quency." Then you will put a smiley face, because that is clearly the most pleasurable aspect of your job, I am sure. We surely will work together with the Chairman in order to ensure that the law says that you must perform this joyous task with great frequency. Mr. Chairman, as you often noted, the United States economy is doing quite, quite well; and Chairman Leach ticked off some of the indicators which reveal that. Surely this is due in considerable part to a reduction in the Federal deficit; surely it is due in considerable part to the fact that the Federal Reserve and the Treasury Depart- ment have effectively managed exposure of the United States econ- omy to the financial and economic crises and difficulties going on internationally. Right now I am most concerned about the international economy and now monetary policy can and will be used to balance domestic and international priorities. Our economy might yet be affected by the past, present, and future international problems, and problems abroad are adversely affecting certain sectors of our domestic econ- omy which averages often mask. In addition, foreign capital flows to the United States have fi- nanced our current account deficit without allowing the problems normally associated with such a deficit. I am concerned about what the prospects are for a possible drying up of those capital flows, what could cause it, if there is anything on the horizon that might do that, and what would the consequences be, and what responses would be available to us, either through fiscal or monetary policy. Moreover, clearly the problems of a global economy are not over. East Asia is not recovering as quickly as we would like. Japan re- mains reluctant to adopt adequate policies to bring itself both out of recession and to resolve its bad bank debt problem. The situation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis in Latin America is murky. The European monetary union is brand new. And according to some information I saw recently, even Ger- many suffered a negative real growth in GDP in the last quarter. There are some other issues of concern I hope we can address this morning. I believe it is your position that the economy may have grown too fast in the last quarter and that it could signal po- tential inflation. Some individuals are concerned that the Fed might, in contemplation of this, be considering increasing interest rates in the future, and yet this obviously would have its downside, too, especially because of the huge amount of consumer debt. Others believe the Federal Reserve is going to rely on the bond market to raise rates, I am interested in your thoughts on that, what are the prospects for that, and what your attitude toward that is. I am also concerned about what the role of the Fed and the Treasury is in foreign exchange markets. The position is that there is no intervention, and that our trading partners are not manipu- lating exchange rates to enhance their trading position with us. Yet our domestic interest rates relative to interest rates abroad clearly affect international trade and capital flows, and I am interested in your comments on that. Most especially we have almost as much trade with Canada and Mexico, our two border countries, as we do the rest of the world. They are now our top two countries, and we have seen a real de- valuation in the currencies of both of those countries. Both are ei- ther at or near their historic lows. This has significance for the totality of our domestic economy, but it has special significance for border communities on the north, from the State of Washington up through New York to Maine. And of course on the entirety of our southern border there has been greater devaluation and volatility with the peso by far than with the looney. I am very interested in what the prospects might be for future stability in that currency relationship and what the importance of that might be, too. These are just some of the myriad of questions that I am hoping you will be able to address as you proceed this morning. Thank you very much. Chairman LEACH. Thank you, John. Mr. Bachus. Mr. BACHUS. Welcome, Chairman Greenspan. Most Americans realize that the economy is doing quite well. I don't think you can turn on the TV set, listen to the radio, without realizing that we have an exceptional economy. But as good as it is, I am not sure that most Americans or that most of us even real- ize how exceptional it is in certain respects. When you look at the record, at the hard numbers, it becomes apparent that the United States is enjoying a period of almost un- paralleled economic prosperity. Some Wall Street pundits have de- scribed this as a "Goldilocks" economy, and that invites skepticism when you use euphoric terms like that. I am sure it sort of bothers you. It is somewhat troubling. But I would say that if there ever has been a Goldilocks economy, it is now. It is difficult to really know why it is so good. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The porridge in the "Goldilocks" fable was neither—it was not too hot and it was not too cold. I think that is what the economists refer to when they refer to a "Goldilocks" economy. But in fact, this economy—I think what they mean is it is hot where it should be hot and it is cold where it should be cold. I think they are referring to that. What I mean by that is, as you know, we throw these figures around, but they are really astounding, and that our gross domestic product grew last year at slightly over 4 percent. In the last quar- ter of last year it grew at about 6 percent. Yet we had an inflation rate of about 1.5 percent last year, which is an astounding com- bination. Economists tell us that that just cannot go on. The other thing I think is exceptional about this economy is how it has reached down to the workers that are most vulnerable. I no- ticed that Senator Sarbanes—I had read an article in the New York Times where it said that the current economic expansion has been a terrific boon to workers, especially those at the bottom of the pay ladder who have had the most trouble getting and keeping jobs, es- pecially good ones. I had that in my remarks, and then I noticed that he complimented you for it. But I want to again compliment you and for your leadership in being a part of creating such an economy. I would just end by saying that last year we created 2.8 million jobs, 2.8 million jobs in the economy. January figures are in, and the economy created 245,000 additional jobs in January, so this is an exceptional story. I will conclude by saying this, that when it can't get any better— that is what people keep saying, unfortunately, it can't get any bet- ter. I think the stock market is pricing in a Nirvana ad infinitum. They are pricing in that it is going to get better, it is great, it is going to keep getting better. I know you are concerned about this, but I am not sure what you can do when things are working very well. I am not sure what you can do. I know there are cold spots. I know our farmers are suffering. I know low commodity prices are causing the domestic oil industry concern. Our exporters, because of the appreciating dollar, are being hurt. But, all in all, I think it has been a very good year. I think your policies at the Federal Reserve have been outstanding, and I compliment you. Thank you. Chairman LEACH. Thank you. I see Ms. Waters is not with us. Please proceed, Mr. Greenspan. Mr. SANDERS. Point of parliamentary privilege, Mr. Chairman. Chairman LEACH. Yes, of course. Mr. SANDERS. I apologize for having come a little bit late, but I thought it was the custom that each Member have a chance to make an opening statement. I think that is a pretty good precedent we should maintain. Chairman LEACH. First, it is a sometime custom in the commit- tee. Second, opening statements under the rules of the House are the prerogative of the Chair. One of our problems, and I respectfully appreciate what the gen- tleman is saying, but we have a 60-Member committee, and under the five-minute rule, with the math on that—and we have a Chair- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis man—when we double that, which is the implications of opening statements, we have real difficulty. Mr. SANDERS. I agree with that, Mr. Chairman. Chairman LEACH. In any event, what I have tried to do, among other things, is shorten the opening statements to three minutes and parse it out. I would say, by the way, that because we have had two on our side and one on your side, if the Ranking Member would like to allow a second speaker on his side this morning, I would be very amenable to that. Mr. LAFALCE. I would certainly request that, Mr. Chairman. Chairman LEACH. It is up to your discretion to designate who. Mr. LAFALCE. Thank you very much, Mr. Chairman. Chairman LEACH. The gentleman had an inquiry. Mr. SANDERS. Your point about five minutes for 60 Members is exactly right, but there is no rule it has to be five minutes apiece. You could limit it to a minute or two. This is an important discussion. Mr. Greenspan is not here every day. I would respectfully request a minute or two minutes, and there may not be a whole lot of folks who would like to talk, but I think that is a good practice. John. Mr. LAFALCE. May I ask which Members of the Democratic side would like to speak for a brief period of time? Would you please Mrs. JONES. I give my time to my colleague. I would encourage you to give any time you are going to give to me to Mr. Sanders. Mr. SANDERS. Thank you. Mr. LAFALCE. How much time do we have allotted, two or three minutes? Chairman LEACH. What the Chairman had designated in ad- vance was four Members would be allowed to speak for three min- utes each, and if you would like to allow Mr. Sanders to speak for three minutes, I am quite amenable. Mr. LAFALCE. I give Mr. Sanders three minutes, yes. Mr. SANDERS. Thank you very much, Mr. Chairman. I would just like to say this. In recent times, Mr. Bachus and I, we find ourselves usually in agreement, but I would suggest we have a disagreement this time. There is no argument that in recent years the economy has in fact been very good, but we should not overdo it in terms of what is going on for the average working person in this country. The good news is that for the last couple of years, for the first time in decades, we have seen wages go up for lower-income work- ers and middle-income workers, for the first time. But the fact is that the median family income in 1996 was $1,000 less than in 1989. The inflation-adjusted earnings of the median workers in 1997 were 3.1 percent lower than in 1989. Over the period from 1989 to 1997 real hourly wages either stagnated or fell for most of the bottom 60 percent of the working population. So while we can say that in the last few years for the average worker things have been getting better, the reality is that most workers in America today are working longer hours and lower Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis wages than was the case ten or twenty years ago. If we say this is as good as it is going to be, that is a pretty pessimistic outlook. More importantly, and this is a point that I want to stress be- cause it is not talked about too much, according to the Economic Policy Institute, the typical married couple family worked 247 more hours per year in 1996 than in 1989. That is more than six or seven weeks worth of additional work. That means all over this country, and I am sure it is in your districts as well as in mine, you see people working two jobs and three jobs. In the beginning of the 20th Century, workers fought and they said, we want a 40-hour work week; that is what we want. One hundred years later workers are working 45, 50, 60 hours a week. Wives are working alongside of husbands because we need two breadwinners in the family to pay the bills. So to my friend, Mr. Bachus, I say, yes, we have seen improvements in the last cou- ple of years, and we should be proud of that and continue that ef- fort. But if we look at what is going on for the average American worker today, in many respects he or she is not where they were twenty years ago. We still have 43 million people without any health insurance. People can't afford the cost of college education. We have the highest rate of childhood poverty in the industrialized world, the greatest gap between the rich and the poor. So if we sit here and say, "Gee, we are living in Utopia, it is not going to get any better than this," boy, I think that would be a very sad and unfortunate statement. That would be my point, Mr. Chairman. Chairman LEACH. Thank you very much for the representation. Chairman Greenspan. STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. GREENSPAN. Thank you very much, Mr. Chairman. Mr. Chairman and Members of the committee, I appreciate the opportunity to present the Federal Reserve semiannual report on monetary policy. The American economy over the past year again performed admi- rably. Despite the challenges presented by severe economic downturns in a number of foreign countries and episodic financial turmoil abroad and at home, our real GDP grew 4 percent for a third straight year. In 1998, 2.75 million jobs were created on net, bringing the total increase in payrolls to more than 18 million dur- ing the current economic expansion, which late last year became the longest in U.S. peacetime history. Unemployment edged down further to a 4V* percent rate, the lowest since 1970. Aiid despite taut labor markets, inflation also fell to its lowest rate in many decades by some broad measures, al- though a portion of this decline owed to decreases in oil, commod- ity, and other import prices that are unlikely to be repeated. Hour- ly labor compensation adjusted for inflation posted further impres- sive gains. Real compensation gains have been supported by robust advances in labor productivity, which in turn have partly reflected heavy investment in plant and equipment, often embodying innova- tive technologies. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Can this favorable performance be sustained? In many respects the fundamental underpinnings of the recent U.S. economic per- formance are strong. Flexible markets and the shift to surplus on the books of the Federal Government are facilitating the buildup in cutting-edge capital stock. That buildup, in turn, is spawning rapid advances in productivity that are helping to keep inflation well behaved. New technologies and the optimism of consumers and investors are supporting asset prices and sustaining spending. But, after eight years of economic expansion, the economy ap- pears stretched in a number of dimensions, implying considerable upside and downside risks to the economic outlook. The robust in- crease of production has been using up our Nation's spare labor re- sources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise questions about whether shares are overvalued. The debt of the household and business sec- tors has mounted, as has the external debt of the country as a whole, reflecting the deepening current account deficit. We remain vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be transmitted to the United States markets quickly and traumatically. In light of all of these risks, monetary policy must be ready to move quickly in either direction, should we perceive imbalances and distortions developing that could undermine the economic ex- pansion. The Federal Open Market Committee conducted monetary policy last year with the aim of sustaining the remarkable combination of economic expansion and low inflation. In the wake of the Russian crisis last August and subsequent difficulties in other emerging market economies, investors perceived that the uncertainties in fi- nancial markets had broadened appreciably, and as a consequence they became decidedly more risk averse. As a result, quality spreads escalated dramatically, especially for lower-rated issuers. Many financial markets turned illiquid, with wider bid-asked spreads and heightened price volatility, and issuance was disrupted in some private securities markets. To cushion the domestic economy from the impact of the increas- ing weakness in foreign economies and the less accomodative condi- tions in U.S. financial markets, the FOMC, beginning in late Sep- tember, undertook three policy casings, reducing the Federal funds rate from 5Yz percent to 4% percent. Our economy has weathered the disturbances with remarkable resilience, though some yield and bid-asked spreads still reflect a hesitancy on the part of market participants to take on risk. The Federal Reserve must continue to evaluate, among other issues, whether the full extent of the policy easings undertaken last fall to address the seizing-up of financial markets remains appro- priate as those disturbances abate. To date, domestic demand and hence employment and output have remained vigorous. At the same time, no evidence of any up- turn in inflation has as yet surfaced. The U.S. economy's perform- ance should remain solid this year, though likely with a slower Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis s pace of economic expansion and a slightly higher rate of overall in- flation than last year. The stocks of business equipment, housing, and household dura- ble goods have been growing rapidly to quite high levels relative to business sales or household incomes during the past few years, and some slowing in the growth of spending on these items seems a reasonable prospect. Moreover, part of the rapid increase in spending, especially in the household sector, has resulted from the surge in wealth associated with the run-up in equity prices that is unlikely to be repeated, and the purchasing power of income and wealth has been enhanced by declines in oil and other import prices, which also are unlikely to occur this year. Assuming that aggregate demand decelerates, underlying infla- tion pressures, as captured by core price measures, in all likelihood will not intensify significantly in the year ahead, though the Fed- eral Reserve will need to monitor developments carefully. We per- ceive stable prices as optimum for economic growth. Both inflation and deflation raise volatility and risks that thwart maximum eco- nomic growth. The economic outlook involves several risks. The continuing downside risk posed by possible economic and financial instability around the world was highlighted earlier this year by the events in Brazil. Although financial contagion elsewhere has been limited to date, more significant knock-on effects in financial markets and in the economies of Brazil's important trading partners, including the United States, are still possible. Moreover, the economies of several of our key industrial trading partners have shown evidence of weakness which, if it deepens, could further depress demands for our exports. Another downside risk involves a potential correction to stock prices. Such a decline would increase the cost of equity capital, slowing the growth of capital spending. It would also tend to re- strain consumption spending through its effect on household net worth. But on the upside, our economy has proven surprisingly robust in recent years. More rapid increases in capital spending, produc- tivity, real wages, and asset prices have combined to boost eco- nomic growth far more and far longer than many of us would have anticipated. This "virtuous cycle" has been able to persist because the behav- ior of inflation also has been surprisingly favorable, remaining well contained at levels of utilization of labor that in the past would have produced accelerating prices. That they have not done so in recent years has been the result of a combination of special one- time factors holding down prices that I have already mentioned and more lasting changes in the processes determining inflation. In the current economic setting, businesses sense that they have lost pricing power and generally have been unwilling to raise wages any faster than they could support at current price levels. Firms have evidently concluded that if they try to increase their prices, their competitors will not follow, and they will lose market share and profits. Given the loss of pricing power, it is not surprising that individ- ual employers resist pay increases. But why has pricing power of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis late been so delimited? Monetary policy certainly has played a role in constraining the rise in the general level of prices and damping inflation expectations over the 1980's and 1990's. But our current discretionary monetary policy has difficulty anchoring the price level over time in the same way that the gold standard did in the last century. Enhanced opportunities for productive capital investment to hold down costs also may have helped to damp inflation. Through the 1970*8 and 1980's, firms apparently found it easier and more profit- able to seek relief from rising nominal labor costs through price in- creases than through cost-reducing capital investments. Price relief evidently has not been available in recent years, but relief from cost pressures has. The newer technologies have made capital in- vestment distinctly more profitable, enabling firms to substitute capital for labor far more productively than they would have a dec- ade or two ago. The surge in investment not only has restrained costs, it has also increased industrial capacity faster than factory output has risen. The resulting slack in product markets has put greater competitive pressures on businesses to hold down prices, despite taut labor markets. The role of technology in damping inflation is manifest not only in its effects on U.S. productivity and costs, but also through inter- national trade, where technological investments have progressively broken down barriers to cross-border trade. The enhanced competi- tion in tradeable goods has enabled excess capacity previously bot- tled up in one country to augment worldwide supply and exert re- straints on prices in all countries' markets. Although the pace of productivity increase has picked up in re- cent years, the extraordinary strength of demand has meant that the substitution of capital for labor has not prevented us from rap- idly depleting the pool of available workers. The number of people willing to work can be usefully defined as the unemployed component of the labor force plus those not ac- tively seeking work, and thus not counted in the labor force, but who, nonetheless, say they would like a job if they could get one. This pool of potential workers aged 16 to 64 currently numbers about 10 million, or just 5% percent of that group's population, the lowest such percentage on record, which begins in 1970, and 2Vz percentage points below its average over that period. The number of potential workers has fallen since the mid-1990's at a rate of a bit under 1 million annually. We cannot judge with precision how much further this level can decline without sparking ever-greater upward pressures on wages and prices. But should labor market conditions continue to tighten, there has to be some point at which the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will begin to accelerate. Before closing, Mr. Chairman, I would like to address an issue that has been receiving increasing attention, the 20th Century date change. While no one can say that the rollover to the year 2000 will be trouble free, I am impressed by the efforts to date to ad- dress the problem in the banking and financial system. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 For our part, the Federal Reserve System has now about com- pleted remediation and testing of its mission-critical applications. We opened a test facility in June at which more than 6,000 deposi- tory institutions to date have conducted tests of their Y2K compli- ant systems, and we are well along in our risk mitigation and con- tingency planning activities. As a precautionary measure, the Federal Reserve has acted to in- crease the currency in inventory by about one-third, to approxi- mately $200 billion in late 1999, and has other contingency ar- rangements available if needed. The banking industry is also working hard, and with evident suc- cess, to prepare for the event. By the end of the first quarter, every institution in the industry will have been subject to two rounds of on-site Y2K examinations. The overwhelming majority of the indus- try has made impressive progress in their remediation, testing, and contingency planning efforts. Americans can justifiably feel proud of their recent economic achievements. Competitive markets, with open trade both domesti- cally and internationally, have kept our production efficient and on the expanding frontier of technological innovation. The determina- tion of Americans to improve their skills and knowledge has al- lowed workers to be even more productive, elevating their real earnings. Macroeconomic policies have provided a favorable setting for the public to take greatest advantage of opportunities to im- prove its economic well-being. The restrained fiscal policy of the Administration and the Con- gress has engendered the welcome advent of a unified budget sur- plus, freeing up funds for capital investment. A continuation of re- sponsible fiscal and, we trust, monetary policies should afford Americans the opportunity to make considerable further economic progress over time. Mr. Chairman, I have excerpted from my prepared remarks and would request that the latter be included for the record. [The prepared statement of Hon. Alan Greenspan can be found on page 50 in the appendix.] Chairman LEACH. Without objection, of course. Mr. Greenspan, I want to just begin with a question, asking you to put some macroeconomic meaning to the political discussions of the day. By that, it seems to me that we have a lot of divisive polit- ical rhetoric between the political parties, but there is surprisingly not as much distinction in the end effect of policies advocated. For example, generally speaking, as you look at the surplus which Republicans claim disproportionate credit for, the Repub- licans want to either save the surplus or use it for tax cuts. The Democratic Party in large measure wants to dedicate to Social Se- curity 60 percent, which the Republicans also have endorsed, and advance a bit IRAs and increase a little bit domestic spending, and Republicans would increase a little bit military spending. But isn't it true that, macroeconomically, the notion of putting 60 percent aside for Social Security is the equivalent of reducing the deficit, and then expanding IRAs is the equivalent of a tax cut? And that when you are really looking at the differences between the parties, it is a very small percentage of the presumed surplus Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 and how to allocate it in the years ahead. Is that a valid way of looking at this issue? Mr. GREENSPAN. I think so, Mr. Chairman. There seems to be a general conclusion, and a proper one, that allowing part of the sur- plus, indeed, a significant part of the surplus, to run will maintain a level of national savings in this country which is crucial. The one thing that is economically unquestioned is that we are about to have in the early part of the 21st Century a very major increase in the proportion of retirees to working people. Unless we wish to have difficulty in allocating the then gross domestic prod- uct between workers and retirees and an increasingly friction- based argument, it is crucially important for us to accelerate the building of our capital stock and its efficiency so that there will be more than adequate goods and services for retirees when they re- tire, the big Baby Boom retirees, and of course continued rising standards of living for our working people. That means that we need to have adequate savings to do that. My sense of the political rhetoric of late is that there is a grow- ing awareness of that, and I agree with you, that it does seem to cut across parties. Chairman LEACH. My final question relates to commodity prices. As you know, worldwide, developing countries are seeing certain difficulties because of low commodity prices. Internally in this country the agricultural economy is reeling in very major ways. Do you have any advice on how to rebolster the Midwestern farm econ- omy and address this issue? Mr. GREENSPAN. One of the problems with the Midwest farm economy is it is an extraordinarily productive segment of our econ- omy, and the production for export has, of course, been a very cru- cial aspect over the generations of our farm system. It is difficult to measure exactly how effective the weakness in Asia has been on our farm exports, but my recollection is that our exports of agricul- tural commodities to Japan, which is one of our very largest cus- tomers, has gone down very dramatically. Needless to say, the rest of Asia is also weakened quite considerably. When you take out a substantial chunk of demand on American agricultural resources, the fact that prices have gone down is, I would suspect, by no means a great surprise. Prices of wheat and soybeans, corn, are all down quite significantly. Hogs, until very re- cently, as you know better than anybody, underwent an extraor- dinarily sharp contraction in price. My own judgment is that short of a significant building back of export demand it is going to be difficult to work our way through this particular problem; and, obviously, we have also had difficul- ties, which I think Mr. LaFalce was referring to earlier, in the sense that, for example, on the wheat front, our two major competi- tors are Australia and Canada, both of whom are major commodity producers who have had the same problems and whose currencies vis-a-vis the American dollar have weakened considerably, with the obvious implications relevant to competition in the world markets for some of our major grain products. So all in all, if one looks across the spectrum of what the prob- lems are, they just fall very directly in the area of deficient export Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 demand, and that is substantially attributable to the very sharp contraction in the demand for American farm products from Asia. Chairman LEACH. Thank you. Mr. LaFalce. Mr. IAFALCE. Thank you very much. Mr. Chairman, I raised a number of issues in my opening state- ment. If you recall some of them, I will let you address them di- rectly. If not, I will reiterate some. Do you recall some of the points I raised? Mr. GREENSPAN. You raised a number of interesting points. Which would you like me to respond to? Mr. LAFALCE. All right. Let's deal with the question of what I perceive as the reluctance on the part of the Fed to raise interest rates, a disposition not to decrease them, I could be wrong in that impression, and a reliance on the part of the Fed for the bond mar- ket to increase rates. Mr. GREENSPAN. Again, we don't endeavor to try to manipulate the bond market to act as a proxy for Federal Reserve action. The major reason is we wouldn't know how, because it is just not some- thing that we are capable of doing without major secondary distor- tions and unexpected feedbacks on the economy. What we do in monetary policy, as I have mentioned before this committee on many occasions in the past, is endeavor to respond to the full complex of events; both real, meaning goods and serv- ices; and financial; and employ monetary policy in a sense to en- deavor to affect the marginal changes that are going on in the fi- nancial system. Obviously, we can't fully control the economy and have no inter- est in doing so, but we do impact upon the financial system, and that does affect aggregative demand. But to say, as a number of people have said, that we control the bond market and that there- fore we have the capacity to employ not only the Federal funds rate, which we do have full control over, and the bond market, which we do not, and that we use these in some combination is just contrary to the facts. Mr. LAFALCE. Let me switch now to the exchange rate relation- ship that exists internationally, and most especially with our two major trading partners. We have an increasingly shrinking—or I shouldn't say shrinking, but an interrelated global economy. If this is to continue with some predictability and sustainability, it seems to me that there must be stability within the exchange rate rela- tionship, more so in the future than we have seen in the past. We have seen significant depreciation in the Canadian dollar and much greater depreciation in the Mexican peso, as just two exam- ples, since we entered into our trade agreements about a decade ago with the Canadian-American FTA and, earlier this decade, the NAFTA. As part of your dealings in the global scene with this new global economic architecture, what are we discussing that could achieve greater future currency stability? Mr. GREENSPAN. Mr. LaFalce, as I have testified before this com- mittee previously, starting in the early part of the 1990's there was a very dramatic increase in the amount of cross-border finance. That is, I used to characterize it as the new financial system, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 which in many respects is not inappropriate, in the sense that there are really quite major differences which result very largely from technological changes which have proliferated in the early 1990's that have had a very dramatic effect on the nature and the number of different types of financial products, which, by unbundling risk, have increasingly served consumers and busi- nesses in a more effective manner. The consequence of this is that we are dealing with a far more potentially volatile set of movements of finance, and this is an issue which clearly both we and the Treasury, as well as our other colleagues in the international financial arena, have addressed in- creasingly and in more detail as we have learned, essentially by doing, what this new international financial structure is and how it functions. We have drawn certain conclusions. One, it would be desirable, were it possible, to have much more stable exchange rates than we have seen. I don't think anybody seriously questions that. But, ob- viously, volatility in exchange rates creates risks. It creates all sorts of negative implications with respect to all types of invest- ments. The question is, how do you do that? We have concluded that the means that have been used in the past, that is, so-called sterilized intervention, just does not work. It may have worked in part a lit- tle in the past, but even that is dubious. But every analysis that anybody has done has concluded that that is not the way to do it. The problem of monetary policy, employing that to affect the ex- change rate, will often get you into the position where your ex- change rate will be soft when your economy is soft, and the obvious monetary policy reaction would be to increase interest rates to harden the currency, but that would be wholly inappropriate for domestic policy purposes. Cutting the rest of the detailed argument short, it comes down to the general conclusion that the best way to maintain, in general, stable exchange rates is to maintain a stable international econ- omy, and very basically, a low inflation economy. There is nothing more relevant than stable prices to create stable exchange rates. We are, nonetheless, examining this whole issue in greater de- tail. We have continuous discussions with the Treasury and with others in other countries, as I indicated. And this larger group will be coming forward with ideas and particular programs which are directed at the new international financial structure and, very spe- cifically, the type of regulatory structure which is appropriate to that. One of the issues undoubtedly will be endeavors to make sure that exchange rates, in the context of the total, are as stable as we can make them. But if we try to do it in a manner which is coun- terproductive, it will have very negative effects on the total system. Mr. LAPALCE. Thank you, Mr. Chairman. My time has expired, but I would like you to expand either personally or in writing about divisions that may have existed at your recent meeting with the Germans and the French on one hand with respect to some bonds and the position that you and Mr. Rubin took. Maybe we could just have some follow-up personal dialogue. Chairman LEACH. Mr. McCollum. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 Mr. McCOLLUM. Thank you very much. Mr. Chairman, I think most of us would agree, I suspect we would get virtually unanimity, that the monetary policy leadership you have provided over the past few months has been excellent. The economy is not only doing well, but despite those treacherous waters that you are foreseeing coming up ahead, the Board has done quite well. The Open Market Committee has done quite well. But the other half of the matter, which probably leads to as many disturbing consequences for your monetary policy decisions, is the fiscal policy decision the Chairman of the committee alluded to a minute ago. I found it intriguing last week that the Wall Street Journal edi- torial board chose to engage you in somewhat of an open public dia- logue. They suggested criticism because they say that you urged surpluses to be dedicated to reducing Government debt before taxes are cut. They went on to say some intriguing thoughts about the impor- tance, relative importance, of paying down the debt or not. They suggest that paying down the country's debt would not make the Nation better off, and they suggest that the argument of crowding out, which I have heard a long time since I have been on this com- mittee, by Government spending is not a valid argument. They go on to suggest that the national debt does not really mat- ter, at least it is a secondary issue to the economy, until it starts to exceed 100 percent of GDP or so. They go on to say what matters is outlays the size of Government relative to the private sector and marginal tax rates, the measures of incentives. In other words, they say that this is what constitutes the latter three, the engines of economic growth, and that we really shouldn't be focused on fiscal policy and paying down the debt at this time because it doesn't exceed 100 percent of GDP. How do you respond to that? I found that the most succinct statement on the other side of the question of debt that I have read in a long time, and I thought I would give you the chance to re- spond. Mr. GREENSPAN. Thank you, Congressman. I happen to agree with the general position that the smaller the total of Government both receipts and expenditures are relative to the private sector, the better off we are with respect to economic growth. The question of what the optimum size of the debt is is a factual question. The issue really, as far as I can see, is that the evidence is fairly convincing that the lower the debt, the lower long-term borrowing costs. It is not as though when you hit 100 percent of the GDP something happens. That particular relationship, as best I can judge, carries all the way down below 100 percent. So that the question really gets down to, in a period such as we are now in, reducing the debt because we need increased savings. I shouldn't argue that that would not become private savings. It might if you basically cut taxes. I am not sure about that. But I think the main thrust of the issue is one that we have to increase savings for reasons I mentioned before about the issue of the demographics that are coming up. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 But to the extent that we can reduce spending and return that to the taxpayer, I am fully supportive of that, and that is the type of tax cuts that I would like to see. I don't like to see tax cuts which are effectively those which are made available by increasing debt. And this is where I think there are disagreements, but I must say that in the broad, general thrust of that editorial, I didn't find difficulties with it. But I do think that their notions, very specifi- cally, about the lack of debt reduction having positive effects is not, in my judgment, verified by the facts. Mr. McCoLLUM. What you are talking about when you are talk- ing about the debt and the interest on the debt is that huge per- centage of our budget that goes to paying the interest. If I recall now, it is somewhere around 30 or 40 percent or so of the entire spending we have to put out right now is on interest on that debt. I assume that is what you are talking about, the interest costs? Mr. GREENSPAN. No, I was talking about interest rates within the economy. In other words, when you look across the spectrum of countries and within economies, the lower the overall level of public debt, the lower tends to be the level of interest rates. That is clearly the case in Europe, and as best I can judge, it is also the case here. Mr. McCoLLUM. It sounds to me what we need is a balanced ap- proach on how we need to get there in some manner which gets there within the framework of your concerns and at the same time keeps the economic engine running. That is always going to be a debate up here. But you do not oppose tax cuts, it is just which ones they are and when they come? Mr. GREENSPAN. On the contrary, I have been very supportive of marginal tax cuts. Indeed, as you may recall, I am quite a strong supporter of reducing the capital gains tax and even eliminating it. At the appropriate time, I am very much strongly in favor of tax cuts. It is at this particular time that that would not be my first priority. It is my second priority, as I think I have mentioned to this committee before. That is, if you can't, for political reasons, hold the surplus in place and reduce the debt, then I would be far more supportive of cutting taxes than increasing spending. Mr. MCCOLLUM. Thank you very much, Mr. Chairman. Thank you. Chairman LEACH. Mr. Frank. Mr. FRANK. Thank you, Mr. Chairman. It is somewhat unaccustomed, particularly for those of us on this side, to referee the dispute between yourself and the Wall Street Journal editorial board. I admire your effort to turn the other cheek. I think it will be unavailing. But I do take it that there is disagreement. Your first priority right now, your first preference, would be to reduce the debt? Mr. GREENSPAN. That is correct. Mr. FRANK. And theirs would be not to worry about the debt until it reaches 100 percent of GDP, but to cut taxes. So there is that disagreement between you and them. Mr. GREENSPAN. I would assume that is the case. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 Mr. FRANK. You assume it? Mr. GREENSPAN. Because I must admit I read it when it was originally written, but I can't say I can quote you verbatim. Mr. FRANK. The particular editorial? Mr. GREENSPAN. Yes. Mr. FRANK. Did you read it when it was originally written before it was published or after it was published? Mr. GREENSPAN. I misspoke. My apologies. Mr. FRANK. But you dion't answer that question. Mr. GREENSPAN. I will answer it. I read it probably the same time you did. Mr. FRANK. No, I didn't read it and have no intention of reading it. Mr. GREENSPAN. I read it when it was published. Mr. FRANK. I do want to acknowledge, and I think that is actu- ally indicative—I want to acknowledge my appreciation of your willingness over the years to resist people who might have seen you as an ideological confrere and were in fact sometimes angry at you for not giving in. I think it is enormously to your credit that interest rates were not raised in anticipation of an inflation rate that prevailing doc- trine predicted a few years ago. There were people who said if the unemployment rate got as low as it did and growth stayed as high as it did, inflation would be inevitable. I realize that you deserve a great deal of the credit for resisting that, and I think you have been proven correct. Of course, the award for being proven correct is people are mad at you, but you are used to that. I do want to acknowledge that I think your willingness to, in fact, look at the facts and make these judgments based on the em- pirical evidence has been very important. I am particularly struck that, while we mentioned the Wall Street Journal, the New York Times financial pages also were from time to time disappointed in you for not raising interest rates when the rules said they should have been. Now, without ever acknowl- edging their error, now they have converted, so I think that is im- portant. The second thing I want to acknowledge is I appreciate your ref- erence here to even more public announcements. You mention that there will now be sometimes announcements of a change in—I was about to say a change in orientation, but I am reluctant to use that phrase—but a change in general inclination by the Fed, even with- out a change in actual interest rates. I am glad you are doing that. I think it validates the fact that your increased openness since 1994, announcing FOMC policy on the same day, has been very useful. I hope you will agree that one of those who was pushed hardest was our former Chairman, Mr. Gonzalez. He used to argue strong- ly, and now obviously he had some disagreements with you on some things, but it does seem to me much of what Mr. Gonzalez argued about, an ability for the system to tolerate more openness and more publicity, has in fact proven beneficial. I thought that was important. The one substantive point I had is, on page 13, I was pleased to note the following, because this is relevant. You say, talking about Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 shifts in the market environment which have accounted for the lack of inflation, the benign overall price behavior, and you say, "Undoubtedly, other factors have been at work," including the tem- porary factors, oil prices and other drops, and then, "some more lasting, such as worldwide deregulation and privatization," and this I think is particularly relevant to us today, "and the freeing up of resources previously employed to produce military products that was brought about by the end of the Cold War." Now I cite that because, obviously, we have a dispute about what amount of military spending we need from a national security standpoint. But in every debate I have been in on military spend- ing in the 19 years I have been here, there were those who argue that we shouldn't cut military spending because it would be bad economically. Indeed, we have some people who are very occasional Keynesians. When military spending comes up, they become very much in favor of the stimulative effects of Government spending. I take it what you are saving is that dollar for dollar, military products, as you previously said here, have no end use, but are there as insurance—I think that is an analogy that you have used before, and to the extent you could put those same dollars into other areas, maybe education and job training, maybe into trans- portation, you are dollar for dollar likely to have a better economic effect, and in fact it is less inflationary. Is that an accurate reference to what you are saying here? Mr. GREENSPAN. Yes it is, Mr. Frank. Incidentally, I was referring not only to the United States but the whole Soviet Union and all other related Mr. FRANK. I appreciate that. Because as my former colleague, Mr. Kennedy, used to—you may remember when we did inter- national financial institutions—argue that one of the things we ought to be urging on developing nations was a reduction in their military budgets, because it was an unproductive use of their re- sources. So I take the point as one of general application. But that is an accurate statement? Mr. GREENSPAN. It is, indeed. Mr. FRANK. To the extent that you can reduce military spending, consistent with your security needs, that is going to have a good economic effect? Mr. GREENSPAN. Yes. Chairman LEACH. Thank you very much. Mrs. Roukema. Mrs. ROUKEMA. Mr. Chairman, I certainly appreciate your re- sponse to both Mr. Leach and Mr. McCollum's questions regarding financial matters relative to Social Security paying down the debt, and I am in general agreement with that approach. I am going to go into a different area of questioning. Could you address the following question, which I believe is very relevant to the U.S. economy. I have noticed the news this week that hit the headlines about the extraordinary, and I mean extraordinarily large, layoffs at Levi Strauss. Are we are dealing here with export- ing jobs, literally exporting U.S. jobs overseas? Do you view this as the beginning of a surge of U.S. job declines and exporting and wage depressions? How do you view it from your Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 position, whether directly or only indirectly related to monetary policy? Mr. GREENSPAN. Congresswoman, the nature of the American economy has always been one of what Joseph Schumpeter, a long time ago called "creative destruction"; that is, we continuously churn, in the sense that the capital in lower technologies is gradu- ally moved to higher technologies, and that is indeed the way standards of living grow. The problem that unfortunately occurs as a sidebar of that is that you find that there are a lot of people who have been in jobs for very long periods of time in industries whose technology is less than the cutting edge relevant to what is new. And even though there are major technological improvements in apparel and in tex- tiles, nonetheless it is the economic forces that are shifting the cap- ital out of those industries into industries at the higher level of technology. The problem that I think we have with that is not a macro- economic problem. It has been going on for generations. I think that is a problem for how does one address the hardship that is created in these circumstances in a manner which does not distort the desirable moving of assets from one area to another. I do not think, however, that as you implied in your question, that this particular layoff is a signal that something very signifi- cant more is happening. Mrs. ROUKEMA. You do not? Mr. GREENSPAN. I do not. And indeed, what you see at this stage is the actual number of people seeking initial claims for unemploy- ment insurance has fallen to very low levels, which suggests that since that is the broadest measure we have, that the layoff rate is really down quite significantly. Mrs. ROUKEMA. But this Levi Strauss announcement is an indi- cation of a trend in job declines, would you not say so? Mr. GREENSPAN. No, I wouldn't. I think that is a very specific problem associated with the industry and with the company. And it is to be regretted, but I can't say that I see it as a broadening issue. Mrs. ROUKEMA. I hope you are right. I am glad to hear that. Now, let me go back to what I think was Mr. LaFalce's related question regarding the G-7 meeting that you recently returned from. I understand Secretary Rubin was part of that meeting. Tell me, what are your views? Are we, the international community, making progress in the area of financial reform? Is there something that we are going to be able to do for the world's international fi- nancial architecture? And that, of course, is related to last year's IMF funding debate. I don't think we can do the IMF reforms in this short period of time, but give me your perspective on the results of, and progress at, the G-7 meeting. Mr. GREENSPAN. Yes. As I indicated earlier, we are seeing an evolving new international economy. It is changing very much rel- evant to what we have seen in the past. We are in the process of learning how it works as we are dealing with it, so it is sort of learning by doing. That is not the most desirable means that one can conceive of. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 Fortunately, the international trauma that came out of the Rus- sian default created so much risk aversion in the system that the amount of capital flows, especially to emerging nations, has slowed down; and, indeed, there is some evidence that there is a general temporary slowdown in this huge surge in capital flows, which means that we probably have a little time to be deliberative in making judgments as to how the structure ought to be altered. The Gr-7 meeting had very detailed discussions of this. The Bank for International Settlements in Basel is a significant player, as is the IMF and the World Bank. There are innumerable fora which are involved in trying to examine all the various different aspects of this, and I think we are moving forward. We are not moving forward in a dramatically rapid way, and I am pleased at that, because I don't think that this is either nec- essary or desirable. But I do believe at the end of the day we will find an appropriate mix of policies which will best address the ap- propriate supervision and regulation of this new international fi- nancial and trade system. Mrs. ROUKEMA. Thank you, Mr. Greenspan. If you do have fur- ther amplification or documentation, we would appreciate it if you could submit it to us in writing. Mr. GREENSPAN. Certainly. Mrs. ROUKEMA. Thank you. Chairman LEACH. Thank you, Ms. Roukema. Mr. Vento. Mr. VENTO. Thank you. Chairman Greenspan, thanks for your appearance this morning and your statement. In trying to analyze this, obviously, one of the concerns we have in the months ahead is there has been a significant surge in terms of imports, and this could, of course, lead to some sectoral prob- lems. Obviously, the steel issue comes to mind. We have concerns with that and with some agriculture products. In fact, the market for ag- ricultural exports is really quite down. We are producing a lot more food, so we are seeing the effects of that in my home State, both in iron mining and, for instance, in various types of products—agri- cultural products—in place. At the same time, obviously, we would see a tendency in terms of the cuts, the lower prices in terms of some of these commodities, whether it is pork, grain, or steel, there is a tendency to hold down inflation. It is a major benefit that we are receiving right now. Ob- viously, in the oil sector we have the same circumstance going on. That isn't one that we have to worry about too much in Minnesota, but it is a factor. Monetary policy could help in terms of providing some stimulus. How do you see that being coordinated down the road in terms of providing that without overheating the economy? That is obviously the dilemma that we face. Mr. GREENSPAN. Mr. Vento, I think you raise the sort of fun- damental dilemma of monetary policy in the sense that if you have an integrated, interrelated economy, such as that which is in the United States, the 50 States, that there can only be one monetary policy. We do not have the capacity to have different policies in dif- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 ferent regions which have different difficulties. So what we have is a policy which endeavors to address the total system, and invari- ably it is not the appropriate policy for individual sectors. I remember a colleague of mine a number of years ago talking about California. He said, if we didn't have a single currency and a single monetary policy, California would have a different set of policies than the rest of the country. Now, that cannot be done un- less you split off parts of the system, and we don't do that because it is highly inefficient. As far as individual areas are concerned, I think that it is cer- tainly the case that steel imports surged very dramatically and in- duced fairly pronounced declines in prices. From what we see, those prices are stabilizing, and indeed, orders are coming back a bit now, and the real pressures are easing in the steel industry. In- deed, there have been significant cutbacks in exports to the United States by a number of the countries which have been very large shippers here. So the system in steel does appear to be stabilizing. I don't know whether or not that has yet filtered back to the Mesabi Range. I suspect not. It takes a while. But the underlying demands are clearly Mr. VENTO. I just think that—excuse me, Mr. Chairman, but I just think that we need to respond in terms of maybe with the re- ductions of interest rates, obviously on a national basis to deal with it. One of the aspects here in terms of—and I know my colleague from New York, Mr. LaFalce, talked about the instability of cur- rency. But there have been some overtures especially to, in fact, harmonize currency values with the euro. Obviously, Argentina suggested using it as a benchmark. What is your view with regard to that and those particular initiatives? I noticed that the Secretary of the Treasury was less than enthusiastic about this prospect. Mr. GREENSPAN. Yes, I thought for good reason. You become en- thusiastic only when things make sense and are likely to work. Mr. VENTO. Some of this may be involuntary in terms of what Argentina may do or other countries may do. Mr. GREENSPAN. Remember, we have no objection whatsoever if Argentina or any other country decides unilaterally to make the U.S. dollar its medium of exchange. We do recognize that if you have a broadened set of regional areas, like, say, the euro for all of Europe, or most of Europe, and the dollar, say, for a goodly part of Latin America and the United States, there is no question that were that to happen you will get a lesser degree of instability in exchange rates. There are downsides, however. It creates additional pressures. There will be pressures in Europe because they have eliminated the capacity for exchange rate adjustment at their borders when problems are arising. That means that those adjustments are going to occur in different ways. The same thing would be true in Latin America. There is no question that there is very considerable value in having large cur- rency blocks in that regard, but there are also significant downsides as well. We and the Treasury have been discussing these issues at some length. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 As you may know, we were approached by Argentina to consider certain broader aspects of the dollarization program, and there are numbers of discussions that are going on inside the American Gov- ernment on the appropriate response to this. So it is an interesting aspect, and perhaps an inevitable aspect, of the major changes that are currently underway in the international financial system. Mr. VENTO. Mr. Chairman, I will be submitting some questions in writing. Thank you. Chairman LEACH. Thank you. Mr. Bachus. Mr. BACHUS. Thank you, Mr. Chairman. Mr. Greenspan, yesterday when you testified before the Senate they asked you to also comment on financial modernization. As you know, one of the obstacles right now to the financial modernization legislation is this disagreement over holding companies and sub- sidiaries, and we discussed that the last time you were before the committee. We respect your opinion very much and respect the opinion of Secretary Rubin, so we are in, I think, an uncomfortable position in that we are continuing to get a mixed message. I would ask you this. I know that you and the Secretary are friends. I think that would be a fair comment, would it not? Mr, GREENSPAN. Indeed. Mr. BACHUS. And you have great respect for each other? Mr. GREENSPAN. I certainly have great respect for him. I assume and hope he has respect for me. Mr. BACHUS. He has publicly said that he does. My question is this—and I think you think the President has tremendous intellect. That is so, is it not? President Clinton? This is not a trick question. He is very intelligent? Mr. GREENSPAN. Yes. I don't think there is any question about that. Mr. BACHUS. And I know that Secretary Rubin believes that, and I think most Members of Congress agree that he has outstanding intellect. That being said, I know you have great respect for his un- derstanding of economic abilities, too, do you not? Mr. GREENSPAN. I do. Mr. BACHUS. Has there been any attempt—you know, the Con- gress has asked you and Secretary Rubin to meet together. Has there been any attempt for the President to become involved in those discussions? Mr. GREENSPAN. Not to my knowledge. Mr. BACHUS. To me it appears only natural that the President would get a three-way conversation between you, Secretary Rubin and the President, because his advice and consent I know is impor- tant to you, it is important to Secretary Rubin—that that meeting ought to occur. Mr. GREENSPAN. Let me say this, Congressman. I think that get- ting financial modernization is a very important issue, as I testified before this committee a few days ago. I am more than willing to sit down and try to find a way in which we can coordinate these very—this is a very important issue. It really refers to the struc- ture of American banking and finance in the 21st Century. It is not a technical question. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 I am more than willing to sit down, as I indicated previously, with Secretary Rubin and anyone else who wishes to participate in the discussions to find a way to meet their requirement, as they stipulated, for broader oversight of the banking system. We are willing, in effect, if it is necessary, to move the bill to give up some of our so-called turf, if you want to do it that way. But what our major concern is, is that it not be done in the man- ner in which the Secretary is now proposing it, which effectively would mean that you would get a major move of all of the affiliates of the holding companies which have any assets at all into the subs of the bank where they could get subsidies. And if they were reluc- tant to do that, I would assume their shareholders would push them, because it was so obviously the right thing to do. The difficulty is that the reason that that is an issue is that that would make the Comptroller of the Currency the very major player in supervision and regulation. We have no objection to that. It is just that using that particular vehicle to do it strikes me as creat- ing far greater problems for the international and the domestic fi- nancial system. And so that if they want to sit down and talk about the alloca- tion of turf, so to speak, I am more than willing to do that. We don't need turf for all of the things that we are doing. But we do have a responsibility to maintain the systemic stability of our sys- tem, and in our judgment moving in the direction of operating subs instead of affiliates of holding companies is a potentially very seri- ous question. Mr. BACKUS. I appreciate that. And I respect your opinion and I respect Secretary Rubin's, we in Congress do. I am simply saying that you have a President who negotiated a Middle East peace agreement, he has negotiated with some very adverse parties in Northern Ireland, and here we have two of his appointees, and I would just invite or urge the President—I intend to write a letter to him and hope maybe Mr. LaFalce and maybe the Chairman will join with me and ask that you all put your heads together. Because I feel we would be much more comfortable if a consensus could be formulated. And I know there may be reservations, and I think certainly they would be trying to express those reserva- tions, but at least to make that attempt. Mr. LAFALCE. Could I respond to that? First of all, I am very willing to proceed cooperatively with the Chairman and other Members of the committee in order to achieve consensus. And, second, we have heard from the regulators repeat- edly on this issue, from the Chairman of the Federal Reserve Board, from the Secretary of the Treasury, from the Chairman of the FDIC, from past chairmen of the FDIC. It would be desirable if they could come into full agreement, but it is not necessary. What is necessary is for us to decide. I am per- sonally of the opinion that it might be fruitless to pursue the achievement of a consensus among all the other parties outside the Congress. I am more concerned about the Members of this commit- tee and this Congress coming to a consensus as to what is nec- essary to pass good financial services modernization. There will al- ways be differences of opinion in the outside world. Thank you. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 Mr. BACKUS. I will just respond, and I respect your opinion. I would just simply say that I think that if the Administration as one voice could move toward some consensus—and I would invite the President to become involved, I think particularly when we have two members of his Administration. I don't discount that these are serious differences, and I happen to believe that Secretary Rubin and yourself are more informed on these issues than the average Member of Congress, and even the average Member of this committee, more so than this committee. And it would certainly be of assistance to us. We all have great respect for the President's intellect and for his understanding of economic policies. I just—I believe it is time for that meeting to occur. Thank you. Chairman LEACH. If the gentleman will yield just briefly, just to put out the historical record. It is the case that we would all like the advice of the Treasury and the Fed coming together. As re- cently as last Friday representatives of both groups met, and very intelligent people seemed to have a difference in judgment. Mr. LaFalce is of course right, that in that circumstance in par- ticular we have to reach a judgment. On the other hand, if there were to be a consensus, it would seriously be reviewed. This com- mittee would never give carte blanche to a consensus arrived out- side it, but it would certainly have a major impact on the commit- tee. The Secretary of the Treasury is the President's representative in this. Basically, I view Mr. Greenspan as part of the congres- sional branch appointed by the President. That is facetious, but technically the Federal Reserve is not quite within the Administra- tion, although certainly the Chairman and the whole board are ap- pointed by the President. Mr. BACKUS. I am not saying that a consensus is attainable. I am saving it ought to be attempted on something of what I con- sider to be this great economic importance and national interest. Chairman LEACH. I couldn't agree more. You have isolated the signal problem. You have also isolated the desire for consensus within the Treasury and the Fed. It may not be exactly achievable, in which case we are going to have to make some difficult judg- ments, and that sometimes is a circumstance that we are just obli- gated to do. Mr. BACKUS. It would be made less difficult. At least I would ex- tend that idea. I plan to write the President. If anyone wants to join me and urge that-—and I think the meeting ought to be the three of you all, initially. Chairman LEACH. Ms. Waters. Ms. WATERS. Thank you very much. I would like to thank Mr. Greenspan for coming over and sharing with us this important information on the economy and helping us to understand the direction of this Nation. As you know, Mr. Greenspan, my continuing issue of capital for- mation is one that remains, the idea of getting an investment in inner cities so that we could realize some of the benefits of the growing economy is still a concern that I have that I will continue to talk with you about and not today but at another time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 Even though you give some very positive descriptions of our bal- ance of payments problem, I guess deciding that it has helped to hold down inflation, I wonder about our future relative to balance of payments and our ability to export and sell more, and I wonder about places that don't get talked about a lot. We have an African trade bill. I am told that we are trading partners with Africa, but I never quite understand the relationship of that trade to our economy and whether or not there is something there that we can develop further by way of this African trade bill. I would like to hear just a little bit about that. But I want to ask you a very controversial question about a coun- try that is 90 miles from our shores where Europeans are develop- ing and selling and appearing to be doing extraordinarily well and a country that needs everything and that has opened up invest- ment opportunities and joint venture opportunities. They are so concerned about their ability to grow their country and to get what they need to do that that they are working with the other Carib- bean countries and with the European Union to form a little bloc. I wonder what that will mean if they are able to do that. I am talking about Cuba. We have an embargo. I don't know what role you played in Helms-Burton, if they asked your opinion at all. But J would like to hear what you think about that. Mr. GREENSPAN. Well, Congresswoman, the issue of Cuba goes back really to 1959 and 1960, as you know. And the politics, the international confrontations, the history is replete with more things than any of us could write about in 500,000 pages. The one thing I will say to you is that it is one of the very rare parts of the world where we probably have very little expertise and nave given very little thought to; and the issue, as best I can judge, is really fundamentally a practical political one. I don't think there are great disputes about whether opening up their markets and having democratic elections and having some- thing far closer to what exists among their neighbors as far as soci- eties are concerned. That would be helpful and would clearly en- gage a goodly part of the American business establishment beyond the global markets. I would think that if the political issues were resolved—and I recognize there are very significant problems— there is very little doubt that, given the situation in Cuba, that one must presume that there is a great deal of potential investment if that were to become a free economy, which it is not. Ms. WATERS. As opposed to China? Mr. GREENSPAN. It is tough to make the economic distinctions. The main issues here are fundamentally political. It is the type of thing which central banks ought to stay away from, because I can give you my judgments about what particular aspects of the Chi- nese economy are doing, or probably even the Cuban economy, but it is so fundamentally political that I really can't address the issue in any useful way that I would feel comfortable with. Ms. WATERS. And the African trade bill? Mr. GREENSPAN. The issue of trade is an issue of importance largely because the world is becoming increasingly integrated. That is, the technology has so dramatically altered the nature of the movement of goods and services and, very specifically, the move- ment of data, ideas and the like, through the huge telecommuni- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 cations system, and so there is a real sense in which there is globalization in this world, and it benefits everybody. It has got ob- vious problems associated with it, but it strikes me as related to long-term policy, and I think most of us should be really endeavor- ing to find a way to increase trade while at the same time being aware that a lot of people are disrupted, a lot of companies are dis- rupted. My major point would be that we should address those individual disruptions and not try to block trade because it creates those dis- ruptions, because trade is such a fundamentally healthy thing for standards of living, for everybody who engages in it. So I merely want to say that the issues are not trade. Trade is something we should very strongly support. But we should give very significant scrutiny to those who are hurt by trade problems and deal with them and, very specifically, rather than try to pre- vent the disruptions from happening by preventing trade from hap- pening. Mr. BACKUS. [Presiding.] Thank you, Mr. Chairman. Mr. Castle, do you have questions? Mr. CASTLE. Yes, and this is going to be tough because I have to ask a brief question or two, and I have to ask for a brief answer because we have a vote in about six or seven minutes here. But when we did the minimum wage a couple of years ago I ended up supporting it. I basically went back and looked at infla- tion over a period of time and what the minimum wage was, and they were roughly equivalent in terms of what the new minimum wage would be. Now there is a discussion of a new minimum wage. You probably opined on this before, and maybe I have heard you, but I can't re- member the answer. I don't know if you feel that the minimum wage increase at the Federal level has any kind of an inflationary factor in it or not or is it irrelevant to the economy because it only pertains to a small part of the economy and, if so, if there is some way that we should be looking at that and judging it? So that is one question. Let me ask my second question. I am increasingly concerned about the proliferation of savings plans that we have in this coun- try. I know that this last year the savings rate was down, in spite of—or maybe because of—a strong economy. People perhaps felt they didn't need to save. I don't know. And I think that there has been a wonderful job done with the IRAs, Roth IRAs, and tuition plans, but there are all kinds of income cutoffs, and there seem to be competing plans. Are we on the right track with respect to our tax-benefited sav- ings plans in this country? Or should we be thinking about some kind of consolidated plans at the $2000 level, IRAs which have been around a long time? I would like your comments on those two subjects. Mr. GREENSPAN. First of all, Congressman, the evidence that we have does suggest that there are inflationary impacts from increas- ing the minimum wage. My main concern is less that than the issue of individuals who become unemployed because of the mini- mum wage. The evidence as far as we are concerned is fairly con- clusive in that regard, and being unemployed when you are a teen- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 ager, for example, which is where most of the issue lies, is very det- rimental to getting on the first step of getting on the business lad- der, getting a job, learning by training, and becoming a productive member of the work force. In today's environment that is not relevant because there is a huge demand for workers, well in excess of what the supply is, and, hence, the minimum wage is not, as far as I can see, having a spe- cific impact now in that area. My concern is when the economy turns down at some point, and I do think that we are going to find: one, that teenage unemployment will be higher than it would oth- erwise have been; and two, that there will be inflationary impacts because of that. In other words, when you withdraw labor from the market, the inevitable effect is to increase the price level. With respect to the second question, I think you are raising a very important issue. There is a big dispute at this stage as to whether this proliferation of savings plans is indeed increasing the savings rates. There are some fairly sophisticated mathematical models which seem to suggest that there may be some positive ef- fect, but, if there is, it is not a very large one and something of a more consolidated nature, something which really gets to the issue of private pension types of organizations, pension plans or savings vehicles, strikes me as probably wise to think about. Mr. CASTLE. Thank you, Mr. Chairman. I am not going to ask any follow-up questions, except to say that I think that is an area that we really should be focusing on in this country. I have often found a confusion in governmental policy and tax benefit, and these things sometimes don't happen. When it is made simpler it tends to move forward, so I hope we all can make some progress on that. I yield back the balance of my time. Mr. BACKUS. Mr. Chairman, I was hoping I could get in the chair here and slip in another question, but Mr. Sanders has stayed. Mr. SANDERS. Obstinate that I am. Mr. BACKUS. Mr. Sanders. Mr. SANDERS. Thank you very much, Mr. Chairman. Ironically, I was going to ask a similar question to what Mr. Cas- tle asked over on the minimum wage. Some of us see the positive signs in the current economy in that real wages for low-income workers have finally gone up after many years of stagnation and decline. I am surprised, therefore, about your response to Mr. Castle. Because one of the positive things— some people would argue that one of the reasons that wages for low-income workers have gone up is an increase in the minimum wage, and you and others argued that two years ago when we raised the minimum wage from $4.25 to $5.15 there would be mas- sive unemployment among workers. Unemployment is now at a record low. So my question is, I gather you still oppose raising—the Presi- dent would like to raise the minimum wage by a buck over a two- year period. Many would like it to go higher. Are you still opposed to raising the minimum wage? Mr. GREENSPAN. I still think it is a bad idea, because, as I said to Mr. Castle, you don't see the effects when you have a huge de- mand for labor. The real crucial way to test whether it is a desir- able thing to have is when the economy is slack. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 As far as I can judge from the data that we tend to find quite compelling is that teenage unemployment does go up with the min- imum wage. If that is in fact the case, I think it is a disservice to the people. Mr. SANDERS. Unemployment now is almost at a record, and we have raised the minimum wage. Mr. GREENSPAN. You won't see it today. I agree with that. Mr. SANDERS. Let me ask you this question. If you are concerned about wage increases developing an inflationary spiral, how do you feel about CEOs of large corporations now making 200 times what their workers are making and getting huge golden handshakes and all this kind of stuff? Does that concern you? Mr. GREENSPAN. If their shareholders are willing to do it, they are wasting their money in many respects, and I find a lot of that stuff frankly—I find a lot of what is being paid to individual CEOs not directed to the value that they are producing for their share- holders who are paying the bill. Mr. SANDERS. Be that as it may, when we talk about inflation, then you may be right or may not. But what we are seeing, CEOs now make 200 times what workers make. You are expressing a concern of raising the minimum wage of over $5.15 an hour, but I would hope you would see that same concern about CEOs getting golden handshakes with tens and tens of millions of dollars. Mr. GREENSPAN. In both cases I am arguing that the Govern- ment should not be involved. I am being consistent in that respect. Mr. SANDERS. Let me ask you another question, the global econ- omy. Some people would argue, including Business Week, the New York Times, the World Bank, many others, that IMF policy in Mex- ico, Asia, Russia, and Brazil has largely failed over the last several years. Are you prepared to join such institutions as Business Week in urging a rethinking of the fundamental tenets of the IMF in terms of austerity programs, capital flow, and so forth? Business Week, in a recent editorial, said, and I quote: "The aus- terity policies of the IMF and the U.S. Treasury aren't part of the solution, they are part of the problem." I believe the World Bank said something similar. There is increased discussion that basic IMF philosophy has failed. Are you calling for changes in basic IMF policy? Mr. GREENSPAN. Let me just say that we are having conversa- tions, as we always do, on issues of the structure of international financial institutions with the Treasury. We are the relevant agen- cies in this regard, or the ones who are most directly involved. The Secretary is the senior member of our representation with the IMF. I am the alternate delegate. We are the two who are effectively interfacing with that. I don't think it is appropriate for me to be discussing what it is we discuss or the like. I think it is appropriate for us to be thinking about these issues; and, obviously, we are. Mr. SANDERS. I am not hearing you vigorously defending current IMF policies. Mr. GREENSPAN. You are not going to see me defend a number of things which are part of joint discussions with the Treasury, and there are certain things that I think when we are ready to an- nounce something, I think you will hear an announcement, if there Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 are such views. I don't want to discuss what goes on in these joint meetings. I think it probably would not be productive. Mr. SANDERS. Lastly, a brief question. I mentioned earlier that a recent report indicated that the typical married couple in the United States is currently working 247 more hours in 1996 than in 1989. Now, tell me, when we talk about the economic boom and the economy being so great, I know that in my State it is not uncommon for people to be working 50, 60, some- times 70 hours a week. At the beginning of the century, as you will remember, I know you are a historian, workers said, "We want a 40-hour work week. We don't want to work 50 or 60 hours." One hundred years have come and gone, new technology, and people are working huge hours. What do you think? How can we lower the work week so people have more time for their kids, can relax, not be so stressed out? Mr. GREENSPAN. One of the interesting things, Congressman, is the fact that there was a very dramatic and protracted decline in the average work week for a number of years, and it stopped. And there is an interesting issue which I don't know, the issue as to the extent to which people do that voluntarily. You are saying in effect, and I am sure you are quite correct in this regard, that in certain instances people have been working more hours because they needed to. But I have always a suspicion that there is a desire to be working; in other words, that there are enough areas of our economy where people could very easily be working fewer hours and having more leisure time and are choos- ing not to. Now I don't know what the mix is, but I think it is a very inter- esting sociological, as well as economic, question. Mr. SANDERS. I would tend to agree with you, but you are cer- tainly not denying that in many instances people are working longer hours and their wives are working, who might otherwise prefer to stay home with the children, not out of—not as something they want, but as something that they have to do? Mr. GREENSPAN. I am sure that is true. Mr. SANDERS. I would just ask you, Mr. Chairman, that when we talk about there being a booming economy, let us not forget that a lot of folks are not booming and they are working 50 and 60 hours a week. Mr. GREENSPAN. There is a significant part of our work force who are not doing well and haven't been doing well for quite a long pe- riod of time. I don't deny that at all. Mr. SANDERS. Thank you, Mr. Chairman. Chairman LEACH, [presiding.] Thank you, Mr. Sanders. Dr. Paul. Dr. PAUL. Thank you, Mr. Chairman. Mr. Greenspan, a lot of economists look to the price of gold as an indicator and as a monetary tool. It has been reported that you might even look at the price of gold on occasion. Last summer on a couple of occasions here when you were talk- ing before the committees on securities and on derivatives you mentioned something that was interesting. You said that central Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 banks stand ready to sell gold in increasing quantities should the price rise, which I thought was rather interesting. Then I followed up with a letter to you to ask you whether or not our central bank might not be involved in something like that, in the gold market. And you did answer me and stated that since the 1930's the Federal Reserve has had no authority to be involved with the gold markets. I am quite confident that the Treasury has authority to be in gold markets, but you stated that the Federal Reserve did not. But this contradicts some reports that have been made by some Federal Reserve officials that said that the New York Fed was very much involved in the London gold pool from 1961 to 1971. But your an- swer implied that the Fed has never been involved since the 1930's, which I think is interesting. The reason why this could be of importance is that we do know that our Treasury was supporting a fixed price of gold at $35 an ounce in the 1960's, so therefore the price of gold of $35 an ounce was totally useless in predicting what might happen and what did happen in the 1970's. So if central banks stand ready to lease and sell gold in increasing amounts should the price rise, we are more or less, you know, in a time when the gold price is probably so- called fixed; and we do know that the evidence is there that central banks do loan gold, they sell gold. So could it be that the price of gold today is less valuable to the economists, who think that gold could help us, in thinking that maybe we are in a period of time comparable to what we had in the 1960's? Mr. GREENSPAN. I think the price of gold has, over the decades, been a generally usable indicator of what the level of inflation has been. Obviously, during the period of an active gold standard, which was really prior to World War I, the price level pretty much locked itself in to the gold price. In fact, by definition it did. The issue of buying and selling gold as the price changes is in- deed exactly what we used to do. We used to, at a certain thing called the gold points, which was the price of gold plus the trans- portation cost differentials, we, that is, the United States Treasury, stood ready to buy and sell gold at a spread, as indeed all other participants in the gold standard did. So in that regard that was exactly what was happening. But, needless to say, since we have gone off the gold standard, and especially since 1973, there has been basically a general float of the dollar vis-a-vis gold, which means that the gold price is like another commodity's price. Nonetheless, like a lot of commodity prices, and perhaps better than most, it has been useful, in my judgment, in trying to get some sense of what inflationary pressures have evolved in this country. Dr. PAUL. Even if the central banks, who are the major holders of gold, are willing to sell gold in order to manipulate the price or hold the price at a certain level? We are not on a gold standard, so what would the motivation be? Mr. GREENSPAN. They are not doing it for purposes of fixing the gold price. They are looking for it to reduce their stock of gold when they have sold on the grounds that: one, it costs to store the gold; and, two, it didn't obtain any interest. So they perceived it to be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 a poor asset to hold. But the purpose was not to manipulate the price of gold. Dr. PAUL. Another quick question on another subject, on Argen- tina. You stated earlier that you have been studying this and will answer the question about whether Argentina can use the dollar as their currency. It has been reported that there was a consideration, and I surely hope this is not true, that the Federal Reserve could become the lender of last resort, and they would have access to the discount window. Along that line, how does it work when a foreign country dollarizes and they expand their credit through fractional reserve banking? Does that put an obligation on us and can that interfere with the dollar's value? Mr. GREENSPAN. That is a good question, Congressman. The an- swer is no. We view monetary policy in the United States as for the United States. We have no interest in, nor does the Treasury, of being a lender of last resort outside the United States. Dr. PAUL. Outside the IMF? Mr. GREENSPAN. The issue of whether or not another country wishes to use the American dollar as its medium of exchange is theirs to make. They can do it unilaterally. Panama did. Liberia did. If they choose to do that, that is their sovereign right to do that. But we have no obligation in that regard. Clearly, we do sense some obligation with respect to our Latin American colleagues for the same reason that we have had rela- tionships with all of our trading partners. Their interests do con- cern us, and we would like them to be prosperous. To the extent that we are helpful in trade negotiations or other negotiations, that is fine. But lender of last resort, no. Chairman LEACH. Thank you, Dr. Paul. Mr. Ryan. Mr. RYAN. Thank you. Mr. Greenspan, I would like to ask you to comment on a few things, but first I would like to go off of that last question. Are you suggesting that you prefer unilateral dollarization for a country like Argentina versus giving an arrangement that gives them ac- cess to the Fed window? You are not advocating a treaty with Ar- gentina to grant them access to the Fed window, you are suggest- ing that a unilateral dollarization is preferable from our point of view? Mr. GREENSPAN. Access to the Fed window I think is nothing ei- ther we nor our colleagues at the Treasury think is a good idea. Indeed, we would oppose it. Dr. PAUL. Thank you. That is very informative. Thank you. I would like to pull back, broadly speaking, and I would like you to comment on a few things, namely, the worldwide call for new currency regimes, both in broad currency unions and in individual currency regimes. Do you believe that is preferable, to advocate more currency unions, such as the euro, for areas such as Latin America? And in individual nations, what is your preferable currency re- gime, generally speaking, a peg, a float, a currency board, or uni- lateral dollarization? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 Mr. GREENSPAN. The change in the international financial struc- ture has re-raised all of these issues and put them really up front, whereas they had not been before. There is very considerable de- bating in the academic community and indeed among central bank- ers on all of these questions. The euro is going to be a very interesting experiment. It is going to teach us an awftil lot about how those systems work when you start from scratch. It has not been tested yet. Obviously, it is going to take years before there have been really significant tests in that system. We all have a lot of general views as to what the appropriate currency regimes are. At the moment, most people I would suspect say that floating is perhaps the least worst of all of the various dif- ferent Mr. RYAN. Do you share that point of view? Mr. GREENSPAN. I generally do. In other words, I would prefer to have a stable rates structure. I don't think it is feasible. If you can't have it and you have a very major set of financial flows, you are creating all sorts of problems in trying to fix rates, as indeed many of the emerging nations have exhibited in the last two or two-and-a-half years. I think currency boards work on occasion, under certain cir- cumstances. I think crawling pegs, so to speak, I find not particu- larly useful. But we are going to know a lot about all of these things I would say in the next two or three years, because we are getting to the point where the amount of knowledge we are about to obtain on how all of this works is increasing very markedly. Mr. RYAN. Do you believe that we as a member of the G-7 should encourage other countries such as Russia to legalize the use of other currencies within their markets? Mr. GREENSPAN. It is really their judgment. If you are asking me whether or not they would be helped by an external currency such as the euro, for example, if they made it work, the answer is un- questionably, yes. It is regrettable at this particular point, but their financial sys- tem is in a high degree of instability. If they could find a way to make the euro their currency with all of the implications it has, which are really far more than most people realize—it is not only the political problems, but a very significant number of economic and central banking problems that would be involved—if they could make it work, by definition they would be a far more stable and far more productive economy. But it is not a simple issue of going from here to there. Mr. RYAN. One more quick question. Could you comment directly on the deflationary signals we are being sent specifically through gold? The CRB commodity index is at its 24-year low. Do these in- dications tell you—how do they affect your judgment as far as judg- ing inflation on the horizon, given these deflationary signals at home and abroad? Mr. GREENSPAN. They are one of the indications. In other words, clearly the general decline or weakness in commodities of every dif- ferent type has been really quite apparent. It is telling something broader than what each individual commodity is telling you. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 Having said that, it is important also to remember that commod- ities are an ever-decreasing part of our economies. That is, high- tech and more impalpable types of economic products are becoming ever-increasingly more important, so you have to recognize that there is a very limited role for commodities as a price indicator, but it is a useful role. But I would not want to make it as the fun- damental determinant, because it cannot be. Mr. RYAN. Because of this change in relationship, are you sug- gesting that the impact of these commodity indicators on your deci- sionmaking is changing? Is it lessening with regard to these other indicators? Mr. GREENSPAN. I would think so over the years, largely because the share of commodities in the total economy has been declining. But they still offer very useful indications for one very important reason. These prices are available not only daily, but hourly, and you get sometimes indications of what broader changes are well be- fore the official data are available. So, in that regard, there is a timeliness about them which makes them more usefiil than the just general weights that one would have in that regard. Mr. RYAN. Thank you very much, Mr. Chairman. Chairman LEACH. Thank you, Mr. Ryan. Mrs. Maloney. Mrs. MALONEY. Thank you, Mr. Chairman. It is always a pleasure to welcome one of the outstanding citizens from the great State of New York. Mr. GREENSPAN. Thank you. Mrs. MALONEY. I have heard you say many times, and the Presi- dent say many times, that we are moving towards a world econ- omy. Throughout your remarks you talk about the problems of the rest of the world. Roughly a third of the rest of the world is experi- encing a recession. I would like to know, Mr. Greenspan, what would be the effect of raising interest rates on these countries, and how much do you take into consideration the influence on world markets when you are formulating monetary policy in the United States? I read in The Washington Post this weekend that you have to read so much more now, since you are not just following the Amer- ican economy, you are following the world economy. I think it is a stunning statement on the health of our own economy that so much of the world is having financial difficulties, yet we have not experi- enced it in our own country. My question is, how much of an em- phasis do you now place in your decisions on monetary policy, and what would be the effect of raising interest rates on roughly one- third of the world that is suffering this recession? Mr. GREENSPAN. Our interest rates or theirs? Mrs. MALONEY. Ours. Mr. GREENSPAN. OK. What we do, Mrs. Maloney, is to endeavor to understand how the world at large is impacting on us. And that is becoming ever-increasingly more complex; and, as a consequence of that, I think that we need to spend a good deal more time, as indeed I am, in trying to understand what is going on out there. As I said to one of your colleagues earlier, we are learning while we are doing. In other words, we don't have simple textbooks at this stage which suggest exactly how the world works the way we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 sort of thought we did 30 years ago. That means we are functioning in a manner where we need ever-increasing detail and understand- ing of the various different cross-currents to get a sense of how it is going to impact on the United States. Our central focus on policy is the United States. I don't deny that we take considerations of what is going in the rest of the world as important, because it does impact us. And to the extent that it im- pacts us, we essentially obviously consider it. Whether we lower or raise interest rates, the essential focus is our long-term goal, which is maximum sustainable economic growth in the United States. And to the extent that we succeed in that, that is the best we can do for any of our trading partners. Because to the extent that they rely on our markets, if we are doing well, they are doing well. I would never want to be concerned about how our individual policies impact everybody else, because we would never be able to get a sensible policy for the United States, and I think that would not be appropriate for us. Indeed, as I read the statutes which give us the authorities that enable us to function as a central bank, it is the United States, and solely the United States, which must be the focus of our policies. Mrs. MALONEY. In reading the reactions to your comments yes- terday in Bloomberg and the Wall Street Journal and others, some of them interpreted your comments as "it might be good, it might be bad." The bond markets, as you know, fell. Is that the message you were trying to send, the reaction of the markets? Mr. GREENSPAN. I try, with my colleagues, to say what we want to say, and I am speaking for the Board, not for myself, when I come before this committee, especially in our formal presentations under the Humphrey-Hawkins Act. I don't want to go beyond that. Whether or not people interpret what we are saying the way we thought they would interpret it, I would say some do, some don't. That has just always been the case. I find more often than not that there are diametrically opposite interpretations of what I say, which probably means we have suc- ceeded. Mrs. MALONEY. Thank you. If I could ask one brief question that builds on your former ques- tion, Mr. Chairman? Chairman LEACH. I might come back. Mr. Royce. Mr. ROYCE. Thank you, Mr. Chairman. Secretary Greenspan, I remember that some four years ago you testified before the committee. I think we were still running $200 billion budget deficits at that time. You said that if we could slow the rate of Government spending and bring the budget into bal- ance, that interest rates would probably fall by 2 full percentage points at least. Since that time, interest rates have fallen by 3 per- centage points in terms of the long-term Treasury rate. Another comment you had made was that the ideal capital gains rate in terms of economic growth was zero; and, indeed, as we low- ered the capital gains rate to 20 percent, we have now seen actu- ally an increase in economic growth and additional revenues come in. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 So we have a situation now over the last three years where we have seen the greatest economic growth that we have seen for some time—unemployment at a 30-year low, the Federal budget surplus is growing. I wondered if you would rank the factors, maybe five factors, that contributed to this. One would be balancing the budget, presum- ably. Another might be the capital gains tax cut. Another would be globalization and that effect, the information revolution, and credi- ble monetary policies. Which of these do you think, in ranking order, would be most im- portant in terms of establishing this 4 percent economic growth a year, and can we sustain it? Mr. GREENSPAN. I would say the number one is clearly the fall in the rate of inflation. Because what we have observed over the years is that as the inflation rate moves toward price stability, that the volatility and risk premium associated with inflation falls. That is a very positive contribution. Technology has also been a crucial issue. That is the result of synergies of previous technologies which are not easy to forecast but which invariably have had a major effect. I think, but I don't know for sure, that the capital gains tax re- duction engendered increased revenues, but what obviously even more increased revenues than that was the fact that, as inflation declined, long-term risk declined, and the markup on long-term earnings rose, which led to a huge increase in asset prices, specifi- cally equity prices. That obviously had a major impact, as best we can judge, on the revenues, which has moved us into a significant surplus on the unified budget at this particular point. It is very difficult to make judgments of exactly how the capital gains tax impacts on the economy. My major point four years ago, and indeed it is today, is I find it a not particularly useful means of raising revenue. Irrespective of what its impact is, I would say it is not a good way to raise revenue, because it is directly on cap- ital—capital is where we get increasing standards of living. Mr. ROYCE. Let me ask you about one of the worries that I have. Let me ask you how you react to the concern that the savings rate arguably would have to continue to go lower since the other drags on the economy such as the rising trade deficit and slowing global demand means that growth here depends on continued consumer spending. How do you react to that? Mr. GREENSPAN. I think you are raising the basic issue a number of people have raised; namely, that the spreading out, the decline hi the private savings rate and the continuation of very strong cap- ital investment is stretching the financial funding system, and something has to give, and indeed, something will give at one point or another. It is hard to know exactly how it is going to rebalance. Our judgment, and it is a judgment which we recognize has un- certainties associated with it, is that the level of consumption growth, which has been extraordinarily strong, will slow down. In- deed, that is the essential content of my prepared remarks. We believe also that the dramatic expansion and capital invest- ment will slow down to a more long-term sustainable path, and that will close the gap between private savings and investment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 The presumption is that public savings, largely through the sur- plus in the unified budget account, will continue. That offsets this gap in large part, as indeed does the current account deficit. But— then that has to all close and balance. That is true by just the na- ture of the fact that savings must equal investment at all times in our economy. Something will give. Something will eventually change the pat- tern. But there are a number of different ways that that can hap- pen. Mr. ROYCE. Thank you, Chairman Greenspan. Thank you, Mr. Chairman. Chairman LEACH. Thank you, Mr. Chairman and Mr. Royce. Mr. Bentsen. Mr. BENTSEN. Thank you, Mr. Chairman. Chairman Greenspan, I have about three questions I would like to get to you. The first is maybe more of a statement based upon some earlier comments of both the Chairman and then Mr. McCol- lum with respect to the Wall Street Journal, and I didn't read the opinion piece that was discussed. But looking at the Fed's February 23rd Monetary Report, I think the answer that you gave, and I just want to verify this, you wouldn't support borrowing to pay for tax cuts or new spending, for that matter, is that correct? Do you think that is an inefficient use of resources? Mr. GREENSPAN. I think that, in line with the statements I have made before this committee on many occasions in the past, I be- lieve that we would be far better off with lower levels of spending and lower levels of taxes. I do think that having a budget deficit is not a good idea, and having lower debt is a good idea as far as long-term economic growth is concerned. I don't know whether that responds to your question. Mr. BENTSEN. But spending surplus on tax cuts or new spending in lieu of paying down publicly-held debt does have a cost associ- ated with it, the carrying cost of that debt, correct? Mr. GREENSPAN. Yes. Mr. BENTSEN. And you would be opposed to that? Mr. GREENSPAN. Under most circumstances, I am usually in favor of reducing taxes, as I am reducing Government expendi- tures. In todays environment, where we have the economy going flat out at this particular point and we have a substantial unified budg- et surplus, from an economic policy point of view I envisage the best thing that we can do at this particular stage is to allow that surplus to run. What that means, of course, is that the debt to the public de- clines, interest costs on that debt decline and, in my judgment, that contributes to lower long-term interest rates. Mr. BENTSEN. Your report also—and.I am going to have one other question I want to try to get in. Your report also indicates that social insurance tax receipts as a source of Federal revenue in- creased by 6 percent in step with growth and wages and salaries. That is as a result of increased profit, I would assume. In part that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 is helping raise personal income. I think that is what you are say- ing in your statement. Is that also a reflection—or is it too early to tell if that is a re- flection of increasing the gross national savings rate by booking the surplus and paying down the debt? Mr. GREENSPAN. No, I think it is more likely at this stage the result of the fairly dramatic increases in productivity which have been occurring in large part, as I indicated in my prepared re- marks, as a consequence of the rate of return on new investments rising. So that, as productivity rises, as nominal wages and salaries rise, you pick up increased Social Security taxes and other types of taxes on the wage base. Mr. BENTSEN. In the long run, that should be helpful to the trust funds, though, correct? Mr. GREENSPAN. Yes, of course. Mr. BENTSEN. Let me ask, and I hope you get to testify before the committee on the budget. It may be that we go ahead and mark up a budget without this, with only one set of hearings. But be- cause there are a number of—I would like to talk to you in more detail about the President's proposal at the appropriate time, but I am not going to bring that up here. Let roe talk about another issue with respect to the oil economy. In your report, a lot of times you state what the level of imports is with respect to oil. I didn't find it, but I may have skipped over it. Previously, we have seen imports rising to the 50 percent level of consumption. I would assume that it is greater than that now with the world oil glut. We have discussed this before, but I would like to raise it again. You also state in your testimony, I believe, that a decline in oil prices, which are at the lowest level in a 25-year span, I think, and particularly at the retail level, was unlikely to recur. So I guess you are projecting—and I have a two-part question. I guess you are projecting that you think oil prices and, thus, gas prices, will start a trend back up, although we haven't seen any evidence of that so far. Second of all, as we get to the 60 percent, or whatever the level of imports is, and we see not just a decline in production in the United States, but an elimination of production capability through more rigs going off-line, the capping of marginal wells, where the recovery cost goes up quite dramatically to bring those capital items back into line, are we looking at the possibility of a transfer of wealth in our oil production capabilities outside the United States, and is that something we should be more concerned about than the usual concern of competitive or comparative advantage in means of production? Mr. GREENSPAN. We are merely reflecting in the oil price essen- tially what the futures markets are showing. In other words, West Texas Intermediate, as you know, is selling at a premium in the far distant months, and that is the best guess that we can make at this particular point. But as you have experienced more than most anyone around here, those prices fluctuate, because it is very tough to get a good fix on the balance of world crude oil supply and demand because Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 there are so many players; not only producers, but huge numbers of consumers all over the world. It is a major international com- modity. The issue of how we deal with our resources, the clear problem that we have, obviously, is that the cost of producing crude in the Middle East, specifically in Saudi Arabia, is very significantly below our marginal costs, even among our best wells and our best fields. We have to make the judgment, and I guess we do it by implica- tion, about what we wish to do about that. And the general judg- ment is that we are allowing the market to do what the markets do, namely, allocate resources to various different places of produc- tion. The consequence of that has been, as you point out, a fairly sig- nificant contraction in strip oil production in the United States, which continues. The rigs in operation have fallen very signifi- cantly, and basically because the incentives to find new oil or gas, for that matter, at these prices is clearly far less than it has been. It is pretty easy to define what the nature of the problem is. It is another issue altogether to get a rational national policy to ad- dress it, or whether a national policy is even appropriate. I think that is an issue which has always engaged the Congress as long as I remember, and I suspect that will continue to be the case. Mr. BENTSEN. You are not willing to give an opinion as to wheth- er or not there ought to be a national policy, or what that might be? With respect to oil and gas? Mr. GREENSPAN. Frankly, Congressman, I lived through too many national oil policies which didn't work all that well that my enthusiasm is less than terrific. Mr. BENTSEN. Thank you. Thank you, Mr. Chairman. Chairman LEACH. My apologies to Mr. Goode, but Mr. Watt was here at the beginning of the hearing. Let me just say the order will be Mr. Watt, Mr. Goode, and then we will come to Mr. Sherman. Mr. Watt. Mr. WATT. Thank you, Mr. Chairman. I have three areas that I would like to get Mr. Greenspan's comment on. First of all, 10 or 15 years ago we heard a lot of comment and concern about the balance of trade, and there seems to be, as we have moved toward a world economy, less and less concern about that, less and less discussion of it, at least. I wonder if you might comment briefly on the growing deficit, trade deficit balance and the impact, either good or bad or indifferent. Second, there is a proposal on the table that the President ad- dressed in his State of the Union Address to increase the minimum wage. I would like to get your opinion about what, if any, impact that would have on the continuing movement in the economy. Third, obviously, given historical patterns, we can't continue to go on like the economy has been going. I am wondering what im- pact you see if there is a slowdown in the economy for the last hired in this employment cycle and typically the most vulnerable people who are probably the least skilled and more likely to lose their jobs if there is a slowdown. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 If you could comment briefly on those three things, it would help me to evaluate all the perspectives and probably help me to have some more intelligent discussions with my constituents when I go back home, also. Mr. GREENSPAN. Well, Mr. Watt, I think you raised really an in- teresting question, because I think you are right, that the concerns about trade are less than they were 15 years ago. My suspicion is that there is a greater acceptance that we are living in a world economy and that trade is a crucial element in that. It is possibly also the case that there is an increasing acceptance of the fact that—what most economists think is demonstrable— namely, that standards of living do really rise with the division of labor and trade that goes with it. The issue of the trade deficit, which is rising, is a complex ques- tion at this particular stage because there are two issues that are really relevant here. One is that the trade balance and its financ- ing—one of the characteristics of this trade balance or the trade deficit is that it is in part engendered by the fact that there has been a fairly strong demand for U.S. dollars, especially drawn into the United States to supplement what has been meager domestic savings. If you have a lot of foreign savings coming into the United States, it necessarily means that you are also having a current ac- count deficit, and that it is hard to know how the whole system is directly being put together because we only see the end result of that. But we are very much aware and spend a good deal of time fo- cusing on this interaction to understand how our economy is behav- ing and, therefore, what is the appropriate monetary policy. With respect to the minimum wage, I will repeat what I men- tioned to your colleagues who have asked similar questions. My concern with the minimum wage is that the evidence that we have seen over the years very clearly indicates that young teenagers are the ones whose employment seems to be significantly impacted by that. It wouldn't be in today's environment. The demand for labor is so strong that anybody who wants a job has a very considerable chance in getting it, and I doubt very much if the minimum wage is having an important impact. I am concerned, however, the next time the economy softens, be- cause not only would a higher minimum wage tend to price out of the market the number of teenagers who want to get on the lower rungs of the ladder of learning how to get into the business world, get on-the-job training and the like, but knocking them off the lad- der is not very helpful. Which gets to your third issue, which is one that I think we all struggle with with respect to hiring policies and who gets laid off when the economy weakens. That clearly is not a problem today. On the contrary, what we have seen is a fairly dramatic increase of employment of those with less than high school educations; that we are seeing for the first time significant absorption of a lot of people who were not capable of getting on the lower rung of the ladder and work their way up who are now being able to do that. I would be concerned that the next time the economy weakens that it is going to reverse, which is one of the reasons why we be- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 lieve that it is very important to keep this economy going as long as we can in the context of stability. Because, clearly, the longer time people have to get on-the-job training, the more likely they are to be continued to be employed when the economy inevitably slows down, and that is inevitably going to be the case. So it is a set of tough decisions, but policy has never been easy. It has gotten likely to be less easy because of the new complexities with which we are dealing. Mr. WATT. Thank you, Mr. Chairman. Chairman LEACH. Thank you, Mr. Watt. Mr. Goode. Mr. GOODE. Thank you, Mr. Chairman. Much has been said about the economy being good, and my area is one of the weaker areas. The seniors are all concerned, or many are concerned, about their Social Security checks. I know that you stated that you would not be in favor of the Social Security reve- nues being invested in common stocks. Is that right? Mr. GREENSPAN. Yes. Mr. GOODE. How about investing in corporate bonds, AA and AAA? Would you still have a similar reservation? Mr. GREENSPAN. My major concern, Congressman, is that unless you increase national savings in the process, to the extent that you increase the rate of return on Social Security investments you de- crease the rate of return exactly the same amount in the private sector, where people's savings are largely for retirement as well. So in the broadest sense, merely shifting who invests in what will change what each individual pool is earning, but it is by no means clear that it increases the total amount of monies available for retirement of our population when it goes to retirement age. So my main concern with all of this type of discussion is that somehow it appears as though there is a free lunch here. There is not. If it actually increased national savings in the process, then it is a different issue. But I can find no reason that is of a positive nature to change the pattern of Social Security investments, be- cause it can only be by switching the investments with the ele- ments in the private sector, which essentially are also for the pur- pose of creating retirement income. I think it gives a sense of well- being to the Social Security Trust Fund which is unreal, and I think that is a mistake as far as national policy is concerned. Mr. GOODE. To follow up, then, would your answer be similar if we switched the bonds for the future from non-negotiable in the So- cial Security Trust Fund to negotiable and if you made your check for your 6.2 employee and your 6.2 employer tax payable to the So- cial Security fund instead of the U.S. Treasury, like it is now? Mr. GREENSPAN. I am not sure about the last, which I am not familiar with, but I will say that whether or not you are holding marketable securities or special issues doesn't matter in the slight- est. It is the same security. Mr. GOODE. Which would you—do you think—I know a lot of the seniors in my area would feel safer if the check for the Social Secu- rity taxes was made payable to the U.S. Social Security fund and there was a real fund instead of the U.S. Treasury. Mr. GREENSPAN. I think there is no doubt that there is an impor- tant question here about whether the trust fund should be split off Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 from the budget. I think there is a good argument to be made of really taking Social Security off-budget. We do it in a mechanical sense now, but when you negotiate with respect to the issue of what expenditures are and taxes are, you think wholly in terms of the unified budget, or almost wholly in terms of it. All of the agree- ments, all the deals, all the caps and the pay-goes, they are all uni- fied budget. If you took Social Security fully off-budget, made it a special trust fund, even investing in U.S. Treasury securities, and dealt with the on-budget issue, I think we would get a higher rate of sav- ings in this country. That in my judgment is crucial. Mr. GOODE. That would be good? Mr. GREENSPAN. Yes, indeed. Chairman LEACH. Thank you, Mr. Goode. Mr. Sherman. Mr. SHERMAN. Thank you, Mr. Chairman. I have a brief amount of time. I would like to comment on a cou- ple of the exchanges, and then ask the question I came to ask. I know that Mr. Watt asked about the trade imbalance. I would point out that during this there has been a tendency to always blame America for the trade imbalance. First, we were told our products were no good, and then our autos got better. Then we were told our Federal Government was no good because we were fiscally irresponsible, and there was a direct correlation between the budget deficit and the trade deficit, and now we are the most fiscally responsible Government in the developed world. I think ultimately our trade imbalance is, in large part, the re- sponsibility of our trade negotiators, who have taken the position that we would like the honor of defending the world for free and are willing to make major trade concessions in order to obtain that honor. But rather than ask the Chairman to address that, I am going to have the honor of asking those same questions to the Secretary of State Albright tomorrow. I do also want to comment on the exchange with Mr. Goode. I know that the Chairman has been a supporter of a capital gains tax reduction or elimination, and I would say in my 15 years of ex- perience as a tax lawyer and CPA no one ever was influenced by me on the spending-saving decision. They are influenced by the tax law and their tax advisors, only on what to invest, in the decision. For us to give the rich major tax incentives to move their money from debt instruments to equity instruments because that is alleg- edly important for the economy, but then to say that it does not help the economy when the Social Security Trust Fund does the same thing is somewhat baffling. I tend to think that nothing we do, at least with the clientele I serve, the upper income that could afford my fees, will influence the trade-spend decision. First, they bought the Rolls-Royce; then they drove it to my office and told me how much money they had to invest. But what I want to turn to is Mrs. Maloney's questions about the effect that the Fed's decisions have internationally, because I think when the history of the latter part of this decade are written, there are two possible histories. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 One will be the "Age of Greenspan," a discussion of how America finally found fiscal discipline and created long-term low inflation- ary growth. The other will be a history that America fiddled around with its domestic economy while ignoring the fact that Rus- sia was disintegrating. I grew up in the 1960's when the bumper stickers, along with the peace sign, said that "One nuclear bomb could ruin your whole day." In the language of this committee, I would say that "One thermonuclear explosion can adversely impact your entire fiscal quarter." Obviously, the primary focus of the Fed has to be non-inflation- ary growth for the U.S. economy, but reasonable minds have dif- fered by as much as 50 basis points on what the right course is. Within that reasonable range, the question is, is there anything that U.S. monetary policy could do to reduce the likelihood that Russia will continue to disintegrate? Would a reduction in Amer- ican interest rates allow the Russian government to survive, which is important for the Russian people, but to continue to control its nuclear weapons? If so, would the Fed view that as an important goal, or will we have the first non-inflationary period of growth of 10, 15 years in- terrupted sometime next decade when we find out that several hundred nuclear weapons have leaked out of Russia and that a few of them had exploded in American cities? Mr. GREENSPAN. It is not conceivable to me that anything that we in the Federal Reserve could do in either raising or lowering in- terest rates would have any material effect on the Russian finan- cial system. They have very serious problems, as you know, and they are struggling with them. At the usual G-7 meeting over the weekend, a group of us in Frankfurt met with our Soviet colleagues, or rather, our Russian colleagues, and it was a very interesting discussion. Very interest- ing discussions were going on. Mr. SHERMAN. I think we are all acutely aware of the issue of the existence of nuclear warheads in an economic environment which is deteriorating, and the maintenance of the system to make sure that those systems are in sound order is not cheap. They have a very large system. They have very large requirements; and they have, as everyone has indicated, a very difficult problem. To the extent that they have difficult problems, you don't think 25 or 50 points on world interest rates—their problems are so ex- treme that it is not at the margin, where it pencils out—it is not that kind of decision? Mr. GREENSPAN. No, it is not. It may have been three or four years ago when they were actually coming back. The price of oil de- clining actually really did a great deal of damage to their economic recovery. But now I would say that the issues are far more fun- damental and essentially things which they are going to have to themselves get resolved. Mr. SHERMAN. Thank you, Mr. Chairman. Chairman LEACH. Thank you very much. We have had our last round. The gentleman from California would like to ask one brief follow- on question. I have, of course, asked about the price of corn, Mr. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 Bentsen the price of oil. I assume your concern is artichokes and eggplants out there. Mr. ROYCE. Thank you, Mr. Chairman. Those will be submitted for the record. One last question. History has not had happy results with cen- tral governments investing taxpayer dollars into the market. Italy in the 1930's comes to mind. But one of the experiments we have seen over the last few years, maybe 18 years ago, was written get- ting its taxpayers through a choice in the individual social security accounts system, a choice in investing some of their savings for their retirement into the marketplace. The choice, the decision not being made by the Federal Government, but instead being made under constraints that it be in some AAA bonds and blue chip stocks, that this be controlled by some means by the Government. But, nevertheless, that then arguably helped handle an anemic savings rate. Some of the states did this because their own social security systems were changing as a result of demographic changes in the population, Chile and England being two. What would your thoughts be, theoretically, on, as we move for- ward on this debate on Social Security, allowing some element of choice to the individual to make such investments in blue chip stocks and bonds of sound investments? Mr. GREENSPAN. The crucial determinant is whether or not the process increases the national savings rate. I have always argued that if you move funds into private either defined contribution or defined benefit plans, that the requirement that they be fully fund- ed, or at least the defined benefit would be fully funded, in my judgment would make it easier to get a higher savings rate, and that therefore I support it for that reason. I think that there are a lot of arguments that I have heard for private investments which I don't find persuasive. But the issue of full funding is to me a crucial one, and a higher savings rate would be implicit in that. I have always supported that, supported a sig- nificant part of Social Security moving into the private sector for precisely that reason. Mr. ROYCE. Arguably over the next 20 years this could help change the negative savings rate into a positive rate? I know we have seen that in some countries. Mr. GREENSPAN. I would think so. I would think that, in fact, that is precisely what I am saying would happen, and I would hope it would be, in fact, the case. Mr. ROYCE. Thank you, Mr. Greenspan. Thank you, Mr. Chairman. Chairman LEACH. Thank you. Mr. Chairman, I have several more questions, but I really think we appreciate your coming, and this would be a good time to bring this to an end. We appreciate your perspective, and we thank you and your staff for your assistance on a host of issues. Is there anything you want to say in conclusion? Mr. GREENSPAN. No, thank you very much. I think it has been a most interesting session today. Chairman LEACH. Thank you. The hearing is adjourned. [Whereupon, at 12:48 p.m., the hearing was adjourned.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A P P E N D IX February 24, 1999 (43) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 CURRENCY Committee on Banking and Financial Services .lanit's A. I.L'adi, Chairman For Immediate Release: Contact: David Rnnkel or Andrew Parmentier Wednesday, February 24,1999 (202) 226-0471 Statement by Representative Jam*) A. Leach Chalmun, Committee on Binldng and Financial Service! Humphrey-Hawking! Hearing with Testimony from Alan Greenspan The Committee meets today to receive flic semiannual report of the Board of Governors of the Federal Reserve System on the conduct of monetary policy and the state of the economy, as mandated in the Full Employment and Balanced Growth Act of 1978. Chairman Greenspan, welcome back to die House Banking Committee. It has long been my view that no Committee has a greater oversight obligation than this Committee with its jurisdiction over the Federal Reserve Board and its conduct of monetary policy. In order dial all Members may have an opportunity to question Chairman Greenspan, it is the intention of the Chair to limit opening statements to the Chainnan and Ranking Member of the full committee as well as the Subcommittee on Domestic and International Monetary Policy. AU other opening statements will be included for the record. In mil regard, it has come to my attention that the semiannual report on the conduct of monetary policy and the state of the economy is one among many such reports scheduled to terminate at the end of mil year under a 1995 statute. I would tike to assure Members of this Committee that we are working closely with the House leadership to rectify this issue on a timely basis. Hilt tuhnriier nr not there ccmtimiM In hj- « lrfi*taivr HniAta far regular OmgreMinnal review nf the Fgd'g cnnihirt of monetary polky, it would be the Committee's intent to require die Chairman of the Board of Governors to report regularly on the state of die economy and the Federal Reserve's policies to sustain economic growth and promote the fullest credible employment of the American work force. The combination of a more disciplined fiscal policy promulgated by Congress and (he prudential stewardship of monetary policy by (he Federal Reserve Board has produced the longest peacetime expansion in modem U.S. history. The facts speak for themselves: the unemployment rate is at a 29-year low, inflation is at a 33-year low, inflationary pressures appear subdued, and me federal budget surplus is growing. la this reinforcing cycle, low inflation and low real interest rates have produced rising real wages for the American people. This circumstance, particularly the fact that the federal budget has moved from a deficit to surplus position, means that issues like future shortfalls in Social Security can be credibly addressed without massive wrenches in the economy. In this context let me just stress mat as Chairman of the Committee of oversight over monetary policy that 1 take as the highest of obligations the necessity of maintaining the independence of the Federal Reserve System, which I consider to be the 20* century's most innovative institutional addition to the science of government at the national level. There are, of course, areas of concern such as the decline in personal savings, potential decline in US business investment, the size of the U.S. current account deficit, and the wildcard of the Y2K computer problem and its potential effect on the economy. From a Midwestern agricultural perspective, there is particular concern brought about by falling commodity prices in soybeans and hogs, together with recessions or depressions in many U.S. agricultural export markets. These conditions, working together, are wreaking havoc on the livelihood of America's family farmers. The government must be, it seems to mis Member, more active in developing and expanding exports markets. At the same time, banks in the agriculture heartland of America are obligated to provide credit extensions where possible to help farmers preserve their livelihood. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 In (his global context, the world economy remains extraordinarily dependent on U.S. growth for leadership. The American economy (tunned most forecasters by producing growth close to 4% during 1998 despite a large expansion of the trade deficit, exceptional volatility in financial markets, and some erosion of corporate profits. Despite Monetary Union, Europe appears likely to record only modest growth during 1999. Across the Pacific. Japan continues to suffer from a complex array of crises dial may make it difficult to achieve recovery in the near future. Meanwhile, much of the developing world is suffixing directly or indirectly from the effects of the emerging market crisis that began in the summer of 1997. There ire no assured remedies for stabilizing today's global financial markets, but it is self evident that the U.S. should not abandon leadership of international financial institutions. Cooperation with our friends and allies on strategies to advance suttainable economic growth is a critical ingredient of advancing global economic growth and stability. New prudential approaches to international economic problem-solving on issues like contagion, moral hazard, and private sector burden-sharing and allegations to the rule of law need to be developed before die global trend toward democracy and open markets is placed in serious jeopardy. It appean that there is some progress toward a "new financial architecture," albeit on an incremental as opposed to systemic basts. During the last Congress the Banking Committee sought to work cooperatively with die Administration and the Federal Reserve on national interest issues such as international financial reform and replenishment of the IMF. New Members should be aware that during the IDS"1 Congress this Committee laid the groundwork for a much more active and continuous oversight of the IMF, especially with regard to progress on international financial reform. In mts regard, however, last November's dubiously conceived assistance package for Brazil and a looming new crisis in Russia raise a number of difficult questions. One relates to the evolution of the IMF as a defacto lenderof last resort Another relates to exchange rate regimes and whether it was sound policy for the U.S. to champion me defense of a Brazilian exchange rate regime, widely regarded as untenable, with public money. With respect to Russia, which is on the precipice of defaulting on its external obligations, me issue is even more stark: will the West require credible anti-corruption and fiscal reform* before it extends new IMF loans or not? This Member is prepared to be generous in assisting the Russian people attempt m historic transition from communism to democracy, but if assistance simply amounts to the transfer of public funds to pad private pockets no legitimate case can be made for aiding any country. To conclude, this Committee is looking to Chairman Greenspan for guidance on dtese difficult questions. As always, we are denuded to have you with us and look forward to a lively discussion. ###### Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 House Banking Committee Humphrey-Hawkins Hearing Wednesday, February 24,1999 Mr. Chairman, thank you for the opportunity to submit this statement for the record on Chairman Greenspan's monetary policy report on the state of our economy. Once again, our economy seems to be growing. After eight consecutive years of economic expansion, and contrary to the predictions of many economic experts, our national output continues to grow in a climate free of debilitating inflation. If the Federal Reserve can continue to keep a tight collar on inflation through its judicious control of the money stock, there is no reason why future economic growth should not emulate recent growth; why future employment opportunities should not continue to be available to all who want to work at decent wages; and why investments in the stock market should not continue to provide double-digit rates of return. The economic projections for this year are encouraging and seem to indicate housing activity will continue to spearhead the gains in domestic demand. If business investment of the recent past can continue unabated into the future without the shackles of increased government regulation (the "hidden" tax) or of increased explicit taxation such as profits taxes and capital gains taxes, Congress will have done well to encourage economic growth and to secure the nation's future. One issue of some concern to the future of our economy is that of tax cuts. Broad, across-the-board tax cuts on individual incomes will help to return hard earned money back to the working families who earned it. Last year, Republicans fought to pass H.R. 4579, a bill which proposed to reduce individual taxes by an estimated $80 billion over five years. H.R. 4579, also provided a tax reduction for married couples, to reduce the so-called "marriage tax penalty." H.R. 4579 also extended a number of temporary tax Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 benefits that had recently expired or that were due to expire ("extenders"). In addition, H.R. 4579 provided several tax benefits for savings, investing, education, and small businesses. Finally, H.R. 4579 contained little in the way of revenue-raising offsets; its cuts would be funded out of expected budget surpluses. Sadly, President Clinton's threat to veto H.R. 4579 killed all efforts to further invigorate the American economy and to provide more and better opportunities to the tax burdened and hard working citizens of our country. It is my hope this baton will be taken up, and carried across the finish line in the 106th Congress. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 Opening Statement of Rep. Frank Mascara Before the Committee on Banking and Financial Institutions Receiving Testimony from Federal Reserve Chairman Alan Greenspan February 24,1999 Thank you Mr. Chairman for appearing before our Committee today. I believe your biannual appearances here are very helpful to die members on this Committee, as well as to the country at large. It is very reassuring to hear about the strength of our nation's economy. I am concerned, however, about the status of our trade imbalance and the effects of illegal foreign trade in my area. While the national economy is performing well, the effects of illegal steel imports is hurting the economy of Southwestern Pennsylvania. In direct violation of international trade law, subsidized steel is being sold below profit in the United States at the expense of the American steelworker. I sense that while the President and others in the administration would like to deal with the unfair trade practices of our trading partners from around the world, they are fearful of doing so concerned about international financial instability. Mr. Chairman, given the strength of our economy, and the need for certain foreign countries to trade with the United States to lift themselves out of recession, doesn't it make sense for the U.S. to press for trade fairness now, particularly in the case of the steel industry? Shouldn't we be negotiating from a position of strength when foreign countries suffering from recession urgently need export markets. Do you not believe we should demand fairness from our trading partners who so desperately need access to our markets, particularly in the case of the steel industry? Mr. Chairman, I commend your effectiveness in helping to guide our economy to its present status of unprecedented growth. I just hope that this economic success does not come at the expense of the American steelworker. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 Questions for Chairman Greenspan: 1. Mr. Chairman, given the strength of our economy, and the need for certain foreign countries to trade with the United States to lift themselves out of recession, doesn't it make sense for the U.S. to press for trade fairness now, particularly in the case of the steel industry? 2. Mr. Chairman, Shouldn't we be negotiating from a position of strength when foreign countries suffering from recession urgently need export markets? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 Statement of Alan Greenspan Chaiiman Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services House of Representatives February 24,1999 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 Mr. Chairman and members of the Committee, I appreciate the opportunity to present the Federal Reserve's semi-annual report on monetary policy. The U.S. economy over the past year again performed admirably. Despite the challenges presented by severe economic downturns in a number of foreign countries and episodic financial turmoil abroad and at home, our real GDP grew about 4 percent for a third straight year. In 1998, 2-3/4 million jobs were created on net, bringing the total increase in payrolls to more than IS million during the current economic expansion, which late last year became the longest in U.S. peacetime history. Unemployment edged down further to a 4-1/4 percent rate, the lowest since 1970. And despite taut labor markets, inflation also fell to its lowest rate in many decades by some broad measures, although a portion of this decline owed to decreases in oil, commodity, and other import prices that are unlikely to be repeated. Hourly labor compensation adjusted for inflation posted further impressive gains. Real compensation gains have been supported by robust advances in labor productivity, which in turn have partly reflected heavy investment in plant and equipment, often embodying innovative technologies. Can this favorable performance be sustained? In many respects the fundamental underpinnings of the recent U.S. economic performance are strong. Flexible markets and the shift to surplus on the books of the federal government are facilitating the build-up in cutting- edge capital stock. That build-up in turn is spawning rapid advances in productivity that are helping to keep inflation well behaved. The new technologies and the optimism of consumers and investors are supporting asset prices and sustaining spending. But, after eight years of economic expansion, the economy appears stretched in a number of dimensions, implying considerable upside and downside risks to the economic outlook. The Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 robust increase of production has been using up our nation's spare labor resources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise questions about whether shares are overvalued. The debt of the household and business sectors has mounted, as has the external debt of the country as a whole, reflecting the deepening current account deficit. We remain vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be transmitted to U.S. markets quickly and traumatically. I will be commenting on many of these issues as I review the developments of the past year and the prospects going forward. In light of all these risks, monetary policy must be ready to move quickly in either direction should we perceive imbalances and distortions developing that could undermine the economic expansion. Recent Developments A hallmark of our economic performance over the past year was the continuing sharp expansion of business investment spending. Competitive global markets and persisting techno- logical advances both spurred the business drive to become more efficient and induced the price declines for many types of new equipment that made capital spending more attractive. Business success in enhancing productivity and the expectation of still further, perhaps accelerated, advances buoyed public optimism about profit prospects, which contributed to another sizable boost in equity prices. Rising household wealth along with strong growth in real income, related to better pay, slower inflation, and expanding job opportunities, boosted consumption at the fastest clip in a decade and a half. The gains in income and wealth last year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 along with a further decrease in mortgage rates, also prompted considerable activity in the housing sector. The impressive performance of the private sector was reflected in a continued improve- ment in the federal budget. Burgeoning receipts, along with continuing restraint on federal spending, produced the first unified budget surplus in thirty years, allowing the Treasury to begin to pay down the federal debt held by the public. This shift in the federal government's fiscal position has fostered an increase in overall national saving as a share of GDP to 17-1/4 percent from the 14-1/2 percent low reached in 1993. This rise in national saving has helped to hold down real interest rates and to facilitate the financing of the boom in private investment spending. Foreign savers have provided an additional source of funds for vigorous domestic investment. The counterpart of our high and rising current account deficit has been ever faster increases in the net indebtedness of U.S. residents to foreigners. The rapid widening of the current account deficit has some disquieting aspects, especially when viewed in a longer-term context. Foreigners presumably will not want to raise indefinitely the share of their portfolios in claims on the United States. Should the sustainability of the buildup of our foreign indebtedness come into question, the exchange value of the dollar may well decline, imparting pressures on prices in the United States. In the recent economic environment, however, the widening of the trade and current account deficits had some beneficial aspects. It provided a safety valve for strong U.S. domestic demand, thereby helping to restrain pressures on U.S. resources. It also cushioned, to some extent, economic weakness in our trading partners. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 Moreover, decreasing import prices, which partly came from the appreciation of the dollar through mid-summer, contributed to low overall U.S. inflation, as did ample manufactur- ing capacity in the United States and lower prices for oil and other commodities stemming from the weak activity abroad. The marked drop in energy prices significantly contributed to the subdued, less than 1 percent, increase in the price index for total persona] consumption expendi- tures during 1998. In addition, supported by rapid accumulation of more efficient capital, the growth of labor productivity picked up last year, allowing nominal labor compensation to post another sizable gain without putting added upward pressure on costs and prices. I shall return to an analysis of the extraordinary performance of inflation later in my remarks. The Federal Open Market Committee conducted monetary policy last year with the aim of sustaining the remarkable combination of economic expansion and low inflation. At its meetings from March to July, the inflation risks accompanying the continued strength of domestic demand and the tightening of labor markets necessitated that the FOMC place itself on heightened inflation alert. Although the FOMC kept the nominal federal funds rate unchanged, it allowed the real funds rate to rise with continuing declines in inflation and, presumably, inflation expectations. In August, the FOMC returned to an unbiased policy predilection in response to the adverse implications for the U.S. outlook of worsening conditions in foreign economies and in global financial markets, including our own. Shortly thereafter, a further deterioration in financial market conditions began to pose a more serious threat to economic stability. In the wake of the Russian crisis and subsequent difficulties in other emerging-market economies, investors perceived that the uncertainties in financial markets had broadened appreciably and as a consequence they became decidedly more Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 risk averse. Safe-haven demands for U.S. Treasury securities intensified at the expense of private debt securities. As a result, quality spreads escalated dramatically, especially for lower- rated issuers. Many financial markets turned illiquid, with wider bid-asked spreads and heightened price volatility, and issuance was disrupted in some private securities markets. Even the liquidity in the market for seasoned issues of U.S. Treasury securities dried up, as investors shifted toward the more actively traded, recently issued securities and dealers pared inventories, fearing that heightened price volatility posed an unacceptable risk to their capital. Responding to losses in foreign financial markets and to pressures from counterparties, highly leveraged investors began to unwind their positions, which further weighed on market conditions. As credit became less available to business borrowers in capital markets, their demands were redirected to commercial banks, which reacted to the enlarged borrowing, and more uncertain business prospects, by tightening their standards and terms on such lending. To cushion the domestic economy from the impact of the increasing weakness in foreign economies and the less accommodative conditions in U.S. financial markets, the FOMC, beginning in late September, undertook three policy casings. By mid-November, the FOMC had reduced the federal funds rate from 5-1/2 percent to 4-3/4 percent These actions were taken to rebalance the risks to the outlook, and, in the event, the markets have recovered appreciably. Our economy has weathered the disturbances with remarkable resilience, though some yield and bid- asked spreads still reflect a hesitancy on the part of market participants to take on risk. The Federal Reserve must continue to evaluate, among other issues, whether the full extent of the policy casings undertaken last fall to address the seizing-up of financial markets remains appropriate as those disturbances abate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 To date, domestic demand and hence employment and output have remained vigorous. Real GDP is estimated to have risen at a annual rate exceeding 5-1/2 percent in the fourth quarter of last year. Although some slowing from this torrid pace is most likely in the first quarter, labor markets remain exceptionally tight and the economy evidently retains a great deal of underlying momentum despite the global economic problems and the still-visible remnants of the earlier financial turmoil in the United States. At the same time, no evidence of any upturn in inflation has, as yet, surfaced. Abroad, the situation is mixed. In some East Asian countries that, in recent years, experienced a loss of investor confidence, a severe currency depreciation, and a deep recession, early signs of stabilization and economic recovery have appeared. This is particularly the case for Korea and Thailand. Authorities in those countries, in the context of IMF stabilization programs, early on established appropriate macroeconomic policies and undertook significant structural reforms to buttress the banking system and repair the finances of the corporate sector. As investor confidence has returned, exchange rates have risen and interest rates have fallen. With persistence and follow-through on reforms, the future of those economies has promise. The situations in some other emerging market economies are not as encouraging. The Russian government's decision in mid-August to suspend payments on its domestic debt and devalue the ruble took markets by surprise. Investor flight exacerbated the collapse of prices in Russian financial markets and led to a sharp depreciation of the ruble. The earlier decline in output gathered momentum, and by late in the year inflation had moved up to a triple-digit annual rate. Russia's stabilization program with the IMF has been on hold since the financial crisis hit, and the economic outlook there remains troubling. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 The Russian financial crisis immediately spilled over to some other countries, hitting Latin America especially hard. Countering downward pressure on the exchange values of the affected currencies, interest rates moved sharply higher, especially in Brazil. As a consequence of the high interest rates and growing economic uncertainty, Brazil's economic activity took a turn for the worse. Higher interest rates also had negative consequences for the fiscal outlook, as much of Brazil's substantial domestic debt effectively carries floating interest rates. With budget reform legislation encountering various setbacks, market confidence waned further and capital outflows from Brazil continued, drawing down foreign currency reserves. Ultimately, the decision was taken to allow the real to float, and it subsequently depreciated sharply. Brazilian authorities must walk a very narrow, difficult path of restoring confidence and keeping inflation contained with monetary policy while dealing with serious fiscal imbalances. Although the situation in Brazil remains uncertain, there has been limited contagion to other countries thus far. Apparently, the slow onset of the crisis has enabled many parties with Brazilian exposures to hedge those positions or allow them to run off. With the net exposure smaller, and increasingly held by those who both recognized the heightened risk and were willing to bear it, some of the elements that might have contributed to further contagion may have been significantly reduced. The Economic Outlook These recent domestic and international developments provide the backdrop for U.S. economic prospects. Our economy's performance should remain solid this year, though likely with a slower pace of economic expansion and a slightly higher rate of overall inflation than last year. The stocks of business equipment, housing, and household durable goods have been Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 growing rapidly to quite high levels relative to business sales or household incomes during the past few years, and some slowing in the growth of spending on these items seems a reasonable prospect. Moreover, part of the rapid increase in spending, especially in the household sector, has resulted from the surge in wealth associated with a runup in equity prices that is unlikely to be repeated. And the purchasing power of income and wealth has been enhanced by declines in oil and other import prices, which also are unlikely to recur this year. Assuming that aggregate demand decelerates, underlying inflation pressures, as captured by core price measures, in all likelihood will not intensify significantly in the year ahead, though the Federal Reserve will need to monitor developments carefully. We perceive stable prices as optimum for economic growth. Both inflation and deflation raise volatility and risks that thwart maximum economic growth. Most Governors and Reserve Bank Presidents foresee that economic growth this year will slow to a 2-1/2 to 3 percent rate. Such growth would keep the unemployment rate about unchanged. The central tendency of the Governors' and Presidents' predictions of CPI inflation is 2 to 2-1/2 percent. This Jevel represents a pickup from last year, when energy prices were falling, but it is in the vicinity of core CPI inflation over the last couple of years. This outlook involves several risks. The continuing downside risk posed by possible economic and financial instability around the world was highlighted earlier this year by the events in Brazil. Although financial contagion elsewhere has been limited to date, more significant knock-on effects in financial markets and in the economies of Brazil's important trading partners, including the United States, are still possible. Moreover, the economies of several of our key industrial trading partners have shown evidence of weakness, which if it deepens could further depress demands for our exports. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 Another downside risk is that growth in capital spending, especially among manufactur- ers, could weaken appreciably if pressures on domestic profit margins mount and capacity utilization drops further. And it remains to be seen whether corporate earnings will disappoint investors, even if the slowing of economic growth is only moderate. Investors appear to have incorporated into current equity price levels both robust profit expectations and low compensa- tion for risk. As the economy slows to a more sustainable pace as expected, profit forecasts could be pared back, which together with a greater sense of vulnerability in business prospects could damp appetites for equities. A downward correction to stock prices, and an associated increase in the cost of equity capital, could compound a slowdown in the growth of capital spending. In addition, a stock market decline would tend to restrain consumption spending through its effect on household net worth. But on the upside, our economy has proven surprisingly robust in recent years. More rapid increases in capital spending, productivity, real wages, and asset prices have combined to boost economic growth far more and far longer than many of us would have anticipated. This "virtuous cycle" has been able to persist because the behavior of inflation also has been surprisingly favorable, remaining well contained at levels of utilization of labor that in the past would have produced accelerating prices. That it has not done so in recent years has been the result of a combination of special one-time factors holding down prices and more lasting changes in the processes determining inflation. Among the temporary factors, the sizable declines in the prices of oil, other internation- ally traded commodities, and other imports contributed directly to holding down inflation last year, and also indirectly by reducing inflation expectations. But these prices are not likely to fall Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 further, and they could begin to rise as some Asian economies revive and the effects of the net depreciation of the dollar since mid-summer are felt more strongly. At the same time, however, recent experience does seem to suggest that the economy has become less inflation prone than in the past, so that the chances of an inflationary breakout arguably are, at least for now, less than they would have been under similar conditions in earlier cycles. Several years ago I suggested that worker insecurity might be an important reason for unusually damped inflation. From the early 1990s through 1996, survey results indicated that workers were becoming much more concerned about being laid off. Workers' underlying fear of technology-driven job obsolescence, and hence willingness to stress job security over wage increases, appeared to have suppressed labor cost pressures despite a reduced unemployment rate. More recently, that effect seems to have diminished in part. So while job loss fears probably contributed to wage and price suppression through 19%, it does not appear that a further heightening of worker insecurity about employment prospects can explain the more recent improved behavior of inflation. Instead, a variety of evidence, anecdotal and otherwise, suggests that the source of recent restrained inflation may be emanating more from employers than from employees. In the current economic setting, businesses sense that they have lost pricing power and generally have been unwilling to raise wages any faster than they can support at current price levels. Firms have evidently concluded that if they try to increase their prices, their competitors will not follow, and they will lose market share and profits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 Given the loss of pricing power, it is not surprising that individual employers resist pay increases. But why has pricing power of late been so delimited. Monetary policy certainly has played a role in constraining the rise in the general level of prices and damping inflation expectations over the 1980s and 1990s, But our current discretionary monetary policy has difficulty anchoring the price level over time in the same way that the gold standard did in the last century. Enhanced opportunities for productive capital investment to hold down costs also may have helped to damp inflation. Through the 1970s and 1980s, firms apparently found it easier and more profitable to seek relief from rising nominal labor costs through price increases than through cost-reducing capital investments. Price relief evidently has not been available in recent years. But relief from cost pressures has. The newer technologies have made capital investment distinctly more profitable, enabling firms to substitute capital for labor far more productively than they would have a decade or two ago. Starting in 1993, capital investment, especially in high-tech equipment, rose sharply beyond normal cyclical experience, apparently the result of expected increases in rates of return on the new investment. Had the profit expectations not been realized, one would have antici- pated outlays to fall back. Instead, their growth accelerated through the remainder of the decade. More direct evidence confirms improved underlying profitability. According to rough estimates, labor and capital productivity has risen significantly during the past five years. It seems likely that the synergies of advances in laser, fiber optic, satellite, and computer technologies with older technologies have enlarged the pool of opportunities to achieve a rate of return above the cost of capital. Moreover, the newer technologies have facilitated a dramatic Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 foreshortening of Ihe lead times on the delivery of capital equipment over the past decade, presumably allowing businesses to react more expediliously to an actual or expected rise in nominal compensation costs than, say, they could have in the 1980s. In addition, the surge in investment not only has restrained costs, it has also increased industrial capacity faster than factory output has risen. The resulting slack in product markets has put greater competitive pressure on businesses to hold down prices, despite laut labor markets. The role of technology in damping inflation is manifest not only in its effects on U.S. productivity and costs, but also through international trade, where technological developments have progressively broken down barriers to cross-border trade. The enhanced competition in tradeable goods has enabled excess capacity previously bottled up in one country to augment worldwide supply and exert restraint on prices in all countries' markets. The resulting price discipline also has constrained nominal wage gains in internationally tradeable goods industries. As workers have attempted to shift to other sectors, gains in nominal wages and increases in prices in nontradeable goods industries have been held down as well. The process of price containment has potentially become, to some extent, self-reinforc- ing. Lower inflation in recent years has altered expectations. Workers no longer believe that escalating gains in nominal wages are needed to reap respectable increases in real wages, and their remaining sense of job insecurity is reinforcing this. Since neither firms nor their competi- tors can count any longer on a general inflationary tendency to validate decisions to raise their own prices, each company feels compelled to concentrate on efforts to hold down costs. The availability of new technology to each company and its rivals affords both the opportunity and the competitive necessity of taking steps to boost productivity. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 It is difficult to judge whether these significant shifts in the market environment in which firms function is sufficient to account for our benign overall price behavior during the past half decade. Undoubtedly, other factors have been at work as well, including those temporary factors I mentioned earlier and some more lasting I have not discussed, such as worldwide deregulation and privatization, and the freeing up of resources previously employed to produce military products that was brought about by the end of the cold war. There also may be other contributory forces lurking unseen in the wings that will only become clear in time. Over the longer run, of course, the actions of the central bank determine the degree of overall liquidity and hence rate of inflation. It is up to us to validate the favorable inflation developments of recent years. Although the pace of productivity increase has picked up in recent years, the extraordi- nary strength of demand has meant that the substitution of capital for labor has not prevented us from rapidly depleting the pool of available workers. This worker depletion constitutes a critical upside risk to the inflation outlook because it presumably cannot continue for very much longer without putting increasing pressure on labor markets and on costs. The number of people willing to work can be usefully defined as the unemployed component of the labor force plus those not actively seeking work, and thus not counted in the labor force, but who nonetheless say they would like a job if they could get one. This pool of potential workers aged 16 to 64 currently numbers about 10 million, or just 5-3/4 percent of that group's population-the lowest such percentage on record, which begins in 1970, and 2-1/2 percentage points below its average over that period. The rapid increase in aggregate demand has generated growth of employment in excess of growth in population, causing the number of potential workers to fall since the mid-1990s at a rate of a bit under 1 million annually. We Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 cannot judge with precision how much further this level can decline without sparking ever greater upward pressures on wages and prices. But, should labor market conditions continue to tighten, there has to be some point at which the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will begin to accelerate. Ranges for Money and Credit At its February meeting, the Committee elected to ratify the provisional ranges for all three aggregates that it had established last July. Specifically, the Committee again has set growth rate ranges over the four quarters of 1999 of 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for domestic nonfinancial debt. As in previous years, the Committee interpreted the ranges for the broader monetary aggregates as benchmarks for what money growth would be under conditions of price stability and sustainable economic growth, assuming historically typical velocity behavior. Last year, these monetary aggregates far overshot the upper bounds of their annual ranges. While nominal GDP growth did exceed the rate likely consistent with sustained price stability, • the rapid growth of M2 and M3 also reflected outsized declines in their velocities, that is, the ratio of nominal GDP to money. M2 velocity dropped by about 3 percent, while M3 velocity plunged by 5-1/4 percent. Part of these velocity declines reflected some reduction in the opportunity cost of holding money; interest rates on Treasury securities, which represent an alternative return on non- monetary assets, dropped more than did the average of interest rates on deposits and money market mutual funds in M2, drawing funds into the aggregate. Even so, much of last year's aberrant behavior of broad money velocity cannot readily be explained by conventional determi- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 nants. Although growth of the broad aggregates was strong earlier in the year, it accelerated in the fourth quarter after credit markets became turbulent. Perhaps robust mouey growth late in the year partly reflected a reaction to this turmoil by the public, who began scrambling for safer and more liquid financial assets. Monetary expansion has moderated so far this year, evidently in lagged response to the calming of financial markets in the autumn. Layered on top of these influences, though, the public also may have been reapportioning their savings flows into money balances because the huge runup in stock prices in recent years has resulted in an uncomfortable portion of their net worth in equity. For the coming year, the broad monetary aggregates could again run high relative to these ranges. To be sure, the decline in the velocities of the broader aggregates this year should abate to some extent, as money demand behavior returns more to normal, and growth in nominal GDP should slow as well, as suggested by the Governors' and Presidents' central tendency. Both factors would restrain broad money expansion relative to last year. Still, the growth of M2 and M3 could well remain outside their price-stability ranges this year. Obviously, considerable uncertainty continues to surround the prospective behavior of monetary velocities and growth rates. Domestic nonfmancial debt seems more likely than the monetary aggregates to grow within its range for this year. Indeed, domestic nonfmancial debt also could grow more slowly this year than last year's 6-1/4 percent, pace, which was in the upper part of its 3 to 7 percent annual range. With the federal budget surplus poised to widen further this year, federal debt should contract even more quickly than last year. And debt in each of the major nonfederal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 sectors in all likelihood will decelerate as well from last year's relatively elevated rates, along with the projected slowing of nominal GDP growth. The FOMC's Disclosure Policy The FOMC at recent meetings has discussed not only the stance of policy, but also when and how it communicates its views of the evolving economic situation to the public. The FOMC's objective is to release as much information about monetary policy decision making, and as promptly, as is consistent with maintaining an effective deliberative process and avoiding roiling markets unnecessarily. Since early 1994, each change in the target nominal federal funds rate has been announced immediately with a brief rationale for the action. The FOMC resolved at its December meeting to take advantage of an available, but unused policy, originally stated in early 1994, of releasing, on an infrequent basis, a statement immediately after some FOMC meetings at which the stance of monetary policy has not been changed. The Federal Reserve will release such a statement when it wishes to communicate to the public a major shift in its views about the balance of risks or the likely direction of future policy. Such an announcement need not be made after every change in the tilt of the directive. Instead, this option would be reserved for situations in which the consensus of the Committee clearly had shifted significantly, though not by enough to change current policy, and in which the absence of an explanation risked misleading markets about the prospects for monetary policy. Year 2000 Issues Before closing, I'd like to address an issue that has been receiving increasing attention— the century date change. While no one can say that the rollover to the year 2000 will be trouble free, I am impressed by the efforts to date to address the problem in the banking and financial Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 system. For our part, the Federal Reserve System has now completed remediation and testing of 101 of its 103 mission-critical applications, with the remaining two to be replaced by the end of March- We opened a test facility in June at which more than 6000 depository institutions to date have conducted tests of their Y2K compliant systems, and we are well along in our risk mitiga- tion and contingency planning activities. As a precautionary measure, the Federal Reserve has acted to increase the currency in inventory by about one-third to approximately $200 billion in late 1999 and has other contingency arrangements available if needed. While we do not expect currency demand to increase dramatically, the Federal Reserve believes it is important for the public to have confidence in the availability of cash in advance of the rollover. As a result of these kinds of activities, I can say with assurance that the Federal Reserve will be ready in both its operations and planning activities for the millennium rollover. The banking industry is also working hard, and with evident success, to prepare for the event. By the end of the first quarter, every institution in the industry will have been subject to two rounds of on-site Y2K examinations. The Federal Reserve, like the other regulators, has found that only a small minority of institutions has fallen behind in their preparations, and those institutions have been targeted for additional follow-up and, as necessary, formal enforcement actions. The overwhelming majority of the industry has made impressive progress in their remediation, testing, and contingency planning efforts. Concluding Comment Americans can justifiably feel proud of their recent economic achievements. Competitive markets, with open irade both domestically and internationally, have kept our production efficient and on the expanding frontier of technological innovation. The determination of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Americans to improve their skills and knowledge has allowed workers to be even more productive, elevating their real earnings. Macroeconomic policies have provided a favorable setting for the public to take greatest advantage of opportunities to improve its economic well being. The restrained fiscal policy of the Administration and the Congress has engendered the welcome advent of a unified budget surplus, freeing up funds for capital investment. A continua- tion of responsible fiscal and, we trust, monetary policies should afford Americans the opportu- nity to make considerable further economic progress over time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 Chairman Greenspan's responses to written questions from Chairman Leach following February 24, 1999, hearing on the conduct of monetary policy: Overview Q.I. In your testimony, you noted that "the Federal Reserve must continue to evaluate, among other issues, whether the full extent of policy casings undertaken last fall to address the seizing-up of financial markets remains appropriate as those disturbances abate." In reaction to this statement, several financial analysts have suggested that an important precedent for considering FOMC policy settings in a post-crisis climate is the Federal Reserve's reaction to the stock market crash of October 1987. Is the comparison between 1987 and the current situation valid? Why or why not? A. 1. The conduct of monetary policy inevitably requires ongoing consideration of the special circumstances prevailing at any point in time and of the confluence of forces that are acting on the economy. More often than not, there are significant differences in the economic environment over time that limit the comparability of the situations faced by policymakers. Consequently, it would be a mistake to draw strong parallels between our current circumstances and those that existed in 1987. As you know, monetary policy was eased considerably in the wake of the sharp decline of the stock market in October 1987. An important motivation for these casings was me need to provide ample liquidity to ensure the smooth functioning of financial markets in response to serious market dislocations. In addition, the FOMC faced considerable uncertainty about the underlying-strength of the economy at the time and the extent of any curtailment in activity that would ensue following the stock market break. The federal funds rate was reduced in several steps between October 1987 and February 1988. By the spring of 1988, with the economy showing signs of marked strength accompanied by a pick up of inflation that threatened to derail the expansion, me FOMC began to tighten policy. Although there are same similarities, recent circumstances differ considerably from those of the 1987-88 period. Most notably, the implications for the U.S. economy of the weakness of foreign economies and the fragility of foreign financial markets—along with the less accommodative conditions in domestic financial markets—were prominent considerations in the easing of policy that occurred this fall. We shall, of course, continue to monitor these developments in setting the course of monetary policy. Q.2. A recent lead editorial in the Economist warns about the growing danger of deflation. According to the editorial, while G-7 policymakers have enjoyed great success over the last 20 years, reducing inflation to the lowest in half a century at a mere I %, monetary policy in the industrial economies looks "dangerously tight." The editorial warns that "If the economies of America or Europe were now to take a sodden hirch Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 downwards, the world might easily experience outright depression, with prices and output falling together, just as they did 70 years ago." Is the Economist right? Please comment. A.2. The current global economic situation certainly involves some risks. Many economies are experiencing significant restraints on their expansion, stemming in part from spillover effects of the financial developments over the past eighteen months or so that have adversely affected a number of emerging market economies. Although these developments have also affected U.S. markets, our economy remains fundamentally healthy, with weakness in net exports more than offset by strong domestic demand. Indeed, as I noted in my Humphrey-Hawkins testimony, the upside risks to inflation in the United Slates are not negligible, especially in view of increasingly tight conditions in labor markets. In other western industrial countries, monetary authorities are well aware of the evidence of slackening demand and have adjusted the stance of their monetary policies in response. The situation in Japan, however, remains a significant concern. I am confident that officials in the other G-7 countries are prepared to take the necessary measures to guard against a sharp economic downturn that could develop into world depression. Q.3. Based on the failure of the Brazilian financial crisis to trigger the all too familiar signs of cross-border contagion, is it fair to say that we are witnessing the beginning of the end of the global currency crisis of the last 19 months? A.3. Brazil's difficulties over the past several months have, in fact, precipitated some signs of cross-border contagion, but it is true that they have been muted, and, to date, reasonably well contained. Although Brazil has continued to work constructively with the IMF and its creditors, there is much left to do before anyone would want to say that the adjustment process in Brazil is complete, and it would seem to be premature to declare even a limited victory, let alone the beginning of the end of the global currency crisis. One factor contributing to the relatively subdued cross-border spillovers from Brazil's problems (so far) might be that the crisis was fairly long in developing. Thus, at least some market participants may have had time to take defensive postures and to make adjustments to their investment positions. The relatively mild reaction on international financial markets to the Brazilian difficulties to date has certainly been welcome, but significant downside risks remain. The U.S. authorities, in cooperation with the IMF and other members of the official international community, will continue to work with the Brazilians, and, at the same time, seek to contain any further cross-border contagion effects. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 Q.4. How fragile is the situation in Brazil? Can Brazil establish a new post-real plan anchor for monetary policy without exacerbating its public debt-a& some 70% of domestic public debt is linked to short-term interest rates? A.4. As suggested in the answer to the preceding question, the economic and financial situation in Brazil remains quite fragile. The Brazilian government has revised and strengthened its economic adjustment program with the IMF. Brazilian authorities will need to follow through and implement this program fully, including a primary budget surplus in excess of 3 percent of GDP this year. With the currency having been allowed to float, monetary policy must be aimed at keeping inflation under control. To contain the inflationary effects of the recent sharp depreciation of the real and to regain the confidence of international investors, interest rates must be kept elevated for a time. In the longer term, assuming Brazil meets its stated goals with respect to the primary surplus, a sustainable fiscal position (declining debt/GDP ratio) can be achieved if the real interest rate (i.e., the nominal rate minus expected inflation) recedes to around 10 percent or less. If inflation is contained and confidence is regained via a steady hand on the tiller of Brazil's economic policies, nominal interest rates should begin to fall as the inflationary effect of the depreciation diminishes over time. The new leadership team at the Central Bank of Brazil is off to a promising start, but the challenges it faces over the period ahead are considerable. Q.5. In testimony before this Committee last year, you stated in effect mat the U.S. needed to support the IMF because it was the best mechanism we have for international financial crisis management. But you also indicated that after the crisis had passed the role of the IMF and our other institutional pillars of the global financial system needed fundamental review. Are you satisfied with the pace and scope of that reform? A.5. There is an ongoing process in various fora through which the role of the IMF is being assessed. At this time, I am satisfied with the pace and scope of the assessment process, but it will be some time before it is appropriate to make final judgments. The review of the IMF is taking place, even though it may be premature to declare the passing of international financial crises. Q. 6. The development of electronic commerce seems likely to transform banking and finance as we know it. Without the ability to electronically transfer value through electronic payments, electronic commerce might amount to little more than computerized window shopping. In this context, does the Federal Reserve or any other federal banking agency "regulate" emerging retail electronic payment systems? Please explain. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 A.6. Electronic commerce has been growing rapidly. To date, consumers appear to be relying heavily on credit cards to pay for transactions. Other payment instruments for use in electronic commerce are in various stages of development with mixed results so far. The Federal Reserve has encouraged experimentation with new electronic means of payment to meet the needs of the rapidly changing market for electronic commerce, and to improve the efficiency of the U.S. payment system more generally. Whether the Federal Reserve or another federal banking agency would have regulatory authority over one or more aspects of an emerging retail payment system would need to be determined on a case- by-case basis in view of the design of the system, its relationship to federally regulated entities, and the subject matter to be regulated. More broadly, no federal banking agency has overall authority with respect to emerging private-sector payments systems, as such, and it is by no means clear that establishing such overall authority at this time would be likely to promote the continuing innovation that will be needed to support the growth of electronic commerce. For the time being, we believe that regulatory efforts with respect to electronic commerce should focus on removing unnecessary impediments to innovation that are frequently based on outmoded technological assumptions. Q.7. As retail electronic payment systems evolve, nonbanks may become significantly more involved in payment system operations than they are today. How would this development affect the Federal Reserve's role as the central bank for settlement of interbank payments? Likewise, how might it affect the efficiency, reliability, and accessibility of payments systems as a whole? A.7. Nonbanks currently provide a variety of payment and payment-related services to banks, businesses, and consumers. Increased competition between banks and nonbanks in the development and provision of retail payment services, as well as increased cooperation in some instances, appears to have served as a major spur to innovative activity. The result of this activity likely will be to increase the efficiency, reliability, and accessibility of the U.S. payment system over the long term. It is not yet clear how these new developments will affect the role of the Federal Reserve in interbank settlements for retail payments. Although the role of nonbanks in retail payment systems may grow, it is also likely that settlements for systems involving nonbanks will take place through the banking system, possibly on a net basis. These settlements, like many current settlements, are also likely to rely on central bank payment or net settlement services in order to ensure timely and final settlement. In this regard, the need to develop market confidence in new payment systems may cause these systems to be particularly aware of the benefits of efficient and reliable settlement services, such as those provided by the Federal Reserve. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 Q.8. Three years ago the G-10 issued a report on the implications of electronic commerce for banking and finance, as well as the conduct of monetary policy. It concluded that the new forms of payments systems and technologies-stored value products, digital cash, and the like-presently posed no threat to the ability of central banks to control the money supply. Is this still your view? Why or why not? A.8. We continue to believe that electronic money poses little threat to the ability of central banks to conduct monetary policy. In general, central banks conduct monetary policy by affecting conditions in the market for bank reserves and thus influencing short- term interest rates. Significant adverse effects of electronic money on monetary control could come about only if electronic money severely eroded the reserve base or otherwise significantly reduced the ability of central banks to predict the demand for reserves or affect the supply of reserves. The experience with electronic money to date suggests little likelihood that electronic money will become popular enough over the next few years to have a significant effect on conditions in bank reserve markets. International Financial Issues Q.9. The advent of the euro as a major new currency has invited a great deal of hype and speculation about the prospects for the currency, as well as its impact on the dollar and international financial markets. In general, how do you assess the current and prospective impact of the euro? A.9. Since the advent of monetary union in Europe at the beginning of this year, the dollar has appreciated roughly 8 percent against the new euro currency. The dollar's near term appreciation appears to have resulted largely from diminished prospects for growth in continental Europe juxtaposed with continued strong performance of the U.S. economy. Thus, the behavior of the foreign exchange value of the euro since its introduction could be said to have resulted primarily from differences in the phase of economic cycles across countries. Over the longer term, in light of the similarity in the economic size of the euro area and the United States and in light of the continued development of financial markets in the euro zone, it is likely that the euro will begin to surpass the German mark in terms of its importance in world financial circles. The euro may begin to rival the dollar to some extent as a currency for holding official reserves, invoicing transactions, and other activities typically associated with a currency's international status. However, it is unlikely that the dollar's international currency status would diminish very rapidly, as currency preferences typically are characterized by a good deal of inertia. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Q. 10. It appears likely that Japan will set a record for the longest and most severe recession to occur in any industrial country since the Great Depression. The outlook for Japan is poor because it is suffering from overlapping crises in the banking system, corporate profitability, wobbly pension funds, and a growing fiscal deficit which have in turn weakened consumer confidence and caused a rise in personal savings. Given these difficulties, can Japan return to sustainable growth without undertaking bold economic adjustments at odds with its consensus-based society? A. 10. Japanese GDP has now contracted for five consecutive quarters and is down over 5 percent from its most recent peak during die first quarter of 1997. It is evident that the implementation of deep structural reforms will be necessary to increase the efficiency of the Japanese economy and, thus, to pave the way for a return to domestic-demand led growth. High on the list of needed structural reforms are a restructuring of the banking system, freeing up and adding liquidity to the real estate market, reducing the extent of government regulation in many sectors, and making the economy more open to international trade and competition. Such reforms may be politically divisive-and may require a painful period of transition-but they would appear to be the only way to increase the economy's productive capacity in the medium- to long-run. Q.ll. As you know, many Asian officials feel tremendous frustration about the dramatic financial upheavals which have occurred in the region during the past year. Some officials in Hong Kong and Malaysia have blamed collusive activity on the part of hedge funds and investment banks for "speculative" attacks on their currencies. Are you aware of any credible evidence to substantiate the charge that attacks on the Hong Kong dollar last fall were die result of a coordinated attack by speculators? A. 11. When Hong Kong's currency peg came under pressure last August, some Hong Kong authorities attributed the pressure to a so-called "double-play" by speculators who simultaneously shorted the stock market and the currency in the hopes that the currency attack would force interest rates upwards and die stock market down. However, we are not aware of any evidence that speculators (hedge funds or investment banks in particular) acted collusively to make a coordinated attack on the Hong Kong dollar last fall. At times of substantial exchange market pressure, such as Hong Kong experienced last fall, trading volume is usually very large and there are typically a wide range of different types of market participants with often differing interests involved. Under such conditions, groups of market participants may move in similar directions without in any way colluding or deliberately coordinating their actions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 Q.12. I understand that the G-7 recently announced the creation of a new financial and stability forum designed to improve the coordination and monitoring of international financial crises. Can you tell the Committee more about the purpose and structure of the new body? A.12. The new body—the Financial Stability Forum-will be comprised of representatives from national authorities responsible for financial stability (including finance ministries, central banks, and financial sector supervisory and regulatory authorities), relevant international financial institutions and organizations (the IMF, the World Bank and the OECD), and various international supervisory bodies such as the Basle Committee. Initially, the Forum will be the initiative of the G-7 countries, but over time additional national authorities will be included to broaden participation. The first chairman will be Mr. Andrew Crockett, General Manager of the Bank for International Settlements, for a term of three years. The purpose of the new forum will be to contribute to improved international financial stability and to reduced systemic risk by enhancing international coordination and cooperation among the various official entities and expert groupings that participate in financial market supervision and surveillance. Q. 13. In past testimony before this Committee, you have described excessive reliance on interbank funding as the "Achilles' heel" of the international financial system. Among the proposals to rectify this problem are basing capital requirements for banks on their liabilities as well as assets, or by imposing reserve requirements on interbank liabilities. What is the preferred approach to addressing this problem? A.13. I continue to believe that we should consider possible measures to impose added discipline on interbank markets to reduce the risk of serious disruptions to financial markets. Indeed, this line of thought has been incorporated into and has gone forward with a general reconsideration of the Basle Accord designed to increase the risk-sensitivity of the capital regulations, as part of a more general effort to improve banks' risk manage- ment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 Q. 14. As you know, there has been a growing debate about various exchange rate regimes and which in general appear most appropriate. I gather there is a developing consensus that fixed exchange rates, like Argentina and Hong Kong, as well as floating rates, such as that used by the U.S., tend to work relatively well. On the other hand, so called "target zones" or adjustable pegs-like Brazil's ultimately unsuccessful real plan -- may work less well. Could you reflect on these issues for the Committee? • In particular, if adjustable pegs tend not to be sustainable in today's global economy, please explain why it would have been appropriate for the U.S. and IMF to commit billions of dollars in support of such a regime? A. 14. Exchange rate changes provide one mechanism through which economies can adjust to internal and external economic developments. In floating exchange rate arrangements, like that of the United States, exchange rates absorb a share of the adjustments, along with domestic interest rates, prices, incomes, and economic activity. In exchange rate arrangements like those of Argentina and Hong Kong, monetary policy is devoted rigidly to maintaining exchange rate pegs. In essence, these economies have essentially foresworn exchange rate adjustment and, as a consequence, have shifted the full burden of adjustment to domestic interest rates, prices, incomes, and economic activity. Intermediate exchange rate arrangements, like adjustable pegs, permit exchange rates to absorb the burden of adjustment only at the time pegs are adjusted. Because under these regimes the adjustment is often deferred too long, the ultimate adjustment often occurs under duress after a period in which the domestic monetary authorities attempt to defend the peg with sales of foreign currency reserves and high domestic interest rates. The United States has committed billions of dollars not to support any particular exchange rate regime but to foster a more orderly adjustment of policies in certain countries and to prevent the financial market turbulence centered in those economies from spilling over to the United States and our major trading partners. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 Chairman Greenspan's responses to written questions from Representative Barbara Lee following February 24, 1999, hearing on the conduct of monetary policy: Q.I. As you know. Chairman Greenspan, the banks in our country often respond to any changes the Federal Reserve makes in their monetary policy-when they raise or lower the federal funds rate-by immediately changing the prime rate. That appears to be a politically correct move of well covered changes in interest rates. However, in the 1990's the banks have not always responded to falling market rates by lowering the prime rate. The difference between the prime rate and a comparable short term interest rate—the 3-month commercial paper rate—is now nearly 3 percentage points. This big spread has not occurred since 1980 when the prime rate went to near 20 percent. Millions of consumers who have credit cards, small business owners, and people widi variable rate mortgages which are tied to the prime rate are not benefiting from the present lower interest rates. Experts, such as Professor Robert Auerbach of the LBJ School of Public Affairs who was on the Committee's staff for 11 years, say that the prime rate system of pricing is a form of price discrimination which injures consumers and small business owners. WHAT IS THE FEDERAL RESERVE DOING ABOUT THIS UNFAIR METHOD OF PRICING LOANS? WHAT EVIDENCE DO YOU HAVE THAT THE RISK IS GETTING WORSE TO JUSTIFY THE DIFFERENCE NOW? A. 1. The level of the prime rate appears to reflect changes in the nature of prime- based loans. The prime rate is no longer commonly used as the base rate for loans to large, highly creditworthy businesses. Instead, it is more likely to be the base rate for loans to smaller businesses or to households. Because of their relatively small size, these loans may be more costly to make, per dollar loaned, and they also may involve a higher degree of risk. As a result, the prime rate may reflect the higher rates warranted by the loans that now have rates tied to prime. In any case, the prime rate does not appear to be a constraint on competition in the loan market. Some banks-generally smaller ones- establish prime rates that differ from the prevailing prime rate. More importantly, banks can and do compete aggressively on the spreads of loan rates over the prime rate and also on other loan terms. Indeed, rates on prime-based business loans vary over a wide range, In addition, the average amount by which the rates on prime-based loans exceed the prime rate has declined considerably in recent years, from between 1 and 1-1/2 percentage points Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 in the late 1980s to less than 1/2 percentage point most recently, and so the wider spread of the prime rate over market rates does not necessarily indicate relatively more costly credit. At the same time, the share of business loans extended at rates tied to prime has declined, as the share of middle-market loans tied to market rates has increased. Q.2. Chairman Greenspan, the news summaries of your testimony yesterday before Senate Banking indicated that you thought lowering interest rates last year might have been a bad idea. Bloomberg news reported: "Greenspan shook the bond traders by acknowledging there's some question about whether the three rate cuts made late last year remain "appropriate" now that global markets have calmed. He also said there's "no evidence of any upturn in inflation." Since there is approximately zero domestic inflation it is assumed that your main concern is that stock market prices are higher than can be justified by expected profits. If this is correct, would the Federal Reserve be justified in tightening monetary policy even if a rise in domestic interest rates might start a domestic downturn and cause an increased drain of capital from countries around the world which are experiencing depression conditions? A.2. The Federal Reserve eased monetary policy on three occasions last autumn to cushion the domestic economy from the effects of increasing weakness in foreign economies and less accommodative conditions in U.S. financial markets. Our economy has continued to perform we]! since the autumn, and financial market uncertainties have ebbed. Thus, the Federal Reserve, as part of its policymaking process, will need to continue to evaluate whether the easing last fall remains appropriate in light of current conditions. In doing so, the Federal Reserve will have to assess the risks to the expansion. In evaluating these risks and setting monetary policy, the Federal Reserve will endeavor to sustain the current expansion by heading off possible imbalances in either direction that could put continued economic growth at risk. Stock prices enter this process through their effects on spending by households and firms. Any change in the stance of policy will be keyed to the performance of the economy, not the level of equity prices. Q.3. Chairman Greenspan, you have repeatedly warned over the last couple of years that a tight labor market would drive up prices. Even though many Americans have prospered in the recent period large segments of the country still suffer from low pay and unemployment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 We don't even know the extent of these unemployment problems because we have not had adequate sampling surveys by the government of the people who are not included in the Labor Department's monthly survey of unemployed because they have no phone or permanent residence. In formulating the nation's monetary policy and the condition of the labor market, how will you take into account these problems? What guidelines will you use to determine if the labor market is tight and the Federal Reserve has to resort to a tighter monetary policy to prevent inflation? A. 3. One goal of monetary policy is to maintain the growth of the economy at a sustainable level. The unemployment rate is one piece of information employed to evaluate the likely pressures on the economy's productive potential going forward, but many other variables also contribute to that evaluation. I have testified to the Congress several times on the importance of potential workers not counted in the labor force but available to work. Because these sorts of measurement issues are common, the Federal Reserve evaluates a wide variety of economic and financial indicators when formulating monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 Chairman Greenspan's response to a written question from Representative Doug Ose following February 24, 1999, hearing on the conduct of monetary policy: Q. 1. Chairman Greenspan, my concern continues to be the efficient allocation of capital. With respect to our fiscal policy, does our continued funding of IMF with respect to countries such as Russia or Indonesia positively or negatively influence the allocation of capital? If the influence is negative, is there some means of making the influence positive? A.I. Economists often reason that the return to capital has the potential of being higher in developing countries or countries in transition since capital tends to be scarce in those economies relative to advanced economies like the United States. While in theory this is correct, in practice it depends on whether the capital is employed efficiently in the capita] importing country. Countries such as Russia and Indonesia have the potential to employ capital efficiently. In order to do so, these economies must pursue prudent macroeconomic policies, pursue structural reforms, and have stable legal and political systems. The pursuit of such policies is primarily the responsibility of the countries themselves. On balance, I think it is helpful to have organizations like the IMF and the World Bank providing advice and resources to countries that are attempting to create an environment where capital has the potential to be employed efficiently. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 For use at 10:00 a.m., E.S.T, Tuesday February 23, 1999 Board of Governors of the Federal Reserve System ''?*4'' Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 23, 1999 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C.. February 23. 1999 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 ttie Congress, pursuant to the Full Employment and Balanced Growth Act ot 1978. Sincerely, Alan Greenspan, Chairman Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 Table of Contents Monetary Policy and the Economic Outlook Economic and Financial Developments in 1998 and Early 1999 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 Monetary Policy Report to the Congress Report submitted la the Congress on February 23, The Russian crisis in mid-August precipitated a 1999, pursuant to the Full Employment and Balanced period of unusual volatility in world financial mar- Growth Ac! of 1978 kets. The losses incurred in Russia and in other emerging market economies heightened investors' MONETARY POLICY AND THE and lenders' concerns about other potential problems ECONOMIC OUTLOOK and led them to become substantially more cautious about taking on risk. The resulting effects on U.S. In 1998. the US. economy again performed impres- financial markets included a substantial widening of sively. Output expanded rapidly, the unemployment risk spreads on debt instruments, a jump in measures rale fell to the lowest level since 1970. and inflation of market uncertainty and volatility, a drop in equity remained subdued. Transitory factors, most recently prices, and a reduction in the liquidity of many mar- falling prices for imports and commodities, espe- kets. To cushion the U.S. economy from Ihe effects of cially oil, have helped to produce the favorable out- these financial strains, and potentially to help reduce comes of recent years, but technological advances the strains as well, the Federal Reserve eased mone- and increased efficient)', likely reflecting in pan tary policy on three occasions in the fall. Global heightened global competition and changes in busi- financial market stresses lessened somewhat after ness practices, suggest thai some of the improvement mid-autumn, reflecting, in pan, these polity steps as will be more lasting. well as interest rate cuts in other industrial countries Sound fiscal and monetary policies have contrib- and international efforts to provide support to uted importantly to the good economic results: Bud- troubled emerging market economies. Although some getary restraint at the federal level has bolstered U.S. financial flows were disrupted for a time, most national saving and permitted the Federal Reserve ID firms and households remained able to obtain suffi- maintain lower interest rates than would otherwise cient credit, and the turbulence did not appear to have been possible. This policy mix and sustained constrain spending to a significant degree. More progress toward price stability have fostered clearer recently, some markets were unsettled by the devalu- price signals, more efficient resource use, robust busi- ation and subsequent floating of the Brazilian real in ness investment, and suable advances in the produc- mid-January, and the problems in Brazil continue to tivity of labor and in ihe real wages of workers. The pose risks to global markets. Thus far, however, more rapid expansion of productive potential has, in market reaction outside Brazil to that country's diffi- turn, helped to keep inflation low even as aggregate culties has been relatively muted. demand has been surging and as labor markets have The foreign exchange value of ihe dollar rose tightened. substantially against the currencies of the major for- This past year, economic troubles abroad posed a eign industrial countries over the first eight months of significant threat to the performance of the economy. 1998, but subsequently it fell sharply, ending the year Foreign economic growth slowed markedly, on aver- down a litlle on net. The appreciaiion of the dollar in age, as conditions in many countries deteriorated. the first half of the year carried it to an eight-year The recession in Japan deepened, and several emerg- high against the Japanese yen. In June, this strength ing market economies in Asia, which had started to against the yen prompted the first US. foreign weaken in the wake of the financial crises of 1997, exchange intervention operation in nearly three years, contracted sharply. A worsening economic situation an action that appeared to slow the dollar's rise in Russia last summer led to a devaluation of the against the yen over the following days and weeks. ruble and a moratorium by that country on a substan- Later in the summer, concerns about the possible lial portion of its debt payments. As the year pro- impact on the U.S. economy of increasing difficulties gressed, conditions in Latin America also weakened. in Latin America began to weigh on the dollar's Allhough some of the troubled foreign economies are exchange value against major foreign currencies. showing signs of improvement, others either are not After peaking in mid-August, it fell sharply over the yet in recovery or are still contracting. course of several weeks, reversing by mid-October Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 Monetary Policy Report to the Congress D February 1999 the appreciation that had occurred earlier in the year. lower-rated borrowers. All told, household and busi- The depreciation during this period was particularly ness outlays rose even more rapidly than in 1997, and sharp against the yen. The reasons for this decline that acceleration kept the growth of real GDP strong against the yen are not clear, but repayment of yen- even as net exports were slumping. denominated loans by international investors and Deteriorating economic conditions abroad, coupled decisions by Japanese investors to repatriate their with the strength of the dollar over the first eight assets in light of increased volatility in global mar- months of the year, helped to hold down inflation in kets seem to have contributed. The exchange value the United States by trimming the prices of oil and of the dollar fluctuated moderately against the major other imports. These declines reduced both the prices currencies over the rest of the year, and after declin- paid by consumers and the costs of production in ing somewhat early in 1999. it has rebounded many lines of business, and the competition from strongly in recent weeks, as incoming data have abroad kept businesses from raising prices as much suggested continued strength of economic activity in as they might have otherwise. As the result of a the United Stales. Since the end of 1998, the dollar reduced rate of price inflation, workers enjoyed a has appreciated about 7 percent against the yen, larger rise in real purchasing power even as increases partly reflecting further monetary easing in Japan. At in nominal hourly compensation picked up only the turn of the year, the launch of the third stage of slightly on average. Because of increased gains in European Economic and Monetary Union fixed the productivity, corporations in the aggregate were able eleven participating countries' conversion rates and to absorb the larger real pay increases without suffer- created a new common currency, the euro. The dollar ing a serious diminution of profitability. has appreciated more than 5 percent against the euro, in part because of signs that growth has slowed recently in some euro-area economies. Monetary Policy, Financial Markets, With the U.S. economy expanding rapidly, the and the Economy over 1998 and Early J999 economies of many U.S. trading partners struggling, and the foreign exchange value of the dollar having Monetary policy in 1998 needed to balance two major risen over 1997 and the first part of 1998, the U.S. risks to the economic expansion. On the one hand, trade deficit widened considerably last year. Some with the domestic economy displaying considerable domestic industries were especially affected by momentum and labor markets tight, the Federal Open reductions in foreign demand or by increased com- Market Committee (FOMC) was concerned about the petition from imports. For example, a wide range of possible emergence of imbalances that would lead to commodity producers, notably those in agriculture, higher inflation and thereby, eventually, put the sus- oil, and metals, experienced sharp price declines. tainability of the expansion at risk. On the other hand, Pans of the manufacturing sector also suffered troubles in many foreign economies and resulting adverse consequences from the shocks from abroad. financial turmoil both abroad and at home seemed, at Overall, real net exports deteriorated sharply, as times, to raise the risk of an excessive weakening of exports stagnated and imports continued to surge. aggregate demand. The deterioration was particularly marked in the Over the first seven months of the year, neither of first half of the year; the second half brought a these potential tendencies was sufficiently dominant further, more modest, net widening of the external to prompt a policy action by the FOMC. Although deficit. the incoming data gave no evidence of a sustained Meanwhile, domestic spending continued to slowing of output growth, the Committee rnembers advance rapidly. Household expenditures were bol- believed that the pace of expansion likely would stered by gains in real income and a further rise moderate as businesses began to slow the rapid rates in wealth, while a low cost of capital and optimism at which they had been adding to their stocks of about future profitability spurred businesses to invest inventories and other investment goods, and as heavily in new capital equipment. Although securi- households trimmed the large advances in their ties markets were disrupted in late summer and early spending on consumer durables and homes. Rela- fall, credit generally remained available from alterna- tively firm real interest rates, buoyed by a high real tive sources. Once the strains on securities markets federal funds rate resulting from the decline in the had eased, businesses and households generally had level of expected inflation, were thought likely to ready access to credit and other sources of finance on help restrain the growth of spending by businesses relatively favorable terms, although spreads in some and households. Another check on growth was markets remained quite elevated, especially for expected to come from the effects on imports and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 Board of Governors of the Federal Reserve System Selected interest rates Thiny-yar TRMO) Five-par Treunry ^™ \ Thm-moddi Tmury DiKouMnu (Mendedfedcnl ta&rale I il I I NOTE. The <ta n <Wty. Venial lino irtwe 4« ifayi M vfekfe Ac m uii« tew an whkt after OB FOMC bdd i KfcaMal neon; < nitid Hi mi ••inn ill i «u i in In j jinlir] mini Til il»tii m «ir liiiiinn JB*CJ nan m namaced. L«n ofctmakM » to Febnury 19.1994. exports of the economic difficulties in emerging mar- difficulties had been weighing on U.S. asset markets: ket economies in Asia and elsewhere. Indeed, produc- Stock prices had fallen sharply in late July and into tion in the manufacturing sector slowed substantially August as investors became concerned about the in the first half of the year, and capacity utilization outlook for profits, and risk spreads in debt markets dropped noticeably. Moreover, inflation remained had widened, albeit from very low levels. Taking subdued, and a pickup was not expected in the near- account of these circumstances, the Committee again to-intermediate term because of declining oil prices, left monetary policy unchanged at the August meet- and because of economic weakness abroad and the ing, but it shifted to a symmetric directive, reflecting appreciation of the dollar, which were expected to its perception that the risks to the economic outlook, trim the prices of imported goods and to increase at prevailing short-term rates, had become roughly price competition for many U.S. producers. None- balanced. theless, with labor markets already quite taut and Over subsequent weeks, conditions in financial aggregate demand growing rapidly—a combination markets and the economic outlook in many foreign that often has signaled the impending buildup of countries deteriorated further, increasing the dangers inflationary pressures—the Committee, at its meet- to the U.S. expansion. With investors around the ings from March through July, judged conditions to world apparently reevaluating the risks associated be such that, if a policy action were to be taken in the with various credits and seemingly becoming less period immediately ahead, it more likely would be a willing or able to bear such risks, asset demands tightening than an easing; its directives to the shifted toward safer and more liquid instruments. Account Manager of the Domestic Trading Desk at These shifts caused a sharp fall in yields on Treasury the Federal Reserve Bank of New York noted that securities. Spreads of yields on private debt securities asymmetry. over those on comparable Treasury instruments By the time of the August FOMC meeting, how- widened considerably further, and issuance slowed ever, the situation was changing. Although tight labor sharply. Measures of market volatility increased, markets and rapid output growth continued to pose and liquidity in many financial markets was curtailed. a risk of higher inflation, the damping influence of Equity prices continued to slide tower, with most foreign economic developments on the U.S. economy broad indexes falling back by early September to seemed likely to increase. The contraction in the near their levels at the start of the year. Reflecting the emerging market economies in Asia appeared to be weaker and more uncertain economic outlook, some deeper than had been anticipated, and the economic banks boosted interest rate spreads and fees on new situation in Japan had deteriorated. Financial markets loans to businesses and tightened their underwriting in some foreign economics also had experienced standards. greater turmoil, and, the day before the Committee Against this backdrop, at its September meeting met, Russia was forced to devalue the ruble. These the FOMC looked beyond incoming data suggesting Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 Monetary Policy Report 10 ihe Congress D February 1999 that the economy was continuing 10 expand at a bringing the total reduction during the autumn to robust pace, and it lowered the intended level of the Vt percentage point. The Board of Governors also federal funds rate Vt percentage poini. The Commit- approved a second '/* percentage point cut in the tee noted that the rate cut would cushion the effects discount rate. The Committee believed that, with this on prospective U.S. economic growth of increasing policy action, financial conditions could reasonably weakness in foreign economies and of less accommo- be expected to be consistent with fostering sustained dative conditions in domestic financial markets. The economic expansion while keeping inflationary pres- directive adopted at the meeting suggested a bias sures subdued. The action provided some insurance toward further easing over the iniermeeting period. In against an unexpectedly severe weakening of the the days following the policy move, disturbances in expansion, and the Committee therefore established a financial markets worsened. Movements in the prices symmetrical directive. By the time of the December of securities were exacerbated by a deterioration meeting, the situation in financial markets had in market liquidity, as some securities dealers cut changed little, on balance, and Ihe Committee back on their market-making activities, and by the decided that no further change in rates was desirable expected unwinding of positions by hedge funds and and that the directive should remain symmetrical. other leveraged investors. In early October, Treasury Some measures of financial volatility eased further yields briefly tumbled to their lowest levels in many in the new year, although risk spreads on corporate years, reflecting efforts by investors to exchange bonds remained at quite high levels. Yields on Trea- other instruments for riskless and liquid Treasury sury securities were about Mat, on balance, in Janu- securities. ary, as the effect of stronger-lh an -expected economic Although some measures of market turbulence had growth appeared to be about offset by data suggesting begun to ease a bit by mid-October, financial markets that inflation remained quiescent and perhaps also by remained extremely volatile and risk spreads were the effects of some safe-haven flows prompted by very wide. On October 15, consistent with the direc- the deteriorating situation in Brazil. Over the same tive from the September meeting, the intended fed- period, stock prices surged higher, led by computer eral funds rate was trimmed another 14 percentage and other technology shares, and most slock price point, to 5 percent. This policy move, which occurred indexes posted new highs. By the time of the Feb- between FOMC meetings, came at the initiative ruary 2-3 meeting, financial markets were easily of Chairman Greenspan and followed a conference accommodating robust demands for credit, and eco- call with Committee members. At the same time, nomic activity seemed to have more momentum than the Board of Governors approved a L/4 percent- many had anticipated. However, the foreign sector age point reduction in the discount rate. These continued to pose a threat lo U.S. growth going actions were taken to buffer the domestic economy forward, inflation showed no signs of picking up firora the impact of the less accommodative condi- despite Ihe rapid pace of growth and the very tight tions in domestic financial markets, in pan by con- labor market, and some slowing of economic growth tributing to some stabilization of the global financial remained a likely prospect. In these circumstances, situation. the FOMC concluded that it was prudent to wait for Following the October policy move, strains in further information, and it left policy unchanged. domestic financial markets diminished considerably. As safe-haven demands for Treasury securities ebbed. Treasury yields generally trended higher, and mea- Economic Projections for 1999 sures of financial market volatility and illiquid!ty eased. Nonetheless, risk spreads remained very wide, By and large, the members of the Board of Governors and liquidity in many markets continued to be lim- and the Federal Reserve Bank presidents, all ited. Moreover, although pressures on some emerging of whom participate in the deliberations of the market economies had receded a bit, partly reflecting FOMC, expect the economy to expand moderately, concerted international efforts to provide assistance on average, in 1999. The central tendency of the to Brazil, the foreign economic outlook remained FOMC participants' forecasts of real GDP growth uncertain. With downside risks still substantial, and from the fourth quarter of 1998 to the fourth quarter in light of the cumulative effect since August of the of 1999 is 21/! percent to 3 percent. The anticipated tightening in many sectors of the credit markets and expansion is expected to create enough new jobs to the weakening of economic activity abroad, the keep the civilian unemployment rate near its recent FOMC reduced the intended federal funds rate a average, in a range of 4]/4 percent to 4*A percent. further Vt percentage point at its November meeting. With tightness of the labor market expected to persist Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 88 Board of Governors ofOte Federal Reserve System I. Economic projections for 1999 posted in recent years would contribute to some faaat moderation in spending growth, especially by house- Fedflnl Raervc pntnat holds. Government spending, which accounts for lidicw miHaavc for* pn.i|rimi about one-sixth of domestic demand, seems likely to R^ ndacy expand at • moderate pace overall. Along with the numerous other uncertainties that attend the outlook, Oa*tt, fimnk quinti — an additional uncertainty is present this year because to fimah qmarrrr ' J»-i 4.0 of the approach of the year 2000 and the associated 2-3 M 1.0 Comu price Juki > . . 1W-2W 2-2W 2.1 Y2K problem. Attrage leuri Growth abroad is expected to remain sluggish, on jotrtli quarter balance, in 1999, limiting the prospects for exports. ^%-4V. 4(4-4'-* J.9 At the same time, growth of the US. economy prob- 1. Chimr from rm& la fm* qnner of 1998 u i>tn(c to four* ably will continue to generate fairly brisk increases in imports. In total, real net exports of goods and ser- 2 J. . O AH n u r - n w t« d " tM co e M d u . meti. vices seem likely to fail further in the coming year, although several factors—the decline in the dollar from its peak of last summer, the expected slow- and oil and import prices unlikely to be as weak in ing of income growth in (he United Sates, and the 1999 as they were in 1998, inflation is expected to possibility of a slight pickup in economic growth move up somewhat from the rate of this past year but abroad—provide a basis for thinking that this year's to remain low by the standards of the past three drop in net exports might not be as large as that of decades: Tic central tendency of the FOMC partici- 1998. pants' CPI inflation forecasts for 1999 is 2 percent to The future course of inflation will depend in part 2'/2 percent The Federal Reserve officials' inflation on what happens to the prices of oil and other forecasts are closely aligned with that of the Admin- imports, and restraint from those sources seems istration, and their forecasts of real GDP and unem- unlikely to be as great as it was in 1998. The drop in ployment depict a somewhat stronger real economy the price of oil this past year left it toward the lower than the Administration is projecting. end of its range of the past couple of decades and Present circumstances suggest that domestic has thereby reduced the incentives for exploration, demand could continue to rise briskly for a while drilling, and production. Futures markets have been longer. Consumer spending continues to be driven showing a gradual rise in the price of oil going by strong gains in employment, increases in real forward. Prices of nonoil imports changed little in the incomes, and rising levels of wealth. Those same fourth quarter of last year after having fallen sharply factors, together with low mortgage interest rates, are in previous quarters. Indicators of the pressures keeping housing activity robust. Businesses are still on domestic resources provided mixed signals over investing heavily in new capital, especially comput- the past year. In manufacturing, capacity utilization ers and other-high-tech equipment. Households and declined considerably, to a level below its long run businesses appear willing to take on more debt in average, reflecting slower production growth and siz- support of spending; although spreads on corporate able additions to the stock of capital. However, labor debt remain elevated, rate levels are perceived to be markets remained very taut, and with the economy attractive for most borrowers, and restraint on access apparently carrying substantial momentum into this to finance is not much in evidence. year, data on costs and prices will need to be moni- As the year progresses, however, gains in domes- tored carefully for signs that a rising inflation pat- tic spending should begin to moderate. Spending tern might start to take hold. In that regard, the increases for housing, consumer durables, and busi- FOMC will continue to rely not only on the CPI but ness equipment have been exceptionally large for a also on a variety of other price measures to gauge while now, substantially raising the rate of growth in the economy's inflation performance in the period the amounts of these goods owned by businesses and ahead. households; some moderation in outlays seems likely, lest tnese holdings become disproportionate to under- lying trends in income and output. The outlook for Money and Debt Ranges for 1999 spending continues to be obscured to some degree by uncertainties about the course of equity prices; a At its most recent meeting, the FOMC reaffirmed the failure of these prices to match the outsized gains 1999 monetary growth ranges that were chosen on a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 Monetary Policy Report 10 the Congress D February 1999 2. Ranges for growth of monetary and debt aggregates tors to redirect savings flows away from equities after several years of out si zed gains in stock market AlfKfMt 1W1 iwe I9W wealth. With equity wealth still elevated and the yield curve likely to remain flat, M2 velocity could continue to fall this year. However, the pace of 3-7 decline should slow as some households respond to NHTI. Oun|e bum ntt^t fa fourth qumer of f the easing of concerns about financial market volatil- fourth qiwter of yek indktfed ity by reversing a portion of the shift toward M2 assets that occurred last fall. Indeed, this effect may provisional basis last July: 1 percent to 5 percent for already be visible, as M2 growth, while still robust, M2, and 2 percent to 6 percent for M3. As has been has slowed considerably early this year. If velocity the case for some time, the FOMC intends these does fall, given the Committee's expectations for money growth ranges to be benchmarks for growth nominal income growth, M2 could again exceed its under conditions of price stability, sustainable real price-stability benchmark range. economic growth, and historical velocity relation- M3 expanded 11 percent last year, and its velocity ships rather than ranges that encompass the expected fell 51/* percent, the largest drop in many years. The growth of money over the coming year or that serve rapid growth in this aggregate owed in large pan to as guides to policy. a substantial rise in institutional money funds. These Given continued uncertainly about movements in funds ha-ve been expanding rapidly in recent years as the velocities of M2 and M3 (the ratios of nominal nonfinancial firms increasingly employ them to pro- GDP to the aggregates), the Committee would have vide cash management services. Investments in these little confidence that money growth within any par- funds provide businesses with greater liquidity than ticular range selected for the year would be associ- direct holdings of money market instruments, and by ated with the economic performance it expected or substituting for such direct holdings, they boost M3. desired. Nonetheless, the Committee believes that, M3 was also buoyed last year by a large advance despite the apparent large shift in velocity behavior in in the managed liabilities banks used to fund rapid the early 1990s, money growth has some value as an growth in bank credit. In part, the growth in bank economic indicator. Indeed, some FOMC members credit reflected demand by borrowers shifting from have expressed the concern that the unusually rapid the securities markets, and with these markets again growth in the money and debt aggregates in 1998 receptive to new issues, bank credit growth this might have reflected monetary conditions that were year is expected to slow to a pace more in line with too accommodative and would ultimately lead to an broader debt aggregates However, institutional increase in inflation pressures. The Committee will money funds are likely to continue their robust gains, continue to monitor the monetary aggregates as well contributing to a further diminution in M3 velocity as a wide variety of other economic and financial data and, possibly, to growth of this aggregate above its to inform its policy deliberations. price-stability range. Last year, M2 increased 8V5 percent, and with Domestic nonfinancial debt grew dVt percent in nominal GDP rising 5 percent, M2 velocity decreased I99S, somewhat above the middle of the 3 percent to 3 percent. This drop in velocity was considerably 7 percent growth range the Committee established larger than would have been expected on the basis of last February. This robust growth reflected large rises historical relationships and the modest decline in the in the debt of businesses and households owing opportunity cost of M2 (measured as the difference to substantial advances in spending as well as debt- between the interest rale on Treasury bills and the financed mergers and acquisitions. However, the weighted average rate available on M2 assets). The increase in private-sector debt was partly offset by fall in velocity in part reflected an increased demand the first annual decline in federal debt in almost thirty for the safe and liquid assets in M2 as investors years. As with the monetary aggregates, the Commit- responded to the heightened volatility in financial tee left the range for debt growth unchanged for markets in the second half of the year. Other factors 1999. After an aberrant period in the 1980s during (hat may have contributed include lower long-term which debt growth greatly exceeded growth of nomi- interest rates and a very flat yield curve, which might nal GDP, debt growth over the past decade has have suggested to households that they would be returned to its historical pattern of about match- giving up very little in earnings by parking savings in ing growth of nominal GDP, and the Committee short-term assets in M2. In addition, M2 may have members expect debt to fall within its range this been boosted by a desire on the pan of some inves- year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 Board of Governors of the Federal Reserve System ECONOMIC AND FINANCIAL DEVELOPMENTS Change in teal GDP IN 1998 AND EARLY 1999 Perm, annul at* The U.S. economy continued to display great vigor in 1998, despite a sharp slowing of growth in foreign economies and an unsettled world financial environ- ment According to the Commerce Department's advance estimate, real GDP increased a little more than 4 percent over the four quarters of the year. The economic difficulties facing many of our trading part- Jlllliil ners and the strength of the dollar through much of the year led to sluggishness in real exports of goods and services. However, the drag on the economy from that source was more than offset by exceptional I ] strength in the real expenditures of households and 1991 1992 1993 1994 I99S 1996 1997 LWS businesses, which were powered by strong real Hon.. In Mi dun **) in Mibw^jan dani fat *™ *t ompoocm of income growth, large gains in the value of household ml GDP. ctuntei BE motored <o the inl ijunt at fe period imaanA, from Ibc final quvtei of the pKcednf period. Lau etta pane » from te *dvwce wealth, ready access to finance during most of the GDP report for I »9S.Q4 year, and widespread optimism regarding the future of the economy. Although turmoil in financial mar- hourly pay gave another appreciable boost to the kets seemed to threaten the economy for a time in growth of real labor income. At the same time, the late summer and early autumn, that threat later wealth of households recorded another year of sub- receded, in part because of the steps taken by the stantial increase, bolstered in large part by the contin- Federal Reserve to prevent the tightening of credit ued rise in equity prices. Although not all balance markets from impairing the expansion of activity. sheet data for the end of 1998 are available, house- The final quarter of the year brought brisk expansion hold net worth at that point appears to have been up of employment and income, and the limited indi- about 10 percent from the level at the end of cators of activity in early 1999 have been strong, on 1997. The cumulative gain in household wealth since balance. 1994 has amounted to nearly 50 percent. The increase in the general price level this past The rise in net worth probably accounts for much year was smaller than that in the previous year, which of the decline in the personal saving rate over the past had itself been among the smallest in decades. The few years, to an annual average of Vt percent in 1998. chain-type price index for GDP rose slightly less than Households tend to raise their saving from current 1 percent. The further slowing of price increases was income when they feel that wealth must be increased in large part a reflection of sluggish conditions in the to meet longer-run objectives, but they are willing to world economy, which brought declines in the prices reduce their saving from current income when they of a wide range of imported goods, including oil and feel that wealth already is at satisfactory levels. The other primary commodities.. In the domestic econ- omy, nominal hourly compensation of workers picked up only slightly despite the tightness of the labor Change in real income and consumption market, and much of the compensation increase was offset by gains in labor productivity. As a result, unit labor costs, the most important item in total business Q DUpooMe pertonil income _ • Pmontl conmmplioii e costs, rose only modestly. The Household Sector Personal consumption expenditures increased more than 5 percent in real terms in 1998, the biggest gain in a decade and a half. Support for the large rise in spending came from a combination of circumstances that, on the whole, were exceptionally favorable to households. Strong gains in employment and real 1941 H91 mi 19*4 KM 1996 1997 I99S Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Monetary Policy Report to the Congress D February 1999 Wealth and savings In the single-family sector, sales of new and exist- ing homes surged, the former rising more than 10 percent from the previous year's total and the latter more than 13 percent. Construction of single- family houses strengthened markedly. The number of these units started during the year was the largest since the late 1970s, and it exceeded the previous year's total by about 12 percent. In the fourth quarter, unusually mild weather permitted builders to main- tain activity later into the season than they normally would have and gave an added kick to housing starts. Starts increased further in January of this year, despite harsher weather in some regions. In contrast to the strength in the single-family l%2 196* I97J I960 1986 1992 1998 sector, the number of multifajntly units started in I. The ratio of net worth of hoiuctwUs ro Aponble personal income. 1998 was up only a little from the total for 1997. After bottoming out at a very low level early in the 1990s, construction of these units had been trending back up fairly briskly until this past year. But with low level of the saving rale in 1998 is not so remark- vacancy rates on multifamily rental units running a able when gauged against a wealth-lo-income ratio touch higher this past year, builders and their credi- thai has been running in a range well above its tors may have become concerned about adding too longer-run historical average. many new units to the stock. Financing appeared All of the major categories of personal consump- generally to be in ample supply for projects that tion expenditures—durables, nondurables, and looked promising; during the period of financial tur- services—recorded gains in 1998 that were the moil, the flow of credit was supported by substantial largest of the 1990s. Spending on durable goods rose purchases of multifamily mortgages and mortgage- more than 12 percent over the year. Within that backed securities by Freddie Mac and Fannie Mae. category, expenditures on home computers once Total outlays for residential investment increased again stood out, rising roughly 70 percent in real about ]2'/2 percent in real terms during 1998, accord- terms, a gain that reflected both increased nominal ing to the Commerce Department's initial tally. The outlays and a further substantial decline in computer large increase reflected not only the construction prices. Consumer outlays on motor vehicles also rose work undertaken on new residential units during the sharply, despite some temporary limitations on sup- year but also sizable advances in real outlays for ply from a midyear auto strike. Spending on most home improvements and in the volume of sales activ- other types of durable goods registered increases that ity being carried on by real estate brokers, which were well above the averages of the past decade or generated substantial gains in commissions. so. Because goods such as these are not consumed all at once—but, rather, add to stocks of durable goods that will be yielding services to consumers for a Change in real rcsideniial investment number of years—they embody a form of economic saving that is not captured in the normal measure of the saving rate in the national income accounts. The increases in income and net worth that led households to boost consumption expenditures also led them to invest heavily in additions to the stock of housing. Declines in mortgage interest rates weighed in as well, helping to maintain the affordabilily of housing even as house prices moved up somewhat faster than overall inflation- These developments brought the objective of owning a home within the reach of a greater number of households, and the home-ownership rate, which has been trending up _L_ . I 1 I 1991 \9K 1993 1994 1995 1996 1997 199* this decade, rose to another new high in 1998. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 Board of Governors of the Federal Reserve System The robust growth in household expenditures in because of difficulties in the market for securities 1998 was accompanied by an expansion of household backed by such loans. debt that likely exceeded 8W percent, a somewhat Despite the rapid increase in debt, measures of larger rise than in other recent years. Nonmortgage household financial stress were relatively stable last debt increased about 6 percent, about 2 percentage year, although some remained at high levels. The points above the previous year's pace but down con- delinquency rate on home mortgages has stayed quite siderably from the double-digit increases posted in low in recent years, white the delinquency rate on 1994 and 1995. Home mortgage debt is estimated to auto loans at domestic auto finance companies has have jumped more than 9 percent, its largest annual trended lower. The delinquency rate on credit card advance since 1990, boosted in part by the robust loans at banks fluctuated in a fairly narrow range in housing market. In addition, with mortgage rates 1997 and 1998. but it remained elevated after having reaching their lowest levels in many years, many posted a substantial rise over the previous two years. households refinanced existing mortgages, and some Personal bankruptcy filings have followed a broadly households likely look the opportunity presented by similar pattern: Annual growth has run at about 3 per- refinancing to increase the size of their mortgages, cent over the past year and a half, down from annual using the extra funds raised to finance current expen- increases of roughly 25 percent between mid-1995 ditures or to pay down other debts. and early 1997. The stability of these measures over The growth in household debt reflected both sup- the past couple of years likely owes in part to the ply and demand influences. With wealth rising faster earlier tightening of standards and terms on consumer than income over the year and with consumer con- loans. In addition, lower interest rates and longer loan fidence remaining at historically high levels, house- maturities, which resulted from the shift toward mort- holds were willing to boost their indebtedness to gage finance, have helped to mitigate Ihe effects finance increased spending. In addition, lenders gen- of increased borrowing on household debt-service erally remained accommodative toward all but the burdens. most marginal households, even after the turmoil in many financial markets in the fall- After a more general tightening of loan conditions in response to a The Business Sector rise in losses on such loans between mid-1995 and mid-1997, a smaller and declining fraction of banks Business fixed investment increased about \21A per- tightened consumer lending standards and terms last cent during 1998, with a 17W percent rise in equip- year, according to Federal Reserve surveys. However, ment spending more than accounting for the overall the availability of high loan-to-value and subprime advance. The strength of the economy and optimism home equity loans likely was reduced in the fall about its longer-run prospects provided underpin- nings for increased investment. Outlays were also bolstered by the efficiencies obtainable with new technologies, by the favorable prices at which many Delinquency rales on household loons types of capital equipment could be purchased, and. except during the period of financial market turmoil, by the ready availability and low cost of finance, either through borrowing or through the issuance of equity shares. Real expenditures on office and computing equip- ment, after having risen at an average rate of roughly 30 percent in real terms from 1991 through 1997, shifted into even higher gear in 1998, climbing about 65 percent. The outsized increase likely owed in part to the efforts of some businesses to put new computer systems in place before the end of the millennium, in hopes of circumventing potential difficulties arising from the Y2K problem. But, beyond that, investment 19*8 1990 1992 1994 1996 199! in computers is being driven by the same factors NOTE. The Am nt qiwtnty. Data on credit-on) dclinpencki n from that have been at work throughout the expansion— buk Call Reports: dn> on BIID km delinquencies iff from ihe Big Three namely, the introduction of machines that offer •aorakcn: dm on mortgage dcUnquenciei at from *K Mongi|E Bukcn greater computing power at increasingly attractive Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 Monetary Policy Report lo the Congress D February 1999 Change in real business fixed investment pasl year. Although some of the more speculative construction plans may have been shelved because of a tightening of the terms and standards on loans, D SttWTOTS partly in reaction to Ihe financial turmoil, most build- • Pmhicm' durable equipment ers appear to have been able 10 eventually obtain financing. Despite the sluggishness of spending on structures this past year, the level of investment remained high enough to generate continued moder- ate growth in the real stock of structures. Business inventories increased about 4Vz percent in real terms this past year after having risen more than 5 percent during 1997. Stocks grew at a 7 per- cent annual rate in the first quarter, appreciably faster than final sales, but inventory growth over the IW2 1994 1996 1998 remainder of the year was considerably slower than in the first quarter. At year-end, stocks in most non- farm industries were at levels that did not seem likely prices and that provide businesses new and more to cause firms to restrain production going forward. efficient ways of organizing their operations. Price Inventories of vehicles may even have been a little on declines this pasl year were especially large, as the the lean side, as a result of both a strike that held cost reductions associated with technical change were down assemblies through the middle part of 1998 and augmented by heightened international competition exceptionally strong demand, which prevented the in Ihe markets for semiconductors and other com- rebuilding of stocks later in the year. By contrast, puter components and by price cutting to work down inventories al year-end appear to have been excessive the stocks of some assembled products. in a few nonfarm industries that have been hurt by Investment in communications equipment— the sluggish world economy. Stocks of farm com- another high-tech category that is an increasingly modities also appeared to be excessive, having been important part of total equipment outlays—rose about boosted further this past year by large harvests and 18W percent in 1998. After having traced out an sluggish export demand. erratic pattern of ups and downs through the latter The economic profits of U.S. corporations—that is, part of the 1980s and the eafly 1990s, real outlays book profits adjusted so that inventories and fixed on this type of equipment began to record sustained capital are valued at their current replacement cost— large annual increases in 1994, and the advance last rose further, on net, over the first three quarters of year was one of the largest. Spending on other types 1998 but at a much slower pace than in most other of equipment displayed varying degrees of. strength years of the current expansion. Companies' earnings across different sectors but recorded a sizable gain from operations in the rest of the world fell back a overall. Investment in transportation equipment was bit, as did the profits of private financial corporations strong across \he board, spurred by the need to move greater volumes of goods or to carry more passengers in an expanding economy. Spending on industrial Change in nonfarm business inventories machinery advanced about 4'A percent after larger gains in most previous years of the expansion, a pattern that mirrored a slowing of output growth in the industrial sector. Business investment in nonresidential structures, which accounts for slightly more than 20 percent of total business fixed investment, was down slightly ill,III in 1998, according to the advance estimate. Sharply divergent trends were evident within the sector, rang- ing from considerable strength in the construction of office buildings to marked weakness in the construc- tion of industrial buildings. The waxing and waning of industry-specific construction cycles appears to be the main explanation for the diverse outcomes of this Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 Board of Governors of the Federal Reserve System Before-lax profits as a share of GDP tion activity. Indeed, mergers and acquisitions, share repurchases, and foreign purchases of US. firms last year overwhelmed the high level of both initial and Nonfimncul corponucm seasoned public equity issues, and net equity retire- ments likely exceeded $250 billion. The disruptions in the financial markets in late summer and early fall appear to have had little effect on total business borrowing but caused a substantial temporary shift in the sources of credit. With inves- tors favoring high credit quality and liquidity, yields on lower-rated corporate bonds rose despite declining Treasury rates; the spread of yields on junk bonds over those on comparable Treasury securities roughly I I I J 1 I I I I I I I I I I I I I I I I I 1 doubled between mid-summer and mid-autumn I9T7 LWO I9P IWt I9M an IMS J9M before falling back somewhat as conditions in finan- Ninf. Profiii fron domotic openuoBL wirii jnvniory vduitioii J0d opilil cial markets eased. The spread of rates on lower-tier coo»npiii» idjitioicHi. divided by gran domtnk prataci o( nmlimariJl arpame tKKr. commercial paper over those on higher-quality paper rose substantially during the fall but had retraced the rise by the early part of this year. from domestic operations. The profits of nonfinancial Reflecting these adverse market conditions, non- corporations from domestic operations increased at financial corporate bond issuance fell sharply in an annual fate of about I54 percent. Although the August and remained low through mid-October, with volume of output of the nonfinancial companies con- issuance of junk bonds virtually halted for a time. tinued to rise rapidly, profits per unit of output were Commercial paper issuance rose sharply in August squeezed a bit by companies' difficulties in raising and September, as some firms apparently decided to prices in step with costs in a competitive market delay bond issues, turning temporarily to the com- environment. mercial paper market instead. Bond issuance picked With profits expanding more slowly and invest- up again in late October, however, and issuance in ment spending still on the upswing, businesses1 November was robust Reflecting this rebound, com- external funding needs increased substantially last mercial paper outstanding fell back in the fourth year. Aggregate borrowing by the nonfinancial busi- quarter. More recently, bond issuance has remained ness sector is estimated ID have expanded 9Vi percent healthy, while borrowing in the commercial paper from the end of 1997 to the end of 1998, the largest market has picked up. increase in ten years. The rise reflected growth in all During the period when financial markets were major types of business debt. Business borrowing strained, some borrowers substituted bank loans—in was also boosted by substantial merger and acquisi- some cases under credit lines priced before the mar- Gross corporate bond issuance A S O N Di F M A MJ S O N O I im i iw NOT*. Evbdei onrd iuwt uA tana wU j Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 Monetary Policy Report 10 the Congress D February 1999 kets became volatile—for other sources of credit, and Federal receipts and expenditures business loans at banks expanded very rapidly for a time before tailing off late in the year. Federal ul KKDIftal GDP Reserve surveys indicate that banks responded to the turmoil in financial markets by tightening standards and terms on new loans and credit lines, especially Toul npendirures loans to larger customers and those to finance com- mercial real estate ventures. The tightening reflected the less favorable or more uncertain economic out- look as well as a reduced tolerance for risk on the part of some banks. Bank lending standards and terms appear to have tightened only a little further Tool receipts since the fall, however, and business loans at banks have expanded a bit since the end of December. I _1_ [ _L 1 _L. I -L I J I Despite the rapid growth in debt and the relatively 1982 IM6 1990 small gain in profits last year, the financial condition MOTE. TAD on rcctipb ipd expenditure! ve ham the unified budget and are of nonfinancial businesses remained strong. Interest for ihc Sicd yen ewdoi in Sepwrtw rates for many businesses fell, on balance, over the course of the year, and bond yields for investment- October, business failures remained at the low end of grade firms reached their lowest level in many years. the range seen over the past decade. Reflecting these low borrowing costs, the aggregate debt-servke burden for nonfinancia) corporations, measured as the ratio of net interest payments to cash The Government Sector flow, remained about 9V4 percent, near its low of 9 percent in 1997 and less than half the peak level The federal government recorded a surplus in the reached in 1989. The delinquency rate for banks' unified budget this past fiscal year for the first time in commercial and industrial loans also remained near nearly three decades. The surplus, amounting to the trough reached in late 1997, while that for com- $69 billion, was equal to about3/* percent of GDP, a mercial real estate loans fell a bit further from the huge turnabout from the deficits of the early 1990s, already very low level posted in 1997. Although which in some years were more than 4V4 per- Moody's Investors Service downgraded more non- cent of GDP. The swing from deficit to sur- financial firms than it upgraded over the second half plus over the past few years is partly the result of the year, the downgraded firms were smaller on of fiscal policies aimed at lowering the deficit and average, and so the debt of those upgraded about partly the result of the strength of the economy and equaled the debt of those downgraded. Through the stock market Excluding net interest payments— a charge stemming from past deficits—the gov- ernment recorded a surplus of more than $300 billion Net interest payments or nonfinaflcial corporations in fiscal 1998. relative to cash flow The improvement in the government's saving posi- tion has permitted national saving—the combined gross saving of households, businesses, and governments—to move up about 3 percentage points from its low of a few years ago, even though personal saving has fallen sharply. In turn, that increase in national saving has helped facilitate the boom in investment spending—in contrast to the experience of the 1980s and early 1990s, when persistent large budget deficits tended to reduce national saving, boost interest rates higher than they otherwise would have been, and thereby crowd out private capital formation. Federal receipts in the unified budget in fiscal year 1998 were up 9 percent from the previous fiscal year, NOTE. The tec n qurtoly. with much of the gain coming from personal income Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 Board of Governors of the Federal Reserve System National saving boosted to some degree by new budget authority for a variety of functions, including defense, embassy security, disaster relief, preparation for Y2K, and aid to agriculture; this authority was created in emer- gency legislation that provided an exception to statu- tory spending restrictions. Real federal outlays for consumption and invest- ment, the part of federal spending that is counted in GDP, increased I percent, on net. from the final quarter of calendar year 1997 to the final quarter of 1998. A reduction in real defense outlays over that period was more than offset by a jump in the non- defense category. L I I I I 1 I I With the budget balance shifting from deficit to surplus, the stock of publicly held federal debt NOTE. Nwoinl avinj UKlodei *e (RBS «"isj of hawhoUi. huiHiHm. declined last year for the first time since 1969 and fell Ud £OVennncllU. further as a share of GDP. From the end of 1997 to the end of 1998, U.S. government debt fell ) '/a per- taxes, which rose more than 12 percent for a second cent, as the government reduced the outstanding consecutive year. These receipts have been rising stock of both bills and coupon securities. Despite the faster than personal income in recent years, for sev- reduction in its debt, the federal government contin- eral reasons: Tax rates at the high end of the income ued substantial gross borrowing to fund the retire- scale were raised by legislation that was passed ment of maturing securities. However, with the need in 1993 to help reduce the deficit; more taxpayers for funds trimmed substantially, the Treasury changed have moved into higher tax brackets as income has its auction schedules, discontinuing the three-year increased; and large increases in asset values have note auctions and moving to quarterly, rather than raised tax receipts from capital gains. Social insur- monthly, auctions of five-year notes. By reducing the ance tax receipts, the second most important source number of coupon security issues, the Treasury is of federal revenue, increased 6 percent in fiscal 1998, able to boost the size of each, thereby contributing to just a touch faster than the increase in fiscal 1997 and their liquidity. The decrease in the total volume of roughly in step with the growth of wages and sala- coupon securities is intended to boost the size of bill ries. Receipts from the taxes on corporate profits, offerings over time, helping liquidity in that market which account for just over 10 percent of federal and also allowing, as the Treasury prefers, for bal- revenues, rose less rapidly than in other recent years, anced issuance across the yield curve. The Treasury restrained by the slower growth of corporate profits. also announced in October that all future bill and In the first three months of fiscal 1999, net receipts coupon security auctions would employ the single- from corporate taxes dipped befow year-earlier lev- price format that had already been adopted for the els, but gains in individual income taxes and payroll taxes kept total federal receipts on a rising trajectory. Unified outlays increased 3Vt percent in fiscal 1998 Federal government debt held by Ihe public after having risen 2'/4 percent in the preceding fiscal year. Net interest payments and nominal expenditures for defense fell slightly in the latest fiscal year, and outlays for income security and Medicare rose only a little. Social security expenditures increased moder- ately but somewhat less than in other recent years. By contrast, the growth of Medicaid payments picked up to about 6 percent after having increased less than 4 percent in each of the preceding two years; how- ever, even the 1998 rise was not large compared with those of many earlier years when both medical costs and Medicaid caseloads were increasing rapidly and rates of federal reimbursement to the states were I | I I I lil 1| I I I I I]] I I Nljjl LI LLIIU 11 II II it NHl being raised. Federal spending in fiscal 1999 will be I9M 1962 196(1 1974 I9M 1984 IW2 1*98 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 Monetary Policy Report to the Congress D February 1999 iwo-year and five-year note auctions and Tor auctions refunding activity last year was the resut of lower of inflation-indexed securities. The Treasury judged borrowing costs. Although yields on tax-exempt that the single-price formal had reduced servicing municipal securities did not decline nearly as much costs and resulted in broader market participation. as those on comparable Treasury securities, they The Treasury continued to auction inflation- nonetheless reached their lowest levels in many years, indexed securities in substantial volume last year in tn addition, rating agencies upgraded about five times an effort to build up this part of the Treasury market. as many state and local government issues last year In April, the Treasury issued ils first thirty-year as they downgraded, trimming borrowing costs fur- indexed bond, and in September it announced a tegu- ther for the upgraded entities. lar schedule of ten- and thirty-year indexed security auctions. The Treasury also began offering inflation- indexed savings bonds in September. The External Sector State and local governments recorded further increases in their budgetary surpluses in 1998, both Trade and the Current Account in absolute terms and as a share of GDP. Revenue from the taxes on individuals' incomes has been U.S. external balances deteriorated further in 1998, growing very rapidly, keeping total receipts on a largely because of the disparity between the rapid solid upward course. At the same time, the growth growth of the U.S. economy and the sluggish growth of transfer payments, which had threatened to over- of the economies of many of our trading partners. whelm state and local budgets earlier in the decade, The nominal trade deficit for goods and services was has slowed substantially in recent years. Growth of $169 billion, considerably larger than the $110 bil- other types of spending has been trending up moder- lion deficit in 1997. For the first three quarters of the ately, on balance. The 1998 rise in real expenditures year, the current account deficit averaged 3220 bil- for consumption and investment amounted to about lion at an annual rate, substantially larger than the 2'/4 percent, according to the initial estimate; annual 1997 deficit of $155 billion. The large current gains have been in the range of 2 percent to IV* per- account deficits of recent years have been funded cent in each of the past seven years. with increased net foreign saving in the United States. Despite rising surpluses, state and local govern- As a result, U.S. gross domestic investment has ment debt increased an estimated 7 percent in 1998, a exceeded the level that could have been financed by pickup of about 2 percentage points from growth gross national saving alone, but at the cost of a rise in in 1997. Somewhat more than half of the long-term net U.S. external indebtedness. borrowing by state and local governments last year The increase in the current account deficit last year reflected new borrowing to fund current and antici- was due to a decline in net exports of goods and pated capital spending on utilities, transportation, services as well as a further weakening of net invest- education, and other capital projects. The combina- mem income from abroad. Until 1997, net investment tion of budget surpluses and relatively heavy borrow- income had helped to offset persistent trade deficits. ing likely reflected a number of factors. First, some of But as the U.S. net external debt has risen in recent these governments may have spent the newly raised funds on capital projects while at the same time building up surpluses in "rainy day funds" for later U.S. current account use. Second, because state and local governments under some circumstances are allowed to hold funds raised in the markets for as long as five years before spending them, some of the money raised last year may not have been spent. Finally, there was a sub- stantial volume of "advance refunding" last year. In an advance refunding, the borrower issues new bonds before existing higher-rate bonds can be called, in anticipation of calling the old bonds on the date that option becomes available. While this son of refinanc- ing temporarily boasts total debt, it allows the state or local government to lock in the lower rate even if municipal bond yields subsequently rise over the period before the call date. The high level of advance- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 Board of Governors of the Federal Reserve System years, net investment income has become increas- rise in 1997. Declines during the first three quarters ingly negative, moving from a $14 billion surplus in (especially in machinery exports) were offset by a 1996 to a $5 billion deficit in 199? and < deficit rebound in the fourth quarter, which was led by averaging $15 billion at an annual rue over the first increases in exports of automotive products. The three quarters of (998. Net income from portfolio price competitiveness of U.S. products decreased, investment became increasingly negative during that reflecting the appreciation of the dollar through mid- period as the net portfolio liability position of the August. In addition, economic activity abroad weak- United States grew larger. In addition, net income ened sharply; total average foreign growth (weighted from direct investment slowed last year because by shares of US. exports) plunged from 4 percent in slower foreign economic growth lowered U.S. earn- 1997 to an estimated 1/2 percent in 1998. Moderate ings on investment abroad, the appreciation of the expansion of exports to Europe, Canada, and Mexico dollar reduced the value of US. earnings, and buoy- was about offset by a decline in exports associated ant U.S. growth boosted foreigners' earnings on direct with deep recessions in Japan and the emerging Asian investment in the United States. economies (particularly in the first half of the year) The rise in the trade deficit reflected an increase of and in South America (in the second half of the about 10 percent in real imports of goods and ser- year). vices during 1998. according to the advance esti- mates from the Commerce Department The expan- Capital Flows sion was fueled by robust growth of U.S. domestic demand and by continued declines in import prices, The financial difficulties in a number of emerging which stemmed in part from the strength of the dollar market economies had several noticeable effects on through mid-August and in part from the effects of U.S. international capital flows in 1998. Financial recessions abroad. Of the major trade categories, turmoil put strains on official reserves in many increases in imports were sharpest for finished goods, emerging market economies. Foreign official assets especially capital equipment and automotive prod- in the United States fell $43 billion in the first three ucts. The quantity of imported oil rose appreciably as quarters of the year. This decline, which began in the demand increased in response to the strength of U.S. fourth quarter of 1997, has been largest for devel- economic activity and lower oil prices, while domes- oping countries, as many of them drew down their tic production declined slightly. The price of imported foreign exchange reserves in response to exchange oil fell about $6.50 per barrel over the four quarters rate pressures. OPEC nations' foreign official of the year. World oil prices fell in response to reserves also shrank in the first three quarters of reduced demand associated with the economic slow- 1998, as oil revenues dropped. Preliminary data indi- down in many foreign nations and with unusually cate that foreign official assets in the United States, warm weather in the Northern Hemisphere as well as especially those of industrial countries, rebounded in to an increase in supply from Iraq. the fourth quarter. Real exports of goods and services grew about Private capital flows also were affected by the 1 percent, on net, in 1998 after posting a 10 percent global turmoil. On a global basis, capital flows to emerging market economies fell substantially in the first half of 1998 and then dropped precipitously in Change in real imports and exports of goods and service* late summer and early fall in the wake of the Russian crisis. During the first half of the year, U.S. residents acquired more than £40 billion of foreign securities. Q Imports Net purchases virtually slopped in July, and in the August-October period U.S. residents, on net, sold about $40 billion worth of foreign securities. Prelimi- nary data indicate a resumption of net U.S. purchases in the final two months of 1998. Foreign net pur- chases of U.S. securities, which were substantial in the first half of the year, fell off markedly in the July-October period, but preliminary data suggest a significant recovery in November and December. Thus, there is some evidence that the contraction in 1 I I _ ' _ I II I —IJ gross capital flows seen in late summer and early fall 1*9! 1994 1996 IWS waned somewhat in the fourth quarter. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 Monetary Policy Repon 10 ihe Congress D February 1999 Balance of payments data available through the Change in ouipui per hour firsi three quarters of 1998 show that total private foreign purchases of U.S. securities amounted to $194 billion, somewhat below the level in the first three quarters of 1997. Private foreign purchases of US, Treasury securities were only $22 billion in the first three quarters, compared with 5)47 billion for all iLjhl of 1997. Private foreigners' purchases of other US. securities shifted away from equities anil toward bonds, relative to 1997. U.S. purchases of foreign securities slowed markedly from their 1997 pace, totaling only $27 billion for the first three quarters of 1998 compared with $89 billion for all of the preced- 1 • ing year. The contraction in private portfolio capital t I ) ' I II I 1 j L_| flows, though large, was overshadowed by huge 1990 I9« 1944 19% 1998 direct investment capital Rows, which resulted in pan NOTE. Nonfarm txuineu sector. from a number of very large cross-border mergers. The $72 billion in foreign direct investment into the United States in the firsi three quarters, together with lion. Manufacturers reduced employment over the several large mergers that occurred in the fourth year, but in other parts of the economy the demand quarter, arc certain to bring the tola! for last year well for labor continued to rise rapidly. The construction above the record-high $93 billion posted in 1997. industry boosted employ men! about 6 percent over Merger activity also buoyed US. direct investment the year, and both the services industries and the abroad: The pace of such investment in the first three finance, insurance, and rea! estate sector posted quarters suggests that the annual total will be near the increases of more than Vh percent. Stores selling record-high $122 billion recorded in 1997. building materials and home furnishings expanded employment rapidly, as did firms involved in com- puter services, communications, and managerial ser- The Labor Market vices. In the first month of 1999, nonfarm payrolls increased an additional 245.000. The rapid growth of output in 1998 was associated Output per hour in the nonfarm business sector with both increased hiring and continued healthy rose 2V4 percent in 1998 after having increased about growth in labor productivity The number of jobs on IV4 percent, on average, over the two previous years. nonfarm payrolls rose about VA percent from the end By comparison, the average rate of rise during the of 1997 to the end of (998, a net increase of 2.8 mil- 1980s and the firsi half of the 1990s was just over 1 percent pet year. Because productivity often picks up to a pace above its long-run trend when economic growth accelerates, the results of the past three years Chinge in payroll employment might welt be overstating the rate of efficiency gain thai can be maintained in coming years. However, reasons for thinking thai the trend might have picked up to some degree we becoming more compelling in view of the incoming data. The 1998 gain in output per hour was particularly impressive in this regard, in pan because it came at a time when many businesses were diverting resources to correct the Y2K problem, •llllll a move that likely imposed a bit of drag on growth of output pet hour. Higher rates of capital formation are raising the growth of capital per worker, and workers are likely becoming more skilled in employing the new technologies. Businesses not only are increasing i. i ; i i i i i i i their capital inputs but also are continuing to imple- IMC I9K I9W 1996 199* ment changes to their organizational structures and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 100 Board of Governors of the Federal Reserve System operating procedures thai might enhance efficiency Change in employment cost index and bolster profit margins. The rising demand for labor continued to strain supply in 1998. The civilian labor force rose just a Hourly comp H en&flkm um touch more lhan I percent from the fourth quarter of 1997 to the fourth quarter of 1998, and with the number of persons holding jobs rising somewhat faster than the labor force, the civilian unemployment rate fell still further. The unemployment rale was 4.3 percent at the end of 1998; ihe average for the full year-—4,5 percent—was the lowest of any year in almost three decades. In January of this year, the size of the labor force rose rapidly, but so did employ- mem, and the unemployment rate remained at 4.3 percent. The percentage of the working age popu- 1990 H9Z lation that is outside the labor force and is interested NOTE. Private Lndumy. excfmiiag ftrm jui rK«*d»W in obtaining work but not actively seeking it edged down further this past year and has been in the lowesi range since the collection of these data began in tiourly compensation of workers in private nonfarm 1970. With Ihe supply of labor as tight as it is, industries rose 3Vi percent in nominal terms during businesses are reaching further into the pool of indi- 1998, a touch more than in (997 and Vi percentage viduals who do not have a history of strong attach- point more than in 1996. Taking the consumer price ment to the labor force; persons who arc attempt- index as the measure of price change, this increase in ing to move from welfare to work are among the nominal hourly compensation translated into a 2 per- beneficiaries. cent increase in real hourly pay. one of the largest on Workers have realized large increases in real wages record in a series that goes back to the start of the and real hourly compensation over the past couple of ) 980s; the gain was bigger still if the chain-type price years. The increases have come partly through faster index for personal consumption expenditures is used gains in nominal pa> than in the mid-1990s hut also as the measure of consumer prices. Moreover, the though reductions in the rate of price increase, which employment cost index does not capture some of the have been enhancing the real purchasing power of forms of compensation that employers have been nominal earnings, perhaps to a greater degree than using to attract and retain workers—for example, workers might have anticipated. According to the stock options and signing bonuses. Labor Department's employment cost index, the Because of the rapid growth in labor productivity. unit labor costs have been rising much less rapidly lhan hourly compensation in recent years. The Civilian unemployment rale increase in unit labor costs in the nonfarm business sector was only I '& percent in (998. Businesses were unable to raise prices sufficiently to recoup even this small increase in costs, however. Labor gained a greater share of the income generated from produc- tion, and the profit share, though still high, fell back a little from its 1997 peak. Prices The broader measures of aggregate price change showed inflation continuing to slow in 1998. The consumer price index moved up I1/: percent over the four quarters of the year after having increased nearly NOIE. Tht tmk m diu M lawny 1994 nartj the inmxluctioo c 2 percent in 1997. A steep decline in energy prices in redesigned sum;, itus fion ihur point on nt BM directly caiymtile < ihov of eklier periods. (he CPI more than offset a small acceleration in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 101 Monetary Policy Report to the Congress Cl February 1999 in consumer 3. Alternative measures of prictf change Percent r*«™n« 19»T 19*8 Co E nf x u c m lu e d r in p g r ic fo e o i d n a to n * d e . n . e r . g . y . - . . — ; I . S ; 2 I. . S 4 mill Orou dometfic purchiuei 13 .5 Personal amumpapn eKp^Ddiluies . IJ & ^AcLudmg food ifld enEriy 1.6 I.J Molt. Change* are baled on quarterly average* and arc mcKiirel lo ihe fourth quWf of die year indicated Iran ihe fourth quarter of the {KCVIOU& yeai commodity prices in sluggish world markets helped reduce domestic production costs to some degree. . Consumer price index for aM urfem consume!*. In manufacturing, one of the sectors most heavily affected by the softness in demand from abroad, the rale of plani capacity utilization fell noticeably over prices of other goods and services. Only pan of the the year—even as the unemployment rate continued deceleration in the total CPI was attributable to tech- lo decline. The divergence of these two key measures nical changes in data collection and aggregation.' of resource use—the capacity utilization rate and the Measures of aggregate price change from the unemployment rale—is unusual: They typically have national income and product accounts, which draw exhibited similar patterns of change over the course heavily on data from the CPI but also use daia from of the business cycle. Because the unemployment other sources, showed a somewhat more pronounced rale applies to the entire economy, it presumably deceleration of prices in 1998. The chain-type price should be a better indicator of the degree of pressure index for personal consumption expenditures, (he on resources in general. At present, however, slack in measure of consumer prices in the national accounts, the goods-producing sector—a reflection of the siz- rose V* percent after increasing V/i percent in 1997. able additions to capacity in this country and excess The chain-type price index for gross domestic capacity abroad—seemingly has enforced a disci- purchases—the broadest measure of prices paid by pline of competitive price and cost control that has U.S. households, businesses, and governments— affected the economy more generally. increased only }/i percent in 1998 after moving up Prices this past year tended to be weakest in the 1W percent over the previous year. The rise in the sectors most closely linked to the external economy. chain-type price index for gross domestic product of The price of oil fell almost 40 percent from Decem- slightly less than 1 percent was down from an ber 1997 to December 1998. This drop triggered increase of IV* percent in 1997. steep declines in the prices of petroleum products Developments in the external sector helped to purchased directly by households. The retail price of bring about die favorable inflation outcome of 1998. motor fuel fell about 15 percent over the four quarters Consumers benefited directly from lower prices of of the year, and the price of home heating fuel also finished goods purchased from abroad. Lower prices plunged. With the prices of natural gas and electricity for imports probably also held down the prices also falling, the CPI for energy was down about charged by domestic producers, not only because 9 percent over the year after having slipped I percent businesses were concerned about losing market share in 1997. to foreign competitors but also because declines in Large declines in the prices of internationally traded commodities other than oil pulled down the prices of many domestically produced primary inputs. I. Sinceiheemf of 1994, die BUBCMI of LabOrStttistics hasoikeni The producer price index for crude materials other number of aeps to male ihe consumer price index a more accurate than energy, which reflects the prices charged by price measure. The agency also introduced new weighs into the CPI domestic producers of these goods, felt more than « die son of 199S. In tool, these changes probably reduced ihe 1998 rise in die CPI by jligbdy less th*o ¥> percentage point, relative to the 10 percent over the year. However, because these increase thai would have been repotted using ihe methodologies and non-oil commodities account for a small share of weighs in existence M Ihe end of 1994. Without die changes thai tool: total production costs, the effect of their decline on effect in 1998. the decchmion in the CPI last year probably would have been about naif as large as was reported. inflation was much less visible further down the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 102 Board of Governors of the Federal Reserve System chain of production. Intermediate materials prices U.S. Financial Markets excluding food and energy fell about V/2 percent over the four quarters of the year, and the prices of U.S. interest rates fluctuated in fairly narrow ranges finished goods excluding food and energy rose about over the first half of 1998, and most equity price 1 Vi percent. The latter index was boosted, in pan, by indexes posted substantial gains. However, after the an unusually large hike in tobacco prices that fol- devaluation of the Russian ruble in August and subse- lowed the settlement last fall of stales' litigation quent difficulties in other emerging market econo- against the tobacco companies. In the food sector as mies, investors appeared to reassess the risks and well, (he effects of declining commodity prices uncertainties facing the U.S. economy and concluded became less visible further down the production that more cautious postures were in order. That senti- chain; the PPI for finished foods was about ment was reinforced by the prospect of an unwinding unchanged, on net. over the year, and price increases of positions by some highly leveraged investors. The at the retail level, though small, were somewhat resulting shift toward safe, liquid investments ted to a larger than those of the preceding year. substantial widening of risk spreads on debt instru- Consumer prices excluding those of food and ments and to volatile changes in the prices of many energy—the core CPI—continued to rise in 1998, assets. Financial market volatility and many risk but not very rapidly. As measured by the CPI, these spreads relumed to more normal levels later in the prices increased nearly 2!£ percent from the final year and early this year, as lower interest rales and quarter of 1997 to the final quarter of 1998, a shade robust economic data seemed to reassure market par- more than in 1997. The chain-type price index for ticipants that the economy would remain sound, even personal consumption expenditures excluding food in the face of additional adverse shocks from abroad. and energy—the core PCE price index—decelerated However, lenders remained more cautious than they a bit further, rising at roughly half the pace of the had been in the first pan of last year, especially in the core CPI. Methodological differences between the case of riskier credits. two measures are numerous; some of the technical problems that have plagued the CPI are less pro- nounced in the PCE price measure, but the latter also Interest Rates depends partly on imputations of prices for which observations are not available. Both measures, how- Over the first half of 1998, short-term Treasury rates ever, seemed to suggest thai the underlying ireod of moved in a narrow range, anchored by unchanged consumer price inflation remained low. A similar monetary policy, while yields on intermediate' and message came from surveys of consumers, which long-term Treasury securities varied in response to showed expectations of future price increases easing the market's shifting assessment of the likely impact a bit further in 1998—although, as in other recent of foreign economic difficulties on the U.S. economy. years, the expected increases remained somewhat In late 1997 and into 1998. spreading financial crises higher than actual price increases. in Asia were associated with declines in U.S. interest rates, as investors anticipated that weakness abroad would constrain US. economic growth and cushion Change in consumer prices excluding food and energy the impact of tight U.S. labor markets on inflation. However, interest rates moved back up later in the first quarter of 1998, as the US. economy continued to expand at a healthy pace, fueled by hefty gains in domestic demand. After a couple of months of small changes, Treasury rates fell in May and June, when concerns about foreign economies, particularly in Asia, once again led some observers to expect weaker growth in (he United Stales and may also have boosted the demand for safe Treasury securities rela- tive 10 other instruments. Treasury rates changed little, on net, in the early summer, but they slipped lower in August, reflecting increased concern about the Japanese economy and IWO I9»2 19*4 19% I«H financial problems in Russia. The default by Russia NOTE. ConMjpg ftta i*Jc* far iff n on some government debt obligations and the devalu- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 103 Monetary Policy Report to the Congress O February 1999 Selected Treasury rales, daily data Spreads ot corporate bond yields over Treasury security yields Nort. TUc <Mi n Aily- The ipod of high-yield bMrfi omum fee yield o. riK MoriR Lyndi Miwer n imfci wM dw o* i tevn-yai TmKy; *e ation of the ruble in mid-August not only resulted in atae two ipofe confute yields en On ipfKfrinK Merrill Ljmdi udeia widi ihtt n» larye* Tia"»y. LM cAtenMani KC tn FcbruKy 19.1994. sizable losses for some investors but also undermined confidence in other emerging market economies. The currencies of many of these economies came under increased sharply. As a result, spreads of private rates substantial pressure, and the market value of the over Treasury rates rose substantially, reaching levels international debt obligations of some countries not seen for many years, and issuance of corporate declined sharply. U.S. investors shared in the result- securities dropped sharply. ing losses, and U.S. economic growth and the profits The desire of investors to limit risk-taking as mar- of US. companies were perceived to be vulnerable. kets became troubled in the late summer showed up In these circumstances, many investors, both here clearly in mutual fund flows. High-yield bond funds, and abroad, appeared 10 reassess the riskiness of which had posted net inflows of more titan SI billion various counterparties and investments and to each month from May to July, saw a $3.4 billion become less willing to bear risk. The resulting shift outflow in August and inflows of less than $400 mil- of demand toward safety and liquidity led to declines lion in September and October before rebounding of 40 lo 75 basis points in Treasury coupon yields sharply in November. By contrast, inflows to govern- between mid-August and mid-September. In contrast, ment bond funds jumped from less than $1 billion in yields on higher-quality private securities fell much July to more than $2 billion a month in August and less, and those on issues of lower-rated firms September. Equity mutual funds posted net outflows totaling nearly $12 billion in August, the first monthly outflow since 1990, and inflows over the rest Selected Treasury rates, quarterly data of the year were well below those earlier in the year. In part, the foreign difficulties were transmitted to U.S. markets by losses incurred by leveraged investors—including banks, brokerage houses, and hedge funds—as the prospects for distress sales of riskier assets by such investors weighed on market sentiment, depressing prices. Many of these entities did reduce the scale of their operations and trim their risk exposures, responding to pressures from more cautious counterparties. As a result, liquidity in many markets, declined sharply, with bid-asked spreads widening and large transactions becoming more diffi- cult to complete. Even in the market for Treasury 196) I96» 1*7) I»7S 1983 198* securities, investors showed an increased preference for the liquidity offered by the most recent issues at Mm. TVl*e««y.^Tr««w(yl»«d rile U ii Mill *t*rHiiHi«iice of frenrny feoxt in FttnHiy 1977. each maturity, and the yields on these more actively Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 104 Board of Governors of the Federal Reserve System traded "on-the-mn" securities fell noticeably relative counterparties to undertake reviews of the practices to those available on "off-the-run" issues, (he ones those firms employed in managing their risks. These that had been outstanding longer. reviews have suggested significant weaknesses in the Conditions in U.S. financial markets deteriorated risk-management practices of many firms in their further following revelations in mid-September of dealings with LTCM and—albeit to a lesser the magnitude of the positions and the extent of degree—tn (heir dealings with other highly leveraged the losses of a major hedge fund, Long-Teim Capital entities. Few counterparties seem to have had a com- Management. LTCM indicated that it sought high plete understanding of LTCM's risk profile, and their rates of return primarily by identifying small discrep- credit decisions were heavily influenced by the firm's ancies in the prices of different instruments relative reputation and strong past performance. Moreover, to historical norms and then taking highly leveraged LTCM's counterparties did not impose sufficiently positions in those instruments in the expectation that light limits on their exposures to LTCM, in part market prices would revert to such norms over time. because they relied on collateral agreements requir- In pursuing its strategy. LTCM took very large posi- ing frequent marking to market to limit the risk of (ions, some of which were in relatively small and their exposures. While these agreements generally illiquid markets. provided for collateral with a value sufficient to cover LTCM was quite successful between 1995 and current credit exposures, they did not deal adequately 1997, but the shocks hitting world financial markets with the potential for future increases in exposures last August generated substantial losses for the firm. from changes in market values. This shortcoming Losses mounted in September, and before new inves- was especially important in dealings with a firm like tors could be found, the firm encountered difficulties LTCM, which had such large positions in illiquid meeting liquidity demands arising from its collateral markets that its liquidation would likely have moved agreements with its creditors and counterparties. With prices sharply against its creditors. In such cases, world financial markets already suffering from creditors need to take further steps to limit their heightened risk aversion and iitiquidity, officials of potential future exposures, which might include re- the Federal Reserve Bank of New York judged that quiring additional collateral or simply scaling back the precipitous unwinding of LTCM's portfolio that iheir activity with such firms. would follow the firm's default would significantly The private-sector agreement to recapitalize LTCM add to market problems, would distort market prices, allowed ils positions to be reduced in an orderly and could impose large losses, not just on LTCM's manner over time, rather than in an abrupt fire sale. creditors and counterparties, but also on other market Nonetheless, (he actual and anticipated unwinding of participants not directly involved with LTCM. LTCM's portfolio, as well as actual and anticipated In an effort to avoid these difficulties, the Federal sales by other similarly placed leveraged investors, Reserve Bank of New York contacted the major likely contributed materially to the tremendous vola- creditors and counterparties of LTCM to see if an tility of financial markets rn early October. Market alternative to forcing LTCM into bankruptcy could be found. At the same time. Reserve Bank officials informed some of their colleagues at the Federal Implied volatilities Reserve Board, the Treasury, and other financial regulators of their activities. Subsequent discussions among LTCM's creditors and counterparties led to an agreement by the private-sector parties to provide an additional $3W billion of capital to LTCM in return for a 90 percent equity stake in the firm. Because of the potential for firms such as LTCM to have a large influence on U.S. financial markets. Treasury Secretary Robert Rubin asked the Presi- dent's Working Group on Financial Markets to study the economic and regulatory implications of the operations of firms like LTCM and their relationships with their creditors. In addition, the extraordinary degree of leverage with which LTCM was able to operate has led the federal agencies responsible for . The diM mt dajly. lirplied volfltiliws are cafculaed from the prudential oversight of the fund's creditors and u w for Ftbmry 19. 1999. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 105 Monetary Policy Report to (he Congress Q February 1999 expectations of asset price volatility going forward, on December 2, when that maturity crossed year-end, as reflected in options prices, rose sharply, as bid- and then reversed the rise late in the month. asked spreads and the premium for on-the-run securi- By shortly alter year-end, some measures of mar- ties widened. Long-term Treasury yields briefly ket stress had eased considerably from their levels dipped to their lowest levels in more than thirty in the fall, although markets remained somewhat years, in part because of large demand shifts resulting illiquid relative to historical norms, and risk spreads from concerns about the safety and liquidity of pri- on corporate bonds stayed quite elevated. Nonethe- vate and emerging market securities. Spreads of rates less, with Treasury yields very tow, corporate bond on corporate bonds over those on comparable Trea- rates were apparently perceived as advantageous, sury securities rose considerably, and issuance of and—following a lull around year-end—many corpo- corporate bonds, especially by lower-rated firms, rate borrowers brought new issues to market The remained very low. devaluation and subsequent floating of the Brazilian By mid-October, however, market conditions had real in mid-January had a relatively small effect on stopped deteriorating, and they began to improve US. financial markets. More recently, intermediate- somewhat in the days and weeks following the cut in and long-term Treasury rates have increased, as in- the federal funds rate on October 15, between Federal coming data have continued to show the economy Open Market Committee meetings. Internationally expanding briskly, and investors have come to be- coordinated efforts to help Brazil cope with its finan- lieve that no further easing of Federal Reserve policy cial difficulties, culminating in the announcement of is likely. an IMF-led support package in mid-November, con- tributed to the easing of market strains. In the Trea- sury market, bid-asked spreads narrowed a bit and Equity Prices the premium for on-lhe-rtin issues declined. With the earlier flight to quality and liquidity unwinding. Trea- Most equity indexes rose strongly, on balance, in sury rates backed up considerably. Corporate bond 1998, with the Nasdaq Composite Index up nearly spreads reversed a part of their earlier rise, and 40 percent, the S&P 500 Composite Index rising investment-grade bond issuance rebounded sharply. more than 25 percent, and the Dow Jones Industrial In the high-yield bond market, investors appeared to Average and the NYSE Composite Index advancing be more hesitant, especially for all but the best- more than 15 percent. Small capitalization stocks known issuers, and the volume of junk bond issuance underperformed those of larger firms, with the Rus- picked up less. In the commercial paper market, sell 2000 Index off 3 percent over the year. The yields on higher-quality paper declined; yields on variation in stock prices over the course of the year lower-quality paper remained elevated, however, and was extremely wide. Prices increased substantially some lower-tier firms reportedly drew on their bank over the first few months of 1998, as concerns eased tines for funding, giving a further boost to bank that Asian economic problems could lead to a slow- business lending, which had begun to pick up during down in the United Stales and to a consequent decline the summer. Market conditions improved a bit further immedi- Major stock price indexes ately after the Federal Reserve's November rate cut, but some measures of market stress rose again in late Juki IJwBiy 1.1W! . IO» November and in December. In pan, this deterio- ration reflected widespread warnings of lower-than- expected corporate profits, a weakening economic outlook for Europe, and renewed concerns about the situation in Brazil. In addition, with risk a greater- than-usual concern, some market participants were likely less willing to bold lower-rated securities over year-end, when they would have to be reported in annual financial statements. As a result, liquidity in some markets appeared to be curtailed, and price movements were exaggerated. These effects were particularly noticeable in the commercial paper mar- J FMAMI JASONDJ FMAMJ ) A S ONDI F ket: The spread between rates on top-tier and lower- ""____„__. iwi _ i»»t tier thirty-day paper jumped almost 40 basis points Hint. ThedaKediity. L»i**B™baa»tfatf«*iniiry 19,199*. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 106 Board of Governors of the Federal Reserve System in profits. The major indexes declined, on balance, Equity valuation and long-term real interest rale over the following couple of months before rising sharply, in some cases to new records, in late June and early July, on increasing confidence about the outlook for earnings. The main exception was the Russell 2000; small capitalization stocks fell more substantially in the spring, and their rise in July was relatively muted. Rising concerns about the outlook for Japan and other Asian economies, as well as the deepening financial problems in Russia, caused stock prices to retrace their July gains by early August. After Russia devalued the ruble and defaulted on some debts in mid-August, prices fell further, reflecting the general turbulence in global financial markets. By the end of 1980 1*83 1M6 1989 1995 ibe month, most equity indexes had fallen back to Merit. Tbe itan m monthly. Tbe otrdatt-frKf ntio i> bMed « the I/IVES roughly their levels at the start of the year. Commer- J m fl m en d u u n . o T u li L e m ln lM cr. K e r a n n lT em fle i i i t t u te ii H yi K eld o o f p e A v le n H ln i- p y e o n v 1 t T t rc th m e r c y o i o n n in e g te w n i I v t e e cial bank and investment bank slocks fell particularly ttn~j« intakni eipecMiMi Ann Hit Fedml Row™ Bnk of Philideliilii sharply, as investors became concerned about the Survey t effect on these institutions' profits of emerging mar- ket difficulties and of substantial declines in the val- Philadelphia Federal Reserve Bank's survey of pro- ues of some assets. Equity prices rose for a time in fessional forecasters, real yields fell appreciably September but then fell back by early October before between late 1997 and early 1999. (The yield on rebounding as market dislocations eased and interest ten-year inflation-indexed Treasury securities actu- rates on many private obligations fell. By December, ally rose somewhat last year. However, the increase most major indexes were back near their July highs, may have reflected the securities' lack of liquidity although the Russell 2000 remained below its earlier and the substantial rise in the premium investors were peak. willing to pay for liquidity.) Since mid-1998, the real In late December, and into the new year, stock interest rate has declined somewhat more than the prices continued to advance, with several indexes forward earnings yield on stocks, and the spread reaching new highs in January. The devaluation of between the two consequently increased a bit, per- the Brazilian real caused some firms' shares to drop haps reflecting the greater sense of risk in financial as investors Devaluated prospective earnings from markets. Nonetheless, the spread has remained quite Latin American operations, but all the major stock small relative to historical norms: Investors may indexes posted gains in January; the Nasdaq be anticipating rapid long-term earnings growth- advanced nearly IS percent over the month, driven consistent with the expectations of securities by large advances in the stock prices of high- analysts-—and (hey may still be satisfied with a lower lechnology firms, especially ibose related to the Inter- risk premium for holding stocks than they have net. More recently, however, stock prices fell back, as demanded historically. interest rates rose and some investors apparently con- cluded that prices had risen too far, given the outlook for earnings. Debt and the Monetary Aggregates The increase in equity prices last year and early this year, coupled with the slowing of earnings Debt and Depository Intermediation growth, left many valuation measures beyond their historical ranges. After ticking higher in the late From the fourth quarter of 1997 to the fourth quarter summer and early autumn, the ratio of consensus of 1998, the total debt of the U.S. household, govern- estimates of earnings over the coming twelve months ment, and nonfinancial business sectors increased to prices in the S&P 500 later fell back, dropping about 6'A percent, in the top half of its 3 percent to to a new low in January. In part, the decline in this 7 percent range and considerably faster than nominal measure over the past year likely reflected lower real GDP. Buoyed by strong spending on durable goods, long-term bond yields. For example, as measured by housing, and business investment, as well as by the difference between the (en-year nominal Treasury merger and acquisition activity that substituted debt yield and inflation expectations reported in the for equity, nonfederal debt expanded about 9 percent Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 107 Monetary policy Report w the Congress O February 1999 Domestic noflfinincul detM: Annual range and actual level M2: Annual range and actual level last year, more than 2 percentage points faster than in range was the rc&uk of faster growth in nominal 1997. By contrast, federal debt declined VA percent, spending than would likely be consistent with sus- following a rise of'/«percent the previous year. tained price stability. In addition, the velocity of M2 Credit market instruments on the books of deposi- (defined as the ratio of nominal GDP to M2) fell tory institutions rose at a somewhat slower pace than 3 percent. Some of the decline resulted from the did the debt aggregate, posting a 5'A percent rise in decrease in short-term market interest rates last 1998, about half a percentage point less than in 1997. year—as usual, rales on deposits fell more slowly Growth in depository credit picked up in the second than market rates, reducing the opportunity cost of half of the yew, as the turbulence in financial markets holding M2 (defined as the difference between the apparently led many firms to substitute bank loans for rate on Treasury bills and the average return on M2 funds raised in the markets. Banks also added con- assets). siderably to their holdings of securities in the third However, the bulk of the decline cannot be and fourth quarters, in part reflecting the attractive explained on the basis of the historical relationship spreads available on non-Treasury debt instruments. between the velocity of M2 and this measure of its Financial firms also appeared to turn to banks for opportunity cost Three factors not captured in that funding when the financial markets were volatile, and relationship likely contributed to the drop in velocity. U.S. banks substantially expanded their lending to First, households seem to have allocated an increased financial firms through repurchase agreements and loans to purchase and carry securities. As a result, growth of total bank credit, adjusted to remove the M2 velocity and the opportunity cost of holding M2 effects of mark-to-market accounting rules, acceler- ated to lOVi percent on a fourth-quarter to fourth- quarter basis, ate largest annual increase in more than a decade. The Monetary Aggregates The broad monetary aggregates expanded very rap- idly last year. From the fourth quarter of 1997 to the fourth quarter of 1998, M2 increased 8W percent, placing it well above the upper bound of its I percent to 5 percent range. However, as the FOMC noted last February, this range was intended as a benchmark, for I I 1 1 l_LJ_l_l_l 1 1 1 1 ] I I I I l_lJ money growth under conditions of stable prices, real _JW» 19*3 mt 1993 MM economic growth near trend, and historical velocity NOTE, nc J«a»t n»imifr. Ml Oftar**i<y am iufcc nn-ifiiner tttumt mngc of Me Om-mft Tretmy Ml ate leu the watMc*4wtM> rmc fmd relationships. Part of the excess of M2 above Us Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 108 Boon! of Governors of the Federal Reserve System M3: Annual range and actual level being reversed, growth in the broad monetary aggre- gates, while still brisk, has slowed appreciably early this year. M3 expanded even faster than M2 in 1998, posting an 11 percent rise on a founh-quarter to fourth- quarter basis. Lasi year's growth was the fastest since 1981 and left the aggregate well above the top end of its 2 percent ID 6 percent growth range. As with M2, however, the FOMC established the M3 range as a benchmark for growth under conditions of stable prices, sustainable output growth, and the historical behavior of velocity. The rapid growth of M3 in pan simply reflected the rise in M2. In addition, the non-M2 components of M3 increased ]&W percent over the year, following an even larger advance in 1997. The substantial rise in these components last year was partly the result of the funding of the robust growth in bank credit with managed liabilities, many share of savings flows to monetary asseU rather than of which are in M3. However, M3 growth was equities following several years of outsized gains in boosted to an even greater extent by flows into stock market wealth. Second, some evidence sug- institution-only money funds, which have been gests that in the 1990s the demand for M2 assets has expanding rapidly in recent years as they have become more sensitive to longer-term interest rates increased their share of the corporate cash manage- and to the slope of the yield curve, and so the decline ment business. Because investments in these funds in long-term Treasury yields last year, and the conse- substitute for business holdings of short-term assets quent flattening of the yield curve, may have that are not in M3, their rise has generated an increase increased the relative attractiveness of M2 assets. in M3 growth. In addition, institution-only funds Finally, a critical source of the especially rapid M2 pay rates thai lend to lag movements in market rates, expansion in the fourth quarter likely was an and so their relative attractiveness was temporarily increased demand for safe, liquid assets as investors enhanced—and their growth rate boosted—by responded to the heightened volatility in financial declines in short-term market interest rates late last markets. With some of these safe-haven flows likely year. 4. Crovxih of money and debt Period Ml M2 u' , BOO D fi o n m ilK r B af l c fcbl Annual' I9SS J.5 .6 6.4 1 2 41 S 1WO 41 .: 19 M .1 1.1 5 \<m 14 3 s 6 i IWJ (0 2 .6 3 . 3 6 1 1. 0 7 9 » I 1 9 9 9 9 S 6 . - - -1 4 l . I . . 3 5 t t . . 8J ( » , 11 6 8 6 . . . 0 8 1 8 0 4 1 * Qaaanh laamal rare)' -1 3 1. 2 0 0 6 1 1 1 0 0 8 . . 3 1 6 2 0 1 5.0 1 *0 132 t4 N*m. Ml cottier* of cwrency, mwJc» cbecki-dupnid deposiu. avJoAer crab nufcel deb* of Ac US- jowmnwnf. me **d fcca) go dvckafefc dejmUt- Mlcorefeu of Ml phu uvniga depotta (intbdi^ money mrta dtptHi «xoHiu)i umlMfenon^nion time depwu. md tnlvo« in Rfsf rovey mvfcd foods. M3 cooiim of M2 ph» brtestenorambw IHW I. From avenge for tfmntr tjoarter of pfrrtdmj yvt lo tvaafc for ffn depwns. MlvKti hi intWiMk**] money mata fiHdt HP lirttEi w of y*a iAdktd and ittm). *nd EurodofhR (crmgj* jprf n™y. Debt toonuj of iht . From avenge for p«xtfdiiij quavr vt avera^r for qc**Kf irtdkjgfri Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 109 Monetary Policy Report 10 the Congress D February 1999 Ml increased Wt percent over the four quarters of administrative measures and financial penalties. 1998, its first annual increase since 1994. Currency Thus, as required operating balances decline coward expanded at an S'/t percent pace, its largest rise since the minimum level needed to clear banks' trans- 1994. The increase apparently reflected continued actions, banks are less and less able lo respond to strong foreign shipments, though at a slower pace fluctuations in the federal funds rate by lending funds than in 1997, and a sharp acceleration in domestic when the rate is high and borrowing when the rate is demand. Deposits in Ml declined further in 1998, low. As a result, when required operating balances reflecting the continued introduction of retail are low, the federal funds rate is likely to rise further "sweep" programs. Growth of Ml deposits has been than it otherwise would when demands for reserves depressed far a number of years by these programs, are unexpectedly strong or supplies weak; conversely, which shift—or "sweep"—balances from household the federal funds rate is likely to fail more in the transactions accounts, which are subject to reserve event of weaker-than-expected demand or stronger- requirements, into savings accounts, which are not. thati-expecied supply. One way to ease this difficulty Because the funds are shifted back to transactions would be to pay interest on required reserve balances, accounts when needed, depositors' access to their which would reduce banks' incentives to expend funds is not affected by these programs. However, resources on sweeps and other efforts to minimize banks benefit from the reduction in holdings of these balances. required reserves, which do not pay interest. Over Despite the low level of required operating bal- 1998, sweep programs for demand deposit accounts ances, the federal funds rate did not become notice- became more popular, contributing to a 4Vt percent ably more volatile over the spring and summer of decline in such balances. By contrast, new sweep 1998. In part, this result reflected more frequent programs for other checkable deposits, which had overnight open market operations by the Federal driven double-digit declines in such deposits over the Reserve to better match the daily demand for and previous three years, were less important in 1998, supply of reserves. Also, banks likely improved the and, with nominal spending strong and interest management of their accounts at the Federal Reserve rates lower, other checkable deposits were about Banks. Moreover, large banks apparently increased unchanged on the year. their willingness to borrow at the discount window. As a result of the introduction of retail sweep The Federal Reserve's decision to return to lagged accounts, UK average level of required reserve bal- reserve accounting at the end of July also likely ances (balances that must be held at Reserve Banks contributed to reduced volatility in the federal funds to meet reserve requirements) has trended lower over market by enhancing somewhat the ability of both the past few years. The decline has. been associated banks and the Federal Reserve to forecast reserve with an increase in banks' required clearing balances, demand. which are balances that banks agree in advance to In the latter part of 1998 and into 1999, however, hold at their Federal Reserve Bank in order to facili- the federal funds rate was more volatile. The increase tate ihe clearing of their payments. Unlike required may have owed partly to further reductions in reserve balances, banks earn credits on their required clearing balances that can be applied to the use of Effective federal funds ride less target rate Federal Reserve priced services. Despite the increase in required clearing balances, required operating bal- ances, which are the sum of required reserve balances and required clearing balances, have declined over the past few years and in late 1998 reached their lowest level in several decades. The decline in required operating balances has generated concerns about a possible increase in the volatility of the federal funds rate. Because a bank's required level of operating balances must be met only on average over a two-week maintenance period, banks are free to allocate their reserve holdings across the days of a maintenance period in ordct \o mini- _1 mize their reserve cosis. However, banks must also J F M A MJ J A S O V DJ f manage their reserves in order to avoid overdrafts, 1998 1999 which the Federal Reserve discourages through MOTE. Das ire isily LM otnerMoon is fin Febninry 19.1999 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis no Board of Governors of the Federal Reserve System required operating balances resulting from new The Asian crisis contributed to a deepening recession sweep programs, but other factors were probably in Japan last year, and as the year progressed, growth more important, at least for a time. Market partici- in several other major foreign industrial economies pants were scrutinizing borrowing banks more slowed as well. closely, and in some cases lenders pared or more At the beginning of 1998, many Asian currencies tightly administered their counterparty credit limits, were declining or were under pressure. The Indone- or shifted more of their placements from term to sian rupiah dropped sharply in January, amid wide- overnight maturities. The heightened attention to spread rioting and talk of a coup, and fell again in credit quality also made banks less willing to borrow May and lune, as the deepening recession prompted at the discount window, because they were concerned more social unrest and ultimately the ouster of that other market participants might detect their bor- Presidem Suharto. Some of the rupiah's losses were rowing and interpret it as a sign of financial weak- reversed in the second half of the year, following the ness. As a result, many banks that were nei takers of relatively orderly transition of power to President funds in short-term markets attempted to lock in their Habibie. Tighter Indonesian monetary policy, which funding earlier in the morning. On net, these forces pushed short-term interest rates as high as 70 percent boosted the demand for reserves and put upward by July, contributed to the rupiah's recovery. On pressure on the federal funds rate early in the day. To balance, between December 1997 and December buffer the effect of these changes on volatility in the 1998, the rupiah depreciated more than 35 percent federal funds market, the Federal Reserve increased against the dollar. the supply of reserves and. at times, responded to the In contrast, the Thai baht and Korean won, which level of the federal funds rate early in the day when had declined sharply in 1997, gained more than deciding on the need for market operations. Because 20 percent against the dollar over the course of 1998. demand had shifted 10 earlier in the day, however, the Policy reforms and stable political environments federal funds rate often fell appreciably below its helped boost these currencies. Between these target level by the end of the day. extremes, the currencies of the Philippines, Malaysia, At its November meeting, the FOMC amended the Singapore, and Taiwan fluctuated in a narrower Authorization for Domestic Open Market Operations range and ended the period little changed against the to extend me permitted maturity of System repur- dollar. In September, Malaysia imposed capital and chase agreements from fifteen to sixty days. Over the exchange controls, fixing the ringgit's exchange rale remainder of 1998, the Domestic Trading Desk made against the dollar. The Hong Kong dollar came under use of this new authority on three occasions, arrang- pressure at limes during the year, but its peg to the ing System repurchase agreements with maturities of U.S. dollar remained intact, although at the cost of thirty to forty-five days to meet anticipated seasonal interest rates that were at times considerably ele- reserve demands over year-end. While the Desk had vated. Short-term interest rates in Asian economies in the past purchased inflation-indexed securities other than Indonesia declined in 1998, and &s some when rolling over holdings of maturing nominal secu- stability returned to Indonesian markets near the end rities, il undertook its first outright open market pur- of the year, short-term rates in that nation began to chase devoted solely to inflation-indexed Treasury retreat from their highs. securities in 1998, thereby according those securities As the year progressed, the financial storm moved the same status in open market operations as othet from Asia to Russia. At first the Russian central bank Treasury securities. was able to defend the ruble's peg to (he dollar with interest rate increases and sporadic intervention. By midyear, however, the government's failure to reach IntemaiMMal Developments a new assistance agreement with the International Monetary Fund, reported shortfalls in lax revenues, In 1998, developments in international financial mar- and the disruption of rail travel by striking coal kets continued to be dominaied by the unfolding miners protesting late wage payments brought to crises in emerging markets that had begun in Thai- the fore the deep structural and politics) problems land in 1997. Financial market turbulence spread to faced by Russia. In addition, declining oil prices were other emerging markets around the globe, spilling lowering government revenues and worsening the over from Korea, Indonesia. Malaysia, Singapore, the current account. As a result of these difficulties, die Philippines, and Hong Kong in late 1997 arid in the ruble came under renewed pressure, forcing Russian first put of 1998 to Russia in (he summer, and to interest rates sharply higher, and Russian equity Latin America, particular)}' Brazil, shortly Thereafter, prices fell abruptly. A disbursement of $4.8 billion Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ill Monetary Policy Report ID the Congress a February 1999 from the IMF in July was quickly spoil lo keep the pressure again in early January after the state of currency near hs level of 6.2 rubles per dollar, but the Minas Gersis threatened not to pay its debt to Ihe lack of progress on fiscal reform put the next IMF federal government. On January 13, the rent was tranche in doubt devalued 8 percent, and two days later it was allowed On August 17, Russia announced a devaluation of to float. Since the end of 1998, the real has depreci- the ruble and a moratorium cm servicing official short- ated nearly 38 percent against the dollar, and capital term debt Subsequently, the ruble depreciated more flight from Brazil has likely persisted. The collapse than 70 percent against the dollar, the government of the real exerted some downward pressure on the imposed conditions on most of its foreign and domes- currencies of other Latin American countries. Thus tic debt that implied substantial losses for creditors, far, however, contagion has been more limited than it and many Russian financial institutions became was after the Russian devaluation; unlit* Russia, insolvent The events in Russia precipitated a global Brazil has continued to meet debt service obligations, increase in financial market turbulence, including a and investors apparently had an opportunity to adjust pullbadt of credit to highly leveraged investors and a positions in advance of the devaluation and have widcniig of credit spreads in emerging market econo- drawn a distinction between Brazil's problems and mies and in many industrial countries, which did not those of other economies. abate until after centra} banks in a number of indus- The fallout from the financial crises that hit several trial countries eased policy in the fall. Asian emerging market economies in late 1997 trig- Latin American financial markets were only mod- gered a further decline in output in the region ia early erately disrupted by the Asian and Russian prob- 1998. In Ihe countries most heavily affected— lems during the first half of 1998. The reaction to the Thailand, Korea, Malaysia, and Indonesia—output Russian default, however, was swift and strong, and dropped at double-digit annual rates in the first half the prices of Latin American assets fell precipitously. of the year, as credit disruptions, widespread failures UK spreads between yields on Latin American Brady in the financial and corporate sectors, and a resulting bonds aid comparable U.S. Treasuries widened con- high degree of economic uncertainty depressed activ- siderably (with increases tanging from 900 basis ity severely. Output in Hong Kong also dropped in points in Argentina to 1500 basis points in Brazil) early 1998, as interest rates rose sharply amid pres- and peaked in early September before retracing part sure on its currency peg. Laler in the year, with of the rise. Latin American equity prices plunged, financial conditions in most of the Asian crisis coun- ending Ihe year down 25 percent or more. Several tries stabilizing somewhat, output started 10 bottom currencies came under pressure, despite sharp out. increases in shon-term interest rates. The Mexican The Asian crisis had a relatively moderate effect on peso, which was also weakened by the effects of China, although it may have encouraged authorities falling oil prices, depreciated IS percent against the in that country to move ahead more quickly with dollar over the year. The Colombian peso and the various financial sector reforms. Financial tensions Ecuadorian sucre were devalued, but Argentina's cur- mounted early this year as foreign investors have rency board arrangement survived. reacted with concern to the failure of the Guangdong Brazil's central bank defended the real's crawling International Trust and Investment Corporation. peg until mid-January 1999 but is estimated to have Chinese growth remained fairly strong throughout used more than half of the $75 billion in foreign 1998. despite a dramatic slowdown in the growth of exchange reserves it had amassed as of last April. exports. Anticipation of the IMF-led financial assistance pack- Inflation in the Asian developing economies rose age for Brazil helped spur a partial recovery in Latin only moderately on average in 1998, as the inflation- American asset markets in late September and Octo- ary effects of currency depreciations in the region ber. The details of me $41.5 billion loan package were largely offset by the deflationary influence were announced in November, but after the package of very weak domestic activity. The current account was approved by the IMF in early December, Brazil's balances of Ihe Asian crisis countries swung into Congress rejected a part of the government's fiscal substantial surplus last year, reflecting a sharp drop in austerity plan, sparking renewed financial turmoil. In imports resulting from the falloff in domestic demand mid-December, $9.3 billion of the loan package was as well as improvement in the countries' competilive disbursed, but as Ihe year ended, the continuing positions associated with the substantial deprecia- pressure from investors seeking to take funds out of tions of their currencies in late 1997 and early 1998. Brazil put the long-run viability of the crawling In Russia, economic activity declined last year as exchange rate peg in doubt The rtai came under interest rates were pushed up in an attempt to fend off Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 112 tloani afGwerncm ofihe Federal Reserve System pressure on the ruble. After the August debt morato- Nominal dollar exchange rale indexes rium and ruble devaluation, output dropped sharply, ending the year down about 10 percent from its year-«arlier level. The ruble collapse triggered a surge in inflation to a triple-digit annual rate during the latter part of the year. In Latin America, the pace of economic activity slowed only moderately in the first half of 1998, as the spillover from the Asian financial turbulence was limited. The Russian financial crisis in August, in contrast, had a Strong impact on real activity in Latin America, particularly Brazil and Argentina, where interest rates moved sharply higher in response to exchange rale pressures. Output in both cowilries is estimated to have declined in the second half of the 1944 19» 1996 1997 199* (9W year a! annual rales of about 5 percent. Activity in Noil. TDc dm me nuwMy. lixfeui « mk-m^Med iwngei of Ac Mexico and Venezuela was also depressed by lower t a i ] i i a a b t r j o e ad v g r r t o iK up o o f f O m K ^ iM tor li m r * U p 5 im . t i ra m di a n i g n p c v u t n n e m nc . k la i e a i d o b n s ff e o n o m l o i n t* s c o u t m fo n it c t K te i oil export revenues. Inflation rates in Latin American Am One *Bkj of Frtnury 1999. countries were little changed in 1998 and ranged from i percent in Argentina and 3 percent in Brazil to 31 percent in Venezuela. resuh of concerns about the effects of the Asian crisis The dollar's value, measured on a trade-weighted on the already-weak Japanese economy and further basis against the currencies of a broad group of signs of deepening recession and persistent banking important U.S. trading partners, rose almost 7 percent system problems in that country. It reached a level during the first eight months of 1998, but it then fell, of almost 147 yen per dollar in mid-June, prompting by December reaching a level about 2 percent above coordinated intervention by U.S. and Japanese au- its year-earlier level. (When adjusted for changes in thorities in foreign exchange markets that helped to U.S. and foreign consumer price levels, the real value contain further downward pressure on the yen. The of the dollar in December 1998 was about 1 percent dollar resumed its appreciation against the yen, albeit below its level in December 1997.) Before the Rus- at a slower pace, in July and early August. sian default, the dollar was supported by the robust The turning point in the dollar-yen rate came after pace of U.S. economic activity, which at times gener- the Russian collapse, amid the global flight from risk ated expectations that monetary policy would be thai caused liquidity to dry up in the markets for tightened and which contrasted wilh weakening eco- many assets. During the first week of October, the nomic activity abroad, especially in Japan, Occasion- dollar dropped nearly 14 percent against the yen in ally, however, the positive influence of the strong extremely illiquid trading conditions. Although fun- economy was countered by worries about growing U.S. external deficits. From August through October, US, exchange rale wilh Japan in (he aftermath of the Russian financial meltdown, concerns that increased difficulties in Latin America might affect the US. economy disproportionate Jy, as welt as expectations of lower U.S. interest rates, weighed on the value of the dollar, and it fell sharply. The broad index of the dollar's exchange value eased a bit further during the fourth quarter of the year. So far in 1999, the dollar has gained nearly 3 percent in terms of the broad index. Against the currencies of the major foreign indus- trial countries, the dollar declined 2 percent in nomi- nal terms over 1998, on balance, reversing some of its tO percent appreciation the preceding year. Among these currencies, the dollar's value fluctuated most widely against the Japanese yen. The dollar rose NOTE. Tht dMa are montiily. Lau otaervauon is fa ite rim tfm* wwts of against the yen during the first half of the year as a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 113 Monetary Policy Report to the Congress D February 1999 damental factors in Japan, such as progress on bank US. dollar exchange me againsl Ihe reflated German mark reform, fiscal stimulus, and the widening trade sur- and the euro plus may have helped boost the yen against the dntnc K* Ifftmi dollar, market commentary at the time focused on reports that some international investors were buying large amounts of yen. These large purchases report- edly/ were needed to unwind positions in which inves- tors had used yen loans to finance a variety of specu- lative investments. On balance, Ac dollar depreciated almost 10 percent against the yen in 1998, reversing most of its net gain during 1997. It depreciated fur- ther against the yen in early 1999, hitting a two-year Healed Gmun nwct low on January II, but it then rebounded somewhat amid reports of intervention purchases of dollars by the Bank of Japan. More recently, (he Bank of Japan has eased monetary policy further, and the dollar has strengthened against the yen. So far this year, the Nun. UK dm ft «™Mj. Homed Gema imrt a rht <MlM-/mik exdunge i«e loafed by die oficiil convenioa boat between At mark and dollar has gained about 7 percent against the yen. teem. 1.93SSI. Arafli December 1998 Esn> eiduBfe me a of lanry Japanese economic activity contracted in 1998, as the country remained in its most protracted recession of the postwar era. Business and residential invest- expected economic data in the United Slates, con- ment plunged, and private consumption stagnated, trasted with weakey-than-expected data in [he euro more Uian offsetting positive contributions from gov- area. ernment spending and net exports. Core consumer In tile eleven European countries whose currencies prices declined slightly, while wholesale prices fell are now fixed against the euro, output growth slowed almost 4'/2 percent. In April, the Japanese govern- moderately over the course of 1998. as net exports ment announced a large fiscal stimulus package. Dur- weakened and business sentiment worsened. Unem- ing ihe final two months of the year, the government ployment rates came down slightly, but the average announced another set of fiscal measures slated for of these raws remained in the double-digit range. implementation during 1999, which included perma- Consumer price inflation continued to slow, helped nent personal and corporate income tax cuts, various by lower oil prices. In December, the harmonized incentives for investment, and further increases in CPI for the eleven countries stood V* percent above public expenditures. its year-earlier level, meeting the European Cen- Against the German mark, the dollar depreciated tral Bank's primary objective of inflation below about 6 percent, on net, during 1998. Late in the year 2 percent. the dollar moved up against the marie, as evidence of Between December 1997 and December 1998, the a European growth slowdown raised expectations of average value of the dollar changed little against the easier monetary conditions in Europe. In the event, British pound but rose 8 percent against the Canadian monetary policy was eased sooner than market par- dollar. Weakness in primary commodity prices, ticipants had expected, with a coordinated European including oil, likely depressed the value of the Cana- interest rate cut coining in early December. dian dollar. The Bank of Canada raised official rates A major event at the turn of the year was the birth in January 1998 and again in August, in response of the euro, which marked the beginning of Stage to currency market pressures. The Bank of England Three of European Economic and Monetary Union raised official rates in June 1998 to counter inflation (EMU). On December 31, the rates locking the euro pressures. Tighter monetary conditions in both coun- with the eleven legacy currencies were determined; tries, as well as a decline in net exports associated based on these rates, the value of the euro at the with global difficulties, contributed to a slowing of moment of its creation was $1.16675. Trading in the output growth in the second half of the year. The euro opened on January 4, with the first trades reflect- deceleration was sharper in the United Kingdom than ing a significant premium for the euro over its initial in Canada. U.K. inflation eased slightly to near its value. As the first week of trading progressed, target rate, while Canadian inflation remained near however, ihe initial euphoria wore off, and so far the bottom of its target range. In response to weaker this year the dollar has strengthened more than 5 per- economic activity as well as to the expected effects of cent against the euro, partly reflecting beuer-than- the global financial turmoil, both the Bank of Canada Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 114 Board of Governors of the Federal Reserve System US. and foreign interest rales December 1997 and December 1998, len-yeiir inter- est rates fell ISO basis points in the United Kingdom and 150 basis points in Germany. The ten-year rate fell only 30 basis points in Japan, on balance, declin- ing about 90 basis points over the first an months of the year but backing up hi November and December. Market participants attributed the increase to con- cerns thai the demand for bonds would be insufficient to meet the surge in debt issuance associated with the latest fiscal stimulus package. Share prices on European stock exchanges posted another round of strong advances last year, with price indexes rising 8 percent in the United Kingdom, about 15 percent in Germany, nearly 29 percent in France, and 41 percent in Italy. In contrast. Japanese equity prices felt more than 9 percent in (998, and Canadian share prices decreased 4 percent. After a considerable run-up earlier in the year, share prices around the globe fell sharply in August and Septem- ber, but they rebounded in subsequent months as the Federal Reserve and central banks in many other industrial countries eased monetary policy. On November !7, the FOMC voted unanimously to reauthorize Federal Reserve participation in the North American Framework Agreement (NAFA), established in 1994. and in the associated bilateral 1W2 tWJ IWJ IMS l»7 IMS 1W reciprocal currency swap arrangements with the Bank TtK dau an monthly La&i otnervaiaag are for the Am three weeks of Canada and the Bank of Mexico. On December 7, I9M. the Secretary of the Treasury authorized renewal of the Treasury's participation in the NAFA and of the and the Bank of England have lowered official inter- associated Exchange Stabilization Agreement with est rales since September. Mexico. Other bilateral swap arrangements with the The general trend toward easier monetary condi- Federal Reserve—those with the Bank for Interna- tions was reflected in declines in short-term interest tional Settlements, the Bank of Japan, and many rales in almosi all the G-10 countries during the year. European central hanks—were allowed to lapse in Interest rates in the euro area converged to relatively light of their disuse over the past fifteen years and in low German levels in anticipation of the launch of the presence of other well-established arrangements the third stage of EMU Yields on ten-year govern- for international monetary cooperation. The swap ment bonds in the major foreign industrial countries arrangement between the Treasury's Exchange Stabi- declined significantly over the course of the year, as lization Fund and the German Bundesbank was also economic activity slowed, inflation continued Co mod- allowed to lapse, erate, and investors sought safer assets. Between Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1999, February 23). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19990224_chair_conduct_of_monetary_policy_report_of

@misc{wtfs_testimony_19990224_chair_conduct_of_monetary_policy_report_of,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1999},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19990224_chair_conduct_of_monetary_policy_report_of},
  note = {Retrieved via When the Fed Speaks corpus}
}