Congressional Testimony

CONDUCT OF MONETARY POLICY Report of the Federal Reserve Board pursuant to the Full-Employment and Balanced Growth Act of 1978 P.L. 95-523 and The State of the Economy HEARING BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED SIXTH CONGRESS SECOND SESSION FEBRUARY 17, 2000 Printed for the use of the Committee on Banking and Financial Services Serial No. 106-46 U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 2000 For sale by the U.S. Government Printing Office Superintendent of Documents, Congressional Sales Office, Washington, DC 20402 ISBN 0-16-060556-3 HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES JAMES A. LEACH, Iowa, Chairman BILL McCOLLUM, Florida, Vice Chairynan MARGE ROUKEMA, New Jersey JOHN J. LAFA^CE, New York DOUG K. BEREUTER, Nebraska BRUCE F. VEMTO, Minnesota RICHARD H. BAKER, Louisiana BARNEY FRANK,"Ttfassachiisetts RICK LAZIO, New York PAUL E. KANJORSKI, Pennsylvania SPENCER BACKUS III, Alabama MAXINE WATERS, California MICHAEL N. CASTLE, Delaware CAROLYN B. MALQNEY, New York PETER T. KING, New York LUIS V. GUTIERREZ, Illinois TOM CAMPBELL, California NYDIA M. VELAZQUEZ, New York EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York JACK METCALF, Washington KENNETH E. BENTSEN JR., 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 FRANK R. MASCARA, Pennsylvania STEVEN c. LATOURETTE, Ohio JAY INSLEE, Washington DONALD A. MANZULLO, Illinois JANICE D. SCHAKOWSKY, Illinois WALTER B. JONES JR., North Carolina DENNIS MOORE, Kansas PAUL RYAN, Wisconsin CHARLES A. GONZALEZ, Texas DOUG OSE, California STEPHANIE TUBES JONES, Ohio JOHN E. SWEENEY, New York MICHAEL E. CAPUANO, Massachusetts JUDY BIGGERT, Illinois MICHAEL P. FORBES, New York LEE TERRY, Nebraska MARK GREEN, Wisconsin BERNARD SANDERS, Vermont PATRICK J. TOOMEY, Pennsylvania (ID CONTENTS Hearing held on: February 17, 2000 .. 1 Appendix: February 17, 2000 45 WITNESSES THURSDAY, FEBRUARY 17, 2000 Greenspan, Hon. Alan, Chairman, Board of Governors, Federal Reserve System f APPENDIX Prepared statements: Leach, Hon. James A 46 Bachus, Hon. Spencer 47 Forbes, Hon. Michael P 52 Roukema, Hon. Marge 53 Ryan, Hon. Paul 59 Greenspan, Hon. Alan 91 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Bachus, Hon. Spencer: Letter to Chairman Alan Greenspan, February 17, 2000, with response, March 10, 2000 49 Roukema, Hon. Marge: "Shrinking Treasury Debt Creates Uncertain World," New York Times, February 17, 2000 55 Greenspan, Hon. Alan: Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978, February 17, 2000 61 Written response to a question from Hon. James A. Leach 104 Written response to questions from Hon. Spencer Bachus 105 Written response to questions from Hon. Ron Paul 108 Written response to questions from Hon. Bernard Sanders Ill Written response to questions from Hon. Brad Sherman 112 (III) CONDUCT OF MONETARY POLICY THURSDAY, FEBRUARY 17, 2000 U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON BANKING AND FINANCIAL SERVICES, Washington, DC. The committee met, pursuant to call, at 10:07 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding. Present: Chairman Leach; Representatives Roukema, Bachus, Castle, Royce, Paul, Ryun of Kansas, Hill, Ryan of Wisconsin, Ose, Biggert, Terry, Toomey, LaFalce, Kanjorski, Sanders, Watt, Bentsen, J. Maloney of Connecticut, Sherman, Inslee, and Moore. 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, welcome back to the House Banking Com- mittee and congratulations on your renomination and reconfirma- tion as Chairman of the Federal Reserve. The President of the United States and the Senate have made a wise and timely deci- sion. It underscores that this country has been well served by an independent non-partisan Federal Reserve. The Act under which this hearing is held prescribes that the Federal Reserve System conduct policies to bring to realization "the goals of maximum employment, stable prices, and moderate long- term interest rates." As we exit the 20th Century and enter a new millennium, the underpinning goals of the Humphrey-Hawkins legislation appear to have been met. More Americans have jobs than ever before; the un- employment rate is at a historic modern-day low; inflation is in check; productivity growth is the highest in fifteen years; and not only is the Federal budget in balance, but to the astonishment of most, surpluses are forecast for the foreseeable future. Sustained economic growth has occurred in part due to signifi- cant private sector productivity increases, in part as a result of a mix of fiscal and monetary policies which, perhaps for the first time in decades, are working in sync rather than in juxtaposition. The budget surplus, which has had the effect of reducing reliance of debt issuances at the Federal level, has increased the flexibility of the Fed to manage monetary policy. Divided Government has had its rewards. A conservative bent to the Congress has moderated the Executive Branch and has served well the American economy. In this regard, it deserves stressing (1) that just as the Executive Branch has primary responsibility in the fields of international affairs and the Fed and the Open Market Committee have authority over the conduct of monetary policy, the Congress is preeminently accountable for Federal budgetary mat- ters. One of the stark difficulties in our economy is that while the gap between the well-to-do and the less-well-off is widening, job cre- ation appears to be spreading to the most disadvantaged parts of the population. Growth has been propelled in a circumstance where per capita Federal Government spending has leveled off, or perhaps even declined, giving rise to the conclusion that for the vast major- ity of Americans, the economics of compassion is the economics of Governmental restraint. Before turning to your testimony, Mr. Chairman, I would like to ask if the Ranking Member of the Full Committee and the Chair- man and Ranking Member of the Monetary Policy Subcommittee have opening statements. [The prepared statement of Hon. James A. Leach can be found on page 46 in the appendix.] Chairman LEACH. Mr. LaFalce. Mr. LAFALCE. Yes, Mr. Chairman. Chairman Greenspan, we are delighted to have you before us again, and I sincerely am delighted that you were reappointed as the Chairman of the Federal Reserve Board. You have done your job admirably. You have done your job regardless of the President being a Republican or a Democrat, and I know you will continue to do that regardless of the circumstances, regardless of whether there is a Republican or Democratic Congress and you have been constant in your thinking and your policies and objective in every- thing you have done. Whether you or the President or the Congress, too, we have all been tremendous beneficiaries of having to do our job in the age of technology. Sometimes people ask me "Who deserves more cred- it, Alan Greenspan, the President, Democrats or Republicans?", and I always give them the same answer: "technology." It has been tremendous. It has been phenomenal. I also think that your ap- pearance under the auspices of Humphrey-Hawkins is extremely important. It gives us an opportunity to dialog on some very impor- tant issues. Your domain is primarily economic and primarily monetary pol- icy as opposed to fiscal policy, although everything is interrelated. And yet we do not live in a vacuum. We live with statistics, but not statistics as an end in and of themselves, statistics as a reflec- tion of where we have been, where we are and where we might go. We have to penetrate these statistics. What does it mean when we talk about unemployment rate? Well, first of all I suppose we have to ask ourselves how accurate are those unemployment figures. What is the extent of our under-employment? Are people making more real money? That is extremely important. Do they have to rely on two jobs or two incomes or three or four incomes in order to keep up? You talk about productivity improvements, but how accurate are those productivity measurements? Are people really working longer hours at home with the laptops that they are able to bring home, and do we therefore really have enhanced productivity? Are we coming to these productivity improvement judgments backward, looking at output and then extrapolating that there has been these huge productivity improvements? But beyond questions such as that, I would like to see Congress have hearings not just on these statistics, but the true social health of the Nation. We are in an era of unprecedented growth. Do we have better health care, and for whom? You know, how is it that in an era of unprecedented economic growth, so they say, we have 45 million Americans without any health insurance whatsoever. What is the disconnect? Why is that happening? Does that mean that there is increased disparity within our society? What is the status of education? Are those in affluent areas get- ting better and better education and those in poorer areas getting worse and worse education? This is not exclusively within your domain, but you are a great collector of data and figures. And do these data and these figures come within your public concern or personal concern and what are your comments on it. So we have a great shining city on the Hill, but what about that other portion of the city that is not shining so greatly? And it would be remiss on our part if we just use these hearings to regur- gitate dry economic statistics without relating these statistics to the human condition, and whether or not there are better ways of life for not just those of the top rungs of society, but for all rungs of society given the prosperity that we love to proclaim and boast so much about. Thank you. Chairman LEACH. Chairman Bachus. Mr. BACHUS. Thank you, Mr. Chairman. I thank you, Chairman Greenspan. I want to first assure you that you won't have to wait an hour like you did in the Senate last week to testify. And I will try to wrap this up. First of all, I want to commend you on your reappointment and also on your accomplishments. Under your tenure mortgage rates have dropped about 2Vz per- cent, inflation is down 1.7 percent, unemployment is down almost 2 percent. And that is quite an achievement. We have got low infla- tion, low unemployment, rising wages, robust economy, a rising stock market, undoubtedly your leadership on the Federal Reserve has been a significant part of that. So you are to be commended. Today we are going to hear what is required by the Humphrey- Hawkins law which was passed in 1978. There is some sort of rum- ble in the Senate that we may quit having these hearings or we may go to a different format. And I would simply like to say that it is my opinion that these hearings are very helpful. They are helpful for the public to get to share in the discussion and I think they are very useful. Of course they can have temporary effects on the stock market one way or the other, but I think it is something that is very important and ought to be continued. I want to make that clear. I also want to point out this in the context of the Humphrey- Hawkins, for the first time since Humphrey-Hawkins was passed under your leadership this country has achieved the goals of Hum- phrey-Hawkins. We have not only achieved them, but we have maintained them over the past eighteen months. Balanced budget, adequate productivity growth, reasonable price stability, and unem- ployment rate near 4 percent, all were goals of Humphrey-Haw- kins. In fact, when that legislation passed most economists said that we would never reach those goals. Others said that if we reached all those goals together, they would work at cross purposes and we wouldn't have a good economy. So, the wisdom of those goals, now that they have been achieved, I think is being demonstrated daily in our economy. But as we prepare to enter the new millennium, I think it is important for the Federal Reserve, and I think today gives you a good opportunity to clearly articulate the principles on which future policy decisions will be made. Particularly speak to us and discuss why the Fed thinks it is necessary to maintain this tightening bias or tightening mode when we are seeing very little real inflation. We may be seeing signs of inflation, but the inflation rate is still low. Let me conclude by saying I know there are a lot of pitfalls out there, a lot of potential things that can affect the economy. Obvi- ously inflation is something we talk about all the time and we have a spike in oil prices, which is of great concern. You have expressed your opinion on that. Also, the inversion of the bond yields, which historically both when you get—obviously inflation, but also when you get a bond yield that stays inverted, it usually portends an eco- nomic downturn. So I would like you to discuss that bond inver- sion. Also, I would like you to talk about what you consider some other danger signs. Let me just offer two of them to you, one that I am especially concerned about that sort of was confirmed in the Sev- enth Federal Reserve Report is margin lending. Now margin lend- ing tends to go up when the market goes up, so we should expect that margin lending would go up. But actually what we are seeing is we are seeing margin lending going up faster than the market as a whole. I would like you to discuss what concerns you have about that, particularly in that the banks are increasing their lend- ing to security brokers and security brokers are increasing their lending not only to their internal accounts, but also to other inves- tors. So I would like you to touch on that. The second thing is our U.S. current account deficit, which is forecast to climb to 4.2 percent GDP this year. And to not only that, but to remain above 4 percent for 2001. I know that can cause problems if investors don't continue to purchase U.S. denominated financial assets on a large scale and large enough to finance our external debt. So I would hope you will comment on that. It is undeniable that our economy, our prosperity in this country, the growth, is at a historical high, but at the same time, Mr. Chair- man, there are potential dangers that exist and threaten our econ- omy. And we will be counting on you to help guide us down the unmapped and the untraveled roads of the new millennium. I will say this to the committee and to the American people that your ex- perience and intellect should serve us well in this endeavor, one that will have unprecedented challenges and complexities. Thank you. [The prepared statement of Hon. Spencer Bachus can be found on page 47 in the appendix.] Chairman LEACH. Thank you, Mr. Chairman. For a final opening comment, Mr. Sanders. Mr. SANDERS. Thank you, Mr. Chairman. And welcome, Mr. Greenspan. I do not share the rosy outlook of my friend from Ala- bama. And I want to pick up on some of the points made by Mr. LaFalce, because after all of the statistics are out there, really what matters is what is going on with the average person. And I know that the average person turns on the television every day and hears that the economy is booming, we have never had it so good. But sometimes those average working people have a little difficulty watching the television, because they are out working longer hours for lower wages than they used to. And the statistics are pretty clear that between 1973 and 1998 real wages for the av- erage American worker declined. Now in the last few years we have seen some increases and we are appreciative of that. But let's not kid ourselves, the average American today is working longer hours for lower wages. It is not uncommon for that worker, wheth- er it is in the State of Vermont or New York State or anyplace else, to have to work two or three jobs. Mr. Greenspan, when you and I were a bit younger what used to be understood is that one breadwinner in a family, before the great economic boom, could go out and work forty hours a week and bring in enough income to take care of the family. Well, you know what? In the State of Vermont and throughout the country in the midst of this great booming economy I do not see so many families where one breadwinner working forty hours a week is earning enough money to take care of the family. What I see are wives out working, as well as husbands. I see people working fifty or sixty hours a week. I see people working two jobs and three jobs. So let me respectfully disagree with those people who say the economy is booming for all people. Now, is the economy booming for some people? Sure it is. The wealthiest people in this country have never had it so good. Even magazines like U.S. News talk about the rich getting richer. We have today in the United States the largest gap between the rich and the poor of any Nation in the industrialized world. And let me not just talk about economics, let me talk about morality, if I might, something we don't always talk about in the Banking Committee. We have got to raise the question of whether it is ap- propriate in our Nation, under current economic policy, that we see a proliferation of millionaires and billionaires, and at the same time throughout this country the emergency food shelves are over- flowing because low income people don't have enough food to eat. We continue to have—we don't talk about this issue—by far the highest rate of child poverty in the industrialized world. Scandinavia and many of the European countries have basically wiped out childhood poverty, and yet 20 percent of the kids in this country live in poverty. Mr. LaFalce appropriately mentioned that close to 45 million Americans have zero health insurance and many more are underinsured. I think we have got to, as a committee, as a Nation, start dealing with the reality of the very unequal dis- tribution of income and wealth in this country. Is it appropriate, my colleagues, that the wealthiest 1 percent of the population owns more wealth than the bottom 95 percent, or that one person owns more wealth than the bottom 40 percent of the families in this country? I am also concerned about something that recently came to the public's eye, and maybe Mr. Greenspan can comment on this later. The International Labor Organization, the ILO, recently published a report, and working people in the United States now have the du- bious distinction of working longer hours than the Japanese, and longer hours than the workers of any other industrialized nation. In fact, we have a situation where the number of Americans working more than one job at a time increased 92 percent between 1973 and 1997. Americans who hold more than one job work an av- erage of forty-eight hours a week, and 40 percent of them work fifty to sixty hours a week. Is this a booming economy? Why, if this economy is booming, why aren't people making more money and working fewer hours and having more time with their families? So, Mr. Chairman, I would hope, and I echo Mr. LaFalce, that we have look at what is happening to the average person in this country, and the quality of life of that person. And I think the end result is that we need some fundamental changes in economic pol- icy to make the economy work for the middle class and the working class, and not just for the millionaires and the billionaires. Thank you, Mr. Chairman. Chairman LEACH. I thank the distinguished gentleman. Mr. Chairman, you may proceed with the understanding that there are philosophical divides in America on this as reflected in the committee. Please. STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. GREENSPAN. I must say, Mr. Chairman, that that is what makes our country great. That is the ability to have differences freely expressed and debated, and there are not that many coun- tries in the world which can say that they have it at the level that we do. I think that is a great strength of this Nation. Mr. Chairman and Members of the committee, I appreciate the opportunity to present the Federal Reserve's Semiannual Report on the Economy and Monetary Policy. There is little evidence that the American economy, which grew more than 4 percent in 1999 and surged forward at an even faster pace in the second half of the year, is slowing appreciably. At the same time, inflation has remained largely contained. An increase in the overall rate of inflation in 1999 was mainly a result of high- er energy prices. Importantly, unit labor costs actually declined in the second half of the year. Indeed, still-preliminary data indicate that total unit cost increases last year remained extraordinarily low, even as the business expansion approached a record nine years. Domestic operating profit margins, after sagging for eighteen months, apparently turned up again in the fourth quarter, and profit expectations for major corporations for the first quarter have been undergoing upward revisions since the beginning of the year, scarcely an indication of imminent economic weakness. Underlying this performance, unprecedented in my half-century of observing the American economy, is a continuing acceleration in productivity. Non-farm business output per work hour increased 3^4 percent during the past year—likely more than 4 percent when measured by non-farm business income. Security analysts' projec- tions of long-term earnings, an indicator of expectations of company productivity, continued to be revised upward in January, extending a string of upward revisions that began in early 1995. One result of this remarkable economic performance has been a pronounced increase in living standards for the majority of Americans. Another has been a labor market that has provided job opportunities for large numbers of people previously struggling to get on the first rung of a ladder leading to training, skills, and permanent employ- ment. Yet those profoundly beneficial forces driving the American econ- omy to competitive excellence are also engendering a set of imbal- ances that, unless contained, threaten our continuing prosperity. Accelerating productivity entails a matching acceleration in the po- tential output of goods and services and a corresponding rise in real incomes available to purchase the new output. The problem is that the pickup in productivity tends to create even greater in- creases in aggregate demand than in potential aggregate supply. This occurs principally because a rise in structural productivity growth has its counterpart in higher expectations for long-term cor- porate earnings. This, in turn, not only spurs business investment, but also increases stock prices and the market value of assets held by households, creating additional purchasing power for which no additional goods or services have yet been produced. Historical evidence suggests that perhaps three to four cents out of every additional dollar of stock market wealth eventually is re- flected in increased consumer purchases. The sharp rise in the amount of consumer outlays relative to disposable incomes in re- cent years and the corresponding fall in the savings rate, has been consistent with this so-called wealth effect on household purchases. Outlays prompted by capital gains in excess of increases in in- come, as best we can judge, have added about 1 percentage point to annual growth of gross domestic purchases, on average, over the past five years. The additional growth in spending of recent years that has accompanied these wealth gains as well as other support- ing influences on the economy appears to have been met in about equal measure from increased net imports and from goods and services produced by the net increase in newly hired workers over and above the normal growth of the work force, including a sub- stantial net inflow of workers from abroad. But these safety valves that have been supplying goods and serv- ices to meet the recent increments to purchasing power largely gen- erated by capital gains cannot be expected to absorb an excess of demand over supply indefinitely. First, growing net imports and a widening current account deficit require ever larger portfolio and direct foreign investments in the United States, an outcome that cannot continue without limit. 8 Imbalances in the labor markets perhaps may have even more serious implications for inflation pressures. While the pool of offi- cially unemployed and those otherwise willing to work may con- tinue to shrink, as it has persistently over the past seven years, there is an effective limit to new hiring, unless immigration is un- capped. At some point in the continuous reduction in the number of available workers willing to take jobs, short of the repeal of the law of supply and demand, wage increases must rise above even impressive gains in productivity. This would intensify inflationary pressures or squeeze profit margins, with either outcome capable of bringing our growing prosperity to an end. As would be expected, imbalances between demand and potential supply in markets for goods and services are being mirrored in the financial markets by an excess in the demand for funds. As a con- sequence, market interest rates are already moving in the direction of containing the excess of demand in financial markets and there- fore in product markets as well. For example, BBB corporate bond rates adjusted for inflation expectations have risen by more than 1 percentage point during the past two years. However, to date, ris- ing business earnings expectations and declining compensation for risk have more than offset the effects of this increase, propelling equity prices and the wealth effect higher. Should this process con- tinue, however, with the assistance of a monetary policy vigilant against emerging macro-economic imbalances, real long-term rates will at some point be high enough to finally balance demand with supply at the economy's potential in both the financial and product markets. Other things equal, this condition will involve equity dis- count factors high enough to bring the rise in asset values into line with that of household incomes, thereby stemming the impetus to consumption relative to income that has come from rising wealth. This does not necessarily imply a decline in asset values, although that, of course, can happen at any time for any number of reasons, but rather that these values will increase no faster than household incomes. With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will deter- mine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process. On a broader front, Mr. Chairman, there are few signs to date of slowing in the pace of innovation and the spread of our newer technologies that, as I have indicated in previous testimonies, have been at the root of our extraordinary productivity improvement. In- deed, some analysts conjecture that we still may be in the earlier stages of the rapid adoption of new technologies and not yet in sight of the stage when this wave of innovation will crest. With so few examples in our history, there is very little basis for determin- ing the particular stage of development through which we are cur- rently passing. Without doubt, the synergies of the microprocessor, laser, fiber- optic glass, and satellite technologies have brought quantum ad- vances in information availability. These advances, in turn, have dramatically decreased business operational uncertainties and risk premiums and, thereby, have engendered major cost reductions and productivity advances. There seems little question that further major advances lie ahead. What is uncertain is the future pace of the application of these innovations, because it is this pace that governs the rate of change in productivity and economic potential. Monetary policy, of course, did not produce the intellectual in- sights behind the technological advances that have been respon- sible for the recent phenomenal reshaping of our economic land- scape. It has, however, been instrumental, we trust, in establishing a stable financial and economic environment with low inflation that is conducive to the investments that have exploited these innova- tive technologies. Federal budget policy has also played a pivotal role. The emer- gence of surpluses in the unified budget and of the associated in- crease in Government saving over the past few years has been ex- ceptionally important to the balance of the expansion, because the surpluses have been absorbing a portion of the potential excess of demand over sustainable supply associated partly with the wealth effect. Moreover, because the surpluses are augmenting the pool of domestic saving, they have held interest rates below the levels that otherwise would have been needed to achieve financial and eco- nomic balance during this period of exceptional economic growth. They have, in effect, helped to finance and sustain the productive private investment that has been key to capturing the benefits of the newer technologies that, in turn, have boosted the long-term growth potential of the U.S. economy. The recent good news on the budget suggests that our longer- term prospects for continuing this beneficial process of recycling savings from the public to the private sectors have improved great- ly in recent years. Nonetheless, budget outlays are expected to come under mounting pressure as the baby boom generation moves into retirement, a process that gets under way a decade from now. Maintaining the surpluses and using them to repay debt over com- ing years will continue to be an important way the Federal Govern- ment can encourage productivity-enhancing investment and rising standards of living. Thus, we cannot afford to be lulled into letting down our guard on budgetary matters. Although the outlook is clouded by a number of uncertainties, the central tendencies of the projections of the Board members and Reserve Bank presidents imply continued good economic perform- ance in the United States. Most of them expect economic growth to slow somewhat this year, easing into the 3Y2 to 3% percent area. The unemployment rate would remain in the neighborhood of 4 to 4V2 percent. The rate of inflation for total personal consump- tion expenditures is expected to be 1% to 2 percent, at or a bit below the rate in 1999, which was elevated by rising energy prices. Continued favorable developments in labor productivity are an- ticipated both to raise the economy's capacity to produce, and through its supporting effects on real incomes and asset values, to boost private domestic demand. When productivity-driven wealth increases were spurring demand a few years ago, the effects on re- source utilization and inflation pressures were offset in part by the effects of weakening foreign economies and a rising foreign ex- change value of the dollar, which depressed exports and encour- aged imports. Last year, with a welcome recovery of foreign econo- 10 mies and with the leveling out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign economic activity is expected to continue this year, and other things equal, the effect of the previous appre- ciation of the dollar should wane, augmenting demand on U.S. re- sources and lessening one source of downward pressure on our prices. As a consequence, the necessary alignment of the growth of ag- gregate demand with the growth of potential aggregate supply may well depend on restraint on domestic demand, which continues to be buoyed by the lagged effects of increases in stock market valu- ations. Accordingly, the appreciable increases in both nominal and real intermediate- and long-term interest rates over the last two years should act as a needed restraining influence in the period ahead. However, to date, interest-sensitive spending has remained ro- bust, and the Federal Open Market Committee will have to stay alert for signs that real interest rates have not yet risen enough to bring the growth of demand into line with that of potential sup- ply, even should the acceleration of productivity continue. Achieving that alignment seems more pressing today than it did earlier, before the effects of imbalances began to cumulate, lessen- ing the depth of our various buffers against inflationary pressures. Labor markets, for example, have tightened in recent years as de- mand has persistently outstripped even accelerating potential sup- ply. As I have noted previously, we cannot be sure in an environ- ment with so little historical precedent what degree of labor mar- ket tautness could begin to push unit costs and prices up more rap- idly. We know, however, that there is a limit, and we can be sure that the smaller the pool of people without jobs willing to take them, the closer we are to that limit. As the Federal Open Market Committee indicated after its last meeting, the risks still seem to be weighted on the side of building inflation pressures. Mr. Chairman, as the American economy enters a new century as well as a new year, the time is opportune to reflect on the basic characteristics of our economic system that have brought about our success in recent years. Competitive and open markets, the rule of law, fiscal discipline, and a culture of enterprise and entrepreneur- ship should continue to undergird rapid innovation and enhance productivity that in turn should foster a sustained further rise in living standards. It would be imprudent, however, to presume that the business cycle has been purged from market economies so long as human expectations are subject to bouts of euphoria and disillu- sionment. We can only anticipate that we will readily take such di- versions in stride and trust that beneficent fundamentals will pro- vide the framework for continued economic progress well into the next millennium. Thank you, Mr. Chairman. I hope and trust that my full remarks will be included for the record. I look forward to your questions. [The prepared statement of Hon. Alan Greenspan can be found on page 91 in the appendix.] Chairman LEACH. Thank you, Mr. Chairman. Without objection, your full remarks will be placed in the record. Without objection, 11 any opening statements of Members of the committee will be placed in the record as well. The Chair would like to note that we have been given new equip- ment in terms of timing that the committee has never had before. Now we not only have precise measurements of the five minutes, but we also have a clock that indicates the amount of seconds and minutes Members go over. And given that this is a large commit- tee, let me indicate to Members that this will be watched very care- fully at this kind of setting. Let me, if I could, begin with a question about the numerical as- pects of labor in this sense, that economists in the 20th Century have varying views about the intermix of the importance of capital and labor. But in countries like Japan it looks like there could well be a sustaining weakness in the economy based on the fact that the country is getting quite elderly. In parts of Europe that is the case and America seems to be about to confront the problem in about a decade. So the question I would ask you, and I don't know if the Federal Reserve has ever opined, does the Federal Reserve—or do you— have views on issues of a nature like the need or lack thereof for expanding visas for high tech employees and does that have an ef- fect on the inflation rate? Does it have an effect on sustaining So- cial Security? Mr. GREENSPAN. I am sorry, could you speak into the microphone a little closer. I was having trouble hearing the question. Chairman LEACH. The question relates to whether the Federal Reserve would have a position on the appropriateness of increas- ing, for example, visas for high tech employees. And does that have an effect on the inflation rate, does it have an effect on whether or not over a period of time Social Security can be handled more readily. Mr. GREENSPAN. It is fairly apparent that we are under fairly ex- treme pressure in high skilled labor markets, especially in the high tech areas. And I know that Congress has been pressured consider- ably by a number of high tech companies seeking to get increased visas and increased capacity to bring people into the country. We do not at the Fed have an official position on that. I would merely express, as I indicated in my prepared remarks, that it is fairly ap- parent that the people who are being brought in—and indeed the growth in our total labor force is approximately one-third immi- grants, a little more than that actually in recent years—and there is no question that they contribute substantially to economic growth in this country. Chairman LEACH. If I could turn to another subject, oil is on the minds of many people with the price of oil going above $30 a bar- rel. And you have indicated that in a percentage basis some of that was factored into the last half of last year's inflation index. Are you concerned that another oil shock could have deterring aspects on our economy? Mr. GREENSPAN. Mr. Chairman, I have been through too many oil shocks to take them unseriously. Even if the evidence does fair- ly conclusively indicate that the proportion of both the American economy, and indeed the rest of the world that is dependent on oil for energy sources, is declining, and has declined very measurably. 12 The problem that I think we have is, even in its reduced status, it is a very important element within an industrial system. And if the price changes fairly rapidly, it has a major impact on the struc- ture of our economy. We are all acutely aware that the inventory levels of oil, both crude and products, in the United States has been driven down very substantially—well below normal. Indeed, some are joking that we need to measure the fumes to get any measure of inventory at all these days. And what we know about very low inventories of any commodity is that if an untoward pressure, an unexpected pressure of demand surges, there is no buffer. And the result is a very substantial spike in prices with fairly substantial negative consequences to the econ- omy. I don't forecast that, I merely recognize that the inventory levels worldwide in the so-called commercial stocks, which are those stocks available as a buffer to unexpected demands, are ex- ceptionally low. And even though we are moving into a period when the normal pressures begin to ease, we are starting from a very low base. And the simple answer to your question is yes, I am concerned about what is happening to oil prices. Chairman LEACH. Thank you. Mr. LaFalce. Mr. LAFALCE. Thank you very much, Mr. Chairman. First of all, just a few observations. I think I read between the lines, Dr. Greenspan, that you might be suggesting that we could use more immigration in the United States in order to buttress our work force and actually add to the body politic. That certainly is my position. I think that what made the Buffalo, New Yorks great at the turn of the century, and so forth, and so forth, were the huge influx of immigrants and I think that can certainly help us in the future too. Was I correct in reading that between the lines? Mr. GREENSPAN. Well, I personally have always been of that per- suasion, but I cannot speak for the Federal Open Market Commit- tee in that regard, mainly because I have not discussed it with them in detail. I am obviously aware, as we all are, that this is a very difficult problem, a trade off against many other consider- ations, and I am not arguing that economics is the sole consider- ation here by far. Mr. LAFALCE. Not at all. Let's talk about economics not being the sole consideration in your future testimony too. Let's talk about so- cioeconomic conditions and the relationship between the two—the Federal Reserve Board, the central bank of the United States, you are the central bank here, to a certain extent you are the central bank of the world. We don't want to lose sight of your primary mis- sion in life, granted, but what are the present capacities of the Fed- eral Reserve Board, what are the present practices of the Federal Reserve Board in data collection that could give us a better socio- economic map or report card? I don't want you to reinvent the wheel of what you are doing, but if I were to sit down and say, look it, if I wanted you to give testimony on the following, could you? On educational status, on the amount of debt per household per person, on the amount of debt that college kids are assuming, be- cause they must have a college education today, and what its ef- fects are on their ability to have children, their ability to buy homes, on their ability to live where they want to live, perhaps 13 where they grew up with their families as opposed to seek new jobs. What is this changing economic dynamic doing to pensions, because of the portability of jobs and perhaps the non-portability? What about health care, because so many jobs today are not per- manent jobs, but temporary jobs or part time jobs, and so forth. If I were to sit down with you or your economists, could you tell me what data you collect that could, if Congress requested or if Mem- bers requested, give us a better indication of the social condition of America? Do we have not just one-worker families, but two or three or four or five, because they want to or because they have to, and so forth? Mr. GREENSPAN. Mr. LaFalce, it is a very difficult issue you are raising. It turns out that, because of the fairly extensive state of knowledge about all sorts of issues by the staff of the Federal Re- serve, because many or most come out of an academic environment specializing in a number of issues related to economics, but which spill over into other considerations, we do have access to a vast amount of information. But it is from secondary sources. In other words, we know in some detail what the Census Bureau collects, which is extraordinary in detail for many, many different types of issues for which they survey the American population. Mr. LAFALCE. Do you ever gather this information together in a way that could give me a report card on the issues that I am most concerned about? Mr. GREENSPAN. The answer to your question is we probably could, but we are not the best suited to do that. What we are good at doing in this regard is to handle, in an effective manner I should think, other people's data. We do have our own Survey of Con- sumer Finances in which we do collect data every several years. Mr. LAFALCE. Do you know of any other entity, especially within the Federal Government, that either does this or is better suited to do it? Mr. GREENSPAN. The Council of Economic Advisors, for example, is also exceptionally well staffed with people who, frankly, are in a much mere recent context, having come out of the universities. And the types of issues that you are raising, while important, can- not be the focus of monetary policy. Nonetheless, we are all citi- zens, we are all very much aware of what numbers mean to various people and they represent various things, so I would say that I hate to impose a burden on the Council of Economic Advisors, but unfortunately, they are very well qualified. Mr. LAFALCE. Let me suggest this. I would like to get together with some representative from the Federal Reserve Board and maybe the Chairman of the Council of Economic Advisors and try to devise some type of a report card. I would like your help in that. Mr. GREENSPAN. I think you will find Mr. LAFALCE. I think Congress needs it. I think the American public need it. And I have yet to hear it presented to the Congress or to the American people. Mr. GREENSPAN. I would suggest, Mr. LaFalce, that you have people on your staff contact us or others and we will try to find a way to inform you on what is available, what could be done and what can't be done. Mr. LAFALCE. That would be great. 14 Mr. GREENSPAN. Because there is a lot in the latter category as well. Mr. LAFALCE. That would be great. Thank you. Chairman LEACH. Thank you. And the Chair would like to give a resoundingly high mark to the gentlelady from New Jersey and her report card. But please go forth. Mrs. ROUKEMA. Thank you very much, Mr. Chairman. I am not going to go into that question of immigration cap. But I do want to discuss what I see as your report here today in the context of some policy questions that we are going to have to be facing as we approach the budget, tax policy and the question of Eaying down the debt. Mr. Chairman, of course you are always pro- >und and substantive in your analysis, and I would like to take you on to another step. As you remember last year, my question to you, and it was in the context of the tax debate at that time, was the relationship be- tween tax cuts, paying down the debt, and the economic growth and inflation rates. Now, I had planned this question prior to reading this morning's New York Times article, but I am going to reference it and direct my question in the context of statements made in this article. It is prompted by Treasury Secretary Summers' proposal for pay- ing off the debt by 2013. The article is entitled "Shrinking Treasury Debt Creates an Un- certain World." It goes right to the essence of what you are talking about today in terms of its relationship to inflation. It may or may not be true. Let me just quote from the article and ask you for your response and how you would advise the Congress in terms of both debt and its relationship to the tax policies and balancing the budget and the spending policies. The reference is to last month, when Treasury outlined an ag- gressive plan to reduce the debt and to buy back debt already in investors' hands. At that time, this article says, "the market went haywire." It then goes on to say, "More important, economists and market strategists are saying that the Treasury's plan and the ensuing rush to long-term bonds are throwing sand into the gears that the Fed uses to keep the economy perking while protecting against in- flation." Mr. Chairman, I would like your reaction to that statement. How can we put that paying down the debt and effective monetary pol- icy in balance? In addition, how would you advise us as we in the Congress face the budget this year, as well as another tax bill, and what has been a stated priority of paying down the debt? Could you respond, please? Mr. GREENSPAN. Indeed, I think that it is extraordinarily impor- tant to maintain surpluses and to pay down the debt in a signifi- cant manner. The argument that the process itself would undermine Federal Reserve policy is not correct. The reason it is not correct is that while it is certainly the case that when suggestions were made of a significant reduction in long-term maturities outstanding for 15 Treasury issues, that they took on scarcity value. The prices went up very substantially and their interest rates fell dramatically, which would seem to be counter to the issue of maintaining an ade- quate degree of liquidity and liquidity positioning in the market- place. If that had simultaneously created a major decline in long-term interest rates or intermediate interest rates in the private sector, then the argument would have been valid, but that indeed did not happen. It is the case that some very long private issues declined in yield, but not anywhere near as much as the Treasury yield. But, the vast proportion of private lending showed very little change in the level of interest rates, and it is that market which we are interact- ing with in an endeavor to get the appropriate degree of liquidity in the system to maintain economic balance. So it is certainly the case that there have been large gyrations and volatility in the Treasury bond market, especially for longer issues, but, as far as we can judge, it has had very little effect on policies of the Federal Reserve, and it is more important to under- stand that the only way that you can have these surpluses over the long run is to reduce the Federal debt to the public. So it is not as though you can have a surplus and not have debt reduction. The only alternative would be for the Federal Government to cre- ate assets or to purchase a lot of private assets. I don't think that is a good alternative. Mrs. ROUKEMA. Thank you, Mr. Chairman. I know my time is up, but I am going to ask the Chairman in writing if he could then project how far into the future and to what point we pay down the debt over a time period. I appreciate your advice and counsel in that aspect of it. Mr. GREENSPAN. I would be glad to. [Chairman Greenspan subsequently provided the following response for the record: Although the Federal Reserve does not make longer- term projections on Federal debt outstanding and the time frame over which the projected paydown would occur, the Congressional Budget Office released on January 26 an updated set of such projections, based on three alternative scenarios. The projections appear in the Budget and Eco- nomic Outlook: Fiscal Years 2001-2010, pages 19-21. A copy of the relevant pages is attached. [The pages referred to can be found on page 56 in the appendix.] Chairman LEACH. Thank you, Mrs. Roukema. Mr. Kanjorski. Mr. KANJORSKI. Thank you, Mr. Chairman. Mr. Greenspan, you are probably not aware of it, but I am the new Chairman of the Greenspan Memorial in Washington, DC. We are thinking that this upstanding economy certainly should have your fingerprint and perhaps your silhouette somewhere in Wash- ington. I congratulate you, because as you may recall, maybe a decade ago, you and I were not quite certain that your activities in mone- 16 tary policy were going to afford us the opportunity of this great growth. In 1991 or 1992, you assured me that your policies would create an economy that would be second to none. I think that has happened. With the budget agreement of 1993, I think both fiscal and monetary policies working together have really accounted for a good part of this great economy, plus, of course, the private sector. Mr. Greenspan, last year you told us to run the surplus, and I thought your advice was excellent. Last week I was one of only ten Members of Congress to oppose any tax cuts. I intend to pursue that position until we establish a plan for Government spending levels, paying down the national debt, and securing Medicare and Social Security's long-term solvency, because I very fundamentally believe that we should not get to the dessert before we have had the entree. Do you still hold your positions in terms of what we do with re- duction of taxes and the surplus? And I assume from your answer to the last colleague of mine that it is the same as last year; is that correct? Mr. GREENSPAN. Yes, indeed, Congressman, I still have the same position that I reiterated here a year ago and elsewhere since then, and I covered in some detail some of the data and some of the issues in my prepared remarks, even though I did not use them in my oral text. Essentially, the issue gets down to how secure we are in these surplus forecasts. As I tried to point out in my prepared remarks, there are very substantial uncertainties in both directions. It is quite conceivable that we may end up with even larger sur- pluses than we are currently projecting. But also because we are quite uncertain of the reasons why the ratio of tax receipts to tax- able income in the individuals sector of the economy has been going up so significantly, even adjusting for what we know about capital gains and bracket creep and the like, because there is a large ele- ment in those increased revenues which we cannot explain until we see detailed tax reports on what has happened, which will take several years in the so-called statistics of income tabulation tables, we will not know how secure the forecasts are. My argument basically is to be patient, allow the surpluses to run as far as we can, to let debt as a consequence decline, and then, when we have a firmer view of what proportion of the sur- pluses, if any, are permanent, we then can create an aggregate fund, so to speak, which would tell us the extent to which long- term commitments could be made employing those monies. Paying down the debt is not forever disposing of the surplus. It is merely putting it aside, because you can always reborrow it for whatever purposes you would want. My own judgment, as I believe I indicated last year, and I repeat, is that delaying employing those surpluses causes no harm of which I am aware, and awaiting the clarification of what parts of the surpluses are secure for longer- term calculations, I think will pay substantial dividends. Mr. KANJORSKI. Mr. Greenspan, moving completely off that sub- ject and to another subject, I am disturbed about high oil prices and the impact they can have in drawing funds out of the market- place to be used for investment. I am also concerned about unfairly 17 distributing that burden on lower-income people and truckers who are independent contractors who cannot make the adjustment. For the third time in the last twenty-five years we have not as a Congress addressed this idea of whether oil and gasoline should be the basic product of our energy supply. As we move into the hy- brid corn market and the new technologies of the 21st Century, do you think the President or the Federal Reserve or both in conjunc- tion should convene some discussion of the fuel cell evolution? Should we look to the oil industry as the basic industry to feed that energy source? Or should we be looking at hydrogen production, since that takes us into a realm where we would control the com- modity, as opposed to foreign control of the commodity? Mr. GREENSPAN. Congressman, I have been through innumerable synthetic fuels discussions, programs, and endeavors to counter previous oil shocks. I think our experience suggests that we ought to leave it to the marketplace to make these judgments. I think it is doing it at this stage. That is, as I indicated before, the weight of oil in our econ- omy is falling fairly significantly. My concern is not the longer term. That is pretty much locked into the type of technological changes that are going on. I do have short-term concerns, because of the extraordinary low level of in- ventory at the moment. But looking at the longer-term question, I think we are going to find that that issue will resolve itself fairly readily, and it is not evident to me that a specific Government program will foster that. We have spent very considerable resources over the decades in al- ternate means of technologies, and some have worked and some have not worked. But the thing that has worked most effectively is the fact that energy is being substantially—or I should say, oil— is being significantly priced out of the market. That is, at the cur- rent costs of crude oil in the recent ranges, it is still an expensive commodity; and as a consequence, energy sources are moving in the other direction, or, more importantly, are being so altered that the amount of energy we need per unit of output is going down very dramatically. So I am not particularly concerned about the longer term, but I do share a number of the concerns of your Members here about the immediate problem. Mr. KANJORSKI. Thank you. Chairman LEACH. Thank you, Mr. Kanjorski. Mr. Bachus. Mr. BACHUS. Thank you, Mr. Chairman. Mr. Greenspan, Mr. Chairman, I mentioned in my brief opening statement margin lending. We have just had a February 7 report by the Federal Reserve which shows that bank lending to security brokers and dealers was unusually strong in the final two months of 1999. There has been—although margin lending I think amounts to only 1.5 percent of the total market value, in some technology stocks, momentum stocks, it is much, much higher. Apparently it has increased about one-third or more in the last six months of 1999. 18 My question is this—and let me just throw in one other thing. There is also some evidence that it is not individual investors as much as it is some hedge funds and highly leveraged professional traders. But the last two or three real market downturns have been very much hedge funds and some of the professional traders. So are you following this issue closely? I know you have some concerns, but I know you said, or at least your last statement on this was you don't intend to take any action. Let me ask you, is this because—I know if you took action, it might actually cause a correction and aggravate the problem. But could you just comment on the general issue? Mr. GREENSPAN. First of all, I want to point out that the fairly significant rise in margin lending, as large as it was, as you point out, is still a small part of market values. Most stocks are bought with strictly cash or employing other sources of funding. It is not basically coming out of the banking system. A good deal of the recent moves in bank lending probably are Y2K related, in part increasing liquidity, and a goodly part of the lending that occurs is clearly for Government securities or other forms of non-stock market-related issues. The problem that I have had with the issue of moving on mar- gins is not a concern of what it would do to the marketplace. It is the evidence which suggests that it has very little impact on the price structure of the market or anything else. It has one char- acteristic, however. It basically has its impact, its incidence, on smaller investors, because they have no alternative means of fi- nancing. Large investors have all forms of financing, and margin is a very small part of their financing. It is true that there probably are some professional investors who are using margin debt for purposes of various different types of hedging or what have you. My impression is that it is probably very small and not an issue that one should be concerned about. Second, I view margins per se as essentially prudential, meaning that they are set or should be set by brokers or dealers or whoever is involved in lending to customers in order to protect the solvency of the broker-dealership. And as a consequence of that, even though we at the Federal Reserve stipulate initial margins, and by implication, perhaps maintenance margins, most of the individual brokerage firms have margins well in excess of that. So it is not a particular problem in that regard. Haying said all of that, I must tell you that the sharp rise in margin debt in November, December, and January, has not gone without awareness on the part of the Federal Reserve, because it may be telling us things that we need to know about the overall structure of the marketplace. We obviously are in constant discus- sion with a number of our colleagues in the Securities and Ex- change Commission and elsewhere to better understand what is going on. So, as I have said before, and I will just really repeat, we are aware of something that appears to be somewhat different from what we have seen. The issue that engaged us wasn't so much the rise in margin debt. It was the rise in margin lending relative to the value of assets. Even though it is from an extremely low base, it has indeed accelerated. And that type of spike or type of statis- 19 tical aberration invariably captures the Federal Reserve's atten- tion, one way or the other. Mr. BACKUS. Thank you. Mr. Chairman, could I ask one follow-up question on what Chair- woman Roukema said? Chairman LEACH. Let me say this: we are going to go by this rule, and I am going to make a caveat to it, that no further ques- tions can be asked beyond the five-minute, but if you want to ask a quick question for a response in writing, the Chair will accept that. Mr. BACKUS. Let me do that. Mrs. Roukema talked about, with the Treasury bond, if we pay down the debt, we eliminate a lot of the Treasury bonds. I will sub- mit this in writing. My question is, What type of instrument do you then use for your operations? I will submit it in writing. Thank you. [Chairman Greenspan's reply to Hon. Spencer Bachus can be found on page 105 in the apppendix.] Chairman LEACH. Thank you. Mr. Sanders. Mr. SANDERS. Thank you, Mr. Chairman. Mr. Greenspan, I have four questions that I would appreciate you responding to. Thirty percent of American workers earn poverty or near poverty wages. In fact, low-wage workers in the United States are the low- est paid low-wage workers in the industrialized world. The mini- mum wage, as you know, is now $5.15 an hour. If it had kept pace with inflation since 1968, it would now be $7.33 an hour. Many of us believe it is important to protect low-wage workers and raise the minimum wage so nobody in this country who works forty hours a week lives in poverty. Can you make a recommendation to Congress? In your judgment, should the minimum wage be raised? Mr. GREENSPAN. I do not. The reason I do not, strangely enough, Congressman, starts off with the same premise that you did, name- ly, that I, too, am chagrined about the extent of the dispersion of incomes in this country and as I have said many times publicly, you cannot have an effective society unless you have the assent of all parties in it that the system is fair. My concern about the minimum wage is it does not do what you suggest it does. Mr. SANDERS. I would respectfully suggest the evidence Mr. GREENSPAN. I understand that. I will give you my reasons. Mr. SANDERS. I have three other questions. You don't surprise me by telling me that you are against the minimum wage. I apolo- gize. I don't have a whole lot of time. As you know, and I think agree, the United States has the most unfair distribution of wealth and income in the industrialized world. The richest 1 percent own 40 percent of our wealth, which is more than the wealth owned by the bottom 95 percent of all Americans. Meanwhile, 20 percent of our children live in poverty. We have millions of people who are experiencing hunger. We have some homelessness. People cannot afford health insurance and can- not afford to send their kids to college. 20 Could you briefly tell us what policies you would recommend to Congress to do away with or to ease this disparity of wealth that we are currently experiencing? Mr. GREENSPAN. Let me start, Congressman, by saying what I would not suggest. What I would not suggest is a means which would somehow obliterate the wealth of those who are in the upper-income groups or upper-asset groups, because there is no evi- dence to suggest at all that if you were to take the top 20, 50, 100, 500 people and essentially eliminate all the wealth that they had, that that would improve the standard of living of anybody. So merely obliterating wealth or merely confiscating wealth strikes me as a wholly inappropriate policy if the purpose is to achieve higher standards of living. Mr. SANDERS. Nobody is talking about obliterating or confis- cating wealth. We are talking about fairness and the appropriate- ness of one person having $180 billion in wealth while children go hungry. My next question, I noted you played an active role as Chairman of the Federal Reserve in orchestrating a bailout of the $5 billion hedge fund known as Long-Term Capital. You came before our committee, and what you had to say was very interesting. Are you concerned about such mergers as Travelers Insurance and Citicorp when they form a company with assets of almost $700 billion, 140 times as large as Long-Term Capital? What happens if they fail? Who in God's name is going to bail them out? Are you concerned about that? Mr. GREENSPAN. First of all, let me just say that we don't con- sider that bringing in private investors into the Long-Term Capital Management problem was a bail-out. It was their money, their in- terest, and all we did was to offer them an office space to come around and Mr. SANDERS. You were very concerned about the implications of failure. Mr. GREENSPAN. I certainly was. Mr. SANDERS. If you were concerned about that failure, what about the failure of a company Mr. GREENSPAN. We would be concerned about the failure of any large institution. But let me suggest further, we do not believe that in the event that it turns out that a substantial institution fails that they should be bailed out. In effect, what we may conclude for purposes of stabilizing the system is that an orderly liquidation of an institu- tion is far superior to letting it crash with all of the implications that would occur. That would mean, of course, that all equity owners are out; it would mean that perhaps some debt debenture owners would also have losses. Our notion would not be the question of perceiving that an institution is "too big to fail" and that therefore it gets Gov- ernment support. Mr. SANDERS. I apologize. Let me ask you my last question. I don't mean to be rude. Chairman LEACH. Excuse me, Mr. Sanders. This last question will have to be answered in writing. Mr. SANDERS. Yes, Mr. Chairman. 21 In your own Federal Reserve Report on the Survey of Consumer Finances, if you look on page 5—the statistics on before-tax mean family income—it shows that for all families earning less than $100,000 a year, the mean family income went down between 1995 and 1998. That is on page 5. Meanwhile, the incomes of people earning over $100,000 a year went up. Given that reality, I don't know how you keep talking about a booming economy if only the people on the top are doing quite so well. Mr. GREENSPAN. I hate to trash some of the data that we collect, but that is a sample mean, and we have far superior data for the aggregate of the mean. Mr. SANDERS. You are criticizing your own data? Mr. GREENSPAN. No. The problem, basically, is that these are sample statistics. The purpose of this is the distribution, which it is. I agree with your conclusion about the distribution. I just want- ed to point out that the actual real median family income between 1995 and 1998 actually went up. Mr. SANDERS. For everybody? Mr. GREENSPAN. For everybody. Mr. SANDERS. But not for people with $100,000 a year or less? Mr. GREENSPAN. All I would say to you is I think the data are accurate in the relevant sense and the conclusion that you draw I don't find objection to. Mr. SANDERS. OK. I am using your statistics, sir. [Chairman Greenspan's response to Hon. Bernard Sanders can be found on page 111 in the appendix.] Chairman LEACH. The gentleman's time has expired. Mr. Castle. Mr. CASTLE. Chairman Greenspan, I come from Delaware. We are not exactly the Northeast. We are a mid-Atlantic State, but we are also very dependent upon oil for heating and gasoline and whatever. So following up on what Mr. Leach, Mr. Kanjorski, and others have asked about oil prices, I would be interested in devel- oping a little beyond what you have already stated. I have heard clearly what you have stated here in your testimony about leaving it to the marketplace. I don't disagree with that. I would like to ask two questions along the lines of short-term and long-term. First, when you are talking about leaving it to the marketplace, I thought you were talking more long-term than you were short-term. Maybe I am wrong about that, and it will take care of itself. When you say you are concerned short-term, I don't know if you mean you are concerned enough to deal with one of the potential solutions which is out there or one which you might sug- gest. And I'm not saying we should. I am just curious as to what your opinions are, dealing with the strategic petroleum reserves, releasing those? The President yesterday released more of the low-income heating assistance yesterday and suggested that Congress should approve even more within that area, I guess in endeavoring to help the low- income people and to some degree to keep prices down. I am interested in your comments with respect to the short-term, if there is anything we should do. Let me ask the other part of the question. We can just do it together. That is longer term. 22 I and you and many others have seen the problems in the 1970's and 1990's caused by sharp rises in oil prices. We were more de- pendent. You have indicated we are not as dependent now. I don't know what your data is. We are clearly, by anybody's standards, less dependent on oil now than we were then. In the longer term we are going to be less dependent, and technology will help us take care of that. But we are still pretty dependent. I am not sure that I agree with the policies that the United States has. Unfortunately, I don't have an alternative to that that I can articulate to you, but I don't know if the Strategic Petroleum Reserve is really a good mechanism to deal with this. We deal with OPEC. OPEC is an oligopoly, I guess; but it is made up of a series of countries with which we have foreign rela- tions, and in some instances we have military relations. In some cases we have excellent relations, and in some cases less excellent relations. I don't know if our trade representatives, our Secretaries of State, our Presidents, regardless of political party in this particular circumstance, are doing the right thing or not with respect to the long-term oil policy, because we keep coming back to this crisis. Frankly, it has at least been a major factor in driving two reces- sions. I don't think it necessarily would this time, but it could; and it sure as heck is creating a lot of havoc for constituents of ours and yours and a lot of people in this country with respect to the higher prices. I am interested in that, too. In addition to the short-term ques- tion, I am interested in the long-term question, too, are our policies really correct, or should we be doing something more aggressively to prevent this from becoming a crisis, even in this time of perhaps declining dependency upon oil? Mr. GREENSPAN. Well, Congressman, as I said before, I believe that the long-term trends are going to gradually take care of this problem better than anything we are able to do. Mr. CASTLE. So our policies are satisfactory and we should not Mr. GREENSPAN. I will try to respond. First of all, let me say that I have always viewed the Strategic Petroleum Reserve as a reserve in the event of a serious crisis. By that, I mean a shutdown in Middle East oil or something of that nature, because of a catastrophe of some form. I think it would be a mistake to try to move market prices by small additions or subtractions from the Strategic Petroleum Re- serve. We are dealing with an overall world market which is huge relative to our Strategic Petroleum Reserve. It is foolishness to be- lieve that we could have any significant impact short of a very major liquidation in the short term of that reserve, and I don't think anybody is arguing for that. I think the way you phrase the problem is correct; there is more to this than economics. It is a diplomatic-security question which I think has engaged everybody. I want to say parenthetically that while I don't deny that there are numbers of oil producers around the world who view the short- term price as the only thing they look at, and the higher, the bet- ter, most of them do not. I think they recognize that their longer- 23 term interest, meaning the maximum value of the reserves they have in the ground, is fostered by a price which is generally mod- erate from the point of view of consumers. So I don't think that there is a significant difference of opinion in a number of these crucial areas. I do agree with you: it is an oligopoly. Oligopolies have the capacity to restrict supply and affect price. They do that. OPEC does it. That is its purpose. Fm not terribly concerned over the longer term, nor do I think there are major changes in American policy in this regard that really are required. Mr. CASTLE. Thank you, Chairman Greenspan. Chairman LEACH. Thank you, Mr. Castle. Mr. Bentsen. Mr. BENTSEN. Thank you, Mr. Chairman. Chairman Greenspan, I must say, from my perspective, I guess I am a little less startled about oil prices today than I was a year ago when they were around $10 or $12 a barrel, and $30 a barrel at least in my neck of the woods is close to a fair price. I would say from our perspective, we are more concerned about long-term than the short-term, because the short-term looks pretty good, but the long-term I think we see fluctuation in price. I think at least people in the oil business that I talk to see this more as a predatory or structural issue with respect to OPEC and some of the other large producers that eventually will break and we will go back to perhaps a glut. It is interesting, in a discussion I had with someone from the En- ergy Department recently, that their bigger concern is the natural gas market, and that the decline in EMP and natural gas could lead to a lack of stock in the medium term that could affect prices, particularly as we expand the utilization. I do want to talk about a couple of other things. I will just read off the questions, and if you could get to them, that would be great. I also would just say from your testimony, in what I read, it would appear to me that the Fed remains vigilant toward its inter- est rate outlook, and that at least from my perspective, it would appear that you all are perhaps not finished with tightening. I would like you to comment on your colleague in economics, Ste- phen Roach's, comments. He has written a number of articles re- cently where he is saying that perhaps we are misinterpreting pro- ductivity numbers. Mr. LaFalce referred to them. Second of all, if you could comment, there has been a discussion about the Treasury market. If in fact we do pay down public debt by 2013, what do you view as will be the store of value to replace the Treasury for pricing purposes in the credit markets, and do you perceive any problem with that? And then with respect to Government spending—and this may be more of a comment—you state that we should pay down debt before anything else, and I agree with you on that. You then state in the absence of that, if Congress cannot control itself, that then we should pursue tax cuts rather than any spending increases. You state that the reason for that, one of the large reasons for that, is that it is easier to back away from tax cut policy if our surplus pro- tections turn out to be wrong than open-ended spending commit- ments. 24 As you know, we are having a major debate in Congress over what the budget baseline should be going forward and how we should project the surplus and how that fits into the tax-and- spending policies. First of all, I would say this: I think if you look at Congress' ex- perience from 1980 to 1993, when we saw a quadrupling of the na- tional debt, a lot of that was related to tax policy implemented in 1981 that took Congress over a decade to get a handle on the debt that was occurring. Now, there were spending decisions made as well, but in the con- text of that, if you look at discretionary spending, both defense and non-defense discretionary spending, it has gone down dramatically as a component of the Federal budget and as a percentage of the gross domestic product. In particular, nondiscretionary spending has declined quite dramatically over that period of time. I guess my question is, while I know that you, from your philo- sophical standpoint, think that most Government spending is a drag on the economy, even though we have seen the economy per- form quite well over these last nine years, I am not sure how your testimony adds up, given our experience with the 1980's and trying to dig out of this hole, which it did take many measures to do so in reversing some tax policy, and the fact that where you have basic functions of Government, be they defense and non-defense on the discretionary side, where we have really seen some declines in that area, that we should take this into consideration when we are looking to determine what our baseline is? Mr. GREENSPAN. Congressman, first of all, I would reach over a much longer period, going back into the 1960's and even the 1950's. If you take the full context of the period—and I might add, the most recent year or two, especially the handling of the budget last year—what that suggests to me is that the bias is far more the problem on expenditures than on taxes. I would conclude that while my first priority, as indicated before, is to get the debt down and allow the surplus to run, if somebody tells me that that is po- litically infeasible, I think we are far better off lowering taxes than allowing new programs with long extended potential projections to be put into place. With respect to the first question you raise relevant to the issue of our productivity data being distorted by the fact that a lot of peo- ple work overtime and they don't get recorded, I wish to say that if that is true, that is, if there are hours which are uncounted, so to speak, and therefore output per hour is being overestimated as a consequence, you would also get a far lower level of compensation per hour, and indeed, if there is any significant change in the pro- ductivity data, there must be exactly the same change in average hourly compensation. And we have independent estimates of that which suggest that there is very little range in which the real hourly compensation could have changed, and as a consequence of that, I find the notion of a real bias as a result of underestimating hours most unlikely. On the Treasury issue question, I would merely say that mone- tary policy can be run in a number of different ways, and I don't perceive this as an imminent problem in any respect whatever. 25 Clearly, if we had to, we could invest in private securities or quasi- private securities. Mr. BENTSEN. That was not my question. My time is up, but if you could answer for the record, what I am more interested in is today most private debt and other types of public debt is priced off of intermediate and long-term Treasury debt. Now, in the event that there is no public Treasury debt, what re- places that in the marketplace for pricing stability in that area? It is not a question related to—— Mr. GREENSPAN. There will emerge benchmark private issues which will be created by the marketplace and fulfilled substantially by individuals or companies who will find, for example, the ability to create triple A-plus private issues. And if there is a market defi- ciency in that regard, it will become profitable for numbers of peo- ple in the financial industry to supply it. I have no question what- ever that that will occur if we significantly reduce the total debt to the public. Mr. BENTSEN. Thank you. Chairman LEACH. Mr. Royce. Mr. ROYCE. Thank you. Mr. Chairman, actually, marginal rate reduction, the rated tax reduction as a result of that, the total revenues doubled between 1980 and 1990. As I recall, it was Congress increasing spending by 2.3 times that brought about the increase in the deficits. The spending was going up faster than the revenue increase. I think that would argue for your point. But I want to ask you about one of your arguments about the movement from non-market economies to market economies, this evolution of free enterprise around the world and open market ac- cess that you argue is leading to keeping inflation in check by cre- ating competitive cost pressures and also that you argue is leading to greater productivity by a more effective application of assets to more productive uses. We have a decision to make here in the Congress in terms of cer- tain trade bills: the Africa trade bill, the Caribbean Basin Initia- tive, whether or not we have China move into the World Trade Or- ganization. My question is, What would be the effect of these initiatives on economic growth in the United States, in your opinion, and what would be the effect on net job gains or losses in the United States if we go down this road of continued trade liberalization? Mr. GREENSPAN. Trade liberalization in my judgment, Congress- man, has been a significant net positive for the American economy and the American standard of living, for all the reasons you sug- gest. I have never argued that it is a job-creating program. I don't think that is what the purpose of trade is. The purpose of trade is to create a competitive environment which improves productivity and induces lower costs of goods to consumers. There should be no significant employment effect one way or the other, or at least that is what most academic evaluations have concluded. The effect on real growth and on standards of living around the world is unquestionably very significant, and I would argue very strenuously that the more that we in this country can do to be the 26 leader in enhancing free trade, as we have been since the end of World War II, the better it will be for the United States and all of our trading partners. Mr. ROYCE. Let me ask you two other questions: What Govern- ment policy is the biggest impediment to continued economic ex- pansion, in your view? And second, as you know, productivity growth is an important element of the GDP forecast that Congress gets from the Administration and from the Congressional Budget Office. These forecasts suggest that the rate of productivity growth, ac- cording to them, is expected to fall from 3 percent per year to V/2. to 2 percent per year as we move out toward 2005. Based on what you know, is this a reasonable assumption on the part of the Administration and the Congressional Budget Office, or are they being unduly pessimistic here? You have spoken of accelerating rates of growth, and this would be counterintuitive. What they are giving us here is a forecast that is very pessimistic only compared to that. Mr. GREENSPAN. With respect to your last question, as I say in my prepared remarks, I raise the possibility that there is a much wider range of potential productivity gains than is implicit in the average forecasts, because the average forecasts all look the same. The trouble is that each one of them has a wide potential range; but all they publish is the average, so what we see is that each forecast looks very close to the other. So I think we have to be pre- pared for the fact that we may get a fairly broader range. Having said that, I don't think, from the point of view of an aver- age forecast, that either the CBO or OMB forecasts are particularly inappropriate. Mr. ROYCE. They might have been prudent conservatism? Mr. GREENSPAN. They might. Or, they might also prove accurate or too high. That is a long projection period, and there is a substan- tial uncertainty there. But more important is not so much the fore- cast of productivity, but the issue I raised before, namely, translat- ing the behavior of economy into revenues. That is where the real issue is. With respect to the issue of impediments to the continued expan- sion, I am sure there are a lot of them, but you know something? I am inclined to answer the question in a different context in that what we have observed in the last fifteen or twenty years, is a major move toward free market economies in the world and espe- cially in the United States. There has been a major move toward deregulation, and we have unbound a lot of Government impedi- ments. This has been true irrespective of which party has been in power. So rather than look at the issue of what remains to be done, I think it is important for us to recognize that what has been done is really very impressive. The fact that we have heard very little about it is that it has been noncontroversial. The trouble with non- controversial issues, as important as they are, is that you never hear them discussed. Mr. ROYCE. Thank you, Mr. Chairman. Thank you, Chairman. Chairman LEACH. Thank you, Mr. Royce. 27 Mr. Sherman. Mr. SHERMAN. Thank you, Mr. Chairman. Mr. Chairman, I would ask—and you may have done this before- hand—that we may have five days to submit questions for the record and ask the Chairman and his staff to answer those for the record. Chairman LEACH. Without objection, that request is granted. Mr. SHERMAN. Thank you. Mr. Chairman, in the limited amount of time, I don't have a chance to ask the questions orally that I would like to, and in the written questions I will ask about the oil price rise and whether that is a reason to tighten monetary policy, because it is inflation- ary, or to loosen that because the oil price rise is such a drag on economic expansion. I will ask about the trade deficit. I will ask whether a deficit hawk like Chairman Greenspan would advocate, even though he does not want us to spend money, perhaps spending $100 million or so more on gathering economic statistics and getting those out sooner. It is ridiculous in this Information Age that we don't know why we have a revenue increase and won't know for several more years, and certainly his advocacy for his advocacy on spending more and getting statistics out quicker would be useful. I will also ask about whether we should take into account in our monetary policy the fact that lower interest rates in the United States could lead to stability in Russia, whose nuclear weapons may pose a greater threat to us than all of the economics that we are talking about here today. I agree with Chairman Greenspan, that we are just on the begin- ning of a wave of increase in private technology. The issues before us are, first, how we can avoid screwing that up, but second, how we allocate those benefits. One economic standard that I would propose is the Joe Hill standard, that is, whether a person with a high school education, perhaps one or two years beyond that, can support a family in forty hours of work. By that standard, we may not be as well off today as we were thirty-five years ago. We have with us here today elements of the huge and expanding business news industry that is aimed as those who have capital. Those reports have seeped into our consciousness. They always go something like this: wages are up, that is bad; unemployment is down, that is bad; immigration will help keep labor costs down, so immigration is good. It is not surprising that media aimed at those with capital fo- cuses on those conclusions. What is of concern is that that kind of thinking seeps into the pores of decisionmakers, both the Fed and in Congress. My constituents tend to think that the whole purpose of the study of economics is to raise wages. That is what my constituents rely on. In fact, they are bemused that when they do tune into eco- nomic discussions, higher labor costs are thought to be a bad thing. Mr. Chairman, you commented on the fact that it is possible in the future that labor costs will rise more quickly than productivity, and this would squeeze profits; and you implied that, therefore, it 28 would be a bad thing. Yet in your testimony you talk about the wealth effect. I would say that if profits were to go down and wages were to go up, if anything, you would have a decline in demand, because the wealth effect would not apply to working people the way it does now, a slight increase in the profits of a corporation leading to a huge increase in the stock of that corporation, leading to the own- ers of that corporation being able to spend more. The question that I would like you to answer is what fiscal pol- icy, what congressional policy, what immigration policy could we adopt if the whole purpose of our policy were to have higher wages for working families? Mr. GREENSPAN. First of all, I look forward to answering the pre- vious questions in writing. Our goal shouldn't be higher wages; it should be higher real wages, that is, wages adjusted for purchasing power. Mr. SHERMAN. That is my question. Mr. GREENSPAN. Our specific goal, as we have enunciated before this committee on many occasions, is maximum sustainable eco- nomic growth. That means maximum sustainable real wages. So our concern is not that wages go up; our concern is if wages go up more than productivity it will create an inflationary imbalance which undercuts the economy and the ability of real wages to grow. So, while I certainly agree with you, much of the rhetoric which is employed in a number of discussions is a little loose on this ques- tion, because clearly it would be a mistake to view the issue of lower wages per se as being of value. It cannot be the case if our goal is maximum sustainable economic growth. So, I would suggest to you that an appropriate monetary policy which endeavors to contain inflation and thereby maximize eco- nomic growth is wholly consistent with the maximum sustainable real wage growth, as well. Mr. SHERMAN. I may have misstated my question. I realize we have to go on. But perhaps for the record you will be able to ex- plain not only how we can adopt policies that give us the maximum real sustainable economic growth, but how we allocate the fruits of that growth to working families, as opposed to seeing what appears to be the bulk of those fruits go to those with capital and with stock ownership. Mr. GREENSPAN. Shall I answer that in written form? Mr. SHERMAN. Unless the Chairman Chairman LEACH. It would be preferable. Mr. GREENSPAN. I will be glad to. [Chairman Greenspan's written response to the question from Hon. Brad Sherman can be found on page 112 in the appendix.] Chairman LEACH. Dr. Paul. Dr. PAUL. Thank you, Mr. Chairman. Good morning, Mr. Greenspan. I understand that you did not take my friendly advice last fall. I thought maybe you should look for other employment, but I see you have kept your job. I am pleased to see you back, because at least you remember the days of sound money, and you have some respect for it. Even though you do describe it as nostalgia, you do remember the days of sound money. So I am pleased to have you here. 29 Of course, my concern for your welfare is that you might have to withstand some pummeling this coming year or two when the correction comes, because of all the inflation that we have under- gone here in the last several years. But I, too, like another Member of this committee, believe there is some unfairness in the system, that some benefit and others suf- fer. Of course, his solutions would be a lot different than mine, but I think a characteristic of paper money, of fiat money, is that some benefit and others lose. A good example of this is how Wall Street benefits. Certainly Wall Street is doing very well. Just the other day, I had one of my shrimpers in my district call me and say he is tying up his boat. His oil prices have more than doubled and he cannot afford it, so for now he will have to close down shop. So he suffers more than the person on Wall Street. So it is an unfair system. This unfairness is not unusual. This characteristic is well-known, that when you destroy and debase a currency, some people will suf- fer more than others. We have concentrated here a lot today on prices. You talk a lot about the price of labor. Yet, that is not the inflation, according to sound money economics. The concern the sound money economist has is for the supply of money. If you increase the supply of money, you have inflation. Just because you are able to maintain a price level of a certa'n level, because of technology or for some other reason, this should not be reassurance, because we still can have our mal-investment, our excessive debt and borrowing. It might contribute even to the margin debt and these various things. So I think we should concentrate, especially since we are dealing with monetary policy, more on monetary policy and what we are doing with the money. It was suggested here that maybe you are running a policy that is too tight. Well, I would have to take exception to that, because it has been far from tight. I think that we have had tremendous growth in money. The last three months of last year might be his- toric highs for the increase of Federal Reserve credit. In the last three months, the Federal Reserve credit was increasing at a rate of 74 percent at an annual rate. It is true, a lot of that has been withdrawn already, but this credit that was created at that time also influenced M3, and M3 during that period of time grew significantly, not quite as fast as the credit itself, but M3 was rising at a 17 percent annual rate. Now, since that time, a lot of the credit has been withdrawn, but I have not seen any significant decrease in M3. I wanted to refer to this chart that the Federal Reserve prepared on M3 for the past three years. It sets the targets. For three years, you have never been once in the target range. If I set my targets and performed like that as a physician, my patient would die. This would be big trouble in medicine, but here it does not seem to bother anybody. And if you extrapolate and look at the targets set in 1997 and carry that set of targets all the way out, you only missed M3 by $690 billion, just a small amount of extra money that came into circulation. But I think it is harmful. I know Wall Street likes it and the economy likes it when the bub- ble is getting bigger, but my concern is what is going to happen 30 when this bubble bursts? I think it will, unless you can reassure me. But the one specific question I have is will M3 shrink? Is that a goal of yours, to shrink M3, or is it only to withdraw some of that credit that you injected through the noncrisis of Y2K? Mr. GREENSPAN. Let me suggest to you that the monetary aggre- gates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts. The problem we have is not that money is unimportant, but how we define it. By definition, all prices are indeed the ratio of ex- change of a good for money. And what we seek is what that is. Our problem is, we used Ml at one point as the proxy for money, and it turned out to be very difficult as an indicator of any financial state. We then went to M2 and had a similar problem. We have never done it with M3 per se, because it largely reflects the extent of the expansion of the banking industry, and when, in effect, banks expand, in and of itself it doesn't tell you terribly much about what the real money is. So our problem is not that we do not believe in sound money; we do. We very much believe that if you have a debased currency that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the stand- ard we employ is whether it gives us a good forward indicator of the direction of finance and the economy. Regrettably none of those that we have been able to develop, including MZM, have done that. That does not mean that we think that money is irrelevant; it means that we think that our measures of money have been inad- equate and as a consequence of that we, as I have mentioned pre- viously, have downgraded the use of the monetary aggregates for monetary policy purposes until we are able to find a more stable proxy for what we believe is the underlying money in the economy. Dr. PAUL. So it is hard to manage something you can't define. Mr. GREENSPAN. It is not possible to manage something you can- not define. Chairman LEACH. Is the gentleman finished? Dr. PAUL. Yes. Chairman LEACH. Thank you very much, Dr. Paul. Mr. Watt. Mr. WATT. Thank you, Mr. Chairman. Chairman Greenspan, it is good to see you again. I always have to reiterate my constant state of confusion about the matters that you testify about probably a lot more, because I just don't under- stand the language that by and large you are communicating in and because of any problem that you are having with it is just my own problem. But that is not unusual. You cautioned, Chairman Greenspan, in the last bit of your oral presentation about bouts of euphoria and disillusionment. I confess that to some extent I found your presentation, the first part, pretty disillusioning and the second part, at a minimum, optimistic, if not euphoric. So it may be that what is happening with the human ex- pectations taking a cue from that kind of dichotomy that you seem to be projecting. The question I wanted to ask, though, and I am sure you are always reluctant to comment on the stock market, but 31 when you talk about the wealth effect, I take it that the primary aspect of that is the buying of and bidding up of stock. And I am wondering whether the approximately 9 to 10 percent correction that has taken place in the market during the first month or so of this year in any way reassures you or leads you to believe that maybe that wealth effect may be beginning to diminish some. Mr. GREENSPAN. Congressman, I think you are quite correct that I have been and will continue to be reluctant to answer questions of that sort. Let me just say Mr. WATT. Does that mean that I am not going to get an answer to that? Go ahead. Mr. GREENSPAN. I guess that is right. Let me add, however, that the wealth effect is a much broader issue than strictly stocks. For example, it is certainly the case that stock prices move around fair- ly quickly. But a not insignificant part of the wealth effect is com- ing out of housing. We estimated roughly about a sixth of it. And the reason is that the average turnover of a home is about nine years. So even though annual percentage changes may not be all that large, with the increase in values over a nine-year period, you begin to pick up some fairly substantial capital gains, so that upon the sale of the house there is a fairly large capital gain that comes out of the transaction which is unencumbered by debt to the seller after the down payment on the next home, which means there is a substantial amount of liquidity which we estimate is about a sixth of the total wealth effect. Mr. WATT. What are the other components to the wealth effect? You have housing, you have stock values, what are the other fac- tors? Mr. GREENSPAN. If fact, what we actually measure the wealth ef- fect by is the ratio of household wealth to household income. And so we don't get a wealth effect if the aggregate assets of the house- hold go up about the same amount as income. It is only over and above that do we measure the so-called wealth effect. It is a defini- tion that we employ which gives us the ability to separate the ef- fects of income on consumption and wealth change. Mr. WATT. You talked about housing being one-sixth of that wealth effect has occurred. What are some of the other components of it? Mr. GREENSPAN. The main other component is equities. But there are debt instruments which could be part of it. Obviously any instrument whose market value doesn't change is not particularly relevant. For example, a savings deposit, whose value doesn't change, a short term bond whose value changes very, very little, is in the net assets of households, but it rarely has any impact that we consider a wealth effect. Mr. WATT. I appreciate your not answering the other part of my question. I am sure the stock market appreciates it even more. They probably don't want you to answer that question either. Chairman LEACH. Thank you, Mr. Watt. Mr. WATT. I yield back. Chairman LEACH. Mr. Hill. Mr. HILL. Thank you, Mr. Chairman. Chairman Greenspan, thank you very much for being here. In reading your testimony and the report that you gave to Congress 32 basically I would summarize it by saying that it is your intention to continue to raise interest rates until the aggregate demand is more in line with the output of the economy, is that a correct sum- mation? Mr. GREENSPAN. I tried to phrase exactly what we meant in the words that are in the testimony. And I choose not to go any fur- ther. Mr. HILL. Part of aggregate demand is Government spending, is that right? Mr. GREENSPAN. That is correct. Mr. HILL. So an important part of the effort to get aggregate de- mand back in line with output is to continue the constraints on the rate of growth of Government spending; you agree with that? Mr. GREENSPAN. Yes. Mr. HILL. And an earlier question was asked you of whether or not your position has changed with regard to what ought to be done with surpluses. I believe you stated no, that position hadn't changed. I just want to clarify for the record what that position is because it is in your testimony. And in it you said that "I recognize that growing budget surpluses may be politically infeasible to de- fend. If this proves to be the case, as I have testified previously, the likelihood of maintaining a still satisfactory overall budget posi- tion over the long run is greater, I believe, if surpluses are used to lower tax rates rather than to embark on new spending pro- grams." It continues to be your position that the choice is between in- creasing spending or reducing taxes with surpluses. You believe lowering taxes would be better for the economy. Mr. GREENSPAN. I do, Congressman. Mr. HlLL. And there is a difference between projected surpluses and I think you have testified that we shouldn't be doing anything with surpluses we don't know we are going to realize, which are protected. Mr. GREENSPAN. We should not make long-term commitments to surpluses we don't feel secure about. Mr. HILL. But on the alternative there are surpluses, that this year's budget we know fairly well that we are going to have a $20- some billion surplus in the fiscal year we are in now and I think reasonably accurately can project that we are going do have a sig- nificant surplus in the next fiscal year, the budget we are working on now. Would you say it is appropriate that we can make deci- sions with regard to that, the three decisions being pay down the debt, reduce taxes or additional spending? Mr. GREENSPAN. I would say it applies both to the short term and the long term. Mr. HILL. One last question and that is with respect to the situa- tion in Japan, there are some indications that Japan has experi- enced its second quarter of negative economic growth. That is an economic term, negative economic growth. Should that concern us with regard to how the economy in Japan might impact aggregate demand in the United States? Mr. GREENSPAN. Well, it is certainly the case that early indica- tions of fourth quarter GDP in Japan are negative, at least accord- ing to the people who produce the data. And they are usually a 33 good source for that sort of thing. I believe they publish their figure on March 10th or some time earlier in March, so the official figure is not yet out. There are some conflicting data, however, about the extent of weakness in the Japanese economy in the sense that their GDP to be sure is negative, but their industrial production is not, at least not as negative. As a result of this, it is not terribly clear how one should characterize the period they are going through. It is a sluggish period. It is one in which they are struggling to work their way through the huge overhang that has occurred in the economy following the collapse of the real estate and equity bubbles of 1990, which has worked through the financial system and cre- ated very considerable havoc, because the collateral that was used in the banking system has gone down well over 50 percent and that has created a huge backing up of non-performing loans and the credit system has been in serious trouble. They are gradually work- ing out of that, and working very hard at it I might add. And there is evidence to suggest that they are coming out of this. I would not characterize what has occurred at this stage as falling back into re- cession, but there is no question that they are struggling. Mr. HILL. Thank you, Mr. Chairman. Chairman LEACH. Thank you, Mr. Hill. Mr. Moore. Mr. MOORE. Chairman Greenspan, last year, July 22 of last year, you testified to this committee, "If I was asked what our first prior- ity should be, it would be to let the surplus run and reduce the Federal "debt. If I was asked what my second priority is, it would be to cut taxes rather than expand spending." And essentially you have reiterated that today, maybe in a little different words. And this is not a direct quote, but I think you said something to the ef- fect, "be patient, let the surpluses run and let surplus run and let debt decline." Is that essentially correct, Mr. Chairman? Mr. GREENSPAN. Yes, Congressman. Mr. MOORE. Shortly after your testimony in July of last year, Chairman Greenspan, Congress passed a $792 billion tax cut which was subsequently vetoed by President Clinton. This year, just last week in fact, the House passed about a $180 billion marriage pen- alty tax relief bill. And it appears, and this is not clear yet, with we don't have a budget resolution, but it appears that maybe the intention of the Majority party is to bring out one tax cut bill at a time for passage, and I don't know what their intention is as to a total. The concern that I have, and I guess what I want to ask you a question about is assuming that—and there have been proposals by some figures on the national level and some Presidential contend- ers that there be tax cuts totaling between $700 billion and a tril- lion dollars. My question, Chairman Greenspan, is that consistent with your recommendation to Congress or do you still believe that our first priority should be to let the surplus run? Mr. GREENSPAN. I still believe that the first priority should be to let the surplus run. I don't want to comment on any particular pro- posals of anybody, and I would just let the statement that I have made stand, if I may. 34 Mr. MOORE. You have heard, at least I have heard projections, the projections for real surplus may range somewhere between $750 billion on the conservative side and I think that figure as I believe, as I understand it, at least is if Congress adheres to the spending caps which we don't seem to be able to do, and if it is not adjusted for inflation, the $750 billion surplus figure over the next ten years, then I have heard other projections as high as $2 tril- lion. I am sure you have heard the same projections. Do you have a crystal ball or have you ventured any guesstimate as to what an accurate figure might be as far as a ten-year projec- tion, sir? Mr. GREENSPAN. The answer is no, I do not. And I tried to ad- dress that very specifically in my prepared remarks, trying to point out why it is so difficult to dp so. And the major reason is not so much the economic forecast, it is that we do not understand pre- cisely why the revenues that we have had in the last several years are as high as they are, or very specifically why the ratio of indi- vidual tax revenues relative to taxable individual incomes moved up as high as they have, even with pretty good estimates what the capital gains tax would be and bracket creep would be. So there is a substantial excess of revenue, the underlying cause of which we do not yet fully understand. And we don't know wheth- er it will continue, whatever it is, or if it is a surprise, could just reverse, go in the other direction. And that is a large enough num- ber to really impact very significantly on these various estimates. And that is the reason why I think you have to be cautious about the employment of long-term commitments of budget surpluses when you really do not yet have any real feel as to how solid they are. Mr. MOORE. Would that uncertainty then cause you some con- cern about—and not commenting on any particular tax cut pro- posal—but tax cuts in the range of $750 billion to $1 trillion over the next ten years? Mr. GREENSPAN. I don't want to get involved in the specific dis- cussion of that nature if you don't mind. Mr. MOORE. Thank you, Mr. Chairman. Chairman LEACH. Thank you, Mr. Moore. Mr. Ryan. Mr. RYAN OF WISCONSIN. Thank you, Mr. Chairman. Thank you for being here. Good to see you again, Mr. Chairman. Actually I would like to follow up on my colleague from Kansas. The difference in the surplus estimates between the Administration and Congress is not over the revenues; it is over the spending. The Administration will admit that they are estimating essentially a $2 trillion non-Social Security surplus. The difference is that they are also estimating that we are going to increase spending by $1.3 tril- lion. Now given the fact that we have heard you consistently repeat that the first priority ought to be debt reduction, second priority ought to be, if that is politically infeasible, tax reduction, and the last priority ought to be new expenditures, given the fact that we can't operate in that policy vacuum that we have to operate here in Congress, we have already accomplished a very historic agree- ment, I believe, with the Administration, which is to dedicate all 35 of the Social Security surplus, the $2 trillion toward debt reduction. I think that is something that is a great accomplishment of this Congress and this Administration. On the non-Social Security surplus, the Administration just gave us a budget ten days ago, which calls for increasing spending by $1.3 trillion, specifically $800 billion increase in discretionary spending and a $500 billion increase in mandatory spending partly to pay for the creation of 84 new Federal spending programs. That is what the President's budget does. So if you are to juxtapose a $1.3 trillion spending increase over the next ten years, as the President's budget proposes, versus say a $700- to $800-billion tax cut, I think under your standard the tax cut may be preferable. But I would like to ask you a question about which kind of tax cuts. Because clearly not all tax reductions are created equal. I would like to bring your attention to a chart over here. If we look at the capital gains tax rate, that we have seen, and this is a fairly simple crude chart that we had the Budget Committee put to- gether, the capital gains tax rate over the last number of years, we had a 28 percent tax rate, that was reduced in the 1997 tax bill to 20 percent. But it is also interesting to note that under the most recent IRS income data that capital gains tax revenues actually in- creased, whereas in 1996 we had $66 billion coming in from capital gains tax receipts; 1997, $79 billion coming in from capital gains tax receipts; then after the rate was actually cut from 28 to 20 per- cent for the top rate, we actually had an increase in capital gains tax revenues to $91 billion in 1998 to a $101 billion in 1999, based on these most recent statistics that we have from the IRS. So given the fact that that tax reduction actually led to an in- crease in revenues and an increase in economic activity, wouldn't it be prudent to follow this kind of policy for the future, rather than a new spending increase like the Administration is calling for, and more importantly, wouldn't these kinds of tax reductions fuel more surpluses which will give us more money to actually produce more debt reduction? So I would like if you could comment on that, and given the fact that the alternative here in Washington outside of the policy vacu- um is the President's budget which is to increase spending from the non-Social Security surplus to the tune of $1.3 trillion. Mr. GREENSPAN. Let me just say first that there is no question that if you lower capital gains tax rates, as you do, then you will unleash a good deal of potential capital gains sales or sales of cap- ital assets and create revenues. A goodly part of the increased revenues obviously has got to be the rise in asset values that has occurred as a consequence of all of that. There is the notion that certain cuts in taxes can engender in- come increases and tax revenues which make them engender more revenues than existed before. In other words, you would cut taxes and get higher revenues, but obviously there has got to be a limit to that and indeed we don't know where we are in the curve, be- cause if you continue to cut taxes, revenues cannot continue to in- crease, because at one point you are going to get to a zero tax rate, and you won't get any revenues. So the issue cannot be a general statement. 36 The broad notion, however, that there are certain tax cuts which engender revenues and economic activity better than others I would certainly agree with. And as I say in my prepared remarks, I am a strong supporter of cuts in marginal tax rates as a vehicle for increasing economic activity. I think, however, in today's con- text that that is better served by reducing the debt and getting a lower cost of capital to create the same process. But I would readily acknowledge that on other occasions tax cuts would be superior to reducing the debt. I don't believe that is the case now, but I do think it is clearly feasible at other times. Mr. RYAN OF WISCONSIN. I am interested that you mentioned the curve. I don't know if you are mentioning the Laffer curve or not. We may be in the prohibitive range right now. But given the fact that rates surged after the last capital gains tax cut and the capital gains tax cut before then, do you believe that we are still in a pro- hibitive range on the tax curve subject to capital gains so that if we do continue to cut capital gains taxes such as last year's tax bill did by 2 percentage points or simply index the capital gains tax, that we would actually extract more revenues? Mr. GREENSPAN. I don't know the answer to that. And one of the reasons I don't know the answer is we don't actually have data for 1999 yet. Those are estimates. Mr. RYAN OF WISCONSIN. These are preliminary. Mr. GREENSPAN. Not even preliminary, they are rough estimates which could be significantly off. So I don't think we have the evi- dence of this at this particular stage. Mr. RYAN OF WISCONSIN. If I could ask one quick question, if we have a choice here in Congress, one choice, increase spending by $1.3 trillion out of a non-Social Security surplus as the President is proposing, or to add more money to debt reduction, say $300 bil- lion in debt reduction and let's say just for sake of argument a tril- lion dollar tax cut, would you choose more debt reduction and tax reduction versus the President's call to increase spending by $1.3 trillion? Mr. GREENSPAN. I would find a way not to answer the question. Mr. RYAN OF WISCONSIN. Thank you very much. That is all I have, Mr. Chairman. Chairman LEACH. Thank you, Mr. Ryan. Mr. Inslee. Mr. INSLEE. Thank you, Mr. Chairman. I would like to share some good news along with yours, which we appreciate hearing from you, and that is that I really think the American people are with you on this issue of giving debt reduction the highest priority. I just want to report to you I think we had a real good test of this last fall when there was a proposal by some in Congress that in fact would have ripped the heart out of our ability to maintain those surpluses to reduce the Federal deficit. I just want to report to you that that proposal which would have pre- vented us from paying down the debt was rejected in the East and the Midwest and the Rockies and the West Coast and certainly in my neighborhood, my neck of the woods, because people really do get this on Main Street. They understand that this has the virtue of reducing our interest obligations, and it is not something lost on them. 37 So, I just want to share that good news with you that people this argument that you are prevailing and I hope that we will low in that regard. I would like you, if you can, you made an interesting comment in your written testimony, I don't know if you talked about it this morning, about really maybe in a sense questioning whether we really have a unified surplus today if you look at it from an accrual basis. And I wonder if you could just describe to us what you mean by that, how should we look at this surplus issue from an accrual basis? Mr. GREENSPAN. I didn't cover this issue in my oral remarks, but I have in my written remarks. The agreement that has been fairly quick and fairly impressive by the Congress and the Administra- tion to take the Social Security surplus off-budget, I think is a re- markably wise judgment. We may bicker on the margins of a lot of different programs, whether it is tax or spending or what have you, but the judgment to agree on taking that off the budget was really an extraordinary decision which is going to have very posi- tive consequences, in my judgment, for years to come. So, I would just basically say that we are making progress in this area. Mr. INSLEE. We appreciate that. Let me allude if I can, switching g;ears a bit, one of my constituents has been referred to several times in the testimony today, and that is the wealthiest person on earth who happens to live in my district, who got there due to in- credible creativity and now is becoming the most prolific philan- thropist in world history, which we also appreciate. But there is another side of some constituents I represent. I go to one side of a lake in my district and I find some incredibly economically effec- tive people, I go to another side of the lake in my district and I recently visited a food bank where I met a whole bunch of folks who were working hard, had full time plus jobs, and were coming into the food bank to get food literally to feed their children. And I think they would want me to ask this question of you, is there something, something structurally going on where some working people, people who are in fact hard working, dedicated, get up in the morning, go to work kind of folks are not realizing the productivity gains that in fact are being realized? Is there some- thing going on structurally in our economy where we are not allow- ing these working people to get the fruits of their productivity in- creases? Because I think by all measure we are finding some ex- traordinary increases in productivity, largely because of the tech- nology that is being developed, much of it in my district. But I guess the question I have for you, is there something going on that we need to be concerned about that we are not allowing those working people to capture some of those benefits associated with their productivity increases? If so, what are they? Tell me your genus on how we move ahead on that front. Mr. GREENSPAN. I think one of the problems that we have is that as you move towards, first, an increasingly concept-based economy, as we have for generations, where an increasing proportion of the GDP is more value-created through ideas rather than physical brawn or materials or physical things. That has been the long-term trend. Second, superimposed on that has been the really dramatic 38 synergies of these numbers of technologies which have been so ex- traordinary in the last decade, I guess even longer than that, but not much. The consequence of this, until very recently—the last two or three years— has been an opening up or dispersion of incomes in the country which reflects the degree of education. The so-called college premium in the market has opened up and the premium of high school versus those with less than high school education has opened up. And it is part of the problem. It strikes me that the so- lution is education, to find means by which you can increase the education capacity of individuals so that they can share in the fruits of what is an increasingly conceptual high tech economy. That doesn't mean that everyone has to be a computer programmer or a nuclear physicist or whatever, but you have to be in a position where you are part of that overall structure and everyone can be. And that is, I think, the challenge: that we have to create an edu- cational system which enables people coming out of high school or college to move into productive activities in those particular areas. If we can't do that, I don't think we are going to solve the prob- lem which you put on the table. Mr. INSLEE. Thank you, Mr. Chairman. I will relate your answer to my eighth grader when he works on algebra next week. Mr. GREENSPAN. It will be helpful. Chairman LEACH. Mr. Ose. Mr. OSE. Thank you, Mr. Chairman. Mr. Greenspan, I note on page 10 of your written testimony your comments about factoring in the unified budget on an accrual basis as it relates to the revenues flowing in. And if we did that account- ing for the obligation, the future obligations of Social Security, we would be arguably in a deficit as opposed to a surplus. We in Con- gress have spent a lot of time talking about paying down the pub- licly-held debt. And I notice in your other locations in your written testimony a difference, very subtle, in some of your comments about debt versus public debt. Now, we have engaged in a long discussion here about paying down the publicly-held debt, those of us on this side of the testi- mony table. Your comments are inescapable in terms of actually re- tiring debt, rather than substituting one creditor for another. And I would appreciate any comments you might have as it relates to substituting in this discussion about paying down the publicly-held debt, substituting, for instance, members of the general public as the creditor in lieu of say the Social Security Trust Fund. I don't happen to believe to the extent that we are using Social Security Trust Funds to buy T bills and T notes that we are having an ap- preciable long term impact on the overall claim on the U.S. Treas- ury. I understand the short term consequence in the financial mar- kets from a crown-out effect, but I would be curious about your re- marks in this regard otherwise. Mr. GREENSPAN. I think that what we have to be aware of is we have differing types of accounting systems which serve different purposes. We have moved from the unified budget to an on-budget system by effectively agreeing that the Social Security Trust Fund is off-budget. On-budget is a good way toward a full accrual system which is the norm in the private sector. The appropriate accounting 39 for an accrual system would have receipts generally as they are, outlays would be accrued outlays, where when the credit was earned in Social Security, it gets recorded at that time. It shows up not in the debt to the public or even in the public debt which is a different issue, it shows up as a contingent liability. So that if you look at the Government's balance sheet in this accrual sense, you end up with debt to the public and contingent liabilities. To the extent that we have moved from a unified budget to on- budget, we have moved toward the accrual system. The reason it is important is that if you go beyond the year 2030, when we are still building up the Social Security Trust Fund, depending on which assumptions you make, certainly when we get out to mid- century we are getting into a huge deficit on the unified basis. And what an accrual system would do is fully recognize the very much longer term so that commitments would be made and funded for an accrual system at the time they are made in precisely the same manner as a private insurance system does. So, the point that I raised within my testimony was merely not to argue that we should go to an accrual system right.now—I don't think we can—but we should recognize that when we are talking about paying off the debt, we are talking about paying off the debt to the public, but contingent liabilities are still rising. And in one sense unless the Congress repudiates those obligations—which we have never done and nobody believes we will ever do, which is one of the reasons we have the credit in this country that we have— we will have a very substantial amount of liability as the decades go on. So, I do think it is important to keep in context that these types of budgets have different uses. From an economist's point of view, the unified budget is what we find the most useful, because it tells us exactly what is happening to the cash flow of the Government. And as you know, if you run a unified surplus, which is solely from the Social Security Trust Fund, we will be reducing the debt by that amount. And that is very important to the economic structure of the economy. On-budget is a more useful budget for purposes of forward planning for Government revenues. The accrual system is to carry the on-budget still further to completion. Mr. OSE. I want to thank the Chairman for that very clear expla- nation. I got it, and I do appreciate it. Because it is a point that is lost amongst the many of us on this side of the aisle, or this side of the table, excuse me. Thank you, Mr. Chairman. Chairman LEACH. Well, thank you, Mr. Ose. Mrs. Biggert. Mrs. BlGGERT. Thank you, Mr. Chairman. Mr. Greenspan, on page 2 of your remarks you talk about the sharp rise in the amount of consumer outlays relative to disposable income and the corresponding fall in consumer savings. And I think the latest reports show that personal savings rate continues to decline and it has fallen from 8.7 percent in 1992 to 2.4 last year. And I would like just to know what effect this can have on our economy. Will the worsening of the savings rate sidetrack our current economic expansion at all? And I wonder if you could com- ment on what we need to do to spur increased saving rates. And is there something within the Government such as tax incentives 40 that would help to do this. I remember back in the Reagan days we had the All Savers Accounts that seemed to be very popular that people put money in and didn't have to pay the interest rates on them, that certainly savings accounts they do now. Mr. GREENSPAN. Congresswoman, the savings rate has gone down basically, because individuals perceive that they have pur- chasing power beyond their disposable incomes, which is capital gains, unrealized capital gains very specifically against which they borrow. Because they perceive it as real wealth, it may go down some, but it is not going to go to zero. So they borrow against it or capitalize it in one form or another. What that means statistically is the consumption that they make out of those capital gains is included in the aggregate consumption figure we have and lowers our measure of savings out of income. We have to be a little careful here, because if you ask the aver- age person in that context have you lowered your savings rate, they will say no. We are in fact spending the same proportion of our re- sources that we have always spent. And we have saved some. So the problem is this tricky accounting issue of how to account for the amount of consumption which doesn't relate to income. In part it is also an issue of the fact that in disposable income, there are capital gains taxes. As you know, capital gains are not included in income, but the taxes are. And as a consequence disposable per- sonal income from which you subtract consumption to get savings is reduced still further. And so I am not concerned about the level of published savings. It is in large part being offset by a marked increase in Government savings to finance the capital investments that we need. I do think, however, as we get down the road, as we get beyond this big bulge in wealth and we get back to more normal rates in a lot of these relationships, that we ought to relook at the issues that you raised; namely, to maintain incentives to save. And I think that we should do that now, but we have to recognize that the results are very sig- nificantly being distorted by these very large changes in wealth that we have seen in recent years. Mrs. BIGGERT. Are you concerned about, for example, the high tech companies that have come into existence and their rapid growth at the time and then those capital gains could disappear very shortly if that Mr. GREENSPAN. Oh, I assume there are going to be a lot of ups and downs in some of these companies. There is one very famous one which everyone now likes to cite. It was a brochure for an IPO that came out in which the company said, "We don't produce any- thing, we don't do anything," and they sold their stock. Mrs. BIGGERT. Thank you very much. Chairman LEACH. It wasn't called the Federal Reserve. Mr. Toomey. Mr. TOOMEY. Thank you, Mr. Chairman. And thank you, Chairman Greenspan, for your patience this morning. I have to ask to indulge your patience for one last ques- tion about the fiscal year 2000 budget surplus, but I can assure you that it will indeed be the final question, if only because I am the last person to be asking questions this morning. And I will try to be brief. 41 As we discussed earlier, there is a reasonably high degree of cer- tainty now that for fiscal year 2000, anyway, we have a budget sur- Elus that will be fairly substantial considering last year's spending jvels. I am very concerned that the forces for ever-greater spend- ing in this town are well underway in an attempt to spend much, if not all, of this $23 billion. I think it would be a terrible precedent to do that with this surplus. I frankly think we already spent too much money last year in the appropriation bills that were signed into law. And I am very concerned that by adding now to fiscal year 2000 spending, we decrease future surpluses because spending tends to grow, always as a function of the previous year's level. I have a bill that is designed to increase the likelihood that as much of the fiscal year 2000 surplus as possible will go toward ei- ther paying down public debt, lowering taxes, or in the event of a miracle, structural reform of Social Security or Medicare, which I doubt will take effect in fiscal year 2000. I am not asking you to comment on my bill obviously, but is it fair to say that these are in your judgment the right goals and that all of this surplus should be used for some combination of those purposes? Mr. GREENSPAN. Well, as I said previously, and just to repeat, I do think there are very great benefits by allowing the surpluses to run and the consequent reduction in debt occur. I also think we have to be a little careful about this question of what we mean by Social Security reform. When we used to talk about that years ago, we always presumed, at least when I was Chairman of the Social Security Commission at that time, which was almost twenty years ago, it is remarkable, but there was a very strong notion that So- cial Security should be a social insurance system, which meant that benefits should be paid only out of Social Security taxes. I am not saying that there is not an argument at this particular point about whether in fact in these particular times general revenues should be put in the system to finance benefits as distinct from taxes. I would think, however, that there would be more discussion on that issue. It is remarkably absent today from the debate as to whether in fact we should restrict benefits only to tax receipts or to general revenues, meaning shall taxes from non-Social Security be applied to fund Social Security benefits. I repeat, I am not saying that it is clear to me which argument is good or bad, but I do think before the issue of the social insur- ance nature of Social Security is abandoned, which is what hap- pens if you bring general revenues onto the scene, that there at least should be some objective discussion of the fact that it is being done. Mr. TOOMEY. I agree with that. I think that discussion will take place before any such reform is likely to get enough support to ac- tually pass. Personally I think it could very well be justified as a transformation, as a means of providing the financing for a trans- formation of the Social Security system to one that would be more geared toward a personal savings system. I did have one other question I was wondering if you would com- ment on. And it seems to me fiscal conservatives, and I consider myself one, have often argued against excessive Government spending using sort of derivative arguments. In the 1980's we talked about not being able to afford more spending because of our 42 debt and our deficits, more recently we have made the point we need to restrain spending so as not to spend Social Security monies on other Government programs, both of which I agree with, but both of which miss the central point of whether or not we are at the appropriate level of Government spending itself. Now, whether Government spending can be virtually unlimited, perhaps, if it is not funded with deficits or from other programs. And I was wondering if you would comment on the question of in order to reach the goal that you described earlier of maximum sustainable real growth, do you believe we are more likely to achieve that level if a greater share of our GDP is in the private sector and therefore less in the Government at all levels than the current level; in other words, should we be moving in the direction of lesser Government spending as a percentage of our economy? Mr. GREENSPAN. I have always argued that particular point. There are economists who don't agree with that. In other words, it is very difficult analytically to make judgments as to the optimum level of Government spending with respect to economic growth as an example. My own view is not based on definitive econometrical analysis, because the data just don't enable you to infer that, but on watching the way an economy functions. How individual compa- nies function and how Government works and how Federal funds are dispersed and what happens to them, I have concluded, person- ally, that the less the share of economy that goes to Government, the better. But what I do want to emphasize is that that is not a view which is universally held. And indeed I am not certain that I would be representative of the center of the economics profession by any means. But it is probably the most important broad fun- damental issue which the Congress and the Administration has to deal with: that is, what is the size of Government, what is the opti- mum size to fulfill the role of Government and to maximize eco- nomic growth. And in that regard, I think that, as I indicated be- fore, relevant to the issue of marked trends toward deregulation of markets, there has been in this country a very significant shift, ir- respective of party, toward the view that the private sector is the primary force creating economic substance and growth. Mr. TOOMEY. Time for a quick question? Chairman LEACH. Yes, sir. Mr. TOOMEY. And while it may be very difficult to quantify that precisely through an economic model, I think there is tremendous empirical evidence if you compare the economic performances of relatively free economies to the economic performances of relatively unfree or less-free economies, that evidence seems to be over- whelmingly in favor. Mr. GREENSPAN. I think that is generally accepted in the eco- nomics profession. Mr. TOOMEY. Thank you. Chairman LEACH. Well, thank you. Our final questioner has just presented his question. I would just like to end with a kind of a large query in terms of the role of monetary policy, and that is we are in a period of economic growth, we are in a period which "steady as you go" seems to be a mantra that we all appreciate. And yet, is there such a thing as monetary policy hubris; that is, are we better off with a system that grows 3 percent a year for 43 three years or might we be better off with a system that grows 6 percent one year, zero the next and 4 percent the third? Can you comment on that, particularly in relationship with what appears to be some breaking point in the economy when you have testified that per unit economic labor costs are actually going down? Is that a credible question to ask? Mr. GREENSPAN. Clearly, stability engenders maximum growth. In other words, you can demonstrate, I believe, that if the goal is maximum sustainable economic growth, that a volatile economy or a volatile monetary policy is not likely to contribute to that. And I should think that the issue of a stable incremental policy for monetary authorities is always best if that is feasible. There are occasions when events occur which are not continuous, they occur unexpectedly and monetary policy becomes a reflection of that phe- nomenon. But I think history will demonstrate that the less vola- tile policy changes are, the less volatile fluctuations in the financial system are, the greater is the long-term sustainable economic growth. Chairman LEACH. Well, thank you very much. And your testi- mony is very much appreciated. And certainly this committee would be remiss not to go on record again with: A, support of your renomination; and B, more importantly, support for the independ- ence of the Federal Reserve System. Thank you very much. Mr. GREENSPAN. Thank you very much, Mr. Chairman. Chairman LEACH. The hearing is adjourned. [Whereupon, at 12:54 p.m., the hearing was adjourned.] A P P E N D IX February 17, 2000 (45) 46 CURRENCY Committee on Banking and Financial Services James A. Leach, Chairman For Immediate Release: Contact: David Runkel or Thursday, February 17,2000 Brookly McLaughlin (202) 226-0471 Opening Statement Of Representative James A. Leach Chairman, Committee on Banking and Financial Services Humphrey-Hawkins Hearing on the Conduct of Monetary Policy The Committee meets today to receive the 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 the House Banking Committee and congratulations on your renomination and reconfirmation as Chairman of the Federal Reserve. The President and Senate have made a wise and timely decision. It underscores that the country has been well served by an independent, non-partisan Federal Reserve. The Act under which this hearing is held prescribes that the Federal Reserve System conduct policies to bring to realization "the goals of maximum employment, stable prices and moderate long-term interest rates." As we exit the 20th century and enter a new millennium, the underpinning goals of the Humphrey-Hawkins legislation appear to have been met More Americans have jobs than ever before; the unemployment rate is at an historic modern day low; inflation is in check; productivity growth is the highest in 15 years; and not only is the federal budget in balance, but to the astonishment of most, surpluses are forecast for the foreseeable future. Sustained economic growth has occurred in part due to significant private sector productivity increases, in part as a result of a mix and fiscal and monetary policies which, perhaps, for the first time in decades are working in sync, rather than in juxtaposition. The budget surplus which has had the effect of reducing reliance of debt issuance at the federal level has increased the flexibility of the Fed to manage monetary policy. Divided government has had its rewards. A conservative bent to Congress has moderated the Executive Branch and has served well the American economy. In this regard, it deserves stressing that just as the Executive Branch has primary responsibility in the field of international affairs and the Fed and the Open Market Committee have authority for the conduct of monetary policy, the Congress is preeminently accountable for federal budgetary matters. While one of the stark difficulties in our economy is that the gap between the well-to-do and the less well off is widening, job opportunities are expanding to the most disadvantaged parts of the population. Growth has been propelled in a circumstance where per capita federal government spending has leveled off, or perhaps even declined, giving rise to the conclusion that for the vast majority of Americans the economics of compassion is the economics of governmental restraint Before turning to your testimony, Mr. Chairman, I would like to ask if the Ranking Member of the Full Committee and Chairman and Ranking Member of the Monetary Polky Subcommittee have opening statements. 47 CURRENCY Committee on Banking and Financial Services James A. Leach, Chairman For Immediate Release: Contact: David Runkel or Thursday, February 17,2000 Brookly McLaughlin (202) 226-0471 Opening Statement Chairman Spencer Bachus Subcommittee on Domestic and International Policy Humphrey-Hawkins Hearing, February 17, 2000 Chairman Greenspan, you should be congratulated on your recent reappointment and for your accomplishments as Chairman of the Federal Reserve since 1987. Three key facts show what Chairman Greenspan has accomplished. During your term in office, mortgage rates are down 2.4 percent, inflation is down 1.7 percent, and unemployment is down 1.9 percent Low inflation, low unemployment, and rising wages have created significant economic opportunities for all Americans. The robust stock market has also created opportunities for many. Undoubtedly much of the credit for today's positive economic scenario is owed to the policies you have implemented as Chairman of the Federal Reserve Board. Today we will hear your testimony as required by the Humphrey-Hawkins law, which requires a semi-annual report by the Fed to Congress on the conduct of monetary policy. Since there is some question as to whether the Senate will vote to continue having the Humphrey-Hawkins hearings, I would like to affirm my desire that they continue. And, even if these hearings do not continue in their current form, I believe it's very important that the essential content of these hearings should still be presented. I would also like to point out that, for the first time, most of the goals imposed on the Fed by Humphrey-Hawkins, such as a balanced budget, adequate productivity growth, reasonable price stability, and an unemployment rate near 4 percent, have been achieved and maintained under your Chairmanship. For years most economists thought these goals were impossible to accomplish or, if accomplished would be at cross-purposes, but you and the economy have proven them wrong. As we prepare to enter the new millennium, today's hearing represents an important opportunity for the Federal Reserve to clearly articulate the principles on which its future policy decisions will be based. In particular, it should be made clear why the Fed thinks it is necessary to adopt a tightening mode in the absence of signs of rising inflation pressures. This task won't be easy. Serious observers and analysts have been repeatedly surprised in the past few years by the US economy's rapid growth and stunning productivity surge. There has been such incredible development in the economy over the last 16 years that some people have been over-awed with the results. Today you could give us an economic road map for 48 the future, where are we headed, what are the limits, what are the potential detours. It is important to know where the economy is going, and especially to be aware of any future bumps in the road or potential detours that might be ahead (as we drive into the future). You have mentioned previously your concerns about inflation, but there may be others. The recent spike in oil prices and a flattening or inversion of the bond yield are both historically linked to the economic downturn that plagued our economy in the seventies, and the brief recessions in the beginning of the 80's and the 90's. Another possible concern is the significant rise in margin lending. The level of debt to purchase stocks has risen to $243 billion, or 1.5 percent of market value. Margin lending has historically moved in tandem with the market's value, but the recent burst of margin borrowing in the market has been more alarming because it has outrun the rise in stocks' value. Looking at the global economic picture, the U.S. current account deficit is forecast to climb to 4.2% of GDP this year (from 3.7% in 1999) and remain above 4% through 2001. This could cause problems if investors do not continue to purchase U.S. dollar financial assets on a scale large enough to finance the external deficit (without large fluctuations in either exchange rates or interest rates). Therefore, while it is undeniable that our economy has reached record levels of prosperity and growth, it is also apparent that several potential dangers exist that threaten our economy. Mr. Chairman, we will be counting on you to help guide us down the unmapped and untraveled roads of the new millennium. Your experience and intellect should serve us well in this endeavor, one of unprecedented challenges and complexities. 49 U.S. HOUSE OF REPRESENTATIVES CC'.'Mi'TEE CN SArjKiNG A';D HNANCiAL SERVICES ONE HUNDRED SIXTH CONGRESS 2129 RAYBURN HOUSE CFFiCE BUILDNG WASHINGTON. DC 20515-6050 February 17, 2000 Alan Greenspan Chairman Board of Governors Federal Reserve System Washington, DC 20551 Dear Chairman: Thank you for your responses today to questions regarding the economic and monetary policy implications of eliminating the federal debt. As you know, the President has called for paying off the federal debt by the year 2013, which is estimated will cost around $2.5 trillion. Currently, the Federal Reserve relies on treasury bonds to conduct open market operations. In response to questions by Representatives Roukema, Bentscn and myself, you indicated that you perceived no imminent difficulty in your ability to perform open market operations, but that eventually the Fed may turn to the highest grade, say AAA+ private market bonds. Several questions arise from this possibility. First, given the current rate of reduction in the federal debt, have you estimated at what point in the future that you could no longer effectively implement open market operations using the Treasury bond market? Most importantly, how would the Fed avoid "allocating credit" when it chooses a new instrument for its operations? Second, what would be the economic effect of significantly reducing or eliminating Treasury bonds on the private bond market? Would the Treasury bond market remain, perhaps on a much smaller scale, or would it be completely eliminated? Where else could investors find comparably risk-free bonds? Would they be able to turn to Fannie Mae or Freddie Mac? What would become the new benchmark for commercial loans and particularly inoYtgafjtt? I look forward to receiving your response to these questions at your earliest convenience. If you have any questions or would like more information, please feel free to call me, or have your staj^call mine at 224-0763. Sii 50 BOARD OF GOVERNORS OP THE FEDERAL RESERVE SYSTEM WASHINGTON. D. C. EO55I March 10, 2000 The Honorable Spencer Bachus House of Representatives Washington, D.C, 20515 Dear Congressman r Thank you for giving me the opportunity to respond to your questions on the economic and policy implications of eliminating the federal debt. The Federal Reserve has not prepared any forma] estimates of the point at which it would experience difficulties in conducting open market operations as the federal debt is paid down, and we do not expect to encounter significant difficulties in the near future. As you know, even though the Treasury has been paying down debt for the past two years or so, the recent surpluses followed a very long period of large federal deficits, and consequently the volume of federal debt outstanding remains quite large. Moreover, the Federal Reserve Act enables us to transact in Treasury securities, and certain other instrumems (such as obligations of federal agencies, certain obligations of state and local governments, foreign exchange, sovereign debt, etc.) on both an outright and a temporary, repurchase basis. The Federal Reserve already has been placing considerable emphasis on repurchase transactions in our operations. The availability of repurchase agreements against non-Treasury instruments as well as against Treasury securities will continue to contribute to our flexibility in an environment of declining Treasury debt. As you suggest, an objective of the Federal Reserve in implementing monetary policy is to minimize interference in the allocation of credit in the money and capital markets. Meeting this objective would be an important consideration in the design of any implementation alternatives, should declines in Treasury debt eventually make modifications of our current techniques desirable. I should clarify that current statutory authority docs not permit the Federal Reserve to make purchases of high-grade private bonds on either an outright or temporary basis. If at some future lime it should become apparent that additional authority is desirable, we would request that the Congress make technical changes in the Federal Reserve Act to permit transactions in a broader range of assets. 51 The precise market responses lo a reduction or even complete elimination of Treasury debt arc difficult to judge in advance. (The main variable determining whether Treasury debt is eliminated entirely is the realized amount of federal surpluses.) Since Treasury obligations have been acting as benchmark issues, some market adaptations certainly will be required if Treasury debt shrinks significantly. As I mentioned at the hearing, I am confident that the capital markets would create alternative benchmarks to fill the void left by disappearing Treasury debt. Fannie Mae and Freddie Mac already have attempted to take advantage of this situation by issuing so-called "benchmark" and "reference" issues, but it is possible that obligations of entirely private firms eventually could serve as benchmarks. As I often have emphasized, there is considerable uncertainty about the size of future surpluses and, indeed, about whether they will even continue to materialize. Consequently, we should be cautious about making plans based on projections of large surpluses. If the surpluses do eventuate, the implied smaller federal presence in credit markets will have substantial benefits for the economy. The reduced volumes of federal debt will tend to lower even private real interest rates and more generally will foster a receptive climate for private financing of capital formation, which will help to maximize sustainable economic growth. Any adaptations that may eventually be required in Federal Reserve operations are insignificant in comparison 10 those benefits. Similarly, I am quite confident that any market adaptations in response to declining Treasury debt will ultimately preserve and possibly even enhance the efficiency of our capital markets. 52 Opening Statement of U.S. Rep. Michael P. Forbes House Committee on Banking & Financial Services Hearing on February 17,2000 Mr. Chairman, I am proud to be here today with the esteemed Federal Reserve Board Chairman, Alan Greenspan. With Chairman Greenspan's assistance, our economy has experienced its longest economic expansion in history - over 7 years of prosperity. My priority today is that we work to sustain the economic prosperity our country is now enjoying. In particular, my neighbors in Long Island are concerned about rising interest rates, the high price of home heating oil, and the future of Social Security and Medicare. Like other areas around our country, Suffolk County, NY is plagued with high property taxes and very expensive real estate prices. Because of these high costs, buying a home is often prohibitively expensive - even for middle-income families. With every small percentage increase of interest rates, my neighbors are experiencing even more difficulty buying a home. Homeownership is a pivotal building block for family security, stability, and strong communities. All families deserve the opportunity to achieve the American dream of owning a home. I am interested in hearing what Chairman Greenspan will say today about the delicate balance between rising inflation and interest rates. In addition, my neighbors on Long Island are having great difficulties paying for the significant increases in home heating oil. Oil price increases are, proportionately speaking, almost identical to 1979 and 1991. Along with many of my colleagues from the Northeast, I have asked President Clinton to release some of the Strategic Petroleum Reserves (SPR). This will alleviate the shortage of crude oil in the United States and thus the extraordinary prices we are experiencing. The SPR's current size — more than 560 million barrels — represents $20 billion investment by the taxpayers of our country. I believe that this is an appropriate occasion to use some of this investment. I am interested in hearing Chairman Greenspan's comments on the impact of the high oil prices on our economy. Will high oil rates cause our economy to slow down? If President Clinton agrees to release some of the SPR and oil prices level out, won't that have a positive impact on the economy? Finally, I want to thank Chairman Greenspan for all his work in advocating for the reduction of the national debt. Like Chairman Greenspan, I believe that we must reduce the debt. With 12% of the federal budget going to interest on the debt, significantly reducing the debt is the only way to really save Social Security and Medicare. I am looking forward to Chairman Greenspan's comments about the amount that the debt must be reduced to save Social Security and Medicare. Thank you. 53 OPENING STATEMENT Hon. Marge Roukema Humphrey Hawkins Hearing February 17, 2000 House Banking and Financial Services Committee Thank you, Mr. Chairman. It is very good to see you again, Chairman Greenspan. Congratulations on your renomination and recent confirmation by the Senate to a 4th Term as Chairman of the Board of Governors of the Federal Reserve System. I think I speak for all of us here when I say that we are lucky to have you as the Chairman of the Federal Reserve for the next 4 years. As with most Humphrey Hawkins Hearings, you are going to get a wide variety of questions and comments. For instance, I am sure that you will have at least 5 questions on the high price of oil. The price of a barrel of oil passed $30 just the other day which is a 9 year high. Many of my colleagues will inquire as to what effect this increase will have on consumers and inflation. In my state of New Jersey and the entire Northeast we are facing a crisis. Because of high, sometimes doubled, cost of heating their homes, many residents have less discretionary income to spend or save each month. And high diesel fuel prices threaten the truck, trains, and ships that carry the commerce across the economic crossroads of the nation - the Northeast. This dramatic rise in oil prices could have a significant negative impact on our economy. I would like you to know your thoughts on this issue. Others will inquire about mortgage rates. As you know, mortgage rates are approaching a 4 year high and could go over the 9% mark. This surge in interest rates could have a large impact on homebuyers, the housing industry and the economy. Mortgage rates are a politically sensitive issue, if ever there was one. Still others will raise issues such as safety and soundness of the banking system in light of the passage of the Gramm-Leach-Bliley Act, merging the BIF and SAIF deposit insurance funds, establishing caps and rebates, OTC derivatives, financial privacy, expanding CRA, the evils of mixing banking and commerce and who knows what else. Last year, at this hearing I questioned you on the related subjects of the size of tax cuts, paying down the debt and the relation to economic growth and inflation. Today I would like to inquire, however, about your views on the Administration's proposal to retire all $3.6 Trillion of the publicly held Treasury debt by 2013. Is this a good idea? I would like to direct your attention to the article in this morning's New York Times entitled "Shrinking Treasury Debt Creates Uncertain World" which suggests that paying off all $3.6 Trillion in publicly held Treasury debt 54 would have an adverse effect on the Federal Reserve's ability to conduct monetary policy. See attached. I think it is fair to say that the Government Bond market has been volatile in the last 3 weeks. Its not clear whether the market thinks paying all the Treasury debt is good or bad. Are there any good policy reasons for maintaining a modest amount of publicly held Treasury debt rather than paying it all off? Could this move adversely affect the banking system? The FED buys and sells large amounts of Treasuries through its open market operations. What effect, if any, will this plan have on the Federal Reserve's ability to conduct monetary policy and what debt security would most likely replace U.S. Government bonds for such activities. Thank you. Shrinking Treasury Debt Creates Uncertain World said. "So in addition to increased ty GHETCHEN MORGENSON Ko M no ay m b y e a s n o d . t B ow ut e r I i n n t t e h r e e st m r e a a t n es ti m fo e r , a l t l h . e t m o a b in e I m n u th c e h s m hr o in re k in pr g o m ne a r t k o e w t a il r d e s e w xp in e g c s te i d n N.J B . e " c I a t u a se ff t e h c e ts m ev a e r r k y e b t o f d o y r . T " reasury debt is volatility, we are dealing with almost Treasury's plan to reduce Its debt is roiling price and thereby riskier for investors. the largest and most heavily traded m the by definition a riskier bond market Lawrence H. Summers, secretary of the the financial markets and raising the pros- Finally, corporations wilt probably issue world, and because investors evaluate al- as well" Treasury, is clearly relishing his rale as pect of far-reaching, unintended effects on more debt to fill the public demand for most every other type of bond using a This is quite a change, given that the man who put the nation on a no-debt the economy and investors. bonds, creating a debt burden that could Treasury security as a benchmark, even much of the bond market has been a diet. In Congressional testimony last week, One immediate effect of the shrinking make it much more difficult for the nation the smallest change in the government's refute for investors seeking safety Mr. Summers predicted that by 2013. the Treasury debt market, economists say, is to shake off a downturn in the economy. financing has effects at home and abroad. and security in their holdings. Few $3.9 trillion in Treasury debt held by the to make It tougher for the Federal Reserve "The surplus has forced the Treasury to "One of the reasons the US. has been the are confident that investors have public would be eliminated, repurchased Board to cool the economy because « it crtange the way they do business, and we dominant factor in the world is we were the by funds from budget surpluses that the raises short-term interest rates, tcng-term are looking at the consequences," said only place with a deep, liquid debt mar- will need to take when they Invest in roaring American economy has wrought rates are not rising in tandem. Ward McCarthy, principal at Stone fc Mc- bonds as the Treasury bows out of The result, he said, will be an even stronger In addition, the debt securities that re- Carthy Research Associates in Princeton. Continued on Page /1 the market and corporate issuers take its place. Moreover, investors may not rec- ognize the implications of a big In- crease in corporate debt when the nation experiences a recession. "When you go into an economic stow- down and there Is • large amount of government debt outstanding and a small amount of corporate debt out- standing, that's not a problem." Mr. Kaufman explained. "All you need is an easing In monetary policy and off we go again. But when the private I sector is heavily burdened when we slow down, that will require more stimulation. This is a concern." the budget surplus to finance a buy- back of existing Treasury debt could cause inflation. Robert H. Parks, a professor of finance at the Lubtn Graduate School of Business at Pace University, said: "This Increases the money supply, and it also increases the reserves of private financial In- stitutions. It is highly expansionary and potentially inflationary In an 56 CHAPTER ONE THE BUDGET OUTLOOK available for redemption could be retired by 2009. The Outlook for "Available" is the key word: some portion of the out- standing debt will remain in public hands because Federal Debt many 30-year bonds are not slated to mature until af- ter 2010. The Treasury has announced that it plans to Measures of federal debt are meant to tally the accu- begin repurchasing some outstanding debt in 2000; mulated past obligations of the government—what the however, it is unlikely that over time, all holders of government owes. Yet the two primary measures 30-year bonds (or even a significant portion of them) present vastly different perspectives on the magnitude will choose to sell their securities at prices that the of such obligations and what they might be like in the government would be willing to pay. Furthermore, future, given the outlook for the budget. unless the government discontinues the Treasury's programs for savings bonds and state and local gov- Debt held by the public—the most economically ernment securities, those forms of debt will continue to meaningful measure of previous obligations—is the be issued and will remain outstanding at the end of the net amount of money that the federal government has projection period. borrowed to finance all of the deficits accumulated over the nation's history, less any surpluses, as well as Under each of the discretionary spending varia- other, considerably smaller financing needs. At the tions of CBO's baseline, the Treasury would have suf- end of 1999, debt held by the public totaled $3.6 tril- ficient cash on hand sometime between 2007 and 2009 lion—$88 billion less than at the end of the previous to retire all debt held by the public. For the reasons year and $138 billion less than at its 1997 peak. Un- given above, it could not devote all of those funds to der all three variations of the baseline, CBO projects that purpose. Under such circumstances, it might be that debt held by the public will decline. more plausible to assume that the Congress and the President would decide to cut taxes and increase Gross federal debt—and a similar measure, debt spending to dissipate any surplus cash that either was subject to limit—counts debt issued to government not needed to pay for the government's activities and accounts as well as debt held by the public. Debt is- services or that remained after all available debt had sued to government accounts does not flow through been redeemed. However, because CBO makes no the credit markets; such transactions are intragovem- assumptions about future policy actions, its projec- mental and have little or no effect on the economy. tions simply assume that the Treasury will invest all Under all three baseline variations, both gross federal excess cash at a rate of return equal to the average debt and debt subject to limit are rising by 2009. rate projected for Treasury bills and notes. Why Debt Held by the Public Does Not Decline by Debt Held by the Public the Amount of the Surplus. In most years, what the Treasury borrows closely reflects the total deficit or surplus. However, a number of factors broadly la- To cover the difference between revenues and expendi- beled "other means of financing" also affect the gov- tures, the Department of the Treasury raises money by ernment's need to borrow money from the public. selling securities to the public. Between 1969 and Those factors include reductions (or increases) in the 1997, the Treasury sold ever-increasing amounts of government's normal cash balances needed for day-to- those securities to finance continuing deficits, thus day operations, seigniorage, and other, miscellaneous causing debt held by the public to climb from year to changes. The largest of those other borrowing needs year. CBO's current baseline paths now point toward reflects the capitalization of financing accounts used a different outcome. If the projected surpluses materi- for credit programs. Direct student loans, rural hous- alize, debt held by the public will decline substantially ing programs, loans by the Small Business Adminis- from today's level of $3.6 trillion (see Table 1-5). tration, and other credit programs require the govern- ment to disburse money up front on the promise of Indeed, CBO estimates that under all three ver- repayment at a later date. Those up-front outlays are sions of its baseline, debt held by the public that is not counted in the budget, which reflects only the esti- 57 THE BUDGET AND ECONOMIC OUTLOOK: RSCAL YEARS 2001-2010 January 2000 Table 1-5. CBO Projections of Federal Debt at the End of the Year Under Alternative Versions of the Baseline (By fiscal year, In billions of dollars) Actual 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Discretionary Spending Grows at the Rate of Inflation After 2000* Debt Held by the Public 3,633 3,455 3,292 3,097 2,884 2,651 2,394 2,080 1,721 1,330 1,016 941 Debt Held by Government Accounts Social Security 855 1,009 1,175 1,358 1,554 1,763 1,988 2,2272,481 2.749 3,030 3.325 Other government accounts* 1.118 1.201 1.282 1.367 1.450 1.530 1.609 1.696 1.783 1.867 1.951 2.035 Subtotal 1,973 2,210 2,458 2,725 3,004 3,293 3,597 3,923 4,264 4.616 4,981 5,360 Gross Federal Debt 5,606 5,665 5,750 5.822 5.888 5,944 5.991 6,003 5,984 5,946 5,997 6,300 Debt Subject to Umif 5,568 5,627 5,712 5,784 5.851 5,908 5,955 5,967 5,949 5,911 5,963 6,267 Accumulated Excess Cash Greater Than Debt Available for Redemption Debt Held by the Public as a Percentage of GDP 39.9 36.1 32.8 29.5 26.3 232 20.1 16.7 13.2 Discretionary Spending Is Frozen at the Level Enacted for 2000* Debt Held by the Public 3,633 3.455 3,281 3,062 2,805 2,506 2,162 1.739 1,249 1.078 1.016 941 Debt Held by Government Accounts Social Security 855 1,009 1,175 1.358 1,554 1.763 1.988 2,227 2,4812,749 3,030 3,325 Other government accounts" 1.118 1.201 1.282 1.367 1.450 1.530 1.609 1.696 1.7831.867 1.951 2.035 Subtotal 1.973 2.210 2,458 2,725 3,004 3,293 3.597 3,923 4,264 4,616 4.981 5.360 Gross Federal Debt 5.606 5.665 5.739 5.787 5,809 5.799 5,759 5,662 5.512 5.693 5,997 6,300 Debt Subject to Umif 5.568 5.627 5.701 5.750 5,772 5.762 5,723 5,627 5.478 5,659 5,963 6.267 Accumulated Excess Cash Greater Than Debt Available for Redemption n.a. n.a. 377 935 1,555 Memorandum: Debt Held by the Public as a Percentage of GDP 39.9 36.1 32.7 29.2 25.6 21.9 18.1 14.0 9.6 7.9 Disci try Spending Equals CBO's Estimates of the Statutory Caps Through 2002 and Grows at the Rate of Inflation Thereafter Debt Held by the Public 3,633 3,455 3.234 2,954 2,647 2.314 1,949 1,522 1,142 1,078 1.016 941 Debt Held by Government Accounts Social Security 855 1,009 1,175 1,358 1,554 1,763 1,988 2,227 2,481 2.749 3.030 3.325 Other government accounts6 1.118 1.201 1.262 1.367 1.450 1.530 1.609 1.696 1.783 1.867 1.951 2.035 Subtotal 1.973 2.210 2.458 2.725 3.004 3.293 3,597 3.923 4,264 4.616 4.981 5.360 Gross Federal Debt 5.606 5,665 5,692 5.679 5,651 5,608 5.546 5.445 5.406 5.693 5,997 6,300 Debt Subject to Umif 5,568 5,627 5,654 5,641 5,614 5,571 5.510 5,410 5.371 5,659 5.963 6.267 Accumulated Excess Cash Greater Than Debt Available for Redemption n.a. n.a. 96 549 1.058 1.608 Debt Held by the Public as a Percentage of GDP 36.1 32.2 28.1 24.2 20.3 16.3 12.2 8.8 7.9 7.2 6.3 SOURCE: Congressional Budget Office. NOTE: n.a = not applicable a. After adjustment for advance appropriations. b. Mainly Civil Service Retirement, Military Retirement, Medicare, unemployment insurance, and the Airport and Airway Trust Fund. c. Differs from the gross federal debt primarily because most debt issued by agencies other than the Treasury is excluded from the debt limit (currently. $5.950 billion). 58 CHAPTER ONE THE BUDGET OUTLOOK mated subsidy costs of such programs. Because the Figure 1-3. amount of the loans being disbursed is larger than the Debt Held by the Public as a Share of GDP repayments and interest flowing back into the financ- (By fiscal year) ing accounts, the government's annual borrowing Percentage of GDP needs are $7 billion to $14 billion higher than the bud- get surplus would indicate. 100 In 1999, the Treasury ended the fiscal year with an unusually large cash balance for operations. Nor- 60 mally, the Treasury tries to end the year with between $40 billion and $50 billion in cash, but on September 30, the balance totaled $56.5 billion. The unneeded portion of the cash balance will be used to reduce debt held by the public during fiscal year 2000. 20 Toward the end of the projection period, public 1940 1950 1960 1970 1980 debt is projected to decline by less than the amount of the surplus (adjusted for other means of financing, SOURCE: Congressional Budget Office. such as seigniorage). CBO assumes that by that time, proceeds from excess cash will help to increase the surplus but excess cash (by definition) will not con- Gross Federal Debt tribute to reductions in debt. For example, under the inflated version of the baseline, the surplus in 2010 is projected to be $489 billion. Of that total, approxi- In addition to selling securities to the public, the Trea- mately $75 billion may be used to redeem available sury has issued nearly $2 trillion in securities to vari- debt, another $8 billion would be consumed by other ous government accounts (mostly trust funds). The means of financing, and the remaining $406 billion largest balances are in the Social Security trust funds would represent excess cash. ($855 billion at the end of 1999) and the retirement funds for federal civilian employees ($492 billion). Debt Held by the Public as a Percentage of GDP. The total holdings of government accounts grow ap- As a share of GDP, debt held by the public reached a proximately in step with projected trust fund sur- plateau in the 1990s and held steady at about 50 per- pluses. The funds redeem securities when they need to cent from 1993 through 1995 (see Figure 1-3). Since pay benefits; in the meantime, the government both then, it has fallen to 40 percent of GDP. By 2004, pays and collects interest on those securities. under all three of CBO's baseline variations, that share will plunge below its post-World War n nadir of Investments by trust funds and other government 24 percent (achieved in 1974). accounts are handled within the Treasury, and the pur- chases and sales (with very rare exceptions) do not Over time, the nation's shrinking debt will gener- flow through the credit markets. Similarly, interest on ate considerable savings in the government's interest those securities is simply an intragovernmental trans- payments. Reducing debt in the near term can sub- fer: it is paid by one part of the government to another stantially decrease interest payments in the future. In part and does not affect the total deficit or surplus. fact, by 2005, net interest spending is projected to Thus, participants in financial markets view trust fund drop to between 1.2 percent and 1.3 percent of GDP holdings as a bookkeeping entry—an intragovern- —as a share of the economy, half as large as it was in mental IOU. Nevertheless, those holdings indicate a 1999. commitment by the government to use future resources for the trust fund programs, although the amount of the holdings may eventually be insufficient to sustain the programs' benefits at the levels defined undercur- rent law. 59 Rep. Paul Ryan, Wisconsin A new Investor Class is emerging as a result of America's dynamic economy. More and more, workers are coming to own the means of production. Karl Marx must be turning in his grave - and Lenin in his glass display box. As the demographics investing are changing, so are the reasons for investing. The best thing that Congress can do, not only to encourage more investment, but also to facilitate further economic growth, is to reduce capital gains taxes and index them to inflation. Currently, 80 million Americans, or 43 percent of U.S. households, own stock or mutual funds. Between 1989 and 1995, shareholding increased significantly among every age group, income level, race, and occupation. Individuals who had not previously participated in the stock market are now not only purchasing stock, but actively managing them as well. This participation in capital markets has led to overall economic growth, by giving companies the resources to increase overall productivity. It has also enhanced investors' retirement savings, eased pressure on education funding, and rewarded personal productivity. As more Americans embrace investment in capital markets, the longer their time horizons become. Today, the majority of American stockholders invest with a long-term strategy in mind. An Investment Company Institute survey investigated the motives that led Americans to invest in the market. According to this poll of mutual fund shareholders, 84 percent invested for supplementary retirement income, 26 percent to pay for education expenses, 9 percent to supplement current expenses, and 7 percent to buy a home. Investors interviewed by Peter D. Hart Research Associates listed similar priorities. 89 percent invested for retirement security, 28 percent to pay for a child's education, 18 60 percent to afford a major new purchase such as a car, 13 percent to be able to support an elderly parent, and 10 percent to buy a new home. These are not necessarily "the rich." These are average Americans wanting to purchase a home, put a child through college, pay future medical bills, and - most importantly - to save for retirement. A characteristic of the new Investor Class - as opposed to the perceived "traditional stockholder" - is their resilience to capital market turmoil in support of long-term savings goals. The secret is out - stocks consistently produce a higher-rate of return over other investments over time. Generally, only investors looking to make a "quick buck" off the market buy and sell in short time intervals. In 1997, when the capital gains tax rate was cut from 28 to 20 percent, capital gains tax receipts have soared. As stock values increased - a result of the tax cut - America experienced its highest gains in productivity and private-sector capital investment in a decade. As the tax rate most sensitive to change, reductions in the capital gains tax rate has historically led to increases in tax collection and tax payments and thus greater government revenue. This is a classic example of lowering a tax rate and broadening the tax base. As more and more Americans become part of the Investor Class, the tax base will continue to broaden - as long as Congress continues to lower the tax rate. The current punitive capital gains tax will only serve to keep more Americans from investing - reducing their impetus to save for the future. It also slows the capital formation and the entrepreneurship that has fueled our economic growth. 61 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 17, 2000 62 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 17, 2000 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Alan Greenspan, Chairman 63 Table of Contents Page Monetary Policy and the Economic Outlook Economic and Financial Developments in 1999 and Early 2000 64 Monetary Policy Report to the Congress Report submitted to the Congress on February 17, its tightest in three decades and becoming tighter, the 2000, pursuant to the Full Employment and Balanced risk that pressures on costs and prices would eventu- Growth Act of 1978 ally emerge mounted over the course of the year. To maintain the low-inflation environment that has been so important to the sustained health of the current MONETARY POLICY AND THE expansion, the FOMC ultimately implemented four ECONOMIC OUTLOOK quarter-point increases in the intended federal funds rate, the most recent of which came at the beginning The U.S. economy posted another exceptional perfor- of this month. In total, the federal funds rate has been mance in 1999. The ongoing expansion appears to raised 1 percentage point, although, at 53/4 percent, it have maintained strength into early 2000 as it set a stands only 1A point above its level just before the record for longevity, and—aside from the direct autumn-1998 financial market turmoil. At its most effects of higher crude oil prices—inflation has recent meeting, the FOMC indicated that risks appear remained subdued, in marked contrast to the typical to remain on the side of heightened inflation pres- experience during previous expansions. The past year sures, so it will need to remain especially attentive to brought additional evidence that productivity growth developments in this regard. has improved substantially since the mid-1990s, boosting living standards while helping to hold down increases in costs and prices despite very tight labor Monetary Policy, Financial Markets, markets. and the Economy over 1999 and Early 2000 The Federal Open Market Committee's pursuit of financial conditions consistent with sustained expan- The first quarter of 1999 saw a further unwinding of sion and low inflation has required some adjustments the heightened levels of perceived risk and risk aver- to the settings of monetary policy instruments over sion that had afflicted financial markets in the autumn the past two years. In late 1998, to cushion the U.S. of 1998; investors became much more willing to economy from the effects of disruptions in world advance funds, securities issuance picked up, and risk financial markets and to ameliorate some of the spreads fell further—though not back to the unusu- resulting strains, money market conditions were ally low levels of the first half of 1998. At the same eased. By the middle of last year, however, with time, domestic demand remained quite strong, and financial markets resuming normal functioning, for- foreign economies showed signs of rebounding. The eign economies recovering, and domestic demand FOMC concluded at its February and March meet- continuing to outpace increases in productive poten- ings that, if these trends were to persist, the risks of tial, the Committee began to reverse that easing. the eventual emergence of somewhat greater inflation As the year progressed, foreign economies, in pressures would increase, and it noted that a case general, recovered more quickly and displayed could be made for unwinding part of the easing greater vigor than had seemed likely at the start of actions of the preceding fall. However, the Commit- the year. Domestically, the rapid productivity growth tee hesitated to adjust policy before having greater raised expectations of future incomes and profits and assurance that the recoveries in domestic financial thereby helped keep spending moving up at a faster markets and foreign economies were on firm footing. clip than current productive capacity. Meanwhile, By the May meeting, these recoveries were solidi- prices of most internationally traded materials fying, and the pace of domestic spending appeared to rebounded from their earlier declines; this turn- be outstripping the growth of the economy's poten- around, together with a flattening of the exchange tial, even allowing for an appreciable acceleration value of the dollar after its earlier appreciation, trans- in productivity. The Committee still expected some lated into an easing of downward pressure on the slowing in the expansion of aggregate demand, but prices of imoorts in general. Core inflation measures the timing and extent of any moderation remained generally remained low, but with the labor market at uncertain. Against this backdrop, the FOMC main- 65 Monetary Policy Report to the Congress D February 2000 tained an unchanged policy stance but announced the Manager of the System Open Market Account to immediately after the meeting that it had chosen a counter potential liquidity strains in the period around directive tilted toward the possibility of a firming of the century date change and that would also help rates. This announcement implemented the disclosure ensure the effective implementation of the Commit- policy adopted in December 1998, whereby major tee's monetary policy objectives. Although members shifts in the Committee's views about the balance of believed that efforts to prepare computer systems for risks or the likely direction of future policy would be the century date change had made the probability of made public immediately. Members expected that, by significant disruptions quite small, some aversion to making the FOMC's concerns public earlier, such Y2K risk exposure was already evident in the mar- announcements would encourage financial market kets, and the costs that might stem from a dysfunc- reactions to subsequent information that would help tional financing market at year-end were deemed to stabilize the economy. In practice, however, those be unacceptably high. The FOMC agreed to autho- reactions seemed to be exaggerated and to focus even rize, temporarily, (1) a widening of the pool of collat- more than usual on possible near-term Committee eral that could be accepted in System open market action. transactions, (2) the use of reverse repurchase agree- Over subsequent weeks, economic activity contin- ment accounting in addition to the currently avail- ued to expand vigorously, labor markets remained able matched sale-purchase transactions to absorb very tight, and oil and other commodity prices rose reserves temporarily, and (3) the auction of options further. In this environment, the FOMC saw an on repurchase agreements, reverse repurchase agree- updrift in inflation as a significant risk in the absence ments, and matched sale-purchase transactions that of some policy firming, and at the June meeting it could be exercised in the period around year-end. raised the intended level of the federal funds rate The Committee also authorized a permanent exten- '/4 percentage point. The Committee also announced sion of the maximum maturity on regular repurchase a symmetric directive, noting that the marked degree and matched sale-purchase transactions from sixty to of uncertainty about the extent and timing of prospec- ninety days. tive inflationary pressures meant that further firming The broader range of collateral approved for repur- of policy might not be undertaken in the near term, chase transactions—mainly pass-through mortgage but that the Committee would need to be especially securities of government-sponsored enterprises and alert to emerging inflation pressures. Markets rallied STRIP securities of the U.S. Treasury—would facili- on the symmetric-directive announcement, and the tate the Manager's task of addressing what could be strength of this response together with market com- very large needs to supply reserves in the succeeding mentary suggested uncertainty about the interpreta- months, primarily in response to rapid increases in tion of the language used to characterize possible the demand for currency, at a time of potentially future developments and about the time period to heightened demand in various markets for U.S. gov- which the directive applied. ernment securities. The standby financing facility, In the period between the June and August meet- authorizing the Federal Reserve Bank of New York ings, the ongoing strength of domestic demand and to auction the above-mentioned options to the gov- further expansion abroad suggested that at least part ernment securities dealers that are regular counter- of the remaining easing put in place the previous fall parties in the System's open market operations, to deal with financial market stresses was no longer would encourage marketmaking and the maintenance needed. Consequently, at the August meeting the of liquid financing markets essential to effective open FOMC raised the intended level of the federal funds market operations. The standby facility was also rate a further [A percentage point, to 51A percent. The viewed as a useful complement to the special liquid- Committee agreed that this action, along with that ity facility, which was to provide sound depository taken in June, would substantially reduce inflation institutions with unrestricted access to the discount risks and again announced a symmetric directive. In a window, at a penalty rate, between October 1999 and related action, the Board of Governors approved an April 2000. Finally, the decision to extend the maxi- increase in the discount rate to 43/4 percent. At this mum maturity on repurchase and matched sale- meeting the Committee also established a working purchase transactions was intended to bring the terms group to assess the FOMC's approach to disclosing of such transactions into conformance with market its view about prospective developments and to pro- practice and to enhance the Manager's ability over pose procedural modifications. the following months to implement the unusually At its August meeting, the FOMC took a number large reserve operations expected to be required of actions that were aimed at enhancing the ability of around the turn of the year. 66 Board of Governors of the Federal Reserve System Selected interest rates I i | i i I 8/18 9/2910/15 11/17 12/22 5/18 6/30 8/24 10/5 11/16 12/21 2/2 1999 2000 MOTH. The data are daily. Vertical lines indicate the days on which the tal axis are those on which either the FOMC held a scheduled meeting o Federal Reserve announced a monetary policy action. The dates on the horizon- policy action was announced. Last observations are for February 11. 2000. Incoming information during the period leading up Governors approved an increase in the discount rate to the FOMC's October meeting suggested that the of '/4 percentage point, to 5 percent. growth of domestic economic activity had picked up At the December meeting, FOMC members held from the second quarter's pace, and foreign econo- the stance of policy unchanged and, to avoid any mies appeared to be strengthening more than had misinterpretation of policy intentions that might been anticipated, potentially adding pressure to unsettle financial markets around the century date already-taut labor markets and possibly creating change, announced a symmetric directive. But the inflationary imbalances that would undermine eco- statement issued after the meeting also highlighted nomic performance. But the FOMC viewed the risk members' continuing concern about inflation risks of a significant increase in inflation in the near term going forward and indicated the Committee's inten- as small and decided to await more evidence on how tion to evaluate, as soon as its next meeting, whether the economy was responding to its previous tighten- those risks suggested that further tightening was ings before changing its policy stance. However, the appropriate. Committee anticipated that the evidence might well The FOMC also decided on some modifications signal the need for additional tightening, and it again to its disclosure procedures at the December meet- announced a directive that was biased toward ing, at which the working group mentioned above restraint. transmitted its final report and proposals. These Information available through mid-November modifications, announced in January 2000, consisted pointed toward robust growth in overall economic primarily of a plan to issue a statement after every activity and a further depletion of the pool of unem- FOMC meeting that not only would convey the ployed workers willing to take a job. Although higher current stance of policy but also would categorize real interest rates appeared to have induced some risks to the outlook as either weighted mainly toward softening in interest-sensitive sectors of the economy, conditions that may generate heightened inflation the anticipated moderation in the growth of aggregate pressures, weighted mainly toward conditions that demand did not appear sufficient to avoid added may generate economic weakness, or balanced with pressures on resources, predominantly labor. These respect to the goals of maximum employment and conditions, along with further increases in oil and stable prices over the foreseeable future. The changes other commodity prices, suggested a significant risk eliminated uncertainty about the circumstances that inflation would pick up over time, given prevail- under which an announcement would be made; ing financial conditions. Against this backdrop, the they clarified that the Committee's statement about FOMC raised the target for the federal funds rate an future prospects extended beyond the intermeeting additional 1A percentage point in November. At that period; and they characterized the Committee's views time, a symmetric directive was adopted, consistent about future developments in a way that reflected with the Committee's expectation that no further policy discussions and that members hoped would policy move was likely to be considered before the be more helpful to the public and to financial February meeting. In a related action, the Board of markets. 67 Monetary Policy Report to the Congress D February 2000 Financial markets and the economy came through 1. Economic projections for 2000 the century date change smoothly. By the February Percent 2000 meeting, there was little evidence that demand Federal Reserve governors w r r i i s s a k e s s n c . o o A m f t i i n n t g h f e la i n t m i t o o n e e a li r t n y in e g i w , m i t b t h h a e l p a F o n O t c e e M n s t C ia a l p r p s a e u i a s p r e p e d l d y , i t t a s o n t d a h r a t g h v e e e t Indicator 19 M 99 e m ac o t : ual and R R a e n s g e e rve Bank te C n p e d r n e e t s n r i a d c l y ents for the federal funds rate '/4 percentage point to Change, fourth quarter In fourth quarter' 5V4 percent, and characterized the risks as remain- Nominal GDP 5-6 5'/4-5'/2 ing on the side of higher inflation pressures. In a R PC e E a l c G h D ai P n ' -type price index . 3 V ' / / - 4 -2 -4 V ' 2 /i I y V / * i- -2 yA related action, the Board of Governors approved a Average Iwel. '/4 percentage point increase in the discount rate, to fourth quarter 5 '/4 percent. Civilian unemployment 1. Change from average for fourth quarter of 1999 to average for fourth quarter of 2000. Economic Projections for 2000 2. Chain-weighted. The members of the Board of Governors and the by a combination of factors, including reduced Federal Reserve Bank presidents, all of whom partici- restraint from non-oil import prices, wage and price pate in the deliberations of the FOMC, expect to see pressures associated with lagged effects of the past another year of favorable economic performance in year's oil price rise, and larger increases in costs that 2000, although the risk of higher inflation will need might be forthcoming in another year of tight labor to be watched especially carefully. The central ten- markets. dency of the FOMC participants' forecasts of real The performance of the economy—both the rate of GDP growth from the fourth quarter of 1999 to the real growth and the rate of inflation—will depend fourth quarter of 2000 is 3V6 percent to 33/4 per- importantly on the course of productivity. Typically, cent. A substantial part of the gain in output will in past business expansions, gains in labor productiv- likely come from further increases in productivity. ity eventually slowed as rising demand placed Nonetheless, economic expansion at the pace that is increased pressure on plant capacity and on the work- anticipated should create enough new jobs to keep force, and a similar slowdown from the recent rapid the unemployment rate in a range of 4 percent pace of productivity gain cannot be ruled out. But to 4!/4 percent, close to its recent average. The central with many firms still in the process of implementing tendency of the FOMC participants' inflation fore- technologies that have proved effective in reorganiz- casts for 2000—as measured by the chain-type price ing internal operations or in gaining speedier access index for personal consumption expenditures—is to outside resources and markets, and with the tech- !3/4 percent to 2 percent, a range that runs a little to nologies themselves still advancing rapidly, a further the low side of the energy-led 2 percent rise posted in rise in productivity growth from the average pace of 1999.' Even though futures markets suggest that recent years also is possible. To the extent that rapid energy prices may turn down later this year, prices productivity growth can be maintained, aggregate elsewhere in the economy could be pushed upward supply can grow faster than would otherwise be possible. However, the economic processes that are giving rise to faster productivity growth not only are lifting 1. In past Monetary Policy Reports to the Congress, the FOMC has aggregate supply but also are influencing the growth framed its inflation forecasts in terms of the consumer price index. of aggregate spending. With firms perceiving abun- The chain-type price index for PCE draws extensively on data from the consumer price index but. while not entirely free of measurement dant profit opportunities in productivity-enhancing problems, has several advantages relative to the CPI. The PCE chain- high-tech applications, investment in new equipment type index is constructed from a formula that reflects the changing has been surging and could well continue to rise composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the rapidly for some time. Moreover, expectations that weights are based on a more comprehensive measure of expenditures. the investment in new technologies will generate Finally, historical data used in the PCE price index can be revised to high returns have been lifting the stock market and, account for newly available information and for improvements in measurement techniques, including those that affect source data from in turn, helping to maintain consumer spending at a the CPI; the result is a more consistent series over time. This switch in pace in excess of the current growth of real dispos- presentation notwithstanding, the FOMC will continue to rely on a able income. Impetus to demand from this source variety of aggregate price measures, as well as other information on prices and costs, in assessing the path of inflation. also could persist for a while longer, given the current 68 Board of Governors of the Federal Reserve System high levels of consumer confidence and the likely serious inflationary consequences because they have lagged effects of the large increments to household been offset by the advances in labor productivity, wealth registered to date. The boost to aggregate which have held unit labor costs in check. But the demand from the marked pickup in productivity pool of available workers cannot continue to shrink growth implies that the level of interest rates needed without at some point touching off cost pressures that to align demand with potential supply may have even a favorable productivity trend might not be able increased substantially. Although the recent rise in to counter. Although the governors and Reserve Bank interest rates may lead to some slowing of spending, presidents expect productivity gains to be substantial aggregate demand may well continue to outpace again this year, incoming data on costs, prices, and gains in potential output over the near term, an imbal- price expectations will be examined carefully to make ance that contains the seeds of rising inflationary sure a pickup of inflation does not start to become and financial pressures that could undermine the embedded in the economy. expansion. The FOMC forecasts are more optimistic than the In recent years, domestic spending has been able to economic predictions that the Administration recently grow faster than production without engendering released, but the Administration has noted that it is inflation partly because the external sector has pro- being conservative in regard to its assumptions about vided a safety valve, helping to relieve the pressures productivity growth and the potential expansion of on domestic resources. In particular, the rapid growth the economy. Relative to the Administration's fore- of demand has been met in part by huge increases in cast, the FOMC is predicting a somewhat larger rise imports of goods and services, and sluggishness in in real GDP in 2000 and a slightly lower unemploy- foreign economies has restrained the growth of ment rate. The inflation forecasts are fairly similar, exports. However, foreign economies have been firm- once account is taken of the tendency for the con- ing, and if recovery of these economies stays on sumer price index to rise more rapidly than the course, U.S. exports should increase faster than they chain-type price index for personal consumption have in the past couple of years. Moreover, the rapid expenditures. rise of the real exchange value of the dollar through mid-1998 has since given way to greater stability, on average, and the tendency of the earlier appreciation Money and Debt Ranges for 2000 to limit export growth and boost import growth is now diminishing. From one perspective, these exter- nal adjustments are welcome because they will help At its most recent meeting, the FOMC reaffirmed the slow the recent rapid rates of decline in net exports monetary growth ranges for 2000 that were chosen and the current account. They also should give a on a provisional basis last July: 1 percent to 5 percent boost to industries that have been hurt by the export for M2, and 2 percent to 6 percent for M3. As has slump, such as agriculture and some parts of been the case for some time, these ranges were manufacturing. At the same time, however, the chosen to encompass money growth under conditions adjustments are likely to add to the risk of an upturn of price stability and historical velocity relationships, in the inflation trend, because a strengthening of rather than to center on the expected growth of money exports will add to the pressures on U.S. resources over the coming year or serve as guides to policy. and a firming of the prices of non-oil imports Given continued uncertainty about movements in will raise costs directly and also reduce to some the velocities of M2 and M3 (the ratios of nominal degree the competitive restraints on the prices of U.S. GDP to the aggregates), the Committee still has little producers. confidence that money growth within any particular Domestically, substantial plant capacity is still range selected for the year would be associated with available in some manufacturing industries and could the economic performance it expected or desired. continue to exert restraint on firms' pricing decisions, even with a diminution of competitive pressures from 2. Ranges for growth of monetary and debt aggregates abroad. However, an already tight domestic labor Percent market has tightened still further in recent months, and bidding for workers, together with further Aggregate 1998 1999 2000 increases in health insurance costs that appear to be M2 1-5 1-5 1-5 coming, seems likely to keep nominal hourly com- M De 3 bt 2 3- - 7 6 3 2 - - 7 6 2 3 - - 6 7 pensation costs moving up at a relatively brisk pace. NOTH. Change from average for fourth quarter of preceding year to average To date, the increases in compensation have not had for fourth quarter of year indicated. 69 Monetary Policy Report to the Congress D February 2000 Nonetheless, the Committee believes that money ECONOMIC AND FINANCIAL DEVELOPMENTS growth has some value as an economic indicator, and IN 1999 AND EARLY 2000 it will continue to monitor the monetary aggregates among a wide variety of economic and financial data The U.S. economy retained considerable strength to inform its policy deliberations. in 1999. According to the Commerce Department's M2 increased 61A percent last year. With nominal advance estimate, the rise in real gross domestic GDP rising 6 percent, M2 velocity fell a bit overall, product over the four quarters of the year exceeded although it rose in the final two quarters of the year as 4 percent for the fourth consecutive year. The growth market interest rates climbed relative to yields on M2 of household expenditures was bolstered by further assets. Further increases in market interest rates early substantial gains in real income, favorable borrowing this year could continue to elevate M2 velocity. Nev- terms, and a soaring stock market. Businesses seek- ertheless, given the Committee's expectations for ing to maintain their competitiveness and profitability nominal GDP growth, M2 could still be above the continued to invest heavily in high-tech equipment; upper end of its range in 2000. external financing conditions in both debt and equity M3 expanded 7'/2 percent last year, and its velocity markets were quite supportive. In the public sector, fell about 1% percent, a much smaller drop than in further strong growth of revenues was accompanied the previous year. Non-M2 components again exhib- by a step-up in the growth of government consump- ited double-digit growth, with some of the strength tion and investment expenditures, the part of gov- attributable to long-term trends and some to pre- ernment spending that enters directly into real GDP. cautionary buildups of liquidity in advance of the The rapid growth of domestic demand gave rise to a century date change. One important trend is the shift further huge increase in real imports of goods and by nonfinancial businesses from direct holdings services in 1999. Exports picked up as foreign econo- of money market instruments to indirect holdings mies strengthened, but the gain fell short of that for through institution-only money funds; such shifts imports by a large margin. Available economic indi- boost M3 at the same time they enhance liquidity for cators for January of this year show the U.S. economy businesses. Money market funds and large certifi- continuing to expand, with labor demand robust and cates of deposit also ballooned late in the year as a the unemployment rate edging down to its lowest result of a substantial demand for liquidity around the level in thirty years. century date change. Adjustments from the tempo- The combination of a strong U.S. economy and rarily elevated level of M3 at the end of 1999 are improving economic conditions abroad led to firmer likely to trim that aggregate's fourth-quarter-to- prices in some markets this past year. Industrial com- fourth-quarter growth this year, but not sufficiently to modity prices turned up—sharply in some cases— offset the downward trend in velocity. That trend, after having dropped appreciably in 1998. Oil prices, together with the Committee's expectation for nomi- responding both to OPEC production restraint and to nal GDP growth, will probably keep M3 above the the growth of world demand, more than doubled over top end of its range again this year. the course of the year, and the prices of non-oil Domestic nonfinancial debt grew 6'/2 percent in imports declined less rapidly than in previous years, 1999, near the upper end of the 3 percent to 7 percent jjiiiii growth range the Committee established last Feb- Change in real GDP ruary. This robust growth reflected large increases in the debt of businesses and households that were due to substantial advances in spending as well as to debt-financed mergers and acquisitions. However, the increase in private-sector debt was partly offset by a substantial decline in federal debt. The Committee left the range for debt growth in 2000 unchanged at 3 percent to 7 percent. After an aberrant period in the 1980s during which debt expanded much more rap- idly than nominal GDP, the growth of debt has returned to its historical pattern of about matching the growth of nominal GDP over the past decade, and the Committee members expect debt to remain within its range again this year. 1991 1993 1995 1997 1999 70 Board of Governors of the Federal Reserve System Change in PCE chain-type price index Change in real income and consumption D Disposable personal income Illlllhl • Personal consumption expenditures I i i i i i i i i i i I I I I 1991 1993 1995 1997 1999 the past five years, a period during which yearly when a rising dollar, as well as sluggish conditions gains in household net worth have averaged more abroad, had pulled them lower. The higher oil prices than 10 percent in nominal terms and the ratio of of 1999 translated into sharp increases in retail energy household wealth to disposable personal income has prices and gave a noticeable boost to consumer prices moved up sharply. overall; the chain-type price index for personal The strength of consumer spending this past consumption expenditures rose 2 percent, double the year extended across a broad front. Appreciable gains increase of 1998. Outside the energy sector, however, were reported for most types of durable goods. consumer prices increased at about the same low rate Spending on motor vehicles, which had surged about as in the previous year, even as the unemployment 131/2 percent in 1998, moved up another 5'/2 per- rate continued to edge down. Rapid gains in pro- cent in 1999. The inflation-adjusted increases for ductivity enabled businesses to offset a substantial furniture, appliances, electronic equipment, and other portion of the increases in nominal compensation, household durables also were quite large, supported thereby holding the rise of unit labor costs in check, in part by a strong housing market. Spending on ser- vices advanced about 4'/2 percent in real terms, led by and business pricing policies continued to be driven to a large extent by the desire to maintain or increase sizable increases for recreation and personal business market share at the expense of some slippage in unit services. Outlays for nondurables, such as food and profits, albeit from a high level. clothing, also rose rapidly. Exceptional strength in The Household Sector Wealth and saving Personal consumption expenditures increased about 5'/2 percent in real terms in 1999, a second year of Wealth-to-income ratio1 exceptionally rapid advance. As in other recent years, the strength of consumption in 1999 reflected sus- tained increases in employment and real hourly pay, which bolstered the growth of real disposable per- sonal income. Added impetus came from another year of rapid growth in net worth, which, coming on top of the big gains of previous years, led households in the aggregate to spend a larger portion of their 2 — current income than they would have otherwise. The personal saving rate, as measured in the national I I I I I 1 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I income and product accounts, dropped further, to an 1962 1968 1974 1980 1986 1992 1998 average of about 2 percent in the final quarter of 1. Ratio of net worth of households to disposable personal income. The data extend through 1999:Q3. 1999; it has fallen about 4'/2 percentage points over 2. The data extend through 1999:Q4. 71 Monetary Policy Report to the Congress ID February 2000 Change in real residential investment multifamily units also were started, about the same number as in each of the two previous years. House Percent. Q4 to Q4 prices rose appreciably and, together with the new investment, further boosted household net worth in residential real estate. The increases in consumption and residential investment in 1999 were, in part, financed by an expansion of household debt estimated at 9'/2 per- li. ••!• cent, the largest increase in more than a decade. Mortgage debt, which includes the borrowing against owner equity that may be used for purposes other than residential investment, grew a whopping 10!/4 percent. Higher interest rates led to a sharp drop in refinancing activity and prompted a shift toward 1991 1993 1995 1997 1999 the use of adjustable-rate mortgages, which over the year rose from 10 percent to 30 percent of origina- tions. Consumer credit advanced 7'/4 percent, boosted the purchases of some nondurables toward the end by heavy demand for consumer durables and other of the year may have reflected precautionary buying big-ticket purchases. Credit supply conditions were by consumers in anticipation of the century date also favorable; commercial banks reported in Federal change; it is notable in this regard that grocery store Reserve surveys that they were more willing than in sales were up sharply in December and then fell back the previous year or two to make consumer install- in January, according to the latest report on retail ment loans and that they remained quite willing to sales. make mortgage loans. Households also continued to boost their expendi- The household sector's debt-service burden edged tures on residential structures. After having surged up to its highest level since the late 1980s; however, 11 percent in 1998, residential investment rose about with employment rising rapidly and asset values 3'/4 percent over the four quarters of 1999, according escalating, measures of credit quality for household to the advance estimate from the Commerce Depart- debt generally improved in 1999. Delinquency rates ment. Moderate declines in investment in the second on home mortgages and credit cards declined a bit, half of the year offset only part of the increases and those on auto loans fell more noticeably. Per- recorded in the first half. As with consumption expen- sonal bankruptcy filings fell sharply after having ditures, investment in housing was supported by the risen for several years to 1997 and remaining ele- sizable advances in real income and household net vated in 1998. worth, but this spending category was also tempered a little by a rise in mortgage interest rates, which likely was an important factor in the second-half Delinquency rates on household loans downturn. Nearly all the indicators of housing activity showed upbeat results for the year. Annual sales of new and existing homes reached new peaks in 1999, surpass- ing the previous highs set in 1998. Although sales dropped back a touch in the second half of the year, their level through year-end remained quite high by historical standards. Builders' backlogs also were at high levels and helped support new construction ac- tivity even as sales eased. Late in the year, reports that shortages of skilled workers were delaying con- struction became less frequent as building activity wound down seasonally, but builders also continued to express concern about potential worker shortages in 2000. For 1999 in total, construction began on NOTK. The dala are quarterly. Data on credit-card delinquencies are from more than 1.3 million single-family dwellings, the bank Call Reports: data on auto loan delinquencies are from the Big Three automakers: data on mortgage delinquencies are from the Mortgage Bankers most since the late 1970s; approximately 330,000 72 Board of Governors of the Federal Reserve System The Business Sector nesses wanting to stand pat with existing systems until after the turn of the year. Growth in computer Private nonresidential fixed investment increased investment in the final quarter of 1999, just before the 7 percent during 1999, extending by another year a century rollover, was the smallest in several quarters. long run of rapid growth in real investment outlays. Spending on other types of equipment rose moder- Strength in capital investment has been underpinned ately, on balance, in 1999. Outlays for transportation in recent years by the vigor of the business expan- equipment increased substantially, led by advances sion, by the advance and spread of computer tech- in business purchases of motor vehicles and aircraft. nologies, and by the ability of most businesses to By contrast, a sharp decline in spending on industrial readily obtain funding through the credit and equity machinery early in the year held the yearly gain for markets. that category to about 2 percent; over the final three Investment in high-tech equipment continued to quarters of the year, however, outlays picked up soar in 1999. Outlays for communications equipment sharply as industrial production strengthened. rose about 25 percent over the course of the year, Private investment in nonresidential structures fell boosted by a number of factors, including the expan- 5 percent in 1999 according to the advance estimate sion of wireless communications, competition in tele- from the Commerce Department. Spending on struc- phone markets, the continued spread of the Internet, tures had increased in each of the previous seven and the demand of Internet users for faster access to years, rather briskly at times, and the level of invest- it. Computer outlays rose nearly 40 percent in real ment, though down this past year, remained relatively terms, and the purchases of computer software, which high and likely raised the real stock of capital in the national accounts are now counted as part of invested in structures appreciably further. Real expen- private fixed investment, rose about 13 percent; for ditures on office buildings, which have been climbing both computers and software the increases were rapidly for several years, moved up further in 1999, roughly in line with the annual average gains during to the highest level since the peak of the building previous years of the expansion. boom of the 1980s. In contrast, investment in other The timing of investment in high-tech equipment types of commercial structures, which had already over the past couple of years was likely affected to regained its earlier peak, slipped back a little, on net, some degree by business preparations for the century this past year. Spending on industrial structures, date change. Many large businesses reportedly in- which accounts for roughly 10 percent of total real vested most heavily in new computer equipment be- outlays on structures, fell for a third consecutive year. fore the start of 1999 to leave sufficient time for their Outlays for the main types of institutional structures systems to be tested well before the start of 2000; a also were down, according to the initial estimates. very steep rise in computer investment in 1998 — Revisions to the data on nonresidential structures roughly 60 percent in real terms — is consistent with often are sizable, and the estimates for each of the those reports. Some of the purchases in preparation three years preceding 1999 have eventually shown a for Y2K most likely spilled over into 1999, but the good bit more strength than was initially reported. past year also brought numerous reports of busi- After increasing for two years at a rate of about 6 percent, nonfarm business inventories expanded more slowly this past year—about 3'/4 percent Change in real nonresidential fixed investment according to the advance GDP report. During the year, some businesses indicated that they planned to carry heavier stocks toward year-end to protect them- Structures selves against possible Y2K disruptions, and the rate Equipment and software of accumulation did in fact pick up appreciably in the fall. But business final sales remained strong, and the Mil ratio of nonfarm stocks to final sales changed little, holding toward the lower end of the range of the past decade. With the ratio so low, businesses likely did not enter the new year with excess stocks. After slowing to a 1 percent rise in 1998, the economic profits of U.S. corporations—that is, book profits with inventory valuation and capital consump- I II i ii i ii i tion adjustments—picked up in 1999. Economic prof- 1991 1993 1995 1997 1999 its over the first three quarters of the year averaged 73 Monetary Policy Report to the Congress D February 2000 Change in real private nonfarm inventories Before-tax profits as a share of GDP Nonfinancial corporalio iJII 1 I I I I II I I I I 1991 1993 1995 1997 1999 1978 1981 1984 1987 1990 1993 19% 1999 NOTK. Profits from domestic operations, with inventory valuation and capital consumption adjustments, divided by gross domestic product of nonfinancial corporate sector. The data extend through I999.-Q3. about 3'/2 percent above the level of a year earlier. The earnings of corporations from their operations outside the United States rebounded in 1999 from a ume substantially further over the past two years, but brief but steep decline in the second half of 1998, profits per unit of output have dropped back some- when financial market disruptions were affecting the what from their 1997 peak. As of the third quarter world economy. The profits earned by financial cor- of last year, economic profits of nonfinancial corpo- porations on their domestic operations also picked up rations amounted to slightly less than 11 '/> percent after having been slowed in 1998 by the financial of the nominal output of these companies, compared turmoil; growth of these profits in 1999 would have with a quarterly peak of about 12-V4 percent two years been greater but for a large payout by insurance earlier. companies to cover damage from Hurricane Floyd. The borrowing needs of nonfinancial corporations The profits that nonfinancial corporations earned on remained sizable in 1999. Capital spending out- their domestic operations in the first three quarters of stripped internal cash flow, and equity retirements 1999 were about 2'/2 percent above the level of a year that resulted from stock repurchases and a block- earlier; growth of these earnings, which account for buster pace of merger activity more than offset record about two-thirds of all economic profits, had slowed volumes of both seasoned and initial public equity to just over 2 percent in 1998 after averaging 13 per- offerings. Overall, the debt of nonfinancial businesses cent at a compound annual rate in the previous six grew 10'/> percent, down only a touch from its years. Nonfinancial corporations have boosted vol- decade-high 1998 pace. Gross corporate bond issuance Millions ol dollars D High yield Investment grade A S O N DJ F M A MJ J A S O N DJ MOTH. Excludes unrated issues and is 74 Board of Governors of the Federal Reserve System The strength in business borrowing was wide- in particular, exhibited upward pressure at this time. spread across funding sources. Corporate bond The likelihood of year-end difficulties seemed to issuance was robust, particularly in the first half of diminish in the fall, and spreads again retreated, the year, though the markets' increased preference ending the year down on balance but generally above for liquidity and quality, amid an appreciable rise the levels that had prevailed over the several years up in defaults on junk bonds, left issuance of below - to mid-1998. investment-grade securities down more than a quarter Federal Reserve surveys indicated that banks from their record pace in 1998. The receptiveness of firmed terms and standards for commercial and indus- the capital markets helped firms to pay down loans at trial loans a bit further, on balance, in 1999. In the banks—which had been boosted to an 11% percent syndicated loan market, spreads for lower-rated bor- gain in 1998 by the financial market turmoil that rowers also ended the year higher, on balance, after year—and growth in these loans slowed to a more rising substantially in 1998. Spreads for higher-rated moderate 5'/4 percent pace in 1999. The commercial borrowers were fairly steady through 1998 and early paper market continued to expand rapidly, with 1999, widened a bit around midyear, and then fell domestic nonfinancial outstandings rising 18 percent back to end the year about where they had started. on top of the 14 percent gain in 1998. The ratio of net interest payments to cash flow for Commercial mortgage borrowing was strong again nonfinancial firms remained in the low range it has as well, as real estate prices generally continued occupied for the past few years, but many measures to rise, albeit at a slower pace than in 1998, and of credit quality nonetheless deteriorated in 1999. vacancy rates generally remained near historical Moody's Investors Service downgraded more non- lows. The mix of lending shifted back to banks and financial debt issuers than it upgraded over the year, life insurance companies from commercial mortgage- affecting a net $78 billion of debt. The problems that backed securities, as conditions in the CMBS market, emerged in the bond market were concentrated especially investor appetites for lower-rated tranches, mostly among borrowers in the junk sector, and partly remained less favorable than they had been before the reflected a fallout from the large volume of issuance credit market disruptions in the fall of 1998. and the generous terms available in 1997 and early Risk spreads on corporate bonds seesawed during 1998; default rates on junk bonds rose to levels not 1999. Over the early part of the year, spreads reversed seen since the recession of 1990-91. Delinquency part of the 1998 run-up as markets recovered. During rates on C&I loans at commercial banks ticked up in the summer, they rose again in response to concerns 1999, albeit from very low levels, while the charge- about market liquidity, expectations of a surge in off rate for those loans continued on its upward trend financing before the century date change, and of the past several years. Business failures edged up anticipated firming of monetary policy. Swap spreads, last year but remained in a historically low range. Spreads of corporate bond yields over Treasury security yields Net interest payments of nonfinancial corporations relative to cash flow SONDJ FMAMJ JASONDJ F 19' 1999 2000 Noi>:. The data are daily. The spread of high-yield bonds compares the yield >n the Merrill Lynch 175 index with that on a seven-year Treasury: the other :wo spreads compare yields on the appropriate Merrill Lynch indexes with that an a ten-year Treasury. Last observations are for February 11. 2000. MOTH. The data are quarterly and extend through 1999:Q3. 75 Monetary Policy Report to the Congress D February 2000 Annual change in real government expenditures growth of these outlays has picked up appreciably as on consumption and investment the expansion has lengthened. At the federal level, expenditures in the unified budget rose 3 percent in fiscal 1999, just a touch less D Federal than the 3!/4 percent rise of the preceding fiscal year. • State and local Faster growth of nominal spending on items that are included in consumption and investment was offset in the most recent fiscal year by a deceleration in other categories. Net interest outlays fell more than 5 per- cent—enough to trim total spending growth about % percentage point—and only small increases were recorded in expenditures for social insurance and income security, categories that together account for nearly half of total federal outlays. In contrast, fed- I I eral expenditures on Medicaid, after having slowed in 1996 and 1997, picked up again in the past two fiscal years. Spending on agriculture doubled in fiscal The Government Sector 1999; the increase resulted both from a step-up in payments under farm safety net programs that were Buoyed by rapid increases in receipts and favorable retained in the "freedom to farm" legislation of 1996 budget balances, the combined real expenditures of and from more recent emergency farm legislation. federal, state, and local governments on consumption Federal receipts grew 6 percent in fiscal 1999 after and investment rose about 4% percent from the fourth increases that averaged close to 9 percent in the two quarter of 1998 to the fourth quarter of 1999. Annual previous fiscal years. Net receipts from taxes on data, which smooth through some of the quarterly individuals continued to outpace the growth of per- noise that is often evident in government outlays, sonal income, but by less than in other recent years, showed a gain in real spending of more than 3'/2 per- and receipts from corporate income taxes fell moder- cent this past year, the largest increase of the expan- ately. Nonetheless, with total receipts growing faster sion. Federal expenditures on consumption and than spending, the surplus in the unified budget con- investment were up nearly 3 percent in annual terms; tinued to rise, moving from $69 billion in fiscal 1998 real defense expenditures, which had trended lower to $124 billion this past fiscal year. Excluding net through most of the 1990s, rose moderately, and interest payments—a charge resulting from past outlays for nondefense consumption and investment deficits—the federal government recorded a surplus increased sharply. Meanwhile, the consumption and of more than $350 billion in fiscal 1999. investment expenditures of state and local govern- Federal saving, a measure that results from a trans- ments rose more than 4 percent in annual terms; lation of the federal budget surplus into terms consis- tent with the national income and product accounts, amounted to 2'/4 percent of nominal GDP in the first Federal receipts and expenditures three quarters of 1999, up from l'/2 percent in 1998 and '/2 percent in 1997. Before 1997, federal saving had been negative for seventeen consecutive years, Total expenditures by amounts exceeding 3 percent of nominal GDP in several years—most recently in 1992. The change in the federal government's saving position from 1992 to 1999 more than offset the sharp drop in the per- sonal saving rate and helped lift national saving from less than 16 percent of nominal GDP in 1992 and 1993 to a range of about 18!/a percent to 19 percent over the past several quarters. Federal debt growth has mirrored the turnabout in the government's saving position. In the 1980s and I I I I I I I I I I I I I I | I I I early 1990s, borrowing resulted in large additions 1984 1987 1990 1996 1999 to the volume of outstanding government debt. In in N S O ep T t E em . T be h r e . data are from the unified budget and are for die fiscal year ended contrast, with the budget in surplus the past two 76 Board of Governors of the Federal Reserve System National saving large volumes of debt. Alternate quarterly refunding auctions of five- and ten-year notes and semiannual Percent ol nominal GDI' auctions of thirty-year bonds will now be smaller reopenings of existing issues rather than new issues. Thirty-year TIIS will now be auctioned once a year Excluding federal saving rather than twice, and the two auctions of ten-year TIIS will be modestly reduced. Auctions of one-year Treasury bills will drop from thirteen a year to four, while weekly bill volumes will rise somewhat. Finally, the Treasury plans to enter the market to buy back in "reverse auctions" as much as $30 billion of Total saving outstanding securities this year, beginning in March or April. State and local government debt expanded 4'/4 per- cent in 1999, well off last year's elevated pace. NOTH. National saving includes the gross saving of households, businesses, Borrowing for new capital investment edged up, but and governments. The data extend through I999:Q3. the roughly full-percentage-point rise in municipal bond yields over the year led to a sharp drop in years, the Treasury has been paying down debt. With- advance refundings, which in turn pulled gross issu- out the rise in federal saving and the reversal in ance below last year's level. Tax revenues continued borrowing, interest rates in recent years likely would to grow at a robust rate, improving the financial have been higher than they have been, and private condition of states and localities, as reflected in a capital formation, a key element in the vigorous ratio of debt rating upgrades to downgrades of more economic expansion, would have been lower, per- than three to one over the year. The surplus in the haps appreciably. current account of state and local governments in the The Treasury responded to its lower borrowing first three quarters of 1999 amounted to about '/2 per- requirements in 1999 primarily by reducing the num- cent of nominal GDP, about the same as in 1998 but ber of auctions of thirty-year bonds from three to two otherwise the largest of the past several years. and by trimming auction sizes for notes and Treasury inflation-indexed securities (TIIS). Weekly bill vol- umes were increased from 1998 levels, however, to The External Sector help build up cash holdings as a Y2K precaution. For 2000, the Treasury plans major changes in debt man- Trade and the Current Account agement in an attempt to keep down the average maturity of the debt and maintain sufficient auction U.S. external balances deteriorated in 1999 largely sizes to support the liquidity and benchmark status of because of continued declines in net exports of goods its most recently issued securities, while still retiring and services and some further weakening of net investment income. The nominal trade deficit for Federal government debt held by the public goods and services widened more than $100 billion in 1999, to an estimated $270 billion, as imports IVrccni ol nominal GDI' expanded faster than exports. For the first three quar- ters of the year, the current account deficit increased more than one-third, reaching $320 billion at an annual rate, or 3'/2 percent of GDP. In 1998, the current account deficit was 2'/2 percent of GDP. Real imports of goods and services expanded strongly in 1999—about 13 percent according to preliminary estimates—as the rapid import growth during the first half of the year was extended through the second half. The expansion of real imports was fueled by the continued strong growth of U.S. domes- tic expenditures. Declines in non-oil import prices through most of the year, partly reflecting previous . The data are annual. dollar appreciation, contributed as well. All major 77 Monetary Policy Report to the Congress C3 February 2000 U.S. current account Capital Account IVrcem of nominal GDI' U.S. capital flows in 1999 reflected the relatively strong cyclical position of the US. economy and the global wave of corporate mergers. Foreign purchases of U.S. securities remained brisk—near the level of the previous two years, in which they had been elevated by the global financial unrest. The composi- tion of foreign securities purchases in 1999 showed a continued shift away from Treasuries, in part because of the U.S. budget surplus and the decline in the supply of Treasuries relative to other securities and, perhaps, to a general increased tolerance of foreign I II investors for risk as markets calmed after their tur- 981 1983 1985 1987 1989 1991 1993 1995 1997 1999 moil of late 1998. Available data indicate that private . The observation for 1999 is the average for the first three quarters of foreigners sold on net about $20 billion in Trea- suries, compared with net purchases of $50 billion in 1998 and $150 billion in 1997. These sales of Trea- import categories other than aircraft and oil recorded suries were more than offset by a pickup in foreign strong increases. While U.S. consumption of oil rose purchases of their nearest substitute—government about 4 percent in 1999, the quantity of oil imported agency bonds—as well as corporate bonds and was about unchanged, and inventories were drawn equities. down. Foreign direct investment flows into the United Real exports of goods and services rose an esti- States were also robust in 1999, with the pace of mated 4 percent in 1999, a somewhat faster pace than inflows in the first three quarters only slightly below in 1998. Economic activity abroad picked up, par- the record inflow set in 1998. As in 1998, direct ticularly in Canada, Mexico, and Asian developing investment inflows last year were elevated by several economies. However, the lagged effects of relative large mergers, which left their imprint on other parts prices owing to past dollar appreciation held down of the capital account as well. In the past two years, exports. An upturn in U.S. exports to Canada, many of the largest mergers have been financed by Mexico, and key Asian emerging markets contrasted a swap of equity in the foreign acquiring firm for with a much flatter pace of exports to Europe, Japan, equity in the U.S. firm being acquired. The Bureau and South America. Capital equipment composed of Economic Analysis estimates that U.S. residents about 45 percent of U.S. goods exports, industrial acquired more than $100 billion of foreign equity supplies were 20 percent, and agricultural, automo- through this mechanism in the first three quarters of tive, and consumer goods were each roughly 1999. Separate data on market transactions indicate 10 percent. that U.S. residents made net purchases of Japanese equities. They also sold European equities, probably in an attempt to rebalance portfolios in light of the Change in real imports and exports of goods and services equity acquired through stock swaps. U.S. residents on net purchased a small volume of foreign bonds in K-ivcm.04toQ4 1999. U.S. direct investment in foreign economies Imports also reflected the global wave of merger activity in 1999 and will likely total something near its record level of 1998. Available data indicate a return to sizable capital inflows from foreign official sources in 1999, follow- ing a modest outflow in 1998. The decline in foreign official assets in the United States in 1998 was fairly widespread, as many countries found their currencies under unwanted downward pressure during the tur- moil. By contrast, the increase in foreign official I I 1 11 I I I I I I reserves in the United States in 1999 was fairly 1991 1993 1995 1997 1999 concentrated in a relatively few countries that expert- 78 Board of Governors of the Federal Reserve System enced unwanted upward pressure on their currencies Change in payroll employment vis-a-vis the U.S. dollar. Thousands iif johs. monthly average The Labor Market .iliiin As in other recent years, the rapid growth of aggre- gate output in 1999 was associated with both strong growth of productivity and brisk gains in employ- ment. According to the initial estimate for 1999, output per hour in the nonfarm business sector rose 3!/4 percent over the four quarters of the year, and historical data were revised this past year to show I i I i i i i I I I I stronger gains than previously reported in the years 1991 1993 1995 1997 1999 preceding 1999. As the data stand currently, the aver- age rate of rise in output per hour over the past four years is about 23/4 percent—up from an average of 1 '/2 percent from the mid-1970s to the end of 1995. by many of the same categories that had been strong Some of the step-up in productivity growth since in previous years—transportation and communica- 1995 can be traced to high levels of capital spending tions, computer services, engineering and manage- and an accompanying faster rate of increase in the ment, recreation, and personnel supply. In the con- amount of capital per worker. Beyond that, the causes struction sector, employment growth remained quite are more difficult to pin down quantitatively but brisk—more than 4 percent from the final quarter of are apparently related to increased technological 1998 to the final quarter of 1999. Manufacturing and organizational efficiencies. Firms are not only employment, influenced by spillover from the disrup- expanding the stock of capital but are also discover- tions in foreign economies, continued to decline ing many new uses for the technologies embodied in sharply in the first half of the year, but losses there- that capital, and workers are becoming more skilled after were small as factory production strengthened. at employing the new technologies. Since the start of the expansion in 1991, the job count The number of jobs on nonfarm payrolls rose in manufacturing has changed little, on net, but with slightly more than 2 percent from the end of 1998 to factory productivity rising rapidly, manufacturing the end of 1999, a net increase of 2.7 million. Annual output has trended up at a brisk pace. job gains had ranged between 2'/4 percent and 23/4 percent over the 1996-98 period. Once again in 1999, the private service-producing sector accounted Measures of labor utilization for most of the total rise in payroll employment, led Change in output per hour Augmented unemployment rate Civilian unemployment rate I I I I I I I I I I I I I I I I I 1 I I I 1970 1975 1980 1985 1990 1995 2000 NOTK. The augmented unemployment rate is the number of unemployed plus those who are not in the labor force and want a job. divided by the civilian labor force plus those who are not in the labor force and want a job. The break in data at January 1994 marks the introduction of a redesigned survey: data from that point on are not directly comparable with those of earlier periods. The data NOTE. Nonfarm business sector. extend through January 2000. 79 Monetary Policy Report to the Congress D February 2000 In 1999, employers continued to face a tight labor Change in unit labor costs market. Some increase in the workforce came from the pool of the unemployed, and the jobless rate lViwni.Q4u>Q4 declined to an average of 4.1 percent in the fourth quarter. In January 2000, the rate edged down to 4.0 percent, the lowest monthly reading since the start of the 1970s. Because the unemployment rate is a reflection only of the number of persons who are available for work and actively looking, it does not capture potential labor supply that is one step removed—namely those individuals who are inter- ested in working but are not actively seeking work at the current time. However, like the unemployment rate itself, an augmented rate that includes these interested nonparticipants also has declined to a low level, as more individuals have taken advantage NOTK. Nonfarm business sector. of expanding opportunities to work. Although the supply-demand balance in the labor about 4 percent in each of the two previous years. market tightened further in 1999, the added pressure The hourly cost to employers of the non wage benefits did not translate into bigger increases in nominal provided to employees also rose 3'/2 percent in 1999, hourly compensation. The employment cost index for but this increase was considerably larger than those hourly compensation of workers in private nonfarm of the past few years. Much of the pickup in benefit industries rose 3.4 percent in nominal terms during costs came from a faster rate of rise in the costs of 1999, little changed from the increase of the previous health insurance, which were reportedly driven up by year, and an alternative measure of hourly compensa- several factors: a moderate acceleration in the price tion from the nonfarm productivity and cost data of medical care, the efforts of some insurers to rebuild slowed from a 5'/4 percent increase in 1998 to a profit margins, and the recognition by employers that 4'/2 percent rise this past year. Compensation gains in an attractive health benefits package was helpful 1999 probably were influenced, in part, by the very in hiring and retaining workers in a tight labor low inflation rate of 1998, which resulted in unex- market. pectedly large increases in inflation-adjusted pay in Because the employment cost index does not cap- that year and probably damped wage increments last ture some forms of compensation that employers year. According to the employment cost index, the have been using more extensively—for example, hourly wages of workers in private industry rose stock options, signing bonuses, and employee price 3'/2 percent in nominal terms after having increased discounts on in-store purchases—it has likely been understating the true size of workers' gains. The productivity and cost measure of hourly compensa- tion captures at least some of the labor costs that the Change in employment cost index employment cost index omits, and this broader cov- erage may explain why the productivity and cost Hourly compensation measure has been rising faster. However, it, too, is affected by problems of measurement, some of which would lead to overstatement of the rate of rise in hourly compensation. With the rise in output per hour in the nonfarm business sector in 1999 offsetting about three-fourths of the rise in the productivity and cost measure of nominal hourly compensation, nonfarm unit labor costs were up just a shade more than 1 percent. Unit labor costs had increased slightly more than 2 percent in both 1997 and 1998 and less than 1 percent in 1996. Because labor costs are by far the most impor- tant item in total unit costs, these small increases NOTE. Change from one year earlier. Private industry, excluding farm and household workers. Data extend through December 1999. have been crucial to keeping inflation low. 80 Board of Governors of the Federal Reserve System Alternative measures of price change but it rose 3 percent in 1999. A big swing in oil prices—down in 1998 but up sharply in 1999— accounted for a large part of this turnaround. Exclud- ing oil, the prices of imported goods continued to fall Chain-type in 1999 but, according to the initial estimate, less Gross domestic product Gross domestic purchases rapidly than over the three previous years, when Per E s x on c a lu l d c i o n n g s f u o m o p d t i a o n n d e e x n p er e g n y d i . u . downward pressure from appreciation of the dollar had been considerable. The prices of imported mate- Fi.wJ-weight Consumer price index rials and supplies rebounded, but the prices of im- Excluding food and energy ported capital goods fell sharply further. Meanwhile, Noi>. Changes are based on quarterly averages and are measured to the the chain-type price index for exports increased 1 per- fourth quarter of the year indicated from the fourth quarter of the preceding year. cent in the latest year, reversing a portion of the 2'/2 percent drop of 1998, when the sluggishness of Prices foreign economies and the strength of the dollar had pressured U.S. producers to mark down the prices Rates of increase in the broader measures of aggre- charged to foreign buyers. gate prices in 1999 were somewhat larger than those Prices of domestically produced primary materials, of 1998. The chain-type price index for GDP—which which tend to be especially sensitive to developments measures inflation for goods and services produced in world markets, rebounded sharply in 1999. The domestically—moved up about 1 '/> percent, a pickup producer price index for crude materials excluding of !/2 percentage point from the increase of 1998. In food and energy advanced about 10 percent after comparison, acceleration in various price measures having fallen about 15 percent in 1998, and the PPI for goods and services purchased amounted to 1 per- for intermediate materials excluding food and energy centage point or more: The chain-type price index for increased about 1 Vi percent, reversing a 1998 decline personal consumption expenditures increased 2 per- of about that same size. But further along in the chain cent, twice as much as in the previous year, and the of processing and distribution, the effects of these chain-type price index for gross domestic purchases, increases were not very visible. The producer price which measures prices of the aggregate purchases of index for finished goods excluding food and energy consumers, businesses, and governments, moved up rose slightly less rapidly in 1999 than in 1998, and close to 2 percent after an increase of just % percent the consumer price index for goods excluding food in 1998. The consumer price index rose more than and energy rose at about the same low rate that it had 2'/2 percent over the four quarters of the year after in 1998. Large gains in productivity and a margin of having increased 1 '/> percent in 1998. excess capacity in the industrial sector helped keep The acceleration in the prices of goods and ser- prices of goods in check, even as growth of domestic vices purchased was driven in part by a reversal in demand remained exceptionally strong. import prices. In 1998, the chain-type price index for "Core" inflation at the consumer level—which imports of goods and services had fallen 5 percent, takes account of the prices of services as well as the prices of goods and excludes food and energy Change in consumer prices prices—changed little in 1999. The increase in the core index for personal consumption expenditures, 1 !/2 percent over the four quarters of the year, was D Consumer price index about the same as the increase in 1998. As measured • Chain-type price index for PCE by the CPI, core inflation was 2 percent this past year, about '/4 percentage point lower than in 1998, but the deceleration was a reflection of a change in CPI methodology that had taken place at the start of last year; on a methodologically consistent basis, the rise in the core CPI was about the same in both years. In the national accounts, the chain-type price index for private fixed investment edged up '/4 percent in 1999 after having fallen about 3/4 percent in 1998. With construction costs rising, the index for residen- tial investment increased 33/4 percent, its largest NOTE. Consumer price index for all urban c< advance in several years. By contrast, the price index 81 Monetary Policy Report to the Congress D February 2000 Change in consumer prices excluding food and energy Selected Treasury rates, daily data IVrvx-m. O4 ID O4 O Consumer price index Thirty-year — • Chain-type price index for PCE Treasury J FMAMJ J ASONDJ FMAMJ J ASONDJ F No IK. Consumer price index for all urban consumers. 1998 1999 2000 NOTK. Last observations are for February 11. 2000. for nonresidential investment declined moderately, as a result of another drop in the index for equipment likelihood of outsized demands for credit and liquid- and software. Falling equipment prices are one chan- ity over the year-end subsided, causing spreads to nel through which faster productivity gains have been narrow, and stock prices surged once again. After reshaping the economy in recent years; the drop in the century date change passed without disruptions, prices has contributed to high levels of investment, liquidity improved and trading volumes grew, rapid expansion of the capital stock, and a step-up in although both bond and equity prices have remained the growth of potential output. quite volatile so far this year. Interest Rates US. Financial Markets Over the first few months of 1999, short-term Trea- Financial markets were somewhat unsettled as 1999 sury rates moved in a narrow range, anchored by began, with the disruptions of the previous autumn an unchanged stance of monetary policy. Yields on still unwinding and the devaluation of the Brazilian intermediate- and long-term Treasury securities rose, real causing some jitters around mid-January. How- however, as the flight to quality and liquidity of the ever, market conditions improved into the spring, preceding fall unwound, and incoming data pointed evidenced in part by increased trading volumes and narrowed bid-asked and credit spreads, as it became increasingly evident that strong growth was continu- Selected Treasury rates, quarterly data ing in the United States, and that economies abroad were rebounding. In this environment, market partici- pants began to anticipate that the Federal Reserve would reverse the policy easings of the preceding fall, and interest rates rose. Nevertheless, improved profit expectations apparently more than offset the interest rate increases, and equity prices continued to climb until late spring. From May into the fall, both equity prices and longer-term interest rates moved in a choppy fashion, while short-term interest rates moved up with monetary policy tightenings in June, August, and November. Worries about Y2K became pronounced after midyear, and expectations of an acceleration of borrowing ahead of the fourth quarter prompted a resurgence in liquidity and credit premi- NOTE. The twenty-year Treasury bond rate is shown until the first issuance of the thirty-year Treasury bond in February 1977. The data extend through the ums. In the closing months of the year, however, the fourth quarter of 1999. 82 Board of Governors of the Federal Reserve System to continued robust economic growth and likely Fed- measured as the implied forward rate for a monthlong eral Reserve tightening. Over most of the rest of the period spanning the turn relative to the rate for a year, short-term Treasury rates moved broadly in line neighboring period—rose earlier and reached much with the three quarter-point increases in the target higher levels than in recent years. federal funds rate; longer-term yields rose less, as Those year-end premiums peaked in late October markets had already anticipated some of those policy and then declined substantially, as markets reflected actions. increased confidence in technical readiness and spe- Bond and note yields moved sharply higher from cial assurances from central banks that sufficient early November 1999 to mid-January 2000, as Y2K liquidity would be available around the century date fears diminished, incoming data indicated surprising change. Important among these assurances were sev- economic vitality, and the century date change was eral of the Federal Reserve initiatives described in the negotiated without significant technical problems. first section of this report. Securities dealers took In recent weeks, long-term Treasury yields have particular advantage of the widened pools of accept- retraced a good portion of that rise on expectations able collateral for open market operations and used of reduced supply stemming from the Treasury's new large volumes of federal agency debt and mortgage- buy back program and reductions in the amount of backed securities in repurchase agreements with the bonds to be auctioned. This rally has been mostly Open Market Desk in the closing weeks of the year, confined to the long end of the Treasury market; which helped to relieve a potential scarcity of Trea- long-term corporate bond yields have fallen only sury collateral over the turn. Market participants also slightly, and yields are largely unchanged or have purchased options on nearly $500 billion worth of risen a little further at maturities of ten years or less, repurchase agreements under the standby financing where most private borrowing is concentrated. facility and pledged more than $650 billion of collat- Concerns about liquidity and credit risk around the eral for borrowing at the discount window. With the century date change led to large premiums in private smooth rollover, however, none of the RP options money market rates in the second half of 1999. were exercised, and borrowing at the discount win- During the summer, this "safe haven" demand held dow turned out to be fairly light. down rates on Treasury bills maturing early in the new year, until the announcement in August that the Treasury was targeting an unusually large year-end Equity Prices cash balance, implying that it would issue a substan- tial volume of January-dated cash management bills. Nearly all major stock indexes ended 1999 in record Year-end premiums in eurodollar, commercial paper, territory. The Nasdaq composite index paced the term federal funds, and other money markets— advance by soaring 86 percent over the year, and the S&P 500 and Dow Jones Industrial Average posted Eurodollar deposit forward premium over year-end still-impressive gains of 20 percent and 25 percent. Major stock price indexes Index (January 4. 1999 = Oct. Nov. Dec. No IK. The data are daily. For October the forward premiums are one-month forward rates two months ahead less one-month forward rates one month ahead: for November they are one-month forward rates one month ahead less one- J FMAMJ JASONDJFMAMJ JASONDJF month deposit rates: and for December they are three-week forward rates one 1998 1999 2000 week ahead less one-week deposit rates. The December forward premiums extend into the third week of December. NOTE. The data are daily. Last observations are for February 11. 2000. 83 Monetary Policy Report to the Congress D February 2000 Equity valuation and long-term real interest rate Domestic nonfinancial debt: Annual range and actual level 1980 1984 1988 1992 1996 2000 O N DJ F M A MJ J A S O N DJ No IK. The data are monthly and extend through January 2000. The earnings- 1998 1999 2000 price ratio is based on the I/B/E/S International. Inc.. consensus estimate of earnings over the coming twelve months. The real interest rate is the yield on the ten-year Treasury note less the ten-year inflation expectations from the Federal Reserve Bank of Philadelphia Survey of Professional Forecasters. from an already-slim 1 '/4 percent to '/2 percent, sug- gesting that investors are pricing in expectations of Last year was the fifth consecutive year that all three tremendous earnings growth at technology firms rela- indexes posted double-digit returns. Most stock tive to historical norms. indexes moved up sharply over the first few months of the year and were about flat on net from May through August; they then declined into October Debt and the Monetary Aggregates before surging in the final months of the year. The Nasdaq index, in particular, achieved most of its Debt and Depository Intermediation annual gains in November and December. Stock price advances in 1999 were not very broad-based, how- The debt of domestic nonfinancial sectors is esti- ever: More than half of the S&P 500 issues lost value mated to have grown 6!/2 percent in 1999 on a over the year. So far in 2000, stock prices have been fourth-quarter-to-fourth-quarter basis, near the upper volatile and mixed; major indexes currently span a end of the FOMC's 3 percent to 7 percent range and range from the Dow's nearly 10 percent drop to the about a percentage point faster than nominal GDP. As Nasdaq's 8 percent advance. was the case in 1998, robust outlays on consumer Almost all key industry groups performed well. durable goods, housing, and business investment, One exception was shares of financial firms, which as well as substantial net equity retirements, helped were flat, on balance. Investor perceptions that rising sustain nonfederal sector debt growth at rates above interest rates would hurt earnings and, possibly, con- cern over loan quality apparently offset the boost Domestic nonfinancial debt as a percentage of nominal GDP resulting from passage in the fall of legislation reforming the depression-era Glass-Steagall con- straints on combining commercial banking with insurance and investment banking. Small-cap stocks, which had lagged in 1998, also performed well; the Russell 2000 index climbed 20 percent over the year and finally surpassed its April 1998 peak in late December. At large firms, stock price gains about kept pace with expected earnings growth in 1999, and the S&P 500 one-year-ahead earnings-price ratio fluc- tuated around the historically low level of 4 per- cent even as real interest rates rose. Meanwhile, the Nasdaq composite index's earnings-price ratio (using actual twelve-month trailing earnings) plummeted 84 Board of Governors of the Federal Reserve System 9 percent. Meanwhile, the dramatically increased M3: Annual range and actual level federal budget surplus allowed the Treasury to reduce its outstanding debt about 2 percent. These move- Trillions ol dollars ments follow the pattern of recent years whereby increases in the debt of households, businesses, and state and local governments relative to GDP have come close to matching declines in the federal gov- ernment share, consistent with reduced pressure on available savings from the federal sector facilitating private borrowing. After increasing for several years, the share of total credit accounted for by depository institutions lev- eled out in 1999. Growth in credit extended by those institutions edged down to 6!/2 percent from 6% per- cent in 1998. Adjusted for mark-to-market account- O N D J F M A M J J A S O N DJ ing rules, bank credit growth retreated from 10'/4 per- 1998 1999 2000 cent in 1998 to 5'/2 percent last year, with a con- siderable portion of the slowdown attributable to an unwinding of the surge in holdings of non-US, The Monetary Aggregates government securities, business loans, and security loans that had been built up during the market disrup- Growth of the broad monetary aggregates moderated tions in the fall of 1998. Real estate loans constituted significantly last year. Nevertheless, as was expected one of the few categories of bank credit that acceler- by the FOMC last February and July, both M2 ated in 1999. By contrast, thrift credit swelled 9 per- and M3 finished the year above their annual price- cent, up from a 4!/2 percent gain in 1998, as rising stability ranges. M3 rose 7'/2 percent in 1999, some- mortgage interest rates led borrowers to opt more what outside the Committee's range of 2 percent frequently for adjustable-rate mortgages, which to 6 percent but far below the nearly 11 percent thrifts tend to keep on their books. The trend toward pace of 1998. M3 growth retreated early in 1999, as securitization of consumer loans continued in 1999: the surge in depository credit in the final quarter of Bank originations of consumer loans were up about 1998 unwound and depository institutions curbed 5 percent, while holdings ran off at a l?/4 percent their issuance of the managed liabilities included pace. in that aggregate. At that time, the expansion of 4. Growth of money and debt Percent Period Ml M2 MM- , non D fin o a m nc e i s a t l ic debt Annual' 1989 .3 5.2 4.1 7.4 1990 4.2 4.2 1.9 7 1991 3.1 I.I 5 1992 14 1 8 6 5 1993 10 1.4 1.0 9 1994 .6 1.7 9 1995 -1 3.9 6.1 5 1996 -4 4.5 6.8 4 1997 5.6 8.9 2 1998 2 8.5 10.9 7 1999 6.2 7.5 6 Quarterly- (annual rate)- 19991 75 82 67 2 2 6.0 6.0 6.9 1 55 5 1 60 5 5.4 10.0 6.2 NOTE. Ml consists of currency, travelers checks, demand deposits, and other standing credit market debt of the U.S. government, state and local govern- checkable deposits. M2 consists of Ml plus savings deposits (including money ments, households and nonprofit organizations, nonfinancial businesses, and market deposit accounts), small-denomination time deposits, and balances in farms. retail money market funds. M3 consists of M2 plus large-denomination time 1. From average for fourth quarter of preceding year to average for fourth deposits, balances in institutional money market funds. RP liabilities (overnight quarter of year indicated. and term), and eurodollars (overnight and term). Debt consists of the out- 2. From average for preceding quarter to average for quarter indicated. 85 Monetary Policy Report to the Congress D February 2000 M2: Annual range and actual level in the year. Early in 2000, these effects began to unwind. Trillions of dollars M2 increased 6J/4 percent in 1999, somewhat above the FOMCs range of 1 percent to 5 percent. Both the easing of elevated demands for liquid assets that had boosted M2 in the fourth quarter of 1998 and a rise in its opportunity cost (the difference between inter- est rates on short-term market instruments and the rates available on M2 assets) tended to bring down M2 growth in 1999. That rise in opportunity cost also helped to halt the decline in M2 velocity that had begun in mid-1997, although the 1% percent (annual rate) rise in velocity over the second half of 1999 was not enough to offset the drop in the first half of the year. Within M2, currency demand grew briskly over O N DJ F M A MJ J A S O N DJ 1998 1999 2000 the year as a whole, reflecting booming retail sales and, late in the year, some precautionary buildup for Y2K. Money stock currency grew at an annualized institution-only money funds also slowed with the rate of 28 percent in December and then ran off in the ebbing of heightened preferences for liquid assets. weeks after the turn of the year. However, M3 bulged again in the fourth quarter In anticipation of a surge in the public's demand of 1999, as loan growth picked up and banks for currency, depository institutions vastly expanded funded the increase mainly with large time deposits their holdings of vault cash, beginning in the fall and other managed liabilities in M3. U.S. bran- to avoid potential constraints in the ability of the ches and agencies of foreign banks stepped up issu- armored car industry to accommodate large currency ance of large certificates of deposit, in part to aug- shipments late in the year. Depositories' cash draw- ment the liquidity of their head offices over the ings reduced their Federal Reserve balances and century date change, apparently because it was drained substantial volumes of reserves, and, in mid- cheaper to fund in U.S. markets. Domestic banks December, large precautionary increases in the Trea- needed the additional funding because of strong loan sury's cash balance and in foreign central banks' growth and a buildup in vault cash for Y2K contin- liquid investments at the Federal Reserve did as well. gencies. Corporations apparently built up year-end The magnitude of these flows was largely anticipated precautionary liquidity in institution-only money by the System, and, to replace the lost reserves, funds, which provided a further boost to M3 late during the fourth quarter the Desk entered into a number of longer-maturity repurchase agreements timed to mature early in 2000. The Desk also M2 velocity and the opportunity cost of holding M2 executed a large number of short-term repurchase Ratio scale Ptttunta|>c points, ratio scale transactions for over the turn of the year, including some in the forward market, to provide sufficient reserves and support market liquidity. The public's demand for currency through year- end, though appreciable, remained well below the level for which the banking system was prepared, and vault cash at the beginning of January stood about $38 billion above its year-ago level. This excess vault cash, and other century date change effects in money and reserve markets, unwound quickly after the smooth transition into the new year. I I I 1989 International Developments No IK. The data are quarterly and extend through 1999:Q4. The velocity of M2 is the ratio of nominal gross domestic product to the stock of M2. The opportunity cost of M2 is a two-quarter moving average of the difference Global economic conditions improved in 1999 after a between the three-month Treasury bill rate and the weighted average return on assets included in M2. year of depressed growth and heightened financial 86 Board of Governors of the Federal Reserve System market instability. Financial markets in developing was maintained only at the cost of continued high countries, which had been hit hard by crises in Asia real interest rates that contributed to the decline in and Russia in recent years, recovered last year. The real GDP in 1999. In contrast, real GDP in Mexico pace of activity in developing countries increased, rose an estimated 6 percent in 1999, aided by higher with Asian emerging-market economies in particular oil prices and strong export growth to the United bouncing back strongly from the output declines of States. The peso appreciated against the dollar for the the preceding year. Real growth improved in almost year as a whole, despite a Mexican inflation rate all the major industrial economies as well. This about 10 percentage points higher than in the United strengthening of activity contributed to a general rise States. in equity prices and a widespread increase in interest The recovery of activity last year in Asian devel- rates. Despite stronger activity and higher prices for oping countries was earlier, more widespread, and oil and other commodities, average foreign inflation sharper than in Latin America, just as the downturn was lower in 1999 than in 1998, as output remained had been the previous year. After a steep drop in below potential in most countries. activity in the immediate wake of the financial crises Although the general theme in emerging financial that hit several Asian emerging-market economies in markets in 1999 was a return to stability, the year late 1997, the preconditions for a revival in activity began with heightened tension as a result of a finan- were set by measures initiated to stabilize shaky cial crisis in Brazil. With the effects of the August financial markets and banking sectors, often in con- 1998 collapse of the ruble and the default on Russian junction with International Monetary Fund programs government debt still reverberating, Brazil was that provided financial support. Once financial condi- forced to abandon its exchange-rate-based stabiliza- tions had been stabilized, monetary policies turned tion program in January 1999. The real, allowed to accommodative in 1998, and this stimulus, along float, soon fell nearly 50 percent against the dollar, with the shift toward fiscal deficits and an ongoing generating fears of a depreciation-inflation spiral that boost to net exports provided by the sharp deprecia- could return Brazil to its high-inflation past. In addi- tions of their currencies, laid the foundation for last tion, there were concerns that the government might year's strong revival in activity. Korea's recovery default on its domestic-currency and dollar-indexed was the most robust, with real GDP estimated to have debt, the latter totaling more than $50 billion. In the increased more than 10 percent in 1999 after falling event, these fears proved unfounded. The turning 5 percent the previous year. The government contin- point appears to have come in March when a new ued to make progress toward needed financial and central bank governor announced that fighting infla- corporate sector reform. However, significant weak- tion was a top priority and interest rates were substan- nesses remained, as evidenced by the near collapse of tially raised to support the real. Over the remainder Daewoo, Korea's second largest conglomerate. Other of the year, Brazilian financial markets stabilized Asian developing countries that experienced financial on balance, despite continuing concerns about the difficulties in late 1997 (Thailand, Malaysia, Indone- government's ability to reduce the fiscal deficit. Infla- sia, and the Philippines) also recorded increases in tion, although accelerating from the previous year, real GDP in 1999 after declines the previous year. remained under 10 percent. Brazilian economic activ- Indonesian financial markets were buffeted severely ity also recovered somewhat in 1999, after declining at times during 1999 by concerns about political in 1998, as the return of confidence allowed officials instability, but the rupiah ended the year with a to lower short-term interest rates substantially from modest net appreciation against the dollar. The other their crisis-related peak levels of early in the year. former crisis countries also saw their currencies stabi- The Brazilian crisis triggered some renewed finan- lize or slightly appreciate against the dollar. Inflation cial stress in other Latin American economies, and rates in these countries generally declined, despite the domestic interest rates and Brady bond yield spreads pickup in activity and higher prices for oil and other increased sharply from levels already elevated by commodities. Inflation was held down by the ele- the Russian crisis. However, as the situation in vated, if diminishing, levels of excess capacity and Brazil improved, financial conditions in the rest of unemployment and by a waning of the inflationary the region stabilized relatively rapidly. Even so, the impact of previous exchange rate depreciations. combination of elevated risk premiums and dimin- In China, real growth slowed moderately in 1999. ished access to international credit markets tended to Given China's exchange rate peg to the dollar, the depress activity in much of the region in the first half sizable depreciations elsewhere in Asia in 1997 and of 1999. Probably the most strongly affected was 1998 led to a sharp appreciation of China's real Argentina, where the exchange rate peg to the dollar effective exchange rate, and there was speculation 87 Monetary Policy Report to the Congress D February 2000 last year that the renminbi might be devalued. How- further rise in U.S. external deficits—with the U.S. ever, with China's trade balance continuing in sub- current account deficit moving up toward 4 percent of stantial, though reduced, surplus, Chinese officials GDP by the end of the year—may have tended to maintained the exchange rate peg to the dollar last hold down the dollar because of investor concerns year and stated their intention of extending it through that the associated strong net demand for dollar assets at least this year. After the onset of the Asian finan- might prove unsustainable. So far this year, the dol- cial crisis, continuance of Hong Kong's currency- lar's average exchange value has increased slightly, board-maintained peg to the U.S. dollar was also boosted by new evidence of strong U.S. growth. questioned. In the event, the tie to the dollar was Against the currencies of the major foreign industrial sustained, but only at the cost of high real interest countries, the dollar's most notable movements in rates, which contributed to a decrease in output in 1999 were a substantial depreciation against the Japa- Hong Kong in 1998 and early 1999 and a decline of nese yen and a significant appreciation relative to the consumer prices over this period. However, real GDP euro. started to move up again later in the year, reflecting in The dollar depreciated 10 percent on balance part the strong revival of activity in the rest of Asia. against the yen over the course of 1999. In the first In Russia, economic activity increased last year half of the year, the dollar strengthened slightly rela- despite persistent and severe structural problems. tive to the yen, as growth in Japan appeared to remain Real GDP, which had dropped nearly 10 percent in sluggish and Japanese monetary authorities reduced 1998 as a result of the domestic financial crisis, short-term interest rates to near zero in an effort to recovered about half the loss last year. Net exports jumpstart the economy. However, around mid-year, rose strongly, boosted by the lagged effect of the several signs of a revival of activity—particularly the substantial real depreciation of the ruble in late 1998 announcement of unanticipated strong growth in real and by higher oil prices. The inflation rate moderated GDP in the first quarter—triggered a depreciation of to about 50 percent, somewhat greater than the depre- the dollar relative to the yen amid reports of large ciation of the ruble over the course of the year. inflows of foreign capital into the Japanese stock The dollar's average foreign exchange value, mea- market. Data releases showing that the U.S. current sured on a trade-weighted basis against the currencies account deficit had reached record levels in both the of a broad group of important U.S. trading partners, second and third quarters of the year also appeared to ended 1999 little changed from its level at the begin- be associated with depreciations of the dollar against ning of the year. There appeared to be two main, the yen. Concerned that a stronger yen could harm roughly offsetting, pressures on the dollar last year. the fledgling recovery, Japanese monetary authorities On the one hand, the continued very strong growth of intervened heavily to weaken the yen on numerous the U.S. economy relative to foreign economies occasions. So far this year, the dollar has firmed tended to support the dollar. On the other hand, the U.S. dollar exchange rate against the Japanese yen Nominal dollar exchange rate indexes and the euro Index. January 1997 = 100 Index. January 1997 = 100 _J | _J | 1997 1998 1999 1997 1998 1999 NOTE. The data are monthly. Indexes are trade-weighted averages of the NOTE. The data are monthly. Restated German mark is the dollar-mark exchange value of die dollar against major currencies and against the currencies exchange rate reseated by the official conversion factor between the mark and of a broad group of important US. trading partners. Last observations are for the the euro, 1.95583. through December 1998. Euro exchange rate as of January first two weeks of February 2000. 1999. Last observations are for the first two weeks of February 2000. 88 Board of Governors of the Federal Reserve System about 7 percent against the yen. Japanese real GDP 25 basis points earlier this month. The euro-area increased somewhat in 1999, following two consecu- inflation rate edged up in 1999, boosted by higher oil tive years of decline. Growth was concentrated in the prices, but still remained below the 2 percent target first half of the year, when domestic demand surged, ceiling. led by fiscal stimulus. Later in the year, domestic Growth in the United Kingdom also moved higher demand slumped, as the pace of fiscal expansion on balance in 1999, with growth picking up over the flagged. Net exports made virtually no contribution course of the year. Along with the strengthening of to growth for the year as a whole. Japanese consumer global demand, the recovery was stimulated by a prices declined slightly on balance over the course of series of official interest rate reductions, totaling the year. 250 basis points, undertaken by the Bank of England The new European currency, the euro, came into over the last half of 1998 and the first half of 1999. operation at the start of 1999, marking the beginning Later in 1999 and early this year, the policy rate was of stage three of European economic and monetary raised four times for a total of 100 basis points, with union. The rates of exchange between the euro and officials citing the need to keep inflation below its the currencies of the eleven countries adopting the 2'/2 percent target level in light of the strength of new currency were set at the end of 1998; based on consumption and the housing market and continuing these rates, the value of the euro at its creation was tight conditions in the labor market. On balance, the just under $1.17. From a technical perspective, the dollar appreciated slightly against the pound over the introduction of the euro went smoothly, and on its course of 1999. first day of trading its value moved higher. However, In Canada, real growth recovered in 1999 after the euro soon started to weaken against the dollar, slumping the previous year in response to the global influenced by indications that euro-area growth slowdown and the related drop in the prices of Cana- would remain very slow. After approaching parity dian commodity exports. Last year, strong demand with the dollar in early July, the euro rebounded, from the United States spurred Canadian exports partly on gathering signs of European recovery. How- while rising consumer and business confidence sup- ever, the currency weakened again in the fall, and in ported domestic demand. In the spring, the Bank of early December it reached parity with the dollar, Canada lowered its official interest rate twice for a about where it closed the year. The euro's weakness total of 50 basis points in an effort to stimulate late in the year was attributed in part to concerns activity in the context of a rising Canadian dollar. about the pace of market-oriented structural reforms This decline was reversed by 25-basis-point increases in continental Europe and to a political wrangle over near the end of the year and earlier this month, as the proposed imposition of a withholding tax on Canadian inflation moved above the midpoint of its investment income. On balance, the dollar appreci- target range, the pace of output growth increased, and ated 16 percent relative to the euro over 1999. So U.S. interest rates moved higher. Over the course of far this year, the dollar has strengthened 2 percent 1999, the U.S. dollar depreciated 6 percent on bal- further against the euro. Although the euro's for- ance against the Canadian dollar. eign exchange value weakened in its first year Concerns about liquidity and credit risk related to of operation, the volume of euro-denominated the century date change generated a temporary bulge transactions—particularly the issuance of debt in year-end premiums in money market rates in the securities—expanded rapidly. second half of the year in some countries. For the In the eleven European countries that now fix their euro, borrowing costs for short-term interbank fund- currencies to the euro, real GDP growth remained ing over the year changeover—as measured by the weak early in 1999 but strengthened subsequently interest rate implied by the forward market for a and averaged an estimated 3 percent rate for the year one-month loan spanning the year-end relative to the as a whole. Net exports made a significant positive rates for neighboring months—started to rise in late contribution to growth, supported by a revival of summer but then reversed nearly all of this increase demand in Asia and Eastern Europe and by the in late October and early November before mov- effects of the euro's depreciation. The area wide ing up more moderately in December. The sharp unemployment rate declined, albeit to a still-high rate October-November decline in the year-changeover of nearly 10 percent. In the spring, the European funding premium came in response to a series of central bank lowered its policy rate 50 basis points, to announcements by major central banks that outlined 2'/2 percent. This decline was reversed later in the and clarified the measures these institutions were year in reaction to accumulating evidence of a pickup prepared to undertake to alleviate potential liquidity in activity, and the rate was raised an additional problems related to the century date change. For yen 89 Monetary Policy Report to the Congress D February 2000 Forward premium for deposits over year-end Foreign ten-year interest rates Noi>.. The data are monthly. Last observation is for the first two weeks of February 2000. Equity prices showed strong and widespread increases in 1999, as the pace of global activity quickened and the threat from emerging-market financial crises appeared to recede. In the industrial countries equity prices on average rose sharply, extending the general upward trend of recent years. The average percentage increase of equity prices in developing countries was even larger, as prices recov- Aug. Sept. 1999 ered from their crisis-related declines of the previ- NOTE. The data are daily. Year-end premium measured by the interest rate on ous year. The fact that emerging Latin American and a one-month instrument spanning the year-end relative to the rates for neighbor- Asian equity markets outperformed those in indus- ing months. Last observation is for December 29. 1999. trial countries lends some support to the view that global investors increased their risk tolerance, espe- funding, the century date change premium moved in cially during the last months of the year. a different pattern, fluctuating around a relatively low Oil prices increased dramatically during 1999, fully level before spiking sharply for several days just reversing the declines in the previous two years. The before the year-end. The late-December jump in the average spot price for West Texas intermediate, the yen funding premium was partly in response to date change-related illiquidity in the Japanese government bond repo market that emerged in early December Foreign equity indexes and persisted into early January. To counter these conditions, toward the end of the year the Bank of Japan infused huge amounts of liquidity into its domestic banking system, which soon brought short- term yen funding costs back down to near zero. Bond yields in the major foreign industrial coun- tries generally moved higher on balance in 1999. Long-term interest rates were boosted by mounting evidence that economic recovery was taking hold abroad and by rising expectations of monetary tight- ening in the United States and, later, in other indus- trial countries. Over the course of the year, long-term Developing Asia interest rates increased on balance by more than 100 basis points in nearly all the major industrial countries. The notable exception was Japan, where NOTE. The data are monthly. Last observation is for the first t> long-term rates were little changed. February 2000. 90 Board of Governors of the Federal Reserve System U.S. benchmark crude, more than doubled, from further on speculation over a possible extension of around $12 per barrel at the beginning of the year to current OPEC production targets and the onset of more than $26 per barrel in December. This rebound unexpectedly cold weather in key consuming regions. in oil prices was driven by a combination of strength- The price of gold fluctuated substantially in 1999. ening world demand and constrained world supply. The price declined to near a twenty-year low of about The strong U.S. economy, combined with a recovery $250 per ounce at mid-year as several central banks, of economic activity abroad and a somewhat more including the Bank of England and the Swiss normal weather pattern, led to a 2 percent increase National Bank, announced plans to sell a sizable in world oil consumption. Oil production, on the portion of their reserves. The September announce- other hand, declined 2 percent, primarily because of ment that fifteen European central banks, including reduced supplies from OPEC and other key produc- the two just mentioned, would limit their aggregate ers. Starting last spring, OPEC consistently held pro- sales of bullion and curtail leasing activities, saw the duction near targeted levels, in marked contrast to the price of gold briefly rise above $320 per ounce before widespread lack of compliance that characterized ear- turning down later in the year. Recently, the price has lier agreements. So far this year, oil prices have risen moved back up, to above $300 per ounce. 91 Statement of Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services U.S. House of Representatives February 17,2000 92 I appreciate this opportunity to present the Federal Reserve's semiannual report on the economy and monetary policy. There is little evidence that the American economy, which grew more than 4 percent in 1999 and surged forward at an even faster pace in the second half of the year, is slowing appreciably. At the same time, inflation has remained largely contained. An increase in the overall rate of inflation in 1999 was mainly a result of higher energy prices. Importantly, unit labor costs actually declined in the second half of the year. Indeed, still-preliminary data indicate that total unit cost increases last year remained extraordinarily low, even as the business expansion approached a record nine years. Domestic operating profit margins, after sagging for eighteen months, apparently turned up again in the fourth quarter, and profit expectations for major corporations for the first quarter have been undergoing upward revisions since the beginning of the year-scarcely an indication of imminent economic weakness. The Economic Forces at Work Underlying this performance, unprecedented in my half-century of observing the American economy, is a continuing acceleration in productivity. Nonfarm business output per workhour increased 3-1/4 percent during the past year-likely more than 4 percent when measured by nonfarm business income. Security analysts' projections of long-term earnings, an indicator of expectations of company productivity, continued to be revised upward in January, extending a string of upward revisions that began in early 1995. One result of this remarkable economic performance has been a pronounced increase in living standards for the majority of Americans. Another has been a labor market that has provided job opportunities for large numbers of people previously struggling to get on the first rung of a ladder leading to training, skills, and permanent employment. 93 Yet those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained, threaten our continuing prosperity. Accelerating productivity entails a matching acceleration in the potential output of goods and services and a corresponding rise in real incomes available to purchase the new output. The problem is that the pickup in productivity tends to create even greater increases in aggregate demand than in potential aggregate supply. This occurs principally because a rise in structural productivity growth has its counterpart in higher expectations for long-term corporate earnings. This, in turn, not only spurs business investment but also increases stock prices and the market value of assets held by households, creating additional purchasing power for which no additional goods or services have yet been produced. Historical evidence suggests that perhaps three to four cents out of every additional dollar of stock market wealth eventually is reflected in increased consumer purchases. The sharp rise in the amount of consumer outlays relative to disposable incomes in recent years, and the corresponding fall in the saving rate, has been consistent with this so-called wealth effect on household purchases. Moreover, higher stock prices, by lowering the cost of equity capital, have helped to support the boom in capital spending. Outlays prompted by capital gains in excess of increases in income, as best we can judge, have added about 1 percentage point to annual growth of gross domestic purchases, on average, over the past five years. The additional growth in spending of recent years that has accompanied these wealth gains as well as other supporting influences on the economy appears to have been met in about equal measure from increased net imports and from goods and services produced by 94 the net increase in newly hired workers over and above the normal growth of the work force, including a substantial net inflow of workers from abroad. But these safety valves that have been supplying goods and services to meet the recent increments to purchasing power largely generated by capital gains cannot be expected to absorb an excess of demand over supply indefinitely. First, growing net imports and a widening current account deficit require ever larger portfolio and direct foreign investments in the United States, an outcome that cannot continue without limit. Imbalances in the labor markets perhaps may have even more serious implications for inflation pressures. While the pool of officially unemployed and those otherwise willing to work may continue to shrink, as it has persistently over the past seven years, there is an effective limit to new hiring, unless immigration is uncapped. At some point in the continuous reduction in the number of available workers willing to take jobs, short of the repeal of the law of supply and demand, wage increases must rise above even impressive gains in productivity. This would intensify inflationary pressures or squeeze profit margins, with either outcome capable of bringing our growing prosperity to an end. As would be expected, imbalances between demand and potential supply in markets for goods and services are being mirrored in the financial markets by an excess in the demand for funds. As a consequence, market interest rates are already moving in the direction of containing the excess of demand in financial markets and therefore in product markets as well. For example, BBB corporate bond rates adjusted for inflation expectations have risen by more than 1 percentage point during the past two years. However, to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this 95 increase, propelling equity prices and the-wealth effect higher. Should this process continue, however, with the assistance of a monetary policy vigilant against emerging macroeconomic imbalances, real long-term rates will at some point be high enough to finally balance demand with supply at the economy's potential in both the financial and product markets. Other things equal, this condition will involve equity discount factors high enough to bring the rise in asset values into line with that of household incomes, thereby stemming the impetus to consumption relative to income that has come from rising wealth. This does not necessarily imply a decline in asset values-although that, of course, can happen at any time for any number of reasons-but rather that these values will increase no faster than household incomes. Because there are limits to the amount of goods and services that can be supplied from increasing net imports and by drawing on a limited pool of persons willing to work, it necessarily follows that consumption cannot keep rising faster than income. Moreover, outsized increases in wealth cannot persist indefinitely either. For so long as the levels of consumption and investment are sensitive to asset values, equity values increasing at a pace faster than income, other things equal, will induce a rise in overall demand in excess of potential supply. But that situation cannot persist without limit because the supply safety valves are themselves limited. With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process. Technological Change Continues Apace On a broader front, there are few signs to date of slowing in the pace of innovation and the spread of our newer technologies that, as I have indicated in previous testimonies, have been 96 at the root of our extraordinary productivity improvement. Indeed, some analysts conjecture that we still may be in the earlier stages of the rapid adoption of new technologies and not yet in sight of the stage when this wave of innovation will crest. With so few examples in our history, there is very little basis for determining the particular stage of development through which we are currently passing. Without doubt, the synergies of the microprocessor, laser, fiber-optic glass, and satellite technologies have brought quantum advances in information availability. These advances, in turn, have dramatically decreased business operational uncertainties and risk premiums and, thereby, have engendered major cost reductions and productivity advances. There seems little question that further major advances lie ahead. What is uncertain is the future pace of the application of these innovations, because it is this pace that governs the rate of change in productivity and economic potential. Monetary policy, of course, did not produce the intellectual insights behind the technological advances that have been responsible for the recent phenomenal reshaping of our economic landscape. It has, however, been instrumental, we trust, in establishing a stable financial and economic environment with low inflation that is conducive to the investments that have exploited these innovative technologies. Federal budget policy has also played a pivotal role. The emergence of surpluses in the unified budget and of the associated increase in government saving over the past few years has been exceptionally important to the balance of the expansion, because the surpluses have been absorbing a portion of the potential excess of demand over sustainable supply associated partly with the wealth effect. Moreover, because the surpluses are augmenting the pool of domestic 97 saving, they have held interest rates below the levels that otherwise would have been needed to achieve financial and economic balance during this period of exceptional economic growth. They have, in effect, helped to finance and sustain the productive private investment that has been key to capturing the benefits of the newer technologies that, in turn, have boosted the long-term growth potential of the U.S. economy. The recent good news on the budget suggests that our longer-run prospects for continuing this beneficial process of recycling savings from the public to the private sectors have improved greatly in recent years. Nonetheless, budget outlays are expected to come under mounting pressure as the baby boom generation moves into retirement, a process that gets under way a decade from now. Maintaining the surpluses and using them to repay debt over coming years will continue to be an important way the federal government can encourage productivity- enhancing investment and rising standards of living. Thus, we cannot afford to be lulled into letting down our guard on budgetary matters, an issue to which I shall return later in this testimony. The Economic Outlook Although the outlook is clouded by a number of uncertainties, the central tendencies of the projections of the Board members and Reserve Bank presidents imply continued good economic performance in the United States. Most of them expect economic growth to slow somewhat this year, easing into the 3-1/2 to 3-3/4 percent area. The unemployment rate would remain in the neighborhood of 4 to 4-1/4 percent. The rate of inflation for total personal consumption expenditures is expected to be 1-3/4 to 2 percent, at or a bit below the rate in 1999, which was elevated by rising energy prices. 98 In preparing these forecasts, the Federal Open Market Committee members had to consider several of the crucial demand- and supply-side forces I referred to earlier. Continued favorable developments in labor productivity are anticipated both to raise the economy's capacity to produce and, through its supporting effects on real incomes and asset values, to boost private domestic demand. When productivity-driven wealth increases were spurring demand a few years ago, the effects on resource utilization and inflation pressures were offset in part by the effects of weakening foreign economies and a rising foreign exchange value of the dollar, which depressed exports and encouraged imports. Last year, with the welcome recovery of foreign economies and with the leveling out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign economic activity is expected to continue this year, and, other things equal, the effect of the previous appreciation of the dollar should wane, augmenting demand on U.S. resources and lessening one source of downward pressure on our prices. As a consequence, the necessary alignment of the growth of aggregate demand with the growth of potential aggregate supply may well depend on restraint on domestic demand, which continues to be buoyed by the lagged effects of increases in stock market valuations. Accordingly, the appreciable increases in both nominal and real intermediate- and long-term interest rates over the last two years should act as a needed restraining influence in the period ahead. However, to date, interest-sensitive spending has remained robust, and the FOMC will have to stay alert for signs that real interest rates have not yet risen enough to bring the growth of demand into line with that of potential supply, even should the acceleration of productivity continue. 99 Achieving that alignment seems more pressing today than it did earlier, before the effects of imbalances began to cumulate, lessening the depth of our various buffers against inflationary pressures. Labor markets, for example, have tightened in recent years as demand has persistently outstripped even accelerating potential supply. As I have previously noted, we cannot be sure in an environment with so little historical precedent what degree of labor market tautness could begin to push unit costs and prices up more rapidly. We know, however, that there is a limit, and we can be sure that the smaller the pool of people without jobs willing to take them, the closer we are to that limit. As the FOMC indicated after its last meeting, the risks still seem to be weighted on the side of building inflation pressures. A central bank can best contribute to economic growth and rising standards of living by fostering a financial environment that promotes overall balance in the economy and price stability. Maintaining an environment of effective price stability is essential, because the experience in the United States and abroad has underscored that low and stable inflation is a prerequisite for healthy, balanced, economic expansion. Sustained expansion and price stability provide a backdrop against which workers and businesses can respond to signals from the marketplace in ways that make most efficient use of the evolving technologies. Federal Budget Policy Issues Before closing, I should like to revisit some issues of federal budget policy that I have addressed in previous congressional testimony. Some modest erosion in fiscal discipline resulted last year through the use of the "emergency" spending initiatives and some "creative accounting." Although somewhat disappointing, that erosion was small relative to the influence of the wise choice of the Administration and the Congress to allow the bulk of the unified budget 100 surpluses projected for the next several years to build and retire debt to the public. The idea that we should stop borrowing from the social security trust fund to finance other outlays has gained surprising-and welcome-traction, and it establishes, in effect, a new budgetary framework that is centered on the on-budget surplus and how it should be used. This new framework is useful because it offers a clear objective that should strengthen budgetary discipline. It moves the budget process closer to accrual accounting, the private-sector norm, and—I would hope—the ultimate objective of federal budget accounting. The new budget projections from the Congressional Budget Office and the Administration generally look reasonable. But, as many analysts have stressed, these estimates represent a midrange of possible outcomes for the economy and the budget, and actual budgetary results could deviate quite significantly from current expectations. Some of the uncertainty centers on the likelihood that the recent spectacular growth of labor productivity will persist over the years ahead. Like many private forecasters, the CBO and the Office of Management and Budget assume that productivity growth will drop back somewhat from the recent stepped-up pace. But a distinct possibility, as I pointed out earlier, is that the development and diffusion of new technologies in the current wave of innovation may still be at a relatively early stage and that the scope for further acceleration of productivity is thus greater than is embodied in these budget projections. If so, the outlook for budget surpluses would be even brighter than is now anticipated. But there are significant downside risks to the budget outlook as well. One is our limited knowledge of the forces driving the surge in tax revenues in recent years. Of course, a good part of that surge is due to the extraordinary rise in the market value of assets which, as I noted 101 earlier, cannot be sustained at the pace of recent years. But that is not the entire story. These relationships are complex, and until we have detailed tabulations compiled from actual tax returns, we shall not really know why individual tax revenues, relative to income, have been even higher than would have been predicted from rising asset values and bracket creep. Thus, we cannot rule out the possibility that this so-called "tax surprise," which has figured so prominently in the improved budget picture of recent years, will dissipate or reverse. If this were to happen, the projected surpluses, even with current economic assumptions, would shrink appreciably and perhaps disappear. Such an outcome would be especially likely if adverse developments occurred in other parts of the budget as well~for example, if the recent slowdown in health care spending were to be followed by a sharper pickup than is assumed in current budget projections. Another consideration that argues for letting the unified surpluses build is that the budget is still significantly short of balance when measured on an accrual basis. If social security, for example, were measured on such a basis, counting benefits when they are earned by workers rather than when they are paid out, that program would have shown a substantial deficit last year. The deficit would have been large enough to push the total federal budget into the red, and an accrual-based budget measure could conceivably record noticeable deficits over the next few years, rather than the surpluses now indicated by the official projections for either the total unified budget or the on-budget accounts. Such accruals take account of still growing contingent liabilities that, under most reasonable sets of actuarial assumptions, currently amount to many trillions of dollars for social security benefits alone. 102 Even if accrual accounting is set aside, it might still be prudent to eschew new longer-term, potentially irreversible commitments until we are assured that the on-budget surplus projections are less conjectural than they are, of necessity, today. Allowing surpluses to reduce the debt to the public, rather than for all practical purposes irrevocably committing to their disposition in advance, can be viewed as a holding action pending the clarification of the true underlying budget outcomes of the next few years. Debt repaid can very readily be reborrowed to fund delayed initiatives. More fundamentally, the growth potential of our economy under current circumstances is best served, in my judgment, by allowing the unified budget surpluses presently in train to materialize and thereby reduce Treasury debt held by the public. Yet I recognize that growing budget surpluses may be politically infeasible to defend. If this proves to be the case, as I have also testified previously, the likelihood of maintaining a still satisfactory overall budget position over the longer run is greater, I believe, if surpluses are used to lower tax rates rather than to embark on new spending programs. History illustrates the difficulties of keeping spending in check, especially in programs that are open-ended commitments, which too often have led to larger outlays than initially envisioned. Decisions to reduce taxes, however, are more likely to be contained by the need to maintain an adequate revenue base to finance necessary government services. Moreover, especially if designed to lower marginal rates, tax reductions can offer favorable incentives for economic performance. Conclusion As the U.S. economy enters a new century as well as a new year, the time is opportune to reflect on the basic characteristics of our economic system that have brought about our success in 103 recent years. Competitive and open markets, the rule of law, fiscal discipline, and a culture of enterprise and entrepreneurship should continue to undergird rapid innovation and enhanced productivity that in turn should foster a sustained further rise in living standards. It would be imprudent, however, to presume that the business cycle has been purged from market economies so long as human expectations are subject to bouts of euphoria and disillusionment. We can only anticipate that we will readily take such diversions in stride and trust that beneficent fundamentals will provide the framework for continued economic progress well into the new millennium. 104 Question Submitted for the Record for Federal Reserve Chairman Alan Greenspan from Chairman James Leach Q.I. Despite the fact that stock market valuations may indirectly affect economic activity, does the Fed have a proper role either in "jawboning" the market or making interest rate decisions designed principally to affect market levels? In a time when some might consider market valuations to be unrealistically high, is it wiser to raise interest rates, which presumably disproportionately hit small businesses and middle class Americans, or to raise margin requirements which exclusively affect deep-pocketed, leveraged investors? Or are the effects of changes in margin requirements so marginal that their impact is "de mimimis" on the market itself? A.I. The Federal Reserve is not "jawboning" the stock market or targeting stock prices. Rather, the Federal Reserve is concerned about imbalances between aggregate demand and supply and their implications for inflation and thus sustainability of the expansion. The sharp increase in equity valuation appears to have been an important factor behind an apparently developing imbalance. With regard to margin requirements, studies suggest that changes in such requirements have no appreciable and predictable effect on stock prices. Nonetheless, the Federal Reserve recognizes that considerable risks can be involved in the purchase of equity on margin, especially in volatile markets, and believes that lenders and borrowers need to assess carefully the risks they are assuming through the use of margin. 105 Chairman Greenspan subsequently submitted the following for the record: The Federal Reserve has not prepared any formal estimates of the point at which it would experience difficulties in conducting open market operations as the federal debt is paid down, and we do not expect to encounter significant difficulties in the near future. As you know, even though the Treasury has been paying down debt for the past two years or so, the recent surpluses followed a very long period of large federal deficits, and consequently the volume of federal debt outstanding remains quite large. Moreover, the Federal Reserve Act enables us to transact in Treasury securities and certain other instruments (such as obligations of federal agencies, certain obligations of state and local governments, foreign exchange, sovereign debt, etc.) on both an outright and a temporary, repurchase basis. The Federal Reserve already has been placing considerable emphasis on repurchase transactions in our operations. The availability of repurchase agreements against non-Treasury instruments as well as against Treasury securities will continue to contribute to our flexibility in an environment of declining Treasury debt. As you suggest, an objective of the Federal Reserve in implementing monetary policy is to minimize interference in the allocation of credit in the money and capital markets. Meeting this objective would be an important consideration in the design of any implementation alternatives, should declines in Treasury debt eventually make modifications of our current techniques desirable. I should clarify that current statutory authority does not permit the Federal Reserve to make purchases of high-grade private 106 bonds on either an outright or temporary basis. If at some future time it should become apparent that additional authority is desirable, we would request that the Congress make technical changes in the Federal Reserve Act to permit transactions in a broader range of assets. The precise market responses to a reduction or even complete elimination of Treasury debt are difficult to judge in advance. (The main variable determining whether Treasury debt is eliminated entirely is the realized amount of federal surpluses.) Since Treasury obligations have been acting as benchmark issues, some market adaptations certainly will be required if Treasury debt shrinks significantly. As I mentioned at the hearing, I am confident that the capital markets would create alternative benchmarks to fill the void left by disappearing Treasury debt. Fannie Mae and Freddie Mac already have attempted to take advantage of this situation by issuing so-called "benchmark" and "reference" issues, but it is possible that obligations of entirely private firms eventually could serve as benchmarks. As I often have emphasized, there is considerable uncertainty about the size of future surpluses and, indeed, about whether they will even continue to materialize. Consequently, we should be cautious about making plans based on projections of large surpluses. If the surpluses do eventuate, the implied smaller federal presence in credit markets will have substantial benefits for the economy. The reduced volumes of federal debt will tend to lower even private real interest rates and more generally will foster a receptive climate for private financing of capital formation, which will help to maximize 107 sustainable economic growth. Any adaptations that may eventually be required in Federal Reserve operations are insignificant in comparison to those benefits. Similarly, I am quite confident that any market adaptations in response to declining Treasury debt will ultimately preserve and possibly even enhance the efficiency of our capital markets. 108 Questions Submitted for the Record for Federal Reserve Chairman Alan Greenspan from Congressman Ron Paul Q. 1. In early February foreign holdings of U.S. debt jumped significantly to over $700 billion. What is the explanation for this? For whom does the Federal Reserve hold these new funds and in what form? A.I. The only data available on foreign holdings of U.S. debt in February are partial data on foreign official reserves held at the Federal Reserve Bank of New York. These holdings were in the $740-$750 billion range in February, but they did not increase significantly during February and have exceeded $700 billion since December of 1998. The Federal Reserve Bank of New York (FRBNY) acts as custodian for most foreign governments and central banks as well as several international organizations. U.S. Treasury securities make up by far the bulk of these assets held in custody-over $625 billion, or eighty percent of the total. In addition to Treasuries, FRBNY also holds Agency securities, CDs, commercial paper, bankers' acceptances, bank deposits, repurchase agreements, and gold for its foreign official customers. Q.2. Jerry L. Jordan of the Federal Reserve Bank of Cleveland at the Cato Institute's 17th Annual Monetary Conference, "The Search for Global Monetary Order," on October 21, 1999, remarked, "If monetary sovereignty or independence is not worth much in today's global capital markets, and if seignorage is quite small in a noninflationary world, then the costs and risks associated with a national central bank and a national currency become harder to justify."* These comments were characterized as central banks are becoming obsolete. Do you agree with Jerry Jordan's statement and its characterization? A.2. In my view, national central banks continue to have an important role to play in promoting the goals of financial stability and sustainable economic growth. Even in today's highly integrated global economic and financial system, national central banks can exert a considerable influence on domestic price and economic developments and thus help to make progress toward these goals. Q.3. One effect of the Federal Funds Rate Target is to smooth short-term rates, such as the prime rate, over the short term (over a few weeks to a few months). To what extent has this short-term smoothing effect exacerbated the stock market bubble by largely removing the financing cost risk of making leveraged bets in the stock market? 109 A.3. I do not believe that our short-term monetary policy operating procedures have a significant effect on stock prices. Our operating procedures, as you suggest, do tend to smooth short-run fluctuations in short-term interest rates. However, the risks of investing in-equities come primarily from uncertainty about future earnings and about the longer-term interest rates at which those future earnings should be discounted, and not mainly from the possibility that the short-run cost of financing stock positions could increase. Consequently, even if our operating procedures were associated with somewhat larger movements in short-term rates, I doubt that investors* perceptions of equity risks would be much affected and thus that equity prices would be significantly influenced. Q.4. On April 1, 2000,1 will be the keynote speaker at a Freedom Rally in California where NORFED will be issuing the first Gold Certificate since 1933. Given your professed "nostalgia" for the gold standard, is there anything you would suggest I add to the speech? A.4. Thank you for the opportunity, but there is nothing in particular that I would like to suggest. Q.5. Dr. Kurt Richebacher, former chief economist and managing partner at Germany's Dresdner Bank, has issued dire predictions for the global economy: "a deflationary collapse lies ahead that will ravage the world's bourses and usher in a dark period of austerity and financial discipline," according to Rick Ackerman in The Sunday Examiner. He reportedly bases his predictions, in part, on the "statistical hoax" of our government's 1995 implementation of a "hedonic" price index, which he characterized as akin to measuring GM's auto sales by tallying the horsepower of all the engines in its cars. With the proliferation of the use of cellular telephones, emails and faxes, and the greater subsequent blurring of home and work, measuring hours worked has become more difficult. Given your testimony on the importance of estimated productivity gains and your comment that it is "impossible" to manage something one cannot define, what precautions should policy makers take in case these gains have been overestimated? A.5. Possible errors in the measurement of real output and productivity in and of themselves are not the central issue: Correction of the errors would not alter the balance of potential supply and actual production, for both would be adjusted by like amounts. The key for monetary policy is the balance between supply and demand, as gauged, for example, by changes in the utilization of labor or of plant capacity. 110 However, to the extent that output is being mis-measured owing to errors in deflation of nominal expenditures, it follows that our price indexes may be giving misleading signals about the true rate of inflation. This is a troubling issue—one that I have noted on many occasions. Especially in a world in which products are becoming more and more difficult to define, price measurement will be an increasing challenge. This is one reason why strict quantitative inflation targeting might be undesirable. But, in any event, it behooves us, when the measured rate of price increase is relatively low, to keep a close eye on the economy for indications of the sorts of financial and economic tensions that typically have accompanied deflationary pressures-such as debt service problems and contractionary tendencies in economic activity. At this point, I do not see any signs that we have a problem of this sort. Q.6. The Gold Anti-Trust Action (GATA) open questions in the Roil Call ad raised the profile of speculation of government and central bank manipulation of the gold market. Because the Federal Reserve Bank of New York acts as the agent for all international transactions of the Fed and the Treasury, can you end any speculation of U.S. involvement by saying unequivocally that the N. Y. Fed has not intervened for itself, Treasury or as an agent for anyone else? A.6. I don't know if I will able to end speculation about U.S. involvement in the gold market, but I can say unequivocally that the Federal Reserve Bank of New York has not intervened in the gold market in an attempt to manipulate the price of gold on its own behalf or for the U.S. Treasury or anyone else. Ill Chairman Greenspan subsequently submitted the following in response to Congressman Sanders' questions: I would like to elaborate, in writing as requested, on the issue of income disparities as measured by the Survey of Consumer Finances, as well as the earlier issue you raised regarding the impact of the minimum wage. You noted that the Survey of Consumer Finances conducted by the Federal Reserve showed, among the various income groups identified in a summary table, only those earning $100,000 or more had shown a gain in average income between 1995 and 1998, and asked how such a pattern could be seen as consistent with what some characterize as a "booming economy." As a technical matter, these data do not trace the fortunes of individual families over time, and thus may not provide precisely the kind of information you would wish. But, setting aside the finer statistical issues, I have already indicated that I share your concerns about the fact that there are still many families that are struggling in this country. I do believe that the continuing economic expansion is bringing new opportunities to many who had not previously been able to find employment, and it is our objective—by avoiding inflationary imbalances in the economy-to prolong that expansion and its benefits for these people and their families. Regarding the issue of the minimum wage, I do not believe that raising the minimum wage is the appropriate tool to address the problem of income disparities. Increases in the minimum wage make it more costly for employers to hire workers whose current skills would not permit them to be productive enough to make it profitable to employ them. By avoiding setting such an artificial barrier, we can facilitate the flow of less skilled individuals into the work force, where they can gain the work experience and on-the-job training that will enhance their value to employers and put them on a path toward greater economic welfare. 112 Chairman Greenspan subsequently submitted the following response for inclusion in the record: This question of what government policy actions would be appropriate in raising real wage rates, perhaps at the expense of lowering business profits, is difficult. I believe that the primary focus of policy action should be the maximization of the total income "pie" of the economy, the amount that can be divided between labor and capital. The crucial element in the growth of real wages and labor incomes over time is the improvement of labor productivity—the amount of output produced per hour of work. And one of the most important contributors to productivity growth is the increase in the capital stock available to workers. If workers have more equipment to leverage their efforts, they will produce more and, history suggests strongly, they will share with the owners of capital the fruits of that additional production. Appropriate taxation of returns on capital and a non- inflationary environment in which the price mechanism works most effectively in guiding the allocation of capital are conditions conducive to efficient investment. Workers will also be more productive if they are well trained and if they find their way to the positions in which they can be put to best use. This suggests that policies that promote the development of worker skills and the dissemination of information about job availability may be helpful in enhancing productivity, though incentives are already quite strong for the private sector to do much of this job. 113 Chairman Greenspan subsequently submitted the following response for inclusion in the record: You raised the issue of the role of the oil price in the design of monetary policy. You also asked about whether the Federal Reserve would take account of the repercussions in foreign countries, in particular Russia, of its monetary policy actions. As your question on how oil prices affect U.S. economic performance and thus monetary policy implies, oil price increases by themselves can have somewhat contradictory implications for the setting of monetary policy. They would have to be considered in the context of all the other influences on progress toward the goals of price stability and sustainable economic growth. Although the likely direction of influence on monetary policy of a given change in oil prices remains uncertain, it can safely be said that over time the effects of a given change in oil prices on both inflation and real economic growth have diminished, simply because the share of oil-based products in our GDP has fallen. As for Russia, the Federal Reserve interprets its legislative mandates as promoting sustainable growth and price stability for the U.S. economy. Aside from the effects on our economy, it does not routinely consider how its policies affect foreign countries or take account of foreign policy considerations in its setting of monetary policy. o

Alan Greenspan (2000, February 16). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20000217_chair_conduct_of_monetary_policy_report_of

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  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {2000},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20000217_chair_conduct_of_monetary_policy_report_of},
  note = {Retrieved via When the Fed Speaks corpus}
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