Congressional Testimony

FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2000 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED SIXTH CONGRESS SECOND SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 JULY 20, 2000 Printed for the use of the Committee on Banking, Housing, and Urban Affairs 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 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS PHIL GRAMM, Texas, Chairman RICHARD C. SHELBY, Alabama PAUL S. SARBANES, Mainland CONNIE MACK, Florida CHRISTOPHER J. DODD, Connwticu ROBERT F. BENNETT, Utah JOHN F. KERRY? MaBStwfowtts ROD GRAMS, Minnesota RICHARD H. BRYAN, Nevwur WAYNE ALLARD, Colorado TIM JOHNSON, South Dakota MICHAEL B. ENZI, Wyoming JACK REED, Rhode Island CHUCK HAGEL, Nebraska CHARLES E. SCHUMER, New York RICK SANTORUM, Pennsylvania EVAN BAYH, Indiana JIM BUNNING, Kentucky JOHN EDWARDS, North Carolina MIKE CRAPO, Idaho WAYNE A. ABERNATHY, Staff Director STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel JOHN E. SILVIA, Chief Economist MARTIN J. GRUENBERG, Democratic Senior Counsel GEORGE E. WHITTLE, Editor (ID C O N T E N TS THURSDAY, JULY 20, 2000 Page Opening statement of Chairman Gramm 1 Opening statements, comments, or prepared statements of: Senator Sarbanes 2 Senator Shelby 3 Senator Mack 4 Senator Grams 4 Senator Bayh 5 Senator Bennett 6 Senator Reed 25 Senator Schumer 27 Senator Sunning 30 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem, Washington, DC 7 Prepared statement 30 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Monetary Policy Report to the Congress, July 20, 2000 34 (III) FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2000 THURSDAY, JULY 20, 2000 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10 a.m., in room 216 of the Hart Senate Office Building, Senator Phil Gramm (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN PHIL GRAMM Chairman GRAMM. Let me call the Committee to order. Today we begin our semiannual report from the Chairman of the Federal Reserve System, Alan Greenspan, on the state of the econ- omy and monetary policy. As many of you know, we have worked out a bipartisan consensus as to how to proceed in the future as we move away from the Humphrey-Hawkins report toward a re- port that more meets the needs of the era that we are blessed to live in. We were unable to pass permanent legislation to annualize this meeting, not because of a dispute about the nature of Chairman Greenspan's testimony, but basically because of a dispute about how many reports to Congress we want to continue. There tends to be, in some hearts, a love of reports and bureaucrats and dust. But, in any case, this is a free country, and if people feel they need more reports, I'm sure we have the people in those two great big buildings at the Federal Reserve who are ready and willing to give us all the reports we need. We are very glad to have you here again, Chairman Greenspan. You have become a national phenomenon. We are told Wall Street is waiting for a big day today, and so are we. We are blessed with the strongest, most vibrant economy that I can remember in my study of American economic history. There are many who would be quick to take credit, but I think if you had to narrow it down to who deserves more credit than any- body else on the planet, that person is sitting before us today, and his name is Alan Greenspan. We are very proud to have you here, Chairman Greenspan, and we are eager to hear from you. We're eager to begin our new set of hearings based on the state of the economy and monetary policy, and we welcome you this morning. With that, let me recognize our Ranking Democratic Member, Senator Sarbanes. (l) OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you very much, Mr. Chairman. First of all, I'm pleased to join you in welcoming Chairman Greenspan before the Committee this morning to give the Federal Reserve's Monetary Policy Report to the Congress. I join with you in the observation concerning the statutory re- quirement that the Fed submit its semiannual report on monetary policy to Congress, which expired, actually, earlier this year. As we know, the House has passed the bill reauthorizing those reports, as well as a number of other reports that have been sunsetted. I be- lieve there's a general consensus that some reports were dropped that should have been kept. Our staffs are working together now, and I hope we can work out an understanding with respect to those reports. As you note, there's no controversy over the Monetary Policy Re- port to the Congress. In fact, to its credit, the Federal Reserve has supported making the monetary policy reports, and we are pleased that they are here this morning. I want to take just a moment or two to address this monetary policy question. When the Fed's Open Market Committee last met on June 28 and announced its decision not to raise rates, it issued the following statement, and I must say, as an aside, I think the increased transparency which the Fed has brought to its decision- making is all to the good. I welcome the fact that they announce the decisions and give some rationale for them, although I guess some of us feel they could give some additional rationale and some- times that it shouldn't be quite as opaque as it is. But, neverthe- less, at their last meeting they said: Recent data suggests that the expansion of aggregate demand may be moderating toward a pace closer to the rate of growth of the economy's potential to produce. Although core measures of prices are rising slightly faster than a year ago, con- tinuing rapid advances in productivity have been containing costs and holding down underlying pressures. I hope that kind of analysis will lead to the conclusion that we do not need to go back on the path of raising rates. I don't believe there has been a significant change in the economy since the last meeting of the Federal Open Market Committee that would justify a rate hike. I think it's important to keep in mind that the Federal Reserve has already raised rates six times over the past year, including a half-point hike just 8 weeks ago. The Federal funds rate is now 2 percentage points higher than it was a year ago. The low core rate of underlying inflation means that rising nominal rates have trans- lated directly into higher real interest rates. In fact, real interest rates now are at their highest level since 1989, just before the last recession. Not surprisingly, interest-sensitive sectors of the economy now show declines. Just this morning, the Commerce Department re- leased the June numbers on housing starts and housing permits. Housing starts in June are at their lowest point since May 1998. Over the last 4 months of this year, housing starts have fallen 15 percent. Housing permits in June are at their lowest point since December 1997. Even with last month's rise in durable goods orders, they now stand at the same level they were at in the beginning of the year. Sales of domestic cars and light trucks have fallen for 4 consecutive months, with a total decline of 13 percent over that period. Obviously, this slackening of demand has resulted in some weak- ening of employment opportunities. In fact, the private sector over the last 3 months has added just over 330,000 jobs, the poorest 3- months' performance in 4V2 years. And the unemployment rate for blacks and Hispanics has started to rise again, after having, fortu- nately, come down in an impressive manner. I should note, Mr. Chairman, that Chairman Greenspan, in my judgment, to his credit, has been sensitive to these concerns. In fact, he concluded his statement before the Banking Committee at this time last year with the following comment: As a result of our Nation's ongoing favorable economic performance, not only has the broad majority of our people moved to a higher standard of living, but a strong economy also has managed to bring into the productive workforce many who had for too long been at its periphery. The unemployment rate for those with less than a high school education has declined from 10% percent in early 1994 to 63/4 percent today, twice the percentage point decline in the overall unemployment rate. These gains have enabled large segments of our society to obtain skills on the job and the self-esteem associated with work. It is important to note, I believe, that the rate hikes have taken place in an economy that is showing virtually no evidence of infla- tion. The core rate stands at about the same pace as it's been over the 4 preceding years. The same thing is true for producer prices. And, of course, this is all coupled with a sustained strong level of improvement in productivity, up 3.7 percent over the last year. This has kept unit labor costs down—in fact, those costs have de- celerated. They are actually pulling inflation down. I believe there is strong evidence that the FOMC's increase in in- terest rates over this past year has slowed the economy, and I'm very much hopeful that at its next FOMC meeting, the Fed will not raise rates again. Hopefully, the current slowing in the economy is a move toward the soft landing that many economic observers have been talking about. We certainly don't want a hard landing, and I hope the Fed will not contribute to that possibility. I join in welcoming Chairman Greenspan once again before the Committee. I look forward to hearing his testimony and the oppor- tunity to put questions to him. Thank you very much. Chairman GRAMM. Thank you, Senator Sarbanes. Senator Shelby. OPENING COMMENTS OF SENATOR RICHARD C. SHELBY Senator SHELBY. Chairman Greenspan, I want to join in wel- coming you. We all have deep respect for you and appreciate your coming before this Committee again to talk with us about mone- tary policy, at least the current status of it. We all like low interest rates, but I think what we want is sound monetary policy first. The Federal Reserve was created as a central bank to be independent, and it will be, should be, up to you and your colleagues to determine issues such as that. You see things about the economy that perhaps we don't see every day. That is something that is incumbent upon you. I would love to see interest rates drop a couple of points, but at the same time, monetary policy, sound monetary policy, I believe, is more important than anything. Thank you, Mr. Chairman. Chairman GRAMM. Thank you, Senator Shelby. Senator Mack. OPENING COMMENTS OF SENATOR CONNIE MACK Senator MACK. Thank you, Mr. Chairman. Welcome, Chairman Greenspan. This is the last time I will have the opportunity as a Member of the Senate to listen to your testimony. I want to person- ally commend and thank you for your stewardship at the Fed. I think you have proven, I hope for the last time, that the most important contribution that the Fed can make to this country is a commitment to price stability. That is the underlying foundation for long-term growth, job creation, and improved quality of life for all Americans. Again, I commend you for your hard work and for your effort. To continue on with what Senator Shelby said, everyone would like to see lower interest rates, but the commitment, the continued commitment to price stability is what I want to see the Fed pur- suing. That is something that I believe you have done throughout your career at the Fed and, again, I commend you for that. I would like to raise an additional issue. Yesterday, I believe the Domestic and International Monetary Policy Subcommittee of the House Banking Committee defeated legislation with respect to dol- larization on a vote of 11 to 10. This is just the beginning of this debate. Obviously, I am disappointed in that, but I take this oppor- tunity to raise the issue with respect to the relationship between the United States and Latin America. In the past, almost all bonds issued by Latin American countries were denominated in dollars. Today, the percentage issued in euros is approaching 25 percent. The failure of the Congress to provide the President with fast-track authority for trading negotiations has sent a message, I believe, to the Latin American leaders that their economic future may be tied to Europe, not to the United States. I believe yesterday's decision by the Banking Committee on the House side is regrettable, and I take this opportunity to try to re- mind my colleagues of the significance of Latin America to our fu- ture. Today, there is less trade that takes place with 500 million Latin Americans than with 30 million Canadians, and if we don't wake up and become more engaged in our relationships with Latin America, I think we're making a tragic mistake. Mr. Chairman, I appreciate the opportunity to raise that issue. Chairman GRAMM. Senator Grams. OPENING COMMENTS OF SENATOR ROD GRAMS Senator GRAMS. Thank you very much, Mr. Chairman. Welcome, Chairman Greenspan. It is nice to see you again. As always, we welcome the opportunity to hear your analysis of our current eco- nomic conditions and also your expectations for any of the near- term changes. In previous visits with our Committee, we had some discussion of a "soft landing" for our economy. The timing of that landing seemed to be an indeterminate time in the future, but the financial press is now suggesting that our economy may be on a glidepath and may even be ready to request landing clearance. I believe the possibility of a soft landing is now more of an immediate interest, and I look forward to your comments this morning and your cur- rent evaluation. On one other matter, I'm sure that you recall during the passage of the Gramm-Leach-Bliley bill last fall that several of the Mem- bers of this Committee, myself included, expressed our belief that a bill of the magnitude of GLB would require extensive followup oversight hearings to assure that the congressional intent of the bill was being followed in its implementation. As Chairman of the Securities Subcommittee, I have called two such oversight hearings. The first hearing concerned the so-called NARAB provisions impacting the insurance industry. The second hearing, held jointly with the Financial Institutions Subcommittee, on June 13, concerned the interim rules and proposed regulations for merchant banking activities. Governor Meyer testified on behalf of the Fed. After the hearing, eight Senators, Members of the Fi- nancial Institutions and Securities Subcommittees, joined on a fol- lowup letter to Governor Meyer. We have expressed our concerns that the regulations, in some instances, go beyond the intent of GLB. That letter was sent to Governor Meyer yesterday. Chairman Greenspan, I am aware that the Fed is still in the comment period with respect to the merchant banking rules. I men- tion this letter this morning only to alert you to its existence and just to ask that the letter, which is a bipartisan letter, come to your attention as well. It would be premature, of course, to ask this morning for any reaction from you at this time. But please know that the merchant banking rules have caused great consternation in some sectors of the financial industry and among several Members of this Committee. I mention that because we hope the Fed will consider making the appropriate changes in issuing the final regulations. Again, thank you very much for your attention to this matter. Thank you, Mr. Chairman. Chairman GRAMM. Thank you, Senator Grams. Senator Bayh. OPENING COMMENTS OF SENATOR EVAN BAYH Senator BAYH. Thank you, Mr. Chairman. I find myself in the unusual position here today of being all alone on the right, which, Chairman Gramm, is not very often the case when you and I are together. [Laughter.] But I am pleased to be here today. Chairman GRAMM. We should be together more. [Laughter.] Senator BAYH. That's right. We are together from time to time, and that's a good thing. Chairman Greenspan, we are here today to hear from you, not to hear from each other. I would just like to comment; I could not help but to notice in the popular press yesterday, I see there's one candidate for the Presidency, not representing either of the two major political parties, who has suggested that, if elected, he would like to "reeducate" you. [Laughter.] I hope today we can educate the American people about the dif- ficult job you have. We have seen 20 million new jobs created over the last several years, 2 million new businesses created. The unemployment rate is at about a 30-year low, and the incidence of homeownership is at an all-time high. It is my understanding of your purposes that you would like to contain inflationary pressure so that this expansion might continue and we might add to those numbers. Since there will be a great many Americans watching, I hope we can focus on the relationship between containing inflationary pressures and ex- panding this wonderful period of prosperity we have had. I believe that to be your intention, and I hope that we can edu- cate the American people, and perhaps a few of the candidates, to that fact. Thank you for joining us today. I look forward to hearing from you. Chairman GRAMM. Senator Bennett. OPENING COMMENTS OF SENATOR ROBERT F. BENNETT Senator BENNETT. Maybe we need to educate that candidate in the way the law is structured. As President, he has no ability to fire the Chairman of the Federal Reserve System. But then, that candidate has trouble understanding a great number of things. [Laughter.! Chairman Greenspan, with the rest of the Committee, I welcome you and congratulate you on your performance. Your stewardship over the economy has been remarkable. I signal in advance one issue that I hope you will deal with, if not in your opening statement, at least in the question and answer period. That is, the difference between nominal interest rates and real interest rates, real interest rates being calculated on the gap between inflation and interest rates, so that if interest rates are at, illustratively, 6 percent and inflation is at 6 percent, real interest rates are at zero. We have had that situation during your time at the Fed, where real interest rates were very close to zero. Now, while the nominal interest rate is not particularly high, with infla- tion well under control, the real interest rate is approaching some historic highs, and the impact of that on the real estate industry is beginning to concern me a little. I would appreciate it if you would address that. I think, as the stock market has demonstrated, they are able to shrug off almost anything, but some of the folks in both the private housing real estate market and the commercial real estate market are beginning to complain a little, at least to me, about the impact of real interest rates, and the sense that there is a slowdown in the real estate sector. Coming from one of the fastest-growing States in the Union, where people need to be housed as they move in or as our birthrate continues, that scenario is of some concern to me. I would like to hear about that in your opening statement, and if not, I hope we can get into it in the question period. Thank you, Mr. Chairman. Chairman GRAMM. Thank you. When the ancient Greeks journeyed to Delphi, they passed through two gates. One said, "Know thyself." The other said, "Mod- eration in all things." With those two warnings, let the oracle speak. [Laughter.] Chairman GREENSPAN. The oracle is temporarily speechless. [Laughter.] Chairman GRAMM. But never for long. [Laughter.] Chairman GREENSPAN. The big problem with oracularness is that words come from deep depths of thought which are indescribable, unprovable, and rarely correct. OPENING STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Mr. Chairman and other Members of the Committee, I appreciate, as always, this opportunity to present the Federal Reserve's report on monetary policy. The Federal Reserve has been confronting a complex set of chal- lenges in judging the stance of policy that will best contribute to sustaining the strong and long-running expansion of our economy. The challenges will be no less in the coming months as we judge whether ongoing adjustments in supply and demand will be suffi- cient to prevent distortions that would undermine the economy's extraordinary performance. For a while now, the growth of aggregate demand has exceeded the expansion of production potential. Technological innovations have boosted the growth rate of potential, but as I noted in my tes- timony last February, the effects of this process also have spurred aggregate demand. It has been clear to us that, with labor markets already quite tight, a continuing disparity between the growth of demand and potential supply would produce disruptive imbalances. A key element in this disparity has been the very rapid growth of consumption resulting from the effects on spending of the re- markable rise in household wealth. However, the growth in house- hold spending has slowed noticeably this spring from the unusually rapid pace observed late in 1999 and early this year. Some argue that this slowing is a pause following the surge in demand through the warmer-than-normal winter months and hence a reacceleration can be expected later this year. Certainly, we have seen slowdowns in spending during this near-decade-long expansion which have proven temporary, with aggregate demand growth subsequently re- bounding to an unsustainable pace. But other analysts point to a number of factors that may be ex- erting more persistent restraint on spending. One factor they cite is the flattening in equity prices, on net, this year. They attribute much of the slowing of consumer spending to this diminution of the wealth effect through the spring and early summer. This view looks to equity markets as a key influence on the trend in con- sumer spending over the rest of this year and next. Another factor said by some to account for the spending slow- down is the quickly rising debt burden of households. Interest and amortization as a percent of disposable income have risen materi- 8 ally during the past 6 years, as consumer and especially mortgage debt has climbed and, more recently, as interest rates have moved higher. In addition, the past year's rise in the price of oil has amounted to an annual $75 billion levy by foreign producers on domestic con- sumers of imported oil, the equivalent of a tax of roughly 1 percent of disposable income. This burden is another conceivable source of the slowed growth in real consumption outlays in recent months, though one that may prove to be largely transitory. Mentioned less prominently have been the effects of the faster increase in the stock of consumer durable assets—both household durable goods and houses—in the last several years, a rate of in- crease that history tells us is usually followed by a pause. Stocks of household durable goods, including motor vehicles, are estimated to have increased at nearly a 6 percent annual rate over the past 3 years, a marked acceleration from the growth rate of the previous 10 years. The number of cars and light trucks owned or leased by households, for example, apparently has continued to rise in recent years despite having reached nearly 194 vehicles per household by the mid-1990's. Notwithstanding their recent slowing, the sales of new homes continue at extraordinarily high levels relative to new household formations. While we will not know for sure until the 2000 census is tabulated, the surge in new home sales is strong evidence that the growth of owner-occupied homes has accelerated during the past 5 years. Those who focus on the high and rising stocks of durable assets point out that even without the rise in interest rates, an eventual leveling out or some tapering off of purchases of durable goods and construction of single-family housing would be expected. Reflecting both higher interest rates and higher stocks of housing, starts of new housing units have fallen off of late. If that slowing were to persist, some reduction in the rapid pace of accumulation of house- hold appliances across our more than 100 million households would not come as a surprise, nor would a slowdown in vehicle demand so often historically associated with declines in housing demand. Inventories of durable assets in households are just as formid- able a factor in new production as inventories at manufacturing and trade establishments. The notion that consumer spending and housing construction may be slowing because the stock of consumer durables and houses may be running into upside resistance is a credible addition to the possible explanations of current consumer trends. This effect on spending would be reinforced by the waning effects of gains in wealth. Because the softness in outlay growth is so recent, all of the aforementioned hypotheses, of course, must be provisional. It is cer- tainly premature to make a definitive assessment of either the re- cent trends in household spending or what they mean. But it is clear that, for the time being at least, the increase in spending on consumer goods and houses has come down several notches, albeit from very high levels. In one sense, the more important question for the longer-term economic outlook is the extent of anv oroductivity slowdown that might accompany a more subdued pace~oTproduction and consumer spending, should it persist. Therhekayiawrf nroductivitv. mnder such 9 circumstances will be a revealing test of just how much of the rapid growth of productivity in recent years has represented structural change as distinct from cyclical aberrations and, hence, how truly different the developments of the past 5 years have been. At issue is how much of the current downshift in our overall economic growth rate can be accounted for by reduced growth in output per hour and how much by slowed increases in hours. So far there is little evidence to undermine the notion that most of the productivity increase of recent years has been structural and that structural productivity may still be accelerating. New orders for capital equipment continue quite strong—so strong that the rise in unfilled orders has actually steepened in recent months. Capital-deepening investment in a very broad range of equipment embodying the newer productivity-enhancing technologies remains brisk. To be sure, if current personal consumption outlays slow signifi- cantly further than the pattern now in train suggests, profit and sales expectations might be scaled back, possibly inducing some hesitancy in moving forward even with capital projects that appear quite profitable over the longer run. In addition, the direct negative effects of the sharp recent run up in energy prices on profits as well as on sales expectations may temporarily damp capital spend- ing. Despite the marked decline over the past decades in the en- ergy requirements per dollar of GDP, energy inputs are still a large element in the cost structure of many American businesses. For the moment, the drop-off in overall economic growth to date appears about matched by reduced growth in hours, suggesting continued strength in growth in output per hour. The increase of production worker hours from March through June, for example, was at an annual rate of Vz percent compared with SVi percent the previous 3 months. Of course, we do not have comprehensive meas- ures of output on a monthly basis, but available data suggest a roughly comparable deceleration. A lower overall rate of economic growth that did not carry with it a significant deterioration in productivity growth obviously would be a desirable outcome. It could conceivably slow or even bring to a halt the deterioration in the balance of overall demand and po- tential supply in our economy. As I testified before this Committee in February, domestic de- mand growth, influenced importantly by the wealth effect on con- sumer spending, has been running \Yz to 2 percentage points at an annual rate in excess of even the higher, productivity-driven growth in potential supply since late 1997. That gap has been filled both by a marked rise in imports as a percent of GDP and by a marked increase in domestic production resulting both from signifi- cant immigration and from the employment of previously unuti- lized labor resources. I also pointed out in February that there are limits to how far net imports—or the broader measure, our current account deficit— can rise, or our pool of unemployed labor resources can fall. As a consequence, the excess of the growth of domestic demand over po- tential supply must be closed before the resulting strains and im- balances undermine the economic expansion that now has reached 112 months, a record for peace or war. 10 The current account deficit is a proxy for the increase in net claims against U.S. residents held by foreigners, mainly as debt, but increasingly as equities. So long as foreigners continue to seek to hold ever-increasing quantities of dollar investments in their portfolios, as they obviously have been, the exchange rate for the dollar will remain firm. Indeed, the same sharp rise in potential rates of return on new American investments that has been driving capital accumulation and accelerating productivity in the United States has also been inducing foreigners to expand their portfolios of American securities and direct investment. The latest data pub- lished by the Department of Commerce indicate that the annual pace of direct plus portfolio investment by foreigners in the U.S. economy during the first quarter was more than 2Vi times its rate in 1995. There has to be a limit as to how much of the world's savings our residents can borrow at close to prevailing interest and ex- change rates. And a narrowing of disparities among global growth rates could induce a narrowing of rates of return here relative to those abroad that could adversely affect the propensity of for- eigners to invest in the United States. But, obviously, so long as our rates of return appear to be unusually high, if not rising, bal- ance of payments trends are less likely to pose a threat to our pros- perity. In addition, our burgeoning budget surpluses have clearly contributed to a fending off, if only temporarily, of some of the pressures on our balance of payments. The stresses on the global savings pool resulting from the excess of domestic private invest- ment demands over domestic private saving have been mitigated by the large Federal budget surpluses that have developed of late. In addition, by substantially augmenting national saving, these budget surpluses have kept real interest rates at levels lower than would have been the case otherwise. This development has helped foster the investment boom that in recent years has contributed greatly to the strengthening of U.S. productivity and economic growth. The Congress and the Administration have wisely avoided steps that would materially reduce these budget surpluses. Contin- ued fiscal discipline will contribute to maintaining robust expan- sion of the American economy in the future. Just as there is a limit to our reliance on foreign saving, so is there a limit to the continuing drain on our unused labor resources. Despite the ever-tightening labor market, as yet, gains in com- pensation per hour are not significantly outstripping gains in pro- ductivity. But as I have argued previously, should labor markets continue to tighten, short of a repeal of the law of supply and de- mand, labor costs eventually would have to accelerate to levels threatening price stability and our continuing economic expansion. The more modest pace of increase in domestic final spending in recent months suggests that aggregate demand may be moving closer into line with the rate of advance in the economy's potential, given our continued impressive productivity growth. Should these trends toward supply and demand balance persist, the ongoing need for ever-rising imports and for a further draining of our lim- ited labor resources should ease or perhaps even end. Should this favorable outcome prevail, the immediate threat to our prosperity from growing imbalances in our economy would abate. 11 But as I indicated earlier, it is too soon to conclude that these concerns are behind us. We cannot yet be sure that the slower ex- pansion of domestic final demand, at a pace more in line with po- tential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures. As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up—even the core measures that do not include energy prices di- rectly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation. Furthermore, energy prices may pose a challenge to containing inflation. Energy price changes represent a one-time shift in a set of important prices, but by themselves generally cannot drive an ongoing inflation process. The key to whether such a process could get underway is inflation expectations. To date, survey evidence, as well as readings from the Treasury's inflation-indexed securities, suggests that households and investors do not view the current energy price surge as affecting longer-term inflation. But any dete- rioration in such expectations would pose a risk to the economic outlook. As the financing requirements for our ever-rising capital invest- ment needs mounted in recent years—beyond forthcoming domestic saving—real long-term interest rates rose to address this gap. We at the Federal Reserve, responding to the same economic forces, have moved the overnight Federal funds rate up !3/4 percentage points over the past year. To have held to the Federal funds rate of June 1999 would have required a massive increase in liquidity that would presumably have underwritten an acceleration of prices and, hence, an eventual curbing of economic growth. By our meeting this June, the appraisal of all the foregoing issues led the Federal Open Market Committee to conclude that, while some signs of slower growth were evident and justified stand- ing pat at least for the time being, they were not sufficiently com- pelling to alter our view that the risks remained more on the side of higher inflation. The last decade has been a remarkable period of expansion for our economy. Federal Reserve policy through this period has been required to react to a constantly evolving set of economic forces, often at variance with historical relationships, changing Federal funds rates when events appeared to threaten our prosperity, and refraining from action when that appeared warranted. Early in the expansion, for example, we kept rates unusually low for an ex- tended period, when financial sector fragility held back the econ- omy. Most recently we have needed to raise rates to relatively high levels in real terms in response to the side effects of accelerating growth and related demand-supply imbalances. Variations in the stance of policy—or keeping it the same—in response to evolving forces are made in the framework of an unchanging objective—to foster as best we can those financial conditions most likely to pro- mote sustained economic expansion at the highest rate possible. 12 Maximum sustainable growth, as history so amply demonstrates, requires price stability. Irrespective of the complexities of economic change, our primary goal is to find those policies that best con- tribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal. Mr. Chairman, I request that my full statement be included in the record. Thank you. Chairman GRAMM. Chairman Greenspan, let me thank you. It has been my privilege to hear every report that you have given to the Senate since you have been Chairman. And I would have to say I believe this is the finest report that you have ever delivered. I also think it's very instructive that it was a sobering report, and yet the reactions in the market are positive—the Dow is up 141 points—which says to me that what American investors want is not cheerleading, not instant gratification, but a steady hand on the wheel. As I always say to those who are critical of your policies and who wonder why I'm not more critical, I don't criticize success. When something's working, I believe you should stay with it. I have a couple of questions I want to ask. We have started a vote, so it would be my intention to ask my questions, then to rec- ognize Senator Sarbanes. When we get to the point that we have to go vote, it would be my objective to temporarily adjourn the hearing. That will give you a moment to relax and have a glass of water. Senator SARBANES. Or something stronger. [Laughter.] Senator SHELBY. Coffee. [Laughter.] Chairman GRAMM. When we return from the vote, we will con- tinue with the hearing. First of all, Chairman Greenspan, as you are well aware, we have spent years battling the effort by American Government to use trade as a tool of foreign policy. Hardly anything is more de- nounced than export controls in terms of limiting the ability of our farmers to sell agricultural products or our manufacturers to sell manufactured products based upon our approval or disapproval of potential customers. Except for those pariah states where we have virtually a state of war in terms of our conflicts in foreign policy, we have moved away from using economic trade as a tool of foreign policy. We now have a new proposal, as I'm sure you are aware, called the China Nonproliferation Act, which was introduced by Senator Thompson, that seeks for the first time to use access to our capital market and access to our banking system as an instrument of American foreign policy. The objectives of the bill are goals that no one would disagree with, that we would like nations not to proliferate in terms of weapons sales. But the tools that are being used represent, in my opinion, a very real threat to our prosperity and finally, in posing the question, a paradox, in the sense that we bargained harder in our relations with China, in the normal trade relation agreements and the Chi- 13 nese accession to the WTO—we bargained harder to open the ac- cess that our banking system and our investment system has to the Chinese market than in almost any other area. Having looked at this proposal, I wanted to give you an oppor- tunity to respond to it. Chairman GREENSPAN. Mr. Chairman, I certainly agree with the comments you have made and I clearly understand the motives un- derlying Senator Thompson's bringing this amendment forward. As you know, my own view is that our gradual increase in en- gagement commercially with China is undermining many of the types of structures which I think lead to the problems we have. I believe, contrary to engaging them in less commercial activities, it is very much to our advantage to significantly increase involving them in free trade, open-market economics, and basically the type of dynamics which raise standards of living, and ultimately create significant changes in societies. In addition to questioning the value of this amendment, there's a very serious question as to whether it will produce, indeed, what is suggested it will produce. First, let me say that the remarkable evolution of the American financial system, especially in recent years, has undoubtedly been a major factor in the extraordinary economy we have experienced. It is the openness and the lack of political pressures within the system which has made it such an effective component of our economy and, indeed, has drawn for- eigners generally to the American markets for financing as being the most efficient place in many cases where they can raise funds. But it is a mistake to believe that the rest of the world is without similar resources. Indeed, there are huge dollar markets all over the world to lend dollars. And because of the arbitrage that exists on a very sophisticated level throughout the world, the interest rates and the availability of funds are not materially different abroad than here. We do have certain advantages, certain tech- niques which probably give us a competitive advantage, but they are relatively minor. Most importantly, to the extent that we block foreigners from investing, from raising funds in the United States, we probably undercut the viability of our own system. But far more important is, I am not even sure how such a law would be effectively implemented, because there is a huge amount of transfer of funds around the world. For example, if we were to block China, or anybody else for that matter, from borrowing in the United States, they could readily borrow in London and be financed by American investors. If London were not financed by American investors, London could be financed, for example, by Paris inves- tors, and we finance the Paris investors. In other words, there are all sorts of mechanisms that are in- volved here, and the presumption that somehow we can block the capability of China or anybody else from borrowing at essentially identical terms abroad as here, in my judgment, is a mistake. My most fundamental concern about this particular amendment is it doesn't have any capacity, of which I am aware, to work. But being put into effect, the only thing that strikes me as a reasonable expectation is it can harm us more than it would harm others. Therefore, I must say, Mr. Chairman, I join you in your concerns about that amendment and I trust it would not move forward, even 14 though I respect the motives of Senator Thompson and understand where he's coming from, but I trust that he will try to achieve his ends in a somewhat different manner and a more effective way. Chairman GRAMM. I thank you, Chairman Greenspan. Let me ask one more question. Maybe I'm like the old cold war warrior that has not discovered that the cold war is over, but it makes me nervous that we are in the midst of the greatest spending spree in discretionary programs since Jimmy Carter was President. There is the real possibility that by the end of this year we will have ex- ceeded the Carter Presidency, and you would have to go back to the Johnson Presidency to find a period where real spending in discre- tionary programs would exceed what is happening this year. We are spending at a rate where, if it continues, discretionary spending growth will eat up probably $1 trillion of the surplus in a decade. We have Medicare proposals that are misleading in the sense that we hear dollar figures quoted, but the programs don't go into effect for 3 years, so that when you look at them fully im- plemented, you are looking at proposals that, realistically, would cost $350 billion over a 10-year period. Now, quite aside from all of the benefits of spending this money or the benefits from adding to the services that people get through very popular programs, and justifiably so, such as Medicare, sitting where you're sitting, looking at the big picture, does this spending concern you? Chairman GREENSPAN. Very much, Mr. Chairman, and the rea- son is not the nature of spending per se, but the rapid dissipation of the projected surpluses. Let us understand that what we are ob- serving at this particular point is a very extraordinary and, as you point out, quite unprecedented economic prosperity that we're now experiencing. It stems, to a large extent, from a remarkable change in tech- nology that started at the end of World War II and finally became operationally effective on output-per-hour in the mid-1990's. It es- sentially drove the economy upward at a remarkable pace, but like all such rapidly changing vehicles, there is a degree of instability that occurs when you move at that pace, and, as a consequence, a free-market economy such as ours develops a series of buffers which prevent the economy from going off the rails. I have mentioned two directly as a means by which we supply the excess of demand over production, or potential supply, but I think we are missing an understanding of the fact that the increas- ing surplus—not its level—but the fact that it has been continu- ously increasing has been a very major stabilizing force in keeping the savings-investment imbalances and their relationship to our current account deficit within limits that allow the economy to move forward at this very dramatic pace, with all the wonderful consequences that have derived from that. I'm not saying that if we now turn the deficit down, even if it continues as a positive number, that that is going to necessarily de- rail the recovery, but it certainly removes some of the buttress and buffer in this rapid economic expansion. What my concern is, is that in the endeavor to employ all of these deficits for various different projects, whether they are spend- ing initiatives or tax cut initiatives, we are removing part of that 15 valuable buffer. From an economic point of view, I submit to you that it is increasing the risks in this economy. I am hopeful that, despite the fact that we have all of these various recommendations out there in various different stages of initiatives, at the end of the day, we will allow most of this still-rising surplus to act in the manner which it is acting. Only when we achieve balance, finally, and we are out of danger, if I may put it that way, can one more readily look at a rational approach to this particular problem. But I do acknowledge the fact that some of the numbers you have cited and a number of the potential programs, both expendi- ture and tax cuts, in the pipeline do give me some concern. Chairman GRAMM. You haven't changed your relative priorities. Your first objective would be to keep the money in the surplus; if you are not going to do that, you should cut taxes; but the last, least desirable thing would be to spend it. Chairman GREENSPAN. I still hold to that view, Mr. Chairman. Chairman GRAMM. Senator Bennett has voted. Let me recognize Senator Sarbanes. I think he wanted to make a comment. Would you prefer to take a break, or would you rather go on? Chairman GREENSPAN. Let's keep going, Mr. Chairman. Chairman GRAMM. OK. Senator SARBANES. Mr. Chairman, Fm going to leave to vote. The only comment I wanted to make was to commend Chairman Green- span on his very well-balanced statement before the Committee. I am reminded of the story of President Truman who said he wanted a one-armed economist. They asked him why he wanted a one-armed economist and he said, because I have these economists and when I ask them for advice, they say, "On the one hand, and then on the other hand." [Laughter.] Your statement certainly did that here today, and I just wanted to say that I was reminded of that Truman story. But I will be back with my questions. Chairman GRAMM. Chairman Greenspan, I will be glad to take a break if you would like. Senator BENNETT. I would prefer the opportunity of questioning you unencumbered. [Laughter.] Chairman GREENSPAN. I knew I had gotten myself into trouble. [Laughter.] Senator BENNETT [presiding]. I timed it. It took me 12 minutes; 6 minutes to go over and 6 minutes to come back. If it takes them the same amount of time, I will have more time than I ever get at one of these hearings. I'm not going to pass up that opportunity. Let's go back and talk about your discussion with Chairman Gramm with respect to what to do with the surpluses. At the risk of sounding heretical, I am one who believes that a little bit of debt, properly managed, is not necessarily a bad thing. I look at the national debt not in total terms, but in relative terms. The na- tional debt is now falling as a percentage of GDP, and falling as a percentage of the economy as the economy grows more rapidly than the debt does. The debt may be going up in nominal terms. I believe it is, is it not? 16 Chairman GREENSPAN. It's true the public debt, which includes the issues to the Social Security trust fund, is still going up, but the debt to the public has been going down for quite a number of quarters. Senator BENNETT. Yes, the debt held outside of the Government. Chairman GREENSPAN. We are included outside of the Govern- ment in those calculations. But it's true either way, whether the Federal Reserve is included or not. Senator BENNETT. So it is outside of the debt owed to Federal trust funds that the nominal debt is coming down? Chairman GREENSPAN. Yes. Senator BENNETT. And as a percentage of the economy, of course, it is coming down dramatically because the economy is going up. Let's talk philosophically about whether it would be desirable to bring that to absolute zero. I don't know of very many businesses who bring their debt load to absolute zero. They always have some bonds outstanding to pay for capital improvements, acquisitions, or so forth by debt, and use debt, properly managed, as a tool for growth. Does that same principle apply to the Federal Government, or should we have as our "holy grail" the reduction of the debt to zero? Chairman GREENSPAN. First of all, I would say that the analogy is somewhat different in the sense that a private corporation en- deavors to achieve a certain optimum degree of leverage which minimizes risk in the context of maximizing rate of return. It is very rarely the case that the optimum debt level in a business is zero. We, of course, in the Federal Government, are not created in that context. I think you are correct, certainly in the sense that there are certain advantages to having a risk-free asset out there for peo- ple to invest in. There is no question that U.S. Treasury instru- ments have become, in a sense, the primary vehicle for investment for, not only U.S. investors, but a very substantial part of the rest of the world. It has become a particular security against which all others tend, in one form or another, to be measured. If that were the only consideration, there is no question that having a substan- tial amount of U.S. Treasury debt outstanding to fill the invest- ment requirements of the rest of the world would in and of itself be of value. But there is the extraordinary value of having a large surplus currently, and presumably in the intermediate future, which ne- cessitates the level of the debt going down, with the possible excep- tion of the Government investing in private securities, which raises other complications. We are confronted with the trade-off between the advantages of very large surpluses, which are acting as a buffer to keep this recovery in check, but of necessity implies that the level of the Treasury debt goes down. I think we have to balance those particular views. In my judgment, it is not a close call. I believe the advantages of having that surplus in there, hopefully rising, are extraordinarily greater than the loss that occurs to our economy and to the rest of the world of having a reduced supply of risk-free U.S. treasuries. 17 My judgment is, and I suspect this is already happening, that having a decreasing supply of U.S. treasuries, whose scarcity value is lowering their interest rates relative to other securities, has made them less attractive. There is evidence that a number of port- folio managers are shifting out of U.S. treasuries and into higher- yielding, but still high-grade, private securities. That process will doubtless continue, and as is now scheduled, we reduce our out- standing debt quite considerably. It is a very interesting trade-off that we have. I must say to you, it's one of those better trade-offs in life to have. It's a "good" versus another "good." It's a question of which is the more valuable. I would conclude that, while there are unquestionably losses and problems that emerge as a consequence of reducing the supply of U.S. treasuries to the public, the benefits of the surplus which cre- ates that problem far exceed the costs. Senator BENNETT. I tend to agree with you, at least for now. Does there come a point at which you say, OK, we have gone far enough, and now we level out and the benefits of having some pub- lic debt are such that we can do other things with the surplus, or should we let it continue to run until we get to absolute zero? Chairman GREENSPAN. No, I don't believe the issue really rests on the goal of eliminating the debt. I think the goal should be, from an economic point of view, to have high or rising surpluses, so long as they contribute to long-term economic growth. I would presume at some point this extraordinarily accelerating path of technology and productivity growth is going to flatten out or slow down. That's not to say it's in any way going back to where we were, but the rate of change almost surely will slow down. It's conceivable to me, at that particular point, that we have re- turned to the type of balances, for example, on the current account or savings-investment balance, that the need to have the surpluses is not still there. It is quite conceivable to me that the balance of this trade-off at some point down the road can shift in the other direction; that it is conceivable that the need to have surpluses— which, remember, essentially is the employment of resources for purposes other than what the American public may want—is no longer there. They may want a very large tax cut, or they may want some major expenditure programs. It is conceivable to me at that point that all of the various balances may suggest that eliminating the surplus may not be a bad idea. It would stop the decline in the issuance of U.S. Treasury securities, and I could conceive of the fact that that might be the optimum position. I would certainly never conclude that in and of itself, without any qualifications, zero debt should be our irrevocable goal. I think it's very useful if we reach that. It has a lot of advantages. But I would scarcely argue that it is the primary economic goal of this Government. Senator BENNETT. As is everything that you have outlined in your prepared statement, it is a matter of balancing and picking and choosing and trying to find your way through the maze. If there were shining goals that were clear and absolute that we should always reach for, your job would be a whole lot easier, and so would ours. Chairman GREENSPAN. Indeed. 18 Senator BENNETT. Thank you for the seminar on that particular issue. It's one that I have been interested in, and I think we need, as politicians, to pay more attention to it, instead of simply grab- bing for the headlines that say, "Let's reduce the debt to zero by a date certain," or "Let's return the money to the taxpayer of a cer- tain amount by a date certain." Those simple headline-grabbing statements by politicians obscure the subtleties that you have ex- plored here, and I thank you for that. Let's return to the issue that I talked about in my opening state- ment and talk about the real estate market and what you see there. You referred to it in your prepared statement to a certain degree, but let's talk about it a little more. I gather from your statement that you're not as concerned about it as some of the real estate people in my State are. Is that because you're dealing with national statistics and I'm dealing with a local situation? Are they being unduly parochial, or are there other as- pects here that you deal with when you talk about the impact of interest rates on both commercial and residential real estate? Chairman GREENSPAN. No, I think there's clear evidence of con- cern on their part. I think it's one of the problems that we have with the industry, in the sense that housing is a very crucial and very large part of our economy, but one which, by its nature, is sen- sitive to interest rates. We have had over the years—and I think, in my judgment, detrimentally—far too many big cycles in housing. It has created big problems for builders, for people in the real es- tate business, and for mortgage lenders. That has not been good. I think all of the goals that I perceive for housing should try to sta- bilize longer-term housing as best one can. The difficulty is, of all of the major sectors of the economy, it is by far the most interest-sensitive, for obvious reasons. Long-term debt financed and small changes in interest rates for long-term debt have significant effects on the amounts of monthly payments that are involved in financing a home. I think there is no way to avoid the fact that we have ups and downs. When we had low mortgage interest rates in recent years, we had an extraordinary expansion in both new and existing home sales. As I pointed out in my prepared remarks, the effect of that was to very dramatically increase the stock of single-family dwell- ings which are mainly owner-occupied, but not wholly. At some point, that rate of increase, being much faster than the rate of in- crease in household formations, obviously had to slow down. It would have slowed down whether interest rates were high or low. But clearly, with mortgage interest rates going up as much as they have in the last number of quarters, it was inevitable, in my judg- ment, for housing to quite significantly slow down. Are the builders and the real estate people in your State being, in a sense, unduly concerned? No, I believe that their business, as best we can judge, is going down. That is, the starts numbers, espe- cially the numbers, for example, that were published this morning, do indicate that we are coming off those extraordinary highs of re- cent years. But we are still at reasonably good levels. There are indeed many builders who said, "We are delighted by the fact that the intensity of the market has come down," because they had been unable to meet the demand and, as a consequence, 19 have probably behaved in a manner relative to their markets which was not optimum for their long-term profitability. It is a problem, I think, that has always existed in housing. From the point of view of the Federal Reserve, we hope and endeavor to find ways in which the fluctuations in that cycle can be smoothed in some respect, but there is no way to prevent it from occurring so long as that market is as interest-sensitive as it is. The only way to avoid that would be going wholly to a cash market, and that is just not credible. In fact, it is not desirable. I should think that one of the problems that we all face is how to narrow the fluctuations in the cycle. I do not think we can elimi- nate them. But I do believe it's the proper goal of people in the real estate business and in the financial business to try to find vehicles which smooth out that cycle. Senator BENNETT. Thank you. Senator Sarbanes. Senator SARBANES. Thank you very much, Mr. Chairman. Chairman Greenspan, the FDIC, in its national edition Regional Outlook for the second quarter for 2000, said the following: During 1999, the FDIC reported the first annual loss for the Bank Insurance Fund since 1991. This loss primarily resulted from an uptick in unanticipated and high- cost bank failures. Some of these failures were associated with high-risk activities, such as subprime lending, and some were related to operational weaknesses and fraud. The emergence of these problems in the midst of a strong economic environ- ment raises concerns about how the condition of the banking industry might change if economic conditions deteriorate. Do you share those concerns? What's your reaction to this report from the FDIC? Chairman GREENSPAN. I believe that is a balanced appraisal. There is no question that if you look at the banking system overall, as of today, all of the various measures of current activity and rela- tionships and risk indicate a fairly strong system. In other words, delinquency rates are very low, charge-off rates are exceptionally low, losses overall are very small to the banks. The number of bankruptcies have been rather few, but in the cases that they have arisen, there have been very large losses to the FDIC. But I believe the issue I have discussed previously, and I know my colleagues in the other agencies have also commented upon, is the fact that when you have an extended period of expansion, which now, as I indicated in my prepared remarks, is 112 months, invariably you are going to find that there is a tendency to reach for types of loans which shouldn't be reached for, if I may put it that way, because there are lots of companies which look better than they should, if for no other reason than they have not con- fronted a recession for more than a decade. They look creditworthy as a consequence. It has been everybody's experience that bad loans are made es- sentially at the top of the business cycle or after a very extended period of expansion, and I have no doubt that the long period of expansion that we have seen has induced a number of loans which, in retrospect, will appear to have been mistakenly made. In that regard, there are basic concerns, and there should be. And in this context, it is, I must say, gratifying that there has been some tightening up within the banking system. Our senior loan of- ficer survey, the last one, did indicate that there is a general rec- 20 ognition that lending standards had to be tightened and, indeed, that's occurring. But I do find that the statement of the FDIC is reasonably bal- anced and, I think, one to which I would subscribe. Senator SARBANES. Would you expect us to have serious banking problems if we had an economic downturn, on the basis that this kind of looseness had entered into the system? Chairman GREENSPAN. I think individual banks will have trou- ble. I must say that the overall state of the banking system is in reasonably good shape, and I would say that it could resist fairly significant economic disruption without a major problem within the banking industry. But remember that loan losses are exceptionally low, that bankruptcies of banks are exceptionally low, and if we run into a recession, I have no doubt that some form of rise in bankruptcies and liquidations will occur, that some increase in the underlying quality of the measured risks at the time will also take place. I believe the new technologies that have evolved in the banking industry, the extraordinary capacities that they now have to hedge risks, has put them in a position where they are extraordinarily re- sistant, in my judgment, to being upended by any type of economic problem that I can perceive. Senator SARBANES. Let me ask a question on the Fed's figures on industrial production, because I want to go behind the general figure. Your figures indicate a growth of manufacturing output at about 7 percent for each of the last three quarters. At first glance, that would suggest that raising the interest rates and monetary policy has not had much effect yet on industrial production. I understand, though, that these aggregate numbers disguise a dramatic slowdown in manufacturing outside of the information technology sector. That sector, which makes up only 10 percent of total manufacturing output, has been growing at, I guess, what one might call an incredible rate—31 percent, 60 percent, figures of that sort, year to year. The growth in output for the other 90 percent of manufacturing, according to the figures I'm given, has dropped from a 4V2 percent rate in the last quarter of 1999, down to a mere ¥2 percent rate for the quarter just ended. The pace of consumer goods production has also skidded from a near 3 percent rate last year to a ^10 of a percent rate last quarter. Would you agree that interest rate hikes are having a serious ef- fect on manufacturing output outside of the information technology sector? Chairman GREENSPAN. Yes, I would. I think it's the rise in real long-term corporate rates which has been quite a major factor in basically slowing some aspects of the nontechnology part of the economy. But remember that another reason for that is there has been a shift of capital out of the so-called old economy into the new econ- omy, so that, in a sense, you can't merely say that if the new tech- nology part of the economy were gone or disappeared, somehow we would be left with an economy which was extremely sluggish and scarcely rising at all. Indeed, as my recollection serves me, outside 21 of the high-tech area, manufacturing production had zero change since the beginning of the year. Part of that is an issue of merely observing resources going into those areas where the potential rates of return are higher. Indeed, you will always find that if you subtract at any time in history those areas of industrial production which are rising inordinately, the remainder, I can assure you, will be either negative or flat. That, in itself, doesn't tell you very much. Are you asking me, is the process such that the combination of the differential rates of return plus the significant rise in real long- term corporate rates had an effect on what we now call the older economy? I would say definitely that is the case. It is the type of thing which we try to understand and evaluate as best we can. Senator SARBANES. Mr. Chairman, I see my time has expired. Senator SHELBY [presiding]. Chairman Greenspan, recently, the Securities Subcommittee on the Banking Committee conducted a hearing and they called it, "Adapting a 1930's Financial Reporting Model to the 21st Century." At the hearing, accounting experts testified that current financial reporting models do not sufficiently capture significant sources of value, specifically intangible assets like knowledge and innovation, on which new business models rely. The lack of appropriate meas- urement can cause distortions in economic reporting, as well as risk to business leaders who make decisions based on insufficient and sometimes even misleading information. It was stated at the hearing that "Government also tracks eco- nomic indices based on an industrial age economy." My question is, what indicators do you believe best track the economic health of the new economy, as well as prominent players in the economy like Schwab, America Online, Cisco, et cetera? What is being done to ensure, Chairman Greenspan, that the economic data Government collects is reflective of today's economy, and how do you do it? Chairman GREENSPAN. The issue arises most directly in our GDP accounts by what we capitalize and what we don't. In years past, the Department of Commerce used to write off all software outlays as expensed. To the extent that there was value-added created there, even other than intermediate product, it was mismeasured. As a consequence, an awareness on the part of the Department of Commerce that it was underestimating the GDP induced them a year or two ago to measure final output software and include it as a capitalized item. Remember that in accounting terms, you should capitalize any outlay which increases the long-term value of the firm. As a con- sequence, you would presumably in today's environment take a number of the types of outlays which we write off and capitalize them. But because of our tax system, we are induced essentially to write them all off. In a sense, a large amount of outlay—for exam- ple, just in organizing a high-tech firm—is expensed. Yet the book value of the firm because of that is negligible; the market value is huge. What that is saying is the accounting is inappropriate and that if one were endeavoring to catch the true value of the firm and using the concept of what outlays enhance its value, you would cap- italize them. 22 Now, if they were capitalized and appeared in the same sense that software appears, as capitalized expenditures, the GDP would increase immeasurably. I might add that the net domestic product, which is a more technically complex term which takes depreciation out of the system, would not go up nearly as much. But the gross domestic product would very much increase. I must say there are a number of academics who argue that we are significantly underestimating the extent of measured GDP, al- though it gets to be an important argument of whether, in that case, you depreciate immediately, which is what happens when you write it off, or depreciate in 6 months, 1 year, 2 years, 3 years, or whether that really matters. But it is an issue. Senator SHELBY. Is the Federal Reserve presently working with the FASB and the SEC to address these accounting problems or in- sufficiencies? Are you working with them at all? Chairman GREENSPAN. The issues we are addressing with them relate more to technical questions of essentially banking accounting issues, specifically with respect to appropriate reserving or the like. The other issue is a different issue. We are not involved with the FASB or the American Institute of Certified Public Accountants on that issue. We have other issues with them. But we do believe the issue that you raised originally is a very important question, and I think that goes to the root of a much broader question of how one appropriately keeps accounts for value-added in this new economy, so to speak. Senator SHELBY. Mr. Chairman, may I quickly ask one additional question? Chairman GRAMM. Sure. Senator SHELBY. Last month, Chairman Greenspan, in a speech before the New York Association for Business Economics, you spoke about what you call "multifactor productivity," which you stated is "that portion of labor productivity that cannot be explained by other identifiable inputs in the production process." I wonder if you could elaborate on that briefly for the Committee? Chairman GREENSPAN. Obviously, we have direct measures of output per hour of input, and clearly, output per hour is the most crucial determinant of standards of living because it moves closely with real income per capita and all of the various relationships that are involved in it. Economists endeavor to try to determine what causes that to happen, and if you are looking at output per labor hour of input, it is obvious that the amount of capital investment per worker is a critical determinant of that. In the broader sense, the aggregate GDP has essentially capital input and labor input. But we have the capacity to so evaluate those inputs to deter- mine what proportion of the output they both reflect, and what we find, over the years, over the generations, is that there is a signifi- cant what we call "multifactor productivity residual," which cannot be explained by the amount of capital investment, on the one hand, or labor input on the other. We infer that it is a measure of techno- logical advancement or managerial improvement. It could be any- thing which improves output without labor or capital input, which encompasses many things, but technology and managerial restruc- turing are the main issues which do that. That's a very important 23 measure of whether technology is being applied and what rates of return are on the facilities. Senator SHELBY. What's been the trend in the last year regard- ing this? Chairman GREENSPAN. It's been going up, especially if we meas- ure the gross domestic product as gross domestic income. Remem- ber that gross domestic income is conceptually identical to gross domestic product, but they are measured differently and there is a statistical discrepancy. Gross domestic income has been rising far faster than gross domestic product, and as a consequence, shows a much larger unexplained residual, if I may put it that way, what we call "multifactor productivity," than would the product side, but both are showing an increase in that residual. Senator SHELBY. Thank you, Mr. Chairman. Chairman GRAMM. Thank you, Senator Shelby. Let me announce that for some reason that has absolutely noth- ing to do with this hearing, someone has objected to committees meeting. As a result, we are going to be out of business at about 11:45 a.m. Let me apologize to my colleagues. As you know, from time to time, this happens. What I am going to try to do is go quickly to our remaining Members. I would like to ask you to try to hold your statement to under 5 minutes. Chairman Greenspan, if you would speed up without lowering the quality, we would appreciate it. Senator Bayh. Senator BAYH. Thank you, Chairman Gramm. Senator SARBANES. Just say "maybe" as an answer. [Laughter.] Senator BAYH. Chairman Greenspan, you said something in your testimony I found myself in complete agreement with. When you said, in praising Congress, that Congress has wisely avoided the steps that would materially reduce our surpluses, I couldn't agree more. Chairman Gramm mentioned something that I also agreed with when he said, "Americans don't want instant gratification, but a steady hand at the wheel," in praising you. I'm having difficulty reconciling these statements with Congress' current attempts to set fiscal policy, not just for this year, but for the next 10 years, in a highly politicized environment which has led normally prudent, responsible people, in my opinion, to behave otherwise and to propose things that would materially reduce the surplus, apparently in pursuit of instant gratification, political or otherwise. I would like to ask, very briefly, three questions designed to deal with the surplus and the timing of the kind of action that we are taking here and elicit your views on these things. First, I understood your testimony to say that if the economy is in fact softening a little here, we may be about to get a test of whether the increases in the rate of productivity growth that we have experienced over the last several years have been aberrational or, in fact, are more enduring in character. My question is, if we are about to have such a test, wouldn't it be prudent to wait and see before we make major fiscal decisions? Chairman GREENSPAN. Yes, Senator. [Laughter.! 24 Senator BAYH. Thank you. [Laughter.] Chairman GRAMM. Good. Senator BAYH. He is not only brilliant, but follows instructions. This is a wonderful thing. [Laughter.] Second, the estimates of the size of the surplus have varied by more than $1 trillion in just the last few months. Since tax cute or spending increases tend to be more permanent in nature, while the size of the surplus seems to fluctuate dramatically, wouldn't that also argue for the prudent course of action being to wait a while longer to make such important decisions that will affect our country for the next decade? Chairman GREENSPAN. I hate to repeat myself, Senator Bayh, but, again, yes. [Laughter.] Senator BAYH. This is wonderful. I have one last question. Chair- man Gramm, maybe I can go three for three. You mentioned that our goal here is to bring supply and demand into balance. My question to you, Chairman Greenspan, is that if the Congress, if the elected branches of Government decide to pur- sue a more stimulative fiscal policy, we would give the appearance of having the Federal Reserve pursuing a more cautious monetary policy while the elected branches of Government were pursuing a more stimulative policy. What impact would that have on the kind of decisions you would have to make, again, perhaps arguing to see if we didn't create an equilibrium before taking action? Chairman GREENSPAN. Senator, it would depend, obviously, on what impacts changing fiscal policy had on the economy, because it's that to which we respond, not fiscal policy directly itself. Senator BAYH. Thank you, Chairman Greenspan. I would wrap up, Chairman Gramm, by saying that, Chairman Greenspan, I, too, favor tax cuts, but I think the question here is timing rather than the long-term desirability. I take it that's your position as well. Thank you, Mr. Chairman. Chairman GRAMM. Thank you. Senator Mack. Senator MACK. That was a rather remarkable set of exchanges. I want to focus on the issue that I always seem to focus on, and that's the issue of price stability and inflation. Some people believe that the unemployment rate needs to go to 5 percent in order to prevent inflation. I suppose that is what is referred to as the so- called "NAIRU" theory. We are presently at 4 percent, which would mean we would have to, over time, see the unemployment rate rise back to 5 percent. I have gone back and looked since the 1940's, and every single time that we have had an unemployment rate go up by 1 percent, whether that was over a 1-year period, 2-year pe- riod, 3-year period, or 4-year period, we have had a recession. That theory concerns me. My question is, in you view, can we achieve price stability with unemployment at 4 percent, or do we need to move the unemploy- ment rate higher in order to achieve price stability? 25 Chairman GREENSPAN. In my judgment, the evidence indicating that we need to raise the unemployment rate to stabilize prices is unpersuasive. It's a major issue in the economics profession, under significant debate. My forecast is that the NAIRU, which served as a very useful statistical procedure to evaluate how the economy was behaving over a number of years, like so many types of tem- porary models which worked, is probably going to fail in the years ahead as a useful indicator, at least an anywhere near as useful indicator as it was through perhaps a 20-year period up until fairly recently. Senator SARBANES. Are the question and answer sessions of the Chairman with the Congress made available to the other members of the Federal Open Market Committee? Chairman GREENSPAN. They are in the public record. Senator SARBANES. I would think it would be helpful if they were made available to the other members of the Federal Open Market Committee. Senator MACK. Let me be more specific. I think at the beginning you started to address the question, and I gathered from your re- sponse to the earlier part of the question, you believe that you can maintain price stability with unemployment at 4 percent. Chairman GREENSPAN. I don't know that for sure. Indeed, in my prepared remarks, I did indicate that is an open question. I suspect the answer is yes, but I must say that the evidence on either side of this question is not yet of sufficient persuasiveness to convince everybody. Senator MACK. Thank you, Mr. Chairman. Chairman GRAMM. Thank you. Senator Reed. OPENING COMMENTS OF SENATOR JACK REED Senator REED. Thank you, Mr. Chairman. Chairman Greenspan, from your colloquy with Chairman Gramm, someone could, I believe, deduce the impression that you have a hierarchy of policy: First, save the surplus; second, cut taxes; and third, increase spending. My sense is that both cutting taxes and increasing spending would have virtually the same effect on the economy. They would both stimulate the economy and dissipate the surplus. From your position, both would be objectionable. Is that correct? Chairman GREENSPAN. Senator, in that context, you are quite correct. The reason why I would prefer, if necessary, dissipating the surplus through tax cuts is because I believe it is much more difficult to maintain a continuous expansionary imbalance in fiscal affairs if you reduce taxes because there is a downside limit to how far you can go, but the issue of producing long-term entitlement programs is virtually without limit. As a consequence, I think there is a bias in the system over the longer term which suggests to me that we are fiscally safe if we have to get rid of surpluses, to get rid of them on the tax side rather than on the expenditure side. Senator REED. The experience in 1993 was that we made quite significant cuts in discretionary programs and also increased taxes, equally arduous votes. Some would argue that sometimes it's much harder to reverse tax cuts than it is to cut back programs. 26 Chairman GREENSPAN. Senator, I am talking in the context, not of the most recent period, but over the last half-century. I think, should that indeed turn out to be the new trend, then I would change my view. Senator REED. I have an unrelated question, Chairman Green- span. The trade deficit continues to explode. Do you sense that you have both the predictive tools to anticipate a meltdown, if you will, as a result of the trade deficit, and the policy levers, both in the Federal Reserve and within the Federal Government, to deal with the potentialities of that threat to our economy? Chairman GREENSPAN. Senator, the trade deficit or the current account deficit, which is a somewhat broader definition of the same problem, is an issue to which we have addressed a very consider- able amount of research resources to endeavor to evaluate, project, and understand. As I have indicated in the past, and indeed in my prepared remarks, we have more than financed in some sense the trade deficit by the extraordinary inclination on the part of for- eigners to invest in the United States. If we were in trouble on this issue, our exchange rate would be falling, and indeed it is not. But over the longer run, we have certain structural differences in our trade accounts which induce us to import at a faster pace, relative to our income, than our trading partners. If everybody is growing at their potential, we would be chronically increasing our deficits. That would mean that foreigners would be increasing in- definitely the size of their portfolio of claims against American resi- dents. Clearly, there is a limit to how far that can go. We have been endeavoring to fully understand the process, to see what various different types of measures could be addressed in the event of problems emerging, and we are looking to do more work on that. However, for the moment, it's quite remarkable: the same forces that are engendering the huge increase in capital investment—that is, the high rates of return—are attracting very large investments from foreigners into the United States, and that's been keeping our system in balance. Senator REED. Thank you, Mr. Chairman. Chairman GRAMM. Thank you, Senator Reed. I want the record to show that at this point, we ended the hear- ing and embarked on a short period for an informal briefing. [Whereupon, at 11:45 a.m., the hearing was adjourned, and an informal Committee briefing convened, the transcript of which is as follows:] INFORMAL COMMITTEE BRIEFING Federal Reserve's Second Monetary Policy Report for 2000 Chairman GRAMM. We are going to end this briefing in 10 min- utes. I want to recognize Senator Grams for 5 minutes, then I will recognize Senator Schumer, and then we will end the briefing. Senator GRAMS. Thank you very much, Mr. Chairman. Chairman Greenspan, I will be very brief. We have talked about heavy industry and the new economy, about electronics, a big part of the economy, and about agriculture. Where does agriculture fit in right now? What is the state of our ag economy? We are facing emergency bills to help farmers. Where is our agricultural economy compared to productivity of our competitors around the world? Chairman GREENSPAN. First, let me state that productivity in agriculture has actually been rising at a pace faster than in the nonfarm area—that is, the extraordinary rise in yields has been nothing short of awesome over the last 50 years, after a remark- ably stable period of flat yields for corn and wheat, even before we used to plant soybeans. But that plus productivity in the livestock area of our economy has really in a sense outstripped what we are capable of doing in industry. What that has done is created a huge capacity to produce for which we must find demand. As you know better than anybody, Senator, the proportion of agriculture produced domestically which is consumed in the United States is a good deal less than half. For many of our crops it is substantially less than half, requiring that we find export markets to meet the demand for our output, which is the reason I believe it's crucial for us to keep opening up mar- kets abroad, for agriculture especially, the issues in Europe and in Asia. I think the fixture of American agriculture depends vitally on our ability to continuously increase our export capabilities, because we produce far beyond the capability of the needs of the American people, even as our consumption per capita continues to rise. I believe that, in one sense, we are confronted with a really quite remarkable industry. What we have been able to do in agriculture is something which we should be exceptionally proud of. But it does make it incumbent upon us to ensure that the new production we are turning out has markets into which it can be sold. Senator GRAMS. Thank you very much, Mr. Chairman. Chairman GRAMM. Thank you. Senator Schumer. OPENING COMMENTS OF SENATOR CHARLES E. SCHUMER Senator SCHUMER. Thank you, Mr. Chairman. I have two questions. My first relates to Congress. My good friend and colleague, Senator Gramm, talked about the contrast of discre- tionary spending versus tax cuts. I have a different perspective, be- cause we are not increasing discretionary spending too much. Yet (27) 28 in the last few weeks, in either the House or Senate, and in some cases both, we have voted for a $750 billion estate tax cut and a $750 billion, over a 20-year period, marriage tax reduction. There is talk now of lowering the marginal rate to 14 percent from 15 percent. That's $300 billion over the first 10 years and $1 trillion over the next 20 years. There is talk of other tax reduction as well. I'm worried we are entering a phase of Voodoo II tax cuts—not targeted tax cuts, not limited tax cuts, but cut after cut after cut that jeopardize the balanced budget life that both Democrats and Republicans in recent years have come to accept as a consensus. Let's say this year we were to spend the entire projected surplus of $1.7 trillion on tax cuts. Would that throw a monkey wrench into the prosperity that we have been seeing, just as that amount of dis- cretionary spending might do the same? Chairman GREENSPAN. Senator, in response to that, and the re- lated questions earlier, I indicated that my major concern is a dis- sipation of the surplus, irrespective of how, because it's been fairly clear to me and my colleagues that the dramatic rise in the surplus has been an extraordinarily important buffer to the potential vola- tility that would occur in an economy such as ours which is being driven sharply higher by remarkable changes in technology. One of the major elements which has kept our expansion stable has been the growing surplus—not even the level of the surplus, but the fact that it is growing. I indicated earlier that were we able to continue that until we finally achieved some balance and sta- bility in this expansion, it would be very much to our interest. Senator SCHUMER. So there's a danger. Let's not label how much, but there is a danger that too many tax cuts could jeopardize the continued growth of expansion. Chairman GREENSPAN. I would say that anything, whether it is tax cuts or expenditure increases, which significantly slows the rise in surpluses or eventually eliminates them, would put the economy at greater risk than I would like to see it exposed to. Senator SCHUMER. I agree with you on both sides of the ledger. My second question deals with energy prices. We have seen an in- crease in the price of oil. We have also seen that natural gas is higher than it has been, I think, on record. I believe it was $4.43 for a million cubic—I guess it's feet they measure it in, not yards. Electricity prices are going up. We face some electricity shortages in different parts of the country. Do you worry that the general shortages we face in the face of increasing demand could create problems for our economy on the inflation front? I have not witnessed all three major sources of energy used in this country—oil, gas, and electricity—being in such short supply, or at least demand pushing things up on all three fronts as much as it has in a pretty long time, 20 years. Do you worry about this? What should we be doing about it? Chairman GREENSPAN. I do worry about it, Senator, and I worry about it largely despite the fact that the proportion of energy per dollar of GDP has come down very dramatically over the years, and our reliance on energy and supply of energy is, accordingly, signifi- cantly less. But it is still substantial and still capable of having fairly dramatic negative effects on the economy. 29 The major problem that we confront in all these areas is the fact that our ability to control our supply has been undercut. Clearly, in the oil markets, American crude production, despite remarkable technological advances, still trends downward. The Alaska North Slope peaked a number of years ago and has been coming down. We have offset it in part in drilling in the Gulf. But we are ever decreasing the amount of crude that we can produce domestically, and that means we are increasingly reliant on others. We have also run into a problem where the propensity to build new electric power facilities is being disincentivized. I'm not aware of all of the various ramifications of the problems that are involved in building a new electric utility plant, but my impression is that whatever they may be, they have succeeded in slowing down the rate of expansion materially, As a consequence of that, I'm not worried as much on the issue of inflation because you can contain that. I'm worried about the in- stability that creates within the economy and the difficulties that might emerge as a consequence of that. While I don't want to say I'm not concerned about the inflationary implications, obviously I am, I don't want to leave the impression that's the only thing that is involved. It is an issue that we need to address. Senator SCHUMER. I want to make one more point. I believe the sleeper in all of this is the price of natural gas, which had always stayed low, even when oil went up. Now it is at record highs, for reasons I'm not clear on. Does that concern you, too? Chairman GREENSPAN. What happened was that there's a cycli- cal storage in natural gas where we build up at certain times and we bring levels of inventories down, and in the last year or so, we have slipped below the normal trend, and we are now looking at marginally lower levels of shut-in storage for natural gas than we typically need at this time of the year. As a consequence of that, pressures are beginning to build, and we are getting the types of price expansions which you would expect. Unlike crude oil, our ability to find new gas is there. It's the fact that we are not drilling in the way that we had been. Eventually, that is likely to improve, but it takes a long while to get wells in place and to bring up the level of inventories of natural gas to a level which will bring prices off the huge spike which we have per- ceived recently. Senator SCHUMER. Thank you, Mr. Chairman. Chairman GRAMM. Chairman Greenspan, thank you for a great hearing. Take care of yourself. We will see you next year. Chairman GREENSPAN. Thank you, Mr. Chairman. [Whereupon, at 12 noon, Thursday, July 20, 2000, the briefing was concluded.] [Prepared statements and additional material supplied for the record follow:] 30 PREPARED STATEMENT OF SENATOR JIM SUNNING Mr. Chairman, I would like to thank Alan Greenspan, Chairman of the Federal Reserve System, for testifying today. I am very interested in hearing Chairman Greenspan's semiannual comments on monetary policy. As the Chairman knows, productivity has continued to grow, quar- ter after quarter. Much of this can be attributed to the information revolution. I be- lieve these continuing productivity increases have effectively mitigated the potential inflationary impact of our tight labor markets. I also believe the increase in informa- tion technology has led to not just a temporary spike in productivity, but instead reflects a fundamental structural change. The latest CPI figures do not indicate any disturbing signs of inflationary pres- sures growing. If you remove the spike caused by the aurge in energy prices, the CPI is very stable. Additionally, it appears that the higher interest rates imposed in the last year or so have started slowing parts of the economy, such as the housing market. I hope Chairman Greenspan has come to the same conclusion I have—that there is no need to raise interest rates again. Chairman Greenspan has achieved his goal, although it is one I do not share. The economy has slowed. I still fear that the further raising of rates by the Fed could slow the economy so much that we fall into a recession. I will repeat what I said to you the last time you came up here, Chairman Greenspan. I do not believe you want a recession on your watch, and I know I don't want one on mine. Please do not raise rates again, Chairman Greenspan. Our economy does not need a monetary policy designed to eliminate inflation that does not exist. Thank you very much, Mr. Chairman. PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD op GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 20, 2000 Introduction Mr. Chairman and other Members of the Committee, I appreciate this opportunity to present the Federal Reserve's report on monetary policy. The Federal Reserve has been confronting a complex set of challenges in judging the stance of policy that will best contribute to sustaining the extremely strong and long-running expansion of our economy. The challenges will be no less in the coming months as we judge whether ongoing adjustments in supply and demand will be suf- ficient to prevent distortions that would undermine the economy's extraordinary performance. For some time now, the growth of aggregate demand has exceeded the expansion of production potential. Technological innovations have boosted the growth rate of potential, but as I noted in my testimony last February, the effects of this process also have spurred aggregate demand. It has been clear to us that, with labor mar- kets already quite tight, a continuing disparity between the growth of demand and potential supply would produce disruptive imbalances. A key element in this disparity has been the very rapid growth of consumption resulting from the effects on spending of the remarkable rise in household wealth. However, the growth in household spending has slowed noticeably this spring from the unusually rapid pace observed late in 1999 and early this year. Some argue that this slowing is a pause following the surge in demand through the warmer-than- normal winter months and hence a reacceleration can be expected later this year. Certainly, we have seen slowdowns in spending during this near-decade-long expan- sion that have proven only temporary, with aggregate demand growth subsequently rebounding to an unsustainable pace. But other analysts point to a number of factors that may be exerting more per- sistent restraint on spending. One they cite is the flattening in equity prices, on net, this year. They attribute much of the slowing of consumer spending to this diminu- tion of the wealth effect through the spring and early summer. This view looks to equity markets as a key influence on the trend in consumer spending over the rest of this year and next. Another factor said by some to account for the spending slowdown is the rising debt burden of households. Interest and amortization as a percent of disposable in- come have risen materially during the past 6 years, as consumer and particularly mortgage debt has climbed and, more recently, as interest rates have moved higher. 31 In addition, the past year's rise in the price of oil has amounted to an annual $75 billion levy by foreign producers on domestic consumers of imported oil, the equiva- lent of a tax of roughly 1 percent of disposable income. This burden is another likely source of the slowed growth in real consumption outlays in recent months, though one that may prove to be largely transitory. Mentioned much less prominently have been the effects of the faster increase in the stock of consumer durable assets—both household durable goods and houses— in the last several years, a rate of increase that history tells us is usually followed by a pause. Stocks of household durable goods, including motor vehicles, are esti- mated to have increased at nearly a 6 percent annual rate over the past 3 years, a marked acceleration from the growth rate of the previous 10 years. The number of cars and light trucks owned or leased by households, for example, apparently has continued to rise in recent years despite having reached nearly 1% vehicles per household by the mid-1990's. Notwithstanding their recent slowing, sales of new homes continue at extraordinarily high levels relative to new household formations. While we will not know for sure until the 2000 census is tabulated, the surge in new home sales is strong evidence that the growth of owner-occupied homes has ac- celerated during the past 5 years. Those who focus on the nigh and rising stocks of durable assets point out that even without the rise in interest rates, an eventual leveling out or some tapering off of purchases of durable goods and construction of single-family housing would be expected. Reflecting both the higher interest rates and higher stocks of Housing, starts of new housing units have fallen off of late. If that slowing were to persist, some reduction in the rapid pace of accumulation of household appliances across our more than 100 million households would not come as a surprise, nor would a slow- down in vehicle demand which so often is historically associated with declines in housing demand. Inventories of durable assets in households are just as formidable a factor in new production as inventories at manufacturing and trade establishments. The notion that consumer spending and housing construction may be slowing because the stock of consumer durables and houses may be running into upside resistance is a cred- ible addition to the possible explanations of current consumer trends. This effect on spending would be reinforced by the waning effects of gains in wealth. Because the softness in outlay growth is so very recent, all of the aforementioned hypotheses, of course, must be provisional. It is certainly premature to make a de- finitive assessment of either the recent trends in household spending or what they mean. But it is clear that, for the time being at least, the increase in spending on consumer goods and houses has come down several notches, albeit from very high levels. In one sense, the more important question for the longer-term economic outlook is the extent of any productivity slowdown that might accompany a more subdued pace of production and consumer spending, should it persist. The behavior of pro- ductivity under such circumstances will be a revealing test of just how much of the rapid growth of productivity in recent years has represented structural change as distinct from cyclical aberrations and, hence, how truly different the developments of the past 5 years have been. At issue is how much of the current downshift in our overall economic growth rate can be accounted for by reduced growth in output per hour and how much by slowed increases in hours-. So far there is little evidence to undermine the notion that most of the produc- tivity increase of recent years has been structural and that structural productivity may still be accelerating. New orders for capital equipment continue quite strong— so strong that the rise in unfilled orders has actually steepened in recent months. Capital-deepening investment in a broad range of equipment embodying the newer productivity-enhancing technologies remains brisk. To be sure, if current personal consumption outlays slow significantly further than the pattern now in train suggests, both profit and sales expectations may be scaled back, possibly inducing somehesitancy in moving forward even with capital projects that appear quite profitable over the longer run. In addition, the direct negative ef- fects of the sharp recent run up in energy prices on profits as well as on sales expec- tations may temporarily damp capital spending. Despite the marked decline over the past decades in the energy requirements per dollar of GDP, energy inputs are still a significant element in the cost structure of many American businesses. For the moment, the drop-off in overall economic growth to date appears about matched by reduced growth in hours, suggesting continued strength in growth in output per hour. The increase of production worker hours from March through June, for example, was at an annual rate of Va percent compared with 3V4 percent the previous 3 months. Of course, we do not have comprehensive measures of output on a monthly basis, but available data suggest a roughly comparable deceleration. 32 A lower overall rate of economic growth that did not carry with it a significant deterioration in productivity growth obviously would be a very desirable outcome. It could conceivably slow or even bring to a halt the deterioration in the balance of overall demand and potential supply in our economy. As I testified before this Committee in February, domestic demand growth, influ- enced importantly by the wealth effect on consumer spending, has been running 1 '/2 to 2 percentage points at an annual rate in excess of even the higher, productivity- driven growth in potential supply since late 1997. That gap has been filled both by a marked rise in imports as a percent of GDP and by a marked increase in domestic production resulting both from significant immigration and from the employment of previously unutilized labor resources. I also pointed out in February that there are limits to how far net imports—or the much broader measure, our current account deficit—can rise, or our pool of un- employed labor resources can fall. As a consequence, the excess of the growth of do- mestic demand over potential supply must be closed before the resulting strains and imbalances undermine the economic expansion that now has reached 112 months, a record for peace or war. The current account deficit is a proxy for the increase in net claims against U.S. residents held by foreigners, mainly as debt, but increasingly as equities. So long as foreigners continue to seek to hold ever-increasing quantities of dollar invest- ments in their portfolios, as they obviously have been, the exchange rate for the dol- lar will remain firm. Indeed, the same sharp rise in potential rates of return on new American investments that has been driving capital accumulation and accelerating productivity in the United States has also been inducing foreigners to expand their portfolios of American securities and direct investment. The latest data published by the U.S. Department of Commerce indicate that the annual pace of direct plus portfolio investment by foreigners in the U.S. economy during the first quarter was more than 2Va times its rate in 1995. There has to be a limit as to how much of the world's savings our residents can borrow at close to prevailing interest and exchange rates. And a narrowing of dis- parities among global growth rates could induce a narrowing of rates of return here relative to those abroad that could adversely affect the propensity of foreigners to invest in the United States. But, obviously, so long as our rates of return appear to be unusually high, if not rising, balance of payments trends are less likely to pose a threat to our prosperity. In addition, our burgeoning budget surpluses have clearly contributed to a fending off, if only temporarily, of some of the pressures on our bal- ance of payments. The stresses on the global savings pool resulting from the excess of domestic private investment demands over domestic private saving have been mitigated by the large Federal budget surpluses that have developed of late. In addition, by substantially augmenting national saving, these budget surpluses have kept real interest rates at levels lower than they would have been otherwise. This development has helped foster the investment boom that in recent years has contributed greatly to the strengthening of U.S. productivity and economic growth. The Congress and the Administration have very wisely avoided steps that would materially reduce these budget surpluses. Continued fiscal discipline will contribute to maintaining robust expansion of the American economy in the future. Just as there is a limit to our reliance on foreign saving, so too is there a limit to the continuing drain on our unused labor resources. Despite the ever-tightening labor market, as yet, gains in compensation per hour are not significantly outstrip- ping gains in productivity. But as I have argued previously, should labor markets continue to tighten, short of a repeal of the law or supply and demand, Jabor costs eventually would have to accelerate to levels threatening price stability and our con- tinuing economic expansion. The more modest pace of increase in domestic final spending in recent months suggests that aggregate demand may be moving closer into line with the rate of advance in the economy's potential, given our continued impressive productivity growth. Should these trends toward supply and demand balance persist, the ongoing need for ever-rising imports and for a further draining of our limited labor resources should ease or perhaps even end. Should this favorable outcome prevail, the imme- diate threat to our prosperity from growing imbalances in our economy would abate. But as I indicated earlier, it is much too soon to conclude that these concerns are behind us. We cannot yet be sure that the slower expansion of domestic final de- mand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncer- tainty about whether the current level of labor resource utilization can be main- tained without generating increased cost and price pressures. As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up—even the core measures that 33 do not include energy prices directly. Higher rates of core inflation may mostly re- flect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation. Moreover, energy prices may pose a challenge to containing inflation. Energy price changes represent a one-time shift in a set of crucial prices, but by themselves gen- erally cannot drive an ongoing inflation process. The key to whether such a process could get underway is inflation expectations. To date, survey evidence, as well as readings from the Treasury's inflation-indexed securities, suggests that households and investors do not view the current energy price surge as affecting longer-term inflation. But any deterioration in such expectations would pose a risk to the eco- nomic outlook. As the financing requirements for our constantly rising capital investment needs mounted in recent years—beyond forthcoming domestic saving—real long-term in- terest rates rose to address this gap. We at the Federal Reserve, responding to the same economic forces, have moved the overnight Federal funds rate up 1% percent- age points over the past year. To have held to the Federal funds rate of June 1999 would have required a massive increase in liquidity that would presumably have underwritten an acceleration of prices and, hence, an eventual curbing of economic growth. By our meeting this June, the appraisal of all the foregoing issues led the Federal Open Market Committee to conclude that, while some signs of slower growth were evident and justified standing pat at least for the time being, they were not suffi- ciently compelling to alter our view that the risks remained more on the side of higher inflation. As indicated in their forecasts, FOMC members and nonvoting presidents expect that the long period of continuous economic expansion will be extended over the next l¥z years, but with growth at a somewhat slower pace than that over the past several years. For the current year, the central tendency of Board members' and Re- serve Bank presidents' forecasts is for real GDP to increase 4 to 4Vz percent, sug- gesting a noticeable deceleration over the second half of 2000 from its likely pace over the first half. The unemployment rate is projected to remain close to 4 percent. This outlook is a little stronger than that anticipated last February, no doubt owing primarily to the unexpectedly strong jump in output in the first quarter. Mainly re- flecting higher prices of energy products than had been foreseen, the central tend- ency for inflation this year in prices for personal consumption expenditures also has been revised up somewhat, to the vicinity of 2Va to 23/4 percent. Given the much firmer financial conditions which have developed over the past 18 months, the Committee expects economic growth to moderate somewhat next year. Real output is anticipated to expand 314 to 3% percent, somewhat less rapidly than in recent years. The unemployment rate is likely to remain close to its recent very low levels. Energy prices could ease somewhat, helping to trim PCE inflation next year to around 2 to 21/2 percent, somewhat above the average of recent years. Conclusion The last decade has been a remarkable period of expansion for our economy. Fed- eral Reserve policy through this period has been required to react to a constantly evolving set of economic forces, very often at variance with historical relationships, changing Federal funds rates when events appeared to threaten our prosperity, and refraining from action when that appeared warranted. Early in the expansion, for example, we kept the rates unusually low for an extended period, when financial sector fragility held back the economy. Most recently we have needed to raise rates to relatively high levels in real terms in response to the side effects of accelerating growth and related demand-supply imbalances. Variations in the stance of policy— or keeping it the same—in response to evolving forces are made in the framework of an unchanging objective—to foster as best we can those financial conditions that are most likely to promote sustained economic expansion at the highest rate pos- sible. Maximum sustainable growth, as history amply demonstrates, requires price stability. Irrespective of the complexities of economic change, our primary goal is to find those policies that best contribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal. 34 For use at 10:00 a.m., EOT Thursday July 20, 2000 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 20, 2000 35 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington. D.C., July 20, 2000 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to forward its Monetary Policy Report to the Congress. Strwerely, Alan Greenspan, Chairm 36 Table of Contents Page Monetary Policy and the Economic: Outlook I Economic and Financial Developments in 2000 4 37 Monetary Policy Report to the Congress Report forwarded to ike Congress on Jul\ 20. 2000 tighter monetary policy and rising interest rates in most other industrial countries. Perhaps partly reflecting firmer financial condi- MONETARY PQUCY Mb THE tions, Ihe incoming economic data since May have ECONOMIC OUTLOOK suggested some moderation in the growth of aggre- gate demand. Nonetheless, labor markets remained The impressive performance of the U.S. economy light at the lime of the FOMC meeting in June, and it persisted in the firs! half of 2000 with economic was unclear whether Ihe slowdown represented a activity expanding at a rapid pace. Overall rates of decisive shift to more sustainable growth or just a inflation were noticeably higher, largely as a result pause. The Committee left the stance of policy of steep increases in energy prices. The remarkable unchanged but saw the balance of risks to the eco- wave of new technologies and the associated surge in nomic oullook as stil! weighted toward rising capital investment have continued to boost potential inflation. supply and to help contain price pressures at high levels of labor resource use. At the same time, rising productivity growth—working through its effects Monetary Policy, Financial Markets. on wealth and consumption, as well as on investment and the Economy over the First Half of 2000 spending—has been one of Ihc important factors contributing to rapid increases in aggregate demand When the FOMC convened for its first two meetings that have exceeded even the stepped-up increases of Ihe year, in February and March, economic condi- in potential supply. Under such circumstances, and tions in the Uniied Stales were pointing toward an with the pool of available labor already at an unusu- increasingly lam labor market as a consequence of ally low level, Ihc continued expansion of aggregate a persistent imbalance between the growth rates of demand in excess of the growth in potential supply aggregate demand and potential aggregate supply. increasingly threatened to set off greater price pres- Reflecting the underlying strength m spending and sures. Because price stability is essential to achieving expectations of tighter monetary policy, market inter- maximum sustainable economic growth, heading off est rates were rising, especially after the century date these pressures has been critical to extending the change passed without incident. But, at the same extraordinary performance of the U.S. economy. time, equity prices were still posting appreciable To promote balance between aggregate demand gains on nel. Knowing thai the iwo safety valves that and potential supply and to contain inflation pres- had been keeping underlying inflation from picking sures, the Federal Open Market Committee (FOMC) up until then—Ihe economy's ability to draw on the took additional firming actions this year, raising the pool of available workers and !o expand its trade benchmark federal funds rate I percentage point deficit on reasonable terms—could not be counted on between February and May. The tighter stance of indefinitely, the FOMC voted for a further tightening monetary policy, along with the ongoing strength of in monetary policy at both its February and its March credit demands, has led to less accommodative finan- meetings, raising the target for the overnight federal cial conditions: On balance, since the beginning of the funds rate 25 basis points on each occasion. In related year, real interest rates have increased, equity prices actions, the Board of Governors also approved have changed little after a sizable run-up in 1999, and quarter-point increases in Ihe discount rate in both tenders have become more cautious about emending February and March. credit, especially to marginal borrowers. Still, house- The FOMC considered larger policy moves at its holds and businesses have continued to borrow at a first two meetings of 2000 but concluded thai signifi- rapid pace, and the growth of M2 remained relatively cant uncertainty about the outlook for the expansion robust, despite the rise in market interest rates. The of aggregate demand in relation to that of aggregate favorable outlook for the U.S. economy has contrib- supply, including the liming and strength of ihe uted to a further strengthening of the dollar, despite economy's response to earlier monetary policy tight- 38 2 Monetary Policy Report to (he Congress D July 2000 Selected interest i N<m. The dou MT daily Venial lines lockout ihc days on which the Federal Rcsovr umnunced a chancre m Ihe inunded runtta rak The daiei on the enings, warranted a more limited policy aciion. Still, spread market expectations of such an aciion. Even noting thai there had been few signs that the rise in after taking into account its latest action, however, interest, rates over recent quarters had begun to bring the FOMC saw the strength in spending and pres- demand in line with potential supply, the Committee sures in labor markets as indicating that the balance decided in both instances thai the balance of risks of risks remained tilted toward rising inflation. going forward was weighted mainly in the direction By the June FOMC meeting, the incoming data of rising inflation pressures. In particular, il was were suggesting that the expansion of aggregate de- becoming increasingly clear that the Committee mand might be moderating toward a more sustainable would need to move more aggressively at a later pace: Consumers had increased their outlays for meeting if imbalances continued to build and infla- goods modestly during the spring; home purchases tion and inflation expectations, which had remained and starts appeared to have softened; and readings on relatively subdued until ihen. began 10 pick up.1 the labor market suggested that the pace of hiring Some readings between the March and May meet- might be cooling off. Moreover, much of the effects ings of the FOMC on labor costs and prices sug- on demand of previous policy firmings, including the gested a possible increase of inflation pressures. 50 basis point tighten ing in May, had not yet been Moreover, aggregate demand had continued to grow fully realized. Financial market participants inter- at a fast clip, and markets for labor and other preted signs of economic slowing as suggesting that resources were showing signs of further tightening. the Federal Reserve probably would be able to hold Financial market conditions had firmed in response to inflation in check without much additional policy these developments; the substantial rise in private firming. However, whether aggregate demand had borrowing rales between March and May had been moved decisively onto a more moderate expansion influenced by (he buildup in expectations of more track was not yet clear, and labor resource utilization policy tightening as market participants recognized remained unusually elevated. Thus, although the the need for higher short-term interest rates. Given all FOMC decided to defer any policy aciion in June, it these circumstances, the FQMC decided in May to indicated that the balance of risks was still on the side raise the target for the overnight federal funds rate of rising in Ration in the foreseeable future.2 SO basis points, to 6Y* percent. The Committee saw little risk in the more forceful aciion given the strong momentum of (he economic expansion and wide- 2 M hs June meeting. Ihe FOMC rW rax establish ranges for jrawh of money and deW in 3000 and 2001. The legal requirement to establish ml TO announce nicti ranges lad expired and owing m nnmtainitts abota the behavior of The velocities of (kin and money, 1. At its March ond May m«nii(s, the FOMC took a number of these raflfcs for many years tint not provided useful benchmark! for actions ihv vert ami • adjuring the imptementaiWm of moocary the conduct of monetary policy. Nevertheless, the FOMC believes Uui policy lo actual md prospective reductions in ihe Hock of Treasury the behavior of money and ciedii will continue 10 have value for deni ncyriiitt. These octiont are described in the disunion or U S. gauging canonic end financial omdiikms. am) inis report discuss** financia recent developmenK in money and ciedM in mine detail. 39 Board of Governors of the Federal Reserve System 3 Economic Projections for 2000 and 2001 high, and given the rapid pace of technological change, firms will continue u> exploit opportunities to The members of the Board of Governors and [he implement more-efficient processes and to speed the Federal Reserve Bank presidents expect the current Row of information across markets. In such an envi- economic expansion to continue through next year, ronment, a further pickup in productivity growth is a but tU a more moderate pace than the average over distinct possibility. However, a portion of the very recent quarters. For 2000 as a whole, the central rapid rise in measured productivity in recent quarters tendency of their forecasts for the rate of increase may be a result of the cyclical characteristics of ibis in real gross domestic product (GDP) is 4 percent to expansion rather than an indication of structural rates 4!£ percent, measured as the change between the of increase consistent with holding the level of fourth quarter of 1999 and the fourth quarter of 2000. resource utilization unchanged. Current levels of Over the four quarters of 2001. the central tendency labor resource utilization are already unusually high. forecasts of real GDP are in the 3Vi percent lo To date, this has not led to escalating unit labor costs, 3% percent range. With this pace of expansion, the but whether such a favorable performance in the civilian unemployment rate should remain near its labor market can be sustained is one of the important recent level of 4 percent. Even with the moderation in uncertainties in the outlook. the pace of economic activity, the Committee mem- On the demand side, the adjustments in financial bers and nonvoting Bank presidents expect that infla- markets that have accompanied expected and actual tion may be higher in 2001 than in 1999, and the tighter monetary conditions may be beginning to Committee will need to be alert to the possibility that moderate the rise in domestic demand. As thai pro- financial conditions may need to be adjusted further cess evolves, the substantial impetus that household to balance aggregate demand and potential supply spending has received in recent years from rapid and to keep inflation tow. gains in equity wealth should subside. The higher Considerable uncertainties attend estimates of cost of business borrowing and more-restrictive credit potential supply—both the rate of growth and the supply conditions probably will not exert substantial level of the economy's ability to produce on a sus- restraint on investment decisions, particularly as long tained non-inflationary basis. Business investment in as the costs and potential productivity payoffs of new new equipment and software has been exceptionally equipment and software remain attractive. The slow- ing in domestic spending will not be fully reflected in a more moderate expansion of domestic production. 1. Economic projections for 2000 and 2001 Some of the slowing will be absorbed in smaller increases in imports of goods and services, and given -~ l-ederal Mucne povewrt continued recovery in economic activity abroad, and Reicrvc B*n* peiidHHi domestic firms are expected to continue seeing a B""™f, t C n t r n i 0 w^y «— boost to demand and to production from rising exports. MOO Regarding inflation. FOMC participants believe that the rise in consumer prices will be noticeably larger this year than in 1999 and that inflation will ihen drop bacV somewhat in 2001. The central ten- dency of their forecasts for the irwrease in the chain- type index for personal consumption expenditures is 2Vi percent to 2-V-i percent over the four quarters of 2000 and 2 percent lo 2'A percent during 2001. Shaping the contour of this inflation forecast is the expectation that the direct and indirect effects of the Hamiwt OCT boos! to domestic inflation this year from the rise in Red GDI" rce pm» the price of world crude oil will be partly reversed next year if, as futures markets suggest, crude oil prices retrace this year's run-up by next year. None- theless, these forecasts show consumer price inflation 1. Ounce hod ivcn^c K» founh quWf oi pitvinu yev to i in 2001 lo have moved above the rates that prevailed f«rnh (pincr at fttt nt&csteA over the 1997-93 period. Such a trend, were it not to show signs of quickly stabilizing or reversing, would 40 pose a considerable risk to the continuation of the Change in PCS chain-iypL' price inde< extraordinary economic performance of reccni years. The economic forecasts of ihe FOMC are similar to those recently released by ihc Administration In its Mid-Session Review of the Budget. Compared with the forecasts available in February, the Administra- tion raised its projections for the increase in real GDP in 2000 and 2001 to rates thai lie at the low end of the current range of central tendencies of Federal Reserve policymakers. The Administration also expects that the unemployment rale will remain close to 4 per- IlilJ cent. Like the FOMC, the Administration sees con- sumer price inflation rising this year and failing back in 2001. After accounting for the differences in ihe construction of the alternative measures of consumer IWI IW IW6 1907 1WS \WP> J!X»1 prices, the Administration's projections of increases in the consumer price index (CPI) of 3.2 percent in 2000 and 2.5 percent in 2001 are broadly consistent with the Committee's expectations for the chain-type second half of 1999, were particularly robust, rising price index for personal consumption cxpcndilures. at an annual rale of almost 10 percent in the first quarter. Underlying that surge in domestic spending were many of the same faciors that had contributed ECONOMIC AND FINANCIAL DEVELOPMENTS to the considerable strength of outlays in the second IN 2000 half of 1999. The ongoing influence of substantial increases in real income and wealth continued to fuel The expansion of U.S. economic activity maintained consumer spending, and business investment, which considerable momentum through the early months of continues to be undergirded by the desire to take 2000 despite the tinning in credit markets that has advantage of new. cost-saving technologies, was fur- occurred over the past year. Only recently has the ther buoyed by an acceleration in sales and profits pace of real activity shown signs of having moder- late last year. Export demand posted a solid gain ated from the extremely rapid rate of increase that during the first quarter while imports rose even more prevailed during the second half of 1999 and the rapidly to meet booming domestic demand. The first quarter of 2000. Real GDP increased at an annual available data, on balance, point to another solid rate of 5W percent in the first quarter of 2000. Privale increase in real GDP in the second quarter, although domestic final sales, which hud accelerated in the ihey suggest thai private household and business fixed investment spending likely slowed noticeably from the extraordinary first-quarter pace. Through Change in real GDP June, the expansion remained brisk enough to keep labor utilisation near the very high levels reached at the end of 1999 and to raise the factory utilization rate to close to its long-run average by early spring. Inflation rates over the lirsl half of 2000 were elevated by an additional increase in the price of imported crude oil. which led to sharp hikes in retail energy prices early in the year and again around midyear. Apart from energy, consumer price infla- tion so far this year has been somewhat higher than during 1999, and some of thai acceleration may be attributable to the indirect effects of higher energy costs on the prices ot' core goods and services. Sustained strong gaim in worker productivity LW7 IWS 1W9 MOO have kept increases in unit labor costs minimal despite the persistence of a historically low rate of unemployment. 41 Board of Goifmon of the Federal Restrvt System 5 Change in reai income and consumption In recent months, the rise in consumer spending has moderated considerably from the phenomenal pace of the first quarter, with much of the slowdown in outlays for goods. At an annual rate of 17 V* mil- lion units in the second quarter, light motor vehicles sold at a rate well below their first-quarter pace. Nonetheless, (hat level of sales is still historically high, and wilh prices remaining damped and auto- makers continuing to use incentives, consumers' assessments of the motor vehicle market continue to be positive. The information on retail sales for the ApriWf-Iune period iiwlicale thai consumer expendi- tures for other goods rose markedly slower in the second Quarter than in the first quarter, at a pace well IN6 tWT 1W8 IW JOOO below the average rate of increase during the pre- ceding two years. In contrast, personal consumption expendilures for consumer services continued lo rise 'ousehold Sector relatively briskly in April and May. Real disposable personal income increased at an Consumer Spending annual rale of about 3 percent between December and May—slightly below (he 1999 pace of 3'/i per- Consumer spending was exceptionally vigorous dur- cent. However, Ihe impetus to spending from the ing the first quarter of 2000. Real personal consump- rapid rise in household net worth was still consider- tion expenditures rose at an annual rate of 73/4 per- able, labor markets remained tight, and confidence cent, the sharpest increase since early 1983. At that was still high. As a result, households continued to time, the economy was rebounding from a deep aliow their spending to outpace their How of current recession during which households had deferred income, and Ihe personal saving rate, as measured in discretionary purchases. In contrast, the first-quarter the national income and product accounts, dropped surge in consumption came on the heels of two years further, averaging less than I percent during the fim of very robust spending during which real outlays five months of the year. increased at an annual rate of more than 5 percent, After having boosted the ratio of household net and the personal saving rate dropped sharply. worth to disposable income to a record high in the Outlays for durable goods, which rose at a very first quarter, stock prices have fallen hack, suggesting fasi pace in 1998 and 1999, accelerated during the less impetus lo consumer spending going forward. In first quarter lo an annual rate of more than 24 percent. addition, smaller employment gains and the pickup in Most notably, spending on motor vehicles, which had climbed to a new high in 1999, jumped even further in the first quarter of 2000 as unit sales of light moior Wealth and saving vehicles soared to a record rale of IB.l million units. In addition, households' spending on computing equipment and software rebounded after the turn of the year; some consumers apparently had postponed their purchases of these goods in laic 1999 before the century dale change. Outlays for nondurable goods posted a solid increase of 5Vi percent in the first quarter, marked by a sharp upturn in spending on clothing and shoes. Spending for consumer services also picked up in the first quarter, rising at an annual rate of 5'/> percent. Spending was quite brisk for a number of non-energy consumer services, ranging from recreation and telephone use to brokerage fees. Also contributing to the acceleration was a rebound tVJV IW3 l«t> IWO IfU 1998 in outlays for energy services, which had declined in late 1999. when weather was unseasonably warm. 42 6 Monetary Policy Repon 10 UK Congress D My 2000 energy prices have moderated the rise in real income lowest level in more than nine years. Survey respon- of lale. Although these developments left some dents noted that, besides higher financing costs, imprint on consumer attitudes in June, households higher prices of homes were becoming a factor in remained relatively upbeat about their prospective iheir less positive assessment of market conditions. financial situation, according to [he results of tfie Purchases of existing homes were little changed, University of Michigan Survey Research Center on balance, in April and May from the firsi-quarter (SRC) survey. However, ihey became a bil less posi- average; however, because these sales arc recorded & tive about the outlook for business conditions and the time of closing, they tend to be a lagging indica- saw a somewhat greater likelihood of a rise in unem- tor of demand. Sates of new homes—a more current ployment over Ihe coming year. indicator—fell hack in April and May, and home- builders reported thai sales dropped further in June. Perhaps a sign that softer demand has begun to affect Residential Investment con struct i on, suns of new single-family homes slipped to a rale of I Vi million units in May. That Housing activity stayed at a high level during the firsi level of new homebuilding, although noticeably half of this year. Hume builders began the year with a slower than the robust pace thai characterized the fall considerable backlog of projects thai had developed and winter period, is only a bit below the elevated as the exceptionally strong demand of the previous leve! that prevailed throughout much of 1998. when year strained capacity. As a result, they maintained single-family starts reached their highest le%'el in starts of new single-family homes at an annual rate of twenty years. Starts lit" mullifamify housing unils, 1.33 million units, on average, through April— which also had stepped up sharply in the first quarter matching 1999's robust pace. Households' demand of the year, to an annual rate of 390.000 units, settled for single-family homes was supported early in the back to a 340,0(10 unit rate in April and May. year by ongoing gains in jobs and income and the earlier run-up in wealth; those forces apparently were sufficient to offset the effects that higher mortgage Household Finance interest rates had on the affoniabfljly of new homes. Sales of new homes were particularly robust, setting Fueled by robust spending, especially early in the a new record by March; but sales of existing units year, the expansion of household debt remained brisk slipped below their 1999 high. As a result of the during the first half of 2000. although below the very continued strength in sales, the home-ownership rate strong 1999 growth rale. Apparently, a favorable reached a new high in the first quarter. outlook for income and employment, along with ris- By the spring, higher mortgage interest rates were ing wealth, made households feel confident enough leaving a clearer mark on the altitudes of both con- to continue to spend and take on debt. Despite rising sumers and builders. The Michigan SRC survey mortgage and consumer ioan rates, household debt reported that households' assessments of homebuy- increased at an annual rale of nearly 8 percent in the ing conditions dropped between April and June to ihe firsi quarter, and preliminary data point to a similar increase in the second quarter. Mortgage debt expanded at an annual rate of 7 per- Private bousing starts cent in the first quarter, boosted by the high level of housing activity. Household debt not secured by real estale—including credit card balances and auto loans—posted an impressive 10 percent gain in the firsi quarter !o help finance a large expansion in outlays for consumer durables, especially motor vehi- cles. The moderaiion in the growth of household debt this year has been driven primarily by ils mortgage component: Preliminary data for the second quarter suggest that, although consumer credit likely deceler- ated from the first quarter, it still grew faster than in 1999. Debt in margin accounts, which is largely a house- hold liability and is not included in reported measures of credit market debt, has declined, on net, in recent 43 Board of Governors of the Federal Resent Syittm 7 Delinquency tales on household loans Change in real business tiled investment Ifl4 i«9;t 1996 WJ I99B 1W» 3)00 <nr Djla « mdH c*rt delmomoe* art from ton* Call Rtvwtrdare on loan dchBquciicica are Irom Iht fl>( Thme waiflBfcers. ilflia <v> mflgoge nquencifs a* noni the Mortgage Bnnki desire to take advantage of more-efficient technolo- gies is diminishing. Real business fixed investment months, following a surge from late in the third surged at an annual rate of almost 24 percent in the quarter of 1999 through the end of March 2000. first quarter of the yeat, rebounding sharply from its There has been no evidence that recent downdrafts in lull at the end of 1999. when firms apparently post- share prices this year caused serious repayment prob- poned some projects because of the century date lems ai the aggregate level that might pose broader change. In recent months, the trends in new orders systemic concerns. and shipments of nondefense capital goods suggest The combination of rapid debt growth and rising that demand has remained solid. interest rales has pushed (he household debt-service Sustained high rates of investment spending have burden to levels not reached since the 'ale 1980s. been a key feature shaping the current economic Nonetheless, with household income and net worth expansion. Business spending on new equipment and both having grown, rapidly, and employment pros- software has been propelled importantly by ongoing pects favorable, very few signs of worsening credit advances in computer and information technologies problems in the household sector have emerged, and that can be applied to a widening range of business commercial banks have reported in recent Federal processes. The ability of firms to take advantage of Reserve surveys that they remain favorably disposed these emerging de.vekipmeiw.5 has been supjxmed by to make consumer installment and mortgage loans. the strength of domestic demand and by generally Indeed, financial indicators of [he household sector favorable conditions in credit and equity markets. In have remained mostly positive: The rale of personal addition, because these high-technology goods can be bankruptcy filings fel! in the first quarter 10 its lowest produced increasingly efficiently, their prices have level since 1996; delinquency rates on home mort- continued to decline steeply, providing additional gages and auto loans remained low; and the delin- incentive for rapid investment. The result has been a quency rale on credit cards edged down further, significant rise in the stock of capital in use by although it remained in the higher range that has businesses and an acceleration in the flow of services prevailed since the mid-1990s. However, delinquency from that capital as more-advanced vintages of equip- rates may be held down, tn some ex lent, by the surge ment replace older ones. The payoff from the pro- in new loan originations in recent quarters because longed period during which firms have upgraded newly originated loans are less likely to be delinquent their plant and equipment has increasingly shown than seasoned ones. through in the economy's itnpvoved productivity performance. The Business Sector Real outlays for business equipment and software shot up at an annual rate of nearly 25 percent in the Fixed Investment first quarter of this year. That jump followed a mod- est increase in the final quarter of 1999 and put The boom in capital spending extended into we first spending for business equipment and software back half of 2000 with few indications that businesses' on the double-digil uptrend that has prevailed 44 H Monetary Policy Report to the Congress D July 2000 throughout the current economic recovery. Concerns ing on office buildings, other commercial facilities, about potential problems with the century dale and industrial buildings recorded early this year change bad ibe most noticeable effect on the patterns would seem to accord well with the overall strength (if spending for computers and peripherals and for in aggregate demand. However, the fundamentals in communications equipment in ihe fourth and first this sector of the economy are mixed. Available infor- quarters; expenditures for software were also mation suggests that property values for offices, retail affected, although less so. For these categories of space, and warehouses have been rising more slowly goods overall, the impressive resurgence in business than they were several years ago. However, office purchases early this year left little doubt that the vacancy rates have come down, which suggests that, underlying strength in demand for high-tech capital at least at an aggregate level, the office sector is not goods had been only temporarily intermpied by the overbuilt. The vacancy rate for industrial buildings century date change. Indeed, nominal shipments of has also fallen, but in only a few industries, such as office and computing equipment and of communi- semiconductors and other electronic components, are cation devices registered sizable increases over the capacity pressures sufficiently intense to induce sig- April-May period. nificant expansion of production facilities. In the first quarter, business spending on computers and peripheral equipment was up almost 40 percent from a year earlier—a pace in line with the trend of Inventory Investment the current expansion. Outlays for communications equipment, however, accelerated; the first-quarter The ratio of inventories to sales in many nonfarm surge brought the year-over-year increase in spend- industries moved lower early this year. Those firms ing to 35 percent, twice the pace that prevailed a year that had accumulated some additional stocks toward earlier. Expanding Internet usage has been driving the end of 1999 as a precaution against disruptions the need for new network architectures. In addition, related to ihe century date change seemed lo have cable companies have been investing heavily in little difficulty working off those inventories after preparation for their planned entry into ihe markets the smooth transition to the new year. Moreover, the for residential and commercial telephony and broad- first-quarter surge in final demand may have, to some band Internet services, extent, exceeded businesses* expectations. In current- Demand for business equipment outside of the cost terms, non-auto manufacturing and trade estab- high-tech area was also strong at the beginning of the lishments built inventories in April and May at a year. In (he first quarter, outlays for industrial equip- somewhat faster rate than in the first quarter but still ment rose at a brisk pace for a third consecutive roughly in line with the rise in their sales. As a result, quarter as the recovery of the manufacturing sector the ratio of inventories to sates, at current cost, for from the effects of Ihe Asian crisis gained momen- these businesses was roughly unchanged from the tum. In addition, investment in farm and construction first quarter. Overall, the ongoing downtrend in the machinery, which had fallen steadily during most of ratios of inventories 10 sales during the past several 1999, turned up. and shipments of civilian aircraft to years suggests that businesses increasingly are taking domestic customers increased. More recent data show a further rise in the backlog of unfilled orders placed with domestic firms for equipment and machinery Change in real nonfarm business invenlorie (other than high-tech items and transportation equip- nii.iiiiu ment), suggesting that demand for these items has been well maintained. However, business purchases of motor vehicles are likely to drop back in the second quarter from the very high level recorded at the beginning of the year. In particular, demand for heavy trucks appears to have been adversely affected by higher costs of fuel and shortages of drivers. Real investment in private nonresidemial struc- tures jumped at an annual rate of more than 20 per- cent in the first quarter of the year after having declined in 1999. Both last year's weakness and this year's sudden and widespread revival are difficult lo J 1 1 1 I I I UJ explain fully. Nonetheless, the higher levels of spend- l»4 19W 19% 1*97 199S \VH 2WO 45 Board of Cowmen of ihe Federal Reserve System advantage of new technologies and software to imple- BefonHax profits of nonfinancial cciporalkms ment better inventory management. at a share of GDP The swing in inventory investment in the motor vehicle industry has been more pronounced recently. Dealer stocks of new cars and tight trucks were drawn down during the first quarter as sales climbed to record levels. Accordingly, auto and truck makers kept assemblies ai a high level through June in order to maintain ready supplies of popular models. Even though demand appears to have softened and inven- tories of a few models have hacked up, scheduled assemblies for the third quarter arc above the elevated level of the first half. Business Finance I9SU IM.1 14X6 I TO 1991 1W8 2000 Null-. Pnjfltt froa tkrneibf ofVimDOir wilhtfitaoiy valuation M«Jc*ral The economic profits of nonfinancial U.S. corpora- tt*onv*HNi H^OCIIHV divided b> pro domenf product of norritawcial lions posted another solid increase in the firs) quarter The profits that nonftnracia! cwpwaiions earned on their domestic operations were 10 percent above the term sources of credit and less on the bond market, level of a year earlier the rise lifted the share of although the funding mix has fluctuated widely profits in this sector's nominal output close to its in response to changing market conditions. After the 1997 peak. Nonetheless, with investment expanding passing of year-end, corporate borrowers returned to rapidly, businesses' external financing requirements, the bond market in volume in February and March, measured as the difference between capita) expendi- but subsequent volatility in the capital market in tures and internally generated funds, stayed ai a high April and May prompted a pullback. In addition. level in the first half of this year. Businesses' credit corporate bond investors have been less receptive to demands were also supported by cash-financed smaller, less liquid offerings, as has been true for merger and acquisition activity. Total debt of non- sometime. financial businesses increased at a 10!* percent clip In the investment-grade market, bond issuers have in the first quarter, close to the brisk pace of 1999, responded to investors' concents about the interest and available information suggests that borrowing rate and credit outlook by shortening the maturities of remained strong into the second quarter. their offerings and by issuing more Boating-rate secu- On balance, businesses have altered the composi- rities. In the below-investment-grade market, many tion of their funding this year to rely more on shorter- of the borrowers who did tap the band market in Cross corporate bond issuance 1 J A S Q N D J F M A MJ J A S O N OJ F M A MJ Niilt. Eiclinfc! unnuM r 46 10 Monetary Policy Report In the Congress D July 2000 SpreaJs of corporate bond yields Default rates on outstanding junk bonds over the ten-year swap rate 1 1 • ••••III I IASONDJ KM AM I ] A5ONI1J TMAMI J iw* iwi rooo Ntm. The iota jic dwl>- The sprKhll "Hnpare U* yiultb 01 Ibt Mcrntt Ljnth J.A. BBS ml 175 mdnci until Ihe ten-yen iw<u> on tram BloombciJ l.mi Miisi.aioni are lot July 17. '(CO banks have expanded briskly, even as a larger per- centage of banks have reported in Federal Reserve February and March did so hy issuing convertible surveys thai they have been tightening standards and bonds and other equity-related debt instruments. Sub- terms on such loans. sequently, amid increased equity market volatility Underscoring lenders' concerns about the credit- and growing investor uncertainty abou! the outlook won hincss of borrowers, the ratio of liabilities of for prospective borrowers, credit spreads in the cor- failed businesses to total liabilities has increased fur- porate bond market widened, and issuance in the ther so far this year, and the default rate on outstand- below-invest menl-grade market dropped sharply in ing junk bonds has risen further from the relatively April and May. Conditions in the corporate bond elevated level reached in 1999. Through midyear, market calmed in iaie May and June, and issuance Moody's Investors Service has downgraded, on net, recovered 10 close to its first -quarter pace. more debt in the non financial business sector than it As the bond market became less hospitable in the has upgraded, although it has placed more dent on spring, many businesses evidently turned to banks watch for future upgrades than downgrades. and to the commercial paper market for financing. Commercial mortgage borrowing has also Partly as & result, commercial and industrial loans al expanded at a robust pace over the first half of 2000. as investment in office and other commercial building strengthened. Emending lasi year's ircnd. borrowers Ratio of liabilities of failed nonfinancial firms have tapped banks and life insurance companies as to liabilities of jll non financial firm> the financing sources of choice. Banks, in particular, have reported stronger demand for commercial real estate loans this year even as they have lighlened standards a bii for approving such loans. In ihe mar- ket foi commercial mortgage-backed securities, yields have edged higher since the beginning ol the year. 111 The Government Sector Federal Govern mem lllllllllll The incoming information regarding the federal hud- gel suggests that Ihe surplus in (he current fiscal year will surpass last year's hy a considerable amount. Over ihe first eight months of fiscal year 2000—the 47 Board of Governors ofihf Federal Reserve System 11 National saving at a share of nominal GNP saving chat occurred over the same period. As a result, gross saving by households, businesses, and governments has stayed above 18 percent of GNP since 1997. compared with t6'A percent over (he preceding seven years. The deeper pool of national saving, along with the continued willingness of for- eign investors to finance our current account deficit, remains an important factor in containing increases in the cost of capital and sustaining the rapid expansion of domestic investment. With longer-run projections showing a rising federal government surplus over the next decade. Ihis source of national saving could continue to expand. The reccn! good news on the federal budget has been primarily on the receipts side of the ledger. Nonwithheld tax receipts were very robust this spring. Both final payments, on personal income lax liabilities for 1999 and final corporate tax payments period from October lo May—the unified budget for 1999 were up substantially. So far this year, the recorded a surplus of about SI 20 billion, compared withheld tax and social insurance contributions on with $41 billion during ihe comparable period of \his year's earnings of individuals have also been fiscal 1999. The Office of Management and Budget strong. As a result, federal receipts during the first and the Congressional Budget Office are now fore- eight months of the fiscal year were almost 12 per- casting thai, when the fiscal year closes, the unified cent higher than they were during the year-earlier surplus will be around $225 billion to $230 billion, period. $100 billion higher than in the preceding year. That While receipts have accelerated, federal expendi- oulcome would likely place the surplus at more lhan tures have been rising only a little faster than during 2V* percent of GDP, which would exceed the most fiscal 1999 and continue to decline as a share of recent high of 1.9 percent, which occurred in 1951. nominal GDP. Nominal outlays for the first eight The swing in [he federal budget from deficit to months of the current fiscal year were W* percent surplus has been an important factor in maintaining above the year-earlier period. Increases in discretion- national saving. The rise in federal saving as a per- ary spending have picked up a bit so rai this yew. In centage of gross national product from -3.5 percent particular, defense spending has been running higher in 1992 to 3.1 percent in the first quarter of this year in the wake of ihe increase in budget authority has been sufficient (o offset the drop in personal enacted last year. The Congress has also boosted agricultural subsidies in response to the weakness in farm income. While nondiscretionary spending con- Federal receipts and ospenditures as a share at nominal GDP tinues to be held down by declines in net interest payments, categories such as Medicaid and other health programs have been rising more rapidly of late. As measured by the national income and product accounts, real federal expenditures for consumption and gross investment dropped sharply early (his year after having surged in the fourth quarter of 1999. These wide quarter-to-quarter swings in federal spending appear to have occurred because. the Depart- ment of Defense speeded up iis payments to vendors before the century date change; actual deliveries of defense goods and services were likely smoother. On average, teal defense spending in the fourth and first quarters was up moderately from (he average level in fiscal 1999. Real nondefense outlays continued to t B o u r t M ft: e ) n ,, u th c e c Q um ftc i rise slowly. 48 12 Monetary Policy Report 10 ihe Congress D July 2000 Federal government debt held by the public soned, less liquid, deb! securities with surplus cash, enabling it to issue more "on-the-run" securities. The Treasury noted that it would buy hack as much as $30 billion this year. The first operation took place in March, and in May the Treasury announced a schedufc of two operations per mnrtth through the end of July of this year. Through midyear, the Treasury has conducted eight buyback operations, redeeming a total of S15 billion. Because an impor- tant goal Ot" the buyback program is to help forestall further increases in the average maturity of the Trea- sury's publicly heid debt, the entire amount redeemed so far has corresponded to securities with remaining maturities at the long end of the yield curve (at least IW9 fifteen years]. !*>n Tht dam « annual and titentl IlKWifh 2000. Fuferal M* held t) p^Die inveMcn is giva* federal d*W feu itbi IwU b> frdeial Fowrnmeil ati-iHHM *Tj MK fedrutl Rfseiw Syuen Thr vatef /« 3000 is an cwiiruih-- bated «i ihf A*ruD«nuiuB'.lii« St MiASMHion RC.KH nl*t Budjln State and Local Governments In the state and local sector, real consumption and With current hadget surpluses coming in above investment expenditures registered another strong expectations and large surpluses projected 10 con- quarter at the beginning of this year. In part, the tinue for the foreseeable future, the federal govern- unseasonably good weather appears to have accom- ment has taken additional steps aimed at preserving a modated more construction spending than usually high level of liquidity in the market for its securities. occurs over the winter. However, some of the recent Expandirig on efforts to concentrate its declining dent rise is an extension of the step-up in spending that issuance in fewer highly liquid securities, the Trea- emerged last year, when real outlays rose 5 percent sury announced in February its intention to issue only after having averaged around 3 percent for the pre- iwo new five- and ten-year notes and only one new ceding three years. Higher fedcrai grams for highway thirty-year bond each year. The auctions of five- and construction have contributed to the pickup in spend- len-year notes will remain quarterly, alternating ing. In addition, many of these jurisdictions have between new issues and smaller reopemngs. and the experienced solid improvements in their fiscal condi- bond auctions will be semiannual, also alternating tions, which may be allowing them to undertake new between new and smaller reopened offerings. The spending initiatives. Treasury also announced that it was reducing the The improving fiscal outiook for slate and local frequency of its one-year bill auctions from monthly governments has affected both ihe issuance and the to quarterly and cutting the size of the monthly quality of state and local debt. Borrowing by slates two-year note auctions. In addition, the Treasury and municipalities expanded sluggishly in the first eliminated the April auction of the thirty-year half of this year. In addition to ihe favorable budget- inflation-indexed bond and indicated that the size of ary picture, rising interest rates have reduced the the ten-year in nation-indexed note offerings would demand for new capital financing and substantially be modestly reduced. Meanwhile, anticipation of limited refunding issuance. Credit upgrades have out- even larger surpluses in the wake of the surprising numbered downgrades hy a substantial margin in the strength of incoming tax receipts so far in 2000 led stale and local sector. the Treasury to announce, in May, that it was again catling ihe size of Ihe roonlhly two-year note auc- lions. The Treasury also noted thai it is considering The External Sector additional changes in its auction schedule, including ihe possible elimination of ihe one-year bill auctions Trade and Current Account and a reduction in the frequency of its two-year note auctions. The deficits in U.S. external balances have conlinued Early in the year, the Treasury urtt'eited (he doails to get even larger Ihis year. The current account of its previously announced re verse-auction, or debt deficit reached an annual rate of $409 billion in the huyhack, program, whereby it intends lo retire sea- first quarter of 2000, or 4h/t percent of GDP. com- 49 Board of Governors of Ihf Federal Reserve S\sttm ciation. By market destination, U.S. exports to Can- ada, Mexico, and Europe increased the most. By product group, export expansion was concentrated in capita! equipment, industrial supplies, and consumer goods. Preliminary data for April suggest that growth of real exports remained strong. The quantity of imported goods and services con- tinued [o expand rapidly in the first quarter. The increase in imports, at an annual rale of 11 y> percent, was the same in the first quarter as in the second haif of 1999 and reflected both the continuing strength of U.S. domestic demand and the effects of past dollar appreciation on price competitiveness. Imports of consumer goods, automotive products, semicon- 1904 |W< 11% IWV ms TW9 ductors, telecommunications equipment, and other machinery were particularly robust. Data for April suggest that the second quarter got off to a sirong pared with $372 billion and 4 percent in the second start. The price of non-oil goods imports rose at an half of 1999. Ncl payments of investment income annual rate of l*/4 percent in the first nuarier, the were a hit less in the firsc quarter than in the second second consecutive quarter of sizable price increases hall' of last year owing to a sizable increase in income following four years of price declines; non-oil import receiptsi from direct iftvestmenl abroad. Most of the prices in the second quarter posted only moderate expansion in the current account deficit occurred in increases. trade in goods and services. In the first quarter, (he A number of developments affecting world oil deficit in trade in goods and services widened to an demand and supply led to a further step-up in the spot annual rate of $345 billion, a considerable expansion price of Wesi Texas intermediate (WTI| crude this from ihc deficit of $298 billion retorted in the sec- year, along with considerable volatility. In the wake ond half of 1999. Trade data for April suggest that of the plunge of world oil prices during 1998, the the deficit may have increased further in the second Organization of Petroleum Exporting Countries quarter. (OPEC] agreed in early 1999 to production rcstramts U.S. exports of real goods and services rose at an that, by late in the year, restored prices to their 1997 annual rate of 6Vi percent in the first quarter, follow- level of about t20 per barrel. Subsequently, contin- ing a strong increase in exports in the second half of ued recovery of world demand, combined with some last year. The pickup in economic activity abroad that began in 1999 continued (o support export demand dSid partly offset negative effects on price competi- Prices for oil and older commodities tiveness of U.S. products from the dollar's past appre- Change in real imports anil exports or" goods and service1 50 14 Monetary Policy Report 10 ihe Congress D July 2000 supply disruptions, caused the WTI spol price to investment was associated with cross-border merger spike above $34 per barrel during March of this year, activity. the highest level since the Gulf War more than nine Capita] inflows from foreign official sources in the years earlier. Oil prices dropped back temporarily in first quarter of this year were sizable—$20 billion, April, hut in May and June (he price of crude oi! compared with .$43 billion for all of 1999. As was the moved back up again, as demand was boosted further case last year, the increase in foreign official reserves by strong global economic activity and by rebuilding in the United Stales in the first quarter was concen- of oil stocks. In late June, despite an announcement trated in a relatively few countries. Partial data for by OPEC that it would boost production, the WTI ihe second quarter of 2000 show a small official spot price reached a new high of almost $35 per out tow. barrel, hul by early July the price had settled back to ahoul $30 per barrel. The labor Markei Financial Account Employment and Labor Supply Capital flows in the first quarter of 2000 continued to The labor market in early 2000 continued to be reflect the relatively strong performance of the U.S. characterized by substantial job creation, a histori- economy and transactions associated with global cally low level of unemployment, and sizable corporate mergers. Foreign private purchases of U.S. advances in productivity thai have held labor costs in securities remained brisk—well above the record check. The rise in overall nonfarm payroll employ- pace set last year. In addition, the mix of U.S. securi- ment, which totaled more lhan 1 '/• million over the ties purchased by foreigners in the [irsl quarter first half of the year, was swelled by the federal showed a continuation of last year's trend toward government's hiring of intermittent workers to con- smaller holdings of U.S. Treasury securities and duct the decennial census. Apart from that temporary larger holdings of U.S. agency and corporate securi- boosi. which accounted for about one-fourth of the ties. Private-sector foreigners sold more than $9 bil- net gain in jobs between December and June, non- lion in Treasury securities in the first quarter while farm payroll employment increased an average of purchasing more than $26 billion in agency bonds. 190,000 per month, somewhat below the robust pace Despite a miied performance of U.S. stock prices, of the preceding four yean. foreign portfolio purchases of U.S. equities exceeded Monthly changes in private payrolls were uneven $60 billion in the first quarter, more lhan half of Ihe at times during the first half the year, but, on balance, record annual total set last year. U.S. purchases of the pace of hiring, while still solid, appears to have foreign securities remained strong in ihe firsl quarter modcraled between the first arid second quarters. In of 2000. some industries, such as construction, the pattern Foreign direct investment flows into the United appears to have been exaggerated by unseasonably States were robust in the first quarter of this year as high levels of aciiviiy during the winter that acceler- well. As in the past (wo years, direct investment inflows have been elevated by the extraordinary 'evel of cross-border merger and acquisition activity. Port- ctiango in liMal noritarm payroll employ mem folio flows have also been affected by this activity. For example, in recent years, many of the largest acquisitions have been financed by swaps of equity in the foreign acquiring firm for equity in the U.S. firm being acquired. The Bureau of Economic Analy- sis estimates that U.S. residents acquired $123 billion of foreign equities in this way last year. Separate data on market transactions indicate that U.S. residents .llllllll made net purchases of Japanese equities but sold European equities. The latter sales likely reflect a rebalancing of portfolios after stock swaps. U.S. direct investment in foreign economies has also remained sirong, exceeding $.10 billion in the first quarter of 2000. Again, a significant portion of this l«9l CWJ 199.' IWJ 1W IS% IW7 tWS ITO9 2001) 51 Board of Governors af the Federal Reserve System 15 ated hiring [hat typically would have occurred in the beginning of 1997 !o just over 4 percent at the the spring. After a robust first quarter, construction end of 1999. employment declined between April and June; on This year, the labor force participation rale ratch- average, hiring in this industry over the first half of eted up sharply over the first four months of the year the year was only a bit slower than [he rapid pace that before dropping back in recent months as employ- prevailed from 1996 to 1999. However, employment ment slowed. The spike in participation early this gains in the services industry, particularly in business year may have been a response to ready availability and heaiih services, were smaller in the second quar- of job opportunities, but Census hiring may also have ter than in the first while job cutbacks occurred temporarily attracted some individuals into the work- in finance, insurance, and real estate after four and force. On net, growth of labor demand and supply one-half years of steady expansion. Nonetheless, have been more balanced so far this year, and the strong domestic demand far consumer durables and unemployment tale has held near its ihirt^-yeaT low business equipment, along with support for exports of 4 percent. At midyear, very few signs of a signifi- from Ihe pickup in economic activity abroad, led lo a cant easing in labor market pressures have surfaced. leveling off in manufacturing employment over ihe Employers responding to various private surveys of first half of 2000 after almost iwo years of decline. business conditions report lhat they have been unable And. with consumer spending brisk, employment to hire as many workers as they would like because at retail establishments, although fluctuating widely skilled workers are in short supply and competition from month to month, remained generally on a solid from other firms is keen. Those concerns about hiring uptrend over the first half. have persisted even as new claims for unemployment The supply of labor increased slowly in recent insurance have drifted up from very low levels in the years relative to the demand for workers. The labor past several months, suggesting that some employers force participation rate was unchanged, on average, may be making workforce adjustments in response to at 67.1 percent from 1997 to 1999; that level was just slower economic activity. 0.6 percentage point higher than al the beginning of the expansion in 1990. The stability of the partici- pation rale over ihe 1997-99 period was somewhat Labor Costs and Productivity surprising because ihe incentives to enter the work- force seemed powerful: Hiring was strong, real wages Reports by businesses that workers are in short sup- were rising more rapidly than earlier in the expan- ply and that ihey are under pressure lo increase sion, and individuals perceived that jobs were plenti- compensation to be competitive in hiring and retain- ful. However, the robust demand for new workers ing employees became more intense early this year. instead led to a substantial decline in unemployment, However, the available statistical indicators are pro- and the civilian jobless rate fell from 5W percent ai viding somewhat raised and inconsistent signals of whether a broad acceleration in wage and benefit costs is emerging. Hourly compensation, as measured Measures of tabor utiiizalinn by the employment cost index (EC1) for private non- farm businesses, increased sharply during the first quarter to a level more than 4Vi percent above a year earlier. Before that jump, year-ovcr-year changes in the ECI compensation series had remained close io 3'/j percent for three years. However, an alternative measure of compensation per hour, calculated as pan of the productivity and cost series, which has shown higher rales of increase than the ECI in recent years, slowed in the first quarter of this year. For the non- farm business sector, compensation per hour in the first quarter was 4'/i percent higher than a year ear- lier; in the first quarter of 1999, the four-quarter 2000 change was 51/* percent.' . The augmented antmploynvnT rftis Ihe number of anenntioY«t frius o are iwi in ihc gator force and ware a ron. ibvEded ty Ihe civilian labor 3 The figures for compensation pet hour in [he nonfiaancial corpo- those who we FKH tn rht labor for" and HW a fob. The break jn daia rate sector arc similar, an increase nf nboin 4 peirenl for ihe year cy ]*** marks die introduction of a redesigned survey, dalo from iliu ending in [he fits! quarter of this year compared wilh almas! s1/; per- rciiOEuirctf^ comparable w»h rtwscol earlier period; cent fm (he year ending in the tint quarter of IW9. 52 16 Monetary Policy Report 10 the Congress D July 2000 Measures of Ihc change in hourly compensation Change in output per hour for the nonfurm business sector iL.iill JWI IW2 IW I9W 1907 ]*M 1999 20011 Won-,. the ECI is for pnvnc inimduJustorryy eeuululfcikg farm and hometa ThevstatotJUOOQI is ihc p pickup in benefit costs was associated with faster Part of ihe acceleration in the EG in the first rales of increase in employer contributions to health quarter was Ihe result of a sharp step-up in ihe wage insurance, and the first-quarter ECI figures indicated and salary component of eompensalion change. another step-up in this component of costs. Private While higher rales of straight-time pay were wide- survey information and available measures of prices spread across industry and occupational groups, (he in Ihe health care industry suggest that the upturn in most striking increase occurred in the finance, insur- the employer costs of health care benefits is asso- ance, and real estate industry where the year-over- ciated with both higher costs of health care and year change in wages and salaries jumped from about employers' willingness to offer attractive benefit 4 percent for the period ending in December 1999 to packages in order to compete for workers in a tight almost &'A percent for the period ending in March of labor market. Indeed, employers have been reporting this year The sudden spike in wages in that sector that they are enhancing compensation packages with could be related to commission; that are lied directly a variety of benefits in order to hire and retain to activity levels in the industry and, thus, would not employees. Some of these offerings are included in represent a lasting influence on wage inflation. For the ECI; for instance, the ECI report for the first other industries, wages and salaries accelerated mod- quarter nofed a pickup in supplemental forms of pay, erately, which might appear plausible in light of such as overtime and nonproduclion bonuses, and in reports that employers are experiencing shortages of paid leave. However, other benefits cited by employ- some types of skilled workers. However, the uptrend ers, including stock options, hiring and retention in wage inflation that surfaced in the ftrsl-quarlet ECI bonuses, and discounts on store purchases, are not has not been so readily apparent in the monthly data measured in the ECI.* The productivity and costs on average hourly earnings of production or nonsu- measure of hourly compensation may capture more pervisory workers, which are available through June. of the non-wage costs that employers incur, but even Although average hourly earnings increased at an for that series, the best estimates of employer com- annual rate of 4 percent between December and/one. pensation costs are available only after business the June level of hourly wages siood 3^4 percent reports for unemployment insurance and tax records higher than a year earlier, the same as the increase are tabulated and folded into the annual revisions of between June 1998 and June 199V. the national income and product accounts. While employers in many industries appear to have Because businesses have realized si7^ble gains in kept wage increases moderate, they may be facing worker productivity, compensation increases have greater pressures from rising costs of employee bene- fits. The ECI measure of benefit costs rose close to 4. Beginning *ift publication of ihe ECL fix June 2000, ihe Bureau 3'/3 percent during 1999, a pea-entage point faster ol Lubor itali^lic-. plans (o exp^nt ihc Lklinmon of notir^odkiction than during 1998; these costs accelerated sharply honusfi in ihc ETt 10 irurlmie hmng and relenlion bonuses, Thew further in the fir.w quarter of this year 10 a level payment^ are already intruded in rhe wage and ulary rneustn-t ondcr- iying rhe tiafj tut campens-ar™ prr Aoor 51/: percent above a year earlier. Much of last year's 53 Board of Governors of rhe Federal Keserve System M Chartge in unit labor cons forihe nonfarm business sector 2. Alternative measures of [Mice change r««« IWTQI I998.C4 IW80J I«M'Q4 MWM)! 1.0 1.* .Ill Grou dmpeflic iwrbuc* 7 15 fe E n j o ic i l u w } d t& ca f n lo w o t d fK v i t a d il e t n K e p rg c y n t . ftu . m .. . . 30 122 * Friftt-tixit'" CoHunKf pntt inks I.J 26 40 &ctwfi*c 1cx>d Vld tnHBy 2.1 tillIlli . A Aud-wcifte tndt* vm qwnury wcijbU from ihe ha*e year 10 c p**«i Front auh dioinci Uenx cftt^nrj- A. c^uia-iy^u iadu i» ** b year. Qw»(*i *re bawd CHI qoanerlj awnfc« HM 199° MM Niir> Tht value ftn KIOU QltilM pert goods and services purchased by consumers, busi- nesses, and governments has been somewhat greaier: The chain-type price index for gross domestic pur- not generated significam pressure on overall costs of chases rtse ai an annual rate of 3'/: percent in the first production, Outpui per houi in ihe nonfarm business quarter after having increased aboul 2 percent during sector posted another solid advance in the first quar- !999 and just V* percent during 1998. ter, rising to a level 3Y* percent above a year earlier The pass-through of the sleep rise in the cost of and offsetting much of the rise in hourly compensa- imported crude oil that began in early 1999 and tion over Ihe period. For nonfinancial corporations, continued into the first half of this year has been the the subset of the nonfarm business sector that principal factor in the acceleration of (he prices of excludes types of businesses for which output is goods and services purchased. The effect of higher measured tess directly, the 4 percent year-over- energy costs on domestic prices has been most appar- year increase in productivity held unit labor costs ent in indexes of prices paid by consumers. After unchanged. having risen 12 percent during 1999, the chain-type With the further robust increases in labor produc- price index for energy items in the price index for tivity recently, the average rise in output per hour in personal consumer expenditures (PCEJ jumped at an the nonfarm business sector since early IW7 has annual rale of 35 percent in the first quarter of 2000; stepped up further (O 3 percent from the 2 percent ihe firsi-ijuarter rise in the energy component of the pace of the 1995-97 period. What has been particu- CPI was similar. larfy impressive is that the acceleration of pro- Swings in energy prices continued to have a notice- ductivity in the past several years has exceeded the able effect on overall measures of consumer prices pickup in output growth over the period and, thus, does not appear to be simply a cyclical response to Change in consumer prices more rapidly rising demand, Raiher, businesses are likely realizing substantial and lasting payoffs from their investment in equipment and processes that embody the techno logical advances of the past sev- eral years. Prices Rates of increase in the broader measures of prices moved up further in early 2000. After having acceler- ated from 1 percent owing 1998 to lx^ percent last year, the chain-type price index for GDP—prices of goods and services that are produced domestically— IWI IW 19W IW5 IW6 19-»I !99B IW9 20I» increased at an annual rate of 3 percent in the first quarter of this year. The upswing in inflation for 54 18 Monetary Policy Report to the Congress D July 2000 in the second quarter. After world oil prices dropped little below its first-quarter rate. After having risen back temporarily in the spring, ihe domestic price of just over 2 percent between the fourth quarter of 1998 motor fuel dropped in April and May, and consumer and the fourth quarter of 1999, the CPI excluding prices for energy, as measured by the CPI. retraced food and energy increased at an annual rate of some of the firsi-quaner increase. As a result, the 2'A percent in ihe first quarter of 2000 and at a overall CPI was little changed over the two months. 2% percent rate in the second quarter. In pan, Ihe rise However, with prices of crude oil having climbed in core inflation likely reflects the indirect effects of again, the bounceback in prices of motor fuel led to higher energy costs on the prices of a variety of a sharp increase in the CPI for energy in June. In goods and services, although these effects are diffi- addition, with strong demand pressing against avail- cult to quantify with precision. Moreover, prices of able supplies, consumer prices of natural gas contin- non-oil imported goods, which had been declining ued in rise rapidly in the second quarter. In contrast to from fare I99S through the middle of last year, con- the steep rise in energy prices, Ihe CM for food has tinued to trend up early this year. risen slightly less than other non-energy prices so far The pickup in core inflation, as measured by the this year. CPI, has occurred for both consumer goods and ser- Higher petroleum costs also fed through into higher vices. Although price increases for nondurable goods producer cosis for a number of intermediate materi- excluding food and energy moderated, prices of con- als. Rising prices for inputs such as chemicals and sumer durables, which had fallen between 19% and paints contributed importantly to the acceleration in 1999, were Hide changed, on balance, over the first the producer price index for intermediate materials half of this year. The CPI continued to register steep excluding food and energy from about IVj percent declines for household electronic goods and comput- during 1999 to an annual rate of 3'f^ percent over t)x ers, hoi prices of other types of consumer durables first half of this year. Upward pressure on input prices have increased, on net, so far this year. The rate of was also apparent for construction materials, although increase in the prices of non-energy consumer ser- these have eased more recently. Prices of imported vices has also been somewhat faster; the CPI for industrial supplies also picked up early this year these items increased at an annual rate of 3'/3 percent owing to higher costs of petroleum inputs. during the first two quarters of this year compared Core consumer price inflation has also been run- with a rise of 2Vj percent in 1999. Larger increases ning a little higher so far this year. The chain-type in the CPI measures of rent and of medical services price index for personal consumption expenditures have contributed Importantly to this acceleration. other than food and energy increased at an annual Another factor has been a steeper rise in airfares, rate of 214 percent in the first quarter compared with which have been boosted in part to cover the higher an increase of 1W percent during 1999. Based on the cost of fuel. monthly estimates of PCE prices in April and May, In addition to slightly higher core consumer price core PCE price inflation looks to have been just a inflation, the national income and product accounts measure of prices for private fixed investment goods shows that the downtrend in prices for business fixed investment items has been interrupted. Most Change in consumer prices excluding food and energy notably, declines in the prices of computing equip- ment became much smaller in the final quarter of last ChaiiMypo pnct md(i for PCE year and the first quarter of this year. A series of dis- ruptions to the supply of component inputs to com- puting equipment has combined with exceptionally strong demand to cut the rate of price decline for computers, as measured by the chain-type price index, to an annual rate of 12 percent late lust year and early this year—half the pace of the preceding three and one-half years. At the same time, prices of other types of equipment and software continued to be little changed, and the chain-type index for non- residential structures investment remained on a mod- eraie uptrend. In contrast, the further upward pressure on construction costs at the beginning of the year r pri« indt* tot all uttan omsun Voluti for 20110 01 and QJ m pert continued to push the price index for residential 55 Board of Governors of ike Federal Keierve System 19 construction higher; after having accelerated from Selected Treasury rates, quarterly data 3 percent to 3'/i percent between 1998 and 1999, this index increased at an annual rate of 4'A percent in the first quarter of 2000. Although actual inflation moved a bit higher over the first half of 2000, inflation expectations have been tittle changed. Households responding to the Michi- gan SRC survey in June were sensitive to the adverse effect of higher energy prices on their real income but seemed to believe that the inflationary shock would be short-lived. The median of (heir expected change in CPI inflation over the coming twelve months was 2.9 percent. Moreover, they remained optimistic that Treuury J-VMiin-Vy \^^J inflation would remain at about that rate over I I I I r I M M j I I I J_)j. j_)J4J I I I I I 1 N II I M I 1 I the longer run, reporting a 2.8 percent median of 1%4 IW IOTJ 1»T9 JW JW» l»»4 IfW expected inflation during the next live to ten years. In Nijih. The iwenty.rev Tnuury bond rjK it tftown gnirl Ihr bM >nu. both instances, their expectations are essentially the of the ihiify-ycar Timuiy bond ID Ftbniry l1'^ tul o^"Boons a? MO«K» same as at the end of 1999, although the year-ahead expectations are above the lower levels thai had prevailed in 1997 and early 1998. this year, with short-term real rales having increased the most. Rising market interest rates and heightened US. Financial Markets uncertainties about corporate prospects, especially with regard to the high-tech sector, have occasionally Conditions in markets for private credit firmed on dampened flows in the corporate bond market and balance since the end of 1999. Against a backdrop of have weighed on the equity market, which has, at continued economic vitality in the United States and limes, experienced considerable volatility. Through a tighter monetary policy stance, private borrowing mid-July, the broad-based Wilshire 5000 equity index rates are higher, on net. particularly those charged to was up approximately 3 percent for the year. riskier borrowers. In addition, banks have tightened terms and standards on most types of loans. Higher real interest rates—as measured based on inflation Interest Rues expectations derived from surveys and from yields on the Treasury's inflation-indexed securities— As the year began, with worries related to the century account for the bulk of the increase in interest rates date change out of the way, participants in the rixed- income market turned their attention to the signs of continued strength in domestic labor and product Selected Treasury rates, daily data markets, and they quickly priced in the possibility of a more aggressive tightening of monetary policy. Both private and Treasury yields rose considerably. In the latter part of January, however. Treasury yields plummeted, especially those on longer-dated securi- ties, as the announced details of the Treasury's debt buyback program and upwardly revised forecasts of federal budget surpluses led investors to focus increasingly on the prospects for a diminishing sup- ply of Treasury securities. A rise in both nominal and inflation-indexed Treasury yields in response to strong economic daia and tighter monetary policy in April and May was partly offset by supply factors and by occasional safe haven flows from the volatile F M A M I J 15ONDJ F M A M ) I A S O N D I FMAMJ J equity market. Since late May, market interest rates I4M l*« 2000 have declined as market participants have interpreted the incoming economic data as evidence that mone- 56 20 Monetary Policy Reporl to ihe Congress D July 2000 Selecied yield corves. July 17. 2000 Spread of BBB corporate yields eration in economic growth and expectations that the tary policy might not have to be tightened as much as economy will be on a sustainable, non-inflationary had been previously expected On balance, while track, with little further monetary policy lightening. Treasury bill rales and yields on shorter-dated notes The disconnect between longer-term Treasury and have risen 15 to 80 basis points since the beginning private yields as a consequence of supply factors of Ihe year, intermediate- and long-term Treasury in the Treasury market is distorting readings from yields have declined 5 lo 55 basis points. In the yield spreads. For instance, taken at face value, the corporate debt market, by contrast, bond yields have spread of BBB corporate yields over Ihe yield on the risen 10 to 70 basis points so far this year. ten-year Treasury note would suggest Ihat conditions Forecasts of steep declines in the supply of longer- in the corporate bond market so far in 2000 are worse dated Treasuries have combined with tighter mone- than those during the financial market turmoil of tary policy conditions to produce an inverted Trea- (998. In contrast, the spread of the BBB yield over sury yield curve, starting with the two-year maturity. the ten-year swap rate paints a very different picture, In contrast, yield curves elsewhere in Ihe U.S. fixed- with spreads up this year but below iheir peaks in income market generally have not inverted. In the 1998. Although the swap market is still not as liquid interest rate swap market, for instance, the yield as the Treasury securities market, and swap rates are curve has remained flat lo upward sloping for maturi- occasionally subject to supply-driven distortions, ties as long as ten years, and the same has been inie such distortions have been less pronounced and more for yield curves for the most actively traded corporate short-lived than those affecting Ihe Treasury securi- bonds.5 Nonetheless, private yield curves are flatter ties market of late, making swap rales a better bench- than usual, suggesting that, although supply consider- mark for judging the behavior of other corporate ations have played a potentially important role in the yields. inversion of the Treasury yield curve this year, inves- Aware thai distortions to Treasury yields are likely tors' forecasts of future economic conditions have to become more pronounced as more federal debt is also been a contributing factor. In particular, private paid down, market participants have had lo look for yield curves are consistent with forecasts of a mod- alternatives to Ihe pricing and hedging roles tradition- ally played by Treasuries in U.S. financial markets. In addition to interest rate swaps, which have featured 5. A lypial iMeretl rate twap it an acreement between l»o panto prominently in the list of alternatives to Treasuries, lo enchante fined tad varubk twit* THE payments an a nntonal debt securities issued by ihe three governmeni- principal amMni over a pndttenMned period ranging dan OK to sponsored housing agencies—Fannie Mae, Freddie Urinyyeui. The notional amount BuUit never nrtrapj). Typically, me variable inures! IMC is ibe London InuifcMk Offered Hut Mac, and the Federal Home Loan Banks—have been (LIBOR). and Ihe hied nMnsI me—caltad Ihe >«p me—is dcttr- used in both pricing and hedging. The three housing nincd in die ivan mfkel. The overall craft qaaliiy of nfta agencies have continued to issue a substantial volume participants B tiiin. lypicilty A or above: lho« emitiet with cmltt nunjs of BBB « kmer arc generally either rejectee1 or reqwtd la of debt this year in an attempt to capture benchmark adupt cradtr-nih»cia| mechannnn. typically by poumj collHenl. status, and the introduction in March of futures and 57 Board of Caff mars of the federal Restive System 21 options contracts based on five- and ten-year notes Major siock price indexes issued by Fannie Mae and Freddie Mac may help enhance the liquidity of (he agency securities market. Nonetheless, the market for agency debl has been affected by some uncertainty this year regarding the agencies' special relationship with the government. Both the Treasury and the Federal Reserve have suggested that it would he appropriate for the Con- gress 10 consider whether the special standing of ihese institutions continues to promote the public interest, and pending legislation would, among other things, restructure the oversight of these agencies and reexamine iheir lines of credit with the U.S. Treasury. The implementation of monetary policy, too, has had to adapt to the anticipated paydowns of market- able federal debt. Recognizing thai there may be limitations on ils ability to rely as much as previously on transactions in Treasury securities to meet the reserve needs of depositories and to expand (he sup- ply of currency, the FOMC decided at ils March 2000 result in a greater percentage of holdings of shorter- meeting to facilitate umil its first meeting in 2001 the term security issues than of longer-dated ones. The Trading Desk's abilily to continue to accept a broader schedule ranges from 35 percent of an individual range of collateral in its repurchase transactions. The initial approvals to help expand the collateral pool were granted in August I9*W as part of the Federal on July 5, replacing a procedure in which alt matur- Reserve's efforts lo better manage possible disrup- ing holdings were rolled over and in which coupon tions 10 financial markets related lo the century dale purchases were spread evenly across the yield curve. change. At the March 2000 meeting, (he Committee also initiated a study to consider alternative asset classes Equity f>rices and selection crileria that could he appropriate for the System Open Market Account (SOMA) should the Major equity indexes have posted small gains so far si?* of the Treasury securities market continue to this year amid considerable volatility. Fluctuations in decline. For the period before ihe completion and technology stocks have been particularly pronounced: review of such a study, the Committee discussed, a! After having reached a record high in March— its May meeting, some changes in the management of 24 percent above its 1999 year-end value—the the System's portfolio of Treasury securities in an Nasdaq composite index, which is heavily weighted environment of decreasing Treasury debt. The toward technology shares, swung widely and by mid- changes aim to prevent the System from coming to July was up 5 percent for the year. Given its surge in hold high and rising proportions of new Treasury the second half of 1999, the mid-July level of the lichl issues. They will alsn help the SOMA to limit Nasdaq was about 60 percent above its mid-1999 any Further lengthening of the average maturity of ils reading, The broader S&P 500 and Wilshire 5000 portfolio while continuing to meet long-run reserve indexes have risen close to 3 percent since the begin- needs to the greatest extent possible through outright ning of the year and are up about 10 percent and purchases ol Treasury securities.1' The SOMA will 13 percent, respectively, from mid-1999. cap the rollover of its existing holdings at Treasury Corporate earnings reports have, for the mosl pan, auctions and will engage in secondary market pur- exceeded expectations, and projections of future chases according to a schedule thai effectively will earnings continue to be revised higher. However, the increase in interest rates since ihe beginning of the year likely has restrained ihe rise in equity prices. In h The FOMC i*tler> a ponf oilo with J shnri average mammy because ihe higher lumiivvr rate of such u (KMtlblfO givis it preaitr addition, growing unease about ihe lofty valuations fte*to|jiiy IQ irffeem sccuriil*A in times of financial market sires4;- reached by technology1 shares and rising default rates whirl, ™y ^.nre^nlj;il ilecre&tts In the securities poirfolio in Ihe corporate sector may have given some inves- tors a belter appreciation of the risks of holding 58 22 Monetary Pnlicy Report lo the Congress D July 2000 stocks in general. Reflecting the uncertainty about debt have helped lo ease the pressure on available the future course of Ihe equity market, expected and savings and have facilitated tne rapid expansion of acitial volatilities of slock returns rose substantially nonfederal debt outstanding; The federal government in the spring, A( that lime, volatility implied by paid down 5218 billion of debt over the ftrsl hall of options on the Nasdaq 100 index surpassed even the 2000, compared with paydowns of $56 billion and elevated levels reached during the financial markel $101 billion in the first six months of calendar years turmoil of 1998. I99S and 1999 respectively. Higher volatility and greater investor caution had Depository institutions have continued to play an a marked effect on public equity offerings. The pace important role in meeting the strong demands for of initial public offerings has fallen off considerably credit by businesses and households. Adjusted for in recen! months from as brisk first-quarter rate, with mark-to-market accounting rules, credit extended by some offerings being canceled or postponed and oth- commercial banks rose 11'/: percent in the first hall ers Doing priced well short of earlier expectations. On of 2000. This advance was paced by a brisk expan- the other hand, households' enthusiasm for equity sion of loans, which grew at an annual rate of nearly mutual funds, especially those funds that invest in the 13 percent over this period. Bank credit increased in technology and international sectors, remains rela- part because some businesses sought hank loans as an tively high, although it appears to have faded some alternative to a less receptive corporate bond market. after the run-up in stock market volatility in the In addition, (he underlying strength of household spnng. Following a first-quarter surge, net inflows spending helped boos* the demand for consumer and ID slock funds moderated substantially in the second mortgage loans. Banks' holdings of consumer and quarter but still were above last year's average pace. mortgage loans were also supported by a slower pace of sccuritizations this year. In the housing sector, for instance, the rising interest rate environment has kept Debt and the Monetary Aggregates the demand for adjustable-rale mortgages relatively elevated, and banks tend to hold these securities on Debt and Depository Intermediation their books rather than securitize them. Banks have tightened lerms and standards on Itians The total debt of the U.S. household, government, further this year, especially in the business sector, and nonfinancia! business sectors is estimated to have where some lenders have expressed concerns about a increased at close to a SW percent annual rale in the more uncertain corporate outlook. Bank regulators first half of 2000. Outside the federal government have noted that depository institutions need to take sector, debt expanded at an annual rate of roughly particular care in evaluating lending risks to account y'/? percent, buoyed by strength in Household and for possible changes in the overall macroecanaimc business borrowing. Continued declines in federal environment and in conditions in securities markets. nf domestic nonlinancial Jebi 59 Board of Governors of the Federal Reserve System 23 M2 erowth rale M3 growth rale Ilii.Ill 1WO 1901 1992 [993 |yyj m$s ]*•* I9y? J99K )9W MOO pace as in 1999—supported by the rapid expansion of The Monetary Aggregates nominal spending and income. M2 velocity—the ratio of nominal income tci M2— Growth of the monetary aggregates over (he first half has increased over the rirsi half of this year, consis- of 2000 has been buffeted hy several special factors. tent with its historical relationship with the interest The unwinding of ihe buildups in liquidity thai forgone ("opportunity cost") from holding M2. As occurred in late ] 999 before the century date change usual, rales offered on many of Ihe components of depressed growth m (he aggregates early this year. M2 have not tracked the upward movement in market Subsequently, M2 rebounded sharply in anticipation interest rales, and the opportunity cost of holding M2 of ouisized tax payments in the spring and then ran has risen. In response, investors have reallocated off as those payments cleared. On nei, despiie the some of their funds within M2 toward those compo- cumulative finning of monetary policy since June nents whose rales adjust more quickly—such as small 199°, M2 expanded a! a relatively robust. 6 percent, time depoiits—and have restrained flows into M2 in annual rate during the (irsi half of 2000—ihe same favor ot longer-term mutual funds and direct hold- ings of market instruments, M3 expanded at an annual rate of 9 percent in the M2 velocity and IlK opportunity cosi of holding M2 first half of 2000, up from 7W percent for all of 1999. The robust expansion of bank credit underlies much of the acceleration in M3 ihis year. Depository insti- tutions have issued large time deposits and other managed liabilities in volume to help fund the expan- sion of their loan and securities portfolios. In con- trast, flows to institutional money funds slowed from the rapid pace of late 1999 after the heightened preference for liquid assets ahead of the century date change ebbed. As has been the case since 1994. depository institu- tions have continued to implement new retail sweep programs over the fiist half of 2000 in order to avoid having to hold non-inierest-bearing reserve bal- ances with the Federal Reserve System. As a result, Norh ThedBtJwqHMierlyiinilmcihiou(h?CCKHJI The \tl«ityof M? i ihf in in of nominal RTOU dnnvsirc prudufi 'nihc *l«k pf M- The E^pofTuifr required reserve balances are still declining gradu- ally, adding to concerns (hit, under current proce- ihrw-irionch Trea^ur> Iwll faie and rt* wnphted n-,cmp: niuin un <i»sei nicLBded in Ml dures., low balances might adversely aft'eei the imple- 60 24 Monetary Policy Report to the Congress D July 2000 menlalion of monetary policy hy eventually leading Higher oil prices bumped up broad measures of infla- to increased volatility in the federal funds market, tion almost everywhere, but measures of core infla- The pending legislation that would allow the Federal tion edged up only modestly, if at all. Reserve to pay interest on balances held at Reserve Monetary conditions generally were tightened in Banks would likely lend to a partial unwinding over foreign industrial countries, as authorities removed lime of the ongoing trend in retail sweep programs. stimulus by raising official rates. Yield curves in several key industrial countries tended to flatten, as interest rates on foreign long-term government secu- International Developments rities declined on balance after January, reversing an upward trend seen since the second quarter of 1999. In the first half of 2000, economic activity in foreign Yields on Japanese governmenl long-term bonds economies continued The strong overall performance edged upward slightly, but at midyear stilt were only thai was registered hat year. W/iJ? a few excepfions, aboiii 1W percent. most emerging-market countries continued to show Concerns in financial markets at the end of last signs of solid recoveries from earlier recessions, sup- year about potential disruptions during the century ported hy favorable financial market conditions. date change dissipated quickly, and global markets in Average real GDP in (he foreign industrial countries the early months of this year returned to the compara- accelerated noticeably in the first half of this year tively placid conditions seen during most of 1999. after a mild slowdown in late 1999. The pickup Starting in mid-March, however, global financial reflected in large part better performance ol Japanese markets were jolted by several episodes of increased domestic demand (although its sustainabilily has been volatility set off typically by sudden dowodrafts in questioned) and further robust increases in Europe US. Nasdaq prices. At that time, measures of market and Canada. In many countries, economic slack risk for some emerging -market countries widened, diminished, heightening concern about inflation risks. but they later retraced most of these increases. The performances of broad stock market indexes in the Foreign interest rales industrial countries were mixed, but they generally tended to reflect their respective cyclical positions. Slocks in Canada. France, and Italy, for example, continued to make good gains, German stocks did (ess well, and UK. stocks slipped. Japanese shares also were down substantially, even though the domes- tic economy showed some signs of firmer activity. In general, price volatility of foreign high-tech slocks or stock indexes weighted toward technology-intensive sectors was quite high and exceeded that of corre- sponding broader indexes. The dollar continued to strengthen during most of the first half of the year. It appeared to be supported mainly by continuing positive news on the perfor- mance of the U.S. economy, higher U.S. short-term interest rates, and for much of (he first half, expecta- tions of further tightening of monetary policy. Early in the year, the attraction of high rates of return on U.S. equities may have been an additional supporting factor, but the dollar maintained its upward trend even after U.S. stoek prices leveled off near the end of the first quarter and then declined for a while. In June, the dollar eased hack a bit against the curren- cies of some industrial countries amid signs lhai U.S. growth was slowing. Nevertheless, for the year so far, the dollar is up on balance about 5'/i percent against the major currencies; against a broader index of trading-partner currencies, the dollar has appreciated aboul 3V» percent on balance. 61 Board of Governors of ihe Federal Reserve System 25 Nominal U.S. dollar exchange rales area in the first half of 2000 was somewhat stronger lhan the brisk 3 percent pace recorded last year. Investment was robust, and indexes of both business and consumer sentiment registered record highs. The average unemployment rate in the area continued to move down to nearly 9 percent, almost a full percent. age point lower than a year earlier. At the end of the first half, the euro-area broad measure of inflation, partly affected by higher oil prices, was above 2 per- cent, while core inflation had edged up to IVt per- cent. Variations in the pace of economic expansion and the intensity of inflation pressures across the region added to (he complexity of the situation con- fronting ECB policymakers even though Germany and Italy, two countries that had lagged the euro-area average expansion of activity in recent years, showed signs that they were beginning to move ahead more rapidly. After having raised its refinancing rate 50 basis points in November 1999, Ihe ECB followed with three 25-point increases in the first quarter and another 50-point increase in June. The ECB pointed to price pressures and rapid expansion of monetary aggregates as important consrderaiions behind the moves. Compared with its fluctuations against the euro, the dollar's value was more stable against the Japa- nese yen (luring the first half of 2000- In late 1999. private domestic demand in Japan slumped badly, NUTP.. Thif dra me weekly, Indexes io lh* upper panel are (nfe-v *vprape$ 5< Ihe exctnoge value o! the dollar agtunu nu|or ninCM even though the Bank of Japan continued to hold agunsr the cumpctas of a hood fr our> of imponam t" 5 truing porfn its key policy rate at essentially zero. Several times obwrvMkms uc [or UK week emUnj July I !. 2000 during the first half of this year, the yen experienced strong upward pressure, often associated with market The dollar has experienced a particularly large perceptions that activity was reviving and with specu- swing againsi the euro. The euro started this year lation that the Bank of Japan soon might abandon its already down more lhan ! 3 percent from its value zero-interest-rate policy. This upward pressure was against the dollar at the time when the new European resisted vigorously by Japanese authorities on several currency was introduced in January 1999, and ii occasions with sales of yen in foreign exchange mar- continued to depreciate during most of the first hall' kets. The Bank of Japan continued to hold overnight of 2000, reaching a record low in May. During this interest rates near zero through the first half of 2000. period, the euro seemed to he especially sensitive to The Japanese economy, in fact, did show signs of news and public commentary by officials about the stronger performance in the first half. GDP rose at an strength of the expansion in the euro area, the pace of annual rate of 10 percent in the first quarter, with economic reform, and the appropriate macroeco- particular strength in private consumption and invest- nomic policy mix. Despite a modest recovery in ment. Industrial production, which had made solid recent weeks, the euro still is down against the dollar gains last year, continued to expand at a healthy pace, almosi 7 percent on balance for the year so far and and surveys indicated that business confidence had about y/t percent on a trade-weighted basis. picked up. Demand from the household sector was The euro's persistent weakness posed a challenge less robust, however, as consumer confidence was for authorities at the European Central Bank as they held back by historically high unemployment. A large sought to implement a policy stance consistent with and growing outstanding stock of public debt (esti- their official inflation objective (2 percent or less for mated at more than 110 percent of GDP) cast increas- harmonized consumer prices) without threatening the ing doubt about the extent to which authorities might euro area's economic expansion. Supported in part be willing to use additional fiscal stimulus to boost by euro depreciation, economic growth in the euro demand. Even though some additional government 62 26 Monetary Policy Report in Ihe Congress D July 1000 expenditure for coming quarters was approved in laK Emerging maikets 1999, government spending did not supply stimulus in the first quarter. With coie consumer prices mov- ing down at an annual rate thai reached elmost I per- cent at midyear, deflation also remained a concern. Economic activity in Canada so fat this yeai stowed a bi( from its very strong performance in the second half of 1999, but it still was quile robust, generating strong gains in employment and reducing the remaining slack in the economy. The expansion was supported by both domestic demand and spill- overs from the U.S. economy. Higher energy prices pushed headline inflation to near the top of the Bank of Canada's 1 percent to 3 percent target range; core inflation remained jus! below !>/• percent. The Cana- dian dollar weakened somewhat againsi the U.S. dol- lar in the first half of ihe year even though ihe Bank of Canada raised policy interest rales 100 basis points, matching increases in U.S. rales. !n ihe United Kingdom, the Bank of England continued a round of tightening that started in mid-1999 by raising official rates 25 basis points twice in the first quarter. After March, indications that Ihe economy was slowing and thai inflationary pressures might be ebbing under the effect of the tighter monetary stance and strength of sterling—especially against the euro—allowed the Bank 10 hold rales constant. In recent months, ster- ling has depreciated on balance as official interest rates have been raised in other major industrial I<i7*. The d«a arc vcckly. EMBI- (t P Morgan cnErgjn? rarkri bold countries. *) spreads (Of Hnpped Braty-tond yield spifcKb °*w U.S, ^n In developing countries, the strong recovery of TvMHiiH m fnt Uic *n;k tndins lul, I i 2000 economic activity last year ro both developing Asia and Latin America generally continued inio (he tirsi remained generally favorable, and Ihe won came half of 2000. However, after a fairly placid period under upward pressure periodically in the first half of ihai extended into the firsi few months of this year, this year. Nonetheless, the acute financial difficulties financial market conditions in some developing coun- of Hyundai, Korea's largest industrial conglomerate, tries became more unsettled in the April-May period. highlighted the lingering effect on the corporate In some countries, exchange rates and equity prices and financial sectors of the earlier crisis and the need weakened and risk spreads widened, as increased for further restructuring. Economic activity in other political uncertainty interacted with heightened finan- Asian developing countries that experienced difficul- cial maiket volatility and rising interest rales in ties in 1997 and 1998 (Thailand, Indonesia, Malay- the industrial countries. In general, financial markets sia, Singapore, and the Philippines) also continued now appear to be identifying and distinguishing those to firm this year, but at varying rales. Nonetheless, emerging-market countries with problems more financial market condnions have deteriorated in effectively than they did several years ago. receni months fot some countries in the region. In emerging Asia, the strong bounceback of activ- In Indonesia and the Philippines, declines in equity ity last year from the crisis-related declines of 1998 prices and weakness in exchange rates appear to have continued into the first half of this year. Korea, which stemmed from heightened market concerns over recorded Ihe strongest recovery in the region last year political instability and prospects for economic with real GDP rising at double-digit rates in every reform. Output in China increased at near double- quarter, has seen some moderation so far in 2000. digit annual rates in the second half of last year and However, with inventories slill being rebuilt, unem- remained strong in the first half of this year, boosted ployment declining rapidly, and inflation showing mainly by surging exports. In Hong Kong, real GDP no signs of accelerating, macroeconomic conditions rose at an annual rale of more than 20 percent in the 63 Board of Governors of the Federal Reserve System 27 firsi quarter of this year after a strong second half in cent, boosted by strong exports to the United Slates, 1999. Higher consumer confidence appears to have soaring private investment, and increased con- boosted private consumption, and trade flows through sumer spending. Mexican equity prices and the Hong Kong, especially to and from China, have peso encountered some downward pressure in the increased. approach of the July 2 national election, but once the The general recovery seen last year in Latift election was perceived to be fail and ihe transition of America from effects of the emerging-market finan- power was under way, both recovered substantially, cial crisis extended inlo the first pan of this year. In Argentina, ihe pace of recovery appears to have In Brazil, inflation was remarkably well contained, slackened in the early pan of ihis year, as the govern- and imcresi rales were towered, bul unemployment ment's fiscal position and. in particular, iis ability to has remained high. An improved financial situation meet the targets of its International Monetary Fund allowed the Brazilian government to repay most of program remained a focus of market concern- Height- the funds obtained under its December 1998 interna- ened political uncertainly id Venezuela, Peru, Colom- tional support package. However, Brazilian financial bia, and Ecuador sparked financial market pressures markets showed continued volatility this year, espe- in recent months in those countries, too. In January, cially at times of heightened market concerns over authorities in Ecuador announced a program of "dol- ihe stains of fiscal reforms, and risk premiums wid- larizalion," in which the domestic currency would be ened in the first half of 2000 on balance. In Mexico. entirely replaced by U.S. dollars. The program, now activity has been strong so far this year. In the first in the process of implementation, appears to have quarter, real GDP surged ai an annual rate of 11 per helped stabilize financial conditions there.

Alan Greenspan (2000, July 19). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20000720_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_20000720_chair_federal_reserves_second_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {2000},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20000720_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}