Congressional Testimony

CONDUCT OF MONETARY POLICY Report of the Federal Reserve Board pursuant to the Full-Employment and Balanced Growth Act of 1978, P.L. 95-523 and The State of the Economy HEARING BEFORE THE COMMITTEE ON. BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES ONE HUNDRED SIXTH CONGRESS SECOND SESSION JULY 25, 2000 Printed for the use of the Committee on Banking and Financial Services Serial No. 106-68 U.S. GOVERNMENT PRINTING OFFICE 65-973 CC WASHINGTON : 2001 For sale by the Superintendent of Documents, Congressional Sales Office U.S. Government Printing Office, Washington, DC 20402 HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES JAMES A. LEACH, Iowa, Chairman BILL McCOLLUM, Florida, Vice Chairman- MARGE ROUKEMA, New Jersey JOHN J. LAFALOE; Kew York DOUG K. BEREUTER, Nebraska BRUCE F. VENT0, Minnesota RICHARD H. BAKER, Louisiana BARNEY FRANK, Massachusetts RICK LAZIO, New York PAUL E. KANJORSKI. Pennsylvania SPENCER BACKUS III, Alabama MAXINE WATER^&SHa^ MICHAEL N. CASTLE, Delaware CAROLYN B. MALONE^T &w York PETER T. KING, New York LUIS V. GUTIERREZ, Illinois TOM CAMPBELL, California NYDIA M. VELAZQUEZ, New York EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York JACK METCALF, Washington KENNETH E, BENTSEN JR., Texas ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut BOB BARR, Georgia DARLENE HOOLEY, Oregon SUE W. KELLY, New York JULIA M. CARSON, Indiana RON PAUL, Texas ROBERT A. WEYGAND, Rhode Island DAVE WELDON, Florida BRAD SHERMAN, California JIM RYUN, Kansas MAX SANDLIN, Texas MERRILL COOK, Utah GREGORY W. MEEKS, New York BOB RILEY, Alabama BARBARA LEE, California RICK HILL, Montana FRANK R. MASCARA, Pennsylvania STEVEN c. LATOURETTE, Ohio JAY INSLEE, Washington DONALD A. MANZULLO, Illinois JANICE D. SCHAKOWSKY, Illinois WALTER B. JONES JR., North Carolina DENNIS MOORE, Kansas PAUL RYAN, Wisconsin CHARLES A. GONZALEZ, Texas DOUG OSE, California STEPHANIE TUBES JONES, Ohio JOHN E. SWEENEY, New York MICHAEL E. CAPUANO, Massachusetts JUDY BIGGERT, Illinois MICHAEL P. FORBES, New York LEE TERRY, Nebraska MARK GREEN, Wisconsin BERNARD SANDERS, Vermont PATRICK J. TOOMEY, Pennsylvania (ID CONTENTS Hearing held on: July 25, 2000 1 Appendix: July 25, 2000 57 WITNESSES TUESDAY, JULY 25, 2000 Greenspan, Hon. Alan, Chairman, Board of Governors, Federal Reserve System APPENDIX Prepared statements: Leach, Hon. James A 58 Paul, Hon. Ron 60 Greenspan, Hon. Alan 61 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Maloney, Hon. Carolyn B.: "Greenspan's Needle", Barren's, July 24, 2000 59 Greenspan, Hon. Alan: Board of Governors of the Federal Reserve System, Monetary Policy Report to the Congress, July 20, 2000 78 Written response to questions from Congressman Gonzalez 72 Written response to questions from Congressman Mascara 76 (III) CONDUCT OF MONETARY POLICY TUESDAY, JULY 25, 2000 U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON BANKING AND FINANCIAL SERVICES, Washington, DC. The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding. Present: Chairman Leach; Representatives Roukema, Baker, Castle, Lucas, Metcalf, Kelly, Paul, Hill, Ryan, Terry, Green, Toomey, LaFalce, Frank, Waters, Sanders, C. Maloney of New York, Watt, J. Maloney of Connecticut, Sherman, Meeks, Lee, Mascara, Inslee, Schakowsky, Moore, Gonzalez and Forbes. Chairman LEACH. The hearing will come to order. The committee meets today to receive the Semi-Annual Report of the Board of Governors of the Federal Reserve System on the Con- duct of Monetary Policy and the State of the Economy. We welcome Chairman Greenspan. As Members are aware, although the Chairman's appearance be- fore the committee today is no longer a requirement of law, there is little more important congressional oversight responsibility than that of the Banking Committee's semiannual review of the Federal Reserve's Conduct of Monetary Policy. In this regard, I have been working with Senator Gramm on legislation renewing the Federal Reserve's reporting requirements; and I am optimistic that the statutory reporting mandate will be renewed before the adjourn- ment of this Congress. Turning to the state of the economy, it appears that the Fed is succeeding in monitoring the rate of the U.S. economic growth without precipitating a hard landing, while providing a soft cushion for fiscal policymakers. Inflationary pressures remain relatively modest due, in part, to the Fed's restraint and, in part, to the ongoing improvements in productivity in the economy. On the other hand, we are all aware that the U.S. continues to run a substantial current account deficit that must be financed from abroad. We look forward to any comments that the Chairman might make on how long this situation can persist, its possible im- pact on the dollar, and what steps policymakers can take to bring national savings and investment into balance. With reference to fiscal policy, the moderation of Federal spend- ing brought about by difficult decisions by the Congress over the past five years has contributed, along with the Fed's Monetary Pol- icy decisions, to much sooner than expected end of Federal budget (l) deficits than anyone ever envisioned and to a far greater extent than anyone ever projected. I sometimes joke to constituents that there appear to be three po- litical parties in Washington today: the Republicans who suggest that taxpayers should be rewarded with a tax cut; the Democrats who argue that the fiscal surplus makes more spending a social im- perative; and the Greenspanites who say Congress should do noth- ing, at least until the deficit is wiped out. In any regard, maintain- ing the economic progress of the United States is a challenge to the monetary policymakers of the Fed and to the fiscal policymakers here on the Hill. We welcome the perspective of the Chairman in this regard. Mr. LaFalce. [The prepared statement of Hon. James Leach can be found on page 58 in the appendix.] Mr. FRANK. Mr. Chairman, may I ask the gentleman to yield briefly? I am wondering if the Chairman was switching parties. We might be making more news today. Chairman LEACH. No, but I do expect that the most important question to be asked today is whether Mr. Greenspan turned down the vice presidential possibility. Mr. LaFalce. Mr. LAFALCE. That assumes he is a Democrat. Otherwise, I un- derstand it has been filled. Mr. Chairman, we will keep a spot open for you if it is really close. I would like to thank Chairman Greenspan for agreeing to con- tinue the Humphrey-Hawkins report to Congress, notwithstanding what I hope will be only the temporary lapse in the statutory re- quirement for the report. An independent Central Bank is critically important for a well-functioning economy, but an independent bank only functions well within a democracy when it is subjected to ap- propriate public oversight. The Humphrey-Hawkins law ensured that a dialogue on monetary policy would take place between the Federal Reserve and the American people through their elected representatives, and that is why I think it is important for the Sen- ate to adopt the House-passed bill that would renew the Hum- phrey-Hawkins Report and other important reports that provide important information to the Congress on the state of our economy and our banking system, the protection of our consumers, and the state of housing in America. Many individuals, institutions and phenomena deserve credit for today's economy. Much of that credit must go to the enormous strides that have been made in technology, strides that are beyond the wildest expectations we had a decade ago. And much credit must go to the decision of President Bush in 1990 to enter into a compact with the Congress, the decision of President Clinton and Vice President Gore to enter into a compact with the Congress in 1993, and so forth, so that we could have fiscal sanity within the budget process. And much credit must go to the Federal Reserve Board and the Open Market Committee and particularly to its leader, Chairman Greenspan, who has helped more than anyone over those years to guide us to the 112th month of economic expan- sion. Our House Banking Committee has now had the luxury for five days to study Chairman Greenspan's report to the Senate Banking Committee, and in Chairman Greenspan's testimony last Thursday he forecast an unemployment rate of approximately 4 percent for the remainder of the year. However, I am concerned that the Fed- eral Open Market Committee believes that there still is a risk of higher inflation, notwithstanding signs of slower growth and con- tinuing increases in productivity. It is important to note that we have not felt the impact of the last three rate increases which took place in February, March and May of this year. According to the Federal Reserve, interest rate increases take about six months to have an effect on the economy. So we do not yet know how the last 100 basis points of interest rate increases will affect growth. I think it would be a serious error to raise interest rates now, amidst substantial evidence of a slow- ing economy and with the impact of the last increases still un- known. It was for those reasons, amongst others, that I joined with David Bonior, Barney Frank, Maxine Waters, and Nydia Velazquez and others in a letter not so long ago to the Federal Open Market Committee in which we warned that further efforts to slow down the economy would likely result in increased unemployment and adversely impact many American families, particularly those who have yet to benefit from the substantial prosperity we now enjoy. That is a very, very serious problem in our body politic, this dis- parity, income disparity in wealth, disparity in totality of benefits; and we can never forget that. Millions of Americans have benefited from the current economic expansion. Their prosperity has been a benefit, a blessing, both for them and for our Nation. But our current good times have not reached millions of other American families; and for those less for- tunate amongst us life remains a struggle, because they lack de- cent and affordable housing, they lack wages that can sustain a family, they lack adequate health care or any health care, they lack enough food to eat. Our Congress needs better information on the quality of life of Americans up and down the socioeconomic ladder in order to evalu- ate the effectiveness of our country's overall economic policies. When Chairman Greenspan testified last February, I raised the need for this type of information. Maybe we should have the Chair- man of the Council of Economic Advisors before us in order to have his perspective on these issues. But today, we have the Chairman of the Federal Reserve Board, and so today I address Chairman Greenspan and hope that he will be able to shed some additional light on these quality-of-life issues, such as the true purchasing power of both minimum wage workers and average workers during the course of today's hearing. If that is not possible at this hearing, I would hope our committee might have another hearing that particularly focuses on these specific issues. It is simply not good enough for us to speak in broad gener- alities about macro-economic facts and figures; we must under- stand how current economic policy impacts the lives of our citi- zenry. Mr. Chairman, I thank you; and I look forward to Chairman Greenspan's testimony. Chairman LEACH. Thank you. Generally at these hearings I like to just call on the Chairman and Ranking Member of the two subcommittees of jurisdiction, but neither are with us at the moment. Does anyone on this side wish to be recognized briefly? Mr. Frank. Mr. FRANK. Thank you, Mr. Chairman. I will be brief to get to the questions. In general, I want to express my hope that the moderation we saw from the Federal Open Market Committee at the last meeting continues, and I appreciate the extent to which the Chairman has been a moderating force against some people whose belief that in- terest rates must rise when unemployment drops is irrefutable, even in the face of the evidence. I am struck by the tenacity of the belief of some that a 4 percent unemployment rate must bring inflation, and I am surprised when I read the speeches of some on the Fed to learn that a form of Marxism has taken root there. It is Chico Marxism: Who are you going to believe, me or your own eyes? And they persist in believ- ing themselves and not our own eyes, which say that a 4 percent unemployment rate has been quite consistent with low inflation. I do have one question, Mr. Greenspan, that I hope you are going to be able to address; and it is the equity issue. One of the prob- lems we have is that we have greatly increased our wealth, but there has always been an exacerbation of inequality. On page 16 of the Monetary Report, there has been an example of the problem. You note that there has been an acceleration in the employment cost index, and the Fed cites the fact that this was most striking in the finance, insurance and real estate industry, perhaps because of commissions, reflecting the compensation structure there. Then you do go on to say: "However, the uptrend in wage infla- tion that surfaced in the first quarter ECI has not been so readily apparent in the monthly data on average hourly earnings of pro- duction or non-supervisory workers." This is the dilemma we have not collectively dealt with appro- priately. It is especially going to be a problem if, in fact, at some point the FOMC returns to the notion that inflation has become a threat, it certainly has not yet become a reality, and decides it has to raise interest rates, slowing down growth and reducing wage pressure. The problem is, as your Monetary Policy Report quite cor- rectly notes, the benefits of this have not primarily gone to people in the production and non-supervisory fields; and that is the di- lemma we face. As long as we have a situation where there is inequality in the way in which these gains are transmitted through the economy and our only response to the fear of overheating is an across-the-board slam on the brakes, which then will rain on the just and the unjust alike, we are going to have a problem; and that is the problem that is going to continue to manifest itself in the degree of opposition to global economic integration that you and others lament. So I just again want to emphasize I think we can cite this report as an example of our problem. The ECI is going up. That bothers people, as it should, given certain contexts. But the report itself cites the fact that that reflects an inequality, and when the wages of production and non-supervisory workers are not showing any in- flationary pressure, but they may have to suffer because of infla- tionary pressures elsewhere in the economy and that, of course, in- cludes the stock market, then we have problems. Thank you, Mr. Chairman, for the indulgence. Chairman LEACH. Dr. Paul. Dr. PAUL. Thank you, Mr. Chairman. I would like to just take one moment to thank the Chairman of the committee, Mr. Leach, for holding these hearings. I understand under the law now these are not required. I consider them very im- portant, so I appreciate very much his efforts to continue these hearings. I am a little bit disappointed in the trend away from the empha- sis on monetary policy; and I would be concerned, even if we con- tinue with these hearings, that we might be talking about central economic planning more than monetary policy; and I think the in- tent originally was that we would be talking about monetary policy. I believe it is very clear in the Constitution and very clear in my mind that we do have a responsibility here in the Congress to pro- tect the value of the dollar; and too often we forget about this and we allow the dollar to be controlled by outside forces and we do not concern ourselves about protecting the value. I say this with con- cern for a serious problem. To me, the nature of an inflated cur- rency really undermines the middle-class and the lower-middle in- come. These are the people that the left would like to just subsidize by further taxation, but I see this as a consequence of an inflated currency. So I hope Chairman Greenspan will continue to be will- ing to come and talk about monetary policies. I imagine we won't have any more targets to look at any more, because targets do not work very well, and I would understand that. And, over the years, my guess would be that the targets on money supply probably were never met about 90 percent of the time. But, still, the money supply is important. We should not ig- nore it. And I appreciate very much that we are still having these hearings. I hope they will continue. I thank the Chairman of the Committee on Banking for making an effort for these hearings to proceed. [The prepared statement of Hon. Ron Paul can be found on page 60 in the appendix.] Chairman LEACH. Well, thank you very much, Dr. Paul. Mr. Sanders. I wanted to do just two and two on each side as opening statements. Mr. LAFALCE. Mr. Chairman, I would suggest two Republicans, two Democrats and one Independent. Chairman LEACH. Let me just say we will offer an option to Mr. Sanders, of course, and then to Mr. Baker. Mr. Sanders, you are recognized. Mr. SANDERS. Thank you, Mr. Chairman. Thank you for holding these hearings; and thank you, Mr. Greenspan, for again joining us. I would agree with those who have already indicated the impor- tance of these hearings; and I hope that, by law, we maintain them. I would also agree very strongly with the points that Mr. LaFalce and Mr. Frank have already raised; and I think, Mr. Greenspan, we need to hear more from you on this issue. In one sense, there is no question but the economy is doing well; and there is wide- spread agreement. But I would hope that you will speak out to the American people and say what is obviously the truth, that despite the so-called booming economy there are tens of millions of Amer- ican workers today who are working longer hours for lower wages than was the case 25 years ago. So while Mr. Gates and other people are doing very well, that does not mean to say that there are not many, many other people who are struggling very hard to keep their heads above water. What we have got to do, and I would hope you would agree, is cre- ate an economy that works well not just for the people on top, but for ordinary people. I would hope that perhaps later on you might want to comment on how, in the midst of this booming economy, the average Amer- ican workers have now achieved the dubious distinction of working longer hours than the workers of any other country on earth. We recently surpassed the people in Japan. In fact, the average Amer- ican worker today is working 160 hours a year more than was the case 20 years ago. So, again, when we look at the booming economy, we need to see how it affects the average American worker. I think that Mr. La- Falce is quite right, that we need information which tells us that. How is the average American worker doing? Second of all, I would hope that you will comment on not only the issue of the fact that the United States has the most unequal distribution of income in the industrialized world, but also the im- pact of us having, by far, the most unequal distribution of wealth. Is it good economics that, in the United States today, the wealthi- est 1 percent of the population owns more wealth than the bottom 95 percent and that the gap between the rich and the poor is grow- ing wider? Is it good economics that one person owns more wealth than the bottom 45 percent of the people in this country? And then go beyond the individual and look at what is happening to the economy in terms of corporate control of one segment of the econ- omy after the other. This committee, of course, deals with banking. Do you have con- cerns about the fact that we have lost thousands of banks in the last 20 years and that the concentration of ownership in the bank- ing industry rests with fewer and fewer very, very large institu- tions? In the media, concentration of ownership rests with fewer and fewer large corporations. In many other industries, that reality exists. Should we feel comfortable that so few own so much and have so much power over the American economy? I would hope that when you get a chance to speak you can address some of those issues. Thank you, Mr. Chairman. Chairman LEACH. Thank you, Mr. Sanders. Mr. Baker. Mr. BAKER. Thank you, Mr. Chairman. Chairman Greenspan, I will be very brief. I don't have a question during this opening statement period, but I do wish to make ref- erence to a portion of the Monetary Report, specifically, page 21 in which the Chairman cites: "The Treasury and the Federal Reserve suggest it would be appropriate for Congress to consider whether the special standing of these institutions"—referencing the GSEs, Mr. Chairman—"should continue to promote the public interest and that pending legislation would, among other things, restruc- ture the oversight of these agencies and reexamine their lines of credit with the U.S. Treasury." I don't intend to ask questions today on that subject, Mr. Chair- man, but I wanted to make you aware that we are trying to con- struct the appropriate method of inquiry to your office during the month of August perhaps for you to instruct us further as to appro- priate policy that would be least disruptive to the markets. As you know, the committee has been involved for some time now in exam- ination of these questions, and your inclusion of this statement in your report I found very significant, and I wanted to thank you for that. Thank you, Mr. Chairman. Chairman LEACH. Thank you very much. I would also, before turning to the Chairman, want to notify the committee that the second bill up today is a bill that has a title, I believe it is going to be called Title VI, the American Private In- vestment Company Act, which is a bill that came from this com- mittee. So it is possible that people might want to speak to this on the floor, and people ought to be aware of that. Chairman Greenspan, please proceed, and welcome back again to this committee. STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. GREENSPAN. Thank you very much, Mr. Chairman. I very much appreciate the opportunity to appear before this committee to present the Federal Reserve's Report on Monetary Policy. I must say I subscribe to the comments that many of you have made that we at the Federal Reserve found exceptionally useful. And, indeed, in our judgment, as I believe Mr. LaFalce indicated, in a democratic society where you have an independent Central Bank, it is incumbent that we appear before the Congress at fixed times in the year to explain in as best detail that we can. I think we recognize that the system functions best if oversight is complete and instructive, if I may put it in those terms. 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 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 some time now, the growth of aggregate demand has exceed- ed the expansion of production potential, which, if it continued, would produce disruptive imbalances. The key element in this dis- 8 parity 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 no- ticeably 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. But other analysts point to a number of factors that may be ex- erting more persistent 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 diminution of the wealth effect through the spring and early summer. Another factor said by some to account for the spending slow- down is the rising debt of households. 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 equivalent of a tax of roughly 1 percent of disposable income. Men- tioned 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. 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 because the stock of consumer durables and houses may be running into upside resistance. The softness in outlay growth being so recent, all of the afore- mentioned 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 any productivity slowdown that might accompany a more subdued pace of production and consumer spending, should it persist. The behavior of productivity 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 five years have been. 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 broad range of equipment embodying the newer productivity-enhancing technologies remains brisk. And, for the moment, the drop-off in overall economic growth to date ap- pears about matched by reduced growth in hours, suggesting con- tinued strength in growth in output per hour. 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. In recent years, the sizable gap between the growth of domestic demand and potential supply has been filled both by a marked rise in imports as a percent of GDP and by a marked increase in do- mestic production resulting both from significant immigration and from the employment of previously unutilized labor resources. However, there are limits to how far net imports or—the broader measure, our current account deficit—can rise or our pool of unem- ployed labor resources can fall. The current account deficit is a proxy for the increase in net claims against U.S. residents held by foreigners. So long as for- eigners continue to seek to hold ever-increasing quantities of dollar investments in their portfolios, as they obviously have been, the ex- change 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 produc- tivity in the United States has also been inducing foreigners to ex- pand their portfolios of American securities and direct investment. But there has to be a limit as to how much of the world's savings our residents can borrow at close to prevailing interest rates and exchange rates, especially if a narrowing of disparities among glob- al growth rates induces a narrowing of rates of return here relative to those abroad. 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. By substantially augmenting national savings, these budget sur- pluses also 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 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 savings, so there is a limit to the continuing drain on our unused labor re- sources. Despite the ever-tightening labor market, as yet, gains in compensation per hour are not significantly outstripping gains in productivity. 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 in 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. But, as I indicated earlier, it is much too soon to conclude that our concerns are behind us. We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with po- 10 tential supply, will persist and there is still uncertainty about whether the current level of labor resource utilization can be main- tained without generating increased cost and price pressures. Inflation has picked up—even the core measures that do not in- clude energy prices directly. 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 re- source utilization may put upward pressure on inflation. Moreover, energy prices may pose a challenge to containing inflation if they become embedded in long-term inflation expectations. 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 1% 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 last meeting in June of this year, the appraisal of all of 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 suf- ficiently compelling 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 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 accel- erating growth and related demand-supply imbalances. Variation in the stance of policy—or keeping it the same—in response to evolving forces are made in the framework of an unchanging objec- tive, to foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate pos- sible. Maximum sustainable growth, as history so amply dem- onstrates, requires price stability. Irrespective of the complexities of economic change, our primary goal is to find those policies that best contribute to a non-inflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal. Thank you, Mr. Chairman. I would ask that my full remarks be included for the record. [The prepared statement of Hon. Alan Greenspan can be found on page 61 in the appendix.] Chairman LEACH. Without objection, your full statement will be in the record. Let me just return to one part of the economic picture that seems to me to be most imperfect at this time, and I don't want to dwell 11 on it, because there is always something that is up and something that is down. But the trade deficit does seem to be remarkably high. Would you care to lend your perspective on that and what can be done to reduce that deficit and what views you have on how this may be developing or help the economy? Mr. GREENSPAN. I think, Mr. Chairman, that we recognize where it is coming from and what the underlying causes are. The first time it appeared as though there were some abnormali- ties in the American trade balance that occurred many years ago. Indeed, back in the 1960's, certain analysts observed a persistent tendency on the part of the United States to import at a far higher rate relative to changes in income than existed among our trading partners. Arithmetically, that meant that if everyone was growing at the same rate throughout the world, we would be creating an ever-increasing chronic trade deficit, while others, of course, would have a corresponding trade surplus. Because of the fact that for many years following that period we grew at a slower pace than the rest of the world, that abnormality essentially was hidden in the differential growth rates, and, as a consequence, we maintained fairly substantial export surpluses for quite a substantial period. Two things have happened since. One, of course, is that the tre- mendous acceleration in economic activity in the United States has outstripped the growth rates of our trading partners, and, hence, we have had a double effect: our increasing growth rate expanded our net of exports, but that old basic coefficient of the relationship between imports and income has remained, quite remarkably. Second, the very forces, as I indicate in my prepared remarks, that engender this very substantial rise in economic activity, name- ly dramatic increases in potential rates of return, have attracted very substantial amounts of capital into the United States, which has meant that we could sustain a very substantial and indeed ex- panding rate of imports to GDP without pressure on the dollar's ex- change rate. Indeed, in certain measures, the dollar has actually firmed in this most recent period, suggesting that the propensity to invest in this country is actually, in a certain sense, marginally more powerful than our propensity to import goods and services. The difficulty that is fairly obvious is, as I mentioned in my re- marks, that this cannot go on indefinitely. That is, the current ac- count deficit is, with a few statistical and accounting adjustments, equal to the net change in the debt and, indeed, equity claims as well, of foreigners on U.S. residents. So long as they are willing to expand their portfolios of claims against the United States, every- thing is fine when we are in balance, and indeed, that is what has been going on for a number of years. At some point we have to expect that there will be a lessening interest on the part of foreigners in increasing their portfolios of dollars, at which point we are going to begin to get, invariably, some pressure on our accounts, and the adjustment processes will begin. Fortunately, also as I mentioned earlier, this rising surplus in the budget, and I emphasize the word rising as distinct from the level, has been a very major buffer preventing negative effects oc- curring to our economy as a consequence of our international defi- cits. And, I would suggest that we be quite conscious of the really 12 quite important elements of our economic stability that we now ob- serve that come directly from not only the level of budget sur- pluses, but the fact that they are still rising. And I think that the longer-term outlook of how we are going to address and adjust the trade balance suggests to me immediately that above all, the thing that the Congress, and indeed the thing that economic policy most generally can do to ease the adjustment on the international side, is to maintain the momentum of these budget surpluses, because I think it will only be in retrospect that we will truly understand how important they were to this prosperity we are now experi- encing. Chairman LEACH. Well, thank you very much, Mr. Chairman. Mr. LaFalce. Mr. LAFALCE. Thank you very much. Mr. Chairman, about a month or so ago, I went to a one-person post office in my district in Middleport, New York, and the post- master there told me the biggest complaint he ever gets from indi- viduals who have to go and pay their bank bill, checking account, with certified mail, registered receipt requested, and they have to pay $3 to $5 in order to avoid a $29 late penalty. In that small lit- tle village, he said, there are at least 20 to 30 people per week who do that. Last Wednesday, I wrote about half a dozen checks myself that had a due date of July 23rd, which was Sunday, and I thought, "Gee, if I get it in the mail tomorrow, Thursday, I am wondering if I am going to get a late fee, because they might not be received until Saturday, it might not be posted until Monday, the 24th, and here it was last Wednesday. I am going to be interested to see what happens on that." Then Monday morning, I went to the post office in Kenmore, New York 14217, and the woman in front of me was doing the same thing, trying to make sure that there could be some delivery the next day to avoid a $30 fee. The statutory requirement for the Fed report to Congress on bank fees has expired. I wrote to you on Friday requesting that you don't wait until the legislation passes to begin this, that you could do this on your own. What is the disposition of. the Fed to con- tinuing the study on bank fees? I think that this is a very impor- tant issue. Mr. GREENSPAN. I understand the problem quite well, Congress- man. I don't fully have an answer yet to respond to your letter, but if the Congress does not pass the legislation, implying that it is the congressional will to, in fact, eliminate that particular report, we are then in a position where we would be overriding the Congress and that would require, obviously, a whole series of procedures that we would have to go through. Mr. LAFALCE. You can study anything at any time that you think is important without a mandate to study it, could you not? Mr. GREENSPAN. Well, I hesitate to respond fully to your question as indeed I have not, nor has my staff, fully come to grips with how to respond to you on this question. I am giving you our early thought patterns. It is not that we question the substance at all. I mean, on the contrary, obviously it is an important issue to a number of people. 13 Mr. LAFALCE. OK. Let me go on then, and then I will await an answer from you at some later date. There are a number of phenomena that I would like to talk about very briefly. Globalization, a lot of good, a lot of problems with it. Tremendous increase in technology, particularly in the financial services sector; a lot of good, a lot of problems with it. My first question is, what problems do you see with globalization and the increased use of technology? Who will experience those problems, and what options are you coming up with, if any, for the Fed to do something about it within your limited sphere, and what recommendations for others, including the Congress, to do some- thing about it within our sphere of influence? The next question if we have time, one of the biggest concerns of mine is the increased need for financial literacy in this newly globalized and technological world. I am wondering what the Fed with its various offices around the country might be able to do, working in concert with others, the Department of Education, to significantly enhance the level of financial literacy of our constitu- ents? Mr. GREENSPAN. Congressman, the issue of globalization is prob- ably one of the most important issues confronting not only the United States, but all of our trading partners as well. The cause is fairly evident; that is, the technology that has emerged has blos- somed forth in a remarkable way, and the proliferation of financial products has created strong pressures to deregulate, because, in a sense, the markets were creating very significant efficiencies, and the need to break down barriers came up fairly quickly. And I must say, to the Congress' credit, the response over the years, I think, has been really quite appropriate and, indeed, quite rapid, and it has enhanced the United States' position in the global world. However, one of the characteristics of rapid globalization is that it is rapid, and rapidity creates mistakes, it creates instabilities, and it creates very significant concerns on the part of the people who are dealing in an environment which they have difficulty un- derstanding in the sense that things are moving too fast and are not readily understandable. Nonetheless, the bottom line of globalization by all of the evi- dence that we can marshal is that it has been a major factor in in- creasing living standards not only in the United States where it is quite evident, at least on average, but pretty much around the rest of the world. And as a consequence of that, the one thing we ought to be very careful about is to be sure to recognize that there are shortfalls and difficulties in the implementation of a globalized economy, and indeed, we must address them as best we can. The thing we ought to avoid like the plague is anything which undercuts the actual continuation of that progress, because there is too much poverty in the world which is being addressed by this dramatic globalization. I should think that all of us, observing the unquestioned advantages of improved trade across national borders and the efficiencies that that evokes, that we ought to be acutely aware of how important that is to living standards. I do not deny that it carries with it the side effects which have all sorts of nega- tive consequences. I think they have to be addressed, but we should 14 be as forthright as possible not to inadvertently upend this process of globalization which is doing so much for everybody. With respect to the second question relevant to financial literacy, we at the Federal Reserve endeavor to do that. Indeed, a number of the individual Reserve Banks have all sorts of mechanisms and seminars and the like to communicate to the public as best we can on numbers of issues on improving financial literacy. I do believe that the degree of financial literacy in this country, on average, has gone up dramatically in the last two or three dec- ades. There are still, obviously, problems. There is a lot of difficulty in understanding certain technical interest rates and discounts and other financial matters that it would be helpful if there was more awareness of a lot of these issues. I do think, however, that progress is being made, but we at the Federal Reserve look forward to doing whatever it is that we can do in that regard. Chairman LEACH. Thank you very much. Mrs. Roukema. Mrs. ROUKEMA. Thank you. Mr. Chairman, we greet you again today, and we acknowledge the fact that you are doing an excellent job, and testimony to that was that the day after your testimony before the Senate on this subject, stocks rose 100 points, and I don't know what is going to happen tomorrow after your testimony today, but let's hope we are looking at the same kind of thing. But seriously, I believe that you have given us good advice and set a good standard for us, and that we have our job to do in con- tinuing to pay down the debt and dealing intelligently and appro- priately in a fiscally responsible way with the surplus, as you have outlined. But, I have a specific question with respect to looking at safety and soundness and continuing banks operations in the short term, as well as the long term. Of course, financial institutions today are benefiting from the strong economy, clearly, but many seasoned bankers remember the days when the times weren't all this posi- tive. And as many say, some of the worst loans are made in the best of times. I don't know if you agree with that or see any evidence of that in this climate particularly, but that is why I have been so con- cerned about a recent accounting proposal made by the American Institute of Certified Public Accountants. The proposal, as I under- stand it, would seem to constrain—it is a proposal to the Financial Accounting Standards Board, and it would seem to constrain the ability of bank management to set an appropriate level of loan loss reserves. I sent a letter to the SEC and to FASB expressing my concerns. It is only a recent letter, I have not gotten an answer back, but the letters addressed my concerns over this draft proposal, and I think that I would like to have your opinion concerning this. What level of direction do you believe is appropriate for bank management and the Federal bank regulators in setting sufficient loan loss reserves? That is the heart of the question. Do you believe that having a strong level of loan loss reserves in this strong econ- omy would lessen and kind of anticipate potential problems and 15 diffuse them if and when there is a financial downturn? I am deep- ly concerned about that, and I think it gets to the heart of safety and soundness questions that we have dealt with in the recent past. Mr. GREENSPAN. Well, we share your concerns, Congresswoman. Indeed, the banking regulators have sent a letter to the AICPA in- dicating that we thought that the proposed rules were counter- productive to the safety and soundness of the banking system. The problem that we have, of course, is that the banking regu- lators can do whatever they choose, but if the accountants specify that you cannot include in reserves generalized estimates of where risks are, which is effectively codifying management's views, but are required instead to only create those reserves on the basis of absolute evidence of losses or potential losses, it strikes me that we would get a very significantly suboptimum degree of bank reserv- ing, and that, in my judgment, would be a mistake. I think that the criteria that are being set up for the purposes of making a judgment as to when the generic reserve can be put in place is far too high a barrier, and, indeed, it tends to mechanize what is a very sophisticated banking procedure. The one thing that banking is all about is judging future losses, and the extent to which you are a good banker is the extent to which you can do that. You are going to make loans which fail, which are not repaid. You don't know which they are, or obviously you would not make them, but you have a general sense of what is out there. What differentiates good from bad bankers—is those who can do that, and it strikes me to inhibit that particular char- acteristic of banking from being reflected on the books of the bank is a mistake. Mrs. ROUKEMA. Well, then, we should all be working together to counteract this action and to assure that it is not going to take place and not going to be put into procedure, correct? Mr. GREENSPAN. Well, I should certainly hope so. Mrs. ROUKEMA. Well, we will keep this conversation going and align ourselves and take whatever action we need to. You haven't gotten a response yet, or have you? Mr. GREENSPAN. Not to my knowledge. Let me just say this on behalf of the SEC. Their concerns are le- gitimate—that bank reserves not be manipulated to alter the per share earnings estimates and expectations of companies traded on organized exchanges. We had a long discussion with the SEC, and we have come to a general agreement, but that is not reflected, at least that is my understanding, in the AICPA. Mrs. ROUKEMA. That is my understanding as well, but we can all work together on that and come to a precise definition. I will recognize that Mr. Baker has already raised the subject of the GSEs, Fannie Mae and Freddie Mac and the Federal Home Loan Banks. I would simply say that I am going to be listening very carefully, and we have gone through a number of hearings on this subject. And of course I recognize the legitimate questions that Mr. Baker's subcommittee is addressing, particularly the mission creep aspect of it, but I will be holding off and listening very care- fully to your responses to those particular subjects of Freddie Mac and Fannie Mae. But I do want to state to you unequivocally that 16 I think there are so many complexities on this that we should not be rushing to judgment and would want to work in a very thought- ful and profound manner on the subject as we move forward on the issues. Mr. GREENSPAN. I just want to say that clearly nobody wishes to rush to judgment, but the notion that the issue is on the table and must be examined, I think, is going to be healthy for all parties concerned, including the GSEs, I might add. Mrs. ROUKEMA. Yes. I agree. Thank you very much. Chairman LEACH. Mr. Frank. Mr. FRANK. Preliminarily, Mr. Chairman, just in line with what Mr. LaFalce noted with regard to the banks, and this is really, for me, a kind of a model of the broader issue to get into. One of the problems we have, I think, is that the consolidation we have seen in the financial industry generally has been a good thing, but the problem is it creates macro-efficiencies and micro-inconveniences, to the public, the micro-inconveniences are far more clear. I would urge both the regulators and particularly the institutions them- selves to worry more about those inconveniences, because the cu- mulative negative effect of the inconveniences builds up, and you have opposition to the kind of public policies that would move for- ward. That is really what I want to get into with regard to globalization. I was interested, as you have in the past, you have candidly acknowledged that there are some negative side effects. The problem is that I think the way in which you now structurally address policy, I am talking now about the Fed and the rest of the Federal Government, we are helpless to ameliorate the side effects, and the negative side effects buildup to counter our ability to go forward. I say that even though I want to acknowledge that I think you have been very constructive in holding off the Luddites who do not think productivity is relevant to the unemployment/inflation issue, and the fact that you have resisted pressures to raise unemploy- ment unnecessarily is a benefit. But here is the dilemma we have. You acknowledge that there are negative side effects. In your speech in April of 1999 in Texas, you acknowledged again that some production workers are hurt by the very factors, globalization, changes in the economy, that help all of us. Now, you explained then, in part, that they were experi- encing the Schumpeterian phenomenon of creative destruction. I tried it out, and it doesn't buy you a great deal when you explain it to them. But the problem we have is, OK, if Schumpeter does not get us out of this dilemma with the people who are losing their jobs, what will? And here are the problems. Your charge, as you see it, is price stability. I am struck—it does seem to me at the close when you say, our primary goal is to find those policies that best contribute to a non-inflationary environ- ment and, hence, to growth, is kind of a de facto amendment of the act here; that the two goals which had been coequal of growth and price stability, what happens is that price stability becomes the goal, and growth becomes the second goal. But here is the problem. You list some problems that may re- quire you to reduce aggregate demand. In the past you have ex- 17 pressed concern about the excessive variation of the stock market. Today you address both in your comments and in the report the problem of a growing trade imbalance. You also talk about the problem of increasing pressure on wages, because of the shrinkage of the available labor pool. Now, all three of these are problems that could lead to inflation or other dislocation. The response in every case is to reduce aggregate demand by raising interest rates, by slowing down economic activity. As you say, you welcome here—a lower overall rate of economic growth that did not carry with it a significant deterioration would be a desirable outcome. Well, from the macro sense, yes. But if you are one of those workers who has not been doing very well, it is not a desirable outcome. It is an undesirable outcome with undesir- able consequences. Here is the problem. What do we do about this? Ultimately you say we may have to drop aggregate demand because of the trade imbalance. Your report on page 16 notes that we have some wage inflation, but not primarily for the lower income people; for exam- ple, non-supervisory and production workers. People on commis- sions, people in the newer economy sectors are the ones who ben- efit. Certainly when we have to think about slowing down, because the stock market is improving, we are not helping people at the low end. Now, some of us have said, all right, well, maybe there will be some Government intervention, but you also want us not to spend any Government money. You want to keep the surpluses growing. Now, as the Chairman pointed out, that is a problem for the people who want to cut taxes, and it is a problem for the people who want to raise spending. Well, if the response to wage inflation primarily among upper-in- come people and not among lower-income people, is an increased stock market, for upper more than lower, a trade deficit which in itself hurts the workers, so here is the real problem for them. They are hurt in the short term by the trade deficit, and then the re- sponse of the trade deficit that hurts them is, we have to hurt them again, because we have to slow down aggregate demand, and then if we don't spend any money to help them with health care, and so forth, all I can tell you is don't be surprised when Schumpeter is a lot less persuasive to them than it might be in another context and they are going to continue to oppose the very things you talk about. You say you don't want to see globalization undermined. Well, the major force undermining globalization in this country today is the reality and the perception of inequity. They overlap, they are not identical, but they are both important facts; the reality and the perception of inequity, and all of what I just talked about exacer- bates that. If the only response we have to the trade deficit, to wage inflation, to the stock market, if the only response is to re- duce aggregate demand by raising interest rates and not to in- crease any kind of governmental spending to try to help out, then, as I said, you are going to have to continue to cope with this resist- ance, and that, more than anything else, will be the negative factor that you will face. 18 Mr. GREENSPAN. Let me comment on a few points that you are making, Congressman. First, let me just say for the record we do not and have not been targeting the stock market for purposes of endeavoring to stabilize this economy. We react if and when stock market price changes impact on the economy. We respond to the economy. Mr. FRANK. I understand that, and I don't say that you are. Mr. GREENSPAN. I just want to say that for the record. Mr. FRANK. I appreciate that, but here is what you have ac- knowledged, and it is the same point. I spoke in shorthand, and I apologize. You have noted that the wealth effect, if the market goes up, how that contributes to spending, so once again we have a phe- nomenon where as people at the higher end of the economy do very well, that generates inflationary pressures, the brunt of which are felt by people at the lower end when we take corrective measures. Mr. GREENSPAN. Let me first say that the economy has been moving at a fairly dramatic pace, as you well know. The effect of this is to essentially stop the erosion that was occurring in the labor markets, where, as a consequence of a number of techno- logical problems, the dispersion of incomes, the inequality of in- comes, was increasing. That has stopped in recent years, and ev- erybody in this economy is, at least, moving higher. The problem that exists here is that unless we can close the gap between supply and demand by accelerating productivity, which we are doing in part, that the remainder has to occur on the demand side. If it does not, then the prosperity which everyone is experi- encing will be put at great jeopardy. I did not say, and I do not say, that I am against all actions that ameliorate the problems of those, for example, who have been im- Eacted by trade liberalization. Indeed, I have said on many dif- jrent occasions that it is the problem of retraining and addressing their problems rather than endeavoring to protect the industries from adjusting to the marketplace which ultimately they will lose, a process that will occur in any event. So I am not against the issue of expenditures or other governmental programs which actu- ally assist and assuage the problems that occur as a consequence of globalization. I am against all of those activities which prevent the economic problems, economic adjustments from occurring, be- cause you cannot hold back the dam. All you do is you hurt the people whom you are trying to help. Mr. FRANK. Mr. Greenspan, the effect of—and I appreciate if I could get one more minute, Mr. Chairman—I acknowledge, yes, it has been the growth that has stopped the erosion, but what we have are other people on the Fed, and I appreciate the fact that you have stood against them, who want to stop the very trend that has prevented the erosion, and the only thing that has dealt with inequality in recent years has been the great rate of growth. If we slow that down, we get back into it. So I welcome your resistance to some of them, but I fear the consequences of a renewed slowing down of growth. But the other issue is, I am glad to hear you say you are for these programs, but to be honest, it comes in response to my ques- tions, the thrust of your remarks doesn't leave us a lot of room for them, and I would then appreciate if you would give us your eval- 19 uation. Obviously my time is up. Are we doing enough in this area, and if not, what more should we be doing? Because unless we are doing more than we now are doing, you are going to continue to have this resistance. Chairman LEACH. Mr. Baker. Mr. BAKER. Thank you very much, Mr. Chairman. Chairman Greenspan, as all others have, I compliment you and those on staff for exceptional and adroit skill in management of fi- nancial markets, allowing significant economic growth without ab- errant inflationary consequences. I think it important to note, however, that technological diversity and marketplace changes are inevitable; that there were those in the manufacture of steam locomotives who were very adversely im- pacted by developments of more efficient and environmentally re- sponsive methods of moving freight. And the economic history is re- plete with examples that worked in one instance which no longer are valid. In your managerial responsibility, if it were not for the con- sequences of slowing unwarranted rates of growth, the very people some Members have concerns about would be the most adversely impacted, with increasing interest rates, the higher cost of goods and services, and diminishing wage rates, as pressures in the com- petitive market have that consequence. Those low-income individ- uals are the least capable of adapting to the inflationary con- sequences of an uncontrolled, unbridled growth. So it is a very difficult mission. On the one hand, control the growth to not promote inflationary forces, but don't slow it enough to where opportunities don't continue to develop in the market with new investment. So I think there has been exceptional skill demonstrated in that arena. In fact, as a result of the managed growth, the unexpected revenue increase to the Government has caused us to see extraor- dinary paydown of public debt, which I think all of us agree is a positive development. At the same time, and I quote from page 20 of the report: "Aware that distortions in Treasury yield are likely to become more pro- nounced as more Federal debt is paid down, market participants have had to look for alternatives in the pricing and hedging roles traditionally played by the Treasury in U.S. financial markets." And you go on to cite interest rate swaps as a significant contrib- utor. In fact, over the decade, the derivative market has had an ex- traordinary rate of growth, and the notional amount of those secu- rities is exceedingly high. In fact, of that derivatives market, in ex- cess of 90 percent, I am told, are now purely financial transactions in nature. The reason for this short background is that now pending is a debate in the Congress about the appropriate role of Federal finan- cial regulators in relation to this derivatives market. Given the fact that there is an enormous amount of these transactions which are purely financial, the fact that they have developed over a very short period of time, have achieved international market penetra- tion, not just domestic, given the consequences of missteps in that marketplace to the soundness of future economic growth, would you feel more comfortable in our determinations on this matter if the 20 primary regulator of these activities were a Federal financial regu- lator as opposed to an agricultural commodity regulator, given the history, the dynamic growth, the complexity? And I think you make reference somewhere else later in your report that something less than a month ago, the market developed a new futures product re- lating to Fannie and Freddie, extraordinarily complex institutions, very difficult to understand the consequences of a misstep, and that these securities point to the likely direction of the develop- ment of this derivatives market in the years to come. We can't even define what they are, much less satisfy ourselves that we thor- oughly understand the risks they present. I, for one, would be much happier with a financially competent regulator looking at these activities and recommending appropriate action to the Congress. Are you comfortable in responding to that? Mr. GREENSPAN. Congressman, let me just say that the bill that is proceeding through the Congress, hopefully prior to the expira- tion of the Commodity Exchange Act—I think it is September 30— has got some very important and very useful aspects to it. It cre- ates, finally, legal certainty on the whole structure of over-the- counter derivatives. Over-the-counter derivatives are not unregu- lated. Financial institutions regulate them. In other words, the banking agencies are the regulators of the over-the-counter deriva- tives market. The question of whether, in fact, the CFTC should continue to regulate the exchanges on which derivatives are traded is another question. My own judgment is that they have been doing a reason- ably good job of it, and indeed, the most recent rulemaking on the part of the CFTC seems to address a number of the issues that have emerged over the years, which have created a degree of com- petitive imbalance between derivatives traded on exchanges and those over the counter. Indeed, the way in which all of us in the Working Group perceive that that is appropriately addressed is to balance the regulatory structure in a manner which looks forward to legal certainty on over-the-counter derivatives and the expansion of the derivatives markets, with the CFTC, the banking agencies and the SEC all doing their appropriate role, in recognition of the importance of this market and how crucial it has been to the economic prosperity we are now experiencing. I think there is a general agreement amongst financial institu- tions and, as best I can judge, within the Congress on this issue, and it is really quite a remarkable consensus, and I trust that the inevitable endeavors to fine-tune the edges of this in many dif- ferent areas will not prevent the essential thrust of this legislation getting through this summer. Chairman LEACH. Ms. Waters. Ms. WATERS. Thank you very much, Mr. Chairman. Chairman Greenspan, it is good to see you. We welcome you back. Of course, you come in on the heels of recent testimony at the Senate and a very interesting article written by Mr. Arbach, who creates more discussion about the fact that there is a strong belief that you are using monetary policy to target the stock mar- ket. I think, even though it was alluded to in the last discussion, 21 well, in the discussion you had with Mr. Frank, I would like to hear a little bit from you about whether or not there are tran- scripts from the 1994 meetings of the Federal Open Market Com- mittee indicating that you were going to target the stock markets with statements like, I think there is a lot of bubble left around, and the comments by Mr. Arbach, and if this is not true, why do you think there is lingering discussion about your using monetary policy to target the stock market? Mr. GREENSPAN. No, that is a very important question. Just sub- sequent to that particular transcript to which you are referring, I raised in a speech the whole broad issue of whether monetary pol- icy should direct itself, in part at least, at asset values generally. Prior to then, and indeed it was reflected in my views in 1994, I frankly wasn't clear on whether we should or we shouldn't. I raised the general notion in a speech in, as I recall, December of 1996 about whether it is appropriate or not. In subsequent evaluations and a good deal of thinking about the process, I concluded not, and it is my judgment as of today, and indeed, it has been my judgment for the last two or three years. It was not my judgment in the earlier period, and indeed, it was not my judgment in 1994. Ms. WATERS. Well, thank you. I appreciate that clarification. Let me just say that, again, each time you come before this com- mittee, I am reminded of your visit to my district and the walk that you took along one of the avenues where we had vacant lots and boarded-up buildings. And while the economy is doing extraor- dinarily well in some places, there are many places in this country, such as the street you walked down and in some rural areas, that are not doing so well. And what I really want to understand is when you talk about Government surplus and you say to us that we must continue in ways that will help to have a Government sur- flus and pay down the deficit, because this is good for the economy, want to know, is there room for discussion about what is a pru- dent reserve or surplus; and what does the Government do to fur- ther the aims and goals and elimination of poverty; and what good, if any, is tremendous investment in job training; what does a trained people do to help foster the growth and development in an economy; and should the Government have a role in that? Does that eliminate poverty; does that create growth? And second, while I know that you don't particularly favor Gov- ernment investing in business opportunities in these areas or in any areas, when do you send a message to those who are doing well that investment—not subsidies, but investment—in inner city and rural areas would be good for the economy, and that is what we should be doing when we are experiencing such growth in our economy? Mr. GREENSPAN. Well, Congresswoman, I have always supported endeavors by the private sector to take more risks in our inner cit- ies, because, as you know, my view is that we are plowing too much in the way of debt in the cities and creating a large debt obli- gation. What we really need is equity. And indeed, I think the ex- tent to which we can encourage investments in the inner cities, we will find that that is, by far, the best way to create significant im- provements. 22 I have not been very favorably disposed to a large number of the job training programs which I have seen occur over the years in which we appropriate funds, we set up a program, subsequently we review it, and find out that it didn't do anything. Indeed, there has been a very significant effort on the part recently of the Adminis- tration, indeed, recent Administrations, to consolidate a number of these particular programs. In my judgment, the best job training is on the job, and there is no substitute for getting people employed. The dramatic decline in the unemployment rate of those with lesser skills in this economy is by far the most important job-training process that we have had in this country in a very long period of time. People have been able to pick up job skills, which has enabled them to get on the first rung of the job ladder and to climb up, and in the event of the next economic downturn, a far greater proportion of the lesser-skilled people will have gotten sufficiently secure in their jobs that they will not, as they have so often in the past, be laid off as in the ear- lier stages of an economic recession. So as far as I am concerned, the most important thing that we as a Government can do to enhance the economic capabilities of the lesser-skilled people in this country and the inner cities is to keep this economic growth going, keep it producing the type of job de- mand that we see, and create significant, strong improvements in the underlying skills of our work force. The one caveat I raise with respect to this issue is that there is a quite legitimate question of whether we get to the point where we have gotten labor markets at such a tightened level that they cease to be a net positive on balance, doing the type of good they have been doing for so long. It is possible to get markets which are too tight, which create inflationary imbalances and ultimately un- dercut the recovery. In my judgment, it is appropriate for us to find the right balance. There is, to be sure, dispute within the economic fraternity, as has been alluded to previously, as to where the appropriate balance is. At the moment I think the evidence is difficult to come by on both sides of this, but that there is such a point, which is an opti- mum balance of a tight labor market, creating job training, job skills, and forward momentum in the whole area of employment. There is a point at which that is maximized, but there also is a point, if you go too far, at which it becomes counterproductive. Ms. WATERS. If you will yield for one moment so that I can be clear. Are you saying that you recommend that some level of unem- ployment is good for the economy? Mr. GREENSPAN. I would say there is some level of unemploy- ment in which you can create an imbalance in the labor markets in which you get wage inflation rising faster than productivity. There is a big dispute as to where that level is. This is not, inciden- tally, the nature of the NAIRU question, which is another issue. It is the question of how we can make this economy function in an efficient way. There are those in the economics profession who believe we have already gone beyond the point at which we are creating instabil- ities. I personally don't believe that, but, to be fair to all sides in this argument, the evidence is not yet clear which side is right. 23 Ms. WATERS. Let me just ask, for those in your world that rec- ommend that there is some level of unemployment that is basically good for the economy, that is stabilizing, are there any subsequent recommendations about what you do for the people who are caught in the situation who will be the unemployed? Then does the Gov- ernment have a greater role to do something because it is in the best interest of everybody for them? Mr. GREENSPAN. Remember, when we talk about unemployment, it is important to distinguish between so-called frictional or quasi- voluntary unemployment and the actual level. In other words, there is invariably, in a free labor market where people are free to quit, to get a job, do whatever they wish, a number of people who are between jobs for voluntary reasons—they want go on vacation, or what have you. They are, in most instances, counted as unem- ployed at that particular point. So that the issue here really relates more to the question of the voluntary, so-called frictional unem- ployment level, not to the necessity, as some people put it. I agree that you need a number of people who are unemployed to hold wages down. I don't believe that is what the issue is. It is an issue of trying to define at what point do you create instabilities in the labor market which are counterproductive to everybody's in- terest, including those who seek a job. Because one of the charac- teristics of a low unemployment rate is that for those people who are out of a job, their unemployment spell is much shorter than it is in periods when the unemployment rate is high. So it is to everybody's interest to keep this market working as efficiently as possible, and that is a difficult issue to make judgments on, and there are legitimate differences amongst those who are specialists in this area. Ms. WATERS. Thank you. Mrs. ROUKEMA. Thank you. Mr. Castle. Mr. CASTLE. Thank you very much, Madam Chairwoman. Good morning, Chairman Greenspan. It is a pleasure to have you here. I am going to shift gears enough that it may even throw you off a little bit to a subject that you are not that familiar with, but it is something that is under the Federal Reserve that is of par- ticular interest to me for reasons which I will explain. And that is I was a sponsor of the legislation that created the 50 State quarter program and the new golden dollar program. So as a result of that, when there are concerns about this, I seem to hear about it I guess a little more than perhaps some other Mem- bers of Congress; and about two months ago we convened a meet- ing in Bloomington, including representatives of the Federal Re- serve, about some coinage shortages across the United States of America and as they pertain particularly to the Bloomington, Dela- ware, area, but seemingly reflected elsewhere. This is obviously a Mint problem, a Treasury problem, but also a Federal Reserve problem as the distribution agency for coins and paper currency to financial institutions around the country. The problem basically is that these programs have been perhaps more successful than had been anticipated. In fact, many of us who had never thought about collecting coins at all are collecting coins al- 24 most to the point of every American family in some way or another collecting coins and taking them out of circulation. The manufacturing of these coins, which as you know takes place at our Mint sites throughout the United States of America, has in- deed forced shortages I guess in other areas, based on what I am hearing. That is in pennies, although there are many people who think we should eliminate pennies. We have not. We still need to distribute them. The banks still need to deal with them. While all this is fun and highly educational in terms of the quar- ter programs and people are enjoying it, this is creating some real- life problems for the banks across the United States of America. Again, I am not sure you are familiar with this. I don't know if I am going to be asking about a specific answer, but just for you to look into it. But the bottom line is, I have been talking to the peo- ple again in Delaware about this, and I understand that the Fed- eral Reserve is only allowing banks to order 50 percent of their nor- mal orders for pennies and 80 percent of their normal order for quarters at this present time. Again, I think it is because of the Mint usages which is going on. The next quarter to be issued is a New Hampshire quarter on August 7th, and apparently the security people who deliver the quarters are saying they are going to have to wait for three ship- ments from the Federal Reserve before they can deliver them, and then all of those quarters go at once. There are lines, there are peo- ple who are frustrated, because they can't get them, and that is a problem. The Federal Reserve's position is, once they are in circulation that there are plenty of quarters, that there is not an inadequate number of quarters per se, and you can mix them together, that is, all the various States and every other quarter that ever existed, and redistribute them, which is probably correct. But the bottom line is the banks have this huge demand for the new quarters as they are being issued; and, because there are suffi- cient quantity overall of quarters, the statement is we are not going to make more in terms of the various States. And I am not necessarily suggesting they should, but I am saying the banks are complaining vociferously about this to the Mint, to the Treasury and to the Federal Reserve. So that is a concern that I have, but the greater concern may be some of the shortages which are occurring—and, quite frankly, I am not totally convinced that all of these separate agencies are speaking to one another about these problems and with the bank- ing community in terms of actually finding solutions, or I may be wrong about that, because I am not familiar with the internal workings of what is going on at the Federal Reserve. I have a hunch this is beneath your particular pay grade in terms of the things you have to think about in respect to all the global issues. But, quite candidly, when you deal with the banks, they are raising quite a fuss about this. And it comes to me, and I hear about it. And I said, I think I know exactly the man to ask. And here we are, and that is my question to you, if you could help me. Mr. GREENSPAN. I think you indicated the cause of the problem originally, Congressman, in that there is a remarkable accumula- 25 tion of all sorts of coins somewhere, because we know they are pro- duced. We know in a general way what probably is required for transaction balances throughout the system and the numbers of coins produced are really quite beyond that. I have forgotten what the number is, I think it is something like half the new dollar coins are out of circulation, in somebody's piggybank or whatever. And one of the problems that you are get- ting, I assume, is the fact that, perhaps because of the general level of prosperity, people perceive that coins are throwaways in some form or another, that you stick them in a drawer and they just sit there without interest. I admit to the fact that I probably have a lot more pennies than I probably should have. That is because when you get change they add up, and you don't know what to do with them. I think it is a problem which the Mint is struggling with mightily, and I would scarcely argue, as you indicated, that I am in any way an expert on this issue. I am aware of the problem. I do know that there is very good interaction between the Federal Reserve people at the Federal Re- serve Banks, at the Board, the Treasury, the Mint and the like. So I know the coordination is going on. But I am sure they have got a solution to this. I just don't know what it is at the moment. Mr. CASTLE. If I could just follow up, Madam Chairwoman, just very briefly with a statement. With respect to the people's treat- ment of coinage, I don't think people are treating particularly the 50 State quarter program as if it is insignificant from a monetary point of view so much as a brilliant investment. Mr. GREENSPAN. Are you saying we shouldn't have done the State program? Mr. CASTLE. I think it is an excellent program. I think it has worked extraordinarily well. I just think we as a Government need to make the adjustments to it to make sure that our banking sys- tem can meet the needs. Let me just say that if you had purchased the Delaware quarters initially you would have about a 400 percent return in a couple of years. There are not many stocks which have done that. I think ac- tually people are hoarding these quarters on the basis that they are going to become more valuable, which was never the intent, but that really is a factor out there that has to be taken into consider- ation. Mr. FRANK. If the gentleman would yield, don't get him started on another wealth effect. Mr. CASTLE. I wasn't trying to do that. I would just point out that little fact out, and I do think we do need to communicate. The program is infinitely more successful than anybody expected. That is generating revenues, as you know, for the Federal Government. So I think it is a good program, but we do need to address the Eroblems. I hope you will continue to communicate, and I yield ack the balance of my time. Mrs. ROUKEMA. Thank you, Mr. Chairman. Now we have Mr. Sanders of Vermont. Mr. SANDERS. Thank you, Madam Chairwoman. Madam Chairwoman, one of the reasons in the United States that we have by far the lowest voter turnout of any major country 26 is that I think, increasingly, the average American no longer sees a connection between what takes place in Washington and what takes place in his or her life. They hear us talking; and they say, "Well, that is very interesting. Does it impact on my life?" And I would suggest, Mr. Greenspan, that when you and perhaps some Members of this committee say today that this economy is really doing well for everybody, the average American looks around and says, 'Well, maybe the friends that Mr. Greenspan has in the country club, that they are doing well, but they are not doing well for the average working person." I regard it as an insult to keep talking about the so-called boom- ing economy when, in fact, millions of Americans are working longer hours for lower wages, when the minimum real purchasing power of the minimum wage is significantly lower than it used to be, when large numbers of people who want to work full-time jobs are now working part-time jobs or they are working temporary jobs with even no benefits or inadequate benefits, when low-wage work- ers in the United States are the lowest paid low-wage workers of any major country, when 20 percent of our children live in poverty, which is many times higher than the child poverty level of Europe or Scandinavia. How do we talk about a booming economy when we have the in- sult of having the highest rate of childhood poverty in the industri- alized world, when millions of elderly people cannot afford their prescription drugs and are cutting their dosages in half, when 44 million Americans have no health insurance, when in city after city we have major housing crises and working people are paying 30, 40, 50 percent of their limited income for housing? I would suggest we stop the nonsense about talking about how the economy is booming for everybody. Mr. Greenspan, the Federal Reserve's most recent survey of con- sumer finances, your own agency, says that the mean income of poor families, those earning less than $10,000, and middle income families, those earning between $25,000 and $99,000, actually fell between 1989 and 1998 after adjusting for inflation; while high-in- come families, those earning $100,000 or more, saw their average incomes rise. That is your report from the Federal Reserve. That is the first point that I want to make. The second point that I want to make is that I have real con- cerns—maybe no one else does, but I do—about the growing con- centration of ownership in this country and in fact throughout the global economy. Mr. Greenspan, as you will remember, Mr. Leach held an impor- tant hearing here several years ago on the fact that the Federal Reserve Board orchestrated an international bailout of a $5 billion hedge fund known as the Long-Term Capital Management; and you, of course, testified at that hearing and played an important role in that bailout. That hedge fund had borrowed heavily to make losing bets on currencies, and you were concerned and helped put together a consortium of folks in the banking community to partici- pate in that bailout. You were concerned that the failure of Long- Term Capital Management threatened its lenders with losses that could disrupt the entire United States financial system. That is how concerned you were about that. 27 Now my question is, if you had to act so boldly, erratically—I think you held a Sunday morning meeting that you put together with a consortium of bankers—what do you think about the fact that we are seeing recently mergers such as that between Trav- elers Insurance and Citicorp to form a company with assets of al- most $700 billion, 140 times larger than the assets of Long-Term Capital Management? We are seeing big banks becoming bigger and the question is, what happens if their loans go south? What is going to happen to our economy? How many meetings are you going to have to take to put together consortiums to bail them out? How much money are the taxpayers of the country going to have to come up with in order to preserve the economy? So those are my two questions. I would prefer, strongly prefer, that you not continue to talk about the so-called booming economy. Come to me to Vermont where two weeks ago I was at a food distribution program for sen- ior citizens and see them lined up, people earning less than $9,000 a year who are in need of Federal commodity food programs. Come to them and tell them about the booming economy and talk to mil- lions of other American workers about the so-called booming econ- omy when, in fact, it is benefiting the wealthy, but it is not bene- fiting large numbers of middle income and working families. Those are my two questions, Mr. Greenspan. Mr. GREENSPAN. Let me say, first, that the LTCM so-called bail- out, as you put it, was not a bailout. Mr. SANDERS. I understand that, but you were deeply concerned, were you not? Mr. GREENSPAN. No, what I am trying to communicate is that what that was, in fact, was bringing together those who were the shareholders of that organization to indicate to them that they ought to look at the issue of whether they wanted that institution to liquidate or not from their point of view and their interest. Mr. SANDERS. Were you not concerned about the overall impact on the national economy? Mr. GREENSPAN. We were. That is the reason we suggested to them that they look at it. But it was their choice. It was not tax- payer funded. Mr. SANDERS. I understand. Mr. GREENSPAN. What you are raising secondarily, which is this issue of too big to fail, all I will say to you is the fact that there are no institutions in this country which we perceive as too big to fail. There are institutions which we believe should be liquidated in a manner which does not disrupt the structure of the financial system. And, as I have said previously with respect to this issue, if and when such an event occurs, the immediate effect would be for the shareholders to be liquidated immediately. And to the ex- tent that there was any endeavor on the part of either the Federal Reserve or other agencies of Government to create a situation in which there was a stable liquidation of a whole structure of assets, to the extent that we want an orderly reduction in an organization of that sort, we would get involved. But in no way would the share- holders get anything or in fact could the debtors assume that they would not be getting significant handouts. 28 Mr. SANDERS. That wasn't my question. My question was, aren't you concerned with such a growing concentration of wealth that if one of these huge institutions failed that it will have a horrendous impact on the national and global economy? Mr. GREENSPAN. No, I am not. I believe that the general growth in large institutions has occurred in the context of an underlying structure of markets in which many of the larger risks are dra- matically, or I should say, fully hedged. That is not to say that I have no concerns that at some point we are going to run into insti- tutional failures. We will. We always have. There is no conceivable scenario of which I am aware which says that we will not have those types of problems. I think the crucial issue is, one, how do we keep the probabilities that they will occur to a minimum; and, secondarily, how to be cer- tain that when and if they occur we have mechanisms in place which effectively either insulate or significantly diminish the im- pact of such failures on the rest of the economy. Mr. SANDERS. Will you back up then? I don't agree with you, but will you back up and go to the question—as I understand that a little while ago you were talking about how everybody is doing well in this economy. That is your own report. Did I hear you correctly say that a few minutes ago? Mr. GREENSPAN. Yes. If you also take the report from 1995 to 1998 you will find that a goodly part of that decline is 1989 to 1995 when indeed there was a significant erosion in the real incomes of many of our workers in the lower areas of the income group. That has since stabilized. Mr. SANDERS. I am reading the last report that you published. Mr. GREENSPAN. I know, but I am basically saying that if you look not only at our data, but everybody else's data, they all show that an erosion was occurring in real terms from the 1980's into the early part of the 1990's, and that since 1995 or perhaps, de- pending on which data you use, 1996. Mr. SANDERS. I am looking at your data which says 1998. Mr. GREENSPAN. No, but you are taking 1989 to 1998. I am say- ing all of that decline that you are referring to actually occurs be- tween 1989 and 1995 and that since 1995 it has not continued. Mr. SANDERS. Are you suggesting that there are not millions of workers today whose real income, compared to 25 years ago, is not lower today than it was then? Mr. GREENSPAN. No, indeed there are, but I am just basically saying that five years ago Mr. SANDERS. OK. Well, if there are, then how can you talk about booming economy? Chairman LEACH. Mr. Metcalf. Mr. METCALF. Thank you, Mr. Chairman. I have a short introduction and then a question. I read some time ago in the London Economist and elsewhere that the Fed has dropped the use of monetary indicators like M- 1 and M-2 for determining Fed policy. I was led to understand that another indicator has been adopted called wage inflation. Now it is my understanding that the underlying cause of infla- tion is too much money chasing too few goods. I thought at one time that this was your understanding also. I can understand why 29 employers would want to see wages constrained, driven downward by interest rates, but I fail to see the wages of workers as some kind of indicator for impending inflationary pressures. Wages are the consequence of so many other factors, not the least of which is workers negotiating better wages after a corporation registers record profits. I believe in the name of price stability the Fed reduces wages rather than inflation itself by raising interest rates. This assuredly throws workers out of work. I am surprised then that your own Federal Reserve Bank of Cleveland has produced a policy paper that argues against measuring wage inflation as a tool to control inflation. In fact, it argues that wages have no effect on inflation, but that expanding the money supply certainly does and that the best indicator—and is the best indicator still. The paper was enti- tled, "Does Wage Inflation Cause Price Inflation?" The author per- suasively answers, no. So I would ask, Mr. Chairman, is wage inflation the cause of price inflation? Should American workers' wages be a determining factor at all? Mr. GREENSPAN. Wage inflation by itself does not. The issue basi- cally is the question of whether wage inflation, as you put it, or, more appropriately, increases in aggregate compensation per hour are increasing at a pace sufficiently in excess of the growth in pro- ductivity so that the unit labor costs effectively accelerate and gen- erally drive up the price level. It is not wages per se. Indeed, to the extent that our goals should be maximum sustainable economic growth, implicit in that is actually a maximum increase in real wages. The issue is that what you do not want to encourage are nominal increases in wages which do not match increases in productivity, because history always tells you that that is a recipe for inflation and for economic recession. We discarded using M-l and M-2 not because we believed or changed our view that inflation is at root a monetary phenomenon. I do believe it is, and I think it is almost by definition, because it is the exchange rate between goods and money. The difficulty we have been having is to try to find that particular set of proxies in the monetary accounts which represent the true concept of money as a force in the issue of inflation or non-inflation. We have not succeeded in doing that. All the various different measures we use do not obviously *fclate to the way money is func- tioning in our system. That is not to say that it is not functioning. It is just that we—nor, in fact, has anybody else been able to find the appropriate proxy. And remember, all of these measures we use are proxies for real money. My guess is that what is happening in our system is that with all of the new financial products that have been created in recent years the central focus of what really is money is changing from period to period faster than we can capture its underlying relation- ship with the economy. So we have not abandoned money in that sense. Nor have we, as you indicated, chosen wages as some indi- cator of monetary policy. That is not the case. What we are trying to do is, as I indicated before, to maintain maximum sustainable economic growth. And in our judgment the 30 crucial variable there is price stability, and to that extent the ap- proximate goal of Federal Reserve policy is price stability, largely because we believe it is a necessary and probably a sufficient condi- tion for maintaining long-term growth in the economy and max- imum rates of growth in real earnings. Ms. CARSON. Mr. Chairman. Chairman LEACH. Yes, I want to go in order, but please go ahead. Ms. CARSON. OK. Chairman LEACH. Excuse me, did you have a question to the Chair? Ms. CARSON. OK, I will yield, but then I am next. I do have a question of Mr. Greenspan. Chairman LEACH. Mrs. Maloney. Mrs. MALONEY. Thank you, Mr. Chairman; and welcome, Mr. Chairman, and congratulations on your leadership. These Humphrey-Hawkins appearances before Congress mark one of the limited opportunities for the outside world to gain an ex- planation of the Fed's current thinking and plans for the future. As Members of this committee, we have been fortunate to be here dur- ing a period of economic growth and low unemployment, but should we experience a substantial slowdown in the economy I believe that our constituents would be very disturbed that Congress allowed the requirement that the Fed Chairman make a semi-annual appear- ance on Capitol Hill to expire. And I just want to state how impor- tant it is that we reauthorize Humphrey-Hawkins in this—as we have in this committee—but the Senate has yet to act. Earlier, Mr. Chairman, you responded really to questions of Con- gressman Frank and Congresswoman Waters and you said that the Fed does not target stock markets. I think that is a substantial statement, and I would like to place in the record the article that they both referred to. It is in Barren's this week. And I think it is important to note and that prior to 1994, because in this article they quote the minutes from the meetings, you felt that monetary policy could target the stock market and that is what basically was quoted in here. So I would ask Mr. GREENSPAN. As I indicated in my response, at that time I thought it might be appropriate and, indeed, on occasion thought it was. I have since changed my mind on that issue. Mrs. MALONEY. I think that is a substantial statement, and I just wanted to make sure that this was in the record. [The information can be found on page 59 in the appendix.] Mrs. MALONEY. Mr. Chairman, one of the most important current consumer issues in the financial area is the growing problem of predatory lending. As you are aware, predatory lenders target un- sophisticated borrowers and often use deceptive sales techniques to persuade them to enter into high-cost loans that often lead them to financial ruin. In May, this committee held a hearing on the topic; and a bipar- tisan consensus emerged that the financial services regulators must be more aggressive in using their existing authority to target predatory lending. At that hearing, Federal Reserve Governor Gramlich said that the Fed would study what additional steps it can take under its current statutory authority to deal with abusive 31 mortgage lending practices under the 1994 Home Ownership and Equity Protection Act such as lowering the rate figures. Last year, the General Accounting Office released a report that urged the Board to conduct examinations of bank holding compa- nies subsidiaries that engage in subprime lending. While I know that it is Fed policy not to conduct consumer compliance exams of non-bank subsidiaries, I urge you and your staff to carefully con- sider the recommendations of the GAO as you study this issue. I believe that if the Fed is serious about combatting abusive lending it has an opportunity to do so in this area. Subprime lending is an area where the Fed's macro-economic management and its actions as a bank regulator may interact. While I strongly believe in expanding access to credit for tradi- tionally underserved communities, the number of subprime home equity loans has exploded from 80,000 in 1993 to 790,000 in 1998. Mr. Chairman, what progress has the Fed made since May, if any, in deciding how to combat predatory lending and from a macro standpoint does the explosion in subprime lending pose any type of danger to the economy? Mr. GREENSPAN. Well, Congresswoman, we have been aware of the issue of predatory lending for quite a while, and indeed I think it is quite a number of months ago that I commented on it when we began to see signs that practices were emerging amongst the subprime lenders which clearly were inappropriate by any stand- ard that we could see. Part of the problem, as you alluded to, Congresswoman, is the very dramatic rise in subprime lending itself. And that in and of itself should not be a problem, because indeed there are many good things that occurred as a consequence of that. Numbers of people have not been able in the past to get loans because they had mar- ginal credit capabilities, and I think what has occurred is a general awareness that, while there were higher losses in these types of lending activities, that there is nonetheless a market out there which is useful and, if appropriately managed, is a positive net ad- dition to our financial system. But I suspect as a consequence of the very dramatic rise that has occurred—the tremendous growth that has occurred in this market—that numbers of regrettable ac- tivities have emerged as a consequence. And, as Governor Gramlich has said, he mainly has been focused on this issue quite assidu- ously in recent months. As a consequence, he has scheduled hear- ings, and he has endeavored to find mechanisms by which we will get a far better understanding of what basically has been going on. We have already scheduled four hearings: in Charlotte, Boston, San Francisco and Chicago over the next two months. I should hope that, at the conclusion of those hearings, we will have accu- mulated enough information which would give us some basic better insight into, one, what authorities the Federal Reserve has to ad- dress what problems we find; and two, to the extent that the prob- lems are of a significant nature which cannot be readily addressed by the Federal Reserve under its existing authorities, whether ad- ditional authorities are appropriate. Chairman LEACH. Thank you. Mrs. Kelly. Mrs. KELLY. Thank you, Mr. Chairman. 32 Mr. Greenspan, thank you for being so patient with us all this morning. I was looking and realized that the conference board just came out with a new consumer confidence number this morning. They reported that consumer confidence has risen to 141.7 in July, because confidence is up in six of nine regions in July, but fewer households expect business conditions to improve and buying plans have weakened. To what extent do you intend to take these two factors into account when you are thinking of a possible additional rate hike in August? Mr. GREENSPAN. We find that, historically, various different ele- ments of the consumer confidence indices—both those of the Con- ference Board and of the University of Michigan—have been useful indicators of the direction of consumer spending and some of its composition. As you point out, these data that were released this morning are too new to get any particular evaluation of. The rise that occurred in the July index still leaves it somewhat below the May index, which, as I recall, was in excess of 144, but, nonetheless, it is clear that consumer confidence remains quite high in this country and that, despite the evidence of some slowing down in consumer buy- ing, we are not confronted with a buyer strike by any remote sense of the meaning. So, in that sense, what happens in these markets over the next number of weeks—and there are a number of weeks before the FOMC has to make a judgment—will clearly have an impact on what type of decision the committee makes. There is an awful lot of information about what is happening and what is likely to hap- pen which will occur between now and our scheduled meeting, and I think it will have a significant effect upon what action the com- mittee chooses to take. Mrs. KELLY. Since confidence is up in six of nine regions, will you take a regionality approach to this when you look at it? Mr. GREENSPAN. No, we do not, Congresswoman. And the reason is that, unlike the American economy of, say, 70, 80, or 100 years ago, when there truly were regional economies, we have, for good, I think, ended up with a single integrated economy in this country. We have certainly ended up with a single financial market in that whereas, you know, 30 or 40 years ago you used to have significant differences in mortgage rates, say, in California versus the East Coast. That no longer exists. The Federal Reserve has only one Federal funds rate that we handle, and indeed we no longer have the capacity, as indeed we did in years past, to have different dis- count rates in different areas of the country reflecting differences. Now the system has to be uniform, because if it is not uniform it will be arbitraged very significantly to nobody's good. So the answer to your question is that while we recognize that there are differences that are occurring area by area in this coun- try, and while I would not say that there is a disconnect between various areas because there are differences in levels of economic ac- tivity in various different areas of our country, but monetary policy, regrettably, cannot address that. We only have one tool, and that is an issue for other economic policies of governments—State, local and Federal. 33 Mrs. KELLY. I have just one other question to ask. I find it inter- esting that wholesale prices in retail sales were slower in June and I wonder if you feel that is a direct result of the Federal Reserve rate increase or do you think it is just too soon for that to have shown? Mr. GREENSPAN. It is hard to judge. Part of it probably is. I mean, certainly part of it is a result of the significant rise in real corporate long-term interest rates, which have moved mortgage rates that has been going on for a good deal of time—not a good deal longer, but somewhat longer than we have been moving inter- est rates. So, interest rates have had to have some effect in that regard. But, as one of your colleagues mentioned earlier, there is still a significant amount of recent interest rate changes, which clearly have not yet impacted the economy. Remember that what we are observing at this particular point is an economy, which is still out of balance in the sense that demand does exceed underlying poten- tial supply, even though it has eased down. And one way to evalu- ate what we have already done with respect to interest rates is that the process is moving forward and the interest rates are be- ginning to adjust the economy, as indeed we hope they would and should. We don't know and cannot know at this particular stage whether that process is accelerating, slowing down or the like, and we will not know for a while. We will know more, I would presume, by the time of our next meeting, and at that particular point we will make a judgment as to whether or not further action or no action is the more appropriate policy for the purpose of creating a more bal- anced economy which has the capacity to continue this quite ex- traordinary 112-month expansion. Mrs. KELLY. Thank you very much. Chairman LEACH. Mr. Watt. Mr. WATT. Thank you, Mr. Chairman. Chairman Greenspan, let me start by thanking you for the Fed's recent baseline study on the impact of CRA. While some of us had some concerns about some of the process issues related to it, I con- tinue to believe that having a baseline study will improve the qual- ity of debate in the future and enable us to have a more fact-based debate as opposed to just speculating about what impact CRA is having on lending and on economic development in some of our communities. So we thank you for that. I wanted to zero in on one particular part of your testimony, Chairman Greenspan, starting with pages one and two of your pre- pared comments. You indicated that household spending has slowed, and you talked about several theories about why that has occurred—flattening in equity prices this year, which I guess is a reduction in the so-called wealthy effect that I think you testified about on a prior trip to the committee. The one aspect of this that I wanted to zero in on, however, is the second one of these, which is—second reason for the spending slowdown, which is the rising debt burdens of households. A num- ber of us are concerned about the rising debt burdens of house- holds, and I am wondering if you could just talk a little about what impact that has on the economy. 34 It is described in your statement almost as if it were a good thing to slow down the economy, but I doubt that that is what you in- tended by the comments. I think that is just the way it kind of played itself out in the section that you talked about it. But one of the things, I recall that you were very adamantly op- posed to increasing deficits and debt spending by the Government. And I am wondering whether family household deficits and debt spending, as opposed to family savings, which would be, I guess, the equivalent to our surpluses at the Federal Government level, have pretty much the same impact in the private sector that debt and deficits have in the public sector. If you would just talk about that. I don't have a specific question, but I am trying to get a framework for my own evaluation of the impact of family and household debt and the impact that is likely to have if substantial debt continues over a long period of time. Mr. GREENSPAN. It is a very important issue, Congressman. I would first distinguish the debt creation by the Federal Govern- ment, as distinct from households in the sense that the Federal Government can borrow at any time as much as it wants with no limit. Households, obviously, cannot. And in that regard the behav- ior of debt in the household is quite significantly different in its im- pact in the economy generally. To be sure, all debt is effectively purchasing power which must balance with potential supplies to make sure the economy is run- ning at a stable pace. What we know about household debt is that even though the ratio of debt to income has been rising, that the debt service burdens, meaning the actual monthly payments as a percent of disposable incomes, have been rising, and although they nonetheless have been rising in the last couple of years or so as I recall. There is very little evidence to suggest that rising debt bur- dens on the part of households per se are a trigger for economic recession. Most people have a generally good idea of how much debt they can carry, and they don't go beyond it. The problem is not that rising debt will create a problem for the economy, but that should the economy turn down then the high debt burdens could create some significant debt problems for a number of America's households. That has been the typical pattern over the years. Consumer debt has been a remarkably munificent force in mov- ing people into the middle class in this country over the last two or three generations, and it continues to be a very potent and very desirable financial feature, but you are quite correct in raising the issue that there are potential concerns. The concerns are, however, when the potential recession occurs. Evidence certainly does not suggest that is a problem now. Mr. WATT. Thank you, Mr. Chairman. Chairman LEACH. Dr. Paul. Dr. PAUL. Thank you, Mr. Chairman. Mr. Greenspan, I have a couple of questions today. One is a gen- eral question. I want to get a comment from you dealing with the Austrian free market explanation of the business cycle. I will lead into that, as well as a question about the productivity statistics that are being challenged in a few places. But first off, I would like to lead off with a quote that I think is important that we should not forget about our past history. 35 "Every new era in our history"—and we have had several—"has been based upon the exaggerated enthusiasm and the inflationary forces set in motion by some single new industry or industrial ac- tivity." This was written by BusinessWeek in 1930, a couple of days after the crash. Also, I would like to remind my colleagues about surpluses, and I know we look forward to all the surpluses. First, that portion of the national debt we pay the interest on is still going up. So there is a question about if we have true surpluses. But even if we did, I would like to remind my colleagues that we were, as a country and as money managers, reassured in the 1920's that our surpluses in the 1920's would serve us well, and it did not predict what was happening in the 1930's. Basically, the way I understand the Austrian free market expla- nation of a business cycle is once we embark on inflation, the cre- ation of new money, we distort interest rates and we cause people to do dumb things. They overinvest, there is malinvestment, there is overcapacity and there has to be a correction, and the many good members or well-known members of the Austrian school, I am sure you are well aware of them, Mises, Hayek and Rothbord, as well as Henry Hazlitt, have written about this, and really did a pretty good job on predicting. It was the reason I was attracted to their writing, because certainly, Mises understood clearly that the Soviet system wouldn't work. In the 1920's, the Austrian economic policy explained what would probably come in the 1930's. None of the Austrian economists were surprised about the bursting of the bubble in Japan in 1989, and Japan, by the way, had surpluses. And of course, the best pre- diction of the Austrian economists was the breakdown of the Brettan Woods agreement, and that certainly told us something about what to expect in the 1970's. But the concerns from that school of thought would be that we still are inflating. Between 1995 and 1999, our M-3 money supply went up 41 percent. It increased during that period of time twice as fast as the GDP, contributing to this condition that we have. We have had benefits as a reserve currency of the world, which allows us to perpetuate the bubble, the financial bubble. Because of our huge current account deficit, we are now borrowing more than a billion dollars a day to finance, you know, our prosperity, and most economists, whether they are from the Austrian school or not, would accept the notion that this is unsustainable and something would have to happen. Even recently I saw a statistic that showed total bank credit out of the realm of day-to-day activity in control of the Fed is increas- ing at the rate of 22 percent. We are now the biggest debtor in the world. We have $1.5 trillion foreign debt, and that now is 20 per- cent of the GDP, and these statistics concern many of the econo- mists as a foreboding of things to come. And my question dealing with this is, where do the Austrian economists go wrong? And where do you criticize them and say that we can't accept anything that they say? My second question deals with productivity. There are various groups that have said that our statistics are off. Estevao and Lach claim, and this was written up in the St. Louis Fed pamphlet, that 36 the temps aren't considered and that distorts the views. Stephen Roach at Morgan Stanley said we don't take into consideration overtime. Robert Gordon of Northwestern University says that 99 percent of the productivity benefits were in the computer industry and had very little to do with the general economy, and therefore, we should not be anxious to reassure ourselves that the productive increases will protect us from future corrections that could be rath- er serious. Mr. GREENSPAN. Well, I will be glad to give you a long academic discussion on the Austrian school and its implications with respect to modern views of how the economy works having actually at- tended a seminar of Ludwig Mises, when he was probably 90, and I was a very small fraction of that. So I was aware of a great deal of what those teachings were, and a lot of them still are right. There is no question that they have been absorbed into the general view of the academic profession in many different ways, and you can see a goodly part of the teachings of the Austrian school in many of the academic materials that come out in today's various journals, even though they are rarely, if ever, discussed in those terms. We have an extraordinary economy with which we have to deal both in the United States and the rest of the world. What we find over the generations is that the underlying forces which engender economic change themselves are changing all the time, human na- ture being the sole apparent constant throughout the whole proc- ess. I think it is safe to say that economists generally continuously struggle to understand which particular structure is essentially de- fining what makes the economy likely to move in one direction or another in the period immediately ahead, and I will venture to say that that view continuously changes from one decade to the next. We had views about inflation in the 1960's, and in fact, the desir- ability of a little inflation, which we no longer hold any more, at least the vast majority no longer hold as being desirable. The general elements which contribute to stability in a market economy change from period to period as we observe that certain hypotheses about how the system works do not square with reality. So all I can say is that the long tentacles, you might say, of the Austrian school have reached far into the future from when most of them practiced and have had a profound and, in my judgment, probably an irreversible effect on how most mainstream economists think in this country. Dr. PAUL. You don't have time to answer the one on productivity, but in some ways, I am sort of hoping you would say don't worry about these Austrian economists, because if you worry too much about them, and these predictions they paint in the past came true, in some ways we should be concerned, and I would like you to reas- sure me that they are absolutely wrong. Mr. GREENSPAN. Let me distinguish between analyses of the way economies work and forecasts people make as a consequence of those analyses. The remarkable thing about the behavior of econo- mies is they rarely square with forecasts as much as one should hope they did. I know there is a big dispute on the issue of produc- tivity data. I don't want to get into that. We would be here for the rest of the month. I think the evidence, in my judgment, is increas- 37 ingly persuasive that there has been an indeed underlying struc- tural change in productivity in this country. Chairman LEACH. Thank you. Ms. Carson. Ms. CARSON. I too want to thank you, Mr. Chairman Leach, cer- tainly you, Mr. Greenspan, for being here and raising the intel- ligence, if you will, of this prestigious committee. Having said that, I would like to know your comment earlier when Congresswoman Waters was here about believing not in con- sumption, but in equity, and believing that we don't need training programs, we rather need on-the-job training. And I am from Indi- anapolis, Indiana, where a major bank merger occurred which pro- pelled unemployment up for a while because the banks merged. 4,000 people, as a result of that merger, were laid off. Their jobs were taken away from them, the tellers and the clerks and less and sundry individuals who wanted to work and who were productive in their jobs, but who were laid off because of the merger. Now, were you suggesting, just from my information, not to be combative at all, that those 4,000 people don't need other kinds of job training since the job that they had are no longer available? Mr. GREENSPAN. No, Congresswoman, I was merely reflecting on the experiences I have had being in and out of Government now since the early 1970's, and I have seen an extraordinarily large number of Federal job training programs year after year, which all look very good politically and made a lot of people who initiated them think they were doing something useful for people who need- ed the skills to get jobs. I am merely raising the basic question, did they, in fact, do what they were supposed to do? And from what I could judge, they fell far short of what they were originally pro- jected to do, and in my judgment, the funds could probably have been used far more effectively in other ways. What I have been able to observe looking at industry, looking at the job market generally, is that the best job training that exists unquestionably is on-the-job, doing something specific, learning something directly relevant to a particular activity in an organiza- tion and learning in that process. The trouble with job training pro- grams generally is, of necessity, they are generic. They tell you how to do various general things, but rarely can they get to the specific activity which you need to know in order to do a job correctly. And it is no fault of the job training program, because you do not know what type of individual activity you are going to need to have, and therefore, I think that to the extent that we can keep this economy going, to the extent that we can keep the extraor- dinary demand for labor continuing is, in that regard I believe, the best program for improving the skills of all the various people in the structure of our labor markets to get jobs. Ms. CARSON. OK. I don't want to belabor the point much longer. Thank you very much for your response. Congresswoman Maloney talked about predatory lending. Credit card companies can charge you any amount of interest that they want to charge you. They can charge you 30 percent, 40 percent, speaking of predatory lending, and they also send a lot of their cus- tomers checks in the mail where they can make them out for any amount they want to. Ordinarily, people would get credit cards who 38 would be prime for predatory lenders or people who the banks have turned down for credit, so there is this abundance of credit card use in existence. Does there exist regulatory authority over the amount of interest rates that can be applied by credit card compa- nies on to consumers? Mr. GREENSPAN. I do not believe so. Ms. CARSON. How does that escape predatory lending observa- tions? Mr. GREENSPAN. Let me suggest to you the reason for this. In the past, we have had innumerable statutes which indeed endeavored to cap rates, the effect of which was for the market to be elimi- nated. I think the really challenging issue that confronts us today is how to maintain the tremendous growth in subprime lending, which, in my judgment, has done a lot of good and created lending capabilities for a lot of households, which were able to pay off the loans, but whose credit was quite marginal, without the obvious negative consequences that have occurred, probably as a con- sequence of the very rapid growth itself. In my judgment, the task here is to find the appropriate balance. I do not believe that you get very much in limiting interest rates, in other words, limiting the rates that people can pay, and in effect, imposing usury stat- utes. I think over the years they have not been terribly successful in doing what people thought they were going to be doing. They al- most never created lending at lower rates. What they created was no lending, and that strikes me as not the appropriate means of handling this. I do think that there are a lot of issues, and this is, in fact, the general purpose of these hearings, which Governor Gramlich has scheduled for four different cities in the next two months. We are going to learn, I hope, a good deal of what we need to know to find out how does one maintain a significant degree of subprime market growth without the adverse secondary consequences, which are re- sulting as a consequence of that growth. Ms. CARSON. Thank you. Chairman LEACH. Well, thank you, Mrs. Carson. Mr. Hill. Mr. HILL. Thank you, Mr. Chairman and Chairman Greenspan, thank you. I echo the comments of my colleagues. Thank you for being here today. In reading your report and your testimony, I don't think you are saying much different today than you said when you were here three months ago or so about the state of the economy and where we are. I think you said then that aggregate demand exceeds sup- ply, and at that point you suggested interest rates were going to have to go up until they got back into balance. I think you just stated earlier that we are still out of balance, demand and supply are not yet in balance. Mr. GREENSPAN. The data that we have for the first quarter still suggest as of then it was out of balance. As I indicated in my pre- pared remarks, we seem to be moving closer to balance in the last two or three months, but we do not as yet have adequate data to suggest how much closure has occurred, and we will not have for a while. 39 Mr. HILL. And the consequence of this imbalance is higher infla- tion than we had last year, higher interest rates than we had last year, and a larger trade imbalance than we had last year; is that correct? Mr. GREENSPAN. Yes, sir. Mr. HILL. You stated in your testimony, I think, and in the re- port, that the Government surpluses that we are experiencing today have been a buffer for you. It has given you more flexibility, perhaps, in your monetary policy by virtue of the fact that our fis- cal policy has been more responsible. I just want to ask you, isn't it true that the spending constraint of Government has been the largest contributor to that, the fact that the nominal rate of growth of Government spending is down and also a percentage of GDP Government spending is down? Mr. GREENSPAN. Well, it has certainly been a factor, because growth in Medicare spending seemed to be accelerating at a clearly unsustainable pace, and I think that the endeavors on the part of the Congress and the Administration to come to grips with that clearly historically have been successful. The major cause of the surplus, however, is on the revenue side. We have had an extraor- dinary increase in revenues, in large part, as a consequence of sig- nificant asset price increases, not only capital gains taxes, but a very substantial amount of revenue that occurs in the individual, both withheld and non-withheld accounts, which we can't now fully explain, but which, in retrospect, we are going to be able to at- tribute directly to the fact there has been a very large increase in assets, and the consequence of that is that we have an unexplained element of revenue increase, which has been a major factor here in this extraordinary rise in surpluses. Mr. HILL. But in terms of the issue of balance, if Government spending goes up, it crowds out spending by consumers and crowds out spending by business and business investment, doesn't it? Mr. GREENSPAN. Yes. Mr. HILL. I mean, consumer spending and business investment are good things for the economy, and so if Government spending goes up, it creates further imbalance, pressure for higher interest rates, and higher inflation. Mr. GREENSPAN. There was no question that if we did not have the acceleration of surpluses, which are coming both from the rev- enue side and the expenditure side, that we would have had a higher degree of instability in this economy, and far more difficult problems to address than indeed we have today. Mr. HlLL. You did note in your report, however, in the fourth quarter of 1999, Government spending was accelerating again. Does that cause alarm to you? Mr. GREENSPAN. Well, I have to be a little careful. Some of that, as I recall, is a result of significant progress payments being made on military contracts which get offset at a later time, so it is sort of like inventory in process being financed, which unwinds, and that indeed is what has happened since then. Mr. HILL. One of the big debates. Mr. GREENSPAN. I might add, however, that in general, total uni- fied outlays have been accelerating quite significantly in the last two or three quarters. 40 Mr. HILL. That could cause problems, further imbalances if it is not constrained. Mr. GREENSPAN. Yes, I agree with that. Mr. HILL. You also note in your testimony that the effect of these higher oil prices represents the equivalent of a $75 billion tax in- crease on the American people by about 1 percent of the GDP. Mr. GREENSPAN. 1 percent of disposable income. Mr. HILL. I stand corrected, which is going to have a damaging effect on the economy as these higher interest rates probably will as well. I guess one of things we are debating, of course, is what to do with the surplus. You are on the record repeatedly, we ought to let it just ride, if you will. It doesn't appear that Congress is going to do that. But I would note that the $75 billion tax increase, this higher oil price, represents greater than the combination of all the tax reductions that have been proposed in this Congress to- gether, and by the same token, during the markup of the appro- priation bills, there were literally dozens and dozens and dozens of amendments offered to those appropriation bills, almost all of them ruled out of order because they exceeded the budget that would have dramatically increased spending even beyond the amounts we have noted earlier. How important is it that we stay within this budget in terms of controlling spending and maintaining these surpluses and main- taining Government savings? Mr. GREENSPAN. Well, I never expected when the original Budget Control and Empowerment Act of 1974, as I recall, was enacted that it was going to do anything, and in retrospect, all of the budg- etary mechanisms that we placed on ourselves, so to speak, have had a really quite dramatic and very positive effect in restraining spending. I never believed that caps were going to work or PAYGO was going to work, because all it required was a majority of the body to override them. But apparently, there has been a very sig- nificant desire on the part of the American people for far more fis- cal responsibility than we had exhibited in our earlier years, and that message clearly has gotten through. The effects of it have been very positive on our economy, and I think that we should recognize that these various mechanisms which we put in place, which have done so much good, should be kept in place and function in a man- ner which will keep balance in our fiscal affairs. Mr. HILL. Thank you, Mr. Chairman: Chairman LEACH. Thank you very much, Mr. Hill. Mr. Sherman. Mr. SHERMAN. Thank you, Mr. Chairman. Chairman Greenspan, I want to thank you for the written an- swers that you provided to questions I raised the last time you were here. And perhaps some of the questions I raise now you won't have a chance to answer except in writing, and it is a great way to communicate. I asked you then what we could do to raise real wage rates. You pointed out that real wages were dependent on productivity, two ways to increase productivity, more capital in- vestment and more education. You came down on the side, really, I think of more capital investment and indicated that one way to do that would be to reduce taxes on returns to capital. 41 I would point out that I think education may do just as much for productivity and has the additional advantage that the asset, the education, is owned by the worker, and so whatever increase in productivity occurs is more likely to accrue to the worker's benefit, whereas additional capital may increase productivity, but it is fun- damentally owned by the owner of capital, and I would expect it to lead to higher profits before it led to higher wages. I would. Mr. GREENSPAN. It does, but not for long. I mean, you are quite right, it does lead initially to higher profits, but at the end of the day, it leads to higher real wages. Mr. SHERMAN. I would point out that increased capital invest- ment can be literally moved offshore and taken away from the ben- efit of American workers, whereas when we educate American workers, all that benefit is inherently Mr. GREENSPAN. I happen to agree with you. I am not sure if I have phrased it the way you are suggesting, as putting down the advantage of education. I would certainly not mean to do that, be- cause I think you can't have capital equipment if no one can run it. Mr. SHERMAN. At the margins the decisions we have to make in Congress are do we cut taxes on capital or do we invest in edu- cation, and I would like to answer the question yes to both, but ob- viously we can only do one or the other to a limited extent, and would argue more in favor of investing in education than cutting taxes on capital. If we do want to reduce taxes, another way to do it, of course, is to reduce taxes on working families by increasing the earned income tax credit. I want to shift to the trade deficit, but before I do that, just a word about economic statistics. You testified back when I was on the Budget Committee that the consumer price index overstates in- flation, and I assume that in setting monetary policy, you have a way to adjust, or at least mentally take into account the fact that the CPI, which at times might be alarming, may simply be over- stating inflation. I know that you are loathe to see any increase in Federal spending, but one area that might be useful is to spend more on gathering economic statistics so that they are more accu- rate, more useful and more timely, and I wonder if you would be willing to provide to Congress or to this committee a plan for in- vesting more and gathering more timely or more relevant economic statistics to help the Fed and other economic policymakers do their job, and would this be a good place to invest? Mr. GREENSPAN. It has always created a problem for me, because I generally have been strongly, over the years, urging spending re- straint, and I felt that it seemed a bit hypocritical to find areas which might be useful to me or my agency that were exempt from that general proposition, but I am hard-pressed to disagree with the position you are taking as the rate of return to the society from very small amounts of money can create quite significant advan- tages, I find it also difficult to disagree that to the extent that we can enhance the capability of understanding what is going on in our economy, not referring only to Government officials or to the Federal Reserve, but the business community generally, I think that knowledge is terribly crucial and timely. Knowledge is very important for the types of decisions which business people can 42 make which can keep our economy generally stable. And I do think that since the amounts are really quite small, that I feel less of a violation of my general principle than ordinarily. Mr. SHERMAN. I would hope that you would furnish us with a blueprint, a wish list, because I do think that it would be a good investment. On the trade deficit, I would just point out that we have the largest trade deficit in the history of life on this planet. It may very well grow to $400 billion or $500 billion a year for as long as the eye can see. Do you think we could just run another $5 trillion accumulated trade deficits over the next decade without problem? And do you have an emergency plan for what happens if the dollar crashes, not this year, but after a few more years of un- believably high and unsustainable trade deficits? Mr. GREENSPAN. Well, I addressed that issue in considerable length when your Chairman put this question "number one," so that it indicates that it is a priority issue. It is a very important issue, and I think it is probably the most difficult one which we economic policymakers, Treasury, ourselves and others, have to confront. As I indicated in my earlier comments to Chairman Leach, at the moment we are observing a remarkable balance in the sense that the propensity to invest in the United States, because of very high rates of return is just about offsetting the amount of demand for imports, with the net effect being the exchange rate hasn't changed very much, and indeed, it is the exchange rate which is at the ful- crum of this balance of supply and demand for external finance. We recognize that over the very long run, that you cannot continue this addition to external claims against the United States, which, of course, the current account deficit is almost, by definition, the net change in net claims. So at some point something has got to give, and we don't know when it is going to be. We don't know whether it will be protracted over a very long period of time, in which case the adjustments will occur in the normal manner without any significance, or whether they will occur more abruptly. We don't know the answers to those questions. We are aware of the consequences of various different scenarios and we and the Treasury have spent a considerable amount of time involved in evaluating various different alter- natives. However, we have been concerned about problems of the current account deficit for a number of years. The markets have adjusted. There has been no evident, particular problem as a consequence, and conceivably this could go on for quite a while longer, but it is an issue which has very much drawn our attention. Mr. SHERMAN. With the Chair's indulgence, since there might be a crash, do you have a plan, an emergency plan? Mr. GREENSPAN. Well, first of all, I would never admit to there being a crash or if or when, and indeed, all I can suggest to you is that we have an awful lot of analyses that go on for various dif- ferent scenarios to which we attribute very small probabilities, but you recognize that very low probability events occur on very rare occasions, but they do occur, and so you ought to be able to have, as indeed I believe Government policymakers have had over the generations, all sorts of plans to address vast numbers of contin- 43 gencies, 99.8 percent of which never happen. That doesn't mean you still don't have contingencies. Chairman LEACH. Thank you, Mr. Sherman. Mr. Ryan. Mr. RYAN. Thank you, Mr. Chairman. I just have two questions I want to address to you. One, I am interested in your take on a debate that is waging among economists between how you measure productivity, and I was very intrigued with your comments that there are structural changes in productivity, and that implies that we will have struc- tural changes in the way we measure productivity, but what I am specifically interested in is your opinion between sort of the old economy theorists which have theories that are now considered sac- rosanct, but may be turned on their head, such as law of dimin- ishing returns, the fact that value is added with scarcity, that those ideas and concepts may be replaced with, some people refer to as network economics. What is your take on this idea of network economics? Do you be- lieve that in some significant sectors of our economy, the law of di- minishing return is being replaced for law of increasing returns, that value is being added with abundance, and that some of these older theories are indeed being replaced with subsequently the re- verse of their theories. What is your take on that? Mr. GREENSPAN. Well, I would argue that there is nothing changed as far as the conceptual relationship is concerned. What has happened is that there are clearly certain industries and cer- tain endeavors which have extremely high fixed costs, but neg- ligible variable costs, software industry being a classic case where an awful lot of effort and capital expense are put into developing a very elaborate software program which does lots of marvelous things. To reproduce a new version of that could be 3 cents, be- cause all it requires is just making a copy off of the actual program itself. That does have economic consequences. It creates a very in- teresting market force which tends to lead toward natural monopo- lies, at least temporary natural monopolies, until newer tech- nologies undercut those monopolies, and you get into a different se- quencing of events. I would never argue, however, that these new types of processes are undermining the older principles of economics. It is just that they have different characteristics. I mean ordinarily, when you built a steel mill 50 years ago, you had a significant fixed cost, but also a fairly significant variable cost as well, and that indicated how you would engage in the marketplace and what type of com- petition you would have. And we often found that the pressures for natural monopolies in the vast, vast majority of industries of that type never really existed. You did get them, however, compared with the old electric utility markets where we had the tendency for a natural monopoly, we have today a lot of wheeling of power by generators across all sorts of boundaries. But that is within the realm of all the old notions of how markets work, and indeed, while networking has obvious very interesting implications as to the way competition functions, as to the way markets function, as to the way incentives work, it is still based on a lot of the old principles; it is just that the parameters are different. 44 Mr. RYAN. Do you think the parameters imply that you have to readjust the way you measure productivity growth? Mr. GREENSPAN. No, I think productivity is measured technically as real value added per hour of input. It does mean that the en- deavor to determine what is real implies that you can define what is price and sometimes trying to define what is the price of a par- ticular piece of software, and therefore, what is its real value is very difficult. It is certainly true that in the current environment, the measurement problems are far more difficult because of the price issue, but it doesn't mean that productivity means something different. Mr. RYAN. Last, I would like to turn quickly to an issue that we have dealt with quite a bit here on this committee. We are having a hearing right now on the Budget Committee talking about Gov- ernment-sponsored enterprises, specifically the housing GSEs; and you have testified here a number of times on the need to reduce and eliminate the public debt, on how that is a very important, worthy goal in the conduct of monetary policy and fiscal policy. I would be interested in what your impression is on GSE debt, but specifically with respect to GSE debt that is raised for repur- chasing of mortgage-backed securities. Do you believe that what some refer to as excessive debt or Fannie and Freddie's debt attrib- uted to repurchasing mortgage-backed securities introduces a new type of risk on their books of business such as a prepayment inter- est rate risk? Do you believe that it is excessive debt and do you believe that it is mission-critical debt and do you believe that the existence of this debt raises the similar concerns that, given the implied taxpayer liability, raises a similar kind of concern that you have voiced in this committee with respect to the national debt and the public debt? Mr. GREENSPAN. Well, Mr. Ryan, one of the things we don't yet understand is why, in fact, the GSEs have been able to effectively buy mortgage-backed debt at a yield which is in excess of the yield which they themselves can get in the marketplace, which is attrib- uted apparently, you point out, to the prepayment premiums that they are able to achieve in the marketplace. We don't at this stage know the extent to which the prepayment premiums are a function of the subsidy they have on the sale of their debentures, and this is a critical issue to understand because it gets to the whole series of questions which Congressman Baker has been raising with re- spect to the GSEs and their financing and their subsidies and their role within the intermediation process. I think we don't understand the answer to that yet, but I do think that everyone is looking at this question now that the issues have surfaced. Hopefully, we will be able to get far greater insight into exactly what the incidence of the subsidies on the debentures are. Indeed, as I understand it, CBO is in the process at this par- ticular stage of updating the study it made five years ago, as I re- call, and in that process I think we are going to learn a great deal more about how this whole process works. Mr. RYAN. But at this time in the conduct of monetary policy, you are not looking at their debt in much the same way as you look at Treasury debt. 45 Mr. GREENSPAN. We look at overall agency and corporate debt as we look at Treasury debt, as parts of a very large financial system, and they impact and they have effects. And to the extent that they have effects which engender actions on the part of the Federal Re- serve then you can say that they affect monetary policy, but, again, so do fifty other things that are going on in the economy. Mr. RYAN. Thank you. Chairman LEACH. Thank you, Paul. Mr. Meeks. Mr. MEEKS. Thank you, Mr. Chairman. Mr. Chairman, I have just got a couple of questions. One, somewhat to clarify, you stated in your testimony how im- portant globalization was and that we need not to block it, because it is like blocking the dam, so to speak, and as a result there are side effects that may occur. But, you did not specify—we didn't talk—I didn't hear much about those side effects. I made the pre- sumption that some of those side effects have has to deal with some of those individuals who may be left out of the booming econ- omy and yet—I mean, they would know you are one when you speak people listen as to what we can do to remedy some of those side effects so that people who are not benefiting from this eco- nomic boom will benefit from it or will at least do better than they are doing now. I have heard questions to you from—a number of my colleagues talked about poverty in their districts; and clearly there are some abandoned buildings and things of that nature in my district and I think throughout rural and urban America. So I was wondering whether or not you could talk about—because you said we shouldn't spend the surplus money either, you know, and we are debating in Congress. Some want tax cuts. Some want some other things like minimum wage to help disposable income for those who are on the bottom. I am wondering if you could just articulate a little bit more about those side effects and what we can do to rec- tify some of these side effects. Mr. GREENSPAN. Mr. Meeks, I indicated that I thought it was very important for the surplus to keep rising. That can occur even with some tax cuts and some expenditure programs. So it is not a fact that one does nothing. The issue that you are dealing with when you have this globalization and dramatic changes in technology is a very difficult one, because it is moving so fast. Ordinarily, over the past when you had economies evolving slowly, productivity growing modestly, you would have capital moving out of one industry and into an- other; and indeed that is the normal process by which standards of living rise. It would happen at a pace which was not all that in- consistent with the retirement patterns within various industries. And you would often find that the reduction that would occur in employment in a particular industry, if its demand were fading— if consumers, for example, didn't particularly want the product as much as they used to, then you would have demand declining, em- ployment declining, but it would mainly occur through attrition and you would not have particular problems that we currently have. 46 Move fast forward—and I use the word fast in the context here where things are moving very rapidly—and what you have got, for example, are industries which were more modestly declining or growing very marginally all of a sudden having to compete in a market where consumers want a whole different array of products, high-tech products and a variety of other things. This essentially means that not only are the savings of the community going in to finance these new products, but you are also getting a grain of cap- ital out of the older industries to help finance those products. As a consequence, the pressure for reduction in those industries is far faster and it is greater than the normal attrition would be, and you are creating numbers of individuals who find that they are 45, 50 years old and are losing their jobs, which makes it very dif- ficult for them to move on. And I do think that we must address that problem. I do not think, however, that the solution is to freeze the econ- omy, and say, don't let this increased productivity occur, because it is creating too many problems. That is not an option, because it is helping everybody over the long run to allow this process to ac- celerate, to allow globalization, productivity growth, and standards of living to rise. It is incumbent, however, upon us to find means to address the problems of those who are left in the wake of that. Somebody said Schumpeter and creative destruction, and I do think that that issue must be addressed, and I think it will be addressed. But my main message is to be careful to pinpoint it, to do what one can. The solution is not to slow the economy down or to put up trade barriers or other things which endeavor to fend off competition. At the beginning of the day, it may appear to assuage some of the pain that that adjustment process has. At the end of the day, it helps nobody. Mr. MEEKS. Just one other quick question, just based upon that the Federal Reserve has been using an increase in interest rates to slow down the demand of the economy. Why is this preferential to increasing the required reserve ratio for banks? I am concerned because of higher interest rates to households that are seeking to buy homes and are automatically, therefore, finding themselves with higher rates on credit cards and credit card debt. Mr. GREENSPAN. If we increased reserves, the effect is to increase interest rates. In other words, what we are doing, as I indicated in my prepared remarks, is recognizing that the supply and de- mand imbalance for funds basically in the long end of the market has created a fairly significant rise in the long-term corporate real interest rates, long-term real mortgage interest rates, and as I indi- cated in my remarks, had we endeavored a year ago June to keep the Federal funds rate where it was at that time, rather than cali- brate it up with the rest of the market, that could only have been done by suppressing the markets by creating a massive amount of liquidity which would invariably have financed a significant further acceleration and brought this recovery to a very quick end. So it is not a choice. We don't have alternatives. When the demand for credit exceeds the supply, there are no tools other than the price of credit going up, as indeed the price of anything goes up when 47 demand exceeds supply to bring supply up and demand down into balance. Chairman LEACH. Mr. Toomey. Mr. TOOMEY. Thank you, Mr. Chairman; and thank you, Chair- man Greenspan, for your testimony this morning. I would like to get back briefly if I could to the issue of our trade and current account deficits. It strikes me as extraordinary that, despite the record size of our trade deficit and the record size of our current account deficit and the many years in which these defi- cits have been growing, that, nevertheless, the dollar remains rel- atively stable and relatively strong, as you pointed out earlier, off- set by investments that have been coming in from overseas, despite even a year at least now in which the stock market has not been performing, has basically been moving sideways with respect to big industries. Some have even been declining. Now I understood your comment earlier to suggest that you be- lieve this combination of deficits is not permanently sustainable, this can't go on forever. I guess my question is, given that it has been so extraordinary I think and lasted for some time now, what should we use as our early warning indicator that the problem is imminent? Is it just the weakening dollar? Is there anything else that will point to that sooner? Mr. GREENSPAN. I think not, Congressman, largely because there are other events which will occur concurrently. But we don't meas- ure them in the timeframe that we measure the exchange rate. Now the exchange rate is available to us 24 hours a day, minute by minute, second by second; and it is the best measure we have of the net balance between the supply of funds and the demand for funds in the sense that it is the measure which tells us whether the demand for assets in the United States exceeds or falls short of the demand for goods and services, net, on the part of the Amer- ican people. It is really quite an extraordinary system which has one single price which balances all of that whole process; and it is, in my judgment, probably the best signal that we have that the balance is changing. And I say—as I said before, there is just no evidence at this stage that that is changing. The dollar has stayed remark- ably stable, and that is an indication that the high rates of return in this country are quite attractive for foreign investment. Mr. TOOMEY. In fact, the disparity in the rates, better rates in this country relative to oversees, is what is attracting that invest- ment. Assuming that can't last forever, it seems to me one of two things or some combination—either the dollar weakens or there is greater demand for American goods and services relative to our own imports. Do you think that we can eliminate this problem over time or diminish it dramatically primarily through economic de- mand from overseas rather than through a weakening of the dol- lar? Or is it inevitable that the dollar is going to weaken? Mr. GREENSPAN. I don't think we know. I do think that it is in- cumbent on us to monitor this situation very clearly, very closely and to try to work through, as indeed we have, all the various dif- ferent scenarios that can bring us to equilibrium. And that we are doing and have been doing for quite a considerable period of time. 48 But I don't think we have the capacity to forecast exactly how it is going to emerge. And indeed whether it is a very gradual adjust- ment process which virtually nobody will recognize as it is hap- pening except the few international financial economists who work at those things, or whether it is a more disjointed type of event, I don't think we know the answer to that question. Mr. TOOMEY. If I can ask one other question on a different topic, getting back to the housing GSEs for a moment. Clearly, there has been considerable growth in their debit issue, and it has attracted a lot of attention. One of the things I was wondering, if you could comment on it. It seems possible that the benefits that are con- ferred upon these entities by Government increase as these institu- tions grow naturally. Perhaps that creates an even greater incen- tive to grow than a dissimilar company might have. At the same time perhaps, given the implied Government guar- antee of the debt issued by these enterprises, there is some diminu- tion of the market's ability to put a control, a brake on the cost, at least in the form of higher cost of funds. Although, admittedly, the market could still lower the stock price. Is there any danger that we create a dynamic where we create a greater incentive to grow and a lesser ability for the market to discipline that growth and that in the event of hard times the taxpayer is put at greater risk than might otherwise be, given this dynamic? Mr. GREENSPAN. We are dealing with a rather complex problem. These GSEs are rather well run institutions, and they have got very good risk management procedures in and of themselves. I think the issue is less that they will run into trouble than the gen- eral impact of their size and growth as it impacts on the rest of the financial system and creates potential imbalances which could create secondary problems. I think this is the area where a lot of examination has got to be made. It is not credible to me that you can have a subsidy—and there is a real subsidy there—without distortions occurring. I don't think that we know exactly the specific sequence of the types of problems which can or will arise. I do know that the simple notion that the big problem is that these are institutions which could fail and cre- ate major problems, that is not the highest probability, in my judg- ment, because they do have fairly significant hedging capabilities and their long-term liabilities are structured in a manner which prevents short-term liquidity problems. That is not to say they are invulnerable. That is sort of, obviously, not accurate, especially with their low capital ratios. But I think the issues are much broader, and I think it is wise for the Congress to have a broad view of all the relevant consequences of what happens when you get such extraordinary changes going on in a market of this size. Mr. TOOMEY. Thank you. Chairman LEACH. Mrs. Lee. Ms. LEE. Thank you. Mr. Chairman, good morning. Good to see you. It has been very interesting listening to your testimony this morning, Mr. Green- span. As you know, I am from northern California, Oakland, Berkeley, one of the highest cost of housing areas in our country. But in many regions of our country, wages have not really kept pace with 49 the high cost of housing. For example, some families making $30,000 to $50,000 would love to purchase a home, but in some areas the average cost of a house is, for instance, $500,000 or $300,000. But yet we witness this enormous boom in the housing industry and the construction industry which is good for the econ- omy, but now we find that the average middle-income person in many areas cannot qualify for a mortgage nor can they meet monthly mortgage payments. Also, we know that, of course, the dream of home ownership is one that we all have and it is the actual primary means for many families to acquire wealth, to send their children to college, to start up in the small businesses. That in effect is being eroded in terms of wealth accumulation due to the inability to qualify and purchase a home. So, what I am asking you today is, what is it that you think the Congress should do, what the Federal Reserve can do in terms of monetary policy to really help to begin to mitigate against this? Be- cause we know it is going to take a variety of strategies. But when you have a booming economy such as we have and in some areas, for instance, the technology, the success of the technology and the dot.com industry has been great, but on one hand its impact had been negative, because it has actually driven up the cost of hous- ing. So I know it is not an easy solution, but we have got to begin to attack it, and none of the additional approaches are going to work. Mr. GREENSPAN. Well, I think you are raising a very important question; and I don't say to you that I know the answer. Because what we are dealing with is a limited amount of savings in the community, whether it is your community or another com- munity. And the demand for the use of those savings in your case, say, for example, housing on the one hand and Silicon Valley on the other, both can't get all they want. There is a limit, and the limit is caused by the fact that people just save a certain amount. And supply for funds must equal the demand for funds, and there effectively occurs market adjustments. And the form of the market adjustment is what you are observing, namely, a dramatic rise in a lot of housing prices, especially amongst the high-tech area around San Jose. And it is a difficult problem. Unless there is a massive increase in construction which just floods the market—and obviously, espe- cially in San Francisco, of the ability to build new single family homes or new homes in general in that area is limited by regula- tions so that you have got a very difficult problem with—I know that Congressman Sanders doesn't like me to talk about a booming economy, but I will anyway, because indeed that is the only way to describe it. And when you have a booming economy you get a situation in which demand exceeds the supply of savings that is occurring, and you get increased house prices which occurs in certain areas of the economy, and the ratio of house prices to income probably rises quite significantly, which makes it very difficult for a middle in- come person to afford housing. Ms. LEE. But then how do we convince the average American family that home ownership is a good thing, that in fact working 50 makes sense and that even though they may not make $100,000— even $100,000 a year in some areas now is middle income—even though they are only making $30,000 to $50,000 a year, they have been denied now the opportunity to buy into the American dream. It seems that we have got a responsibility beyond telling them that it is the market forces and the great results of the economy that is causing this to happen. What do we tell people? Mr. GREENSPAN. Congresswoman, these are real forces. These are not just arbitrary things that Government can just turn a knob on or create something. You can't create something out of nothing. What we have got, regrettably, is a very difficult situation in which the type of problem that you are concerned with is real. It is not readily resolved by just some simple device. I think what we have to do is to convince people that there is indeed opportunity at the end of the road. It may not be today. It may not be tomorrow. It may not be next year. Look, we have all sort of grown up—I did—at the lower end of the economic ladder and struggled hard, and I knew that there was opportunity out there, but it didn't occur as fast as I would like, and it is tough. I mean, I don't know what to say in answer. I wish it were otherwise, but there are limits in the real world that we have to confront, and we have to do the best we can. But I do think that you are absolutely correct in recognizing that the issue of people seeing that they have a shot at what everyone else has is a very crucial issue in this country, because, as I have said before, if we ever get to the point where people are going to be discouraged and think that the society that they live in is un- just, then I don't think that society can function. Ms. LEE. Thank you, Mr. Greenspan. I appreciate your very can- did response, but it is very dismal. Mr. GREENSPAN. I wish I could say to you I have a program which will either knock $100,000 off every home or raise incomes by some specific amount. The problem is that those are paper val- ues, but there are real things out there, I mean, real houses. It is brick, it is mortar, it is a roof, it is a car, it is an education, which is real. It is the world, and it is not the way we would always like it to be. Ms. LEE. Thank you. I will just conclude by mentioning Members of Congress will be participating in a regional housing summit in Oakland, California, August 12th. We are going to come up with some recommenda- tions. We would be happy to share some of those recommendations with you for your response. Chairman LEACH. Thank you, Mrs. Lee. Ms. Schakowsky. Ms. SCHAKOWSKY. Thank you, Mr. Chairman. Thank you, Chairman Greenspan, for your patience and your stamina and for sticking with us. It is a privilege to be able to ask you some questions. I first do feel compelled to comment on what my colleague has said about the housing issue. You know, one of the byproducts of this boom system that in communities like those I represent in the north side of Chicago and some of our suburbs is that it is a terrible irony for some people, that as the economy gets better for some, this housing crisis does get worse, and I think 51 that is a challenge we have to embrace. How do we maintain mixed income communities? How, as we improve our cities and we gentrify our communities, do we still find a place for those people who can't afford these $100,000-$200,000 homes, and that it is not sufficient to say this is just a fact of life, these are the source forces out there, but I think we do need to figure out some interventions so that we can have the kind of fair and diverse communities that we want for people. That is not my question. I have two, actually. One, I know that Mr. GREENSPAN. Let me answer, I don't disagree with you. I just want to emphasize, let us make sure when we intervene it works and not—I have seen too many activities we have all engaged in which we promised people things—we say we are going to do this and this is going to happen and it doesn't happen. There is the dis- couragement that happens to a lot of people that I think is a poten- tially very sad thing that we all are too often responsible for, and you know, Government basically promises things and we can't de- liver, and I think that undercuts society. I don't disagree with your general concern, but let us be careful to be sure we know what we are doing. Ms. SCHAKOWSKY. Should be careful, but I think we cannot af- ford to give up on it. Mr. GREENSPAN. I agree with that. I agree with that. Ms. SCHAKOWSKY. There was some discussion about predatory lending, and I know I have a piece of legislation to deal with preda- tory lending, another problem in my community. Mr. LaFalce has a bill. We heard testimony. I know you are holding hearings. But on one particular question, I know that in other contexts that Fair Lending and the CRA come to mind, that the Fed has opted not to exercise its authority to examine bank subsidiaries. Through the various hearings that we have had, we have discovered that many bank subsidiaries actually engage in harmful, predatory lending. I am wondering what factors will determine whether the Fed might reverse its positions and examine subsidiaries for predatory lending? Mr. GREENSPAN. I think that will occur as a consequence of these hearings that we are engaged in at this stage. Ms. SCHAKOWSKY. And many of the provisions in my bill as in others are really within your purview, you could do it without legis- lation, it seems to me, all the things we talk about, the triggers, some of the practices that need to be prohibited, like flipping or lump-sum credit life insurance funding, appraisal manipulation, and so forth. I think those are things that you could just do and that would be wonderful. Mr. GREENSPAN. Well, I think that Governor Gramlich, who is in charge of this project for us, is in the process of a fairly extensive examination of various alternatives, on which, under existing stat- utes, the Federal Reserve has authority to act. Ms. SCHAKOWSKY. One last thing. Over the years, including over the months, a year ago almost to this day at this hearing, you talked about immigration and expanding immigration in July last year, if we can open up our immigration roles significantly, that clearly will make the unemployment rates affect inflation less and less of a problem. You called for reviewing our immigration laws 52 in January, and then in February, after the AFL-CIO talked about a fairly broad amnesty plan, that there is an effective limit to new hiring unless immigration is uncapped. I am wondering exactly what you are proposing, or what you would think would be appro- priate policies. Mr. GREENSPAN. Actually, I am not proposing anything. The rea- son I am not is I think that immigration policy is a very crucial political issue for a society in which the elected representatives make very important judgments. What I am trying to do, and hope- fully trying to stay away from a recommendation, is merely citing what I think the statistics and economics are saying and not mak- ing judgments as to whether Hl-B should be increased, decreased, in a certain manner. I do recognize that there would be benefits in- volved in a number of these different types of activities, but I have tried to stop short of recommending any specific detailed program, because I do think that that is going well beyond anything that is appropriate for central banks, or anything related to issues which are major value judgments of a society which, in my judgment, are wholly within the realm, and should stay there, of the elected rep- resentatives of the people. Ms. SCHAKOWSKY. Thank you for that. I do appreciate the direc- tion in which your comments point, however, and thank you very much for your responses. Chairman LEACH. Thank you, Ms. Schakowsky. Mr. Moore. Mr. MOORE. Thank you, Mr. Chairman. Chairman Greenspan, I too, appreciate very much your patience here and we are just about finished. You testified before the Senate last week that energy prices may pose a challenge to containing inflation, because, and I think this is close to a quote, because energy inputs are a significant element in the cost structure of any businesses. And you testified that re- cent price spikes in energy represent a one-time shift and cannot generally drive an ongoing inflationary process. And I think you conclude, and I am trying to be fair in summarizing here, that the key to whether such a process could get underway is inflation ex- pectations, and that right now, households and investors don't view the current energy price surge as affecting long-term inflation, and I think your testimony today was essentially consistent with that and probably about the same. And what I want to ask you, just two or three questions about today. Chairman LEACH. If you could withhold for one second. If I could, what I would like to do, because we do have a vote at the risk of presumption, is to hold your questions to five minutes, then we can get Mr. Gonzalez for five minutes, and we can finish for the day, if that is all right. Mr. Moore, please. Mr. MOORE. Thank you. I wanted to ask you just very briefly about in the energy area. Americans went to the gas pumps during the last two to three months, and were, I think, shocked to find gas prices up 20, 30, 40, 50 cents a gallon, and while recent decisions from OPEC nations have brought some relief to the energy crisis in oil and gasoline areas, I think there is another emerging crisis, 53 and I read some of the press reports, and even the stock market indicate the next big energy crisis may be in the natural gas area, and natural gas spiked recently to an all-time high of $4.72 per million BTUs on June 27th, and some analysts are now suggesting that the price of natural gas could rise higher to as much as dou- ble, up to almost $8 per million BTU this winter. And I guess my questions are these, and I would just like your observations if you have any in this area. First, does the evidence you cite in your testimony suggesting that expectations with regard to energy price surges will not affect longer-term inflation take into consideration the natural gas prices and what is happening there and what may happen in the near future as far as doubling, if that happens in natural gas prices? Mr. GREENSPAN. I assume that we are going to be able to bring resources to bear. It is certainly the case that we have lagged sig- nificantly in increasing reserves of natural gas in this country rel- ative to the increased demand, which has occurred, remember, fair- ly dramatically as a consequence of a fairly substantial shift from coal to natural gas in the electric power industry, and all of a sud- den, where natural gas used to be perceived as a very limited and very valuable product which we shouldn't use, it all of a sudden ap- peared in great abundance as our new technologies are growing, all of a sudden brought forth a huge plethora of gas capability. Our overall drilling has, however, slimmed down and when the natural gas prices were low, there was very little capital going into the natural gas industry, and as a result, we began to find that the storage quantities which we built up got down to low levels—be- cause obviously, it is very difficult to maintain inventories of gas, but we didn't maintain even normal levels—and we got down to very low levels, which all of a sudden, with the demand for electric power, triggered a significant increase in natural gas prices. I would presume that at these particular levels, the profitability of drilling has gone up very dramatically, and I do think that it is just a matter of time before we are going to find resources coming in which will bring up the supply, but it is a problem in the sense that it doesn't come overnight, and it is going to be two or three years before we are back in balance. I do not think that natural gas, per se, has the capacity to engender changes in inflationary expectations of the type that could be a problem, but there is no question that it is an issue which has emerged fairly recently, and to many people, it has sort of just snuck up on us, and the first time we knew anything was going on was when we began to see what was happening to inventories of stored gas. Mr. MOORE. Which leads into my second question/observation, and I would like you to just make any observations you feel com- fortable making. There currently exists, under the tax code, Section 29, to stimulate the production and supply of certain types of liquid fuels and gases, including natural gas, this credit is set to expire in about eighteen months. I just wondered if you would have any observations or thoughts about whether extension of this credit and a subsequent increase in production might relieve some of the mar- ket's expectations of future shortages or do you have other sugges- tions, number one? 54 And number two, and this will be the last question, the demand for natural gas has increased as electric power generators are switching to natural gas from coal and fuel oil to eliminate pollu- tion emissions. And I guess several States have also moved to de- regulate the electricity industry, and the last question I have is this, what impact, if any, would this move on higher natural gas prices have on your economic outlook, and maybe you answered the last part of that already. Mr. GREENSPAN. I don't know enough about the particular tax credit that you are referring to to make a judgment on it. I do know that there is nothing more forceful than higher prices to en- gender investment in a particular industry, and I would wait to see exactly what type of drilling rig expansion occurs as a consequence of these prices and make judgments thereafter. So it is hard for me to tell without looking at the details of various different scenarios in that regard. Mr. MOORE. Thank you, Chairman. Chairman LEACH. Mr. Gonzalez. Mr. GONZALEZ. Thank you, Mr. Chairman. Thank you very much and again, thank you for your patience, Mr. Chairman. My question has to do with independent, small banks, commu- nity banks, whatever you want to call them, and the important role that they play in our communities. We passed the Banking Mod- ernization Act last year. Prior to that year we passed H.R. 1151, and if you think in terms of where that placed credit unions and where that also placed the larger financial institutions, the insur- ance industry and the securities industry, the small banks are caught in the middle, and I don't believe that is just perception or an argument that they advance. On one end, of course, it is hard to compete against the credit unions, which I believe there is an element of truth to that. On the other end of it, they can't compete against the big guys. Do you see that it is not a level playing field, and is there any- thing that we should be addressing at this point or in the future in the way of legislation? Mr. GREENSPAN. I do think that the overall financial system of this country is undergoing significant change as a degree of homog- enization begins to increase with respect to various different types of products sold by different types of vendors. My own belief is that there is a very crucial role for community banks in this country in that they are the vehicle by which a particular type of product can be put forward, which is personal lending, individual banking, which these larger institutions don't have the competitive capa- bility of engaging in. My own judgment is that the issue of personal banking is something which will always exist in this country and the demand for it will always exist. How significant that will work its way through the banking structure, I really don't know. As you know we are undergoing major changes all over the place. A goodly part of the problem with the community banks has been the dramatic rise in mutual funds, which has drained off a signifi- cant part of their usual sources of funds, of funding, and it is hard to know where that is going. So that there are a lot of dynamics that are going on here and a lot of changes, and I don't venture to say that I know exactly how 55 it is all going to come out, or do I feel comfortable in a lot of the different proposals that I hear with respect to resolving problems, because a number of the solutions create more problems than I think the problems themselves are creating. Mr. GONZALEZ. I am sure it is going to be addressed, because I know there have been discussions by Members of this committee of doing something to assist them, to help them remain competitive. And as you have indicated, they have a very special niche in the financial world, and believe me, the people that really make those loans have the personal relationships in the community, under- stand the community, have been there, and have a personal stake, are the community banks, and I really appreciate your sensitivity. Mr. GREENSPAN. I think that gives them a competitive advantage which big banks have very considerable difficulty penetrating. Mr. GONZALEZ. I hope so, but it does not appear that it is trans- lating to that. You may still have some sort of that allegiance and the understanding, but what it really comes down to in the market- place, you generally will go with what is the best deal, and it is difficult for community banks to compete in the present environ- ment. Thank you very much. Chairman LEACH. Well, thank you, Charles. Mr. Chairman, we appreciate your testimony. It is thoughtful, reasonable, not market-rocking, and we thank you very much. The hearing is adjourned. [Whereupon, at 1:30 p.m., the hearing was adjourned.] A P P E N D IX July 25, 2000 (57) 58 CURRENCY Committee on Banking and Financial Services James A. Leach, For Immediate Release: Contact: David Runkel or Tuesday July 25,2000 Brookly McLaughlin at 226-0471 Opening Statement Of Representative James A. Leach Chairman, Committee on Banking and Financial Services Hearing on the Conduct of Monetary Policy July 25,2000 The Committee meets today to receive the semiannual report of the Board of Governors of the Federal Reserve System on the conduct of monetary policy and trie state of the economy. Welcome, Chairman Greenspan. As Members are aware, although Chairman Greenspan's appearance before the Committee today is no longer a requirement of law there is perhaps no more important Congressional oversight responsibility than that of the Banking Committee's semiannual review of the Federal Reserve's conduct of monetary policy. In this regard, I have been working closely with Senator Gramm on legislation renewing the Federal Reserve's reporting requirement and am optimistic that the statutory reporting mandate will be renewed before the adjournment of the 106th Congress. Turning to the state of the economy, it appears that the Federal Reserve is succeeding in moderating the rate of U.S. economic growth without precipitating a "hard landing," while providing a "soft cushion" for fiscal policymakers. Inflationary pressures remain relatively modest, due in part to Federal Reserve restraint, in part to the on-going improvements in productivity. On the other hand, we are all aware that the U.S. continues to run a substantial current account deficit that must be financed from abroad. We look forward to any comments you might make on how long this situation can persist, its possible impact on the dollar, and what steps policymakers can take to bring national savings and investment into balance. With reference to fiscal policy, the moderation in federal spending brought about by difficult decisions by the Congress over the past five years, has contributed - along with the Fed's monetary policy decisions - to a much sooner end of federal budget deficits than anyone ever envisioned and to far greater projected surpluses than ever foreseen. I sometimes joke to constituents that there appear to be three political parties in Washington today ~ the Republicans who suggest taxpayers should be rewarded with a tax cut; the Democrats who argue that the fiscal surpluses make spending increases a social imperative; and the Greenspanites who say Congress should do nothing, at least until the deficit is wiped out. In any regard, maintaining the economic progress of the United States is both a challenge to the monetary policymakers at the Federal Reserve Board and to the fiscal policymakers of the Legislative and Executive Branches. With these few comments, I'll turn to the distinguished Ranking Member, Mr. LaFalce for an opening statement and then to the Chair and Ranking Member of the Domestic and International Monetary Policy Subcommittee, Mr. Bachus and Ms. Waters for their statements before recognizing Chairman Greenspan. Mr. LaFalce. 59 Greenspan's Needle Despite denials, Fed chairman takes credit for pricking the markets' bubbk BY ROBERT D. AUERBACH • When Federal Reserve Chairman Alan Greenspan testified before pected, was . very purposeful endeavor the Senate Banking Committee on Thursday, he made no mention of the stock market save for readjust holdings from weak hands into noting that the unsustainable pace of increase in household wealth had slowed, due to the flat- tening of equity prices. And while the Fed's six rate hikes over the past 1 2 months certainly have^^^J^j^ bubble*"''' And uhfak played a role in the stock market's slow- But concern over rising equity prices equity markets .... So, what has oc-what we have reached in conclusion at down, the chairman didn't 'fess up to clearly loomed large in the Fed's deci- curred is that while this capital gainsthis particular point is the defusion of a targeting the market with monetary sion-making six years ago. bubble in all financial assets had togood part of the bubble. policy. On February 4, 1994, the central come down, instead of the decline being "I think there's still a lot of bubble In private, however, his remarks bank raised the federal-funds target concentrated in the stock area, itaround; we have not completely elimi- have been as pointed as the needle he from 3% to 325%. This was the first of shifted over into the bond area. But thenated it Nonetheless, we have the capa- used to prick the market balloon. In- seven increases that doubled the target effects are the same." bility, I would say at this stage, to move deed, recently released transcripts of rate to 6% on February 1, 1995. Osten- At the April 18, 1994, FOMC meet-more strongly than we usually do with- Federal Open Market Committee meet- sibly, the Fed was conducting a ing, Greenspan heralded a decrease inout the risk of cracking the system." ings show that the Fed has been target- preemptive strike against inflation, the financial markets' bubble. Accord- On November 15, 1994, Philadelphia ing equity prices since early 1994, when though the consumer price index rose ing to a transcript of the conferenceFed Bank President Edward Boehne (a the Dow Jones Industrial Average by just 2.61% in 1994, and Greenspan call, he opined, "[T]he sharp declines innon-voting FOMC participant) summed stood around 3900. contended that it was overstated by as both stock and bond prices since ourup the Fed's actions in raising interest Then, ax now, the Fed Chairman in- much as 1V4 percentage points. The Fed last meeting, I think, have defused arates: "I think you argued rather clicated he was fighting expected infla- boss did testify before the Senate Bank- significant part of the bubble which hadpersuasively, Mr. Chairman, that we tion. But Greenspan's private words ing Committee on May 27 that he been previously built up. We let a lot ofhad a bubble in financial markets and show another motive for doubling rates thought the average stock's price was air out of the tire, so to speak . . . that we had to deflate that rather in 1994-95. And those words are likely a too high. He didn't, however, indicate "[The] dangers of breaking the BUT-slowly. Otherwise we could take a big good proxy for the thinking behind the he would use monetary policy to fine- face tension of the markets clearly arehit In hindsight, I think that was wise." recent - and likely unfinished - round tune equity prices. less than they were at the time of the In 1994, Greenspan twice reported of tightening*. After the first increase in February last meeting .... The problem, as I've the rationale for monetary policy before In the February, March, April and 1994, Greenspan evidently was pleased, argued in recent meetings, is that wethe House Senate and Banking Corn- May 1994 meetings and phone confer- "I think we partially broke the back of have to be careful about breaking thismittees. These semiannual appearances ences, Greenspan explained the need to an emerging speculation in equities," so-called surface tension of the marketat the Humphrey-Hawkins hearings prick the "bubble" in the stock market, reads the transcript of the February 28, and ... selling begetting selling. That iswould have been much more productive to let the air out slowly and to produce 1994, FOMC conference call. "We potentially quite dangerous." if the transcripts had been available t>n uncertainty to curb speculation in finan- pricked that bubble {in the bond mar- On May 17, 1994, Greenspan tolda timely basis. The vague minutes of cial assets. No such motives, however, kets] ss well .... We also have created FOMC members that ever since theFOMC meetings are, nearly worthless were ever officially expressed - and a degree of uncertainty; if we were "1987 peaks after the stock marketfor revealing individual FOMC roem- with good reason. looking at the emergence of speculative crash," uncertainty was diminishing andbers' responsibility for monetary policy. After all, the Full Employment and forces, which clearly were evident in there was "an element of euphoria that In the hearings, Greenspan raised Balanced Growth Act of 1 978 sets the very early stages, then I think we had a gripped the markets." By 1993, the tran-topics such as the debatable theoretical Fed's "goals of maximum employment desirable effect" script of the meeting states, "everybodypoint that a low real federal-funds rate is~ stable prices, and moderate long-term Greenspan had expected that the just looked as though the markets hada predictor of inflation. This served to interest rates." These goals were drawn Fed's higher interest-rate policy would no downside risks ... the mere fact thatlimit questions about monetary policy from the Employment Act of 1946, reduce equity prices. According to the uncertainty did not exist was not a good;from most Banking Committee members which instructs federal government en- transcripts of the March 22, 1994, call, it clearly was a bad. And our endeavorwho aren't versed in economics. It's a titles to "promote maximum employ- he told the FOMC: "When we moved on to break that pattern, which we had totactic used to deflect questions about ment production and purchasing February 4. 1 think our expectation was do even though it turned out to be amonetary policy, one that was also bla- power." In both cases, what was to be that we would prick the bubble in the much bigger problem than we sus-tantly practiced by former Fed Chair- stabilued were the prices of nun Arthur Burns, goods and services - not Pop Goes The Market wCnoon g u ress with five ----- it coma to the money, each in un- stock mar**, racenily nltattd tnuuerifl* tfim FMbraJ Opm moiutonfpofevtoi vitia tfkt (Mote tkt role in 1994 raises gotten aJuad tfitielf. what he is telling the FOMC mem- ben now. If he was trying to prick the bubble in 1994, what is be doing in 2000 when the Dow is nearly three 60 Opening Statement of Rep. Ron Paul Hearing on the Conduct of Monetary Policy House Committee on Banking and Financial Services July 25, 2000 I would like to start off by clearly thanking my friend Chairman Jim Leach for his successful efforts keeping the "Humphrey-Hawkins" tradition of semi-annual hearings by the chairman of the Federal Reserve Board on monetary policy. Monetary policy is extremely important but not well understood. These hearings provide a useful means of education as well as Congressional oversight. Chairman Leach's efforts are much appreciated. In the testimony of Chairman Greenspan, he refers to labor pressure costs being "held in check by productivity gains," but other reports-including at least one from the Fed-question this premise. Non-farm worker productivity growth, reported by the Bureau of Labor and Statistics, averaged 1.9% a year in the 1990s, up a half-percentage point from the 1980s, with productivity growth in the manufacturing sector up a "phenomenal" four percent annual rate. However, those estimates are based on assumptions that are challenged by many analysts. Morgan Stanley chief economist Stephen Roach maintains that these estimates have been exaggerated for several years since many workers are putting in more time than previously, thus skewing the measurements of output per worker- hour ("Productivity: Why Output Per Worker Matters So Much," Gene Epstein, Barron 's, July 17, 2000). In addition, a report by economists Marcello Estevyo and Saul Lach explains that the BLS statistics overstate productivity gains because the BLS only counts those on the payroll of manufacturing firms (not those paid by someone else—such as a temporary agency) "even though they are producing output for manufacturers" ("Overblown Productivity?," Adam M. Zaretsky, National Economic Trends, The Federal Reserve Bank of St. Louis, June 2000). They estimate that the official statistics overstate productivity growth figures by about one half of one percent per year. In other words, there is no increase in productivity gains holding inflationary pressures in check. Jim Grant ("The great productivity delusion," Grants Interest Rate Observer, March 31, 2000) and other analysts have made similar arguments. Robert J. Gordon, professor of economics at Northwestern University, notes that nearly all of the increase in productivity gains is concentrated in the high technology sector. "There has been no productivity growth acceleration in the 99% of the economy located outside the sector which manufactures computer hardware," he wrote in a paper presented to the Congressional Budget Office. Since the increase in computer hardware and software purchases and upgrades in preparation for the "Y2K" problem created an artificial clip in the statistics, it is unlikely to be sustained. Some analysts such as Frank Veneroso, et al., even question the validity of those real productivity gains. Since real productivity gains have not kept inflation in check, where is the inflation? Robert D. Auerbach ( a professor of public affairs at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin and a former economist with the House Committee on Banking and Financial Services) argues that Mr. Greenspan himself thinks it has manifested itself in a stock market bubble. He wrote "In the February, March, April and May 1994 meetings and phone conferences, Greenspan explained the need to prick the "bubble" in the stock market, to let the air out slowly and to produce uncertainty to curb speculation in financial assets ("Greenspan's Needle: Despite denials, Fed chairman takes credit for pricking the market's bubble," Barron's, July 24,2000)." Indeed, equity prices, in comparison with current corporate earnings, are historically very dear. The price to earnings ratio (price of a typical stock to the earnings per share) for the S&P 500 was 32.4 in January 2000. This ratio is higher than any previous annual measurement ("Stock Prices and Consumption," Christopher J. Neely, Monetary Trends, Federal Reserve Bank of St. Louis, July 2000). These figures suggest that we do have a stock market bubble. The clangers of ignoring the inflation manifested in the stock market are great. Many observers have even been making Great Depression era comparisons. "Every new era in our history--and we have had several-has been based upon the exaggerated enthusiasm and the inflationary forces set in motion by some single new industry or industrial activity (BusinessWeek, January 29,1930, cited in AIC Investment Bulletin, June 19,2000)." In the July Richebacher Letter (printed in Barron's, July 24,2000), Kurt Richebacher ends his comments, "Adhering to the famous postulate of Austrian theory that the length and severity of recessions or depressions depend critically on the magnitude of the dislocations and imbalances that have accumulated in the economy during the preceding boom, we take it for granted that a hard, even a very hard, landing is absolutely inevitable for the U.S. economy." These sobering words are worthy of a cautionary note. 61 Statement of Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Committee on Banking and Financial Services U.S. House of Representatives July 25, 2000 62 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 strong and long-running expansion of our economy. The challenges will be no less in coming months as we judge whether ongoing adjustments in supply and demand will be sufficient 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 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 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 expansion that have proven 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 persistent restraint on spending. One they cite is the flattening in equity prices, on net. this year. They attribute much of the slowing of consumer >penJmLT to thi-> diminution of the wealth effect 63 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 income have risen materially during the past six 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 consumers of imported oil, the equivalent 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 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 estimated to have increased at nearly a 6 percent annual rate over the past three years, a marked acceleration from the growth rate of the previous ten 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 1-3/4 vehicles per household by the mid-1990s. 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 iif owner-occupied homes has accelerated during the past five \ear>. 64 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 household appliances across our more than hundred 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 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 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 certainly premature to make a definitive assessment of either the recen.t 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 productivity under such circumstances 65 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 five 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 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, 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 runup in energy prices on profits as well as on sales expectations 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 dropoff 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 1/2 percent compared with 3-1/4 percent the previous three months. Of course, we do not 66 have comprehensive measures 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 potential supply in our economy. As I testified before this committee in February, domestic demand growth, influenced importantly by the wealth effect on consumer spending, has been running 1-1/2 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 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 potential supply niu>t 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 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 invotments that ha> been driving capital accumulation 67 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 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 two and one-half 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 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 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 balance 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 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. 68 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 compensation per hour are not significantly outstripping gains in productivity. But as I have argued previously, should labor markets continue to tighten, short of a repeal of the law of supply and demand, 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 forever-rising imports and for a further draining of our limited 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. 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 demand, 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 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 directly. 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. Moreover, 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 under way 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 economic outlook. As the financing requirements for our ever-rising capital investment 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 1-3/4 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 standing pat at least for the time being, they were not sufficiently 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 year and one-half. 70 but with growth at a somewhat slower pace than over the past several years. For the current year, the central tendency of Board members' and Reserve Bank presidents' forecasts is for real GDP to increase 4 to 4-1/2 percent, suggesting 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 anticipated last February, no doubt owing primarily to the unexpectedly strong jump in output in the first quarter. Mainly reflecting higher prices of energy products than had been foreseen, the central tendency for inflation this year in prices for personal consumption expenditures also has been revised up somewhat, to the vicinity of 2-1/2 to 2-3/4 percent. Given the firmer financial conditions that have developed over the past eighteen months, the Committee expects economic growth to moderate somewhat next year. Real output is anticipated to expand 3-1/4 to 3-3/4 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 2-1/2 percent, somewhat above the average of recent years. 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 extended period, when financial sector fragility held back the economy. MCKI recentls we have needed to 71 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 objecti ve- to foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate possible. 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 contribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal. 72 Chairman Greenspan subsequently submitted the following in response to written questions from Congressman Charles A. Gonzalez received after the monetary policy hearing of July 25, 2000, before the Committee on Banking and Financial Services: Q.I. About a month or so ago, you wrote a letter to Rep. Richard Baker suggesting growth of the housing Government Sponsored Enterprises (GSEs) is creating "systemic risk." I believe you were referring to two issues: (1) the huge percentage of mortgages either owned or guaranteed by Fannie and Freddie, and (2) the magnitude of GSE investments (stock and mortgage-backed securities) that insured institutions now hold on their balance sheets. Just how significant is this risk, both in absolute terms and relative to other risks in the financial services marketplace? Do the Federal Home Loan Banks present similar risks? What steps might Congress consider to address these risks? A.I. As I wrote to Congressman Baker, as a general practice, the Federal Reserve does not comment on any institution or a particular group of institutions with regard to systemic risks. The GSEs--the Federal Home Loan Banks (FHLBs), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac)—collectively dominate the United States residential housing markets. They clearly benefit from government sponsorship—particularly from their ability to borrow funds at a lower cost than comparably situated private sector borrowers. The lower borrowing costs of these institutions, of course, reflect the belief of purchasers of their debt that the government is unlikely to let a GSE fail. Such federal government guarantees-- implicit or explicit-are one way, along with government outlays and mandates on the private sector, that the federal government makes claims on the real resources of the private sector. As for what steps Congress might consider, implicit interest rate subsidies such as those that arise from ambiguity in investors' beliefs, by their nature, are created with few limitations on the debt issuer and are not controlled by the congressional appropriations process. Since these subsidies have important consequences for the structure and efficiency of the financial markets and the productive allocation of real resources, it is appropriate for Congress periodically to consider and evaluate these implicit subsidies. Q.2. The U.S. trade deficit continues to increase, and it is significantly higher than in past years. What does this mean for the U.S. in the long run and is there anything specific that we should be doing to address this? A.2. As I stated in my testimony, domestic demand growth, influenced importantly by the wealth effect on consumer spending, has been running 1-1/2 to 2 percentage points at an annual rate in excess of even the higher, productivity-driven growth in potential 73 supply since late 1997. That gap has been filled in part by a marked rise in imports as a percent of GDP, resulting in significantly higher U.S. trade and current account deficits. The technological advances that have boosted productivity have also engendered a sharp rise in potential rates of return on new American investments. This sharp rise in potential rates of return attracts foreign capital inflows as investors seek these higher returns; foreigners expand their claims on U.S. residents, and in the process finance our external deficits. 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. Moreover, a narrowing of disparities among global growth rates over time may well induce a narrowing of rates of return in the United States relative to those abroad, and result in a decline in the attractiveness to foreigners of investment in the United States. There are at least two specific things that we should be doing to address the expansion of the current account deficit. First, the growth of domestic demand and that of potential supply must be brought into balance. Second, the rate of U.S. national saving must be brought more closely in line with the rate of domestic investment. Since the economy requires investment in order to replenish the capital stock and maintain or increase the trend rate of the growth of output, economic policies aimed at reducing the current account deficit should target increases in saving rather than reductions in investment. The large budget surpluses that have developed recently have substantially augmented national saving. The Congress and the Administration should avoid steps that would materially reduce these budget surpluses and with them, U.S. national saving. Q.3. With technology reshaping the delivery of financial services, do we need a new legal framework for banking and consumer protection that is relevant in an electronic world which does not easily recognize geographic borders? Do laws, federal or state, need to be changed to facilitate electronic commerce and still assure consumer protection? A.3. Rapid advances in technology and electronic commerce have had a significant effect in changing the scope, utility, and delivery of financial services. Business practices across various credit markets are also evolving to reflect these changes. As a general matter, the adoption of an entirely new legal framework to address these changes may not be necessary, but some laws enacted to regulate the traditional structure for delivering financial services-including the consumer financial services laws-- may need to be revised. Government should review federal and state laws and regulations and, where necessary, change them to facilitate electronic commerce while continuing to maintain consumer protection. Such efforts are taking place. For example, section 729 of the Gramm-Leach-Bliley Act requires the federal banking agencies to conduct a study of 74 banking regulations regarding the delivery of financial services and report their recommendations on adapting those existing requirements to online banking and lending. To keep pace with the changes in the financial services industry, the Board periodically reviews the regulations that it administers to update them. In 1996, the Board began considering amendments to its consumer regulations to permit financial institutions and others to provide in electronic form disclosures required to be given to consumers in writing. The goal of the amendments was two-fold, to facilitate electronic commerce and, consistent with the intent of consumer protection laws, to ensure that consumers accepting the electronic delivery of financial services continue to receive cost and other disclosures designed to aid them in making informed financial decisions. Consistent with this goal, in June of this year, the Electronic Signatures in Global and National Commerce Act, P.L. 106-229 (the E-SIGN Act), became law. Similar to the Board's proposals and interim rules, the act provides that consumer disclosures provided electronically satisfy requirements for written disclosures. The Board is in the process of evaluating the impact of the E-SIGN Act on the Board's proposals and interim rules permitting electronic disclosures. Q.4. In the last session of the 106th Congress, we passed H.R. 10, which became S. 900 and is now known as the Gramm-Leach-Bliley Act. I have heard from several constituents who contend that this new law essentially benefits financial institutions which in the past have been deemed to be "too-big-to-fail," insurance companies and securities firms. Several years ago, Congress also passed H.R. 1151 which became law and which benefits the credit unions. My question to you now is what about community banks? Do you have any suggestions or recommendations for Congress in terms of changes to existing laws or regulations that could help community banks compete? I am hearing more and more from community banks on how difficult it is for them to compete with the large brokerage firms, the credit unions and the very large banks, and I would like to have some concrete suggestions on what Congress Can do to help level the playing field. A.4. The Gramm-Leach-Bliley (GLB) Act contains a number of provisions attractive to community banks. As of early July, almost three out of four domestic Financial Holding Companies (FHCs)--the entities authorized by GLB to engage in wider activities—were organized by banks with less than $500 million of assets. Many of these used the new authority to operate the more flexible insurance agencies authorized by GLB. In addition, GLB permitted banks to underwrite municipal bonds and a small number of other securities transactions in the bank, rather than in an affiliate, provisions particularly attractive to smaller banks. The provisions in GLB on bank borrowing from the Federal Home Loan Banks (FHLB) were particularly helpful to community banks. Not only did it authorize banks with less than $500 million of assets to use small business and agriculture 75 loans as collateral, it exempted these banks from the requirement that they meet minimum mortgage loan holdings in order to borrow from the FHLB. Beyond the benefits of GLB, our analysis of the data suggests that community banks have been quite successful competitors. Our staff recently reviewed the experience of 7,700 small banks~i.e., all those beyond the 1,000th largest bank-with average assets of $88 million, the largest of which was $328 million. We found their assets, core deposits, large time deposits, and that portion of all their deposits that was uninsured had grown faster than those at large- and medium-sized banks in the 1990s. The smallest sub group- the 3,300 banks with assets less than $50 million—had the fastest growth rate. Small banks did pay more than large banks to attract interest-bearing deposits in the last half of the 1990s, but this does not seem to affect their high profit margins or their stable return on equity. These are averages, to be sure, and, by definition, some banks are below average. There might also be pockets with special regional difficulties, and we are looking into that possibility. We would appreciate hearing of any evidence of more generalized difficulties. At this time, we have not been able to determine the need for any specific Congressional action for the benefit of this critical and important segment of our banking system. As in the past, they have continued to be very successful competitors. Q.5. There is a segment of the American population that has never had credit before and/or that has a blemished credit record for one reason or another. What are your views on the value added to or simply the value to our economy and to our constituents of the extension of credit card opportunities to what some call the "gateway market," those with blemished credit and/or new to the credit market? Do these credit card companies and "gateway" markets provide a service to our economy? A.5. Credit cards may provide several benefits to consumers. In addition to being a flexible source of credit, they are commonly used as payment instruments. And, in certain cases, credit cards may be essential to obtain services, or for identification, such as for renting cars or making hotel or airline reservations. For consumers with blemished credit history, or no credit history, the cost of opening and maintaining a credit card account may be high. But initially obtaining a secured credit card or a high cost card account can allow consumers to demonstrate that they are good credit risks, and ultimately to obtain an unsecured or lower rate credit card. In some cases, consumers who are not financially sophisticated may become overextended in their use of credit cards. And in some cases, they may be less inclined to comparison shop for favorable terms, and therefore may be more likely to use credit cards with high costs. But it is important that consumers have access to credit. If that access is not available to consumers through credit cards, consumers with blemished or no credit histories may seek credit alternatives that may be more costly than credit cards (such as high cost short-term personal or mortgage loans). 76 Chairman Greenspan subsequently submitted the following in response to written questions from Congressman Frank Mascara received after the monetary policy hearing of July 25, 2000, before the Committee on Banking and Financial Services: Q.I. Chairman Greenspan, in your testimony you referred to the gap between domestic demand growth and the weaker growth in supply as contributing to increased immigration and the employment of unutilized labor resources. Can you explain what these unutilized labor resources are—and would you agree that increased investment in worker training programs might alleviate the need to import immigrant labor? A.I. In my statement, I said "domestic demand growth influenced importantly by the wealth effect on consumer spending, has been running 1-1/2 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." Arithmetically, the growth of gross domestic purchases (that is, GDP plus net imports) equals the sum of the growth of productivity, population, the labor force participation rate, and one minus the unemployment rate, plus the contribution of net imports. During the four quarters ending in 2000:Q2, gross domestic purchases rose 6.9 percent, of which about 1-1/2 percentage points was met by falling unemployment and rising labor force participation—that is, a shrinking pool of available workers—as well as the widening trade deficit. That 1-1/2 percentage points reflects an excess of aggregate demand growth over the growth of aggregate supply. There are two ways to satisfy above trend growth of domestic demand: we can make the goods here, or foreigners can make them for us. If we make them here, we can do it by drawing more people into the workforce or increasing productivity. But the pool of available workers, what I called "unutilized labor resources" in my statement, cannot be drawn down forever; likewise, the trade deficit cannot widen forever. As I went on to say in my statement, "the excess of the growth of domestic demand over potential supply must be closed before the resulting strains and imbalances undermine the economic expansion." Certainly, efforts to provide workers with the skills that are demanded in today's labor market have a beneficial effect. Such programs, when successful, improve the productivity of the workforce. That is one reason many employers have established on the job training programs and "corporate universities" that allow employees to upgrade and enhance their skills. Indeed, the most successful programs tend to be those initiated by employers, who have detailed knowledge of the skill requirements of their businesses. Efforts by firms to reach out and provide training to those who are unemployed or out of 77 the labor force can expand the pool of workers available to help satisfy the production needs associated with rapid growth of domestic demand. Q.2. Chairman Greenspan, you noted in your testimony that the increase in oil prices have amounted to $75 billion in added energy costs for consumers, yet you also suggest that the effects of these costs to slow consumption may only be temporary. Do you arrive at this conclusion because you anticipate oil prices to fall, or because high oil prices do not contribute to inflation? Would you be inclined to interpret future decreases in oil prices as reducing inflationary pressures? A. 2. In my statement, I noted that "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 equivalent 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." I suggested that the imported "oil tax" might be transitory because, at the time of my statement, crude oil prices were beginning to fall from their peaks. In particular, the spot price for West Texas Intermediate (WTI) crude peaked at almost $35 per barrel on June 23 and had dropped to about $28 per barrel on July 24. Since then, WTI prices have moved back to around the $32 per barrel level. In the short run, movements in oil prices have an effect on the broad indexes on consumer prices, such as the price index for personal consumption expenditures or the CPI. More fundamentally, however, 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 under way is inflation expectations. To date, it appears that households and investors do not view the recent energy price surge as affecting longer-term inflation. But any deterioration in such expectations, which could be ignited and inflamed by unsound monetary policy, would pose a risk to the economic outlook. Of course, a reversal of the runup in oil prices would, undoubtedly, lower the headline inflation figure for a time. 78 Board of Governors of the Federal Reserve System Monetary Policy Report to the Congress July 20, 2000 79 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. Sincerely, Alan Greenspan, Chairman 80 Table of Contents Page Monetary Policy and the Economic Outlook Economic and Financial Developments in 2000 81 Monetary Policy Report to the Congress Report forwarded to the Congress on July 20, 2000 tighter monetary policy and rising interest rates in most other industrial countries. Perhaps partly reflecting firmer financial condi- MONETARY POLICY AND THE tions, the 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 tight at the time of the FOMC meeting in June, and it persisted in the first half of 2000 with economic was unclear whether the 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 outlook as still 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 the 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 the year, in February and March, economic condi- in potential supply. Under such circumstances, and tions in the United States were pointing toward an with the pool of available labor already at an unusu- increasingly taut labor market as a consequence of ally low level, the 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 in 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 net. Knowing that the two 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—the economy's ability to draw on the took additional firming actions this year, raising the pool of available workers and to expand its trade benchmark federal funds rate 1 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 the discount rate in both lenders have become more cautious about extending 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 that 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 timing and strength of the uted to a further strengthening of the dollar, despite economy's response to earlier monetary policy tight- 82 Monetary Policy Report to the Congress D July 2000 Selected interest rates 2/4 3/31 5119 7/1 8/18 W2910/1511/17 12/22 2/3 3/30 5/18 6/30 8/24 10/5 11/16 12/21 2/3 3/21 5/16 6/28 1998 1999 2000 NOTE. The data are daily. Vertical lines indicate the days on which the horizontal axis are those on which either the FOMC held a scheduled mee Federal Reserve announced a change in the intended funds rate. The dates on the a policy action was announced. Last observations are for July 17. 2000. enings, warranted a more limited policy action. Still, spread market expectations of such an action. Even noting that 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 that 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, it 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 then, began to 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 tightening 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 rates between March and May had been moved decisively onto a more moderate expansion influenced by the 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 action in June, it these circumstances, the FOMC 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 inflation in the foreseeable future.2 50 basis points, to 6'/2 percent. The Committee saw little risk in the more forceful action given the strong momentum of the economic expansion and wide- 2. At its June meeting, the FOMC did not establish ranges for growth of money and debt in 2000 and 2001. The legal requirement to establish and to announce such ranges had expired, and owing to uncertainties about the behavior of the velocities of debt and money, 1. At its March and May meetings, the FOMC took a number of tnese ranges for many years have not provided useful benchmarks for actions that were aimed at adjusting the implementation of monetary the conduct of monetary policy. Nevertheless, the FOMC believes that policy to actual and prospective reductions in the stock of Treasury the behavior of money and credit will continue to have value for debt securities. These actions are described in the discussion of U.S. gauging economic and financial conditions, and this report discusses financial markets. recent developments in money and credit in some detail. 83 Board of Governors of the Federal Reserve System Economic Projections for 2000 and 200 J high, and given the rapid pace of technological change, firms will continue to exploit opportunities to The members of the Board of Governors and the implement more-efficient processes and to speed the Federal Reserve Bank presidents expect the current flow 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 at 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 this in real gross domestic product (GDP) is 4 percent to expansion rather than an indication of structural rates 4'/2 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 31A percent to 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 that 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 low. 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 Percent increases in imports of goods and services, and given Federal Reserve governors continued recovery in economic activity abroad, and Reserve Bank presidents Indicator Administration domestic firms are expected to continue seeing a Range te C n e d n e t n ra c l y boost to demand and to production from rising 2000 exports. Regarding inflation, FOMC participants believe t C o h f a o n u g rt e h , fo q u u r a t r h te r q * uarter that the rise in consumer prices will be noticeably Nominal GDP 6-7'/4 6'/4-6V4 6.0 larger this year than in 1999 and that inflation will R PC ea E l G pr D ic P e 2 s 3V 2 4 - - 2 5 Y 4 2V 4 4 - - 4 2V '/2 4 3 3 . .9 2' then drop back somewhat in 2001. The central ten- Average level, dency of their forecasts for the increase in the chain- fourth quarter type index for personal consumption expenditures Civili r a a n te unemployment 4-4'/4 About 4 4.1 is 2'/2 percent to 23/4 percent over the four quarters 2001 of 2000 and 2 percent to 2Vi percent during 2001. Shaping the contour of this inflation forecast is the to fourth quarter1 expectation that the direct and indirect effects of the N R o e m al i G na D l P G 2 DP 2'/ 5 2 - ^ 6 l '/4 3 5 '/ '/ 4 2 - - 3 6 y 4 3 5 . . 2 3 boost to domestic inflation this year from the rise in PCE prices l'/4-3 2-2 '/2 2.5' the price of world crude oil will be partly reversed next year if, as futures markets suggest, crude oil f C ou iv r i t l h ia n q u u a n r e te m r ployment prices retrace this year's run-up by next year. None- rate 4-41/2 4-4'/4 4.2 theless, these forecasts show consumer price inflation n average for fourth quarter of previous year to average for in 2001 to have moved above the rates that prevailed fourth quarter of year indicated. over the 1997-98 period. Such a trend, were it not to 2. Chain-weighted. 3. Projection for the consumer price index. show signs of quickly stabilizing or reversing, would 84 Monetary Policy Report to the Congress D July 2000 pose a considerable risk to the continuation of the Change in PCE chain-type price index extraordinary economic performance of recent years. The economic forecasts of the FOMC are similar to those recently released by the 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 that lie at the low end of the llh,I current range of central tendencies of Federal Reserve policymakers. The Administration also expects that the unemployment rate will remain close to 4 per- cent. Like the FOMC, the Administration sees con- sumer price inflation rising this year and falling back in 2001. After accounting for the differences in the construction of the alternative measures of consumer 1994 1995 19% 1997 1998 1999 2000 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 expenditures. at an annual rate of almost 10 percent in the first quarter. Underlying that surge in domestic spending were many of the same factors 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 firming 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 5 '/> percent in the first quarter of 2000. Private increase in real GDP in the second quarter, although domestic final sales, which had accelerated in the they suggest that 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 utilization 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 first 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 that acceleration may be attributable to the indirect effects of higher energy costs on the prices of core goods and services. Sustained strong gains in worker productivity 1994 1995 1996 1997 1998 1999 2000 have kept increases in unit labor costs minimal NOTE. In Ibis chart and in subsequent charts that show the components of despite the persistence of a historically low rate of rt^GDP.chMgesaremeaiuredWthefia.lcHiancro the final quarter of the previous period. unemployment 85 Board of Governors of the Federal Reserve System Change in real 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 D Disposable personal income in outlays for goods. At an annual rate of 17'/4 mil- • Personal consumption expenditures lion units in the second quarter, light motor vehicles sold at a rate well below their first-quarter pace. Nonetheless, that level of sales is still historically high, and with 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 April-to-June period indicate that consumer expendi- tures for other goods rose markedly slower in the second quarter than in the first quarter, at a pace well 1994 1995 1996 1997 1998 1999 below the average rate of increase during the pre- ceding two years. In contrast, personal consumption expenditures for consumer services continued to rise The Household Sector relatively briskly in April and May. Real disposable personal income increased at an Consumer Spending annual rate of about 3 percent between December and May—slightly below the 1999 pace of 3% per- Consumer spending was exceptionally vigorous dur- cent. However, the 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 7% 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 allow their spending to outpace their flow of current recession during which households had deferred income, and the 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 1 percent during the first 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 back, suggesting fast pace in 1998 and 1999, accelerated during the less impetus to consumer spending going forward. In first quarter loan 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 motor Wealth and saving vehicles soared to a record rate of 18.1 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 late 1999 before the century date change. Outlays for nondurable goods posted a solid increase of 5% 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'/s 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 in outlays for energy services, which had declined in late 1999, when weather was unseasonably warm. dis N po O s T a * b . l e T p h e e r s w on ea a h l h in -1 c 0 o - m in e come ratio is the ratio of net worth of households to 86 Monetary Policy Report to the Congress D July 2000 energy prices have moderated the rise in real income lowest level in more than nine years. Survey respon- of late. 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 their less positive assessment of market conditions. financial situation, according to the results of the Purchases of existing homes were little changed, University of Michigan Survey Research Center on balance, in April and May from the first-quarter (SRC) survey. However, they became a bit less posi- average; however, because these sales are recorded at 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. Sales of new homes—a more current ployment over the coming year. indicator—fell back in April and May, and home- builders reported that sales dropped further in June. Perhaps a sign that softer demand has begun to affect Residential Investment construction, starts of new single-family homes slipped to a rate of l'/4 million units in May. That Housing activity stayed at a high level during the first level of new homebuilding, although noticeably half of this year. Homebuilders began the year with a slower than the robust pace that characterized the fall considerable backlog of projects that had developed and winter period, is only a bit below the elevated as the exceptionally strong demand of the previous level that prevailed throughout much of 1998, when year strained capacity. As a result, they maintained single-family starts reached their highest level in starts of new single-family homes at an annual rate of twenty years. Starts of multifamily housing units, 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 340,000 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 affordability 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 rate. 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 attitudes of both con- to continue to spend and take on debt. Despite rising sumers and builders. The Michigan SRC survey mortgage and consumer loan rates, household debt reported that households' assessments of homebuy- increased at an annual rate of nearly 8 percent in the ing conditions dropped between April and June to the first quarter, and preliminary data point to a similar increase in the second quarter. Mortgage debt expanded at an annual rate of 7 per- Private housing starts cent in the first quarter, boosted by the high level of housing activity. Household debt not secured by real estate—including credit card balances and auto loans—posted an impressive 10 percent gain in the first quarter to help finance a large expansion in outlays for consumer durables, especially motor vehi- cles. The moderation in the growth of household debt this year has been driven primarily by its 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 87 Board of Governors of the Federal Reserve System Delinquency rates on household loans Change in real business fixed investment O Structures • Equipment and software NOTE. Data on credit card delinquencies are from bonk Call Reports; data on auto loan delinquencies are from the Big Three automakers: data on mortgage delinquencies are from the Mortgage Bankers Association. 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 year, 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 at 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 rates has pushed the household debt-service Sustained high rates of investment spending have burden to levels not reached since the late 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 developments has been supported by to make consumer installment and mortgage loans. the strength of domestic demand and by generally Indeed, financial indicators of the household sector favorable conditions in credit and equity markets. In have remained mostly positive: The rate of personal addition, because these high-technology goods can be bankruptcy filings fell in the first quarter to its lowest produced increasingly efficiently, their prices have level since 19%; 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 rate 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, to some extent, 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 improved 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 the first spending for business equipment and software back half of 2000 with few indications that businesses' on the double-digit uptrend that has prevailed 88 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 date and industrial buildings recorded early this year change had the most noticeable effect on the patterns would seem to accord well with the overall strength of spending for computers and peripherals and for in aggregate demand. However, the fundamentals in communications equipment in the 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 interrupted 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 the century date change seemed to have cable companies have been investing heavily in little difficulty working off those inventories after preparation for their planned entry into the 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 the 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 sales, at current cost, for from the effects of the 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 to 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 inventories (other than high-tech items and transportation equip- 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 nonresidential 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 to explain fully. Nonetheless, the higher levels of spend- 1994 1995 1996 1997 1998 1999 2000 89 Board of Governors of the Federal Reserve System advantage of new technologies and software to imple- Before-tax profits of nonfinancial corporations ment better inventory management. as 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 light trucks were drawn down during the first quarter as sales climbed to record levels. Accordingly, auto and truck makers kept assemblies at 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 backed up, scheduled assemblies for the third quarter are above the elevated level of the first half. Business Finance 1977 1980 1983 1986 1989 1992 1995 1998 2000 NOTTS. Profits from domestic operations, with inventory valuation and capital The economic profits of nonfinancial U.S. corpora- consumption adjustments, divided by gross domestic product of nonfinancial tions posted another solid increase in the first quarter. The profits that nonfinancial corporations 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 capital expendi- but subsequent volatility in the capital market in tures and internally generated funds, stayed at 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- some time. financial businesses increased at a 10'/2 percent clip In the investment-grade market, bond issuers have in the first quarter, close to the brisk pace of 1999, responded to investors' concerns 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 floating-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 bond market in Gross corporate bond issuance Billions ol dollars D High yield • • Investment grade NOTE. Excludes unrated issues and issues sold abroad. 90 Monetary Policy Report to the Congress D July 2000 Spreads of corporate bond yields Default rates on outstanding junk bonds over the ten-year swap rate NOTE. The data are daily. The spreads compare the yields on the Merrill Lynch AA. BBB, and 175 indexes with the ten-year swap rate from Bloomberg. Last observations are for July 17. 2000. banks have expanded briskly, even as a larger per- centage of banks have reported in Federal Reserve February and March did so by issuing convertible surveys that 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 about the outlook worthiness 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-investment-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 late May and June, and issuance Moody's Investors Service has downgraded, on net, recovered to close to its first-quarter pace. more debt in the nonfinancial business sector than it As the bond market became less hospitable in the has upgraded, although it has placed more debt 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 a result, commercial and industrial loans at expanded at a robust pace over the first half of 2000, as investment in office and other commercial building strengthened. Extending last year's trend, borrowers Ratio of liabilities of failed nonfinancial firms have tapped banks and life insurance companies as to liabilities of all nonfinancial firms the financing sources of choice. Banks, in particular, have reported stronger demand for commercial real estate loans this year even as they have tightened standards a bit for approving such loans. In the mar- ket for commercial mortgage-backed securities, yields have edged higher since the beginning of the year. III The Government Sector lllllllllill Federal Government The incoming information regarding the federal bud- get suggests that the surplus in the current fiscal year 1989 1991 1993 I99S 1997 1999 will surpass last year's by a considerable amount. Over the first eight months of fiscal year 2000—the 91 Board of Governors of the Federal Reserve System National saving as a share of nominal GNP saving that 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 16!/2 percent over the preceding seven years. The deeper pool of national Excluding federal saving 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, this source of national saving could continue to expand. The recent good news on the federal budget has been primarily on the receipts side of the ledger. No IK. Nationals;ring comprises the gross saving of households, businesses. Nonwithheld tax receipts were very robust this spring. Both final payments on personal income tax liabilities for 1999 and final corporate tax payments period from October to May—the unified budget for 1999 were up substantially. So far this year, the recorded a surplus of about $120 billion, compared withheld tax and social insurance contributions on with $41 billion during the comparable period of this 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 that, 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- outcome would likely place the surplus at more than tures have been rising only a little faster than during 2!/4 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 the federal budget from deficit to months of the current fiscal year were 5'/4 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 far this year. 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 the increase in budget authority has been sufficient to 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 expenditures as a share of 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 this 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 its payments to vendors before the century date change; actual deliveries of defense goods and services were likely smoother. On average, real defense spending in the fourth and first quarters was up moderately from the average level in NOTK. Data on receipts and expenditures are from the unified budget. Values fiscal 1999. Real nondefense outlays continued to f B o u r d 2 ge 0 t 0 0 b y a t r h e e c O ur ff r i e c n e t o s f e r M v a ic n e a s g e e m sti e m nt a t a e n s d f B ro u m dg e th t. e Mid-Session Review of the rise slowly. 92 Monetary Policy Report to the Congress D July 2000 Federal government debt held by the public soned, less liquid, debt securities with surplus cash, enabling it to issue more "on-the-run" securities. The Treasury noted that it would buy back as much as $30 billion this year. The first operation took place in March, and in May the Treasury announced a schedule of two operations per month through the end of July of this year. Through midyear, the Treasury has conducted eight buyback operations, redeeming a total of $15 billion. Because an impor- tant goal of the buyback program is to help forestall further increases in the average maturity of the Trea- sury's publicly held debt, the entire amount redeemed so far has corresponded to securities with remaining maturities at the long end of the yield curve (at least 1959 1969 1979 198 1999 fifteen years). NOTK. The data are annual and extend through 2000. Federal debt held by private investors is gross federal debt less debt held by federal government accounts and the Federal Reserve System. The value for 2000 is ai based on the Administration's June 26 Mid-Session Review of the Budget. State and Local Governments In the state and local sector, real consumption and With current budget surpluses coming in above investment expenditures registered another strong expectations and large surpluses projected to 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 Expanding on efforts to concentrate its declining debt 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- two new five- and ten-year notes and only one new ceding three years. Higher federal grants for highway thirty-year bond each year. The auctions of five- and construction have contributed to the pickup in spend- ten-year notes will remain quarterly, alternating ing. In addition, many of these jurisdictions have between new issues and smaller reopenings, 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 outlook for state and local frequency of its one-year bill auctions from monthly governments has affected both the issuance and the to quarterly and cutting the size of the monthly quality of state and local debt. Borrowing by states 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 the favorable budget- inflation-indexed bond and indicated that the size of ary picture, rising interest rates have reduced the the ten-year inflation-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 by a substantial margin in the strength of incoming tax receipts so far in 2000 led state and local sector. the Treasury to announce, in May, that it was again cutting the size of the monthly two-year note auc- tions. The Treasury also noted that it is considering The External Sector additional changes in its auction schedule, including the possible elimination of the one-year bill auctions Trade and Current Account and a reduction in the frequency of its two-year note auctions. The deficits in US. external balances have continued Early in the year, the Treasury unveiled the details to get even larger this year. The current account of its previously announced reverse-auction, or debt deficit reached an annual rate of $409 billion in the buyback, program, whereby it intends to retire sea- first quarter of 2000, or 41A percent of GDP, com- 93 Board of Governors of the Federal Reserve System U.S. current account ciation. By market destination, US. exports to Can- ada, Mexico, and Europe increased the most. By product group, export expansion was concentrated in capital 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- — 140 tinued to expand rapidly in the first quarter. The increase in imports, at an annual rate of 11% percent, — 2JO was the same in the first quarter as in the second half 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- 1994 1995 19% 1997 1998 1999 2000 ductors, telecommunications equipment, and other machinery were particularly robust. Data for April suggest that the second quarter got off to a strong pared with $372 billion and 4 percent in the second start. The price of non-oil goods imports rose at an half of 1999. Net payments of investment income annual rate of 1% percent in the first quarter, the were a bit less in the first quarter than in the second second consecutive quarter of sizable price increases half of last year owing to a sizable increase in income following four years of price declines; non-oil import receipts from direct investment 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, the 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 West Texas intermediate (WTI) crude this from the deficit of $298 billion recorded 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 restraints 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 6!/4 percent in the first quarter, follow- level of about $20 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 to support export demand and partly offset negative effects on price competi- Prices for oil and other commodities tiveness of U.S. products from the dollar's past appre- Index. January I«W = I(K> Change in real imports and exports of goods and services Non-oil commodities Q2 Q3 Q2 1999 2000 NOTE. The oil price is the spot price of West Texas if The price for non-oil commodities is a weighted average of thirty-nine non-fuel primary-commodity prices from the International Monetary Fund. The data are 1994 I99S 1996 1997 1998 1999 2000 a m v o e n ra th g l e y . t h T ro h u e g h la s J t u l o y b 1 se 2 r . v 2 a 0 t 0 io 0 n . for non-oil commodities is May; for oil. July 94 Monetary Policy Report to the Congress D July 2000 supply disruptions, caused the WTI spot 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 Capital 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, but in May and June the price of crude oil 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 States 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 the second quarter of 2000 show a small official spot price reached a new high of almost $35 per outflow. barrel, but by early July the price had settled back to about $30 per barrel. The Labor Market 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 that 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 than 11/2 million over the ties purchased by foreigners in the first 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- boost, 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 mixed performance of U.S. stock prices, of the preceding four years. foreign portfolio purchases of U.S. equities exceeded Monthly changes in private payrolls were uneven $60 billion in the first quarter, more than half of the 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 the first quarter moderated between the first and 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 activity during the winter that acceler- well. As in the past two years, direct investment inflows have been elevated by the extraordinary level of cross-border merger and acquisition activity. Port- Net change in total nonfarm payroll employment folio flows have also been affected by this activity. For example, in recent years, many of the largest ;of johs. m 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 made net purchases of Japanese equities but sold Jlliil European equities. The latter sales likely reflect a rebalancing of portfolios after stock swaps. U.S. direct investment in foreign economies has also remained strong, exceeding $30 billion in the first I I I I t I I I I I I 1 quarter of 2000. Again, a significant portion of this 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 95 Board of Governors of the Federal Reserve System ated hiring that typically would have occurred in the beginning of 1997 to 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 rate 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 the 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 health 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 for consumer durables and unemployment rate has held near its thirty-year low business equipment, along with support for exports of 4 percent. At midyear, very few signs of a signifi- from the pickup in economic activity abroad, led to a cant easing in labor market pressures have surfaced. leveling off in manufacturing employment over the Employers responding to various private surveys of first half of 2000 after almost two years of decline. business conditions report that 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 at the beginning of the expansion in 1990. The stability of the partici- pation rate over the 1997-99 period was somewhat Labor Costs and Productivity surprising because the 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 they are under pressure to 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 5'/4 percent at viding somewhat mixed and inconsistent signals of whether a broad acceleration in wage and benefit costs is emerging. Hourly compensation, as measured Measures of labor utilization by the employment cost index (ECI) for private non- farm businesses, increased sharply during the first quarter to a level more than 4'/2 percent above a year earlier. Before that jump, year-over-year changes in the ECI compensation series had remained close to 3!/2 percent for three years. However, an alternative measure of compensation per hour, calculated as part of the productivity and cost series, which has shown higher rates 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'/4 percent higher than a year ear- lier; in the first quarter of 1999, the four-quarter change was 5'/4 percent.3 1970 1975 1980 1985 1990 1995 tho N s O e T w K h . o T a h r e e a n u o g t m in e n th te e d l a u b n o e r m f p or lo c y e m a e n n d t w ra a t n e t i a s j t o h b e . n d u iv m id b e e d r o b f y u t n h e e m ci p v l i o l y ia e n d p la l b u o s r 3. The figures for compensation per hour in the nonfinancial corpo- force plus those who are not in the labor force and want a job. The break in data rate sector are similar: an increase of about 4 percent for the year at January 1994 marks the introduction of a redesigned survey: data from that ending in the first quarter of this year compared with almost 5'/2 per- point on are not directly comparable with those of earlier periods. cent for the year ending in the first quarter of 1999. 96 Monetary Policy Report to the Congress D July 2000 Measures of the change in hourly compensation Change in output per hour for the nonfarm business sector Employment cost index 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 NOTE. The EG is for private industry excluding farm and household work- NOTE. The value for 2000:Q1 is the percent change from a year earlier. ers. Nonfarm compensation per hour is for the nonfarm business sector. pickup in benefit costs was associated with faster Part of the acceleration in the ECI in the first rates of increase in employer contributions to health quarter was the result of a sharp step-up in the wage insurance, and the first-quarter ECI figures indicated and salary component of compensation change. another step-up in this component of costs. Private While higher rates of straight-time pay were wide- survey information and available measures of prices spread across industry and occupational groups, the in the 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 8'/2 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 commissions that are tied 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 noted a pickup in supplemental forms of pay, erately, which might appear plausible in light of such as overtime and nonproduction 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 first-quarter ECI bonuses, and discounts on store purchases, are not has not been so readily apparent in the monthly data measured in the ECI.4 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 June, pensation costs are available only after business the June level of hourly wages stood 33/4 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 1999. the national income and product accounts. While employers in many industries appear to have Because businesses have realized sizable 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 with publication of the ECI for June 2000, the Bureau 3'/2 percent during 1999, a percentage point faster of Labor Statistics plans to expand the definition of nonproduction than during 1998; these costs accelerated sharply bonuses in the ECI to include hiring and retention bonuses. These further in the first quarter of this year to a level p ly a i y n m g e th n e ts d a a r t e a a o lr n e a c d o y m p in e c n l s u a d t e io d n i n p e th r e h o w u a r g c e a a lc n u d l a s t a e l d a r f y o r m th ea e s u p r r e o d u u n c d ti e v r - - 5'/2 percent above a year earlier. Much of last year's ity and cost series. 97 Board of Governors of the Federal Reserve System Change in unit labor costs for the nonfarm.business sector 2. Alternative measures of price change Perecm.04u.g4 I997:Q4 1 998:O4 1 999:Q4 to to I998:O4 I999:Q4 2000:0 1 Chain-npe Gross domestic product 1.0 1.6 3.0 Gross domestic purchases .7 1.9 3.5 Personal consumption expenditures . , . .9 2.0 3.5 Excluding food and energy 1.3 1.5 2.2 Fixed-weight Consumer price index 1.5 2.6 4.0 Excluding food and energy 2.4 2.1 2.3 • 111111II - NOTE. A fixed-weight index uses quantity weights from the base year to aggregate prices from each distinct item category. A chain-type index is the geometric average of two fixed-weight indexes and allows the weights to change each year. Changes are based on quarterly averages. 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 No IK. The value tor 2000:QI is the percent change from a year earlier. goods and services purchased by consumers, busi- nesses, and governments has been somewhat greater: The chain-type price index for gross domestic pur- not generated significant pressure on overall costs of chases rose at an annual rate of 3'/2 percent in the first production. Output per hour in the nonfarm business quarter after having increased about 2 percent during sector posted another solid advance in the first quar- 1999 and just -Vi percent during 1998. ter, rising to a level 3% percent above a year earlier The pass-through of the steep 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 the 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 the prices of excludes types of businesses for which output is goods and services purchased. The effect of higher measured less 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 (PCE) jumped at an the nonfarm business sector since early 1997 has annual rate of 35 percent in the first quarter of 2000; stepped up further to 3 percent from the 2 percent the first-quarter rise in the energy component of the pace of the 1995-97 period. What has been particu- CPI was similar. larly 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. Rather, businesses are likely realizing substantial and lasting payoffs from ftrccm. Q4 to Q4 their investment in equipment and processes that n Chain-type price index for PCE embody the technological advances of the past sev- • Consumer price index <j 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 during 1998 to ll/> percent last year, the chain-type price index for GDP—prices of goods and services that are produced domestically— 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 increased at an annual rate of 3 percent in the first NOTE. Consumer price index for all urban consumers. Values for 2000:Q1 quarter of this year. The upswing in inflation for and Q2 are percent changes from the previous quarter at an annual rate. 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, the 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 first-quarter increase. As a result, the 2'/4 percent in the first quarter of 2000 and at a overall CPI was little changed over the two months. 23/4 percent rate in the second quarter. In part, the 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 to rise rapidly in the second quarter. In contrast to from late 1995 through the middle of last year, con- the steep rise in energy prices, the CPI 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 costs 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 1996 and paints contributed importantly to the acceleration in 1999, were little 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 1% percent declines for household electronic goods and comput- during 1999 to an annual rate of 3V^ percent over the ers, but 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 3t£ 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 23/4 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 2V-t percent in the first quarter compared with which have been boosted in pan to cover the higher an increase of 1 '/2 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 Q Chain-type price index for PCE year and the first quarter of this year. A series of dis- — • Consumer price index 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 last 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- erate uptrend. In contrast, the further upward pressure 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 on construction costs at the beginning of the year j. Values for 200&Q1 continued to push the price index for residential 99 Board of Governors of the Federal Reserve System construction higher; after having accelerated from Selected Treasury rates, quarterly data 3 percent to 3'/2 percent between 1998 and 1999, this index increased at an annual rate of 4!/4 percent in the first quarter of 2000. Although actual inflation moved a bit higher over the first half of 2000, inflation expectations have been little 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 their expected change in CPI inflation over the coming twelve months was 2.9 percent. Moreover, they remained optimistic that inflation would remain at about that rate over the longer run, reporting a 2.8 percent median of 1979 1984 1989 1994 1999 expected inflation during the next five to ten years. In NOTK. The twenty-year Treasury bond rate is shown until the first issuance both instances, their expectations are essentially the o 2 f 0 0 t 0 h : e Q t 2 h . irty-year Treasury bond in February 1977. Last observations are for same as at the end of 1999, although the year-ahead expectations are above the lower levels that had prevailed in 1997 and early 1998. this year, with short-term real rates 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 times, 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 Rates 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 fixed- 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 _ Thirty-year Treasury 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 data and tighter monetary policy in April and May was partly offset by supply factors and by occasional safe haven flows from the volatile JFMAMJJASONDJFMAMJJASONDJFMAMJJ equity market. Since late May, market interest rates 1998 1999 2000 have declined as market participants have interpreted the incoming economic data as evidence that mone- 100 Monetary Policy Report to the Congress D July 2000 Selected yield curves. July 17, 2000 Spread of BBB corporate yields NOTK. Last observations are for July 17. 2000. The data are daily. SOUKCK. Swap rates are from the International Swaps and Derivatives Asso- ciation, as reported by Reuters. 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 tightening. Treasury bill rates and yields on shorter-dated notes The disconnect between longer-term Treasury and have risen 15 to 80 basts points since the beginning private yields as a consequence of supply factors of the year, intermediate- and long-term Treasury in the Treasury market is distorting readings from yields have declined 5 to 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 the yield on the risen 10 to 70 basis points so far this year. ten-year Treasury note would suggest that 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- 1998. 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 the U.S. fixed- with spreads up this year but below their 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 to upward sloping for maturi- occasionally subject to supply-driven distortions, ties as long as ten years, and the same has been true such distortions have been less pronounced and more for yield curves for the most actively traded corporate short-lived than those affecting the Treasury securi- bonds.5 Nonetheless, private yield curves are flatter ties market of late, making swap rates 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 that 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 to look for yield curves are consistent with forecasts of a mod- alternatives to the pricing and hedging roles tradition- ally played by Treasuries in U.S. financial markets. In addition to interest rate swaps, which have featured prominently in the list of alternatives to Treasuries, S. A typical interest rale swap is an agreement between two panics to exchange fixed and variable interest rate payments on a notional debt securities issued by the three government- principal amount over a predetermined period ranging from one to sponsored housing agencies—Fannie Mae, Freddie thirty years. The notional amount itself is never exchanged. Typically, Mac, and the Federal Home Loan Banks—have been the variable interest rate is the London Interbank Offered Rate (LIBOR). and the fixed interest rate—catted the swap rate—is deter- used in both pricing and hedging. The three housing mined in the swap market. The overall credit quality of market agencies have continued to issue a substantial volume participants is high, typically A or above; those entities with credit of debt this year in an attempt to capture benchmark ratings of BBB or lower are generally either rejected or required to adopt credit-enhancing mechanisms, typically by posting collateral. status, and the introduction in March of futures and 101 Board of Governors of the Federal Reserve System options contracts based on five- and ten-year notes Major stock price indexes issued by Fannie Mae and Freddie Mac may help enhance the liquidity of the agency securities market. Index. June .10. !<*« = 100 Nonetheless, the market for agency debt 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 be appropriate for the Con- gress to consider whether the special standing of these institutions continues to promote the public interest, and pending legislation would, among other things, restructure the oversight of these agencies and reexamine their lines of credit with the U.S. Treasury. The implementation of monetary policy, too, has had to adapt to the anticipated paydowns of market- j JASONDJ FMAMJ 1ASONOJ FMAMJ J able federal debt. Recognizing that there may be 1998 1999 2000 limitations on its ability to rely as much as previously NOTE. The data are daily. Last observations are for July 17. 2000. on transactions in Treasury securities to meet the reserve needs of depositories and to expand the sup- ply of currency, the FOMC decided at its March 2000 result in a greater percentage of holdings of shorter- meeting to facilitate until its first meeting in 2001 the term security issues than of longer-dated ones. The Trading Desk's ability to continue to accept a broader schedule ranges from 35 percent of an individual range of collateral in its repurchase transactions. The issue for Treasury bills to 15 percent for longer-term initial approvals to help expand the collateral pool bonds. These changes were announced to the public were granted in August 1999 as part of the Federal on July 5, replacing a procedure in which all matur- Reserve's efforts to better manage possible disrup- ing holdings were rolled over and in which coupon tions to financial markets related to the century date purchases were spread evenly across the yield curve. change. At the March 2000 meeting, the Committee also initiated a study to consider alternative asset classes Equity Prices and selection criteria that could be appropriate for the System Open Market Account (SOMA) should the Major equity indexes have posted small gains so far size of the Treasury securities market continue to this year amid considerable volatility. Fluctuations in decline. For the period before the completion and technology stocks have been particularly pronounced: review of such a study, the Committee discussed, at 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 debt issues. They will also help the SOMA to limit Nasdaq was about 60 percent above its mid-1999 any further lengthening of the average maturity of its 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 of Treasury securities.6 The SOMA will 13 percent, respectively, from mid-1999. cap the rollover of its existing holdings at Treasury Corporate earnings reports have, for the most part, auctions and will engage in secondary market pur- exceeded expectations, and projections of future chases according to a schedule that effectively will earnings continue to be revised higher. However, the increase in interest rates since the beginning of the year likely has restrained the rise in equity prices. In beca 6 u . s e T h th e e F h O ig M he C r p tu re rn fe o r v s e r a ra p t o e r t o fo f l io su c w h i t a h p a o r s t h fo o l r i t o a g v i e v r e a s g e i t m gr a e t a u t r e it r y addition, growing unease about the lofty valuations flexibility to redeem securities in times of financial market stress, reached by technology shares and rising default rates which may require substantial decreases in the securities portfolio in the corporate sector may have given some inves- over a relatively short period, such as during an acute banking crisis that involves heavy lending through the discount window. tors a better appreciation of the risks of holding 102 Monetary Policy Report to the Congress D July 2000 stocks in general. Reflecting the uncertainty about debt have helped to ease the pressure on available the future course of the equity market, expected and savings and have facilitated the rapid expansion of actual volatilities of stock returns rose substantially nonfederal debt outstanding: The federal government in the spring. At that time, volatility implied by paid down $218 billion of debt over the first half of options on the Nasdaq 100 index surpassed even the 2000, compared with paydowns of $56 billion and elevated levels reached during the financial market $101 billion in the first six months of calendar years turmoil of 1998. 1998 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 recent months from its 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 Vi percent in the first half ers being 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 bank 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, the underlying strength of household spring. Following a first-quarter surge, net inflows spending helped boost the demand for consumer and to stock 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 securitizations this year. In the housing sector, for instance, the rising interest rate environment has kept Debt and the Monetary Aggregates the demand for adjustable-rate mortgages relatively elevated, and banks tend to hold these securities on Debt and Depository Intermediation their books rather than securitize them. Banks have tightened terms and standards on loans The total debt of the U.S. household, government, further this year, especially in the business sector, and nonfinancial business sectors is estimated to have where some lenders have expressed concerns about a increased at close to a 5!/2 percent annual rate 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 9'/2 percent, buoyed by strength in household and for possible changes in the overall macroeconomic business borrowing. Continued declines in federal environment and in conditions in securities markets. Growth of domestic nonfinancial debt Illlllll • Total D Federal • Nonfederal 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 NOTE. Total debt consists of the outstanding credit market debt of the U.S. of year indicated. Growth in the first half of 2000 is computed from average for government, state and local governments, households and nonprofit organiza- fourth quarter of 1999 to average for the second quarter of 2000 and expressed tions. nonfinancial businesses, and farms. Annual growth rates are computed at an annual rate. The growth rate for 2000:HI is currently based on partially from average for fourth quarter of preceding year to average for fourth quarter estimated data. 103 Board of Governors of the Federal Reserve System M2 growth rate M3 growth rate I'erctni. annual me h ill UJll 1990 1991 1992 1993 1994 1995 19% 1997 1998 1999 2000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 NOTE. M2 consists of currency, travelers checks, demand deposit! NOTK. M3 consists of M2 plus large-denomination time deposits, balances checkable deposits, savings deposits (including money market deposit at on institutional money market funds. RP liabilities (overnight and term), and small-denomination time deposits, and balances in retail money market funds. eurodollars (overnight and term). See footnote under the domestic nonfinancial See footnote under the domestic nonfinancial debt chart for details on the com- debt chart for details on the computation of growth rates. putation of growth rates. pace as in 1999—supported by the rapid expansion of The Monetary Aggregates nominal spending and income. M2 velocity—the ratio of nominal income to M2— Growth of the monetary aggregates over the first half has increased over the first half of this year, consis- of 2000 has been buffeted by several special factors. tent with its historical relationship with the interest The unwinding of the buildups in liquidity that forgone ("opportunity cost") from holding M2. As occurred in late 1999 before the century date change usual, rates offered on many of the components of depressed growth in the aggregates early this year. M2 have not tracked the upward movement in market Subsequently, M2 rebounded sharply in anticipation interest rates, and the opportunity cost of holding M2 of outsized tax payments in the spring and then ran has risen. In response, investors have reallocated off as those payments cleared. On net, despite the some of their funds within M2 toward those compo- cumulative firming of monetary policy since June nents whose rates adjust more quickly—such as small 1999, M2 expanded at a relatively robust, 6 percent, time deposits—and have restrained flows into M2 in annual rate during the first half of 2000—the same favor of longer-term mutual funds and direct hold- ings of market instruments. M2 velocity and the opportunity cost of holding M2 M3 expanded at an annual rate of 9 percent in the first half of 2000, up from 7'/2 percent for all of 1999. The robust expansion of bank credit underlies much of the acceleration in M3 this 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 first half of 2000 in order to avoid having to hold non-interest-bearing reserve bal- 1978 1983 1988 1993 1998 ances with the Federal Reserve System. As a result, the N r O a T ti E o . o T f h n e o m da i t n a a l a r g e r o q s u s a r d t o er m ly e s a t n ic d p a r r o e d t u h c r t o u to g h th 2 e 0 s 0 t 0 oc .Q k I o . f T M he 2 . v e T l h oc e i t o y p p o o f r M tun 2 it i y s required reserve balances are still declining gradu- cost of M2 is a two-quarter moving average of the difference between the ally, adding to concerns that, under current proce- t in h c re lu e d -m ed o n in th M T 2 r . easury bill rate and the weighted average return on assets dures, low balances might adversely affect the imple- 104 Monetary Policy Report to the Congress D July 2000 mentation of monetary policy by 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 lead to a partial unwinding over foreign industrial countries, as authorities removed time 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 government long-term bonds economies continued the strong overall performance edged upward slightly, but at midyear still were only that was registered last year. With a few exceptions, about !3/4 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 by favorable financial market conditions. date change dissipated quickly, and global markets in Average real GDP in the 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 of Japanese markets were jolted by several episodes of increased domestic demand (although its sustainability has been volatility set off typically by sudden downdrafts in questioned) and further robust increases in Europe U.S. 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 rates industrial countries were mixed, but they generally tended to reflect their respective cyclical positions. Stocks in Canada, France, and Italy, for example, Short-term (three-month) continued to make good gains, German stocks did less well, and U.K. 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 stocks or stock indexes weighted toward technology-intensive — Euro-area interbank 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 Long-term (ten-year government bonds) interest rates, and for much of the first half, expecta- Canada 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. stock prices leveled off near the end of the first quarter and then declined for a while. In June, the dollar eased back a bit against the curren- cies of some industrial countries amid signs that U.S. growth was slowing. Nevertheless, for the year so far, the dollar is up on balance about 53/4 percent against Q2 Q3 the major currencies; against a broader index of 1999 trading-partner currencies, the dollar has appreciated Jul N y O 1 T 2 F . . 2 . 0 T 0 h 0 e . data are weekly. Last observations are for the week ending about y/4 percent on balance. 105 Board of Governors of the Federal Reserve System Nominal U.S. dollar exchange rates area in the first half of 2000 was somewhat stronger than the brisk 3 percent pace recorded last year. HIM week 1999 = 100 Investment was robust, and indexes of both business Exchange rate indexes 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 11A per- cent. Variations in the pace of economic expansion and the intensity of inflation pressures across the region added to the complexity of the situation con- fronting ECB policymakers even though Germany and Italy, two countries that had lagged the euro-area Selected bilateral rates 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, the 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 considerations behind the moves. Compared with its fluctuations against the euro, the dollar's value was more stable against the Japa- nese yen during the first half of 2000. In late 1999, NOTE. The data are weekly. Indexes in the upper panel are trade-weighted private domestic demand in Japan slumped badly, averages of the exchange value of the dollar against major currencies and even though the Bank of Japan continued to hold o ag b a s i e n r s v t a t t i h o e n s c u a r r r e e n fo ci r e t s h e o f w a e e b k ro e a n d d i g n r g o u J p u l o y f 1 i 2 m . p 2 o 0 r 0 ta 0 n . t U.S. trading partners. Last its key policy rate at essentially zero. Several times 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 against the euro. The euro started this year lation that the Bank of Japan soon might abandon its already down more than 13 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 it occasions with sales of yen in foreign exchange mar- continued to depreciate during most of the first half 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 be 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, almost 7 percent on balance for the year so far and and surveys indicated that business confidence had about y/4 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 106 Monetary Policy Report to the Congress D July 2000 expenditure for coming quarters was approved in late Emerging markets 1999, government spending did not supply stimulus in the first quarter. With core consumer prices mov- ing down at an annual rate that reached almost 1 per- i Dollar exchange rales cent at midyear, deflation also remained a concern. Economic activity in Canada so far this year slowed a bit from its very strong performance in the second half of 1999, but it still was quite 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 just below 1 '/2 percent. The Cana- dian dollar weakened somewhat against the U.S. dol- EMBI+ spreads lar in the first half of the year even though the Bank of Canada raised policy interest rates 100 basis points, matching increases in U.S. rates. In the 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 the economy was slowing and that inflationary pressures might be ebbing under the effect of the tighter monetary stance and strength of sterling—especially against the euro—allowed the Bank to hold rates constant. In recent months, ster- Ql Q2 Q3 Ql 02 03 ling has depreciated on balance as official interest 1999 2000 rates have been raised in other major industrial NOT*. The data are weekly. EMBI+ (J.P. Morgan e countries. index) spreads are stripped Brady-bond yield spreads over U.S. Treasuries. Last observations are for the week ending July 12.2000 In developing countries, the strong recovery of economic activity last year in both developing Asia and Latin America generally continued into the first remained generally favorable, and the won came half of 2000. However, after a fairly placid period under upward pressure periodically in the first half of that extended into the first 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 market volatility and rising interest rates 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 rates. Nonetheless, emerging-market countries with problems more financial market conditions have deteriorated in effectively than they did several years ago. recent months for 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 the 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 still 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 rate of more than 20 percent in the 107 Board of Governors of the Federal Reserve System first quarter of this year after a strong second half in cent, boosted by strong exports to the United States, 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 Latin election was perceived to be fair and the transition of America from effects of the emerging-market finan- power was under way, both recovered substantially. cial crisis extended into the first part of this year. In Argentina, the pace of recovery appears to have In Brazil, inflation was remarkably well contained, slackened in the early part of this year, as the govern- and interest rates were lowered, but unemployment ment's fiscal position and, in particular, its 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 uncertainty in Venezuela, Peru, Colom- tional support package. However, Brazilian financial bia, and Ecuador sparked financial market pressures markets snowed 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- the status of fiscal reforms, and risk premiums wid- larization," 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 at an annual rate of 11 per- helped stabilize financial conditions there.

Alan Greenspan (2000, July 24). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20000725_chair_conduct_of_monetary_policy_report_of

@misc{wtfs_testimony_20000725_chair_conduct_of_monetary_policy_report_of,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {2000},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20000725_chair_conduct_of_monetary_policy_report_of},
  note = {Retrieved via When the Fed Speaks corpus}
}