Congressional Testimony

S. HRG. 109–204 FEDERAL RESERVE’S SECOND MONETARY POLICY REPORT FOR 2005 HEARING BEFORETHE COMMITTEE ON BANKING, HOUSING, ANDURBANAFFAIRS UNITED STATES SENATE ONE HUNDRED NINTH CONGRESS FIRST SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANTTOTHEFULLEMPLOYMENTANDBALANCEDGROWTHACTOF1978 JULY 21, 2005 Printed for the use of the Committee on Banking, Housing, and Urban Affairs ( Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html U.S. GOVERNMENT PRINTING OFFICE 24–852 PDF WASHINGTON : 2005 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00001 Fmt 5011 Sfmt 5011 24852.TXT SBANK4 PsN: SBANK4 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS RICHARD C. SHELBY, Alabama, Chairman ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota CHUCK HAGEL, Nebraska JACK REED, Rhode Island RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky EVAN BAYH, Indiana MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan ELIZABETH DOLE, North Carolina JON S. CORZINE, New Jersey MEL MARTINEZ, Florida KATHLEEN L. CASEY, Staff Director and Counsel STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel PEGGY R. KUHN, Senior Financial Economist MARTIN J. GRUENBERG, Democratic Senior Counsel AARON D. KLEIN, Democratic Economist JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator GEORGE E. WHITTLE, Editor (II) VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00002 Fmt 0486 Sfmt 0486 24852.TXT SBANK4 PsN: SBANK4 C O N T E N T S THURSDAY, JULY 21, 2005 Page Opening statement of Chairman Shelby................................................................ 1 Opening statements, comments, or prepared statements of: Senator Schumer .............................................................................................. 2 Senator Allard................................................................................................... 2 Senator Reed ..................................................................................................... 3 Senator Bunning............................................................................................... 3 Senator Bennett ................................................................................................ 5 Senator Dole...................................................................................................... 5 Senator Crapo ................................................................................................... 6 Senator Sarbanes.............................................................................................. 15 Senator Corzine ................................................................................................ 25 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve Sys- tem, Washington, DC ........................................................................................... 6 Prepared statement .......................................................................................... 31 Response to written questions of: Senator Reed.............................................................................................. 36 Senator Bennett ........................................................................................ 36 Senator Corzine ......................................................................................... 38 ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD Various charts submitted to the Committee ......................................................... 40 Letter to Senator Bennett from Alan Greenspan dated September 2, 2005....... 53 Monetary Policy Report to the Congress, July 21, 2005....................................... 59 (III) VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00003 Fmt 5904 Sfmt 5904 24852.TXT SBANK4 PsN: SBANK4 VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00004 Fmt 5904 Sfmt 5904 24852.TXT SBANK4 PsN: SBANK4 FEDERAL RESERVE’S SECOND MONETARY POLICY REPORT FOR 2005 THURSDAY, JULY 21, 2005 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The Committee met at 10:07 a.m., in room SD–538, Dirksen Sen- ate Office Building, Senator Richard C. Shelby (Chairman of the Committee) presiding. OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY Chairman SHELBY. The hearing will come to order. We are very pleased this morning to welcome Chairman Green- span once again before the Committee on Banking, Housing, and Urban Affairs to testify on the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress. The June meeting of the Federal Open Market Committee marked the 1 year anniversary of incremental increases in the Fed- eral funds rate from a low of 1 percent. These measured changes appear to have been accommodated pretty well by the economy. GDP has sustained a strong rate of growth, increases in core infla- tion have been moderate, and we have seen a continued decline in unemployment. The country is also fortunate to have enjoyed an unexpected increase in tax revenues and subsequent reduction in the Federal deficit for this fiscal year. But as your report high- lights, Mr. Chairman, there are also some cautionary factors that we need to be mindful of in the months ahead. This morning we will have ample opportunity to discuss in great- er detail the Federal Reserve’s performance in carrying out mone- tary policy and its views on the future direction of our Nation’s economy. I look forward, as others will, to raise a number of issues during our discussion. Chairman Greenspan, I am told that today marks the 18th anni- versary of your first appearance before the Congress for the nomi- nation to be Federal Reserve Chairman. Since that time, you have made 34 appearances before this Committee to discuss monetary policy and conditions alone. While this morning may be your last appearance—I hope it will not be, but it could be—as Federal Re- serve Chairman testifying on the Federal Reserve’s Semi-Annual Monetary Policy Report, the Committee would certainly extend a warm welcome to you at any time should we end up hosting you again in February of 2006. But on behalf of the Committee, I want to thank you for your many years of service and your respected counsel. I suspect that (1) VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 2 this Committee may still be interested in hosting you as a witness on other topics in the months ahead. Beyond your tenure, Mr. Chairman, your voice will undoubtedly continue to be valued after your departure from the Fed. We hope you will continue to accept our invitation in the years ahead. Senator Schumer. STATEMENT OF SENATOR CHARLES E. SCHUMER Senator SCHUMER. Thank you, Mr. Chairman. I just ask to make a brief statement. First, I want to join you, Mr. Chairman, in thanking Chairman Greenspan for his amazing service to this country and his willing- ness. I only served under two Fed Chairmen, both of whom have been very accessible, but your accessibility and interest in things that we ask you about is just incredible, and we appreciate that. And one of the things that we have worked together on, of course, is the Chinese currency, and as you know, this morning the Chi- nese made their first step to revalue their currency. So, I just wanted to read a brief statement on that. And what I believe, Mr. Chairman, is that this is a good first step, albeit a baby step. It is smaller than we had hoped. But to paraphrase the Chinese philosophers, a trip of a thousand miles can well begin with the first baby step. The most significant thing about this move is that the Chinese, in effect, have conceded that pegging their currency is bad for China, for the world economy, and for the United States. And we are glad they have come to this understanding. If there are not larger steps in the future we will not have accomplished very much. But after years of inaction, this step is welcome. Again, I want to thank Chairman Greenspan. I want to thank Senator Graham as well as Senator Bunning and Senator Dole on this Committee, and Senator Bayh, Senator Reed, and some others who were part of our effort, and we are beginning to bear some fruit. So, I thank you, Mr. Chairman. Chairman SHELBY. Senator Allard. STATEMENT OF SENATOR WAYNE ALLARD Senator ALLARD. Thank you, Mr. Chairman, for holding this hearing, and I would like to join my colleagues in welcoming Fed- eral Reserve Board Chairman Greenspan to the Committee today to discuss monetary policy and the state of the U.S. economy. I also look forward to the opportunity to hear from Chairman Greenspan. His expertise and insight is always helpful to the Com- mittee. Chairman Greenspan, I was pleased to hear in your testimony before the House yesterday that the outlook for the U.S. economy is positive and one of sustained growth. Under your leadership, the Federal Reserve Board has done a good job monitoring the U.S. economy and managing monetary policy, as appropriate. Since this will be the last time you will be delivering the Fed’s monetary pol- icy report in your current term—and I hope you continue to serve— I want to take this opportunity to congratulate you on a job well done. I also want to thank you on behalf of the American people VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 3 for your years of public service. We have all been the beneficiaries of your careful approach, and your service has set a high standard. Thank you for taking the time out of your busy schedule to be here, and I look forward to hearing your testimony. Chairman SHELBY. Senator Reed. STATEMENT OF SENATOR JACK REED Senator REED. Thank you very much, Mr. Chairman. And let me commend you, Chairman Greenspan, for your extraordinary service over 18 years, and I think you will continue to be invited back to the Committee for many years to come. We have a challenging economy before us. Last June, employ- ment added about 146,000 jobs, which might be appropriate at the end of an expansion, but we are coming out of a long, protracted job slump. And this is far from the numbers we saw in the Clinton Administration of 200,000 to 300,000 jobs a month. So we have es- sentially a jobless recovery, and the unemployment rate, although it edged down to 5 percent, the Boston Fed points out there is still considerable evidence of hidden unemployment that does not show up. Labor force participation has not rebounded in this recovery. A study finds that the labor force shortfall is between 1.6 million and 5.1 million people. Employers are not hiring as though they believe the economy is strong, and potential workers are staying out of the labor force. We have discussed many times, Mr. Chairman, the fact that there are disturbing trends in the distribution of earnings. Things seem to be getting worse in this recover, with most of the gains from productivity going into profits, not wages, and overall real earnings remaining stagnant. And the only group that seems to be doing exceptionally well are those at the top of the distribution of earnings and wages. People in the middle and further down are seeing their purchasing power fall because of rising costs of gaso- line, food, medical care, housing, really eating into their ability to maintain their families. And then we have seen some news that the deficit—progress has been made, but if you look behind the numbers, it looks like a one- time situation where certain tax advantages came to pass in this particular period but are not sustainable over a longer time. The deficit still is extraordinarily burdensome on our economy as we go forward. Low national savings rates and the widening trade deficit are problems that we have to deal with, an we are not dealing with them effectively and permanently. I hope at the hearing today, Mr. Chairman, that you will touch on these issues, and once again let me commend you for your serv- ice and judgment in so many different ways. We have disagreed, but it has been a productive exchange, and I thank you for that. Chairman SHELBY. Senator Bunning. STATEMENT OF SENATOR JIM BUNNING Senator BUNNING. Thank you, Mr. Chairman, particularly for holding this meeting today. I would especially like to thank Chair- man Greenspan for delivering what will probably be your last mon- etary policy report to Congress. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 4 According to the Congressional Research Service, this is the 35th time that you have appeared before a Committee on which I sit. I think I am finally starting to understand your statements and answers—— [Laughter.] Which probably means it is time for one of us to go. [Laughter.] Seriously, I will miss our sparring, and I thank you for your serv- ice. I am sure you would be disappointed if I gave you a speech full of flowery tributes, and I would hate for you to be disappointed in what could be your last appearance before this Committee. So, I will point out my differences with the FMOC latest monetary policy decision. As my good friend and fellow Hall of Famer Yogi Berra once said, it is de´ja` vu all over. Once again, I believe the FMOC is taking us down the economic path that is fraught with peril by unnecessarily raising interest rates. Surveys show that Americans are much more worried about filling their gas tanks than they are about fitting into their swim- suits this summer, which may be a first. But, nonetheless, despite record high energy prices, the FMOC continues to raises rates. I believe that you are fighting an inflationary bogeyman that does not exist. This reminds me of the summer of 2000 when all signs pointed toward a recession, but the FMOC refused to cut interest rates. When you finally did cut rates on January 3, 2001, in an emer- gency meeting after refusing to cut them at the FMOC’s regular meeting on December 19, 2000, the damage was done and the re- cession then took place. That was greatly exacerbated by Sep- tember 11, and it was already underway before that took place. I am very concerned with the Federal Reserve’s continuing rais- ing interest rates. The FMOC, it seems to me, continues to fix an economy that just is not broken. It is almost as if the Fed is fright- ened by success. The FMOC is once again throwing a wet blanket on the inflationary fire that does not exist. As I have said before, I do not believe the Federal Reserve eco- nomic models are factoring in the impact of new technologies on the economy. I also do not believe they take into account the psy- chological effect of higher energy prices and economic worries in general. People in my State get nervous about our economy’s future every time they fill up their gas tank. I also know that despite very good economic numbers, many Americans are worried about the fu- ture. They are worried that if they lose their current job, they will be unable to find another. I believe we are coming to a critical point in our economy—a point where it cannot sustain higher and higher interest rates. We almost have an inverted curve, as you know. There are only 20 basis points between the 5-year note and the 10-year note right now. As our interest rates rise, our economy will suffer. Housing starts will be down, and we will lose the economic momentum that we have enjoyed. We just got good news about increased tax revenues helping reduce our deficits. I know you are a deficit hawk, Mr. Chairman. I hope you will do what you can to sustain our growth and help reduce the deficit. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 5 Once again, thank you, Mr. Chairman, for coming before this Committee today and for your long and distinguished service to our country. Chairman SHELBY. Senator Bennett. STATEMENT OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you very much, Mr. Chairman. Chairman Greenspan, listening to all of the comments about your service and your performance here reminds me of the story of Henry Kissinger, who was in a group and the person presiding over that particular event said, ‘‘We have with us today Henry Kis- singer, who needs no introduction.’’ And Henry Kissinger said, ‘‘While it is true that I need no introduction, no one enjoys an in- troduction more than I do.’’ And you do not need the kind of praise that is being heaped upon you, but I hope you enjoy it because it is certainly deserved. And I want to join in it. We appreciate your testimony here today. I have looked through it, and I look forward to asking you some questions about it. But I would hope that the tradition that when Greenspan speaks the entire country listens will hold true for your testimony today, be- cause the recovery that we are in could be labeled ‘‘the Rodney Dangerfield recovery’’: It don’t get no respect. And your comments about where we are and how robust the recovery is I think should get a lot of respect and a lot of currency. So, I appreciate your testimony and look forward to having the opportunity to question you here today. Chairman SHELBY. Senator Dole. STATEMENT OF SENATOR ELIZABETH DOLE Senator DOLE. Thank you, Chairman Shelby. I want to join with Senator Schumer in recognizing the impor- tance of China’s removal of their peg of their currency to the dollar. This is significant and an important first step toward our long-term goal of having the yuan freely float. Welcome, Chairman Green- span, for what appears to be your final semi-annual report to the Congress. Your service as Chairman of the Federal Reserve has been truly admirable and deeply appreciated. While some may worry if the overall economy will continue to improve without you in the Chairman’s seat, I know that your efforts have put us on the track to find long-term sustainable growth. The times during which you have served, Mr. Chairman, have been filled with extraordinary events and personalities. Over your 18 years as the Chairman of the Federal Reserve, the American people’s understanding of the markets has dramatically improved, as has our understanding of the role of the Federal Reserve Board. I believe the relatively new measured pace that the Federal Re- serve has adopted in its adjustments to the rates is part of this progress, and this predictability has benefited our economy. Three weeks ago, the Federal Open Market Committee again raised its target for the Federal funds rate and the discount rate by 25 basis points. This was the ninth straight increase in the Federal funds rate. The release noted robust underlying growth in productivity and a gradually improving labor market. These obser- vations appear to indicate a positive track for economic expansion VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 6 in the coming years. While these trends certainly are encouraging, I continue to be concerned about the slower pace of job creation. As you well know, the State of North Carolina continues to expe- rience dramatic losses in employment, especially in textile and fur- niture manufacturing. While the national economy may be trending positively, we continue to focus special attention on those who have lost their jobs as their companies struggled to compete with foreign firms that operate with dramatically lower cost structures. Con- gress continues to debate the positives and negatives of free trade, and I continue to believe we must work on agreements that bring new benefits to American workers and consumers while minimizing the negative effects. In this changing economic environment, there are fewer and fewer opportunities for lower-skilled workers. The opportunity gap is widening. We must do everything in our power to make sure that these people do not fall through the cracks. We must educate our less-skilled workers so they take advantage of new jobs created by the expanding economy. To this end, I believe we should take steps to improve trade adjustment assistance and continue to make the goal of strenghtening our community colleges a top priority. In addition to the President’s $125 million proposal to establish a new community college access grant program, which is included in this year’s Labor-HHS-Education appropriations bill, Senator Baucus and I have introduced legislation, S.1068, which provides better links between our higher education institutions and the business community. This will help prepare a new generation of skilled workers so our workforce will remain strong and competi- tive in years to come. The bill is currently in the Senate HELP Committee, and I look forward to working with Chairman Enzi to see that it becomes law. And, of course, I also remain concerned about high energy prices, the rise in steel prices, and the growing size of our trade deficit. But in spite of these concerns, I am confident that through in- creased trade, hard work, global communications, and improved education of our workforce, we will achieve new levels of oppor- tunity for the people of North Carolina and for all Americans. I look forward to hearing from you on these and other matters, Chairman Greenspan. Thank you very much for joining us today. Chairman SHELBY. Senator Crapo. STATEMENT OF SENATOR MIKE CRAPO Senator CRAPO. Thank you very much, Mr. Chairman. I came to listen to Chairman Greenspan, so I will save everybody from hav- ing to listen to my opening statement. Chairman SHELBY. Thank you. Chairman Greenspan, your written statement will be made part of the record today. You proceed as you wish. Welcome again to the Committee. STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Thank you, Mr. Chairman. I have ex- cerpted only part of that rather extended statement. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 7 Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve’s Monetary Policy Report to the Congress. In recent weeks, employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels have been modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to pro- vide a lift to housing activity. Although both overall and core con- sumer price inflation have eased of late, the prices of oil and nat- ural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near term. Should the prices of crude oil and natural gas flatten out after their recent run-up—the forecast currently embedded in futures markets, incidentally—the prospects for aggregate demand appear favorable, and upward pressures on inflation would be reduced. Thus, our baseline outlook for the U.S. economy is one of sus- tained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation. This generally favor- able outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, ex- tent, and duration of that slowdown are not yet clear. Energy prices represent a second major uncertainty in the eco- nomic outlook. A further rise could materially cut into private spending and thus damp the rate of economic expansion. More favorably, the current and prospective expansion of U.S. ca- pability to import liquefied natural gas will help ease long-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 41⁄ 4 percent, is about 50 basis points below its level of late spring 2004. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Some, but not all, of the decade-long trend decline in bond yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 8 In addition to these factors, the trend reduction worldwide in long-term rates surely reflects an excess of intended saving over in- tended investment. What is unclear is whether the excess is due to a glut of savings or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended sav- ing and investment can be quite wide and variable. It is real inter- est rates that bring actual capital investment worldwide and its means of financing, global savings, into equality. As best we can judge, both high levels of intended saving and low levels of in- tended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990’s, a significant increase in the share of world gross domestic product produced by economies with persistently above average saving—predominantly the emerging economies of Asia—has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil-export- ing countries, which more recently have built surpluses because of steep increases in oil prices. Softness in intended investment is also evidence. Although cor- porate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow. Whether the excess of global intended saving over intended in- vestment has been caused by weak investment or excessive sav- ing—that is, weak consumption—or, more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year. Inflation premiums in for- ward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. Risk takers apparently have been encouraged by a perceived in- crease in economic stability to reach out to more distant time hori- zons. These actions have been accompanied by significant declines in measures of expected volatility and equity in credit markets. History cautions that long periods of relative stability often engen- der unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, cer- tainly, the exceptionally low interest rates on 10-year Treasury notes and hence on home mortgages have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 9 for the Nation as a whole are overvalued relative to underlying de- terminants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with specula- tive fervor. The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have sup- pressed existing home sales. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and intended investment. We are the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. We collectively confront many risks beyond those I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month—and, I might add, some questions about what is going on in London today—terrorism and geopolitical risk have become enduring features of the global landscape. An- other prominent concern is the growing evidence of anti- globalization sentiment and protectionist initiatives, which, if im- plemented, would significantly threaten the flexibility and resil- ience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan ef- fort aimed at reducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contrib- uted so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges I have high- lighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ‘‘. . . believes that policy accommo- dation can be removed at a pace that is likely to be measured. Nonetheless, the committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price sta- bility.’’ Thank you very much. I look forward to your questions. Chairman SHELBY. Thank you, Mr. Chairman. Mr. Chairman, some Fed watchers speculate that the Federal Open Market Committee may halt its incremental increases after VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 10 reaching a Federal funds rate of 4 percent in November, which as- sumes three additional quarter-point increases in upcoming FOMC meetings. Mr. Chairman, to what extent does the Federal Open Market Committee consider the long-term interest rate in pursuing changes to the Federal funds rate? For example, would the Federal Open Market Committee continue raising the Federal funds rate even if the yield curve, which Senator Bunning alluded to, becomes inverted in the months ahead? Chairman GREENSPAN. First of all, I cannot comment for the Federal Open Market Committee’s actions in the future because we have not taken them, and we will obviously engage in ongoing de- liberations to make judgments at each of our meetings. But I think there is a misconception relevant not to what we may do but to the importance of an inverted yield curve. It is certainly the case that if you go back historically, an in- verted yield curve has actually been a reasonably good measure of potential recession in front of us. The quality of that signal has been declining in the last decade, in fact, quite measurably, and the reason basically is that it was a good measure in the early pe- riod when commercial banks were the major financial inter- mediaries, and when you had long-term interest rates rise. I should say that when short-term interest rates—rise relative to long-term interest rates, it usually implied a squeeze on the profitability of commercial banks because they tend to hold somewhat longer ma- turities on the asset side of their balance sheet than on the liability side. As a consequence, that squeeze was usually associated with an economy running into some trouble. But extraordinary new avenues of financial intermediation have developed over the last decade and a half, and, therefore, there are innumerable other ways in which savings can move into invest- ment without going through the commercial banks. As a result, a straightforward statistical analysis of the efficacy of the yield curve inversion as a forecasting tool has diminished very dramatically be- cause of economic events. So, yes, we do look at the structure of long-term rates and the inversion of yields as well as a whole panoply of everything else, before we make judgments as to the Federal funds rate. Our basic goal, as I have indicated many times here, is essentially to create an environment which sustains maximum sustainable growth, and we have always argued—because the data are so persuasive that inflation stability is a necessary condition to achieve that goal. In that context, we make our judgments meeting by meeting. Chairman SHELBY. But is the possibility of an inverted yield curve still relevant to your thinking along with other factors? Chairman GREENSPAN. Yes, it is, and even though its forecasting or anticipatory capability is greatly diminished, it is not zero. Chairman SHELBY. I want to touch on something else that you have spoken on many times here, and that is the GSE’s. You stress the need for any GSE reform, Mr. Chairman, to provide clear guid- ance over the GSE’s portfolio. You have also indicated that you do not believe that focusing GSE’s on their core mission and securitization mission would not adversely impact liquidity in the mortgage markets. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 11 As this Committee moves forward hopefully toward a markup next week, I would ask you to elaborate again for the record on the issue of the GSE’s’ role of providing liquidity in the mortgage mar- kets and how you see the GSE’s’ securitization and portfolio busi- ness affecting the GSE’s’ ability to carry out a liquidity role. In other words, how important is the portfolio? And I know you have spoken of the risk for the GSE’s being in a portfolio and so forth. Chairman GREENSPAN. First of all, Mr. Chairman, let me stipu- late that the secondary mortgage market functions of the GSE’s are critical to our evolving economy. And indeed, I might say that is one of the means of improved intermediation which I was referring to previously. So let me just say that the actual actions taken by the GSE’s to purchase mortgages, securitize them, and sell them into the market has been an extraordinarily valuable addition to American finance. Chairman SHELBY. It brought liquidity to the housing market. Chairman GREENSPAN. It brought very significant liquidity to the housing market and indeed has offered the mortgage instrument in a securitized form to a much broader segment of American inves- tors, and that has been very helpful to them as well. That particular function is unaffected, in our judgment, whether purchases of mortgages by the GSE’s are securitized and sold off in the market, held as mortgages on the balance sheet of the GSE, or securitized and held on the balance sheet. So, in effect, the com- position of the secondary market purchases—which is what their charter is all about—as best we can judge, between portfolio accu- mulation and securitization, has very little effect on market liquid- ity, interest rates, or anything else except the profitability of the GSE’s. It is strikingly obvious to those of us who have looked at this in some detail that the motive for accumulating portfolios is solely, es- sentially in all respects, profitmaking. Now, I have no objection to that. Indeed, they are profitmaking organizations. They are chartered as such. And indeed their share- holders could very well presumably sue if they did not pursue those goals. But accumulating portfolios is not adding liquidity to the housing market, nor in our judgment is it assisting the market generally. In addition, because it is a highly leveraged operation, and one which requires very sophisticated hedging of interest rate risk, it is imparting a significant potential systemic risk to the American financial system. Chairman SHELBY. Thank you. Senator Sarbanes. Senator SARBANES. Senator Reed. Chairman SHELBY. You want to defer to him? Go ahead, Senator Reed. Senator REED. Thank you very much, Mr. Chairman. Just to follow up with respect to the GSE’s, there are several issues here. One is liquidity to the market, which you talked about. Another is systemic risk. It strikes me, though, that many institu- tions that you regulate have very large portfolios, and they main- tain them to increase their profits, which is not something bad. Would you urge that we enact legislation to set limits on these portfolios? VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 12 Chairman GREENSPAN. No, we do not, and the major reason is that these are not leveraged in anywhere near the extent to which the GSE’s are. A critical aspect here of the problem is the fact that the GSE’s have relatively small amounts of capital relative to the assets they hold. Indeed, they hold 1 to 2 percent of assets. The commercial banks, as you know, are several multiples above that. And indeed interest rate risk originally was not even hedged at all by commer- cial banks and savings and loans in the very early years, largely because their capital was adequate to self-insure. The GSE’s cannot self-insure. Their capital segment in their bal- ance sheet is too small. They cannot risk not fully hedging their po- sition. Senator REED. You raise, I think, an interesting point because the typical way risk is managed in a regulatory process is to in- crease capital rather than to put limits on growth portfolios. That is essentially what the Federal Reserve does. If you are concerned about the ability to manage risk in an institution, your first re- sponse, your first authority is to increase capital, which to me, frankly, is probably an appropriate response to some of the risk that has been illustrated in GSE’s. Let me change the subject slightly, and that is, I presume that the current portfolio does not engender great risk since many of your institutions hold a great deal of the paper of these GSE’s. They must find that these investments are prudent. Chairman GREENSPAN. They hold them wholly because there is a perception they are guaranteed by the full faith and credit of the U.S. Government, despite the fact that the debentures which they buy literally say, as required by law, that this instrument is not backed by the full faith and credit. The problem basically is if you ask anybody on Wall Street, they do not care about the status of the GSE’s, the financial state. It goes up and it goes down. The stock prices of these companies move all over the place, but the yield spread against U.S. Treas- uries locks, and the reason is that they do not envisage their hold- ings of GSE’s to have anything to do with the GSE’s. Senator REED. Are there some investors that buy the debt and equity of companies you regulate because they feel that you could never let them go out of business, the ‘‘too big to fail’’ phenomenon? Chairman GREENSPAN. If, in fact, we found that the debentures that they issued had very narrow spreads against U.S. Treasuries, I would say yes. But they do not. There are very substantial spreads. The only way you can tell whether they believe it is to watch the spreads. The spreads of comparable debentures for large commercial banks or even large mortgage holding commercial banks is very substantially higher. Senator REED. Let me change the subject. I mentioned in my opening remarks the study by the Boston Federal Reserve with re- spect to labor participation, which suggests there is a significant and growing lack of participation in the labor force which distorts our ability to see how well we are doing with respect to recoveries. In fact, one thing that I found interesting was the ratio of employ- ment to population, 62.7 percent, is below the level at the start of VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 13 the economic recovery in November 2001. And this is the first time the ratio has failed to surpass its trial level so far into a recovery. The reality is—this is not just statistics—there could be millions of people who have been discouraged by the workforce not working, and we have to respond to that. Can you comment? Chairman GREENSPAN. Yes. We have looked at the Boston report, and I must say Board staff does not come up with numbers any- where near what they have. We have, as I think it is, less than half a percentage point. Senator REED. Could you share those numbers with us, Mr. Chairman? Chairman GREENSPAN. Certainly we can. But let me express to you very succinctly why that is the case. Labor force participation over the longer-run has been driven by two factors here of importance. One is, as you know, a very marked increase in the participation of adult women in the labor force, which has been going up very dramatically for decades; it finally reached a level which is about as high as apparently it is going to go, and it has flattened out. At the same time, the demographics are moving closer to retire- ment ages where the ordinary early retirement begins to occur. So those two structural factors are very dominant forces as to why we have not gotten that pickup that you were mentioning. And the re- sult is that there is some evidence that the participation rate is down partly because of economic forces, but our numbers are no- where near the dimensions that the Boston Fed is showing. Senator REED. Just if I may make a final point, if, in fact, there is this type of employment slack in the economy, it would argue against precipitously increasing the interest rates because you still have some capacity, I would suspect. Chairman GREENSPAN. Well, it would certainly be arguing against concerns with respect to rising unit labor costs and the ele- ments underlying the economic outlook, which we obviously ap- praise, of course. Senator REED. Thank you. Thank you, Mr. Chairman. Chairman SHELBY. Senator Bunning. Senator BUNNING. Thank you, Mr. Chairman. Chairman Greenspan, I have been in some other hearings on the Pension Guaranty Corporation, and they face a deficit of over $20 billion presently. With a large number of pension plans appearing to be teetering, we appear to be facing a very serious situation in that Pension Benefit Guaranty Corporation. What impact do you think would the dumping of a few more large pension plans on the PBGC have on the economy, if any? Chairman GREENSPAN. It is difficult to judge. It has similar ef- fects of other types of deficits in the Federal system. It clearly is negative, and I think it is a worrisome thing for American tax- payers, needless to say. But it is hard to see at this stage any spill- over effects yet on economic forces. As large as the numbers are, relative to a $12 trillion economy obviously they are not yet critical. My main concern is that it ulti- mately will require U.S. Treasury bonds to fill in the gap, which VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 14 is another way of saying increasing the deficit and increasing the Federal debt. Senator BUNNING. Do you have any comment on this morning’s report that the Chinese are moving away from the dollar peg to- ward a currency basket? Chairman GREENSPAN. I have not had a chance to look at the full detail of what is going on, but I must say I associate myself with Senator Schumer. This is certainly a good first step. It is the type of step that you would want to take when you have a decade-long fixed structure. And so they have been cautious, and I think admi- rably so. But I look at it as the first step in a number of further adjustments as they invariably increase their participation in the world trading markets. And so I believe it is a good start. Senator BUNNING. Yesterday, in response to a question from Con- gressman Royce of California regarding moving the goalpost on this legislation, you claimed that the Federal Reserve had no concerns regarding the portfolios of Fannie Mae and Freddie Mac until re- cently. These companies have been around in one form or another since 1938. How is it that the portfolios of the two largest financial services companies in the country, which you claim pose a systemic risk to the Nation’s financial security, went unnoticed until the past year by the Federal Reserve? Chairman GREENSPAN. Well, that is a good question. First of all, the portfolios did not exist in any substantial form prior to, say, 1990. Yesterday, I was asked why I have not previously raised the issue. Let me answer this very simply. It has taken me quite a good deal of time to disentangle the very complex structure of these institutions to really understand how they work, what motivates them, and where the sensitive points are. When I first looked at this situation, I knew what the stock of the debt was and the types of risks that held. But I was not aware of how sensitive their profitability was between securitizing and selling mortgages that they purchased and the amount that they accumulated in their portfolio. It is only fairly recently that it finally became clear to me that that was basically how the system works, and I must say that it was a revelation in certain respects. The more I have looked at it since, I am impressed at how quickly, once they realized in the early 1990’s how important a vehicle this was to profitability, how aggressively they pursued it. Senator BUNNING. Last question. Do you believe energy prices have stabilized, or do you believe consumers and businesses can ex- pect lower or higher energy prices? Chairman GREENSPAN. Senator, I cannot answer that question, and I tried to express some of the reasons in the formal remarks which I put in the record. The big problem is that demand has picked up and has been going forward now, especially because of increased pickup in oil demand in emerging Asia, and, incidentally, also in the United States, the consequence of which has been, after a very gradual rise over the years, the rate of increase has picked up enough that it has eaten into the excess capacity of the system. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 15 As I point out in my prepared remarks, the geographic location of proved reserves is relatively concentrated in the Middle East, and most of the oil-producing countries who perceive they had poor results when private international oil companies were extracting their oil have essentially restricted the entrance of either the ma- jors who have significant financing capabilities. The result of this is that they have found, because of their growing population needs, they require a goodly chunk of the revenues from oil to finance their domestic needs. Therefore, there has been, as best we can judge, an inadequate amount of investment to convert the proved reserves into actual productive oil capacity, that is, oil wells and the infrastructure in which you can actually extract it. The mar- kets, as far as long-term futures are concerned, have expressed real concern about the balance of supply and demand. But let me just say this to you: It is a very narrow balance, and it can go either way. So we have had a very significant run-up, and it is perfectly credible that it could go down for a while. But I do think that we are in a position where forecasting the direction of oil is a particularly tricky issue short term, but longer term, unless we address the issue of getting adequate investment to convert the proved reserves into productive oil capacity, we are going to have trouble meeting long-term demands of the world a decade forward or thereabouts. Senator BUNNING. Thank you, Mr. Chairman. Chairman SHELBY. Senator Sarbanes. STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Thank you very much, Mr. Chairman. First of all, Mr. Chairman, I am pleased to welcome you back be- fore the Committee. I think, if I am correct, this will be your last opportunity to come before us to submit a report on the conduct of monetary policy by the Fed pursuant to the changes that were made to the Federal Reserve Act to require the semiannual report to the Congress. I know we worked together on bringing about that change. My recollection is you were supportive of it at the time. Chairman GREENSPAN. I was. Senator SARBANES. And I hope you feel that it has proven out. I think it has been very beneficial to have these two set periods for an open report by the Fed with respect to the development of mon- etary policy. And before, we were on a kind of ad hoc, hit-or-miss basis. I do not think that was really very satisfactory, and my per- ception is that it has worked very well, and I hope you feel the same. Chairman GREENSPAN. I certainly agree with you, Senator. Senator SARBANES. Thank you. Now, first, I have a few questions I want to put to you. There is a vote on, so we will try to do the best we can within its constraints. I want to address minimum capital standards for the banks to begin with in the context of the efforts to negotiate the Basel Cap- ital Accords. Congress has expressed concern repeatedly that the minimal capital requirements on federally insured banks should be preserved in hearing after hearing. And we have been regularly as- sured by the bank regulators that that would happen. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 16 Therefore, it was with some concern that we read the comments by Federal Reserve Governor Bies back in March when she spoke to the Institute of International Bankers Annual Washington Con- ference, and I will just quote the article reporting on that speech. ‘‘Ms. Bies made it clear the Fed still intends to jettison the straight capital assets leverage ratio eventually. It is a position some other regulators, particularly Mr. Powell at the FDIC, oppose. Executives at the largest banks, however, have argued it makes no sense to implement Basel II without also lifting the leverage minimums. ‘The leverage ratio down the road has got to disappear,’ Ms. Bies said. ‘I would say to the industry, if you work with us and be pa- tient, we understand the concerns about leverage ratios, and as we get more confidence in the new risk-based approach, it will be easi- er for us to move away from the leverage ratio.’’’ And at a hearing before this Committee, you were asked about the minimum capital issue, and you responded as follows, and this was to Senator Bunning: ‘‘I think the issue that is raised with re- spect to the leverage ratio is that it duplicates numbers of other types of measures of capital. As you move into the Basel II frame- work, which is a far more sophisticated capital ratio, the need to get the old-fashioned leverage ratio, which has worked for many generations—we basically employed as a sole measure of capital— the need for that is significantly diminished.’’ So we had that indication of the attitude at the Fed on this issue. Recently, at the end of May, Governor Bies gave another speech. She said, ‘‘While the regulatory capital requirements ultimately produced by Basel II would be, we believe, considerably more risk- sensitive than the current capital regime, this is not the only cap- ital regulation under which U.S. institutions would operate.’’ More than a decade ago, the Congress, as part of the FDIC Im- provement Acts, prompt corrective action to find a critically under- capitalized insured deposit institution by reference to a minimum tangible equity to asset requirement, a leverage ratio. The agencies have also used other leverage ratios because experience has sug- gested there is no substitute for an adequate equity to asset ratio. Federal Deposit Insurance Corporation, which was responsible to the Congress for the management of the critical deposit insurance portion of the safety net, has underlined the importance of that minimum leverage ratio. The Federal Reserve concurs with the FDIC’s view. Just to be clear, what is the Fed’s view on the minimum capital issue, and does the Fed take the position that the leverage ratio down the road has to disappear? Chairman GREENSPAN. The general view that we are endeavor- ing to express is that when you have a Basel type capital accord down the road, which is essentially fully sensitive to the various different capital needs of an institution, that there is no further need for other measures because, by definition, the system is fully controlled. We are not yet there with respect to Basel II. As I have often said, there will be a Basel III and there will be a Basel IV because the technologies are changing, commercial banking is evolving, and supervision and regulation should not be fixed, it should actually VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 17 endeavor to adjust to the changing structure of a financial or com- mercial banking system. So when we get to the point—and I do not think we are there yet—that the various structures defining what capital should be address everybody’s concerns about supervision and control, then there is no longer a need for a minimum capital requirement. It would be merely duplicative, and indeed, if the system is working well, it is actually inoperative. We are not there yet, and I think what Governor Bies is trying to say is that we recognize that that not yet being there, there is still a role for minimum capital and a leverage ratio. But that does not change the fact that when we get a sufficiently sophisticated structure of capital supervision, that issue will be- come moot. So it is really a question of, as you quoted earlier, the word is ‘‘eventually,’’ and where that is, I do not yet know. But I do know, as indicated by both Governor Bies and Chairman Powell, that we are not there yet. Senator SARBANES. One quick question and then I will—— Chairman SHELBY. Proceed. Senator SARBANES. Every statistical study shows a marked grow- ing inequality in the distribution of income and wealth in the coun- try. The disparities are actually the largest of any of the advanced industrial countries, and they also loom out at you when you look at the United States in historical terms unless you go way back into—— Chairman GREENSPAN. The ‘‘Gilded Age’’ as they like to say. Senator SARBANES. —the Roaring 1920’s or the Roaring 1890’s or something. What is your view of that development? Chairman GREENSPAN. I think it is a very disturbing trend, Sen- ator, and the reason I say that is twofold. One, it is a reflection, as best I can judge, of a faulty educational system in the United States. As you know, we receive relatively poor marks internation- ally, especially as our students move from the 4th grade to the 12th grade. That, as I think I have testified here before, creates a inadequate movement of students through high school, into college, and into skilled jobs, so that the total supply of skilled workers is sufficiently large relative to the increasing demand for skills be- cause of technology to keep the skilled wage level down. We have been unable to do that, and indeed, we end up with too many people who are lesser skilled, vying for jobs which are declin- ing in number, so that the wage rates there are constricted, and it is causing this rather major dispersion. A free market democratic society is ill-served by an economy in which the rewards of that economy distributed in a way which too many of our population do not feel is appropriate. More impor- tantly, they do not feel the advantages and benefits coming from the system that a smaller but still significant group have experi- enced. So, I am concerned about this. I think it is a major issue in this country. Senator SARBANES. Thank you very much. Thank you, Mr. Chairman. Senator ALLARD. [Presiding.] Thank you, Senator Sarbanes. The Chairman has stepped out. My turn is next, so I will go ahead and resume questioning. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 18 As Chairman of the Housing Subcommittee, I would like to dis- cuss a number of issues related to housing. Your testimony men- tioned exotic loan products, and that caught my attention because I believe that Colorado is probably one of the higher States as far as foreclosures are concerned. Many in Congress I think have shared your concerns about those certain loan products such as in- terest-only loans, and also what we call negative advertising loans. My question is, do these loan products create new sustainable homeownership? In other words, these new products, are they re- placing the conventional loan, and are there some negative results as a result of that? Chairman GREENSPAN. Well, Senator, actually all of these loans, properly used, are not bad instruments. In other words, they give the consumers, the mortgagors, indeed the mortgagees as well, a broader set of instruments which can be employed, so there is greater consumer choice. Our concern is that a number of these instruments are being used to enable people to purchase homes who would otherwise not have been able to do so. In other words, they are stretching to make the payments, and that is not good lending practice for banks or other purveyors of mortgages, and certainly it is not good prac- tice on the part of pending homeowners. It is a concern to us. Fortunately, it is not a large enough part of the market to create serious systemic problems, but it is an issue, and we at the Federal Reserve and other banking super- visors are looking at that. We are examining these issues, and we are making decisions as to what, if any, guidance to the banking system we would endeavor to convey. Senator ALLARD. So just to follow up on that, you do not see any need for any kind of legislative remedy or anything at this point in time? Chairman GREENSPAN. We do not need any legislative remedy. It is wholly under the regulatory authorities of the banking agencies. Senator ALLARD. Do you think the banks are utilizing proper un- derwriting standards for these type of products, and are we having more of a problem in certain States than in other States? Chairman GREENSPAN. I do not know that. That is factually ca- pable of being ascertained, and I assume some of my colleagues do know the answer to that question. It is not, in my judgment, at least what I have heard, an issue that is critical or something that requires immediate response. But it is enough of an issue that I think we have to look at it, and that is what we are doing, we are looking very closely. Senator ALLARD. I appreciate your response on that. Now, on various occasions you have downplayed the idea of a na- tional housing bubble, and have instead pointed to a situation which some regions of the country are exhibiting signs of, I quote, ‘‘froth’’ I guess. And I am pleased to hear comments that while housing prices may well decline, such a decline would not nec- essarily derail the economy. Would you not agree though that while this may be true for the Nation as a whole, a correction could have a significant impact within a specific community or region? Could you please elaborate what the future could hold for such a city or VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 19 region, and what can or should be done to mitigate the damage such a correction could cause? Chairman GREENSPAN. We have had such experiences in the past, and quite correctly, there have been regional problems associ- ated with unwinding of frothy local housing markets. One thing that obviously is an issue with respect to the overall economy of these metropolitan areas, is that unlike earlier history, we have developed a mortgage instrument to a point, and the abil- ity to extract equity from homes to such an extent, that now a sur- prisingly large proportion of consumer expenditures and home mod- ernization outlays are financed by home equity extraction. That is clearly a consequence of one, house turnover, largely because, of course, the seller of the home extinguishes a mortgage which is less than the mortgage of the buyer of the home, which is essentially a reduction or extraction of equity from that home of that exact dif- ference. Then of course there are cash-outs, which have increased over the years, associated with refinancing, and then finally, a sig- nificant amount of extraction of unrealized capital gains essentially from home equity loans. These are large enough to be an issue in the overall consumption expenditures of a local community, and in the event that you begin to get a retrenchment in house turnover, which would presumably be associated with unwinding of a frothy market, you would prob- ably also have impacts on consumer expenditures in that particular area. There are obviously national implications of this as well. We would expect as the housing boom eventually simmers down, as we have long expected it would but find no evidence that it is about to, that it would begin to have some impact on consumption ex- penditures, and if not for the fact that we perceive capital invest- ment picking up the slack, it would give us some pause as to economic consequences of the adjustment process. Senator ALLARD. Mr. Chairman, you kind of moved into my sec- ond question where people were extracting this equity out of their home. If the value of these homes should begin drop or something, that could create some problems for our national economy, or would it not? Chairman GREENSPAN. Well, the run up in prices has been so significant, and the accumulated equity has been so large, indeed, it has been larger than the debt increase. So that the ratio of eq- uity in homes to debt has been rising in the most recent period. So there is a fairly significant buffer. But there is no question that, if you confronted a situation of declining house turnover and even declining house prices, home equity extraction would be expected to decrease. Senator ALLARD. Mr. Chairman, I have a few questions, if I may proceed. Chairman SHELBY. [Presiding.] You go ahead, you take your time. Senator ALLARD. This has to do with the terrorist attacks and the security in our financial industry. Do you believe that the fi- nancial services industry is prepared to protect people, processes, and infrastructure against potential disruptions from a terrorist at- tack, and do you see any further steps that need to be taken if not? VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 20 Chairman GREENSPAN. This is obviously under significant discus- sion now with the question of the expiration of TRIA. It gets to the base of a very difficult question: How does a civilized society with an economy based on the rule of law deal with the losses from vio- lence? What we have done over the years is very successfully construct an insurance system which basically has picked up a lot of dif- ferent losses from disruption from violence, from everything else, and it is a very sophisticated system which has evolved over the years and is still evolving. We are now confronted with something different, and it is dif- ferent because of the technological changes and the ways in which things can be destroyed. There is a potential very large scope of damage that can occur, which the existing insurance system would have difficulty figuring out how to insure and basically cope with the problem. This is why I have argued that there should be a fall-back posi- tion for very large terrorist attacks, where as the Government so- cializes a good deal of potential violence—and that is what our military budgets are, that is what our police forces are—there is a role if this terrorism level continues to pose the potential for very large disasters. So, I would perceive that until and unless we get this issue of terrorism to a dimension where the private sector can fully handle it, there is a role here for Government. Senator ALLARD. So you think that at this particular point, it might be appropriate for the Congress to provide some subsidy to the terrorist insurance, on the umbrella coverage? Chairman GREENSPAN. Yes. But I think the Administration’s pro- posals of delimiting some of it and having very large copayments are very sensible. The reason is that to the extent you socialize risks, you cause the misallocation of capital in a market economy and this reduce the standards of living, and so you have a tradeoff here. The more socialization of risk that you create, which is what we are talking about, the more potential distortion in the private sector’s capital account allocation. So we have to be very careful about what types of things we are trying to insure against, and it should be very succinctly limited to very large events. Part of the reason is that the technology has never been there for a small number of people to create as much damage as they apparently can with essentially various different forms of terrorism, which we have not really experienced in this country, and hopefully will never. If we, however, can find ways of diminishing the risk, at some point it is conceivable the private sector could handle the whole thing. Senator ALLARD. Thank you, Mr. Chairman. You have been very tolerant. And thank you, Chairman Greenspan. Chairman SHELBY. Senator Bennett. Senator BENNETT. Thank you very much. Several items, Chairman Greenspan. In your prepared testimony, in that portion which you read to us, you made reference to—let me read it because I was struck by it as important to note—‘‘A VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 21 prominent concern is the growing evidence of antiglobalization sen- timent and protectionist initiatives, which if implemented, would significantly threaten the flexibility and resilience of many econo- mies. The situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a succes- sion of large shocks in recent years with only minimal economic disruption.’’ I am fishing here for a comment on the importance of CAFTA. I think economically CAFTA is a relatively small deal because the economies of Central America are not that vital to our $12 trillion economy, but symbolically I think CAFTA is a very big deal, and I get the sense from your testimony that you would agree. But I want to give you the opportunity to comment rather than just put words in your mouth. Chairman GREENSPAN. I do, Senator, and the reason is it is part of the very critical issue of globalization. We in this country have embraced globalization over the decades, very much to our benefit. The world trading system has expanded dramatically. World stand- ards of living have expanded dramatically, and it is we in the United States who have benefited the most. We recognize, however, that the very nature of globalization, which creates ever higher standards of living, also is a process which we call ‘‘creative destruction,’’ which essentially means that the depreciation reserves of obsolescent capital get employed to fi- nance cutting edge capital, and the differential productivity be- tween the obsolescent capital and the newer capital creates the increase in standards of living. That is the actual thing which en- genders the result. The problem with creative destruction is that it is destruction, and there is a very considerable amount of turmoil that goes on in the process. As I have mentioned here many times, we hire and es- sentially let go a million workers a week in this country. It is a huge churning turnover. What we must focus on is that as we gain the benefits of globalization, it is important that the problems of those who are on the destruction side of the globalization problem be addressed appropriately. As Senator Dole said earlier today, we have to get focused on training, on the issue of various different means to retrain workforces which are being altered, or doing what is required to recognize the nature of the problems of those people who are asso- ciated—it is a minority of the people, but it is a large enough mi- nority that we have to address the fact that they are in serious trouble on occasion. Senator BENNETT. When you are a member of the minority, it is not a small problem. Chairman GREENSPAN. It is 100 percent of the problem. Senator BENNETT. Let me turn again to the GSE’s and the issue. One of the facts of life that I have learned here is that you can tell how a piece of legislation is going to affect the marketplace by see- ing who is lined up on which side of the issue. And as people have come to see me, pleading that heavy restrictions be put on the port- folio size of the GSE’s, and then others have come to see me plead- ing that nothing be done with respect to the portfolios of the GSE’s, aside from the GSE’s themselves—you know, you kind of set aside VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 22 their statements because their position is fairly clear. A pattern has seemed to emerge. The small banks, the mortgage brokers, the homebuilders, realtors, are all saying do not mess with the port- folios of the GSE’s. The big banks, Citibank, Wells Fargo, saying yeah, absolutely do this to the GSE’s. This may be an oversimplification, but as I sort through the ad- vocates on either side of this fight, I find it is kind of rural on one side and big city on another. It is kind of small bank brokerage op- erations that deal with small institutions on one side, big banks on the other. The implication being that the independent banks, the community banks are benefitted by the present situation and the big banks are competing with the present situation; therefore, the one would like to see it stay and the other would like to see it change. Fannie Mae and Freddie Mac do not require anybody to sell them a mortgage. The market works. People bring it to them. And the only reason that somebody would bring a mortgage to Fannie Mae would be if the price were better or if the service were better. And as I have talked to people on the anti side, if you will, they have indicated that they believe if Fannie Mae and Freddie Mac are constrained in their portfolios, that the price will go up and they will be forced to deal with other institutions where they think the service—if the price goes up, they still would rather deal with Fannie Mae because they think it is more convenient, they move more rapidly, they are much more flexible. What would you say to these groups, legitimate groups, who are not shareholders of Fannie Mae or Freddie Mac? How would you reassure them that if we did what you wanted to do, they were going to be just fine? Chairman GREENSPAN. It is a question of fact. See, here is what the problem is, to directly relate to your issue. I am a community bank and I have been very appreciative of the secondary mortgage market to take the mortgages I have and sell to them. They are confronted with an issue of uncertainty as to what would happen in the event if the portfolio of the GSE’s went down. The GSE’s and a lot of other people say it is going to cause interest rates to go up. Nobody says, including the Federal Reserve, that will cause in- terest rates to go down. So, they are confronted with an uncertainty of the fact that they seem to be better off with the status quo. The truth of the matter is they are not. That is, there is no evidence that the amount of purchases made by Fannie, Freddie, and indeed a very large and increasing private sector, would be bidding significantly different prices for their home mortgages. And the decision whether those accumulated mortgages by, say, Fannie and Freddie, end up in their portfolio or end up securitized and sold into the marketplace is essentially made after they are purchased from, let us say, a community bank. So there is an understandable concern if you are not fully famil- iar with how the markets work and there is no potential on the other side. In other words, if I am confronted with very little knowledge but I know the chances are only that a certain thing can go in the wrong direction for me, I will argue for the status quo. Now, that is a perfectly understandable and reasonable case, and VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 23 that is true, incidentally, I think, of the homebuilders as well. I think they are mistaken. Indeed, I know they are mistaken. But I fully understand where they are coming from. So the concern that I have is that over the longer-run they are actually at risk here, as we will all be at risk if indeed there is a systemic problem. Then there will be very serious problems for the housing market and they will find that they are at significant risk. They do not perceive that now because they do not perceive what could conceivably be occurring in the future, which is what is moti- vating Federal Reserve. So it is a difficult issue of who knows what about what is going on. I do not find any difficulty in under- standing where these various positions are coming from. And I would make the same argument, incidentally, in reverse, for the big banks. Senator BENNETT. If I may, Mr. Chairman, go forward with that. Chairman SHELBY. Go ahead. Senator BENNETT. You would make the same argument in re- verse? Chairman GREENSPAN. Yes, in other words—— Senator BENNETT. The big banks presumably will increase their market share—— Chairman GREENSPAN. Yes, what I am basically saying is I think that the amount of market share that they think that will occur as a consequence of this is not obvious to me in any particular way. Senator BENNETT. Okay, so you are saying that the big banks who are beating on me, you have to do this, this is a terrible com- petitive they are going to be disappointed. Chairman GREENSPAN. Well, unless they are using the argu- ments that I am using. We have to distinguish between the mort- gage market and the securitized market. In the securitized market, yes, the commercial banks will probably pick up some advantages because indeed that will be one of the purposes of changing the system. I think, however, that the nature of the argument misses the really fundamental point, which is that we are creating a po- tential very serious systemic risk. And to have arguments that are going on about whose market share or whose potential profits will change in somewhat different ways, I think, is missing the much larger point. Let me respond in writing to you about how I think the specific changes might occur in these markets. There are changes. I do not want to deny that there will be changes. But I think people ex- traordinarily exaggerate what the implications are. And for the self-interest of all parties, in my judgment, making certain that we do not have a systemic problem occurring because there is a very large accumulation created by incentives to hold ever-increasing portfolios to get ever-increasing incomes, in the long-run will re- dound to nobody’s benefit, because we will all lose. Chairman SHELBY. Mr. Chairman, I would also request a copy of that letter, if you would, please. Senator BENNETT. Yes, that would be very helpful. And my time is gone, but I look forward to having additional conversations with you about this. Thank you very much. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 24 Chairman SHELBY. Chairman Greenspan, since we are talking about GSE’s, how many companies with $12 billion accounting er- rors—which would be representing a significant portion of the cap- ital of that company—see no increase in debt cost in the market after that? I am referring to Fannie Mae. Chairman GREENSPAN. It is very simple. Because it has nothing to—— Chairman SHELBY. Oh, it is the implicit guaranty. Chairman GREENSPAN. Yes. It has nothing to do with the status of Fannie Mae or Freddie Mac. Chairman SHELBY. Thank you. This Committee has previously raised questions with you, Mr. Chairman, and Treasury Secretary Snow regarding the large Chi- nese and Japanese official holdings of U.S. Treasuries. Your report today indicates that data from Treasury indicates that demand for these securities from foreign official investors has ebbed during the first 5 months of this year. Obviously, the Chinese Government an- nouncement to switch to a currency basket in setting its peg could also affect that demand. Mr. Chairman, do you anticipate that long-term rates may be af- fected by the changes in foreign official demand, or do you expect such changes to unfold slowly over time and thus be absorbed into the market? Chairman GREENSPAN. Well, two things happened. We have esti- mated, I think I have testified before, that the accumulation on for- eign account has probably subtracted something under 50 basis from long-term interest rates in the United States. Should that un- wind, that is about the order of magnitude we are talking about. But markets anticipate what is likely to occur. As a consequence of that, you could very well get changes that are up front in antici- pation of things that will go on longer term. Chairman SHELBY. Factored it in, in a sense? Chairman GREENSPAN. Yes. In other words, the markets do not wait—they anticipate. So we could get some impact sooner rather than later. Chairman SHELBY. Mr. Chairman, the Chinese Government today, as we have been talking about, announced a 2 percent re- evaluation of its currency and the move to a currency peg linked to a basket of currencies rather than just linked to the U.S. dollar. Other Asian countries, like Japan and Korea, who have extensive trade relationships with China, have grown accustomed to China’s fixed exchange rate policies. How will China’s other Asian trading partners manage this transition by the Chinese, and won’t these countries have to allow more flexibility in their currencies in order to see a more level playing field for the United States? Chairman GREENSPAN. I think we are already seeing that. I mean, Malaysia this morning also moved, as I recall. Chairman SHELBY. So the market again anticipated this move and has reacted to it? Chairman GREENSPAN. Yes. If you look, for example, the dollar weakened significantly against the yen this morning, as a con- sequence of this move. Chairman SHELBY. Mr. Chairman, your testimony also discussed at length what others have referred to as the savings glut. One fac- VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 25 tor you note is corporate behavior and the softness in capital in- vestment. This is particularly puzzling in light of strong profits in the corporate sector and lower interest rates. Could you touch fur- ther on the potential causes of this behavior and whether our Na- tion’s economy has ever experienced similar circumstances? Should the situation persist, how would this affect the Federal Reserve’s growth projections? Chairman GREENSPAN. Well, as I indicated in my prepared re- marks, capital investment in the United States is expanding, and indeed we are expecting it to expand a good deal further. Chairman SHELBY. Do you think it is adequate? Chairman GREENSPAN. It is less than one would have expected, given the levels of cashflow and, indeed, other measures that usu- ally were associated with capital investment. I attribute this in my remarks to the aftermath of the stock market liquidation and the corporate scandals, which had a fairly profound effect on corporate governance and on the risk aversion of corporate managers. I think we are still seeing the aftermath of that, although there is some evidence that it is beginning to dissipate, and that is one of the reasons we perceive that the outlook for capital investment in the United States is quite favorable. Chairman SHELBY. Thank you. Oh, excuse me, Senator Corzine. My eyes aren’t as good as yours. Senator Corzine. STATEMENT OF SENATOR JON S. CORZINE Senator CORZINE. Your eyes are pretty good, particularly when we are looking at legislation, Mr. Chairman. I appreciate the Chairman being here. Let me ask, have you com- mented today, with respect to the House bill, with regard to GSE’s? Chairman GREENSPAN. I have not, Senator. Senator CORZINE. Do you have views with regard to the House bill? Chairman GREENSPAN. You are talking about what the House Fi- nancial Services Committee voted on? Senator CORZINE. Yes. Chairman GREENSPAN. That question was asked me yesterday at that Committee, and I said it did not address the problems that I thought were extant with respect to the GSE’s, and indeed, went further and said that we would probably be better off with no bill than a bill of that nature. Senator CORZINE. And your major problems? Chairman GREENSPAN. Largely the issue of portfolio to what we have been discussing with—— Senator CORZINE. And I know you have spoken often about this, but have you narrowed or become more precise on how you believe those portfolios restrictions should—— Chairman GREENSPAN. I thought that the particular formulation by the Secretary of the Treasury with respect to what he thought would be an appropriate bill struck us as pretty much where we thought it should be. That is essentially, as you may recall, stipu- lating that the level of portfolio should reflect, aside from obvious liquidity needs and the turnover of very vast amounts of mort- gages, the charter requirements of the GSE’s, but that strictly for VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 26 the purpose of creating increased earnings would not be a justifica- tion for building up portfolios. Senator CORZINE. But are you suggesting, and is the Treasury Secretary suggesting, in your view, that would be based on risk- based modeling with respect to what was an appropriate—— Chairman GREENSPAN. You mean for the GSE’s? Senator CORZINE. Yes. Chairman GREENSPAN. No. We are not raising the question with respect to the portfolios as a risk to the GSE’s; on the contrary. It is expanding their profitability and everything else that goes with it. Our concern is the systemic risk, not safety and soundness risk. The House bill specifically puts the capability of a regulator to ad- just portfolios on the basis of safety and soundness, which I read refers to the safety and soundness of the GSE’s, not the systemic questions that we raise. Senator CORZINE. Is that consistent with bank regulation? Chairman GREENSPAN. No, it is a different standard. Senator CORZINE. It is a different standard for GSE’s? Chairman GREENSPAN. Yes, indeed. At least in my judgment. Senator CORZINE. And could you explain to me why that systemic risk is so much different in an institution of a trillion dollars in one format versus a trillion dollars in another format? Chairman GREENSPAN. Let me be very explicit. It has to do with the extent of leverage. In commercial banks, for example, I should say capital is several multiples, many multiples higher than what the GSE’s are holding. As a consequence, banks do not, in our judg- ment, raise the level of systemic risk that the GSE’s raise. It is a different order of magnitude largely because of, one, the size of the leverage and two, the extent to which the financial markets grant the GSE’s effective U.S. Treasury status with respect to their bond issuance, when they do not do for commercial banks. Senator CORZINE. Okay, so if it were capital, then risk capital as- sociated with the underlying assets should put them on an equal playing field, I would think. If their regulator chose risk capital measures—— Chairman GREENSPAN. There would be two issues here. Unques- tionably, if their risk-based capital were raised to the level of where the commercial banks are, that would assuage a good deal of the problem. It would still leave the issue, however, of the ability of the part of these institutions to raise any amount of capital at very low interest rates, irrespective of the status of the institution. Indeed as the Chairman pointed out, how is it possible I do not know whether that was just before you came in or not—— Senator CORZINE. I apologize. I had other things—— Chairman GREENSPAN. —how is it possible to have these huge accounting losses and serious questions about what the earnings of these institutions are and have virtually no effect on the rates at which they can sell debentures. The reason, essentially, is that the financial state of Fannie and Freddie has almost nothing to do with what the interest rate is on their debentures or their ability to ac- tually sell them. Senator CORZINE. Supply and demand, at some point, has impact on rates. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 27 Chairman GREENSPAN. It does, and it will eventually occur with U.S. Treasury issues, and I presume at that time it will affect the GSE’s. Senator CORZINE. May I ask one other question? Chairman SHELBY. Go ahead. Senator CORZINE. Have you been asked about TRIA? Chairman GREENSPAN. Yes, I have. Senator CORZINE. I will check the record, then, unless you want to repeat. Chairman GREENSPAN. I will be glad to respond in writing to you if there are other things that you would like. Senator CORZINE. Please. Thank you. Chairman SHELBY. I will get Senator Bennett first. I think he has a question. Senator BENNETT. Yes, one quick additional issue that I would like to raise with you again just to get this on the record. As we grapple with the Social Security problem, and I am trying to craft a solution that deals with the solvency challenge, I think the political situation says that the personal accounts will be a fight we will have at some future point. I think there are good enough idea that they will stay around and I think eventually the Congress will adopt them. But in this Congress, there does not seem to be an appetite to do that and the solvency issue is still very much with us. So, I have tried to craft a bill to deal with that, as my colleagues know. But in this process, I come back to an issue that you have com- mented on in the past and I would like to get a fresh response from you so that I am not guilty of using outdated information. This has to do with the professional consensus among economists which says that the CPI overstates changes in the cost of living, and the Bu- reau of Labor Statistics in 2002, perhaps in response to that con- sensus, began publishing a new index called the Chain CPI. I had a little trouble understanding what that meant. But it takes into account the fact that consumers will make substitutions in their purchases. If the price of X goes so high, they will switch to Y, and so their standard of living presumably has not changed that much, but the cost of living is better measured by the chain CPI. My staff on the Joint Economic Committee has come up with in- formation that the implications of using the chain CPI as opposed to the CPI are huge. Over 10 years, the Boskin Commission says, quoting CBO, that if CPI overstated the cost of living by 1.1 per- cent per year, the standard programs that we have in place would increase the national debt by a trillion dollars over a 10-year pe- riod. And Congress may want, as a matter of policy, to say let’s in- crease the national debt by a trillion dollars in order to increase these programs by more than the cost of living, but at least the stated position of Congress in the current law is that we simply want to have the actual cost of living taken care of. Another side of it is that CPI is tied to the taxation bracket, which means that people get a massive tax cut over time with re- spect to the issue of bracket creep. Bracket creep is dampened by using the CPI. So you get less revenues and more expenditures by doing this, which means that the trillion-dollar number may be ex- acerbated by the impact on the tax side. I do not think they took VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 28 the tax side into consideration when they looked at the expenditure side. Could you comment on all of this and where you think we as pol- icymakers should go on this issue? Chairman GREENSPAN. We at the Federal Reserve Board have been looking at this for a number of years. I think our most recent estimate is that the Consumer Price Index itself is biased upward by a little under 1 percent at this stage. Senator BENNETT. That is a little less than the Boskin thing, so it would not be quite a trillion dollars. Chairman GREENSPAN. Yes. The reason for that is, remember that the Bureau of Labor Statistics has made a number of changes addressing the problems of the Boskin Commission, which in retro- spect probably underestimated the extent of what the issue of the bias was. Because if you take our current evaluation and add back the BLS adjustments, I think we go higher than the Boskin Com- mission data would suggest. What we also find is that the CPI chain index takes off roughly half of that bias. It does not take the whole bias out, and indeed, if the Congress literally wanted to have an index which was the op- timum estimate of what the cost-of-living change really was, you would need to find a mechanism that actually made the adjustment for the full bias. And that, you know, is close to the 1.1 percent number to which you were referring. I think that is very difficult to do unless you get, as I suggested many years ago, a commission which would sit there each year, re- evaluate what the nature of the bias was, and set what the adjust- ment for all Federal programs would be. Short of that, switching to the chain index, which is just a reweighting in a fully mechan- ical, understandable way by the BLS, would give us a far superior, less biased measure of what the cost of living is. It will not go all the way, but it will take a good deal out of both, obviously, the tax side and the spending side. Senator BENNETT. Thank you very much. Chairman SHELBY. Mr. Chairman, just for the record again, I would like to know what size portfolio, in your judgment, roughly, should the GSE’s maintain? Chairman GREENSPAN. I do not have a specific number. It is sig- nificantly below where it is now. They still have very significant needs for liquidity, but incidentally, that liquidity should be in Treasury bills. But they do not want to hold Treasury bills, because to sell debentures and invest in Treasury bills does not make any money; in fact, you would probably lose something. It is the selling of debentures to invest in mortgage-backed securities which gives you a nice big fat yield. So the presumption that is often stated—that they need this whole stock of mortgage-backed securities for liquidity purposes— raises a very interesting point: How in the world does holding mortgage-backed securities in your portfolio give you the capability of buying other mortgage-backed securities? In other words, the only thing that will do that—— Chairman SHELBY. That is a bogus argument, really. Chairman GREENSPAN. Yes. The only thing that will do that is if they built up either cash balances or Treasury bills or something VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 29 which they could liquidate quickly and employ. The presumption that you have a large portfolio of mortgage-backed securities for the purposes of liquidity presupposes that you sell a mortgage- backed security to get the cash to support another mortgage-backed security. That obviously is a zero-sum game. So the amount of liquidity that is involved and required, strikes me as something that the regulator has to make a judgment on. But I do think that what should be specified is what that portfolio could be held for. There are liquidity purposes; there are a signifi- cant number of mortgages which cannot be securitized, a lot of them basically under affordable housing programs, and we would say they should be held in the portfolio; and a number of other things. But essentially restrict it to the purposes of the charter. Chairman SHELBY. The mission, huh? Chairman GREENSPAN. Yes. Chairman SHELBY. Thank you. Senator Schumer. Senator SCHUMER. Well, thank you, Mr. Chairman. I apologize for being away for a long, busy day in many ways. I know you have talked a little bit about the Chinese currency, so I will not have you repeat that. You were asked about terrorism insurance, so I will not have you repeat that. And I could not agree with you more, the private market cannot handle this alone. I have one topic I would like to ask about, and I thank the Chair- man. As you know, Mr. Chairman, there are ongoing discussions as to whether we should fully repeal the estate tax—this is a tax that affects about one American in 100—or whether there can be some reasonable or permanent compromise that can garner the nec- essary 60 votes, because it breaks the Budget Act, as you know. The Federal deficit this year, excluding Social Security, will be huge, more than half a trillion this year alone. You also know, of course, that full repeal would cost $300 billion in the next 10 years and $750 billion if you go between 2011 and 2020—you know, the years that the present law is not in effect. And that would be if the costs are not offset. So my question is, given these deficits and the cost of repeal, if there are no offsets, can we afford to repeal the estate tax and in- crease the deficit by another $750 billion, if there are no offsets? Chairman GREENSPAN. I think that is the critical question be- cause, as I have testified on numerous occasions, I am strongly in favor of reducing taxes on capital, but under PAYGO. As a con- sequence, I would say if there are no offsets, obviously PAYGO is operative in that respect and the issue is moot. Senator SCHUMER. The issue is not moot. Chairman GREENSPAN. Well, the issue—in other words, if you— the issue—— Senator SCHUMER. Not everyone has your view. Chairman GREENSPAN. Okay. Well, that is a—— Senator SCHUMER. But I just—if we could just translate—— Chairman GREENSPAN. I will rephrase. Senator SCHUMER. If we could just translate that into a straight—you know, into—— Chairman GREENSPAN. I am trying not to translate. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 30 Senator SCHUMER. Oh, c’mon. This is your last time here. We have a big, big deficit. Chairman GREENSPAN. You mean I am going to become perfectly clear the last time I come here? Senator SCHUMER. Yeah, exactly. [Laughter.] But is it unfair to say you would advise not to repeal the estate tax if there are not offsets, if there is no PAYGO? Chairman GREENSPAN. That is correct. I think that PAYGO is an essential ingredient going forward and that all programs, both the spending and revenue programs, come under that. Senator SCHUMER. I take it there is a proposal for a compromise, which would cost about 80 to 90 percent of the full cost. In other words, some have proposed going to a capital gains rate rather than the 55 percent—that would be 15—and raising the floor to about $7.5 million. It is now, I do not know, it was originally 1. I think it is 1.5 now. It is one and a half now; it goes up and then it goes back down. I take it that would cost, instead of $750 billion over the next 10 full years, v2011 to 2020, that would cost $600, $625, $630 billion. I take it, again, without PAYGO, without an offset, you would think we should not do that at this point. Chairman GREENSPAN. That is correct. Senator SCHUMER. Thank you, Mr. Chairman. Chairman SHELBY. Chairman Greenspan, thank you for your ap- pearance today and all the other appearances and your service to the country. The hearing is adjourned. [Whereupon, at 12:10 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and addi- tional material supplied for the record follow:] VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4 31 PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARDOFGOVERNORSOFTHEFEDERALRESERVESYSTEM JULY21, 2005 Mr. Chairman and Members of the Committee, I am pleased to be here to present the Federal Reserve’s Monetary Policy Report to the Congress. In mid-February, when I presented our last report to the Congress, the economy, supported by strong underlying fundamentals, appeared to be on a solid growth path, and those circumstances prevailed through March. Accordingly, the Federal Open Market Committee (FOMC) continued the process of a measured removal of monetary accommodation, which it had begun in June 2004, by raising the Federal funds rate 1/4 percentage point at both the February and the March meetings. The upbeat picture became cloudier this spring, when data on economic activity proved to be weaker than most market participants had anticipated and inflation moved up in response to the jump in world oil prices. By the time of the May FOMC meeting, some evidence suggested that the economy might have been entering a soft patch reminiscent of the middle of last year, perhaps as a result of higher energy costs worldwide. In particular, employment gains had slowed from the strong pace of the end of 2004, consumer sentiment had weakened, and the momentum in household and business spending appeared to have dissipated somewhat. At the May meeting, the Committee had to weigh the extent to which this weak- ness was likely to be temporary—perhaps simply the product of the normal ebb and flow of a business expansion—and the extent to which it reflected some influence that might prove more persistent, such as the further run-up in crude oil prices. While the incoming data highlighted some downside risks to the outlook for eco- nomic growth, the FOMC judged the balance of information as suggesting that the economy had not weakened fundamentally. Moreover, core inflation had moved higher again through the first quarter. The rising prices of energy and other commodities continued to place upward pressures on costs, and reports of greater pricing power of firms indicated that they might be more able to pass those higher costs on to their customers. Given these consider- ations, the Committee continued the process of gradually removing monetary accom- modation in May. The data released over the past 2 months or so accord with the view that the ear- lier soft readings on the economy were not presaging a more serious slowdown in the pace of activity. Employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels are modest, and business investment appears to have firmed. At the same time, low long-term interest rates have contin- ued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on con- sumer prices, at least over the near-term. Slack in labor and product markets has continued to decline. In light of these developments, the FOMC raised the Federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 21⁄4percentage points. Should the prices of crude oil and natural gas flatten out after their recent run- up—the forecast currently embedded in futures markets—the prospects for aggre- gate demand appear favorable. Household spending—buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates—is likely to continue to expand. Business investment in equipment and soft- ware seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in nonresidential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressures on inflation. Overall inflation would probably drop back noticeably from the rates experienced in 2004 and early 2005, and core inflation could hold steady or edge lower. Prices of crude materials and intermediate goods have softened of late, and the slower rise in import prices that should result from the recent strength in the foreign exchange value of the dollar could also re- lieve some pressure on inflation. Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00035 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4 32 require the Federal Reserve to continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties that warrant careful scrutiny. With regard to the outlook for inflation, future price performance will be influ- enced importantly by the trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour. Over most of the past several years, the behavior of unit labor costs has been quite subdued. But those costs have turned up of late, and whether the favorable trends of the past few years will be main- tained is unclear. Hourly labor compensation as measured from the national income and product accounts increased sharply near the end of 2004. However, that meas- ure appears to have been boosted significantly by temporary factors. Other broad measures suggest hourly labor compensation continues to rise at a moderate rate. The evolution of unit labor costs will also reflect the growth of output per hour. Over the past decade, the U.S. economy has benefited from a remarkable accelera- tion of productivity: Strong gains in efficiency have buoyed real incomes and re- strained inflation. But experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology. Over the past 2 years, growth in output per hour seems to have moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. The traditional measure of the growth in output per hour, which is based on output as measured from the product side of the national accounts, has slowed sharply in recent quarters. But a conceptually equivalent measure that uses output measured from the income side has slowed far less. Given the divergence be- tween these two readings, a reasonably accurate determination of the extent of the recent slowing in productivity growth and its parsing into cyclical and secular influ- ences will require the accumulation of more evidence. Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut materially into private spending and thus damp the rate of economic expansion. In recent weeks, spot prices for crude oil and natural gas have been both high and volatile. Prices for far-future delivery of oil and gas have risen even more markedly than spot prices over the past year. Apparently, market partici- pants now see little prospect of appreciable relief from elevated energy prices for years to come. Global demand for energy apparently is expected to remain strong, and market participants are evidencing increased concerns about the potential for supply disruptions in various oil-producing regions. To be sure, the capacity to tap and utilize the world’s supply of oil continues to expand. Major advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever fewer discoveries of major oil fields. But, going forward, because of the geographic location of proved reserves, the great majority of the in- vestment required to convert reserves into new crude oil productive capacity will need to be made in countries where foreign investment is currently prohibited or restricted or faces considerable political risk. Moreover, the preponderance of oil and gas revenues of the dominant national oil companies is perceived as necessary to meet the domestic needs of growing populations. These factors have the potential to constrain the ability of producers to expand capacity to keep up with the pro- jected growth of world demand, which has been propelled to an unexpected extent by burgeoning demand in emerging Asia. More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease longer-term natural gas stringencies and per- haps bring natural gas prices in the United States down to world levels. The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on 10-year Treasury notes, currently near 41⁄4 percent, is about 50 basis points below its level of late spring 2004. Moreover, even after the recent widening of credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than those on Treasury notes over the same period. This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast approaching retirement of the baby- boom generation.1 The drop in long-term rates is especially surprising given the in- 1Under current law, those longer-run pressures on the Federal budget threaten to place the economy on an unsustainable path. Large deficits could result in rising interest rates and ever- growing interest payments on the accumulating stock of debt, which in turn would further aug- ment deficits in future years. That process could result in deficits as a percentage of gross domestic product rising without limit. Unless such a development were headed off, these deficits could cause the economy to stagnate or worse at some point over the next couple of decades. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00036 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4 33 crease in the Federal funds rate over the same period. Such a pattern is clearly without precedent in our recent experience. The unusual behavior of long-term interest rates first became apparent last year. In May and June 2004, with a tightening of monetary policy by the Federal Reserve widely expected, market participants built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with an initial rise in the Federal funds rate. Accordingly, yields on 10- year Treasury notes rose during the spring of last year about 1 percentage point. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, long-term rates once again began to rise, but like last year, market forces came into play to make those increases short lived. Considerable debate remains among analysts as to the nature of those market forces. Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major foreign financial markets than in the United States. Two distinct but overlapping developments appear to be at work: A longer-term trend decline in bond yields and an acceleration of that trend of late. Both develop- ments are particularly evident in the interest rate applying to the 1 year period end- ing 10 years from today that can be inferred from the U.S. Treasury yield curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it had de- clined to about 61⁄2 percent—an easing of about 15 basis points per year on aver- age.2 Over the past year, that drop steepened, and the forward rate fell 130 basis points to less than 5 percent. Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a mod- eration of the business cycle over the past few decades.3 This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace. And this increase in capacity, in turn, has doubtless contributed to expectations of lower in- flation and lower inflation-risk premiums. In addition to these factors, the trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment. This configu- ration is equivalent to an excess of the supply of funds relative to the demand for investment. What is unclear is whether the excess is due to a glut of saving or a shortfall of investment. Because intended capital investment is to some extent driv- en by forces independent of those governing intended saving, the gap between in- tended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its means of financing, global saving, into equality. We can directly observe only the actual flows, not the saving and investment tendencies. Nonetheless, as best we can judge, both high lev- els of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade. Since the mid-1990’s, a significant increase in the share of world gross domestic product (GDP) produced by economies with persistently above-average saving— prominently the emerging economies of Asia—has put upward pressure on world saving. These pressures have been supplemented by shifts in income toward the oil- exporting countries, which more recently have built surpluses because of steep in- creases in oil prices. The changes in shares of world GDP, however, have had little effect on actual world capital investment as a percentage of GDP. The fact that in- vestment as a percentage of GDP apparently changed little when real interest rates were falling, even adjusting for the shift in the shares of world GDP, suggests that, on average, countries’ investment propensities had been declining.4 2Dollar interest rate swaps 5 years forward and maturing in 10 years declined 19 basis points per year on average over the same period. Comparable euro (pre-1999, Deutschemark) swaps declined 27 basis points, sterling swaps 35 basis points, and yen swaps 23 basis points. 3Term premiums measure the extent to which current prices of bonds discount future uncer- tainties. 4Nominal GDP figures by country are estimated in dollars by the International Monetary Fund using purchasing power parities (PPP) of currencies. These GDP figures are used to cal- culate weights applied to national saving and investment rates to form global measures. When the GDP figures are instead measured at market exchange rates, the results are similar. The PPP estimates emphasize the economic factors generating investment and the use of saving. Ex- change rates emphasize the financial forces governing the financing of investment across bor- ders. Both approaches are useful. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00037 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4 34 Softness in intended investment is also evident in corporate behavior. Although corporate capital investment in the major industrial countries rose in recent years, it apparently failed to match increases in corporate cashflow.5In the United States, for example, capital expenditures were below the very substantial level of corporate cashflow in 2003, the first shortfall since the severe recession of 1975. That develop- ment was likely a result of the business caution that was apparent in the wake of the stock market decline and the corporate scandals early this decade. (Capital in- vestment in the United States has only recently shown signs of shedding at least some of that caution.) Japanese investment exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990’s. And investment in emerging Asia excluding China fell appreciably after the Asian financial crisis in the late 1990’s. Moreover, only a modest part of the large revenue surpluses of oil-pro- ducing nations has been reinvested in physical assets. In fact, capital investment in the Middle East in 2004, at 25 percent of the region’s GDP, was the same as in 1998. National saving, however, rose from 21 percent to 32 percent of GDP. The unused saving of this region was invested in world markets. Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving—that is, by weak consumption—or, more likely, a combination of both does not much affect the intermediate-term out- look for world GDP or, for that matter, U.S. monetary policy. What have mattered in recent years are the sign and the size of the gap of intentions and the implica- tions for interest rates, not whether the gap results from a saving glut or an invest- ment shortfall. That said, saving and investment propensities do matter over the longer-run. Higher levels of investment relative to consumption build up the capital stock and thus add to the productive potential of an economy. The economic forces driving the global saving-investment balance have been un- folding over the course of the past decade, so the steepness of the recent decline in long-term dollar yields and the associated distant forward rates suggests that some- thing more may have been at work over the past year.6 Inflation premiums in for- ward rates 10 years ahead have apparently continued to decline, but real yields have also fallen markedly over the past year. It is possible that the factors that have tended to depress real yields over the past decade have accelerated recently, though that notion seems implausible. According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp decline in the 10-year forward 1 year rate over the past year appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest that risk takers have been encouraged by a perceived increase in economic stability to reach out to more dis- tant time horizons. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its perma- nence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks. And, certainly, the exceptionally low in- terest rates on 10-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices. Whether home prices on average for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascer- tain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels. Among other indica- tors, the significant rise in purchases of homes for investment since 2001 seems to have charged some regional markets with speculative fervor. The apparent froth in housing markets appears to have interacted with evolving practices in mortgage markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are develop- ments of particular concern. To be sure, these financing vehicles have their appro- priate uses. But some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market. Moreover, these contracts may leave some mortgagors vulnerable to adverse events. It is important that lenders fully ap- 5A significant part of the surge in cashflow of U.S. corporations was accrued by those finan- cial intermediaries that invest only a small part in capital assets. It appears that the value added of intermediation has increased materially over the past decade because of major ad- vances in financial product innovation. 6The decline of euro, sterling, and yen forward swap rates also steepened. VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00038 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4 35 preciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change. The U.S. economy has weathered such episodes before without experiencing sig- nificant declines in the national average level of home prices. Nevertheless, we cer- tainly cannot rule out declines in home prices, especially in some local markets. If declines were to occur, they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial. Nationwide bank- ing and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of regional house-price correction. Moreover, a decline in the national housing price level would need to be substantial to trigger a significant rise in foreclosures, because the vast majority of homeowners have built up substantial equity in their homes despite large mortgage- market-financed withdrawals of home equity in recent years. Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that argu- ably has financed a noticeable share of personal consumption expenditures and home modernization outlays. The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced importantly by the worldwide evolution of intended saving and in- tended investment. We at the Federal Reserve will be closely monitoring the path of this global development few, if any, have previously experienced. As I indicated earlier, the capital investment climate in the United States appears to be improving following significant headwinds since late 2000, as is that in Japan. Capital invest- ment in Europe, however, remains tepid. A broad worldwide expansion of capital in- vestment not offset by a rising worldwide propensity to save would presumably move real long-term interest rates higher. Moreover, with term premiums at histor- ical lows, further downward pressure on long-term rates from this source is un- likely. We collectively confront many risks beyond those that I have just mentioned. As was tragically evidenced again by the bombings in London earlier this month, ter- rorism and geopolitical risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for the United States, where openness and flexibility have allowed us to absorb a suc- cession of large shocks in recent years with only minimal economic disruption. That flexibility is, in large measure, a testament to the industry and resourcefulness of our workers and businesses. But our success in this dimension has also been aided importantly by more than two and a half decades of bipartisan effort aimed at re- ducing unnecessary regulation and promoting the openness of our market economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years. In conclusion, Mr. Chairman, despite the challenges that I have highlighted and the many I have not, the U.S. economy has remained on a firm footing, and inflation continues to be well contained. Moreover, the prospects are favorable for a continu- ation of those trends. Accordingly, the Federal Open Market Committee in its June meeting reaffirmed that it ‘‘. . . believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.’’ VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00039 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4 36 RESPONSE TO A WRITTEN QUESTION OF SENATOR REED FROM ALAN GREENSPAN Q.1. I mentioned in my opening remarks the study by the Boston Federal Reserve with respect to labor participation, which suggests there is a significant and growing lack of participation in the labor force which distorts our ability to see how well we are doing with respect to recoveries. In fact, one thing that I found interesting was the ratio of employment to population, 62.7 percent, is below the level at the start of the economic recovery in November 2001. And this is the first time the ratio has failed to surpass its trial level so far into a recovery. Can you comment? A.1. At my July 21 testimony before the Senate Banking Com- mittee, you asked if I could provide additional detail concerning the Board staff’s assessment of recent developments in labor force par- ticipation and their implications for the interpretation of the unem- ployment rate as a measure of slack in the labor market. As I noted in my response at the hearing, while cyclical factors likely have contributed to the weak recovery in labor force participation, our staff estimates that part of that weak performance in recent years can also be traced to a downtrend in the underlying rate of participation. The change in the overall trend has occurred both be- cause the trend in the participation of adult women appears to have flattened out and because the large baby boom cohorts are moving into the age range in which their labor force participation will likely drop off sharply as many workers in these cohorts retire. More specifically, we estimate that the underlying trend in the par- ticipation rate has fallen from a little more than 661⁄ 2 percent of the civilian working-age population in 2001 to about 661⁄ 4 percent this year. Because the participation rate in recent months has averaged just over 66 percent, we estimate that the implied cyclical shortfall in participation equates to a few tenths of a percentage point on the unemployment rate. Our estimates are broadly similar to those of the Congressional Budget Office. Differences between our estimates and those re- ported in the Boston Fed study that we discussed at my hearing primarily reflect different views about the evolution of trends in participation for various demographic groups and different ways to measure the size of the current participation shortfall. In par- ticular, the Boston Fed study examines a range of alternative tra- jectories for participation rates for women and older workers and calibrates the size of the estimated current shortfall as a percent- age of the labor force. Of course, all such estimates are subject to considerable uncertainty, and our understanding of the relationship between labor force participation and labor market slack will un- doubtedly benefit from additional research on this topic. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM ALAN GREENSPAN Q.1. What guidance could you offer for selection of an index to use for maintaining purchasing power over time in Federal programs with cost-of-living adjustments? A.1. As you know, I have long advocated improvements in the price indexes published by the Bureau of Labor Statistics (BLS). As you VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00040 Fmt 6602 Sfmt 6602 24852.TXT SBANK4 PsN: SBANK4 37 have indicated, this issue is important for several reasons. In addi- tion to the need for accurate measures of inflation, price indexes are used for the automatic inflation adjustments of many Federal tax and spending programs, and inaccurate price measures can lead to adjustments that are inconsistent with true changes in the cost of living. In recent years, the BLS has taken important steps to improve the quality of the price indexes. However, reviews of the academic literature on price measurement suggest that frequently cited con- sumer price indexes published by the BLS still tend to overstate increases in the cost of living. This evidence indicates that, if Con- gress intends the inflation adjustments to compensate for changes in the cost of living, adjustments based on the CPI-U or CPI-W will be too large, perhaps by a significant amount. Q.2. Do you believe that replacing the CPI-U with the C-CPI-U in indexing Federal programs would be truer to the original intent of Congress in making cost-of-living adjustments? A.2. As indicated, research suggests that the CPI-U and CPI-W overstate increases in the cost of living. A portion of this measure- ment error owes to substitution bias, and, to address this problem, the BLS recently developed the Chained CPI-U (C-CPI-U). Although the C-CPI-U is still subject to other sources of bias— especially those related to changes in the quality of existing prod- ucts and introduction of new goods and services—basing inflation indexation of Federal programs on the C-CPI-U would, in my view, give us a less biased measure of changes in the cost of living. Q.3. Because construction of the C-CPI-U requires data on the changing expenditure patterns of consumers as relative prices shift, the index is subject to revision as better data on expenditures be- come available. However, this presents a problem because retro- active adjustments may become necessary as revisions are made if the C-CPI-U were to be used for indexation purposes in Federal programs. One possible way to overcome such a problem would be to use ‘‘true up’’ factors as revisions are made. For example, if last year’s C-CPI-U growth was revised down by 0.2 percent and this year’s C-CPI-U growth was 1.4 percent, then we could actually increase whatever is being indexed by only 1.2 percent (this year’s 1.4 per- cent less a ‘‘true up’’ factor of 0.2 percent to reflect the revision). Assuming that errors are unbiased (essentially, that revisions have mean zero), such a procedure should average out correctly over time. However, in the short-run, revision issues could be signifi- cant. If you believe that the C-CPI-U represents a truer measure of the cost of living than the CPI-U, how would you address the prob- lem of data revisions? A.3. As you noted, the indexation of Federal programs to a price index that is subject to revision, such as the C-CPI-U, does lead to certain complications. If the index is subsequently revised, then programs tied to that index will have been set at levels learned, ex post, to have been inappropriate. (Of course, use of a price index that is not subject to revision also may generate inappropriate ad- justments to Federal programs, and the absence of revision may VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00041 Fmt 6602 Sfmt 6602 24852.TXT SBANK4 PsN: SBANK4 38 mean that any such errors are never corrected.) The complications introduced by such revisions are readily surmountable, however. Indexation formulas may be structured in ways that take such re- visions into account and ensure that, in the period following the re- vision, the programs are set back at appropriate levels. The use of ‘‘true up’’ factors, as you suggest, is one way to achieve this goal. Q.4. If you were to change the price measure used in indexing Fed- eral programs, how would you respond to a criticism that such a change is merely a sneaky way of cutting benefits and increasing taxes? A.4. As indicated above, I believe that it would be desirable, insofar as possible, to index Federal programs in a way that captures ac- tual changes in the cost of living. Q.5. In remarks on price measurement at the Center for Financial Studies in Frankfurt, Germany on November 7, 1997, you advo- cated establishment of an objective, nonpartisan, and independent national commission to set annual cost-of-living adjustment factors for Federal programs. Do you still feel that it would be beneficial to establish such a commission? How would you constitute such a commission? Would you be willing to coordinate research efforts of Federal Reserve staff with those of my staff on the Joint Economic Committee to help explore the possibility of formalizing such a commission? A.5. Further improvements in our price indexes would be a wel- come development. In the meantime, it is important to consider how best to index Government programs, given price measures still appear to suffer from significant biases. Many approaches to this latter problem have the potential to yield progress, including the establishment of an independent commission. RESPONSE TO A WRITTEN QUESTION OF SENATOR CORZINE FROM ALAN GREENSPAN Q.1. This morning, the Senate Agriculture Committee is marking up legislation reauthorizing the Commodities Futures Trading Commission. The proposed legislation would modify the Commodity Futures Modernization Act (CFMA) of 2000, which, as you know, this Committee and Agriculture jointly worked on to develop. That effort was based on recommendations from the President’s Working Group (the Federal Reserve, Treasury, SEC, and CFTC) on Finan- cial Markets. Yesterday, you expressed concerns to Agriculture Committee Chairman Chambliss about the legislation in response to a letter from Senator Crapo. Those concerns seem to revolve around the fact that the President’s Working Group has not had the oppor- tunity to review or deliberate key proposals contained in the draft reauthorization legislation. SEC Acting Chairman Glassman has expressed a similar concern, and Chairman Shelby and Ranking Member Sarbanes have done so as well. As you know, of major concern with the draft legislation are the provisions that would modify portions of the CFMA that were painstakingly crafted to balance the differing interests of all Fed- eral financial regulators. I wonder if you could discuss more in depth the nature of the concerns you expressed in your letter and VerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00042 Fmt 6602 Sfmt 6602 24852.TXT SBANK4 PsN: SBANK4 39 what specific harm could come from Congressional action that, done in haste, could disrupt the balance and legal certainty the CFMA struck which has aided the development of important finan- cial markets and reaped significant benefits for the broader econ- omy? A.1. The Federal Reserve Board believes the CFMA has unques- tionably been a successful piece of legislation. It enacted provisions that excluded transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency from regulation under the Commodity Exchange Act (CEA). This exclusion resolved long-standing concerns that a court might find that the CEA applied to these transactions, thereby making them legally unenforceable. Another important part of the CFMA addressed problems associ- ated with ‘‘bucket shops’’ that were marketing foreign currency fu- tures to retail customers (that is, an individual or business that does not meet the definition of eligible counterparty). The legisla- tion marked up by the Senate Agriculture Committee in July 2005 would apply the CEA as a whole to certain retail foreign currency contracts, regardless of whether they are futures contracts. We se- riously question whether it is necessary to apply all the provisions of the CEA to these transactions in order to enable the CFTC to address fraud, and believe that a broad application of the Act could have unintended consequences. 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Alan Greenspan (2005, July 20). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_20050721_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_20050721_chair_federal_reserves_second_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {2005},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_20050721_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}