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98–356 PDF 2004

S. HRG. 108–769

FEDERAL RESERVE’S SECOND MONETARY POLICY

REPORT FOR 2004

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

ON

OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

JULY 20, 2004

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

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

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

TUESDAY, JULY 20, 2004

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Dole ...................................................................................................... 2

Senator Bunning ............................................................................................... 2

Senator Carper ................................................................................................. 3

Senator Reed ..................................................................................................... 4

Senator Crapo ................................................................................................... 4

Senator Bayh .................................................................................................... 4

Senator Sununu ................................................................................................ 5

Senator Sarbanes .............................................................................................. 5

Senator Hagel ................................................................................................... 6

Senator Dodd .................................................................................................... 6

Senator Allard ................................................................................................... 6

Prepared statement ................................................................................... 36

Senator Schumer .............................................................................................. 7

Senator Corzine ................................................................................................ 7

Senator Bennett ................................................................................................ 26

WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 7

Prepared statement .......................................................................................... 36

Response to written questions of:

Senator Shelby ........................................................................................... 40

Senator Bunning ....................................................................................... 42

Senator Crapo ............................................................................................ 43

Senator Sununu ......................................................................................... 44

Senator Stabenow ...................................................................................... 46

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Foreign Official Assets in the United States chart, submitted by Senator

Paul S. Sarbanes .................................................................................................. 48

Monetary Policy Report to the Congress, July 20, 2004 ....................................... 49

(III)

(1)

FEDERAL RESERVE’S SECOND MONETARY

POLICY REPORT FOR 2004

TUESDAY, JULY 20, 2004

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met, at 2:31 p.m., in room SH–216 of the Hart

Senate 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. I am very

pleased this afternoon to welcome Chairman Greenspan before the

Committee on Banking, Housing, and Urban Affairs, to testify on

the Federal Reserve’s Semi-Annual Monetary Policy Report to the

Congress.

Chairman Greenspan, the U.S. economy is continuing its expansion with real GDP increasing 3.9 percent in the first quarter of

2004. I hope we can now also point to strong job growth with payroll employment increasing for 10 straight months with an average

of 200,000 jobs per month in the first half of this year. I think overall this is good news for the American worker and we hope to see

even better numbers on jobs and wages in the months ahead.

When this Committee heard from you in February of this year,

the Federal Open Market Committee had just stated that the Committee could be ‘‘patient’’ in changing its accommodative monetary

policy. The FOMC then indicated in May that changes in its policy

were ‘‘likely to be measured.’’ At its June meeting, the Federal

Open Market Committee raised its target for the Federal funds

rate by 25 basis points to 11⁄4 percent—the first increase since May

2000. This move was widely anticipated by financial markets, and

I think overall it has helped ease inflationary fears.

Some Fed watchers have expressed the concern that the FOMC

waited too long to increase its target Federal funds rate target.

However, last week’s report on retail sales and industrial production seemed to indicate that the Fed’s actions have been prudent.

Also, since the FOMC’s June action, the markets have responded

by a reduction, as you well know, in the long-term interest rate.

This afternoon, I think we will have ample opportunity to discuss

the Federal Reserve’s views on the economy and how we might interpret the FOMC statement on changes in monetary policy which

are ‘‘likely to be measured.’’ And, perhaps we will even garner some

insight as to the FOMC’s consideration at its upcoming August

meeting.

2

Mr. Chairman, as I had indicated to you a minute ago, there is

a vote going on. Some of us voted early, and we will have a lot of

Members to join us. We look forward to your remarks, but first,

Senator Dole, any statement?

STATEMENT OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Chairman Shelby.

Today, we welcome Chairman Greenspan back to this Committee

for our fourth and final Semi-Annual Monetary Policy Report of the

Federal Reserve for this Congress. I appreciate the Chairman’s

willingness to visit with us so often, and explore areas of concerns

with regard to our economy and monetary policy.

Last month, Chairman Greenspan assured us that he has observed real wages increasing for Americans in the past 4 months.

This, in turn, has helped increase disposable income, a trend that

I understand Chairman Greenspan expects to continue as the natural course of the recovery and growing strength of our economy.

I cannot overstate the importance of this trend for our men and

women in the workforce, and appreciate Chairman Greenspan’s

continued optimism in the American economy. I was very pleased

with the release last week of the June industrial production data,

indicating the growing strength in the manufacture of durable capital goods. North Carolina has been hit very hard by the loss of

manufacturing jobs over the past years. Any reversal of this trend

is indeed welcome news.

There have been some excellent numbers for North Carolina—according to figures released today from the Bureau of Labor Statistics—North Carolina has created 35,400 new jobs in the month of

June. This positive news highlights the transition which is occurring in North Carolina with the loss of low-skilled manufacturing

jobs and the creation of jobs in service sectors which require a good

education with a demand on computer skills. Continuing education

must continue to be a top priority for us to respond to this demand.

I have spoken before about the work that Senators Enzi, Alexander, and I are undertaking to write the Higher Education Access,

Affordability, and Opportunity Act of 2004. It will provide additional assistance to our community colleges and other institutions

of higher learning for training and retraining students in highgrowth job markets. We hope to introduce this bill shortly.

In addition, I remain concerned about a number of factors such

as high energy prices, the rise in steel prices, and the size of our

trade deficit. Despite these concerns though, I am confident that

through increased trade, hard work, global communications, and

continuing education of our workforce, we will achieve new levels

of opportunity for all Americans and global security.

I, again, thank Chairman Greenspan for joining us here today,

and I will look forward to his testimony.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman.

I am glad that we get you first this time, Chairman Greenspan—

the House usually shares that opportunity with us—because given

3

the June economic figures, especially the housing figures that came

out today, I know many want to know what you make of these figures, and that is especially true of this Committee.

When the FOMC raised rates 25 basis points on June 30, it was

a move that was largely expected. Many in the economic talking

heads class said the market had already built in this rate adjustment. However, since that raise, as of last night’s close, the Nasdaq

market has lost 164 points, and the Dow has lost 341 points. It has

not been a very good 3 weeks for our stock markets. I am not sure

the June economic figures were what the FOMC had in mind when

it made its decision to raise rates. I do not think any of us like the

figures we have seen. We can do better on all fronts. We did have

another jobs increase, but I still think we can do better. We need

to make sure those who want a job can find one.

I am also concerned with some of the recent corporate earnings

that have been reported, especially in the airlines industry. Delta

Airlines has been a major presence in Northern Kentucky and in

Kentucky in general. Their Northern Kentucky hub has been an

economic engine for all of Kentucky. It is a major reason why companies such as Toyota, Fidelity, Citigroup, to name a few, have

built facilities in Kentucky. Delta also has a great many employees

in my State, about 8,000 in the Northern Kentucky area. Delta’s

health is a very large concern to my State.

I do not know what the answer is, but I know other Members

of this Committee have similar concerns about airlines with major

operations in their States. I also think many are concerned about

the new housing starts figures that were released today. As you

know, the housing sector helped carry our economy during the last

recession. Obviously, at some point this would have to cool down,

just a little I hope, but it was a pretty dramatic drop both in May

and in June. That came as a surprise to me. I would like to hear

your take on this. Is this so-called housing bubble bursting? Is it

something we need to be concerned with, or was it inevitable that

the housing market would have to slow some?

I am concerned with how our economy is faring right now, especially with the June figures coming in. Energy prices were falling,

but they are back on the rise. The stock market is down and housing is down. It seems that our recovery had a definite hiccup in

June. I guess the $64,000 question, was it a hiccup or something

that we should be more concerned about?

Also, as I mentioned earlier, most of the economic talking heads

stated that the FOMC rate raise was built into the market. They

seem to have been proven wrong. They also stated that a second

rate increase was pretty much a done deal for August. I hope the

Fed is not on automatic pilot. I would like you to look closely at

the June figures, and I know you will, before a decision is made

in August. I do not want a hiccup to turn into the flu.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Carper.

COMMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. I have no prepared remarks, Mr. Chairman.

Chairman Greenspan, welcome. I look forward to hearing your

testimony.

4

Chairman SHELBY. Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman.

Thank you, Chairman Greenspan, for attending.

It does look like we are recovering jobs, but those jobs seem to

not have the same wages and earnings of previous jobs that were

lost, and that is a significant issue. We have had a chance to talk

about this before, but until we can really establish wage and earning growth among a broad sector of American workers, I do not

think we are going to see a robust economic recovery, and we are

going to continue to have families that are trying to make ends

meet by borrowing. And as interest rates go up—and you have already raised them and you might contemplate raising again—that

will put additional pressure on families. So there is perhaps some

encouraging news, but there is also a very different reality we have

to cope with, and I am looking forward to your testimony.

Thank you.

Chairman SHELBY. Senator Crapo.

COMMENTS OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman.

Chairman Greenspan, it is a pleasure to welcome you back here.

I am going to say at the outset my duty is to preside over the

floor in about 18 minutes, so I will not be here too far into your

testimony. In fact, I may miss your testimony. I am going to read

it very carefully, however, and I do share some of the questions

that you have already heard. The main question, of course, that we

want to see, is whether the expansion that we are now seeing is

capable of sustaining itself, what the numbers from June meant,

and how we can look forward now in terms of gauging the strength

of the expansion and what is going to happen with inflation. I do

appreciate your careful attention to the inflation in our economy.

I do want to pose one question for you to consider either during

your testimony or perhaps in follow up if it does not come up there.

That is, as you know, a divided SEC voted 3 to 2 last Wednesday

to seek comments on a proposal for mandatory registration of

hedge funds advisers with the SEC. My question is whether you

are concerned with this SEC proposal for mandatory registration of

hedge fund advisers with the SEC, and whether you think it would

be advisable for the President’s Working Group on Financial Markets to become involved in issues relating to the regulation of the

hedge fund industry.

With that, again, I welcome you here, and I look forward to your

testimony.

Chairman SHELBY. Senator Bayh.

COMMENT OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Mr. Chairman. I look forward to hearing from Chairman Greenspan, and I will reserve other comments

until the question period.

Chairman SHELBY. Senator Sununu.

5

COMMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. I have no opening statement. Welcome, Mr.

Chairman.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Mr. Chairman, thank you very much. I am

pleased to welcome Chairman Greenspan back before our Committee to testify on the Federal Reserve’s Semi-Annual Monetary

Policy Report to Congress.

This was a requirement put into law by this Committee with actually the support of the Fed, and I think it has worked very well

over the years.

As we all know, of course, at the last meeting of the Federal

Open Market Committee, they decided to raise the target for the

Federal funds rate by 25 basis points to 11⁄4 percent, the first

change in interest rates by the Fed in about a year’s time.

In a statement released after the meeting—and I want to commend Chairman Greenspan and his colleagues for this shift in

practice, whereby after the FOMC makes decisions, they seek to

explain them, however briefly, to the public. The FOMC said they

‘‘perceive the upside and downside risks to the attainment of both

sustainable growth and price stability for the next few quarters are

roughly equal. With underlying inflation still expected to be relatively low, the Committee 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.’’

The final sentence of that paragraph has generally been read to

suggest that the FOMC will take a more aggressive stance toward

monetary policy if economic conditions warrant. But, I would just

like to note, in light of the recent economic indicators that have

been released, that the sentence could also be read to suggest that

the FOMC may tilt in the other direction if, in fact, it is necessary.

While the outlook for economic growth remains positive, most

forecasts are being revised downward. GDP growth for the first

quarter of the year was revised downward to 3.9 percent. Last

week, the Commerce Department reported an unexpectedly large

decline in retail sales for June of 1.1 percent. The Fed reported a

0.3 percent decline in industrial production. And just this morning,

the Commerce Department reported that housing construction fell

81⁄2 percent in June, the sharpest drop since February 2003.

While these are all just monthly numbers, they raise questions

about the strength of the economic outlook. That is particularly

true when taken together with a continuing weakness in the labor

market.

Job growth in May declined from the 300,000 figure of March

and April to 250,000, and in June was cut in half to 112,000. As

a result of the prolonged labor market weakness, the economy remains 1.2 million jobs below the level when the recession began 39

months ago. Compared to the average economic recovery of the

post-war era, today’s economy is nearly 6 million jobs short.

Further, in June, 1.7 million of the unemployed, 21.6 percent of

the total, had been unemployed an average duration of 20 weeks.

6

The long-term unemployed have made up over 20 percent of the

unemployed for the past 21 months, surpassing the record set from

1982 to 1984.

As The New York Times reported on Sunday, the slack labor

market is resulting in the failure of hourly pay in the United

States to keep pace with inflation. The article points out that the

Bureau of Labor Statistics reported last Friday, that hourly earnings of production workers fell 1.1 percent over the past 12 months,

after accounting for inflation. The decline is the steepest since the

recession of 1991.

And only this morning, The Wall Street Journal had an article

entitled, ‘‘So Far, Economic Recovery Tilts to Highest-Income

Americans,’’ and goes on to note that, ‘‘The recovery’s primary

beneficiaries have been upper-income households.’’

Finally, Mr. Chairman, in closing I simply want to take note that

Virgil Mattingly, who had served as General Counsel for the Federal Reserve Board and the Federal Open Market Committee for

the past 15 years, and who served a total of 30 years at the Federal

Reserve, just retired on June 30.

Virgil Mattingly worked closely with the Members and staff of

this Committee on every major piece of banking legislation enacted

over the past 20 years. He always provided not only exceptionally

intelligent and competent technical assistance to the work of this

Committee, but also wise counsel and wise advice. He was, in my

view, an extraordinarily able and dedicated public servant, and

upheld, and indeed in some measure helped to define, the tradition

at the Federal Reserve of an outstanding career of service. He

made very significant contributions to our Nation and to the formulation of public policy. I simply wanted to take this opportunity to

wish him well in his retirement, and to express appreciation for the

fine work he did over the years.

I also want to take this opportunity to congratulate Scott Alvarez, who has been Associate General Counsel for the Federal Reserve, and has been appointed to succeed Virgil Mattingly as the

Fed’s General Counsel. Scott Alvarez is also well known and highly

regarded by the Members and staff of this Committee, and we look

forward to continuing to work closely with him in his new capacity.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Hagel.

COMMENT OF SENATOR CHUCK HAGEL

Senator HAGEL. I have no statement, Mr. Chairman.

Chairman SHELBY. Senator Dodd.

COMMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Mr. Chairman, I will wait, and I will just ask

unanimous consent that my statement be included in the record.

Chairman SHELBY. Without objection, so ordered.

Chairman SHELBY. Senator Allard.

COMMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, I would like to thank you for

holding this hearing, and I always look forward to hearing from the

Chairman, and I will submit my full statement to the record.

7

Chairman SHELBY. Without objection, it will be made part of the

record.

Chairman SHELBY. Senator Schumer.

COMMENTS OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. I would ask that

my full statement be submitted to the record.

Chairman SHELBY. Without objection, so ordered.

Senator SCHUMER. The only observation I would make is there

are two wings to our economic policy here. There is fiscal policy

and monetary policy. The thing you are here to report on and the

thing you are in charge of, monetary policy, I think you are doing

a superb job. I think the quarter-inch steps that you have made is

just about perfect for our situation. But I do worry about our fiscal

policy, and sometimes, as you well know, much of the time, lower

interest rates are better for the economy than lower taxes, and that

will be the line of my questions.

Chairman SHELBY. Thank you, Senator Schumer.

Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. I will submit a statement for the record.

Chairman SHELBY. Without objection, your opening statement

will be made part of the record.

Chairman Greenspan, if you will abide us a few minutes, we

have established a quorum and would like to move the Committee

to Executive Session and ask for a vote on our nomination for the

Department of the Treasury and the Department of Housing and

Urban Development.

Chairman Greenspan, you proceed as you wish. Thank you.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Mr. Chairman, if I may before I start, I

would like to thank the Senator for his very thoughtful remarks

with respect to Virgil Mattingly’s tenure at the Federal Reserve.

We will miss him, and we certainly concur in how you evaluated

his service and his contributions, I must say, to this Committee,

and assisting in innumerable pieces of legislation, for which, for

some reason or other, he always had the right balanced insight.

We know Scott Alvarez, who worked closely with him over the

years, will not become a Virgil clone, but we would not mind if he

did.

Mr. Chairman, with respect to Federal Reserve’s Monetary Policy

Report to the Congress, I cannot remember how many times I have

been here, but it is always a fascinating experience because it gives

us a chance, in this requirement, to review every 6 months what

is going on in the economy and our interfacing with it. As Senator

Sarbanes said, it has probably been a major element in our generalized communications policy, and I know that we always look forward to meeting with this Committee.

Economic developments in the United States have generally been

quite favorable in 2004, lending increasing support to the view that

the expansion is self-sustaining. Not only has economic activity

8

quickened, but the expansion also has become more broad-based

and has produced notable gains in employment. The evident

strengthening in demand that underlies this improved performance

doubtless has been a factor contributing to the rise in inflation this

year. But inflation also seems to have been boosted by transitory

factors such as the surge in energy prices. Those higher prices, by

eroding households’ disposable income, have accounted for at least

some of the observed softness in consumer spending of late, a softness which should prove short-lived.

When I testified before this Committee in February, many of the

signs of the step-up in economic activity were already evident. Capital spending had increased markedly in the second half of last

year, no doubt spurred by significantly improving profits, a low cost

of capital, and the investment tax incentives enacted in 2002 and

enhanced in 2003. The renewed strength in capital spending

carried over into the first half of 2004. Orders and shipments of

nondefense capital goods have been on the rise, and backlogs of unfilled orders for new equipment continue to build.

A key element of the expansion that was still lacking in February, however, was evidence that businesses were willing to ramp

up hiring to meet the stepped-up pace of sales and production.

Businesses’ ability to boost output without adding appreciably to

their workforces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment,

which was an apparent outgrowth of the capital goods boom of the

1990’s. Indeed, over much of the previous 3 years, managers had

seemed to pursue every avenue to avoid new hiring despite rising

business sales. Their hesitancy to assume risks and expand employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the

decline in stock prices and also, of course, by the environment of

heightened geopolitical tensions. Even now, following the pattern of

recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cashflow. The protracted

nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total

employment continues to rise, underscoring that business caution

remains a feature of the economic landscape.

That said, there have been much clearer indications over recent

months that conditions in the labor market are improving. Most

notably, gains in private nonfarm payroll employment have averaged about 200,000 per month over the past 6 months, up sharply

from the pace of roughly 60,000 per month registered over the

fourth quarter of 2003.

The improvements in labor market conditions will doubtless have

important follow-on effects for household spending. Expanding

employment should provide a lift to personal disposable income,

adding to the cuts in personal income taxes over the past year. In

addition, the low interest rates of recent years have allowed many

households to lower the burdens of their financial obligations. Although mortgage rates are up from recent lows, they remain quite

attractive from a longer-term perspective and are providing solid

support to home sales. Despite the softness of recent retail sales,

the combination of higher current and anticipated future income,

9

strengthened balance sheets, and still-low interest rates, bodes well

for consumer spending.

Consumer prices excluding food and energy, so-called core prices,

have been rising more rapidly this year than in 2003. For example,

the 12-month change in the core personal consumption expenditures price index stood at 0.8 percent in December of last year and

climbed to 1.6 percent by May of this year. Core inflation, of

course, has been elevated by the indirect effects of higher energy

prices on business costs and by increases in non-oil import prices

that reflect past dollar depreciation and the surge in global prices

for primary commodities. But the acceleration of core prices has

been augmented by a marked rise in profit margins, even excluding

domestic energy companies.

This surge in profits reflects, at least in part, the recent recovery

of demand after a couple of years during which weak demand led

to relatively heavy price discounting by businesses. Profits of nonfinancial corporations, as a share of sector output, after falling to

7 percent in the third quarter of 2001, rebounded to 12 percent in

the first quarter of 2004, a pace of advance not experienced since

1983. Half of this rise in profit share occurred between the first

quarter of 2003 and the first quarter of 2004, a period during

which costs were unusually subdued. In fact, consolidated unit

costs of business for the nonfinancial corporate business sector actually declined during this period. The increase in output per hour

in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline in unit costs. The remainder was due to the effects of rising output in reducing

nonlabor fixed costs per unit of output. Hence, at least from an accounting perspective, between the first quarter of 2003 and the

first quarter of 2004, all of the 1.1 percent increase in prices of

final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than rising

cost pressures.

However, businesses are limited in the degree to which they can

raise margins by raising prices. An increase in margins should affect mainly the level of prices associated with any given level of

unit costs but, by itself, should not prompt a sustained pickup in

the rate of inflation going forward. In a market economy, any tendency for profit margins to continue to rise is countered largely by

the entry of new competitors willing to undercut prices and by increased labor costs as more firms attempt to exploit the opportunity for outsized profits by expanding employment and output.

That increase in competitive pressure, as history has amply demonstrated, with time, returns markups to more normal levels.

The profit share in the first quarter of this year, at about 12 percent, was well above normal. The gap suggested that the growth

of unit profits would eventually slow relative to increased unit

costs. This outlook had accorded with analysts’ expectations for

earnings growth over the next year, which are substantially below

the realized profit growth of profit in recent quarters.

Indeed, some leveling or downward pressure on profit margins

may already be in train, owing to a pickup in unit labor costs. And,

although advances in productivity are continuing at a rate above

the long-term average, they have slowed from the extraordinary

10

pace of last summer and are now running below increases in hourly compensation. The available information suggests that hourly

compensation has been increasing at an annual rate of about 41⁄2

percent in the first half of the year. To be sure, the increases in

average hourly earnings of nonsupervisory workers have been subdued in recent months and barely budged in June. But other compensation has accelerated this year, reflecting continued sizable

increases in health insurance costs, a sharp increase in business

contributions to pension funds, and an apparently more robust rate

of growth of hourly earnings of supervisory workers. The larger

wage gains for supervisory workers together with anecdotal reports

of growing skill shortages are consistent with earlier evidence of

rising wage premiums for skilled workers relative to less-skilled

workers.

For the moment, the modest upward path of unit labor costs does

not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more

intense competitive pressures at home and from abroad. Although

some signs of protectionist sentiment have emerged, there is little

evidence that the price-containing forces of ever widening global

competition have ebbed. In addition, the economy is not yet operating at its productive capacity, which should help to contain cost

pressures. But we cannot be certain that this benign environment

will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation. Accordingly, in assessing the appropriateness of the stance of policy,

the Federal Reserve will pay close attention to incoming data, especially on costs and prices.

As always, considerable uncertainties remain about the pace of

the expansion and the path of inflation. Some of those uncertainties, especially ones associated with potential terrorism, both here

and abroad, are difficult to quantify. Such possibilities have threatened the balance of world supply and demand in oil markets in recent months, especially as demand has risen with the pace of world

economic growth. Yet aside from energy, markets exhibit little evidence of heightened perceptions of risk. Credit spreads remain low,

and market-based indicators of inflation expectations, after rising

earlier this year, have receded.

With growth of aggregate demand looking more sustainable and

with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly

unnecessary.

If economic developments are such that monetary policy neutrality can be restored at a measured pace, as the FOMC expects,

a relatively smooth adjustment of businesses and households to a

more typical level of interest rates seems likely. Even if economic

developments dictate that the stance of policy must be adjusted in

a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. Of course, considerably more uncertainty and hence

risk surrounds the behavior of an economy with a more rapid tightening of monetary policy than is the case when tightening is more

measured. In either scenario, individual instances of financial

strain cannot be ruled out.

11

The protracted period of low interest rates has facilitated a restructuring of household and business balance sheets. Businesses

have been able to fund longer-term debt at highly favorable interest rates, and by extending the maturity of their liabilities, have

rendered net earnings and capital values less exposed to destabilizing interest rate spikes. Households have made similar adjustments.

Financial intermediaries are profitable, well-capitalized, and appear to be well-positioned to manage in a rising rate environment.

In short, Mr. Chairman, financial markets along with households

and businesses seem to be reasonably well-prepared to cope with

a transition to a more neutral stance of monetary policy. Some

risks necessarily attend this transition, but they are outweighed, in

our judgment, by those that would be associated with maintaining

the existing degree of monetary policy accommodation in the current environment. Although many factors affect inflation in the

short-run, inflation in the long-run, it is important to remind ourselves, is a monetary phenomenon.

As we attempt to assess and manage these risks, we need, as always, to be prepared for the unexpected and to respond promptly

and flexibly as situations warrant. But although our actions need

to be flexible, our objectives are not. For 25 years, the Federal Reserve has worked to reestablish price stability on a sustained basis.

An environment of price stability allows households and businesses

to make decisions that best promote the longer-term growth of our

economy and with it our Nation’s continuing prosperity.

Thank you very much, Mr. Chairman. I have excerpted from my

prepared remarks and request that they be included in the record

in full, and I look forward to your questions.

Chairman SHELBY. Without objection, it will be. Thank you, Mr.

Chairman.

Chairman Greenspan, your testimony, among other things, indicates that the economic expansion is self-sustaining, and that it

has become broad based with strengthened demand and employment gains. You also indicate that financial markets, along with

households and businesses, seem to be reasonably well prepared to

cope with a transition to a more neutral sense of monetary policy.

Can we interpret those comments as indicating that the Federal

Open Market Committee, FOMC, will be inclined to raise the Federal funds target by an additional 25 basis points in August, and

would this be a measured pace?

Chairman GREENSPAN. I think we have very purposely refrained

from defining what we mean by that term. Obviously, I try to raise

two general scenarios as to how we would ultimately restore the

Federal funds rate to neutrality, where we believe it will need to

go. One is measured, which I guess the dictionary says means

gradual; and the other is one which we do not perceive is the most

likely, but still we are prepared for if necessary, if the economy

shows signs of exhibiting significant inflationary pressures, in

order to maintain the mandate which the Congress has given us

to create price stability mainly for the purpose of maintaining and

fostering maximum, sustainable long-term growth. Because that is

our objective, we will do what is required to achieve that objective.

12

Chairman SHELBY. In February, the Fed’s forecast for growth

was between 4.5 and 5 percent for 2004. Today’s forecast gives a

range of 4.5 to 4.75 percent, or a slight reduction. It is close. At

the same time we have seen evidence of higher inflation in recent

months.

Others argue that the economy does not have as much excess capacity as utilization data would imply, with the implication there

that the inflation threat may be stronger in the Fed’s view.

What is your assessment, Mr. Chairman, of whether the economy

is in any danger of moving into a slowdown characterized by higher

inflation?

Chairman GREENSPAN. Mr. Chairman, this is always our concern. I should say most of us lived through the stagflation of the

1970’s, and it was a very, I would say, disconcerting experience.

Chairman SHELBY. A bad situation.

Chairman GREENSPAN. And the concern that we have, obviously,

in this context, is something that obviously occurred in that period,

namely a sharp rise in oil prices. Now, obviously, the levels of oil

prices in real terms are nowhere near today where they were back

then. But we will always be confronted with issues of trying to

maintain an economy in which low inflation exists in the context

of strong growth in the economy and in employment.

We try to calibrate our policies to achieve that end as best we

can. Sometimes the real world does not offer us the opportunities

that we would like, but we work as expeditiously as we can to calibrate policy to achieve those ends.

Chairman SHELBY. Chairman, how comfortable are you with the

data being gathered on production capacity, which seems to imply

that there is still room to absorb additional production without generating significant inflation? You alluded to that earlier.

Chairman GREENSPAN. Mr. Chairman, these data are collected

through surveys of plant managers who were asked at what level

in their judgment at a certain period of time their plant is operating. And what we do is essentially collect, reweigh, and process

those data and make a judgment as to what the facility’s capacity

and excess capacity is, recognizing that this is not necessarily the

same thing as saying, what is the capability of these plants, because there may be shortages of skilled workers or surpluses of

skilled workers, and obviously, capacity in any meaningful sense is

an integration of the physical facilities and a workforce capable of

effectively operating those facilities.

Chairman SHELBY. Chairman Greenspan, the House has been

considering a bill that effectively blocks FASB from requiring the

expensing of all employee stock options. Some of us here have

grave concerns about the Congress becoming involved in such technical accounting issues. What message would the Congress send by

intervening in FASB’s rulemaking process? What would the implications have for the current standard-setting process?

Chairman GREENSPAN. I would be most concerned if the Congress intervened. Accounting, remember, is for the purpose of trying to get records which tell companies whether their strategies for

success are succeeding or not. Accounting is difficult because a lot

of it requires forecasts. FASB endeavors to obtain all of the various

differing views on the way certain particular accounting procedures

13

should be implemented, and I think that they do a good job. It is

a tough job. And if the Congress dictates what they can do or

should do, I think it undercuts the ability of the business community to effectively measure what it is doing.

Chairman SHELBY. Thank you.

Senator Carper.

Senator CARPER. Thank you, Mr. Chairman.

Chairman Greenspan, this past weekend I flew out to Kentucky

to visit my mother. Senator Bunning, she lives over in Ashland,

Kentucky, real close to Huntington, West Virginia. While traveling

there and back to Delaware I had some down time because our

planes were delayed, and I had a chance to catch up on some of

my reading.

Among the things that I read about were the competitive disadvantage that a lot of our manufacturers face because of the rising, still-high cost of natural gas compared with natural gas costs

for a lot of our competitors around the world. I read about the competitive disadvantage that a number of our employers face in this

county—I will call them legacy costs—which relate to pension costs

for pensions that you are attempting to fund, and pension costs for

those that are already retired. I read about the health care cost

that we face in this country, double digit increases again in health

care costs for employees and for those who are retired. And I read

about the disadvantages that we face with respect to legal costs.

We tried mightily earlier this month to pass class action reform

legislation in the Senate, have not yet been successful, although I

certainly hope we are not giving up. And another is with respect

to costs growing out of asbestos, and the question whether or not

we are going to be able to come to grips with a more rational approach for compensating those who have been damaged by exposure to asbestos.

I am going to ask you to maybe address a couple of those. First

of all, if you will, just maybe a minute or two with respect to natural gas prices. I did not fully appreciate earlier how much higher

our natural gas prices are to those in other parts of the world and

how regionalized the prices are and what that means to us. If you

could just dwell on that a little bit. As you know, we are supposed

to be in conference with the House on a FISC ETI bill, so-called

the Jobs Bill or Tax Bill. There are provisions in that legislation

for energy conservation and production. Just a thought, if you will,

to start off on natural gas prices and what these are doing to our

competitiveness.

Chairman GREENSPAN. Senator, I think you are raising a very

critical issue which I have addressed before this Committee in the

past, and regrettably, things have not changed or improved much.

Our basic problem is that natural gas is essentially unlike crude

oil or all of the oil products, where because we have a significant

world trade, when we run into shortages here as we do, and indeed

we are always short in the sense we are importing a very significant amount of our oil in this country, we have the capability from

almost any part of the world to draw in additional supplies of crude

oil and petroleum products. As a consequence, our prices tend to

be, at least domestically, fairly close to those amongst our competitors around the world.

14

That is not true, as you point out, with natural gas. The basic

reason is that as our demand for natural gas in this country has

increased year-by-year in part because it is obviously the preferred

fuel in so many applications, we have begun to run out of the ability to supply that from domestic sources or from Canada, which has

historically supplied us with about a sixth of our needs. Because

trade in natural gas is about half the size, relative to total consumption worldwide that oil is, we have very considerable difficulty

importing. One of the reasons is that while we do import from Canada, we can no longer expand Canadian imports. What we have to

do is very markedly increase our supplies of liquified natural gas,

which means what we have to do is get gas which is put in

liquified form for transport in a cryogenic state, and bring it in to

terminals in the United States. Our terminal capacity is not at this

stage large enough to fill our import needs, and I trust we will be

moving fairly rapidly to increase our capacity to bring in foreign

gas, but until that occurs, I am fearful, as I suspect you are from

the remarks you were making, that we are going to erode our competitive advantage where natural gas is a key input into the production process.

And I trust we can expedite our ability to raise our import capa- bilities and bring gas prices, which now are close to $6 per million

BTU, well above the world competitive level, back to levels which

enable our companies to be far more competitive.

Senator CARPER. Mr. Chairman, I mentioned earlier that we

have been unsuccessful, at least this month, in passing class action

reform legislation. Later today or maybe tomorrow Senator Frist is

expected to meet with Senator Daschle and make a counter-proposal, if you will, to the offer Senator Daschle made maybe 4 weeks

ago on asbestos litigation reform. We have about 70 to 75 companies that have gone bankrupt in this country. A number of others

are threatened at this point in time. Could you take a minute and

share with us your views of the importance of our trying to reach

an accommodation in this area?

Chairman GREENSPAN. I am not someone who has looked at the

details of the legislation, or in fact, the depth of the problem. In

my early years, asbestos was something that was considered an exceptionally valuable product and——

Senator CARPER. Times have changed.

Chairman GREENSPAN. Times have definitely changed. And I

cannot add terribly much to this, but hope that the obvious business uncertainty which the lack of a resolution of this question is

creating can be expeditiously resolved.

Senator CARPER. Thank you, sir.

Chairman SHELBY. Senator Dole.

Senator DOLE. Mr. Chairman, I am concerned about how movement in the Chinese economy could affect us, and I would like to

ask you about this. The Chinese, of course, have a very weak banking sector. Half of their loans are bad. There are signs of a growing

bubble in their commercial real estate sector, a growing U.S. currency reserve at $415 billion as of January.

Chairman Greenspan, while the Chinese economy is small compared to ours, how concerned are you about these and other potential problems in the Chinese economy? Recently, China appeared to

15

have realized that their growth is not sustainable, and have taken

steps to slow down their rapid growth. One of the areas where they

have pulled back is with steel production. Recently, I have been

contacted by our transit authorities, both in Charlotte and Raleigh,

North Carolina, because they are going to be starting soon on construction, and they have expressed deep concern on how this rise

in steel prices is presenting real problems to their cost projections.

I have to imagine that commercial real estate and other industries

will be impacted and will suffer because of these cost increases.

Could these steps by the Chinese Government to slow down their

economy potentially trigger inflation in the United States with continued globalization? Can China, in combination with other countries with high growth, export inflation to the United States, and

if so, do we have any monetary tools to combat such a problem?

Chairman GREENSPAN. Senator, the Chinese economy is slowing

down, and it is a deliberate effort on the part of what is a partial,

centrally planned economy with an ever-growing market segment,

and it is a very tricky policy that they have to implement to get

it right.

The rate of increase in investment has gone down very materially on a year over year basis, and clearly through the second quarter, where their quarter-by-quarter rate of growth really slowed

virtually to a halt, they exhibited considerable removal of very

major elements of growth. However, they do not seem to be sinking

much further. In fact, their exports look, frankly, a little bit better

in June, and overall, it is very likely that, largely because of the

nature of the central planning, they will try to calibrate it in a way

which improves the outlook. But their economy, as you point out,

is still relatively small in the areas which impact directly on us.

I find it most unlikely that their contraction of steel product, as

large a producer as they are, will induce any significant rise in

steel prices.

There has been, as you know, some significant decline in steel

prices in the United States, but judging from the scrap prices in

recent weeks, it has come back a bit in part because the demand

is still reasonably strong. I do not believe that the Chinese can export inflation to us. It is extremely difficult to do that, and they are

not the type of economy which so interfaces with us that would create such a problem.

It is important that they move as quickly as they can to a market economy, and I think that they are trying to move in that direction. But until they have succeeded, they will still have the types

of problems that you suggest.

Senator DOLE. The Bureau of Labor Statistics reported that in

June that the U.S. economy created about 112,000 new jobs nationwide. I have been amazed that some have stated that since this

number was less than half of that projected for new jobs, that

somehow this is an indication that our economy is headed back into

recession again.

For the record, how do you view these lower-than-expected job

figures?

Chairman GREENSPAN. Senator, we have approximately 130 million people on payrolls in this country, and I am surprised that we

16

can estimate the change from month to month as accurately as we

do. The range is really quite large.

I know a number of people looked at those data and took it as

some indication that there is some significant weakness developing.

If that were the case, I think we would have seen it in a marked

pickup in initial claims for unemployment insurance, which of

course we have not, and all of the other qualitative indicators we

have currently in the third quarter suggest that employment is

continuing to expand. And indeed, while there has been weakness

in June, and a number of your colleagues mentioned this, I might

say that July seems to be somewhat better, even though we are

going through a soft patch.

Motor vehicle sales, which for example, were an important part

of the weakness in the June retail sales data, as least so far as the

first 10 days were concerned, shows a very significant snap-back

largely because discounts have been expanded again. Our anecdotal

data on new orders arriving during the month of July showed that

the system is holding up. There is no real underlying evidence of

any cumulative weakness here.

It is nonetheless the case that the little bulge in inflationary

pressure seems to have created a soft patch here, and it is something obviously we are watching very closely.

Senator DOLE. Just one final question. Recently, some have suggested that most of the new jobs being created in the last year are

paying an average $1,500 to $9,000 less than those jobs lost over

the past few years. Obviously, often an unemployed person that

finds a new job, they may be at a lower salary for a short time.

But does your analysis show that the current jobs being created are

basically lower-wage jobs with little or no benefits?

Chairman GREENSPAN. The answer is no. But let me say that

there are several different statistics that I think are important.

The one that you cite is an important fact, namely, that people who

do lose their jobs tend to have difficulty restoring the level of their

original wage for quite a while. And that is part of the process

which goes on in the very significant churning in the labor market.

We have looked at this question in the broader sense of are we

essentially downgrading the types of jobs that are being created,

say, over the past year, and the answer is we find very little evidence of that.

There are essentially two ways to interpret how one should

evaluate this. One, is to look at the question as to whether the

growth in jobs is disproportionately in industries where the average wage rate is higher than average for the economy as a whole.

There seems to be a slight indication of a decline in that regard,

meaning more workers going into industries with slightly below nationwide average earnings.

And two, when we look at it in the context of occupation, where

clearly one gets a sense of what is happening to particular types

of job slots, the answer is exactly in the opposite direction.

Now, these are not contradictory. In other words, you can have

an increasing spread within industries where there is a greater

skill dispersion while still having the average of the industry go

down. But the bottom line in all of this is these data are so marginal that the conclusion that there is anything going on other than

17

just average expectation of changes in jobs does not seem, in our

judgment, to be supported by the underlying data which is broadly

available.

Senator DOLE. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

Actually, Senator Dole touched on a couple of issues I wanted to

address. One is the current account deficit, which is now at about

5.5 percent of GDP, the highest level, as I understand it, in U.S.

economic history, at least according to Pete Peterson, who said in

an article in The Washington Post on Sunday, ‘‘This deficit requires us Americans to borrow about $2 billion from foreigners every

working day. No expert I know believes that this is sustainable.’’

And, Chairman Greenspan, if I recall correctly, you have stated before this Committee in the past that a current account deficit of

this magnitude is not sustainable, as I recall.

Chairman GREENSPAN. That is correct, Senator.

Senator SARBANES. Now, I am concerned not only about the deficit but that the source of the foreign borrowing has shifted. In its

February report, the Fed found, ‘‘The financing counterpart to the

current account deficit experienced a sizable shift in 2003 as net

private inflows fell while foreign official inflows increased. Foreign

official purchases of U.S. assets surged to record levels in 2003,

with the accumulation of dollar reserves particular high in China

and Japan.’’

I have a chart here that I want to show this surge and which

I think highlights that our dependence on foreign capital has increasingly been supplied by foreign governments, specifically, according to the Fed, China and Japan. And this is the foreign official

assets in the United States. This is 1976. This is 1993. And then

we see the steady pace—and then it is almost going up at a perpendicular rate now.

I find this troubling. I guess I find any chart that all of a sudden

seems to leap out in some different direction from what we have

generally been experiencing a matter of concern. What is happening here and what are its implications? Are China and Japan

doing this to manipulate the currency in order to gain a trade advantage and help their export position? And what are the potential

consequences for us in this scenario, particularly assuming it might

continue?

Chairman GREENSPAN. Well, let me answer the second part of

your question first. We have obviously been monitoring these flows

very closely for precisely the reasons that you indicate. It is turning

out that the impact on the international markets on the value of

the dollar and, hence, on the value of the United States’ internal

economic system from these shifts between foreign private funding

of our current account deficit to last year’s very significant public

funding, it is turning out that in 2004 we are beginning to see a

reversal of that without any serious consequences, meaning that

the shift between foreign public financing of the deficit and private

financing is not a significantly large issue. The Japanese, for example, stopped intervening to accumulate American dollars in March

of this year, after very heavy purchases earlier this year, and the

Chinese purchases have flattened out. We see very little evidence

18

that the shift of that official financing to private financing is impacting on the economy in general.

Nonetheless, there is no question that, as I am sure you are

aware, almost half of Federal marketable debt outstanding that we

issue, is held abroad. And these trends are significant, and they do

raise serious questions. But so far, the flexibility of our international financial system has been such that we have had very little problem in financing these very large deficits.

Now, as I have testified before this Committee on innumerable

occasions, this cannot go on indefinitely because at some point we

are going to reach a status where our net debt to foreigners—currently a little under a fourth of GDP—will get exceptionally large,

and the holding of dollar assets as reserves for both the private and

public sectors abroad will become abnormally large relative to their

needs and they will stop purchasing dollars. That will have an obvious significant impact on us when it occurs.

I do not know when that date is. I know at some point in the

future something of that nature has to occur, unless there are

shifts in the world economy such that our trade deficit and, therefore, our current account deficit falls measurably. If that does not

happen, then we are going to see a clear indication on the part of

foreign investors in the United States to start to hold back and diversify, even if the rates of return here remain high. Since we are

at unprecedented levels—and it could conceivably be higher, as I

indicated in a speech earlier this year—at some point it has to

shift.

Senator SARBANES. I want to touch on one other subject that

Senator Dole raised, and that is the weakness of the labor market.

The participation rate between the first quarter of 2001 and the

second quarter of 2004 dropped to such an extent that actually we

would have 2.5 percent more people in the labor force today if the

participation rate was what it was just 3 years ago.

In June, 21.6 percent of the total of unemployed have been unemployed over 20 weeks. This is quite a change, as we can see

here, in terms of having crossed above the 20-percent line and staying up there, which actually now it has been there for 21 months.

It surpassed the record set from 1982 to 1984.

Finally, the job growth, although we have had some job growth

in recent months, we still remain below where we were in the level

of jobs 39 months ago when the recession began. In every economic

recovery since the Depression, the economy has recaptured all of

the jobs it lost well within the 39 months. So this is the longest

job loss recovery. And, in fact, there is a very marked contrast between the current recovery and the average of post-war recessions.

If we just match the average, we would have about 6 million more

jobs currently.

Now, looking at all of this, and, of course, you know, we are getting a lot of comment in the newspapers and in the magazines

about this very difficult problem, it seems to me we have not been

able to bring jobs back online in a way that gives us encouragement in terms of putting people back to work. We still have this

job gap, this slack in the labor market. How do we explain it? I

mean, it is a very marked contrast——

Chairman GREENSPAN. It is.

19

Senator SARBANES. —where we are today with previous recoveries.

Chairman GREENSPAN. Senator, I think there are two basic

forces at play here. The first is that productivity growth over this

period has been extraordinarily large, far in excess of the rate of

increase in output per hour that was experienced during other periods that you draw on the average of your chart. And so as production picked up, we were not hiring, basically for reasons which I

indicate in my prepared remarks, and that has continued, not to

the extent that it existed last year, but productivity is still running

above the averages of a goodly part of the period which you have

on your chart.

Second, we have had an exceptionally shallow recession—in fact,

the shallowest recession in the post-World War II period—so that

the normal rebound that we experienced in a lot of the recoveries

which are part of the average that you show on your chart was not

possible.

If, as I suspect is the case, the growth rate of productivity will

slow down from the extraordinary levels of last year, growth will

continue in payrolls, and at a fairly significant pace. I do not know

that I can pinpoint the actual number. It will depend crucially on

every tenth of a percent in the productivity numbers and obviously

in the GDP. But it does not look as though the growth in employment is stalling, though there is no question that it is moving up

at a pace far less rapid than you point out has been our history.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman Greenspan, how concerned should we be about the

June housing figures, 8.4-percent reduction following a 3.5-percent

reduction in May?

Chairman GREENSPAN. Senator, the figures for June came out

below where we would have expected them to be, but not appreciably. The reason essentially is that as mortgage rates began to

move up several months ago, we began to see a significant pick-up

in housing sales, people endeavoring to get in under the wire, so

to speak. The result was clearly a borrowing of housing starts from

the future. And that I think is part of the June experience.

If that is the case, then we would expect some short-term recovery from the June decline, and, indeed, that is suggested in the detail that we get along with housing starts, which tries to measure

the permit data that go along with the starts data, coupled with

backlogs of unused permits. And those data indicate that a significant part of the drop, almost half, is not reflected in the decline in

so-called adjusted permits, meaning for single-family dwellings it

would be permits of single-family dwellings plus the number of

starts in nonpermitted issuing areas. Those numbers are down

roughly half what the actual starts figure is.

So the number is weak, there is no question about that, and definitely below where our expectations are. But we do not believe it

is a cause for concern. Our general forecast, as it has been for quite

a while, is that housing starts which have come up at an extraordinary pace in recent years are very likely to shade lower over the

next couple of years. It is hard to maintain the pace that we are

maintaining, but we do not expect that the fall-off will be abrupt

20

or significant. And as a consequence of that, we do not perceive the

June figure to be a harbinger of worse to come.

Senator BUNNING. Does the June producer price index drop make

you feel better about inflation or not?

Chairman GREENSPAN. Obviously somewhat better, but still, a

number of the prices that are built into that index were rising recently at a somewhat faster pace than we expect in the context of

maintaining long-term price stability. But it is the case that the

modest slowdown in the inflation rate was welcome.

Senator BUNNING. Let me ask you, you talked productivity and

how important it was for the job market and other things. What

is the Fed’s view as far as additional productivity gains as we look

down through the third and fourth quarter of this year? Do you see

an average gain of productivity? Or where are we?

Chairman GREENSPAN. It is one of the most difficult statistics to

forecast, Senator. We can forecast aggregative demand reasonably

well, plus or minus a half a percentage point annual rate, most of

the time. We know that when we have profit margins at the levels

they are now, there are very significant incentives on the part of

business to expand their workforces and in the process be less focused on cost reduction, which is the major component of productivity growth.

So it is difficult for us to make judgments as to the path of productivity or exactly how the increase in the GDP will be distributed

between that produced by increased employment and that produced

by increased productivity. Our general judgment is that it is probably going to be average, but the truth of the matter is we have

very little experience in dealing with productivity numbers as high

as they have been, and our forecasting success in the last year or

two in trying to judge where these numbers were likely to go has

been one of our poorer set of projections.

Senator BUNNING. The last question, and this has to do with energy costs, the cost of crude oil, the cost of natural gas, and everything. How much more cost increase can this economy stand before

it becomes a very significant factor in the overall well-being of the

economy?

Chairman GREENSPAN. Senator, that is one of the most important questions that we focus on. It depends in part on what these

oil prices or gas prices are going to rise from here. Their impact

on the economy will depend on how fast they are moving, because

what our data show, especially for oil, is that over the longer run,

say a series of years, the elasticity of demand for oil with respect

to price is pretty high. In other words, if prices stay high, after several years we will shift the structure of our economy to less oil-intensive structures. The nature of our light motor vehicle stock, for

example, will shift significantly to types of cars and trucks which

consume far less motor gasoline. And the same will hold true in

lots of other areas of the economy.

If, however, prices spike in the short run, where those adjustments are not possible, then history tells us it has significant impacts. And, indeed, that is what happened to us in the latter part

of the 1970’s. So it depends very critically, if we are to run into a

problem, whether it is a gradual change in price or whether it is

a short-term change. But as I indicated earlier, even though we are

21

approaching record nominal prices of crude oil in the world, we obviously are well below where we were, for example, in 1979 in real

terms.

Senator BUNNING. Thank you.

Chairman SHELBY. Senator Reed.

Senator REED. Thank you, Mr. Chairman.

Chairman Greenspan, one of the issues we have talked about on

several occasions is this lack of growth in wages and earnings for

workers, and that is a critical issue. Increases are necessary to

meet increased obligations of housing, education, health care, but

also there is a distributional effect which you have pointed out,

where higher-skilled workers seem to do okay and lower-skilled

workers seem to be falling behind, creating social tensions.

Senator REED. Looking at the numbers I have, over the last year

average hourly earnings decline 1.1 percent in real terms. Average

weekly earnings declined 1.4 percent. This is in a situation where

the economy is recovering. We are seeing GDP growth and, as you

point out, where productivity has been growing significantly, allowing, one presumes, increases of wages.

Can you explain the apparent contradiction between these falling

wages and increased productivity and expansion?

Chairman GREENSPAN. Senator, I believe—I think it was the last

time I was here—we had a fairly extensive discussion in the question-and-answer period on the issue of education. I believe you

were participating in that.

Senator REED. That is right, and can I say, I think this is a

slightly different question, because we are not talking about people

entering the workforce with different skills. We are talking about

apparently workers that are already employed within a year. I

would think that factor would not be the most critical.

Chairman GREENSPAN. In a way it is, and the reason I say that

is that, as I tried to define the problem back then, what has been

happening to our labor force is that we have not been able to keep

up the average skill level in our workforce to match the required

increases of increasing technology. And what that has meant has

been that rather than getting an ever increasing number of college

graduates at a far faster rate than we have been getting them and,

hence, higher skills, to create a surplus or at least a significantly

large supply of skilled workers relative to the demand in order to

keep skilled wages down and because you move up people from the

lesser skilled areas to the skilled, you lower the number of surplus

workers in those markets for lesser skilled and, hence, remove the

downside pressure on wages.

In other words, this is an issue which has been regrettably going

on for 15 years, or thereabouts, creating an ever increasing opening

up of the skilled versus lesser-skilled gap. And as you point out,

if you put the wage changes in nominal terms, for the lesser-skilled

they have been growing in many parts of the last 15 years at less

than the increase in the Consumer Price Index. That is, of course,

not true for wages and salaries as a whole. Indeed, the ratio of average hourly earnings for supervisory workers that one can infer

from the data systems that we have, have been rising relative to

average hourly earnings, which you cite, for quite a considerable

period of time, and they account for 40 percent of the aggregate

22

wage and salary totals. So we are getting a problem here which I

think has got to be addressed, and as I had indicated last month,

I think the effective increase in the concentration of incomes here,

which is implicit in this, is not desirable in a democratic society.

Senator REED. We have several problems. One problem is training and retraining individuals and, you know, if you are starting

off with high school or elementary children, you maybe can have

an effect. That is 5 or 10 years out. The situation is: What do we

do in this year, next year, and the following years to raise the

wages of people whose skills cannot be——

Chairman GREENSPAN. I think the way you raise those wages is

you remove the large number of younger people whose skills should

be upgraded significantly from being an overhang on the job markets in which we have got, from as best I can see, an excess of supply over demand, and that has got to be changed.

Senator REED. I do not see a ready policy there, but I see a concept.

Chairman GREENSPAN. Whether you have a policy or not, I think

it is right to get the analysis right. Because if we do not understand what is causing this, our policies are not going to address

what is a significant problem.

Senator REED. What specific policies should we adopt today?

Chairman GREENSPAN. Well, I mean, if we can move——

Senator REED. Because that helps us understand.

Chairman GREENSPAN. First of all, we know that from the fourth

grade to the twelth grade, our children somehow are falling behind

international standards.

Senator REED. Mr. Chairman, I accept that, but policies that are

applied to people currently in the workforce today, adults who are

working hard, they are seeing corporate profits go up dramatically.

They are getting very little share of those corporate profits as the

data indicates.

Chairman GREENSPAN. I think what you are going to find is that

that share will now start to increase.

Senator REED. Now, one of the places that this share increases

is labor costs, because employers will spend more for health care

and for other benefits, which workers appreciate. That still does

not increase the take-home.

Chairman GREENSPAN. I agree with that, and what I am saying

is that, as I indicated I think the last time I was here, virtually

all of the increase in productivity during the year starting in the

first quarter of 2003 shows up not as real wages, but as increased

profitability. That stopped some time in the last several months,

and what history tells us is that the shift now goes in the other

direction, and you get, with a delayed effect, the increased productivity showing up as real wages overall, and I would think that

while certainly supervisory workers are going to contribute or

share significantly, it will also be true of the 80 percent of payrolls

which are nonsupervisory workers as well.

Senator REED. My time has expired. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

Senator ALLARD. Thank you, Mr. Chairman. I want to pose a

housing question to Chairman Greenspan.

23

Low mortgage rates I think for the last year have probably contributed substantially to increased sales of existing residences,

helping to boost the national homeownership rate to the highest

level ever. Could you please discuss your views on what lies in

store for housing, particularly in terms of other factors such as consumer confidence, unemployment rates, as well as wage rate? And

what trends do you see for the homeownership rate?

Chairman GREENSPAN. Senator, as you know, the homeownership rate in the United States has risen quite materially in the last

decade. We went from about 64 percent to probably around 69 percent now. We are seeing that household growth is holding up reasonably, and indeed a significant part of that is actually the result

of immigration. And with household growth holding up, and the inclination of renters to move into an owner-occupied status, we still

seem to be getting a fairly pronounced growth in homeownership,

and indeed the broad policies and effectiveness of our mortgage

markets are clearly working in that direction.

To the extent, obviously, that homeownership becomes a critical

continuing factor, it creates big demand for single-family dwellings,

and that is the reason why we have had approximately a million

and a half plus single-family dwellings annually for a number of

years as homeownership has moved forward.

Now, obviously, as we get into ever higher numbers, there is

some amount of desire to be a renter, not an owner. So at some

point we will slow down, but I see no evidence at this stage that

slowdown is occurring, and as a consequence I think the underlying

demand for housing is going to remain reasonably solid, although

presumably less than the peaks that we have seen in recent

months.

Senator ALLARD. I also understand that the number of jobs coming from—to change the subject—other countries to the United

States is growing at a faster rate than jobs lost overseas. According

to the Organization for International Investment over the last 15

years, the numbers of manufactured jobs insourced, coming into

the United States, have grown by 82 percent, while the number

outsourced overseas grew by only 23 percent. This study indicated

that these insourced jobs are offering higher pay than those

outsourced. Furthermore, last month the Labor Department released the first official Government study that revealed only 2.5

percent of the 182,456 workers who lost their jobs in the first quarter of this year were due to jobs being sent abroad.

Would you please share your thoughts on these numbers, and is

outsourcing really taking away as many American jobs as people

are claiming it is?

Chairman GREENSPAN. Senator, I have not checked the specific

numbers, but it does not seem different from what I am generally

aware of, depending on how you define a lot of these categories.

We are in a global economy, and increasingly so, and it has been

to the advantage of the United States to be in this global economy,

and indeed in the position of leadership, which we have been in,

and it has contributed, in my judgment, to a very significant increase in standards of living of the average American.

As the world becomes ever more complex and as we find we go

to ever increasingly more sophisticated levels of specialization in

24

the division of labor, it necessarily means that we reach out to engage in trade with the rest of the world at an increasing rate, and

indeed, the aggregate amount of trade worldwide has been growing

almost every year relative to world GDP for the last half century.

This means that you are getting imports as a share of domestic

GNP’s, on average, rising. And as a consequence of this, we are engaged in ever more insourcing and outsourcing, depending how you

want to define it, and while it is certainly the case that outsourcing

as estimated for the current period is quite small, I think it is

going to be rising, and I do not think that is bad. I think that is

going to be part of a broader expansion which will lead to higher

standards of living in this country and an ability for our expertise

to be most effectively applied in international markets.

Senator ALLARD. Mr. Chairman, may I follow with a question on

protectionism?

Chairman SHELBY. Go ahead.

Senator ALLARD. You have cautioned repeatedly about the danger of protectionism, and that it could provide a barrier to the economic growth that has picked up in recent months. Could you

elaborate on that for us, please?

Chairman GREENSPAN. Looking back at the post-World War II

period, this very expansion of globalization which I have referred

to is also capable of being viewed as an ever wider degree of international stimulus to the United States, and indeed, I think that

our ability to engage the international community has significantly

enhanced our standard of living, as I just indicated. But it depends

on that expansion continuing, because it is the rate of change in

expansion which creates the level of economic growth here, and I

think that what one requires to recognize is that if the Doha

Round, for example, fails to be completed—and there is some concern, as you know, about how that is evolving, especially this

month—I would have a concern that we would find that losing this

stimulus from the international system will work negatively on economic growth in the United States, and I, accordingly therefore,

hope that we can continue our efforts to make sure that

globalization continues if we are to reap the benefits of it.

Senator ALLARD. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bayh.

Senator BAYH. Thank you, Mr. Chairman.

Chairman Greenspan, I would like to follow up on Senator Sarbanes first line of questioning with regard to our growing dependence upon foreign borrowing and the consequences for our domestic

economy. I think you indicated that at some point we will reach a

position where the rest of the world’s appetite for U.S. denominated

assets has been satiated. We do not know when that point will arrive. Are there any studies under way to try and determine, using

portfolio theory or other types of analysis, when that point might

be reached?

Chairman GREENSPAN. Senator, it is very interesting because

there has been a very considerable amount of work endeavoring to

unearth where those points are. We do know that in developing

countries in the past, as individual countries have gotten up to ever

higher current account deficits, they turned around. In some cases

they got to double digits before they turned around. But they usuVerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1
25

ally, if the economies were flexible, adjusted without any real crisis

occurring. But a number of us have been trying to figure out

whether there are leading indicators as to when this type of thing

turns. What has been examined are all the various different types

of flows, private flows, equity flows, debt flows, flows of governments. What we find is that none of them work.

What that says is that the markets internationally are so efficient that the substitutability of various different instruments to finance, for example, our current account deficit, is extraordinarily

high, and while it clearly affects prices of bonds and stocks and exchange rates in the process, the adjustments continue in a way

which it is very difficult to determine when certain types of flows

are occurring and when the aggregate deficit is about to turn

around.

Senator BAYH. Let me follow up. I was concerned about part of

your response to Senator Sarbanes, where I believe you indicated

that when the satiation point arrives, that even a higher rate of return on U.S. denominated assets would not lead them to acquire

more of our assets, which means that if the deficit has to be financed entirely domestically, the increase in interest rates and

other adjustments that might flow from that would have to be even

more severe. I find that potential to be rather alarming.

Chairman GREENSPAN. I think the way I put it, I said that even

if rates of return stay high. I did not say necessarily ‘‘increase.’’

The reason I put it that way, Senator, is that if you think about

rates of retutn being high in the United States, and people therefore continually wish to invest here, you can conceive of a situation

in which even though the rate of return does not change, they will

eventually say, ‘‘I am over committed. I have too much. I want to

diversify, even though I will get a lower rate of return.’’

Senator BAYH. Does that not imply more adverse consequences

for us domestically?

Chairman GREENSPAN. If we get to the point where there is a

cliff effect, obviously, it would, but I think we are so flexible and

the markets are so flexible, and I assume we will keep them flexible, that the international system does not work that way. It works

incrementally. But you are quite right. I mean ultimately if we cannot continue to attract investment at current interest rates or current rates of return, and we still are running very large trade, and

therefore capital account deficits, all economic theory says that

rates have to rise.

I am a little suspicious of that conclusion largely because of a lot

of those conclusions are based on the way the markets functioned

30, 40, 50 years ago, when remember, they were not flexible. We

had all sorts of capital controls and all sorts of rigidities. But I do

not think we can readily dismiss it out of hand as a possibility.

Senator BAYH. Our focus as policymakers, when we are concerned about this issue, should be on maintaining the flexibility of

the international financial system and hoping there is not an exogenous shock of some kind that would lead to a rapid readjustment.

Chairman GREENSPAN. Senator, I would generalize that. I say

the experience we have had in the last decade has indicated that

the most important thing we can do with respect to policy, both domestically and internationally, is to create flexibility, because it obVerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1
26

viously is a factor in the resilience of an economy to respond to

shocks, and indeed, I do not think that we could have successfully

gotten through September 11, for example, unless we had an exceptionally flexible financial and economic system domestically.

Senator BAYH. My final question, Mr. Chairman, and thank you

for this discussion, it is something I am concerned about. I hope

that the flexible nature of the markets will enable us to make a

gradual adjustment but I am somewhat concerned.

I would like to just change the topic and ask my final question.

A recent Fed study entitled ‘‘The Price and Quantity of Residential

Land in the United States’’ was just completed, and concluded that

over the next 3 years in the aggregate, housing prices on a cumulative basis, will go up, they predict, 2.6 percent, which is the lowest increase on record according to the report. Given the role that

real estate values played in getting us through the recent softness

and sustaining consumer demand, is that not the source of some

concern?

Chairman GREENSPAN. It would be if it were an abrupt change.

Remember that we have had a fairly significant rise in real residential prices in recent years, and historically if you look back, that

is not unusual. But what does tend to happen is that we go up for

quite a while, and then we flatten out, and I do not know what the

actual number is. I have not read the details of the study, nor do

I know whether the data are accurate in that regard, but I certainly do not——

Senator BAYH. If you are having a restless night and have trouble nodding off, I recommend it.

Chairman GREENSPAN. I find the best thing to do if I run into

that occasion is to read some of my speeches.

[Laughter.]

Senator BAYH. Thank you, Mr. Chairman. The reason for my

question was simply—by the way, that has been said about mine

as well—is your sanguine view about the sustainability of the

recovery, and it seems one of the legs that we have relied upon recently is—I may perhaps be ameliorating a little bit here going forward, but you think that will be more than offset by other things.

Chairman GREENSPAN. Yes, that is our forecast.

Senator BAYH. Thank you.

Chairman SHELBY. Senator Bennett.

STATEMENT OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you very much, Mr. Chairman.

One of the advantages of coming a little bit late is that you get

to hear all of your colleagues ask your own brilliant questions before you can get to them, but you can also take notes on the things

that people say.

You said in response to Senator Shelby, when he was talking

about where interest rates should be, and you very appropriately

and predictably did not give us a number. But you said you were

hoping we could get back to neutrality. So let me take one more

stab at it and ask what number is neutrality?

Chairman GREENSPAN. I knew you were going to ask that question, Senator. Actually, we do not know what neutrality is until we

get there. The reason I say that is the notion of stability, or a state

27

where the financial markets are in some form of equilibrium, depends on a number of things. You can tell whether you are below

or above, but until you are there, you are not quite sure you are

there. We know at this stage that at 11⁄4 percent Federal funds

rate, are below neutral. When we arrive at neutral, we will know

it, and we can take whatever actions we consider desirable or not

desirable at that time, but I think that estimates that people try

to make as to where that so-called neutrality is, fall in a fairly

broad range, and I would just choose not to speculate where it is.

Senator BENNETT. You said to Senator Allard that outsourcing is

rising and that is good.

Chairman GREENSPAN. It is very low at this stage, but what I

was saying is, as part of the globalization process, which I think

is good for the American economy, and probably an inevitable component is increasing trade of all sorts, and therefore, outsourcing

both into the United States and out is likely to rise. And as Senator Allard suggests, a number of studies say at this stage that the

outsourcing into the United States may very well be larger than

the outsourcing. I do not think this is a critical issue. I am really

quite surprised at how big an issue this has become. I fully understand the real and serious problems that individuals have who lose

their jobs in this process, and indeed, we should do whatever is required to make their lives better, but shutting off international

trade as a means of doing that is essentially very counterproductive to everybody’s standard of living.

Senator BENNETT. I happen to feel the same way. When you

made the statement ‘‘that is good,’’ I thought it is a good thing he

is not Chairman of the Council of Economic Advisers, because if

you were, tomorrow morning there would be calls for his resignation and attempts on the part of the political arm of White House

to distance themselves from your testimony, because that is exactly

what Greg Mankiw said to the Joint Economic Committee, and

that is what happened when he said that.

Chairman GREENSPAN. I think the response to Greg Mankiw’s remark was unfortunate.

Senator BENNETT. Yes, and you are not going to be invited to Lou

Dobbs’ show any time soon.

[Laughter.]

Let us talk for just a little bit about oil prices. Oil is traded in

dollars. The dollar is losing its value vis-a`-vis the euro, the British

pound, and some other currencies. Is there a temptation therefore

on the part of OPEC to get their real return back up to what it

might have been by raising the denomination of a barrel of oil in

dollars? In other words, is it in their interest to try to take the

price of oil in dollars up to the point where they are getting as

much real income as they used to get when the dollar and the euro

were in parity?

Chairman GREENSPAN. Senator, I do not think that the particular denomination in which oil is priced affects the overall price.

In other words, the way I would put it is we could trace oil prices

in euros, for example, or in dollars or in yen, and while there are

certain technical issues which are a slight problem here, if we were

to officially switch the unit in which oil was denominated, I do not

28

think it would change the price patterns in dollars, yen or euros

in any significant manner.

Senator BENNETT. I do not think it would either at the moment

the switch were made, but if a dollar is seen as continuing to depreciate with respect to other world currencies, is there an incentive over time for an OPEC country——

Chairman GREENSPAN. Oh, I see. There obviously is a sense in

which if a dollar purchases less in other currencies, that one could

conceive that they might try to raise prices in order to offset that.

Senator BENNETT. Offset the declining value of the dollar. Do you

see that in OPEC strategy?

Chairman GREENSPAN. Well, they are certainly not doing it now.

They essentially have opened up the taps as best one can judge.

Supply is increasing, but demand overall is increasing more, and

that is what the difficulty is. I cannot say to you that I see any

evidence that OPEC is constraining production for the purpose of

raising price at this particular time.

Senator BENNETT. My observation of the current increase of the

price of oil has more to do with uncertainty over the situation in

Russia than it does with OPEC strategy. Do you have a reaction

to that?

Chairman GREENSPAN. Let me say this. I am talking about shortterm strategy obviously. There is a long-term strategy about the

capacity of crude oil in OPEC producing countries, which is a different issue, but clearly, the problems in Russia involve a significant concern about a curtailment of crude oil production if Yukos

went into bankruptcy and it was dismembered or something like

that. That was clearly in the marketplace.

But also in the marketplace is something which is disturbing in

the sense that the very long-term futures, that is, those for 2010,

for example, have risen very substantially in recent years, which

is unusual because in years past the so-called long-term supply

price of crude oil in dollars was about $20 a barrel, and irrespective

of what the spot price was, the long-term price stabilized somewhere in that $20 area. In the last several years, the long-term

price has gone up very substantially, and it is not because of cost.

It is basically fear of long-term supply in a number of the areas of

the world where geopolitical concerns have risen.

Senator BENNETT. Thank you.

Chairman SHELBY. Senator Dodd.

Senator DODD. Thank you very much, Mr. Chairman.

Thank you, Mr. Chairman, for being here today. I was not here

for your confirmation hearing, but let me once again say I think

of how fortunate we are in this country that you are the Chairman

of the Federal Reserve, and you have done a tremendous job over

the past 16 years.

Chairman GREENSPAN. Thank you very much.

Senator DODD. I suspect the next 16 years are going to be difficult ones, and in your contribution to this discussion, debate is

very much appreciated. Let me begin with those comments.

Senator Schumer, when he was speaking a little while ago, mentioned that these two wings, like a wonderful physical analogy,

talking about monetary policy and fiscal policy. I know you are

here to give a monetary policy report, but I cannot resist the opporVerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1
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tunity to raise issues with you involving fiscal policy. We are policy

setters up here. We have about 20 working days by my calculations, between now and the adjournment of this Congress, which

is not a great deal of time left. Two issues that I would like to raise

with you, both of which you have commented on in the past. In

fact, you did again today in part. One has to do with the growing

and dangerous gap between those who are more affluent and those

who are not in the country. The second issue has to do with the

Federal deficit.

I recall sitting here, it was about 42 months ago, when you were

sitting in that very chair in January 2001, and we had this incredible conversation, that is, you did with the Committee, about the

potential effects of eliminating the national debt and how we

should respond to it, a conversation I suspect many of us only a

few years earlier never would have imagined occurring.

Chairman GREENSPAN. Nor I.

Senator DODD. All of us have in our minds those clocks, whether

it was in New York or Washington, that would tick off every nanosecond the accumulation of debt, and here we were, only 42 months

ago, literally talking about the implications of eliminating the national debt. You spoke at that time about realistically getting to the

level of Federal debt that is an effective irreducible minimum. I am

quoting you from your testimony on that day in January 2001.

Let me begin if I can with the gap question and wealth, because

some of the things we have heard today and some of the statistics

you point to, indicate that that is going on. I do not know if you

had the opportunity this morning to read an article in The Wall

Street Journal entitled ‘‘So Far Economic Recovery Tilts to the

Highest-Income Americans.’’ The article quotes Dan Maki, M-a-ki, a former member of the staff of the Federal Reserve and currently an economist.

Chairman GREENSPAN. Dean Maki, I believe.

Senator DODD. What is it?

Chairman GREENSPAN. Dean.

Senator DODD. Dean, yes. He is an economist today with

JPMorgan. He says, ‘‘Today the recovery’s primary beneficiaries

have been upper-income households.’’ Your own testimony of course

mentions a similar point when you find that increases in average

hourly earnings of nonsupervisory workers have been subdued in

recent months and barely budged in June, while also find an apparently more robust rate of growth for hourly earnings of supervisory workers. I wonder if I can conclude from your testimony

here today that you would in general agree with Dean Maki’s findings, that the primary beneficiaries of this recovery have been

upper-income households?

He goes on, by the way, in the article, to compare purchases that

are occurring in some of the high end value stores. Nieman Marcus

sales are up 131⁄2 percent, whereas Payless Shoe Stores have seen

sales fall by 1 percent, of low cost product. Putting that together,

have we seen the wealthy, who were given huge tax cuts over the

past 3 years, turn around and spend their tax cuts on these luxury

items, while average workers of course have seen their wages stagnate? What are the implications? It worries me deeply. I think it

30

does you as well. If these trendlines continue, what happens to the

social fabric of a country where those kind of gaps exist?

Chairman GREENSPAN. I am not concerned about what people

spend money on. That is not an issue so much. But it is the resource issue.

Senator DODD. But as an evidentiary piece.

Chairman GREENSPAN. Yes. I agree with Dean Maki’s conclusions. That is what our data show as well. That is the reason why

I think, as I indicated earlier, that is very important to understand

the process that is going on here and find a way to have public policy address it.

My own judgment, and I think the data strongly support the underlying forces, is that the problem is essentially an educational

issue, plus I would suspect it may have something to do with immigration policy as well. But we have been unable to create a level

of skills which would enable a significant part of our population to

earn skilled wages. Unless we can do that, I am not sure how we

get out of this bind.

Obviously, we could slow down the growth of the economy, stabilize our technology, try not to be innovative, and that will actually create a stabilization in the income shares. But that is scarcely

an acceptable way to come at this. Rather than try to essentially

curtail economic growth, we should determine why it is that the

skills of our schoolchildren, which in the fourth grade internationally are above average, somehow deteriorate by the time they get

to the twelfth grade to well in the lower echelons of children

around the world.

It cannot be that our children are somehow inferior. The fourth

graders are not. And if they are not interior in the fourth grade,

I do not know how they become inferior thereafter. So it is not the

quality of the students. It is something we do wrong. I am not

knowledgeable enough to know, but this is a crucial issue.

Senator DODD. It would be worthwhile to have maybe a longer

conversation. One of the factors I think is we—I think the high

rate at one point in the Nixon Administration is we were spending

something close to 6 percent of the Federal budget on secondary

and elementary education in this country, the Federal Government

was. Today, I think the figure is less than 2 percent. And when you

look at disparities that exist within school systems, even adjoining

ones or neighboring ones where I think the average of a noncertified teacher in a poor rural and urban school is hovering around

35 percent of the teachers not certified to teach the classes they are

teaching, class sizes being huge, there are factors there that make

it difficult for students to learn.

I think we should look at our choices. We can come down to

where we allocate resources and how we make choices between the

issue of tax cuts for the top 1 percent of income earners versus investing in a No Child Left Behind bill, or special education funds

and so forth that I think could contribute to that. But it is an interesting point and I appreciation your observation because I think it

does contribute to it.

Let me jump to the deficit issue, because my colleague from New

York is here and I suspect he may want to talk about the same

subject matter. I want you to use a little bit if you can here the

31

bully pulpit of this chair have you. Again, we are here from monetary policy. We have no budget. Not likely to get one. Maybe we

will, but I doubt it at this point. We are going to be asked later

this week to vote for a tax cut which we are going to be asked not

to pay for. No matter how much you may find it attractive politically to be for it, there is no provision apparently to accommodate

for the cost of it. We may be asked to vote for an omnibus appropriations bill, because we have only passed one appropriations bills,

the Department of Defense appropriation bill. Otherwise, 12 appropriations bills have not been enacted.

The House has done more, but nonetheless, not likely to reach

some common agreement between the two.

We are going to be asked to increase the debt ceiling by some $680 billion, therefore getting near $8 trillion in debt figures. That

is in 42 months going from a projected, I think it was in excess of

$3 trillion, surplus over 10 years to now $8 trillion in deficit. I

know you feel strongly about this and it just seems to me we need

to hear your voice again on this subject matter. That our fiscal policies are out of control here and we need some voices of discipline

warning members.

Again, I am not suggesting you come up with a policy solution,

but I think we need to hear from you as often as we can. Along

with the trend lines in the gap in wealth in this country are disturbing, the trend lines on Federal deficits are deeply alarming.

And our inability or unwillingness to come to terms with them is

a growing concern, it should be to all of us. I wonder if you might

take a few minutes and express your views on this subject matter

once again.

Chairman GREENSPAN. Senator, let me just say that I think we

are, at the moment, reaping some of the consequence of the failure

to extend PAYGO and discretionary cap legislation in September

2002. You are dealing with long-term budgets, which has been

something novel in this country in the last 20 years. It was not all

that long ago, in the 1960’s and certainly in the 1950’s, that there

were very few long-term programs. The F–4, for example, was a

project which took a number of years in the military, and we had

certain agricultural programs which extended, but we did not have

very long-term commitments as we have today.

The problem is that our ability to forecast what the budget will

look like 15 years from today is extremely limited. We can estimate

within a reasonable degree of accuracy where, for example, Social

Security, a defined-benefit program, will ultimately come out because it is a defined benefit and forecasting only a limited number

of variables will tell us where we are going to be. In contrast, we

have extraordinarily limited understanding of the forces that are

going to drive Medicare 15 to 20 years from now. We know that

the recipient population is going to rise very sharply. But if we try

to determine what benefit outlay per recipient is going to be, we

would have a long list of things we needed to forecast. But the variance in every one of them is very large. As a consequence, the product of those variances creates huge uncertainty.

Unless we have a process which, for example, has a means to

control the long-term projections, for example, to have triggers in

the programs, both taxes and outlays, which go off, so to speak,

32

when a program is significantly off the originally expected path.

We clearly should be looking at the issue of sunset legislation,

automatically requiring reevaluations of programs. The vast majority of programs will probably be extended by voice vote on the floor.

But there would be an awfully large number of individual programs which really should be looked at. And if you look at them,

some of them require major change, or elimination.

We at the Federal Reserve, for example, have a process where

every 5 years we scrub all of the regulations that we have built up

over the years to determine which of them still are applicable. Had

we not done that we would have had a huge number of regulations.

So, I think what is wrong at the moment is that we do not have

process. It is very difficult to vote on individual bills without the

context of everything else. And 30, 40 years ago we did not need

triggers. We did not need PAYGO. We did not need sunset legislation, largely because the vast majority of what the Congress voted

on was relatively short term and you could make some reasonably

good forecasts and reasonably good judgments.

We can no longer do that. Unless we find that we can address

process first and get the Budget Committees back in play and get

the process by which the overall budget is constructed in the way

we did prior to September 2002, I do not know how you figure out

how to go forward. I do not think you can construct a Medicare program, or any amendments to Medicare, without some advertence to

what the long-term fiscal outlook is, and I do not know how you

do it without process.

Senator DODD. Thank you for that. I guess I can conclude, at

least in the short term here, your view would be that on the various proposals we have before us in the budget that PAYGO at the

very least is something the Congress to endorse; is that correct?

Chairman GREENSPAN. Indeed.

Senator DODD. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you, Senator Dodd.

Senator Schumer.

Senator SCHUMER. Thank you, Mr. Chairman. And thank you,

Chairman Greenspan, as well.

Hearing the summary of your statement and your answers to

questions, I guess if I had to summarize it I would say, the recovery is sustainable. That seems to be the tone. The disparity I think

some of us face as we go around our States and our country is

there does not seem to be a tremendous amount of confidence about

that. You can look at two measures. One, consumer confidence has

been relatively flat. We have the oil prices, which you mentioned.

And for the higher income people, since we have talked a lot about

disparities, the stock market has actually gone down since the good

numbers have started going up.

I guess the question I have, the first question I have is, why do

you think that is? Does it have an effect on the economy? You mentioned terrorism in your statement. Obviously, that is something

that is out there that is hard to quantify. Do disparate incomes create that? Does the deficit help create lower confidence? And how

much effect, if this lower confidence that is not as optimistic—it

does not seem that average people, the consumer end, whether it

is higher end or lower end seem to have that kind of confidence.

33

Businesses seem to have a little more confidence these days. But

even they are saying that profitability, which was enormously high

in the last few quarters, is going to decline some.

Could you just talk a little bit about this phenomenon which is

confusing in certain ways? Particularly the stock market. I am puzzled how the stock market has gone down. The Dow Jones has gone

down 400 points as all these numbers are good.

Chairman GREENSPAN. Senator, this is not atypical of a recovery.

If you go back historically and read the records of the time when

you know that subsequently things got extraordinarily positive,

people were glum. You have to put it in context. With regard to today’s environment, for example, the June figures, and this soft

patch we are going through, I do not recall a recovery in which

there were not several soft patches. It’s the way the markets work.

There is something different here, in a sense as you point out,

that the level of confidence is less. The way we know that, or the

way I would suggest is a indication of it, is we have for the first

time in a quarter-century, or more than that I think, the aggregate

of capital investment and inventory investment running less than

cashflow. The typical pattern is that businesses when they are confident are expanding. They are borrowing, and capital investment

expands way beyond cashflow.

If you look at the debt markets, the corporate debt markets, they

are barely moving. In fact, I think in June, the preliminary estimate is that corporate debt on balance declined. In other words, repayments were greater than new extensions because cashflow is so

high. I think the reasons for that are largely the aftermath of terrorism. I still think there are concerns out there. Corporate scandals have created a really serious issue of caution on the part of

business who are terribly fearful of doing things which are perceived to be inappropriate. So that there is this sense of general

lack of charging ahead, which clearly was the case in the latter

part of the 1990’s. It is likely that the mere aftermath of the 1990’s

themselves had some effect.

But it does not appear to be enough to hold back the gradual

broadening we perceive to be going on. Some things go down, some

things go up, but the markets and the economy continues to grow.

The stock market does not always respond to good news positively, and in fact in most instances where the perception is that

a rising economy or a booming economy will somehow create increased interest rates in the context where long-term or short-term

profitability no longer has the upside to move as fast as it has,

markets will go down under those conditions. So, I would say that

the weakness in the stock market is a perfectly typical type of pattern that one sees over the years, and more generally that the way

this economy is behaving with its obvious idiosyncratic characteristics, as all recoveries have, is nothing that we perceive at the Fed

as particularly surprising.

Senator SCHUMER. One more question, if I might, Mr. Chairman.

Chairman SHELBY. Go ahead.

Senator SCHUMER. Although I would just make a comment I

made in my opening statement, sometimes maybe for the stock

market and maybe for the economy, lower interest rates are better

than lower taxes. That is a debate on the fiscal side that we have

34

been having here, although it affects you. I take it you would not

disagree with that necessarily as long as underline——

Chairman GREENSPAN. I can conceive of situations in which you

could be accurate.

Senator SCHUMER. How about now?

[Laughter.]

Here is my other question. This is a bit off the topic but I had

wanted to ask you this before. Last week, we had a very interesting

hearing that the Chairman led on hedge funds. It was an interesting discussion and I, for one, have not made up my mind on this

thing. I have a bent that regulation, if it is not heavy-handed, has

been good for the markets. People complain about it, but it works,

and it has led people’s view that our markets are on the level.

The proposal made by Chairman Donaldson, who I know is your

friend and whom I know you disagree with on this issue, he made

a pretty good argument in saying, first of all, that 40 to 50 percent

of the funds register now and there does not seem to be too many

complaints. In fact, they voluntarily register. That he thought registration might increase because pension funds and other types of

funds that are dealing with consumers and others might feel better

with the registration. He mentioned that the financial cost was

quite low. I think he said it would cost about $45,000 or $50,000

to do the registration, which for a large pension fund is a drop in

the bucket, particularly given their profitability.

And he seemed to feel that the act of registering would not create

any kind of systemic risk—sorry, you said the systemic risk. But

he felt that the act of registering would not get in the way of any

kind of thing that a hedge fund wanted to do in terms of its entrepreneurial zest, activity, risk taking, et cetera.

I am wrestling with issue and I think some of us on the Committee are, could you give us your views on this, particularly on the

aspect of, does required registration cause—oh, one other point he

mentioned, which made a difference to me since hedge funds are

based in New York and I try to make sure businesses come to New

York and not run away, that you would not have people go overseas. I had heard from some hedge funds, well, we will just go overseas. He said, it does not matter. If they had U.S. investors they

would still have to be through the same—they would meet the

same legal requirements and have to register anyway.

Could you comment on the issue in general, and specifically your

view about how required registration would affect the entrepreneurial zeal and zest, risk-taking of the hedge funds?

Chairman GREENSPAN. Senator, I actually was writing down a

few comments on this particular issue, not sure where I would use

it, just to get my own thoughts. It will take a couple of minutes

for me to read it. Let me read it to you, if you do not mind.

Senator SCHUMER. That would be great.

Chairman GREENSPAN. If you do not mind, with the Chairman’s

acceptance.

Chairman SHELBY. Yes, sir, go ahead.

Chairman GREENSPAN. Hedge funds have become major contributors to the flexibility of our financial system; an issue I raised earlier. That development proved essential to our ability to absorb so

many economic shocks in recent years. Hedge funds seek out the

35

abnormal rates of profit often found where markets are otherwise

inefficient. Taking positions in volume, as hedge funds do, tends to

eliminate the abnormal profits and the inefficiencies by aligning

prices across markets and provides liquidity to markets. Successful

or not, when those profit opportunities are perceived to be eliminated, individual funds move on to address other inefficiencies.

But these above-normal profits have attracted a large number of

new entrants seeking to exploit a possibly narrowing field of inefficiencies. Not surprising, the rate of return in this activity is reportedly declining. I would not be surprised if, with time, many of the

new entrants exited, some presumably following large losses.

Chairman Donaldson, who as you mentioned has been a good

friend of mine for 45 years, is certainly right in wanting to eliminate fraud by hedge funds and other financial institutions. Fraud

undermines markets and the efficient functioning of our economy.

My problem with the SEC’s current initiative is that the initiative cannot accomplish what it seeks to accomplish. Fraud and

market manipulation will be very difficult to detect from the information provided by registration under the 1940 Act. Fraud is almost always uncovered through complaints of counterparties or by

accident, such as our uncovering millions of dollars of the new U.S.

currency in Federal Reserve wrappings in Iraq.

This is certainly true, namely the uncovering of fraud, in banking as we experience it, and I assume is also true for regulated

broker-dealers as well. Even should SEC’s proposed risk evaluation

surveillance of hedge funds detect possible trading irregularities,

which I doubt, those irregularities will likely be idiosyncratic and

of mainly historic interest because by the time of detection hedge

funds would have long since moved on to different strategies.

Should the existing proposal fail in achieving its goal, pressure

will become irresistible to expand SEC’s regulatory reach in an endeavor to accomplish it set out to do. Hedge fund arbitragers are

required to move flexibly and expeditiously if they are to succeed.

If placed under increasing restrictions, many will be leave the industry to the significant detriment of our economy.

Senator SCHUMER. So in other words, if I might, and I appreciate

your statement. As I said, I am grappling with this issue and have

not made up my mind, but you are saying registration in itself

would not be detrimental. It might not accomplish what its advocates say, but could leave to other things that would become detrimental. Is that a fair summation?

Chairman GREENSPAN. That is correct.

Senator SCHUMER. Without the erudition that you have.

Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Greenspan, it has been a long

afternoon. I have a number of questions I am going to submit for

the record. We appreciate your candor, your appearance as always,

and we will be watching you and praying for our economy. It is

doing well. Thank you.

Chairman GREENSPAN. Thank you, sir.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 4:55 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

36

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

Thank you, Chairman Shelby, for convening this important hearing. I always look

forward to the opportunity to hear from Chairman Greenspan.

I believe that the U.S. economy is on the right track. The economy is growing,

payroll employment is up, and new and existing home sales set new record highs

in May. This is good news.

However, we cannot take the positive economic news for granted; Congress needs

to do more to continue to promote a healthy economy. First, we need to address the

looming problems in the various entitlement programs.

Second, we need to continue to provide economic incentives through tax cuts, including making the previous tax cuts permanent.

Finally, I believe the most important way that we can ensure the long-term economic vitality of our country is to control Government growth and spending. Congress will not spend the Nation into prosperity. Chairman Greenspan, you and I

have discussed this point a number of times during your previous appearances before the Banking Committee, and I have always appreciated your comments in favor

of Government restraint.

Chairman Greenspan, I know that you have a very busy schedule, so I appreciate

you taking the time to appear before the Committee today. I look forward to your

report and the opportunity to raise several questions with you.

—————

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JULY 20, 2004

Mr. Chairman and Members of the Committee, I am pleased to be here today to

present the Federal Reserve’s Monetary Policy Report to the Congress.

Economic developments in the United States have generally been quite favorable

in 2004, lending increasing support to the view that the expansion is self-sustaining.

Not only has economic activity quickened, but the expansion has also become more

broad-based and has produced notable gains in employment. The evident strengthening in demand that underlies this improved performance doubtless has been a factor contributing to the rise in inflation this year. But inflation also seems to have

been boosted by transitory factors such as the surge in energy prices. Those higher

prices, by eroding households’ disposable income, have accounted for at least some

of the observed softness in consumer spending of late, a softness which should prove

short-lived.

When I testified before this Committee in February, many of the signs of the stepup in economic activity were already evident. Capital spending had increased markedly in the second half of last year, no doubt spurred by significantly improving

profits, a low cost of capital, and the investment tax incentives enacted in 2002 and

enhanced in 2003. The renewed strength in capital spending carried over into the

first half of 2004. Orders and shipments of nondefense capital goods have been on

the rise, and backlogs of unfilled orders for new equipment continue to build.

A key element of the expansion that was still lacking in February, however, was

evidence that businesses were willing to ramp up hiring to meet the stepped-up

pace of sales and production. Businesses’ ability to boost output without adding

appreciably to their workforces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment, which was an

apparent outgrowth of the capital goods boom of the 1990’s. Indeed, over much of

the previous 3 years, managers had seemed to pursue every avenue to avoid new

hiring despite rising business sales. Their hesitancy to assume risks and expand

employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the decline in stock prices and also,

of course, by the environment of heightened geopolitical tensions. Even now, following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cashflow. The protracted nature of

this shortfall is unprecedented over the past three decades. Moreover, the proportion

of temporary hires relative to total employment continues to rise, underscoring that

business caution remains a feature of the economic landscape.

That said, there have been much clearer indications over recent months that conditions in the labor market are improving. Most notably, gains in private nonfarm

payroll employment have averaged about 200,000 per month over the past 6

months, up sharply from the pace of roughly 60,000 per month registered over the

fourth quarter of 2003.

37

The improvement in labor market conditions will doubtless have important followon effects for household spending. Expanding employment should provide a lift to

personal disposable income, adding to the support stemming from cuts in personal

income taxes over the past year. In addition, the low interest rates of recent years

have allowed many households to lower the burdens of their financial obligations.

Although mortgage rates are up from recent lows, they remain quite attractive from

a longer-run perspective and are providing solid support to home sales. Despite the

softness of recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets, and still-low interest rates bodes well for

consumer spending.

Consumer prices excluding food and energy—so-called core prices—have been rising more rapidly this year than in 2003. For example, the 12-month change in the

core personal consumption expenditures price index stood at 0.8 percent in December of last year and climbed to 1.6 percent by May of this year. Core inflation, of

course, has been elevated by the indirect effects of higher energy prices on business

costs and by increases in non-oil import prices that reflect past dollar depreciation

and the surge in global prices for primary commodities. But the acceleration of core

prices has been augmented by a marked rise in profit margins, even excluding domestic energy corporations.

This surge in profits reflects, at least in part, the recent recovery of demand after

a couple of years during which weak demand led to relatively heavy price discounting by businesses. Profits of nonfinancial corporations as a share of sector output, after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent

in the first quarter of 2004, a pace of advance not experienced since 1983. Half of

this rise in the profit share occurred between the first quarter of 2003 and the first

quarter of 2004, a period during which business costs were unusually subdued. In

fact, consolidated unit costs for the nonfinancial corporate business sector actually

declined during this period. The increase in output per hour in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline

in unit costs. The remainder was due to the effects of rising output in reducing

nonlabor fixed costs per unit of output. Hence, at least from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004, all of the 1.1

percent increase in the prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than

rising cost pressures.

However, businesses are limited in the degree to which they can raise margins

by raising prices. An increase in margins should affect mainly the level of prices

associated with any given level of unit costs but, by itself, should not prompt a sustained pickup in the rate of inflation going forward. In a market economy, any tendency for profit margins to continue to rise is countered largely by the entry of new

competitors willing to undercut prices and by increased labor costs as more firms

attempt to exploit the opportunity for outsized profits by expanding employment and

output. That increase in competitive pressure, as history has amply demonstrated,

with time, returns markups to more normal levels.

Over the past three decades, the share of the profits of nonfinancial corporations

in the total nominal income of that sector has fluctuated around a longer-run average of roughly 101⁄2 percent. The profit share in the first quarter of this year, at

about 12 percent, was well above that level. The gap suggested that the growth of

unit profits would eventually slow relative to increases in unit costs. This outlook

had accorded with analysts’ expectations for earnings growth over the next year,

which are substantially below the realized growth of profits in recent quarters.

Indeed, some leveling or downward pressure on profit margins may already be in

train, owing to a pickup in unit labor costs. Although advances in productivity are

continuing at a rate above the long-term average, they have slowed from the extraordinary pace of last summer and are now running below increases in hourly

compensation. The available information suggests that hourly compensation has

been increasing at an annual rate of about 41⁄2 percent in the first half of the year.

To be sure, the increases in average hourly earnings of nonsupervisory workers have

been subdued in recent months and barely budged in June. But other compensation

has accelerated this year, reflecting continued sizable increases in health insurance

costs, a sharp increase in business contributions to pension funds, and an apparently more robust rate of growth of hourly earnings of supervisory workers. The

larger wage gains for supervisory workers together with anecdotal reports of growing skill shortages are consistent with earlier evidence of rising wage premiums for

skilled workers relative to less-skilled workers.

For the moment, the modest upward path of unit labor costs does not appear to

threaten longer-term price stability, especially if current exceptionally high profit

margins begin to come under more intense competitive pressures at home and from

38

abroad. Although some signs of protectionist sentiment have emerged, there is little

evidence that the price-containing forces of ever-widening global competition have

ebbed. In addition, the economy is not yet operating at its productive capacity,

which should help to contain cost pressures. But we cannot be certain that this

benign environment will persist and that there are not more deep-seated forces

emerging as a consequence of prolonged monetary accommodation. Accordingly, in

assessing the appropriateness of the stance of policy, the Federal Reserve will pay

close attention to incoming data, especially on costs and prices.

What does seem clear is that the concerns about the remote possibility of deflation

that had been critical in the deliberations of the Federal Open Market Committee

(FOMC) last year can now be safely set aside. Those deflationary pressures were

largely a consequence of the stock market slump, the capital goods contraction that

commenced in 2000, and, as I noted earlier, the extreme business caution that followed from these events as well as from terrorist attacks, corporate scandals, and

the lead-up to the war in Iraq. Both equity prices and capital goods spending have

turned up over the past year, and the probability that economic activity might stagnate has receded.

As always, considerable uncertainties remain about the pace of the expansion and

the path of inflation. Some of those uncertainties, especially ones associated with

potential terrorism both here and abroad, are difficult to quantify. Such possibilities

have threatened the balance of world supply and demand in oil markets in recent

months, especially as demand has risen with the pace of world economic growth. Yet

aside from energy, markets exhibit little evidence of heightened perceptions of risk.

Credit spreads remain low, and market-based indicators of inflation expectations,

after rising earlier this year, have receded.

With the growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place

starting in 2001 is becoming increasingly unnecessary. In May, the FOMC believed

that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured. At our meeting last month, the

FOMC raised the target Federal funds rate from 1 percent to 11⁄4 percent, and the

discount rate was raised commensurately. Policymakers reiterated that, based on

our current outlook, the removal of accommodation would likely proceed at a measured pace. But in light of the considerable uncertainty surrounding the anticipated

evolution of price pressures, the FOMC emphasized that it will respond to changes

in economic prospects as needed to fulfill its obligation to maintain price stability.

If economic developments are such that monetary policy neutrality can be restored

at a measured pace, a relatively smooth adjustment of businesses and households

to a more typical level of interest rates seems likely. Even if economic developments

dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic

adjustment of interest rates. Of course, considerably more uncertainty and hence

risk surrounds the behavior of the economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. In either scenario,

individual instances of financial strain cannot be ruled out.

The protracted period of low interest rates has facilitated a restructuring of

household and business balance sheets. Businesses have been able to fund longerterm debt at highly favorable interest rates and, by extending the maturity of their

liabilities, have rendered net earnings and capital values less exposed to destabilizing interest rate spikes. Households have made similar adjustments. Between

mid-2002 and mid-2003, homeowners were able to refinance at lower interest rates

almost half of total outstanding home mortgage debt and thereby to substantially

reduce monthly debt service payments. Households also substituted mortgage debt

for more-expensive consumer credit. Moreover, those households and businesses that

held long-term investment-grade bonds in that year accumulated realized and unrealized capital gains as long-term rates declined.

The FOMC judged this extended period of exceptionally low interest rates to have

been helpful in assisting the economy in recovering from a string of adverse shocks.

But in the process of returning the stance of policy to a more neutral setting, at

least some of the capital gains on debt instruments registered in recent years will

inevitably be reversed.

Prices in financial markets have already adjusted in anticipation of a significant

amount of policy tightening, engendering additional alteration of balance sheets in

recent months. An unwinding of carry trades—that is, market positions premised

on low short-term financing costs—seems to be under way, at least judging from a

pronounced shift in the trading portfolios of primary dealers. In addition, investors

classified as noncommercial have established net short positions in 10-year Treasury

note futures in recent months. Indeed, the swing toward a net short position on 10-

39

year Treasury note futures has been the largest since the inception of the contract

in the 1980’s, likely offsetting a significant portion of the interest rate exposure of

previously established carry trade positions.

Moreover, the recent increase in market interest rates has slowed the pace of

mortgage refinancing and reportedly has precipitated some winding down of leveraged positions among major mortgage market participants. These circumstances are

quite different from the situation prevailing at this time last summer. Then, record

levels of refinancing in the second half of 2002 and the first half of 2003 had pushed

the duration of mortgage-backed securities (a measure of the price sensitivity of

fixed-income instruments to changes in interest rates) to exceptionally low levels.

As mortgage and other long-term rates rebounded last summer, a consequence of

rapidly improving economic conditions and the fading of deflationary concerns, refinancing fell sharply, removing most downward pressure on duration. Holders of

mortgage-backed securities endeavoring to hedge the resulting shifts in interest rate

gaps moved rapidly to shed Treasuries and receive—fixed interest rate swaps, and

these actions magnified last summer’s upturn in long-term interest rates. In the

current environment, by contrast, it appears that the scope for such mortgage hedging effects to greatly amplify an increase in long-term rates is much diminished

given the decline in the pace of refinancing and the associated increase in mortgage

durations that have already occurred.

Last, very large fractions of the total outstanding obligations of businesses and

households are long-term, fixed-rate debt. As a result, rising market interest rates

will not have much immediate direct effect on business and household debt service

burdens. Indeed, from early 1999 through early 2000, a period when interest rates

on new home mortgage originations rose more than 150 basis points, the average

interest rate on the total of home mortgage debt outstanding barely moved. Nonetheless, despite the lock-in of low interest rate costs on a substantial share of household and business liabilities, recent higher market interest rates will, in time, show

through into increased charges against household and business income. To be sure,

financial intermediaries and other creditors that extended loans or purchased securities in recent years at relatively low long-term interest rates will sustain capital

losses as rates rise. In general, however, financial intermediaries are profitable,

well-capitalized, and appear to be well-positioned to manage in a rising rate environment.

In short, financial markets along with households and businesses seem to be reasonably well-prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed

in our judgment by those that would be associated with maintaining the existing

degree of monetary policy accommodation in the current environment. Although

many factors may affect inflation in the short-run, inflation in the long-run, it is

important to remind ourselves, is a monetary phenomenon.

As we attempt to assess and manage these risks, we need, as always, to be prepared for the unexpected and to respond promptly and flexibly as situations warrant. But although our actions need to be flexible, our objectives are not. For 25

years, the Federal Reserve has worked to reestablish price stability on a sustained

basis. An environment of price stability allows households and businesses to make

decisions that best promote the longer-term growth of our economy and with it our

Nation’s continuing prosperity.

40

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY

FROM ALAN GREENSPAN

The Housing Sector

Q.1. The semi-annual written report refers to activity in the housing sector remaining ‘‘torrid’’ in the first half of 2004. There have

been some concerns expressed about a potential bubble in housing

prices. Your report indicates that house price increases have outstripped gains in incomes as well as rents in recent years. In a recent speech, one member of the Board of Governors, Governor

Kohn, indicated that ‘‘the odds have risen that these prices could

be out of line with fundamentals.’’ Governor Kohn also indicated

that ‘‘we still cannot be very confident about whether a significant

misalignment exists, however.’’ What is your assessment of the continued rise in housing prices? Are there any particular geographic

sectors that you are more concerned about than others?

A.1. As you note, the most recent Monetary Policy Report to the

Congress indicated that house price increases have outstripped

gains in income as well as rents in recent years. This observation

raises the possibility that real estate prices, at least in some markets, could be out of alignment with the fundamentals. But as

Governor Kohn notes, that conclusion cannot be reached with any

confidence. For example, the rise in house prices relative to rents

and incomes has, no doubt, been influenced by the low level of

mortgage interest rates in recent years in ways that cannot be

gauged precisely. Moreover, the available data are not fully adequate for a complete analysis of the issue; house prices are difficult

to measure given the enormous heterogeneity of the U.S. housing

stock—both within and across geographic regions—and available

measures of residential rents do not match precisely with the units

for which we have prices. Although taking a firm stand on the appropriateness of real estate prices is not possible, policymakers do

need to take account of their influence on economic activity. As is

the case with other asset prices, we monitor real estate prices

closely in developing our economic outlook.

The data limitations that prevent a complete analysis of housing

price developments at the national level are even more binding at

the local level, making it especially difficult to detect asset price

misalignments for specific markets.

Improvements in the World Economy

Q.2. The semi-annual report comments on solid gains in U.S. exports since mid-2003 due to the strong economic performance of

many of the major trading partners. What is your view as to the

continued economic strength of our trading partners? In particular,

do you believe the improvements in Japan will continue?

A.2. Over the past year, the global economic recovery has become

both stronger and more sustainable. Growth has strengthened in

every major region compared with the sluggish performance during

the first half of 2003, and recent indicators suggest that the foreign

economies continue to put in a favorable performance. To be sure,

average growth in emerging Asia appears to have braked sharply

in recent months, as policy measures muffled the boom in the Chinese economy. However, continued strong export growth and recent

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signs of an acceleration in consumer spending suggest that Chinese

GDP growth will rebound in the second half of this year. Recovery

in Canada and in Latin America also appears to be on track, and

economic expansion in the United Kingdom continues unabated.

The pace of recovery in the euro area has been sluggish, however,

with particularly weak activity in Germany.

In Japan, the rebound that began last year has continued to

broaden. Japanese exports have grown rapidly over the past couple

of years, as exports to China and other emerging Asian economies

have surged. The expansion in exports has contributed to a snapback in corporate profits in the export-related manufacturing sector, and the revival in profits appears to be spreading to the more

domestic-oriented nonmanufacturing sector. Rising profitability

along with improving conditions in the corporate sector more generally have allowed investment to rebound from its recent trough.

Labor markets have also revived, with employment rising and the

unemployment rate declining from a peak of 5.5 percent early last

year to 4.6 percent at present. Against this backdrop of strengthening activity, consumer price deflation has eased markedly since

early 2002.

These positive developments suggest that Japan may finally be

on its way to a self-sustaining recovery. However, there are several

risks to the outlook. In particular, the recent run-up in oil prices,

if sustained, may exert a significant drag on Japanese economic activity. Moreover, Japanese consumption has risen sharply over recent quarters, while employee compensation has fallen. The result

has been a marked decline in the household saving rate. Most analysts expect the saving rate to move up as economic conditions

improve. If this happens abruptly, consumption might lag the recovery even if compensation begins to rise. Also, the possibility of

a hard landing in China carries significant risks for Japan as well

as for other Asian economies. Finally, bank lending in Japan continues to contract, and more aggressive financial sector restructuring remains important for Japan’s long-term growth prospects.

The President’s Working Group & Hedge Funds

Q.3.a. In 1999, the President’s Working Group concluded that ‘‘requiring hedge fund managers to register as investment advisers

would not seem to be an appropriate method to monitor hedge fund

activity.’’ In the intervening 5 years, have market conditions

changed in order to justify a different conclusion?

A.3.a. No. The Working Group’s report made two arguments in

support of this conclusion. First, it argued that the provision of the

Investment Advisers Act that exempts hedge fund managers from

registration (Section 203(b)(3)) evidences a Congressional determination that clients of an adviser that has relatively few clients

do not need the substantive protections of the Investment Advisers

Act. Congress has not repealed Section 203(b)(3). Second, it argued

that the sophisticated investors that typically invest in hedge funds

are in a position to protect their own interests. There is no evidence that investors in hedge funds today are less sophisticated

than they were in 1999. Indeed, institutional investors have accounted for a growing share of hedge fund investments, and they

can and should protect their own interests rather than rely on the

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limited regulatory protections that would be provided as a result of

a registration requirement.

Q.3.b. What, if any, mechanism would be the appropriate method

for monitoring hedge fund activity in light of their growth in recent

years and the increased investor involvement while at the same

time being mindful of liquidity concerns?

A.3.b. The case for monitoring hedge fund activity has not been

made. Some have argued that monitoring of hedge funds is necessary to detect and deter market manipulation. However, the data

collected from registered advisers is limited to total assets under

management, which would provide no insight into any manipulative activities. Concerns about market manipulation, whether by

hedge funds or others, can best be addressed by enhanced market

surveillance. If there were a public policy reason to monitor hedge

fund activity, the best method of doing so without raising liquidity

concerns would be indirectly through oversight of those brokerdealers (so-called prime brokers) that clear, settle, and finance

trades for hedge funds. Although the use of multiple prime brokers

by the largest funds would complicate the monitoring of individual

funds by this method, such monitoring could provide much useful

information on the hedge fund sector as a whole.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING

FROM ALAN GREENSPAN

Q.1. The Securities and Exchange Commission (SEC) has recently

issued a proposed rule on the Gramm-Leach-Bliley push-outs provisions governing bank securities activities. It is this Senator’s recollection that Congress intended to allow banks to continue their

existing, limited securities activities that are part of their banking

business, such as trust, fiduciary, and custodial activities. Do you

believe that the SEC proposal accomplishes Congressional intent?

Also, do you believe that this SEC proposal has complied with the

intent of Congress not to impose unnecessary regulatory burdens

on banks?

A.1. Prior to the Gramm-Leach-Bliley Act of 1999 (GLB Act), banks

enjoyed a blanket exception from the definitions of ‘‘broker’’ and

‘‘dealer’’ in the Securities Exchange Act of 1934 (1934 Act). As part

of the GLB Act, Congress replaced this blanket exception for banks

with a series of 15 exceptions designed to allow banks to continue

to conduct securities activities that are part of normal bank activities. When these activity-focused exceptions go into effect, a bank

may avoid registration as a broker-dealer under the 1934 Act only

if the bank limits its securities activities to those covered by one

or more of the new activity-focused exceptions. Because banks cannot as a practical matter register as a broker-dealer, securities brokerage and dealer activities that do not fit within one of these

activity-focused exceptions would have to be ‘‘pushed-out’’ of the

bank to an SEC-registered broker-dealer.

The activity-focused exceptions that Congress adopted for banks

in the GLB Act are broad and were intended to allow banks to continue to provide their customers securities services in connection

with their normal banking activities without significant disruption.

For example, Congress adopted important statutory exceptions for

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the trust, fiduciary, and custodial activities of banks. In adopting

these exceptions, Congress recognized that banks have long provided their customers securities services in connection with their

trust, fiduciary, and custodial activities. Furthermore, Congress

recognized that banks had provided these services for decades prior

to the GLB Act without significant securities-related problems and

under the effective supervision of the Federal and State banking

agencies. The new activity focused exceptions were designed to

complement the new authority granted by the GLB Act, which allowed banks to affiliate with full-service securities firms without

the restrictions embodied in the Glass-Steagall Act, by restricting

the ability of banks to significantly expand their securities services.

In particular, these targeted exceptions were intended to prevent

banks from operating a distinct retail brokerage business within

the bank.

The Board and the other Federal banking agencies previously

expressed concern that earlier SEC proposals to implement the securities provisions of the GLB Act were not consistent with the express terms or the Congressional purpose of the GLB Act. In June,

the SEC requested comment on new rules to implement the

‘‘broker’’ exceptions for banks in the GLB Act, including the important exceptions for bank trust, fiduciary, and custodial activities.

The public comment period on these rules currently is scheduled to

expire on September 1, 2004. Board staff, in conjunction with the

staffs of the other Federal banking agencies, currently is reviewing

and analyzing the SEC’s proposed rules to determine whether

these rules, consistent with Congress’s intent, would permit banks

to continue to effect securities transactions in connection with their

traditional bank activities and without significant disruption. The

Board will provide you a copy of any comment letter that the Board

decides to file with the SEC on the proposed rules.

RESPONSE TO A WRITTEN QUESTION OF SENATOR CRAPO

FROM ALAN GREENSPAN

Q.1. A divided SEC voted 3–2 last Wednesday to seek comments

on a proposal for mandatory registration of hedge fund advisers

with the SEC. Are you concerned with the divided SEC’s proposal

for mandatory registration of hedge fund advisers with the SEC?

Do you think the President’s Working Group on Financial Markets

should be involved in issues related to regulation of the hedge fund

industry?

A.1. I am concerned with the proposal. The proposal seeks to deter

fraud and market manipulation, but it is unlikely to accomplish

those objectives. The information reported to the SEC by registered

advisers is very limited and would be of little value for these purposes. Nor are examinations of advisers likely to uncover much

fraud. Our experience with bank examinations indicates that examiners have great difficulty uncovering fraud. Most often it is uncovered through complaints by customers or disaffected employees

rather than through exams. I believe this was also the case with

the recent scandals in the regulated mutual fund industry. Should

registration fail to achieve the intended objectives, pressure may

well become irresistible to expand the SEC’s regulatory reach from

hedge fund advisers to hedge funds themselves. The application of

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the Investment Company Act to hedge funds would greatly impede

their important contributions to the flexibility and resiliency of our

financial system.

Because of the critical role that hedge funds have come to play

in our financial system, all of the members of the President’s Working Group have an interest in what regulations, if any, apply to

their activities. It was this shared interest that motivated the

Working Group’s April 1999 report on Hedge Funds, Leverage, and

the Lessons of Long-Term Capital Management. More recently, it

has motivated discussions within the Working Group of the SEC’s

adviser registration proposal. In that sense, the Working Group

should be and has been involved in issues related to the regulation

of the hedge fund industry. But decisions about the application of

the Investment Advisers Act to hedge fund advisers fall squarely

within the SEC’s jurisdiction and must be made by the SEC.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SUNUNU

FROM ALAN GREENSPAN

Q.1. I understand that in August 2003, the Federal Reserve proposed a rule to loosen the tying restrictions on bank holding companies—the proposal and the subsequent supervisory guidance would

entail an interpretation of Section 106 of the Bank Holding Company Act Amendments of 1970. Can you describe the intent of the

Fed proposal and comment on the status of the rule? Also, does the

Federal Reserve Board view tying as a problem in large financial

institutions?

A.1. The special antitying restrictions established by Section 106 of

the Bank Holding Company Act Amendments of 1970 are quite

complex. For example, these restrictions apply only to banks and

do not apply to the nonbank affiliates of a bank or other nonbank

entities. In addition, while Section 106 prohibits banks from imposing certain types of tying arrangements on their customers, there

are several important exceptions to the statute. These exceptions,

among other things, expressly allow a bank to condition the availability or price of a product on a requirement that the customer

also obtain a ‘‘loan, discount, deposit, or trust service’’ from the

bank or an affiliate.

These exceptions and the statute’s complex structure can make

applying the statute a challenging and fact-intensive process. In

recent years, the Board has received a number of inquiries

concerning the antitying prohibitions in Section 106 and the compliance of banking organizations with these restrictions. These inquiries indicated that there was some uncertainty, both among

bankers and their customers, as to what types of bank actions are

prohibited by Section 106.

To help address this uncertainty, the Board in 2003 requested

public comment on a formal interpretation of the statute and

related supervisory guidance. The interpretation was intended to

provide banks and their customers a comprehensive guide to the

statute and, thus, improve the public’s understanding of the statute’s restrictions. The proposed interpretation, for example, discusses the necessary elements of a prohibited tying arrangement,

describes the statutory and regulatory exceptions to the statute’s

prohibitions, and provides examples of the types of bank actions

45

that are prohibited and permissible under the statute. The related

supervisory guidance describes the types of internal controls that

should help banks comply with the antitying restrictions in Section

106. The Board has received approximately 40 comments on the

proposed interpretation and related supervisory guidance and we

hope to finalize these documents in the near future.

Federal Reserve examiners review the antitying programs of

bank holding companies and State member banks as part of the

regular compliance reviews of these organizations. In 2002, examiners from the Federal Reserve and the Office of the Comptroller

of the Currency also conducted targeted antitying examinations at

several large banking organizations. The targeted exams indicated

that the banking organizations reviewed generally have adequate

policies and procedures to ensure compliance with the antitying restrictions of Section 106, and the agencies generally did not uncover unlawful tying arrangements in these examinations. The

Government Accountability Office also recently conducted a review

of bank compliance with Section 106 and found that the available

evidence does not substantiate claims that banks are tying the

availability or price of credit to the purchase of debt underwriting

services from a securities affiliate of the bank.

Based on our supervisory experience, it appears that banking

organizations generally have adequate internal controls to help

prevent illegal tying. The Board, however, will take appropriate supervisory action against a bank within our supervisory jurisdiction

if information developed through the supervisory process or provided by a customer indicates that the bank has imposed a tie on

a customer in violation of Section 106. For example, in 2003, the

Board took enforcement action against a foreign bank for violations

of Section 106 after investigating a tying complaint received from

one of the bank’s customers.

Q.2. In November 2003, the DOJ’s Antitrust Division submitted a

comment letter to the Fed on its proposal to address tying. The letter stated that the prohibitions on tying within Section 106 are

much broader than those found in Federal antitrust laws and that

the Fed’s proposed interpretation and supervisory guidance might

continue to prohibit some pro-competitive practices, such as multiproduct discounting. The DOJ expressed concern that Section 106

disadvantages banks as competitors in markets in which banks and

nonbanks compete—lessening competition and ultimately harming

consumers. The DOJ recommended that the Fed’s interpretation of

Section 106 be consistent with, and not broader than, the Federal

antitrust laws.

It would appear that Section 106 was designed to protect small

business customers or individual consumers from being forced to

buy products they do not wish to purchase. The Division’s letter

further recommends that, at a minimum, Section 106 should be

limited to ties involving small businesses and individual consumers.

What are your views regarding the DOJ’s Antitrust Division’s

recommendations that Section 106 not be interpreted to prohibit

conduct that is not found to be anticompetitive under the Federal

antitrust laws? Also, what are your views on applying general antiVerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00049 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1
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trust standards when banks are dealing with large, sophisticated

customers?

A.2. As you note, the Antitrust Division of the Department of Justice has submitted a comment letter to the Board concerning the

Board’s proposed interpretation of Section 106. In the letter, the

Antitrust Division supported the Board’s efforts to clarify that

Section 106 does not prohibit banks from entering into tying arrangements with their customers when these arrangements are

voluntarily entered into or sought by the bank’s customer (so-called

‘‘voluntary ties’’).

The Division’s letter also expressed concern that Section 106 may

itself harm competition and consumers by limiting the ability of

banks to provide their customers discounts on packaged offerings

and by placing banks at a disadvantage in markets where both

banks and nonbank entities compete. Accordingly, the Division recommended that the Board seek to interpret the antitying restrictions in Section 106 in a manner that is consistent with the tying

restrictions that apply to all companies, including banks, under the

Sherman and Clayton Acts. However, the Antitrust Division’s letter

also recognizes that the courts historically have interpreted Section

106 as imposing significantly more stringent antitying prohibitions

on banks than apply to companies generally under the Sherman

and Clayton Acts and that these precedents may constrain the ability of the Board to interpret Section 106 to be coterminous with the

general antitrust laws.

The Board will carefully consider the views of the Antitrust Division as the Board moves forward with the proposed interpretation

and related matters.

RESPONSE TO A WRITTEN QUESTION OF SENATOR STABENOW

FROM ALAN GREENSPAN

Currency Manipulation

Q.1. As you are aware, there has been a lot of concern in the Senate with both China and Japan’s monetary policy actions, particularly related to Japan’s huge interventions in international

currency markets to maintain an artificially weak yen, as well as

China’s dollar peg. The last time you and I discussed this, you referred to it as a ‘‘problem’’—something the Bush Administration

has been unwilling to do. I would argue that it has been an ongoing problem and requires Government action to end this unfair

currency manipulation tax placed on American products.

I believe that Japan’s long-standing and successful efforts in

maintaining an artificially weak yen have been a major factor in

the ongoing weakness of our manufacturing sector. It also has a

very negative impact on the automotive sector.

Although, as you and I discussed recently, Japan had stopped its interventions in the last several months after spending over $138

billion in the first quarter of this year and over $330 billion since

2003, I would note that significant sums of money, perhaps as

much as $50 billion per month, have been budgeted for such future

actions in Japan’s current fiscal year budget. Financial markets are

also clearly wary of statements from senior officials from Japan’s

Ministry of Finance that the government is not ruling out interVerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1
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vening again in massive amounts again if they so choose. And this

threat alone seems to be putting an artificial ceiling on the yen’s

move toward its appropriate value.

Given on-going concerns over Japan’s currency actions in our last

hearing and the ever-present threat of further massive interventions, should the United States and the G–7 make very clear to

Japan that a resumption of such interventions would be unwelcome

and disruptive to the global economy?

Also, can you provide an analysis of the impact to our economy

of Japan’s successful efforts to weaken its yen? Has it undermined

the Federal Reserve’s efforts to stimulate U.S. economic growth

and create jobs, particularly in the manufacturing sector?

A.1. U.S. policy regarding the foreign exchange value of the dollar—against the yen or any other currency—is the province of the

Secretary of the Treasury, who is also the chief spokesperson for

the U.S. Government on these matters. I defer to the Secretary on

any official U.S. response to the concerns you raise about Japanese

policy operations with respect to the dollar’s exchange value

against the yen. G–7 finance ministers, central bank governors,

and their respective deputies meet frequently to discuss exchange

rates and related foreign exchange operations, such as those conducted earlier this year by Japan.

Japan’s official intervention operations, in which the Japanese

government purchased dollars in foreign exchange markets and

sold yen, may have influenced some U.S. asset prices. One effect

could have been on the foreign exchange value of the dollar against

the yen. In principle, the Japanese operations would have weakened the yen against the dollar, and it is possible that the operations did so, although the size and persistence of any effects are

difficult to judge. However, one should keep in mind that, despite

the large scale of the Japanese operations in 2003 and 2004, the

yen has strengthened against the dollar on balance, rising roughly

20 percent from its low point against the dollar in early 2002.

Because the Japanese authorities invested the proceeds of their

dollar purchases in interest-earning, dollar-denominated assets, another effect of their operations on U.S. asset prices could have come

through the potential effect of these operations on U.S. interest

rates. In principle, the operations would have resulted in increased

demand for U.S. securities and somewhat lower U.S. interest rates.

While it is possible that these operations did have such an effect,

the magnitude of any effect is likely to have been quite small. U.S.

securities markets are the deepest and most liquid of any in the

world, and the scale of the Japanese operations, while large by

some standards, was arguably too small to have had a substantial

effect on the general level of U.S. interest rates.

In any event, the operations of the Japanese have not hampered

the Federal Reserve in its efforts to conduct monetary policy to

achieve price stability and maximum sustainable growth for the

U.S. economy.

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