Mr Greenspan presents the Federal Reserve's semi-annual report on monetary policy to the US Senate  (Central Bank Articles and Speeches, 23 Feb 99)
Central bank: fed | Type: speech | Date: 1999-02-23

## Mr Greenspan presents the Federal Reserve's semi-annual report on monetary policy to the US SenateTestimony of the Chairman of the Board of the US Federal Reserve System, Mr Alan Greensp before the Committee on Banking, Housing, and Urban Affairs of the US Senate on 23/02/99.Chairman

and members of the Committee, I appreciate the opportunity to present the F Reserve's semiannual report on monetary policy.The U.S. economy over the past year again performed admirably.

Despite the challenges prese severe economic downturns in a number of foreign countries and episodic financial turmoil and at home, our real GDP grew about 4 percent for a third straight year.

In 1998, 2¾ mi were created on net, bringing the total increase in payrolls to more than 18 million during economic expansion, which late last year became the longest in U.S. peacetime hi Unemployment edged down further to a 4¼ percent rate, the lowest since 1970.And despite taut labor markets, inflation also fell to its lowest rate in many decades by measures, although a portion of this decline owed to decreases in oil, commodity, and oth prices that are unlikely to be repeated.

Hourly labor compensation adjusted for inflation po impressive gains.

Real compensation gains have been supported by robust advances in productivity, which in turn have partly reflected heavy investment in plant and equipme embodying innovative technologies.Can this favorable performance be sustained?

In many respects the fundamental underpinnings recent U.S. economic performance are strong.

Flexible markets and the shift to surplus on of the federal government are facilitating the build-up in cutting-edge capital stock.

Tha turn is spawning rapid advances in productivity that are helping to keep inflation well be new technologies and the optimism of consumers and investors are supporting asset pric sustaining spending.But, after eight years of economic expansion, the economy appears stretched in a num dimensions, implying considerable upside and downside risks to the economic outlook.

The increase of production has been using up our nation's spare labor resources, suggesting t strong growth in spending cannot continue without a pick-up in inflation unless labor pr growth increases significantly further.

Equity prices are high enough to raise questions ab shares are overvalued.

The debt of the household and business sectors has mounted, as external debt of the country as a whole, reflecting the deepening current account deficit. vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be tr to U.S. markets quickly and traumatically.

I will be commenting on many of these issues as the developments of the past year and the prospects going forward.

In light of all these ris policy must be ready to move quickly in either direction should we perceive imbalanc distortions developing that could undermine the economic expansion.

## Recent DevelopmentsA hallmark of our economic performance over the past year was the continuing sharp expans business investment spending.

Competitive global markets and persisting technological advanc spurred the business drive to become more efficient and induced the price declines for many new equipment that made capital spending more attractive.Business success in enhancing productivity and the expectation of still further, perhaps advances buoyed public optimism about profit prospects, which contributed to another sizab in equity prices.

Rising household wealth along with strong growth in real income, relate pay, slower inflation, and expanding job opportunities, boosted consumption at the fastes decade and a half.

The gains in income and wealth last year, along with a further decrease i rates, also prompted considerable activity in the housing sector.The impressive performance of the private sector was reflected in a continued improvement in federal budget.

Burgeoning receipts, along with continuing restraint on federal spending, produce first unified budget surplus in thirty years, allowing the Treasury to begin to pay down the debt held by the public.

This shift in the federal government's fiscal position has fostered an in overall national saving as a share of GDP to 17¼ percent from the 14½ percent low reached 1993.

This rise in national saving has helped to hold down real interest rates and to facili financing of the boom in private investment spending.Foreign savers have provided an additional source of funds for vigorous domestic investment.

T counterpart of our high and rising current account deficit has been ever-faster increases in indebtedness of U.S. residents to foreigners.

The rapid widening of the current account defic some disquieting aspects, especially when viewed in a longer-term context.

Foreigners presumab will not want to raise indefinitely the share of their portfolios in claims on the United State the sustainability of the build-up of our foreign indebtedness come into question, the exchange of the dollar may well decline, imparting pressures on prices in the United States.In the recent economic environment, however, the widening of the trade and current account defi had some beneficial aspects.

It provided a safety valve for strong U.S. domestic demand, the helping to restrain pressures on U.S. resources.

It also cushioned, to some extent, economic wea in our trading partners.Moreover, decreasing import prices, which partly came from the appreciation of the dollar thro mid-summer, contributed to low overall U.S. inflation, as did ample manufacturing capacity in United States and lower prices for oil and other commodities stemming from the weak activity abro The marked drop in energy prices significantly contributed to the subdued, less than 1 perc increase in the price index for total personal consumption expenditures during 1998.

In addi supported by rapid accumulation of more efficient capital, the growth of labor productivity pick last year, allowing nominal labor compensation to post another sizable gain without putting a upward pressure on costs and prices.

I shall return to an analysis of the extraordinary performa inflation later in my remarks.The Federal Open Market Committee conducted monetary policy last year with the aim of sustaining the remarkable combination of economic expansion and low inflation.

At its meetings from March t July, the inflation risks accompanying the continued strength of domestic demand and the tighte of labor markets necessitated that the FOMC place itself on heightened inflation alert.

Althoug FOMC kept the nominal federal funds rate unchanged, it allowed the real funds rate to rise continuing declines in inflation and, presumably, inflation expectations.

In August, the F returned to an unbiased policy predilection in response to the adverse implications for the outlook of worsening conditions in foreign economies and in global financial markets, including own.Shortly thereafter, a further deterioration in financial market conditions began to pose a more threat to economic stability.

In the wake of the Russian crisis and subsequent difficulties i emerging market economies, investors perceived that the uncertainties in financial markets broadened appreciably and as a consequence they became decidedly more risk averse.

Safe-haven demands for U.S. Treasury securities intensified at the expense of private debt securities.

As a quality spreads escalated dramatically, especially for lower-rated issuers.

Many financial ma turned illiquid, with wider bid-asked spreads and heightened price volatility, and issuance disrupted in some private securities markets.

Even the liquidity in the market for seasoned iss U.S. Treasury securities dried up, as investors shifted toward the more actively traded, recentl securities and dealers pared inventories, fearing that heightened price volatility posed an unacc risk to their capital.Responding to losses in foreign financial markets and to pressures from counterparties, hi leveraged investors began to unwind their positions, which further weighed on market conditions. credit became less available to business borrowers in capital markets, their demands were redirto commercial banks, which reacted to the enlarged borrowing, and more uncertain bu prospects, by tightening their standards and terms on such lending.To cushion the domestic economy from the impact of the increasing weakness in foreign econ and the less accommodative conditions in U.S.

financial markets, the FOMC, beginning i September, undertook three policy easings.

By mid-November, the FOMC had reduced the fede funds rate from 5½ percent to 4¾ percent.

These actions were taken to rebalance the ris outlook, and, in the event, the markets have recovered appreciably.

Our economy has weathe disturbances with remarkable resilience, though some yield and bid-asked spreads still hesitancy on the part of market participants to take on risk.

The Federal Reserve must c evaluate, among other issues, whether the full extent of the policy easings undertaken address the seizing-up of financial markets remains appropriate as those disturbances abate.To date, domestic demand and hence employment and output have remained vigorous.

Real GDP estimated to have risen at an annual rate exceeding 5½ percent in the fourth quarter of Although some slowing from this torrid pace is most likely in the first quarter, labor mar exceptionally tight and the economy evidently retains a great deal of underlying momentum the global economic problems and the still-visible remnants of the earlier financial tur United States.

At the same time, no evidence of any upturn in inflation has, as yet, surfaceAbroad, the situation is mixed.

In some East Asian countries that, in recent years, experi of investor confidence, a severe currency depreciation, and a deep recession, early stabilization and economic recovery have appeared.

This is particularly the case for K Thailand.

Authorities in those countries, in the context of IMF stabilization programs established appropriate macroeconomic policies and undertook significant structural ref buttress the banking system and repair the finances of the corporate sector.

As investor con returned, exchange rates have risen and interest rates have fallen.

With persistence and fol on reforms, the future of those economies has promise.The situations in some other emerging market economies are not as encouraging.

The Ru government's decision in mid-August to suspend payments on its domestic debt and devalue th took markets by surprise.

Investor flight exacerbated the collapse of prices in Russia markets and led to a sharp depreciation of the ruble.

The earlier decline in output momentum, and by late in the year inflation had moved up to a triple-digit annual rate. stabilization program with the IMF has been on hold since the financial crisis hit, and t outlook there remains troubling.The Russian financial crisis immediately spilled over to some other countries, hitting Lat especially hard.

Countering downward pressure on the exchange values of the affected cur interest rates moved sharply higher, especially in Brazil.

As a consequence of the high in and growing economic uncertainty, Brazil's economic activity took a turn for the worse. interest rates also had negative consequences for the fiscal outlook, as much of Brazil's domestic debt effectively carries floating interest rates.

With budget reform legislation various setbacks, market confidence waned further and capital outflows from Brazil con drawing down foreign currency reserves.

Ultimately, the decision was taken to allow the rea and it subsequently depreciated sharply.Brazilian authorities must walk a very narrow, difficult path of restoring confidence a inflation contained with monetary policy while dealing with serious fiscal imbalances.

Alt situation in Brazil remains uncertain, there has been limited contagion to other countri Apparently, the slow onset of the crisis has enabled many parties with Brazilian exposures those positions or allow them to run off.

With the net exposure smaller, and increasingly he who both recognized the heightened risk and were willing to bear it, some of the elements have contributed to further contagion may have been significantly reduced.

## The Economic OutlookThese

recent domestic and international developments provide the backdrop for U.S.

economic prospects.

Our economy's performance should remain solid this year, though likely with a slow pace of economic expansion and a slightly higher rate of overall inflation than last year.

The s business equipment, housing, and household durable goods have been growing rapidly to quite hig levels relative to business sales or household incomes during the past few years, and some slowi the growth of spending on these items seems a reasonable prospect.

Moreover, part of the ra increase in spending, especially in the household sector, has resulted from the surge in w associated with a run-up in equity prices that is unlikely to be repeated.

And the purchasing po income and wealth has been enhanced by declines in oil and other import prices, which also unlikely to recur this year.

Assuming that aggregate demand decelerates, underlying infla pressures, as captured by core price measures, in all likelihood will not intensify significant year ahead, though the Federal Reserve will need to monitor developments carefully.

We percei stable prices as optimum for economic growth.

Both inflation and deflation raise volatility and that thwart maximum economic growth.Most Governors and Reserve Bank Presidents foresee that economic growth this year will slow to 2½ to 3 percent rate.

Such growth would keep the unemployment rate about unchanged.

The central tendency of the Governors' and Presidents' predictions of CPI inflation is 2 to 2½ percent.

This represents a pick-up from last year, when energy prices were falling, but it is in the vicinit CPI inflation over the last couple of years.This outlook involves several risks.

The continuing downside risk posed by possible economic a financial instability around the world was highlighted earlier this year by the events in Although financial contagion elsewhere has been limited to date, more significant knock-on effec financial markets and in the economies of Brazil's important trading partners, including the U States, are still possible.

Moreover, the economies of several of our key industrial trading have shown evidence of weakness, which if it deepens could further depress demands for our exportAnother downside risk is that growth in capital spending, especially among manufacturers, co weaken appreciably if pressures on domestic profit margins mount and capacity utilization dr further.

And it remains to be seen whether corporate earnings will disappoint investors, even slowing of economic growth is only moderate.

Investors appear to have incorporated into curr equity price levels both robust profit expectations and low compensation for risk.

As the eco slows to a more sustainable pace as expected, profit forecasts could be pared back, which tog with a greater sense of vulnerability in business prospects could damp appetites for equiti downward correction to stock prices, and an associated increase in the cost of equity capital, compound a slowdown in the growth of capital spending.

In addition, a stock market decline wou tend to restrain consumption spending through its effect on household net worth.But on the upside, our economy has proved surprisingly robust in recent years.

More rapid incre in capital spending, productivity, real wages, and asset prices have combined to boost econo growth far more and far longer than many of us would have anticipated.This 'virtuous cycle' has been able to persist because the behavior of inflation also has surprisingly favorable, remaining well contained at levels of utilization of labor that in the p have produced accelerating prices.

That it has not done so in recent years has been the resul combination of special one-time factors holding down prices and more lasting changes in t processes determining inflation.Among the temporary factors, the sizable declines in the prices of oil, other internationally commodities, and other imports contributed directly to holding down inflation last year, and indirectly by reducing inflation expectations.

But these prices are not likely to fall further, could begin to rise as some Asian economies revive and the effects of the net depreciation o dollar since mid-summer are felt more strongly.At the same time, however, recent experience does seem to suggest that the economy has beco inflation prone than in the past, so that the chances of an inflationary breakout arguably for now, less than they would have been under similar conditions in earlier cycles.Several years ago I suggested that worker insecurity might be an important reason for u damped inflation.

From the early 1990s through 1996, survey results indicated that worke becoming much more concerned about being laid off.

Workers' underlying fear of technology-d job obsolescence, and hence willingness to stress job security over wage increases, appear suppressed labor cost pressures despite a reduced unemployment rate.

More recently, tha seems to have diminished in part.

So while job loss fears probably contributed to wage suppression through 1996, it does not appear that a further heightening of worker insecu employment prospects can explain the more recent improved behavior of inflation.Instead, a variety of evidence, anecdotal and otherwise, suggests that the source of recen inflation may be emanating more from employers than from employees.

In the current econ setting, businesses sense that they have lost pricing power and generally have been unwilli wages any faster than they can support at current price levels.

Firms have evidently conclu they try to increase their prices, their competitors will not follow, and they will lose ma profits.Given the loss of pricing power, it is not surprising that individual employers resist pay why has pricing power of late been so delimited.

Monetary policy certainly has played a constraining the rise in the general level of prices and damping inflation expectations ov and 1990s.

But our current discretionary monetary policy has difficulty anchoring the price time in the same way that the gold standard did in the last century.Enhanced opportunities for productive capital investment to hold down costs also may have h damp inflation.

Through the 1970s and 1980s, firms apparently found it easier and more prof seek relief from rising nominal labor costs through price increases than through cost-reduc investments.

Price relief evidently has not been available in recent years.

But relie pressures has.

The newer technologies have made capital investment distinctly more pro enabling firms to substitute capital for labor far more productively than they would have two ago.Starting in 1993, capital investment, especially in high-tech equipment, rose sharply beyo cyclical experience, apparently the result of expected increases in rates of return investment.

Had the profit expectations not been realized, one would have anticipated outl back.

Instead, their growth accelerated through the remainder of the decade.More direct evidence confirms improved underlying profitability.

According to rough estimate and capital productivity has risen significantly during the past five years.

It seems l synergies of advances in laser, fiber optic, satellite, and computer technologies technologies have enlarged the pool of opportunities to achieve a rate of return above capital.

Moreover, the newer technologies have facilitated a dramatic foreshortening of the on the delivery of capital equipment over the past decade, presumably allowing businesses more expeditiously to an actual or expected rise in nominal compensation costs than, say, have in the 1980s.

In addition, the surge in investment not only has restrained costs, increased industrial capacity faster than factory output has risen.

The resulting slack markets has put greater competitive pressure on businesses to hold down prices, despite markets.The role of technology in damping inflation is manifest not only in its effects on U.S. prod costs, but also through international trade, where technological developments have prog broken down barriers to cross-border trade.

The enhanced competition in tradable goods has excess capacity previously bottled up in one country to augment worldwide supply and exert on prices in all countries' markets.

The resulting price discipline also has constrained n gains in internationally tradable goods industries.

As workers have attempted to shift to ogains in nominal wages and increases in prices in nontradable goods industries have been held d as well.The process of price containment has potentially become, to some extent, self-reinforcing.

Lo inflation in recent years has altered expectations.

Workers no longer believe that escalating g nominal wages are needed to reap respectable increases in real wages, and their remaining sens job insecurity is reinforcing this.

Since neither firms nor their competitors can count any lon general inflationary tendency to validate decisions to raise their own prices, each company compelled to concentrate on efforts to hold down costs.

The availability of new technology to company and its rivals affords both the opportunity and the competitive necessity of taking st boost productivity.It is difficult to judge whether these significant shifts in the market environment in which function are sufficient to account for our benign overall price behavior during the past half Undoubtedly, other factors have been at work as well, including those temporary factors I mentio earlier and some more lasting I have not discussed, such as worldwide deregulation and privatiza and the freeing-up of resources previously employed to produce military products that was brou about by the end of the cold war.

There also may be other contributory forces lurking unseen i wings that will only become clear in time.

Over the longer run, of course, the actions of the bank determine the degree of overall liquidity and hence rate of inflation.

It is up to us to va favorable inflation developments of recent years.Although the pace of productivity increase has picked up in recent years, the extraordinary stren demand has meant that the substitution of capital for labor has not prevented us from rap depleting the pool of available workers.

This worker depletion constitutes a critical upside ris inflation outlook because it presumably cannot continue for very much longer without putti increasing pressure on labor markets and on costs.The number of people willing to work can be usefully defined as the unemployed component of th labor force plus those not actively seeking work, and thus not counted in the labor force, bu nonetheless say they would like a job if they could get one.

This pool of potential workers aged 64 currently numbers about 10 million, or just 5¾ percent of that group's population - the lowest percentage on record, which begins in 1970, and 2½ percentage points below its average over t period.

The rapid increase in aggregate demand has generated growth of employment in excess o growth in population, causing the number of potential workers to fall since the mid-1990s at a r a bit under 1 million annually.

We cannot judge with precision how much further this level decline without sparking ever greater upward pressures on wages and prices.

But, should labor mar conditions continue to tighten, there has to be some point at which the rise in nominal wages wil increasingly outpacing the gains in labor productivity, and prices inevitably will begin to accel

## Ranges for Money and CreditAt its February meeting, the Committee elected to ratify the provisional ranges for all three agg that it had established last July.

Specifically, the Committee again has set growth rate ranges four quarters of 1999 of 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for d nonfinancial debt.

As in previous years, the Committee interpreted the ranges for the bro monetary aggregates as benchmarks for what money growth would be under conditions of price stability and sustainable economic growth, assuming historically typical velocity behavior.Last year, these monetary aggregates far overshot the upper bounds of their annual ranges.

Wh nominal GDP growth did exceed the rate likely consistent with sustained price stability, the growth of M2 and M3 also reflected outsized declines in their velocities, that is, the ratio of GDP to money.

M2 velocity dropped by about 3 percent, while M3 velocity plunged by 5¼ percent.Part of these velocity declines reflected some reduction in the opportunity cost of holding m interest rates on Treasury securities, which represent an alternative return on non-monetary dropped more than did the average of interest rates on deposits and money market mutual fundsM2, drawing funds into the aggregate.

Even so, much of last year's aberrant behavior of bro velocity cannot readily be explained by conventional determinants.

Although growth of th aggregates was strong earlier in the year, it accelerated in the fourth quarter after c became turbulent.

Perhaps robust money growth late in the year partly reflected a reacti turmoil by the public, who began scrambling for safer and more liquid financial assets. expansion has moderated so far this year, evidently in lagged response to the calming of markets in the autumn.

Layered on top of these influences, though, the public also may h reapportioning their savings flows into money balances because the huge run-up in stock recent years has resulted in an uncomfortable portion of their net worth in equity.For the coming year, the broad monetary aggregates could again run high relative to these r be sure, the decline in the velocities of the broader aggregates this year should abate to as money demand behavior returns more to normal, and growth in nominal GDP should slow as w as suggested by the Governors' and Presidents' central tendency.

Both factors would restr money expansion relative to last year.

Still, the growth of M2 and M3 could well remain out price-stability ranges this year.

Obviously, considerable uncertainty continues to su prospective behavior of monetary velocities and growth rates.Domestic nonfinancial debt seems more likely than the monetary aggregates to grow within it for this year.

Indeed, domestic nonfinancial debt also could grow more slowly this year year's 6¼ percent pace, which was in the upper part of its 3 to 7 percent annual range. federal budget surplus poised to widen further this year, federal debt should contract quickly than last year.

And debt in each of the major nonfederal sectors in all like decelerate as well from last year's relatively elevated rates, along with the projected nominal GDP growth.

## The FOMC's Disclosure PolicyThe FOMC at recent meetings has discussed not only the stance of policy, but also when and communicates its views of the evolving economic situation to the public.

The FOMC's objecti release as much information about monetary policy decision making, and as promptly, as is c with maintaining an effective deliberative process and avoiding roiling markets unnecessar early 1994, each change in the target nominal federal funds rate has been announced imme with a brief rationale for the action.

The FOMC resolved at its December meeting to take a of an available, but unused policy, originally stated in early 1994, of releasing, on an in a statement immediately after some FOMC meetings at which the stance of monetary policy ha been changed.

The Federal Reserve will release such a statement when it wishes to communic the public a major shift in its views about the balance of risks or the likely direction o Such an announcement need not be made after every change in the tilt of the directive.

In option would be reserved for situations in which the consensus of the Committee clearly ha significantly, though not by enough to change current policy, and in which the absenc explanation risked misleading markets about the prospects for monetary policy.

## Year 2000 IssuesBefore closing, I'd like to address an issue that has been receiving increasing attention date

change.

While no one can say that the rollover to the year 2000 will be trouble impressed by the efforts to date to address the problem in the banking and financial syste part, the Federal Reserve System has now completed remediation and testing of 101 of i mission-critical applications, with the remaining two to be replaced by the end of March.

W a test facility in June at which more than 6000 depository institutions to date have condu their Y2K compliant systems, and we are well along in our risk mitigation and contingency activities.

As a precautionary measure, the Federal Reserve has acted to increase the c inventory by about one-third to approximately $200 billion in late 1999 and has other co arrangements available if needed.

While we do not expect currency demand to increase dramat the Federal Reserve believes it is important for the public to have confidence in the avcash in advance of the rollover.

As a result of these kinds of activities, I can say with assur the Federal Reserve will be ready in both its operations and planning activities for the mill rollover.The banking industry is also working hard, and with evident success, to prepare for the event.

B end of the first quarter, every institution in the industry will have been subject to two roun site Y2K examinations.

The Federal Reserve, like the other regulators, has found that only a minority of institutions have fallen behind in their preparations, and those institutions ha targeted for additional follow-up and, as necessary, formal enforcement actions.

The overwhelm majority of the industry has made impressive progress in its remediation, testing, and contin planning efforts.

## Concluding CommentAmericans can justifiably feel proud of their recent economic achievements.

Competitive market with open trade both domestically and internationally, have kept our production efficient and o expanding frontier of technological innovation.

The determination of Americans to improve th skills and knowledge has allowed workers to be even more productive, elevating their real earni Macroeconomic policies have provided a favorable setting for the public to take greatest advanta opportunities to improve their economic well being.

The restrained fiscal policy of the Administ and the Congress has engendered the welcome advent of a unified budget surplus, freeing up funds capital investment.

A continuation of responsible fiscal and, we trust, monetary policies should Americans the opportunity to make considerable further economic progress over time.