Mr Greenspan's testimony on monetary policy and the economic outlook in the United
States
Testimony of the Chairman of the Board of Governors of the US Federal Reserve System,
Mr Alan Greenspan, before the Joint Economic Committee of the US Congress on 17 June
1999.
As emphasized by the important hearings this committee has held in the past few days, an
impressive proliferation of new technologies is inducing major shifts in the underlying
structure of the American economy. These fundamental changes appear to be far from
complete. The way America does business, including the interaction among the various
economic players in our economy, is in the midst of a significant transformation, though the
pace of change is unclear.
As a consequence, many of the empirical regularities depicting the complex of economic
relationships on which policymakers rely have been markedly altered. The Federal Reserve
has thus been pressed to continuously update our understanding of how the newer forces are
developing in order for us to address appropriately our underlying monetary policy objective:
maximum sustainable economic growth.
The failure of economic models based on history to anticipate the acceleration in productivity
contributed to the recent persistent underprediction of economic growth and overprediction of
inflation. Guiding policy by those models doubtless would have unduly inhibited what has
been a remarkable run of economic prosperity.
And yet, while we have been adjusting the implicit models of the underlying economic forces
on which we base our decisions, certain verities remain.
Importantly, the evidence has become increasingly persuasive that relatively stable prices -
neither persistently rising nor falling - are more predictable hence result in a lower risk
premium for investment. Because the nation's level of investment, to a large extent,
determines our prosperity over time, stability in the general level of prices for goods and
services is clearly a necessary condition for maximum sustainable growth. However, product
price stability does not guarantee either the maintenance of financial market stability or
maximum sustainable growth.
As recent experience attests, a prolonged period of price stability does help to foster economic
prosperity. But, as we have also observed over recent years, as have others in times past, such
a benign economic environment can induce investors to take on more risk and drive asset
prices to unsustainable levels. This can occur when investors implicitly project rising
prosperity further into the future than can reasonably be supported. By 1997, for example,
measures of risk had fallen to historic lows as businesspeople, having experienced years of
continuous good times, assumed, not unreasonably, that the most likely forecast was more of
the same.
The Asian crisis, and especially the Russian devaluation and debt moratorium of August 1998,
brought the inevitable rude awakening. In the ensuing weeks, financial markets in the United
States virtually seized-up, risk premiums soared, and for a period sellers of even investment
grade bonds had difficulty finding buyers. The Federal Reserve responded with a three step
reduction in the federal funds rate totaling 75 basis points.
Market strains receded - whether as a consequence of our actions or of other forces - and
yield spreads have since fallen but not all the way back to their unduly thin levels of last
summer.
The American economy has retained its momentum and emerging economies in Asia and
Latin America are clearly on firmer footing, though in some cases their turnarounds appear
fragile. The recovery of financial markets, viewed in isolation, would have suggested that at
least part of the emergency injection of liquidity, and the associated 75 basis point decline in
the funds rate, ceased to be necessary. But, with wage growth and price inflation declining by
a number of measures earlier this year, and productivity evidently still accelerating - thereby
keeping inflation in check - we chose to maintain the lower level of the funds rate.
While this stellar noninflationary economic expansion still appears remarkably stress free on
the surface, there are developing imbalances that give us pause and raise the question: Do
these imbalances place our economic expansion at risk?
For the period immediately ahead, inflationary pressures still seem well contained. To be sure,
oil prices have nearly doubled and some other commodity prices have firmed, but large
productivity gains have held unit cost increases to negligible levels. Pricing power is still
generally reported to be virtually nonexistent. Moreover, the re-emergence of rising profit
margins, after severe problems last fall, indicates cost pressures on prices remain small.
Nonetheless, the persistence of certain imbalances pose a risk to the longer-run outlook.
Strong demand for labor has continued to reduce the pool of available workers. Data showing
the percent of the relevant population who are not at work, but would like a job, are around
the low for this series, which started in 1970.
Despite its extraordinary acceleration, labor productivity has not grown fast enough to
accommodate the increased demand for labor induced by the exceptional strength in demand
for goods and services.
Overall economic growth during the past three years has averaged four percent annually, of
which roughly two percentage points reflected increased productivity and about one point the
growth in our working age population. The remainder was drawn from the ever decreasing
pool of available job seekers without work.
That last development represents an unsustainable trend that has been produced by an
inclination of households and firms to increase their spending on goods and services beyond
the gains in their income from production. That propensity to spend, in turn, has been spurred
by the rise in equity and home prices, which our analysis suggests can account for at least one
percentage point of GDP growth over the past three years.
Even if this period of rapid expansion of capital gains comes to an end shortly, there remains a
substantial amount in the pipeline to support outsized increases in consumption for many
months into the future. Of course, a dramatic contraction in equity market prices would
greatly reduce this backlog of extra spending.
To be sure, labor market tightness has not, as yet, put the current expansion at risk. Despite
the ever shrinking pool of available labor, recent readings on year-over-year increases in labor
compensation have held steady or, by some measures, even eased. This seems to have resulted
in part from falling inflation, which has implied that relatively modest nominal wage gains
have provided healthy increases in purchasing power. Also, a residual fear of job skill
obsolescence, which has induced a preference for job security over wage gains, probably is
still holding down wage levels.
But should labor markets continue to tighten, significant increases in wages, in excess of
productivity growth, will inevitably emerge, absent the unlikely repeal of the law of supply
and demand. Because monetary policy operates with a significant lag, we have to make
judgments, not only about the current degree of balance in the economy, but about how the
economy is likely to fare a year or more in the future under the current policy stance.
The return of financial markets to greater stability and our growing concerns about emerging
imbalances led the Federal Open Market Committee to adopt a policy position at our May
meeting that contemplated a possible need for an upward adjustment of the federal funds rate
in the months ahead. The issue is what policy setting has the capacity to sustain our
remarkable economic expansion, now in its ninth year. This is the question the FOMC will be
addressing at its meeting at the end of the month.
One of the important issues for the FOMC as it has made such judgments in recent years has
been the weight to place on asset prices. As I have already noted, history suggests that owing
to the growing optimism that may develop with extended periods of economic expansion,
asset price values can climb to unsustainable levels even if product prices are relatively stable.
The 1990s have witnessed one of the great bull stock markets in American history. Whether
that means an unstable bubble has developed in its wake is difficult to assess. A large number
of analysts have judged the level of equity prices to be excessive, even taking into account the
rise in "fair value" resulting from the acceleration of productivity and the associated long-term
corporate earnings outlook.
But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires
a judgment that hundreds of thousands of informed investors have it all wrong. Betting against
markets is usually precarious at best.
While bubbles that burst are scarcely benign, the consequences need not be catastrophic for
the economy.
The bursting of the Japanese bubble a decade ago did not lead immediately to sharp
contractions in output or a significant rise in unemployment. Arguably, it was the subsequent
failure to address the damage to the financial system in a timely manner that caused Japan's
current economic problems. Likewise, while the stock market crash of 1929 was destabilizing,
most analysts attribute the Great Depression to ensuing failures of policy. And certainly the
crash of October 1987 left little lasting imprint on the American economy.
This all leads to the conclusion that monetary policy is best primarily focused on stability of
the general level of prices of goods and services as the most credible means to achieve
sustainable economic growth. Should volatile asset prices cause problems, policy is probably
best positioned to address the consequences when the economy is working from a base of
stable product prices.
For monetary policy to foster maximum sustainable economic growth, it is useful to pre-empt
forces of imbalance before they threaten economic stability. But this may not always be
possible - the future at times can be too opaque to penetrate. When we can be pre-emptive we
should be, because modest pre-emptive actions can obviate the need of more drastic actions at
a later date that could destabilize the economy.
The economic expansion has generated many benefits. It has been a major factor in
rebalancing our federal budget. But more important, a broad majority of our people have
moved to a higher standard of living, and we have managed to bring into the productive
workforce those who have too long been at its periphery. This has enabled large segments of
our society to gain skills on the job and the self-esteem associated with work. Our
responsibility, at the Federal Reserve and in Congress, is to create the conditions most likely
to preserve and extend the expansion.
Should the economic expansion continue into February of next year, it will have become the
longest in America's economic annals. Someday, of course, the expansion will end; human
nature has exhibited a tendency to excess through the generations with the inevitable
economic hangover. There is nothing in our economic data series to suggest that this
propensity has changed. It is the job of economic policymakers to mitigate the fallout when it
occurs, and, hopefully, ease the transition to the next expansion.