Alan Greenspan: Federal Reserve Board's semiannual monetary policy report
to the Congress
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Committee on Financial Services, US House of Representatives,
27 February 2002.
* * *
Since July, when I last reported to you on the conduct of monetary policy, the U.S. economy has gone
through a period of considerable strain, with output contracting for a time and unemployment rising.
We in the Federal Reserve System acted vigorously to adjust monetary policy in an endeavor both to
limit the extent of the downturn and to hasten its completion. Despite the disruptions engendered by
the terrorist attacks of September 11, the typical dynamics of the business cycle have re-emerged and
are prompting a firming in economic activity. An array of influences unique to this business cycle,
however, seems likely to moderate the speed of the anticipated recovery.
At the time of our last report, the economy was weakening. Many firms were responding to the
realization that significant overcapacity had developed. The demand for capital goods had dropped
sharply, and inventories were uncomfortably high in many industries. In response, businesses slashed
production, and the resulting declines in incomes amplified the cyclical downturn. Real gross domestic
product did not grow in the second quarter and contracted in the third.
A coincident deceleration in activity among the world economies was evident over the past year,
owing, at least in part, to the retrenchment in the high-technology sector and the global reach of the
capital markets in which the firms in that sector are valued and funded. However, before the terrorist
attacks, it was far from obvious that this concurrent weakness was becoming self-reinforcing. Indeed,
immediately prior to September 11, some sectors exhibited tentative signs of stabilization, contributing
to a hope that the worst of the previous cumulative weakness in world economic activity was nearing
an end.
That hope was decisively dashed by the tragic events of early September. Adding to the intense forces
weighing on asset prices and economic activity before September 11 were new sources of uncertainty
that began to press down on global demand for goods and services. Economies almost everywhere
weakened further, a cause for increasing uneasiness. The simultaneous further slowing in activity
raised concerns that a self-reinforcing cycle of contraction, fed by perceptions of greater economic
risk, could develop. Such an event, though rare, would not be unprecedented in business-cycle
history.
If ever a situation existed in which the fabric of business and consumer confidence, both here and
abroad, was vulnerable to being torn, the shock of September 11 was surely it. In addition to the
horrific loss of life, enormous uncertainties accompanied the unfolding events and their implications for
the economy. Indeed, for a period of weeks, U.S. economic activity did drop dramatically in response
to that shock.
In the immediate aftermath of the strikes, the Federal Reserve engaged in aggressive action to
counter the effects of the shock on payment systems and financial markets. We provided a huge
volume of reserves through open market operations, the discount window, and other means to
facilitate the functioning of the financial system. We worked closely with many market participants,
industry groups, and other government officials on a broad range of financial infrastructure problems
that needed to be resolved quickly and in the common interest.
Still, market functioning was impaired for a time. The substantial damage to trading, settlement, and
communications facilities forced many market participants to their backup sites. Owing in part to
careful and thorough contingency planning, many firms, markets, and exchanges were able to resume
business within a few hours or days of the attacks. Nonetheless, the episode did reveal threats to, and
vulnerabilities of, the operations of financial institutions that had not been previously considered and
illustrated the significant interdependence of the modern financial infrastructure. Institutions will need
to continue to work diligently toward ensuring that their backup capabilities are adequate. We at the
Federal Reserve have been reexamining intensively our own contingency capabilities to ensure that
our central banking functions can be performed in the most pressing of emergency circumstances.
In the weeks following the attacks, along with the drops in activity and confidence, equity prices fell
markedly, and lenders became more cautious, boosting risk premiums, especially on credits already
considered to be weak. In response, the Federal Reserve reduced short-term interest rates
considerably further. Longer-term yields, including mortgage rates, fell to extraordinarily low levels.
The monetary stimulus that we provided was visible not only in interest rates but also in a rapid growth
of liquidity over the final months of the year, as gauged by the broad monetary aggregates. As the
fourth quarter progressed, business and consumer confidence recovered, no doubt buoyed by
successes in the war on terrorism. The improved sentiment seemed to buffer the decline in economic
activity.
Indeed, in the past several months, increasing signs have emerged that some of the forces that have
been restraining the economy over the past year are starting to diminish and that activity is beginning
to firm. The appearance of these signs, in circumstances in which the level of the real federal funds
rate was at a very low level, led the Federal Open Market Committee to keep policy unchanged at its
meeting in late January, although it retained its assessment that the risks were tilted toward economic
weakness.
One key consideration in the assessment that the economy is close to a turning point is the behavior
of inventories. Stocks in many industries have been drawn down to levels at which firms will soon
need to taper off their rate of liquidation, if they have not already done so. Any slowing in the rate of
inventory liquidation will induce a rise in industrial production if demand for those products is stable or
is falling only moderately. That rise in production will, other things being equal, increase household
income and spending. The runoff of inventories, even apart from the large reduction in motor vehicle
stocks, remained sizable in the fourth quarter. Hence, with production running well below sales, the lift
to income and spending from the inevitable cessation of inventory liquidation could be significant.
But that impetus to the growth of activity will be short-lived unless sustained increases in final demand
kick in before the positive effects of the swing from inventory liquidation dissipate. Most recoveries in
the post-World War II period received a boost from a rebound in demand for consumer durables and
housing from recession-depressed levels in addition to an abatement of inventory liquidation. Through
much of last year's slowdown, however, spending by the household sector held up well and proved to
be a major stabilizing force. As a consequence, although household spending should continue to trend
up, the potential for significant acceleration in activity in this sector is likely to be more limited than in
past cycles.
In fact, there are a number of cross currents in the outlook for household spending. In recent months,
low mortgage interest rates and favorable weather have provided considerable support to
homebuilding. Moreover, attractive mortgage rates have bolstered the sales of existing homes and the
extraction of capital gains embedded in home equity that those sales engender. Low rates have also
encouraged households to take on larger mortgages when refinancing their homes. Drawing on home
equity in this manner is a significant source of funding for consumption and home modernization. The
pace of such extractions likely dropped along with the decline in refinancing activity that followed the
backup in mortgage rates that began in early November. But mortgage rates remain at low levels and
should continue to underpin activity in this sector.
Consumer spending received a considerable lift from the sales of new motor vehicles, which were
remarkably strong in October and November owing to major financing incentives. Sales have receded
somewhat as incentives were scaled back, but they have remained surprisingly resilient. Other
consumer spending appears to have advanced at a solid pace in recent months.
The substantial declines in the prices of natural gas, fuel oil, and gasoline have clearly provided some
support to real disposable income and spending. To have a more persistent effect on the ongoing
growth of total personal consumption expenditures, energy prices would need to continue declining.
Futures prices do not suggest that such an outcome is in the offing, though the forecast record of
these markets is less than impressive.
Changes in household financial positions in recent years are probably damping consumer spending, at
least to a degree. Overall household wealth relative to income has dropped from a peak multiple of
about 6.3 at the end of 1999 to around 5.3 currently. Moreover, the aggregate household debt service
burden, defined as the ratio of households' required debt payments to their disposable personal
income, rose considerably in recent years, returning last year to its previous cyclical peak of the
mid-1980s.
However, neither wealth nor the burden of debt is distributed evenly across households. Hence, the
spending effects of changes in these influences also will not be evenly distributed. For example,
increased debt burdens appear disproportionately attributable to higher-income households.
Calculations by staff at the Federal Reserve suggest that the ratio of household liabilities to annual
income for the top fifth of all households ranked by income, who accounted for 44 percent of total
after-tax household income last year, rose from about 1.10 at the end of 1998 to 1.20 at the end of the
third quarter of 2001. The increase for the lower four-fifths was only about half as large. Although
high-income households should not experience much strain in meeting their obligations, others might.
Indeed, repayment difficulties have already increased, particularly in the subprime markets for
consumer loans and mortgages. Delinquency rates may well worsen as a delayed result of the strains
on household finances over the past two years. Large erosions, however, do not seem likely, and the
overall levels of debt and repayment delinquencies do not, as of now, appear to pose a major
impediment to a moderate expansion of consumption spending going forward.
Although the macroeconomic effects of debt burdens may be limited, we have already seen significant
spending restraint among the top fifth of income earners, presumably owing to the drop in equity
prices. The effect of the stock market on other households' spending has been less evident.
Moderate-income households have a much larger proportion of their assets in homes, and the
continuing rise in the value of houses has provided greater support for their net worth. Reflecting these
differences in portfolio composition, the net worth of the top fifth of income earners has dropped far
more than it did for the bottom 80 percent.
As a consequence, excluding capital gains and losses from the calculation, as is the convention in our
national income accounts, personal saving for the upper fifth, which had been negative during 1999
and 2000, turned positive in 2001. By contrast, the average saving rate for the lower four-fifths of
households, by income, was generally positive during the second half of the 1990s and has fluctuated
in a narrow range in the past two years. Accordingly, most of the change in consumption expenditures
that resulted from the bull stock market, and its demise, reflected shifts in spending by upper-income
households. The restraining effects from the net decline in wealth during the past two years
presumably have not, as yet, fully played out and could exert some further damping effect on the
overall growth of household spending relative to that of income.
Perhaps most central to the outlook for consumer spending will be developments in the labor market.
The pace of layoffs quickened last fall, especially after September 11, and the unemployment rate
rose sharply. However, layoffs diminished noticeably in January, and the reported unemployment rate
declined though adjusting for seasonal influences was difficult last month. Moreover, initial claims for
unemployment insurance have decreased markedly, on balance, providing further evidence of an
improvement in labor market conditions. Even if the economy is on the road to recovery, the
unemployment rate, in typical cyclical fashion, may resume its increase for a time, and a soft labor
market could put something of a damper on consumer spending.
However, the extent of such restraint will depend on how much of any rise in unemployment is the
result of weakened demand for goods and services and how much reflects strengthened productivity.
In the latter case, average real incomes of workers could rise, at least partially offsetting losses of
purchasing power that stem from diminished levels of employment. Indeed, preliminary data suggest
that productivity has held up very well of late, and history suggests that any depressing effect of rapid
productivity growth on employment is only temporary.
The dynamics of inventory investment and the balance of factors influencing consumer demand will
have important consequences for the economic outlook in coming months. But the broad contours of
the present cycle have been, and will continue to be, driven by the evolution of corporate profits and
capital investment.
The retrenchment in capital spending over the past year and a half was central to the sharp slowing
we experienced in overall activity. The steep rise in high-tech spending that occurred in the early
post-Y2K months was clearly not sustainable. The demand for many of the newer technologies was
growing rapidly, but capacity was expanding even faster, and that imbalance exerted significant
downward pressure on prices and the profits of producers of high-tech goods and services. New
orders for equipment and software hesitated in the middle of 2000 and then fell abruptly as firms
re-evaluated their capital investment programs. Uncertainty about economic prospects boosted risk
premiums significantly, and this rise, in turn, propelled required, or hurdle, rates of return to markedly
elevated levels. In most cases, businesses required that new investments pay off much more rapidly
than they had previously. For much of last year, the resulting decline in investment outlays was fierce
and unrelenting. Although the weakness was most pronounced in the technology area, reductions in
capital outlays were broad-based.
These cutbacks in capital spending interacted with, and were reinforced by, falling profits and equity
prices. Indeed, a striking feature of the current cyclical episode relative to many earlier ones has been
the virtual absence of pricing power across much of American business, as increasing globalization
and deregulation have enhanced competition. In this low-inflation environment, firms have perceived
very little ability to pass cost increases on to customers. To be sure, growth in hourly labor
compensation has moderated in response to slowed inflation and deteriorating economic conditions. A
significant falloff in stock-option realizations and in other forms of compensation related to company
performance has likely been a factor. But over most of the past year, even those smaller hourly
compensation increases outstripped gains in output per hour, on balance, precipitating a marked
decline in profit margins.
Business managers, with little opportunity to raise prices, have moved aggressively to stabilize cash
flows by trimming workforces. These efforts have limited any rise in unit costs, attenuated the pressure
on profit margins, and ultimately helped to preserve the vast majority of private-sector jobs. To the
extent that businesses are successful in stabilizing and eventually boosting profits and cash flow,
capital spending should begin to recover more noticeably.
Part of the reduction in pricing power observed in this cycle should be reversed as firming demand
enables firms to take back large price discounts. Though such an adjustment would tend to elevate
price levels, underlying inflationary cost pressures should remain contained. To be sure, output per
hour is not likely to accelerate this year as much as in a typical recovery because businesses have not
delayed, as they have in past recessions, shedding workers at the first indications of weakened
demand. But slack in labor markets and further increases in productivity should hold labor costs in
check and result in rising profit margins even with inflation remaining low.
Improved profit margins and more assured prospects for rising final demand would likely be
accompanied by a decline in risk premiums from their current elevated levels toward a more normal
range. With real rates of return on high-tech equipment still attractive, that should provide an additional
spur to new investment. Reports from businesses around the country suggest that the exploitation of
available networking and other information technologies was only partially completed when the cyclical
retrenchment of the past year began. Many business managers are still of the view, according to a
recent survey of purchasing managers, that less than half of currently available new, and presumably
profitable, supply-chain technologies have been put into use.
Recent evidence suggests that a recovery in at least some forms of high-tech investment could
already be under way. Production of semiconductors, which in the past has been a leading indicator of
computer production, turned up last fall. Expenditures on computers rose at a double-digit annual rate
in real terms last quarter. But the contraction of investment expenditures in the communications
sector, where the amount of overcapacity was substantial, as yet shows few signs of abating, and
business investment in some other sectors, such as aircraft, hit by the drop in air travel, will
presumably remain weak this year.
On balance, the recovery in overall spending on business fixed investment is likely to be only gradual;
in particular, its growth will doubtless be less frenetic than in 1999 and early 2000--a period during
which outlays were boosted by the dislocations of Y2K and the extraordinarily low cost of equity capital
available to many firms. Nonetheless, if the recent more-favorable economic developments gather
momentum, uncertainties will diminish, risk premiums will fall, and the pace of capital investment
embodying new technologies will increase.
Even a subdued recovery beginning soon would constitute a truly remarkable performance for the
American economy in the face of so severe a decline in equity asset values and an unprecedented
blow from terrorists to the foundations of our market systems. For, if the tentative indications that the
contraction phase of this business cycle is drawing to a close are ultimately confirmed, we will have
experienced a significantly milder downturn than the long history of business cycles would have led us
to expect. Crucially, the imbalances that triggered the downturn and that could have prolonged this
difficult period did not fester. The obvious questions are what has changed in our economy in recent
decades to provide such resilience and whether such changes will persist into the future.
Doubtless, the substantial improvement in the access of business decisionmakers to real-time
information has played a key role. Thirty years ago, the timeliness of available information varied
across companies and industries, often resulting in differences in the speed and magnitude of their
responses to changing business conditions. In contrast to the situation that prevails today, businesses
did not have real-time data systems that enabled decisionmakers in different enterprises to work from
essentially the same set of information. In those earlier years, imbalances were inadvertently allowed
to build to such an extent that their inevitable correction engendered significant economic stress. That
process of correction and the accompanying economic and financial disruptions too often led to deep
and prolonged recessions. Today, businesses have large quantities of data available virtually in real
time. As a consequence, they address and resolve economic imbalances far more rapidly than in the
past.
The apparent increased flexibility of the American economy arguably also reflects the extent of
deregulation over the past quarter century. Certainly, if the energy sector were still in the tight
regulatory fetters of the 1970s, our flexibility today would be markedly less. That the collapse of Enron
barely registered in the relatively recently developed markets for natural gas and electric power was
encouraging. Although the terrorist attacks hit air travel especially hard over the past few months,
deregulation of that industry has demonstrably increased the quantity and flexibility, if not the
profitability, of air travel over the past twenty years. Trucking and rail deregulation has added flexibility
to the movement of goods across our nation.
Both deregulation and innovation in the financial sector have been especially important in enhancing
overall economic resilience. New financial products--including derivatives, asset-backed securities,
collateralized loan obligations, and collateralized mortgage obligations, among others--have enabled
risk to be dispersed more effectively to those willing to, and presumably capable of, bearing it. Shocks
to the overall economic system are accordingly less likely to create cascading credit failure. Lenders
have the opportunity to be considerably more diversified, and borrowers are far less dependent on
specific institutions for funds. Financial derivatives, particularly, have grown at a phenomenal pace
over the past fifteen years, evidently fulfilling a need to hedge risks that were not readily deflected in
earlier decades. Despite the concerns that these complex instruments have induced (an issue I will
address shortly), the record of their performance, especially over the past couple of stressful years,
suggests that on balance they have contributed to the development of a far more flexible and efficient
financial system--both domestically and internationally--than we had just twenty or thirty years ago.
As a consequence of increased access to real-time information and, more arguably, extensive
deregulation in financial and product markets and the unbundling of risk, imbalances are more likely to
be readily contained, and cyclical episodes overall should be less severe than would be the case
otherwise. If this is indeed the case--and it must be considered speculative until more evidence is
gathered--the implied reduction in volatility, other things equal, would lower risk and equity premiums.
Other things, however, may not be wholly equal. The very technologies that appear to be the main
cause of our apparent increased flexibility and resiliency may also be imparting different forms of
vulnerability that could intensify or be intensified by a business cycle.
From one perspective, the ever-increasing proportion of our GDP that represents conceptual as
distinct from physical value added may actually have lessened cyclical volatility. In particular, the fact
that concepts cannot be held as inventories means a greater share of GDP is not subject to a type of
dynamics that amplifies cyclical swings. But an economy in which concepts form an important share of
valuation has its own vulnerabilities.
As the recent events surrounding Enron have highlighted, a firm is inherently fragile if its value added
emanates more from conceptual as distinct from physical assets. A physical asset, whether an office
building or an automotive assembly plant, has the capability of producing goods even if the reputation
of the managers of such facilities falls under a cloud. The rapidity of Enron's decline is an effective
illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation. The
physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can
vanish overnight. A factory cannot.
The implications of such a loss of confidence for the macroeconomy depend importantly on how freely
the conceptual capital of the fading firm can be replaced by a competitor or a new entrant into the
industry. Even if entry is relatively free, macroeconomic risks can emerge if problems at one particular
firm tend to make investors and counterparties uncertain about other firms that they see as potentially
similarly situated. The difficulty of valuing firms that deal primarily with concepts and the growing size
and importance of these firms may make our economy more susceptible to this type of contagion.
Another, more conventional determinant of stability will be the economy's degree of leverage--the
extent to which debt rather than equity is financing the level of capital. The proper degree of leverage
in a firm, or in an economy as a whole, is an inherently elusive figure that almost certainly changes
from time to time. Clearly, firms find some leverage advantageous in enhancing returns on equity, and
thus moderate leverage undoubtedly boosts the capital stock and the level of output. A sophisticated
financial system, with its substantial array of instruments to unbundle risks, will tend toward a higher
degree of leverage at any given level of underlying economic risk. But, the greater the degree of
leverage in any economy, the greater its vulnerability to unexpected shortfalls in demand and
mistakes.
Indeed, on a historical cost basis, the ratio of debt to net worth for the nonfinancial corporate business
sector did rise, from 71 percent at the end of 1997 to about 81 percent at the end of the third quarter of
last year, though it is still well below its level at the beginning of the recession in 1990. The ratio of
interest payments to cash flow, one indicator of the consequence of leverage, has crept up in recent
years, reflecting growth in debt. However, owing to lower interest rates, it remains far below its levels
of the early 1990s.
Although the fears of business leverage have been mostly confined to specific sectors in recent years,
concerns over potential systemic problems resulting from the vast expansion of derivatives have
reemerged with the difficulties of Enron. To be sure, firms like Enron, and Long-Term Capital
Management before it, were major players in the derivatives markets. But their problems were readily
traceable to an old fashioned excess of debt, however acquired, as well as to opaque accounting of
that leverage and lax counterparty scrutiny. Swaps and other derivatives throughout their short history,
including over the past eighteen months, have been remarkably free of default. Of course, there can
be latent problems in any market that expands as rapidly as these markets have. Regulators and
supervisors are particularly sensitive to this possibility. Derivatives have provided greater flexibility to
our financial system. But their very complexity could leave counterparties vulnerable to significant risk
that they do not currently recognize, and hence these instruments potentially expose the overall
system if mistakes are large. In that regard, the market's reaction to the revelations about Enron
provides encouragement that the force of market discipline can be counted on over time to foster
much greater transparency and increased clarity and completeness in the accounting treatment of
derivatives.
How these countervailing forces for stability evolve will surely be a major determinant of the volatility
that our economy will experience in the years ahead. Monetary policy will have to be particularly
sensitive to the possibility that the resiliency our economy has exhibited during the past two years
signals subtle changes in the way our system functions.
Our most recent experiences underscore this possibility, along with the persistence of a long list of
older, well-tested, economic verities. Inventories, especially among producers and purchasers of
high-tech products, did run to excess over the past year, as sales forecasts went badly astray; alas,
technology has not allowed us to see into the future any more clearly than we could previously. But
technology did facilitate the quick recognition of the weakening in sales and backup of inventories.
This enabled producers to respond forcefully, as evidenced by output adjustments that have resulted
in the extraordinary rate of inventory liquidation we experienced late last year.
For the period just ahead, the central tendency of the forecasts of the members of the Federal Open
Market Committee is for real GDP to rise 2-1/2 to 3 percent during 2002. Such a pace for the growth of
real output is somewhat below the rates of growth typically seen early in previous expansions. Certain
factors, such as the lack of pent-up demand in the consumer sector, significant levels of excess
capacity in a number of industries, weakness and financial fragility in some key international trading
partners, and persistent caution in financial markets at home, seem likely to restrain the near-term
performance of the economy.
In line with past experience during the early stages of expansion, labor market performance is
expected initially to lag as firms rely primarily on overtime and shifts from part-time to full-time work.
The unemployment rate is anticipated to rise somewhat further over 2002, to the area of 6 to
6-1/4 percent. FOMC members evidently anticipate that slack in resource utilization, the lagged effects
of past declines in energy prices, and productivity growth will keep inflation low this year, with the price
index for personal consumption expenditure increasing about 1-1/2 percent.
Despite its forecast that economic growth is likely to resume at a moderate pace, as I already noted,
the Federal Open Market Committee at its meeting on January 30 saw the risks nonetheless as
continuing to be weighted mainly toward conditions that may generate economic weakness in the
foreseeable future. In effect, the FOMC indicated that until the dynamics of sustained expansion are
more firmly in place, it remained concerned about the possibility of weak growth for a time, despite the
very low level of the federal funds rate.
Although there are ample reasons to be cautious about the economic outlook, the recuperative powers
of the U.S. economy, as I have tried to emphasize in my presentation, have been remarkable. When I
presented our report on monetary policy to this Committee last summer, few if any of us could have
anticipated events such as those to which our nation has subsequently been subjected. The economic
consequences of those events and their aftermath are an integral part of the many challenges that we
now collectively face. The U.S. economy has experienced a substantial shock, and, no doubt, we
continue to face risks in the period ahead. But the response thus far of our citizens to these new
economic challenges provides reason for encouragement.