Mr Greenspan presents the Federal Reserve's semi-annual report on monetary policy to the US
Senate
Testimony of the Chairman of the Board of the US Federal Reserve System, Mr Alan Greenspan,
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 Federal
Reserve's semiannual report on monetary policy.
The U.S. economy over the past year again performed admirably. Despite the challenges presented by
severe economic downturns in a number of foreign countries and episodic financial turmoil abroad
and at home, our real GDP grew about 4 percent for a third straight year. In 1998, 23⁄4 million jobs
were created on net, bringing the total increase in payrolls to more than 18 million during the current
economic expansion, which late last year became the longest in U.S. peacetime history.
Unemployment edged down further to a 41⁄4 percent rate, the lowest since 1970.
And despite taut labor markets, inflation also fell to its lowest rate in many decades by some broad
measures, although a portion of this decline owed to decreases in oil, commodity, and other import
prices that are unlikely to be repeated. Hourly labor compensation adjusted for inflation posted further
impressive gains. Real compensation gains have been supported by robust advances in labor
productivity, which in turn have partly reflected heavy investment in plant and equipment, often
embodying innovative technologies.
Can this favorable performance be sustained? In many respects the fundamental underpinnings of the
recent U.S. economic performance are strong. Flexible markets and the shift to surplus on the books
of the federal government are facilitating the build-up in cutting-edge capital stock. That build-up in
turn is spawning rapid advances in productivity that are helping to keep inflation well behaved. The
new technologies and the optimism of consumers and investors are supporting asset prices and
sustaining spending.
But, after eight years of economic expansion, the economy appears stretched in a number of
dimensions, implying considerable upside and downside risks to the economic outlook. The robust
increase of production has been using up our nation's spare labor resources, suggesting that recent
strong growth in spending cannot continue without a pick-up in inflation unless labor productivity
growth increases significantly further. Equity prices are high enough to raise questions about whether
shares are overvalued. The debt of the household and business sectors has mounted, as has the
external debt of the country as a whole, reflecting the deepening current account deficit. We remain
vulnerable to rapidly changing conditions overseas, which, as we saw last summer, can be transmitted
to U.S. markets quickly and traumatically. I will be commenting on many of these issues as I review
the developments of the past year and the prospects going forward. In light of all these risks, monetary
policy must be ready to move quickly in either direction should we perceive imbalances and
distortions developing that could undermine the economic expansion.
Recent Developments
A hallmark of our economic performance over the past year was the continuing sharp expansion of
business investment spending. Competitive global markets and persisting technological advances both
spurred the business drive to become more efficient and induced the price declines for many types of
new equipment that made capital spending more attractive.
Business success in enhancing productivity and the expectation of still further, perhaps accelerated,
advances buoyed public optimism about profit prospects, which contributed to another sizable boost
in equity prices. Rising household wealth along with strong growth in real income, related to better
pay, slower inflation, and expanding job opportunities, boosted consumption at the fastest clip in a
decade and a half. The gains in income and wealth last year, along with a further decrease in mortgage
rates, also prompted considerable activity in the housing sector.
The impressive performance of the private sector was reflected in a continued improvement in the
federal budget. Burgeoning receipts, along with continuing restraint on federal spending, produced the
first unified budget surplus in thirty years, allowing the Treasury to begin to pay down the federal
debt held by the public. This shift in the federal government's fiscal position has fostered an increase
in overall national saving as a share of GDP to 171⁄4 percent from the 141⁄2 percent low reached in
1993. This rise in national saving has helped to hold down real interest rates and to facilitate the
financing of the boom in private investment spending.
Foreign savers have provided an additional source of funds for vigorous domestic investment. The
counterpart of our high and rising current account deficit has been ever-faster increases in the net
indebtedness of U.S. residents to foreigners. The rapid widening of the current account deficit has
some disquieting aspects, especially when viewed in a longer-term context. Foreigners presumably
will not want to raise indefinitely the share of their portfolios in claims on the United States. Should
the sustainability of the build-up of our foreign indebtedness come into question, the exchange value
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 deficits
had some beneficial aspects. It provided a safety valve for strong U.S. domestic demand, thereby
helping to restrain pressures on U.S. resources. It also cushioned, to some extent, economic weakness
in our trading partners.
Moreover, decreasing import prices, which partly came from the appreciation of the dollar through
mid-summer, contributed to low overall U.S. inflation, as did ample manufacturing capacity in the
United States and lower prices for oil and other commodities stemming from the weak activity abroad.
The marked drop in energy prices significantly contributed to the subdued, less than 1 percent,
increase in the price index for total personal consumption expenditures during 1998. In addition,
supported by rapid accumulation of more efficient capital, the growth of labor productivity picked up
last year, allowing nominal labor compensation to post another sizable gain without putting added
upward pressure on costs and prices. I shall return to an analysis of the extraordinary performance of
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 to
July, the inflation risks accompanying the continued strength of domestic demand and the tightening
of labor markets necessitated that the FOMC place itself on heightened inflation alert. Although the
FOMC kept the nominal federal funds rate unchanged, it allowed the real funds rate to rise with
continuing declines in inflation and, presumably, inflation expectations. In August, the FOMC
returned to an unbiased policy predilection in response to the adverse implications for the U.S.
outlook of worsening conditions in foreign economies and in global financial markets, including our
own.
Shortly thereafter, a further deterioration in financial market conditions began to pose a more serious
threat to economic stability. In the wake of the Russian crisis and subsequent difficulties in other
emerging market economies, investors perceived that the uncertainties in financial markets had
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 result,
quality spreads escalated dramatically, especially for lower-rated issuers. Many financial markets
turned illiquid, with wider bid-asked spreads and heightened price volatility, and issuance was
disrupted in some private securities markets. Even the liquidity in the market for seasoned issues of
U.S. Treasury securities dried up, as investors shifted toward the more actively traded, recently issued
securities and dealers pared inventories, fearing that heightened price volatility posed an unacceptable
risk to their capital.
Responding to losses in foreign financial markets and to pressures from counterparties, highly
leveraged investors began to unwind their positions, which further weighed on market conditions. As
credit became less available to business borrowers in capital markets, their demands were redirected
to commercial banks, which reacted to the enlarged borrowing, and more uncertain business
prospects, by tightening their standards and terms on such lending.
To cushion the domestic economy from the impact of the increasing weakness in foreign economies
and the less accommodative conditions in U.S. financial markets, the FOMC, beginning in late
September, undertook three policy easings. By mid-November, the FOMC had reduced the federal
funds rate from 51⁄2 percent to 43⁄4 percent. These actions were taken to rebalance the risks to the
outlook, and, in the event, the markets have recovered appreciably. Our economy has weathered the
disturbances with remarkable resilience, though some yield and bid-asked spreads still reflect a
hesitancy on the part of market participants to take on risk. The Federal Reserve must continue to
evaluate, among other issues, whether the full extent of the policy easings undertaken last fall to
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 is
estimated to have risen at an annual rate exceeding 51⁄2 percent in the fourth quarter of last year.
Although some slowing from this torrid pace is most likely in the first quarter, labor markets remain
exceptionally tight and the economy evidently retains a great deal of underlying momentum despite
the global economic problems and the still-visible remnants of the earlier financial turmoil in the
United States. At the same time, no evidence of any upturn in inflation has, as yet, surfaced.
Abroad, the situation is mixed. In some East Asian countries that, in recent years, experienced a loss
of investor confidence, a severe currency depreciation, and a deep recession, early signs of
stabilization and economic recovery have appeared. This is particularly the case for Korea and
Thailand. Authorities in those countries, in the context of IMF stabilization programs, early on
established appropriate macroeconomic policies and undertook significant structural reforms to
buttress the banking system and repair the finances of the corporate sector. As investor confidence has
returned, exchange rates have risen and interest rates have fallen. With persistence and follow-through
on reforms, the future of those economies has promise.
The situations in some other emerging market economies are not as encouraging. The Russian
government's decision in mid-August to suspend payments on its domestic debt and devalue the ruble
took markets by surprise. Investor flight exacerbated the collapse of prices in Russian financial
markets and led to a sharp depreciation of the ruble. The earlier decline in output gathered
momentum, and by late in the year inflation had moved up to a triple-digit annual rate. Russia's
stabilization program with the IMF has been on hold since the financial crisis hit, and the economic
outlook there remains troubling.
The Russian financial crisis immediately spilled over to some other countries, hitting Latin America
especially hard. Countering downward pressure on the exchange values of the affected currencies,
interest rates moved sharply higher, especially in Brazil. As a consequence of the high interest rates
and growing economic uncertainty, Brazil's economic activity took a turn for the worse. Higher
interest rates also had negative consequences for the fiscal outlook, as much of Brazil's substantial
domestic debt effectively carries floating interest rates. With budget reform legislation encountering
various setbacks, market confidence waned further and capital outflows from Brazil continued,
drawing down foreign currency reserves. Ultimately, the decision was taken to allow the real to float,
and it subsequently depreciated sharply.
Brazilian authorities must walk a very narrow, difficult path of restoring confidence and keeping
inflation contained with monetary policy while dealing with serious fiscal imbalances. Although the
situation in Brazil remains uncertain, there has been limited contagion to other countries thus far.
Apparently, the slow onset of the crisis has enabled many parties with Brazilian exposures to hedge
those positions or allow them to run off. With the net exposure smaller, and increasingly held by those
who both recognized the heightened risk and were willing to bear it, some of the elements that might
have contributed to further contagion may have been significantly reduced.
The Economic Outlook
These 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 slower
pace of economic expansion and a slightly higher rate of overall inflation than last year. The stocks of
business equipment, housing, and household durable goods have been growing rapidly to quite high
levels relative to business sales or household incomes during the past few years, and some slowing in
the growth of spending on these items seems a reasonable prospect. Moreover, part of the rapid
increase in spending, especially in the household sector, has resulted from the surge in wealth
associated with a run-up in equity prices that is unlikely to be repeated. And the purchasing power of
income and wealth has been enhanced by declines in oil and other import prices, which also are
unlikely to recur this year. Assuming that aggregate demand decelerates, underlying inflation
pressures, as captured by core price measures, in all likelihood will not intensify significantly in the
year ahead, though the Federal Reserve will need to monitor developments carefully. We perceive
stable prices as optimum for economic growth. Both inflation and deflation raise volatility and risks
that thwart maximum economic growth.
Most Governors and Reserve Bank Presidents foresee that economic growth this year will slow to a
21⁄2 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 21⁄2 percent. This level
represents a pick-up from last year, when energy prices were falling, but it is in the vicinity of core
CPI inflation over the last couple of years.
This outlook involves several risks. The continuing downside risk posed by possible economic and
financial instability around the world was highlighted earlier this year by the events in Brazil.
Although financial contagion elsewhere has been limited to date, more significant knock-on effects in
financial markets and in the economies of Brazil's important trading partners, including the United
States, are still possible. Moreover, the economies of several of our key industrial trading partners
have shown evidence of weakness, which if it deepens could further depress demands for our exports.
Another downside risk is that growth in capital spending, especially among manufacturers, could
weaken appreciably if pressures on domestic profit margins mount and capacity utilization drops
further. And it remains to be seen whether corporate earnings will disappoint investors, even if the
slowing of economic growth is only moderate. Investors appear to have incorporated into current
equity price levels both robust profit expectations and low compensation for risk. As the economy
slows to a more sustainable pace as expected, profit forecasts could be pared back, which together
with a greater sense of vulnerability in business prospects could damp appetites for equities. A
downward correction to stock prices, and an associated increase in the cost of equity capital, could
compound a slowdown in the growth of capital spending. In addition, a stock market decline would
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 increases
in capital spending, productivity, real wages, and asset prices have combined to boost economic
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 been
surprisingly favorable, remaining well contained at levels of utilization of labor that in the past would
have produced accelerating prices. That it has not done so in recent years has been the result of a
combination of special one-time factors holding down prices and more lasting changes in the
processes determining inflation.
Among the temporary factors, the sizable declines in the prices of oil, other internationally traded
commodities, and other imports contributed directly to holding down inflation last year, and also
indirectly by reducing inflation expectations. But these prices are not likely to fall further, and they
could begin to rise as some Asian economies revive and the effects of the net depreciation of the
dollar since mid-summer are felt more strongly.
At the same time, however, recent experience does seem to suggest that the economy has become less
inflation prone than in the past, so that the chances of an inflationary breakout arguably are, at least
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 unusually
damped inflation. From the early 1990s through 1996, survey results indicated that workers were
becoming much more concerned about being laid off. Workers' underlying fear of technology-driven
job obsolescence, and hence willingness to stress job security over wage increases, appeared to have
suppressed labor cost pressures despite a reduced unemployment rate. More recently, that effect
seems to have diminished in part. So while job loss fears probably contributed to wage and price
suppression through 1996, it does not appear that a further heightening of worker insecurity about
employment prospects can explain the more recent improved behavior of inflation.
Instead, a variety of evidence, anecdotal and otherwise, suggests that the source of recent restrained
inflation may be emanating more from employers than from employees. In the current economic
setting, businesses sense that they have lost pricing power and generally have been unwilling to raise
wages any faster than they can support at current price levels. Firms have evidently concluded that if
they try to increase their prices, their competitors will not follow, and they will lose market share and
profits.
Given the loss of pricing power, it is not surprising that individual employers resist pay increases. But
why has pricing power of late been so delimited. Monetary policy certainly has played a role in
constraining the rise in the general level of prices and damping inflation expectations over the 1980s
and 1990s. But our current discretionary monetary policy has difficulty anchoring the price level over
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 helped to
damp inflation. Through the 1970s and 1980s, firms apparently found it easier and more profitable to
seek relief from rising nominal labor costs through price increases than through cost-reducing capital
investments. Price relief evidently has not been available in recent years. But relief from cost
pressures has. The newer technologies have made capital investment distinctly more profitable,
enabling firms to substitute capital for labor far more productively than they would have a decade or
two ago.
Starting in 1993, capital investment, especially in high-tech equipment, rose sharply beyond normal
cyclical experience, apparently the result of expected increases in rates of return on the new
investment. Had the profit expectations not been realized, one would have anticipated outlays to fall
back. Instead, their growth accelerated through the remainder of the decade.
More direct evidence confirms improved underlying profitability. According to rough estimates, labor
and capital productivity has risen significantly during the past five years. It seems likely that the
synergies of advances in laser, fiber optic, satellite, and computer technologies with older
technologies have enlarged the pool of opportunities to achieve a rate of return above the cost of
capital. Moreover, the newer technologies have facilitated a dramatic foreshortening of the lead times
on the delivery of capital equipment over the past decade, presumably allowing businesses to react
more expeditiously to an actual or expected rise in nominal compensation costs than, say, they could
have in the 1980s. In addition, the surge in investment not only has restrained costs, it has also
increased industrial capacity faster than factory output has risen. The resulting slack in product
markets has put greater competitive pressure on businesses to hold down prices, despite taut labor
markets.
The role of technology in damping inflation is manifest not only in its effects on U.S. productivity and
costs, but also through international trade, where technological developments have progressively
broken down barriers to cross-border trade. The enhanced competition in tradable goods has enabled
excess capacity previously bottled up in one country to augment worldwide supply and exert restraint
on prices in all countries' markets. The resulting price discipline also has constrained nominal wage
gains in internationally tradable goods industries. As workers have attempted to shift to other sectors,
gains in nominal wages and increases in prices in nontradable goods industries have been held down
as well.
The process of price containment has potentially become, to some extent, self-reinforcing. Lower
inflation in recent years has altered expectations. Workers no longer believe that escalating gains in
nominal wages are needed to reap respectable increases in real wages, and their remaining sense of
job insecurity is reinforcing this. Since neither firms nor their competitors can count any longer on a
general inflationary tendency to validate decisions to raise their own prices, each company feels
compelled to concentrate on efforts to hold down costs. The availability of new technology to each
company and its rivals affords both the opportunity and the competitive necessity of taking steps to
boost productivity.
It is difficult to judge whether these significant shifts in the market environment in which firms
function are sufficient to account for our benign overall price behavior during the past half decade.
Undoubtedly, other factors have been at work as well, including those temporary factors I mentioned
earlier and some more lasting I have not discussed, such as worldwide deregulation and privatization,
and the freeing-up of resources previously employed to produce military products that was brought
about by the end of the cold war. There also may be other contributory forces lurking unseen in the
wings that will only become clear in time. Over the longer run, of course, the actions of the central
bank determine the degree of overall liquidity and hence rate of inflation. It is up to us to validate the
favorable inflation developments of recent years.
Although the pace of productivity increase has picked up in recent years, the extraordinary strength of
demand has meant that the substitution of capital for labor has not prevented us from rapidly
depleting the pool of available workers. This worker depletion constitutes a critical upside risk to the
inflation outlook because it presumably cannot continue for very much longer without putting
increasing pressure on labor markets and on costs.
The number of people willing to work can be usefully defined as the unemployed component of the
labor force plus those not actively seeking work, and thus not counted in the labor force, but who
nonetheless say they would like a job if they could get one. This pool of potential workers aged 16 to
64 currently numbers about 10 million, or just 53⁄4 percent of that group's population - the lowest such
percentage on record, which begins in 1970, and 21⁄2 percentage points below its average over that
period. The rapid increase in aggregate demand has generated growth of employment in excess of
growth in population, causing the number of potential workers to fall since the mid-1990s at a rate of
a bit under 1 million annually. We cannot judge with precision how much further this level can
decline without sparking ever greater upward pressures on wages and prices. But, should labor market
conditions continue to tighten, there has to be some point at which the rise in nominal wages will start
increasingly outpacing the gains in labor productivity, and prices inevitably will begin to accelerate.
Ranges for Money and Credit
At its February meeting, the Committee elected to ratify the provisional ranges for all three aggregates
that it had established last July. Specifically, the Committee again has set growth rate ranges over the
four quarters of 1999 of 1 to 5 percent for M2, 2 to 6 percent for M3, and 3 to 7 percent for domestic
nonfinancial debt. As in previous years, the Committee interpreted the ranges for the broader
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. While
nominal GDP growth did exceed the rate likely consistent with sustained price stability, the rapid
growth of M2 and M3 also reflected outsized declines in their velocities, that is, the ratio of nominal
GDP to money. M2 velocity dropped by about 3 percent, while M3 velocity plunged by 51⁄4 percent.
Part of these velocity declines reflected some reduction in the opportunity cost of holding money;
interest rates on Treasury securities, which represent an alternative return on non-monetary assets,
dropped more than did the average of interest rates on deposits and money market mutual funds in
M2, drawing funds into the aggregate. Even so, much of last year's aberrant behavior of broad money
velocity cannot readily be explained by conventional determinants. Although growth of the broad
aggregates was strong earlier in the year, it accelerated in the fourth quarter after credit markets
became turbulent. Perhaps robust money growth late in the year partly reflected a reaction to this
turmoil by the public, who began scrambling for safer and more liquid financial assets. Monetary
expansion has moderated so far this year, evidently in lagged response to the calming of financial
markets in the autumn. Layered on top of these influences, though, the public also may have been
reapportioning their savings flows into money balances because the huge run-up in stock prices in
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 ranges. To
be sure, the decline in the velocities of the broader aggregates this year should abate to some extent,
as money demand behavior returns more to normal, and growth in nominal GDP should slow as well,
as suggested by the Governors' and Presidents' central tendency. Both factors would restrain broad
money expansion relative to last year. Still, the growth of M2 and M3 could well remain outside their
price-stability ranges this year. Obviously, considerable uncertainty continues to surround the
prospective behavior of monetary velocities and growth rates.
Domestic nonfinancial debt seems more likely than the monetary aggregates to grow within its range
for this year. Indeed, domestic nonfinancial debt also could grow more slowly this year than last
year's 61⁄4 percent pace, which was in the upper part of its 3 to 7 percent annual range. With the
federal budget surplus poised to widen further this year, federal debt should contract even more
quickly than last year. And debt in each of the major nonfederal sectors in all likelihood will
decelerate as well from last year's relatively elevated rates, along with the projected slowing of
nominal GDP growth.
The FOMC's Disclosure Policy
The FOMC at recent meetings has discussed not only the stance of policy, but also when and how it
communicates its views of the evolving economic situation to the public. The FOMC's objective is to
release as much information about monetary policy decision making, and as promptly, as is consistent
with maintaining an effective deliberative process and avoiding roiling markets unnecessarily. Since
early 1994, each change in the target nominal federal funds rate has been announced immediately
with a brief rationale for the action. The FOMC resolved at its December meeting to take advantage
of an available, but unused policy, originally stated in early 1994, of releasing, on an infrequent basis,
a statement immediately after some FOMC meetings at which the stance of monetary policy has not
been changed. The Federal Reserve will release such a statement when it wishes to communicate to
the public a major shift in its views about the balance of risks or the likely direction of future policy.
Such an announcement need not be made after every change in the tilt of the directive. Instead, this
option would be reserved for situations in which the consensus of the Committee clearly had shifted
significantly, though not by enough to change current policy, and in which the absence of an
explanation risked misleading markets about the prospects for monetary policy.
Year 2000 Issues
Before closing, I'd like to address an issue that has been receiving increasing attention - the century
date change. While no one can say that the rollover to the year 2000 will be trouble free, I am
impressed by the efforts to date to address the problem in the banking and financial system. For our
part, the Federal Reserve System has now completed remediation and testing of 101 of its 103
mission-critical applications, with the remaining two to be replaced by the end of March. We opened
a test facility in June at which more than 6000 depository institutions to date have conducted tests of
their Y2K compliant systems, and we are well along in our risk mitigation and contingency planning
activities. As a precautionary measure, the Federal Reserve has acted to increase the currency in
inventory by about one-third to approximately $200 billion in late 1999 and has other contingency
arrangements available if needed. While we do not expect currency demand to increase dramatically,
the Federal Reserve believes it is important for the public to have confidence in the availability of
cash in advance of the rollover. As a result of these kinds of activities, I can say with assurance that
the Federal Reserve will be ready in both its operations and planning activities for the millennium
rollover.
The banking industry is also working hard, and with evident success, to prepare for the event. By the
end of the first quarter, every institution in the industry will have been subject to two rounds of
onsite Y2K examinations. The Federal Reserve, like the other regulators, has found that only a small
minority of institutions have fallen behind in their preparations, and those institutions have been
targeted for additional follow-up and, as necessary, formal enforcement actions. The overwhelming
majority of the industry has made impressive progress in its remediation, testing, and contingency
planning efforts.
Concluding Comment
Americans can justifiably feel proud of their recent economic achievements. Competitive markets,
with open trade both domestically and internationally, have kept our production efficient and on the
expanding frontier of technological innovation. The determination of Americans to improve their
skills and knowledge has allowed workers to be even mor