Mr. Greenspan presents the US Federal Reserve's mid-year report on monetary
policy Testimony by the Chairman of the Board of Governors of the US Federal Reserve System,
Mr. Alan Greenspan, before the Committee on Banking, Housing, and Urban Affairs of the US Senate on
21/7/98.
Mr. Chairman and members of the Committee, I appreciate this opportunity to present
the Federal Reserve's mid-year report on monetary policy.
Overall, the performance of the US economy continues to be impressive. Over the first
part of the year, we experienced further gains in output and employment, subdued prices, and moderate
long-term interest rates. Important crosscurrents, however, have been impacting the economy. With labor
markets very tight and domestic final demand retaining considerable momentum, the risks of a pickup in
inflation remain significant. But inventory investment, which was quite rapid late last year and early this
year, appears to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in
Asian economies are now demonstrably restraining demands for US goods and services - and those
troubles could intensify and spread further. Weighing these forces, the Federal Open Market Committee
chose to keep the stance of policy unchanged over the first half of 1998. However, should pressures on
labor resources begin to show through more impressively in cost increases, policy action may need to
counter any associated tendency for prices to accelerate before it undermines this extraordinary
expansion.
Recent Developments
When I appeared before your committee in February, I noted that a key question for
monetary policy was whether the consequences of the turmoil in Asia would be sufficient to check
inflationary tendencies that might otherwise result from the strength of domestic spending and tightening
labor markets. After the economy's surge in 1996 and, especially, last year, resource utilization,
particularly that of the labor force, had risen to a very high level. Although some signs pointed to
stepped-up increases in productivity, the speed at which the demand for goods and services had been
growing clearly exceeded the rate of expansion of the economy's long-run potential to produce.
Maintenance of such a pace would put even greater pressures on the economy's resources, threatening
the balance and longevity of the expansion.
However, it appeared likely that the difficulties being encountered by Asian economies,
by cutting into US exports, would be a potentially important factor slowing the growth of aggregate
demand in the United States. But uncertainties about the timing and dimensions of that development
were considerable given the difficulties in assessing the extent of the problems in East Asia.
In the event, the contraction of output and incomes in a number of Asian economies has
turned out to be more substantial than most had anticipated. Moreover, financial markets in Asia and in
emerging market economies generally have remained unsettled, portending further difficult adjustments.
The contraction in Asian economies, along with the rise in the foreign exchange value of the dollar over
1997, prompted a sharp deterioration in the US balance of trade in the first quarter. Nonetheless, the
American economy proved to be unexpectedly robust in that period. The growth of real GDP not only
failed to slow, it climbed further, to about a 51⁄2 percent annual rate in the first quarter, according to the
current national income accounts. Domestic private demand for goods and services - including personal
consumption expenditures, business investment, and residential expenditures - was exceptionally strong.
Evidently, optimism about jobs, incomes, and profits, high and rising wealth-to-income
ratios, low financing costs, and falling prices for high-tech goods fed the appetites of households and
businesses for consumer durables and capital equipment. In addition, inventory investment contributed
significantly to growth in the first quarter; indeed, the growth of stocks of materials and goods outpaced
that of overall output by a wide margin during the first quarter, adding 1 percentage points to the
annualized growth rate of GDP. Although accumulation of some products likely was unintended, surveys
- 2 -
indicate that much of the stockbuilding probably reflected firms' confidence in the prospects for
continued growth.
As evidence piled up that the economy continued to run hot during the winter, the
Federal Reserve's concerns about inflationary pressures mounted. Domestic demand clearly had more
underlying momentum than we had anticipated, supported in part by financial conditions that were quite
accommodative. Credit remained extremely easy for most borrowers to obtain; intermediate- and
long-term interest rates were at relatively low levels; equity prices soared higher, despite some
disappointing earnings reports; and growth in the monetary aggregates was rapid. Indeed, the crises in
Asia, by lowering longer-term US interest rates - through stronger preferences for dollar investments and
expectations of slower growth ahead - and by reducing commodity prices, probably added to the positive
forces boosting domestic spending in the first half, especially in the interest-sensitive housing sector. The
robust expansion of demand tightened labor markets further, giving additional impetus to the upward
trend in labor costs. Inflation was low - though, given the lags with which monetary policy affects the
economy and prices, we had to be mainly concerned not with conditions at the moment but with those
likely to prevail many months ahead. In these circumstances, the Federal Open Market Committee
elected in March to move to a state of heightened alert against inflation, but left the stance of policy
unchanged.
Although national income and product data for the second quarter have not yet been
published, growth of US output appears to have slowed sharply. The auto strike has brought General
Motor's production essentially to a halt, probably reducing real GDP in the second quarter by about
1⁄2 percentage point at an annual rate. The limited available information on inventory investment suggests
that stockbuilding dropped markedly from its unsustainable pace of the first quarter. In addition to the
slower pace of inventory building, Asian economies have continued to deteriorate, further retarding our
exports in recent months.
Indeed, readings on the elements that make up the real GDP have led many analysts to
anticipate a decline in that measure in the second quarter, after the first-quarter surge. Given the
upcoming revisions to the national income accounts, such assessments would have to be regarded as
conjectural. It is worth noting in any case that other indicators of output, including worker hours and
manufacturing production, show a somewhat steadier, though slowing, path over the first half of the year.
And underlying trends in domestic final demand have remained strong, imparting impetus to the
continuing economic expansion.
During the first half of the year, measures of resource utilization diverged. Pressures on
manufacturing facilities appeared to be easing. Plant capacity was growing rapidly as a result of vigorous
investment. And growth of industrial output was dropping off from its brisk pace of 1997, importantly
reflecting the deceleration in world demand for manufactured goods that resulted from the Asian
economic difficulties.
But labor markets, in contrast, became increasingly taut during the first half. Total
payroll jobs rose about one-and-one-half million over the first six months of the year. The civilian
unemployment rate dropped to a bit below 41⁄2 percent in the second quarter, its lowest level in three
decades. Firms resorted to a variety of tactics to attract and retain workers, such as paying various types
of monetary bonuses and raising basic wage rates. But, at least through the first quarter, the effects of a
rising wage bill on production costs were moderated by strong gains in productivity.
Indeed, inflation stayed remarkably damped during the first quarter. The consumer price
index as well as broader measures of prices indicate that inflation moved down further, even as the
economy strengthened. Although declining oil prices contributed to this development, pricing leverage in
the goods-producing sector more generally was held in check by reduced demand from Asia that, among
other things, has led to a softening of commodity prices, a strong dollar that has contributed to bargain
prices on many imports, and rising industrial capacity. Service price inflation, less influenced by
- 3 -
international events, has remained steady at about a 3 percent rate since before the beginning of the
crisis.
Some elements in the goods price mix clearly were transitory. Indeed, the more recent
price data suggest that overall consumer price inflation moved up in the second quarter. But, even so, the
increase remained moderate.
In any event, it would be a mistake for monetary policy makers to focus on any single
index in gauging inflation pressures in the economy. Although much public attention is directed to the
CPI, the Federal Reserve monitors a wide variety of aggregate price measures. Each is designed for a
particular purpose and has its own strengths and weaknesses. Price pressures appear especially absent in
some of the measures in the national income accounts, which are available through the first quarter. The
chain-weight price index for personal consumption expenditures excluding food and energy, for example,
rose 1.5 percent over the year ending in the first quarter, considerably less than the 2.3 percent rise in the
core CPI over the same period. An even broader price measure, that for overall GDP, rose 1.4 percent.
These indexes, while certainly subject to many of the measurement difficulties the Bureau of Labor
Statistics has been grappling with in the CPI, have the advantages that their chain-weighting avoids some
aspects of so-called substitution bias and that already published data can be revised to incorporate new
information and measurement techniques. Taken together, while the various price indexes show some
differences, the basic message is that inflation to date has remained low.
Economic Fundamentals: The Virtuous Cycle
So far this year, our economy has continued to enjoy a virtuous cycle. Evidence of
accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling
still further increases in equity values, and the improvements in productivity have been helping to reduce
inflation. In the context of subdued price increases and generally supportive credit conditions, rising
equity values have provided impetus to spending and, in turn, the expansion of output, employment, and
productivity-enhancing capital investment.
The essential precondition for the emergence, and persistence, of this virtuous cycle is
arguably the decline in the rate of inflation to near price stability. In recent years, continued low product
price inflation and expectations that it will persist have promoted stability in financial markets and
fostered perceptions that the degree of risk in the financial outlook has been moving ever lower. These
perceptions, in turn, have reduced the extra compensation that investors require for making loans to, or
taking ownership positions in, private firms. With risks in the domestic economy judged to be low, credit
and equity capital have been readily available for many businesses, fostering strong investment. And low
mortgage interest rates have allowed many households to purchase homes and to refinance outstanding
debt. The reduction in debt servicing costs has contributed to an apparent stabilization of the financial
strains on the household sector that seemed to emerge a couple of years ago and has buoyed consumer
demand.
To a considerable extent, investors seem to be expecting that low inflation and stronger
productivity growth will allow the extraordinary growth of profits to be extended into the distant future.
Indeed, expectations of earnings growth over the longer term have been undergoing continual upward
revision by security analysts since early 1995. These rising expectations have, in turn, driven stock prices
sharply higher and credit spreads lower, perhaps in both cases to levels that will be difficult to sustain
unless the virtuous cycle continues. In any event, primarily because of the rise in stock prices, about
$121⁄2 trillion has been added to the value of household assets since the end of 1994. Probably only a few
percent of these largely unrealized capital gains have been transformed into the purchase of goods and
services in consumer markets. But that increment to spending, combined with the sharp increase in
equipment investment, which has stemmed from the low cost of both equity and debt relative to expected
profits on capital, has been instrumental in propelling the economy forward.
- 4 -
The consequences for the American worker have been dramatic and, for the most part,
highly favorable. A great many chronically underemployed people have been given the opportunity to
work, and many others have been able to upgrade their skills as a result of work experience, extensive
increases in on-the-job training, or increased enrollment in technical programs in community colleges
and elsewhere. In addition, former welfare recipients appear to have been absorbed into the work force in
significant numbers.
Government finances have been enhanced as well. Widespread improvement has been
evident in the financial positions of state and local governments. In the federal sector, the taxes paid on
huge realized capital gains and other incomes related to stock market advances, coupled with taxes on
markedly higher corporate profits, have joined with restraint on spending to produce a unified budget
surplus for the first time in nearly three decades. The important steps taken by the Congress and the
Administration to put federal finances on a sounder footing have added to national saving, relieving
pressures on credit markets. The paydown of debt associated with the federal surplus has helped to hold
down longer-term interest rates, which in turn has encouraged capital formation and reduced debt
burdens. Maintaining this disciplined budget stance would be most helpful in supporting a continuation
of our current robust economic performance in the years ahead.
The fact that economic performance has strengthened as inflation subsided should not
have been surprising, given that risk premiums and economic disincentives to invest in productive capital
diminish as the economy approaches price stability. But the extent to which strong growth and high labor
force utilization have been joined with low inflation over an extended period is, nevertheless,
exceptional. So far, at least, the adverse wage-price interactions that played so central a role in pressuring
inflation higher in many past business expansions - eventually bringing those expansions to an end - have
not played a significant role in the current expansion.
For one thing, increases in hourly compensation have been slower to pick up than in most
other recent expansions, although, to be sure, wages have started to accelerate in the past couple of years
as the labor market has become progressively tighter. In the first few years of the expansion, the subdued
rate of rise in hourly compensation seemed to be, in part, a reflection of greater concerns among workers
about job security. We now seem to have moved beyond that phase of especially acute concern, though
the flux of technology may still be leaving many workers with fears of job skill obsolescence and a
willingness to trade wage gains for job security. In the past couple of years, of course, workers have not
had to press especially hard for nominal pay gains to realize sizable increases in their real wages. In
contrast to the pattern that developed in several previous business expansions, when workers required
substantial increases in pay just to cover increases in the cost of living, consumer prices have been
generally well-behaved in the current expansion.
A couple of years ago - almost at the same time that increases in total hourly
compensation began trending up in nominal terms - evidence of a long-awaited pickup in the growth of
labor productivity began to show through more strongly in the data; and this accelerated increase in
output per hour has enabled firms to raise workers' real wages while holding the line on price increases.
Gains in productivity usually vary with the strength of the economy, and the favorable results that we
have observed during the past two years or so, when the economy has been growing more rapidly, almost
certainly overstate the degree of structural improvement. But evidence continues to mount that the trend
of productivity has accelerated, even if the extent of that pickup is as yet unclear. Signs of major
technological improvements are all around us, and the benefits are evident not only in high-tech
industries but also in production processes that have long been part of our industrial economy.
Those technological innovations and the rapidly declining cost of capital equipment that
embodies them in turn seem to be a major factor behind the recent enlarged gains in productivity.
Evidently, plant managers who were involved in planning capital investments anticipated that a
significant increase in the real rates of return on facilities could be achieved by exploiting emerging new
technologies. If that had been a mistake on their part, one would have expected capital investment to run
up briefly and then start down again when the lower-than-anticipated rates of return developed. But we
- 5 -
have instead seen sustained gains in investment, indicating that hoped-for rates of return apparently have
been realized.
Notwithstanding a reasonably optimistic interpretation of the recent productivity
numbers, it would not be prudent to assume that even strongly rising productivity, by itself, can ensure a
non-inflationary future. Certainly wage increases, per se, are not inflationary, unless they exceed
productivity growth, thereby creating pressure for inflationary price increases that can eventually
undermine economic growth and employment. Because the level of productivity is tied to an important
degree to the stock of capital, which turns over only gradually, increases in the trend growth of
productivity probably also occur rather gradually. By contrast, the potential for abrupt acceleration of
nominal hourly compensation is surely greater.
As I have noted in previous appearances before Congress, economic growth at rates
experienced on average over the past several years would eventually run into constraints as the reservoir
of unemployed people available to work is drawn down. The annual increase in the working-age
population (from 16 to 64 years of age), including immigrants, has been approximately 1 percent a year
in recent years. Yet employment, measured by the count of persons who are working rather than by the
count of jobs, has been rising 2 percent a year since 1995, despite the acceleration in the growth of
output per hour. The gap between employment growth and population growth, amounting to about 1.1
million persons a year on average since the end of 1995, has been made up, in part, by a decline in the
number of individuals who are counted as unemployed - those persons who are actively seeking work - of
approximately 650,000 a year, on average, over the past two and one-half years. The remainder of the
gap has reflected a rise in labor force participation that can be traced largely to a decline of almost
300,000 a year in the number of individuals (aged 16 to 64) wanting a job but not actively seeking one.
Presumably, many of the persons who once were in this group have more recently become active and
successful job-seekers as the economy has strengthened, thereby preventing a still sharper drop in the
official unemployment rate. In June, the number of persons aged 16 to 64 who wanted to work but who
did not have jobs was 10.6 million on a seasonally adjusted basis, roughly 6 percent of the working-age
population. Despite an uptick in joblessness in June, this percentage is only fractionally above the record
low reached in May for these data, which can be calculated back to 1970.
Nonetheless, a strong signal of inflation pressures building because of compensation
increases markedly in excess of productivity gains has not yet clearly emerged in this expansion. Among
nonfinancial corporations (our most recent source of data on consolidated income statements), trends in
costs seem to have accelerated from their lows, but the rates of increase in both unit labor costs and total
unit costs are still quite low.
Still, the gap between the growth in employment and that of the working-age population
will inevitably close. What is crucial to sustaining this unprecedented period of prosperity is that it close
reasonably promptly, given already stretched labor resources, and that labor markets find a balance
consistent with sustained growth marked by compensation gains in line with productivity advances.
Whether these adjustments will occur without monetary policy action remains an open question.
Foreign Developments
While the United States has been benefiting from a virtuous economic cycle, a number of
other economies unfortunately have been spiraling in quite the opposite direction. The United States,
Canada, and Western Europe have been enjoying solid economic growth, with relatively low inflation
and declining unemployment, but the economic performance in many developing and transition nations
and Japan has been deteriorating. How quickly the latter erosion is arrested and reversed will be a key
factor in shaping US economic and financial trends in the period ahead. With all that is at stake, it would
be difficult to overstate how crucial it is that the authorities in the relevant economies promptly
implement effective policies to correct the structural problems underlying recent weaknesses and to
promote sustainable economic growth before patterns of reinforcing contraction become difficult to
contain.
- 6 -
Conditions in Asia are of particular concern. Aggregate output of the Asian developing
economies has plunged, with particularly steep declines in Korea, Malaysia, Thailand, and Indonesia.
Even the economies of the stalwart tigers - Hong Kong, Singapore, and Taiwan - have softened.
Economic growth in China has also slowed, owing largely to the currency depreciations among its
neighbors and the sharp declines in their demand for imports.
Russia has also experienced some spillover from the Asian difficulties, but Russia's
problems are mostly homegrown. Large fiscal deficits stem from high effective marginal tax rates that
encourage avoidance and do not raise adequate revenue. This and the recent declines in prices of oil and
other commodities have rendered Russian financial markets and the ruble vulnerable, particularly in an
environment of heightened concern about all emerging markets. The Russian government has recently
promulgated a set of new policy measures in connection with an expanded IMF support package in an
effort to address these problems.
In Latin America, conditions vary: Economies that are heavily dependent on exports of
oil and other commodities have suffered as prices of those items have fallen, and several countries in that
region have received more intensive scrutiny in international capital markets, but, on the whole, Latin
American economies continue to perform reasonably well.
Disappointingly, economic activity in Japan - a crucial engine of Asian economic
growth - has turned down after a long period of subpar growth. Gross domestic product fell at a
51⁄4 percent annual rate in the first quarter. More recently, confidence of households and businesses has
continued to erode, the sharp contraction elsewhere in Asia has fed back onto Japan, and the dwindling
domestic demand for goods and services in that country has been further constrained by a mounting
credit crunch. Nonperforming loans have risen sharply as real estate values fell following the bursting of
the asset bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian financial
crisis, have led to market concerns about the adequacy of the capital of many Japanese banks and have
engendered a premium in the market for Japanese banks' borrowing. This resulting squeeze to profit
margins has led to a reluctance to lend in dollars or yen. In response to the weakening economy and
deteriorating banking situation, the Japanese yen has tended to weaken significantly, in often-volatile
markets, against the dollar and major European currencies.
As you know, we have sought to be helpful in the Japanese government's efforts to
stabilize their economy and financial system, reflecting our awareness of the important role that Japanese
financial and economic performance plays in the world economy, including that of the United States. We
have consulted with the relevant Japanese authorities on methods for resolving difficulties in their
banking system and have urged them to take effective measures to stimulate their economy. I believe that
the Japanese authorities recognize the urgency of the situation.
That a number of foreign economies are currently experiencing difficulties is not
surprising. Although many had previously realized a substantial measure of success in developing their
economies, a number had leaned heavily on command-type systems rather than relying primarily on
market mechanisms. This characteristic has been evident not only in their industrial sectors but in
banking where government intervention is typically heavy, where long-standing personal and corporate
relationships are the predominant factor in financing arrangements, and where market-based credit
assessments are the exception rather than the rule. Recent events confirm that these sorts of structures are
ill-suited to today's dynamic global economy, in which national economies must be capable of adapting
flexibly and rapidly to changing conditions.
Responses in countries currently experiencing difficulties have varied considerably.
Some have reacted quickly and, in general terms, appropriately. But in others, a variety of political
considerations appear to have militated against prompt and effective action.
- 7 -
As a consequence, the risks of further adverse developments in these economies remain
substantial. And given the pervasive interconnections of virtually all economies and financial systems in
the world today, the associated uncertainties for the United States and other developed economies remain
substantial as well.
In the current circumstances, we need to be aware that monetary policy tightening actions
in the United States could have outsized effects on very sensitive financial markets in Asia, a
development that could have substantial adverse repercussions on US financial markets and, over time,
on our own economy. But while we must take account of such foreign interactions, we must be careful
that our responses ultimately are consistent with a monetary policy aimed at optimal performance of the
US economy. Our objectives relate to domestic economic performance, and price stability and maximum
sustainable economic growth here at home would best serve the long-run interests of troubled financial
markets and economies abroad.
The Economic Outlook
The Federal Open Market Committee believes that the conditions for continued growth
with low inflation are in place here in the United States. As I noted previously, an important issue for
policy is how the imbalance of recent years between the demand for labor and the growth of the
working-age population is resolved. In that regard, we see a slowing of the growth in aggregate demand
as a necessary element in the mix.
At this time, some of the key factors that have supported strong final demand by
domestic purchasers remain favorable. Although real short-term interest rates have risen as the federal
funds rate has been held unchanged while inflation expectations have declined, the financial conditions
that have fostered the strength in demand are still in place. With their incomes and wealth having been on
a strong upward track, American consumers remain quite upbeat. For businesses, decreasing costs of and
high rates of return on investment, as well as the scarcity of labor, could keep capital spending elevated.
These factors suggest some risk that the labor market could get even tighter. And even if it does not,
under prevailing tight labor markets increasingly confident workers might place gradually escalating
pressures on wages and costs, which would eventually feed through to prices.
But a number of factors likely will serve to damp growth in aggregate demand, helping to
foster a reasonably smooth transition to a more sustainable rate of growth and reasonable balance in
labor markets. We have yet to see the full effects of the crisis in East Asia on US employment and
income. Residential and business fixed investment already have reached such high levels that further
gains approaching those experienced recently would imply very rapid growth of the stocks of housing
and plant and equipment relative to income trends. Moreover, business investment will be damped if
recent indications of a narrowing in domestic operating profit margins prompt a reassessment of the
expected rates of return on investment in plant and equipment. Reduced prospects for the return to
capital would not only affect investment directly but could also affect consumption if stock prices adjust
to a less optimistic view of earnings prospects.
Of course, the demand for labor that is consistent with a particular rate of output growth
also could be lowered if productivity growth were to increase more. And, on the supply side of the labor
market, faster growth of the labor force could emerge as the result of increased immigration or delayed
retirements. Nonetheless, it appears most probable that the necessary slower absorption of labor into
employment will reflect, in part, a deceleration of output growth, as a consequence of evolving market
forces. Failing that, firming actions on the part of the Federal Reserve may be necessary to ensure a track
of expansion that is capable of being sustained.
Thus, members of the Board of Governors and presidents of the Federal Reserve Banks
anticipate a slowing in the rate of economic growth. The central tendency of their forecasts is that real
GDP will rise 3 to 31⁄4 percent over 1998 as a whole and 2 to 21⁄2 percent in 1999. With the rise in the
demand for workers coming into line with that of the labor force, the unemployment rate is expected to
change little from its current level, finishing next year in the neighborhood of 41⁄2 to 43⁄4 percent.
- 8 -
Inflation performance will be affected by developments abroad as well as those here at
home. The extent and pace of recovery of Asian economies currently experiencing a severe downturn
will have important implications for prices of energy and other commodities, the strength of the dollar,
and competitive conditions on world product markets. Should the situation abroad remain unsettled,
these factors would probably continue to contribute to good price performance in the United States in the
period ahead. But it is important to recognize that the damping influence of these factors on inflation is
mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and
oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back
in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the
United States.
On a more fundamental level, it is the balance of supply and demand in labor and product
markets in the United States that will have the greatest effect on inflation rates here. As I noted
previously, wage and benefit costs have been remarkably subdued in the current expansion. Nonetheless,
an accelerating trend in wages has been apparent for some time.
In addition, a gradual upward tilt in benefit costs has become evident of late. A variety of
factors - including the strength of the economy and rising equity values, which have reduced the need for
payments into unemployment trust funds and pension plans, and the restructuring of the health care
sector - have been working to keep benefit costs in check in this expansion. But, in the medical area