Alan Greenspan: The economic outlook
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Joint Economic Committee, US Congress, Washington DC, 9 June 2005.
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Chairman Saxton, Vice Chairman Bennett, and members of the Committee, I am pleased to appear
once again before the Joint Economic Committee. Over the past year, the pace of economic activity in
the United States has alternately paused and quickened. The most recent data support the view that
the soft readings on the economy observed in the early spring were not presaging a more-serious
slowdown in the pace of activity. Consumer spending firmed again, and indicators of business
investment became somewhat more upbeat. Nonetheless, policymakers confront many of the same
imbalances and uncertainties that were apparent a year ago.
Our household saving rate remains negligible. Moreover, modest, if any, progress is evident in
addressing the challenges associated with the pending shift of the baby-boom generation into
retirement that will begin in a very few years. And although prices of imports have accelerated, we are,
at best, in only the earliest stages of a stabilization of our current account deficit - a deficit that now
exceeds 6 percent of U.S. gross domestic product (GDP).
A major economic development over the past year has been the surge in the price of oil. Sharply
higher prices of oil imports have diminished U.S. purchasing power. The value of petroleum imports
rose from 1.4 percent of nominal GDP in the first quarter of 2004 to 1.8 percent in the first quarter of
this year. The alternating bouts of rising and falling oil prices have doubtless been a significant
contributor to the periods of deceleration and acceleration of U.S. economic activity over the past year.
Despite the uneven character of the expansion over the past year, the U.S. economy has done well,
on net, by most measures. Real GDP has grown by 3.7 percent over that period, the unemployment
rate has fallen to 5.1 percent, and core personal consumption expenditure prices have risen a
historically modest 1.6 percent. But the growth of productivity, though respectable at 2-1/2 percent
over the year ending in the first quarter, is far less than the extraordinary pace of 5-1/2 percent during
2003. Excluding a large but apparently transitory surge in bonuses and the proceeds of stock option
exercises late last year, overall hourly labor compensation has exhibited few signs of acceleration.
Thus, the rise in underlying unit labor costs has been mainly the result of the slower growth of output
per hour. At the same time, evidence of increased pricing power can be gleaned from the profit
margins of nonfinancial businesses, which have continued to press higher even outside the energy
sector. Whether that rise in unit costs will feed into the core price level or will be absorbed by a fall in
profit margins remains an open question.
Among the biggest surprises of the past year has been the pronounced decline in long-term interest
rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This
is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent,
is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk
spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have
declined even more than Treasuries over the same period.
The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and
June of last year, market participants were behaving as expected. With a firming of monetary policy by
the Federal Reserve widely expected, they built large short positions in long-term debt instruments in
anticipation of the increase in bond yields that has been historically associated with a rising federal
funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back
down. In March of this year, market participants once again bid up long-term rates, but as occurred
last year, forces came into play to make those increases short lived. There remains considerable
conjecture among analysts as to the nature of those market forces.
That said, there can be little doubt that exceptionally low interest rates on ten-year Treasury notes,
and hence on home mortgages, have been a major factor in the recent surge of homebuilding and
home turnover, and especially in the steep climb in home prices. Although a "bubble" in home prices
for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in
some local markets where home prices seem to have risen to unsustainable levels.
The housing market in the United States is quite heterogeneous, and it does not have the capacity to
move excesses easily from one area to another. Instead, we have a collection of only loosely
connected local markets. Thus, while investors can arbitrage the price of a commodity such as
aluminum between Portland, Maine, and Portland, Oregon, they cannot do that with home prices
because they cannot move the houses. As a consequence, unlike the behavior of commodity prices,
which varies little from place to place, the behavior of home prices varies widely across the nation.
Speculation in homes is largely local, especially for owner-occupied residences. For homeowners to
realize accumulated capital gains on a residence - a precondition of a speculative market - they must
move. Another formidable barrier to the emergence of speculative activity in housing markets is that
home sales involve significant commissions and closing costs, which average in the neighborhood of
10 percent of the sales price. Where homeowner sales predominate, speculative turnover of homes is
difficult.
But in recent years, the pace of turnover of existing homes has quickened. It appears that a
substantial part of the acceleration in turnover reflects the purchase of second homes - either for
investment or vacation purposes. Transactions in second homes, of course, are not restrained by the
same forces that restrict the purchases or sales of primary residences - an individual can sell without
having to move. This suggests that speculative activity may have had a greater role in generating the
recent price increases than it has customarily had in the past.
The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic
increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic
forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these
financing vehicles have their appropriate uses. But to the extent that some households may be
employing these instruments to purchase a home that would otherwise be unaffordable, their use is
beginning to add to the pressures in the marketplace.
The U.S. economy has weathered such episodes before without experiencing significant declines in
the national average level of home prices. In part, this is explained by an underlying uptrend in home
prices. Because of the degree of customization of homes, it is difficult to achieve significant
productivity gains in residential building despite the ongoing technological advances in other areas of
our economy. As a result, productivity gains in residential construction have lagged behind the
average productivity increases in the United States for many decades. This shortfall has been one of
the reasons that house prices have consistently outpaced the general price level for many decades.
Although we certainly cannot rule out home price declines, especially in some local markets, these
declines, were they to occur, likely would not have substantial macroeconomic implications.
Nationwide banking and widespread securitization of mortgages make it less likely that financial
intermediation would be impaired than was the case in prior episodes of regional house price
corrections. Moreover, a substantial rise in bankruptcies would require a quite-significant overall
reduction in the national housing price level because the vast majority of homeowners have built up
substantial equity in their homes despite large home equity withdrawals in recent years financed by
the mortgage market.
In conclusion, Mr. Chairman, despite some of the risks that I have highlighted, the U.S. economy
seems to be on a reasonably firm footing, and underlying inflation remains contained. Accordingly, the
Federal Open Market Committee in its May meeting reaffirmed that it "... believes that policy
accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee
will respond to changes in economic prospects as needed to fulfill its obligation to maintain price
stability."