Alan Greenspan: Semiannual monetary policy report to the US Congress
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, on the occasion of the Federal Reserve Board's semiannual monetary policy report to
Congress, before the Committee on Financial Services, US House of Representatives, 20 July 2005.
Mr Greenspan presented identical testimony before the Committee on Banking, Housing, and Urban
Affairs, US Senate on 21 July 2005.
* * *
Mr Chairman and members of the Committee, I am pleased to be here today to present the Federal
Reserve's Monetary Policy Report to the Congress.
In mid-February, when I presented our last report to the Congress, the economy, supported by strong
underlying fundamentals, appeared to be on a solid growth path, and those circumstances prevailed
through March. Accordingly, the Federal Open Market Committee (FOMC) continued the process of a
measured removal of monetary accommodation, which it had begun in June 2004, by raising the
federal funds rate 1/4 percentage point at both the February and the March meetings.
The upbeat picture became cloudier this spring, when data on economic activity proved to be weaker
than most market participants had anticipated and inflation moved up in response to the jump in world
oil prices. By the time of the May FOMC meeting, some evidence suggested that the economy might
have been entering a soft patch reminiscent of the middle of last year, perhaps as a result of higher
energy costs worldwide. In particular, employment gains had slowed from the strong pace of the end
of 2004, consumer sentiment had weakened, and the momentum in household and business spending
appeared to have dissipated somewhat.
At the May meeting, the Committee had to weigh the extent to which this weakness was likely to be
temporary--perhaps simply the product of the normal ebb and flow of a business expansion--and the
extent to which it reflected some influence that might prove more persistent, such as the further run-up
in crude oil prices. While the incoming data highlighted some downside risks to the outlook for
economic growth, the FOMC judged the balance of information as suggesting that the economy had
not weakened fundamentally.
Moreover, core inflation had moved higher again through the first quarter. The rising prices of energy
and other commodities continued to place upward pressures on costs, and reports of greater pricing
power of firms indicated that they might be more able to pass those higher costs on to their customers.
Given these considerations, the Committee continued the process of gradually removing monetary
accommodation in May.
The data released over the past two months or so accord with the view that the earlier soft readings
on the economy were not presaging a more serious slowdown in the pace of activity. Employment has
remained on an upward trend, retail spending has posted appreciable gains, inventory levels are
modest, and business investment appears to have firmed. At the same time, low long-term interest
rates have continued to provide a lift to housing activity. Although both overall and core consumer
price inflation have eased of late, the prices of oil and natural gas have moved up again on balance
since May and are likely to place some upward pressure on consumer prices, at least over the near
term. Slack in labor and product markets has continued to decline. In light of these developments, the
FOMC raised the federal funds rate at its June meeting to further reduce monetary policy
accommodation. That action brought the cumulative increase in the funds rate over the past year to
21⁄4 percentage points.
Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast
currently embedded in futures markets--the prospects for aggregate demand appear favorable.
Household spending--buoyed by past gains in wealth, ongoing increases in employment and income,
and relatively low interest rates--is likely to continue to expand. Business investment in equipment and
software seems to be on a solid upward trajectory in response to supportive conditions in financial
markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover,
some recovery in nonresidential construction appears in the offing, spurred partly by lower vacancy
rates and rising prices for commercial properties. However, given the comparatively less buoyant
growth of many foreign economies and the recent increase in the foreign exchange value of the dollar,
our external sector does not yet seem poised to contribute steadily to U.S. growth.
A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen
upward pressures on inflation. Overall inflation would probably drop back noticeably from the rates
experienced in 2004 and early 2005, and core inflation could hold steady or edge lower. Prices of
crude materials and intermediate goods have softened of late, and the slower rise in import prices that
should result from the recent strength in the foreign exchange value of the dollar could also relieve
some pressure on inflation.
Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained
inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to
remove monetary accommodation. This generally favorable outlook, however, is attended by some
significant uncertainties that warrant careful scrutiny.
With regard to the outlook for inflation, future price performance will be influenced importantly by the
trend in unit labor costs, or its equivalent, the ratio of hourly labor compensation to output per hour.
Over most of the past several years, the behavior of unit labor costs has been quite subdued. But
those costs have turned up of late, and whether the favorable trends of the past few years will be
maintained is unclear. Hourly labor compensation as measured from the national income and product
accounts increased sharply near the end of 2004. However, that measure appears to have been
boosted significantly by temporary factors. Other broad measures suggest that hourly labor
compensation continues to rise at a moderate rate.
The evolution of unit labor costs will also reflect the growth of output per hour. Over the past decade,
the U.S. economy has benefited from a remarkable acceleration of productivity: Strong gains in
efficiency have buoyed real incomes and restrained inflation. But experience suggests that such rapid
advances are unlikely to be maintained in an economy that has reached the cutting edge of
technology. Over the past two years, growth in output per hour seems to have moved off the peak that
it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear. The
traditional measure of the growth in output per hour, which is based on output as measured from the
product side of the national accounts, has slowed sharply in recent quarters. But a conceptually
equivalent measure that uses output measured from the income side has slowed far less. Given the
divergence between these two readings, a reasonably accurate determination of the extent of the
recent slowing in productivity growth and its parsing into cyclical and secular influences will require the
accumulation of more evidence.
Energy prices represent a second major uncertainty in the economic outlook. A further rise could cut
materially into private spending and thus damp the rate of economic expansion. In recent weeks, spot
prices for crude oil and natural gas have been both high and volatile.
Prices for far-future delivery of oil and gas have risen even more markedly than spot prices over the
past year. Apparently, market participants now see little prospect of appreciable relief from elevated
energy prices for years to come. Global demand for energy apparently is expected to remain strong,
and market participants are evidencing increased concerns about the potential for supply disruptions
in various oil-producing regions.
To be sure, the capacity to tap and utilize the world's supply of oil continues to expand. Major
advances in recovery rates from existing reservoirs have enhanced proved reserves despite ever
fewer discoveries of major oil fields. But, going forward, because of the geographic location of proved
reserves, the great majority of the investment required to convert reserves into new crude oil
productive capacity will need to be made in countries where foreign investment is currently prohibited
or restricted or faces considerable political risk. Moreover, the preponderance of oil and gas revenues
of the dominant national oil companies is perceived as necessary to meet the domestic needs of
growing populations. These factors have the potential to constrain the ability of producers to expand
capacity to keep up with the projected growth of world demand, which has been propelled to an
unexpected extent by burgeoning demand in emerging Asia.
More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas
will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United
States down to world levels.
The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates.
The yield on ten-year Treasury notes, currently near 4-1/4 percent, is about 50 basis points below its
level of late spring 2004. Moreover, even after the recent widening of credit risk spreads, yields for
both investment-grade and less-than-investment-grade corporate bonds have declined even more
than those on Treasury notes over the same period.
This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic
growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with
the fast approaching retirement of the baby-boom generation.1 The drop in long-term rates is
especially surprising given the increase in the federal funds rate over the same period. Such a pattern
is clearly without precedent in our recent experience.
The unusual behavior of long-term interest rates first became apparent last year. In May and June of
2004, with a tightening of monetary policy by the Federal Reserve widely expected, market
participants built large short positions in long-term debt instruments in anticipation of the increase in
bond yields that has been historically associated with an initial rise in the federal funds rate.
Accordingly, yields on ten-year Treasury notes rose during the spring of last year about 1 percentage
point. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In
March of this year, long-term rates once again began to rise, but like last year, market forces came
into play to make those increases short lived.
Considerable debate remains among analysts as to the nature of those market forces. Whatever those
forces are, they are surely global, because the decline in long-term interest rates in the past year is
even more pronounced in major foreign financial markets than in the United States.
Two distinct but overlapping developments appear to be at work: a longer-term trend decline in bond
yields and an acceleration of that trend of late. Both developments are particularly evident in the
interest rate applying to the one-year period ending ten years from today that can be inferred from the
U.S. Treasury yield curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it
had declined to about 6-1/2 percent--an easing of about 15 basis points per year on average.2 Over
the past year, that drop steepened, and the forward rate fell 130 basis points to less than 5 percent.
Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to
expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a
smaller real term premium that seems due to a moderation of the business cycle over the past few
decades.3 This decline in inflation expectations and risk premiums is a signal development. As I noted
in my testimony before this Committee in February, the effective productive capacity of the global
economy has substantially increased, in part because of the breakup of the Soviet Union and the
integration of China and India into the global marketplace. And this increase in capacity, in turn, has
doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.
In addition to these factors, the trend reduction worldwide in long-term yields surely reflects an excess
of intended saving over intended investment. This configuration is equivalent to an excess of the
supply of funds relative to the demand for investment. What is unclear is whether the excess is due to
a glut of saving or a shortfall of investment. Because intended capital investment is to some extent
driven by forces independent of those governing intended saving, the gap between intended saving
and investment can be quite wide and variable. It is real interest rates that bring actual capital
investment worldwide and its means of financing, global saving, into equality. We can directly observe
only the actual flows, not the saving and investment tendencies. Nonetheless, as best we can judge,
both high levels of intended saving and low levels of intended investment have combined to lower real
long-term interest rates over the past decade.
Since the mid-1990s, a significant increase in the share of world gross domestic product (GDP)
produced by economies with persistently above-average saving--prominently the emerging economies
of Asia--has put upward pressure on world saving. These pressures have been supplemented by
shifts in income toward the oil-exporting countries, which more recently have built surpluses because
of steep increases in oil prices. The changes in shares of world GDP, however, have had little effect
on actual world capital investment as a percentage of GDP. The fact that investment as a percentage
of GDP apparently changed little when real interest rates were falling, even adjusting for the shift in
the shares of world GDP, suggests that, on average, countries' investment propensities had been
declining.4
Softness in intended investment is also evident in corporate behavior. Although corporate capital
investment in the major industrial countries rose in recent years, it apparently failed to match increases
in corporate cash flow.5 In the United States, for example, capital expenditures were below the very
substantial level of corporate cash flow in 2003, the first shortfall since the severe recession of 1975.
That development was likely a result of the business caution that was apparent in the wake of the
stock market decline and the corporate scandals early this decade. (Capital investment in the United
States has only recently shown signs of shedding at least some of that caution.) Japanese investment
exhibited prolonged restraint following the bursting of their speculative bubble in the early 1990s. And
investment in emerging Asia excluding China fell appreciably after the Asian financial crisis in the late
1990s. Moreover, only a modest part of the large revenue surpluses of oil-producing nations has been
reinvested in physical assets. In fact, capital investment in the Middle East in 2004, at 25 percent of
the region's GDP, was the same as in 1998. National saving, however, rose from 21 percent to
32 percent of GDP. The unused saving of this region was invested in world markets.
Whether the excess of global intended saving over intended investment has been caused by weak
investment or excessive saving--that is, by weak consumption--or, more likely, a combination of both
does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary
policy. What have mattered in recent years are the sign and the size of the gap of intentions and the
implications for interest rates, not whether the gap results from a saving glut or an investment shortfall.
That said, saving and investment propensities do matter over the longer run. Higher levels of
investment relative to consumption build up the capital stock and thus add to the productive potential
of an economy.
The economic forces driving the global saving-investment balance have been unfolding over the
course of the past decade, so the steepness of the recent decline in long-term dollar yields and the
associated distant forward rates suggests that something more may have been at work over the past
year.6 Inflation premiums in forward rates ten years ahead have apparently continued to decline, but
real yields have also fallen markedly over the past year. It is possible that the factors that have tended
to depress real yields over the past decade have accelerated recently, though that notion seems
implausible.
According to estimates prepared by the Federal Reserve Board staff, a significant portion of the sharp
decline in the ten-year forward one-year rate over the past year appears to have resulted from a fall in
term premiums. Such estimates are subject to considerable uncertainty. Nevertheless, they suggest
that risk takers have been encouraged by a perceived increase in economic stability to reach out to
more distant time horizons. These actions have been accompanied by significant declines in
measures of expected volatility in equity and credit markets inferred from prices of stock and bond
options and narrow credit risk premiums. History cautions that long periods of relative stability often
engender unrealistic expectations of its permanence and, at times, may lead to financial excess and
economic stress.
Such perceptions, many observers believe, are contributing to the boom in home prices and creating
some associated risks. And, certainly, the 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, home
turnover, and particularly in the steep climb in home prices. Whether home prices on average for the
nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but 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. Among other indicators, the significant rise in purchases of homes for
investment since 2001 seems to have charged some regional markets with speculative fervor.
The apparent froth in housing markets appears to have interacted with evolving practices in mortgage
markets. The increase in the prevalence of interest-only loans and the introduction of more-exotic
forms of adjustable-rate mortgages are developments of particular concern. To be sure, these
financing vehicles have their appropriate uses. But some households may be employing these
instruments to purchase homes that would otherwise be unaffordable, and consequently their use
could be adding to pressures in the housing market. Moreover, these contracts may leave some
mortgagors vulnerable to adverse events. It is important that lenders fully appreciate the risk that
some households may have trouble meeting monthly payments as interest rates and the
macroeconomic climate change.
The U.S. economy has weathered such episodes before without experiencing significant declines in
the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home
prices, especially in some local markets. If declines were to occur, they likely would be accompanied
by some economic stress, though the macroeconomic implications need not be substantial.
Nationwide banking and widespread securitization of mortgages make financial intermediation less
likely to be impaired than it was in some previous episodes of regional house-price correction.
Moreover, a decline in the national housing price level would need to be substantial to trigger a
significant rise in foreclosures, because the vast majority of homeowners have built up substantial
equity in their homes despite large mortgage-market-financed withdrawals of home equity in recent
years.
Historically, it has been rising real long-term interest rates that have restrained the pace of residential
building and have suppressed existing home sales, high levels of which have been the major
contributor to the home equity extraction that arguably has financed a noticeable share of personal
consumption expenditures and home modernization outlays.
The trend of mortgage rates, or long-term interest rates more generally, is likely to be influenced
importantly by the worldwide evolution of intended saving and intended investment. We at the Federal
Reserve will be closely monitoring the path of this global development few, if any, have previously
experienced. As I indicated earlier, the capital investment climate in the United States appears to be
improving following significant headwinds since late 2000, as is that in Japan. Capital investment in
Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by a
rising worldwide propensity to save would presumably move real long-term interest rates higher.
Moreover, with term premiums at historical lows, further downward pressure on long-term rates from
this source is unlikely.
We collectively confront many risks beyond those that I have just mentioned. As was tragically
evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have
become enduring features of the global landscape. Another prominent concern is the growing
evidence of anti-globalization sentiment and protectionist initiatives, which, if implemented, would
significantly threaten the flexibility and resilience of many economies. This situation is especially
troubling for the United States, where openness and flexibility have allowed us to absorb a succession
of large shocks in recent years with only minimal economic disruption. That flexibility is, in large
measure, a testament to the industry and resourcefulness of our workers and businesses. But our
success in this dimension has also been aided importantly by more than two and a half decades of
bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market
economy. Going forward, policymakers will need to be vigilant to preserve this flexibility, which has
contributed so constructively to our economic performance in recent years.
In conclusion, Mr. Chairman, despite the challenges that I have highlighted and the many I have not,
the U.S. economy has remained on a firm footing, and inflation continues to be well contained.
Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal
Open Market Committee in its June 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."