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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1989
HEARING
BEFORE THK
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FIRST CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
FEBRUARY 21, 1989
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S.
GOVERNMENT PRINTING OFFICE
WASHINGTON : 1989
For sale by the Superintendent of Documents, Congressional Sales Office
U.S. Government Printing Office, Washington, DC 20402
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
DONALD W. RIEGLE, JR., Michigan, Chairman
ALAN CRANSTON, California
JAKE GARN, Utah
PAUL S. SARBANES. Maryland
JOHN HEINZ, Pennsylvania
CHRISTOPHER J. DODD, Connecticut
ALFONSE M. D'AMATO, New York
ALAN J. DIXON, Illinois
PHIL GRAMM, Texas
JIM SASSER, Tennessee
CHRISTOPHER S. BOND, Missouri
TERRY SANFORD, North Carolina
CONNIE MACK, Florida
RICHARD C. SHELBY, Alabama
WILLIAM V. ROTH, JR., Delaware
BOB GRAHAM, Florida
NANCY LANDON KASSEBAUM, Kansas
TIMOTHY E. WIRTH, Colorado
LARRY PRESSLER, South Dakota
JOHN F. KERRY, Massachusetts
RICHARD H. BRYAN, Nevada
KEVIN C. GOTTLIEB, Skiff Director
LAMAR SMITH, Republican Staff Director and Economist
STEVEN B. HARRIS, General Counsel
PATRICK A. MDLLOY, Senior Counsel and International Affairs Adviser
RICHARD S. CAKNEIA, Senior Counsel
JOHN C, DUGAN. Republican General Counsel
GARCIA, Assistant Director, General Government Division, GAO
CONTENTS
FEBRUARY 21, 1989
Page
Opening statement of Chairman Riegle
Opening remarks of Senator D'Amato
Prepared statement of Senator D'Amato
Opening statement of Senator Gramro
Opening statement of Senator Heinz
Opening statement of Senator Sasser
Prepared statement of Senator Graham
1
3
3
4
5
5
68
WITNESS
Alan Greenspan, Chairman, Board of Governors, Federal Reserve System
Monetary Policy Report to Congress
Prepared statement
Economic and monetary developments in 1988
Economic prospects and monetary policy for 1989
Monetary policy and long-run economic growth
Financial developments and monetary policy
Conclusion
Response to written questions of Chairman Riegle
Response to written questions of Senator Sarbanes
(in)
34
7
39
40
44
47
52
55
82
90
THE FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1989
TUESDAY, FEBRUARY 21, 1989
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10 a.m. in room SD-538, Dirksen Senate
Office Building, Senator Donald W. Riegle (chairman of the committee) presiding.
Present: Senators Riegle, Graham, Wirth, Heinz, D'Amato,
Gramm, Mack, Kassebaum, and Pressler.
OPENING STATEMENT OF CHAIRMAN RIEGLE
The CHAIRMAN. The committee will come to order.
Let me invite those who are in the room to find seats as best
they can.
Let me just say at the outset that we have a number of committee hearings that are on this morning at precisely this hour. We
have Budget Director Barman up one floor in this building testifying before the Budget Committee. There are several members of
this committee, including myself and others who are here today, on
the Budget Committee.
So there necessarily will be members coming and going, attending different hearings.
The Intelligence Committee and the Appropriations Committee
are meeting at this hour, and several others as well in the course
of the morning, and we will accommodate members as best we can.
I know, Senator D'Amato, you need to leave, I think, quite quickly, and so I am going to just make a brief opening comment. Then I
will yield to you so that you can make your comment and then
excuse yourself.
Let me start by welcoming the Chairman of the Federal Reserve,
Alan Greenspan, before us this morning. This is the first of two appearances that you will make before this committee this week. You
will be back 2 days from now to discuss in detail your thoughts on
the FSLIC savings and loan issue, and we very much look forward
to that discussion and your input will be very important to us.
For the most part, I think we ought to leave that issue aside
today. There may be some questions that arise about how interest
rates and monetary policy may affect the savings and loan issue. I
think that is an appropriate question if somebody wants to raise it,
but generally I would hope that we could set aside a discussion of
(1)
the savings and loan FSLIC issue in any detail until you return
and we can get into it at that time.
Our topic today, of course, is monetary policy. I want to say at
the outset, Chairman Greenspan, that I appreciate the leadership
that you have shown at the Fed in your time there. Certainly the
turbulent period surrounding the market break back in 1987 was a
severe test of the system and all the key players, and I think your
leadership during that time was a very important, positive element
that helped us work through that period.
I appreciate that leadership, and I believe my view is quite
widely shared on this committee and through the Senate as a
whole.
That particular crisis is now nearly a year and a half behind us,
and other economic problems are of more immediate concern. The
business cycle is certainly mature at this point. We have entered the
seventh year of expansion, and I think it has become harder to
steer a prudent course between inflation on the one hand and a recession or slowdown on the other. The Federal budget deficits and
the trade deficit continue to trouble the economy and create problems for us. Obviously, there are some very difficult judgments to
make,
It seems to me that the Fed at the present time is facing a rather
classic policy conflict. On the one hand, there are those who argue
for tighter money to avoid an outbreak of inflation and to preserve
the value of financial assets. On the other hand, there are those
who argue for easier money and lower interest rates in an effort to
stimulate growth and to try to increase tax receipts without raising
tax rates.
I am struck by the fact—and I will ask you about this later if
you don't choose to comment on it directly that your own economic
growth and interest rate forecasts are different than those that are
in the Bush administration budget proposals.
Those are significant matters because depending upon which set
of estimates are right, obviously, we face a very different set of effects and policy outcomes, and so I think we have to discuss today
precisely what the Fed targets are based on and why you see them
the way you do.
For example, with respect to growth forecasts, the administration is forecasting 3.3 percent in 1989 and 3.2 percent in 1990, and
with respect to interest rates the administration is projecting right
now in the first quarter of 1989, 90-day Treasury bills at 8.3 percent, second quarter dropping to 7.8 percent, then dropping to 7.2
percent, in the fourth quarter dropping to 6,6 percent. Hie average
for 1989 being at 7.4 percent, the average for 1990, next year, being
5.5 percent.
That is a pretty remarkable drop in interest rates. It would be
nice if that occurs, but I would be very interested in seeing how
you and your colleagues within the Fed forecast the interest rate
pattern over that same period of time.
In a moment we will get into discussion of your outlook for
growth, employment, exchange rates, the trade deficit, and inflation. We want, in addition, your assessment of the health of the
economy, to hear not only the good news but also where you think
the risks He and the steps you think we need to take.
I want to just make one other point before yielding to Senator
D'Amato, and that is this, I have the strong view as the new chairman of this committee that this committee ought to act, as should
the Congress as a whole when revisions are needed in banking laws
and the financial structure laws of the country. It will be the
intent of this committee to do that, to act and to act promptly and
decisively,
We have got a savings and loan problem in front of us that is an
immediate problem that has to be dealt with, but it would be my
expectation that we will move on into other areas that need attention and act on those, and I would hope that the Fed would not feel
that it has to step into the vacuum because of an absence of congressional action.
I would hope that we would be able to move affirmatively within
the Congress, and I think that Is the way it should be done. I think
we will all be more comfortable with that, and so I hope that we
can follow through in that fashion.
With that, let me now yield to Senator D'Amato.
OPENING REMARKS OF SENATOR D'AMATO
Senator D'AMATO. Thank you, Mr. Chairman.
Mr. Chairman, in the interest of time—and I do have two other
committee hearings—I am going to ask that my statement be included in the record as if read in its entirety.
I would take a moment to observe that notwithstanding the
doom prognosticators—and we do have those—that the old quote
from Mark Twain I think applies to our current U.S. economy.
"Rumors of its demise are greatly exaggerated."
And with that, Mr. Chairman, let me congratulate you for holding this hearing and also welcome Chairman Greenspan, who is
doing an outstanding job.
The CHAIRMAN. Thank you very much, Senator. We will make
your statement a part of the record.
OPENING STATEMENT OF SENATOR D'AMATO
Senator D'AMATO. I welcome Chairman Greenspan and take this
opportunity to observe that another 6 months of sustained economic growth has passed since the last Fed report on monetary policy,
The last time we convened here there was again talk of the impending recession. In fact, for a few years now, the doomsayers
have been predicting an end to good economic times and many
economists are still predicting a recession in the next 2 years. Notwithstanding the many problems that we face today, the old quote
from Mark Twain applies to the current U.S. economy: rumors of
its demise are greatly exaggerated.
I realize that the Fed is ever vigilant against inflation and that
this is a proper concern. Therefore, I commend the Fed for its efforts toward adjusting economic growth as the economy shows
signs of reaching full employment and maximum industrial utilization. I also note the Fed's apparent success in establishing a monetary policy that has slowed growth without choking off the robust
economy which has created jobs and increases opportunity for all
Americans. We cannot overstate the significance of this current
economic expansion.
In the past 8 years, 19 million new jobs have been created, a 17
percent increase in civilian employment. Furthermore, this expansion has been felt in the communities in which increased job opportunity is so much a part of the American dream: employment
among blacks has grown by 30 percent and Hispanic employment
has grown by 45 percent during the sustained period of growth in
the 1980's.
The strong economy of the past 7 years shows that the business
cycle does not need to swing widely from periods of growth to periods of recession; that is, there is no strict rule that says that recession is the inevitable conclusion of a period of economic growth. It
appears that the Fed, and the American free market, are proving
that the economy can be managed at a state of high capacity without bringing on dangerous levels of inflation.
In short, I see no need to accept the inevitability of a recession if
we allow the marketplace and wise government policy to work together in taming the business cycle. Therefore, I commend Chairman Greenspan and the Fed for their commitment to fighting inflation. I also encourage your continued sensitive use of the tools at
your disposal so that the U.S. economy can continue to provide
genuine opportunity and the hope of prosperity to every American.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Kassebaum.
Senator KASSEBAUM. I have no opening statement, Mr. Chairman. I welcome Chairman Greenspan as well.
The CHAIRMAN. Senator Gramm.
OPENING STATEMENT OF SENATOR GRAMM
Senator GRAMM. Thank you, Mr. Chairman.
Chairman Greenspan, I welcome you back before the committee.
I thank you for all of your good work.
Mr. Chairman, I think one of the things we have to look at in
terms of assessing the various projections that are made of the
future is what those projections are based on.
One of the things that I will be questioning Chairman Greenspan
about later today really comes down to that.
Are the assumptions made by CBO and OMB realistic if you
assume, as they do, that the deficit will be reduced by $55 billion?
That would mean that $55 billion less would be absorbed by the
Government out of the private sector, if we meet the GrammRudman targets, meaning that money could go into the private
sector to build new homes, new farms, new factories, and generate
new economic growth. Are the assumptions of the two budget projections realistic if you assume that the outcome of the budget
debate will be such a reduction in the deficit?
Second, I will be asking the Chairman, specifically does it make
a difference from your point of view in terms of trying to promote
economic growth, trying to control price increases so that we don't
repeat a cycle that we paid such a high price to break, does it
make a difference whether we deal with the deficit by raising taxes
or by controlling spending?
Are the two approaches to deficit reduction created equally in
terms of their economic impact, or is one superior to the other
from the point of view of the economic impact in trying to create
growth without inflation?
I think those are the questions that we have to deal with here,
and, Mr. Chairman, I look forward to participating in the hearing.
Like you, I have got to run upstairs to the Budget Committee.
Thank goodness we are here doing all this important work lest it
might not get done.
The CHAIRMAN, Well, try not to be gone too long.
Senator Heinz.
OPENING STATEMENT OF SENATOR HEINZ
Senator HEINZ. Mr. Chairman, I simply want to join in welcoming Alan Greenspan back to this committee and to commend him
for the usual excellent job he has done.
One of the questions that I will want Chairman Greenspan to address is the question not only as posed by Phil Gramm about the
effect of lowering the budget deficit and how it will help make the
economic assumptions or projections in the President's budget
come true, but also how those projections can come true unless we
address the issues that affect real growth in the U.S. economy.
I refer to labor productivity, the competence and technological
ability of management and, most importantly, the cost of capital as
it affects production of products in this country.
It seems to me that we really need to focus on the three main
inputs that drive real productivity. Some of them are very hard to
influence. Labor productivity is influenced by educational levels
and, I suppose, by incentives or morale or motivation. It certainly
is true in the Japanese model. The competence or ability of management is pretty hard to influence in the short term. I will be interested in Chairman Greenspan's comments about what we can do
in improving the access to, and lowering of, the cost of capital as
an important element in the equation.
The CHAIRMAN. Thank you very much, Senator Heinz.
Before we hear from Chairman Greenspan, I have a statement
from Senator Sasser to be inserted in the record.
STATEMENT OF SENATOR JIM SASSER
Senator SASSER. Mr. Chairman, today we hear from the distinguished chairman of the Federal Reserve on the conduct of monetary policy—a critical issue at this time.
Interest rates are rising and this does not bode well for the economy. Every percentage point increase in interest rates will add $11
billion to the deficit. Moreover, a dampening of the economy, that
will surely follow higher rates, could make the deficit virtually impossible to deal with.
We need to closely examine our interest rate policy. Short term
interest rates have increased by 2.5 percentage points—or 50 percent—since June of 1988.
We know that there are basically two factors that can influence
interest rates like this: Inflationary expectations of investors or
monetary policy.
However, surveys of expectations of investors indicate that most
investors believe that inflation will increase only modestly in the
months ahead. There is little upward pressure on rates from the
markets themselves.
Hence, it appears that a very restrictive monetary policy is the
driving force behind the interest rate rise.
We know what has happened in the past when the fed has been
overly restrictive. So we want to hear the Fed's evidence on inflation as well as their projections as to where the economy is going.
Most of all, we want to know if the economy can grow at a rate
that will fulfill the assumptions in the President's budget. Thank
you, Mr. Chairman.
The CHAIRMAN. Let me now just indicate that the monetary
policy report that you are submitting this morning, Dr. Greenspan,
is required by law under the Full Employment and Balanced
Growth Act of 1978.
This is a very important transmittal document, and we will
make the full document a part of the record.
[The complete document follows:]
For use at 10:00 a.m., E.S.T.
Tuesday
February 21, 1989
Board of Governors of the Federal Reserve System
:«.B!f!ffil
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 21, 1989
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 21, 1989
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to subrnil its Monetary Policy Report to trie Congress pursuant to (fie
Full Employment and Balanced Growth Act of 1978.
Sincerely,
Alan Greenspan, Chairman
Table of Contents
Page
Section 1:
Monetary Policy and the Economic Outlook for 1989
1
Section 2:
The Performance of the Economy in 1988
5
Section 3:
Monetary Policy and Financial Developments during 1988
10
Section 1; Monetary Policy and the Economic Outlook for 1989
Overall, 1988 was another year of progress for the
U.S. economy, marked by further substantial increases
in output and employment and by a significant improvement in the balance of trade. The dramatic stock
market break of October 1987 did seem to affect real
activity for a time, but the underlying strength of the
economy soon showed through, and, apart from iosses
of farm output caused by the drought, growth proceeded at a relatively strong pace throughout 1988,
Moreover, the sizable employment gains in January of
this year suggest that the economy entered 1989 with
considerable forward momentum.
Inflation has remained in check into the seventh year
of the expansion. Even so, developments during 1988
were a little worrying, as, for a second year, increases
in prices were somewhat larger than in earlier years of
the expansion. Part of the pressure on prices in 1988
came in the food area and reflected the influence of the
drought. However, with labor markets tightening,
there also was a quickening in the rise of wages and
total hourly compensation, which affected prices more
generally.
Federal Reserve policy mirrored the changing economic circumstances of 1988, Early in the year, as in
late 1987, the Federal Reserve soughtto fim it repercussions from the plunge in stock prices and, in particular,
to guard against the possibility of a significant contraction in business activity. Pressures on the reserve
positions of depository institutions were eased a bit
further in early 1988, and interest rates edged down for
a time, extending the declines thai had begun in
October of 1987, Growth of M2 and M3 was fairly
rapid during this period, nearly reaching the upper
bounds of the annual target ranges established by the
Federal Open Market Committee (FOMC).
As it became clear in the spring that the economy still
was strong, the focus of Federal Reserve policy shifted.
For much of the year, there was heightened concern
about the potential for increased inflation, largely
reflecting rapid growth of spending and a continued
tightening of labor and product markets. A sharp
upswing in real net exports of goods and services that
had begun in 1987 continued into 1988, and while this
upturn was a welcome and necessary part of (he
adjustment of the U.S. economy towards better balance in itr, external accounts, it also intensified the
demands on U.S. producers at a time when the utilization of domestic labor and capital already was quite
high. Accommodating the improvement in our external position while limiting the risk of heightened
inflation required restrain! on the growth of domestic
demand.
The shift by the Federal Reserve toward restraint
was reflected in a tightening of the reserve market
conditions that began in late March and continued, in
several steps, into 1989. short-term market interest
rates moved up during this period, influenced both by
the System's tightening and the strength of the economy, and the discount rate was raised in August, to its
current level of 6 Vi percent. Growth of M2 moderated
after the spring and ended the year just below the
middle of the 1988 target range. The growth of M3 also
ebbed over the last two quarters, as the needs of banks
and thrifts to fund credit expansion slackened.
At present, short-term interest rates are about 2'A
percentage points higher than they were early last
spring. Long-term interest rates, by contrast, have
changed little, on net, over that same period; although
these rates turned up in the spring of 1988, they leveled
off over the summer and edged down in the fall, even as
short-term rates were continuing 10 rise. This behavior
of bond yields seems to have reflected a lowering of
market expectations of long-run inflation.
Monetary Policy for 1989
The commitment by the Federal Reserve to contain
inflationary pressures is reflected in the FOMC's decisions to lower the ranges for monetary and credit
expansion this year. The Committee has set a range of
3 to 7 percent for M2 growth during 1989 and a range
of 3Vi to IVi percent for M3, reaffirming the target
ranges established tentatively in June 1988. These
ranges were reduced from those for 1988—a full
percentage point for M2 and one-half percentage point
for M3 - signalling the Committee's determination to
resist any upward tendencies in inflation in the coming
year and to promote progress toward price stability
over the long run. The monitoring range for growth of
domestic nonfinancial debt for 1989 was set at 6W> to
10 'fi percent, which also is lower than that of last year.
In recognitionof the degree fo which the relationship
between monetary aggregates and economic performance has varied in this decade, the Committee retained the four percentage point spread between the
upper and lower ends of the growth ranges that it
adopted in 1988. Despite the deregulation of deposit
interest rates, M2 velocity has remained very sensitive
to changes in market interest rates over periods as long
as a year or more. Depository institutions have been
10
Ranges of Growth lor Monetary and Credit Aggregates
Percent change,
fount! quarter to fourth quarter
1967
1988
1989
M2
S'/ztoSVz
4 to 8
310 7
M3
Slfe to 8V?
4to0
3Va to 7Vs
Debt
8 to 11
7W11
6^1010^
slow to adjust some of their offering races, causing
substantial changes over the short- and intermediateterm in the relative allractiveness to savers of deposits
versus market instruments. In these circumstances, it
is difficult to specify in advance a narrow range for the
appropriate growth of M2 and the other aggregates in
the coming year; such growth will depend on the forces
affecting the economy and prices and. on the response of
depositor)' institutions to any changes in market interest rates, both of which, are subject to a substantial
degreeof uncertainty. Moreover, in 1989, the behavior
of M2 and M3 also could be influenced fay the resolution of problems in the thrift industry, depending, in
pan, on how pricing practices of these institutions
change, on. the reactions of retail and wholesale depositors in these institutions, and on the extent of any
restraints on the growth of assets of savings and loan
associations.
M2 and M3 are now around the lower ends of their
1989 ranges. This slow growth and the accompanying
rise in velocity reflect the continuing effects of recent
increases in market interest rates. In light of the slow
adjustment of deposit rates, velocity could continue to
increase, with growth in these monetary aggregates in
the lower halves of their ranges. Given the uncertainliet about the relation of movements in the aggregates
to prices and output, the Committee agreed that in
implementing policy, they would need to assess, in
addition to the behavior of money, indicators of inflationary pressures and economic growth, as well as
developments in financial and foreign exchange
markets.
The Committee will continue to monitor the growth
of domestic debt in 1989. The expansion of debt of
nonfinancial sectors may slow a little from the 854
percent pace of 1988, although it is expected once
again to exceed the pace of growth in nominal income.
The growth of debt could be importantly affected by
corporate financial behavior. The expansion of private
debt has been boosted in recent years by the substitution of debt for equity in connection with leveraged
buyouts and other corporate restructurings, and business borrowing is likely to be especially sizable in the
eavly part of this year, owing to the recent heavy
volume of such activity. The federal government, once
again, will be placing heavy demands on credit markets, financing its continuing deficit.
Economic Projections
In general, the Committee members, including the
nonvoting Reserve Bank presidents, anticipate that
real GNP will grow moderately in 1989, that prices
will rise at a pace similar to, or perhaps slightly above,
that of 1988, and that the unemployment rate will
remain near its recent level—the lowest in a decade and
a half. On balance, the FOMC members anticipate a
little less real growth and a somewhar higher rate of
inflation than does the Administration, but the differences are not large.
Members of the Committee believe that the progress
of the economy in 1989 will be determined in large
measure by developments on the inflation front. Although special factors, such as the drought, contributed to price increases last year, there also have been
troubling indications—most notably in recent wage
trends—that inflationary pressures have become more
widespread and, potentially, more deeply rooted.
Given the tightening actions taken by the Federal
Reserve over the past year and the policy of continued
restraint on aggregate demand expressed in the monetary targets for 1989, the members of the Committee
anticipate that, if there is any further acceleration of
prices from the 1988 pace, it will be quite limited. The
majority of the Committee members expect mat the
consumer price index will rise about 4% to 5 percent
this year. This would be a slightly larger increase than
in 1988, and thus would represent something of a
setback relative to Ac Committee's disinflationary
objective. However, in light of the tautness of markets
and the current momentum of wages and prices, these
members viewed such a projection as realistic in the
11
Economic Projections for 1989
FOHC Members and Other FRB Presidents
1988 Actual
Range
Centra) Tendency
Percent change,
fourth quarto? to fourth quarter
Nominal GNP
7,0
5V2 to 8Vz
61/2 to 7</2
Real GNP
2.7
1 1/2 to 3'A
2'A to 3
Consumer price Index
4.3
4V2 to 5
Average level in the
fourth quarter, percent
Unemployment rate
5.3
context of aprudeni effort to restore price stability over
time. It should be noted, however, thai some members
expect a rise in prices (hat is significantly below the
centra] -tendency range; in their view this far more
desirable outcome could flow from the dollar's recent
firmness, which will damp the pressures from rising
import prices, and from the recognition by business
and labor that restraint is needed to preserve gains in
international competitiveness.
A particular uncertainty in the inflation outlook for
1989 centers on the prospects for food prices. FOMC
members generally assumed that a return to more
normal weather conditions this year, together with an
increase in acres planted, would lead to a sharp rebound in crop production, in which case food prices
might help to temper overall inflation. However, because stocks of some key agricultural commodities
have been reduced to low levels, there also is risk that
another year of drought could generate strong upward
pressures on prices. In the energy area, consumer
prices could rise sharply early this year, responding to
the runup in oil prices around the end of 1988; nonetheless, world oil supplies still iook ample, and members of the Committee are assuming that energy prices
will increase only moderately over 1989 as a whole.
With respect to real GNP, the central tendency
forecast of the Committee members is for a rise of
about 2Vi to 3 percent in 1989, about the same as in
1988. However, this forecast incorporates a working
assumption that increased farm output will add around
two-thirds of a percentage point to the growth of
GNP—similar to the amount that the drought pared
from 1988's growth- Excluding this swing in farm
5 to 6
5V4 to 51/2
ouipu!, the central-tendency forecast is for considerably slower growth of real output than last year's gain,
excluding drought losses, of more than 3 percent.
Although the economy clearly has entered 1989 on a
strong note—even discounting the transitory influence
of unusually mild weather in many parts of the country - the members feel that growth soon will move to a
lower trajectory, owing both lo the general influence of
monetary restraint and to a number of sector-specific
trends. In the business sector, the boom in capital
outlays that was evident in the first half of 1988 has
since abated, and surveys of plans for 1989 point to
moderate gains in overall plant and equipment spending. Government purchases are expected to be held
down by budgetary constraints; defense purchases, in
particular, have been trending lower under the influence of cutbacks in real spending authority. Recent
increases in mortgage rates likely portend some slackening in the pace of homebuilding, arid the growth of
consumption expenditures also should begin to taper
off from the rapid pace of 1988, as a slowing of
expansion elsewhere in the economy damps the growth
of real disposable income.
With regard to the external sector, real net exports of
goods and services declined over the second half of
1988, but most members of the Committee expect
some improvement in the months ahead. However,
substantial further progress in external adjustment will
require a continuing commitment on the part of U.S.
firms to capitalize on the enhanced competitiveness
resulting from the depreciation of the dollar since
1985. That commitment must take the form not only of
continued cost control and price restraint, bui also of
12
more intense efforts at marketing abroad and investment in new capacity where constraints are visible.
Failure on these counts would almost certainly leave
the U.S. economy considerably less well off over ihe
long haul.
Government policy can do much to encourage businesses to make the longer-range commitments needed
to bring about better balance in the economy and to
foster longer-run growth. A monetary policy directed
steadfastly at movement toward price stability is one
critical ingredient. Bui also crucial is action to bring
about further progress toward balance in the federal
budget. The Committee has assumed that Gramm-Rudmaa-Holtings targets will be adhered to in the fiscal
1990 budget process, but the creation of an environment favorable for economic growth with stable prices
requires that fiscal policies be put in place to produce
the prescribed budget results in the out-years as well.
13
Section 2: The Performance of the Economy in 1968
The U.S. economy completed a sixth year of expansion in 1988. Real GNP rose about 2 M percent over the
course of the year, the number of jobs increased more
than 3 'A million, and the unemployment rate remained
on a downward course, closing the year at 5.3 percent,
its lowest level in 14 years. Progress also was made
toward restoring external balance, as the merchandise
trade deficit fell sharply.
The year began on a note of uncertainty. The sharp
break in the stock market in the fall of 1987 had raised
concern that the economy might falter, and some signs
of weakness did emerge around (he start of 1988. By
early spring, however, it became clear that the expansion still had considerable vigor, coming in particular
from rising exports ant) a boom in capital spending.
Households, meanwhile, adjusted fairly readily to the
loss of stock market wealth, and consumer spending
rose at a strong pace throughout the year. Toward the
end of the year, net exports and capital spending
softened, but there was enough impetus from other
sectors to keep real GNP on a firm upward course.
The rate of inflation, which had picked up in 1987,
remained somewhat higher in 1988 than in earlier
years. The step-up in inflation in 1987 had resulted
mainly from a rebound in the price of oil and the
passthrough of higher prices for imports. This pasl
year, by contrast, extra price pressures reflected the
impact of drought on the price of food arid, more
generally, a widespread pickup in labor costs in the
domestic economy.
The rise in real GNP last year would have exceeded
3 percent, but for a severe drought—one of the worst of
this century-that caused huge losses of farm output.
These losses accounted for most of the slowdown in
GNP growth that occurred after the first quarter of
1988. Fortunately, inventories of farm products had.
been sizable coming into 1988, and a drawdown of
stocks helped to buffer households and others from the
disruption to output. Within the farm sector, the drought
strained the finances of some producers, but the financial condition of many others was not seriously affected, and the sector as a whole remains stronger
fundamentally than in the first half of die 1980s, when
the boom of the previous decade was unwinding.
In most of the nonfarm economy, the growth of
activity was robust in 1988. Production in the manufacturing sector increased 5 percent, nearly matching the
previous year's gain, and factory employment rose
sharply. Employment also continued to grow rapidly in
retail and wholesale trade and among the providers of
business and health services. However, oil drilling,
which had turned up in 1987 when oil prices were
rising, experienced renewed weakness in 1988, intensifying economic stresses in some parts of the country.
The External Sector
The U.S. external accounts showed considerable
improvement during 1988. On a balance of payments
basis, the deficit on merchandise trade fell from an
annual rate of $ 165 billion in the fourth quarter of 1987
to around $120 billion in the second quarter of 1988
and, on average, remained at that lower level in the
second half of the year. Over the four quarters of last
year, the value of exports rose more than 20 percent;
adjusted for inflation, the increase was around 15
percent. Much of the strength in exports, which was
concentrated in the first half of the year, appeared lo be
associated with an improvement in the price competitiveness of U.S. products, resulting from an earlier
depreciation of the dollar, as well as with efforts at cost
control and increases in productivity among domestic
producers. Demand for exports also was supported by
surprisingly strong economic growth in other industrial countries. The growth in real export volume was
spread over most categories of trade; gains were
particularly large for capital goods (especially computers and computer pans), automotive products, and
consumer goods. The volume of agricultural exports
for 1988 was up 9 percent from that of 1987, despile
declines in the second half of the year; the value of
these exports was boosted further by the droughtinduced rise in crop prices.
The value of merchandise imports, other than oil,
rose about 7 percent during 1988. The volume of
non-oil imports increased about 2 percent. This rise
was concentrated mainly in the capital goods area;
volume was down for other major categories of imports. The prices of imported industrial supplies (excluding oil) rose signifkandy in 1988; smaller increases were recorded forconsumer goods, automotive
products, and various machinery categories. However, price declines for oil and computers held the
overall increase in import prices below that of 1987; on
a fixed-weight basis, the rise in non-oil import prices
during 1988 was 7 W percent. The value of oil imports
declined last year, as an increase in physical volume
was more than offset by the decline in price.
For the first three quarters of 1988, the current
account showed a cumulative deficit of $102 billion,
14
Real GNP
Percent change from and of previous period, annual rate
1983
1984
1985
1986
1987
Industrial Production
1988
Index 1977. 100
160
Jan.
140
120
100
80
1983
1984
1985
1986
1987
1988
Implicit Price Deflator for GNP
Percent change from end of previous period, annual rate
1983
1984
1985
1986
1987
1988
15
Foreign Exchange Value of the U.S. Dollar *
fmtex, March 1973-100
175
150
125
100
75
1983
1984
19B5
1986
1987
1988
U.S. Real Merchandise Trade
Annual rate, billions of 1982 dollars
600
500
Imports
400
Exports
300
200
100
1983
1984
1985
1986
U.S. Current Account
1987
1988
Annual rate, billions of dollars
50
50
!00
150
200
1983
1384
1985
1986
1987
" Index oi weighted average foreign encftange value ol U.S. dollar in terms
of Currencies ot olher G-10 countries plus Switzerland Weights are
1972-76311*31 traded each ol (he 10 counties.
" Average ot first three quarters ol 1988. at an annual rats.
1988
16
which was balanced by recorded net capital inflows of
$88 billion anda statistical discrepancy of $14 billion.
Foreign official assets in the United States increased
$28 billion on net (this rise included about $30 billion,
on net, of official purchases of U.S. government
securities). Net inflows through banks were $21 billion. Excluding banking flows, assets held in the
United States by private foreigners increased $68
billion on net; purchasesof U.S. government securities
were sizable fin contrast to net sales in 1987), and
direct investment by foreigners in the United States
remained near record levels. Excluding bank flows,
the assets held abroad by private U.S. residents increased $26 billion. These recorded capital flows
during the first three quarters of 1988, plus the likely
net inflows in the fourth quarter, brought the recorded
U.S. net indebtedness to foreigners to almost $500
billion at the end of 1988.
The foreign exchange value of the U.S. dollar,
which had fallen sharply from early 1985 through the
end of 1987, has shown wide fluctuations in the
subsequent period. Measured against the other G-10
currencies, the dollar currently is up somewhat, on net,
from its end-of-1987 low. However, it has declined
in real (price-adjusted) terms against (he currencies
of our major trading partners among the developing countries, especially South Korea, Mexico, and
Brazil.
From mid-April to late August of last year, the dollar
rose sharply, on average, against the currencies of the
other industrial countries, reflecting the influences of
Federal Reserve monetary tightening and monthly
trade reports that brightened (he market's assessment
of the outlook for U.S. external adjustment. When
measured against a weighted average of the oiher G-10
currencies, the appreciation during that period was
more than 15 percent. After holding steady through
September, the dollar then declined sharply in October
and November; market perceptions appeared to shift
during that period toward a view that monetary restraint in other countries had increased relative to that
in the United States, and incoming trade data suggested
a stalling of the adjustment process. Since November,
the dollar has again risen, partly in response to further
tightening actions by the Federal Reserve.
Measured against the G-IO currencies, the dollar
currendy is about 7 percent above its December 1987
level. If adjustment is made for changes in relative
prices, the resulting real appreciation is somewhat
greater, as inflation in Ac United States has exceeded
the weighted average of inflation rates of the other
major industrial countries.
The Household Sector
At the stan of 1988, concern about the possible effect
of the stock market break on the real economy centered
on the household sector. The drop in share values had
pared roughly half a trillion dollars from household
wealth, and the degree to which spending would be cut
in response to this loss of wealth was not clear.
In the event, the loss of wealth may indeed have left
an imprint on consumer demand. The personal saving
rate did rise after the crash and, over the next year,
averaged about a percentage point higher than in the
year preceding the crash. But, with exports and capital
investment booming, the growth of jobs and real
incomes remained strong in 1988, and the uncertainties
spawned by the crash soon gave way to renewed
optimism among households. Thus, after the initial,
one-time jump in the saving rate, real consumption
expenditures grew at about the same pace as the trend
in after-ax income; Ihe rise over the year was about
3 W percent.
Consumer spending for big-ticket items was brisk in
1988. The unit sales of domestically produced automobiles moved up a bit from the 1987 pace, and the sales
of light trucks and vans, which have more than doubled
since the expansion began in 1983, reached another
new high. Adjusted for inflation, total consumer spending for motor vehicles increased 6W percent over the
four quarters of the year. Among the household durables, real outlays for furniture and appliances, which
had slowed in 1987, moved up 7V4 percent during
1988, renewing the strength that had been evident over
me 1983-86 period.
Real residential investment fell slightly in the first
half of 1988, but turned up in the second half and, by
the fourth quarter, wasalitdeabove the level of a year
earlier. Starts of multifamily housing units, which had
slumped in 1987, felt further in the first quarter of
1988, but then flattened out over the remainder of the
year; vacancy rates for multifamily dwellings remain
high in many areas and are likely to hold down new
construction of these units for some time. ID the
single-family sector, starts edged down through the
first three quarters of 1988, but rebounded toward
year-end to the highest levels since the fall of 1981. By
historical standards, these swings in single-family
starts during 1988 were relatively mild; indeed, from a
longer-term perspective, the past six years have been
an unusually stable period in the single-family market,
in sharp contrast to the boom and bust cycles of the
1970s and early 1980s. Total housing starts, of course,
have fallen sharply since 1986 because of the steep
decline in construction of multifamily units.
17
The Business Sector
Virtually all indicators of business activity exhibited
slrengtb in 19B8. Business sales, in nominal terms,
rose 9 percent over the year. Hiring was brisk in most
sectors, and operating rates rose further; in the industrial sector, capacity utilization at the end of 1988 was
at its highest level since 1979. Corporate profits remained healthy.
A surge in business equipment spending that had
begun in 1987 extended through the first half of 1988,
when outlays grew, in real terms, at an annual rale of
about 20 percent. The surge was led by sizable invest*
ment in high-technology items - computers, communication equipment, and the like-but outlays for other
types of equipment also were strong. After midyear,
the rise in equipment spending slowed, and some
weakness became evident toward the end of the year.
However, most reports from the field suggest that the
underlying trend in equipment spending still is pointing
firmly upward.
Business spending for new construction declined in
1988, reversing the moderate increase of the previous
year. Commercial Construction, the biggest item in the
total, continued to be restrained in 1988 by the big
overhang of vacancies that grew out of the building
boom of the mid-1980s. Gas and oil drilling, following
the lead of oil prices, fell back a little from the pace of
late 1987, but remained above the lows of 1986.
Construction of buildings for industrial use was lillle
changed over 1988; although capacity utilization is
high in manufacturing, many producers also appear to
be limiting their needs for additional space by shifting
toward technologies that use more compact equipment, by economizing on inventories, or by conserving on space in other ways.
Inventory investment, which had been sizable in late
1987, moderated in 1988, and, with sales on an upward
trajectory, stock overhangs were not a problem for
most businesses. In manufacturing, stocks grew more
rapidly in 1988 than they have in recent years, but
much of the accumulation was in industries in which
orders and shipments also were generally strong; the
ratio of inventories to sales for all of manufacturing
moved down during the year from the already low
levels of late 1987. In retail trade, concern about a
possible overhang of the stocks of nondurables eased a
bit during the year, as the ratio of stocks to sales in that
sector edged gradually lower from aFebruary high. By
contrast, auto dealers' stocks rose sharply in the fourth
quarter, and auto manufacturers have enhanced sales
incentives and moved to a lower assembly rate in an
effort to pare inventories, For all of manufacturing and
trade combined, the ratio of inventories to sales varied
little over the course of 1988 and was near the lower
end of the range in which it has been since the business
expansion began.
The Government Sector
Budgetary constraints have led to a slowing of
government purchases, both at the federal level and
among state and local governments. The federal government's purchases of goods and services — the part of
federal spending that adds directry to the gross national
product—fell 4 percent in real terms from the fourth
quarter of 1987 to me fourth quarter of 1988. Roughly
half of the decline reflected a drought-induced reduction in the farm inventories owned or financed by the
Commodity Credit Corporation (CCC), a reduction
that is counted as a negative federal purchase. Excluding this inventory swing, federal purchases were down
2 percent over the year-the first decline since 1976.
Over the eight years that preceded 1988, real federal
purchases, other than those of the CCC, had risen at an
average pace of nearly 5 percent, considerably faster
than the growth of real GNP. The downturn in 1988
reflected cuts in the defense area; other non-CCC
federal purchases rose somewhat over the year.
On a budget basis, total federal outlays, which are
almost three times as great as federal purchases alone,
continued to rise in fiscal year 1988, but at a somewhat
slower rate than in most previous years. There were
further increases in entitlements, greater demands on
deposit insurance agencies, and increases in net interest payments. Meanwhile, the growth of federal receipts slowed in 1988 from the rapid pace of the
previous year. Receipts from social security taxes rose
more than 10 percent —owing in part to a rate increase
in January of 1988. However, growth in receipts from
personal income taxes slowed, as increases in employment and nominal incomes were offset by final reductions in income tax rates legislated under the 1986 tax
reforms. The federal budget deficit in fiscal year 1988
was $155 billion, slightly above the level of the previous year.
The real purchases of goods and services by stale
and local governments rose 3 percent over the four
quarters of 1988, a little more than in 1987, but less
than the average rate of growth over the preceding
three years. Spending for construction, which had
risen rapidly in the mid-1980s, was little changed
during 1988 as a whole, although some pickup was
evident in the fourth quarter. Employment in the state
and local sector continued to rise during 1988, reflecting, in part, the increased demands for teachers
and other school workers associated with growth in the
number of elementary students.
18
Real Income and Consumption
Percent change from end of previous period, annual rate
.
•-
P|jReal Disposable Persona) Income
r~lRea! Personal Consumption Expenditures
1983
1984
1985
1966
Personal Saving Rale
1987
1988
Percent of disposable income
10
1983
1984
1985
1986
1987
1988
Private Housing Starts
Annual rate, millions of units, quarterly average
2.5
1.5
Single-family'
0.5
1983
1984
1985
19SS
1987
1988
19
Real Business Fixed Investment
Percent change from end of previous period, annual rate
40
||§j Structures
30
I ] Producers' Durable Equipment
20
10
+
0
10
1983
1985
1984
1986
1987
1988
20
Changes in Real Business Inventories
Annual rate, billions of 1982 dollars
90
Total Nonfarm
60
30
LJii
+
0
30
60
1983
1984
1985
1986
1988
1987
After-tax Profit Share of Gross Domestic Product *
Percent
10
Nonlinancial Corporations
1983
1984
1985
1986
1987
* Ratio Of profits from domestic operations with inventory valuation and
capital consumption adjustments to gross domestic product of nonfinancial
corporate sector.
1988
20
The Labor Markets
The rise in the number of jobs during 1988 was
somewhat above that of 19&7 and brought the total
increase in payroll employment since late 1982 to
about 18% million. Virtually all pans of the economy
shared in last year's gain. The number of jobs in
manufacturing increased 400,000; employment in construction was up 300,000, Close to a million new jobs
were created in retail and wholesale trade, and 1.3
million were added in services. Except for a brief
slowdown in the summer, the growth of jobs was
strong throughout the year.
The continued rise in employment last year led to a
tightening of labor markets and called attention to
limits on the potential growth of the supply of labor and
of output. Growth of the working-age population has
slowed in the 1980s, and the increase during 1988 was
the smallest annual rise in more than two decades. This
slowing of papula- tioft growth in the 1980s has led, in
turn, to a more moderate rate of growth in the labor
force, even as the rale of labor force participation,
especially for adult women, has continued to rise. A
big boost to output during the expansion has come from
putting unemployed workers back on the job; now,
however, with the unemployment rate at less than 5 'A
percent, the labor force is more fully utilized than at
any time in the last decade and a half.
The tightening of labor markets in 1988 was associated with a pickup in the rise of wages and labor cosis.
The employment cost index for wages and salaries in
the private nonfarm sector increased a bit more than 4
percent over the year—almost a percentage point more
than in 1987. The pickup was most pronounced among
white collar workers and in the service-producing
industries, where unemployment rates currently are
the lowest. The cosl of benefits provided to employees
rose 6% percent over the year, nearly twice the increase of 1987; the rise reflected both the hike in the
payroll tax at the start of 1988 and asurge in the cost of
health benefits. Total compensation per hour—wages
and salaries plus benefits—rose nearly 5 percent over
the four quarters of 1988, after two years in which the
annual increases had been in the neighborhood of 3W
percent.
Productivity gains slackened somewhat in 1988.
The rise in output per hour in the nonfarm business
sector over the four quarters of the year was only 0.7
percent—about half apercentage point below the average over this decade. This slippage in productivity
growth in 1988, combined with the faster rate of
increase in hourly compensation, resulted in a 4 percent rise in unit labor costs in the notifarm business
sector over the four quarters of 1988—well above the
average rate of increase during the previous fit,
years.
Price Developments
The broader measures of prices—including the GNP
price measures, the producer price index, and the
consumer price index—all indicate that inflation was in
arangeof4lo4Wpercentin 1988- ExceptfortheCPI,
which had moved up into this range in 1987, these
measures showed some acceleration last year, and all
of them—including the CPI—rose more rapidly than in
the first four years of the expansion. In contrast to
1987, when the indexes were boosted by a rebound in
energy prices and rising prices for imports, the inflationary pressures this past year were augmented by
larger increases in labor costs in the U .S. economy and
the drought's influence on agricultural prices.
The drought's effects appeared quickly at the retail
level in the summer, as price increases picked up for a
wide variety of consumer foods. By late autumn,
however, the impact of the drought on food prices
began to dissipate, and inflation in the food sector
returned to a more moderate path. The increase in
consumer food prices over the year as a whole was 5 'A
percent—about 2 percentage points above the average
of the preceding five years. Prices in 1989 will be
sensitive to weather developments over the spring and
summer. In the past, major droughts in the United
Slates have been one-year events, often separated in
lime by several good growing seasons, and most
agricultural observers have been assuming that farm
output will rebound in 1989, thereby restraining the
prices of farm crops. Currently, however, dry conditions still prevail in some important growing regions,
and crop prices could rise abruptly if moisture supplies
are deficient in coming months.
Energy prices were little changed at the consumer
level during 1988 after a sharp rise in 1987—a pattern
that resulted mainly from the continued gyrations in
world oil markets. The price of oil, which had risen
sharply in 1987, moved lower for much of 1988, as the
efforts of OPEC to restrain production unraveled. In
late 1988, a new agreement by OPEC to [unit production, coupled with higher-than-expected oil consumption and production shortfalls in non-OPEC countries,
caused prices to rise sharply once again; however,
despite these fluctuations, prices have not made any
sustained departure from the range in which they
generally have been since the summer of 1986.
Price increases for goods and services other than
food and energy were larger in 1988 than in 1987. The
pickup, while fairly moderate, was widespread and
21
Nonfarm Payroll Employment
Net change, millions of persons, Q4 to Q4
^U Total
—
f^C] Manufacturing
1983
1984
1985
1966
Civilian Unemployment Rate
19fl7
1983
Quarterly average, percent
12
10
1983
1984
1985
1986
Employment Cost Index *
1987
1988
12-month percent change
Total Compensation
1983
1984
1985
1986
1987
' Employment cost index (or private industry, excluding (arm and household
wortiera.
1988
22
GNP Fixed-weighted Prices
Percent change from end of previous period, annual rate
1
I
1983
I
I
1984
1985
1986
1987
1988
Producer Prices
Percent change from end of previous period, annual rate
I
1983
I
I
1984
1985
1986
I
1987
I
1988
Consumer Prices *
Percent change from end of previous period, annual rate
1983
1984
1985
1986
http://fraser.stlouisfed.org/ * Consumer Price Index for all urban consumers.
Federal Reserve Bank of St. Louis
1987
1988
23
Consumer Food Prices *
Percent change from end of previous period, annual rate
1983
1984
1985
1986
1987
1988
Consumer Energy Prices *
Percent change from end of previous period, annual rate
15
15
30
1983
1984
1985
1986
1987
1988
Consumer Prices Excluding Food and Energy *
Percent change from end of previous period, annual rate
[|p| Services Less Energy
|
| Commodities Less Food and Energy
1983
1984
1985
1986
* Consumer Price Index for all urban consumers.
1987
1988
24
probably reflected, in large part, the past year's acceleralion in hourly compensation and unit labor costs in
the domestic economy. By contrast, the pressures from
rising import prices appeared to be a bit less pronounced than in 1987. Even so, higher prices for
imports probably were an influence in some areas; the
retail prices of apparel, for example, rose nearly 5
percent for the second year in A row. The price
increases for industrial commodities slowed in 1988
after steep increases during 1987; by most measures,
however, the year-to-year rate of rise in these prices
has remained somewhat above that of inflation in
general. The producer prices of intermediate inputs,
excluding food and energy, rose more than 7 percent
during 1988, reflecting the high levels of capacity
utilization in a number of industries, as well as the
tightening of labormarkets.
25
Section 3:
Monetary Policy and Financial Developments Ourfng 1988
During 1988, Federal Reserve policy continued to
be characterized by a flexible approach lo monetary
targeting, with System actions responding to emerging
conditions in the economy and in financial markets, as
well as to growth of (he monetary aggregates. This
approach has been necessitated by the short-run variability in the relation of these aggregates to economic
performance, owing primarily to their sizable response
to changing interesi rates, in addition to spending. In
the early months of last year, monetary policy was
eased in light of incoming data suggesting a weakening
in the economic expansion and the possibility of further
financial market disruptions. Subsequent information,
however, suggested a growing threat of inflationary
pressures, as Ihe economic expansion remained strong
and margins of available labor and productive capacity
dwindled. To head off a potential acceleration of
inflation, the Committee tightened reserve conditions
in a series of steps beginning in the spring and extending into 1989. The monetary aggregates were running
close to the upper ends of their growth ranges prior io
the tightening actions, but subsequently slowed, and
they closed the year in the middle portions of their
ranges.
Implementation of Monetary Policy
During the early months of last year, the Federal
Open Market Committee sought lo counter any economic weakness that could result from the slock market break and lo ensure the smooth functioning of
domestic financial markets. Indicators of aggregate
demand suggested that there was a risk of weakness in
the economy that warranted some easing of monetary
policy. In addition, special emphasis was placed on
monitoring domestic financial markets for signs of any
new distress and on being alert to the need lo alter the
provision of reserves quickly in response to any trouble. Against this backdrop, reserve conditions were
eased slightly in early February, contributing to reductions in short- and long-term interes! rates.
Throughout the spring, incoming economic data
suggested that the economy had overcome the effects of
lower equity prices on confidence and spending. This
information indicated (hat the economy was expanding
at a rate that threatened progress toward long-run price
Stability. Bond yields increased during this period, as
indications of economic strength contradicted the earlier market forecasts of a general slowdown and raised
concerns about an uptrend in inflation. Based on evidence of a greater potential for higher wage and price
inflation and in the context of rapid growth in M2 and
M3, the Federal Reserve firmed reserve conditions
further in a series of steps beginning in March and
culminating in early August with a one-half percentage
point hike in the discount rate. These moves brought
about substantial increases in short-term interest rales,
but were accompanied by only small increases in
Treasury bond yields, as investors viewed Federal
Reserve actions as heading off a long-term acceleration
of inflation. The upturn in short-term interest rates,
coupled with more optimistic expectations of future
inflation, helped boost the foreign exchange value of
the dollar during this period.
In view of the policy restraint already in place,
which was being reflected in slowing growth in the
monetary aggregates, and some signs that economic
growth may have been moderating, the Committee
postponed any further action over the late summer and
early fall, awaiting further in forma lion on the courseof
the economy. During October and November, the
foreign exchange value of the dollar declined, partly in
response to a rise in foreign interest rates relative 10
U.S. market interest rates and to investor concern over
the lack of progress in reducing the U .S. federal budget
deficit and the slowing improvement in the U.S. trade
deficit.
In late fall, incoming data suggested that previous
monetary restraint had not been sufficient to relieve the
potential for higher inflation and the Committee resumed tightening reserve conditions in a series of
moves beginning in November and extending into the
new year. As a result of these measures, short-term
market interest rates rose. In contrast, bond yields
continued to fluctuate narrowly, signalling the market's
continued confidence lhat inflationary pressures would
be contained. This confidence together with the firming
of policy contributed to a strengthening of die foreign
exchange value of the dollar.
Behavior of Money and Credit
M2 expanded 5.3 percent last year, jusl below the
middle of its 4-ro-8 percent target range. Although
demands for M2 were supported by strong growth in
income and spending, they were reduced by increases
in its opportunity cost— that is, the difference between
market interest rates and the yields on M2-type instruments. Early in the year, opportunity costs had declined in response to decreases in market interest rates
relative lo deposit rates in late 1987 and early 1988,
26
Short-Term Interest Rates
Monthly
3-morrth Treasury Bill
Cwipw* Equivalent
I
I
Long-Term Interest Rates
Percent
Monthly
1980
1931
1902
1d63
ObaanradOfii are monthly average* <* daily "Jala,
last obawvation IB lor Decantoer 1988,
1984
1965
1986
1967
1966
27
leading to strong growth in M2 and a decline in its
velocity —the ratio of nominal GNP to M2—during the
first quarter. But as market interest rales moved upward after March and deposit rates lagged behind, its
velocity subsequently reversed, rising 1,7 perceni for
all of 1988. The response of offering rates was especially sluggish in the last part of 1988. One reason for
this may have been regulatory pressure on thrifts and
the closing of many insolvent institutions, which often
had been overly aggressive in pricing deposits. The
extent (o which thrifts were offering higher rates than
banks on small time deposits was greatly reduced, and
partly as a consequence, growth of retail deposits was
much stronger at banks than at thrifts.
The composition of the growth of the components of
M2 also responded fo changes in deposit rates and
market interest rates. Yields on liquid deposits—
interest-bearing checking deposits, savings deposits,
and money market deposit accounts—changed very
little over the year. During the first half of 1988, liquid
retail deposits expanded at a strong pace, largely
re fleeting increases in their relative attractiveness stemming from declines in market interest rates and, to a
lesser extent, in rates on small time deposits. Their
growth slowed markedly over the last half of 1988,
following (he reversal in the pattern of imerest rate
movements. Growlh in small denomination time deposits was particularly robust throughout 1988. Expansion
in the early months of the year may have resulted, in
part, from shifts in household investment preferences
away from stocks toward the safety of these savings
instruments. Later, rising yields on small time deposits
relative to those on more liquid deposits led households
to shift funds from liquid to small denomination time
deposit accounts.
M3 grew 6.2 percent fast year, placing it slightly
above the midpoint of its 4-to-8 percent target range.
This increase from a 5.8 percent growth in 1987
reflected a modest pickup in the issuance of managed
liabilities in M3 to fund credit expansion at banks and
thrift institutions, M3 followed a trajectory near the
upper end of its target range in the first half of 1988, but
moderated thereafter, in association with slowing credit
growth at depository institutions. For the year, large
time deposits and other managed liabilities included in
M3 but not in M2 grew rapidly, as inflows into M2-type
deposits were insufficient foe banks and thrifts to
finance their desired pace of asset expansion. This was
particularly true in the second half of the year when M2
growth moderated. To some extent, M3 growth last
year also was bolstered compared with 1987 by a
greater reliance by banks on managed liabilities included in M3 than on nonmoney stock instruments,
such as bank borrowings from overseas branches. In
contrast, as in recent years, the heavy use of Federal
Home Loan Bank advances by thrift institutions—
which are nol included in M3—has had a moderating
effect on M3 growth.
At 4,3 percent, M1 growth last year was down more
than 2 percentage points from 1987. Growlh of interestbearing checking accounts moderated while demand
deposits continued running off. As in recent years, the
growth of Ml displayed great sensitivity to changes in
market rates of interest. Households shifted savings
balances between NOW accounts and those M2 components, such as small time deposits, whose yields
responded to increases in market rates much more
quickly than those on NOW accounts. Because substitutions of this type are internalized within M2, M2 has
displayed less sensitivity to interest rates than has Ml
in this decade. Demand deposits, the other highly
interest sensitive component of M1, again declined in
1988 partly reflecting increases in their opportunity
costs and declines in compensating balances. The
amount of such balances that businesses musi hold in
these noninterest bearing accounts to compensate banks
for services falls when interest rates rise.
The debt of domestic nonfinancial sectors expanded
nearly 834 percent during 1988, down from 9 percent
in 1987, placing it near the midpoint of the Committee's 7-to-11 percent monitoring range. Although debt
expansion was well below the pace of the mid-1980s, it
still exceeded nominal GNP growth. Federal debt grew
marginally faster last year than in 1987. Expansion in
nonfederal debt moderated, as slate and local governments trimmed debt issuance, and as households expanded their mortgage debt at a less robust pace in
response to higher mortgage rates. Growth of business
debt picked up a bit from its 1987 pace, with short-term
debt growing faster than long-term debt. Corporate
borrowing was particularly strong, reflecting increased external financing needs for capital investments and for mergers, buyouts, and stock repurchases.
Other Financial Developments
Although the economy continued to grow at a strong
pace last year and the financial markets recovered from
their skittishness following the stock market break of
1987, financial developments in certain markets and
sectors warranted the attention of policymakers. Of
particular note were the worsening condition of the
thrift industry, the need to achieve sounder capitalization Of commercial banking organizations, and the
rising indebtedness of businesses involved in restructuring activity.
28
Ranges and Actual Money Growth
M2
Billions ol dollars
Rate of Growth
3200
1987 Q4 to 1968 Q4
5-3 Percent
4%
J
O
3000
I
N
D
1967
J
F
M
A
M
J
J
1988
A
S
M3
O
N
D
Billions of dollars
Rate Of Growth
1987 CM to 1988 Q4
6.2 Percent
4% —
O
N D
1987
J
F
U
A
M
J
J
1988
A
S
O
N
D
29
Ranges and Actual Growth of Money and Debt
Debt
Billions of dollars
9-wo
Rate of Growth
9200
1987Q4to1988Q4
8.7 Percent
9000
8800
8600
8400
8200
I
O
N
D
J
F
M
A
M
1987
J
J
A
I
S
O
I
8000
N
O
1988
M1
Billions ot do liars
900
850
800
750
J
O
N
D
J
I
F
I
I
M
1987
A
M
I
J
1988
I
J
A
I
S
I
I
O
N
700
D
Rate of Growth
1987 04 to 1988 Q4
4.3 Percent
30
Velocity of Money and Debt
(Quarterly)
M1
M2
_ .
Ratio scale
1-2
1961
1970
M3
1979
1988
i961
1970
1979
Debt
Ratio scale
Ratio scale
0.8
1961
1970
1988
1961
1970
1979
31
Growth of Money and Debt1 (Percentage changes)
M1
M2
M3
Debtof
domestic
nontlnanclal
sectors
10.4
12.3
Founn quarter to fourth quarter
1979
7.7
1980
7.4
1981
5.2(2.5)
1982
8.7
1983
8.2
9.0
3
9.3
9,1
10.2
12.1
5.3
1984
7.7
3
9.6
12.3
9.9
9.8
10.5
9.6
10.0
9.0
11.3
14.2
1985
12.0 (13.0)
8.9
7.7
13.2
1986
1S.6
9.3
9.1
13.3
1987
6.4
4.2
5.7
9.8
1988
4,3
5.3
6.2
8.7
3.2
6,2
6.8
8.2
Q2
6.4
6.9
7.2
8.7
Q3
5.2
3.8
5.5
8.6
Q4
4.4
3.8
4.9
8.4
Quarterly growth rates
<annual rates)
1988
Q1
1. M1, M2, and M3 incorporate effects of benchmark
and seasonal adjustment revisions made in February 1989
2. M1 figure in parentheses is adjusted for shifts to
NOW accounts in 1981.
3. M1 figure in parentheses is the annualized growth
rate from th« second to the fourth quarter of 1985.
32
As the year wore on, the dimensions of the problems
facing the thrift industry became clearer. Although
industry losses eased in the third quarter from their
record levels in the first half of 1988, this development
appears largely to have reflected FSLIC assistance
transactions during the third quarter, rather than a
significant underlying improvement in earnings.
Despite the turmoil in the thrift industry, there has
been no noticeable disruption of mortgage activity. In
pan, the development of a deep secondary mortgage
market has separated the origination of loans from the
need to fund them. For this reason, the base of mortgage credit has been broadened in recent years, making
the provision of mortgages far less dependent on the
condition of any one type of financial institution or on
the regional supply of loanable funds. During the
1980s, the share of home mortgage credit held in
securitized form has increased from about 10 percent
to more than one-third. The spread between interest
rates on fixed-rate mortgages, which have an average
life of roughly.ten years, and yields on ten-year
Treasury notes did not change appreciably over 1988,
which also implies that the mortgage markets continued functioning well despite the problems of many
savings and loan associations.
In contrast to the thrift industry, preliminary data
indicate that U.S. commercial bank profits were reasonably strong in 1988, even after abstracting from the
one-time jump in fourth quarter earnings associated
with the resumption of Brazilian debt payments. Moreover, most large money-center banks with a significant
amount of loans to developing countries have continued to build capital, which provides a cushion against
default losses. Giving added impetus to efforts to raise
equity was the agreement by bank supervisory authorities of major industrial countries to set more stringent,
risk-based standards of capital adequacy. These standards, to be fully phased in by 1992, place a greater
emphasis on equity capital, take into account the
off-balance sheet activities of banks, and provide a
more uniform regulatory treatment of banks based in
different countries.
As in 1987, banks lent considerable sums 10 finance
mergers and leveraged buyouts. Although banks have
reported that these loans have had a lower rate of loss
than all other business loans combined, and although
LBO borrowers typically obtain some insurance against
higher loan rates, concern remains about bank exposure to losses in the event of an adverse turn in. business
conditions. For this reason, the Federal Reserve is
closely monitoring developments in this area and has
just revised its bank examination guidelines to ensure
that member bank loans used to finance buyouts and
other highly levered corporate restructurings meet
prudent credit standards.
Leveraged buyouts and other mergers and restructurings led to a record pace of net equity retirements by
nonfinancial corporations in 1988. Despite the large
volume of this activity in recent years, the overall
corporate debt-to-equity ratio is not out of line with
observations since the early 1970s, reflecting increased market valuation of equities since the eaily
1980s. Much of the recent financial restructuring has
been a response to fundamental economic factors; it
may impose a discipline on corporate management,
whkh in turn can stimulate efforts to improve productivity. Nevertheless, heavy commitments of cash flow
to service debt reduce a firm's ability to cope with
stresses or industry-specific shocks. To some extent,
the substitution of debt for equity is motivated by
simple tax-saving considerations, such as the full deduction for interest payments and the double taxation
of dividends. For these reasons, reforming the corporate tax system should be a component of public policy
in addressing this difficult issue.
33
The Share of Residential Mortgage Debt Held as Securities
Percent
35
Quarterly through 19S8O3
30
25
20
15
10
1980
1981
1982
1983
1984
1985
1986
1987
The Spread Between Primary Home Mortgage
and 10-year Treasury Bond Rates
1988
Percent
Monthly
liiimimi
1980
1982
1984
1986
1988
Debt to Equity Ratios of Nonfinancial Corporations*
Percent
120
Quarterly through 1988Q4
100
Debt/Equity
80
60
M
1960
20
1964
1968
1972
1976
1980
1984
1988
'Debt and equity are at martot value. In computing nel worth, tangible assets ate valued at
replacement cost or market value while finanaal assets are valued at cost.
34
The CHAIRMAN. I would be very pleased now to have you give us
your oral summary.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. GREENSPAN. Thank you, Mr. Chairman.
I also ask that my full testimony be included as part of the
record as well. I will try to shorten it to a certain extent.
Last year was a challenging one for monetary policy. Early in
the year, uncertainties remained about the impact of the October
1987 worldwide stock market break on the economic expansion and
financial system. Given these risks, the Federal Reserve increased
the availability of bank reserves slightly further and monitored financial and economic indicators closely for any signs that the economic expansion was faltering.
Gradually, however, it became clear that the economic expansion
remained well on track and that the balance of risks was shifting
in the direction of higher inflation. Consequently, the Federal Open
Market Committee applied increased restraints to reserve positions
in a aeries of steps beginning in the spring of 1988 and extending to
the current period. In addition, the discount rate was raised from 6
to 6.5 percent in August.
The policy restraint led to an appreciable rise in short-term
market interest rates and a moderation of money growth beginning
in the spring of 1988. M2 and M3 finished the year around the
middle of their 4-to-8 percent annual target ranges.
Despite tightening money markets, longer term interest rates
have been remarkably stable. Moreover, the stock market recovered relatively steadily over the year and into 1989, and the dollar
has been fairly stable since late 1987.
The optimism of domestic and foreign investors evident in financial markets reflected expectations that inflation would not intensify appreciably as well as the solid performance of the economy and
prospects for its continuation.
Our GNP expanded by around 3.25 percent in 1988, adjusted for
crop losses caused by the drought. This increase helped push the
unemployment rate below 5.5 percent, its lowest level since the
mid-1970's. Employment gains in 1987 and 1988 were strong in
nearly every major sector of the American economy, including
manufacturing. Although in 1988 farmers suffered one of their
worst crop losses in this century, the situation in agriculture remains fundamentally much improved from that earlier in the
1980s.
However, last year's economic performance had some disappointing features. The Federal budget deficit remained high and our national saving low. This contributed to continued large current account and trade deficits. In addition, overall inflation in the area of
4 to 4.5 percent during 1988 was a little above the general range in
which it had fluctuated in the mid-1980's. The drought boosted food
prices, adding somewhat to inflation last year, but this was largely
offset by a leveling off of energy prices. Prices of other consumer
goods and services accelerated a bit. This acceleration is troubling,
35
especially with inflation already at a level that would be unsatisfactory if it persisted.
Although the ster>up in consumer inflation to date has been
rather small, some signs have emerged of greater acceleration in
the broad measures of costs of production. Wage gains accelerated
toward the end of last year. Moreover, benefits took an unusually
large jump in 1988, adding to business costs, and prices of materials also rose at a faster pace.
On the whole, the economic expansion remains vigorous and unusually well-balanced after more than 6 years. But with the economy running close to its potential, the risks seem to be on the side
of a further strengthening of price pressures. In these circumstances, the Federal Reserve remains more inclined to act in the
direction of restraint than toward stimulus.
The determination to resist any pickup in inflation in 1989 and
especially to move over time toward price stability shaped the committee's decisions with respect to monetary and credit ranges for
1989. The FOMC lowered the range for M2 by a full percentage
point to 3 to 7 percent and reduced the range for M3 by one-half of
a percentage point to 3.5 to 7.5 percent. The committee also lowered the monitoring range for domestic nonfinancial sector debt by
one-half of a percentage point to a range of 6.5 to 10.5 percentage
points. These were the ranges adopted on a tentative basis last
June.
We decided to retain the wider, 4-percentage-point ranges that
were adopted in 1988. The potential for sizable and somewhat unpredictable movements in velocity requires fairly broad ranges in
order to have reasonable assurance that the targets are consistent
with satisfactory economic performance.
In view of the rather loose relationship of the aggregates to GNP
and prices that have developed in the 1980's, the committee agreed
to continue its current approach to the implementation of policy,
which involves monitoring a variety of economic and financial indicators, including growth of money and debt.
In this regard, appropriate growth of M2 and M3 relative to their
ranges will be determined in part by developments during the year.
The Federal Reserve expects its policy in 1989 to support continued economic expansion while putting in place conditions for a
gradual easing in the rate of inflation over time. However, the
wage and price process may have developed some momentum. The
central tendency of forecasts made by members of the Federal Reserve Board and presidents of Federal Reserve Banks is for inflation to rise slightly in 1989. But let me stress that the current rate
of inflation, let alone an increase, is not acceptable, and our policies are designed to reduce inflation in coming years.
This restraint will involve containing pressures on our productive resources, and, thus, some slowing in the underlying rate of
growth of real GNP is likely in 1989. The central tendency of GNP
growth forecasts for this year of Board members and Reserve Bank
presidents is between 2.5 and 3 percent; abstracting from the expected rebound from last year's drought losses, real GNP is projected to grow at closer to a 2 percent rate. With demands for labor
growing more in line with expansion of the labor force, the unemployment rate is expected to remain near its recent level over 1989.
36
Maximum sustainable economic growth over time is the Federal
Reserve's ultimate objective. The primary role of monetary policy
in the pursuit of this goal is to foster price stability. Price stability
contributes to economic efficiency in part by reducing the uncertainties that tend to inhibit investment. Also, it directs resources to
productive economic activity that otherwise would tend to be diverted to mitigating the financial effects of inflation.
Price stability—indeed, even preventing inflation from accelerating—requires that aggregate demand be in line with potential aggregate supply. In the long run, that balance depends crucially on
monetary policy. Inflation cannot persist without a supporting expansion in money and credit; conversely, price stability requires
moderate growth in money—at rates below those prevailing in
recent years.
In the short run, demands can fall short of or run ahead of available resources. Monetary policy can assist hi bringing about a
better match between demand and potential supply and thereby
contribute to aggregate price stability.
When the economy is operating below capacity, bringing demand
in line with supply can involve real GNP growth that is faster for
a time than its long-run potential. But when the economy is operating essentially at capacity, monetary policy cannot force demand to
expand more rapidly than potential supply without adverse consequences. Such an attempt will result in accelerating prices and
wages, as producers bid for scarcer, and at the margin less productive, labor and capital. Over time it would result in little, if any,
additional output.
As a result of robust expansion in the last few years, the U.S.
economy has absorbed much of its unused labor and capital resources. No one can say precisely which level of resource utilization
marks the dividing line between accelerating and decelerating
prices. However, the evidence—in the form of direct measures of
prices and wages—is clear that we are now in the vicinity of that
line.
Thus, policies that foster more economic growth, if such growth
is to be sustainable over the long run, should focus on aggregate
supply. The United States could increase growth of supply by stepping up the pace of capital accumulation. Government policies can
contribute to a higher rate of investment. Tax policies can help by
ensuring that returns from capital are not taxed excessively or unpredictably. And fiscal policy can help boost the national saving
rate through a reduction in government dissaving. Congress should
follow the Gramm-Rudman-Hollings timetable and then seek a
budgetary surplus by the mid-1990's, in my judgment.
An improving Federal budget position should have a variety of
favorable effects. It can pave the way for a reduction in our external imbalance by freeing resources currently absorbed by domestic
demand. By putting downward pressure on real interest rates, it
can encourage domestic business capital formation and make housing more affordable. It can encourage households and businesses to
focus more on the long run in economic planning.
Monetary policy also has a role to play in encouraging capital
formation and economic growth over time, by providing a stable
price environment. Although the relationship between growth of
37
money and the economy can vary from year to year, over the long
haul there is a close relationship between money and prices. The
historical evidence suggests that price stability ultimately will require a somewhat slower M2 growth than we have experienced in
recent years.
The Federal Reserve recognizes that monetary policy over the
coming year will be carried out against the backdrop of a financial
system facing certain difficulties. The thrift and FSLIC situation is
perhaps most pressing. The Administration has proposed an extensive, workable plan for dealing with this matter. There appears to
have been little, if any, effect of the S&L problem on mortgage
availability in housing—thanks in part to financial innovation in
the form of the mortgage-backed securities market. However, without quick and effective action the situation could deteriorate.
Developments in the corporate sector warrant close scrutiny as
well. As you know, corporate equity continues to be retired at a
startling rate in conjunction with LBO's and other mergers and restructurings and has involved issuance of a correspondingly large
amount of debt. Although these restructurings often may improve
economic efficiency, the higher leverage leaves these firms and potentially their creditors more vulnerable to financial difficulties in
the event of a downturn. The Federal Reserve and other Federal
regulators are instructing bank examiners to review especially
carefully loans to highly leveraged firms in order to maintain a
safe and sound banking system,
The international economy also will command the continuing attention of policymakers around the world. Among the industrial
countries, greater concern about rising inflation followed the substantial economic growth recorded last year. Meanwhile, the process of adjustment of international imbalances appeared to have
slowed somewhat in the second half of last year, and many developing countries continued to face serious problems of achieving sustained economic growth, fostering development, and servicing large
external debts.
Some have argued that these financial stresses, taken together,
could hamstring the Federal Reserve's anti-inflationary policy. Certainly we have to take account of the effects of our actions on all
sectors of the domestic and international economy and on financial
markets; at the same time we recognize that monetary policy is not
the instrument to deal with structural financial stresses and imbalances here and abroad—and that attempts to do so may even
worsen these problems. Lowering interest rates in the short run
through more rapid money growth against countervailing market
pressures would quickly raise inflationary expectations, leading
sooner to higher, not lower, interest rates.
Instead, the structural financial problems require the prompt application of microeconomically oriented solutions within the supervisory, regulatory, and legal framework. Imbalances in the world
economy require the continued, patient application of responsible
macroeconomic policies in the United States and in other industrial countries, as well as further progress in economic reforms by the
developing countries.
For its part, the Federal Reserve will continue to seek monetary
conditions that will reduce inflation. Our major trading partners
38
are following consistent policies in their own economies. Together,
these policies should bring about a more stable financial environment and promote long-run worldwide economic growth.
Relatively stable long-term nominal interest rates and flattening
yield curves around the industrial world are strong evidence that
savers and investors are in accord with this view. Monetary policy,
at least for the moment, appears on track in the United States.
The task is to keep it on track while making necessary adjustments
to fiscal policy and reforms to the regulation of financial institutions. In this way, we can ensure vigorous and balanced economic
conditions over the long run.
Thank you very much.
[The complete prepared statement of Alan Greenspan follows:]
39
Statement by
Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
of the
U.S. Senate
February 21, 1989
40
Mr. Chairman and members of the Committee, I
appreciate this opportunity to discuss with you recent
monetary policy and our plans for the future.
received our formal report to the Congress.
You have
This morning, I
would like to summarize the important points of that report
and to place monetary policy in the context of the overall
economic and financial situation.
gcgnpmic, and_ jipjie_^a_ryJ3gyej.op_ment3 in 1966
Last year was a challenging one for monetary
policy.
Early in the year, uncertainties remained about the
impact of the October 1987 worldwide stock market break on
the economic expansion and financial system.
Given these
risks, the Federal Reserve increased the availability of
bank reserves slightly further, adding to the easing put in
place immediately following October 19; at the same time we
monitored financial and economic indicators closely for any
signs that the economic expansion was faltering.
Gradually, however, it became clear that the
economic expansion remained well on track and that market
confidence was on the mend.
Spending was robust, and
dwindling margins of unused resources aa employment and
output registered sizable gains indicated that the balance
of risks was shifting in the direction of higher inflation.
Consequently, the FOMC applied increased restraint to
reserve positions in a series of steps beginning in the
41
spring of 1988 and extending to the current period.
In
addition, the discount rate was raised from 6 to 6-1/2
percent in August.
The policy restraint led to an appreciable rise in
short-term market interest rates beginning in the spring of
1988.
Growth of money moderated over the year as rates on
deposits lagged the rise in market interest rates.
M2 and
M3, which were near the upper ends of their target ranges
early in the year, slowed considerably in subsequent months
and finished the year around the middle of their 4 to 8
percent annual target ranges.
Growth of Ml also was
restrained by higher interest rates, slowing to about
4 percent, while the monetary base grew only a bit less
rapidly than in 1987, as currency continued to expand at a
strong pace.
Thus, in both 1987 and 1988, most money
measures grew appreciably more slowly than they had in many
years.
This more moderate pace of monetary expansion has
been a necessary aspect of a monetary policy designed to
contain inflation and promote price stability and economic
growth over timQ,
Despite tightening money markets, longer-term
interest rates have been remarkably stable.
Yields on
Treasury bonds, for example, remained in a fairly narrow
range around 9 percent for moat of the year and have
continued in that range so far in 1989.
Moreover, the stock
market recovered relatively steadily over the year and into
42
1989.
The performance of the bond and stock markets in the
face of rising short-term rates seemed to stem from
expectations of continued relatively balanced economic
expansion in the United States with inflation pressures not
likely to intensify. U.S. investments looked attractive
under these circumstances, and the dollar's average value
against major foreign currencies recovered from the late
1987 plunge and was relatively stable over the course of the
year.
The optimism of domestic and foreign investors
evident in financial markets reflected the solid performance
of the economy and prospects for its continuation.
Our GNP
expanded by around 3-1/4 percent in 1988, adjusted for crop
losses caused by the drought.
employment rose by 3.7 million.
Over the year, payroll
Since the economic
expansion began in late 1982, employment in the United
States has increased by more than 17 million people, pushing
the unemployment rate below 5-1/2 percent, its lowest level
since the mid-1970s.
Employment gains in 1987 and 1988 were
strong in nearly every major sector of the American economy,
including manufacturing, construction, trade, and services.
Although in 1988 farmers suffered one of their worst crop
losses in this century, the situation in agriculture remains
fundamentally much improved from that earlier in the 1980s.
Industrial production in manufacturing rose 5-1/2 percent,
bringing average capacity utilization to the highest level
43
since the late 1970s.
Some industries that had been hit
especially hard by the recession of 1981-82 and by the
erosion of international competitiveness owing to the rise
in the value of the dollar now are considerably improved.
Quite a few firms in those industries are operating
essentially flat out and experiencing notable profit
improvement.
However, last year's economic performance had some
disappointing features.
The federal budget deficit remained
high and our national saving low.
This contributed to a
continued large current account and trade deficit.
By
keeping pressure on interest rates, the low rate of saving
also was a factor behind the performance of business fixed
investment last year.
Investment slowed from 1987,
especially in the second half of the year, even in the face
of relatively rapid expansion of production and high levels
of capacity utilization.
In addition, overall inflation, in the area of 4 to
4-1/2 percent, during 1988 was a little above the general
range in which it had fluctuated in the mid 1980a.
The
drought boosted food prices, adding somewhat to inflation
last year, but this was largely offset by a leveling off of
energy prices.
Prices of other consumer goods and services
accelerated a bit.
This acceleration is troubling,
especially with inflation already at a level that would be
unsatisfactory if it persisted.
44
Although the step-up in consumer inflation to date
hag been rather small, some signs have emerged of greater
acceleration in broad measures of costs of production. Wage
gains accelerated toward the end of last year. Moreover,
benefits took an unusually large jump in 1988, boosted in
part by a sharp rise in health insurance coats and a hike in
social security taxes—both of which add to business costs
as directly as do wages.
Overall, the employment cost
index, a comprehensive measure of hourly wage and benefit
rates, rose 5 percent in 1988, up significantly from
1987.
Materials inputs also were adding to costs; the
producer price index for intermediate materials and supplies
excluding food and energy rose about 7 percent over the past
year.
Economic^Prospects and jtonetary^ Policy for^ 1969
On the whole, the economic expansion remains
vigorous and unusually well balanced after more than six
years.
There are few of the tell-tale distortions, such as
widespread inventory overhangs or constricted profit
margins, that typically have signaled the last phases of
expansions.
But with the economy running close to its
potential, the risks seem to be on the side of a
further strengthening of price pressures.
In these
circumstances, the Federal Reserve remains more inclined to
act in the direction of restraint than toward stimulus.
45
The determination to resist any pickup in inflation
in 1989 and especially to move over time toward price
stability shaped the Committee's decisions with respect to
monetary and credit ranges for 1989.
The Committee agreed
that, particularly in this environment, progress toward
these objectives likely will require continuing restraint on
growth in money and credit.
To this end, the Committee lowered the range for M2
by a full percentage point to 3 to 7 percent and reduced the
range for M3 by 1/2 percentage point to 3-1/2 to 7-1/2
percent.
The Committee also lowered the monitoring range
for domestic nonfinancial sector debt by 1/2 percentage
point to 6-1/2 to 10-1/2 percentage point.
These were the
ranges adopted on a tentative basis last June.
We decided to retain the wider, 4-percentage-point
ranges that were adopted in 1988.
The relationship of the
monetary aggregates to economic performance has been quite
variable in the 1980s.
The relatively high interest
elasticity of the aggregates, even after deregulation, makes
them very sensitive to changes in money market conditions,
which in turn can respond to developments in the real
economy or prices.
The resulting potential for sizable
movements in velocity requires broader ranges in order to
have reasonable assurance that the targets are consistent
with satisfactory economic performance.
Considerable
uncertainties regarding the effects on the monetary
46
aggregates of the resolution of the thrift institution
difficulties also argue for relatively wide ranges this
year.
Depending on the pace of asset growth of thrifts and
changes in their deposit pricing policies, the composition
and growth of their liabilities could vary substantially
from past patterns.
For the same reasons, the Committee agreed to
continue its current approach to the implementation of
policy, which involves monitoring a variety of economic and
financial indicators, including growth of money and debt.
In this regard, appropriate growth of M2 and M3 relative to
their ranges will be determined in part by developments
during the year.
At present, it appears that the velocities
of M2 and MS are likely to rise this year, in response to
the market interest rate increasea to date and unusually
sluggish adjustment of deposit rates.
The Federal Reserve expects its policy in 1989 to
support continued economic expansion while putting in place
conditions for a gradual easing in the rate of inflation
over time.
However, the wage and price process may have
developed some momentum.
The central tendency of forecasts
made by members of the Federal Reserve Board and presidents
of Federal Reserve Banks is for inflation to rise slightly
in 1989.
But let me stress that the current rate of
inflation, let alone an increase, is not acceptable, and our
policies are designed to reduce inflation in coming years.
47
This restraint will involve containing pressures on
our productive resources and, thus, some glowing in the
underlying rate of growth of real GNP is likely in 1989.
The central tendency of GNP forecasts for this year of Board
members and Reserve BanJc presidents is 2-1/2 to 3 percent;
abstracting from the expected rebound from last year's
drought losses, real GNP is projected to grow at closer to a
2 percent rate.
Net exports are expected to continue to
improve in 1989 as we make further progress on reducing our
external imbalances, but this implies the need for restraint
on domestic demand to contain pressures on our productive
resources.
With demands for labor growing more in line with
expansion of the labor force, the unemployment rate is
expected to remain near its recent level over 1989.
Monetary Policy and _Long^r_un_Ecgnomic Growth
Maximum sustainable economic groirth over time is
the Federal Reserve's ultimate objective.
The primary role
of monetary policy in the pursuit of this goal is to foster
price stability.
For all practical purposes, price
stability means that expected changes in the average price
level are small enough and gradual enough that they do not
materially enter business and household financial decisions.
Price stability contributes to economic efficiency in part
by reducing the uncertainties that tend to inhibit
investment.
Also, it directs resources to productive
48
economic activity that otherwise would tend to be diverted
to mitigating the financial effects of inflation.
Price stability—indeed, even preventing inflation
from accelerating—requires that aggregate demand be in line
with potential aggregate supply.
In the long run, that
balance depends crucially on monetary policy.
Inflation
cannot persist without a supporting expansion in money and
credit; conversely, price stability requires moderate growth
in money—at rates below those prevailing in recent years.
In the short run, demands can fall short of, or run
ahead of, available resources, with implications for wage
and price pressures and the appropriate stance of monetary
policy.
By altering reserve conditions and the money
supply, and thus interest and exchange rates and wealth
positions, monetary policy can assist in bringing about a
better match between demand and potential supply and thereby
contribute to aggregate price stability.
When the economy is operating below capacity,
bringing demand in line witfc supply can involve real GNP
growth that is faster for a time than its long-run
potential.
For example, in the mid-1980s, the U.S. economy
was recovering from a deep recession; with utilization of
labor and capital not nearly complete, we were able to bring
these resources back into the production process at a pace
that substantially exceeded their underlying growth rates.
In those circumstances, it is not surprising that growth of
-10real GNP was relatively rapid while inflation performance
was reasonably good.
But when the economy is operating essentially at
capacity, monetary policy cannot force demand to expand
more rapidly than potential supply without adverse
consequences.
Such an attempt will result in accelerating
prices and wages, as producers bid for scarcer, and at the
margin less productive, labor and capital. Over time it
would result in little if any additional output.
As a result of robust expansion in the last few
years, the U.S. economy has absorbed much of its unused
labor and capital resources. No one can say precisely which
level of resource utilization marfca the dividing line
between accelerating and decelerating prices.
However, the
evidence—in the form of direct measures of prices and
wages--is clear that we are now in the vicinity of that
line.
Thus, policies that foster more economic growth, if
such growth is to be sustainable over the long run, should
focus on aggregate supply. Aggregate supply depends on
the size of the labor force and its productivity.
Growth of
the labor force basically is a function of increases in
population and of individuals' decisions with regard to
participation in the labor force.
Labor productivity
depends partly on the quantity and quality of capital and
the overall efficiency in combining labor and capital in the
50
-iiproduction process.
Given projections of likely labor force
expansion and capital accumulation, most estimates of growth
in long-run potential real GNP fall in a range below the
average growth rates of real nonfarm GNP experienced over
the last couple of years.
Faster growth in real GNP would be possible for a
time if we could use more of our labor and plant capacity
without putting pressure on wages and prices.
policy is not a useful tool to accomplish this.
Monetary
But
microeconomic policies may well be, such as policies
designed to improve the match between labor demands and
supplies.
Conversely, we must be careful to avoid
approaches to our national needs that would add unduly to
business costs or increase rigidities in labor and product
markets. Perhaps moat important over the long run, as the
composition of production in the U.S. economy continues to
evolve, we must intensify our efforts to educate our labor
force to be productive in the increasingly high-technology
world marketplace.
In addition, the United States could improve its
longer-run growth prospects by stepping up the pace of
capital accumulation.
Government policies can contribute to
a higher rate of investment.
Tax policies can help by
ensuring that returns from capital are not taxed excessively
or unpredictably. And fiscal policy can help boost the
national saving rate.
51
-12Ideally, increased national saving would involve
some improvement in the private saving rate.
Household
saving is abysmally low in the United States, and business
saving hasn't risen enough to offset that.
However, it is
not clear that past government policies have been very
effective in boosting private saving.
Probably the most
direct and sure way of increasing saving is by a reduction
in government dissaving.
Congress should follow the Gramm-
Rudman-Hollings timetable and then seek a budgetary surplus
by the mid-1990s.
An improving federal budget position should have a
variety of favorable effects.
It can pave the way for a
reduction in our external imbalance by freeing resources
currently absorbed by domestic demand.
By putting downward
pressure on real interest rates, it can encourage domestic
business capital formation and make housing more affordable.
It can encourage households and businesses to focus more on
the long run in economic planning.
Monetary policy also has a role to play in
encouraging capital formation and economic growth over time,
by providing a stable price environment.
Although the
relationship between growth of money and the economy can
vary from year to year, over the long haul there is a close
relationship between money and prices.
Recently, the
Board's staff has done some interesting research on this
subject.
This worJc indicates that future changes in the
52
-13-
rate of inflation have been fairly reliably linked to the
difference between the prevailing price level and its
equilibrium level.
That equilibrium level is calculated at
the current level of M2, assuming that real GNP is at its
potential and velocity is at its long-run average.
As you
can see from the chart, inflation apparently tends to
accelerate with a lag when actual prices are below the
equilibrium value associated with current M2, and to
decelerate when above it. This research suggests that
despite relatively moderate expansion of M2 in recent years,
the equilibrium value still is a little above the current
price level, reinforcing the notion that the present risks
are on the side of a pickup of inflation.
This work also
confirms that price stability ultimately will require
somewhat slower M2 growth than we have experienced in recent
years.
Finaneia 1 Developments and Mongta_rv_Pgl_icy
The Federal Reserve recognizes that monetary
policy over the coming year will be carried out against the
backdrop of a financial system facing certain difficulties.
The thrift and FSLIC situation is perhaps most pressing.
The administration has proposed an extensive, workable plan
for closing insolvent institutions, improving the regulation
and supervision of S&Ls, and strengthening the deposit
insurance funds.
On Thursday, I will be presenting more
detailed testimony on this topic before this committee. For
53
-14now, let me simply encourage you and your colleagues to
take the necessary legislative steps to resolve this
situation promptly.
There appears to have been little, if
any, effect of the S4L problem on mortgage availability and
housing--thanks in part to financial innovation in the form
of the mortgage-backed securities market.
However, without
quick and effective action the situation could deteriorate.
Developments in the corporate sector warrant close
scrutiny as well.
The stock market has been recovering over
the past 15 months, with few signs as yet of speculative
excesses.
However, as you know, corporate equity continues
to be retired at a startling rate in conjunction with LBOs
and other mergers and restructurings and has involved
issuance of a correspondingly large amount of debt.
As I
have noted in recent congressional testimony, this
phenomenon is complex, having both positive and negative
dimensions.
These restructurings often have added economic
value through improved efficiency—an important
consideration given the increasingly competitive nature of
world markets.
But the higher leverage leaves these firms,
and potentially their creditors, more vulnerable to
financial difficulties in event of a downturn.
The Federal
Reserve and other federal regulators are instructing bank
examiners to review especially carefully loans to highly
leveraged firms in order to maintain a safe and sound
banking system.
54
-15The international economy also will command the
continuing attention of policymakers around the world.
Among the industrial countries, greater concern about rising
inflation followed the substantial economic growth recorded
last year.
Meanwhile, the process of adjustment of
international imbalances appeared to have slowed somewhat in
the second half of last year, and many developing
countries
continued to face serious problems of achieving sustained
economic growth, fostering development, and servicing large
external debts.
Some have argued that these financial stresses,
taken together, could hamstring the Federal Reserve's antiinflationary policy.
Certainly we have to take account of
the effects of our actions on all sectors of the domestic
and international economy and on financial markets; at the
same time we recognize that monetary policy is not the
instrument to deal with structural financial stresses and
imbalances here and abroad—and that attempts to do so may
even worsen these problems.
Backing away from policy
adjustments needed to contain inflation will not solve the
thrift problem, make the debt burden of heavily leveraged
firms lighter, speed the process of international
adjustment, or contribute to a fundamental solution of the
economic problems of the developing countries.
In fact, the
thrift industry's problems, as well as the external debt
problems of the developing countries, were exacerbated by
55
-16the inflation of the 1970s.
Attempting to lower interest
rates in the short run through more rapid money growth
against countervailing market pressures would quickly raise
inflationary expectations, leading soon to higher, not
lower, interest rates.
Instead, the structural financial
problems require the prompt application of microeconomically
oriented solutions within the supervisory, regulatory, and
legal framework.
Imbalances in the world economy require
the continued, patient application of responsible
macroeconomic policies in the United States and in other
industrial countries, as well as further progress in
economic reforms by the developing countries.
Conclusion
For its part, the Federal Reserve will continue
to seek monetary conditions that will reduce inflation.
Our
major trading partners are following consistent policies in
their own economies.
Together, these policies should bring
about a more stable financial environment and promote longrun worldwide economic growth.
Relatively stable long-term
nominal interest rates and flattening yield curves around
the industrial world are strong evidence that savers and
investors are in accord with this view.
Monetary policy, at
least for the moment, appears on track in the United States.
The task is to keep it on track while making
necessary
adjustments to fiscal policy and reforms to the regulation
56
-17of financial institutions.
In this way we can ensure
vigorous and balanced economic conditions over the long run,
57
Inflation Indicator Based on M2
Ratio seal*
ISO
100
Current price level (P) /,••'
Long-run equilibrium price level ..
given current M2 (P *)
'''
50
I M I M I I I I I I t I I ) I ! I I M IJJ III I I 1
Percent
1956
1B64
1972
1860
1088
The current price level (P, the solid line In the top panel) la the Implicit QNP deflator, which IB set to 100 In 1982.
The long-run equilibrium price level given currant M2 (P*, the dashed
line In the top panel), Is calculated as P* - (M2 x V'VQ*. where V Is an
estimate of the long-run value of the QNP velocity of M2—the mean of
V2 from 1966:Q1 to 1966:04—and Q* la • Federal Reserve Board staff
measure of potential real GNP.
The verticil lines mark the quarters when the difference between the
currant price level (P) and the long-run equilibrium price level (P*}
switches sign, and thus when Inflation, with a lag, tends to begin
accelerating or decelerating.
Inflation (bottom panel) Is the percentage change In the Implicit QNP
deflator from four quarters earlier.
For more detail*, see Jeffrey Mailman, Richard D. Porter, and David
H. Small, U2 Per Unit of Potent/a/ QNP 99 a Price-Level Anchor, staff
Studies (Board of Governors of the Federal Reserve System,
forthcoming).
58
The CHAIRMAN. Thank you very much, Chairman Greenspan.
We have had Senators Mack and Wirth join us. I gather neither
wish to make an opening statement at this time.
Let me now begin the question period.
In your official forecast of 1989 real GNP growth on page 3 of your
document, you indicate that the central tendency of projections by
you and the other Federal Reserve Governors and bank presidents
is a growth rate somewhere between 2.5 and 3 percent. I note that
among other forecasters, CBO is projecting 2.9 percent, and the blue
chip private forecasters' consensus is 2.7 percent. So those two would
fall within the range of what you describe as the central tendency.
I am concerned, however, about the fact that the administration
for the purpose of building its economic forecasts and budget plan
is assuming 1989 growth of 3.3 percent. That is well above and outside the central tendency range that you have indicated that you
believe is the most likely.
Can you give us any understanding as to what accounts for the
difference here?
I assume you have talked with the administration. They obviously see it one way and you and others see it a different way.
Can you shed any light on that difference?
Mr. GREENSPAN. Yes. First, Mr. Chairman, let me indicate that
the differences between forecasts are not large in the context of the
type of errors that we make as forecasters. There are differences.
Their productivity numbers are stronger than ours. Their GNP is
somewhat stronger.
I would say that ours is somewhat more probable than theirs, although we could have chosen a forecast closer to theirs. I think I
would be doing the process of economic forecasting a disservice if I
indicated that I know for sure that it is not a reasonable forecast to
assume a growth rate higher than 3 percent. If somebody said we
will grow 4 or 5 percent this year, I would say that is most unlikely.
But, frankly, Mr. Chairman, I don't think that the techniques
that we have to forecast are sufficiently refined to argue strongly
that the administration's forecast is outside the range of reasonableness.
The CHAIRMAN. You make a strong case for reducing the Federal
deficit, and I agree with you 100 percent on that issue. But if it
turns out that growth falls short of the administration's forecast,
then the deficit goes higher.
Obviously, that starts to work its way back through creating
pressures on interest rates and other things, and so getting the best
estimate that we can make is critical to building a budget for this
year.
Mr. GREENSPAN. I understand that, Mr. Chairman, but there is a
very difficult problem that we have in this process because what an
administration does when it brings forward a budget is to assume
that the Congress will enact expeditiously that budget line by line
exactly as it has proposed.
If that process actually occurred, I think there is significant justification on the part of the administration to assume they would
have a somewhat stronger economy because, under those conditions, inflation expectations would fall rather significantly, as
59
would long-term interest rates, and it is quite likely that capital investment would accelerate above the path which it currently is on
and certainly above the path which we project.
It is a very difficult problem which you have. It is a chicken and
egg problem, and it is a process which, when I was on the other
side as Chairman of the Council of Economic Advisers, I had difficulties with.
The CHAIRMAN. Let me leave that one for the moment with just
this comment.
Obviously, it matters on how realistic the budget proposal is to
start with. If it is unrealistic in a major dimension and is so seen
by most experts and observers, then the growth rate that would
flow from that also becomes not very realistic.
You don't do an interest rate forecast, and I understand why, but
I think it is very important to get your judgment on the interest
rate forecast that is also among the key economic assumptions that
underlie the budget we are about to construct.
I read you before the 90-day Treasury bill projections running as
follows—for 1989, first quarter, 8.3 percent; second quarter, 7.8 percent; third quarter, 7.2 percent; fourth quarter, 6.6 percent; and the
first quarter of 1990 being at 6 percent and then the average for
the full year 1990 being 5.5 percent. Those are awfully low rates, I
think, relative to what we are seeing today, and it would be a very
startling change over a short period of time from where we find
ourselves literally this minute—are those realistic?
Mr. GREENSPAN. Mr. Chairman, as I said before, implicit in the
administration's forecast, as I understand it, is the expectation of a
fairly expeditious passage of the budget. I think they are correct to
assume a significant decline in interest rates if that occurs. In
other words, it is consistent with the approach which they are
taking. I cannot comment on any of the individual numbers, but I
have a considerable amount of sympathy for their overall notion
that interest rates will fall significantly in that environment.
The CHAIRMAN. Let me just ask you this. Then my time will be
up for this question period.
The 90-day bill rate at the moment is at what percentage figure?
Mr. GREENSPAN. It is 8.5 percent on a discounted basis.
The CHAIRMAN. Roughly 8.5 percent on a discounted basis, and
we are now finishing the first quarter.
The estimate is by the fourth quarter we are going to be down to
6.6 percent. We are going to have a full 2 percentage point drop.
Is that realistic?
Mr. GREENSPAN. Mr. Chairman, I don't feel I can comment very
specifically on individual interest rates. I would just like to reiterate what I said previously—namely, the key to the interest rate
outlook in the administration's forecast is rightfully targeted on
the deficit. I don't think that they or we know exactly whether it is
too much or too little, and I would just as soon not get involved in
trying to fine-tune the forecast.
The CHAIRMAN. Can you just tell me the last time that the 90day T-bill was at 6 percent, going back in time?
[Pause.]
Mr. GREENSPAN. Preliminarily—we will check it—it has to go
back to the late 1970'a.
60
The CHAIRMAN, So it has been a full decade since we have had a
90-day bill rate as low as 6 percent, which we are now projected to
meet within 1 year under the administration plan.
I think that is a startling projection and one that we ought to
take a closer look at.
With that, let me yield to Senator Kassebaum.
Mr. GREENSPAN. I am sorry, Mr. Chairman. May I just have a
moment?
It looks as though it temporarily got down to that level in the
fall of 1986.
The CHAIRMAN. I take it for a very short period of time?
Mr. GREENSPAN. Actually, it carried through a good part of 1987.
Unfortunately, I am reading from a chart.
The CHAIRMAN. At 6 percent?
Mr. GREENSPAN, Yes.
The CHAIRMAN. But you don't infer that that necessarily means
that in the period of a year's time we are going to be back to 6
percent?
Mr. GREENSPAN. I had just as soon not respond to that.
The CHAIRMAN. I can understand why. [Laughter.]
Senator Kassebaum,
Senator KASSEBAUM. Chairman Greenspan, do you sometimes
feel like the Oracle at Delphi? The markets of the world are hanging on every comment you make here or testimony?
I would like to ask you—you stressed a number of times in your
statement the effect of wage and price increases. I would like to
ask if you think any increase in the minimum wage would have an
effect on the inflationary situation.
Mr. GREENSPAN. I don't think there is any question that increasing the minimum wage does have an effect on the overall wage
structure, and to that extent it is something which, other things
equal, would contribute to inflationary forces.
The decision the Congress has to make is whether or not the advantages received from that override what is clearly an element
which does exacerbate the underlying cost structure of American
business.
Senator KASSEBAUM. You mentioned three or four times at least
in here that this is one of the main pressures building on inflation,
and at some point I would guess then you would take that into consideration on what you would do with interest rates.
Mr. GREENSPAN. I wouldn't say that we, as an organization,
would specifically focus on the minimum wage and take action as a
consequence of that,
The issue is essentially why the underlying materials price increases were not reflected in comparable increases in final goods
prices in the Consumers Price Index or even into the Producers
Price Index, until recently. The reason is largely that unit labor
costs, that is, the cost of labor per unit of output, were remarkably
well-behaved.
These costs have taken somewhat of a turn in a worrisome direction now, and that is the reason we are particularly sensitive to the
pattern of wage movements as they are a crucial element in the
underlying cost structure of American business.
61
Senator KASSEBAUM, Do you see it having any effect on GNP
growth if the minimum wage were to be increased?
Mr. GREENSPAN. I frankly would say that within the ranges
which I have heard the minimum wage discussed the effect is
modest. I mean, all economists will argue, I think quite correctly,
that the effect of an increase in the minimum wage is to increase
unemployment somewhat. That does mean that it probably slows
GNP some, but I don't think the effect is large.
Senator KASSEBAUM. You spoke, too, several times to the task of
the Federal Reserve is just simply stability, and right at the end
you were talking about keeping on track and reforms to the regulation of financial institutions.
I would like to have you comment a bit further on that. Do you
have some specific reforms, given your comment earlier about
highly leveraged firms and the impact of that on the stability of
the economy at this point, going beyond just the FSLIC problem?
Mr. GREENSPAN. I was referring to the implications of depository
institution changes. I was addressing not only the FSLIC problem,
but also review of Glass-Steagall issues, as I am sure this committee and the House Banking Committee will understand. Clearly the
difficulties that we have with respect to debt resulting from the
issue of LBO's, in my judgment, does require a longer run view of
the balance of incentives to take on debt relative to equity.
It is not the LBO issue per se which pushed me in this direction.
I think this is something which has been clearly on the agenda for
quite a long period of time, and I believe at some point it would be
appropriate for the Congress to address that question.
Senator KASSEBAUM. Do you think the value of the dollar should
go any lower?
Mr. GREENSPAN. I think the group of seven, the seven major industrial countries, have done an extraordinarily good job, in my
judgment, in keeping the dollar and most major exchange rates relatively stable for well over a year, and I think if we can continue
that process we can contribute to economic growth not only in the
United States but in the world as a whole.
Senator KASSEBAUM. And you have confidence that if we do that
the pressures won't be such that we will see a further decline?
Mr. GREENSPAN. I think that we certainly are seeking continued
stability in the dollar, and I expect that to continue.
Senator KASSEBAUM. Thank you.
The CHAIRMAN. Senator Wirth.
Senator WIRTH. Thank you, Mr. Chairman.
Mr. Greenspan, thank you very much for being here again. We
appreciate your good judgment and stability at the helm of this extraordinarily important institution.
Let me ask you just a little bit so I can understand in layman's
language what looks to me is going on.
You are concerned about a slowly increasing set of inflationary
pressures. As a consequence, what you are doing is slowly calibrating the interest rates to try to dampen that down, is that right?
Mr, GREENSPAN. That is correct as a historical statement.
Senator WIRTH. Historical as opposed to contemporary? How does
that relate to your current acts?
62
Mr. GREENSPAN. Well, I would say, as I indicated in my testimony, it is up to the current period. I just didn't want to imply a forecast.
Senator WIRTH. I have got it. Let me go on.
If in fact we are slowly but surely edging up in interest rates for
the purposes of damping down inflation, the question then has to
be asked, what the impact of increased interest rates could be on
the other problems that we are trying to deal with.
This committee, as you know, is consumed with the S&L crisis
and how we deal with that. It is consumed with the LBO issue and
all of the controversy surrounding that, and also the Third World
debt problem.
Now, is it fair to say that increased interest rates are going to
make it more difficult for us to resolve the S&L problem?
I am not criticizing it in any way, let me say. I am just trying to
understand what the ledger sheet looks like, what the balance
sheet looks like.
Mr. GREENSPAN. The ledger sheet says that the higher the interest rates at any particular time, the more costly the resolutions of
these various problems are.
One of the reasons why we embarked upon this type of policy is
that we are seeking to suppress inflation so that it does not create
a major acceleration in interest rates. It is the judgment of the
committee—and I think it is a very good judgment—that our only
alternative, when confronted with the type of economy we saw in
1988, was to try to suppress inflationary pressures and keep the interest rate increases relatively moderate. The alternative, to abandon that particular policy goal, would result in inflationary expectations rapidly embodied in long-term interest rates, driving mortgage interest rates and other interest rates up very substantially.
I would suspect—and obviously it is a difficult type of retrospective analysis to make—that had we not embarked on a tightening
process throughout 1988 that interest rates today would be higher,
certainly higher in the long end of the market, probably even
higher in the short end, and that costs of the resolution of the various problems that we face would be substantially higher.
Senator WIRTH. The assumption is that you all can calibrate interest rates carefully enough so that you can slowly edge them up
without throwing real crisis into the S&L's beyond where we are
today or cause some of the fragility of various leveraged buyouts to
get real problems because of increased interest rates. That is really
the assumption, and that is the balancing act that you all are in,
correct?
Mr. GREENSPAN. Yes. It is what we are endeavoring to do. It is
not easy.
Senator WIRTH. That is the point that I am making, however. Let
me ask the question.
Is there historic evidence to suggest that you can calibrate that
carefully?
Mr. GREENSPAN. We certainly have in the Federal Reserve an extraordinary information and analytical capability. We have never
confronted a situation that is exactly comparable to what we are in
at this particular stage.
63
Senator WIRTH. Expand on that a little bit, will you, that we
have never been in a situation like this?
Mr. GREENSPAN. We are in the sixth year of a major economic
expansion with a crisis in the thrift industry which we have never
seen. It is the largest financial problem that we have seen in the
post-World War II period. We have a rather significant rise in the
ratio of debt to equity, which is not only LBO's, and it has been
going on for quite a long period of time.
It is an economic environment which, coupled with the very
large trade and central government deficits, creates a set of circumstances that precludes us from looking at some historical
period and saying this situation looks exactly like 1920, and then
evaluate how it came out.
What we have to do is try to bring together what conceptual insights we have about these relationships, the extraordinary detail
that we are able to draw on the economy from our 12 Federal Reserve Banks and other sources, and what I must say is a very quite
remarkable, capable Federal Reserve staff, in order to try to devise
those sets of policies which maximize our capability for bringing
most of these problems to a successful landing.
Senator WIRTH. My time has expired.
I have great respect for the staff and what they are trying to do.
What we have really identified here is really a high wire act that
you are on at this point
Mr. GREENSPAN. It is.
Senator WIRTH [continuing]. And that our economy essentially is
on. We have never been in a situation that is potentially as unfriendly as this economic situation?
Mr. GREENSPAN, All I will say, Senator, is that we are acutely
aware of all of the various elements that are impinging on what
policies we take, and hopefully we will choose the right policies.
Senator WIRTH. We all hope so, too. Thank you very much, Mr.
Greenspan.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Thank you, Mr. Chairman.
Chairman Greenspan, if you were a member of the United States
Senate and you were deeply concerned about rising interest rates
but you weren't on any open market committee and you weren't
setting monetary policy, what would you do?
Mr. GREENSPAN. That is an easy one, Senator.
Senator GRAMM. I knew it was an easy one. That is why I asked
it.
Mr. GREENSPAN. As I have said many times before, and as I said
at the beginning of this testimony, in fact, I think that a significant cut in the Federal budget deficit is essential to resolve the
type of problems which Senator Wirth and I have just been discussing.
It is clear to me that many of the problems that we are confronted with can be assisted in an extraordinarily positive way by a
very expeditious and significant cut in the deficit. I am not one of
those who believes that the process of cutting the deficit can be
overdone. I don't believe that there is too large a cut that can be
done, and I trust that the Congress will move with the administration in that direction.
64
Senator GBAMM. Let me ask you a question, and I am not trying
to inject you into the very difficult policy decision that Congress
has to make. That is a policy decision as to whether we want to
control the growth of spending and limit the growth rate of spending to less than 3 percent above the level we spent last year, to
achieve the deficit reduction targets by controlling spending, or
whether we want to raise taxes so that government spending can
grow by 7, 8, or 9 percent.
Let me just ask you from the point of view of looking at the economy, leaving aside any political factors. Just simply looking at
what would be best in terms of maximizing our chances of sustaining the economic recovery, what would minimize the impact of
rising—or minimize the chances that interest rates would go up
enough to choke off the recovery?
Given the two choices between controlling spending and raising
taxes, simply from the point of view of trying to sustain a recovery
that has created 19 million new jobs, which of those two approaches to deficit reduction is preferable?
Mr. GREENSPAN. Senator, I believe I have said to this committee
before, and I will certainly repeat it, that if the purpose is to get
the deficit down you will have far greater success by focusing solely
on the expenditure side.
Second, I would share your view that freeing private resources is
more apt to create significant economic growth than endeavoring
to close the deficit gap through increasing taxes.
Senator GRAMM. So let me go back and again pose the question
and see if I can get you just to focus on it. You said it, but I want
to hear it in terms of the question.
From the point of view of sustaining recovery and creating jobs,
forgetting all the politics of the decision, would we be better off to
control spending or raise taxes?
Mr. GREENSPAN. Control spending.
Senator GRAMM. Let me ask you a second question.
As I look at the credit market, one of the reasons it seems to me
that deficit reduction is so critical this year is that we are getting
ready to go out and borrow $50 billion as part of the savings-andloan recapitalization program. So, if we meet the Gramm-RudmanHollings targets and reduce projected borrowing by $55 billion, in
essence what we are doing is we are simply offsetting what is already occurring in dealing with the savings-and-loan problem.
Do you see it that way?
Mr. GREENSPAN. Not exactly, Senator, because I think that the
markets already understand the size of savings-and-loan borrowing
requirements.
Senator GRAMM. You're saying that is already reflected in current rates?
Mr. GREENSPAN. As best we can judge. It's already in the market.
Senator GRAMM. So that if we came in with a $55 billion deficit
reduction package to the extent that that is not already in the
market, that would have an impact?
Mr. GREENSPAN. Yes.
Senator GRAMM. As you look at the various projections that are
made by CBO and OMB, how realistic is it to think that we might
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actually stabilize interest rates and bring rates down by the end of
the year if we pass a dramatic deficit reduction action?
Mr. GREENSPAN. I think it's very realistic.
Senator GRAMM. So, you are in essence saying when we vote on
the budget, to the extent that we're voting for lower deficits we are
voting for lower interest rates?
Mr. GREENSPAN. To the extent that the markets believe that
what the Congress is doing is credible. That is an essential element
in this whole equation. Then inflation expectations will fall because I think that the market has only very marginally discounted
a significant decline in the budget deficit at this stage.
Senator GRAMM. Finally, do you think that we should do it
quickly to get the full impact?
Mr. GREENSPAN. Yes, Senator, I do.
Senator GRAMM. Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Greenspan, I want just to ask you one question as a follow-up to something Senator Gramm said before yielding to Senator Heinz. That is this:
He took you over two of the jumps. I don't know if he took you
over the last jump, and I would like to take you over the last jump.
And that is, if it turns out that we are not able, the administration and the Congress together, to come up with enough deficit
spending cuts to really get the deficit down to the targets because
of a number of factors—the savings-and-loan problem, the drug war
problem, the President's new initiatives on education and so
forth—and if the only way to get to the Gramm-Rudman targets is
with some revenue increase, would you favor that? Or do you think
that has to be avoided at all costs even if it means missing the
Gramm-Rudman targets?
Mr. GREENSPAN. Well, Mr. Chairman, I have said previously that
if the negotiations fail, that I would favor going, as the law requires, to a sequester.
The presumption that the Congress will fail in its negotiations on
this issue, I am not at this stage ready to make.
The CHAIRMAN. So, your answer is: Go the sequester route, but
talk of increased revenue of any sort is really so counterproductive,
as you would see it, that you don't want to even entertain the
thought of it?
Mr. GREENSPAN. I would say at this particular stage without
making judgments about the structure of the negotiations and
where we are moving, that short of an agreement between the administration and the Congress I would find a sequester the next desirable step to take if we fail to get the most desirable outcome,
which would be an agreement.
The CHAIRMAN. Let me pass the ball to Senator Heinz.
Senator HEINZ. Thank you very much, Mr. Chairman.
Chairman Greenspan, you are one of the best witnesses that ever
comes before this committee. It's hard to disagree with your contention that if we don't have effective anti-inflation policies, that
this will cause interest rates to rise.
Obviously, we want to avoid an increase in interest rates beyond
where they are, and indeed we would all like, I think, to find a
way, a set of policies, that will allow interest rates to decline.
66
I say that particularly because as measured by the Federal funds
rate, I think we are probably at a historic high for the cost of those
funds, which was as of last Friday 9.31 percent.
That is probably as high a premium over inflation as there has
ever been. That is about a 5 percent, if you will, real interest rate.
Is that, to your knowledge, a historic high for the Federal funds
rate since World War II?
Mr. GREENSPAN. First of all, let me just say this. The real interest rate is, of course, much lower than the market quote on the
Federal funds rate, in the sense that that is the nominal interest
rate. What reducing the deficit would essentially do is to bring real
interest rates down.
That is essentially what is crucially and importantly required.
Senator HEINZ. I understand that. I just wanted to get a characterization of the current Federal funds rate as to whether it is, if
your definition of a real interest rate is the nominal interest rate
less inflation
Mr. GREENSPAN. Inflation expectations.
Senator HEINZ. Isn't that so-called real interest rate at an alltime high, when you're looking at the Federal funds rate?
Mr. GREENSPAN. It was higher in the earlier part of the 1980's,
depending on how one calculates it. The more important real interest rate in the context of economic activity is the long-term real
interest rate, and that also was higher, as best we can judge, in the
early part of the 1980's. It has come down some, but it is clearly
still well above its average over a long period.
Senator HEINZ. Why, if the only time we can remember having a
real interest rate as high as the early 1980's as we were going into
a major recession, is our best previous experience with that, how is
it that you feel confident that a similarly high real interest rate
will not precipitate another significant recession?
Mr. GREENSPAN. First of all, Senator, the real long-term interest
rate is still well below what it was in the early part of the decade.
Even though that rate, for mortgages and other long-term instruments, has come up somewhat during the past year, it really has
not come up a great deal, and as a consequence, both homebuilding
and capital investment remain rather strong.
In that context, what we are seeing is an economy which is still
rather robust.
Senator HEINZ. It seems to me that you can't argue this question
both ways. If in fact the Federal funds rate, as you are saying, or
other snorter-term interest rates are of relatively little consequence to the health of the economy, I don't understand how you
can be successful in pursuing your strategy of demand management.
On the other hand, if you say that the more meaningful rates
are the 30-year T-bonds, which have been in the range of about 9
percent for the last IVa years and probably longer it seems to me
that the market has been saying with great consistency that Fed's
fears about inflation are ill-founded. How do you explain that?
Mr. GREENSPAN. I am not quite sure what the sequence is.
Senator HEINZ. The sequence in the latter part of the question is:
if the market is a good predictor of inflation, if people are unwilling to lend their money for 30 years without adequate compensa-
67
tion for inflation and if the return to those people has been for the
last year and a half roughly around or even below 9 percent and
the only time it has moved up is as the Fed fund rate has moved
up, how do you account for your fears of inflation if the market is
saying those fears are overstated?
Mr. GREENSPAN. I think what the market is saying, if one interprets it in that respect, is that over the long term inflation expectations—meaning average expected inflation over a 10-, 20-, or 30year period—have come down some, but that says very little about
the short run, meaning 2 or 3 years.
You are raising a very interesting question: how do we in fact
contain excess economic growth if what we do is deal in the short
end of the market?
The answer is that long-term real rates have come up in the past
year as we have tightened. Short-term real rates clearly have come
U
PTo answer your earlier question, the real; that is, inflation adjusted, 3-month Treasury bill rate in the early 1980's got up to
about 7 percent. It fell all the way back down to about 2 percent,
and is now back up to 4 percent.
But it is clear that the 4 percent is high enough in real terms to
suppress inventory excess, which is a very crucial element in keeping the economy on a relatively stable path.
It is also true that we have not had a dramatic rise in long-term
real rates. We have had some, but not a sharp one. What that is
saying is that the rate is moving up to a level which is restraining.
In other words, we are getting a level of rates which has slowed
down the rate of growth in capital investment.
My impression is that if real rates were significantly lower, we
would have a much stronger current capital investment environment.
The basic thrust of Federal Reserve policy is to try to keep a
sense of stability in the markets and to try to take a posture with
respect to rates and with respect to the growth in money and credit
aggregates, which is perceived by the markets to be noninflationary over the long term.
Senator HEINZ. Mr. Chairman, I want to thank Chairman Greenspan for delving into what is one of the great ciracular questions of
his job, which is: how do you keep the economy growing, interest
rates low, and keep demand down so inflation is low. I don't envy
him his job.
I would only observe that the increase in long rates that has accompanied the tightening by the Fed over the last 3 or 4 months
obviously will make it harder for this country to engage in productive investment. That will make it harder for us to grow and
reduce the budget deficit through growth. It will make it harder
for us to build the capacity to displace imports. I think it is a very
difficult and troubling question.
I am not here to judge whether your policy is a little high or a
little low. But I do worry enormously about the consequences of
your having to pursue, perhaps for very good reason, a policy that
at the present time would be, by your own admission, working
against our ability to improve our productivity and international
competitiveness.
68
Mr. GREENSPAN. If I may just say very quickly, Senator, that is
the reason \vhy we have argued BO strenuously for quick action on
the budget question because the simplest way to bring real longterm interest rates down is by bringing the budget deficit down significantly.
Senator HEINZ. Are you trying to make us an offer we can't
refuse?
Mr. GREENSPAN. Sure enough.
The CHAIRMAN. Thank you. That was a very useful exchange,
and I think it bodes well for the record.
Senator Graham.
Senator GRAHAM. Mr. Chairman, I have an opening statement
that I would like to file for the record.
The CHAIRMAN. Without objection.
OPENING STATEMENT OF SENATOR BOB GRAHAM
Senator GRAHAM. Mr. Chairman, it is a pleasure to have Chairman Greenspan report to us today on the conduct of monetary
policy. As Chairman Greenspan has stated in the past, monetary
policy alone cannot provide the answers to our economic problems.
We need complementary fiscal and trade policies, and we need to
coordinate these policies with the approaches of the administration,
our trading partners and the Congress.
Chairman Greenspan, it has been said that the Federal Reserve
finds itself between a rock and a hard place when a discussion of
interest rates takes place. Some people, such as yourself, are concerned about inflation moving up; others are concerned about a
slow-down in the country's economic growth. Raising interest rates
keeps inflation under control. However, the administration is predicting lower interest rates to help reduce the budget deficit. As
The Economist quotes, "Mr. Greenspan, having to run America's
monetary policy between the rock of an intractable budget and the
hard place of market skepticism, often has an equally tricky job
persuading his Fed colleagues to unite."
Higher interest rates impact our savings and loan problem as
well as the Latin American debt crisis. The Fed in the past has
been successful in lowering interest rates as well as inflation. This
has helped reduce the crushing interest burden on the debtor countries. If interest rates rise, these debtor countries are put in a more
tenuous position. As to the savings and loans, higher interest rates
also adversely impact them, as they try to compete against institutions paying higher interest rates for funds.
Mr. Greenspan, it is a difficult time. We look forward to your
comments this morning.
Thank you, Mr. Chairman.
Senator GRAHAM. Mr. Chairman, when you appeared on July 13,
we talked a bit about the question of U.S. policy as it relates to
Third World debt. I believe I characterized your statement at that
time as basically advocating a continuation of the policy that was
then in place.
The new administration has indicated a willingness to reopen the
issue and has indicated that there might be some revision to that
policy.
69
From your perspective, what do you recommend now should be
any new directions in the United States leadership relative to
Third World debt and Latin American debt?
Mr. GREENSPAN. Senator, as a result of the President's request to
review that policy—that is, his own review under the leadership of
the Secretary of the Treasury—we at the Federal Reserve are obviously participating to the greatest extent that we can. I cannot at
this stage indicate how the review is going to come out.
I think it is clearly going to continue to emphasize the necessity
of the sound economic policies on the part of the debtor nations,
international economic cooperation, the appropriate means of financing, and presumably will have some focus on the issue of debt
reduction.
The specific details will be presumably announced within a reasonably short period of time.
Senator GRAHAM. One of the criticisms of the debtor nations has
been that the United States regulatory policy relative to its commercial banks has been less forthcoming than has been the case in
some of the major European creditor countries. Do you think that
is a fair characterization?
Mr. GREENSPAN. It's a very complex question because regulations
are difficult to fully understand with respect to their implications
in all regards. I suspect not because I don't think that we see any
material problems emerging from our regulatory structure.
As far as the resolution of the LDC debt problem is concerned,
it's not that there are not problems. We just do not believe that
there are regulatory changes which are going to make a large difference.
Senator GRAHAM. The review of policy that is under way which
may lead to revision, what do you think should be the standards by
which U.S. policy relative to Third World debt should be evaluated
over the next 5 years? What would be the conditions within this
country, within other creditor countries, and within the debtor
countries, in 1994 that would lead you to say we have been successful in the policy directions set and in our pursuit of those directions?
Mr. GREENSPAN. I would say first, Senator, that the economic
policies of the debtor nations brought them back to access to the
financial markets on a voluntary basis. It's clear that a number of
countries could, at this stage, float in the Euro bond markets, but
they would be at interest rates which would be so high that the
debtor countries would have difficulty servicing the debts.
So, the first criterion of success would be the ability of nations in
debt to be able to get into the markets for long-term or intermediate-term borrowing at rates which they could readily service.
Second, what I would see required as a corollary to that is a restoration of the normal borrowing-lending relationships between the
debtor nations and the international commercial banking system.
If you get one, you will clearly get the second. That will create a
situation in which the large block of loans on the books of the
international commercial banking system would be a good deal
more valuable than they are today.
Finally, what we would want to see would be that some of the
debtor nations which have done better than others, that have been,
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in a sense, contaminated by the whole process—such as Colombia,
for example—find that their productive efforts get fully appreciated in the marketplace.
Senator GRAHAM. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you very much.
Senator Mack?
Senator MACK. Thank you, Mr. Chairman.
It's good to see you again this morning. I am delighted to have
the opportunity to raise some points with you.
I wanted to follow up on the suggestion that if we were to substantially or significantly reduce the size of the deficit, there would
be the possibility of a fairly significant reduction in interest rates.
You indicated, I guess, that that would be helpful the earlier
that could be done, but if we didn't do it earlier, your kind of
second suggestion—or maybe that was said for you—is that a sequester would be helpful.
I guess I am wondering, if we went through this whole process
and didn't come to an agreement between the executive and the
legislative branch as to what kind of deficit reduction plans should
be put together and a sequester went into place, would that be sufficient to allow for the possibility of significant reductions in interest rates?
Mr. GREENSPAN. First of all, I think that we have to distinguish
between the processes which the markets will perceive as permanent change and those which they may not.
Clearly, an agreement between the administration and the Congress will carry forward not only into the fiscal 1990 budget, but
also, because of the follow-on effects of any agreement, into the
1991 and the 1992 budgets.
I am not clear to what extent a sequester will create that type of
effect. It will clearly be positive.
Senator MACK. Let me just kind of throw out a couple of
thoughts here. One thing it would do, it obviously creates a lower
baseline for the following year, which would be an advantage.
Mr. GREENSPAN. That's correct.
Senator MACK. No. 2, it would be a statement on the part of the
Congress that we were willing to allow the sequester to go into
effect rather than to relax the Gramm-Rudman targets, which I
would think, if those two things would occur, would be a fairly significant signal to the markets.
Mr. GREENSPAN. I don't think there is any question that if the
Gramm-Rudman targets were relaxed as a means of resolving the
impasse that the markets would view that rather negatively.
Senator MACK. Let me see if I can follow on with that,
A little bit earlier, you implied—or I think specifically said—that
from your viewpoint that the markets had already taken into consideration the cost of the FSLIC problem.
What do you think the markets have done with respect to what
they think we are going to do with respect to the deficit?
Mr. GREENSPAN. It's a difficult question to answer. My impression is that there is a dubiousness out there which is very difficult
to measure. That is the reason I say that should the deficit be reduced materially—and when I say reduced, I don't mean only for
71
fiscal 1990, I mean projected forward—a goodly part would be unanticipated and would affect real interest rates.
The problem I think we ought to focus on, however, is to distinguish between the Gramm-Rudman targets on the one hand and
the actual outcomes on the other, because the targets are for essentially the beginning of the fiscal year.
Obviously, if one says that the target of $100 billion is met, that
is not the same thing as saying that we have guaranteed that the
deficit after the fact in fiscal year 1990 will be $100 billion.
As I have said in other committee hearings, my impression is
that if the market knew for a fact that the actual as distinct from
the targeted deficit would end up somewhere between $110 billion
and $120 billion after the fact, as of the close of business on September 30, 1990, then I think the market would take it as a significant improvement. And I think that interest rates would fall from
current levels as a result.
Senator MACK. Let me take you to another area.
I, from your testimony, drew the implication that we need to be
addressing capital formation in this country. I would just like for
you to respond as to what impact, if any, you think would result
from a reduction in the capital gains rate, as has been proposed.
Mr. GREENSPAN. I have always been in favor of a lower capital
gains tax rate. It would enhance capital investment, especially in
the small business sector of our economy.
I would not, however, be supportive of the cut if it became part
of a deal to unwind what I think were very important benefits in
the Tax Reform Act of 1986—namely, the significant lowering of
the marginal tax rates for all taxpayers.
That to me was a very major event, and I would not like to see
us unwind what was then an important bipartisan compromise.
Senator MACK. Let me just, if I could, restate what I think I
heard you say. In other words, you would not accept, let's say, a
compromise which said, well, we will lower the capital gains rate
but we are going to offset that lowering by raising marginal rates
to compensate for what everyone agreed to was going to be the loss
of revenues as a result, which is a debatable point.
So, you would not make that trade?
Mr. GREENSPAN. That is correct, Senator. I would not.
Senator MACK. But you do believe that the capital gains rate
would assist in capital formation, lowering of the capital gains
rate?
Mr. GREENSPAN. Yes, I do.
Senator MACK. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Pressler?
Senator PRESSLER. Thank you very much.
Welcome to the hearing.
Following up on Senator Mack's question about capital gains, I
have been trying to figure this situation out. I believe the President's economists say that lowering the capital gains tax rate
would actually increase revenue to the government, while I think
the Congressional Budget Office is about to suggest or has suggested that it would decrease revenues to the government.
Let me say that I am not arguing the point here. But what is
your judgment of that question? Am I correct, are there different
72
respected economists who have reached different conclusions on
that?
Mr. GREENSPAN. Yes. Estimating the revenue effects of the
change in the capital gains tax rate is one of the most difficult procedures that economists have to deal with so far as economic policy
is concerned. The reason is that very small changes in the degree
of what we call the "lock-in" of capital gains—people not selling
assets—has very large effects on revenues.
So, it is perfectly conceivable that two equally competent tax revenue analysts can evaluate the President's proposal with rather
dramatically different results. There is no question that the Treasury Department's estimates are credible. The assumptions are not
outlandish.
The problem basically is that it is very difficult to make those
types of judgments. So, I think it's a difficult call.
Senator PRESSLER. As a general rule for this discussion in layman's terms, they say that if capital gains taxes are higher, rich
people put their monies into art, antiques, and things like that, but
if they are lower, they will put them into job-creating business activities.
Is that a true statement?
Mr. GREENSPAN. I think it's difficult to say. As I understand the
President's proposal, he is eliminating artifacts and the like in his
proposal and is essentially focusing on areas that will spur capital
investment.
The impact of changes in the capital gains tax rate has been
argued at extraordinarily great lengths for years. With respect to
just the type of question you raised, Senator, I just want to say the
battle has not been won by any side, of which I am aware, and is
likely to continue for quite a long period of time.
Senator PRESSLER. So, you don t have a clear position on the capital gains tax issue. You would like to see it lower, but you
wouldn't want to see us tackle that, opening up the tax question
again? In general, your recommendation is to leave it alone?
Mr. GREENSPAN. No, I would like to see it lowered, but not if it
causes an offsetting rise in the marginal tax rates for individuals.
Senator PRESSLER. Moving to another area—and again, you've
covered this somewhat—but I want to focus in. I had 16 town meetings in my State last week, and I was trying to explain this but
was unable to do so with certainty.
Aren't the savings-and-loan bonds that are proposed to be
issued—$50 billion of obligations or however we're going to handle
it—part of our national debt? And I agree with you, I consider the
deficit the number one domestic problem, and trust my voting
record reflects that.
But, from your point of view, isn't the adding of that debt in the
aggregate whether it's off budget or on budget or however it's handled, isn't that essentially adding to the national debt, which is
doing just exactly what you don't want to see us do?
Mr. GREENSPAN. There is a difference, Senator. And I think that
the crucial question is more the one of getting the deficit down
than being overly concerned about the level of outstanding public
debt either on budget or off budget because it is essentially the net
claim on savings that is directly related to the deficit and which is
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the crucial reason why the budget deficit is so corrosive a force in
the economy.
The difference between that and a one-shot solution to the savings-and-loan problem is that whatever it costs, it is nonrepetitive.
By that I mean that it does not affect either revenues or expenditures over the long run, or affect the budget deficit materially in
the year, say, 2000, whereas anything that is done with respect to
changing the structure and trend of receipts or expenditures in the
regular budget will affect the long-term budget.
Savings-and-loan financing, irrespective of how it's done, is a oneshot effect and does not materially affect the long-term outlook for
the budget deficit.
Senator PRESSLER. I couldn't agree with you more concerning the
budget deficit. And we all must work together on it. But at some
point someone, a respected national economist such as yourself who
has the pulpit, so to speak, is going to have to outline where those
cuts are going to be taken.
The President gave his State of the Union Address, and in terms
of an opportunity for leadership in this area, do you feel the President sufficiently addressed the budget cut issue in that speech?
Mr. GREENSPAN. Considering he was in office for so short a
period of time, I thought that the Office of Management and
Budget put together a rather substantial budget. Whether it is adequate for the purposes of the negotiations that you are currently
involved in is really not for me to say.
All I can tell you is, having seen how much work was put in, it
was rather impressive. The issue of whether it is adequate, I think,
will be determined very shortly.
Senator PRESSLER. Mr. Chairman, might I ask one more question
here?
The CHAIRMAN. Please do.
Senator PRESSLER. Are agriculture and small business more sensitive to interest rate changes? Are some sectors of the economy
more sensitive? I get the feeling, listening to my small businessmen
and women, that they are extremely sensitive to interest rate
changes. Would you consider that sector to be more or less sensitive to interest rate changes?
Mr. GREENSPAN. I think it's a mixed bag. It depends on the
nature of the leverage. It depends on the nature of the alternative
means of financing. I think interest rates affect both big and small
business and farmers.
I think they affect everybody, but the effect depends on the
degree of leverage in any individual firm or industry. I would not
want to argue that it's a significantly greater factor in small business or agriculture, with the exception that specific aspects of debt
in agriculture and some small businesses do make them more sensitive, but it is not basically because they are small businesses. The
cost of capital to small business for both equity and debt is higher
than for larger, basically seasoned businesses. But the cost of capital is a bigger issue for small business in general. I wouldn't say
interest rates per se necessarily are.
Senator PRESSLER. In my town meetings last week, in 16 South
Dakota towns, I would say that somehow keeping interest rates
down was almost a bigger issue than the farm bill or anything else.
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I know it's tied to the deficit and I know it's tied to a lot of things,
but an increase in interest rates is really on people's minds out
there.
The people I talked to were mostly farmers, small businessmen,
people who come to public meetings. So, I am very interested in
what you have to say and what you and your colleagues do.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Pressler.
I just want to make an observation on your second-to-last question and the Chairman's response in terms of where the cuts might
be made. And I think the new administration was very ambiguous
in that area, and I think Senator Pressler's question is exactly
right.
When you said they haven't been here very long, in a sense they
haven't. But George has been here for the last 8 years. So, in fairness, with respect to the problem of deficits and cuts, he is not a
stranger to this issue.
I am concerned because I think there is a side step going on here
generally, because of the difficulty of reconciling all of the particular problems.
One of the things that you have mentioned today and will talk
about 2 days from now when you come back is paying for the savings-and-loan problem. If we were direct about it, if it's been discounted by the markets, which I thought I earlier heard you say
then why shouldn't we finance it at the lowest possible cost to the
taxpayer? Why shouldn't we go out and raise the amount of money
we need with a direct kind of borrowing that gets the interest rate
costs down to the lowest level?
Mr. GREENSPAN. Mr. Chairman, may I address that on Thursday
because it requires a much broader answer than I think we would
want to discuss today?
The CHAIRMAN. We can take it over at that time. But I don't
think that we should put contradictory ideas on the table today
and not make some effort to reconcile them.
We shouldn't say on the one hand that we want to reduce the
deficit and be honest about the numbers and on the other hand use
an off-budget means of financing, particularly if we have to pay a
premium interest cost for doing so.
Mr. GREENSPAN. The reason I would prefer to hold until Thursday is that I think I would like Secretary Brady to make his presentation on the full details of his program before I discuss some of
the details.
The CHAIRMAN. I won't press that issue now.
Let me go back to something else you said earlier. You were
citing the unique buildup of circumstances that you find today—
the crisis in the thrift industry, the significant rise in the ratio of
debt to equity out in our private sector, the large continuing trade
and Federal Government deficits, the fact that the expansion has
gone on for historically now a very long period of time, and you
have created in that description a set of elements that are unique
and that really pose some dangers to us if we don't deal with them
directly.
I think you clearly felt that way and made that impression. And
I am inclined to agree with you. I think that as we look at these
75
things—the LBO's and everything else—we are in an unprecedented situation and the time to act is now. We are at the beginning of
a new administration. There is a new Congress. We should all step
up to the responsibility of acting. And presumably we can put a
strategy in place which starts to adjust us through this whole set of
problems.
I say all that by way of getting to this question:
You have lived a long time in the world of national and international finance. When you add those issues together in terms of the
kind of threat or risk they present to us if left unresolved, how serious a mixture of problems is this?
I think that Congress needs to understand and the public needs
to understand exactly the dimension of the risk.
How urgent is it that we act on these things? Do these in combination constitute something that would be an 8 on a scale of 1 to
10 in term of the overall urgency and risk that they present to us?
Or are you talking about something that is down in the 5 range or
the 3 range? Where are we exactly?
Mr. GREENSPAN. The truth of the matter is, Mr. Chairman,
that
The CHAIRMAN. In your judgment.
Mr. GREENSPAN. No one really knows, and can't know. We are
dealing with degrees of complexity that anyone who gives you a definitive answer to that question is expressing a degree of ignorance,
not insight.
It's clear that if one evaluates the various risks and if there is
enough of a concern that the risks could be large, then it very significantly skews policy toward reducing the budget deficit and
making certain that inflation does not accelerate and create very
significant additional imbalances in the system.
I think the reason I addressed the issue or the question that Senator Wirth raised earlier in the way I did is that what we have got
is a rather complex structure of problems. What we cannot impose
on them is a renewal of inflation and expect that they will somehow be resolved. They won't. That we know with a high degree of
assurance.
How these elements in the financial structure—the debt question, the trade deficit, the thrift issues—how they all will come out
is difficult to say. But we do have the capability of resolving them
all. It is not a l-shot-in-20. We've got a much higher probability
than that. We can resolve the LDC issue.
The CHAIRMAN. If I may just interrupt there. I agree with you
that we can solve them. But I am really asking you to reflect on a
different question. And that is, suppose we do not resolve them.
They are very difficult to resolve.
If you feel it's important not to let this buildup of situations just
run on and just drift along without some very serious resolution of
these problems, that we may be facing risks of a dimension that we
have not seen in a long period of time, now is a good time to let
everybody know it.
Mr. GREENSPAN. What I don't want to convey to you is more
than I know. I am not saying in effect that we have to resolve the
budget deficit issue within the next 6 weeks or 2 weeks or 2 years.
I don't know the answer to that.
76
What I do know, however, is that the longer we wait to resolve
it, the greater the risks to the system. What I am saying is that
because of the size of the problem what could happen if we fail to
address these problems appropriately is of such an order of magnitude that we should not hesitate to resolve the budget deficit problem.
The CHAIRMAN. What are those risks?
Mr. GREENSPAN. Well, let's assume we do not resolve the budget
deficit question, I would say we'd have a significant acceleration of
inflation in this country and a very considerable set of imbalances
which would lead to a major contraction.
The question which I cannot answer—does that mean we have to
resolve it immediately? I don't think so. I do think we have a little
time, but I don't think we have time to procrastinate and hope it
will all go away, because I don't believe it will go away.
I must say I am somewhat optimistic, knowing the players, that
it will get resolved. But I am saying that we cannot take the
chance of not resolving this problem.
The CHAIRMAN. When you said a little time, I gather you're
thinking in terms of months and not years?
Mr. GREENSPAN. I mean I cannot say to you that if this thing
drags on and we eventually resolve it some time early next year,
that that is too late. I frankly don't know. I would feel uncomfortable about doing that. But I don't know enough, nor does anybody
have the knowledge, to make that judgment.
The CHAIRMAN. I am not asking for precision, because, as you
say, none of us has it. You know, you are a person with very highly
respected professional judgment. You are probably in as good a position to make an overall professional judgment as any person we
might ask. So, I think given that, I think it's fair to ask about the
degree of risk we run here if we should not step up to these things
and resolve them in some rather decisive way.
Mr. GREENSPAN. I would say the degree of risk of allowing this
whole process to fester is unacceptable.
The CHAIRMAN, Senator Pressler?
Senator PRESSLER. I just wanted to get in there because I agree
with you that it is such a severe problem, but I see us going
through the same cycle up here as we have gone through—and I
have been here for 14 years—somehow, and I say this in the background of just having returned from going all over my State.
Somehow we need a presidential speech on where to make the
cuts or what to do about this budget deficit. We need some kind of
national position by people such as yourself because each Member
of Congress, I can give a speech in my hometown and 100 people
will listen to me—and I have a plan, which I won't go into here—
but the point is that by the time we get through—but I would like
to embrace a presidential plan or something of that sort. But we
really haven't had that explained to the American people.
Everybody tells Congress, "You've got to cut the budget." We all
agree. Everybody agrees we've got to have a balanced budget. We
all agree. But we haven't really. Somewhere I think we are crying
out for a national focus of somebody who can explain this thing,
rally support nationwide and so forth.
77
It seems that everybody is kind of passing the buck to everybody
else. That is what is the tragedy of the current situation as far as I
can see it.
Is my analysis correct, or would you disagree with that?
Mr. GREENSPAN. I am a good deal more optimistic than you, Senator. I think that this country, when it comes to the necessity to do
something, has historically done it. While I can abstractly discuss
the various outcomes if we don't do anything, I frankly and honestly don't believe it's going to come out that way.
I do think that we understand what has to be done, and it's not
that great a change. Some less developed countries have undergone
types of adjustments that are far greater than any that we have to
make, so I can't honestly tell you that I think we won't resolve all
the problems because I really believe that we will.
I think there will be a good deal of political negotiation and friction, but in the end I am reasonably certain that we will all come
together with the appropriate policy.
The CHAIRMAN. Senator Pressler, you are next in order, and then
I am going to go to Senator Graham.
Senator PRESSLER. I don't have any further questions.
The CHAIRMAN. Senator Graham?
Senator GRAHAM. I would just like to add to the comments made
by the Chairman and Senator Pressler. I agree the President has
an opportunity and, I think, a national responsibility to be specific
as to where he thinks our Federal fiscal policy should go.
For example, there is tremendous concern among Americans in
the age group 25 to 40 as to whether some of the basic support
system such as Social Security and Medicare are credible for them.
I believe that part of solving the budget deficit is to give some
degree of assurance to Americans as to basic Federal financial commitment to programs on which people are basing a substantial
amount of their lifetime planning.
Early in President Reagan's administration there was a lot of
discussion about the issue of new Federalism, a sorting out of domestic responsibilities among levels of Government.
I think there was a great deal of wisdom in that effort, which is
sort of dissipated. I believe those are two areas in which presidential leadership on more than just that we need to reduce the
budget but also what are some longer-term objectives in reducing
the budget would be very positive and would help to build a national coalition behind the tough decisions that the Chairman has indicated we will have to make.
If I could move to another subject that we have already discussed
somewhat, and that is the capital gains issue.
On page 11 of your statement there is a paragraph which indicates your basic support for capital gains reduction. And I appreciate the further amplification that you have given.
Assuming that the overall budget issue is such that that is a
matter that could be seriously considered, what would be your recommendation as to the shape of a capital gains policy?
Mr. GREENSPAN. I thought the President's proposal was a sensible proposal. In other words, it was a good way of structuring the
proposal. I think if it were enacted, it would have a positive effect.
78
There are different ways in which one can alter the capital gains
tax, but I thought that proposal was a sensible one.
Senator GRAHAM. Let me ask, would you favor a longer holding
period than the 6 months which was applicable when we last had
capital gains; and if so, would you favor a tiered holding period
where greater tax benefits accrued to longer periods of ownership?
Mr. GREENSPAN. It depends on the rate, Senator. In general I
would have some sympathy for that sort of a proposal.
Senator GRAHAM. Do you have any suggestions as to what the relationship of rate to holding period might be, or how do you go
about thinking through reaching the numerical answer?
Mr. GREENSPAN. Senator, years ago I studied the issue in great
detail, and had very specific conclusions with respect to that question. But I have not been in touch with the numbers in the last
several years to a degree to which I would feel comfortable in
giving you such a response.
Senator GRAHAM. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Graham.
Just a few other things to cover, Chairman Greenspan, today.
We have been talking about meeting the Gramm-Rudman-Hollings targets. There are some of us who feel that is an honest discipline. There are some of us who feel it is an inherently dishonest
accounting discipline, the way we do it.
For the fiscal year we are now doing the budget for, we are going
to borrow $68 billion from Social Security.
The regular general Government is going to borrow $68 billion
out of Social Security, give the Social Security fund a series of
IpU's, and we're going to spend the money on the day-to-day operations of government. Some of it goes to the Defense Department,
Some of it goes to the FBI. Some of it goes to the drug war and so
forth. And it will be spent.
The general government will, in effect, owe the Social Security
that money that it has borrowed and will have to pay it back some
time in the future.
As I track this through in my own mind, it seems to me what is
happening here is that individuals who are paying into their Social
Security taxes each day, as I do and you do, are finding out that
the money they are putting in that is supposed to be there to pay
their retirement benefits in the future is being borrowed, taken
over into the general area of government, being spent every day as
part of the way to make the deficit look lower than it really is, and
in the future that money is all going to have to be replaced. It has
got to come from somewhere. It has got to be taken from the general government and sent back over to Social Security to pay those
benefits in the future when it is time for people to receive them.
Now, the actual operating deficit of the budget is about $250 billion at the present time if you take out the Social Security surplus
and the other trust fund surpluses.
How can we continue to do that? We say one thing in terms of
what the deficit figure is, but in cold point of fact the real operating deficit is about $100 billion larger.
Do the financial markets of the world just take this in stride,
this accounting trick? Are they comfortable with it? Can we just do
this indefinitely?
79
Mr. GREENSPAN. I think what the financial markets do is to recognize that there really is a single Federal Government deficit,
what we call the unified budget deficit, and that the issue of various trust funds are merely assumed to be consolidated in the
system and essentially involve intragovernmental transfers.
If we wished to create a significant amount of saving and therefore real investment which generated an increased degree of productivity, which therefore supported the fund from which in real
terms Social Security beneficiaries were paid off, then I think we
would have to deal with the Social Security trust fund as though it
were a separate organization investing in private instruments and
in a sense independent of, as you put it, the operating budget.
When one looks at the question of the overall government, both
Social Security and all other, the crucial issue of total U.S. savings,
must be seen in terms of the unified deficit because if the total
budget, unified budget, goes into surplus because the Social Security surplus is larger than the operating deficit, that creates an increase in total domestic saving for the United States, which is in
my judgment crucial to the long-term problem.
The CHAIRMAN. Let me ask you this. That is, precisely what
the Social Security fund is supposed to be. It is supposed to be a
savings fund; that is, you put the money aside, you invest it presumably in earning assets, and so the capital is safe. The earnings
build up, and the money is there to pay benefits in the future. You
collect that tax for a dedicated purpose.
But what we are doing now is to take that money and spend it
on the daily operations of government. I don't really understand
how you can justify that.
Would you be untroubled if, when the Social Security surpluses
get up to, say, $200 billion a year, that we take it all and spend it
on the daily operations of government and feel that somehow or
another we are not putting ourselves in a terrific problem for the
future?
Mr. GREENSPAN. Actually, in a certain sense, Mr. Chairman, the
problem is even worse than that because to the extent that special
issues are issued by the Treasury to the Social Security Administration, interest is paid on that. That interest becomes a very large
number. My recollection is that by the turn of the century, by the
late 1990's or the early 2000's, the intragovernmental interest payment from the Treasury to the Social Security trust fund is about 1
percent of the GNP, which is a very large number, the equivalent
of $50 billion today.
That means that the outlays for the non-Social Security part of
the budget must include those interest payments to the Social Security trust fund and a substantial part of the very large surplus
that is building in the Social Security trust fund reflects the buildup of intragovernmental interest payments.
When we see in our calculations that, on the one hand, Social
Security annual surpluses are going up like that and non-Social Security deficits are going up like that, both are very significantly affected by the same factor, which when we consolidate the accounts
into the unified budget wash out as intragovernmental transfers
and we never see it.
80
The CHAIRMAN. Don't you think the time has come for us to stop
using the Social Security surpluses as a way to make the deficit
look smaller than it really is? Shouldn't we get down to the hard
job of dealing with the true in-flows and out-flows of the general
government?
Mr. GREENSPAN, I don't disagree that would be useful to do that,
but there is an important distinction in that the unified budget
does have a certain meaning, and I think it is a useful concept because even if you segregate Social Security and were you to invest
the proceeds hi private instruments, combining the two is the
measure of what the government is doing.
The CHAIRMAN. I don't argue with that. But the cold fact of the
matter is that we are running a much bigger operating deficit
today than anybody wants to admit.
You talk about the size of the interest claims in the future being
enormous, and they will be. But the interest payments are exceeded by the principal. We are actually increasing the principal each
day. You are nodding in the affirmative, and I want to make sure
that that shows up on the record.
This is a brand new development. Before the last 2 or 3 years we
were not running these large surpluses in the Social Security fund.
What has happened here, it seems to me, is that we are engaging
in an accounting trick. We are going over and borrowing it, and we
are using it to make it appear as if we are reaching these GrammRudman targets on an operating basis when in fact we are not. We
are off by about $100 billion.
I really think it is dishonest. I think it is one of the issues that
we ought to be facing right now in the first half of 1989, and I see a
side step—I don't say by you going on because we have got a comfortable way to make it appear that we are hitting the GrammRudman-Hollings targets when in fact we are not, not without, in a
sense, looting the Social Security reserves and spending them each
day on other purposes.
It is very frustrating to see that because when you throw that
back in on top of your list—a crisis in the thrift industry, the significant rise in ratio of debt to equity, the large trade and central
budget deficit—and I am just quoting from your comments as I
wrote them down when you made them earlier—it seems to me
that the time to be very hardboiled about it is right now.
It seems to me that you made a case here in an understated way
today that this pile-up of difficulties has taken us to a level of risk
that we haven't seen maybe since the 1930's. We don't face them
honestly and start to resolve them quite quickly, not tomorrow
morning but on an accelerated tune frame.
That is my interpretation of what I think I hear you saying
today.
Mr. GREENSPAN. I am concerned, Mr. Chairman, but as I said
earlier, I have enough confidence in the way our system functions
to believe we will resolve these difficult questions as we have resolved questions in the past, and I think the willingness of the Congress to address those issues as expeditiously as apparently it is
and with the seriousness of purpose which I infer from the attitude
of the President and the key members relative to this whole process, the thrift problems and budget deficit problems to take two
81
major issues, I must say gives me a degree of confidence that we
will come out in a manner which will be the type of resolution
which will make restoration of balance in the system something
which is quite achievable.
The CHAIRMAN. We are going to work to accomplish that in
every way we can.
I want to raise one other thing, then yield to Senator Graham,
and that is this.
The Finance Minister of West Germany is quoted by Reuters on
the 16th of February as saying that "The U.S. Federal Reserve now
estimates U.S. 1989 inflation at 6 percent rather than 5 percent,"
and he went on to note that inflation was pressing upon other
countries. In Britain it was 7 percent. In Italy it was approaching 6
percent. In fact, he was noting an increasing in inflationary pressures in West Germany.
Where does that figure of 6 percent that he cites as being attributable to our Federal Reserve come from?
Mr. GREENSPAN, I frankly don't know, Mr. Chairman. It is possible that I may have inadvertently misspoke in conversations with
him, or one of my colleagues may have. It is not an official figure,
nor is it any figure that we have internally in our staff operations.
So it is likely that I or one of my colleagues misspoke and didn't
get corrected in the process of what our internal forecast structure
is. That is not a forecast.
The CHAIRMAN. So there is no spoken or unspoken expectation
within the Fed that inflation will be 6 percent this year and that is
being conveyed to foreign finance minister?
Mr. GREENSPAN. It certainly has not been conveyed in any sense
that I am aware of other than by somebody misspeaking because it
is not factually the case.
The CHAIRMAN. So that is not the internal view of the Federal
Reserve in terms of the inflation expectations?
Mr. GREENSPAN, It is not, sir.
The CHAIRMAN. Thank you.
Senator Graham.
Senator GRAHAM. Mr. Chairman, I have no further questions. I
appreciate the excellent testimony of the Chairman and hope that
in the near future you will get some political support to match the
monetary leadership that you have given.
The CHAIRMAN. Chairman Greenspan, we thank you very much.
You have been very patient and forthcoming as always. We appreciate your testimony.
The committee stands in recess.
[Whereupon, at 12:15 p.m., the committee was recessed, to reconvene at 10:00 a.m., Wednesday, February 22, 1989.]
[Response to written questions of Chairman Riegle follow:]
82
Chairman Greenspan subsequently submitted the
following in response to written questions from Chairman
Riegle in connection with the hearing held on February 21,
1989:
Question 1: The economic assumptions submitted with the budget
this year show a decline in inflation over the
next 5 years to a 1.8 percent rate, while economic
growth averages 3 to 3.5 percent. The Fed's
central tendency inflation projection for next
year is 4.5 to 5 percent. Is it likely that
inflation can be reduced 3 percentage points so
painlessly?
Answer:
One might argue that this long-run scenario
is optimistic, but there certainly are circumstances in which
it could be realized.
Two key considerations are (1) whether
we can achieve growth in labor productivity more in line with
the experience earlier in the post World War II period, and
(2) whether we can maintain policies that provide people with
some assurance that the government will remain committed to
restoring price stability over time.
Question 2: You have stated that current inflation rates
cannot be acceptable indefinitely. What is an
acceptable rate, and how soon do you expect to
reach it?
Answer:
I have emphasized the importance of reducing
the rate of inflation to a level at which it no longer has
economic significance —
that is, one so low that people no
longer feel the need to make any allowance for inflation in
their decisions about purchasing real or financial assets.
I'm not sure what, in terms of our conventional price indexes,
that translates into quantitatively, but I think we must at
83
this point take as our working assumption that it
approximating zero.
As to a timetable, it
is a number
is clear that we
can't achieve price stability overnight without undue
wrenching of the economy; however, if we do not have at least
a rough sense that we want to achieve this objective within
several years, it will lose operational significance and have
little, if any, of the favorable expectational effect that it
might otherwise have.
Q.3. In response to a question from Senator Heinz, you expressed some
confidence that long-term real interest rates have risen over the past
year in response to your increases in short-term rates. Long-term real
rates can be computed in many ways. How ace the rates you use computed/
and can you give us the estimates for the past decade?
Long-term real interest rates are difficult to determine
precisely because long-term inflation expectations are not directly
observable.
Using survey data of market participants' long-tera
inflation expectations, long-term real interest rates appear to have
risen over the past year as expectations of long-term inflation rates
have dropped while nominal long-term interest rates have been about
stable.
Table 1 shows the results of a survey published by Drexel
Burnham Lambert, which gathers responses from financial market
participants to questions concerning expected inflation rates for the
next 12 months, 5 years, and 10 years; the chart in the lower panel
shows recent 10-year real interest rates based on the responses to this
survey and average monthly 10-year Treasury note rates.
As shown in the
table, expected 10-year inflation rates have declined from 5.3 percent
in January of 1988 to 4.7 percent in February of 1989 {the last
84
available survey).
The chart shows that long-term real interest rates
have risen since 1986 but currently are not as high as they were in the
early 1980s and in 1984.
Another technique sometimes used to proxy inflation
expectations is to assume such expectations are formed by extrapolating
past inflation rates.
Table 2 uses both 12- and 20-quarter moving
averages of past inflation rates (using the PCE deflator) as prozies for
expected future inflation rates to estimate long-term real interest
rates.
Using this proxy, real interest rates are unchanged or up
slightly from early 1988, and are appreciably above their levels of the
first half of 1987, though they have declined from the peaks reached in
the last half of 1987.
85
available survey).
The chart shows that long-term real interest rates
have risen since 1986 but currently are not as high as they were in the
early 1980s and in 1984.
Another technique sometimes us«d to proxy inflation
expectations is to assume such expectations are formed by extrapolating
past inflation rates.
Table 2 uses both 12- and 20-quarter moving
averages of past inflation rates (using the PCE deflator) as proxies for
expected future inflation rates to estimate long-term real interest
rates.
Using this proxy, real interest rates are unchanged or up
slightly from early J988, and are appreciably above their levels of the
first half of 1961, though they have declined from the peaks reached in
the last half of 1987.
Question 4: You stated that the unified budget is the best
measure of the federal government's impact on
national savings, and that you believe we should
generally have a unified budget surplus to
increase national savings. Would you agree that
the surplus should be bigger during periods when
the Social Security trust fund is growing — that
we ought to be saving more when our workforce is
bulging with baby boomers who expect to receive
large benefits in the future?
Answer:
I have stressed the importance of a
consolidated measure of the federal government's budget
position because that is the appropriate index of the sector's
absorption of, or contribution to, national saving.
What we
86
should be seeking is to increase the overall level of national
saving, so that we can finance added capital formaticn.
By
raising saving and investment, we can enhance our productive
potential in the years ahead, and thereby make it possible for
workers in future years to meet, without great sacrifice of
their own living standard, the Social Security commitments
made to the baby boomers.
pugstion 5: Typically, inverted yield curves have been
followed by business recessions. Why will the
relationship between the yield curve and the
economy be different this time?
Answer:
Over the past year, short-term interest
rates have risen sharply while long-term Treasury interest
rates have been stable.
As a result, the Treasury yield curve
has flattened considerably and is inverted between maturities
of two years and thirty years.
This downward sloping portion
of the yield curve implies that market participants expect
interest rates, including long-term rates, to decline in the
future.
Although the last four recessions were all preceded
by inverted yield curves, there are reasons to believe that
circumstances differ today,
compared to those episodes of
inverted Treasury yield curves, the recent flattening has been
modest in both duration and magnitude.
Indeed, three-month
Treasury bill rates are still below longer-term rates.
The
federal funds rate (on a 365-day basis) has been above the
thirty-year Treasury bond rate only since the beginning of
this year, and the spread has only recently widened to
87
85 basis points, which is a smaller spread than observed
before any recession since the 1950's.
In addition, past
recessions followed inversions of the yield curve by up to
two years; thus, it is likely that recent movements in nominal
interest rates are not a reliable predictor of economic
activity, especially in the near term.
Indeed, the more
recent changes in the slope of the yield curve may reflect
only downward revisions to longer-term inflationary
expectations not predictions of a recession.
Further, new financial instruments, markets, and
techniques have broadened the choices available to savers,
spenders, and intermediaries for structuring their assets and
liabilities.
The consequences of these innovations have been
to reduce the effects of liguidity constraints in financial
markets and, thus, to elevate rate movements as a transmission
channel for monetary policy and other influences in the
economy; these developments also imply that historical
associations among interest rates may be subject to change,
making predictions based solely on the slope of the yield
curve uncertain.
Attachments (2)
Table 1
Inflation Kzp*ct»tions
IHoey Survey)
Survey
Date
Next
12 months
First
5 vears
Second
5 vears
10-year
averaae
— -'— -•— ^annual rater percent" —"— ~ —
3 .5
3 .6
4.8
4.7
5.5
5.5
5. 1
3 .8
4,,0
4 .7
4 .6
4..9
4 .7
4 .1
4.9
5.2
5.3
5.2
5-4
5.3
5.0
5.4
5.8
5.4
5.3
5.7
5.6
5.3
5..1
5.,5
5..3
5..3
5,.5
5..4
5..1
1988: January
March
April
June
August
October
November
December
4 .5
4 ,3
4 .7
5 .1
5..3
4 .9
4..8
5 .0
5.2
5.0
5.1
5.1
5-1
4.7
4.6
4.6
5.5
5.3
5.0
4.9
4.8
4.9
4.7
4.6
5..3
5,.2
5..1
1969: February
5..3
4.7
4.7
4,.7
1986: Q3
Q4
1967: January
March
May
June
August
September
November
ESTIMATED REAL INTEREST RATE
10-year Treasury bond yield less 10-year
average Inflation expectation (Hoey survey).
McnfMy
1979
I860
1982
1964
Monthly obMtvMkHW tor furv*ymonthf;lMobMmrton b February IBtot.
5. 1
5..0
4..9
4..8
4,.7
4,.6
89
Table 2
REAL AND MGMZNAI. IKT1REST RATES
(Long-term Treasury bond, in percent)
Real rate
(Alternative A)
Real rate
3
(Alternative Bl
Nominal
bond cate
2.2
1.8
1.3
2.1
1.9
1.9
1.8
2.8
9-0
9.1
9.0
10.1
3.2
2.0
2.0
2.9
4.2
2.8
3.1
4.2
11.7
10.5
10.9
12.1
2.9
3.8
4.8
4.6
4.3
4.9
5.7
5.4
12.5
13.3
13.8
5.0
5.0
4.7
3.1
5.6
5.4
4.6
2.7
14.0
13.5
12.8
10.8
3.8
4.2
5.7
6.3
2.8
3.0
4.2
4.4
10.7
10.6
11.6
11.7
7.1
8.6
8.4
1.1
5.0
6.4
6.3
5.7
12.0
13.1
12.7
11.7
7.8
7.2
T.O
6.5
6.0
5.7
5.6
5.4
11.6
11.0
10.6
10.0
5.4
4.4
4.3
4.5
4.6
3.6
3.7
4.0
8.8
7.5
7.4
•J.5
Q3
Q4
4.3
5.2
5.6
5.7
3.9
4.9
5.5
5.7
7.5
8.5
9.1
9.2
198B-.Q1
02
Q3
Q4
5.2
5.4
5.4
5.2
5.1
5.5
5.6
5.3
8.6
1979:Q1
Q2
Q3
Q4
1980 :Q1
Q2
Q3
04
1961 :Q1
Q2
Q3
Q4
1982:Q1
Q2
Q3
Q4
1983:Q1
Q2
Q3
Q4
1984:Q1
Q2
Q3
Q4
1985-.Q1
Q2
Q3
Q4
1986:Ql
Q2
03
Q*
1987:Q1
02
14.1
9.1
9.2
9.0
1. All interest rate and inflation readings are quarterly averages.
2. Alternative & IB expected inflation measured by a 12-quarter
moving average of past inflation (PCE deflator).
3. Alternative B is expected inflation measured by a 20-quarter moving
average of past inflation (PCE deflator).
90
Chairman Greenspan subsequently submitted the
following in response to a written question from Senator
Sarbanes in connection with the hearing held on
February 21, 1989:
Question 1: The Federal Reserve's Monetary Policy Report to
Congress is made pursuant to the Full Employment
and Balanced Growth Act of 1978, 12 U.S.C. 225(a).
Last year's trade bill, the Omnibus Trade and
Competitiveness Act of 1988, 22 U.S.C. 5306,
amended the 1978 Act to read as follows:
"In furtherance of the purposes of the Full
Employment and Balanced Growth Act of 1978, the
Board of Governors of the Federal Reserve System
shall transmit to the Congress, not later than
February 20 and July 20 of each year, independent
written reports setting forth (1) a review and
analysis of recent developments affecting economic
trends in the nation, including an analysis of_ the
impact of the exchange^rate of the dollar on those
trends'^.
The language that was added to the Act is
underlined. The February 21 Monetary Policy
Report's section on "The External Sector" does
include some analysis of the effect of the
exchange rate on the U.S. external accounts such
as the trade and the current account. However,
the Congress also intended that the analysis of
the exchange rate extend to the effects on other
economic trends central to the purposes of the
Humphrey-Hawkins legislation - growth, inflation,
employment, income, and investment. Please
comment on the impact of the exchange rate on
these measures of economic performance.
More specifically, from mid-1986 to mid-1988,
improvement in the real trade balance contributed
positively to overall GNp growth and stimulated
increases in investment and employment in goods
industries. The real trade balance worsened in
the last two quarters of 1988. What role did the
exchange rate play in the recent deterioration and
in the earlier improvement? How important is the
trend in the real trade balance to overall growth,
investment, and employment? The report notes some
acceleration of domestic inflation. How much of
the recent acceleration of inflation do you trace
to movements in the exchange rate?
91
Answer :
In describing the recent pcrf ormatice of the
U.S. economy, the February 21 Monetary Policy Report to
Congress noted that the gain in U.S. price competitiveness
resulting from the earlier depreciation of the dollar, efforts
at controlling costs, and increases in productivity accounted
for much of the strong growth in exports during the first half
of 1988.
While net exports weakened somewhat toward the end
of the year, there was enough impetus from other sectors to
keep real GNP on a firm upward course.
The report also noted
that the direct effect of rising import prices on domestic
inflation was less pronounced in 1988 than it had been in
1987, although higher import prices probably influenced
pressures on domestic prices in some areas.
Several more specific questions asked about the
relationships among exchange rates, net exports, growth and
inflation:
Ef£ect_ of Exchange Rates _on Real Met Exports,, During
1986-88.
The depreciation of the dollar through 1987 (along
with improved U.S. domestic price, cost, and productivity
performance) probably accounted for much of the overall
improvement in net exports between mid-1986 and mid-1988.
However, the very rapid pace of expansion of exports during
the first half of 1988 was considerably faster than most
analysts and models had anticipated.
92
The substantial slowing of the growth of both exports
and net exports after mid-1988 could have reflected a number
of factors.
Earlier movements in exchange rates probably
continued to have a significant net positive effect on the
real trade balance, despite the rise in the dollar around
mid-year.
Most empirical models suggest that changes in
exchange rates continue to affect trade flows for at least two
to three years, and the rise in the dollar during 1988 was
small relative to the decline over the preceding two years and
came relatively late in the period.
Nevertheless, it is
generally believed that the effects of exchange rate changes
do tend to diminish over time.
The slowing of U.S. external
adjustment since mid-1988 may have reflected, at least to a
small degree, a decline in this positive effect.
Other
factors that could have contributed to the modest widening of
the real trade balance include:
(1) the slowing of domestic
demand in certain foreign markets towards the end of 1988, (2)
emerging capacity constraints in several U.S. manufacturing
sectors, and (3) timing factors, such as the bunching of
orders for agricultural commodities by the Soviet Union and
China into the first half of 1988, a pickup in imports late in
the year from certain Asian countries facing a removal of GSP
privileges at the end of 1988, and a surge in imports of
petroleum as oil prices bottomed out.
These and other timing
factors probably accounted for much of the shift in the pace
of external adjustment between the first half and the second
half of 1988.
93
Effect of Real Met Exports on Growth, Investment, and
Employment -
Between mid-1986 and mid-1988, the increase in
real net exports accounted directly for about 20 percent of
the total increase in GNP.
However, the importance of the
expansion of exports alone as an "exogenous** stimulus to
output and employment during this period was probably greater
than this 20 percent figure suggests.
The growth in exports
undoubtedly had "multiplier" effects on domestic consumption
and investment (particularly on investment in the manufacturing sector).
On the other hand, the effects of the expansion
in exports on the real trade balance was partly offset by an
induced increase in imports.
If GNP had grown 20 percent less
than it did from mid-1986 to mid-1988 (that is, if GNP growth
had been about 3/4 percentage point per year lower than it
was), then as a very rough estimate, the unemployment rate by
mid-1988 might have been as much as 3/4 percentage point
higher than it was.
EjfecV of ^Exchange Rates on the Increase in
Inflation.
Movements in dollar exchange rates probably
contributed no more than 1/4 percentage point to the pickup in
inflation during 1988 through their direct impact on import
prices.
Only about half to three-fourths of the movement in
exchange rates, on average, normally is passed through to
import prices, and some of the effects of the dollar's earlier
depreciation were offset by the appreciation during 1988.
The
full effects of the dollar on the pickup in inflation may be
somewhat greater when one factors in the indirect effects
94
through the stimulus of real net exports to aggregate demand,
and through reduced pressures on U.S. prices and wages arising
front reduced competition from foreign goods.
o
@FedFRASER