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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1996
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FOURTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
FEBRUARY 21, 1996
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON ; 1996
For sale by the U.S. Government Printing Office
Superintendeni of Documents, Congressional Sales Office, Washington, DC 2IM02
I S B N 0-16-052727-9
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
ALFONSE M. D'AMATO, New York, Chairman
PHIL GRAMM, Texas
PAUL S. SARBANES, Maryland
RICHARD C. SHELBY, Alabama
CHRISTOPHER J. DODD, Connecticut
CHRISTOPHER S. BOND, Missouri
JOHN F. KERRY, Massachusetts
CONNIE MACK, Florida
RICHARD H. BRYAN, Nevada
LAUCH FAIRCLOTH, North Carolina
BARBARA BOXER, California
ROBERT F. BENNETT, Utah
CAROL MOSELEY-BRAUN, Illinois
ROD GRAMS, Minnesota
PATTY MURRAY, Washington
PETE V. DOMENICI, New Mexico
HOWARD A MENELL, Staff Director
ROBERT J. GIUFFRA, JR., Chief Counsel
PHILIP E. BECHTEL, Deputy Staff Director
BRENT FRENZEL, Professional Staff Member
STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel
MARTY GRUENBERG, Democratic Senior Counsel
PATRICK A. MULLOY, Democratic Chief International Counsel
EDWARD M. MALAN, Editor
CONTENTS
WEDNESDAY, FEBRUARY 21, 1996
Page
Opening statement of Chairman D'Amato
Prepared statement
Opening statements, comments, or prepared statements of:
Senator Sarbanes
Senator Mack
Senator Faircloth
Senator Gramm
1
2
4
4
5
WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System
Prepared statement
6
31
ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Monetary Policy Report to Congress, February 20, 1996
(ill)
37
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1996
WEDNESDAY, FEBRUARY 21, 1996
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Committee met at 10:10 a.m. in room 538 of the Dirksen
Senate Office Building, Senator Alfonse M. D'Amato (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN ALFONSE M. D'AMATO
The CHAIRMAN. Good morning, Chairman Greenspan. It's good to
see you.
Chairman GREENSPAN. Thank you. Good morning.
The CHAIRMAN. I'm pleased to welcome you here to discuss the
Federal Reserve's semiannual monetary policy report.
I have extended remarks that go for a number of fully typewritten pages, but I want to save some time so that we can hear
from you, Mr. Chairman.
I'm going to ask that my remarks be placed in the record as if
read in their entirety.
I also want to commend you for your able stewardship because
we have come through some very rough waters and notwithstanding our own inability, that being the Congress and the Executive,
to do its business in a manner that would strengthen the economy,
I think you've done admirably well.
I think our failure to come to a budget accord has not helped the
situation out, has created instability, and I say our failure because
we have not been able to accomplish it.
There are no miracles unless we get the deficits under control
with a program that is realistic, not one that is manufactured,
which is not one which is back-loaded with cuts in the last several
years of a projected program to bring the deficit into balance, it
seems to me that regardless of who sits in your chair, the job is
never going to be done adequately and properly.
I think sometimes we place too much attention at one end and
fail to recognize that without there being the kind of action necessary to reduce the deficits and to get spending programs which
are growing at a disproportionate rate, at a rate that cannot be
practically sustained, that we're never going to really have the kind
of success that we could have.
So the responsibility, in great measure, large measure, rests with
Congress and the White House.
(1)
That's my thought. I've asked that ray statement be included in
the record as if read in its entirety.
I want to congratulate you for operating under very difficult circumstances.
Senator Sarbanes.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES
Senator SARBANES. Thank you, Mr. Chairman, and I join you in
welcoming Alan Greenspan, the Chairman of the Board of Governors of the Federal Reserve before the Committee for the semiannual report on monetary policy as required by the Full Employment Balance Growth Act of 1978.
Since the middle of last year, the middle of 1995, the Federal
Open Market Committee has cut the benchmark Federal funds rate
by 94 of a percentage point from the mid-year peak of 6 percent to
a current level of 5.25 percent.
While this has reversed somewhat the steep increase in interest
rates that consumed the attention of the Federal Reserve throughout 1994 and into early 1995, I still regard this as unfinished business.
At the beginning of February, Merrill Lynch, under the heading
"Monetary Policy More Easing Ahead" had the following to say:
Having met market expectation and eased monetary policy on
January 31, we believe that the Fed still has several more rounds
of easing to go. Even after the latest easing—I'm continuing to
quote—we believe the monetary policy remains overly restrictive.
At the moment, consumer spending is barely growing, the industrial sector is at a standstill, and despite lower mortgage rates,
home sales are slipping.
GDP grew by only around 1.5 percent during 1995 and we doubt
that it is growing faster than at a 1-percent rate in the current
order, and it could be weaker. That is well below anyone's estimate
of U.S. non-inflationary growth potential.
Meanwhile, the CPI rose just 2.5 percent during 1995 and industrial commodity prices declined.
Now even with the latest interest rate cut, the real Federal funds
rate is currently 2^4 percent, well above the historical average of
1.85 percent as this chart would demonstrate.
This is the Fed funds, this is the 40-year average, 1.9 percent.
The current is 2.8 percent. This is the prime rate for the 40-year
average of 3.4 percent and is currently 5.8 percent.
The gap between the Federal funds rate and the prime rate has
expanded over recent times. It used to run at about 2 points, or
less than 2 points. It's now running at about 3 points, almost in
tandem. This is a 5.8 percent real prime rate. The 40-year average
on the prime rate is 3.4 percent, and of course the prime rate is
the rate at which the lending from the banks takes place, now
much higher than the historical average.
In fact, the real rates are not much lower than they were last
year when the Fed completed its year-long tightening. Much of the
% point decline in the Federal funds rate simply reflects a lower
inflation. It was running last year at 3 to 3 V* points. Ifs now at
2.5 points, and that's about the change in the fund rates.
The decline actually just about matches two declines in inflation
and the Federal funds rate.
There's evidence that the rate cuts thus far are having little
practical effect on the economic outlook. On February 10, the Blue
Chip Economic Forecasters cut their consensus outlook for GDP by
two-tenths of 1 point. They are now projecting 2 percent growth for
this year.
The recent survey of consumer expectations, done by the University of Michigan Survey Research Center, released on February 9,
found that the recent interest rate cuts will have little impact from
the consumer's point of view.
I quote them:
The recent cuts are likely to have an even smaller impact on bolstering job and
income prospects, the most important concern amongst consumers at the present
time. While consumers do not expect an outright recession, there's ample evidence
that they are becoming increasingly concerned that the recent slowdown in the pace
of economic growth will persist during the year ahead.
The survey also found that consumers expect the unemployment
rate to rise this year.
It would seem that with the economy on the soft side, 2 percent
growth projected for this year and unemployment now at 5.8 percent, that we would be able to absorb stronger growth for monetary
stimulus without an inflation problem.
In fact, the University of Michigan's Survey of Consumers states,
and I quote:
Importantly, the data suggests that some further lowering of interest rates to
stimulate demand would not cause consumers to abandon their resistance to price
increases and product markets, nor escalate their demands for wage increases in
labor markets.
Yesterday marked, and I'll close with this observation, the 50th
anniversary of President Truman signing the Employment Act of
1946. That committed the Federal Government, "To use all practicable means for the purpose of creating and maintaining conditions which promote useful employment opportunities for those
able, willing, and seeking to work."
In fact, for 50 years, following this commitment, we have succeeded in stabilizing the business cycle.
I just want to close with this chart that shows the dramatic difference between the downturns of the last half century before the
Employment Act, and what's occurred since.
This is the Depression of the 1930's. This was just at the end of
the World War II period before the Employment Act, and this is
what we've managed to do in the past 50 years.
We've avoided these very wild fluctuations and have managed to
sustain the economy almost completely in a positive growth mode.
We've gone negative only on a couple of occasions, and then by
very small margins.
I think a concerted use of fiscal and monetary policy has enabled
us to achieve that performance, and I'm very anxious that we continue to do so.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Mack.
OPENING STATEMENT OF SENATOR CONNIE MACK
Senator MACK. Thank you, Mr. Chairman.
Welcome, Chairman Greenspan.
When you became Chairman of the Federal Reserve Board in August 1987, the price of gold was $461 per ounce, and 30-year Treasury bond yields were almost 9 percent. Today gold prices are down
to $400 an ounce and 30-year Treasuries are under 6.5 percent.
In my view, the reason gold prices and bond yields are down is
because inflationary expectations are down.
In the past 5 years, your oversight of monetary policy has kept
inflation below 3 percent.
Mr. Chairman, that is an extraordinary record. The numbers
speak for themselves, and many Americans have benefited. With
mortgage rates down, many people have purchased their first
homes and even more have refinanced at lower rates.
Your management of monetary policy toward price stability has
yielded tremendous results, and you can be proud of that record.
However, in recent months, with signs of weakness in the economy, it has become commonplace to blame the Federal Reserve for
slow growth. The President and other critics of the Federal Reserve
Board refuse to look at the impact of fiscal policy on economic
growth.
Increases in taxes, regulation, and Government burdens during
President Clinton's administration have slowed the potential
growth in the economy.
Job growth, income growth, and opportunity have all suffered as
this recovery continues to under perform.
Let's set the facts straight on growth. I will stand second to none
in my support of policies which enhance economic growth.
Let me be clear. Economic growth does not come from appointing
easy money advocates to the Fed. If it did, counterfeiting would be
legal.
Real growth comes from entrepreneurial activity, savings and investment. The way to increase these activities is to free the economy from the handcuffs of Government.
We must cut taxes, reduce spending, and slash regulation.
For these reasons, I've introduced the Economic Growth and
Price Stability Act. This bill is designed to maximize economic
growth. The Federal Reserve can best maximize economic growth
by keeping prices stable. Any attempt to use the Federal Reserve
to boost growth always results in higher interest rates, more inflation, less employment and slower growth over the long run.
I know you understand this, and I urge the President to renominate you as quickly as possible.
I'm looking forward to your testimony today.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Faircloth.
OPENING STATEMENT OF SENATOR LAUCH FAIRCLOTH
Senator FAIRCLOTH. Thank you, Mr. Chairman.
Just very briefly, Mr. Chairman, I wanted to make the following
point in reaction to the President's statement about Republican
Senators blocking certain people from the Federal Reserve Board.
The President will soon make two and possibly three appointments to the Federal Reserve Board. In making these appointments, I hope he will remember his own phrase about the era of
big Government is over, and that does mean, however, that the era
of easy money has arrived.
The Congress can appropriate money. Congress and the Treasury
can borrow money. The Federal Reserve has the power to create
money. This is an awesome power and it should be delegated carefully.
For this reason, I think the Senate has every right to be very
cautious about who gets on the Board, and who may, in 8 or 12
years from now, become chairman.
I want to compliment you on the job you've done.
The CHAIRMAN. Senator Gramm.
OPENING COMMENTS OF SENATOR PHIL GRAMM
Senator GRAMM. Thank you, Mr. Chairman.
Let me make a few remarks, building on the remarks of my colleagues.
No. 1, when I read about economic growth in the press, the attitude of many is almost as if we choose economic growth with no
sacrifice, with no change in policy required. It's almost as if we
could simply have someone somewhere, in the White House, the
Congress, the Federal Reserve Board, on Wall Street, say, "well
wouldn't it just be a great idea to have 4 percent economic
growth?"
In that light, if we could have growth by wishing it, I don't know
what idiot decided we should have 1.5 percent economic growth,
and all we need to do is have somebody decide that it would be better to have higher growth.
It seems to me that it's very important that we knock that kind
of thinking in the head and make it clear that if you want to have
higher growth, you have to do the hard things that are necessary
in order to have it. You have to have a stable monetary policy. You
have to have low interest rates. You have to have something approaching a balanced budget. You have to lift the regulatory burden. You have to reduce taxes to provide incentives, and that requires positive Government leadership. It means saying no in
Washington so that people that make investment decisions can say
yes.
I see almost a total absence, to some extent in both parties, of
any discussion of these realities.
Let me also say one thing about inflation and interest rates. I
think we all have to be very careful that we not take any action
that would in any way convince the financial markets that we had
lost our commitment to controlling inflation, because if we do, interest rates will spike, and the deficit is going to explode. The impact on the fiscal policy of the country of a weakened resolve to
fight inflation would be cataclysmic.
The final point I want to make I want to pose as a question.
Obviously I have listened to you, Alan, for quite a few years, talk
about the deficits. I know you understand they matter, and that,
in the short run, there's something that we need to do about them.
It seems to me that one of the things that many policymakers have
6
a hard time focusing on is just how seriously we should take the
projections of what the deficit and what the Government will look
like 20 years from now.
I know that probably more than anyone else in the country you,
as Chairman of the Federal Reserve Board, have taken a good,
hard look at what happens 20 years from now if you take the current growth rate that is built into the Government, in what we
have already committed to, and you project that out for 20 years,
and you look at the kind of tax rate that that would call for. You
understand the ability of the economy to sustain tax rates of that
level.
You have to reach a conclusion that that's a future that can't be,
that that's a future that won't be. The question is, what's going to
change it?
One of the things that Fd like to get your views on in your testimony today is, just how seriously should we take that kind of analysis, of looking at economic trends projected 20 years from now?
Should that be something that we should be focused in on, that we
should be trying to make decisions about today? Should our focus
just be on the next 5 to 7 years? How seriously should we take that
long-term problem?
From my own point of view, I take it very seriously, because I
think it shows that we have to make a fundamental decision as to
what kind of country we want.
I don't see much evidence that those decisions are being made.
I'd like at least to get your thoughts about looking at some of these
projections.
The President has used generational accounting. I see a lot of
problems with that. I think if you look at current services government, no new programs, just funding what we already have, when
you look at a generation, 20 years, and you look at the kind of tax
burden that would be required to fund that government, it looks to
me as if that is a very severe problem. It is a problem that nobody
appears to be addressing, and it seems to me it ought to be one of
our concerns.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator.
Alan, now we look forward to hearing from you.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Chairman GREENSPAN. Thank you very much, Mr. Chairman.
I have a rather long official presentation, and have taken the liberty of making major deletions but request, however, that the full
transcript be included in the record.
Mr. Chairman and Members of the Committee, it's always a
pleasure to appear before you to present the Federal Reserve's
semiannual report on monetary policy.
The United States' economy performed reasonably well in 1995.
One and three-quarter million jobs were added to payrolls over the
year, and the unemployment rate was at the lowest sustained level
in 5 years. Despite the relatively high level of resource utilization,
inflation remained well contained with the consumer price index
rising less than 3 percent—the fifth year running at 3 percent or
below. A reduction in inflation expectations, together with anticipation of significant progress toward eliminating Federal budget deficits, was reflected in financial markets, where long-term interest
rates dropped sharply and stock prices rose dramatically over the
year.
With inflation contained and inflation expectations dropping, the
Federal Reserve was able to ease monetary conditions twice in the
second half of the year.
As we entered 1996, information becoming available raised additional questions about the prospective pace of expansion.
The situation was difficult to judge, but several indicators appeared to signal some softening in the economy. A number of factors have prompted the recent tendency toward renewed weakness.
Some are clearly quite transitory, related, for example, to bad
weather or the Federal Government shutdown. Others may be
somewhat more significant but still temporary. A constraint on
Government spending while permanent budget authorizations are
being negotiated is one. Another may be a temporary reduction in
output in some industries as businesses have further adjusted inventories to disappointing sales. As I noted last July, the change
in the pace of inventory investment when the economy shifts gears
can be substantial. Inventory investment surged in 1994 and into
the early months of 1995, but proceeded to fall markedly throughout the rest of the year. This has placed significant downward pressure on output, which should lift as inventory adjustments subside.
But for the moment, the pressures remain, in the motor vehicle
industry and elsewhere.
Ultimately, of course, it is the path of final demand, after the
temporary influences work themselves out, that determines the trajectory of the economy. There are some factors, such as high
consumer debt levels, that may be working to restrain spending.
But as I shall be detailing shortly, a number of fundamentals point
to an economy basically on track for sustained growth, so any
weakness is likely to be temporary.
Nonetheless, the Committee decided in late January that the evidence suggested sufficient risk of subpar performance going forward to warrant another slight easing in the stance of monetary
policy. Given the subdued trends in costs and wages, the odds that
such a move would boost inflation pressures seemed low.
In assessing the likely course of the economy and the appropriate
stance of policy, one question is the significance, if any, of the age
of the business expansion. Some analysts, viewing recent weakness, have observed that the expansion is approaching the start of
its sixth year and is now one of the longer peacetime spans of
growth in the past half century. Economic expansions, however, do
not necessarily die of old age. Although the factors governing each
individual business cycle are not always clear, expansions usually
end because serious imbalances eventually develop.
When aggregate demand exceeds the economy's potential, for example, inflationary pressures pick up. The inevitable increase in
market interest rates, as inflation expectations rise and price pressures intensify, depresses final demand. Lagging demand in turn
sets off an inventory correction that frequently triggers a downturn
in the economy.
Capital expenditures by households and firms can also contribute
significantly through the development of cycle-ending imbalances.
The level of stocks of such real assets have effects on output very
similar to those of business inventories. In typical cycles, capital
expenditures tend to grow rapidly in the early stages of recovery.
Pent-up demands coming out of a recession by consumers and businesses are satisfied by rapid growth of spending on capital assets.
There is a limit, however, on, say, how many cars people choose to
own or how many square feet of floor space retailers need to service
customers. Spending on such assets generally tends to grow more
slowly after the pent-up demand is met. As with business inventories, downshifting of spending on consumer durables or business
plant equipment may not occur smoothly.
The dynamics of expanding output and rising profit expectations
often create a degree of exuberance which, as in much of human
nature, tends on occasion to excess—in this case, in the form of a
temporary over-accumulation of assets. The ensuing correction and
demand for such assets triggers production adjustments that can
significantly mute growth for a time or even cause a downturn if
the imbalances are large enough.
The current extent of any asset overhang is difficult to determine. Growth of demand for durables in some categories of capital
goods evidently has slowed. But the available evidence does not
suggest a degree of saturation in capital assets that would tip the
economy into a downturn.
Moreover, financial conditions are likely to be generally supportive of spending. The low level of long-term interest rates should
have an especially favorable effect. In addition, with the condition
of most financial institutions strong, lenders are likely to remain
willing to extend credit to firms and households on favorable terms.
Against this background, the Federal Reserve policymakers expect the most likely outcome for 1996 as a whole is further moderate growth. The unemployment rate is expected to remain around
recent levels.
The Federal Open Market Committee also anticipates a continuation of reasonably good inflation performance in 1996. The success
during 1995 in keeping the increase in the consumer price index
below 3 percent in the fifth year of an expansion illustrates that
an extended period of growth with low inflation is possible. Keeping inflation from rising significantly during economic expansions
will permit a gradual ratcheting down of inflation over the course
of successive business cycles that will eventually result in the
achievement of price stability.
Determining whether further changes to the stance of monetary
policy will be necessary in the months ahead to foster progress toward our goals will be a continuing challenge. In formulating monetary policy, while we have in mind a forecast of the most likely
outcome, we must also evaluate the consequences of other possible
developments. Thus, it is sometimes the case that we take out
monetary policy "insurance" when we perceive an imbalance in the
net costs or benefits of coming out on one side or the other of the
most probable scenario. For example, in our most recent actions,
we saw a decline in the FfHgral ftinda rate 3s not increasing inflationary risks unacceptably while addressing the downside risks to
the most likely forecast. In assessing the costs and benefits of adjustments to the stance of policy, Members of the Committee recognize that policy affects the economy and inflation with a lag, and
thus needs to be formulated with a focus on the future. Over the
past year, we have kept firmly in mind our goals of containing inflation in the near term, and moving over time toward price stability, and they will continue to guide us in the period ahead.
Structural forces may be assisting us in this regard. Increases in
producers' costs and output prices proved to be a little lower last
year than many had anticipated. While it is too soon to draw any
definitive conclusions, this experience provides some tentative evidence that basic on-going changes in the structure of the economy
may be helping to hold down price increases. These changes stem
from the introduction of new technologies in a wide variety of production processes throughout the economy.
The more rapid advance of information and communications
technology and the associated acceleration in the turnover of the
capital stock are being mirrored in a brisk restructuring of firms.
In line with their adoption of new organizational structures and
technologies, many enterprises are finding that their needs for various forms of labor are evolving just as quickly. Partly for that reason, most corporate restructurings have involved a significant number of permanent dismissals.
An important consequence of the layoffs and dismissals associated with restructuring activity is a significant and widely reported
increase in the sense of job insecurity. Concern about employment
has been manifested in unusually low levels of indicators of labor
unrest. Of particular relevance to the inflation outlook, a sense of
job insecurity is having a pronounced effect in damping labor costs.
For example, the increase in the employment cost index for compensation in the private sector, which includes both wage and salary payments and benefit costs, slowed further in 1995 to 294 percent despite labor market conditions that by historical standards
were fairly tight.
The more rapid pace of technological change is also reducing
business costs through other channels. Initially most important,
the downsizing of products resulting from semiconductor technologies together with the increasing proportion of national output
accounted for by high-tech products has reduced costs of transporting the average unit of the gross domestic product. Quite simply,
small products can be moved more quickly and at lower cost.
More recently, dramatic advances in telecommunications technologies have lowered the costs of production for a variety of products by slashing further the information component of those costs.
Increasingly, the physical distance between communications endpoints is becoming less relevant in determining the difficulty and
cost of transporting information.
To be sure, advancing technology, with its profound implications
for the nature of the economy, is nothing new and the pace of improvement has never been even. But it is possible that we may be
in the midst of a quickening of the process. Nonetheless, we dp
have to be careful in projecting a further acceleration in the application of technology indefinitely into the future. Similarly, suppressed wage cost growth as a consequence of job insecurity can be
10
carried only so far. While it is difficult to judge the timeframe of
such adjustments, the risks to the cost and price inflation going
forward are not entirely skewed to the downside, especially with
the economy so recently operating at high levels of resource utilization.
In light of the quickened pace of technological change, the question arises whether the United States' economy can expand more
rapidly without adding to inflationary pressures. The Federal Reserve would certainly welcome faster growth provided that it is
sustainable.
The particular rate of maximum sustainable growth in an economy as complex and ever-changing as ours is difficult to pin down.
Fortunately, the Federal Reserve does not need to have a firm
judgment on such an estimate for persistent deviations of actual
growth from that of capacity potential will soon send signals that
a policy adjustment is needed. Should the Nation's true growth potential exceed actual growth, for example, the disparity and lessened strain would be signaled in shorter lead times on the delivery
of materials, declining overtime and ebbing inflationary pressures.
Conversely, actual growth in excess of the economy's true potential would soon result in tightened markets and other distortions
which, as history amply demonstrates, would propel the economy
into recession.
The hypothesis that advancing technology has enhanced productivity growth would be more persuasive if national data on productivity increases showed a distinct improvement. To a degree, the
lack of any marked pickup may be a shortcoming of the statistics
rather than a refutation of the hypothesis. Faulty data could be
arising in part because business purchases are increasingly concentrated in items that are expensed but which market prices suggest should be capitalized. In addition, the output of services—and
the productivity of labor in that sector—is particularly hard to
measure.
There is still a nagging inconsistency: The evidence of significant
restructurings and improvements in technology and real costs within the business establishment does not seem to be rally reflected
in our national productivity measures. It is possible that some of
the frenetic pace of business restructuring is mere wheel spinning,
changing production inputs without increasing output, rather than
real increases in productivity. One cause of wheel spinning, if that
is what it is, may be that it takes some time for firms to adapt in
such a way that major new technology is translated into increased
output. It may be that the full advantage of even the current generation of information and communication equipment will be exploited over a span of a few years, and only after a considerably
updated stock of physical capital has been put in place.
To be fully effective in achieving potential productivity improvements, technological innovations also require a considerable
amount of human investment on the part of workers who have to
deal with these devices on a day-by-day basis. On this score, we
still may not have progressed very far. Many workers still possess
only rudimentary skills in manipulating advanced information
technology. In these circumstances, firms and employees alike need
to recognize that obtaining the potential rewards of the new tech-
11
nologies in the years ahead will require a renewed commitment to
effective education and training, especially on-the-job training.
Our Nation faces many important and difficult challenges in economic policy. Nonetheless, we have made significant and fundamental gains in macroeconomic performance in recent years that
enhance the prospects for maximum sustainable economic growth.
Lower rates of inflation have brought a variety of benefits to the
economy including lower long-term interest rates, a sense of
greater economic stability, an improved environment for household
and business planning, and more robust investment in capital expenditures.
We have also made considerable progress on the fiscal front.
Over the past 10 years, and especially since 1993, our elected political leaders, through sometimes prolonged and even painful negotiations, have been successful in reaching several agreements that
have significantly narrowed the budget deficit. But more remains
to be done. As I have emphasized many times, lower budget deficits
are the surest and most direct way to increase national saving.
Higher national saving would help to reduce real interest rates further, promoting more rapid accumulation of productive capital embodying recent technological advances.
Lower inflation and reduced budget deficits will by no means
solve all of the economic problems we face, but the achievement of
price stability and Federal budget balance or surplus will provide
the best possible macroeconomic climate in which the Nation can
address other economic challenges.
Thank you very much.
The CHAIRMAN. Well thank you, Mr. Chairman.
I was going to ask you to summarize, with some particularity,
what would the impact be on the economy, if we ever could bring
about a budget accord or balanced budget between the Congress
and the President. But you summarized that.
With particularity in regard to interest rates. We hear so much
about interest rates and people clamor at you about interest rates.
If we could put aside the political posturing, and get a balanced
budget, that would be sustained by CBO as being achievable, one
that is credible, what impact would that have on interest rates and
inflation in your opinion?
Chairman GREENSPAN. Mr. Chairman, as I've indicated many
times in the past, the significant decline in long-term interest rates
over the past year and a half, has been, to a very significant extent, the result of the financial markets' perception that something
real with respect to balanced budget programs would be initiated.
There's been over the years a very significant degree of skepticism in the financial community that much of what has been
passing as fiscal policy directed at budget balance has been smoke
and mirrors.
That clearly changed last year. With some reluctance, I perceived
that the markets, or more exactly, the people within the markets,
began to realize that perhaps something was changing, as indeed
I think it has. The culture is very obviously changing and if for no
other reason, one need only look at how effective the "paygo" issue
in the budget process has become, even though a majority of the
Congress could readily overthrow it.
12
I also said, in response to similar questions, that in the event
that the significant move toward budget balance fails, part of the
decline that has occurred in anticipation of a successful outcome
will probably be retraced, and part of the move upward in longterm interest rates over the last week or so has basically reflected
some concern in that direction.
If, however, further progress toward getting a credible program
is made which the markets will perceive as real efforts in the direction of budget balance, and which are not just hopeful statements
of where we wish to be, but give the type of specificity and program
changes which would be difficult to change in subsequent years, my
suspicion is that we will find that long-term rates will fall significantly further.
That clearly is the crucial statistic in the current environment
which could be most positive to economic growth. We estimate that
perhaps two-thirds or more of the overall interest rate effect on the
economy comes from changes in longer-term rates because obviously they impact mortgage rates and a number of rates in the private sector where capital investment is involved.
So there's nothing that I could see which would be, in the short
run, more important to galvanize economic growth than to come to
an effective credible agreement on reaching budget balance within
a reasonable period of time.
The CHAIRMAN. Do you believe the marketplace is already beginning to sense that notwithstanding a change in attitude for the better, as it relates to more Members of the Congress on both sides
seeing the importance of bringing about a balanced budget, do they
sense that once again we may hit an impasse, and that this then
would create some instability and also have an adverse impact in
terms of higher interest rates long term?
Chairman GREENSPAN. I think the answer to your question is
generally yes. Nonetheless, I think that what still appears to be in
place is the view within the market that commitments toward significant reductions in budget deficits are still on the table in the
White House and in the Congress, and so we have not had, and I
don't think we will have unless there is a dramatic reversal of this
whole process, a really major rise in long-term interest rates because of failure to come to grips with this particular issue. But I
do think that the clear ebbing of the efforts and the rhetoric to
solve this problem is beginning to have some marked effects as
doubts are beginning to rise. I don't think they have risen to the
level where they are as yet serious but they could.
The CHAIRMAN. That would be unfortunate.
Chairman GREENSPAN. Most certainly.
The CHAIRMAN. If we lose this opportunity to continue to really
bring about a goal of achieving it I think would be an absolute
tragedy.
Chairman GREENSPAN. I agree with that, Mr. Chairman.
The CHAIRMAN. Senator Sarbanes.
Senator SARBANES. Chairman Greenspan, I was intrigued to read
the morning papers reporting on your testimony yesterday before
the House Committee.
One morning paper headlined your testimony as follows:
Greenspan Calls Economy Soft, Hints At Rate Cut.
13
The other one said:
Greenspan Rattles Market As Hopes for Rate Cut Dim.
One says that you're hinting at rate cut and the other one says,
hopes for rate cut dim.
I know you don't like to add clarity to situations.
[Laughter.]
Senator SARBANES. It seems to me for the Chairman of the Fed
to get reported upon in this virtually contradictory manner is not
a good thing for public understanding of the economy or where we
are or what economic, what direction economic policy is moving.
I'd ask you this morning to provide a little guidance in order to
give us some sense about these contradictory reports.
Chairman GREENSPAN. Well, Senator, I obviously will not clarify
it to the point where everyone will be happy. Maybe I can do a little bit in that regard.
The problem is that this is a very unusual type of period that we
find ourselves. We're at the stage of a process which is one in
which we have to be aware of the fact that, as I said in my prepared remarks, we are going through effectively a significant soft
patch in the economy. The probabilities of our coming out and the
economy doing reasonably well are, as they usually are, better than
50/50.
I say that because I think we have to understand what is on the
other side of this issue, namely the question of how do we view the
probabilities of recession, for example. And how would we respond
to that sort of thing. The difficulty that I have with this type of
question is that with extremely rare exceptions, a recession defined
as some breaking of the fabric of the economy so that you get cumulative downward erosion in economic activity, that sort of situation almost at any point in time never has a more than 50 percent
probability. As a consequence, you very rarely see people who have
single line forecasts forecasting recessions except if they want to be
seen as outliers, and usually most of the forecasts of recession turn
out to be wrong.
Nonetheless, there is always a situation underlying any particular type of outlook, especially one such as now in which we are in
a soft patch, when even though the probabilities of a recession
don't seem likely, they do rise. That's invariably the case whenever
you get a situation where you're in a soft economy.
The reason I discussed the issue in some detail in my prepared
remarks with respect to taking out "insurance" is that, as a practical matter, monetary policy cannot and should not be directed at
a single forecast. We do not have the capability, nor does anyone
else, to be able to know with certainty precisely where the economy
is going to be. What you have to do is to try to weigh the pluses
and the minuses of particular policies which you could potentially
make, and what the costs and benefits of those particular policies
are.
As I indicated earlier, since we did not perceive that there was
a significant risk of reigniting inflationary pressures, we did move,
on January 31, 1996, to recognize the fact that we are in a soft
patch.
Where the confusion arises is the fact that you cannot view monetary policymaking as a simple issue of deciding that the most
14
probable outcome is coining out of this soft patch into moderate
growth with low inflation, although I think that is the most probable outcome. That is not the same statement as saying that you
therefore, in the process of implementing monetary policy, or formulating it, I should say, completely disregard what the upsides
and downsides of a potential outcome may be. Therefore it is conceivable, for example, that if we envisage that inflationary pressures are significantly subdued, it would not be inconsistent to
move rates lower, as we did on January 31.
Or, on the other side of the outlook, if we perceived that the
economy were inordinately strong, and not capable of really being
affected significantly by increased interest rates, but which could
very well stem inflationary pressures, we would move.
What's important to recognize is that it is a complex set of
choices that we make. It's that process which we try to expound on
without indicating, as we cannot, precisely where we may come out
at any particular point because that can only be done by the official
process which the Federal Open Market Committee has with respect to when we move, either by moving within a Committee
meeting or by giving authority to the Chairman to move under certain circumstances.
Senator SAKBANES. I see my time's up, and I'll pursue it on the
next round.
The CHAIRMAN. Senator Mack.
Senator MACK. Mr. Chairman, I'm going to, I want to ask an academic question but I want to ask something else first.
In 1995, real GDP expanded at less than 1.5 percent.
In 1996, your forecast is for only 2 percent real growth.
This would represent the slowest 2-year period of growth without
a recession in the U.S. economy since 1956-57.
In your opinion, why is growth so slow?
Chairman GREENSPAN. Basically, it is slow because we have
come out of the 1994 period when the economy was moving at a
fairly impressive pace and pressing resources, as I indicated in my
prepared remarks, and once you get up to where you're running up
against capacity, there is clearly a tendency to start to back off to
a certain extent.
In the last numbers of months we were growing at clearly less
than potential. One need only look at the operating rates, for example, in manufacturing to basically see that. That is part of the normal rhythm of the business cycle and the expectation that one will
be at some firm growth rate for any protracted period of time,
whether it be high, low, or moderate, doesn't properly reflect the
complexity that the economy of our country has.
So it's not easy to answer very specifically unless you want to
look at the details of what's causing it. As I indicated in my prepared remarks, the actual technical reason is that the rate of inventory investment has been falling very dramatically from an
unsustainably high level in the latter part of 1994 and early 1995
to something very significantly less the last few months.
Senator MACK. If we reduced the deficits, reduced taxes, and reduced regulations, would we experience more growth in the economy?
15
Chairman GREENSPAN. I think over the longer run, the answer
is yes because those factors do have positive impacts on the longer
run.
I would hesitate to argue its short-term impact because far more
likely to affect the short-term economic outlook is the behavior of
inventory investment, and, as I indicated in my prepared remarks,
capital expenditures by both business and households.
Senator MACK. But if you had smaller deficits moving toward a
balance long-term interest rates lower
Chairman GREENSPAN. That would sustain capital investment
yes, certainly.
Senator MACK. Which would, in essence, increase the level of
growth?
Chairman GREENSPAN. Yes. The only reason I hesitate to answer
directly is in the short run, there are other forces which will be far
more dynamic than that, but there's no question, Senator that
maintaining direction of lower budget deficits and a return to lower
long-term interest rates will galvanize housing and capital investment in a manner which would sustain maximum long-term
growth.
Senator MACK. Let me go back to raising a question about monetary policy. And as I say, this may be kind of asked from an academic perspective.
Through the first three quarters of last year, the economy grew
4.2 percent, that is, 2.8 percent inflation plus 1.4 percent real
growth.
If somehow the United States was able to change its potential
real growth rate to 4 percent, would monetary policy need to
change?
Chairman GREENSPAN. You mean with essentially zero inflation?
Senator MACK. Right.
Chairman GREENSPAN. The answer is no, because what we essentially finance over the long run, if you can put it that way in the
amount of credit that we support, reflects the nominal gross domestic product.
Senator MACK. Do you have any specific proposals that policymakers could implement to boost potential real growth in the economy?
Chairman GREENSPAN. There is an interesting question first that
we have to answer. And that's this nagging dilemma which exists
about why, with this extraordinary acceleration that we've seen in
technology, at this $ic growth acceleration means acceleration of productivity growth.
It's hard to envisage the state of technological change being more
rapid than we see, and we have to ask ourselves why isn't it not
reflecting itself in the data, even granting, as I point out in my remarks, that we probably are not measuring it correctly. But still,
it's not fully there no matter what.
Professor David of Stanford, made an extraordinarily important
insight into this process a number of years ago when examining
the comparable dilemma, namely, that in the latter part of the
16
19th century, there was a major thrust forward because of the advent of electric power, but it never really embodied itself in real
economic growth until the 1920's. The reason essentially was that
electric motors were put into buildings which were constructed for
the purpose of implementing steam power production. As a consequence of that, you really didn't get the full synergies of electric
motor use in the economy until we built whole new infrastructures
in the 1920's, flat rather than the vertical buildings that had been
the key type of factories we had in the 19th century.
When that all came together, the measured productivity of this
country all of a sudden took off. There are very similar relationships here with respect to trying to impose a silicon-based computer chip telecommunications technology on an infrastructure
which was not put together for that purpose.
As that changes, one would expect, and indeed I do, that there
will be a marked acceleration in productivity. Pending that, we
have to recognize that it may be a few years before it even starts
to take off, because I don't know what state of this process we're
in.
We also have to be aware that you cannot have merely capital
investment as your base for productivity gains. There is the whole
question of what the so-called human capital is that interfaces with
that process. What is terribly obvious, when you begin to look at
the shortfalls of the skills that we have to implement this new
technology, is that it's going to become terribly important to implement a significant amount of education and especially on-the-job
training to make certain that our work force has the skills that are
required to implement this new high-level technology, because we
already have the highest standard of living in the world.
When one perceives of where we go as we move through the rest
of this century into the next, it is a wholly different type of economic structure, one extraordinarily technologically high-skilled
and one which, unless you have the appropriate trained people to
handle those technologies, you will not get the synergisms and the
type of growth rewards, so to speak, that we are all seeking.
Senator MACK. Thank you.
The CHAIRMAN. Senator Faircloth.
Senator FAIRCLOTH. Thank you, Mr. Chairman.
Chairman Greenspan, one of the issues that has been developed
in this election, Presidential primaries, and it was also in the last
election, is a feeling of a middle class discontent.
You hear today that two incomes will not equal what one was
several years ago. Companies are moving jobs overseas to lower
paid workers. Large corporations are laying off workers.
Now we've heard various political solutions put forth, such as flat
tax, trade protection, tax incentives to keep jobs in the United
States.
My question is, what are your thoughts on the issue, and what
is the answer to the fear of the middle class American that their
standard of living is being weakened and continues to erode, they
feel?
Chairman GREENSPAN. Senator, to extend my remarks, one other
aspect of this tremendous move toward high technology products
has been the very evident increase in the premium for intellectual
17
skill, because the products that we're producing are ever increasingly conceptual as distinct from physical.
The consequence of this has been that since the late 1970's, we've
observed that the incomes earned by those who have college degrees have been increasing relative to those who have high school
degrees, and those who have high school degrees have had incomes
rising at a pace faster than those who were high school dropouts,
or I should say, falling less in certain cases. But the consequence
of that has been a very significant dispersion of incomes in our
economy and a not insignificant proportion of the work force, as a
consequence, has actually experienced real declines in income. This
has created a very considerable degree of frustration for a significant part of our work force.
Superimposed on that is the problem that as a logically necessary result of having very high technology products increasingly
becoming embodied in our capital stock, we are finding that the average age of the equipment that people use is falling dramatically
as we get newer and newer types of applications. The consequence
is that rapid change in equipment is making people with any existing level of skills highly insecure because what they are dealing
with is changing all the time and they don't feel secure in their
capacities.
The example I like to use, which I think is a little bit extreme
but nonetheless I think captures the problem, is if you have a
skilled typist who types at an extremely rapid pace, but is confronted every 2 years with somebody coming by and changing the
structure of the keyboard, all of a sudden, that skill that is in one's
fingers just disappears and has to be relearned. If you keep changing the capital stock, as we are, people who are highly skilled feel
very insecure that those skills will not be usable 4 or 5 years down
the road.
This is the reason why I emphasize the fact that in order to handle this problem, it is not protectionism, it is not a lot of other
things that we can do, but if our main purpose is to try to reduce
the degree of anxiety which a very large number of people have in
part because of the increasing job insecurity which I pointed out in
my prepared remarks, what we have got to do is to make certain
that they have a sense of where they are in the infrastructure
which makes them feel confident that they can handle what they're
doing.
As a consequence, we are going inevitably to move toward a very
substantial amount of education taking place within the business
firm, and indeed that already occurs because a lot of firms require
their people to go 2 nights a week, for example, to the company
university to learn the types of things they need for what it is they
are doing.
To a greater or lesser degree, that's inevitably going to occur because that's the only way our system will work. It's the only way
in which the level of anxiety is going to be lowered, and if we find
that we can improve the portability of certain aspects of our pay
programs, then people will not feel all that insecure moving from
one firm to another, provided that it's their skills that they're
bringing forward in the sense that now, for example, physicians
who go from one hospital to another, or people who are truck driv-
18
ers go from one firm to another, it's their skill that gives them
their security, not the particular job. If we can construct that sort
of labor force interface with the business environment, I think we
can successfully confront these issues.
I'm not sure that a lot of other things that are suggested are
going to resolve this. I'm not saying we're not going to have to do
more, but unless we do something with respect to the education
question, other things will not effectively work.
Senator FAIRCLOTH. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Thank you, Mr. Chairman.
I want to touch very briefly if I can, Alan, on a few issues.
First of all, let's assume for a moment that you weren't the head
of the Federal Reserve Board, and someone hired you and said,
"I'm going to give you a bonus as an advisor to the Government.
For every quarter percent you get the economy to grow above the
current level, I'm going to give you $5 million. And I'm going to
give you 10 years to implement this policy."
Off the top of your head, forgetting all political considerations,
tell me what kind of policies you think you would recommend?
Chairman GREENSPAN. Well, the ones I just recommended are
necessary first conditions—namely to take advantage of what appears to be a potential acceleration of growth which is in the pipeline but is not yet evident, and will eventually come on the scene.
I hope it occurs within the 10 years so I get my bonus. But I would
have had nothing to do with that.
I generally believe, as I've said before this Committee on numerous occasions, that maintaining a degree of incentive for capital investment and a degree of regulation which does not hobble those
incentives are necessary conditions for economic growth.
There are enumerable ways in which one could implement that
but I think all of our history suggests that unless you do that, it
is very difficult to create the types of incentives which improve productivity. As I said before, unless the policies that we're implementing improve productivity, they will not increase growth.
Senator GRAMM. As you know, we have strong forces now in both
political parties that are arguing for protectionism. Since our focus
here is on economic growth, I'd like to give you an opportunity to
comment on protectionism and its impact on economic growth.
Chairman GREENSPAN. Protectionism has a number of negative
effects, but one which is very relevant to this issue is it removes
the level of competition in a domestic economy.
Nobody likes competition. As I used to say before this Committee
and other Committees, when I was in the private sector, I hated
competition. I didn't like people who offered services
The CHAIRMAN. I think some of us up here feel the same way.
Chairman GREENSPAN. Yes.
[Laughter.]
Chairman GREENSPAN. But in the calm of the evening, I recognized that that made me work better, that I did things far more
effectively and hearing the pound of my competitors' feet behind
me, I did a lot better and my clients did a lot better.
If you create protectionism around an industry, an economy, anything, you remove those pressures. I have no question that the
19
removal of the competitive pressure will feel good. But I also suggest that it's the last thing that one would want to implement if
the purpose is to improve productivity.
Senator GRAMM. I'll give you a brief example.
In 1992, I bought an American-made sport utility vehicle, and I
already had a 1982 American-made sport utility vehicle which was
a clunker the day I bought it. In those days, you didn't want to buy
a car made on Monday, and you didn't want to buy a car made on
Friday. We had all these guys on assembly lines who, in the words
of that old country and western song, were having daydreams
about night things in the middle of the afternoon.
[Laughter.]
By 1992, we were producing as many good trucks and cars as
anybody in the world, given the price we were charging for them.
But it's very interesting to note what happened when Bill Clinton
reclassified sport utility vehicles as trucks. I went out and looked
at the price of a new sport utility vehicle, like the one I bought,
and it was slightly over $5,000 more expensive than the one I
bought in 1992.
What happened was that Detroit siezed the whole $5,000. I don't
see any evidence that our market share changed, but the consumer
is now paying $5,000 more for a sport utility vehicle. I haven't
looked at the data, but I wouldn't be surprised that if you could
separate that data out, it would turn out that virtually the whole
$5,000 ended up being lost to the consumer.
Let me get back to my first point, about this long-term deficit.
Looking at the actuarial makeup of the country, looking at the
problems with Social Security, looking at the explosive cost of Medicare, how much does this worry you, looking off 20 years into the
future?
Chairman GREENSPAN. Quite a considerable amount, Senator.
One thing we can be reasonably sure of 20 years ahead is the
rough demographic distribution of our population. We know the age
categories. And we can pretty much extend, as a consequence of
that what, under current programs, various benefits would be and
the like.
It is conceivable that if, for whatever reason or by whatever
means, we can significantly accelerate growth and therefore revenues to a number of these programs. The current services projections which, as you well know and pointed out, look awful, but by
2020, may improve. That is really taking a very large chance on
an event which we have really no realistic way to judge is going
to happen.
Therefore, it is essential that we address those issues now,
rather than later, because the types of changes that we have to
make now to bring a number of these benefit programs back in line
under reasonable growth forecasts, reasonable meaning ones we're
currently using in our types of projections, we could probably make
with very little having to be changed say 1 or 2 years from now.
In fact, it is probably quite likely that you could pass legislation
today that would not come into effect for 10 years, and it's far
easier to put legislation in place today with a 10-year lag so that
people can adjust to the timeframe than it is to wait until 2 years
20
before you're running into really serious problems and enact legislation at that point.
If it turns out, having done that, that we have managed to create
a new beneficence and growth, which I think we would all be very
much hoping will occur, it means that there are just more resources to deal with both in the public and the private sectors, and
I don't consider that a negative which one has to be concerned
about.
Senator GRAMM. Well, if I may, Mr. Chairman, just at one figure,
at 4 percent real growth rate
The CHAIRMAN. If I might just intrude upon my friend, since I'm
going to be next, I'm going to ask that we go to me. I'm going to
yield to you, so that we just keep this moving.
Senator GRAMM. Even a 4 percent real growth rate only eliminates half of the growth in the unfunded liability of Social Security.
Even if you could achieve the growth rate we had from 1950 to
1966, which would be an incredible achievement to sustain over 25
years, we only solve half of the problem.
Chairman GREENSPAN. Especially since the population has
Senator GRAMM. That's right, you still don't really nail the problem down. Even growth at a rate that would equal anything we've
had over any extended period of time in the whole history of the
country won't solve the problem. It makes it easier but it still
doesn't eliminate excruciatingly difficult decisions.
Chairman GREENSPAN. That's right.
The CHAIRMAN. Let me ask you this because I was looking at
some of the clips yesterday from your testimony at the House. I
think it underscores the problem that some of us see.
The fact that there are tremendous potentials, and you testified
to it today, hopes and aspirations that the marketplace has
factored in—we're getting spending, particularly long-term growth
in these programs, very important programs, politically sensitive
programs., Medicare, Medicaid, except for social programs that underscore the safety net that we're all concerned about under control. Unless we do something to get the deficit under control for a
period of time to deal with this spending explosion, kind of project
out, and not just pass programs that are going to have implications
of growth in the future and just look the other way, then we're
going to have real serious problems.
Now I can't help but believe that there was not an anticipation,
a very strong anticipation on the part of many that Congress and
the President, for the first time, were really going to do something
about this deficit and not just smoke and mirrors.
I looked at your statement yesterday, and I'm going to read it to
you. I don't know if it's verbatim but it's in one of the newspapers,
the New York Times:
A failure by Congress and the White House to reach agreement
this year on a credible deficit reduction plan would mean that some
of last year's 2 percentage point decline in long-term interest rates
"will have to be refunded."
Then it goes on to say, "passage of a program by contrast would
bring rates down quite a bit further, Mr. Greenspan predicted."
Do you care to comment on that because, you see, I feel very
strongly that we're in for an absolutely horrific awakening that the
21
marketplace will react very, very negatively if we fail in coining to
closure before this next election because the Wall Streeters, the
economists, the people who make their living having followed this,
they're going to say, if you fellows couldn't do this before an election, with the pressure of a Presidential election, by God, there's
no way you're going to do it afterwards.
Do you care to comment?
Chairman GREENSPAN. First of all, let me just say that the New
York Times report is correct. I hope you're mistaken about not
being able to do it if you don't do it before the election, but I fear
that you probably are correct.
The CHAIRMAN. Well, I hope we can do it, I really do. There's a
group of Republicans and Democrats who are working together to
come up with a balanced budget program that's real, that's not
smoke and mirrors, that's not made up of backloading cuts, which
I find absolutely deplorable.
Anybody who says they're going to—and I don't care whose program it comes in, whether it's a congressional program or one that
comes from the Administration—that if you say you're going to
really make all of your spending reductions in the last 2 years of
a 7-year plan, that's just nonsense. That's not realistic.
There is a group of Republicans and Democrats who have been
meeting regularly and who are achieving some real accord. It
would be my hope that absent the ability of the Administration,
and that's the President, and the congressional leaders to come to
closure, because this is a political year and it's very easy to posture
and to frighten people and to tell them what dire repercussions
would take place, that there would be some congressional leadership that would bring to the table ultimately the White House and
congressional leaders to pass a real plan of deficit reduction that
will lead to balancing the budget without smoke and mirrors.
I think there is that opportunity, but if it doesn't take place, I
share the concern that you expressed yesterday and today, that
there will be some very real problems in the marketplace. Notwithstanding all of the technological changes that are taking place, we
can look forward to long-term rates going up tremendously.
I think they factored in, they have already counted on our doing
something of significance.
Chairman GREENSPAN. If I might just make one collateral comment, Mr. Chairman.
As I said earlier, I think that there has nonetheless been a
change in the culture. It's in the economics fraternity, it's in the
Administration, it's in the Congress. I would find it unlikely that
even under the worst scenarios, that we'll go back to some earlier
process which was highly unacceptable by any standard.
Nonetheless, to assume that we can just go through this process
and have the existing negotiations unravel without market consequences is highly unrealistic. Indeed, as I indicated earlier, I
think the backing up of long-term interest rates in the last week
is to a large extent a reflection of that problem.
The CHAIRMAN. Mr. Chairman, I hope that my colleagues and
those who are concerned, and I think all of us are, Republicans,
Democrats, liberals, conservatives, will hear your concern as one
that will give us, give additional impetus for us doing the job. That
22
might mean, you know, that there has to be an accommodation on
both sides. Maybe the tax cut, which I think is secondary, I really
think is secondary to the business of balancing the budget and
making spending cuts and reducing the rate of growth.
Maybe people will be able to give and put aside partisanship and
that means on both sides, to really do the business of the people.
I am very concerned that there will be an additional backup. And
indeed going into this economic downturn or softness could contribute significantly to an economic downturn.
That's my concern.
Senator Sarbanes.
Senator SARBANES. Chairman Greenspan, the Fed doubled the
interest rates, the Federal fund rate between February 1994 and
February 1995, from 3 to 6 percent, correct?
Chairman GREENSPAN. Correct.
Senator SARBANES. Then in July you took it down, and again in
January, so it's now at 5.25 percent.
Chairman GREENSPAN. Yes, sir.
Senator SARBANES. Now, at 5.25 percent, the Federal funds rate
remains 275 basis points above the inflation rate, correct?
Chairman GREENSPAN. Approximately. It depends on where you
envisage the inflation rate at this particular moment.
Senator SARBANES. All right.
Chairman GREENSPAN. But I grant you, you're general
Senator SARBANES. But the long-term average is 175 basis
points. In fact, when we had the hearing in the fall, back in September, you in effect said that, indeed real rates were somewhat
above long-term averages and probably above long-term
equilibriums.
It would be my own perception that that remains the case.
Now, when the Fed took the rates down in July, it said inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions, correct?
Chairman GREENSPAN. Correct.
Senator SARBANES. At that point, the inflation rate for the 12
months ending in May, which was the latest data available, was
3.2 percent.
The inflation rate now is at 2.5 percent. There are indications
that the economy is softening. In fact, you said yesterday to Chairman Leach, that there is no question this is a soft economy, the
Chairman—meaning you—said in response to Representative
Leach.
Now, and of course we've had the blue chip forecasters revise
their forecast downwards now to 2 percent growth for the coming
year.
The point I want to pursue is whether the insurance policy now
ought not to be on the side of growth, given where we are.
I say this in light of this Wall Street Journal article about a
month ago that said even the Fed's Greenspan is fallible when trying to predict a recession. In fact, working off of the minutes of the
Fed for the 1990 period, it takes a long time to get those minutes,
but in any event, I think there are several things we can stipulate
with some degree of certainty.
This is quoting you in August 21, 1990.
23
Namely that those who argue that we are already in a recession
are reasonably certain to be wrong. End of quote.
Then in October and at the moment, it isn't raining, the economy
has not yet slipped into recession.
Of course we now know that the economy had gone into recession
at that time.
Now, given all of this, wouldn't it be wise to try to guard against
the economy moving downward in the period ahead?
Chairman GREENSPAN. Well, Senator, let me first put the summer and fall of 1990 in a certain context. The problem that you
have when you are looking at an economy is that the definition of
what constitutes a recession, in my judgment, is faulty in the following sense.
If the economy had turned up in say October 1990, the fact that
July was a temporary peak would have been lost in history. It is
only in retrospect that where the actual absolute peak of a cycle
was has any meaning.
We have had, and invariably have in all cycles, several declines
which have never turned into recession. I define a recession, as I
indicated earlier, as essentially a significant structural change in
the way the system is working, and it's a sense of a tearing of the
fabric of relationships which induces a major implosion.
Through September 1990 and in the early—I've forgotten exactly
when you could really begin to see when things were happening—
but surely through the end of September 1990, there was no evidence of a recession in the definitional form that I use it. The reason I say that is that at the moment, everyone is saying, well,
we're not in a recession at the moment.
If it turns out 2 weeks from now the economy turns into a recession, everyone will be arguing that the recession began in September last year.
That has no meaning because if, as I expect, the economy picks
up from here, as indeed the vast majority of forecasters believe, no
one will remember that industrial production was at a peak in September 1995.
Senator SARBANES. But the point is that given that it's a slow
economy, by your own statement, and given the performance on the
inflation front which is much better than the performance last July
when you first took rates down, isn't it advisable to guard against
the slow economy?
I don't want a repetition
Chairman GREENSPAN, May I just
Senator SARBANES. Let me make this point, at the February 1990
meeting of the Federal Open Market Committee, Roger Guffy, the
president of the Kansas City Fed, said the following:
And I'm quoting now from the transcript.
The Committee hopes—this is the Open Market Committee—that there's some exogenous event that causes a recession, and we won't get blamed for it, and yet recapture the progress toward price stability.
Now, you know, I hope an attitude of that sort is not present currently on the Open Market Committee because I don't think we
should have a recession, and you certainly ought not to be searching for an exogenous event in order to escape any responsibility for
it.
24
Chairman GREENSPAN. Well that's certainly not my view.
Senator SARBANES. I wouldn't think so.
Chairman GREENSPAN. Senator, you are merely expressing the
reasons why, on January 31, we chose to move lower, I can't go beyond that statement.
The CHAIRMAN. Senator Mack.
Senator MACK. Mr. Chairman, something caught my attention
yesterday when the bond market reacted one way and the price of
gold reacted the other to whatever statements were made yesterday.
The price of gold fell I think about $5, and 30-year bond rates
went up.
Those seem to be contradictory signals.
I mean is there some explanation, from your perspective, as to
why that happened?
Chairman GREENSPAN. Well, over the long run, there is a correlation, as you know, between the gold price and long-term interest rates to the extent that the gold price is a pretty good estimator
of inflation expectations, as indeed is the long-term bond. But on
a day-by-day basis, you cannot expect that these similar events will
affect both. In the gold market, we've had a peculiar problem in recent weeks, which is difficult to segregate from the more fundamental issues that are driving the price of gold, which is the fact
that the so-called lease rate for gold shot up significantly and then
came down again. And with the lag, the price of gold has sort of
picked up part of that problem.
That is clearly a technical market issue which probably temporarily overrides the issue of changes in inflationary expectations.
You often get that sort of problem, so you never quite disentangle
why you seem to get contradictory signals.
Senator MACK. Listening to the discussion that's taking place
here today, I got the impression that most were saying that the
market's reaction to the failure to get an agreement has something
to do with the long-term interest rate going back up somewhere between what, 20 and 25 basis points, I guess, over the last
Chairman GREENSPAN. It's been more than that.
Senator MACK. More than that?
Chairman GREENSPAN. Yes.
Senator MACK. How much more?
Chairman GREENSPAN. It's up 40 basis points.
Senator MACK. Forty basis points in the last 30 days?
Chairman GREENSPAN. Oh, less than that.
Senator MACK. OK.
It would then not be—I mean, I suspect what you're saying,
given the answer to that last question, that then gold prices will
start back up as well?
Chairman GREENSPAN. No. I can't forecast what they're going to
do because I'm not quite sure where the adjusted level is, if I may
put it that way, that is, adjusted for short-term technical factors.
We're going to find out, my guess is, within a week or so how much
of that is merely technical and how much is changed inflation expectations, if any. But I, at this stage, would find it extremely difficult to get a good sense of what part is what.
25
Senator MACK. I'm going to move off of that, though, and raise
some questions about what I refer to as forward-looking indicators.
We've had some discussions about this in the past.
But I'd like to ask you about forward-looking indicators of monetary policy, inflation, and growth.
Would you please discuss the forward-looking indicators that you
believe are important and how you might assess any movement of
them over future months?
For example, bank reserves, yield spreads, commodity prices?
Chairman GREENSPAN. Yes.
Senator what we have found over the years is that to feel confident that we have a sense of how the economy is functioning and
where its weak points and strengths are, is that we look at an extraordinarily wide range of different types of data which capture
various different views of the so-called elephant, if you want to look
at it that way.
It is true that there are certain specific indicators which sometimes seem to capture the overall, sometimes not. For example, the
spread between 6-month commercial paper and 6-month Treasury
bills was an indicator which seemed to have exceptionally powerful
forecasting capability until it was actually applied to a specific
event, which was the 1990-91 recession, and it failed. The term
structure of interest rates, for example, seems to have some forecasting capability. We often find yield spreads of different types
very useful in judging the question of apparent risks in the system.
We use all of them and what we find is that they all work some
of the time but not all of the time. But if you have a large enough
sample, you usually have a fairly good sense of the underlying
forces that are moving the economy.
It's hard to define in any particular case which are the more relevant ones and which are not. Obviously, if we're in a period where
inventory liquidation is a critical phenomenon, we try to look at
those elements which seem to capture those data before they are
officially published, and we therefore will look at certain bank loan
relationships which are used in part to finance inventories. Or we
will look at individual inventory data for motor vehicles, or other
products for which data are available in advance of these aggregative numbers.
What we will tend to do is to get samples and anecdotal evidences to determine whether in fact a particular phenomenon, such
as a degree of inventory liquidation is accelerating or decelerating,
and even though we may not know what the numbers are, we'll get
a qualitative sense, which is enough for us to get a sense of what
the economy is doing. We have a huge effort underway at all times,
not only to process published data but very importantly to reach
out for anecdotal information. Indeed, we talk to a lot of individual
companies with respect to how their orders are doing, what they're
expecting, their backlogs, and what their projects are.
We have our 12 Federal Reserve Banks periodically reaching out
into their particular communities and getting real time judgments
on the part of businesses and others as to what's going on. We find
that very useful. It gives us a real time qualitative view of what's
happening well before we have specific statistical or financial indicators. So what we tend to do is to look at all of that.
24-528
96-3
26
If we could find some specific number which, with an extremely
high degree of accuracy, captured all of this, we wouldn't need to
have the elaborate type of research business evaluation process
that we go through.
But we have not found any alternative to that process.
The CHAIRMAN. Senator Faircloth.
Senator FAIRCLOTH. Thank you, Mr. Chairman.
Chairman Greenspan, I'll try to be real brief with my question,
but it keeps coming back on an annual basis, I guess, because it
does concern me as a 68-year-old man, and I've seen the transitions
that I'm sure you have.
By borrowing $5 trillion or whatever we owe today, have we not
led the so-called middle class that we're asked about, the average
American citizen, to expect a higher standard of living by this continuous borrowing, to expect a higher standard of living than we
can continue to maintain with the productivity of the country?
And just, you know, and you and I have seen it, but so many
young people and younger people have not.
I don't want to return us to today's recession, but I remember
when a deluxe automobile was the one that had two taillights and
two sun visors, and everything else went down from that. Yet
today, if you have a 16-year-old child that doesn't have a super
sport with air-conditioning and every possible accessory, you're depriving the child.
These are just glaring examples of what we have grow. It used
to be a house with one bathroom would certainly handle six people,
and it cost $10,000.
Chairman GREENSPAN. And it was inside.
Senator FAIRCLOTH. That was inside, and one bathroom would
adequately handle six people. Today, if you have six people, you
need six bathrooms.
Have we, because of borrowing $5 trillion, and I don't say it's
bad, I mean, the expectations for vacations and all of the things are
good, and I'm delighted that we have them, and my question is, can
we continue to afford them without going deeper in debt?
Chairman GREENSPAN. Well, Senator, what we have to do is to
view debt both in the public and private sectors, and recognize that
as our standards of living rise, and as we build up assets that invariably occur from one generation to the other, we tend to finance
various different types of purchases by borrowing.
For example, as you well know, in Japan, you usually have to
wait until you can save an adequate amount of money to buy a
home, at least that's what used to be the case, and it was considered inappropriate to borrow. It used to be that way in part in the
United States.
Now the mortgage market is an extraordinarily facile instrument
to enable you to pay off from future earnings and have assets earlier. It's obvious that the extent to which one can move up the process, so to speak, really rests on your ability to borrow other people's
savings and they're of course willing to lend them to you. And what
debt is in the private sector basically is that process.
The comparable feature in the Federal sector is when we sell our
bonds abroad, and effectively borrow foreign savings to do much
the same thing. There are clear limits to that. I think that a lot
27
of economists don't like the usual household analogy about the Federal budget, and indeed there's some differences, but if we got
fairly naive and required that everyone handle Federal finances the
way we handle our household finances, it may be naive, but it
would sure work, and it would solve a lot of the problems that our
Chairman has been terribly concerned about in his remarks today.
Senator FAIRCLOTH. I thank you.
It concerns me maybe as having lived long enough to have seen
just the vast difference in expectations, maybe I'm probably more
sensitive to it than others, but you mentioned a downpayment, just
as an aside.
When I went in the automobile business, the remnant of the
OPA, if anybody remembers that, said you had to have 50 percent
of the money down to buy an automobile, and you were under some
Federal charge not to sell a car unless the customer had 50 percent
of the money or a trade-in.
Chairman GREENSPAN. We ought to tell the next generation and
beyond that that was the Office of Price Administration.
Senator FAIRCLOTH. OPA, Office of Price Administration.
Mr, Chairman, how important is it literally that we keep manufacturing jobs in this country?
Certainly no company can afford to pay American wages, 10
times or whatever, the wage rate in Asia or Mexico, or whatever
the difference might be.
We have seen this movement of manufacturing jobs, as you and
I have discussed, the cut-and-sew industry just left the lofts of New
York in the late 1950's and 1960's and moved south.
The flat buildings that were designed for it, and today some of
the most expensive garments and best in the country are made in
little isolated communities that you would never expect them to be.
Of course we took great pride in that we had gotten rid of the
IG—International Garment Workers—or whatever, but we built
these plants and the cut-and-sew came.
Chairman GREENSPAN. That's IGWA, as I remember.
Senator FAIRCLOTH. IGWA, International Garment Workers.
Thanks. They came.
Now we are seeing all but the highest end of these cut-and-sew
simply move out to offshore.
Now, we survived before they came and I assume we'll keep on
surviving. New York didn't collapse when they left the garment district and moved south, and we'll keep going if they move to Mexico.
So how do we address the problem and how serious a problem
is it?
Chairman GREENSPAN. The first question we have to ask ourselves, which may seem an extraordinarily odd way to answer your
question, Senator, is what do we mean by manufacturing?
The reason I say that—that's a rhetorical question—is that as we
move toward this technologically-based type of economic system,
what we are finding is that the proportion of fabricated goods,
which is what historically has always been our definition of manufacturing, has become increasingly more ideas and less physical
bulk.
In the 1930's, for example, we had radios which were as large as
this desk and had vacuum tubes. Today, our little radios are this
28
size, they are far better, and they're all transistor operated. The
difference between the two are concepts. It's the invention of the
transistor and new insights on how to put materials together to do
things.
We are finding that the average weight of industrial output is
falling dramatically relative to the real value that's being produced.
As a consequence, if you actually weighed the number of tons of
physical things that we turn out, I wouldn't be surprised to find
that even though the real value of industrial output has gone up
quite significantly in the last 40 or 50 years, the actual amount of
tons has not gone up very much at all. The difference is ideas. It's
the downsizing of products. There's far more valuable manufacturing but less bulk.
The problem is that as we continue to project that, we find ourselves, for example, realizing that if we have a software product
that is 98 percent conceptual, but we put it in a CD ROM, a manufactured good, we're getting to the point where the distinction between what is manufacturing and what is not is becoming extremely fuzzy.
My own impression is that 20 years from now, the so-called
standard industrial classification, which we use, will probably no
longer capture correctly what it is we produce. So that what we
will term manufacturing 20 or 30 years from now is going to be
quite different from what it is today, and it will be difficult to say
whether a lot of jobs are factory jobs or non-factory jobs because
the average factory is not going to look like a factory today, and
certainly not the way it looked 30 years ago.
So I don't think we ought to view the issue of jobs as high-paying
factory jobs or low-paying service jobs. That distinction is rapidly
becoming obsolete, and you have to look at where is the valueadded in the economy—whether it's conceptual value-added or
whether it's physical value-added—and not be terribly concerned
whether it is a palpable physical good or whether it's a conceptual
product for as a practical purpose, for the value that is produced,
that is, meaning what it is that is conceived of as a value to human
beings or to people as consumers, whether it's a physical thing or
non-physical thing really doesn't matter all that much. The crucial
issue is what is its value-added and its value to other people, which
means what is our purchasing power. So I would very strongly
argue that this question of distinguishing factory employment,
manufacturing employment, and non-manufacturing employment is
not a useful concept.
Senator FAIRCLOTH. Thank you, sir.
The CHAIRMAN. Mr. Chairman, I just think it's important to note
something. First of all, let me make an observation.
It's based anecdotally, et cetera, but I think the economy is having some problems. I also think that it is absolutely simplistic to
say that those problems can be dealt with by the Reserve by simply
lowering interest rates.
Indeed, they may exacerbate the problem. Indeed, an economic
downturn, and just simply dropping interest rates and somehow
thinking that short-term rates by coming down are going to turn
everything around is fallacious.
29
The marketplace has become very sophisticated, right? I mean
the same computers, studies, thoughts, and young people who are
graduating are working in the marketplaces. They are giving advice to their clients to large pools of money that are available, have
the data, and they're going to respond accordingly.
Your drop of interest rates on a short term is not going to be the
answer. The Government cannot solve all these problems.
But indeed Government can do something to help exacerbating
some of the uncertainty, it would seem to me.
With that as a background, I'd like to share with you, I don't
know if you had an opportunity to read, I don't necessarily subscribe to everything, but certainly I do subscribe to some of the observations made in today's Washington Post, February 21, 1996, by
Robert J. Samuelson,
Did you have an opportunity?
Chairman GREENSPAN. Is that the same article that appeared in
Newsweek this week? I think it may be.
The CHAIRMAN. Very, very interesting.
Let me just take the time to read the first paragraph.
We are now witnessing—this is Mr. Samuelson—another outbreak of one of the most destructive tendencies in American politics, the practice of our leaders to promise phantom solutions to our
economic problems. The latest object of the compulsion is job insecurity. Yo, America. Government can't suppress it and its trying
too hard could cripple the economy's job creating capacity, Mr.
Samuelson goes on to say.
This perpetual pandering to Americans' every anxiety is a political disease that ultimately feeds poplar cynicism.
He goes on to say that, you know, here's government in Canada,
it's running around saying, I'm going to create more jobs, I'm going
to do this, I'm going to do that. You vote for me, and I've got the
magic cure.
What nonsense.
And he does make, I think it's a very balanced argument, I think
he does make some very astute observations.
Let me go to that, where he talks about the role of Government
and what it can do, the next to last paragraph.
He says, politics should focus on what Government can do, not
what it can't do. It can modestly help laid off workers, some improvements in the social safety net.
Then he goes on to quote the Kassebaum-Kennedy bill, legislation that would help fired workers keep their health insurance. The
White House has endorsed it, Congress should pass it.
But sweeping measures to prevent job loss or protect laid-off
workers are self-defeating.
It's a fact.
Maybe we've gotten so involved in our own rhetoric and the ability to want to transform our rhetoric into getting elected that I
think we have a disease up here that maybe you know those who
are espousing these things actually have come to believe them.
It's just really incredible.
Then I go back to one last thing, which I think is worthwhile
ending on.
30
And that is, someone said this, and this is in the American
Banker. "Lower budget deficits are the surest and most direct way
to increase national savings. Higher national savings would help to
reduce real interest rates further."
You know who said that?
Sure you do.
Are you being modest?
Chairman GREENSPAN. No. I agree with that.
The CHAIRMAN. You agree with that.
[Laughter.]
The CHAIRMAN. That was a quote of Chairman Greenspan.
[Laughter.]
The CHAIRMAN. And on that note, I have to say two things.
No. 1, Mr. Chairman, we thank you for coming in and speaking
to us and sharing your thoughts.
No. 2, I couldn't agree more with you, your observations, and
some of those made by Mr. Samuelson.
We had better get to the main task, which is to run and manage
the assets that the people entrust to us in a better way and to be
more candid with the American people.
We haven't had the courage to do what's right. And to really
come together and to put aside the political rhetoric that comes
from both sides.
I would hope that some of my colleagues who are working together, Democrats and Republicans, will achieve some measure of
success.
I am hopeful, I really am, that they can come to a situation
where they can put enough pressure by having a bill that can pass
both in the House and the Senate with significant bipartisan support that will bring the Administration to the table.
If we can't do that, then I think we are in for some tough times
over and above the normal business cycles that are without our
control. We will be exacerbating the problem.
Mr. Chairman, thank you for your participation.
We stand in recess.
[Whereupon, at 12:15 p.m., Wednesday, February 21, 1996, the
Committee was adjourned, subject to call of the Chair.]
[Prepared statement and additional material supplied for the
record follows:]
31
PREPARED STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
WASHINGTON, DC
FEBRUARY 21, 1996
I appreciate the opportunity to appear before this Committee to present the Federal Reserve's semiannual report on monetary policy.
The United States economy performed reasonably well in 1995. One-and-threequarter million new jobs were added to payrolls over the year, and the unemployment rate was at the lowest sustained level in 5 years. Despite the relatively high
level of resource utilization, inflation remained well contained, with the consumer
price index rising less than 3 percent—the fifth year running at 3 percent or below.
A reduction in inflation expectations, together with anticipation of significant
progress toward eliminating Federal budget deficits, was reflected in financial markets, where long-term interest rates dropped sharply and stock prices rose dramatically over the year.
This outcome was influenced in part by monetary policy actions taken by the Federal Reserve in recent years. Responding to evidence that inflationary pressures
were building, we progressively raised short-term interest rates over 1994 and early
1995. Rates nad been purposely held at quite low, stimulative levels in 1993. We
moved in 1994 to levels more consistent with sustainable growth. Our intent was
to be preemptive—to head off an incipient increase in inflationary pressures and to
forestall the emergence of imbalances that so often in the past have undermined
economic expansions.
As we entered the spring of 1995, it became increasingly evident that our policy
was likely to succeed. Although various price indexes were rising a bit more rapidly,
there were indications that pressures would not continue to intensify, and might
even reverse to a degree. Moderating overall demand growth left businesses with
excess inventories. In response, firms initiated production cutbacks to prevent serious inventory imbalances, and the growth of economic activity slowed substantially.
With inflation pressures apparently receding, the previous degree of restraint in
monetary policy was no longer deemed necessary, and the Federal Open Market
Committee consequently implemented a small reduction in reserve market pressures last July.
During the summer and early fall, aggregate demand growth strengthened. As a
result, business stocks of raw materials and finished goods appeared somewhat better aligned with sales. In sum, the economy, as hoped, appeared to have moved onto
a trajectory that could be maintained—one less steep than in 1994, when the rate
of growth was clearly unsustainable, but one that nevertheless would imply continued significant growth in employment and incomes.
Importantly, the performance of the economy seemed to be consistent with maintaining low inflation. Despite the step-up in growth and the relatively high levels
of resource utilization, measured inflation abated a little, and many of the signs
that had been pointing toward greater price pressures gradually disappeared. Expectations of both near- and longer-term inflation fell substantially over the second
half of the year, as gauged by survey results as well as by the downward movements
in longer-term interest rates. The fall in bond rates was also encouraged by improving prospects for significant progress in reducing the Federal budget deficit. The declines in actual and expected inflation meant that maintaining the existing nominal
Federal funds rate would raise real short-term interest rates, implying a slight effective firming in the stance of monetary policy. Such a shift would have been particularly inappropriate because economic growth near the end of the year seemed
to be slowing, and some FOMC members were concerned about the risks of prolonged sluggishness. Consequently, the Committee decided in December that a further reduction in the funds rate was warranted.
Information becoming available in late December and January raised additional
questions about the prospective pace of expansion. The situation was difficult to
judge, partly because economic statistics were more sparse than usual, owing mainly to the Government shutdowns. In addition, harsh weather in January disrupted
both data flows and patterns of economic activity. But several indicators—including
initial claims for unemployment insurance, purchasing managers surveys, and
consumer confidence measures—appeared to signal some softening in the economy.
Consonant with this pattern, some Reserve Bank Presidents reported that they
seemed to be detecting anecdotal indications of weakness in the expansion within
their districts with somewhat greater frequency than previously. Moreover, growth
in several of our major trading partners seemed to be lagging, which could tend to
moderate demand for exports.
32
A number of factors have prompted the recent tendency toward renewed weakness. Some are clearly quite transitory—related, for example, to bad weather or the
Federal Government shutdown. Others may be somewhat more significant, but still
temporary. The constraint on Government spending while permanent budget authorizations are being negotiated is one. Another may be a temporary reduction in
output in some industries as businesses have further adjusted inventories to disappointing sales. As I noted last July, the change in the pace of inventory investment when the economy shifts gears can be substantial. Inventory investment
surged in 1994 and into the early months of 1995, but proceeded to fall markedly
throughout the rest of the year. This has placed significant downward pressure on
output, which should lift as inventory adjustments subside. But for the moment, the
pressures remain, in the motor vehicle industry and elsewhere.
Ultimately, of course, it is the path of final demand after the temporary influences
work themselves out that determines the trajectory of the economy. There are some
factors, such as high consumer debt levels, that may be working to restrain spending. But as I shall be detailing shortly, a number of fundamentals point to an economy basically on track for sustained growth, so any weakness is likely to be temporary. Nonetheless, the Committee decided in late January that the evidence suggested sufficient risk of subpar performance going forward to warrant another slight
easing of the stance of monetary policy. Given the subdued trends in costs and
wages, the odds that such a move would boost inflation pressures seemed low.
In assessing the likely course of the economy and the appropriate stance of policy,
one question is the significance, if any, of the age of the business expansion. Some
analysts, viewing recent weakness, have observed that the expansion is approaching
the start of its sixth year and is now one of the longer peacetime spans of growth
in the past half century. Economic expansions, however, do not necessarily die of
old age. Although the factors governing each individual business cycle are not always clear, expansions usually end because serious imbalances eventually develop.
When aggregate demand exceeds the economy's potential, for example, inflationary pressures pick up. The inevitable increase in market interest rates, as inflation
expectations rise and price pressures intensify, depresses final demand. Lagging demand in turn sets off an inventory correction that frequently triggers a downturn
in the economy. As I noted, we acted in 1994 to forestall such a process. Monetary
policy began to tighten in advance of the buildup of inflationary pressures and, at
least to date, these pressures appear to have been held in check.
Capital expenditures by households and firms can also contribute significantly to
the development of cycle-ending imbalances. The level of stocks of such real assets
have effects on output very similar to those of business inventories. In typical cycles,
capital expenditures tend to grow rapidly in the early stages of recovery: Pent-up
demands coming out of a recession by consumers and businesses are satisfied by
rapid growth of spending on capital assets. There is a limit, however, on, say, how
many cars people choose to own, or how many square feet of floor space retailers
need to service customers. Spending on such assets generally tends to grow more
slowly after the pent-up demand is met. As with business inventories, the
downshifting of spending on consumer durable goods or business plant and equipment may not occur smoothly. The dynamics of expanding output and rising profit
expectations often create a degree of exuberance which, as in much of human nature, tends on occasion to excess—in this case, in the form of a temporary over-accumulation of assets. The ensuing correction in demand for such assets triggers production adjustments that can significantly mute growth for a time or even cause a
downturn if the imbalances are large enough.
The current extent of any asset overhang is difficult to determine. The growth of
demand for durables and some categories of capital goods evidently has slowed, but
the available evidence does not suggest a degree of saturation in capital assets that
would tip the economy into a downturn.
Moreover, financial conditions are likely to be generally supportive of spending.
The low level of long-term interest rates should have an especially favorable effect.
Low rates increase the affordability of housing for consumers and foster investment
in productive plant and equipment by businesses. The decline in interest rates also
has contributed to a pronounced rise in stock prices. The spread of mutual fund investments has meant that the ,gain in wealth as financial asset prices have risen
has been shared by an ever-wider segment of households. These developments
should tend to counter, in part, the depressing effects on spending of rising debt
burdens. In addition, with the condition of most financial institutions strong, lenders are likely to remain willing to extend credit to firms and households on favorable terms. We have seen some move by lenders toward tighter standards, but these
actions are a modest correction after a marked swing toward ease and should not
constrain the availability of funds to creditworthy borrowers.
33
Against this backdrop, Federal Reserve policymakers expect the most likely outcome for 1996 as a whole is further moderate growth. On the new chain-weighted
basis, the central tendency of the forecasts of Board members and Reserve Bank
Presidents is for real gross domestic product to expand 2 to 2Vi percent on a
fourthquarter to fourth-quarter basis, similar to the Administration's outlook. With
output expanding roughly in line with standard estimates of the increase in the productive capacity of the economy, the unemployment rate is expected to remain
around recent levels, as is also forecast by the Administration.
The Federal Open Market Committee expects a continuation of reasonably good
inflation performance in 1996. The success during 1995 in keeping the increase in
the consumer price index below 3 percent in the fifth year of an expansion illustrates that an extended period of growth with low inflation is possible. And most
on the Committee anticipate consumer price inflation at or somewhat below 3 percent in 1996. Although well-known biases in the CPI, as well as the more favorable
price performance of business equipment, which is not included in that index, indicate that the true rate of inflation for the whole economy would be significantly
lower than 3 percent, the Committee recognized that its expectations for inflation
do not imply that price stability has as yet been reached. Nonetheless, keeping inflation from rising significantly during economic expansions will permit a gradual
ratcheting down of inflation over the course of successive business cycles that will
eventually result in the achievement of price stability.
To emphasize its continued commitment to price stability, the Committee chose
to reaffirm the relatively low ranges for money growth in 1996 that it had selected
on a provisional basis last July. These ranges are identical to those employed in
1995-—1 to 5 percent for M2 and 2 to 6 percent for M3. The Committee also
reaffirmed the 3 to 7 percent range for debt. Patterns of money growth and velocity
have been erratic in recent years, but should the monetary aggregates at some point
re-establish their previous trend relationships with nominal income, average growth
near the center of these ranges should be consistent with the eventual achievement
of price stability.
Determining whether further changes to the stance of monetary policy will be necessary in the months ahead to foster progress toward our goals will be a continuing
challenge. In formulating monetary policy, while we have in mind a forecast of the
most likely outcome, we must also evaluate the consequences of other possible developments. Thus, it is sometimes the case that we take out monetary policy "insurance" when we perceive an imbalance in the net costs or benefits of coming out on
one side or the other of the most probable scenario.
For example, in our most recent actions, we saw a decline in the Federal funds
rate as not increasing inflationary risks unacceptably, while addressing the downside risks to the most likely forecast. In assessing the costs and benefits of adjustments to the stance of policy, Members of the Committee recognize that policy affects the economy and inflation with a lag and thus needs to be formulated with
a focus on the future. Over the past year, we have kept firmly in mind our goals
of containing inflation in the near term and moving over time toward price stability,
and they will continue to guide us in the period ahead.
Structural forces may be assisting us in this regard. Increases in producers' costs
and in output prices proved to be a little lower last year than many had anticipated.
While it is too soon to draw any definitive conclusions, this experience provides
some tentative evidence that basic, ongoing changes in the structure of the economy
may be helping to hold down price pressures. These changes stem from the introduction of new technologies into a wide variety of production processes throughout the
economy. Successive generations of these new technologies are being quickly embodied in the nation's capital stock and older technologies are, at a somewhat slower
pace, being phased out. As a consequence, the nation's capital stock is turning over
at an increasingly rapid pace, not primarily because of physical deterioration but
reflecting technological and economic obsolescence.
The more rapid advance of information and communications technology and the
associated acceleration in the turnover of the capital stock are being mirrored in a
brisk restructuring of firms. In line with their adoption of new organizational structures and technologies, many enterprises are finding that their needs for various
forms of labor are evolving just as quickly. In some cases, the job skills that were
adequate only 5 years ago are no longer as relevant. Partly for that reason, most
corporate restructurings have involved a significant number of permanent dismissals.
The phenomenon of restructuring can be especially unfortunate for those workers
directly caught up in the process. Many dedicated, long-term workers in all types
of American businesses—including long established, stable, and profitable firms—
have been let go.
34
An important consequence of the layoffs and dismissals associated with restructuring activity is a significant and widely reported increase in the sense of job insecurity. Concern about employment has been manifested in unusually low levels of
indicators of labor unrest. Work stoppages, for example, were at a 50-year low last
year. And contract negotiators for labor unions have sought to obtain greater job security for their members through very long term labor contracts, including some
with virtually unprecedented lengths of 5 or 6 years.
Of particular relevance to the inflation outlook, the sense of job insecurity is having a pronounced effect in damping labor costs. For example, the increase in the employment cost index for compensation in the private sector, which includes both
wage and salary payments and benefit costs, slowed further in 1995, to 2% percent,
despite labor market conditions that, by historical standards, were fairly tight. With
productivity also expanding, the increase in unit labor costs was even Tower. In
manufacturing, such costs have actually been falling in recent years. While the link
between labor costs, which account for two-thirds of consolidated business sector
costs, and prices is not rigid these very limited increases in labor expenses nonetheless constitute a significant restraint on inflation.
In addition to its effect on labor costs, the more rapid pace of technological change
is reducing business costs through other channels. Initially most important, the
downsizing of products resulting from semiconductor technologies, together with the
increasing proportion of national output accounted for by high-tech products, has reduced costs of transporting the average unit of GDP. Quite simply, small products
can be moved more quickly and at lower cost.
More recently, dramatic advances in telecommunications technologies have lowered the costs of production for a variety of products by slashing further the information component of those costs. Increasingly, the physical distance between communications endpoints is becoming less relevant in determining the difficulty and
cost of transporting information. Once fiber-optic and satellite technologies are in
place, the added resource cost of another 200 or 2,000 miles is often quite trivial.
As a consequence, the movement of inputs and outputs across geographic distance
is progressively becoming a smaller component of overall business expenses, particularly as intellectual—and therefore immaterial—products become proportionately
more important in the economy. This enables an average business firm to broaden
markets and sales far beyond its original domicile. Accordingly, fixed costs are
spread more widely. For the world market as a whole, the specialization of labor
is enhanced to the benefit of standards of hying of all market participants.
To be sure, advancing technology, with its profound implications for the nature
of the economy, is nothing new, and the pace of improvement has never been even.
But it is possible that we may be in the midst of a quickening of the process. It
is possible that the rate at which earlier computer technologies are being applied
to new production processes is still increasing. This would explain the recent decline
in the growth of unit costs. Nonetheless, we have to be careful in projecting a further acceleration in the application of technology indefinitely into the future, as
would be required for technological change to depress the rate of increase in unit
business costs even more. Similarly, suppressed wage cost growth as a consequence
of job insecurity can be carried only so far. At some point in the future, the tradeoff
of subdued wage growth for job security has to come to an end. While it is difficult
to judge the time frame on such adjustments, the risks to cost and price inflation
going forward are not entirely skewed to the downside, especially with the economy
so recently operating at high levels of resource utilization.
In light of the quickened pace of technological change, the question arises whether
the U.S. economy can expand more rapidly on an ongoing basis than the 2 to 2^4
percent range for measured GDP forecasted for 1996 by Government agencies and
most private forecasters without adding to inflationary pressures, which in turn
would undermine growth. The Federal Reserve would certainly welcome faster
growth—provided that it is sustainable.
The particular rate of maximum sustainable growth in an economy as complex
and ever-changing as ours is difficult to pin down. Fortunately, the Federal Reserve
does not need to have a firm judgment on such an estimate, for persistent deviations
of actual growth from that of capacity potential will soon send signals that a policy
adjustment is needed. Should the nation's true growth potential exceed actual
growth, for example, the disparity and lessened strain would be signaled in shorter
lead times on the delivery of materials, declining overtime, and ebbing inflationary
pressures. Conversely, actual growth in excess of the economy s true potential would
soon result in tightened markets and other distortions which, as history amply demonstrates, would propel the economy into recession. Consequently, we must be cautious in reaching conclusions that growth in productivity and hence of potential output has as yet risen to match the evident step-up in technological advance.
35
The hypothesis that advancing technology has enhanced productivity growth
would be more persuasive if national data on productivity increases showed a distinct improvement. To a degree, the lack of any marked pickup may be a shortcoming of the statistics rather than a refutation of the hypothesis. Faulty data could
be arising in part because business purchases are increasingly concentrated in items
that are expensed but which market prices suggest should be capitalized. Growing
disparities between book capital and its valuation in equity markets may in part
reflect widening effects of this misclassification. If this problem is indeed growing,
we may be underestimating the growth of our GDP and productivity.
This classification problem compounds other difficulties with measuring output in
the increasingly important service sector. The output of services—and the productivity of labor in that sector—is particularly hard to measure. In part, the statisticians
have simply thrown up their hands, gauging output in some service industries just
in terms of labor input. By construction, such a procedure will miss improvements
in productivity caused by other inputs. In manufacturing, where output is more tangible and therefore easier to assess, measured productivity has been rising briskly,
suggesting that technological advances are indeed having some effect.
Nonetheless, there is still a nagging inconsistency: The evidence of significant
restructurings and improvements in technology and real costs within business establishments does not seem to be fully reflected in our national productivity measurements. It is possible that some of the frenetic pace of business restructuring is
mere wheel spinning—changing production inputs without increasing output—rather than real increases in productivity- One cause of the wheel spinning, if that is
what it is, may be that it takes some time for firms to adapt in such a way that
major new technology is translated into increased output.
In an intriguing parallel, electric motors in the late 19th century were well-known
as a technology, but were initially integrated into production systems that were designed for steam-driven power plants. It wasn't until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, that firms
were able to take full advantage of the synergies implicit in the electric dynamo,
thus achieving dramatic productivity increases. Analogously, existing production
systems today to some degree cannot be integrated easily with new information and
communication technologies. Some existing equipment is not capable of control by
computer, for example. Thus, it may be that the full advantage of even the current
generation of information and communication equipment will be exploited over a
span of quite a few years and only after a considerably updated stock of physical
capital has been put in place.
While the Federal Reserve does not need to establish targets-—and definitely not
limits—for long-term growth, it is helpful in coming to shorter-run policy insights
to have some judgments about the growth in potential GDP in the past and what
it is likely to be in the future. Judgments of potential, quite naturally, are based
on experience. Through the four quarters of 1994, for example, real GDP, pressed
by strong demand, rose 3¥s percent. If that were the true rate of increase in the
economy's long-run potential, then we would have expected no change in rates ol
resource utilization. Instead, industrial capacity utilization rose nearly 3 percentage
points and the unemployment rate dropped a percentage point. Moreover, we began
to see signs of strains on facilities; deliveries of materials slowed appreciably and
factory overtime rose sharply. These signs of developing pressures on capacity suggest that the growth rate in economic potential in 1994 was below 3V2 percent. Ir
general, as we get close to presumed potential, we are required to step up our surveillance for inflationary pressures.
Estimates of potential growth necessarily recognize that expansion in the econom;
over time comes essentially from three factors—growth in population, increases ir
labor force participation, and gains in average labor productivity. Of these factors
the first two are determined basically by demographic and social factors and seen
unlikely to change dramatically over the next few years. Thus, the source of an;
significant pickup of output growth would need to be a more rapid pace of productiv
ity growth. Here, the uncertainty of the pace of conversion of rapid technological ad
vance into productivity gains is crucial to the determination.
To be fully effective in achieving potential productivity improvements, techno
logical innovations also require a considerable amount of human investment on th<
part of workers who have to deal with these devices on a day-to-day basis. On thii
score, we still may not have progressed very far. Many workers still possess onl;
rudimentary skills in manipulating advanced information technology. In these cir
cumstances, firms and employees alike need to recognize that obtaining the poten
tial rewards of the new technologies in the years ahead will require a renewed com
mitment to effective education and training, especially on-the-job training. This is
especially the case if we are to prevent the disruptions to lives and the nation's ca
36
pacity to produce that arise from mismatches between jobs and workers. We need
to improve the preparation for the job market our schools do, but even better schools
are unlikely to be able to provide adequate skills to support a lifetime of work. Indeed, the need to ensure that our labor force has the ongoing education and training
necessary to compete in an increasingly sophisticated world economy is a critical
task for the years ahead.
Our Nation faces many important and difficult challenges in economic policy.
Nonetheless, we have made significant and fundamental gains in macroeconomic
performance in recent years that enhance the prospects for maximum sustainable
economic growth. Inflation, as measured by the consumer price index, has been
gradually reduced from a peak of more than 13 percent in 1979 to 2Va percent last
year. Lower rates of inflation have brought a variety of benefits to the economy, including lower long-term interest rates, a sense of greater economic stability, an improved environment for household and business planning, and more robust investment in capital expenditures. The years ahead should see further progress against
inflation and the eventual achievement.of price stability.
We have also made considerable progress on the fiscal front. Over the past 10
years and especially since 1993, our elected political leaders, through sometimes
prolonged and even painful negotiations, have been successful in reaching several
agreements that have significantly narrowed the budget deficit. But more remains
to be done. As I have emphasized many times, lower budget deficits are the surest
and most direct way to increase national saving. Higher national saving would help
to reduce real interest rates further, promoting more rapid accumulation of productive capital embodying recent technological advances. Agreement is widely shared
that attaining a higher national saving rate quite soon is crucial, particularly in
view of the anticipated shift in the Nation's demographics in the first few decades
of the next century.
Lower inflation and reduced budget deficits will by no means solve all of the economic problems we face. But the achievement of price stability and Federal budget
balance or surplus will provide the best possible macroeconomic climate in which
the Nation can address other economic challenges.
37
For use at 2:00 p.m., E.S.T.
Tuesday
„..
February 20,1996
Board of Governors of the Federal Reserve System
Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 20,1996
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C.. February 20, 1996
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the
Full Employment ana Balanced Growth Act ot 1978.
Sincerely.
Alan Greenspan, Chairman
\J
Table of Contents
Page
Section 1:
Monetary Policy and the Economic Outlook
1
Section 2:
The Performance of the Economy
5
Section 3:
Financial. Credit, and Monetary Developments
38
Section 1: Monetary Policy and the Economic Outlook
The economy performed well in 1995. Moderate
economic growth kept the unemployment rate ai a
relatively low level, and inflation, as measured by the
change in the consumer price index, was in a range
of 3 parent or less for the fifth straight year, the
first such occurrence in thirty years. This desirable
combination of low inflation and tow unemployment provided further substantiation of a fundamental
point that the Board has made in past reports—
namely, that there is no trade-off in the long run
between the monetary policy goats of maximum
employment and stable prices set in the Federal
Reserve Act. Indeed, it is by fostering price stability
that a central bank can mate its greatest contribution to the efficient operation and overall ability of the
nation's economy to create jobs and advance living
standards over time.
As economic prospects changed in 1995 and early
1996. the Federal Reserve found that promoting full
employment and price stability required several
adjustments in its policy settings. Last February,
the economy still seemed to be pressing against its
potential, and prices were tending to accelerate. To
reduce the risk that inflation might mount, with the
attendant threat to continued economic expansion, the
Federal Open Market Committee raised the federal
funds rate an additional 1A percentage point, to 6 percent. Inflation did. in fact, pick up in the first pan
of 1995. but data released during the spring indicated that price pressures were receding, and the
Committee reduced the federal funds rate 'A percentage point at its July meeting. Through the remainder of the year, inflation was even more favorable
than had been anticipated in July, and inflation
expectations decreased. In addition, an apparent
slowing of economic activity late in the year further
reduced the potential for inflationary pressures going
forward. To forestall an undue increase in real interest
rates as inflation slowed, and to guard against the
possibility of unnecessary slack developing in the
economy, the Committee eased reserve conditions in
December and again at the end of January 1996.
reducing the federal funds rate by a total of Vi percentage point.
Monetary policy easings since mid-1995 contributed to declines in short-term market interest rates,
which by mid-February were down 1 to 2 percentage
points from the highs reached early last year.
Intermediate- and Jong-term rates also moved sharply
lower last year as the risks of rising inflation receded
and as prospects for substantial progress in reducing
the federal budget deficit seemed to improve. As of
mid-February, these rates were t*i to 2¥* percentage
points below iheir levels at the beginning of 1995.
Helped by lower interest rates and favorable earnings,
major equity price indexes rose 30 to 40 percent last
year and have moved still higher in early 1996. These
financial developments reduced the cost to businesses
of financing investment and to households of buying
homes and consumer durables: households were also
aided by substantial additions to financial wealth from
rising bond and equity prices.
The foreign exchange value of the US. dollar,
measured in terms of the currencies of the other G-10
countries, fell about 5 percent, on net, during 1995.
The dollar appreciated substantially from the summer
on and has advanced further on balance in 1996 but
not enough to offset a sharp decline that look place in
the first four months of 1995. Interest rates fell in
most other foreign industrial countries, which also
were experiencing slower economic growth, but by
less than the decline in rates in the United States.
Early in 1995. the dollar also was pulled down by tne
reactions to the crisis in Mexico, but the negative
influence on the dollar from this source appeared to
lessen as Mexican financial markets stabilized over
the balance of the year. Inflation rates in major industrial countries held fairly steady in I99S at levels
somewhat lower than those prevailing in this country:
thus, depreciation of the dollar in real terms against
other G-10 currencies was less than the depreciation
in nominal terms. Against the currencies of a broader
group of U.S. trading partners, the dollar's real depreciation in 1995 was even smaller.
Borrowing and spending in the United States was
facilitated not only by lower interest rates but also by
favorable supply conditions in credit markets. Spreads
between interest rates on securities issued by private
firms and those issued by the Treasury generally
remained narrow, and banks continued to ease terms
and qualifying standards on loans to businesses and
households through most of the year. Total debt of
domestic nonfinancial sectors grew slightly more than
5 percent last year, just above the midpoint of the
Committee's 3 percent to 7 percent monitoring range.
Rapid growth of business spending on inventories and
fixed capital early in the year boosted the credit
demands of firms, despite strong corporate profiis.
39
Borrowing was also lifted by the financing of heavy
net retirements of equity shares in connection with
mergers and share repurchase programs. Growth of
household debt slowed a bit but remained brisk; consumer credit continued to grow quite rapidly. Federal
debt growth was relatively modesi for a second year.
influenced by a lower deficit and constraints on normal seasonal borrowing at year-end owing to the
federal debt ceiling. Outstanding state and local government debt ran off more rapidly than in 1994.
Commercial banks and thrift institutions again
financed a large portion of the borrowing last yean
their share of total outstanding debt of nonfederal
sectors edged up in 1994 and 1995 after declining for
more than fifteen years. The growth in depository
credit was funded primarily with deposits, boosting
the expansion of the broad monetary aggregates. M3
grew 6 percent, at the upper end of its 2 percent to
6 percent annual range established by ihe Committee
at midyear. Depositories relied heavily on largedenomination time deposits for funding, but retail
deposits also showed gains as declining market interest rates made these deposits more attractive to retail
customers. M2 advanced 4'/4 percent, putting it in the
upper portion of its 1 percent to 5 percent annual
range. The expansion of M2 was the largest in six
years, and its velocity was unchanged after increasing
during the previous three years. Nonetheless, growth
of the aggregate was erratic through the year, and die
stability of its relationship to nominal spending
remains in doubt. Ml declined last year for the first
time since the beginning of the official series in 1959.
An increasing number of banks introduced retail
sweep accounts, which shift money from interestbearing checkable accounts to savings accounts in
order to reduce banks' reserve requirements. Without
these shifts. Ml would have risen in 1995. although
slowly.
Economic Projections for 1996
The relatively small amount of information that is
available for 1996 indicates that the economy has
started off slowly early [his year, but fundamental
condiiions appear to be more encouraging than
recent data might seem to suggest. Bad weather in
a number of regions and the partial shutdown of
ihe federal government have been disruptive to the
economy this winter. These influences seem likely to
leave only temporary impnnts on spending and
production, creating volatility in incoming data over
ine near term while having liitle effect on underlying trends.
The economy also has been stowed by production
adjustments in some industries in which efforts are
being made to bring stocks into better alignment with
sales. Inventory accumulation apparently slowed in
the fourth quarter, and with financial conditions
remaining broadly conducive to growth of private
final sales, inventory problems of a degree that might
prompt a sustained period of widespread production
adjustments do not seem likely. In the household
sector, the accumulation of financial wealth brought
on by the rise in the stock market has provided the
wherewithal for increases in consumption greater than
would otherwise have been expected—countering the
potential negative influences of mote burdensome
levels of consumer debt. At the same time, reductions
in mortgage interest rates have put the cost of financing a house within reach of a greater number of
families and made it possible for a significant number
of households to ease their debt-service burdens by
refinancing their homes at lower rates. In the business
sector, reductions in the cosi of financing investment
in new capital are providing some offset to the slowing tendencies that normally accompany a cyclical
moderation in the growth of aggregate output. In
addition, business investment in high-tech equipment
likely will continue to be boosted not only by the
ready availability of finance but also by technological
upgrades and ongoing steep declines in the effective
price of real computing power.
In the US. external sector, growih of exports
strengthened after some sluggishness early in 1995.
Expansion of income abroad seems likely to pick up
this year, although the prospects still are subject to
some downside risk. Imports, meanwhile, have
slowed from the very rapid pace seen earlier in the
expansion. On net. the underlying trends in exports
and impons of goods and services appear to be essentially canceling out in terms of their combined contribution to growth of US. real GDP.
Against the backdrop of these developments, members of the Board of Governors and the Reserve Bank
Presidents, ail of whom participate in the deliberations of the Federal Open Market Committee, anticipate that the US. economy will grow moderately,
with little change in underlying inflation trends. The
central tendency of the participants' forecasts of real
GDP growth ranges from 2 percent to 2W percent,
measured as the cumulative change in output from the
final quarter of 1995 to the final quarter of 1996.
The rise in activity is expected to be accompanied
by further expansion of job opportunities and little
change, on net. in the civilian unemployment rate
over the four quarters of 1996. The central tendency
40
Economic Projections for 1996
Percent
Federal Reserve Governors
and Reserve Bank Presidents
Administration
Indicator
Range
Central
Tendency
4-5
4V4-4V4
Change, fourth quarter
to fourth quartet
Nominal GDP
Real GDP2
Consumer price index3
2-2%
23/4-3
5.1
2.2
3.1
Average level, fourth quarter
Civilian unemployment rate
5Vz-6
1. Change Irom average lw fourth quarter ot 1995 to average tor fourth quarter d 1996.
5.7"
3. All urban consumers.
4. Annual average.
2. Chain-weighted
of the unemployment raie forecasts for the fourth
quarter of 1996 is a range of 5>/i percent 10 5W percent, compared with an average of 5.6 perceru in the
final quarter of 1995. The Committee's forecasts of
economic growth and unemployment are quite similar
to those of the Administratioa
The central tendency of the Governors' and Bank
Presidents' forecasts of she rise in the consumer price
index over the four quarters of 1996 is a range of
2Ki percent to 3 percem. a shade to the high side of
the actual outcome of 1995. At this early point in
1996. wiih grain stocks exceptionally tight, there is
some risk that food price increases at retail could be
larger than those of recent years, especially if crop
production should remain subpar again this year: and.
even though recent upward pressures on energy prices
should diminish with the return of normal weather,
another year of declining prices cannot be taken as a
given. Nonetheless, the experience with inflation at
high levels of resource utilization was favorable in
1995. and with businesses still tightly focused on cost
control and efficiency gain, broad tendencies toward
increased rates of price increase are not anticipated.
The Administration forecast of inflation is higher than
the forecasts of the Federal Reserve officials, but the
difference is not significant, given the uncertainties of
forecasting.
Price increases like those being forecast for the
coming year would leave inflation no higher than it
was in the first year or so of the current economic
expansion, with the rate of increase holding appreciably below the average rate seen during the expansion
of the 1980s. Although the Federal Reserve's longrun goal of restoring price stability has not yet been
achieved, the capping of inflation and its diminution
over recent business cycles is a clear indication of the
substantial progress that has been made to date.
Money and Debt Ranges for 1996
The Committee's intention to make further
progress over rime toward price stability formed the
basis for the selection of the growth ranges for the
monetary aggregates in 1996. In reaffirming the
ranges that were adopted on a provisional basis in
July, the Committee noted that it viewed them as
benchmarks for what would be expected under conditions of reasonable price stability and historical velocity behavior. The Committee set the range for M2 at
1 percent to 5 percent and the range for M3 at
2 percent to 6 percent.
Given its expectations for inflation in 1996. the
Committee anticipates that nominal GDP will grow
somewhat faster this year than would be the case if
the economy already were at price stability. If velocities of the aggregates were to exhibit roughly normal
behavior this year and nominal income were to
41
Ranges for Growth of Monetary and Debt Aggregates
Percent
Aggregate
1994
1995
1996
M2
1-5
1-5
1-5
MS
0-4
2-6'
2-6
4-8
3-7
3-7
Note. Chang* trom average 1or fourth quarter ot preceding year to average (or fourth quarter of year indicated.
1. Revised at July 1995 FOMC meeting.
2. Monitoring range tor debt of domestic nonfinanCtal
eectore
expand as anticipated by the Committee, M2 and M3
might grow near the upper ends of their ranges. In
assessing the possible outcomes, the Committee noted
that considerable uncertainty remains about the usefulness of the monetary aggregates in guiding the
pursuit of its macroeconomic objectives. Although
the monetary aggregates have been behaving more in
line with historical patterns ihan was the case earlier
in the decade, the effects of financial innovation and
deregulation over the years have raised questions
about the stability of the relationships between the
aggregates and nominal GDP that nave yet to be
resolved
The Committee also reaffirmed the 3 percent to
7 percent growth range for debt. Although there are
indications that lenders may no longer be easing
terms and conditions for granting credit to businesses
and households, the Committee anticipated that credit
supplies would remain ample and that debt would
grow at about the same pace as nominal GDP. Such
increases would be consistent with containing inflation and promoting sustainable growth.
42
Section 2: The Performance of the Economy
Measured in terms of the chain-type indexes thai
are now being emphasized by the Buieau of Economic Analysis, growth of real GDP averaged
slightly less than IVi percent at an annual rate
over the firsi three quarters of 1995 after a gain of
3V4 percent in 1994. The rise in aggregate output this
past year was accompanied by an increase in payroll
employment of IV* million, and the unemployment
rate, after having fallen sharply in 1994, held fairiy
steady over the course of ] 995, keeping to a range of
about 5Vi percent to 53/* percent. Consumer prices, as
measured by the CPI for all items, rase 2V* percent
over the four quarters of 1995, an increase that was
virtually the same as those of the two previous years.
Growth of output during die past year was slowed
in pan by the actions of businesses to reduce the pace
of inventory accumulation afiera burst of stockpiling
in 1994. Final sales—a measure of current output
thai does not end up in inventories—rose at an average rate of 2 percent over the first three quarters of
1995 after an increase of 3 percent over the four
quarters of 1994. The slowing of final sales was
largely a reflection of a downshifting in growth of
the real outlays of households and businesses, from
elevated rales of increase in 1994 to rates that were
more sustainable. Real government outlays for consumption and investment edged down slightly, on net,
during the firet three quarters of 1995. Increases in
real exports and real imports of goods and services
were smaller than those of 1994; their combined
contribution to GDP growth in the first three quaners
was slightly negative.
Change in Real GDP
Percent annual rate
7990
1991
1992
1993
1994
1995
The Household Sector
Real personal consumption expenditures rose at an
annual rate of about 2V* percent over the first three
quaners of 1995 after having risen slightly more than
3 percent over Ihe four quaners of 1994. Available
data suggest thai growth of real outlays slowed
further in the fourth quarter. The reduced rate of rise
in consumption spending this past year came against
the backdrop of moderate gains in employment and
income. The financial wealth of households surged,
but impetus to spending from this source evidently
was countered by other influences, such as increases
in debt burdens among some households and an
apparent rise, according to survey data, in consumers' concerns about job security.
Real consumer expenditures for durable goods
increased at an annual rate of 2V* percent over the
first three quaners of 1995, a slower rate of rise than
in other recent years. Consumer expenditures for
motor vehicles declined slightly, on net. over the first
three quarters after moving up nearly 20 percent over
the three previous years: in the fourth quaner. unit
sales of cars and light trucks, a key indicator of real
outlays for vehicles, were down slightly from Iheir
third-quaner pace. Incentive programs that provided
price concessions of one sort or another to buyers
probably gave some lift to sales in 1995. However,
"pent-up" demand, which had helped to boost sales
earlier in the expansion, probably was no longer an
important factor. Recent sales data do not seem to
point to any big shifts in demand for vehicles around
the turn of the year The average rate of sales of cars
and light trucks in December and January was a touch
above the average for 1995 as a whole.
Real outlays for durable goods other than motor
vehicles continued to rise at a brisk pace in 1995. but
not so rapidly as in other recent years. Spending for
furniture and household equipment hit a temporary
lull in the first part of 1995. but picked up again over
the next two quaners. lifted in pan by a rebound
in construction of new houses. Founti-quarter data on
retail sales seem to point to a funher sizable increase
in outlays for household durables: according to most
anecdotal accounts, spending for home computers and
other electronic gear, which has been surging in recent
years, continued to move up rapidly through the latter
pan of 1995.
Consumer expenditures for nondurables increased
at an annual rate of atoul 1 Vy percent, in real terms.
43
over the first three quarters of 1995, a little less than
the average of the previous ten years and considerably
less than in 1994. The growth of real expenditures on
apparel slowed sharply after three years of sizable
advances. In the fourth quarter, real outlays for nondurables appear to have been lackluster.
Real expenditures for services—which account for
more than half of total consumer outlays—increased
at an annual rate of about 23/* percent over the first
three quarters of 1995. moderately faster than in either
1993 or 1994. After declining in 1994. outlays for
energy services increased sharply over the first three
quarters of 1995: The unusually mild weather of late
1994 gave way, first, to more normal winter conditions in early 1995 and. later on, to hot summer
weather that lifted fuel requirements for cooling.
Spending gains for other categories of services proceeded at an annual rate of about 2V« percent over the
first three quarters of 1995, about die same rate of rise
as in the two previous years.
Real disposable persona! income rose at an average
annual rate of about 2Vi percent over the first three
quarters of 1995- a gain that was about inline with the
previous year's increase. Monihly data through
November suggest that growth of real income may
have picked up a little in the fourth quarter Nominal
personal income appears to have increased slightly
faster in 1995 ihan it did in 1994, and growth of
nominal disposable income, which excludes income
taxes, apparently held close to its 1994 pace. Inflation
continued to take only a moderate bile from increases
in nominal receipts: The chain-type price index for
personal consumption expenditures rose at an annual
rate of 2lh percent over the first ihree quarters of
Change in Real Income and Consumption
Percent, annual rale
Q Disposable personal income
R Personal consumption expenditures
1990
1991
1992
1993
1994
1995
1995. matching, almost exactly, the increases in each
of the two previous years.
After little change during 1994, the real value of
household wealth surged in 1995. The value of assets
was boosted substantially by huge increases in the
prices of stocks and bonds. Liabilities continued to
rise fairly rapidly but at a rate well below the rate of
increase in household assets; rapid growth of consumer credit was again the most notable feature on
the liability side. Behind these aggregate measures of
household assets and liabilities was some wide variation in the circumstances of individual householdsAppreciation of share prices and the rally in the bond
market provided a substantial boost to the wealth of
households holding large amounts of those assets.
However, households holding few such assets benefited little from the rally in securities prices, and some
of these households began to experience greater financial pressure in 1995. Debts taken on earlier proved to
be difficult to repay in some instances, and a rising
number of households saw their loans fall into delinquency. Overall, however, the incidence of financial
stress among households appears to have been limited, as sustained increases in persona! income helped
lo facilitate timely repayment of obligations.
Consumers maintained relatively upbeat perceptions of current and future economic conditions during 1995. The measure of consumer confidence that is
prepared by the Conference Board held fairly sieady
at a high level. The index of consumer sentiment that
is compiled by the University of Michigan Survey
Research Center edged down a little, on net. from the
end of 1994 to the end of 1995. but its level also
remained relatively high. By contrast, some survey
questions dealing specifically with perceptions of
labor market conditions pointed to increased concerns
about job prospects during the year; although employment continued to rise in the aggregate, announcements of job cuts by some major corporations may
have rekindled consumers' anxieties about job security. In January of this year, consumer assessments of
labor market conditions softened further, and the
broader indexes of sentiment also declined. The January levels of the indexes were on the low side of their
averages oi" the past couple of years but were well
above levels that were reported through most of the
first three years of the expansion.
Consumers tended to save a slightly higher proportion of their income in 1995 than they had in 1994.
Large increases in financial wealth usually cause
households 10 spend a greater share of their current
income, thereby reducing the share of income that is
44
saved. However, rising debt burdens and increased
nervousness about job prospects would work in the
opposite direction, and these influences may have
offset the effect of increases in wealth. Some households also may have started focusing more intently on
saving for retirement, especially in light of increased
political debate about curbing the growth of entitle;
ments provided under government programs. Nonetheless, the personal saving rate for all of 1995, while
moving up a little, remained in a range that was
relatively low by historical standards.
Residential investment fell in the first half of 1995
but turned up in the third quarter. Both the downswing in the first half and the subsequent rebound
after midyear appear to have been shaped, at least in a
rough way, by swings in mortgage interest rates.
Although housing activity had been slow to respond
to increases in mortgage interest rates through much
of 1994. sizable declines in sales of new and existing
homes started to show up toward the end of that year,
and by early 1995. permits and starts also were dropping. However, the deciine in activity proved to be
relatively short and mild. By March, mortgage interest rates already were down appreciably from the
peaks of late 1994. and midway through the second
quarter, most indicators of housing activity were starting to rebound. Sales of new homes surged to especially high levels during the summer, and permits and
starts of single-family units rose appreciably. In the
autumn, sales retreated from their midyear peaks.
Starts also slipped back somewhat during the autumn,
but permits held firm.
The intra-year swings in the various housing indicators left the annual totals for these indicators at
Private Housing Starts
Millions ol units, annual rale
Quarterly average
1.5
0-5
1989
1991
1993
Construction of multifamily units, after taking a
notable step toward recovery in 1994, rose only moderately further in 1995. Over the first eleven months
of 1995. starts of multifamily units amounted to
280.000 at an annual rate, compared with about
260.000 the previous year and a low of 162,000 in
1993. Financing for the construction of new multifamily projects appeared to be readily available this past
year. However, the national vacancy rate for multifamily rental units, while down from the peaks of a
few years ago. remained relatively high, and increases
in rents were not of a magnitude to provide much
incentive for the construction of new units.
The Business Sector
Most indicators of business activity remained
favorable in 1995. but strength was less widespread
than it had been in 1994. and growth overall was less
robust. The output of all nonfarm businesses rose at
an annual rate of slightly less than 2 percent over the
first three quarters of 1995. after a gain of 4 percent in
1991—a pace that could not have been sustained
given already high operating levels. Inventory
problems cropped up in some lines of manufacturing and trade in 1995 and prompted production
adjustments. Scattered structural problems were
apparem as well, especially in pans of retail trade in
which intense competition for market share caused
financial losses and eventual bankruptcy for some
enterprises. More generally, however, business profits
remained high in 1995. as firms continued to
emphasize strategies that have served them well
throughout the 1990s—most notably, tight control
over costs and rapid adoption of new technologies,
achieved by way of heavy investment in high-tech
equipmera.
1995
Note. Data points for 199S:Q4 ate the averages (or October
and November.
fairly elevated levels. The average pace of sales of
existing homes over the first eleven months of 1995
was well above the average for the 1980s, even after
adjusting for increases in the stock of houses. Starts
and sales of new single-family dwellings in 1995
were about one-tenth higher than their averages for
the 1980s. So far in the 1990s, demographic influences have been less supportive of housing activity
than in the 1980s, as the rate of household formation
has lagged—in part because many young adults have
delayed setting up their own domiciles. However.
offsetting impetus to demand has come from the
improved affordability of housing, brought about in
particular by declines in mortgage interest rates.
In total, real business fixed investment increased at
an annual rate of 8 percent over the first three quarters
45
Change in Real Business Fixed Investment
PwoMit, annual rab
D Structures
Producers' durable
equipment
20
10
10
20
1990
1991
1992
1993
1994
1995
of 1995 after a gain of 10 percent in 1994. Growth in
business spending for equipment continued to outpace the growth of investment in structures, even
though the latter scored its largest gain of the past
several years. On a quanerly basis, investment
remained very strong through the first quarter of
1995. After slowing sharply in the spring, it then
picked up somewhat in the third quarter. Fragmentary
data for the fourth quarter suggest that investment in
plant and equipment recorded a gain of at least moderate size in that period.
Businesses continued to invest heavily in computers in 1995. In real terms, these expenditures rose at
an annual rate of nearly 30 percent over the first three
quarters of the year, an increase that was even more
rapid than that of 1994. Excluding computers, real
investment outlays increased less rapidly, on balance,
than in 1994. and growth after the first quaner was
modest, on net. In the equipment category, outlays for
information-processing equipment other than computers moved up at an annual rate of about 13 percent in
the first half of 1995 but fell back a little in ihe ihird
quaner. Spending for industrial equipment followed
a roughly similar patiem. with a small third-quarter
decline coming on the heels of large gains in the first
half of the year. Real outlays for transportation equipment declined in the second quaner but rebounded in
[he third. Real investmem in nonresideraial structures
moved up in each of the first three quarters of f 995. ai
an annual rate of more than 6 percent, on average,
after a gain of 3'/2 percent during 1994: the most
recent year brought increased construction of most
types of nonresidential buildings.
In the industrial sector, elevated levels of investment in equipment and structures in 1995 led to a
gain of about 4 percent in industrial capacity. However, in a turnabout from ihe outcome of the previous
year, output of the industrial sector rose considerably
less rapidly than capacity: A gain of 1 >/i percent in
total industrial production over the four quarters of
1995 was a sharp slowdown from a 1994 rise of more
than 6Vi percent. Production of consumer goods followed a choppy pattern during 1995 and rose less
than Va percent over the year as a whole, the smallest
annual increase of the current expansion. Ire output
of business equipment advanced in e&h quaner. but a
cumulative gain of 4Vi petcem for this category was
smaller than the increases of other recent years. Production of materials faltered temporarily in the second quarter, but production gains resumed thereafter.
leading to a rise of about 2V* percent over the four
quarters of ihe year.
Industrial Production
Index, 1987 - 100
125
120
115
110
105
j
1990
1991
1992
1993
1994
t
1995
100
1996
With capacity expanding rapidly and production
growth slowing, the rate of capacity utilization in
industry turned down sharply in 1995. backing away
from The high operating rates of late 1994. As of this
past December, the utilization rate in manufacturing
was about Vi percentage point above its long-term
averag;. In January of this year, utilization rates fell
noticeably: Vehicle producers reduced assembly rates
last month, and winter storms temporarily shut down
manufacturing operations more generally.
After rising rapidly during 1994. business inventories continued to build at a substantial pace in
the early part of 1995. By the end of the first quaner,
real inventories of nonfarm businesses were about
5'/i percent above the level of a year earlier. Meanwhile, strength thai had been evident in final sales
during 1994 gave way to more subdued growth in the
46
Manufacturing Capacity UtHizatton Rate
1988
1992
1990
1994
1996
first quarter of 1995. and the ratio of inventories to
sates rose. In the second and third quarters, growth of
inventories was roughly in line with growth of business final sales; consequently, aggregate mveraorysales ratios held fairly steady during this period.
Although data on inventory change in the year's final
quarter are riot yet complete, the available indicators
suggest that significant imbalances probably were
present in only a few industries at year-end. Potential
for wider inventory problems appears to have been
contained through a combination of production
restraint late in 1995, caution in ordering merchandise
from abroad, and discounting by some retailers during
the holiday shopping season. Wholesalers reduced
their inventories in the final two months of 1995. and
manufacturers' stocks rose only slightly: aggregate
inventory-sales ratios moved down in both sectors.
Business profit* rose further over the first three
quarters of 199S. Economic profits of all US. corporalions increased at an annual rate of nearly 11 percent,
a pace similar to that seen over the fonr quarters of
1994. The profits of corporations from their operations in the rest of the world moved up sharply, on
net, and earnings from domestic operations also continued to advance. The strongest gains in domestic
profits came at financial corporations and reflected, in
part, an increased volume of lending by financial
institutions, reduced premiums on deposit insurance
at commercial banks, and rising profits of securities
dealers. The economic profits earned by nonfinancial
corporations from their domestic operations rose at an
annual rate of about 316 percent over the first three
quarters of 1995 after three years in which the annual
increases were 15 percent or more. A moderation of
output growth at nonfinancial corporations and a flattening of the rise in profits per unit of output both
worked lo reduce the rate of growth in nominal earnings in 1995. Nonetheless, with unit costs also moving up at a moderate pace, the share of the value of
nonfinanciaJ corporate output that ended up as profits
changed little, on net. in the first three quarters, holding in a range thai was relatively high in comparison
to the average profit share over the past couple of
decades.
Before-Tax Profit Share of GDP
Percent
Nonfinancial corporations
Change in Real Nonfarm Business Inventories
Percent, annual rate
1989
1991
1993
1995
Note. Piolits from domestic operation* with inventory valuation and capital consumption adjustments, divided by gross
domestic product o( nari inane ial corporate sector.
The Government Sector
1990
1991
1992
1993
1994
1995
At the federal level, combined real outlays for
investment and consumption fell ai an annual rate of
about 4^4 percent over the first three quarters of 1995.
47
dropping to a level aboul 13 percent below its annual
peak in 1990. Both investment and consumption were
cut back over the firs three quarters of 1995. Outlays
for defense continued 10 contract, and nondefense
expenditures turned down, reversing a moderate
increase chat took place over the four quarters of
1994.
Federal outlays in the unified budget, which covers
items such as transfers and giants, as well as consumption and investment expenditures other than UK
consumption of fixed capital, rose 3J/i percent in
nominal terms in fiscal 1995. matching almost exactly
ihe percentage rise of the previous fiscal year. Nominal outlays for defense declined 3V4 percent in both
fiscal 1995 and fiscal 1994. Outlays for social security
increased about 5 percent in both years. Spending for
Medicare and Medicaid continued to rise at rates
appreciably faster than the growth of nominal GDP.
Net interest payments jumped in fiscal 1995 after
three years of relatively little change, but. working in
the other direction, net outlays for deposit insurance
were more negative than in 1994 (i.e., the margin
between insurance premiums and the payout for
losses increased). Proceeds from auctions of spectrum
rights also helped to hold down expenditures: like the
premiums for deposit insurance, these proceeds enter
the budget as a negative outlay. In the first three
months of fiscal 1996—i.e.. the three-month period
ended in December—federal outlays were about
1 percent lower in nominal terms man in the comparable period of fiscal 1995. Nominal outlays for
defense nave continued to trend down this fiscal year,
and the spending restrain: embodied in recent continuChange in Real Federal Expenditures
on Consumption and Investment
Percent. Q4 to Q4
10
1990
7991
1992
1993
1994
1995
Note. Value for 1995 is measured from !994:Q4 to l995:Q3at
an annual rale.
ing budget resolutions has translated into sharp cuts in
nondefense outlays.
Federal receipts rose ~IVi percent in fiscal 1995.
after having increased 9 percent in fiscal 1994. In
both years, categories of receipts that are most closely
related to the state of the economy showed sizable
increases. With receipts moving up more rapidly than
spending in fiscal 1995. the federal budget deficit fell
for a third consecutive year, lo $164 billion. Progress
in reducing ire deficit in recent years has come from
cyclical expansion of the economy, tax increases,
non-recurring factors such as the sale of spectrum
rights, and adherence to the budgetary restraints
embodied in the Budget Enforcement Act of 1990 and
the Omnibus Budgetary Reconciliation Act of 1993.
Federal Unified Budget Deficit
Fiscal years
- 300
- 200
- 100
1990
1991
1992
1993
1994
1995
The economic expansion also has helped to relieve
budgetary pressures that many state and local governments were experiencing earlier in the 1990s. Excluding social insurance funds, surpluses in the combined
current accounts of state and Local governments were
equal to about '/2 percent of nominal GDP in the first
three quarters of 1995: this figure was more than
double the average for 1991 and 1992. when budgetary pressures were most severe.
Even so, state and local fudgets reman ai the
center of strongly competing pressures, with ine
demand tor many of the services that typically are
provided by these governments continuing to nse at a
time when ihe public also is expressing desire for tax
relief. Although states and localities have responded
lo these pressures in different ways, the aggregate
picture is one in which expenditures and revenues
have continued to rise faster than nominal GDP—but
48
by smaller margins than in the early pan of the 1990s.
In total, the current expenditures of state and local
governments, made up mainly of transfers and consumption expenditures, were equal to about 12'A percent of nominal GDP in the first three quarters of
1995. up slightly from the percentages of the two
previous years and about IV* percentage points higher
than the comparable figure for 1989. Total receipts of
state and local governments were equal to about
1 jy* percent of nominal GDP in the first three quarters of 1995, up just a touch from the comparable
percentages of the two previous years but about
1 '/* percentage points higher than the percentage in
1989.
Change in Real State and Local Expenditures
on Consumption and Investment
Percent. 04 to Q4
- 3
- 2
1990
1991
1992
1993
1994
1995
Note. Value for 1995 is measured from 1994:04 to 1995:03 at
an annual rate.
State and local outlays thai are included in GDP
have been rising less rapidly than the current expenditures of these jurisdictions, because GDP excludes
transfer payments, which have been growing faster
than other outlays. In real terms, combined state and
local outlays for consumption and investment
increased at an annual rate of about 2Vy percent over
the first three quarters of 1995. Real investment
expenditures, which consist mainly of outlays for
construction, moved up at an annual rate of almost
7 percent. By contrast, consumption expenditures,
which are about four times the size of investment
outlays, rose only modesily in real terms—at an average annual rate of about l'/3 percent.
The External Sector
Growth of real GDP in the major foreign industrial countries oiher ihan Japan slowed sharply in
1995 from die robust rates of 1994. In Canada, where
economic activity had been particularly vigorous
through the end of 1994, (he slowdown reflected
weaker U.S. growth and macroeconomic policies
intended to achieve improved fiscal balance and to
prevent the reemergence of inflationary pressures. In
Germany and the other European economies, appreciation of their currencies in terms of the dollar during the early months of the year and efforts to reduce
public sector deficits contributed to the decline in the
rate of real output growth. In contrast, Japan showed
some tentative signs of recovery late in 1995 after
almost no growth during the previous three years.
With the expansion of real GDP slowing in the
foreign G-10 countries at a time when some slack
remained, inflation stayed low. The average rate of
consumer price inflation in these countries remained
about 2 percent last year. essentially the same as in
1994 and somewhat less than in the United States.
Economic growth in the major developing countries slowed on average in 1995 from the strong pace
recorded for 1994. The substantial contraction of economic aciiviry in Mexico had important effects on
US. trade, but real output also slowed in other developing countries, including Argentina. In response to
the December 1994 collapse of the Mexican peso,
the Mexican government adopted a set of policies
intended to tighten monetary conditions, maintain
wage restraint, and reduce government spending in
order to mitigate the inflationary impact of die peso's
devaluation and to achieve significant reduction in
the current account deficit in 1995. Through the third
quarter, the Mexican current account was approximately balanced; a deficit of about 520 billion had
cumulated during the comparable three quarters of
1994. The merchandise trade balance improved to
moderate surplus in 1995 from a substantial deficit
in 1994. The improved trade performance in pan
reflected a severe contraction in aggregate demand.
Mexican real output fell sharply early in the year but
picked up toward the end of the year, for an annual
decline of nearly 7 percent.
The newly industrializing economies in Asia—for
example. Malaysia. Korea, and Taiwan—continued to
grow rapidly during 1995. at about the same rate as in
1994, Although growth in mosr of these countries was
driven by a strong expansion in internal demand,
especially in investment, most countries also benefited from very fast export growth. The marked acceleration in exports was attributable at least in part to a
real depreciation of their currencies against the yen
and key European currencies during the eariy part of
the year.
49
In the first eleven raotHhs of 1995 the nominal US.
trade deficit in goods and services reached about
SllS billion at a seasonally adjusted annual rate, a
level slightly greater than the $106 billioa recorded
for 1994. US. income growth in 1995 was similar to
the average for our trading partners, but. as is typically the case, comparable increases in income
seemed to bring forth an increase in U.S. demand for
impons that was larger than the average increases in
demand for our exports by the foreign countries with
which we trade. Effects of the dollar's depreciation
during 1994 and early 1995 worked in the opposite
direction, tending to boost exports and hold down
imparts. Overall, the result of these offsetting tendencies was that the dollar value of exports grew somewhat faster than the dollar value of imports through
November. Nonetheless, with the level of imports
exceeding the level of exports at the start of the year.
these growth rates translated into a slightly larger
deficit. The current account deficit averaged about
$160 billion at an annual rate during the first three
quarters of 1995. Both the trade deficit and the deficit
on net investment income widened somewhat, resulting in an increase from the S15G billion current
account deficit experienced in 1994.
U.S. Current Account
Billions ol dollars, annual rate
50
•\oo
150
i
1989
i
_ i_
1991
i
1993
200
1995
Real exports of goods and services grew at an
annual rate of about 5 percent over the first three
quaners of 1995. Agricultural exports remained at
elevated levels, and the volume of computer exports
continued to rise sharply. Other merchandise exports
expanded in real terms at a marginally slower rate
than did the total: within this broad category, machinery and industrial supplies accounted for the largest
increases. Tabulation of the export data by country of
Cnange in Real Imports and Exports
of Goods and Services
Percent. CM to CM
D Imports
I Exports
15
10
1989
1991
1993
1995
Note. ValuB»for1996a™maa«u*dliomlW»:Q*to199ftO3
at an annual rate.
destination showed divergent patterns: Exports to
Mexico dropped in response to the economic crisis in
that country, but shipments to developing countries
in Asia rose sharply. Exports to Western Europe.
Canada, and Japan increased as well.
Imports of goods and services increased at an
annual rate of about 6 percent in real terms during the
first three quaners. a slower rate of advance than
during 1994. Imports of computers and semiconductors rose sharply, but imports of other machinery,
consumer goods and industrial supplies slowed.
Import prices increased about IVz percent in the
twelve months ending in December 1995. An end to
the very rapid rise in world non-oil commodity prices
and tow inflation abroad helped to restrain the rise in
import prices.
In the first three quaners of 1995, recorded n«
capital inflows irao the United States were substantial
and nearly balanced the deficit in the US. current
account. Sharp increases were reported in both foreign assets in the United States and US. assets abroad.
Foreign official asset holdings in the United States
increased almost $100 billion through September.
These increases reflected both intervention by certain
industrial countries to support the foreign exchange
value of the dollar and very substantial accumulation
of reserves by several developing countries in Asia
and Uuin America, Private foreign assets in the
United States also rase rapidly. Net purchases of US.
Treasury securities by private foreigners totaled
S97 billion, an amount far exceeding previous
50
omy. but gains there were more mixed than mote
of 1994. In manufacturing, employment fell about
160,000 over the twelve months ended in December,
Direct investment inflows reached almost $50 bilreversing almost half of the previous year's gala
lion ill the first three quarters of 1995; this total was
Losses were concentrated in industries that produce
about equal to the inflow during all of 1994 and
nondurables. A decline this past year in the number of
almost matched the record pace of 1989. Mergers and jobs at apparel manufacturers was one of the largest
acquisitions added substantially to the inflow of funds
ever in that industry. Sizable reductions in employfrom foreign direct investors in the United States.
ment also were reported by manufacturers of textiles,
US. direct investment abroad was even larger than
tobacco, leather products, and petroleum and coal. In
foreign direct investment in the United States and also
many of these industries, cyclical deceleration of the
approached previous peak rates. US. net purchases of
economy in 1995 compounded the effects of adjustforeign stocks and bonds were up from 1994, but ments stemming from longer-run structural changes.
below the 1993 peak rate. The bulk of the net U.S. In contrast to the widespread contraction in employpurchases of foreign securities were from the indusment among producers of nondurables. employment
trial countries; net purchases from emerging markets
at the manufacturers of durable goods increased
played a relatively small role.
slightly during 1995. Hiring continued to expand
briskly at firms that produce business equipment.
Metal fabricators also sustained growth in employLabor Markets
ment but at a slower pace than in 1994. The number
of jobs in transportion equipment declined, on net.
The number of jobs on nonfann payrolls increased
IV* million over the twelve months ended in DecemIn most other sectors of the economy, employment
ber 1995. After a sharp rise during 1994, gains in rose moderately last year. The number of jobs in
employment slowed in the first pan of 1995. and the
construction increased 140,000 over the twelve
second quarter brought only a small increase.
months ended in December, a rise of more than 3 perThereafter, increases picked up somewhat. Nearly
cent. In the private service-producing sector, which
450,000 jobs were added in ihe final three months of
now accounts for about three-fourths of all jobs in the
the year, a gain of about 1 Vi percent at an annual rate. private sector, employment increased 1.7 million in
In January of this year, with the weather keeping
1995 after having advanced 2.6 million in 1994.
many workers at home during the reference week
Establishments thai are involved in wholesale trade
for the monthly survey of establishments, payroll
continued to boost payrolls at a relatively brisk pace
employment fell sharply.
in 1995. Retailers also added to employment but at a
considerably slower rate than in 1994: within retail
As in 1994, increases in payroll employment in
trade, employment at apparel outlets fell substantially
1995 came mainly in the private sector of the econlast year, and payrolls at stores selling general merchandise dropped moderately after a large increase in
1994. Providers of health services added slightly more
Net Change in Payroll Employment
jobs than in other recent years. Ai firms that supply
M«fons ol job*
services to other businesses, employment growth
was sizable again in 1995 but less rapid than in either
Total nonfarm
of the two previous years; in this category, providers
of computer services expanded their job counts at
an accelerated pace in 1995. but suppliers of
personnel—a category that includes temporary help
agencies—added jobs at a much slower raie than in
other receru years.
Results from the monthly survey of households
showed the civilian unemployment rate holding in a
narrow range throughout 1995. and the rate reported
in December—5.6 percent of the labor force—was
near the midpoint of that narrow range. In January
of (his year, the unemployment rate ticked up to
1990
1991
1992
1993
1994
1995
5.8 percent.
record*. Net purchase! of US. government agency
bonds and corporate bonds were also very large.
I,
51
Civilian Unemployment Rate
Percent
\r*s~
Jan.
1988
1990
1992
1994
1996
Hote. The break in data at January 1994 marks the introduction ot • realigned survey; data from that poirt on are not
dtoctly corrparaWe with the data of Mri«t period*.
The proportion of working-age persons choosing to
participate in the labor force edged down slightly, on
nei, over the course of 1995. It has changed little, on
balance, since the start of the 1990s. By contrast,
the two previous decades brought substantial net
increases in labor force participation, although longerterm trends during die two decades were interrupted
at times by spells of cyclical sluggishness in the
economy. Two or three years ago. cyclical influences
also seemed to be a plausible explanation for the
sluggishness of labor force participation in the current
business expansion. But, with the participation rate
remaining sluggish as job opportunities have continued to expand, the evidence is pointing increasingly
toward a slower rate of rise in the trend of participation. Slower growth of participation will tend to limit
the growth of potential output, unless an offsetting
rise is forthcoming in the trend of productivity
growth. So far in the current expansion, measured
increases in productivity seem to have followed a
fairly typical cyclical pattern, with larger increases
early in the expansion and smaller gains, on average.
in subsequent years. Overall, however, this pattern
has not yielded evidence of a significant pickup in the
longer-term trend of productivity growth.
The average unemployment rate for all of 1995 was
about Vi percentage point below the average for 1994.
and it was only a little above the levels to which the
unemployment rate fell in the latter stages of the long
business expansion of the 1980s. The low unemployment rates reached back then proved to be unsustainable, as they eventually were accompanied by a significant step-up in the rate of inflation, brought on in
pan by faster rates of rise in hourly compensation and
unit labor costs. The current expansion, in contrast,
has remained relatively free of increased inflation
pressures working through the labor markets. The
employment cost index for hourly compensation of
workers in private nonfarm industries rose only
2.8 percent over the twelve months ended in December, the smallest annual increase on record in a series
that goes back to the start of the 1980s. Hourly wages
increased 2.8 percent during the past year, the same
relatively low rate of increase as in 1994. The cost of
fringe benefits, prorated to an hourly basis, rose only
2.7 percent last year, the smallest annual rise on
record. With many firms still undergoing restructurings and reorganizations, many of which have
involved permanent job losses, workers probably have
been more reluctant to press for wage increases than
they normally would have been during a period of
tight labor markets. Also, firms have been making
unprecedented efforts to gain better control over the
rate of rise in the cost of benefits provided to employees, especially those related to health care. Although
some of these efforts may have only a one-time effect
on the level of benefit costs, groundwork also seems
to have been laid for slower growth of benefits over
time than would otherwise have prevailed.
Change in Employment Cost Index
Percent. Dec. to Dec.
Hourly compensation
1989
1991
1993
1995
Not*, P rival* industry, excluding farm and household wortre
Prices
Early in 1995. inflation pressures that had started
building in 1994 seemed to be gaining in intensity.
Indexes of spot commodity prices continued to surge
in the eariy pan of last year, and in the producer price
index, materials prices recorded some of the largest
52
monthly increases of the past decade and a half.
Consumer prices also began to exhibit some upward
pressure, with the index for items other than food and
energy moving up fairiy rapidly over the first four
months of ihe year
The surge in inflation proved to be relatively shortlived, however. The spot prices of industrial commodities turned down in the spring of the year and
fell further, on net, after midyear. Price increases for
intermediate materials slowed in the second and third
quarters of 1995, and by the final quarter of the year
these prices also were declining. Monthly increases in
the core CPI slowed in May; thereafter, increases
generally were small over the remainder of the year.
The slowing of the economy after the start of the year
appears to have cut short die buildup of inflationary
pressures before they could have much effect on the
underlying processes of wage and price determination. In the end. the rise in the CPI excluding food and
energy from the final quarter of 1994 to the final
quarter of 1995 amounted to 3 percent, an increase
that differed little from those of the two previous
years. The increase in the total CPI in 1995 came in at
2*4 percent, the fifth consecutive year in which it has
been in a range of 3 percent or less.
Change in Consumer Prices
Percent, O4 to O4
1989
1991
1993
1995
Note- Consumer price index tor all urban consume™.
In the aggregate, rates of price increase held fairly
Mi-'acy for both goods and services this past year. The
CPI for commodities other than food and energy rose
lJ/4 perecm over the four quarters of 1995 after
increases of I1/: percent in both 1993 and 1994. The
last three-year period in which prices of these goods
rose by such small amounts came in the middle pan
oi the 1960s. Apparel prices continued 10 decline last
Change in Consumer Prices Excluding
Food and Energy
Parcent, 04 to 04
1989
1991
1993
1995
Note. Consumer price index lor afl urban consumers.
year but not so rapidly as in the previous year. Price
increases for vehicles moderated. The, 1995 rise in the
CPI for services other than energy was 3V* percent;
although this increase exceeded the 1994 rise by a
slight amount, the results for both years were among
the smallest increases for this category in the last
three decades.
Trends in food prices and energy prices remained
favorable to consumers in 1995. The rise in food
prices from the final quarter of 1994 to the final
quarter of 1995 was slightly more than 2V4 percent.
almost exactly the same as the increases of the two
previous years. The last yearly increase in food prices
in excess of 3 percent came five years ago. in 1990.
In the intervening years, production adjustments by
fanners and weather problems of one son or another
have caused temporary surges in the prices of some
farm commodities, but these surges have not resulted
in widespread pressures on food prices at the retail
level. Moderate rates of increase in the costs of nonfarm inputs that contribute heavily to value added
have been an important anchor in the setting of food
prices at the consumer level. Also, if only by chance,
years of poor crops—like thai of 1995. when grain
and oilseed production plummeted—have tended lo
be interspersed with years of good crops, a pattern
dial has prevented sustained upward pressures on
farm and food prices. In the energy area, prices at the
consumer level fell 1V' percent, on net, over the four
quarters of 1995. more than reversing a moderate
1994 increase. Gasoline prices dropped neatly 5 percent, on net. over the four quarters of the year, and
consumer prices of natural gas also declined appre-
53
ciably. However, some upward pressures developed
late in 1995 and early this year, largely in response to
unexpectedly cold temperatures thai boosted fuel
requirements for winter heating.
All told, the price developments of 1995 appear to
have left a favorable imprint on expectations of future
rales of inflation, if results from various surveys of
consumers and forecasters are an accurate reflection
of the views held by the broader public. Monthly
responses lo the surveys tend to bounce around somewhat, but over 1995 as a whole, average readings of
anticipated price increases one year into Che future
were sligndy lower than those of 1994, and survey
responses about inflation prospects over the longer
term came down more substantially. Although the
responses regarding expected inflation still tended, on
balance, to run to the high side of actual rates of price
increase, the easing of inflation expectations this past
year provided another encouraging sign thai inflation
processes that helped to undermine other recent business expansions are still in check- in the current
expansion.
54
Section 3: Financial, Credit, and Monetary Developments
In 1995 and early 1996. the Federal Reserve had
to adjust its policy stance several times to promote
credit market conditions supponive of sustained
growth with low inflation. At the beginning of 1995,
some risk icmained that inflation might rise. To
provide additional insurance against that development, the Federal Open Market Committee (FOMC)
tightened reserve conditions, raising the intended federal funds rate Vt percentage point, to 6 percent,
thereby extending the episode of policy finning that
had begun one year earlier. As time passed, it became
dear that these policy tightening* had been successful in containing inflationary pressures, and the
System initialed V* point reductions in the federal
funds rate in July and December of 1995 and January of 1996.
Domestic Interest Rates
Most market interest rates had peaked before the
policy tightening last February. During the spring.
interest rales declined appreciably, as market participants increasingly came to believe that no additional
policy restraint would be forthcoming, and. indeed,
thai easing might be in the cards. Mounting evidence
that the growth of spending had downshifted and
price pressures were muted, along with greater hopes
that substantial progress would be made toward
reducing the federal budget deficit, contributed to the
change in altitudes and to the drop in interest rates,
especially longer-term rates. On balance during 1995.
interest rates dropped 1 to 2Vi percentage points,
with the largest declines registered on imermediateand long-term securities. This year, short- and
intermediaie-tenn interest rates have fallen somewhat
further, while long-term rates are unchanged to a little
higher.
Short-Term
Monthly
Federal Funds
10
The course of interest rales during the year influenced overall credit flows and their composition. The
expansion of the total debt of domestic nonfinancial
sectors was relatively strong during the first half of
the year but moderated later in 1995. For the year,
debl grew 5<A percent, a bit above the midpoint of its
annual growth range. Initially, household and nonfinancial business credit demands were concentrated
in floating-rate or short-term debt instruments. As the
yield curve flattened, credit demands shifted to fixedraie. long-term debt instruments.
Three-month Treasury bill
Coupon oqurvalonl basis
I
I
I
I
i
1
I
i
1
i
i
1 i
Long-Term
Monthly
Home Mortgage
Primary Conventional
12
Thirty-year Treasury bond
i
i
1984
i
i
i
1986
i
1988
1990 1992
i
i
i
1994 1996
During the first pan of lasi year, expectations of
lower U.S. interest rates relative to other G-10 countries and other factors such as the crisis in Mexico
contributed to a 10 percent depreciation of the tradeweighted exchange value of the dollar. By year-end,
though, the dollar had retraced about half of these
tosses, and it has appreciated further on balance in
1996.
1
Because depository institutions are important
sources of short-term and floating-rate credit to households and businesses, depository assets grew rapidly
early on and then backed off. The need to fund the
increase in assets, along with declines in market interest rates relative 10 yields on recail deposits, led to the
fastest growth in M2 and M3 since the late 1980s; M2
ended the year in the upper pan of its annual range,
and M3 was at the upper end of its range. In contrast.
Ml declined for the first time since the beginning of
the official series in 1959. as many banks introduced
retail sweep accounts that shifted deposits from
55
interest-bearing checking accounts to savings-type
accounts in order to reduce reserve requirements.
The Course of Policy and Interest Rates
The Federal Reserve entered 1995 having tightened
policy appreciably during the previous year. Shortterm interest rates had risen more than 2V4 percentage points from the end of 1993, and long-term rates
were up 2 percentage points. Policy tightening had
been necessitated by the threat of rising inflation
posed by unusually low real short-term interest rates
earlier in the 1990s. Rates had been kept low to
counter the effects of impediments to credit flows and
economic growth. But as these impediments were
reduced, the economy expanded at an unsustainable
pace and margins of underutilized labor and capital
began to erode. Ultimately, absent a firmer policy,
excessive demands on productive resources and
resulting higher inflation would have produced
strains, threatening economic expansion.
In early February the policy actions taken in 1994
did not appear to be sufficient to head off inflationary
pressures. The growth of economic activity had not
shown convincing signs of slowing to a more sustainable pace, and available information, including a
marked rise in materials prices during the last half of
1994, seemed indicative of emerging resource constraints and building inflationary pressures. In these
circumstances, the FOMC agreed on a ¥2 percentage
point increase in the federal funds rate, and the Board
of Governors approved an equal increase in the discount rate.
During the remainder of the winter and through the
spring, incoming data signaled that economic growth
was finally moderating. At first, it was unclear if the
slowdown was temporary or if it was a lasting shift
toward a sustainable rate of economic expansion in
the neighborhood of the economy's potential. Adding
to the uncertainty was a pickup of consumer price
inflation and a pronounced weakening in the foreign
exchange value of the dollar. At the March meeting,
the FOMC determined that it would be prudent to
await further information before taking any additional
policy actions, but it alerted the Manager of the
System Open Market Account that, if intermeeting
action were to be required, the step would more likely
be to firm than to ease.
By the May meeting, substantial evidence had
accumulated that the threat of rising inflation had
lessened. Economic growth had slowed: although the
The Discount Rate and Selected Market Interest Rates
Percent
Daily
12/31 2/4/94
122 4/18 S/17
7/6
8/16
9/27
11(151320 2/1/96
3/28
5/23
7/6
832 9G6
Nate. Oatt*d vertical lines indicate days on which the Committee announced a monetary pofcy action.
Asterisks indicate days on which the FOMC held scheduled meetings.
11/15)2/19101(96
56
adjustment to inventory imbalances thai had developed earlier in the year was contributing to the slowdown, the underlying trajectory of final sales was still
uncertain. The FOMC determined that the existing
stance of policy was appropriate and expressed no
presumption as to the direction of potential poSicy
action over the intermeeiing period, issuing a symmetric directive to the Account Manager.
a softening in spending after the third quarter, but the
extent of any slowing of spending and inflation was
unclear. Although short-term rates remained above
long-term averages on a real, inflation-adjusted basis,
substantial rallies in bond and stock markets were
thought \ikely to buoy spending. Against this backdrop, the FOMC voted to maintain the existing stance
of monetary policy.
Intermediate- and long-term interest rates had
fallen throughout the winter and spring, as evidence
accumulated that the expansion of economic activity
was slowing and that inflationary pressures were ebbing. Furthermore, budget discussions in the Congress
seemed to foreshadow significant fiscal restraint over
the balance of the decade, putting additional downward pressure on these rates. Shon-tenn rates had
declined less, but in late spring, financial market
participants had begun to anticipate an easing of
monetary policy. By midyear, the three-month Treasury bill rate had declined about '/* percentage point
from its level at the beginning of the year, while rates
on securities with maturities greater [nan one year had
dropped as much as 2 percentage points.
The generally positive news about inflation and
hopes for a budget agreement had helped propel the
bond market higher throughout the fall. By the
December meeting, intermediate- and long-term interest rates were IV* to 2W percentage points below their
levels at the beginning of the year. The bond market
rally, along with strong earnings reports, pushed
equity prices higher during the year, and by midDecember, equity price indexes were up about 35 percent from levels at the beginning of the year. Since
the last easing in July, inflation had been somewhat
more favorable than anticipated, and the expansion of
economic activity had moderated substantially after
posting a strong third quarter. With both inflation and
inflation expectations more subdued than expected.
and with the slowing in economic growth suggesting
that price pressures would continue to be contained,
the FOMC decided to reduce the intended federal
funds rate an additional V* percentage point, bringing
it to 5'/4 percent.
Employment data released shortly after the May
FOMC meeting were surprisingly weak, and by the
July meeting it appeared that growth of aggregate
output had sagged markedly during the second quarter as businesses sought to keep inventories from
rising to undesirable levels. This deceleration of output growth was accompanied by a softening of industrial prices and a marked reduction in the pace at
which materials prices were rising. With ihe economy
growing more slowly than had been anticipated and
potential inflationary pressures receding, the FOMC
voted to ease reserve pressures slightly with a '/* percentage point decline in the intended federal funds
rate.
Although financial market participants had anticipated a decline in the federal funds rate at some point,
bond and equity markets rallied strongly immediately
after the change in policy was announced. However, a
pickup in economic growth during the summer made
further reductions in the funds rate appear less likely,
and interest rates backed up for a time.
The- Committee did keep rates unchanged at the
August and September meetings. Although inflation
had improved, the slowdown had been anticipated to
a considerable extent. Moreover, uncertainties arioui
federal budget policies and their effects on the economy remained substantial.
Ai the November meeting, the economic signals
were mixed. Anecdotal information tended to suggest
The data available at the time of the FOMC meeting in late January gave stronger evidence of slowing
economic expansion. This development reduced
potential inflationary pressures going forward and
raised questions about whether monetary policy might
unduly restrain the pace of expansion. The Committee
believed thai a further slight easing in monetary policy was consistent with keeping inflation contained
and fostering sustainable growth, given that price and
cost trends were already subdued. In these circumstances, the Committee lowered the intended federal
funds rate '/* percentage point, to 5Vt percent, and the
Board approved an equivalent reduction in the discount rate, to 5 percent.
Partly as a consequence of the System actions in
December and January, shon- and intermediate-term
interest rates have fallen V* to Vt percentage poini
since mid-December. However, on balance, longerterm rates are unchanged to a little higher. The
absence of a firm agreement to reduce the federal
budget deficit, and some tentative signs most recently
that the economy might not be so sluggish as some
market participants had feared, have held up longerterm rales.
57
Household Financial Condition
Debt Annual Range and Actual Level
BMon* of dofan
N on financial
13000
J 1 1 1 1 1 1 1 1 1 L
Q N O 4 F M A M J J A S O N D
1994
12700
Credit and Money Plows
On balance in 1995. the debt of the domestic
nonfinancial sectors grew at about the same pace as
in [he previous year, although within the year, debt
growth was much stronger in the firs! half than in the
second. Credit supplies remained plentiful: Banks
continued to be willing lenders, and in securities
markets most inierest-rate spreads remained quite
narrow. Debt burdens for households increased, tat
except for a few types of consumer credit obligations, delinquency rates remained at low levels. Rising equity prices bolstered the overall financiaJ condition of households.
Federal debt rose 3% percent in 1995. slightly less
than in 1994. The federal government's demands for
credit fell largely because the budget deficit shrank
about 20 percent for the calendar year. Federal debi
growth also slowed toward year-end as the Treasury
drew down its cash balance to keep borrowing within
the S4.9 trillion debt ceiling.
Stale and local government debt fell 5V4 percent—
more than in 1994. A few years earlier, municipalities
had taken advantage of low long-term rates to prerefund a substantial volume of issues, many of which
were eligible to be called in 1995. As those securities
were called, and with gross issuance light, ihe stock
of municipal securities contracted tor a second consecutive year. Despite ihe overall reduction in debt
outsianding. the ratios of tax -exempt 10 taxable yields
jumped in the flrsi half of the year and. for long-term
debt, held at an elevated level during the remainder of
the year. This increase was associated with concerns
about the effect on demands for tax-free municipal
1980
1985
1990
1995
1995
debt of proposals for changes in federal taxation that
would sharply reduce the tax advantages of holding
municipal bonds.
Household borrowing remained robust in 1995.
moderating only a bit from 1994, and the ratio of
household act* to disposable personal income rose
further. Even so. the financial condition of this sector
remained good on balance, although there were signs
of deterioration. The rally in the domestic equity
markets supported household balance sheets by boosting net worth sharply. In addition, delinquency rates
on home mortgages and closed-end consumer loans
at banks, while rising, remained at low levels.
Other indicators, howevec. provided evidence thai
some households were likely beginning to experience
increased financial pressures. For instance, delinquency rates on credit card debt held by banks and on
Delinquency Rates on Household Loans
Percent
Closed-end consumer
loans al banks
Auto loans at
finance companies
Mortgages
I Li 1 l _ l . t I 1_L.I LJ I IJ I I I I I I I I I I I
1970
1975
1980
1985
1990
1995
58
anto loam booked a captive finance companies rose
sharply. Furthermore, the average household debt service burden—calculated as the share of disposable
income needed to meet required payments on mortgage and consumer debt—continued to rise last year.
Tins measure of debt burden has now reversed about
one-half of the decline ii posted earlier in the decade.
Distribution of Bank Assets
by Capital Status
Under Capitalized
31.3
The average debt service burden of nonfinancial
corporations—the ratio of net interest payments to
cash flow—also rose last year, but it remained well
beneath the most recent peak reached in 1990. The
increase in debt burden was in pan associated with
the relatively strong growth of the debt of nonfinancial businesses. This sector's debt growth was especially robust early in the year, when business fixed
investment picked up further and inventory accumulation was rapid. Debt issuance was also boosted by the
rising wave of mergers, although a good number
involved stock swaps. Financing needs fell back later
on as investment growth slowed and profits increased
Funding patterns also shifted as bond yields fell,
and firms relied more heavily on longer-term debt
Despite the increase in credit demands, interest rate
spreads of investment-grade private securities over
comparable Treasuries widened only slightly and
remained narrow by historical standards, suggesting
that lenders continued to view balance sheets of nonfinancial corporations as remaining healthy on the
whole. Spreads on below-investment-grade debt rose
more sharply but stayed well beneath levels reached
early in the decade.
Adequately Capitalized
38.6
2.9
Well Capitalized
30.1
96.6
Securities as a Percent of Bank Credit
40
30
20
1960
1965
1970
1975
1980
1985
1990
1995
Commercial banks met a significant portion of the
increase in business credit demands last year, which.
in turn, contributed to the rapid expansion of bank
Percent of industry assets
1990:04
1995:Q3
.5
Note. Adjusted for examiner ratings.
balance sheets. Banks funded a portion of the loan
increase by reducing their securities holdings.
although higher market prices of securities and offbalance sheet contracts left reported securities holdings slightly higher for the year. In fact, bank security
holdings relative to the size of their balance sheets
remained elevated and. together with banks' strong
capital positions, indicated that late in the year banks
were well positioned to continue accommodating
the credit demands of households and businesses.
Although qualitative information suggested that banks
were no longer reducing the standards businesses
needed to meet to qualify for loans, some easing of
credit terms continued, with interest-rate spreads on
business loans narrowing further. Growth of real
estate loans held by banks slowed over the year as the
share of fixed-rate mongages in total originations rose
with the decline in long-term rates. Banks tend to
securitize fixed-rate mortgages more than adjustablerate loans. Consumer loans on the books of banks
began the year growing at very high rates: this growth
decelerated throughout 1995 as the volume of securitization increased. In response to rising delinquency
rates, some banks tightened terms and standards for
consumer loans toward the end of 1995 and early
1996.
Total assets of thrift institutions are estimated to
have risen slightly last year. Growth at healthy thrifts
more than offset a substantial transfer of thrift assets
to commercial banks through mergers. The revival of
growth in thrift assets, along with the strong showing
of bank credit, helped to nudge up depository credit
as a share of domestic nonfinancia! debt for the second straight year after fifteen years of declines. Banks
and thrifts still account for more than one-third of all
credit to nonfinancia] sectors.
Banks and thrifts funded a large share of their asset
growth with deposits, and M3 grew 6 percent. The
non-M2 portion of M3 was especially strong, in pan
59
M3: Actual Range and Actual Level
Billon* at dollars
4250
O N D J
F
M
1994
A
M
J
J
A
S
O
N
O
1995
as depository institutions substituted large time deposits for nondeposit sources of funds. The shaip reduction in deposit insurance premiums, which made large
time deposits a more attractive source of funds, probably contributed 10 this shift. Late in the year,
branches and agencies of Japanese banks, facing some
resistance in US. funding markets, ran off time deposits while continuing to increase their funding from
overseas offices.
market instruments were not the whole story for the
growth of M2, however. As the yield curve flattened,
the relative gains from holding longer-term assets
with less certain price behavior fell and probably
strengthened household demand for components of
M2. Even so, M2 velocity was about unchanged after
having increased for four years.
Ml fell almost 2 percent in 1995. the first annual
decline since the beginning of the Board's official
series in 1959. Sweeps of deposits from reservable
checking accounts, a component of Ml. to nonreservable money market deposit accounts were a major
influence. Without these sweeps. Ml would have
risen \ percent. By the end of last year, sweeps had
spread to thirty-two bank holding companies, and the
initial amounts swept by these programs totaled
$54 billion. The corresponding decline of more Ihan
$5 billion in required reserves largely showed through
M1: Actual Level
Billions of dollar*
1220
1200
1180
M2 rose as lower market interest rates and a flatter
yield curve increased the relative attractiveness of
retail deposits. As is typical, deposit interest rates.
and to a lesser extent returns on money market mutual
funds, adjusted slowly to declines in market rases last
year. Falling interest rates for comparable maturity
1160
1140
1120
1100
O N O J F M A M J J A S O N D
M2: Actual Range and Actual Level
Billions ot dollars
3700
3650
3600
3550
3500
3450
O N D J F M A M J J A S O N D
1994
1995
1994
1995
to reserve balances maintained at Federal Reserve
Banks. As banks continue to introduce retail sweep
programs in the future, the aggregate level of required
reserve balances will tend to fall further. Although it
has not happened yet. one possible consequence of
the declining required reserve balances is greater
instabiliry in the aggregate demand for reserves and in
overnight interest rates. In 1991. following the cut in
reserve requirements at the end of 1990, unusually
low levels of required reserve balances were associated with greater variability in the federal funds rate,
as banks' volatile clearing needs began to dominate
the demand for reserves, making daily reserve
demand more difficult to estimate.
60
The runoff in reserve balances held down [he
growth of the monetary base to 4 percent in 1995. In
addition, currency growth slowed, primarily owing to
reduced shipments abroad. Foreign demand moderated with the stabilization of financial conditions in
some countries where dollars circulate widely. Indeed.
reduced demands from abroad contributed to a rare
decline in the currency component of Ml this past
summer, the first decrease since ire early 1960s. The
demand for existing Federal Reserve notes also slackened in anticipation of the introduction of a newly
designed $100 bill that will be harder to counterfeit.
Foreign Exchange Developments
The weighted-average foreign exchange value of
the dollar in terms of the ocher G-10 currencies
declined about 5 percent on balance last year. The
dollar fell sharply through April and reached a low
almost 10 percent below its value at the end of 1994.
The downward pressure against the dollar was
sparked by indications of some slowing of the pace
of US. real output growth, which contributed to
expectations that further increases in US. interest
rates were unlikely, and by the acrimony surrounding the ongoing trade dispute between the United
States and Japan. The crisis in Mexico also weighed
on the dollar. On several occasions in March and
early April the Trading Desk at the New York Federal Reserve Bank, joined by some other central
banks, intervened to buy dollars on behalf of the
Treasury and the Federal Reserve System in an
effort to counter the pressure for dollar depreciation.
The release by the G-7 officials of the communique
from their meeting in late April supporting an orderly
reversal of the dollar's decline and the signing of a
trade agreement between the United States and Japan
at the end of June helped to stabilize the dollar, which
fluctuated narrowly until early August. The dollar
then rebounded somewhat and remained within a
narrow range through the end of the year. The recovery of the dollar stemmed, in part, from perceptions
that its earlier decline, particularly in terms ol" the yen.
had been excessive in light of the underlying fundamentals. Moreover, weakness in the economies of
some other major industrial countries began to
emerge, reducing prospective returns available
U.S. and Foreign Interest Rates
Three-month
Percent
Average foreign
10
Weighted Average Foreign Exchange Value
of the U.S. Dollar
December 1993 « 100
Ten-year
Daily
Percent
100
12
Average foreign
90
NDJFMAMJJASONDJFMAMJJASONDJFM
1993
1994
1995
1996
Note. Index of weighted average foreign exchange value ol
U.S. dollar in terms of currencies ol the other G-10 eouitries.
Weights are based on 1972-76 global trade ol each ol the toreign countries.
U.S. Treasury
SO
i
i
i
i
1984
1986
1988
1990
1992
1994
1996
Note. Average foreign rates are the trade-weighted average,
for the other G-10 countries, of yields on instrumerts eorparable
to U.S. instruments shown. The data are monthly.
61
abroad. At times from May through August, the Trading Desk again entered the market in conjunction with
other central banks to intervene in support of the
dollar, reinforcing the view that US. authorities were
committal to a strong dollar.
In all of the major foreign industrial countries,
long-term interest rates declined during 1995. nearlv
reversing the increases that had occurred during the
previous year. On average, rates on foreign government issues with maturities of ten years fell about
150 basis points in the twelve months to December,
somewhat less than the decline that occurred in the
comparable US. rate. In Canada, where economic
activity slowed sharply, the drop in long-term rates
nearly matched that in the United States, while in
Italy, where political uncertainty remained a concern
throughout the year, rates fell only 100 basis points.
During the first few weeks of this year, long-term
rates abroad generally moved down somewhat more,
but then most recently returned to their December
average levels. An important exception is Japan.
where rates have risen from their late-December levels, apparently reflecting market perceptions that the
stage is set for a Japanese economic recovery. Shonterm market rates in the major foreign industrial countries were mixed, but on average raies moved down.
On balance, the dollar depreciated about 8 percent
in terms of the German mark during 1995 and by
similar amounts in terms of most other currencies
participating in the Exchange Rate Mechanism of the
European Union. After substantial depreciation
against the mark early \n the year, the dollar stabilized
Foreign Exchange Value of the Dollar
in Terms of Selected Currencies
December 1993 - 100
Daily
100
90
NDJFMAMJJASONDJFMAMJJASONDJFM
1993
1994
1995
Hole. Foreign currency units par dollar.
1996
70
and then partly recovered as economic indicators
revealed significant softening in economic activity in
Germany. Easing by the Bundesbank during the second half of the year reinforced the view that mark
interest rates were not likely to rise and might fall
further. The dollar depreciated slightly, on balance, in
icrms of the Canadian dollar, despite periods of selling pressure on the Canadian dollar during the year
related to Canada's fiscal situation and possible secession by Quebec.
Although the dollar did fall to a record low. below
80 yen to the dollar in mid-April, by year-end the
dollar had appreciated slightly in terms of the yen
from its level at the end of 1994. So far this year, the
dollar has appreciated somewhat further against the
yen. Resolution of the trade dispute and repeated
episodes of exchange market intervention by the Bank
of Japan, sometimes in conjunction with US. and
foreign monetary authorities, contributed to the appreciation of the dollar in terms of the yen during the
second half of the year. However, the fundamental
cause of the yen's decline during that period probably
was the easing of monetary policy by the Bank of
Japan that pushed shon-term rnarket interest rates to
extremely low levels.
In terms of the Mexican peso, the dollar appreciated sharply from the onset of the crisis in late
December 1994 to March. The dollar subsequently
retraced some of those gains, and the peso-dollar rare
fluctuated narrowly through the middle of the year.
Uncertainty about the prospects for Mexican economic performance and macroeconoimc policy
sparked renewed appreciation of the dollar in terms of
the peso in November. Since November, data indicating thai the decline in Mexican real economic activity
may have ended, some intervention by the Bank of
Mexico in support of the peso, and a perception that
the decline in the peso may have gone 100 far given
the underlying fundamentals have contributed to some
rebound of the peso. During the year, the Mexican
authorities drew S3 billion on short-term swap lines
with the Federal Reserve and Exchange Stabilization
Fund (ESF) of the US. Treasury and S10.5 billion on
a medium-term swap facility provided by the ESF. By
the end of January 1996. the shon-ierm drawings had
been entirely repaid.
Adjusted for relative consumer price inflation, the
dollar was little changed, on balance, against a
multilateral-trade-weighted average of the currencies
of eight developing countries that are important US.
trading partners. The dollar's 30 percent real appreciation against the Mexican peso was aboui offset by
real depreciations against the other seven currencies.
62
Growth of Money and Debt
Domestic
Period
M1
M2
M3
7.5
5.4 (2.5) s
8.8
8.7
9.0
8.8
12.4
Nonflnanclal
Debt
Year1
1980
1981
1982
1983
1984
10.3
5.4
1985
1986
1987
1988
1989
8.1
9.7
9.5
10.8
9.5
10.2
9.8
11.9
14.6
6.3
4.3
.5
8.6
92
4.2
5.7
5.2
7.7
9.0
5.9
6.3
4.0
4.2
7.9
4.1
3.1
14.3
10.5
1.8
1.4
.6
4.2
1.8
12
.6
1.0
1.6
6.1
6.8
4.6
4.7
5.2
5.2
5.3
4.8
6.7
8.0
4.4
5.3
7.0
4.6
3.9
12.0
15.5
1990
1991
1992
1993
1994
1995
11.8
9.6
2.4
-1.8
14.3
13.3
9.9
9.0
7.8
Quarter {annual rate)3
1995:01
-.1
1.4
Q2
Q3
CM
-.5
-1.5
-5.1
4.3
7.0
4.0
1. From average for fourth quarter of preceding year to
average for fourth quarter of year indicated
2. Adjusted for shift* to NOW accounts in 1981,
1
3. From average for preceolng quarter to aiverage
for
quarter indicated.
@FedFRASER