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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1999

HEAEING
BEFORE THE

COMMITTEE QN
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION

ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
FEBRUARY 23, 1999
Printed for the use of the Committee on Banking, Housing, and Urban Affairs

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2000
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, EMI! 20402
ISBN 0-16-059942-3




COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PHIL GRAMM, Texas, Chairman
RICHARD C. SHELBY, Alabama
PAUL S. SARBANES, Maryland
CONNIE MACK, Florida
CHRISTOPHER J. DODD, Connecticut
ROBERT F. BENNETT, Utah
JOHN F. KERRY, Massachusetts
ROD GRAMS, Minnesota
RICHARD H. BRYAN, Nevada
WAYNE ALLARD, Colorado
TIM JOHNSON, South Dakota
MICHAEL B. ENZI, Wyoming
JACK REED, Rhode Island
CHUCK HAGEL, Nebrauka
CHARLES E. SCHUMER, New York
RICK SANTORUM, Pennsylvania
EVAN BAYH, Indiana
JIM BUNNING, Kentucky
JOHN EDWARDS, North Carolina
MIKE CRAPO, Idaho
WAYNE A ABERNATHY, Staff Director
STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel
WAYNE A. LEIQHTON, Senior Economist
ROBERT STEIN, Staff Director, Economic Policy Subcommittee
MARTIN J. GRUENBEBG, Democratic Senior Counsel
GEORGE E. WHITTLE, Editor




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C O N T E N T S
TUESDAY, FEBRUARY 23, 1999
Page

Opening statement of Chairman Gramm
Prepared statement
Opening statements, comments, or prepared statements of:
Senator Schumer
Senator Mack
Senator Bayh
Senator Enzi
Senator Edwards
Senator Bunning
Senator Kerry
Senator Crapo
Senator Johnson
Prepared statement
Senator Santorum
Senator Bennett
Senator Sarbanes
Senator Dodd
Prepared statement
Senator Reed
Prepared statement
Senator Grams
Senator Allard

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WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC
Prepared statements:
Federal Reserve's First Monetary Policy Report for 1999
Financial Services Modernization Legislation
Response to written questions of:
Senator Sarbanes
Senator Crapo

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Monetary Policy Report to the Congress, February 23, 1999




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61

FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1999
TUESDAY, FEBRUARY 23, 1999

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Committee met at 10 a.m., in room SD—106 of the Dirksen
Senate Office Building, Senator Phil Gramm (Chairman of the
Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PHIL GRAMM

Chairman GRAMM. Good morning.
I want to give our colleagues an opportunity to give a short opening statement. I hope to set the standard in my opening statement.
I want to thank Chairman Greenspan for coming.
We are in a climate where everybody wants to take credit for the
current level of economic activity in our economy. Politicians of all
stripes want to take credit for the fact that we have prosperity in
the American system that is broad-based and probably deeper than
at any time in the modern history of the country.
Most politicians have about as much to do with the current level
of prosperity as the rooster has in crowing over the sun coming up.
My opinion is that basically the emergence and absorption of new
technology, the productivity of the American worker, the expansion
in world trade, the end of the cold war, the fundamental strengths
that were laid in previous Congresses and previous Administrations, really have much to do with our current level of prosperity,
and probably dominate it.
But if there is any person currently in a public policy position
who is due at least partial credit for the current state of the American economy, that person is sitting in front of us today.
Chairman Greenspan, I want to thank you for the great job you
have done. We have had many great men who have been Chairman
of the Federal Reserve System, many great and effective leaders,
but I think that while you still have much of your career in front
of you, and I am grateful for that, I don't have any doubt about the
fact that you will go down as the greatest Chairman in the history
of the Federal Reserve System.
You have done an extraordinary job in balancing the needs of the
economy, and we are very proud of the work that you have done.
I wanted you to know how I feel about it.
Chairman GREENSPAN. I thank you very much, Mr. Chairman.
Chairman GRAMM. Let me call first on Senator Schumer.
(1)




OPENING STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. I appreciate this
opportunity to be here. I have heard Chairman Greenspan many
times, but this is my first from this side of the Capitol, and I'm
glad to be here.
I also want to add my commendation to Chairman Greenspan for
his steadfastness and understanding and the important role that
he plays in assuring people that the economy will stay on an even
keel, that there is a rock at the Fed. I think that has served everybody in the country well. The fear of inflation, which had been so
prevalent in the first years I came here, is so reduced that we hear
more talk about deflation than inflation. I think, Chairman Greenspan, you deserve a heck of a lot of credit for doing that. As you
have prophesied for many decades, even before you were Chair_ man, one of the best ways to make sure the economy stays on an
even keel is to make sure people know that their money is going
to continue to be worth a whole lot, and you have done that.
Today, I would also like to commend you for your leadership in
pointing out the risks ahead. We are doing just great and, in a
sense, this is a golden era. But that is not to say that there aren't
problems that we have to be mindful of; if we're not, we may find
that the golden era comes to an end when we could have kept it
going much longer. A rational and considered outlook, rather than
a euphoric outlook, is always best for producing economic results,
and I thank you for presenting one today.
I look forward to your testimony, and thank Chairman Gramm
for the opportunity to make an opening statement.
Chairman GRAMM. Senator Mack.
OPENING STATEMENT OF SENATOR CONNIE MACK

Senator MACK. I want to associate myself with the comments
made by Chairman Gramm, and also make a further statement, if
I could.
The U.S. economy is exceptionally strong, and while some economists still cling to an outdated theory that says faster growth leads
to higher inflation, a growing body of evidence is proving this false.
During the past 3 years, the economy has grown at a 4-percent
rate. Meanwhile, as measured by gross domestic purchases, inflation is lower than at any time since 1950, when we actually had
deflation. Lower inflation is one of the main reasons for faster economic growth. Lower inflation means a lower effective tax on capital gains and a better return on business investment. By keeping
prices stable, the Federal Reserve keeps the long-term interest
rates down, making it easier for families to buy homes, and for
businesses to expand, hire more workers, and increase wages and
salaries.
It's been 16 years since the Fed broke the back of double-digit
inflation and President Reagan cut taxes across the board. Since
then, the economy has grown at an annual rate of 3.2 percent, and
we have had only 9 months of an official recession. This 16-year period is the longest the United States has gone with only 9 months
of recession since at least the 1850's, and perhaps since the Nation
started.




Clearly, the United States is not without its problems. Too many
families are still struggling to make ends meet and get ahead. The
best way to address this is through pro-growth, pro-family tax relief that helps people save and invest for the future. Before President Reagan, the Federal Government taxed people at rates up to
70 percent and still couldn't balance the books. Now we tax people
at a top rate of approximately 40 percent, and we have surpluses
as far as the eye can see. In other words, lower tax rates can generate both economic growth and more revenue.
Meanwhile, the best assistance we can get from the Federal Reserve is to keep prices stable, avoiding both inflation and deflation.
With Chairman Greenspan at the helm, I remain confident the Fed
will stick to this course.
However, Mr. Greenspan will not be running the Federal Reserve
forever—at least I think that's an accurate statement.
[Laughter.]
That's why I intend to reintroduce legislation that would keep
the Fed focused on the one target it has the tools to consistently
hit, and that's price stability.
As always, Chairman Greenspan, I welcome you to the Banking
Committee.
Chairman GREENSPAN. Thank you, sir.
Chairman GRAMM. Thank you, Senator Mack.
Let me remind the people who are just coming in that we're trying to do these opening statements quickly.
Senator Bayh.
OPENING STATEMENT OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Chairman Gramm.
Senator Mack, your comments about Chairman Greenspan serving in perpetuity bring to mind something my wife once said at the
end of my second term as Governor. She said if there weren't term
limits, perhaps there would be a sanity limit. I don't know, Chairman Greenspan, whether that would apply to the Federal Reserve
as well or not, but we certainly appreciate your service, as long as
you can continue to serve.
I wish to associate myself with the comments made by Chairman
Gramm and praise you for your leadership and stewardship of our
economy. It is good to see you again. I'm going to save the bulk of
my remarks for our question period. I would much rather listen to
you than to myself. I would just make two quick observations.
We have a wonderful opportunity, as public policymakers, to try
to do some good for our country on a long-term basis, in our determinations about what to do with the surplus. I would be grateful
for your thoughts about how we go about setting those priorities.
That's number one.
Number two, it would be very helpful if you would share your
insights, at some point, on those things that we might do to help
improve the long-term productivity growth rates of our economy.
Thank you for your appearance today. I am grateful to you for
your service.
Chairman GRAMM. Thank you.
Senator Enzi.




OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Mr. Chairman. I, too, want to thank
Chairman Greenspan for appearing before the Committee, for his
ever-helpful thoughts on the national economic trends, and, today,
also for some insights into financial modernization.
Much credit has to be given to you and the current policies of the
Federal Reserve for one of the longest periods of economic growth
in the post-World War II era.
I also want to commend you and TIME magazine on the article
in TIME magazine last week. I think it came at a time that is particularly critical in the history of our Nation.
I appreciate your leadership in focusing the Committee on the
issues surrounding our efforts to update the financial services laws.
Financial services modernization is an important issue. I believe
that it's essential to introduce full and open competition across at
least the banking, securities, and insurance industries.
I thank you for being here today.
Chairman GRAMM. Senator Edwards.
OPENING COMMENTS OF SENATOR JOHN EDWARDS

Senator EDWARDS. Thank you, Mr. Chairman.
I will join the remarks of those who have gone before me. Chairman Greenspan, for the great work you have done, I would like to
add my praise. I want to associate myself with the remarks made
by Chairman Gramm.
That's all I have to say at this time.
Chairman GRAMM. Thank you.
Senator Bunning.
OPENING STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman. I would like to personally thank Chairman Greenspan for testifying today. Mr. Greenspan is here, I hope, to talk about the economy in our country.
I was very happy to see that in 1998 the economy grew at a 4.1percent rate, including a 5.6 percent rate, which will probably be
adjusted upward to about 6 percent, for the fourth quarter of 1998.
I was also happy to see that our Nation's unemployment rate is
down to 4.3 percent and that approximately 2.8 million new jobs
were created last year.
I think Chairman Greenspan is also here to talk about financial
modernization. On the surface, the Financial Modernization bill
and the Humphrey-Hawkins law may not seem to have very much
in common. However, I think the fact that Mr. Greenspan is here
today to talk about both of these subjects illustrates very symbolically and very well how interconnected our financial services industry is with the creation of jobs.
Not only do the banking, insurance, and securities industries create jobs, directly in Kentucky and the rest of the United States, but
these industries are also directly involved in the creation and
maintenance of millions of other jobs through the way they allocate
our financial resources. How we reform our financial laws for the
new millennium will directly affect those working in these industries and the majority of Americans that they serve.




I look forward to Chairman Greenspan's comments on our current economy and other issues that affect it. I look forward to his
insight on what he feels is the best way in which to proceed on financial modernization.
Thank you very much.
Chairman GRAMM. Thank you.
Senator Kerry.
OPENING STATEMENT OF SENATOR JOHN F. KERRY

Senator KERRY. Thank you very much, Mr. Chairman.
Chairman Greenspan, I join with everybody in thanking you for
a very extraordinary job. Your stewardship is obvious to all, and
I think is gaining the recognition that it appropriately deserves.
I will just make two quick comments. I would like to note that
you predict inflation may be at a slightly higher rate, but you also
say that unemployment will stay effectively where it is, or close
thereto. I have not had the chance to see your entire testimony and
will listen to what I can of it, but I wonder if you might comment
as you go forward, either in the testimony or afterwards, on two
things.
First, the question of the anemic growth for most Americans, in
the longer hours worked versus the wages gained. Although the
last 18 months have been encouraging and it's going up slightly,
the fact is that inflation-adjusted earnings of the median worker
are lower than they were in 1989. I wonder if you might give us
your thoughts on the wage trend.
The second component is building on the TIME magazine article
and the role you, the Treasury Secretary, and we have played as
a country with respect to globalization. There is a great debate now
about putting a human face on the impact of globalization and
technology and the changes in the world marketplace. I wonder if
somehow you might also find time to comment on how, if there are
any ways we aren't, you might see us sharing better the upsides
that we have experienced with others so that we can continue the
momentum toward the adoption of market economies.
I know in Davos, Switzerland, there was significant discussion at
the World Economic Forum of the counterforces that are pulling at
people's allegiance or willingness to continue down those roads, and
that could have a profound long-term impact, obviously, on our
growth and our success.
If those are things you might find time somehow to address, it
would be wonderful. Thank you very much for what you're doing,
Chairman Greenspan.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Crapo.
OPENING STATEMENT OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you, Mr. Chairman.
I, too, welcome you, Chairman Greenspan. Since you started at
the Fed, the Dow has risen from about 2400 to now more than
9000, and I am sure we all hope that you are able to guide us on
to continued success of that nature. By the arithmetic I have here,
that's about a 14 percent per year increase in the Dow.




I, too, want to associate myself with some of the other comments.
It is going to be interesting to see if this hearing can stick to its
designated topic, because of the range of interests that have been
expressed already by many here.
Although I'm very interested in your comments on financial services modernization and the other issues that you're here prepared
to address, I also will be interested in knowing if you have some
advice to give us with regard to how we manage the surpluses that
the Federal Government now seems fortunate to be able to address
in its budget. There are some questions relating to how we should
deal with Social Security in the context of those surplus dollars
that we now have the opportunity to manage.
Again, I welcome you here and I look forward to your comments
today.
Chairman GRAMM. Senator Johnson.
OPENING COMMENTS OF SENATOR TIM JOHNSON

Senator JOHNSON. I would like to welcome you, Chairman Greenspan. I want to thank you for your willingness to do double duty
before the Committee today, both relative to your economic report
and to your discussion of financial modernization.
I will submit my statement for the record.
Chairman GRAMM. Thank you.
Senator Santorum.
OPENING COMMENTS OF SENATOR RICK SANTORUM

Senator SANTORUM. Thank you, Mr. Chairman.
Welcome, Chairman Greenspan. It's a pleasure to have you here.
Congratulations. I look forward to your testimony.
Thank you.
Chairman GRAMM. Thank you all very much. As you are aware,
Chairman Greenspan is going to give the standard report we receive. At some point we're going to have to sit down, since this report expires with the next presentation, which occurs in the House
first and then the Senate. There is an interest on the Committee
in maintaining it and maybe broadening it to get beyond the narrow elements of Humphrey-Hawkins, but that's something that we
can deal with.
We have been joined by Senator Bennett. I wonder if he has a
short opening statement?
OPENING COMMENT OF SENATOR ROBERT F. BENNETT

Senator BENNETT. No, thank you, Mr. Chairman.
Chairman GRAMM. That's an excellent opening statement.
[Laughter.l
Chairman Greenspan.
OPENING STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. I was terribly concerned by that remark,
Mr. Chairman, because if I say I don't have a statement, you could
say it was excellent.
[Laughter.]




Mr. Chairman and Members of the Committee, I very much appreciate the opportunity to present the Federal Reserve's semiannual report on monetary policy.
The U.S. economy over the past year again performed admirably.
Despite the challenges presented by severe economic downturns in
a number of foreign countries and episodic financial turmoil abroad
and at home, our real Gross Domestic Product (GDP) grew about
4 percent for a third straight year. In 1998, 2.75 million jobs were
created on net, bringing the total increase in payrolls to more than
18 million during the current economic expansion, which late last
year became the longest in U.S. peacetime history. Unemployment
edged down further to a 4.25-percent rate, the lowest since 1970.
And despite taut labor markets, inflation also fell to its lowest
rate in many decades by some broad measures, although a portion
of this decline owed to decreases in oil, commodity, and other
import prices that are unlikely to be repeated. Hourly labor compensation adjusted for inflation posted further impressive gains.
Real compensation gains have been supported by robust advances
in labor productivity, which in turn have partly reflected a heavy
investment in plant and equipment, often embodying innovative
technologies.
Can this favorable performance be sustained? In many respects,
the fundamental underpinnings of the recent U.S. economic performance are strong. Flexible markets and the shift to surplus on
the books of the Federal Government are facilitating the buildup
in cutting-edge capital stock. That buildup, in turn, is spawning
rapid advances in productivity that are helping to keep inflation
well behaved. The new technologies and the optimism of consumers
and investors are supporting asset prices and sustaining spending.
But, after 8 years of economic expansion, the economy appears
stretched in a number of dimensions, implying considerable upside
and downside risks to the economic outlook. The robust increase of
production has been using up our Nation's spare labor resources,
suggesting that recent strong growth in spending cannot continue
without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise
questions about whether shares are overvalued. The debt of the
household and business sectors has mounted, as has the external
debt of the country as a whole, reflecting the deepening current account deficit. We remain vulnerable to rapidly changing conditions
overseas, which, as we saw last summer, can be transmitted to
U.S. markets quickly and traumatically. In light of all these risks,
monetary policy must be ready to move very quickly in either direction should we perceive imbalances and distortions developing that
could undermine the economic expansion.
The Federal Open Market Committee conducted monetary policy
last year with the aim of sustaining the remarkable combination of
economic expansion and low inflation. At its meetings from March
to July, the inflation risks accompanying the continued strength of
domestic demand and the tightening of labor markets necessitated
that the Federal Open Market Committee place itself on heightened inflation alert. In August, the FOMC returned to an unbiased
policy predilection in response to the adverse implications for the




s
U.S. outlook of worsening conditions in foreign economies and in
global financial markets, including our own.
Shortly thereafter, in the wake of the Russian crisis and subsequent difficulties in other emerging-market economies, investors
perceived that the uncertainties in financial markets had broadened appreciably and as a consequence they became decidedly more
risk averse. As a result, quality spreads escalated dramatically,
especially for lower-rated issuers. Many financial markets turned
illiquid, with wider bid-asked spreads and heightened price volatility, and issuance was disrupted in some of the private securities
markets.
To cushion the domestic economy from the impact of the increasing weakness in foreign economies and the less accommodative
conditions in U.S. financial markets, the FOMC, beginning in late
September, undertook three policy casings. By mid-November, the
FOMC had reduced the Federal funds rate from 5.5 to 4.75 percent.
These actions were taken to rebalance the risks to the outlook, and,
in the event, the markets have recovered appreciably. Our economy
has weathered the disturbances with remarkable resilience, though
some yield and bid-asked spreads still reflect a hesitancy on the
part of market participants to take on risk. The Federal Reserve
must continue to evaluate, among other issues, whether the full extent of the policy easings undertaken last fall in order to address
the seizing-up of financial markets remains appropriate as those
disturbances abate.
To date, domestic demand and hence employment and output
have remained vigorous. Real GDP is estimated to have risen at an
annual rate exceeding 5.5 percent in the fourth quarter of last
year. Although some slowing from this torrid pace is most likely in
the first quarter, labor markets remain exceptionally tight and the
economy evidently retains a great deal of underlying momentum
despite the global economic problems and the still-visible remnants
of the earlier financial turmoil in the United States. At the same
time, no evidence of any upturn in inflation has, as yet, surfaced.
Abroad, the situation is mixed. In some East Asian countries
that, in recent years, experienced a loss of investor confidence, a
severe currency depreciation, and a deep recession, early signs of
stabilization and economic recovery have appeared.
The situations in some other emerging-market economies are not
as encouraging. Russia's stabilization program with the IMF has
been on hold since the financial crisis hit, and the economic outlook
there remains troubling.
The Russian financial crisis immediately spilled over to some
other countries, hitting Latin America especially hard. As a consequence of high interest rates and growing economic uncertainty,
Brazil's economic activity took a turn for the worse.
Brazilian authorities must walk a very narrow, difficult path of
restoring confidence and keeping inflation contained with monetary
policy while dealing with serious fiscal imbalances. Although the
situation in Brazil remains uncertain, there has been limited contagion to other countries thus far. Apparently, the slow onset of the
crisis has enabled many parties with Brazilian exposures to hedge
those positions or allow them to run off.




The U.S. economy's performance should remain solid this year,
though likely with a slower pace of economic expansion and a
slightly higher rate of overall inflation than last year. The stocks
of business equipment, housing, and household durable goods have
been growing rapidly to quite high levels relative to business sales
or household incomes during the past few years, and some slowing
in the growth of spending on these items seems a reasonable prospect. Moreover, part of the rapid increase in spending, especially in
the household sector, has resulted from the surge in wealth associated with a run-up in equity prices that is unlikely to be repeated.
And the purchasing power of income and wealth has been enhanced by declines in oil and other import prices, which also are
unlikely to recur this year. Assuming that aggregate demand decelerates, underlying inflation pressures, as captured by core price
measures, in all likelihood will not intensify significantly in the
year ahead, though the Federal Reserve will need to monitor developments carefully. We perceive stable prices as optimum for economic growth. Both inflation and deflation raise volatility and risks
that thwart maximum economic growth.
The economic outlook involves a number of risks. The continuing
downside risk posed by possible economic and financial instability
around the world was highlighted earlier this year by the events
in Brazil. Although financial contagion elsewhere has been limited
to date, more significant knock-on effects in financial markets and
in the economies of Brazil's important trading partners, including
the United States, are still possible. Moreover, the economies of
several of our key industrial trading partners have shown evidence
of weakness, which if it deepens could further depress demands for
our exports.
Another downside risk involves a potential correction to stock
prices. Such a decline would increase the cost of equity capital,
slowing the growth of capital spending. It would also tend to restrain consumption spending through its effect on household net
worth.
But on the upside, our economy has proven surprisingly robust
in recent years. More rapid increases in capital spending, productivity, real wages, and asset prices have combined to boost economic growth far more and far longer than many of us would have
anticipated.
This "virtuous cycle" has been able to persist because the behavior of inflation also has been surprisingly favorable, remaining well
contained at levels of utilization of labor that in the past would
have produced accelerating prices. That it has not done so in recent
years has been the result of a combination of special one-time factors holding down prices and more lasting changes in the processes
determining inflation.
Among the temporary factors, the sizable declines in the prices
of oil, other internationally-traded commodities, and other imports
contributed directly to holding down inflation last year, and also indirectly by reducing inflation expectations. But these prices are not
likely to fall further, and they could begin to rise as some Asian
economies revive and the effects of the net depreciation of the dollar since mid-summer are felt more strongly.




10

At the same time, however, recent experience does seem to suggest that the economy has become less inflation prone than in the
past, so that the chances of an inflationary breakout arguably are,
at least for now, less than they would have been under similar conditions in earlier cycles.
In the current economic setting, businesses sense that they have
lost pricing power and generally have been unwilling to raise
wages any faster than they can support at current price levels.
Firms have evidently concluded that if they try to increase their
prices, their competitors will not follow, and they will lose market
share and profits.
Given the loss of pricing power, it is not surprising that individual employers resist pay increases. But why has pricing power
of late been so delimited? Monetary policy certainly has played a
role in constraining the rise in the general level of prices and
damping inflation expectations over the 1980's and 1990 s. But our
current discretionary monetary policy has difficulty anchoring the
price level over time in the same way that the gold standard did
in the last century.
Enhanced opportunities for productive capital investment to hold
down costs also may have helped to damp inflation. Through the
1970's and 1980's, firms apparently found it easier and more profitable to seek relief from rising nominal labor costs through pnce increases than through cost-reducing capital investments. Price relief
evidently has not been available in recent years. But relief from
cost pressures has. The newer technologies have made capital investment distinctly more profitable, enabling firms to substitute
capital for labor far more productively than they would have a decade or two ago.
According to rough estimates, labor and capital productivity has
risen significantly during the past 5 years. It seems likely that the
synergies of advances in laser, fiber optic, satellite, and computer
technologies with older technologies have enlarged the pool of opportunities to achieve a rate of return above the cost of capital.
Moreover, the newer technologies have facilitated a very dramatic
foreshortening of the lead times on the delivery of capital equipment over the past decade, presumably allowing businesses to react
more expeditiously to an actual or expected rise in nominal compensation costs than, say, they could have in the 1980's. In addition, the surge in investment not only has restrained costs, it has
also increased industrial capacity faster than factory output has
risen. The resulting slack in product markets has put greater competitive pressure on businesses to hold down prices, despite taut
labor markets.
The role of technology in damping inflation is manifest not only
in its effects on U.S. productivity and costs, but also through international trade, where technological developments have progressively broken down barriers to cross-border trade. The enhanced
competition in tradable goods has enabled excess capacity previously bottled up in one country to augment worldwide supply and
exert restraint on prices in all countries' markets. In addition, the
resulting price discipline has constrained nominal wage gains in
the internationally-tradable goods industries. As workers have attempted to shift to other sectors, gains in nominal wages and in-




11
creases in prices in nontradable goods industries have been held
down as well.
The process of price containment has potentially become, to some
extent, self-reinforcing. Lower inflation in recent years has altered
expectations. Since neither firms nor their competitors can count
any longer on a general inflationary tendency to validate decisions
to raise their own prices, each company feels compelled to concentrate on efforts to hold down costs. The availability of new technology to each company and its rivals affords both the opportunity
and the competitive necessity of taking steps to boost productivity.
Although the pace of productivity increase has picked up in recent years, the extraordinary strength of demand has meant that
the substitution of capital for labor has not prevented us from rapidly depleting the pool of available workers. This worker depletion
constitutes a critical upside risk to the inflation outlook because it
presumably cannot continue for very much longer without putting
increasing pressure on labor markets and on costs.
The number of people willing to work can be usefully defined as
the unemployed component of the labor force plus those not actively seeking work, and thus not counted in the labor force, but
who nonetheless say they would like a job if they could get one.
This pool of potential workers aged 16 to 64 currently numbers
about 10 million, or just 5.75 percent of that group's population—
the lowest such percentage on record, which begins in 1970, and
2.5 percentage points below its average over that period. The rapid
increase hi aggregate demand has generated growth of employment
in excess of growth in population, causing the number of potential
workers to fall since the mid-1990's at a rate of a bit under 1 million annually. We cannot judge with precision how much further
this level can decline without sparking ever-greater upward pressures on wages and prices. But, should labor market conditions
continue to tighten, there has to be some point at which the rise
in nominal wages will start increasingly outpacing the gains in
labor productivity, and prices inevitably will begin to accelerate.
Mr. Chairman, Americans can justifiably feel proud of their recent economic achievements. Competitive markets, with open trade
both domestically and internationally, have kept our production efficient and on the expanding frontier of technological innovation.
The determination of Americans to improve their skills and knowledge has allowed workers to be even more productive, elevating
their real earnings. Macroeconomic policies have provided a favorable setting for the public to take greatest advantage of opportunities to improve its economic well-being. The restrained fiscal policy
of the Administration and the Congress has engendered the welcome advent of a unified budget surplus, freeing up funds for capital investment. A continuation of responsible fiscal and, we trust,
monetary policies should afford Americans the opportunity to make
considerable further economic progress over time.
Mr. Chairman, you and the Committee have asked that, in addition to my report on the economy, I present the views of the Federal Reserve System on the need for legislation to modernize the
U.S. financial system. The Federal Reserve continues to support
strongly the enactment of such legislation and I commend the Com-




12

mittee and you, Mr. Chairman, for taking up this vital matter so
promptly.
U.S. financial institutions are today among the most innovative
and efficient providers of financial services in the world. They compete, however, in a marketplace that is undergoing major and fundamental change driven by a revolution in technology, by dramatic
innovations in the capital markets, and by the globalization of the
financial markets and the financial services industry.
In the United States, our financial institutions have been required to take elaborate steps to develop and deliver new financial
products and services in a manner that is consistent with our outdated laws. Unless soon repealed, the archaic statutory barriers to
efficiency could undermine the competitiveness of our financial institutions, their ability to innovate and to provide the very best and
broadest possible services to U.S. consumers, and, ultimately, the
global dominance of American finance.
We believe that it is important that the rules for our financial
services industry be set by the Congress rather than, as too often
has been the case, by banking regulators dealing with our outdated
laws. Only Congress has the ability to fashion rules that are comprehensive and equitable to all participants and that guard the
public interest.
In designing financial modernization legislation, we at the Fed
firmly believe that the Congress should focus on achieving two essential and indivisible objectives: removing outdated, competitively
stifling restrictions on financial affiliations and, most importantly,
adopting a framework for this modernization that promotes the
safety and soundness of our banking and financial system and prevents the extension of the Federal subsidy.
The first objective is achieved by amending the Glass-Steagall
Act and the Bank Holding Company Act to permit financial affiliations and broader financial activities.
In our judgment, the other objective of preserving safety and
soundness and preventing the spread of the Federal subsidy is best
achieved by allowing banks, securities firms, and insurance companies to combine in the financial service holding company structure.
While we enthusiastically support the new powers granted to financial service holding companies, we just as strongly believe that
they should be financed by the marketplace, not by instruments
backed by the sovereign credit of the United States.
The choice of requiring the new powers to be harbored in affiliates of holding companies, not in operating subsidiaries of their
banks, will significantly fashion the underlying structure of twentyfirst century finance. To inject the substantial new subsidies that
would accrue to operating subsidiaries of banks into the currently
mushrooming domestic and international financial system could
distort capital markets and the efficient allocation of both financial
and real resources that has been so central to America's current
prosperity.
New affiliations, if allowed through bank subsidiaries, would accord banking organizations an unfair competitive advantage over
comparable insurance and securities firms—both those that are
operating independently as well as those that are bank holding
company subsidiaries.




13

This choice of the holding company structure is also critical to
the way in which the financial services industry will develop because it provides better protection for and promotes the safety,
soundness, and stability of our banking and financial system. The
other route toward full powered commercial bank operating subsidiaries and universal banking would, in our judgment, lead to
greater risk for the deposit insurance funds and the taxpayer.
A twenty-first century issue that has become a part of the debate
on financial modernization is whether we should move beyond affiliations among financial service providers and allow the full integration of banking and commerce. As technology increasingly blurs
the distinction among various financial products, it is already beginning to blur the distinctions between predominantly commercial
and banking firms. But how the underlying subsidies of deposit insurance, discount window access, and guaranteed final settlement
through Fedwire are folded into a commercial firm, should the
latter affiliate with a bank, is crucially important to the systemic
stability of our financial system. It seems to us wise to move first
toward the integration of banking, insurance, and securities, and
employ the lessons we learn from that important step before we
consider whether and under what conditions it would be desirable
to move to the second stage of the full integration of commerce and
banking.
Nothing will be lost, in my judgment, by making this a two-stage
process. Indeed, there is much to be gained. The Asian crisis highlighted some of the risks that can arise if relationships between
banks and commercial firms are too close, and makes caution at
this stage prudent in pur judgment. In line with these considerations, the Board continues to support elimination of the unitary
thrift loophole, which currently allows any type of commercial firm
to control a federally-insured depository institution.
Mr. Chairman, there is one final point I want to make since it
appears to have driven Treasury's opposition to the financial modernization legislation considered last year. That legislation would
not have altered the Executive branch's supervisory authority for
national banks or Federal savings associations; nor would it have
resulted in any reduction in the predominant and growing share
of this Nation's banking assets controlled by national banks and
Federal savings associations. Indeed, as of September 1998, nearly
58 percent of all banking assets were under the supervision of the
Comptroller of the Currency, up from 55.2 percent at the end of
1996.
Furthermore, the Congress for sound public policy reasons has
purposefiilly apportioned responsibility for this Nation's financial
institutions among the elected Executive branch and independent
regulatory agencies. Action to alter this balance would be contrary
to the deliberate steps that Congress has taken to ensure a proper
balance in the regulation of this Nation's dual banking system.
The markets are demanding that we change outdated statutory
limitations that stand in the way of more efficiently and effectively
delivering financial services to the public. The Federal Reserve
agrees and urges prompt enactment of financial modernization legislation that achieves the two central and indivisible objectives that
I have outlined today.




14

Mr. Chairman, I would appreciate my full testimony being included for the record.
Chairman GRAMM. Chairman Greenspan, both statements will be
printed in the record as if read in their entirety.
I want to thank you very much for your testimony. It is unusual
to ask you to testify on two things, but we are beginning, as of
today, our hearings on financial services modernization. Knowing
you're busy and knowing you already spend half your life in front
of congressional committees, it didn't make any sense to have you
here on Tuesday and then have you come back on Thursday. I appreciate your very strong comments.
I want to pursue a couple of things, and it's repetitive from what
you just said, but you have before you the people who are capable
of making financial services modernization a reality, so I want to
give you one more opportunity to hit on a couple of points. First,
the timeliness of acting now.
Why do you think it is so critical that we pass the bill now?
Chairman GREENSPAN. Chairman Gramm, the domestic and international financial system has been expanding very rapidly as a
consequence of the vast new set of products that have been essentially made possible by the new technologies, and that proliferation
of products is increasing, still, fairly rapidly.
This means that we are endeavoring to run what is essentially
already a twenty-first century financial system with, in many respects, early twentieth-century-type supervision and regulation.
To be sure, we regulators have managed to find ways around a
goodly part of the obsolescent structure as, indeed, have banks
themselves, but it's costly and it unquestionably requires efforts
which could far better be directed to servicing consumers and improving our financial products. There is no reason that anyone that
I know of can conceive of maintaining this type of structure when
it has so evidently long since passed any usefulness.
Chairman GRAMM. Let me talk to you for a minute about unitary
thrifts. You're aware, of course, that over the last 18 months there
has been an explosion of unitary thrifts, a vast expansion in the
number of companies that, I would guess, when we failed to pass
a bill over the last 2 years took the unitary thrift as a way of getting around many of these impediments. In fact, commercial companies are getting into financial services through the unitary thrift.
I understand what you're saying when you talk about cutting off
the pipeline, but how would you go about doing that? Would you
simply say that as of the date that we come forward with our Committee mark, which will be this Friday, any future applications for
a unitary thrift would not be accepted? Would you support any restrictions on those that currently exist?
I have strong views about this, but I would like to hear yours.
Chairman GREENSPAN. Well, Mr. Chairman, I think that grandfathering those which would exist at the time of your mark would
not create any particular problem, because the very substantial
proportion of those unitary thrift applications are from financial
companies.
We do not perceive, as yet, any major breach into the commercial
area. We do believe it will happen, but it has not happened yet in
any material way, so I do not believe there would be a significant




15
problem in essentially grandfathering those institutions which have
already been in application form.
Chairman GRAMM. And imposing no restrictions on them?
Chairman GREENSPAN. That's up to the Congress. I, as far as the
principles which I have outlined, see no need to do that.
Chairman GRAMM. Let me ask you a final question. I personally
do not oppose commercial affiliation with financial institutions. As
I look at the House bill, which basically tries to deal with the problem that banks do come into ownership of commercial enterprises—
in my State, for example, they have come into ownership of a lot
of oil and gas mineral rights, mostly through people defaulting on
loans—the House tries to deal with that with a waiver which you
could initially get for 10 years and then expand to 15. I do not like
waiver legislation, as such.
An alternative would be to have a small commercial market basket and, interesting enough, that is a proposal that is made by
Democrats in the House.
I would like to get your view on this subject as to which of these
imperfect solutions you think is best.
Chairman GREENSPAN. I would prefer the former. I think, Chairman Gramm, that when you deal with baskets, they are deceptive
in the sense that small numbers look small and, indeed, are usually exceptionally large. I say that mainly because the ingenuity of
American business is really without limits. There is no way that
Congress is going to set up a basket which is going to work. It will
work only for a very short period of time. You will be quite surprised when you talk about small numbers, that the ability to leverage off those numbers is really quite substantial.
I, too, Mr. Chairman, have no objection, per se, in principle, of
commercial and banking institutions coming together. In fact, if
there was not a Federal subsidy in the bank, I would say there
would be no reason why any restrictions at this particular stage
would exist or should exist.
It is solely the subsidy question which governs the view that I
have been putting forth in my testimony today, Mr. Chairman.
Chairman GRAMM. Chairman Greenspan, thank you very much
for your testimony. I think anybody who reads it can very clearly
see where you are coming from, and I think it is a boost to what
we are trying to do here.
I am going to go ahead and recognize people on the basis of seniority, the reason being that our junior Members came early and
had an opportunity to give an opening statement. Our more senior
Members came late, so we balance it out that way.
Let me recognize Senator Sarbanes.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Chairman Greenspan, I join with others in
welcoming you here this morning. I want to take a moment or two
to comment about the Monetary Policy Report. I would then like
to ask you a question with respect to that.
The authorization for the Monetary Policy Report expires at the
end of this year. I think that decision was to some extent inadvertent. It was never directly considered by this Committee.




16

What had happened is in 1995 an overall bill called the Federal
Reports Elimination and Sunset Act was added on the floor. During
Senate consideration of that bill, there was a catch-all provision
that provided a sunset date of 4 years after the date of enactment
of the bill for all reports contained on a list prepared by the Clerk
of the House. That list contained literally hundreds of reports, and
among the reports on that list was not only the Federal Reserve's
Monetary Policy Report, but the President's Budget, the Economic
Report of the President, and the Annual Report of the Commerce
Department's Bureau of Export Administration.
I understand that the Fed itself may not have been aware at the
time that the Monetary Policy Report was on the list and that it
would be sunsetted. I don't think this Committee was aware of it,
frankly, at the time.
The legislation was passed with the intent of forcing a review of
all the reports on the list with the expectation that many would be
reauthorized. It is my very strongly held view that the Monetary
Policy Report to Congress by the Federal Reserve should be among
those reauthorized.
It was originally mandated by the Humphrey-Hawkins Act. The
submission of the report and the testimony of the Chairman of the
Federal Reserve Board before the House and Senate Banking Committees has become perhaps the single most important means of
public accountability for the Federal Reserve. The report and the
testimony are an important opportunity for the Federal Reserve to
explain its actions and its view of the outlook for the economy to
the Congress and the public and an opportunity for the market and
the general public to gain some insight into the Federal Reserve's
view of the economy.
Some people contend that the Congress can ask the Fed to come
and testify at any time on its conduct of monetary policy, but it
seems to me that an institutionalized requirement of a semiannual
report and testimony to Congress has been proven to be an effective means of assuring regular congressional oversight of the Federal Reserve. I would also suggest that the obligation to explain
itself on a regular basis to the Congress and the public has been
a valuable disciplining tool for the Fed in its own conduct of monetary policy and analysis of the economy.
In fact, the Federal Reserve's Monetary Policy Report to Congress has become a model that has been looked to by central banks
and national legislatures around the world. This institutionalization of it is important. The Fed knows that twice a year it's going
to have to do this. The public and the financial press know that.
That seems to me a better arrangement than a hit-or-miss summoning of the Fed to come in. In some ways, it seems to me advantageous to the Fed to know it is going to happen. It makes it less
likely that that summoning will take place perhaps on the spur of
the moment, although if a major crisis hits obviously the Congress
will want to hear from the Chairman of the Federal Reserve.
I think it is ironic, in a way, that Congress is being confronted
with this question of reauthorizing the Fed's Monetary Policy Report, just at the time that the Fed itself has been considering ways
to make its policy judgments more transparent. Just this month,
with the release of the minutes of the December 22 meeting of the




17
FOMC, we learned of the decision to expand disclosure of information about its policy decisions after its regular meetings.
Since 1994, you have been announcing whether interest rates
have been raised or lowered, but now you have adopted a policy of
announcing, at least on an occasional basis, as I understand it,
when you alter your view of the direction of possible policy actions
during the intervening period. I gather this would only be when the
FOMC thinks it important for the public to be aware of this shift
in members' views.
I want to commend the Fed. I think this is a very constructive
step. It is actually consistent with a general effort of the Fed in
recent years to operate in a more open and accountable manner,
while maintaining its position as an independent central bank.
The Federal Reserve's semiannual Monetary Policy Report has
been the centerpiece of that effort. I think we have a compelling
interest to reauthorize that report.
Obviously, my question to you has to deal exactly with that report and the view of the Fed with respect to having to make the
semiannual report, now required under law, and whether you see
any problem in reauthorizing that requirement?
Chairman GREENSPAN. None, Senator. As I have testified in the
past, we are an independent institution in a democratic society,
and that means: In order to maintain our independence, it is essential that we are accountable to the public and to the responsible
congressional committees to make clear what it is we are doing and
why, to the extent that we can do so in a responsible way.
We think that coming up on a regularly-scheduled basis has, in
our judgment, been very productive. In a sense, I think you're making a good point, Senator, when you say it requires us on a fairly
consistent basis to make certain that we have a structure of policy
which is coherent to the Congress. It does discipline us, and I think
in an appropriate manner.
There are probably elements of obsolescence in some of the language in the requirements of the report. It may be, as you take up
the question of re authorization, that it might not be a bad idea to
have a discussion on how we can improve the particular transmission of information from the Federal Reserve to this Committee
and the comparable committee in the House. But that is the choice
of the Committee and, as far as we are concerned, we think it is
essential that we continue to be required to come up on a periodic
basis to this Committee and explain what it is we are doing.
Senator SARBANES. Thank you.
Mr. Chairman, may I make a commendation to the Chairman?
Senator MACK [presiding]. Sure.
Senator SARBANES. I know earlier when Members were making
their opening statements, they spoke of the work of the Fed and
its contribution toward the strong economy that we have. I want
to underscore that there was an article in The New York Times on
February 6, that said the economic expansion has been:
A terrific boon to workers, especially those at the bottom of the pay ladder who
have had the most trouble getting and keeping jobs, especially good ones. Unemployment among both black and Hispanic workers, already the lowest in a generation,
drifted even lower last month. So did unemployment among workers with only high
school degrees.




18
I know you have been sensitive to this aspect of the benefit of
sustained economic expansion, because you have expressed concern
about these very groups that are discussed in this article, and I
just want to say that obviously we are impacting in that area. I am
hopeful that it can continue as we move forward.
Chairman GREENSPAN. We are very sensitive to that issue, especially the training capabilities that a number of these people have
had as a consequence of being on the job; getting on-the-job training and starting up the ladder of a business career, which in other
scenarios they may not have gotten a start on.
Senator SARBANES. Thank you, Mr. Chairman.
Senator MACK. Thank you.
I think I want to continue the discussion along the monetary policy side, as opposed to financial modernization.
In the past, you have said that gold and the yield curve are good
measures of expectations of future inflation. The price of gold has
now been below $300 an ounce for almost a year, the longest period
since the late 1970's, and the yield curve is unusually flat.
What do these facts indicate about the Fed's current monetary
policy?
Chairman GREENSPAN. Well, they don't say terribly much about
the Fed's monetary policy, but they do say a lot about the general
expectations of inflation in the economy, and that has become progressively lower; that is, the inflation expectations that we pick up,
either analytically through evaluating such things as yield curves
and prices and relationships, as well as actual questionnaires of
people who are involved in the business community, shows a progressive decline in expected inflation. We see very little in the pipelines of the inflation process which suggests that there is an imminent acceleration.
The reason we have a modest uptick is that it's hard to envisage
the price of oil, and a number of other one-shot declines, continuing
at the rate that they did last June. If you merely go from a sharp
decline to no change, for example, you will raise the average, and
that is to a large extent where our expected pickup in measured
inflation is coming from.
It is really a remarkable phenomenon. I tried to explain in my
prepared remarks a number of the factors which presumably might
be sufficient to explain the phenomenon, but the truth of the matter is that nobody knows quite yet what all of the forces are that
are suppressing inflation in the broad sense.
I suspect that we will learn a good deal more in retrospect, say
5 years from now, looking back, but a number of the elements of
major improvements in technology very clearly explain a goodly
part of it, not only to the extent that the synergies of new technologies create increased productivity and lower unit labor cost, but
also the pressure of deregulation, which has occurred on a worldwide basis, largely because when technology takes hold in telecommunications or in the movement of goods and services, and an
ever-downsizing of goods in the process, the old ability of governments to try to regulate the economy's trade in goods and services
is very dramatically diminished, and that has had an obviously important impact on international trade.




19

Finally, also as I mentioned in my prepared remarks, the end of
this large part of the world which was engaged in central planning
and moving in many ways poorly but, nonetheless, toward market
economies, has created a larger level of potential supply in the
world, and that has helped as well.
Senator MACK. You mentioned trade, so let me move to another
area
Chairman GREENSPAN. May I say one final thing? This refers basically to the views that you have held with respect to monetary
policy generally.
It still is the case that at the end of the day, the level of inflation
is a monetary phenomenon. That is, if the central bank does not
accommodate or constrict it, all of these other forces will not function effectively, so that monetary policy is ultimately what determines, over the long run, the degree of stable or unstable prices.
We are very consciously aware of that, as you know from our testimony before you on the bill that you have put forth on numerous
occasions.
Senator MACK. Again, I want to move to the trade issue. There
has been a discussion in Argentina, Mexico, and El Salvador of giving up their local currencies and adopting the U.S. dollar as their
own. Do you support this idea?
Would it increase long-term growth in these markets?
Would it be good for the United States in terms of stabilizing our
export markets?
Chairman GREENSPAN. Senator, this is an issue which a number
of us are debating. I think we are all aware, but not fully convinced
yet, that having larger global areas with single currencies is an element for stability, such as the euro. It is probably the case that,
other things being equal, a broadened dollar market would clearly
have stabilizing effects, and that is positive not only for those
which employ the dollar as their currency, but also for those of us
who trade with them.
There are potential downsides. The downsides, very clearly, are
that the linkages create some tensions within a dollar or a euro
area, and we would have to be particularly careful to remember
that our monetary policy is first and always for the United States.
We cannot be a central bank for the United States "and others."
And in that context, we have to be careful not to be perceived as
creating a safety net for institutions in dollarized economies.
There is nothing to prevent, nor do we find any reason to inhibit,
the unilateral dollarization of an economy as, indeed, Panama and
Liberia did, and I suspect many others are thinking about doing,
as you point out.
I do not think there is a unanimity as yet in the American Government on exactly how our views should be consolidated into a
central view, but there are discussions underway, if for no other
reason than that we have been approached by Argentina to see
whether there is a more formal relationship which we can create.
I would suspect we will probably have within a short time a unified
position between the Treasury and the Fed on this as the crucial
areas of Government which must address this issue.
Senator MACK. Thank you, Chairman Greenspan.
Senator Dodd.




20
OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you very much, Mr. Chairman. Welcome
once again to the Committee, Chairman Greenspan.
Mr. Chairman, I am going to ask unanimous consent that my full
testimony regarding Humphrey-Hawkins and the financial services modernization be included in the record.
I won't ask that the USA Today article be included in the record
this morning.
Chairman GREENSPAN. Thank you very much.
Senator DODD. I thought you would appreciate that.
Senator MACK. Without objection.
Senator DODD. My colleagues will now intensely want to read
that article this morning.
Let me join in a chorus of praise to you, Chairman Greenspan.
You have done a great job in so many areas. We are very fortunate,
indeed, to have you at the helm and I mean that most sincerely.
There is obviously a lot of ground here to cover and a lot of Members want to ask some questions. Let me ask you about the foreign
markets, if I may, to expand a bit on this. I realize this gets a bit
afield here, but to some extent what happens there has a profound
impact and effect on these issues of financial modernization and,
obviously, Humphrey-Hawkins, as well.
I wonder if you might comment on the impact on the U.S. financial services sector that is involved or that is doing business in the
economies of the Asian markets, and with greater specificity, in the
Americas and Brazil, and to what extent the crisis in these areas
is impacting on U.S. financial institutions.
Then, if you might just give us some expanded thoughts, particularly in the Americas, on the Brazilian issue. For example, to what
extent is that impacting on the other economies of the Americas,
on Argentina, its approximate neighbor? Also, perhaps you might
comment a bit on Mexico. We're going to be confronted here pretty
quickly with a drug certification issue that none of us welcome.
We go through this every year, and we all recognize the problems
associated with it. There is not a single Member that does not care
deeply about what is happening with the proliferation of drugs in
our society. We know that we are a great consumer of this. We also
know there are some implications when we take actions with fragile economies, such as those which can happen in Mexico.
I wonder if you might just share with us some of your thoughts
on that.
Chairman GREENSPAN. Senator, I think we are learning a good
deal about a number of these interrelationships. Let me start with
Brazil, which is, I think, in a sense, the one that's most immediate.
We all have very considerable concerns about the potential impact
of Brazilian problems on Argentina, Mexico, and, indirectly, on the
United States, or even more directly.
As I point out in my prepared remarks, the extended spreading
out in time of various different problems in Brazil has enabled a
fairly substantial part of those who have temporary commitments
in Brazil, bilateral relationships either with the government or the
private sector, to either hedge them or allow them to mature. As
a consequence of that, because of the stretched-out crisis, if I may
call it that, what has obviously been left in Brazil are those with




21

long-term commitments and financial institutions which have fairly
solid ties in the Brazilian financial system and the companies with
long-term economic ties there.
As a consequence of that, when the Brazilian currency fell very
sharply, instead of seeing a dramatic contagion effect in Argentina
and Mexico, we saw, as I remember, on the first day the Mexican
peso dropped sharply and has since recovered all of the loss and,
indeed, actually gone higher. Argentina's Economy Minister mentioned the other day that, in the past, crises had forced Argentina
from being able to get back into the capital market for months because of the unstable nature of the market. As he said, they got
back in 3 weeks, and were able to get a significant amount of borrowed funds at reasonable interest rates.
What we are observing is a much greater degree of sophistication
emerging in the international financial system in how to hedge
against contagion problems. Now, as I also say in my prepared remarks, it is much too soon to assume that the contagion is behind
us, but it does say that it is clearly less, and that what problems
Brazil has—and they're still having considerable problems—I don't
know what the Brazilian real did since I started talking, but it had
weakened considerably earlier this morning.
It had risen, I think, to 205, suggestive of the fact that they have
problems they are going to have to address, and I think they are
very acutely aware of that. People there whom we know are quite
competent, quite knowledgeable, and understand what they have to
deal with, are working on it. We certainly wish them well and suspect that at the end of the day, we are going to find that Brazil
is a very formidable economy, as it has been.
The problems that exist with trade are not yet worked out fully
because when you get a 40 percent devaluation of a currency and
you have this very tight interrelationship between, say, Brazil and
Argentina on trade, it is going to be difficult for Argentina. I think
they are acutely aware of that, and there are going to be adjustment problems which are still down the line. Mexico, of course, has
its major economic trade ties with us and, as a consequence, is
doing fairly well.
The one other area that I think is important to identify here is
that what we are learning increasingly is how crucial the banking
systems of these emerging nations are, and in fact the importance
of having not only a banking system, but hopefully some backup
ability to intermediate savings and investment outside the banks
if the banks go down.
One of the reasons why we did not get hit as hard as we might
have by the Russian crisis is, to be sure, when the Russian crisis
hit our capital markets absolutely seized up—we weren't even getting issuances of investment-grade securities—but our commercial
banks were able to come in and fill part of the role and, as a consequence, combined with Federal Reserve action, we were able to
stabilize the situation reasonably quickly. That type of structure is
not available in emerging nations, and we realize that we are going
to have to find ways to build that up. The international financial
community has, in effect, been quite focused on how to do precisely
that, and I think we have time actually to do it. In other words,
the crisis has created a great deal of caution, and that has meant




22

that a lot of the leverage has worked its way back down again, and
we do not have an extremely unstable system.
We do have time to be deliberate in solving these problems, but
we do not have a great deal of time because if we procrastinate,
we will find ourselves with this huge, burgeoning international financial system creating another crisis for which we did not set an
appropriate regulatory infrastructure to address.
Senator DODD. There was—I believe it was this Sunday in The
New York Times—a lead editorial which goes into this and suggests
some ideas and some pretty radical thoughts, while talking about
a global regulatory scheme of some kind to begin to deal with this.
I commend it to my colleagues and ask them to look at it. It was,
I thought, a very good editorial that addresses in part the point
Chairman Greenspan has raised here.
Thank you, Mr. Chairman.
Senator MACK. Very good. Thank you.
Senator Bennett.
Senator BENNETT. Thank you, Mr. Chairman. I had some questions about the Y2K issues I was going to ask, but I note that
Chairman Greenspan addressed those in his formal statement, and
I appreciate the fact that he has done that.
I want to use my time to talk about the operating subsidiary
question with respect to financial modernization. I do this with
great trepidation, because I hate to disagree with Chairman Greenspan about anything. Whenever I do, I usually end up being wrong
and being instructed, but I have a different view of the operating
subsidiary question in the legislation before us.
Let me phrase it this way: We are focusing on certain basic activities that were deemed impermissible in the 1930's as we talk
about the role of the operating subsidiary in the context of financial
modernization, securities underwriting, merchant banking, insurance underwriting, and so on. Now, are all of these activities equally
dangerous for operating subsidiaries, or can they be distinguished
in terms of risk?
It seems to me we should be looking at the specific risks, rather
than relying on 60-year-old definitions in the law that we're trying
to repeal.
Chairman GREENSPAN. Senator, I actually agree with that. I believe that is a very important issue to address.
Senator MACK. Hearing adjourned.
[Laughter.]
Chairman GREENSPAN. I think there are several elements here.
Where there is dispute, there is a question of whether in fact there
is a subsidy in the bank which gets transmitted to the sub itself,
or whether the amount which gets transmitted to an affiliate of the
holding company is of the same order of magnitude.
Our view is that, while there is some spillover into the affiliate
of the holding company, it is very much smaller and, indeed, crucially smaller than is the amount of subsidy which can come out
of the Federal safety net that inheres in the bank by legislation
and moves down to the sub.
But in order to move that subsidy, it has to be financed. In other
words, the amount of subsidy that is moved is a function of the
degre • of equity capital that moves down. As a consequence, we




23

would argue that agency activities which use very little in the way
of assets and equity do not in our judgment create any particular
problems in a sub of a bank. And any form of activity which by its
nature does not have a significant balance sheet cannot move the
subsidy at all.
When you get into other types of activities, the amount of subsidy that is moved is the same. It is certainly the case, however,
that they have diiferent competitive relationships with nonbankrelated organizations or firms which do not have the subsidy.
It is our view—and I think the data very strongly confirm this—
that there is enough difference between the amount of subsidy to
create a significant difference for an identical credit-rated organization, for example, a holding company on the one hand and a nonbank institution on the other. Moreover, there is already significant
differences in the capital asset requirements that are required between a nonbank and a bank holding company. There is also a significant difference between the holding company of the bank and
the bank itself. Those differences are really very significant when
you look at the differential impact on the profit that one can get
in the bank, versus in the sub of the bank, in the affiliate of the
holding company, or in the nonbank-related independent firm doing
the same type of activity.
As a consequence of that, it is our position and our strong argument that to allow a subsidiary of a bank to have the powers that
we are discussing when we unwind Glass-Steagall risks a significant expansion of underlying subsidies which distort the financial
system and, in my judgment, create a structure for banking and for
finance in the twenty-first century which is clearly suboptimal.
If there were some really significant negatives in having those
powers in the holding company affiliate, then it could be an argument for subs of the banks. But there is no significant structural
difference. There is an argument about the efficiency of having a
bank sub rather than an affiliate of a holding company. As best we
can judge, any efficiencies are small. There may be differences, but
we think they are virtually de minimis.
In effect, if there is no difference between a holding company and
a sub of the bank, why is there such an extraordinary interest
among the banks and others for having this operating sub if they
did not seriously believe that all of the powers would flow into the
sub, because, indeed, that's what would happen, and that that
would create something, one, for the banks who support this—if
the banks didn't support this, I would change my position
[Laughter.)
—and for another issue—I mean, the Treasury makes the point
that they think the Executive branch should have greater control
over banking regulation.
Unless they believed that, indeed, all of the activities would go
into the sub of the bank and that, therefore, the Comptroller's Office, rather than the Fed—which oversees the holding company—
would take over the regulatory power, I don't think they would
have any interest in that. I think there's a general view by the
implication of everybody that if you grant those powers to the subs
of the banks, that indeed all the powers will end up there. If nobody believes that, then this debate we're having makes no sense.




24

Senator BENNETT. Let me very quickly ask a followup question,
Chairman Greenspan.
Basically, what I think you're saying is your objection is based
primarily on the issue of the subsidy and its impact rather than
on a safety and soundness question?
Chairman GREENSPAN. I do think there is a safety and soundness issue in the sense—let me give you an example which actually
changed my mind on this question.
Back in 1987 during the crash—remember that wonderful October 19, 20, and 21, which were extraordinarily unstable days which
we will never forget for decades—one thing that happened which
was fascinating is that Continental Illinois had a sub, which they
could legally hold, and it dealt in options. Within hours, the sub
not only ran through its capital, but also through all of the extension of the loans from the bank to the sub. And that particular sub
created significant problems for the capital of the bank.
One of the reasons why it's crucially important is that in today's
financial environment, things move so rapidly that this presumption that we can somehow prevent monies moving back and forth
by firewalls, is an illusion. Under the press of huge, rapidly moving
funds, people do things automatically. I learned a lesson from that.
The lesson is that the presumption that you can have a sub which
is not a potential threat to the bank is potentially a significant
problem.
Senator MACK. Senator Reed.
OPENING COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman.
Chairman Greenspan, thank you for your testimony, and also for
your leadership. I have two questions.
The first question is more on macroeconomic policy, and that is:
There have been a lot of arguments recently about the appropriate
measures of public debt. In your view, what is the most important
measure, debt held by the public or total debt?
Chairman GREENSPAN. They serve two different purposes. First
of all, if we're looking at the question of what affects interest rates
and what affects the economy, it is the debt held by the public. The
huge amount of special issues that exist largely, for example, in the
Social Security and Civil Service trust funds are intragovernmental
transfers.
There is an issue here which is a broader Social Security question about whether you want to deal with on-budget and off-budget
financing, but that is a different type of question. If you're looking
at the issue of what is the crucial level of debt in the Government
from the economy's point of view, it is total debt owed to the public,
and not what we call "the public debt," which includes the gross
figures, including the intragovernmental transfers.
Senator REED. Thank you, Chairman Greenspan.
On a different topic, and that is with respect to the proposed
modernization bill, first, I note a certain sense of ownership on the
op-sub issue because last year, as you know, I was proposing an
amendment to allow national banks to have operating subsidiaries.
I suspect we will rejoin that debate in the ftiture, but let me put
that aside for the moment.




25
There is concern that I have with respect to the emerging regulatory structure which is incorporated in the Chairman's mark on
financial modernization. I think there are several factors. One is,
it seems to me that the traditional theory of the bank holding company being a source of strength for the underlying depository institution is being weakened, because now with the proposed advent
of insurance powers and of other powers, with the functional regulatory approach where State securities' commissioners and insurance commissioners could essentially decide that they would not
provide resources to help an ailing depository institution, that is a
concern.
There is also a concern because at this time, when we are expanding dramatically the powers of these financial institutions, we
seem to be retracting the regulatory supervision.
For example, there is a proposal that there be no formal approval
of mergers; that is, basically a self-certification process. There is
also the absence within this regulatory structure of a requirement
that you and your colleagues look at safety and soundness issues,
look at public purpose issues.
This kind of passive approach raises severe concerns, because I
know in the past when we have erred, the big mistakes have come
because we have allowed too much discretion and flexibility, I believe, in regulating financial institutions. I wondered if you might
reflect on those concerns, Chairman Greenspan.
Chairman GREENSPAN. Senator, I think that we are all engaged
in a debate not only between various different private groups, but
we have these debates within the Federal Reserve. I think what is
causing the debate is we are dealing with a major, ongoing change
in the financial structure itself, largely driven by technology, but
not wholly. As a consequence, what we have to do is try to address
an appropriate regulatory structure for the newly evolving type of
financial system that is inevitably going to exist in the twenty-first
century.
We have increasingly concluded that the primary source of safety
and soundness and containment of risk is, in the larger firms,
counterparty evaluation, because there is nobody who knows the
underlying potential balance sheet of a customer than somebody
who is lending that institution money. Our ability in the past to
look at balance sheets on a supervisory context is being rapidly
eroded because balance sheets are changing so dramatically that if
we get a print of an investment bank, for example, of 3 weeks ago,
it is going to tell us very little about what the financial status of
that institution is today, except in a very broad sense, obviously.
As a consequence of that, we have recognized that counterparty
surveillance is going to become increasingly relevant and a major
tool to ensure the system's safety and soundness.
As a consequence, we at the Federal Reserve, and I believe at the
other regulatory agencies, also recognize that we have to go ever
more toward an oversight-type of evaluation of the processes by
which a bank or other institution regulates its risk. It is an oversight process which looks at the way they model their risk, both
market and credit risk. It looks at the processes by which an institution makes its loans, and we try to address that as distinct from
spending innumerable hours going through loan files of an institu-




26
tion, which was useful maybe 50 years ago, but is increasingly less
so now.
As a consequence of those changes, largely driven by market and
technology forces, the old notions of source-of-strength and a number of the supervisory structures which we were so used to have
ceased to become the effective means to maintain the safety and
soundness in the system. To be sure, as we go to functional regulation, the source-of-strength doctrine again erodes.
I think we are all groping for the most effective regulatory structure as, indeed, we are groping to understand this hugely changing
financial system—learning as it's happening. I think that we do not
yet fully know where we are going to be 20 years from now as far
as supervision and regulation. We do know that the models of the
past 50 years are increasingly less applicable, and will be, as we
move to the early part of the next century.
Senator REED. Thank you, Mr. Chairman.
Could I ask unanimous consent to include my statement in the
record?
Chairman GRAMM [presiding]. Sure you can.
Senator REED. Thank you, Mr. Chairman.
Chairman GRAMM. Without objection, so ordered.
Senator Grams.
OPENING COMMENTS OF SENATOR ROD GRAMS

Senator GRAMS. Thank you very much, Mr. Chairman.
Welcome, Chairman Greenspan. To follow up on some of those
questions that Senator Bennett had dealing with op-subs versus affiliates, under current law, can mortgage banking be done in the
bank, or is it restricted to holding company affiliates?
Chairman GREENSPAN. There is no restriction on mortgage banking as far as I am aware, and as far as my colleague, who knows
more about this than anybody in the world, says.
[Laughter.]
Chairman GRAMM. A good source.
Senator GRAMS. If a bank can do mortgage banking in the bank,
why do some large holding companies do mortgage banking in an
affiliate instead? Are they foolish not to take advantage of what
you called the "supposed subsidy" that you have talked about?
Chairman GREENSPAN. My recollection is they are moving back
toward the bank in most of those types of institutions. Originally,
there were a number of geographical restrictions and tax restrictions, which are going by the wayside. Where the choices exist, not
only in mortgage banking but in everything—where they have a
choice of affiliate of the holding company or the bank itself, or even
the sub of the bank, all of the evidence we see shows there has
been a major move back toward putting those powers in the bank.
And our evaluation of those which have not yet moved back into
the bank where they can do so legally shows that it's for very specific reasons.
The one thing which is terribly clear is that when these types of
organizations do not use large capital assets or subsidies, then the
real pressure to get back into the bank is less.
But everything we have observed—and 111 be glad to give you details for the record, Senator—shows that activities which had been




27

in the holding company but could be in the bank were there for
reasons other than the subsidy. And when those reasons changed,
they moved back into the bank.
Senator GRAMS. Your feeling is that certain language in this bill,
along with tax ramifications, et cetera, could move from an affiliate
back to the bank?
Chairman GREENSPAN. I'm sorry? Do you mean that it would
make it difficult?
Senator GRAMS. Or that it would be advantageous for them to do
it, or hasten that type of
Chairman GREENSPAN. Well, no, actually not. I mean, they could
do it now, and they are doing it now, so I don't think it's really related to this legislation.
I think there is the presumption that somehow there are numerous organizations which have choices of putting powers in an affiliate of the holding company or in the bank itself, who have chosen
the holding company. I think you will find that as of today, there
is virtually no subsidy used by those institutions, and hence they
don't get the lower cost of capital in the bank, or there are technical issues such as tax or geographical restrictions which, in effect, create costs in moving back to the bank, which is a reverse
subsidy.
Most of it, however, has pretty cleanly gone back into the bank
when the bank is available legally.
Senator GRAMS. Moving to another question, Chairman Greenspan, small community banks, as you know, are the cornerstone of
many of our rural communities, and they are facing greater competition today than last year or the year before.
Do you have any recommendations which could be included in
modernization legislation to help strengthen community banks and
their ability to compete?
Chairman GREENSPAN. Well, the IBAA does support, or has supported, many of the issues, indeed some of the variations of financial modernization.
There is a lot in financial modernization which helps the smaller
banks. I agree with you; I think that there are going to be, at the
end of the day, two fundamentally different types of institutions
which we call "banks" in this country. One is going to be the international, sophisticated institutions which deal everywhere, but on
an impersonal basis. And there is going to be a large segment of
community banks who sell a product the large banks do not have,
which is personal relationships and the ability to be counselor and
adviser on numbers of different transactions, and I think the big
banks do not have a chance at that function.
I think we are going to see with all these major changes that are
going on in the financial system, when it all shakes out, there is
going to be a very large community banking system in this country.
Frankly, I think the fact that it doesn't exist in other countries is
one of the reasons we have a better banking system.
Senator GRAMS. Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Schumer.
Senator SCHUMER. Thank you, Mr. Chairman.




28

Chairman ^Greenspan, again, thank you for your erudite and
thoughtful testimony. I guess my first question relates to one of the
potential downsides that you mentioned in your opening remarks.
When I look at the world, I don't see much cause for optimism
outside of the United States. In other words, it looks like Europe's
growth is slowing down. There are still problems, as you point out,
in Latin America. Xn Asia, China is slowing down, Japan is flat.
Maybe Korea and, I guess, Singapore or Thailand are doing well,
but their gross national product is probably not much more than,
say, Indiana's or North Carolina's, or even
Senator EDWARDS. I think we do a little better than that.
Senator SCHUMER. In any case, my question to you, sir, is: With
all the prognostications around the world being for slow or even
zero growth, low growth or even negative growth, how worried are
you about that on our growth next year, and on the world economy
in general?
Chairman GREENSPAN. Well, clearly, the share of trade, both on
our export and import side, has been growing relative to our domestic economy since the end of World War II, really, and we are
very closely interrelated—not as much as some of the European
countries were, for example, prior to the joining of the European
Union, where their exports were greater than then* net national
product—but we nonetheless are really quite dependent upon what
is going on in the rest of the world and the slowing there does give
us pause.
It's true that we have a very dynamic domestic economy at this
stage, and it is impressive in every respect that one can envisage.
But our industrial sector has slowed down considerably, and, obviously, international trade is almost all physical goods and therefore
would impact on both the export and import side of our industrial
sector. There is clearly a concern, and we are endeavoring to balance the international with the domestic, recognizing that we are
evolving into a new type of international financial system in which
we are, in a sense, learning as we are doing. And that is not the
best way. There is no "Economics 101" which carries us through
what is going on today. We're probably writing the textbooks, but
we do not have them to read yet.
Senator SCHUMER. It seems to me that the international situation could be more of a drag on our economy in this coming year
than it was in the previous years.
Chairman GREENSPAN. I would think so because, as you point
out, Senator, the industrial countries, where we do most of our
business, are slowing down. Europe is slowing down. I think Japan
is still weakening. I do not think it is flat yet, but
Senator SCHUMER. Let me ask you another question, which you
didn't touch on, but which would affect the economy next year, and
that is about Y2K. The Fed has mentioned that our financial institutions themselves are doing quite well in dealing with the problem. But a second and ancillary problem, a serious one, is that consumers, citizens, may be worried about what will happen and will
take their money out of financial institutions toward the second
half of this year because they are worried about this. From what
I understand, the Federal Reserve has set aside a certain amount




29

of reserves for the end of 1999 to deal with that. As I understand,
it is $50 billion.
First, I am curious to know how you arrived at that number.
Second, what else can be done to increase the public's confidence
in how we and our financial institutions are dealing with Y2K? Do
other industrialized countries face this same problem? Are these
countries making the same preparations?
Chairman GREENSPAN. Senator, what we did was to try to make
a judgment, which is very difficult because we have no history, of
what type of conversion of bank and other type of deposits into currency might be made for those who are fearful that their ability to
draw currency over the yearend will be somehow inhibited. And
we know we have enough currency to meet any conceivable demand.
Strangely, the concern that I have is I am worried that people
are going to draw too much out, and walking around with a lot of
$100 bills is not the safest means of keeping your money.
Senator SCHUMER. Right.
Chairman GREENSPAN. I am a little concerned that they may
worry about Y2K and somehow something is going to break down.
Senator SCHUMER. Right.
Chairman GREENSPAN. The one thing we are sure of is they will
not lose any money, because our computer systems are not going
to crash in that regard.
I am getting increasingly concerned that the major danger is
they will draw out money and there are going to be an awful lot
of people who are going to be interested in that.
[Laughter.]
Senator SCHUMER. I will not ask you to name names.
[Laughter.]
It would take too long, I guess.
But I do think it might be a good idea to let people know of the
Federal Reserve's, I think very prudent policy of keeping aside a
certain amount of reserves in case something happens. That would
bolster people's confidence.
Chairman GREENSPAN. We are on a two-pronged policy. First, to
do as much as we can—and we have done an awful lot and will
continue to prevent anything of significance from happening where
we have the capability, double-testing and checking where we can.
Second, to have a whole series of potential actions we would take
in the event that something does happen. We will be doing that obviously in an increasing manner through the rest of the year.
Things that I was concerned about 6 months ago, I must say, are
going much better than I expected. People are getting serious. We
are interrelating with all of our banks, and the testing systems are
going well, so that the worst possibilities I think are behind us.
And most of those are interfaced with the rest of the world where
we don't really know how well they are managing.
Senator SCHUMER. Thank you, Chairman Greenspan.
Chairman GRAMM. I have to leave because of a prior commitment
at noon today, but I want to thank all of the Members and Chairman Greenspan for participating in this very important hearing.
Senator Allard.




30
OPENING STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you very much, Mr. Chairman.
Welcome, Chairman Greenspan. I believe that every time you
have shown up I have asked you about paying down the debt. You
have always had a good answer, but I think I have asked you that
question enough. I am going to move on to some other things relating to the tax reductions and the minimum wage. If we have time,
I may also ask you a question or two about the proposed financial
modernization legislation before this Committee.
I would like to ask you for your comments on what you think—
strictly from an economic standpoint—is the best method of tax relief? Should we go with an across-the-board rate cut, such as the
10 percent that has been mentioned on the Republican side, for income tax, or do we do it with expanding credits and deductions?
I would also like to hear a iew of your comments on what can
be done to help keep our economy strong in that regard.
Chairman GREENSPAN. Senator, as you know, I have always been
strongly supportive of cuts in the marginal tax rate and/or reduction or even elimination of the capital gains tax, which I have always thought to be a poor means of obtaining revenue.
In the current environment, the need to introduce tax cuts to get
the economy going clearly is not particularly the first order of business. As a consequence, I have argued with respect to the surplus
that my ideal economic policy would be to leave it alone, pay down
the debt, lower the long-term interests rates as a consequence, and
that would, in my judgment, be most effective.
If it turns out that it is politically inconceivable that these surpluses can be allowed to run, I have argued that then, unquestionably, tax cuts are the appropriate means, not spending increases,
which are difficult to turn around if they create troubles. I am not
saying that tax cuts are easy to turn around, but I would prefer
that that was done because that would be better for the economy.
Specifically, I think that it is important to distinguish from an
economic point of view the question of whether you are dealing
with marginal tax rate cuts or other types of taxes which reduce
the tax burden but not the marginal rates. In my judgment, the
marginal rate cuts are far superior to any of the other forms, which
clearly have advantages in many respects. In a general way, I have
never seen a tax cut I opposed in the abstract; I mean, the lower,
the better.
But there are differences if you are looking at how the economy
is affected. As it stands now, the most effective means of controlling the economy is to allow the surplus to run. There undoubtedly
will occur a point when that is no longer the case, and I think cuts
in marginal tax rates would be the most appropriate. Whether it
is across-the-board or not is less of an issue. It is administratively
easier to do it that way, but there may be other reasons that you
would want to change it, and I would be glad to comment in detail
on any specific initiative.
Senator ALLARD. I think you have commented adequately on the
tax reduction and I appreciate your insight on that.
I would like to move on to the minimum wage hike. I think in
one of the recent hearings you stated that you think it is not advisable to increase the minimum wage, and I am wondering if there




31
have been any studies or analysis done on your part on the effects
of doing that.
Perhaps you can share with us what the likely impact would be
if we did raise the minimum wage.
Chairman GREENSPAN. There is a very significant debate, as you
well know, Senator, on the impact of this. It was the general consensus of economists over the years that increases in the minimum
wage, indeed the mere existence of the minimum wage, created a
level of unemployment amongst teenagers or those starting at the
bottom of the ladder which wouldn't have existed without the minimum wage. The controversy arose because of a study about differential minimum wage changes in New Jersey and Pennsylvania
in which it was somehow suggested that there either was no impact or indeed it was precisely the opposite.
There has now been a good deal of revision on that view. There
are economists who do believe that the minimum wage does not
have a significant impact on employment. I'm not one of them. I
seriously believe that it does. It's not visible in today's environment
because everybody can get a job today, and there is over-demand
in that regard. We will see the impacts when the demand for labor
eases, And for precisely the same reasons that I think it has been
very important for a number of people at the lower end of the income scale, the younger people who are just starting off, who do
not have the skills to be able to join the workforce, to get on-thejob training, to be able to move up the ladder, so to speak, it is a
minimum wage which in my judgment endeavors to prevent that
from happening under certain conditions.
I have great difficulty seeing the logic of having that type of restriction on that part of our labor market.
Senator ALLARD. Mr. Chairman, I see that my time has run out.
Thank you very much for your time.
Chairman GRAMM. Thank you.
Senator Bayh.

Senator BAYH. Thank you, Mr. Chairman.
Chairman Greenspan, I have not had the pleasure of posing
questions to you before as Senator Allard has, I would like to follow
up on a couple of the points that he made, and I hope that it's not
too redundant.
It seems to me that we have a great opportunity in setting fiscal
policy in this Congress, as we look at the first significant budget
surpluses in a generation, to put our country on the right path for
the long haul. I tend to find myself squarely in the more conservative camp of believing that we need to continue to make sure that
the budget remains balanced. I think it is imperative we make the
changes in the entitlement programs necessary, along with the first
use of any budget surplus to make sure that they are on a longterm sustainable path. Then we have to set priorities among other
options. You mentioned paying down the national debt. There is
also the possibility of tax cuts or investments and other activities
that might increase the productivity of individual workers.
My first question relates specifically to someone I was talking
to last week who was frankly a little skeptical about the Government's, or I should say more specifically, the Congress' ability to
actually pay down the national debt. That, while in theory this is




32

the best thing to do, this particular skeptic just felt that at the end
of the day, the allure of tax cuts or spending would be more than
the Congress could resist.
I would like for you to expand a little on the remarks you made
to Senator Allard and help me explain to the people of Indiana and
to the people of our country why paying down the national debt is
in their long-term best interests: higher wages, more jobs, a better
standard of living.
Chairman GREENSPAN. Senator, what evidence we have, not only
in the United States but pretty much around the rest of the world,
shows that long-term interest rates will fall as you bring the total
debt down. This means that mortgage interest rates will be lower
than they otherwise would be.
Mortgages, as you know, have become increasingly not only a vehicle to fund housing, but also have been used to a considerable extent as consumer debt and have been a major force in that. And
it matters what those interest rates are.
If long-term interest rates are lower and the risk premiums are
lower as a consequence of that, the cost of capital generally is
lower. That, in turn, will mean that productive capital assets are
far more readily to be produced, and they will bring standards of
living up because labor productivity will rise as a consequence.
In fact, all of the arguments that one can make for tax cuts you
can make for the reduction in debt. They are the same forces, but
they occur under different circumstances. In other words, there are
occasions when I would very strongly support reducing taxes even
though you could have reduced the national debt because the economy needs that sort of tax cut to be of assistance.
I am firmly of the belief that you pay down the debt as much as
you can largely because there will occur occasions when you are
going to want to raise it, and if you raise it from much lower levels,
the negative impact on the economy is clearly less. As a consequence of that, in the environment which we have today in which
labor markets are exceptionally tight, in which demand is exceptionally strong, in which productivity is rising fairly dramatically,
what we need is savings to support that type of system. The Government surplus which we have has been quite instrumental and
quite effective in assisting in that process.
Senator BAYH. Thank you, Chairman Greenspan. That is a message we are going to need to continue to make if we are going to
pursue the prudent and, I believe, conservative long-term course
for our country, and I appreciate your helping us make that point
today.
Just very briefly, one additional question, I had the pleasure
some years ago of hearing you make a presentation to the National
Governors' Association. At that time, the topic was the maximum
rate of sustainable noninflationary growth. It doesn't seem to be
quite as hot a topic today for reasons that you have outlined in
your testimony.
My question to you is: Assuming that we are going to get into
a debate about tax cuts in this Congress after we have dealt with
the other items that we have mentioned and hopefully made some
good progress toward paying down the national debt, I am interested in your comments in response to Senator Allard about the




33

benefits of reducing marginal rates and targeting tax cuts for other
activities.
Let me put a finer point on it. I understand the economic benefits of reducing marginal rates, but at the time we were discussing
economic growth a couple of years ago, you said the best thing we
could do in the short run was to increase the productivity of individual workers, and you went on very eloquently about the need to
improve education and training levels in the American economy.
I am interested in why targeting tax cuts toward training, education, and improving skills is not a better way to go to increase
productivity than reducing marginal rates.
Chairman GREENSPAN. It depends on how you evaluate the various priorities with respect to where education is, how it is being
financed, and capital assets.
Senator, there is no question that productivity comes from the
interaction of capital on the one hand, and people on the other. We
have seen a dramatic increase in education in this country mainly
because the economy is pressing for people to have higher skills.
On-the-job training has gone up dramatically. We have what we
call corporate universities now who have effective liberal arts programs as well as technical programs related to the company itself.
Community colleges have gone up remarkably. And one of the most
fascinating things is the proportion of older people who have gone
back to college full-time.
All of this has occurred in the private sector. It has occurred
under the existing financial mechanisms. If you can find vehicles
from the public sector which would help that, then I believe you
have a strong argument to say it stands on the same level as cuts
in taxes which affect investment. I would only wish to argue that
as much as there is need for improved financing of educational institutions, let us not forget that pressures coming from the needs
of the economy have done an awful lot of that already. Is there
more to be done? I suspect so. Would I know how to do it? I woxild
not, but experts probably can find ways of doing it. If the case is
a strong one, I think that I would be unable to argue that tax cuts
are superior to that particular project.
It is a cost/benefit analysis that you are working with.
Senator BAYH. Thank you, Mr. Chairman.
Senator ALLARD [presiding]. Thank you, Senator.
I now recognize the Senator from Kentucky, Senator Bunning.
Senator BUNNING. Thank you very much, Senator Allard. I have
been on committees in the House for years that have had the good
fortune of having Chairman Greenspan testify, and I would like to
ask a couple of questions.
In December 1996, Chairman Greenspan, with the Dow Jones Industrial Average at 6437, you were worried about what you called,
and I quote, "the irrational exuberance of the markets."
With the Dow closing at 9552 yesterday, do you still have those
same fears?
Chairman GREENSPAN. If you go back to the text of that 1996
speech
[Laughter.]
—which was a very turgid speech which put an awful lot of people to sleep through most of it, what I was trying to raise was the




34

fact that I was concerned in a discussion with respect to the various elements of how one should do monetary policy, whether we
should begin to start to look at the issue of not only the price of
goods and services, but also the price of assets as well. I raised the
issues of what had been effectively a bubble in Japan up through
the 1980's into early 1990 and other previous periods where it was
very difficult to know whether you had a bubble or whether you
had some real underlying force in the marketplace. The question
I was asking, abstractly, is how will we know when markets are
gripped by irrational exuberance? I didn't have an answer at that
particular point.
I think I have an answer now; that it is very difficult to judge,
except in retrospect. If the stock market, any stock market, be it
here or abroad, falls by 30 or 40 percent in a matter of weeks or
a very few months, I will grant that there was a bubble back there.
[Laughter.]
The issue of trying to identify a bubble in advance means you
have to be confident enough to predict a decline of that order of
magnitude, and I don't know anyone who knows how to do that.
We are, at this particular stage, caught in an issue where, with
this broadly changing economy that I have discussed with respect
to financial modernization and the issues of inflation, we are seeing
different things that are going on. Clearly, nobody has questioned
at all that the dramatic acceleration that we have seen in some
technologies, and the marked increase in productivity and profitability of American businesses, has undoubtedly had a significant
impact on underlying prices of all capital assets, including equities.
Whether or not it is gripped by irrational exuberance is an issue
that you will not really know for sure except after the fact, but as
I indicated in my prepared remarks, that I suspect that these markets are highly valued leaves me without terribly much doubt at
this point.
Senator BUNNING. In other words, you still have those very same
concerns.
Chairman GREENSPAN. I have concerns. I do not know that they
are the same ones, but I have concerns.
Senator BUNNING. Let me ask you something about trade and
trade deficits. During the Reagan Administration, we also had a
rapidly growing economy, but many were fearful because of our
large trade deficit. Now, once again, we have a healthy economy
and a large trade deficit, but there doesn't seem to be much talk
or concern about the trade deficit.
Do you think the present trade deficit is a cause of concern?
Chairman GREENSPAN. Well, Senator, I do try to address it in my
prepared remarks, not very broadly, but there is a tricky problem
here which we have not been able to solve. We do know that the
trade deficit creates a very large so-called current account deficit,
which is really the net borrowing from the rest of the world.
As a consequence of these increasing current account deficits, the
level of the debt that we owe externally is rising. The debt service
payments are rising as a consequence, and invariably what we are
witnessing is a major increase in the dollar asset holdings by nonAmericans, which is clearly the other side of the trade deficit.




35
As of now, the appetite to hold U.S. dollar-denominated assets
seems quite extensive and there is no evidence that I am aware of
which is suggestive of any individual's eschewing dollar asset holdings because, were that the case, the exchange rate for the dollar
would get exceptionally weak. It has not. On the contrary, it has
been behaving rather well, which is another way of saying that the
absorption of the current account deficit by the willingness to hold
increased claims on the United States has shown no abatement as
of yet.
But the arithmetic of increasingly increasing the debt service
charges, which means that goes into the current account deficit,
can result in, as certain countries have discovered, a very serious
debt problem, which can get out of hand and become cumulative.
Because the interest goes up, that increases the current account
deficit, which in turn increases the debt, you get into a spiral.
We are nowhere near that as yet, but we nonetheless do have the
problem of projecting how far into the future this particular type
of current account deficit can continue without impacting on the exchange rate and, as a consequence, on the whole structure of the
American economy.
Senator BUNNING. Thank you for your answers.
Chairman GREENSPAN. Thank you, Senator.
Senator ALLARD. I recognize the Senator from North Carolina,
Senator Edwards.
Senator EDWARDS. Good morning, Chairman Greenspan. I have
heard some concerns expressed about the lack of definition of insurance in some of these pieces of modernization legislation.
I wonder if you could address that concern and tell us whether
you think it is important for us to make an effort to define insurance for purposes of trying to distinguish between banking products and insurance products, particularly for regulatory purposes?
Chairman GREENSPAN. There are a number of issues that have
emerged in the discussion of financial modernization which are important, but which we do not have any strong views on one way
or the other. This is one of them. I think that the relevant parties
in the insurance business, in the securities business, and elsewhere
have made very commendable efforts to come together and resolve
a number of these issues.
I am sure you are aware, Senator, in years past it was precisely
such differences which made financial modernization exceptionally
difficult to implement. I think we're all coming together, largely because there's a general recognition that the existing structure just
does not any longer make sense, and that everyone has to give a
little bit. I think that's happening. I believe, as a consequence, we
will get Glass-Steagall and all of its negative accoutrements repealed and, hopefully, in the process, some agreements on the various elements of how insurance is handled in the bill contributes
to that.
But we, ourselves, don't have any strong views on that which relate to the system as a whole that we thank are crucial from the
perspective of our obligations.
Senator EDWARDS. Let me change subjects. As you know, some
of the proposals, including the President's, for Social Security reform involve, at least in part, paying down the public debt.




36

I wonder if you would comment briefly on the value or the sensibility of such proposals with respect to Social Security reform?
Chairman GREENSPAN. Well, let me take a step back. The ideal
thing, from an economist's point of view, on Social Security, would
be to leave the current services budget alone. That would create
the maximum amount of increase in the Social Security trust fund
and, as I argued before the Senate Budget Committee recently, the
major shift toward a large increase in the ratio of retirees to workers as we move into the next century, really requires a substantial
increase in net national savings.
The extent to which you get savings from the Government or
from the private sector is important for lots of things about the
structure of the economy, but savings are savings, and if they are
used productively, they will create capital assets and finance the
requirements for goods and services of retirees. So, the greater the
number, the better.
What the President has chosen to do is apparently to recognize,
which a number of your colleagues have so indicated, that leaving
the current services budget in place is not politically feasible. It
would either be spent or returned to the taxpayer. He has effectively argued for legislation that would lock 62 percent of the projected current services budget surplus into the Social Security trust
fund. As I just said, I would prefer doing nothing, which would put
100 percent into the Social Security trust fund, but 62 percent is
better than zero.
Senator EDWARDS. I have one last question. I was interested in
your comments about Y2K and Americans' concerns about Y2K.
What advice would you give a senior citizen in the United States
in December 1999 about what to do with their savings account?
Chairman GREENSPAN. I would say the most sensible thing is to
leave it where it is. That's probably the safest thing. There is almost no conceivable way in which I can envisage that computers
will break down and records of people's savings accounts will disappear. I mean, that's not what the problem is. It is easy to prevent that from happening, and everyone will do that. There are,
fortunately, so many different checks and balances that if it gets
knocked out in one place, it's available in 20 other places.
The real problem, basically, is the issue as to whether, in fact,
a usual means of withdrawing currency will be blocked, whether by
technology breaking down, whether something freezes up, whether
or not the safe in the bank can be opened, or something like that.
That's a minor concern that I am aware of. While I do not deny
that it is certainly preferable to have the currency available rather
than the money temporarily locked up in your bank because the
doors don't open, your money is perfectly safe; you just can't get it.
It's an issue as to whether you're safer taking it out and waving
it around, or whether you're better off just leaving it there.
Senator EDWARDS. Thank you, Chairman Greenspan. Thank you
very much, Senator Allard.
Senator ALLARD. I thank the Senator from North Carolina.
Just so my colleagues know the instructions I have received from
Chairman Gramm, he said that I could go ahead and ask a couple
of questions, and then Senator Sarbanes has a couple of questions
he would like to ask. I don't know whether the Senator from North




37

Carolina has any more questions or not. If not, my intent would be
that we adjourn the Committee at that particular point in time.
Chairman Greenspan, I have a couple of questions I would like
to ask you. Following up on my earlier comment, I would like to
move on now to the Financial Modernization Act. I do think it's important that we look closely at the risks that we may build into the
financial modernization effort.
There is some terminology that's used in the bill that I would be
interested in knowing how you would look at as a regulator. They
talk in the Financial Modernization Act about what is defined as
"well-capitalized" and "well-managed."
How would you define these as a regulator, and how often would
you look at these standards? Do you have any idea how you might
handle those?
Chairman GREENSPAN. Senator, you are raising one of the most
difficult problems that exists in this area. What's the appropriate
level of capital in a bank?
In fact, it's interesting that at a recent meeting of major bankers,
I asked that question of each individual bank: how do they determine how much capital they hold? Because all of them are way
above the regulatory minimums, they couldn't argue that, well, we
keep enough capital because that's what the Federal Reserve, the
OCC, or the FDIC requires. All of the banks had capital well above
the regulatory minimums.
What we observe is the increasing sophistication of evaluating
risk and how, in a sense, do you preserve the franchise of the institution from a particular episode in which losses will essentially upend the bank and eliminate its value. Each bank has a different
way of doing it. It depends on the specific asset mix, the type of
customers, and the type of economy they perceive.
When it gets to regulatory capital, this is a statutory issue which
the Congress imposes or gives us the authority with which to set
various standards. What we try to do is to replicate the same considerations that a responsible bank would be engaged in. It is not
something where you can set a level of rules because in every case,
the amount of bank capital you need is a function of the future,
which is unknowable. You can guess at it, you can forecast it, you
can project it in many different ways, but we don't know what's
going to happen, and capital is future-oriented.
We try to improve the risk measurement measures, we try to do
all of the various other things that are possible, but at the end of
the day, we look to the issue of safety and soundness in the very
broadest sense, and hope that our banks under our supervision and
the banks under the Comptroller's supervision and the FDIC's supervision will recognize where their risks lie and set aside capital
accordingly.
Senator ALLARD. I would also like to bring up an issue which is
not new to this Committee, and it has to do with "too big to fail."
Once again, with the Financial Modernization bill, we have set up
a mechanism where we have a holding company with all these various operations underneath. It looks to me like in order to allow
them to compete internationally, we have also allowed them to get
bigger.




38

How do we deal with that issue so that we don't end up unfairly
subsidizing the larger banks more than the smaller banks and financial institutions?
Chairman GREENSPAN. You have asked two of the most difficult
questions in supervision, one right after the other.
It is very important that we, as supervisors, are careful about
leading the markets to presume that we will prevent an institution
from failing. That is easy; we will let it fail.
The question is, how and to what extent will we go to facilitate
its liquidation? Wiping out the shareholders, which effectively is
what failing will do, is easy to do. What is not easy to do is make
judgments. Take an institution where the assets are significantly
less than the liabilities, but the institution is very large and has
secondary consequences if you liquidate it rapidly, how do you go
about handling that?
One of the tilings we try to envisage—and we haven't confronted
this issue yet—is that if we get one of these very large institutions
which runs into very serious trouble, we would allow it to fail. I
mean, the shareholders basically are out of the game.
We probably, depending on the nature of what type of economy
we had, what type of financial system, will try to make judgments
as to whether, in fact, we prevent that institution from liquidating
in the normal way. As you know, whenever you get defaults, you
create a whole huge set of cross-defaults on all other types of debt,
and if you leave it alone, the whole thing will just implode very
quickly because most everything becomes a demand note. It's that
process which we would probably seek to manage.
But ultimately, unless we allow that to happen, we will create
what economists call significant moral hazard in the economy and
distort capital. As it stands now, even a bank which is one which
regulators have full supervision over has debentures whose yield is
still quite significantly above the U.S. Treasury rate of comparable
maturity.
If the markets believed that we would never allow that institution to fail, then that spread would narrow to negligible differences.
Fortunately, the markets understand that those institutions will
fail. We will allow them to fail. What we will also try to do is manage the failure so that the spillover effects on other institutions are
de minimis.
It's easier said than done; it's a very complex process. I hope that
when confronted with it, we do it with minimum disruption.
Senator ALLARD. Thank you for your answer.
The Senator from Maryland, Senator Sarbanes.
Senator SARBANES. Thank you very much, Mr. Chairman. I am
mindful of the fact that you have a conference that you need to get
to. I have just two subjects I want to cover.
First of all, Chairman Greenspan, I thought the point you made
on the unitary thrifts, that actually it's financial institutions rather
than commercial institutions which have been acquired, was very
enlightening.
On the commercial institutions, which is, of course, the loophole
we want to try to close, you have previously testified—and I assume it is still your position—that we need to at least prohibit or
significantly restrict the ability of the grandfathered unitary thrift




39
holding companies to transfer their legislatively-created grandfather rights to another commercial organization through mergers
or acquisitions.
I take it that remains your position?
Chairman GREENSPAN. That is correct, Senator.
Senator SARBANES. Since these questions were asked about the
surplus by others I hadn't intended on raising this subject, but I
want to go into it just for a moment with you.
From a macroeconomic sense, with unemployment at 4.3 percent,
isn't it counter to appropriate macroeconomic policy to use the surplus in a way that constitutes a stimulative fiscal policy that would
be either through tax cuts or spending increases?
I mean, either would contribute to a total demand on the economy, when we have an economy that is now working pretty close
to capacity or maybe at capacity—and some have even questioned
that—so that holding the surplus and using it to pay down the
debt is not only appropriate just in the sense of trying to reduce
the burden of the debt and what that means into the future, but
it's the appropriate macroeconomic policy at this point.
Chairman GREENSPAN. I agree, Senator. In fact, I hope I made
that point earlier.
Senator SARBANES. We're concerned about national savings. It's
a difficult problem for us because it's hard to get our consumers to
save, as it is. But the most immediate and significant contribution
we could make to national savings would be to, in a sense, hold on
to the surplus for debt reduction.
National savings constitutes in the overall picture, does it not?
Chairman GREENSPAN. It does, Senator.
Senator SARBANES. I don't quite understand where this line is
developing that we may not have the discipline to protect the surplus for these purposes. We have wrestled with this issue for a long
time. We finally have moved the economy into surplus. These projections into the future about large surpluses are simply that; they
are projections. One hopes that they prove out, but it's not quite
clear to me why, without more experience and more of a run to see
that that's going to be the case, we should immediately move to,
in effect, change the dynamics on this surplus issue.
It seems to me we should continue running surpluses for awhile,
devote them to bringing down the debt. It may develop that in a
macroeconomic sense, at some point in the future, we may want to
provide some stimulus to the economy to keep it at high levels. As
you said, I obviously don't think we're at that point right now.
It seems to me that for this whole host of reasons, I agree with
what I understand to be your position; that is, of all the alternatives, the one you rate first and foremost by a significant margin
would be to use the surplus to pay down the debt.
Chairman GREENSPAN. That is correct, Senator.
Senator ALLARD. But how do you save that surplus? I guess the
question is: How do you keep it from getting spent?
Chairman GREENSPAN. What happens is, you do nothing.
Senator ALLARD. While we're on the debt, just to follow up a little bit, where is the optimal level of the Federal debt? I mean, is
it zero, or is it somewhere where it's a percentage of the GDP?




40

Chairman GREENSPAN. My view is; the lower, the better. There
is unquestionably a certain level of debt which some people argue
is useful for the financial system in that U.S. Treasury securities
are a certain type of instrument which cannot be fully replicated
in the private sector. I'm not sure that's right, but there's no question that there is no risk, by definition, hi those securities, and that
it does serve a useful purpose in finance. So you need some debt,
but that's not very large, and one can even argue that if push came
to shove, a lot of the private instruments could generally serve the
same purpose.
There is a whole lot of literature in the academic fraternity that
gets to this issue. It's never convinced me that zero is the wrong
number.
Senator ALLARD. Thank you.
Senator SARBANES. Chairman Greenspan, the only point I want
to make very strongly is that you have to relate this question to
the general condition of the economy. That's why it's so important
right now, because we have an economy that is functioning very
well at high levels of employment.
In fact, I would assume that if the Congress were to embark on
a major stimulative fiscal policy, the Fed would have to consider
adjusting monetary policy in view of that.
You would have to take that into account; would you not?
Chairman GREENSPAN. Senator, what I have answered with respect to questions like that is that the specific actions that are
taken do not directly impact monetary policy.
What does happen is events that occur either in fiscal policy in
the economy or in the international economy, as it affects the economy, we respond to that. It is not as though one can say that if
there was significant increase in fiscal stimulus, the central bank
would automatically respond. The answer is no. However, should
that stimulus create an environment which required us to respond,
it would be the economy to which we were responding, not to the
fiscal stimulus.
Senator SARBANES. Mr. Chairman, I'm very delighted to see that
Chairman Greenspan's ability to address questions has not diminished in the least.
[Laughter.]
Senator ALLARD. With that, I think I want to thank Chairman
Greenspan for spending time with the Committee. It's very much
appreciated. You have been very gracious and generous with the
Members of this Committee, and I want to thank you.
Chairman GREENSPAN. Thank you, Mr. Chairman.
Senator ALLARD. The hearing is adjourned.
[Whereupon, at 12:40 p.m., Tuesday, February 23,1999, the hearing was adjourned.]
[Prepared statements, response to written questions, and additional material supplied for the record follow:]




41
PREPARED STATEMENT OF SENATOR PHIL GRAMM
We are in a climate where everybody wants to take credit for the current level
of economic activity in our economy. Politicians of all stripes want to take credit for
the fact that we have prosperity in the American system that is broad-based and
probably deeper than at any time in the modern history of the country.
Most politicians have about as much to do with the current level of prosperity as
the rooster has in crowing over the sun coming up. My opinion is that basically the
emergence and absorption of new technology, the productivity of American workers,
the expansion in world trade, the end of the cold war, the fundamental strengths
that were laid in previous Congresses and previous Administrations, really have
much to do with our current level of prosperity and probably dominate it.
But if there is any person currently in a public policy position who is due at least
partial credit for the current state of the American economy, that person is sitting
in front of us today.
Chairman Greenspan, I want to thank you for the great job you have done. We
have had many great men who have been Chairman of the Federal Reserve System,
many great and effective leaders, but I think that while you still have much of your
career in front of you, and I am grateful for that, I don't have any doubt about the
fact that you will go down as the greatest Chairman in the history of the Federal
Reserve System.
You have done an extraordinary job in balancing the needs of the economy, and
we are very proud of the work that you have done. I wanted you to know how I
feel about it.
Thank you.
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Thank you, Mr. Chairman. And thank you, Chairman Greenspan, for doing double
duty today. I appreciate your willingness to cover not only the positive economic figures today, but also to comment on the proposed financial services modernization
legislation.
As one of the Democrats who voted for President Clinton's 1993 budget, it is particularly gratifying to me to see the end of the era of budget deficits, and to face
the current dilemma of what to do with our budget surplus. Despite regular predictions of downturns, we are currently enjoying a historic expansion. In my short
time on the Banking Committee, I have grown to appreciate your semiannual reports, and I hope we can continue these helpful reviews of employment and inflation
figures, as well as the general state of the economy.
Regarding the second portion of your presentation, I share my colleagues thoughts
about the importance of financial services modernization legislation. We must pave
the way for our financial services industry to compete in a changing and challenging
global marketplace without sacrificing the small institutions that necessarily have
a narrower focus. Those institutions form the backbone of our small communities
across the country, and they too must be well served by financial modernization. We
must approach this undertaking in a context that preserves and even strengthens
the safety and soundness of our financial services system.
I was very supportive of this Committee's previous efforts to modify financial services firewalls and enable U.S. firms to compete globally. Through tedious, yet ultimately productive effort, we crafted a bill that addressed the major concerns. I fear
we may have strayed from those principles in the current draft under consideration,
and I am hopeful that some specific concerns will be addressed before we move
ahead with this process.
In the process of allowing financial firms to fully serve their customers, we must
also address some concerns of our smaller banking institutions. Given the liquidity
crisis confronting rural America, we must ensure smaller banks have access to the
credit they need to continue supporting small businesses, farmers, and ranchers. We
also must preserve a competitive balance by allowing all sides equal access to these
new markets we are creating.
Mr. Chairman, I support our efforts to provide financial services modernization,
and I am hopeful that we can again work in comity toward that goal. I again thank
Chairman Greenspan for his thoughts today, and I look forward to Secretary Rubin
and the other witnesses in the next few days.
Thank you.




42
PREPARED STATEMENT OF SENATOR CHRISTOPHER J. DODD
It is always a pleasure to welcome Chairman Greenspan of the Federal Reserve
Board here, and I appreciate his coming before the Committee today to deliver the
biannual Humphrey-Hawkins address.
I can think of more difficult duties and responsibilities than reporting to Congress
on a continued robust economy. Inflation and unemployment are down, while job
creation and homeownership are up. The performance of this economy is by virtually all indicators strong, and Chairman Greenspan's steady leadership is no doubt
part of the reason why.
It is equally apparent that the Clinton Administration also shares credit for the
strength and consistency of this recovery. The deficit reduction legislation of 1993
and 1997 which came in the aftermath of President Bush's deficit reduction package
of 1990 have achieved almost $2 trillion in deficit reduction. The Administration's
efforts to reduce taxes on capital gains and small businesses, extend the R&D tax
credit, make homeownership more affordable, and invest in education achievement
for our people have all made huge contributions to our current prosperity.
But this is not a time, obviously, for self-congratulation, or for leaders in the Congress, the Executive branch, or the Fed to sit on their laurels. There are challenges
that loom on the horizon that must be addressed if we are going to continue to build
the kind of economy that allows each and every American an opportunity to build
an economically secure life.
There are several issues that immediately come to mind. First, what are the steps
we can take to assist our trading partners in Asia and Latin America so that overseas markets for U.S. goods and services can get back on a growth path?
Second, what is the long-term outlook for energy prices which are so important
to the continued growth of our economy—particularly to high-energy areas of the
country like the Northeast?
Third, how do we address some of the difficulties posed by technological innovations such as new threats to privacy, the Y2K problem, and on-line trading?
I am hopeful that Chairman Greenspan will be able to address these and other
issues during this morning's hearing. I look forward to hearing his views and those
of my colleagues on the Committee.
We are also fortunate to have Chairman Greenspan here to discuss yet again the
very important issue of financial modernization. Chairman Greenspan speaks with
unique authority and insight into the issue that this Committee will address as we
move to a markup of legislation to modernize our financial services system.
Certainly, one of the key issues we will need to address is the structure of these
new financial services conglomerates. What steps should we be taking to ensure
maximum safety and soundness protections? Obviously, Chairman Greenspan and
Treasury Secretary Rubin have different views on this matter.
Chairman Greenspan believes that financial holding company affiliates and functional regulation are the best guarantors of safety and soundness. Secretary Rubin
argues with equal vigor for a structure that allows for nonbank subsidiaries of
banks, which he asserts will protect safety and soundness while at the same time
ensure the continued substantial regulatory role for the Treasury Department. I am
sure that both officials will forcefully and effectively state their position before the
Committee today and tomorrow.
Another issue we need to address is the Community Reinvestment Act (CRA).
Last year, by a vote of 16-2, this Committee stated very clearly its belief that, in
this brave new world of financial services reform, we have to take care to ensure
that financial institutions continue to meet their responsibilities under the CRA.
That is why H.R. 10 contains exceedingly modest but nonetheless quite significant
CRA provisions.
I know Chairman Gramm has his own strongly held views on this law. I feel with
equal strength that the CRA, while not perfect, has been a real success story. By
some official estimates, more than $1 trillion has been leveraged under this law:
credit for home mortgages, small businesses, and other purposes that have enabled
creditworthy citizens to improve their economic status. This has not been done on
a charitable basis; there is overwhelming evidence that lenders' CRA portfolios are
profitable. Indeed, in previous statements, Chairman Greenspan has voiced concurrence with this viewpoint.
These are two of the critical issues Members of this Committee will be focused
on in the days to come. I look forward to Chairman Greenspan's customarily illuminating testimony on financial modernization. I also look forward to working with
Chairman Gramm and all of the Members of this Committee to fashion what I hope
will be good legislation that gets the support of all, or at least most, of the Members
which we can then bring to the floor for our colleagues' consideration.




43
PREPARED STATEMENT OF SENATOR JACK REED
Mr. Chairman, thank you for calling today's hearing to discuss the Federal Reserve's Monetary Policy Report and financial services modernization legislation. I
am anxious to hear Chairman Greenspan's thoughts on the economy and his impressions on the impact that the continuing crises in Asia, Russia, and Brazil will have
on trade and the entire U.S. economy.
I generally find these hearings to be very informative and I appreciate the opportunity to question Chairman Greenspan on his views, as well as the Federal Reserve s handling of monetary policy. I am concerned, however, that unless Congress
acts, the requirement that the Fed appear before Congress semiannually to present
a monetary policy report will expire at the end of the year. In view of the importance of these hearings, I would like to work with Chairman Gramm to extend the
Humphrey-Hawkins requirements.
With respect to financial services modernization, I would like to applaud Chairman Gramm's commitment to moving forward. I share his views on the importance
of enacting a modernization bill to enhance the efficiency and competitiveness of our
domestic financial services industry. However, given the tremendous difficulty of our
task, I believe our efforts will be successful only if we act in a determined and bipartisan fashion.
To this point, I'm concerned that the bill we are discussing today has been crafted
without Democratic input. Consequently, the bill has a number of flaws, which, in
my opinion, will make it difficult to garner the bipartisan majority necessary for
passage and enactment.
I am concerned about provisions in the bill that will weaken and undermine the
Community Reinvestment Act, which has been responsible for billions of dollars in
bans to low-income urban and rural communities.
In addition, I believe the bill sets up a regulatory framework that is confused, at
best, and nonworkable, at worst. For example, the bill establishes the Federal Reserve as the umbrella regulator for bank holding companies, while creating a loophole that will allow other regulators to act as the umbrella regulator over certain
types of bank holding companies. Furthermore, the regulatory structure undermines
the source-of-strength doctrine, limiting the Fed's authority to require a holding
company affiliate to recapitalize a failing bank. I am concerned that this regulatory
structure might not withstand the stress of an economic downturn.
Finally, I have concerns about the operating subsidiary provisions which are effectively limited to community banks. I believe that all banks should have the flexibility to conduct activities through an operating subsidiary, and I intend to offer an
amendment which will allow securities underwriting and merchant banking in an
operating subsidiary. Indeed, I look forward to questioning Chairman Greenspan
about this issue.
In closing, I would again like to thank the Chairman for holding this hearing, and
I look forward to working with him to discuss the concerns I have outlined in my
statement.
PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
FEBRUARY 23,1999
Federal Reserve's First Monetary Policy Report for 1999
Mr. Chairman and Members of the Committee, I appreciate the opportunity to
present the Federal Reserve's semiannual report on monetary policy.
The U.S. economy over the past year again performed admirably. Despite the
challenges presented by severe economic downturns in a number of foreign countries
and episodic financial turmoil abroad and at home, our real GDP grew about 4 percent for a third straight year. In 1998, 2% million jobs were created on net, bringing
the total increase in payrolls to more than 18 million during the current economic
expansion, which late last year became the longest in U.S. peacetime history. Unemployment edged down further to a 4V4 percent rate, the lowest since 1970.
And despite taut labor markets, inflation also fell to its lowest rate in many decades by some broad measures, although a portion of this decline owed to decreases
in oil, commodity, and other import prices that are unlikely to be repeated. Hourly
labor compensation adjusted for inflation posted further impressive gains. Real compensation gains have been supported by very robust advances in labor productivity,
which in turn have partly reflected heavy investment in plant and equipment, often
embodying innovative technologies.




44
Can this favorable performance be sustained? In many respects, the fundamental
underpinnings of the recent U.S. economic performance are strong. Flexible markets
and the shift to surplus on the books of the Federal Government are facilitating the
buildup in cutting-edge capital stock. That buildup in turn is spawning rapid advances in productivity that are helping to keep inflation well behaved. The new
technologies and the optimism of consumers and investors are supporting asset
prices and sustaining spending.
But, after 8 years of economic expansion, the economy appears stretched in a
number of dimensions, implying considerable upside and downside risks to the economic outlook. The robust increase of production has been using up our Nation's
spare labor resources, suggesting that recent strong growth in spending cannot continue without a pickup in inflation unless labor productivity growth increases significantly further. Equity prices are high enough to raise questions about whether
shares are overvalued. The debt of the household and business sectors has mounted,
as has the external debt of the country as a whole, reflecting the deepening current
account deficit. We remain vulnerable to the rapidly changing conditions overseas,
which, as we saw last summer, can be transmitted to U.S. markets quickly and
traumatically. I will be commenting on many of these issues as I review the developments of the past year and the prospects going forward. In light of all these risks,
monetary policy must be ready to move quickly in either direction should we perceive imbalances and distortions developing that could undermine the economic
expansion.
Recent Developments
A hallmark of our economic performance over the past year was the continuing
sharp expansion of business investment spending. Competitive global markets and
persisting technological advances both spurred the business drive to become more
efficient and induced the price declines for many types of new equipment that made
capital spending more attractive.
Business success in enhancing productivity and the expectation of still further,
perhaps accelerated, advances buoyed public optimism about profit prospects, which
contributed to another sizable boost in equity prices. Rising household wealth along
with strong growth in real income, related to better pay, slower inflation, and expanding job opportunities, boosted consumption at the fastest clip in a decade and
a half. The gains in income and wealth last year, along with a further decrease in
mortgage rates, also prompted considerable activity in the housing sector.
The impressive performance of the private sector was reflected in a continued improvement in the Federal budget. Burgeoning receipts, along with continuing restraint on Federal spending, produced the first unified budget surplus in 30 years,
allowing the Treasury to begin to pay down the Federal debt held by the public.
This shift in the Federal Government's fiscal position has fostered an increase in
overall national saving as a share of GDP to 17V4 percent from the 14Ms percent
low reached in 1993. This rise in national saving has helped to hold down real interest rates and to facilitate the financing of the boom in private investment spending.
Foreign savers have provided an additional source of funds for vigorous domestic
investment. The counterpart of our high and rising current account deficit has been
ever-faster increases in the net indebtedness of U.S. residents to foreigners. The
rapid widening of the current account deficit has some disquieting aspects, especially when viewed in a longer-term context. Foreigners presumably will not want
to raise indefinitely the share of their portfolios in claims on the United States.
Should the sustainability of the buildup of our foreign indebtedness come into question, the exchange value of the dollar may well decline, imparting pressures on
prices in the United States.
In the recent economic environment, however, the widening of the trade and current account deficits had some beneficial aspects. It provided a safety valve for
strong U.S. domestic demand, thereby helping to restrain the pressures on U.S. resources. It also cushioned, to some extent, any economic weakness in our trading
partners.
Moreover, decreasing import prices, which partly came from the appreciation of
the dollar through mid-summer, contributed to low overall U.S. inflation, as did
ample manufacturing capacity in the United States and lower prices for oil and
other commodities stemming from the weak activity abroad. The marked drop in energy prices significantly contributed to the subdued, less than 1 percent, increase
in the price index for total personal consumption expenditures during 1998. In addition, supported by rapid accumulation of more efficient capital, the growth of labor
productivity picked up last year, allowing nominal labor compensation to post another sizable gain without putting added upward pressure on costs and prices. I




45
shall return to an analysis of the extraordinary performance of inflation later in my
remarks.
The Federal Open Market Committee conducted monetary policy last year with
the aim of sustaining the remarkable combination of economic expansion and low
inflation. At its meetings from March to July, the inflation risks accompanying the
continued strength of domestic demand and the tightening of labor markets necessitated that the FOMC place itself on heightened inflation alert. Although the
FOMC kept the nominal Federal funds rate unchanged, it allowed the real funds
rate to rise with continuing declines in inflation and, presumably, inflation expectations. In August, the FOMC returned to an unbiased policy predilection in response
to the adverse implications for the U.S. outlook of worsening conditions in foreign
economies and in global financial markets, including our own.
Shortly thereafter, a further deterioration in financial market conditions began to
pose a more serious threat to economic stability. In the wake of the Russian crisis
and subsequent difficulties in other emerging-market economies, investors perceived
that the uncertainties in financial markets had broadened appreciably and as a consequence they became decidedly more risk averse. Safe-haven demands for U.S.
Treasury securities intensified at the expense of private debt securities. As a result,
quality spreads escalated dramatically, especially for lower-rated issuers. Many financial markets turned illiquid, with wider bid-asked spreads and heightened price
volatility, and issuance was disrupted in some private securities markets. Even the
liquidity in the market for seasoned issues of U.S. Treasury securities dried up, as
investors shifted toward the more actively traded, recently issued securities and
dealers pared inventories, fearing that heightened price volatility posed an unacceptable risk to their capital.
Responding to losses in foreign financial markets and to pressures from counterparties, highly-leveraged investors began to unwind their positions, which further
weighed on market conditions. As credit became less available to business borrowers
in capital markets, their demands were redirected to commercial banks, which reacted to the enlarged borrowing, and more uncertain business prospects, by tightening their standards and terms on such lending.
To cushion the domestic economy from the impact of the increasing weakness in
foreign economies and the less accommodative conditions in U.S. financial markets,
the FOMC, beginning in late September, undertook three policy easings. By midNovember, the FOMC had reduced the Federal funds rate from SVfc percent to 4%
percent. These actions were taken to rebalance the risks to the outlook, and, in the
event, the markets have recovered appreciably. Our economy has weathered the disturbances with remarkable resilience, though some yield and bid-asked spreads still
reflect a hesitancy on the part of market participants to take on risk. The Federal
Reserve must continue to evaluate, among other issues, whether the full extent of
the policy easings undertaken last fall to address the seizing-up of financial markets
remains appropriate as those disturbances abate.
To date, domestic demand and hence employment and output have remained vigorous. Real GDP is estimated to have risen at an annual rate exceeding 5Vz percent
in the fourth quarter of last year. Although some slowing from this torrid pace is
most likely in the first quarter, labor markets remain exceptionally tight and the
economy evidently retains a great deal of underlying momentum despite the global
economic problems and the still-visible remnants of the earlier financial turmoil in
the United States. At the same time, no evidence of any upturn in inflation has,
as yet, surfaced.
Abroad, the situation is mixed. In some East Asian countries that, in recent years,
experienced a loss of investor confidence, a severe currency depreciation, and a deep
recession, early signs of stabilization and economic recovery have appeared. This is
particularly the case for Korea and Thailand. Authorities in those countries, in the
context of IMF stabilization programs, early on established appropriate macroeconomic policies and undertook significant structural reforms to buttress the banking
system and repair the finances of the corporate sector. As investor confidence has
returned, exchange rates have risen and interest rates have fallen. With persistence
and follow-through on reforms, the future of those economies has promise.
The situations in some of the other emerging-market economies are not as encouraging. The Russian government's decision in mid-August to suspend payments on
its domestic debt and devalue the ruble took markets by surprise. Investor flight
exacerbated the collapse of prices in Russian financial markets and led to a sharp
depreciation of the ruble. The earlier decline in output gathered momentum, and by
late in the year inflation had moved up to a triple-digit annual rate. Russia's stabilization program with the IMF has been on hold since the financial crisis hit, and
the economic outlook there remains troubling.




46
The Russian financial crisis immediately spilled over to some other countries, hitting Latin America especially hard. Countering downward pressure on the exchange
values of the affected currencies, interest rates moved sharply higher, especially in
Brazil. As a consequence of the high interest rates and growing economic uncertainty, Brazil's economic activity took a turn for the worse. Higher interest rates
also had negative consequences for the fiscal outlook, as much of Brazil's substantial
domestic debt effectively carries floating interest rates. With budget reform legislation encountering various setbacks, market confidence waned further and capital
outflows from Brazil continued, drawing down foreign currency reserves. Ultimately,
the decision was taken to allow the real to float, and it subsequently depreciated
sharply.
Brazilian authorities must walk a very narrow, difficult path of restoring confidence and keeping inflation contained with monetary policy while dealing with serious fiscal imbalances. Although the situation in Brazil remains uncertain, there
has been limited contagion to other countries thus far. Apparently, the slow onset
of the crisis has enabled many parties with Brazilian exposures to hedge those positions or allow them to run off. With the net exposure smaller, and increasingly held
by those who both recognized the heightened risk and were willing to bear it, some
of the elements that might have contributed to further contagion may have been significantly reduced.

The Economic Outlook
These recent domestic and international developments provide the backdrop for
U.S. economic prospects. Our economy's performance should remain solid this year,
though likely with a slower pace of economic expansion and a slightly higher rate
of overall inflation than last year. The stocks of business equipment, housing, and
household durable goods have been growing rapidly to quite high levels relative to
business sales or household incomes during the past few years, and some slowing
in the growth of spending on these items seems a reasonable prospect. Moreover,
part of the rapid increase in spending, especially in the household sector, has resulted from the surge in wealth associated with a run-up in equity prices that is
unlikely to be repeated. And the purchasing power of income and wealth has been
enhanced by declines in oil and other import prices, which also are unlikely to recur
this year. Assuming that aggregate demand decelerates, underlying inflation pressures, as captured by core price measures, in all likelihood will not intensify significantly in the year ahead, though the Federal Reserve will need to monitor developments carefully. We perceive stable prices as optimum for economic growth. Both
inflation and deflation raise volatility and risks that thwart maximum economic
growth.
Most Governors and Reserve Bank Presidents foresee that economic growth this
year will slow to a 2^ to 3 percent rate. Such growth would keep the unemployment rate about unchanged. The central tendency of the Governors and Presidents'
predictions of CPI inflation is 2 to 2^4 percent. This level represents a pickup from
last year, when energy prices were falling, but it is in the vicinity of core CPI inflation over the last couple of years.
This outlook involves several risks. The continuing downside risk posed by possible economic and financial instability around the world was highlighted earlier
this year by the events in Brazil. Although financial contagion elsewhere has been
limited to date, more significant knock-on effects in financial markets and in the
economies of Brazil's important trading partners, including the United States, are
still possible. Moreover, the economies of several of our key industrial trading partners have shown evidence of weakness, which if it deepens could further depress
demands for our exports.
Another downside risk is that growth in capital spending, especially among manufacturers, could weaken appreciably if pressures on domestic profit margins mount
and capacity utilization drops further. And it remains to be seen whether corporate
earnings will disappoint investors, even if the slowing of economic growth is only
moderate. Investors appear to have incorporated into current equity price levels
both robust profit expectations and low compensation for risk. As the economy slows
to a more sustainable pace as expected, profit forecasts could be pared back, which
together with a greater sense of vulnerability in business prospects could damp appetites for equities. A downward correction to stock prices, and an associated increase in the _ cost of equity capital, could compound a slowdown in the growth of
capital spending. In addition, a stock market decline would tend to restrain consumption spending through its effect on household net worth.
But on the upside, our economy has proved surprisingly robust in recent years.
More rapid increases in capital spending, productivity, real wages, and asset prices




47
have combined to boost economic growth far more and far longer than many of us
would have anticipated.
This 'Virtuous cycle" has been able to persist because the behavior of inflation
also has been surprisingly favorable, remaining well contained at levels of utilization of labor that in the past would have produced accelerating prices. That it has
not done so in recent years has been the result of a combination of special one-time
factors holding down prices and more lasting changes in the processes determining
inflation.
Among those temporary factors, the sizable declines in the prices of oil, in other
internationally-traded commodities, and other imports contributed directly to holding down inflation last year, and also indirectly by reducing inflation expectations.
But these prices are not likely to fall further, and they could begin to rise as some
Asian economies revive and the effects of the net depreciation of the dollar since
mid-summer are felt more strongly.
At the same time, however, recent experience does seem to suggest that the economy has become less inflation prone than in the past, so that the chances of an inflationary breakout arguably are, at least for now, less than they would have been
under similar conditions in earlier cycles.
Several years ago I suggested that worker insecurity might be an important reason for unusually damped inflation. From the early 1990's through 1996, survey results indicated that workers were becoming much more concerned about being laid
off. Workers' underlying fear of technology-driven job obsolescence, and hence willingness to stress job security over wage increases, appeared to have suppressed
labor cost pressures despite a reduced unemployment rate. More recently, that effect
seems to nave diminished in part. So while job loss fears probably contributed to
wage and price suppression through 1996, it does not appear that a further heightening of worker insecurity about employment prospects can explain the more recent
improved behavior of inflation.
Instead, a variety of evidence, anecdotal and otherwise, suggests that the source
of recent restrained inflation may be emanating more from employers than from employees. In the current economic setting, businesses sense that they have lost pricing power and generally have been unwilling to raise wages any faster than they
can support at current price levels. Firms have evidently concluded that if they try
to increase their prices, their competitors will not follow, and they will lose market
share and profits.
Given the loss of pricing power, it is not surprising that individual employers resist pay increases. But why has pricing power of late been so delimited? Monetary
policy certainly has played a role in constraining the rise in the general level of
prices and damping inflation expectations over the 1980*3 and 1990s. But our current discretionary monetary policy has difficulty anchoring the price level over time
in the same way that the gold standard did in the last century.
Enhanced opportunities for productive capital investment to hold down costs also
may have helped to damp inflation. Through the 1970's and 1980's, firms apparently
found it easier and more profitable to seek relief from rising nominal labor costs
through price increases than through cost-reducing capital investments. Price relief
evidently has not been available in recent years. But relief from cost pressures has.
The newer technologies have made capital investment distinctly more profitable, enabling firms to substitute capital for labor far more productively than they would
have a decade or two ago.
Starting in 1993, capital investment, particularly in high-technology equipment,
rose sharply beyond normal cyclical experience, apparently the result of expected increases in rates of return on the new investment. Had the profit expectations not
been realized, one would have anticipated outlays to fall back. Instead, their growth
accelerated through the remainder of the decade.
More direct evidence confirms the improved underlying profitability. According to
some rough estimates, labor and capital productivity has risen significantly during
the past 5 years. It seems likely that the synergies of advances in laser, fiber optic,
satellite, and computer technologies with older technologies have enlarged the pool
of opportunities to achieve a rate of return above the cost of capital. Moreover, the
newer technologies have facilitated a dramatic foreshortening of the lead times on
the delivery of capital equipment over the past decade, presumably allowing businesses to react more expeditiously to an actual or expected rise in nominal compensation costs than, say, they could have in the 1980's. In addition, the surge in
investment not only has restrained costs, it has also increased industrial capacity
faster than factory output has risen. The resulting slack in product markets has put
greater competitive pressure on businesses to hold down prices, despite taut labor
markets.




48
The role of technology in damping inflation is manifest not only in its effects on
U.S. productivity and costs, but also through international trade, where technological developments have progressively broken down barriers to cross-border trade.
The enhanced competition in tradable goods has enabled excess capacity previously
bottled up in one country to augment worldwide supply and exert restraint on prices
in all countries' markets. The resulting price discipline also has constrained nominal
wage gains in internationally-tradable goods industries. As workers have attempted
to shiit to other sectors, the gains in nominal wages and increases in prices in nontradable goods industries have been held down as well.
The process of price containment has potentially become, to a certain extent, selfreinforcing. Lower inflation in recent years has altered expectations. Workers no
longer believe that escalating gains in nominal wages are needed to reap respectable
increases in real wages, ana their remaining sense of job insecurity is reinforcing
this. Since neither firms nor their competitors can count any longer on a general
inflationary tendency to validate decisions to raise their ownprices, each company
feels compelled to concentrate on efforts to hold down costs. The availability of new
technology to each company and its rivals affords both the opportunity and the competitive necessity of taking steps to boost productivity.
It is difficult to judge whether these significant shifts in the market environment
in which firms function are sufficient to account for our benign overall price behavior during the past half decade. Undoubtedly, other factors nave been at work as
well, including those temporary factors I mentioned earlier and some more lasting
I have not discussed, such as worldwide deregulation and privatization, and the
freeing up of resources previously employed to produce military products that was
brought about by the end of the cold war. There also may be other contributory
forces lurking unseen in the wings that will only become clear in time. Over the
longer run, of course, the actions of the central bank determine the degree of overall
liquidity and hence rate of inflation. It is up to us to validate the favorable inflation
developments of recent years.
Although the pace of productivity increase has picked up in recent years, the extraordinary strength of demand has meant that the substitution of capital for labor
has not prevented us from rapidly depleting the pool of available workers. This
worker depletion constitutes a critical upside risk to the inflation outlook because
it presumably cannot continue for very much longer without putting increasing pressure on labor markets and on costs.
The number of people willing to work can be usefully defined as the unemployed
component of the labor force plus those not actively seeking work, and thus not
counted in the labor force, but who nonetheless say they would like a job if they
could get one. This pool of potential workers aged 16 to 64 currently numbers about
10 million, or just 5% percent of that group's population—the lowest such percentage on record, which begins in 1970, and 2Va percentage points below its average
over that period. The rapid increase in aggregate demand has generated growth of
employment in excess of growth in population, causing the number of potential
workers to fall since the mid-1990's at a rate of a bit under 1 million annually. We
cannot judge with precision how much further this level can decline without sparking ever-greater upward pressures on wages and prices. But, should labor market
conditions continue to tighten, there has to be some point at which the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and
prices inevitably will begin to accelerate.
Ranges for Money and Credit
At its February meeting, the Committee elected to ratify the provisional ranges
for all three aggregates that it had established last July. Specifically, the Committee
again has set growth rate ranges over the four quarters of 1999 of 1 to 5 percent
for M2, 2 to 6 percent for M3, and 3 to 7 percent for domestic nonfinancial debt.
As in previous years, the Committee interpreted the ranges for the broader monetary aggregates as benchmarks for what money growth would be under conditions
of price stability and sustainable economic growth, assuming historically typical velocity behavior.
Last year, these monetary aggregates far overshot the upper bounds of their annual ranges. While nominal GDP growth did exceed the rate likely consistent with
sustained price stability, the rapid growth of M2 and M3 also reflected outsized declines in their velocities, that is, the ratio of nominal GDP to money. M2 velocity
dropped by about 3 percent, while M3 velocity plunged by 5Vi percent.
Part of these velocity declines reflected some reduction in the opportunity cost of
holding money; interest rates on Treasury securities, which represent an alternative
return on nonmonetary assets, dropped more than did the average of interest rates
on deposits and money market mutual funds in M2, drawing funds into the aggre-




49
gate. Even so, much of last year's aberrant behavior of broad money velocity cannot
readily be explained by conventional determinants. Although growth of the broad
aggregates was strong earlier in the year, it accelerated in the fourth quarter after
credit markets became turbulent. Perhaps robust money growth late in the year
partly reflected a reaction to this turmoil by the public, who began scrambling for
safer and more liquid financial assets. Monetary expansion has moderated so far
this year, evidently in lagged response to the calming of financial markets in the
autumn. Layered on top of these influences, though, the public also may have been
reapportiorung their savings flows into money balances because the huge run-up in
stock prices in recent years has resulted in an uncomfortable portion of their net
worth in equity.
For the coming year, the broad monetary aggregates could again run high relative
to these ranges. To be sure, the decline in the velocities of the broader aggregates
this year should abate to some extent, as money demand behavior returns more to
normal, and growth in nominal GDP should slow as well, as suggested by the Governors' and Presidents' central tendency. Both factors would restrain broad money
expansion relative to last year. Still, the growth of M2 and M3 could well remain
outside their price-stability ranges this year. Obviously, considerable uncertainty
continues to surround the prospective behavior of monetary velocities and growth
rates.
Domestic nonfmancial debt seems more likely than the monetary aggregates to
grow within its range for this year. Indeed, domestic nonfinancial debt also could
grow more slowly this year than last year's 6Vt percent pace, which was in the
upper part of its 3 to 7 percent annual range. With the Federal budget surplus
poised to widen further this year, Federal debt should contract even more quickly
than last year. And debt in each of the major non-Federal sectors in all likelihood
will decelerate as well from last year's relatively elevated rates, along with the projected slowing of nominal GDP growth.
The FOMC's Disclosure Policy
The FOMC at recent meetings has discussed not only the stance of policy, but also
when and how it communicates its views of the evolving economic situation to the
public. The FOMC's objective is to release as much information about monetary policy decisionmaking, and as promptly, as is consistent with maintaining an effective
deliberative process and avoiding roiling markets unnecessarily. Since early 1994,
each change in the target nominal Federal funds rate has been announced immediately with a brief rationale for the action. The FOMC resolved at its December
meeting to take advantage of an available, but unused policy, originally stated in
early 1994, of releasing, on an infrequent basis, a statement immediately after some
FOMC meetings at which the stance of monetary policy has not been changed. The
Federal Reserve will release such a statement when it wishes to communicate to
the public a major shift in its views about the balance of risks or the likely direction
of future policy. Such an announcement need not be made after every change in the
tilt of the directive. Instead, this option would be reserved for situations in which
the consensus of the Committee clearly had shifted significantly, though not by
enough to change current policy, and in which the absence of an explanation risked
misleading markets about the prospects for monetary policy.
Year 2000 Issues
Before closing, I would like to address an issue that has been receiving increasing
attention—the century date change. While no one can say that the rollover to the
year 2000 will be trouble free, I am impressed by the efforts to date to address the
problem in the banking and financial system. For our part, the Federal Reserve System has now completed remediation and testing of 101 of its 103 mission-critical applications, with the remaining two to be replaced by the end of March. We opened
a test facility in June at which more than 6,000 depository institutions to date have
conducted tests of their Y2K compliant systems, and we are well along in our risk
mitigation and contingency planning activities. As a precautionary measure, the
Federal Reserve has acted to increase the currency in inventory by about one-third
to approximately $200 billion in late 1999 and has other contingency arrangements
available if needed. While we do not expect currency demand to increase dramatically, the Federal Reserve believes it is important for the public to have confidence
in the availability of cash in advance of the rollover. As a result of these kinds of
activities, I can say with assurance that the Federal Reserve will be ready in both
its operations and planning activities for the millennium rollover.
The banking industry is also working hard, and with evident success, to prepare
for the event. By the end of the first quarter, every institution in the industry will
have been subject to two rounds of on-site Y2K examinations. The Federal Reserve,




50
like the other regulators, has found that only a small minority of institutions has
fallen behind in their preparations, and those institutions have been targeted for additional followup and, as necessary, formal enforcement actions. The overwhelming
majority of the industry has made impressive progress in their remediation, testing,
and contingency planning efforts.
Concluding Comment
Americana can justifiably feel proud of their recent economic achievements. Com*
petitive markets, with open trade both domestically and internationally, have kept
our production efficient and on the expanding frontier of technological innovation.
The determination of Americans to improve their skills and knowledge has allowed
workers to be even more productive, elevating their real earnings. Macroeconomic
policies have provided a favorable setting for the public to take greatest advantage
of opportunities to improve its economic well-being. The restrained fiscal policy of
the Administration and Congress has engendered the welcome advent of a unified
budget surplus, freeing up funds for capital investment. A continuation of responsible fiscal and, we trust, monetary policies should afford Americans the opportunity
to make considerable further economic progress over time.
Financial Services Modernization Legislation
The Committee has asked that, in addition to my report on the economy, I present
today the views of the Federal Reserve on the need for legislation to modernize the
U.S. financial system. The Federal Reserve continues to support strongly the enactment of such legislation and I commend the Committee for taking up this vital matter so promptly.
Need for Financial Modernization
U.S. financial institutions are today among the most innovative and efficient providers of financial services in the world. They compete, however, in a marketplace
that is undergoing major and fundamental change driven by a revolution in technology, by dramatic innovations in the capital markets, and by the globalization of
the financial markets and the financial services industry.
The technologically driven proliferation of new financial products that enable risk
unbundling has created new financial instruments that increasingly combine the
characteristics of banking, insurance, and securities products. These changes, which
are occurring all over the world, have also dramatically altered the way financial
services providers operate and the way they market and deliver their products.
In the United States, our financial institutions have been required to take elaborate steps to develop and deliver new financial products and services in a manner
that is consistent with our outdated laws. The costs of these efforts are becoming
increasingly burdensome and serve no useful public purpose. Unless soon repealed,
the archaic statutory barriers to efficiency could undermine the competitiveness of
our financial institutions, their ability to innovate and to provide the very best and
broadest possible services to U.S. consumers, and, ultimately, the global dominance
of American finance.
Without congressional action to update our laws, the market will force ad hoc administrative responses that lead to inefficiencies and inconsistencies, expansion of
the Federal safety net, and potentially increased risk exposure to the Federal deposit insurance funds. Such developments will undermine the competitiveness and
innovative edge of major segments of our financial services industry. We at the Federal Reserve believe it is important that the rules for our financial services industry
be set by the Congress rather than, as too often has been the case, by banking regulators dealing with our outdated laws. Only Congress has the ability to fashion rules
that are comprehensive and equitable to all participants and that guard the public
interest.
For these reasons, we support removal of the legislative barriers that prohibit the
straightforward integration of banking, insurance, and securities activities. There is
virtual unanimity among all concerned—private and public alike—that these barriers should be removed.
In designing financial modernization legislation, we firmly believe that the Congress should focus on achieving two essential and indivisible objectives: removing
outdated, competitively stifling restrictions on financial affiliations and, most importantly, adopting a framework for this modernization that promotes the safety and
soundness of our banking and financial system and prevents the extension of the
Federal subsidy.




51
Framework for Financial Modernization
The first objective is achieved by amending the Glass-Steagall Act and the Bank
Holding Company Act in order to permit financial affiliations and broader financial
activities.
In our judgment, the objective of preserving safety and soundness and preventing
the spread of the Federal subsidy is best achieved by allowing banks, securities
firms, and insurance companies to combine in the financial service holding company
structure. While we enthusiastically support the new powers granted to financial
service holding companies, we just as strongly believe they should be financed by
the marketplace, not by instruments backed by the sovereign credit of the United
States. The requirement that the new powers, at least those conducted as principal,
be conducted through holding company affiliates minimizes the expansion of the use
of the subsidies arising from a safety net backed by the U.S. taxpayer.
The choice of requiring the new powers to be harbored in affiliates of holding companies, not in operating subsidiaries of their banks, will significantly fashion the
underlying structure of twenty-first century finance. To inject the substantial new
subsidies that would accrue to operating subsidiaries of banks into the currently
mushrooming domestic and international financial system could distort capital markets and the efficient allocation of both financial and real resources that has been
so central to America's current prosperity.
New affiliations, if allowed through bank subsidiaries, would accord banking organizations an unfair competitive advantage over comparable insurance and securities
firms—both those operating independently and those that are bank holding company subsidiaries. By fostering a level playing field within the financial services industry, we contribute to full, open, and fair competition.
This choice of the holding company structure is also critical to the way in which
the financial services industry will develop because it provides better protection for
and promotes the safety, soundness, and the stability of our banking and financial
system. At the same time, it accomplishes much needed financial modernization
without damaging the national or State bank charters or limiting in any way the
benefits of financial modernization. The other route toward full powered commercial
bank operating subsidiaries and universal banking would, in our judgment, lead to
greater risk for the deposit insurance funds and the taxpayer.
In addition, the holding company structure promotes effective supervision and the
functional regulation of different activities. The United States is at a historic crossroads in financial services regulation. It is becoming increasingly evident that the
dramatic advances in computer and telecommunications technologies of the past
decade have so significantly altered the structure of domestic, indeed, global finance
as to render our existing modes of supervision and regulation of financial institutions increasingly obsolescent.
The volume, sophistication, and rapidity of financial dealings should continue to
lead to supervisory emphasis on oversight of risk management of financial institutions and a marked scaling back of outmoded loan file and balance sheet surveillance. For the same reasons, affiliation with banks need not—indeed, should not—
create bank-like regulation of the affiliates of banks. A very constructive approach
to supervision for the twenty-first century is captured in the so-called "Fed-light"
provisions of various bills, which focus on and enhance the functional regulation of
securities firms, insurance companies, insured depository institutions, and their affiliates. We at the Fed strongly support this approach.
Banking and Commerce
A twenty-first century issue that has become a part of the financial modernization
debate is whether we should move beyond affiliations among financial service providers and allow the full integration of banking and commerce. As new technology
increasingly blurs the distinction among various financial products, it is already
beginning to blur the distinctions between predominately commercial and banking
firms. But how the underlying subsidies of deposit insurance, discount window access, and guaranteed final settlement through Fedwire are folded into a commercial
firm, should the latter affiliate with a bank, is crucially important to the systemic
stability of our financial system. It seems to us wise to move first toward the integration of banking, insurance, and securities, and employ the lessons we learn from
that important step before we consider whether and under what conditions it would
be desirable to move to the second stage of the full integration of commerce and
banking.
Nothing is lost, in my judgment, by making this a two-stage process. Indeed, there
is much to be gained. The Asian crisis highlighted some of the risks that can arise
if relationships between banks and commercial firms are too close, and makes caution at this stage prudent in our judgment. In line with these considerations, the




52
Board continues to support elimination of the unitary thrift loophole, which currently allows any type of commercial firm to control a federally-insured depository
institution.

Preservation of Executive Branch Influence
There is a final point I want to make since it appears to have driven Treasury's
opposition to financial modernization legislation considered last year. That legislation would not have altered the Executive branch's supervisory authority for national banks or for Federal savings associations; nor would it have resulted in any
reduction in the predominant and growing share of this Nation's banking assets controlled by national banks and Federal savings associations. Indeed, as of September
1998, nearly 58 percent of all banking assets were under the supervision of the
Comptroller of the Currency, up from 55.2 percent at the end of 1996. Moreover,
after controlling for mergers of like-chartered banks, the number of national banks
has increased over the period 1996-98 and the number of State banks has declined.
Furthermore, the Congress, for sound public policy reasons, has purposefully apportioned responsibility for this Nation's financial institutions among the elected
Executive branch and independent regulatory agencies. Action to alter this balance
would be contrary to the deliberate steps that the Congress has taken to ensure a
proper balance in the regulation of this Nation's dual banking system.

Conclusion
In virtually every other industry. Congress would not be asked to address issues
such as these, which are associated with technological and market developments;
the market would force the necessary institutional adjustments. Arguably, this difference reflects the painful experience that has taught us that developments in our
banking system can have profound effects on the stability of our whole economy,
rather than just the limited impact we perceive from the difficulties in most other
industries.
Moreover, as in all major legislation, there are, and will be, numerous provisions
only indirectly associated with the legislation's core objectives that often foster disagreements. These surrounding issues are doubtless important, but not so important
that they should be allowed to defeat the consensus that has developed around these
key goals. It would be a disservice to the public and the Nation if, in the fruitless
search for a bill that pleases everyone in every detail, the benefits of this vital consensus are lost or further delayed.
The markets are demanding that we change outdated statutory limitations that
stand in the way of more efficiently and effectively delivering financial services to
the public. The Federal Reserve agrees and urges prompt enactment of financial
modernization legislation that achieves the two central and indivisible objectives
that I have outlined today.




53
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM ALAN GREENSPAN
Closing the Unitary Thrift Loophole

In testimony before the Senate Banking Committee on June 17,
1998, you urged closing the unitary thrift holding company loophole. You said:
In tight of the dangers of mixing banking and commerce, the Board supports
elimination of the unitary thrift loophole, which currently allows any type of com*
mercial firm to control a federally-insured depository institution. Failure to close
this loophole now would allow the conflicts inherent in banking and commerce combinations to further develop in our economy and complicate efforts to create a fair
and level playing field for all financial services providers.

You added:
Accordingly, the Federal Reserve strongly supports the provisions of H.R. 10 that
would prohibit new unitary thrift holding companies from having nonfinancial affiliations on a prospective basis.

At that hearing, you also recommended limiting transferability.
You said:
The Board, therefore, strongly supports an amendment to H.R. 10 that would at
least prohibit or significantly restrict the ability of grandfathered unitary thrift
holding companies to transfer their legislatively-created grandfather rights to another commercial organization through mergers or acquisitions.

On February 23, 1999, you testified that:
The Board continues to support elimination of the unitary thrift loophole, which
currently allows any type of commercial firm to control a federally-insured depository institution.

Q.I. Would you elaborate on the reasons supporting the Board's position favoring the elimination of the unitary thrift loophole and
limiting transferability of existing thrifts to financial acquirers and
the most serious potential problems if the loophole is not closed?
A.1. As discussed further below, the mixing of banking and commerce involves several risks and presents novel supervisory and
policy issues. For these reasons, the Board believes that Congress
should move cautiously in this area and first allow the full integration of financial activities before addressing the unique and complicated issues associated with mixing banking and commerce.
For these reasons, the Board supports the provisions contained
in the bill recently passed by the Senate Banking Committee that
would close, on a prospective basis, the unitary thrift loophole,
which currently allows any type of commercial firm to control a
federally-insured depository institution. Failure to take this action
now, when only a small number of commercial firms have established affiliations with insured depository institutions, would allow
the conflicts and dangers associated with the mixing of banking
and commerce to spread further. In addition, failure to enact these
provisions could lead to the piecemeal erosion of the walls separating banking and commerce and jeopardize the efforts to create
a fair and level playing field for all financial service providers as
we enter the 21st century.
The Board also supports the provisions in the Senate Banking
Committee's bill that would allow existing unitary thrift holding
companies to maintain the commercial affiliations that they have
already legally established. The Board, however, would hope that




54

the provisions in the Banking Committee's bill that would allow
existing unitary thrift holding companies to transfer their special,
legislatively-created grandfather rights to other commercial firms
through merger or acquisition would be reconsidered. These provisions would convey unique economic benefits on a small number of
grandfathered entities, allow other commercial firms that have no
claim to special, legislative treatment to acquire an insured depository institution, and permit significantly expanded combinations of
banking and commerce in our society.
Keeping Banking and Commerce Separate
On February 23, you testified:
It seems to us wise to move first toward the integration of banking, insurance,
and securities, and employ the lessons we learn from that important step before we
consider whether and under what conditions it would be desirable to move to the
second stage of the full integration of commerce and banking. Nothing is lost, in my
judgment, by making this a two-stage process. Indeed, there is much to be gained.

You also testified:
The Asian crisis highlighted some of the risks that can arise if relationships between banks and commercial firms are too close, and makes caution at this stage
prudent in our judgment.

Q.2. Would you explain in greater detail the risks of mixing banking and commerce at this time, and the lessons we should draw
from the Asian financial crisis in our consideration of whether to
allow banks to affiliate with commercial companies?
A.2. The main risk of integrating banking and commerce at this
time is that there is too much uncertainty over the consequences
of such a move, given that an equally fundamental change in regulatory structure, the integration of banking, insurance, and securities businesses, is on the table as well. Since there is widespread
agreement that the latter reform is urgently needed, it is prudent
to proceed with it alone and wait a few years to judge its consequences for the structure of the financial industry. We can revisit
the question of integrating banking and commerce a few years from
now with a more informed view of its likely effects.
One of the lessons of the Asian financial crisis is that a large
amount of connected lending by banks—lending to commercial companies in which the bank's owners, directors, managers, or their
families have a financial interest—increases the vulnerability of
the financial system. It does so in at least three ways. First, connected lending is more likely to become nonperforming because no
credit evaluation of the borrower's creditworthiness is ever made.
Second, connected lending leads to the misallocation of resources
because commercial firms get access to capital not on the merits of
their investment opportunities, but on the strength of their connections with bank insiders. Third, connected lending allows some
firms to borrow excessively, leading to high leverage.
All three factors—poor bank asset quality, misallocation of resources, and high leverage—make the financial system more vulnerable. All three are currently affecting the Asian crisis countries,
to differing degrees, at least in part due to the large amount of connected lending that went on in those countries prior to the crisis.
Consequently, tightening restrictions on connected lending is part




55

of the structural reform packages adopted by the three hardest-hit
countries: Korea, Indonesia, and Thailand.
Another reason why the financial systems in the Asian crisis
countries were vulnerable to a crisis was that financial liberalization had been poorly managed. Learning from this experience, the
IMF and others are urging developing countries to place strong emphasis on the need to get the sequencing of financial reforms right.
The lesson for us should be the same: financial liberalization should
proceed at a reasoned pace, and reforms that raise the most vexing
questions—like integrating banking and commerce—should wait
until more pressing reforms have been satisfactorily dealt with.
Merchant Banking

H.R. 10, as reported out of the Senate Banking Committee last
year, authorized merchant banking as one of the new powers permitted. However, H.R. 10 specifically provided that ownership interests in companies pursuant to the merchant banking authority
could be held "only for such period of time as will permit the sale
or disposition thereof on a reasonable basis," and that during the
period such ownership interests are held "the bank holding company does not actively participate in the day-to-day management or
operation of such company or entity."
The Staff Discussion Draft of legislation circulated by the Banking Committee on February 16, 1999, also authorized merchant
banking activities and contained the same restrictions as were contained in H.R. 10. However, the Committee Print circulated by the
Committee on March 1 and approved by an 11-9 vote of the Committee on March 4 did not contain the restrictions on the period of
time and the participation in day-to-day management of merchant
banking holdings that were in the Staff Discussion Draft.
Q.3. It appears that eliminating these restrictions would permit a
bank holding company to own an unlimited number of commercial
companies of any size for any period of time and manage them on
a day-to-day basis. Is this correct? What implications does this
have for breaking down the separation of banking and commerce?
A.3. Merchant banking, in its simplest terms, involves making temorary investments in the equity or debt securities of a company
>r the purpose of achieving a profit on the eventual sale or disposition of the investment. These investments may involve the acquisition of a controlling interest in, or even 100 percent of the equity
of, a company. Merchant banking is a volatile activity and, unless
constrained, could lead to a significant breach in the walls separating banking and commerce. The Board has supported efforts to
permit banking organizations, within the proper framework, to engage in these activities in order to facilitate the integration of
banks and securities firms, which are major participants in this
field. The Board believes merchant banking activities should be
permitted through the holding company structure, which provides
a more effective shield against the dangers of mixing banking and
commerce. In addition, the holding company structure best protects
insured depository institutions and the Federal safety net from the
volatility of merchant banking activities, prevents the spread of the
Federal safety net—and its related subsidy—to companies engaged
in these newly authorized activities, and ensures a fair and level

E




56

competitive playing field for all entities engaged in merchant bankingactivities.
The bill passed by the Senate Banking Committee in 1998 placed
certain limits on the merchant banking activities of the bank holding companies to mitigate the potential that these activities would
allow the blending of banking and commerce. These restrictions
would allow a bank holding company to hold a merchant banking
investment only for the period of time necessary to permit the sale
or disposition of the investment on a reasonable basis, and would
prohibit a bank holding company from actively participating in the
day-to-day management or operations of a company in which the
bank holding company had invested (except insofar as necessary to
achieve the holding company's bona fide investment objectives).
The bill passed earlier this month by the Senate Banking Committee, however, did not contain similar restrictions on the merchant banking activities of the banking organizations. We presume
that this change was made to permit the banking agencies added
flexibility in defining the time periods and permissible management relationships for various types of merchant banking investments. We believe that language to carry out this intent should be
included in the legislation.
Home Loan Banks

As was the case last year, proposals have emerged in the context
of financial modernization legislation that would significantly expand the reach and operations of the Federal Home Loan Bank
system. These measures would expand the use of the substantial
Federal subsidy that the Home Loan Banks enjoy due to their status as Government-sponsored enterprises. As you may well know,
last year these subsidies enabled the Home Loan Banks to become
the largest single issuer of debt in the world, larger than even the
U.S. Treasury.
Q.4. Do you feel the system's current activities and those contemplated under the proposed changes—generating dividends through
interest rate arbitrage, moving into what amounts to direct mortgage lending, and offering nonnousing-related products such as the
standby letters of credit—are an appropriate use of Government
subsidies?
What is your view of the impact that a further expansion of this
Government subsidy would have on private capital markets?
A.4. The U.S. financial system is very dynamic, and generally provides whatever credit is demanded at a market interest rate. This
is particularly true for markets where loans are typically collateralized by safe, well-understood assets, such as in most of the home
mortgage market. Government sponsorship allows Federal Home
Loan Banks (FHLB's) to borrow funds at interest rates that are
lower than those charged to comparably situated private sector borrowers because purchasers of FHLB debt believe that the Government would not allow the FHLB's to fail. This Government subsidy,
like all Government subsidies, benefits some groups and disadvantages others. This subsidy, which was intended to promote homeownership, has been expanded far beyond its original beneficiaries,
and such activities as the arbitrage discussed in the question—as
well as expanding the FHLB subsidy more generally—distort the




57

structure of our financial system and potentially foster a suboptimal allocation of resources in our economy. While it may be reasonable to make limited changes to expand access by small banks
to address temporary funding difficulties, given the size and rapid
growth of the Federal Home Loan Banks, as well as the Federal
Home Loan Bank system's unclear social purpose, a thorough congressional review of the system—with very careful consideration of
possible distortions—is appropriate before authorizing a further expansion of FHLB subsidies.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO
FROM ALAN GREENSPAN
Financial Services Modernization

Q.I. Who do you think the biggest winners are if financial services
modernization legislation is enacted? Who loses the most if it is not
enacted in the 106th Congress?
Q.2. American consumers spend an estimated $300 billion annually
on financial services. What does passage of financial services modernization legislation mean for them?
A.1. and A.2. The biggest winners clearly would be the American
consumers, who would be able to benefit both directly and indirectly from the increased competition that would come from breaking down the restrictions on interindustry activity that exists in
current law. Benefits of location, convenience, price, and delivery
mechanisms would be expected to be among the most significant.
Q.3. One of the major issues of debate in this legislation is the degree to which banks will have to conduct activities in an affiliate
versus an operating subsidiary. You and Treasury Secretary Rubin
have been at odds on this issue. Can you explain the importance
of our decision on how to handle this as it relates to moving our
financial services industry into the 21st century?
A.3. One of the principal issues raised by financial modernization
is the appropriate corporate structure for permitting banking oranizations to engage in new financial activities. The issue comes
own to whether these new activities, which the Congress has forbidden for banks, should be conducted through a separately and
market-capitalized nonbank subsidiary of a bank holding company
or through a direct subsidiary of and funded by an insured bank.
This question of structure is not a small matter and will fundamentally affect the development of the financial services industry in the
21st century.
The op-sub structure would inappropriately expand the Federal
safety net—and its related subsidy—to new nonbanking financial
activities, create an unlevel competitive playing field for financial
services, pose serious risks to insured banks and the deposit insurance funds, and conflict with the principles of functional regulation.
While the Federal Reserve supports the broad expansion of powers
for banking organizations, it believes those powers should be financed in the competitive marketplace, not by securities supported,
and subsidized, by the sovereign credit of the United States.
Banks are given access to the Federal safety net, which refers
to FDIC deposit insurance, and access to the Federal Reserve's
discount window and riskless payment system. This access permits

f




58

banks to raise funds at a lower cost than their nonbank competitors and is, in effect, an economic subsidy to banks.
The Treasury structure allows banks to channel these lower-cost
funds to an op-sub engaged in activities that the bank cannot conduct directly, thereby giving them a significant funding advantage
over independent financial service firms. This would weaken our
nonbank financial structure and reduce the flexibility of our economy to withstand systemic risk.
The op-sub structure also provides less protection for Federal deposit insurance funds and the American taxpayer than the holding
company structure. An op-sub could lose much more than its capital, harming its insured parent bank. Similar losses in an affiliate
of the holding company would not affect Federal deposit insurance
funds.
The Federal Reserve, the SEC, and the securities and insurance
industries all agree that the holding company framework provides
the best mechanism for maintaining the functional regulation of
securities and insurance activities, protecting investors and policyholders, reducing the need for duplicative and potentially conflicting
regulation by both a bank supervisor and a functional supervisor,
and promoting the uniform regulation of activities by function.
Q.4. Another hot topic of debate in this modernization bill is the
integration of banking and commerce. You stated that the "Asian
crisis last year highlighted some of the risks that can arise if relationships between banks and commercial firms are too close *
Could you further explain your thoughts on this issue?
A.4. One of the lessons of the Asian financial crisis is that a large
amount of connected lending by banks—lending to commercial companies in which the bank's owners, directors, managers, or their
families have a financial interest—increases the vulnerability of
the financial system. It does so in at least three ways. First, connected lending is more likely to become nonperforming because no
credit evaluation of the borrower's creditworthiness is ever made.
Second, connected lending leads to the misallocation of resources
because commercial firms get access to capital not on the merits of
their investment opportunities, but on the strength of their connections with bank insiders. Third, connected lending allows some
firms to borrow excessively, leading to high leverage.
All three factors—poor bank asset quality, misallocation of resources, and high leverage—make the financial system more vulnerable. All three are currently affecting the Asian crisis countries,
to differing degrees, at least in part due to the large amount of connected lending that went on in those countries prior to the crisis.
Consequently, tightening restrictions on connected lending is part
of the structural reform packages adopted by the three hardest-hit
countries: Korea, Indonesia, and Thailand.
The United States and Global Economy
Q.5. You have commented that the level of economic prosperity the
United States is currently enjoying is probably not sustainable on
a continuous basis—that it is as "impressive" as any you have ever
seen. Assuming this is right, and this growth is not sustainable, at
what point do the financial crises facing Southeast Asia, Russia,
and, recently, Brazil, have a greater impact on the U.S. economy?




59

A.5. The financial crises and downturn in economic activity in key
emerging-market regions have already had a negative effect on the
U.S. economy inasmuch as they have contributed to a significant
decline in U.S. real net exports of goods and services over the past
year. This negative effect from abroad has been partly offset by the
net stimulative effects on the U.S. economy of depressed oil and
commodity prices that have resulted from the slowdown abroad,
and the lower U.S. interest rates that have resulted from increased
demand for dollar-denominated assets. The drag on activity from
abroad seems likely to continue for some time, albeit at a lessening
pace as economic recovery in Asia and Latin America takes hold.
This negative influence on U.S. aggregate demand could very well
show through much more visibly over the year ahead if growth in
U.S. domestic demand begins to slow.
Q.6. The U.S. economy grew by an estimated 3.7 percent last year
and the unemployment rate was a low 4.3 percent—these numbers
despite the world economic problems. Unfortunately, the U.S. trade
deficit also grew to an astonishing $168.6 billion, a level more than
50 percent above the 1997 level. At a recent meeting of the Group
of Seven industrialized countries, several of the G-7 representatives floated the idea of more closely linking the values of the yen,
euro, and the dollar.
Would such a policy endanger our ability to dictate U.S. domestic
monetary policy by making that policy subordinate to international
considerations?
A.6. In short, yes. To the extent that monetary policy is devoted
to stabilizing exchange rates, it will be constrained from pursuing
domestic price stability when the goals of price stability and exchange rate stability are inconsistent. In that case, the credibility
of exchange rate policies depends on the perceived willingness of
monetary authorities to achieve exchange rate stability at the expense of domestic price stability. For large and relatively closed
economies, like that of the United States, in which exchange rate
changes are relatively less important, it is more appropriate for
monetary policy to target price stability than exchange rates.
Social Security and Investment
Q.7. You have rightfully been a harsh critic of President Clinton's
proposal to invest a portion of the Social Security trust fund in the
capital markets. As you are aware, this Committee has jurisdiction
over the stock and bond markets.
While I recognize that an entire hearing could be held on this
subject alone, could you briefly expand on the comments you have
made that allowing the Government to invest in equity markets
may, as you said, "put at risk the efficiency of our capital markets
and thus, our economy"?
Do you believe that the Government is capable of investing in
our capital markets without succumbing to political pressures that
would force investments to be made that result in a lower rate of
return?
A.7. I am leery of the prospect of putting a substantial amount of
corporate equity shares in the hands of a governmental entity of
this sort. Even if the arrangements initially appeared to provide ef-




60

fective insulation from political interference with the allocation of
investments, one could still reasonably be concerned that the laws
controlling the system might be changed at some later date. Given
the fact that the effectiveness of the governmental equity investments in promoting greater national saving and enhanced capital
formation is open to question, it is not clear to me that this is a
risk worth taking.
The Budget Surplus

Q.8. There has been a great deal of talk about what should be done
with the first unified budget surplus this country has seen in three
decades. The discussion has centered around paying down the national debt, giving tax cuts to hard-working Americans, and saving
Social Security.
What advice would you give to the Congress as we tackle this important question?
What use of the budget surplus do you believe is in the best interest of the American people and the overall U.S. economy?
What, if anything, is the downside or danger to using the surplus
to increase Federal Government spending rather than to pay down
the debt, save Social Security, or provide tax cuts?
Q.9. In your written testimony you discuss the increase in real
household income and the rise in the national savings rate and the
importance of these two things to the overall economic prosperity
this country is experiencing.
In light of this, would it be wise to provide Americans with farther tax cuts so these trends continue? If so, of what nature?
A.8. and A.9. Increasing domestic capital formation, to promote
higher levels of potential national output in the coming decades, is
the key to lightening the burden on active workers of the sharply
rising number of retirees whose consumption of goods and services
will have to be supported. The prospect of large Federal surpluses,
which tend to increase national saving, is most welcome in this regard. Under the circumstances, the best outcome of the current
budget debate would be to let the surpluses run and pay down Government debt. If all of the prospective surpluses cannot be preserved for this purpose, my general inclination would be to have
tax cuts rather than additional expenditure programs; I think that
experience suggests that expenditure programs pose a greater risk
to the longer-term ability of the Government to maintain a sound
fiscal position. Of course, the specifics of tax and expenditure options would have to be considered very carefully: I would certainly
advocate that any tax cuts be tailored to achieve maximum gains
in economic productiveness, my preferences being broad reductions
in marginal tax rates and reductions in taxation of capital income.




61
For use at 10:00 a.m., E.S.T.
Tuesday
February 23, 1999

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 23, 1999




62

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington. D.C., February 23. 1999
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board ol Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the
Full Employment and Balanced Growth Act ot 1978,
Sincerely,

Alan Greenspan. Chairman




63
Table of Contents

Monetary Polii;\ and the Economic Outlook
Economic and Financial Developments in 1998 and tiarly 1999







65

Monetary Policy Report to the Congress
Report submitted to the Congress IHI February- 23.
I W9. pursuant to the Full Employment and Bataiiced
Growth Act nf 1978

MONETARY POLICY AND THE
ECONOMIC OUTLOOK
In 1998. the U.S. economy again performed impressively. Output expanded rapidly, the unemployment
rate fell to the lowest level since 1970. and inflation
remained subdued. Transitory factors, mosi recently
falling prices for imports and commodities, especially oil. have helped to produce the favorable outcomes of recent years, but technological advances
and increased efficiency, likely reflecting in pan
heightened global competition and changes in business practices, suggest that some of the improvement
will be more lasting.
Sound fiscal and monetary policies have contributed importantly to the good economic results: Budgetary restraint at the federal level has bolstered
national saving and permitted the Federal Reserve to
maintain lower interest rates than would otherwise
have been possible. This policy mix and sustained
progress toward price stability have fostered clearer
price signals, more efficient resource use, robust business investment, and sizable advances in the productivity of iabor and in the real wages of workers. The
more rapid expansion of productive potential has. in
turn, helped 10 keep inflation low even as aggregate
demand has been surging and as labor markets have
lightened.
This past year, economic troubles abroad posed a
significant threat to the performance of the economy.
Foreign economic growth slowed markedly, on average, as conditions in many countries deteriorated.
The recession in Japan deepened, and several emerging market economies in Asia, which had started 10
weaken in the wake of the financial crises of 1997.
contracted sharply. A worsening economic situation
in Russia last summer led to a devaluation of the
ruble and a moratorium by that country on a substantial portion of its debt payments. As the year progressed, conditions in Latin America also weakened.
Although some of the troubled foreign economies are
showing signs of improvement, others either are not
yet in recovery or are still contracting.




The Russian crisis in mid-August precipitated j
period of unusual volatility in world financial markets. The losses incurred in Russia and in other
emerging market economics heightened investors'
and lenders' concerns about other potential problems
and led them to become substantially more cautious
about taking on risk. The resulting effects on U.S.
financial markets included a substantial widening of
risk spreads on debt instruments, a jump in measures
of market uncertainly and volatility, u drop in equity
prices, and a reduction in the liquidity of many markets. To cushion the U.S. economy from the effects of
these financial strains, and potentially K> help reduce
the strains as well, the Federal Reserve eased monetary policy on three occasions in the fall. Global
financial market stresses lessened somewhat after
mid-autumn, reflecting, in part, these policy steps as
well as interest rate cuts in other industrial countries
and international efforts to provide support to
troubled emerging market economies. Although some
U.S. financial flows were disrupted for a time, most
firms and households remained able to obtain sufficient, credit, and \he iviibutenee did not appear to
constrain spending to a significant degree. More
recently, some markets were unsettled by the devaluation and subsequent floating of the Brazilian real in
mid-January, and the problems in Brazil continue to
pose risks to global markets. Thus far. however,
market reaction outside Brazil to that country's difficulties has been relafively muted.
The foreign exchange value of the dollar rose
substantially against the currencies of the major foreign industrial countries over the first eight months of
1998, but subsequently it fell sharply, ending the year
down a little on net. The appreciation of the dollar in
the first half of the year carried it to an eight-year
high against the Japanese yen. In June, this strength
against the yen prompted the first U.S. foreign
exchange intervention operation in nearly three years,
an action that appeared to slow the dollar's rise
against the yen over the following days and weeks.
Later in ihe summer, concerns about the possible
impact on the U.S. economy of increasing difficulties
in Latin America began to weigh on the dollar's
exchange value against major foreign currencies.
After peaking in mid-August, it fell sharply over ihe
course of several weeks, reversing by mid-October

66
Monetary PnJicy Report to the Congress 3 February

the appreciation ihut had occurred earlier in ihe your.
The depreciation during ihis penod was particularly
sharp against the yen. The reasons tor this decline
against the yen arc not dear, hut repayment ol yendenominated loans hy international investors jnd
decisions hy Japanese investors Ui rcpairiaie their
assets in lifihi ol' increased volatility in global markets seem ui liave contributed. The exchange value
iif ihe dollar lluctuaied moderately against ihe mainr
currencies uver the resi ot' ihe year, and alier declining somewhat early in I9V9, it has rebounded
strongly in recent weeks, as incoming data have
suggesied continued sirengih of economic activity in
ihe United Slaies. Since the end of 19%. ihe dollar
has appreciated ahout 7 percent againsl ihe yen.
partly re dec tiny further monetary easing in Japan. Al
the turn of the year, the launch uf ihe (hird stage of
European Economic and Monetary Union lixed ihe
eleven participating countries' conversion rales anil
created a new common currency, the euro. The dollar
has appreciated more than 5 percent against the euro,
in- part because of signs that growth has slowed
recently in some euro-area economies.
Wiift the U.S. economy expanding rapidly, ihe
economies of many U.S. trading partners struggling,
and the foreign exchange value of the dollar having
risen over 1997 and the first pan of 1998. the U.S.
trade deficit widened considerably las! year. Some
domestic indusiries were especially affected by
reductions in foreign demand or by increased competition from imports. For example, a wide range of"
commodity producers, notably those in agriculture,
oil. and metals, experienced sharp price declines.
Pans of ihe manufacturing sector also suffered
adverse consequences from the shocks from abroad.
Overall, real net exports deteriorated sharply, as
exports stagnated and imports continued to surge.
The deterioration was particularly marked in the
first half of the year; the second half brought a
further, more modest, net widening ol' the external
deficit.
Meanwhile, domestic spending continued 10
advance rapidly. Household expenditures were bolsiered by gains in real income and a further rise
in wealth, while a low cost of capital and optimism
about future profitability spurred businesses to invesi
heavily in new capital equipment. Although securities markets were disrupted in late summer and early
fall, credit generally remained available from alternative sources. Once the strains on securities markets
had eased, businesses and households generally had
ready access to credit and other sources of finance on
relatively favorable terms, although spreads in some
markets remained quite elevated, especially lor




lower-rated borrowers. All (old. household .mil business outlays rose even mure rapidly ihun in 1997. and
(hat acceleration kept ihe growth ol' real GDP strong
even as ni_'i exports were slumping.
Deteriorating economic conditions abroad, coupled
with ihe strength of the dollar over the lirsi eight
months nl ihc year, helped 10 hold down intlauon in
ihe United Stales hy irimmjng ihe prices ol ml jnd
other imports. These declines reduced boih ihe prices
paid hy consumers and ihe costs of production in
many lint* tit husinevs. and ihe compt'liiwn Irom
abroad kepi businesses trom raising prices as much
a.s ihcy mighi have otherwise. A^ the rcsuli of j
reduced rate of price inflation, workers enjoyed a
larger rise in real purchasing power even as increases
in nominal hourly compensation picked up only
slighily on average. Because of increased gams in
productivity, corporations in the aggregate were able
10 absorb the larger real pay increases without suffering a serious diminution of profitability.

Monetary Policy. Financial Markets,
and ihe Economy over J99K wiJ Early J999

Monetary policy in 1998 needed to balance two major
risks to the economic expansion. On the one hand,
with the domestic economy displaying considerable
momentum and labor markets tight, the Federal Open
Market Committee (FOMC) was concerned about the
possible emergence of imbalances that would lead to
higher inflation and thereby, eventually, pui the sustainability of the expansion at risk. On the other hand,
troubles in many foreign economies and resulting
financial turmoil both abroad and at home seemed, ai
times, to raise the nsk of an excessive weakening of
aggregate demand.
Over ihe first seven months of the year, neither of
these potential tendencies was sufficiently dominant
to prompt a policy action by the FOMC. Although
the incoming data gave no evidence of a sustained
slowing of output growth, the Committee members
believed that the pace of expansion likely would
moderate as businesses began to slow the rapid rates
at which they had been adding to their stocks of
inventories and other investment goods, and as
households trimmed the large advances in their
spending on consumer durables and homes. Relatively firm real interest rales, buoyed by a high real
federal funds rate resulting from the decline in the
level of expected inflation, were thought likely to
help restrain ihe growth of spending hy businesses
and households. Another check on growth was
expected lo come from ihe effects on imports and

67
Board of Govtmurs fif the Federal Reserve Sviwni

1

Selected ifilereM rain

TTnnv-y

Vnlh The daa jre Jolly Verucil lines inbcau: the Jj\s :in "hictl IlK
Federal Rujcrve announced 3 montiar} policy acuon The Jauiion rt* hooiun-

Ml .1111 Jrc Ihoi .in whiL-n enter I he l-'OMC held a wlBdtlltd rtleel
polity jcitgn ».» announced Urn obstrvauons jie mi Februarv I1*. I

exports of the economic difficulties in emerging market economies in Asia and elsewhere. Indeed, production in the manufacturing sector slowed substantially
in the tirsl half of the year, and capacity utilization
dropped noticeably. Moreover, inflation remained
subdued, and a pickup was not expected in the near10-intermediate lerm because of declining oil prices,
and because of economic weakness abroad and the
appreciation of the dollar, which were expected to
trim the prices of imported goods and to increase
pnce competition lot many U.S. producers. Nonetheless, with labor markets already quite taut and
aggregate demand growing rapidly—a combination
that often has signaled the impending buildup of
inflationary pressures—the Committee, at its meetings from March through July, judged conditions to
be such that, if a policy action were to be taken in the
period immediately ahead, il more likely would be a
tightening than an easing; its directives to the
Account Manager of the Domestic Trading Desk at
the Federal Reserve Bank of New York noted that
asymmetry.
By the time of the August FOMC meeting, however, the situation was changing. Although light labor
markets and rapid output growth continued 10 pose
a risk of higher inflation, the damping influenee ol
foreign economic developments on the U.S. economy
seemed likely to increase. The contraction in the
emerging market economies in Asia appeared to be
deeper than had been anticipated, and the economic
situation in Japan had deteriorated. Financial markets
in some foreign economies also had experienced
greater turmoil, and. the day before the Committee
mei. Russia was forced to devalue the ruble. These

difficulties had been weighing on U.S. asset markets:
Stock prices had fallen sharply in laic J u l y and into
August as investors became concerned about (he
outlook for prottis, and risk spreads in debt markets
had widened, albeit from very low levels. Taking
account of these circumstances, the Committee again
left monetary policy unchanged at the August meeting, but it shifted to a symmetric directive, reflecting
its perception that the risks to the economic outlook,
at prevailing short-term rates, had become roughly
balanced.
Over subsequent weeks, conditions in financial
markets and the economic outlook in many foreign
countries deteriorated further, increasing the dangers
to the U.S. expansion. With investors around the
world apparently reevaluating the risks associated
with various credits and seemingly becoming less
willing or able to bear such risks, asset demands
shifted toward safer and more liquid instruments.
These shifts caused a sharp fall in yields on Treasury
securities. Spreads of yields on private debt securities
over those on comparable Treasury instruments
widened considerably further, and issuance slowed
sharply. Measures of market volatility increased,
and liquidity in many financial markets was curtailed.
Equity prices continued 10 slide lower, with most
broad indexes falling hack by early September to
near their levels at the start of the year. Reflecting the
weaker and more uncertain economic outlook, some
banks boosted interest rate spreads and fees on new
loans to businesses and tightened their underwriting
standards.
Against this backdrop, at its September meeting
the FOMC looked beyond incoming data suggesting




68
4

Monetary Policy Report to the Congress D February 1999

(hat the economy was continuing lo expand at a
robust pace, and ii lowered the intended level of the
federal funds rate Vi percentage point. The Committee noted that the rale cut would cushion the effects
on prospective U.S. economic growth of increasing
weakness in foreign economies and of less accommodative conditions in domestic financial markets. The
directive adopted at the meeting suggested a bias
toward further easing over the intennecting period. In
the days following the policy move, disturbances in
financial markets worsened. Movements in the prices
of securities were exacerbated by a deterioration
in market liquidity, as some securities dealers cut
back on their market-making activities, and by ihe
expected unwinding of positions by hedge funds and
other leveraged investors. In early October, Treasury
yields briefly tumbled to their lowest levels in many
years, reflecting efforts by investors to exchange
other instruments for riskless and liquid Treasury
securities.
Although some measures of market turbulence had
begun to ease a bit by mid-October, financial markets
remained extremely volatile and risk spreads were
very wide. On October 15, consistent with (he directive from the September meeting, the intended federal funds rate was trimmed another V-t percentage
point, to 5 percent. This policy move, which occurred
between FOMC meetings, came at the initiative
of Chairman Greenspan and followed a conference
call with Committee members. Al the same time,
the Board of Governors approved a 'A percentage point reduction in the discount rate. These
actions were taken to buffer the domestic economy
from the impact of the less accommodative conditions in domestic financial markets, in part by contributing to some stabilization of the global financial
situation.
Following the October policy move, strains in
domestic financial markets diminished considerably.
As safe-haven demands for Treasury securities ebbed.
Treasury yields generally trended higher, and measures of financial market volatility and illiquidity
eased. Nonetheless, risk spreads remained very wide,
and liquidity in many markets continued to be limited. Moreover, although pressures on some emerging
market economies had receded a bit, partly reflecting
concerted international efforts to provide assistance
to Brazil, the foreign economic outlook remained
uncertain. With downside risks still substantial, and
in light of the cumulative effect since August of the
tightening in many sectors of the credit markets and
the weakening of economic activity abroad, the
FOMC reduced the intended federal funds rale a
further '/4 percentage point at its November meeting.




bringing the total reduction during (he autumn to
'/4 percentage point. The Board of Governors also
approved a second 'A percentage point cut in the
discount rate. The Committee believed that, with this
policy action, financial conditions could reasonably
be expected to be consistent with fostering sustained
economic expansion while keeping inflationary pressures subdued. The action provided some insurance
against an unexpectedly severe weakening of the
expansion, and the Committee therefore established a
symmetrical directive. By (he (ime of (he December
meeting, the situation in financial markets had
changed little, on balance, and the Committee
decided that no further change in rates was desirable
and that the directive should remain symmetrical.
Some measures of financial volatility eased further
in the new year, although risk spreads on corporate
bonds remained at quite high levels. Yields on Treasury securities were about flat, on balance, in January, as the effect of stronger-than-expected economic
growth appeared to be about offset by data suggesting
that inflation remained quiescent and perhaps also by
the effects of some safe-haven flows prompted by
ihe deteriorating situation in Brazil Over the same
period, stock prices surged higher, led by computer
and other technology shares, and most stock price
indexes posted new highs. By the time of the February 2-3 meeting, financial markets were easily
accommodating robust demands for credit, and economic activity seemed to have more momentum than
many had anticipated. However, the foreign sector
continued to pose a threat to U.S. growth going
forward, inflation showed no signs of picking up
despite the rapid pace of growth and the very light
labor market, and some slowing of economic growth
remained a likely prospect. In these circumstances,
the FOMC concluded that it was prudent to wait for
further information, and it left policy unchanged.

Economic Projections for 1999
By and large, the members of the Board of Governors
and the Federal Reserve Bank presidents, ait
of whom participate in the deliberations of the
FOMC, expect the economy to expand moderately,
on average, in 1999. The central tendency of the
FOMC participants' forecasts of real GDP growth
from the fourth quarter of 1998 to the fourth quarter
of 1999 is 21/; percent to 3 percent. The anticipated
expansion is expected to create enough new jobs to
keep the civilian unemployment rate near its recent
average, in a range of 4Vi percent to 4Vi percent.
With tightness of the labor market expected to persist

69
Board of Governors of the Federal Reserve System

1.

Economic projections for 1999
Peicew
Federal Reserve pnvcmon
jikJ Rrwrvr Bank president
Indicator

"^

^

Chanitr. fiwlh quarter
Nominal (iDP
Real COP'
CoiuurneT (met indei ' .

)y,_J

4-4 1/:

4U

4H-4I/!

49

M-rmg, Iftrl.
Ovihan unemployment

nuc ...

JV^J'.,

1 Change Trom Jvtra^e lur founli quarter o* I<WS 10 jverape r« iounh
quarvr of 199^
1 Choin-wci;tiiFd.
3. All urtaP coniunvn.

and oil and impon prices unlikely to be as weak in
1999 as they were in 1998. inflation is expected to
move up somewhat from the rate of this past year but
to remain low by the standards of the past three
decades: The central tendency of the FOMC participants' CPI inflation forecasts for 1999 is 2 percent to
21/; percent. The Federal Reserve officials' inflation
forecasts are closely aligned with that of the Administration, and their forecasts of real GDP and unemployment depict a somewhat stronger real economy
than the Administration is projecting.
Present circumstances suggest that domestic
demand could continue to rise briskly for a while
longer. Consumer spending continues to be driven
by strong gains in employment, increases in real
incomes, and rising levels of wealth. Those same
factors, together with low mortgage interest rates, are
keeping housing activity robust. Businesses are still
investing heavily in new capital, especially computers and other high-tech equipment. Households and
businesses appear willing to take on more debi in
support of spending; although spreads on corporate
debt remain elevated, rate levels are perceived to be
attractive for most borrowers, and restraint on access
to finance is not much in evidence.
As the year progresses, however, gains in domestic spending should begin to moderate. Spending
increases for housing, consumer durables, and business equipment have been exceptionally large for a
while now, substantially raising the rate of growth in
the amounts of these goods owned by businesses and
households; some moderation in outlays seems likely,
lest these holdings become disproportionate to underlying trends in income and ouiput. The outlook for
spending continues to be obscured to some degree
by uncertainties about the course of equity prices: a
failure of these prices to match the outsized gains




5

posted in recent years would contribute to some
moderation in spending growth, especially by households. Government spending, which accounts for
about one-sixth of domestic demand, seems likely to
expand at a moderate pace overall. Along with the
numerous other uncertainties that attend the outlook,
an additional uncertainty is present this year because
of the approach of the year 2000 and the associated
Y2K problem.
Growth abroad is expected to remain sluggish, on
balance, in 1999, limiting the prospects for exports.
At the same time, growth of the U.S. economy probably will continue to generate fairly brisk increases in
imports. In total, real net exports of goods and services seem likely to fail further in the coming year,
although several factors—the decline in the dollar
from its peak of last summer, the expected slowing of income growth in the United States, and the
possibility of a slight pickup in economic growth
abroad—provide a basis for thinking that this year's
drop in net exports might not he as large as that of
1998.
The future course of inflation will depend in pan
on what happens to the prices of oil and other
imports, and restraint from those sources seems
unlikely to be as great as it was in 1998. The drop in
the price of oil this past year left it toward the lower
end of its range of the past couple of decades and
has thereby reduced the incentives for exploration,
drilling, and production. Futures markets have been
showing a gradual rise in (he price of oil going
forward. Prices of nonoil imports changed little in the
fourth quarter of last year after having fallen sharply
in previous quarters. Indicators of the pressures
on domestic resources provided mixed signals over
the past year. In manufacturing, capacity utilization
declined considerably, (o a level below its long run
average, reflecting slower production growth and sizable additions to the stock of capital. However, labor
markets remained very taut, and with the economy
apparently carrying substantial momentum into this
year, data on costs and prices will need to be monitored carefully for signs that a rising inflation pattern might start to take hold. In that regard, the
FOMC will continue to rely not only on the CPI but
also on a variety of other price measures to gauge
the economy's inflation performance in the period
ahead.
Money and Debt Ranges for 1999
At its most recent meeting, the FOMC reaffirmed the
1999 monetary growth ranges that were chosen on a

70
6

Monetary Policy Report to the Congress D February 1999

2.

Ranges for growth of monetary and debt aggregates

Afptfac
M>
Ml
Debt. ..

IW

IWS

IW)

1-.1

1-5

1-5
:-6

:-o
J-T

2-t,

.u;

V-l

Nnf h Change rrom average I'or fnuith quarter ot preceding year 10 j
tin rounh quarter of year indicated.

provisional basis last July: I percem to 5 percent for
M2, and 2 percent to 6 percent for M3. As has been
the case for some lime, the FOMC intends these
money growth ranges to be benchmarks for growth
under conditions of price stability, sustainable real
economic growth, and historical velocity relationships rather than ranges that encompass the expected
growth of money over the coming year or that serve
as guides to policy.
Given continued uncertainty about movements in
the velocities of M2 and M3 (the ratios of nominal
GDP to the aggregates), the Committee would have
little confidence that money growth within any particular range selected for the year would be associated with the economic performance it expected or
desired. Nonetheless, the Committee believes that,
despite the apparent large shift in velocity behavior in
the early 1990s, money growth has some value as an
economic indicator. Indeed, some FOMC members
have expressed ihe concern thai the unusually rapid
growth in the money and debt aggregates in 1998
might have reflected monetary conditions that were
too accommodative and would ultimately lead to an
increase in inflation pressures. The Committee will
continue to monitor the monetary aggregates as well
as a wide variety of other economic and financial data
to inform its policy deliberations.
Last year, M2 increased 8'/2 percent, and with
nominal GDP rising 5 percent. M2 velocity decreased
3 percent. This drop in velocity was considerably
larger than would have been expected on the basis of
historical relationships and the modest decline in the
opportunity cost of M2 (measured as the difference
between the interest rate on Treasury bills and the
weighted average rate available on M2 assets). The
fall in. velocity in part reflected an increased demand
for the safe and liquid assets in M2 as investors
responded to the heightened volatility in financial
markets in the second half of the year. Other factors
that may have contributed include lower long-term
interest rates and a very flat yield curve, which might
have suggested to households that they would be
giving up very little in earnings by parking savings in
short-term assets in M2. In addition. M2 may have
been boosted by a desire on ihe part of some inves-




tors to redirect savings flows away from equities after
several years of outsized gains in stock market
wealth. With equity wealth still elevated und the
yield curve likely to remain flat. M2 velocity could
continue to fall this year. However, the pace of
decline should slow as some households respond to
the easing of concerns about financial market volatility by reversing a portion of the shift toward M2
assets that occurred last fall. Indeed, this effect may
already be visible, as M2 growth, while still robust,
has slowed considerably early (Iris year. If velocity
does fall, given the Commitlec's expectations for
nominal income growth, M2 could again exceed its
price-stability benchmark range.
M3 expanded 11 percent last year, and its velocity
fell 5'/4 percem. the largest drop in many years. The
rapid growth in this aggregate owed in large part to
a substantial rise in institutional money funds. These
funds have been expanding rapidly in recent years as
nonftnancial firms increasingly employ them to provide cash management services. Investments in these
funds provide businesses with greater liquidity than
direct holdings of money market instruments, and by
substituting for such direct holdings, they boost M3.
M3 was also buoyed last year by a large advance
in the managed liabilities banks used to fund rapid
growth in bank credit. In part, the growth in bank
credit reflected demand by borrowers shifting from
the securities markets, and with these markets again
receptive to new issues, bank credit growth this
year is expected to slow to a pace more in line with
broader debt aggregates However, institutional
money funds are likely to continue iheir robust gains,
contributing to a further diminution in M3 velocity
and, possibly, to growth of this aggregate above its
price-stability range.
Domestic nonfinancial debt grew 6'/i percent in
1998. somewhat above the middle of the 3 percent to
7 percent growth range the Committee established
last February. This robust growth reflected large rises
in (he debt of businesses and households owing
to substantial advances in spending as well as debtfinanced mergers and acquisitions. However, the
increase in private-sector debt was partly offset by
the first annual decline in federal debt in almost thirty
years. As with the monetary aggregates, the Committee left the range for debt growth unchanged for
1999. After an aberrant period in the 1980s during
which debt growth greatly exceeded growth of nominal GDP. debt growth over the past decade has
returned to its historical pattern of about matching growth of nominal GDP. and the Committee
members expect debt to fall within its range this
year.

71
Board of Governors of lite Federal Reserve System

ECONOMIC AND FINANCIAL DEVELOPMENTS
IN 1998 AND EARLY 1999
The U.S. economy continued to display great vigor in
1998. despite a sharp slowing of growth in foreign
economics and an unsettled world financial environment. According to the Commerce Department's
advance estimate, real GDP increased a little more
than 4 percent over the four quarters of the year. The
economic difficulties lacing many of our trading partners and the strength of the dollar through much of
the year led to sluggishness in real exports of goods
and services. However, the drag on the economy
from that source was more than offset hy exceptional
strength in the real expenditures of households and
businesses, which were powered by strong real
income growth, large gams in the value of household
wealth, ready access to finance during most of the
year, and widespread optimism regarding the future
of the economy. Although turmoil in financial markets seemed 10 threaten the economy for a time in
late summer and early autumn, that threat later
receded, in part because of the steps taken by the
Federal Reserve to prevent the tightening of credit
markets from impairing the expansion of activity.
The final quarter of the year brought brisk expansion
of employment and income, and the limited indicators of activity in early 1999 have been strong, on
balance.
The increase in ihe general price level this past
year was smaller than that in the previous year, which
had itself been among the smallest in decades. The
chain-type price index for GDP rose slightly less than
1 percent. The further slowing of price increases was
in large part a reflection of sluggish conditions in the
world economy, which brought declines in the prices
of a wide range of imported goods, including oil and
other primary commodities. In the domestic economy, nominal hourly compensation of workers picked
up only slightly despite the tightness of the labor
market, and much of the compensation increase was
offset by gains in labor productivity. As a result, unii
labor costs, the most important item in total business
costs, rose only modestly.

Change in rejl GDP

llhll
1993

1994

IW5

Nm» In ihis than Jntl m subsequent chant iluu *how the <i
real GDP. i-hunvcsair meamrcii m ihe liiuu guaner of ihe period i
ihe final quaner ol ihe preceding pennl Uisi daia poini u irn
GDP report tor I9WO4

hourly pay gave another appreciable hoosi to ihe
growth of real labor income. At the same time, the
wealth of households recorded another year of subsianiial increase, bolstered in large part by the continued rise in equity prices. Although not all balance
sheet data for the end of 1998 are available, household net worth at that point appears to have been up
about 10 percent from the level at the end of
1997. The cumulative gain in household wealth since
1994 has amounted to nearly 50 percent.
The rise in net worth probably accounts for much
of the decline in the personal saving rate over the past
few years, lo an annual average of '/a percent in 1998.
Households tend to raise their saving from current
income when they feel that wealth must be increased
to meet longer-run objectives, but they are willing to
reduce their saving from current income when ihey
fee! that wealth already is at satisfactory levels. The
Change in real income and consumption

O Disposable personal i
• Persons! consumption eipendilun

The Household Sector
Personal consumption expenditures increased more
than 5 percent in real terms in 1998, the biggest gain
in a decade and a half. Support for the large rise in
spending came from a combination of circumstances
that, on the whole, were exceptionally favorable to
households. Strong gains in employment and real




199ft

1997

l»*

72
8

Monetary Policy Report 10 the Congress ED February 1999

Wealth and savings

I The ratio of net wonh ol household* 10 diposablc pertonal income

low level of the saving rate in 1998 is not so remarkable when gauged against a wealth-to-income ratio
that has been running in a range well above its
longer-run historical average.
All of the major categories of personal consumption expenditures—durables, n on durables, and
services—recorded gains in 1998 that were the
largest of the 1990s. Spending on durable goods rose
more than 12 percent over the year. Within ihat
category, expenditures on home computers once
again stood out, rising roughly 70 percent in real
terms, a gain [hat reflected both increased nominal
outlays and a further substantial decline in computer
prices. Consumer outlays on motor vehicles also rose
sharply, despite some temporary limitations on supply from a midyear auto strike. Spending on most
other types of durable goods registered increases that
were well above the averages of the past decade or
so. Because goods such as these are not consumed all
at once—but. rather, add to stocks of durable goods
that will be yielding services 10 consumers for a
number of years—they embody a form of economic
saving that is noi captured in the normal measure of
the saving rate in the national income accounts.
The increases in income and net worth thai led
households to boost consumption expenditures also
led them to invest heavily in additions to the stock of
housing. Declines in mortgage interest rates weighed
in as well, helping to maintain the affbrdability of
housing even as house prices moved up somewhat
faster than overall inflation- These developments
brought ihe objective of owning a home within the
reach of a greater number of households, and the
home-ownership rate, which has been trending up
this decade, rose to another new high in 1998.




In the single-family sector, sales ol' new and existing homes surged, the former rising more than
10 percent from the previous year's total and ihe
latter more than 13 percent. Construction of singlefamily houses strengthened markedly. The number ol'
these units started during the year was the largest
since the late 1970s, and it exceeded the previous
year's total by about 12 percent. In the fourth quarter,
unusually mild weather permitted builders to maintain activity later into the season than they normally
would have and gave an added kick to housing
starts. Starts increased further in January of this year,
despite harsher weather in some regions.
In contrast to the strength in the single-family
sector, the number of multil'amily units started in
1998 was up only a little from the total for 1997.
Alter bottoming out at a very low level early in the
1990s, construction of these units had been trending
back up fairly briskly until this past year. But with
vacancy rates on multifamily rental units running a
touch higher (his past year, builders and their creditors may have become concerned about adding too
many new units to the stock. Financing appeared
generally to be in ample supply for projects that
looked promising; during ihe period of" financial turmoil, the flow of credit was supported by substantial
purchases of multifamily mortgages and mongagebacked securities by Freddie Mac and Fannie Mae.
Total outlays for residential investment increased
about 121/: percent in real terms during 1998. according to ihe Commerce Department's initial tally. The
large increase reflected not only the construction
work undertaken on new residential units during the
year but also sizable advances in real outlays for
home improvements and in the volume of sales activity being carried on by real estate brokers, which
generated substantial gains in commissions.
Change in real residential investmenl

ll. ..ll
1991

1992

IWH

1444

IWS

19%

IW7

I44K

73
Board of Governors of the Federal Reserve System

The robust growth in household expenditures in
1998 was accompanied by an expansion of household
debt thai likely exceeded S'/2 percent, a somewhat
larger rise than in other recent years. Nonmortgage
debt increased about 6 percent, about 2 percentage
points above the previous year's pace but down considerably from the double-digit increases posted in
1994 and 1995. Home mortgage debt is estimated to
have jumped more than 9 percent, its largest annual
advance since 1990. boosted in pan by the robust
housing market. In addition, with mortgage rates
reaching their lowest levels in many years, many
households refinanced existing mortgages, and some
households likely took the opportunity presented by
refinancing to increase the size of their mortgages,
using the extra funds raised to finance current expenditures or to pay down other debts.
The growth in household debt reflected both supply and demand influences. With wealth rising faster
than income over the year and with consumer confidence remaining at historically high levels, households were willing to boost their indebtedness to
finance increased spending. In addition, lenders generally remained accommodative toward all but the
most marginal households, even after the turmoil
in many financial markets in the fall. After a more
general tightening of loan conditions in response to a
rise in losses on such loans between mid-1995 and
mid-1997, a smaller and declining fraction of banks
tightened consumer lending standards and terms last
year, according to Federal Reserve surveys. However,
the availability of high loan-to-value and subprime
home equity loans likely was reduced in the fall

Delinquency nues on household loans

NIIIF. The don art qvunoty D«u on credit-cud delinquency are Iran
tank Call Reponi. dau on wo km dthnttuciKKi are from the Bi( Tine
wnomnkcrv dau on mortput iWinquencio are from I!K Monfipe Banken




9

because of difficulties in the market for securities
hacked by such loans.
Despite the rapid increase in debt, measures of
household financial stress were relatively stable last
year, although some remained at high levels. The
delinquency rate on home mortgages has stayed quite
low in recent years, while the delinquency rate on
auto loans at domestic auto finance companies has
trended lower. The delinquency rate on credit card
loans at banks fluctuated in a fairly narrow range in
1997 and 1998. but it remained elevated after having
posted a substantial rise over the previous two years.
Personal bankruptcy filings have followed a broadly
similar pattern: Annual growth has run at about 3 percent over the past year and a half, down from annual
increases of roughly 25 percent between mid-1995
and early 1997. The stability of these measures over
the past couple of years likely owes in part to the
earlier tightening of standards and terms on consumer
loans. In addition, lower interest rates and longer loan
maturities, which resulted from the shift toward mortgage finance, have helped to mitigate the effects
of increased borrowing on household debt-service
burdens.

The Business Sector
Business fixed investment increased about 121/: percent during 1998, widi a I71/; percent rise in equipment spending more than accounting for the overall
advance. The strength of the economy and optimism
about its longer-run prospects provided underpinnings for increased investment. Outlays were also
bolstered by the efficiencies obtainable with new
technologies, by the favorable prices at which many
types of capital equipment could be purchased, and.
except during the period of financial market turmoil,
by the ready availability and low cost t>f finance,
either through borrowing or through the issuance of
equity shares.
Real expenditures on office and computing equipment, after having risen at an average rate of roughly
30 percent in real terras from 1991 through 1997,
shifted into even higher gear in 1998, climbing about
65 percent. The outsized increase likely owed in pan
to the efforts of some businesses to put new computer
systems in place before ihe end o( the millennium, in
hopes of circumventing potential difficulties arising
from the Y2K problem. But. beyond that, investment
in computers is being driven by the same factors
that have been at work throughout the expansion—
namely, the introduction of machines that offer
greater computing power at increasingly attractive

74
10

Monetary Policy Report 10 ihe Congress D February 1999

Change in real business lixed invesiment

G Simciuns
•

Producer* durjhle equipment

JLLLOJ 1
L--J-

prices and thai provide businesses new and more
efficient ways of organizing their operations. Price
declines this past year were especially large, as the
cos! reductions associated with technical change were
augmented by heightened international competition
in the markets for semiconductors and other computer components and by price cutting to work down
the stocks of some assembled products.
Investment in communications equipment—
another high-tech category that is an increasingly
important pan of total equipment outlays—rose about
IS1/: percent in 1998. After having (raced out an
erratic pattern of ups and downs through the latter
part of the 1980s and the early 1990s, real outlays
on this type of equipment began to record sustained
large annual increases in 1994, and the advance last
year was one of the largest. Spending on other types
of equipment displayed varying degrees of strength
across different sectors but recorded a sizable gain
overall. Investment in transportation equipment was
strong across the board, spurred by the need to move
greater volumes of goods or to carry more passengers
in an expanding economy. Spending on industrial
machinery advanced about 416. percent after larger
gains in most previous years of the expansion, a
pattern that mirrored a slowing of output growth in
the industrial sector.
Business investment in nonresidential structures,
which accounts for slightly more than 20 percent of
total business fixed investment, was down slightly
in 1998, according to the advance estimate. Sharply
divergent trends were evident within the sector, ranging from considerable strength in the construction of
office buildings to marked weakness in the construction of industrial buildings. The waxing and waning
of industry-specific construction cycles appears to be
the main explanation for the diverse outcomes of this




past year. Although some of the more speculative
construction plans may have been shelved because of
a tightening of the terms and standards on loans,
partly in reaction to the financial turmoil, most builders appear 10 have been able to eventually obtain
financing. Despite the sluggishness of spending on
structures this past year, the level of investment
remained high enough to generate continued moderate growth in the real slock of structures.
Business inventories increased aboul 4'/*> percent
in real terms this past year after having risen more
than 5 percent during 1997. Slocks grew al a 7 percent annual rate in the first quarter, appreciably faster
ihun linal sales, but inventory growth over the
remainder of ihe year was considerably slower than
in the first quarter. At year-end, stocks in most nonfarm industries were at levels that did not seem likely
to cause firms to restrain production going forward.
Inventories of vehicles may even have been a little on
the lean side, us a result of both a strike that held
down assemblies through the middle part of 1998 and
exceptionally strong demand, which prevented the
rebuilding of stocks later in the year. By contrast,
inventories at year-end appear to have been excessive
in a few nonfarm industries that have been hurt by
the sluggish world economy. Slocks of farm commodities also appeared to be excessive, having been
boosted further this past year by large harvests and
sluggish export demand.
The economic profits of U.S. corporations—that is.
book profits adjusted so that inventories and fixed
capital are valued ai their current replacement cost—
rose further, on net, over the first three quarters of
1998 but at a much slower pace than in most other
years of the current expansion. Companies' earnings
from operations in the rest of the world fell back a
bit. as did the profits of private financial corporations

Change in nonfarm business inventories

I
llJil
l

!

75
Board of Governors of the Federal Reserve Svsiem

Before-lax prolits as a share ill GDP

IW>

11HV

tion activity. Indeed, mergers and acquisitions, share
repurchases, unit foreign purchases of U.S. firms lust
year overwhelmed ihe high level of boih initial and
seasoned public equity issues, and net equity retirements likely exceeded $250 billion.
The disruptions in the financial markets in late
summer and early fall appear to have had liitle effect
on total business borrowing hut caused a substantial
temporary shift in the sources of credit. With investors favoring high credit quality and liquidity, yields
on lower-rated corporate bonds rose despite declining
Treasury vales; ihe spread of yields on junk bonds
over those on comparable Treasury securities roughly
doubled between mid-summer and mid-autumn
before falling back somewhat as conditions in financial markets eased. The spread of rales on lower-tier
commercial paper over those on higher-quality paper
rose substantially during the fall but had retraced the
rise by the early part of this year.
Reflecting these adverse market conditions, nonfinancial corporate bond issuance fell sharply in
August and remained low through mid-October, with
issuance of junk bonds virtually halted for a time.
Commercial paper issuance rose sharply in August
and September, as some firms apparently decided to
delay bond issues, turning temporarily to the commercial paper market instead. Bond issuance picked
up again in late October, however, and issuance in
November was robust. Reflecting this rebound, commercial paper outstanding fell back in ihe fourth
quarter. More recently, bond issuance has remained
healthy, while borrowing in the commercial paper
market has picked up.
During ihe period when financial markets were
strained, some borrowers substituted bank loans—in
some cases under credit lines priced before the mar-

1992

Proflla Irom ikxneslK* operations. with inventory valuation and capital
iion dd)uuinenii. divided hy pro« domestic product at rtorhnancial

from domestic operations. The profits of nontinancia)
corporations from domestic operations increased at
an annual rate of about 1'/» percent. Although the
volume of output of the nontinancial companies continued to rise rapidly, profits per unit of output were
squeezed a bit by companies' difficulties in raising
prices in step with costs in a competitive market
environment.
With profits expanding more slowly and investment spending still on the upswing, businesses'
external funding needs increased substantially last
year. Aggregate borrowing by the nonfinancial business sector is estimated to have expanded 9'/2 percent
from the end of 1997 to the end of 1998. the largest
increase in ten years. The rise reflected growth in all
major types of business debt. Business borrowing
was also boosted by substantial merger and acquisiCross corporals bond issuance

J

J

A

S

N<;r> Eicludts unrated IJSIKJ and i




O

N

D

J

F

M

11

A

M

J

J

76
12

Monetary Policy Report to the Congress Q February

kets became volatile—for other sources of credit, and
business loans at hanks expanded very rapidly for a
time before tailing off late in the year. Federal
Reserve surveys indicate that banks responded to the
turmoil in financial markets hy tightening standards
and terms on new loans and credit lines, especially
loans to larger customers and those to finance commercial real estate ventures. The tightening reflected
the less I'avorable or more uncertain economic outlook as well as a reduced tolerance for risk on the
part of some banks. Bank lending standards and
terms appear to have tightened only a little further
since the fall, however, and business loans at hanks
have expanded a bit since the end of December.
Despite the rapid growth in debt and the relatively
small gain in profits last year, the financial condition
of nonhnanaal businesses remained strong. Interest
rates for many businesses fell, on balance, over the
course of the year, and bond yields for investmentgrade firms reached their lowest level in many years.
Reflecting these low borrowing costs, the aggregate
debt-service burden for nonfinancial corporations,
measured as the ratio of net interest payments to cash
flow, remained about 91/: percent, near its low of
9 percent in 1997 and less than half the peak level
reached in 1989. The delinquency rate for banks'
commercial and industrial loans also remained near
the trough reached in late 1997. while that for commercial real estate loans fell a bit further from the
already very low level posted in 1997. Although
Moody's Investors Service downgraded more nonfinancial firms than it upgraded over the second half
of (he year, the downgraded tirms were smaller on
average, and so the debt of those upgraded about
equaled the debt of those downgraded. Through

Net interest payments of non financial corporations
relative to cash flow

. The d«< ire quarterly




Federal receipts and expenditures

TiHal i-ipendilur.

J4HA

IW*1

Nm» Data HJII receipts and expenditure
r |he meal year ended m September

i he untried taklpet and :

October, business failures remained at the low end of
the range seen over the past decade.

The Government Sector
The federal government recorded a surplus in the
unified budget this past fiscal year for the first time in
nearly three decades. The surplus, amounting to
$69 billion, was equal to about '/i percent of GDP. a
huge turnabout from the deficits of the early 1990s,
which in some years were more than 4!/3 percent of GDP. The swing from deficit to. surplus over the pasi few years is partly the result
of fiscal policies aimed at lowering the deficit and
partly the result of the strength of the economy and
the stock market. Excluding net interest payments—
a charge stemming from past deficits—the government recorded a surplus of more than $300 billion
in fiscal 1998.
The improvement in the government's saving position has permitted national saving—the combined
gross saving of households, businesses, and
governments—to move up about 3 percentage points
from its low of a few years ago. even though personal
saving has fallen sharply. In turn, thai increase in
national saving has helped facilitate the boom in
investment spending—in contrast to the experience
of the 1980s and early 1990s, when persistent large
budget deficits tended to reduce national saving,
boost interest rates higher than they otherwise would
have been, and thereby crowd out private capital
formation.
Federal receipts in the unified budget in fiscal year
1998 were up 9 percent from the previous fiscal year,
with much of the gain coming from personal income

77
Board of Governors of the Federal Reserve System

National saving

N<>u National uvinf includn iht gmi avmt ol hoadwldi.
governments

taxes, which rose more than 12 percent for a second
consecutive year. These receipts have been rising
faster than personal income in recent years, for several reasons: Tax rates at the high end of the income
scale were raised by legislation ihat was passed
in 1993 to help reduce the deficit: more taxpayers
have moved into higher tax brackets as income has
increased; and large increases in asset values have
raised lax receipts from capital gains. Social insurance tax receipts, the second most important source
of federal revenue, increased 6 percent in fiscal 1998.
just a touch faster than the increase in fiscal 1997 and
roughly in step with the growth of wages and salaries. Receipts from the taxes on corporate profits,
which account for just over 10 percent of federal
revenues, rose less rapidly than in other recent years,
restrained by the slower growth of corporate profits.
In the first three months of fiscal 1999, net receipts
from corporate taxes dipped below year-earlier levels, but gains in individual income taxes and payroll
taxes kepi total federal receipts on a rising trajectory.
Unified outlays increased 3'/4 percent in fiscal 1998
after having risen 21/: percent in the preceding fiscal
year. N« interest payments and nominal expenditures
for defense fell slightly in the latest fiscal year, and
outlays for income security and Medicare rose only a
little. .Social security expenditures increased moderately but somewhat less than in other receni years. By
contrast, the growth of Medicaid payments picked up
to about 6 percent after having increased less than
4 percent in each of the preceding two years; however, even the 1998 rise was not large compared with
those of many earlier years when both medical costs
and Medicaid caseloads were increasing rapidly and
rates of federal reimbursement to the states were
being raised. Federal spending in fiscal 1999 will be




13

boosted to some degree by new budget authority for
a variety of functions, including defense, embassy
security, disaster relief, preparation for Y2K. and aid
to agriculture: this authority was created in emergency legislation that provided an exception to statutory spending restrictions.
Real federal outlays for consumption and investment, the part of federal spending that is counted in
GDP. increased I percent, on net. from the final
quarter of calendar year 1997 to the final quarter of
1998. A reduction in real tie tense outlays over that
period was more than offset by a jump in the nondefense category.
With the budget balance shifting from deficit to
surplus, the stock of publicly held federal debt
declined last year for the first time since 1969 and fell
further as a share of GDP. From the end of 1997 to
the end of 1998. US. government debt fell Wi percent, as the government reduced the outstanding
stock of both bills and coupon securities. Despite the
reduction in its debt, the federal government continued substantial gross borrowing to fund the retirement of maturing securities. However, with the need
for funds trimmed substantially, the Treasury changed
its auction schedules, discontinuing the three-year
note auctions and moving to quarterly, rather than
monthly, auctions of five-year notes. By reducing the
number of coupon security issues, the Treasury is
able to boost the size of each, thereby contributing to
(heir liquidity. The decrease in the total volume of
coupon securities is intended to boost the size of bill
offerings over time, helping liquidity in that market
and also allowing, as the Treasury prefers, for balanced issuance across the yield curve. The Treasury
also announced in October that all future bill and
coupon security auctions would employ the singleprice format that had already been adopted for the

Federal government debt held by ihe public
Hcucnl a t.[)!'

1992

1998

78
14

Monetary Policy Report to the Congress D February 1999

two-year and live-year note auctions and Cor auctions
of inflation-indexed securities. The Treasury judged
that the single-price format had reduced servicing
costs and resulted in broader market participation.
The Treasury continued to auction inflationindexed securities in substantial volume last year in
an effort 10 build up this part of the Treasury market.
In April, the Treasury issued its lirst thirty-year
indexed bond, and in September it announced a regular schedule of ten- and thirty-year indexed security
auctions. The Treasury also began offering inflationindexed savings bonds in September.
State and local governments recorded further
increases in their budgetary surpluses in 1998. both
in absolute terms and as it share of GDP. Revenue
from the taxes on individuals' incomes has been
growing very rapidly, keeping total receipts on a
solid upward course. At the same time, the growth
of transfer payments, which had threatened to overwhelm state and local budgets earlier in the decade.
has slowed substantially in recent years. Growth of
other types of spending has been trending up moderately, on balance. The 1998 rise in real expenditures
for consumption and investment amounted to about
2Vt percent, according to the initial estimate: annual
gains have been in the range of 2 percent to 2Vi percent in each of the past seven years.
Despite rising surpluses, state and local government debt increased an estimated 7 percent in 1998, a
pickup of about 2 percentage points from growth
in 1997. Somewhat more than half of the long-term
borrowing by state and local governments last year
reflected new borrowing to fund current and anticipated capital spending on utilities, transportation,
education, and other capital projects. The combination of budget surpluses and relatively heavy borrowing likely reflected a number of factors. First, some of
these governments may have spent the newly raised
funds on capital projects while at the same lime
building up surpluses in "rainy day funds" for later
use. Second, because state and local governments
under some circumstances are allowed to hold funds
raised in the markets for as long as live years before
spending them, some of the money raised last year
may not have been spent. Finally, there was a substantial volume of "advance refunding" last year. In
an advance refunding, the borrower issues new bonds
before existing higher-rate bonds can be called, in
anticipation of calling the old bonds on the date that
option becomes available. While this sort of refinancing temporarily boosts total debt, it allows the state or
local government to lock in the lower rate even if
municipal bond yields subsequently rise over the
period before the call date. The high level of advance-




refunding activity last year was the result of lower
borrowing costs. Although yields on tax-exempt
municipal securities did not decline nearly as much
as those on comparable Treasury securities, they
nonetheless reached their lowest levels in many years.
In addition, rating agencies upgraded about live limes
as many slate and local government issues last year
as they downgraded, trimming borrowing costs further for the upgraded entities.

The External Sector
Trade and the Current Account
U.S. external halances deteriorated further in 1998.
largely because of the disparity between the rapid
growth of the U.S. economy and the sluggish growth
of the economies of many of our trading partners.
The nominal trade deficit for goods and services was
$169 billion, considerably larger than the $110 billion deficit in 1997. For the first three quarters of the
year, the current account deficit averaged $220 billion at an annual rate, substantially larger than the
1997 deficit of $155 billion. The large current
account deficits of recent years have been funded
with increased net foreign saving in the United States.
As a result. U.S. gross domestic investment has
exceeded the kvei that could have been financed by
gross national saving alone, but at the cost of a rise in
net U.S. external indebtedness.
The increase in the current account deficit last year
was due to a decline in net exports of goods and
services as well as a further weakening of net investment income from abroad. Until 1997. net investment
income had helped to offset persistent trade deficits.
But as the U.S. net external debt has risen in recent

U.S. currem account
tlillmns <H Jitlkuj. .uuiual tan:

•nil
IW2

1994

79
Rnard 11} Governors of the Federal Reserve Svsiem

years, net investment income has become increasingly negative, moving from a £14 billion surplus in
1996 lo a $5 billion deficit in 199? and a deficit
averaging $15 billion at an annual rale over the lirsi
ihrce quarters of 1998. Net income from portfolio
investment became increasingly negative during that
period as the net portfolio liability position of the
United States grew larger. In addition, net income
from direct investmeni slowed last year because
slower foreign economic growth lowered U.S. earnings on investment abroad, ihe appreciation of the
dollar reduced ihe value of US. earnings, and buoyant U.S. growth boosted foreigners' earnings on direct
investmeni in the United Slates.
The rise in the irade deficit reflected an increase of
about 10 percent in real imports of goods and services during 1998, according to the advance estimates from the Commerce Department. The expansion was fueled by robust growth of U.S. domestic
demand and by continued declines in import prices,
which stemmed in part from the strength of the dollar
through mid-August and in part from the effects of
recessions abroad. Of the major trade categories,
increases in imports were sharpest for finished goods,
especially capital equipment and automotive products. The quantity of imported oil rose appreciably as
demand increased in response to the strength of U.S.
economic activity and lower oil prices, while domestic production declined slightly. The price of imported
oil fell about $6.50 per barrel over the four quarters
of the year. World oil prices fell in response lo
reduced demand associated with the economic slowdown in many foreign nations and with unusually
warm weather in the Northern Hemisphere as well as
to an increase in supply from Iraq.
Real exports of goods and services grew about
I percent, on net. in 1998 after posting a 10 percent
Change in real imports and exports ot goods and services
Q imponi
• Eipons

Llll




i I

15

rise in 1997. Declines during the lirsi three quarters
(especially in machinery exports) were offset by a
rebound in the fourth quarter, which was led by
increases in exports of automotive products. The
price competitiveness of U.S. products decreased,
reflecting the appreciation of ihe dollar through midAugust. In addition, economic activity abroad weakened sharply; total average foreign growth (weighted
by shares of U.S. exports) plunged from 4 percent in
1997 to an estimated Vi percent in 1998. Moderate
expansion of exports to Europe. Canada, and Mexico
was about offset by a decline in exports associated
with deep recessions in Japan and the emerging Asian
economies (particularly in the lirst half of the yearl
and in South America (in the second half of the
yearl.
Capital Flows
The financial difficulties in a number of emerging
market economies had several noticeable effects on
U.S. international capital Hows in 1998. Financial
turmoil put strains on official reserves in many
emerging market economies. Foreign official assets
in the United Slates fell $43 billion in the first three
quarters of the year. This decline, which began in the
fourth quarter of 1997, has been largest for developing countries, as many of them drew down their
foreign exchange reserves in response to exchange
rate pressures. OPEC nations' foreign official
reserves also shrank in the first three quarters of
1998. as oil revenues dropped. Preliminary daia indicaie that foreign official assets in the United States,
especially those of industrial countries, rebounded in
the fourth quarter.
Private capital flows also were affected by the
global turmoil. On a global basis, capital flows to
emerging market economies fell substantially in the
first half of 1998 and then dropped precipitously in
late summer and early fall in the wake of the Russian
crisis. During the hrsi half of the year, US- residents
acquired more than $40 billion of foreign securities.
Net purchases virtually stopped in July, and in the
August-October period U.S. residents, on net. sold
about $40 billion worth of foreign securities. Preliminary data indicate a resumption of net U.S. purchases
in the final two months of 1998. Foreign net purchases of U.S. securities, which were substantial in
the first half of the year, fell off markedly in the
July-October period, but preliminary data suggest a
significant recovery in November and December.
Thus, there is some evidence that the contraction in
gross capital flows seen in late summer and early fall
waned somewhat in the fourth quarter

80
16

Monetary Policy Report lo the Congress D February 1999

Balance of payments data available through ihe
first three quarters or" 1998 show that lotal private
foreign purchases of U.S. securities amounted to
$194 billion, somewhat below the level in the first
three quarters of 1997. Private foreign purchases of
U.S. Treasury securities were only $22 billion in the
first three quarters, compared with S147 billion for all
of 1997. Private foreigners' purchases of other U.S.
securities shifted away from equities and toward
bonds, relative to 1997. U.S. purchases of foreign
securities slowed markedly from iheir 1997 pace,
totaling only $27 billion for the first three quarters of
1998 compared with $89 billion for all of the preceding year. The contraction in private portfolio capital
flows, though large, was overshadowed by huge
direct investment capital flows, which resulted in part
from a number of very large cross-border mergers.
The $72 billion in foreign direct investment into the
United States in the first three quarters, together with
several large mergers that occurred in the fourth
quarter, are certain to bring the total for last year well •
above the record-high $93 billion posted in 1997.
Merger activity also buoyed U.S. direct investment
abroad: The pace of such investment in the first three
quarters suggests that the annual total will be near the
record-high $122 billion recorded in 1997.

The Labor Market
The rapid growth of output in 1998 was associated
with both increased hiring and continued healthy
growth in labor productivity. The number of jobs on
nonfarm payrolls rose about 2'Xi percent from the end
of 1997 to the end of 1998, a net increase of 2.8 mil-

Change in payroll employment

.llllll
1990

I99J




1994

1*96

Change in output per hour

ll .hi
I WO

No i f

1992

1494

1996

1998

Nonlarmttuun

lion. Manufacturers reduced employment over the
year, but in other parts of the economy the demand
for labor continued lo rise rapidly. The construction
industry boosted employment about 6 percent over
the year, and both the services industries and the
finance, insurance, and real estate sector posted
increases of more than 31/! percent. Stores selling
building materials and home furnishings expanded
employment rapidly, as did firms involved in computer services, communications, and managerial services. In the first month of 1999. nonfarm payrolls
increased an additional 245.000.
Output per hour in the nonfarm business sector
rose 2V: percent in 1998 after having increased about
1 V-i percent, on average, over the two previous years.
By comparison, die average rate of rise during the
1980s and the first half of the 1990s was just over
1 percent per year. Because productivity often picks
up to a pace above its long-run trend when economic
growth accelerates, the results of the past three years
might well be overstating the rate of efficiency gain
that can be maintained in coming years. However,
reasons for thinking that the trend might have picked
up to some degree are becoming more compelling in
view of the incoming data. The 1998 gain in output
per hour was particularly impressive in this regard, in
part because it came at a time when many businesses
were diverting resources to correct the Y2K problem,
a move that likely imposed a bit of drag on growth of
output per hour. Higher rales of capital formation are
raising the growth of capital per worker, and workers
are likely becoming more skilled in employing the
new technologies. Businesses not only are increasing
their capital inputs but also are continuing to implement changes to their organizational structures and

81
Board nf Governors af the Federal Reserve System

operating procedures that might enhance efficiency
and bolster pro lit margins.
The rising demand for labor continued to strain
supply in 1998, The civilian labor force rose just a
touch more ihan 1 percent from the fourth quarter of
1997 lo the t'nutth quarter of 199H. and with the
number of persons holding jobs rising somewhat
faster than the labor force, the civilian unemployment
rate fell still further. The unemployment raie was
4.3 percent at the end of 1998; the average for the full
year—4.5 percent—was the lowest of any year in
almost three decades. In January of ihis year, the size
of the labor force rose rapidly, bui so did employment, and ihe unemployment rate remained at
4.3 percent. The percentage of the working age population that is outside the labor force and is interested
in obtaining work but not actively seeking it edged
down further this past year and has been in the lowest
range since the collection of these data began in
1970. With the supply of labor as tight as it is.
businesses are reaching further into (he pool of individuals who do not have a history of strong attachment to the labor force; persons who are attempting to move from welfare to work are among the
beneficiaries.
Workers have realized, large increases in real wages
and real hourly compensation over the past couple of
years. The increases have come partly through faster
gains in nominal pay than in the mid-1990s but also
though reductions in the rate of price increase, which
have been enhancing the real purchasing power of
nominal earnings, perhaps to a greater degree than
workers might have anticipated. According to the
Labor Department's employmeni cost index, the
Civilian unempioymeni rate

17

Change in employmeni eosl index

Hourly compensaiion

HII
Nnrf Tnvaie mdii£ir>. excluding tarn and houwMd

hourly compensation of workers in private nonfarm
industries rose 31/: percent in nominal terms during
1998. a \ouch mote ihan in 5997 and Vi percentage
point more than in 1996. Taking the consumer price
index as the measure of price change, this increase in
nominal hourly compensation translated into a 2 percent increase in real hourly pay, one of the largest on
record in u series that goes back 10 the start of ihe
1980s: the gain was bigger still if the chain-type price
index for personal consumption expenditures is used
as the measure of consumer prices. Moreover, the
employment cost index does not capture some of the
forms of compensation that employees have been
using to attract and retain workers—for example,
stock options and signing bonuses.
Because of the rapid growth in labor productivity,
unit labor costs have been rising much less rapidly
than hourly compensation in receni years. The
increase in unit labor costs in the nonfann business
sector was only i'/: percent in 1998- Businesses were
unable to raise prices sufficiently to recoup even this
small increase in costs, however. Labor gained a
greater share of the income generated from production, and the profit share, though still high, fell back a
liltle from its 1997 peak.

Prices

Hint The break in Jam in January 194J marts ire introducti
redesigned survey. dau Trom lhar pan an iff not dinrctJy
itto&e of earlier penodv




The broader measures of aggregate price change
showed inflation continuing to slow in 1998. The
consumer price index moved up 1 'A percent over the
four quarters of the year after having increased nearly
2 percent in 5991. A sleep decline in energy prices in
(he CPI more ihan offset a small acceleration in the

82
18

Moneiary Policy Report 10 ihe Congress D February 1999

Change in consumer prices

.V

Alternative measures of price change
Perctni
PiKtnwOT

ft rd-vnela
Ci pwmef poce iihJea .
-KC killing Toud and energy

Illlllll
Nm». Consumer price inde* tor all urban conwrnen

prices of other goods and services. Only pan of the
deceleration in the total CPI was attributable to technical changes in data collection and aggregation.1
Measures of aggregate price change from the
national income and product accounts, which draw
heavily on data from the CPI but also use data from
other sources, showed a somewhat more pronounced
deceleration of prices in 1998. The chain-type price
index for personal consumption expenditures, the
measure of consumer prices in the national accounts,
rose '/4 percent after increasing 1 Vi percent in 1997.
The chain-type price index for gross domestic
purchases—the broadest measure of prices paid by
U.S. households, businesses, and governments—
increased only 'ft percent in 1998 after moving up
\'A percent over the previous year. The rise in the
chain-type price index for gross domestic product of
slightly less than 1 percent was down from an
increase of PA percent in 1997.
Developments in the external sector helped to
bring about the favorable inflation outcome of 1998.
Consumers benefited directly from lower prices of
finished goods purchased from abroad. Lower prices
for imports probably also held down the prices
charged by domestic producers, not only because
businesses were concerned about losing market share
to foreign competitors but also because declines in

I . Since the end of 1994. the Bureau ol Labor Statistics has taken a
number of steps 10 make the consumer price index a more accurate
price measure. The agency also introduced new weights inlo the CPI
at the start of 1998. In total, these ctanges probably reduced [he 1998
rise in Ihe CPI by slightly less than '/i percentage point, relative 10 the
increase that would have been reponed using Ihe methodologies and
weights in existence ai the end of 1994. Withour the changes thai took
effect in 1998. Ihe deceleration in (he CPI last year probably would
have been about half as large as was reponed.




On>*£ Uomesnt producl
(Injss domauc purchases .
Me
deluding load and energy

IW7

lf«

13

y

1 7

U

1 5

16

S

i.:

N i i i h . Changes on based on quarterly iiverages jnd LUC measured 10 Ihe
urth ijuanrr of ihe year indicated from ihr lourih quaner ol Ihe previous yaai

commodity prices in sluggish world markets helped
reduce domestic production costs to some degree.
In manufacturing, one or' the sectors most heavily
affected by the softness in demand from abroad, the
rate ol' plant capacity utilization fell noticeably over
the year—even as ihe unemploymeni rale continued
to decline. The divergence of these two key measures
of resource use—the capacity utilization rate and the
unemployment rate—is unusual; They typically have
exhibited similar patterns of change over the course
of the business cycle. Because the unemployment
rate applies to the entire economy, it presumably
should be a better indicator of' the degree of pressure
on resources in general. At present, however, slack in
the goods-producing sector—a reflection of the sizable additions to capacity in this country and excess
capacity abroad—seemingly has enforced a discipline of competitive price and cost control that has
affected the economy more generally.
Prices this past year tended to be weakest in the
sectors most closely linked to the external economy.
The price of oil tell almost 40 percent from December 1997 to December 1998. This drop triggered
steep declines in the prices of petroleum products
purchased directly by households. The retail price of
motor fuel fell about 15 percent over the four quarters
of the year, and the price of home heating fuei also
plunged. With the prices of natural gas and electricity
also falling, the CPI for energy was down about
9 percent over the year after having slipped 1 percent
in 1997.
Large declines in the prices of internationally
traded commodities other than oil pulled down the
prices of many domestically produced primary inputs.
The producer price index for crude materials other
than energy, which reflects the prices charged by
domestic producers of these goods, fell more than
10 percent over the year. However, because these
non-oil commodities account for a small share of
total production costs, the effect of their decline on
inflation was much less visible further down the

83
Board of Governors of the Federal Restn-e System

chain of production. Intermediate materials prices
excluding food and energy fell about IV: percent
over the four quarters of the year, and the prices of
finished goods excluding food and energy rose about
I 'A percent. The latter index was boosted, in part, by
an unusually large hike in tobacco prices that followed the settlement last fall of states' litigation
against the tobacco companies. In the food sector as
well, the effects of declining commodity prices
became less visible further down the production
chain: the PPI for Finished foods was about
unchanged, on net. over the year, and price increases
at the retail level, though small, were somewhat
larger than those of the preceding year.
Consumer prices excluding those of food and
energy—the core CPI—continued to rise in 1998,
but not very rapidly. As measured by the CPI, these
prices increased nearly 21/: percent from the final
quarter of 1997 to the final quarter of 1998. a shade
more than in 1997. The chain-type price index for
personal consumption expenditures excluding food
and energy—the core PCE price index—decelerated
a bit further, rising at roughly half the pace of the
core CPI. Methodological differences between the
two measures are numerous; some of the technical
problems that have plagued the CPI are less pronounced in the PCE price measure, but the latter also
depends partly on imputations of prices for which
observations are not available. Both measures, however, seemed to suggest that the underlying trend of
consumer price inflation remained low. A similar
message came from surveys of consumers, which
showed expectations of future price increases easing
a bit further in 1998—although, as in other rccem
years, the expected increases remained somewhat
higher than actual price increases.

Change in consumer prices excluding food and energy

lllllll
Host.. Conuner pnce indei lor all urtun comiuncn.




19

US. Financial Markets
U.S. interest rates fluctuated in fairly narrow ranges
over the n'rst half of 1998, and most equity price
indexes posted substantial gains. However, after the
devaluation of the Russian ruble in August and subsequent difficulties in other emerging market economies, investors appeared lo reassess the risks and
uncertainties facing the U.S. economy and concluded
that more cautious postures were in order. That sentiment was reinforced by the prospect of an unwinding
of positions by some highly leveraged investors. The
resulting shift toward safe, liquid investments led to a
substantial widening of risk spreads an debt instruments and to volatile changes in the prices of many
assets. Financial market volatility and many risk
spreads returned to more normal levels later in the
year and early this year, as lower interest rates and
robust economic data seemed to reassure market participants that the economy would remain sound, even
in the face of additional adverse shocks from abroad.
However, lenders remained more cautious than they
had been in the first pan of lost year, especially in the
case of riskier credits.

Interest Rales
Over ihe first half of 1998, short-term Treasury rates
moved in a narrow range, anchored by unchanged
monetary policy, while yields on intermediate- and
long-term Treasury securities varied in response to
the market's shifting assessment of the likely impact
of foreign economic difficulties on the U.S. economy.
In late 1997 and into 1998, spreading financial crises
in Asia were associated with declines in U.S. interest
rates, as investors anticipated that weakness abroad
would constrain U.S. economic growth and cushion
the impact of tight U.S. labor markets on inflation.
However, interest rates moved back up later in the
first quarter of 1998. as the U.S. economy continued
lo expand at a healthy pace, fueled by hefty gains in
domestic demand. After a couple of months of small
changes. Treasury rates fell in May and June, when
concerns about foreign economies, particularly in
Asia, once again led some observers to expect weaker
growth in the United States and may also have
boosted the demand for safe Treasury securities relative to other instruments.
Treasury rates changed little, on net. in the early
summer, but they slipped lower in August, reflecting
increased concern about the Japanese economy and
financial problems in Russia. The default by Russia
on some government debt obligations and the devalu-

84
20

Monetary Policy Report to the Congress D February 1999

Selected Treasury rales, daily data

Spreads af wirporaie bond yields
over Treasury seturily yields

I

F M A M J J A S O N D I F \l A M I J A S 0 S D I F

S

o

N

D

J

NIITK. Lasl observations arc for February 19. 19W

ation of the ruble in mid-August not only resulted in
sizable losses for some investors but also undermined
confidence in other emerging market economies. The
currencies of many of these economies came under
substantial pressure, and the market value of the
international debt obligations of some countries
declined sharply. U.S. investors shared in the resulting Josses, and U.S. economic growth and (he profits
of U.S. companies were perceived to be vulnerable.
In these circumstances, many investors, both here
and abroad, appeared to reassess the riskiness of
various counterparties and investments and to
become less willing to bear risk. The resulting shift
of demand toward safety and liquidity led to declines
of 40 to 75 basis points in Treasury coupon yields
between mid-August and mid-September. In contrast,
yields on higher-quality private securities fell much
less, and those on issues of lower-rated firms
Selected Treasury rates, quarterly data

Nnrt. The iweniy-year rreasiav bond me v. sbo*
ihe tniny-jrear Treasury bond in fehnury 1917




NMTH- Thedaiaare daily. The spread of high-yield bontb comparei the yield
an ihe Merrill Lynch Mailer II index with thai on a seven-year Treasury: the
other TWO ^heaus I'ompaR yields on ihe appropriate Merrill Lynch indexes wiih
inolon nten-«ai Treasury. Last otnervalions are for Frrmiary 19. 1999

increased sharply. As a result, spreads of private rates
over Treasury rates rose substantially, reaching levels
not seen for many years, and issuance of corporate
securities dropped sharply.
The desire of investors to limit risk-taking as markets became troubled in the late summer showed up
clearly in mutual fund flows. High-yield bond funds,
which had posted net inflows of more than $1 billion
each month from May to July, saw a $3.4 billion
outflow in August and inflows of less than $400 million in September and October before rebounding
sharply in November. By contrast, inflows to government bond funds jumped from less than $1 billion in
July to more than $2 billion a month in August and
September. Equity mutual funds posted net outflows
totaling nearly $12 billion in August, the first
monthly outflow since 1990. and inflows over the rest
of the year were well below those earlier in the year.
In pan. the foreign difficulties were transmitted
to U.S. markets by losses incurred by leveraged
investors—including banks, brokerage houses, and
hedge funds—as the prospects for distress sales of
riskier assets by such investors weighed on market
sentiment, depressing prices. Many of these entities
did reduce the scale of their operations and trim their
risk exposures, responding to pressures from more
cautious counterparties. As a result, liquidity in many
markets declined sharply, with bid-asked spreads
widening and large transactions becoming more difficult to complete. Even in the market for Treasury
securities, investors showed an increased preference
for the liquidity offered by the most recent issues at
each maturity, and the yields on these more actively

85
Board of Governor* of ihf Federal Reserve System

traded "on-the-run" securities tell noticeably relative
10 those available on "off-the-run" issues, the ones
that had been outstanding longer.
Conditions in U.S. financial markets deteriorated
further following revelations in mid-September of
the magnitude of the positions and the extent of
the losses of a major hedge fund. Long-Term Capital
Management. LTCM indicated that it sought high
rates of return primarily by identifying small discrepancies in the prices of different instruments relative
to historical norms and then taking highly leveraged
positions in those instruments in the expectation that
market prices would revert to such norms over time.
In pursuing its strategy, LTCM took very large positions, some of which were in relatively small and
illiquid markets.
LTCM was quite successful between 1995 and
1997, but the shocks hitting world financial markets
last August generated substantial losses for the firm.
Losses mounted in September, and before new investors could be found, the tirm encountered difficulties
meeting liquidity demands arising from its collateral
agreements with its creditors and counterparties. With
world financial markets already suffering from
heightened risk aversion and illiquidity, officials of
the Federal Reserve Bank of New York judged that
the precipitous unwinding of LTCM's portfolio that
would follow the firm's default would significantly
add to market problems, would distort market prices,
and could impose large losses, not just on LTCM's
creditors and counterparties, but also on other market
participants not directly involved with LTCM.
In an effort to avoid these difficulties, the Federal
Reserve Bank of New York contacted the major
creditors and counterparties of LTCM to see if an
alternative to forcing LTCM into bankruptcy could
be found. At the &ame time. Reserve Bank officials
informed some of their colleagues at the Federal
Reserve Board, the Treasury, and other financial
regulators of their activities. Subsequent discussions
among LTCM's creditors and counterparties led to an
agreement by the private-sector parties to provide an
additional $3'/6 billion of capital to LTCM in return
for a 90 percent equity stake in the firm.
Because of the potential for firms such as LTCM
to have a large influence on U.S. financial markets,
Treasury Secretary Robert Rubin asked the President's Working Group on Financial Markets to study
the economic and regulatory implications of the
operations of firms like LTCM and their relationships
with their creditors. In addition, the extraordinary
degree of leverage with which LTCM was able to
operate has led the federal agencies responsible for
the prudential oversight of the fund's creditors and




21

counterparties to undertake reviews of [he practices
those firms employed in managing their risks. These
reviews have suggested significant weaknesses in the
risk-management practices «t' many firms in their
dealings with LTCM and—albeit to a lesser
degree—in their dealings with other highly leveraged
entities. Few counterparties seem to have had a complete understanding of LTCM's risk profile, and ihcir
credit decisions were heavily in Hue need by the firm's
reputation and strong past performance. Moreover,
LTCM's counterparties did not impose sufficiently
tight limits on their exposures to LTCM. in pan
because they relied on collateral agreements requiring frequent marking to market to limit the risk of
their exposures. While these agreements generally
provided for collateral with a value sufficient to cover
current credit exposures, they did not deal atiequmely
with the potential for future increases in exposures
from changes in market values. This shortcoming
was especially important in dealings with a firm like
LTCM. which had such large positions in illiquid
markets that its liquidation would likely have moved
prices sharply against its creditors. In such cases.
creditors need to take further steps to limit their
potential future exposures, which might include requiring additional collateral or simply scaling back
their activity with such firms.
The private-sector agreement to recapitalize LTCM
allowed its positions to be reduced in an orderly
manner over time, rather than in an abrupt fire sale.
Nonetheless, the actual and anticipated unwinding of
LTCM's portfolio, as well as actual and anticipated
sales by other similarly placed leveraged investors,
likely contributed materially to the tremendous volatility of financial markets in early October. Market

Implied volatilities

/

F M A M I

i

A S O N O J

IW8

NCIII.. The ilw ore doily. Implied mioulilia are ataOtad t
pricci. UH obstrvononi« for Mmuiy IV. IW

F

19W

86
22

Monetary Policy Report lo the Congress Q February 1999

expectations of asset price volatility going forward,
as re Heeled in options prices, rose sharply, us h idasked spreads and the premium for on-the-run securities widened. Long-term Treasury yields briefly
dipped to their lowest levels in more than thirty
years, in pun because of large demand shifts resulting
from concerns about the safety and liquidity of private and emerging market securities. Spreads of rates
on corporate bonds over those on comparable Treasury securities rose considerably, and issuance of
corporate bonds, especially by lower-rated firms.
remained very low.
By mid-October, however, market conditions had
stopped deteriorating, and they began to improve
somewhat in the days and weeks following the cut in
the federal funds rate on October 15. between Federal
Open Market Committee meetings. Internationally
coordinated efforts to help Brazil cope with its financial difficulties, culminating in the announcement of
an IMF-ted support package in mid-November, contributed to the easing of market strains. In the Treasury market, bid-asked spreads narrowed a bit and
the premium for on-1 he-run issues declined. With (he
earlier flight to quality and liquidity unwinding, Treasury rates backed up considerably. Corporate bond
spreads reversed a part of their earlier rise, and
investment-grade bond issuance rebounded sharply.
In the high-yield bond market, investors appeared to
be more hesitant, especially for all but die bestknown issuers, and the volume of junk bond issuance
picked up less. In the commercial paper market,
yields on higher-quality paper declined; yields on
lower-quality paper remained elevated, however, and
some lower-tier firms reportedly drew on their bank
lines for funding, giving a further boost to bank
business lending, which had begun to pick up during
the summer.
Market conditions improved a bit further immediately after the Federal Reserve's November rate cut,
but some measures of market stress rose again in late
November and in December. In part, this deterioration reflected widespread warnings of lower-thane spec ted corporate profits, a weakening economic
outlook for Europe, and renewed concerns about the
situation in Brazil. In addition, with risk a greaterthan-usual concern, some market participants were
likely less willing to hold lower-rated securities over
year-end, when they would hare to be reported
in annual financial statements. As a result, liquidity in
some markets appeared to be curtailed, and price
movements were exaggerated. These effects were
particularly noticeable in the commercial paper market: The spread between rates on top-tier and lowertier thirty-day paper jumped almost 40 basis points




on December 2, when ihat maturity crossed year-end,
and then reversed the rise late in the month.
By shortly after year-end, some measures of market stress had eased considerably from their levels
in the fall, although markets remained somewhat
illiquid relative lo historical norms, and risk spreads
on corporate bonds stayed quite elevated. Nonetheless, with Treasury yields very low. corporate bond
rates were apparently perceived as advantageous.
and—following a lull around year-end—many corporate borrowers brought new issues lo market. The
devaluation and subsequent floating of the Brazilian
real in mid-January had a relatively small effect on
U.S. financial markets. More recently, intermcdiateand long-term Treasury rates have increased, as incoming data have continued 10 show the economy
expanding briskly, and investors have come to believe that no further easing of Federal Reserve policy
is likely.

Equity Prices
Most equity indexes rose strongly, on balance, in
1998. with (he Nasdaq Composite Index up nearly
40 percent, me S&P 500 Composite Index rising
more than 25 percent, and the Dow Jones Industrial
Average and the NYSE Composite Index advancing
more than 15 percent. Small capitalization stocks
underperformed those of larger firms, with the Russell 2000 Index off 3 percent over the year. The
variation in stock prices over the course of the year
was extremely wide. Prices increased substantially
over the first few months of 1998, as concerns eased
that Asian economic problems could lead to a slowdown in the United States and to a consequent decline
Major stock price indexes

Nasdaq

] F M A M J J A S ON D J F M A M I J A S ON D I F
1997
199)1
1999
Mint. The dnu a« daily Law observanoni aw for February 19. IWJ

87
Board if Guvernnrs nf ihe Federal Reserve System

in profits. The major indexes declined, on balance,
over [he following couple of months before rising
sharply, in some cases to new records, in late June
and early July, on increasing confidence about the
outlook for earnings. The main exception was the
Russell 2000; small capitalization stocks fell more
substantially in ihe spring, and their rise in July was
relatively muied.
Rising concerns about the outlook for Japan and
other Asian economies, as well as the deepening
financial problems in Russia, caused stock prices to
reirace their July gains by early August. After Russia
devalued the ruble and defaulted on some debts in
mid-August, prices fell further, reflecting the general
turbulence in global financial markets. By the end of
the month, most equity indexes had fallen back to
roughly ihcir levels at the start of the year. Commercial bank and investment bank stocks fell particularly
sharply, as investors became concerned about the
effect on these institutions' profits of emerging market difficulties and of substantial declines in the values of some assets. Equity prices rose for a time in
September but then fell back by early October before
rebounding as market dislocations eased and interest
rates on many private obligations fell. By December,
most major indexes were back near their July highs,
although the Russell 2000 remained below its earlier
peak.
In late December, and into the new year, stock
prices continued to advance, with several indexes
reaching new highs in January. The devaluation of
the Brazilian real caused some firms' shares to drop
as investors reevaluated prospective earnings from
Latin American operations, but all the major stock
indexes posted gains in January; the Nasdaq
advanced nearly 15 percent over the month, driven
by large advances in the stock prices of hightechnology firms, especially those related to the Internet. More recently, however, stock prices fell back, as
interest rates rose and some investors apparently concluded that prices had risen too far, given the outlook
for earnings.
The increase in equity prices last year and early
this year, coupled with the slowing of earnings
growth, left many valuation measures beyond their
historical ranges. After ticking higher in the late
summer and early autumn, the ratio of consensus
estimates of earnings over the coming twelve months
to prices in the S&P 500 later fell back, dropping
to a new low in January. In pan, the decline in this
measure over the past year likely reflected lower real
long-term bond yields. For example, as measured by
the difference between the ten-year nominal Treasury
yield and inflation expectations reported in the




2.1

Equity valuation and long-torm real interest rate

19HO

I1HJ

I-WK

19IW

NMTh. rhc ibLi an momhly [he eamingi-pnc
months The real interest nw it ihe yield on the ic
ten-year inflation exptaauooi from ihe hnkral R
Survey or Prole&uonal Foreca&lcrs

istaied onineUB/t/S
tr the coming iwelve
: Bant ul Philadelphia

Philadelphia Federal Reserve Bank's survey of professional forecasters, real yields fell appreciably
between late 1997 and early 1999. (The yield on
ten-year inflation-indexed Treasury securities actually rose somewhat last year. However, the increase
may have reflected the securities' lack of liquidity
and the substantial rise in the premium investors were
willing to pay for liquidity.) Since mid-1998, the real
interest rate has declined somewhat more than the
forward earnings yield on stocks, and the spread
between the two consequently increased a bit. perhaps reflecting the greater sense of risk in financial
markets. Nonetheless, the spread has remained quite
small relative to historical norms: Investors may
be anticipating rapid long-term earnings growth—
consistent with the expectations of securities
analysts—and they may still be satisfied with a lower
risk premium for holding stocks than they have
demanded historically.
Debt and the Monetary Aggregates
Debt and Depository Intermediation
From the fourth quarter of 1997 to the fourth quarter
of 1998, the total debt of the U.S. household, government, and nonfinancial business sectors increased
about 6'/4 percent, in the top half of its 3 percent to
7 percent range and considerably faster than nominal
GDP. Buoyed by strong spending on durable goods,
housing, and business investment, as well as by
merger and acquisition activity that substituted debt
for equity, non federal debt expanded about 9 percent

88
24

Monetary Policy Repon 10 ihe Congress O February 1999

Domestic minlinanciaJ debt: Annual range jnd actual level

MI: Annual range and actual level
Trillion I'ltkilLin

TnllHn ,t ilrilon

last year, more than 2 percentage points Caster than in
1997. By contrast, federal debt declined I'/a percent,
following D rise of/4 percent ihe previous year.
Credit market instruments on the books of depository institutions rose at a somewhat slower pace than
did the debt aggregate, posting a 5-Vj percent rise in
1998. about half a percentage point less than in 1997.
Growth in depository credit picked up in the second
halt of the year, as [he turbulence in financial markets
apparently led many firms to substitute bank loans for
funds raised in the markets. Banks also added considerably to their holdings of securities in the third
and fourth quarters, in pan reflecting the attractive
spreads available on non-Treasury debt instruments.
Financial firms also appeared to turn to banks for
funding when the financial markets were volatile, and
U.S. banks substantially expanded their lending to
financial firms through repurchase agreements and
loans to purchase and carry securities. As a result,
growth of total bank credit, adjusted to remove the
effects of mark-to-market accounting rules, accelerated to ID'/? percent on a fourth-quarter 10 fourthquarter basis, the largest annual increase in more than
a decade.

range was the result of faster growth in nominal
spending than would likely be consistent with sustained price stability. In addition, the velocity of M2
(defined as the ratio of nominal GDP to M2) fell
3 percent. Some of the decline resulted from the
decrease in short-term market interest rates last
year—as usual, rales on deposits fell more slowly
than market rates, reducing the opportunity cost of
holding M2 (defined as the difference between the
rate on Treasury bills and the average return on M2
assets).
However, the bulk of the decline cannot be
explained on the basis of the historical relationship
between the velocity of M2 and this measure of its
opportunity cost. Three factors not captured in that
relationship likely contributed to the drop in velocity.
First, households seem to have allocated an increased
M2 velocity and the opportunity cost of holding M2

The Monetary Aggregates
The broad monetary aggregates expanded very rapidly last year. From the fourth quarter of 1997 to the
fourth quarter of 1998. M2 increased 81/: percent,
placing it well above the upper bound of its I percent
to 5 percent range. However, as the FOMC noted last
February, this range was intended as a benchmark for
money growth under conditions of stable prices, real
economic growth near trend, and historical velocity
relationships. Part of the excess of M2 above its




1

197ft

I

]

I

I

I

1W

I

I

I98K

199?

I99X

Mi)"-. The data are qumcrly M3 opppminity con n On Wo-quantr mo
ivcragcof OK thm-im«h Treasury biltrw kst ihe weighied*jveni£e rare paid
.in M2 componenU-

89
Board of Governors of the Federal Reserve 5w«n

M3; Annual ranuc and actual level

share of savings flows 10 monetary assets rather than
equities following several years of outsized gains in
stock market wealth. Second, some evidence suggests that in the 1990s the demand for M2 assets has
become more sensitive to longer-term interest rates
and to the slope of the yield curve, and so the decline
in long-term Treasury yields last year, and the consequent flattening of the yield curve, may have
increased the relative attractiveness of M2 assets.
Finally, a critical source of the especially rapid M2
expansion in the fourth quarter likely was an
increased demand for safe, liquid assets as investors
responded to the heightened volatility in financial
markets. With some of these safe-haven flows likely

25

being reversed, growth in the broad monetary aggregates, while still brisk, has slowed appreciably early
this year.
M3 expanded even faster than M2 in 1998. posting
an 1 1 percent rise on a fourth-quarter to fourthquaner basis. Last year's growth was the fastest since
1981 and left the aggregate well above the top end of
its 2 percent to 6 percent growth range. As with M2,
however, the FOMC established the M3 range as a
benchmark for growth under conditions of stable
prices, sustainable output growth, and the historical
behavior of velocity. The rapid growth of M3 in part
simply reflected the rise in M2. In addition, the
non-M2 components of M3 increased IS1/; percent
over ihe year, following an even larger Advance in
1997. The substantial rise in these components lasi
year was partly the result of the funding of 'he robust
growth in bank credit with managed liabilities, many
of which are in M3. However, M3 growth was
boosted to an even greater extent by (lows into
institution-only money funds, which have been
expanding rapidly in recent years as they have
increased their share of the corporate cash management business. Because investments in these funds
substitute for business holdings of short-term assets
that are not in M3, their rise has generated an increase
in M3 growth. In addition, institution-only funds
pay rates that tend to lag movements in msrket rates.
and so their relative attractiveness was temporarily
enhanced—and their growth rate- boosted—by
declines in short-term market interest rates late last
year.

Growth of money and debt

Ml

Penod

1988

42
6

. .

1989

M2

56
5-

1990

42

42

1991

SO
143

' 1

1992
1993
1994

10 ft

1995

-1 6

19%
1997-

-4 5
-I 2
1 8

:j

1998

Qtianfrh tanrtvat roit)'
1998.1
3
4

^.2
1.0
-2.0

. .'..'..'.'
.

.

.

.

.

50

NniF Ml £«ititi3 of currency. travelers checks, demand deposits, ant other
checkable depouu M2 consist* of M 1 plus savings deposit* i including money
market1 depoHl account I. smaJI-deowmimnwi nine ilepcniis. jnd hala
retail mo«y market fund*- M3 CQIHUU of M2 plus large-denomination
itposiu, balances m mititulional money market lunU. RP liBbtluiei lavemi
and term!, jnd Eurodollars Cnvemi^hi and terror Debt LTHIU;I» of the




|

M3

h J
41

!

Dpmesuc

1
'

T
5
^
9
9

6 1

4
1

b

1.9
1 2
b
1 0
1 7

J9
46
58
85

86
II U

0

76

10.1

7S

10. 1
86

2
1
0

I.S
1?

69
1.0

68

1.1 :

•'

-i

standing credit market Jetx ol tin U S jovtmnenl- ttate and local governmenu, households jnc nonpront ixjaniuuioni. nonrinoncial businesses, and
I From average for fourth quarter ol preceding year ici average (nr fourth
quarter of year indicated.
2. From averape lor preceding quarter (o average for quariEf indicated.

90
26

Monetary Policy Report to Ihe Congress D February 1999

Ml increased 1 -Vi percent over the four quarters of
1998. its first annual increase since 1994. Currency
expanded at an 8'/j percent pace, its largest rise since
1994. The increase apparently reflected continued
strong foreign shipments, though at a slower pace
than in 1997. and a sharp acceleration in domestic
demand. Deposits in Ml declined further in 1998,
reflecting the continued iniroduciion of retail
"sweep" programs. Growth of Ml deposits has been
depressed for a number of years by these programs,
which shift—or "sweep"—balances from household
transactions accounis. which are subject to reserve
requirements, inlo savings accounis. which are not.
Because the funds are shifted back to transactions
accounis when needed, deposiiors' access to their
funds is not affected by these programs. However.
banks benefit from the reduction in holdings of
required reserves, which do not pay interest. Over
1998, sweep programs for demand deposit accounts
became more popular, contributing to a -IVi percent
decline in such balances. By contrast, new sweep
programs for other checkable deposits, which had
driven double-digit declines in such deposits over ihe
previous three years, were less important in 1998,
and, with nominal spending strong and interest
rates lower, oiher checkable deposits were about
unchanged on the year.
As a result of the introduction of retail sweep
accounts, the average level of required reserve balances (balances that must be held at Reserve Banks
to meet reserve requirements) has trended lower over
ihe past few years. The decline has been associated
with an increase in banks' required clearing balances,
which are balances that banks agree in advance to
hold al their Federal Reserve Bank in order to facilitate the clearing of their payments. Unlike required
reserve balances, banks earn credits on their required
clearing balances that can be applied to the use of
Federal Reserve priced services. Despite (he increase
in required clearing balances, required operating balances, which are the sum of required reserve balances
and required clearing balances, have declined over
the past few years and in late 1998 reached their
lowest level in several decades.
The decline in required operating balances has
generated concerns about a possible increase in the
volatility of the federal funds rate. Because a bank's
required level of operating balances must be met only
on average over a two-week maintenance period,
banks are free to allocate their reserve holdings across
the days of a maintenance period in order to minimize their reserve costs. However, banks must also
manage their reserves in order to avoid overdrafts,
which the Federal Reserve discourages through




administrative measures and financial penalties.
Thus, as required operating balances dech'ne toward
the minimum level needed to clear banks' transactions, banks are less and less able to respond to
fluctuations in ihe federal funds rale by lending funds
when the rale is high and borrowing when ihe rate is
low. As a result, when required operating balances
are low, the federal funds rale is likely 10 rise further
than it otherwise would when demands for reserves
are unexpectedly strong or supplies weak: conversely,
the federal funds rate is likely to fall more in ihe
event of weaker-than-expected demand or strongerth an-ex pec ted supply. One way to ease this difficulty
would he to pay interest on required reserve balances,
which would reduce banks' incentives to expend
resources on sweeps and other effons to minimize
these balances.
Despite the low level of required operating balances, the federal funds rate did not become noticeably more volaiile over the spring and summer of
1998. In part, this result reflected more frequent
overnight open market operations by ihe Federal
Reserve to better malch the daily demand for and
supply of reserves. Also, banks likely improved the
management of their accounts at the Federal Reserve
Banks. Moreover, large banks apparently increased
their willingness to borrow at the discount window.
The Federal Reserve's decision to return to lagged
reserve accounting at the end of July also likely
contributed to reduced volatility in the federal funds
market by enhancing somewhat the ability of both
banks and the Federal Reserve to forecast reserve
demand.
In the latter pan of 1998 and into 1999, however,
the federal funds rate was more volatile. The increase
may have owed partly to further reductions in
Effective federal funds rate less target rale

!

F

M

A

M

J

J

A

S

O

N

D

J

Hint. Dalaare doily LMI Mwrvauon u tor Ftbniary 19. IW>

91
Board of Gavernurs of the Federal Reserve Sclent

required operating balances resulting from new
sweep programs, hut other factors were probably
more important, at lease for a time. Market participants were scrutinizing borrowing banks more
closely. and in some cases lenders pared or more
lightly administered their counterparty credit limits,
or shifted more of their placements from term to
overnight maturities. The heightened attention to
credit quality also made banks less willing to borrow
at the discount window, because they were concerned
that other market participants might detect their borrowing and interpret it us a sign of financial weakness. As a result, many hanks that were net takers of
funds in short-term markets attempted to lock in their
funding earlier in the morning. On net. these forces
boosted the demand for reserves and put upward
pressure on the federal funds rate early in the day. To
buffer the effect of these changes on volatility in the
federal funds market, the Federal Reserve increased
the supply of reserves and. at times, responded to the
level of the federal funds rate early in the day when
deciding on (he need for market operations. Because
demand had shifted (o earlier in ihe day. however, ihe
federal funds rate often fell appreciably below its
target level by the end of the day.
At its November meeting, the FOMC amended the
Authorization for Domestic Open Market Operations
to extend the permitted maturity of System repurchase agreements from fifteen to sixty days. Over the
remainder of 1998, the Domestic Trading Desk made
use of this new authority on three occasions, arranging System repurchase agreements with maturities of
thirty to forty-five days to meet anticipated seasonal
reserve demands over year-end. While the Desk had
in the past purchased inflation-indexed securities
when rolling over holdings of maturing nominal securities, it undertook its first outright open market purchase devoted solely to inflation-indexed Treasury
securities in 1998. thereby according those securities
the same status in open market operations as other
Treasury securities.

International Developments
In 1998. developments in international financial markets continued to be dominated by the unfolding
crises in emerging markets that had begun in Thailand in 1997. Financial market turbulence spread to
other emerging markets around the globe, spilling
over from Korea, Indonesia, Malaysia, Singapore, the
Philippines, and Hong Kong in late 1997 and in the
first part of 1998 to Russia in the summer, and to
Latin America, particularly Brazil, shortly thereafter.




27

The Asian crisis contributed to a deepening recession
in Japan last year, and as the year progressed, growth
in several oihcr major foreign industrial economies
slowed us well.
Ai the beginning of 1998, many Asian currencies
were declining or were under pressure. The Indonesian rupiah dropped sharply in January, amid widespread rioting and talk of a coup, and fell again in
May and June, as the deepening recession prompted
more social unrest and ultimately the ouster of
President Suharto. Some of ihe rupiah's losses were
reversed in the second half of the year, following the
relatively orderly transition of power to Presideni
Habibie, Tighter Indonesian monetary policy, which
pushed short-term interest rates as high as 70 percent
by July, contributed to the rupiah's recovery. On
balance, between December 1997 and December
1998. the rupiah depreciated more than 15 percent
against the dollar.
In contrast, the Thai bahl and Korean won. which
had declined sharply in 1997. gained more than
20 percent against the dollar over the course of 1998.
Policy reforms and stable political environments
helped boost these currencies. Between these
extremes, the currencies of the Philippines, Malaysia.
Singapore, and Taiwan fluctuated in a narrower
range and ended the period little changed against the
dollar. In September. Malaysia imposed capital and
exchange controls, fixing the ringgit's exchange rate
against the dollar. The Hong Kong dollar came under
pressure at times during the year, but its peg to the
U.S. dollar remained intact, although at the cost of
interest rates that were at times considerably elevated. Short-term interest rates in Asian economies
other than Indonesia declined in 1998. and as some
stability returned to Indonesian markets near the end
of the year, short-term rates in that nation began to
retreat from their highs.
As the year progressed, the financial storm moved
from Asia to Russia. At first the Russian central bank
was able to defend the ruble's peg to the dollar with
interest rate increases and sporadic intervention. By
midyear, however, ihe government's failure to reach
a new assistance agreement with the International
Monetary Fund, reported shortfalls in tax revenues,
and the disruption of rail travel by striking coal
miners protesting late wage payments brought to
the fore the deep structural and political problems
faced by Russia. In addition, declining oil prices were
lowering government revenues and worsening the
current account. As a result of these difficulties, the
ruble came under renewed pressure, forcing Russian
interest rates sharply higher, and Russian equity
prices fell abruptly. A disbursement of $4.8 billion

92
28

Monetary Policy Repon lo ihe Congress D February 1999

I'rom Ihe IMF in July was quickly spent 10 keep the
currency near its level of 6.2 rubles per dollar, hut the
lack of progress on fiscal reform put the next IMF
tranche in doubt.
On August 17. Russia announced a devaluation of
the ruble and a moratorium on servicing official shortterm debt. Subsequently, the ruble depreciated more
than 70 percent against the dollar, the government
imposed conditions on most of its foreign and domestic debt that implied substantial losses for creditors.
and many Russian financial institutions became
insolvent. The events in Russia precipitated a global
increase in financial market turbulence, including a
pull back of credit to highly leveraged investors and a
widening of credit spreads in emerging market economies and in many industrial countries, which did not
abate until after central banks in a number of industrial countries eased policy in the fall.
Latin American financial markets were only moderately disrupted by the Asian and Russian problems during the first half of 1998. The reaction to the
Russian default, however, was swift and strong, and
the prices of Latin American assets fell precipitously.
The spreads between yields on Latin American Brady
bonds and comparable U.S. Treasuries widened considerably (with increases ranging from 900 basis
points in Argentina to 1500 basis points in Brazil)
and peaked in early September before retracing part
of the rise. Latin American equity prices plunged,
ending the year down 25 percent or more. Several
currencies came under pressure, despite sharp
increases in short-term interest rates. The Mexican
peso, which was also weakened by the effects of
falling oil prices, depreciated 18 percent against the
dollar over the year. The Colombian peso and the
Ecuadorian sucre were devalued, but Argentina's currency board arrangement survived.
Brazil's central bank defended the real's crawling
peg until mid-January 1999 but is estimated to have
used more than half of the $75 billion in foreign
exchange reserves it had amassed as of last April.
Anticipation of the IMF-led financial assistance package for Brazil helped spur a partial recovery in Latin
American asset markets in late September and October. The details of the $41.5 billion loan package
were announced in November, but after ihe package
was approved by the IMF in early December, Brazil's
Congress rejected a part of the government's fiscal
austerity plan, sparking renewed financial turmoil. In
mid-December. $9.3 billion of the loan package was
disbursed, but as the year ended, the continuing
pressure from investors seeking to lake funds out of
Brazil put the long-run viability of the crawling
exchange rale peg in doubt. The real came under




pressure again in early January after the state of
Minus Gcrais threatened not to pay its debt to the
federal government. On January 13. the real was
devalued 8 percent, and two days later it was allowed
10 float. Since the end of 1998. the real has depreciated nearly 38 percent against (he dollar, and capital
flight from Brazil has likely persisted. The collapse
of the real exerted some downward pressure on the
currencies of other Latin American countries. Thus
far, however, contagion has been more limited than it
was after the Russian devaluation; unlike Russia.
Brazil has continued to meet debt service obligations,
and investors apparently had an opportunity to adjust
positions in advance of the devaluation and have
drawn a distinction between Brazil's problems and
those of other economies.
The fallout from the financial crises that hit several
Asian emerging market economies in late 1997 triggered a further decline in output in the region in early
1998. In ihe countries most heavily affected—
Thailand. Korea, Malaysia, and Indonesia—output
dropped at double-digit annual rates in the first half
of the year, as credit disruptions, widespread failures
in the financial and corporate sectors, and a resulting
high degree of economic uncertainty depressed activity severely. Output in Hong Kong also dropped in
early 1998. as interest rates rose sharply amid pressure on iis currency peg. Later in ihe year, with
financial conditions in most of the Asian crisis countries stabilizing somewhat, output started to bottom
out.
The Asian crisis had a relatively moderate effect on
China, although il may have encouraged authorities
in that country to move ahead more quickly with
various financial sector reforms. Financial tensions
mounted early this year as foreign investors have
reacted with concern to the failure of the Guangdong
International Trust and Investment Corporation.
Chinese growth remained fairly strong throughout
1998. despite a dramatic slowdown in the growth of
exports.
Inflation in ihe Asian developing economies rose
only moderately on average in 1998. as the inflationary effects of currency depreciations in the region
were largely offset by the deflationary influence
of very weak domestic activity. The current account
balances of the Asian crisis countries swung into
substantial surplus last year, reflecting a sharp drop in
imports resulting from the falloff in domestic demand
as well as improvement in the countries' competitive
positions associated with the substantial depreciations of iheir currencies in late 1997 and early 1998.
In Russia, economic activity declined last year as
interest rates were pushed up in an attempt to fend off

93
Board of Governors <if the Federal Reserve System

pressure on the ruble. After Ihe August debt moratorium and ruble devaluation, output dropped sharply,
ending the year down about 10 percent I'rom its
year-earlier level. The ruble collapse triggered a surge
in inflation to a triple-digit annual rate during the
latter part of the year.
In Latin America, the pace of economic activity
slowed only moderately in the first half of 1998. as
the spillover from the Asian financial turbulence was
limited. The Russian financial crisis in August, in
contrast, had a, strong impact on real activity in Latin
America, particularly Brazil and Argentina, where
interest rates moved sharply higher in response to
exchange rate pressures. Output in both countries is
estimated to have declined in the second half of the
year at annual rates of about 5 percent. Activity in
Mexico and Venezuela was also depressed by lower
oil export revenues. Inflation rates in Latin American
countries were little changed in 1998 and ranged
from 1 percent in Argentina and 3 percent in Brazil to
31 percent in Venezuela.
The dollar's value, measured on a trade-weigh ted
basis against the currencies of a broad group of
important U.S. trading partners, rose almost 7 percent
during the first eight months of 1998. but it then fell,
by December reaching a level about 2 percent above
its year-earlier level. (When adjusted for changes in
U.S. and foreign consumer price levels, the real value
of the dollar in December 1998 was about 1 percent
below its level in December 1997.) Before the Russian default, the dollar was supported by the robust
pace of U.S. economic activity, which at times generated expectations that monetary policy would be
tightened and which contrasted with weakening economic activity abroad, especially in Japan. Occasionally, however, the positive influence of the strong
economy was countered by worries about growing
U.S. external deficits. From August through October,
in the aftermath of the Russian financial meltdown,
concerns that increased difficulties in Latin America
might affect the U.S. economy disproportionately, as
well as expectations of lower U.S. interest rates,
weighed on the value of the dollar, and it fell sharply.
The broad Index of the dollar's exchange value eased
a bit further during the fourth quarter of the year. So
far in 1999. the dollar has gained nearly 3 percent in
terms of the broad index.
Against the currencies of the major foreign industrial countries, the dollar declined 2 percent in nominal terms over 1998, on balance, reversing some
of its 10 percent appreciation the preceding year.
Among these currencies, the dollar's value fluctuated
most widely against the Japanese yen. The dollar rose
against the yen during the first half of the year as a




29

Nominal dollar exchange rale indexes

Major current its

I9W

199ft

19*4

NtifK rhc tfciti are numbly IndeJiei vt tnuV-wtifhlrd irtrajes
eachanie value or ihe dulUr against mmc* currencies and apniiHt ihe cur
of i broad pom ol imponani U-S-lading junom Um otncivitttnt u*
1999

result of concerns about the effects of the Asian crisis
on the already-weak Japanese economy and further
signs of deepening recession and persistent banking
system problems in thai country. It reached a level
of almost 147 yen per dollar in mid-June, prompting
coordinated intervention by U.S. and Japanese authorities in foreign exchange markets that helped to
contain further downward pressure on the yen. The
dollar resumed its appreciation against the yen. albeit
at a slower pace, in July and early August.
The turning point in the dollar-yen rate came after
Ihe Russian collapse, amid the global flight from risk
that caused liquidity to dry up in the markets for
many assets. During the first week of October, the
dollar dropped nearly 14 percent against the yen in
extremely illiquid trading conditions. Although funLi. S. exchange rate with Japan

1994

199?

IVW,

1991

1998

IllM

Non. The dau are monthly. U» observantm u lor Che tint dim weeks ol
February IW

94
30

Monetary Policy Report lo Che Congress G February 199V

damental lac tors in Japan, such as progress on hunk
reform, fiscal stimulus, and the widening trade surplus may have helped boost the yen against the
dollar, market commentary at the time focused on
reports lhat some international investors were buying
large amounts of yen. These large purchases reportedly were needed to unwind positions in which investors had used yen loans to finance a variety of speculative investments. On balance, the dollar depreciated
almost 10 percent against the yen in 1998. reversing
most of its net gain during 1997. It depreciated further against the yen in early 1999, hitting a two-year
low on January 1 1 , hut it then rebounded somewhat
amid reports of intervention purchases of dollars hy
the Bank of Japan. More recently, the Bank of Japan
has eased monetary policy further, and the dollar hus
strengthened against the yen. So far this year, the
dollar has gained about 7 percent against the yen.
Japanese economic activity contracted in 1998. as
the country remained in its most protracted recession
of the postwar era. Business and residential investment plunged, and private consumption stagnated.
more than offsetting positive contributions from government spending and net exports. Core consumer
prices declined slightly, while wholesale prices fell
almost 4'/!> percent. In April, the Japanese government announced a large fiscal stimulus package. During the final two months of the year, the government
announced another set of fiscal measures slated for
implementation during 1999. which included permanent personal and corporate income tax cuts, various
incentives for investment, and further increases in
public expenditures.
Against the German mark, the dollar depreciated
about 6 percent, on net. during 1998. Late in the. year
the dollar moved up against the mark, as evidence of
a European growth slowdown raised expectations of
easier monetary conditions in Europe. In the event.
monetary policy was eased sooner than market participants had expected, with a coordinated European
interest rate cut coming in early December.
A major event at the turn of the year was the birth
of the euro, which marked the beginning of Stage
Three of European Economic and Monetary Union
(EMU.). On December 31, the rates locking the euro
with the eleven legacy currencies were determined:
based on these rates, the value of the euro at the
moment of its creation was SI.16675. Trading in the
euro opened on January 4, with the first trades reflecting a significant premium for the euro over its initial
value. As the first week of trading progressed,
however, the initial euphoria wore off. and so far
this year the dollar has strengthened more than 5 percent against the euro, partly reflecting better-than-




LJ.S. dollar cxchunge RIIC jyainsl ihe restated German murk
anil the euro

IWJ

IW7

NIII>. The Jala arc mummy Ke«tai«l German mart i. ihe Julia/mirk
exchange rate reseated hy ite official conwnwn tjtfor between the mart jnl
the euro. I 95583. through December 199S Euro cnctar.pt rate j« ot January
1999 LJII ohKTvation is lor the fi™ three »edis or February IW9

expected economic data in the United States, contrasted with weaker-than-ex pec ted data in the euro
area.
In the eleven European countries whose currencies
are now fixed against the euro, output growth slowed
moderately over the course of 1998. as net exports
weakened and business sentiment worsened. Unemployment rates came down slightly, but the average
of these rates remained in the double-digit range.
Consumer price inflation continued to slow, helped
hy lower oil prices. In December, the harmonized
CPI for the eleven countries stood V-i percent above
its year-earlier level, meeting the European Central Bank's primary objective of inflation below
2 percent.
Between December 1997 and December 1998. the
average value of the dollar changed little against the
British pound but rose 8 percent against the Canadian
dollar. Weakness in primary commodity prices.
including oil, likely depressed the value of the Canadian dollar. The Bank of Canada raised official rates
in January 1998 and again in August, in response
to currency market pressures. The Bank of England
raised official rates in June 1998 to counter inflation
pressures. Tighter monetary conditions in both countries, as well as a decline in net exports associated
with global difficulties, contributed to a slowing of
output growth in the second half of the year. The
deceleration was sharper in the United Kingdom than
in Canada. U.K. inflation eased slightly to near its
target rate, while Canadian inflation remained near
the bottom of its target range. In response to weaker
economic activity as well as to the expected effects of
the global financial turmoil, both the Bank of Canada

95
nf Governors i'f ihe Federal Reserve System

US. and foreign interest raits

1993

IMJ

1904

I99S

1997

1W8

1999

Nitrt. The data are monthly Lm obKrvauoiu arc for the tine dupe *
of fetmuiy 1999

and the Bank of England have lowered official interest rates since September.
The general trend toward easier monetary conditions was reflected in declines in short-term interest
rates in almost all the G-IO countries during the year.
Interest rates in the euro area converged to relatively
low German levels in anticipation of the launch of
the third stage of EMU. Yields on ten-year government bonds in Che major foreign industrial countries
declined significantly over the course of the year, as
economic activity slowed, inflation continued to moderate, and investors sought safer assets. Between




December 1997 and December 1998, ten-year interest rates fell 180 basi* points in ihe United Kingdom
and 150 basis points in Germany. The ten-year rate
fell only 30 basis points in Japan, on balance, declining about 90 basis points over the tirst ten months of
ihe year hm hacking up m November and December.
Market participants attributed the increase to concerns that the demand for bonds would be insufficient
to meet the surge in debt issuance associated wiih ihe
latest Fiscal stimulus package.
Share prices on European stock exchanges posted
another round of strong advances last year, with price
indexes rising 8 percent in the United Kingdom,
about 15 percent in Germany, nearly 29 percent in
France, and 41 percent in Italy. In contrast. Japanese
equity prices fell more than 9 percent in 1998. and
Canadian share prices decreased 4 percent. After a
considerable run-up earlier in the year, share prices
around (he globe Veil sharply in August and September, but they rebounded in subsequent months as the
Federal Reserve and central banks in many other
industrial countries eased monetary policy.
On November 17. the FOMC voted unanimously
to reauthorize Federal Reserve participation in the
North American Framework Agreement (NAFA),
established in 1994. and in (he associated bilateral
reciprocal currency swap arrangements with the Bank
of Canada and the Bank of Mexico. On December 7,
the Secretary of the Treasury authorized renewal of
the Treasury's participation in the NAFA and of the
associated Exchange Stabilization Agreement with
Mexico. Other bilateral swap arrangements wiih ihe
Federal Reserve—chose with the Bank for International Settlements, the Bank of Japan, and many
European central banks—were allowed to lapse in
light of their disuse over the past fifteen years and in
the presence of other well-established arrangements
for international monetary cooperation. The swap
arrangement between the Treasury's Exchange Stabilization Fund and the German Bundesbank was also
allowed to lapse.