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FEDERAL RESERVE'S FIRST MONETARY POLICY
KPORT FOR 2000
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
FEBRUARY 23, 2000
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, DC 20402
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, Nebraska
CHARLES E. SCHUMER, New York
RICK SANTORUM, Pennsylvania
EVAN BAYH, Indiana
JIM SUNNING, Kentucky
JOHN EDWARDS, North Carolina
MIKE CRAPO, Idaho
WAYNE A, ABBRNATHY, Staff Director
STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel
JOHN E. SILVIA, Chief Economist
MARTIN J. GRUENBERG. Democratic Senior Counsel
GEORGE E. WHITTLE, Editor
(TO
CONTENTS
WEDNESDAY, FEBRUARY 23, 2000
Page
Opening statement of Chairman Gramm
Opening statements, comments, or prepared statements of:
Senator Sarbanes
Senator Enzi
Senator Bunning
Senator Allard
Prepared statement
Senator Bayh
Senator Johnson
Senator Mack
Senator Grams
Senator Reed
Senator Bennett
Senator Edwards
Senator Schumer
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WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC
Prepared statement
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39
ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Monetary Policy Report to the Congress, February 17, 2000
(ill)
44
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 2000
WEDNESDAY, FEBRUARY 23, 2000
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Committee met at 10 a.m., in room 216 of the Hart Senate
Office Building, Senator Phil Gramm (Chairman of the Committee)
presiding.
OPENING STATEMENT OF CHAIRMAN PHIL GRAMM
Chairman GRAMM. Let me call the Committee to order.
I understand that Professor Sue Hedley from American University is here. She has her whole class here, and has been here for
11 years in a row. We are going to give an exam after this tutorial,
so everybody be alert out there.
[Laughter.]
Senator SARBANES. They are still trying to figure out what Chairman Greenspan is telling us after 11 years.
[Laughter.]
Chairman GRAMM. Chairman Greenspan, once again, let me welcome you before the Committee. I want to congratulate you on your
renomination. I think the overwhelming vote in the Senate shows
that there's great confidence in your leadership.
More importantly, I want to congratulate you on your record as
Chairman of the Board of Governors of the Federal Reserve System. We now have had price stability for more than a decade. It
is built into long-term interest rates. It has become part of the fabric of American contemporary society.
I know it always makes people nervous when interest rates are
raised, but it seems to me that, in the end, price stability is one
of the foundations of American prosperity.
It's always tempting, when people are trying to second-guess our
monetary policy, to try to second-guess what you are doing, but as
I told somebody the other day, I am not going to get into the business of trying to second-guess the monetary policy of the most successful central banker in the history of the United States.
I want to thank you for the great job you are doing. It makes me
happy when equity values go up because I have my old college
teacher retirement program, as I'm sure you do, TIAA-CREF.
But in terms of American interest, what is most important is
sustaining our economic growth, preserving price stability, and
keeping a recovery that is now reaching every element of American
society.
(1)
It is an important mission you have. We are proud of how you
are performing that mission, and we look forward today to hearing
your report on where we are and what you believe we need to do.
Let me now recognize the Ranking Democrat on the Committee,
Senator Sarbanes.
OPENING COMMENTS OF SENATOR PAUL S. SARBANES
Senator SARBANES. Thank you very much, Mr. Chairman. I join
you in welcoming Chairman Greenspan.
Actually, this is a repeat performance. I know he was before the
House Committee last week. I'm presuming that we will continue
to hold these hearings every 6 months or so, as we have now over
quite a period of time, so that come summer, we will get first crack
at him.
Mr. Chairman, I want to underscore how important I believe it
is to hold these hearings on a regular basis. I believe they have
worked very well, and I think that's Chairman Greenspan's view.
I believe they have made a major contribution toward more openness with respect to the development of monetary policy, and I believe it is enormously helpful to have these sessions.
The last time he appeared before the Committee, I thought we
referred to Chairman Greenspan as "the greatest central banker
in the world." Today, it was "the greatest central banker in the
United States." I presume that was just
Chairman GRAMM. Actually, it was "the greatest central banker
in the history of the world."
Senator SARBANES. "The greatest central banker in the history of
the world," yes.
[Laughter.]
Chairman GRAMM. It's like saying that a person is the greatest
Texan.
[Laughter.]
By definition, Texans are the greatest Americans, the greatest
people on the planet, but I didn't want to overdo it. I sometimes
worry about our good Chairman getting a big head from coming before this Committee and listening to me going on about him.
Chairman GREENSPAN. Mr. Chairman, I am aware of the fact
that, as one of my colleagues said, when you finally climb to the
top of the mountain, all roads lead in only one direction.
Senator SARBANES. The Texas reference reminds me of a Bob
Strauss story, which I have to tell here this morning. You know
that George Washington was actually born in Texas and grew up
there as a very young boy. One day he chopped down the tree, and
they asked who chopped down the tree.
This is a Strauss story. This is a Texan's story about Texas, I
hasten to add, not my story.
Chairman GRAMM. Listen, I know Strauss well.
[Laughter.]
Senator SARBANES. His father asks him, "Who chopped down the
tree?" George Washington says, "Well, I cannot tell a lie; I chopped
down the tree." His father grabs him by the hand and says, "Come
on, son." He says, "We're moving to Virginia. You're never going to
make it here in Texas."
[Laughter.!
Mr. Chairman, I am not going to make an opening statement of
any consequence. I look forward to asking Chairman Greenspan
some questions. I am particularly concerned, if some of our apprehensions are about our future, of the volatility and the overexuberance in the stock market—which there's some reason, I guess,
to think, and that's what a lot of the commentators are saying—
whether there's some way to get that volatility and overexuberance
calmed down without having to take measures that would in effect
calm down the entire economy if the balance of the economy is
working pretty well. Of course, we are now at low unemployment
and low inflation, which is a happy state of affairs, and obviously,
we would like to stay there.
I think one of the questions is whether, in order to address what
may be perceived as a difficulty in a limited portion of the financial
scene, we're taking broad-based measures which may result in restraining general economic activity, which may not need to be restrained. I will try to get at that point in the questioning round.
Thank you, Mr. Chairman,
Chairman GRAMM. Senator Enzi.
OPENING COMMENTS OF SENATOR MICHAEL B. ENZI
Senator ENZI. Thank you, Mr. Chairman.
I want to welcome Chairman Greenspan before the Committee.
Chairman Greenspan, for the great work you have done, I would
like to add my praise. Thank you for joining us today.
Thank you, Mr. Chairman.
Chairman GRAMM. I'm not sure who was here first.
Senator ALLARD. Mr. Chairman, Senator Bunning was here before me.
Chairman GRAMM. Senator Bunning.
OPENING COMMENTS OF SENATOR JIM BUNNING
Senator BUNNING. Thank you, Mr. Chairman.
I would like to thank Chairman Greenspan for testifying before
the Committee today and for giving us an update on the economic
outlook, as required by the Humphrey-Hawkins Act.
However, in the spirit of the Humphrey-Hawkins Act, I must
mention that I am very concerned with the indications that the Fed
continues to pursue a policy that is based on the assumption that
higher interest rates are needed at this time. I think this is a misguided policy which, in itself, could become more of a threat to our
economy than inflation will ever be.
I have no argument with the central premise that inflation is
and should be a serious concern, and that keeping inflation in
check must be a top priority of our central bank. However, the
signs of renewed inflation are simply not there.
All the indicators, with the exception of low unemployment rates,
which I really like to see, show no signs of any resurgence of inflation or of any economy which is overheating. If you look at the
basis of our inflation rate, if you take out energy prices—which are
inflated in a false sense at present because of the OPEC cartel,
which has squeezed to the point where the price per barrel is at
$30 one day, or under, or over—there would be almost deflation in
this economy.
Chairman Greenspan, please don't try to fix an economy that
isn't broken. Don't become so frightened by success that you throw
wet blankets on a fire that isn't burning, fn large part, our current
economic expansion has been built on unprecedented—and I say
this as nicely as I can—new technology and better productivity out
of our workers that have allowed this continued expansion to go on.
I simply don't believe that the Federal Reserve Board's economic
models are factoring in the full impact of these new technologies
and innovations or the sustained growth in productivity which may
have already allowed us to maintain a robust economic expansion
for as long as we have. If you become obsessed with looking for
signs of blazing inflation behind every door, and if you start slamming these doors shut indiscriminately with higher interest rates,
you could easily slam doors shut on economic growth altogether.
I personally believe that we can sustain the kind of productivity
increases that have kept our economy growing with very low inflation rates. But I don't believe we can do it if the Fed continues to
raise interest rates at every opportunity.
As the interest rate climbs closer to 10 percent—prime rate, I'm
speaking about—our economy has to suffer and it has to slow
down. I am convinced that higher interest rates right now, or even
the threat of higher interest rates, are a much greater danger to
our economy than inflation.
I urge Chairman Greenspan and the governors of the Federal Reserve Board to review their policy to make sure that they don't
shut down economic growth and productivity growth, trying to put
out a fire that isn't even burning right now.
Thank you.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Allard.
OPENING COMMENTS OF SENATOR WAYNE ALLARD
Senator ALLARD. Thank you, Mr. Chairman.
I'm going to ask that my formal statement be made a part of the
record.
Chairman GRAMM. Your statement will be made a part of the
record as if read in its entirety.
Senator ALLARD. Along with you, Mr. Chairman, I want to personally welcome Chairman Greenspan to the Committee. I always
appreciate hearing what you have to say, Chairman Greenspan,
and I look forward to your comments this morning as we move forward. Again, welcome to the Committee.
Thank you, Mr. Chairman.
Chan-man GRAMM. Thank you.
Senator Bayh.
OPENING COMMENTS OF SENATOR EVAN BAYH
Senator BAYH. Thank you, Mr. Chairman.
I will reserve my comments for the questioning period, except to
say welcome, Chairman Greenspan. Thank you very much for joining us today.
Thank you, Mr. Chairman.
Chairman GRAMM. Senator Johnson.
OPENING COMMENTS OF SENATOR TIM JOHNSON
Senator JOHNSON. I want to welcome Chairman Greenspan. I am
looking forward to hearing what he has to say. I will forego any
further comments at this time.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Johnson.
Chairman Greenspan, the floor is yours.
OPENING STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Chairman GREENSPAN. Thank you very much, Mr. Chairman and
Members of the Committee.
I, as always, appreciate this opportunity to present the Federal
Reserve's semiannual report on the economy and monetary policy.
There is little evidence that the American economy, which grew
more than 4 percent in 1999 and surged forward at an even faster
pace in the second half of the year, is slowing appreciably. At the
same time, inflation has remained largely contained. An increase
in the overall rate of inflation in 1999 was mainly a result of higher
energy prices. Importantly, unit labor costs actually declined in the
second half of the year. Indeed, still-preliminary data indicate that
total unit cost increases last year remained extraordinarily low,
even as the business expansion approached a record 9 years.
Underlying this performance, unprecedented in my half-century
of observing the American economy, is a continuing acceleration 1in
productivity. Nonfarm business output per workhour increased 3 A
percent during the past year—likely more than 4 percent when
measured by nonfarm business income. One result of this remarkable economic performance has been a pronounced increase in living standards for the majority of Americans. Another has been a
labor market that has provided job opportunities for large numbers
of people previously struggling to get on the first rung of a ladder
leading to training, skills, and permanent employment.
Yet those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained, threaten our continuing prosperity.
Accelerating productivity entails a matching acceleration in the potential output of goods and services and a corresponding rise in
real incomes available to purchase the new output. The problem is
that the pickup in productivity tends to create even greater increases in aggregate demand man in potential aggregate supply.
This occurs principally because a rise in structural productivity
growth has its counterpart in higher expectations for long-term corporate earnings. This, in turn, not only spurs business investment
but also increases stock prices and the market value of assets held
by households, creating additional purchasing power for which no
additional goods or services have yet been produced.
Historical evidence suggests that perhaps 3 to 4 cents out of
every additional dollar of stock market wealth eventually is reflected in increased consumer purchases. The sharp rise in the
amount of consumer outlays relative to disposable incomes in recent years, and the corresponding fall in the savings rate, has been
consistent with this so-called wealth effect on household purchases.
The additional growth in spending of recent years that has accompanied these wealth gains as well as other supporting influences on the economy appears to have been met in about equal
measure from increased net imports and from goods and services
produced by the net increase in newly hired workers over and
above the normal growth of the workforce, including a substantial
net inflow of workers from abroad.
But these safety valves that have been supplying goods and services to meet the recent increments to purchasing power largely generated by capital gains cannot be expected to absorb an excess of
demand over supply indefinitely.
First, growing net imports and a widening current account deficit
require ever larger portfolio and direct foreign investments in the
United States, an outcome that cannot continue without limit.
Second, at some point in the continuous reduction in the number
of available workers willing to take jobs, short of the repeal of the
law of supply and demand, wage increases must rise above even
impressive gains in productivity. This would intensify inflationary
pressures or squeeze profit margins, with either outcome capable of
bringing our growing prosperity to an end.
With the assistance of a monetary policy vigilant against emerging macroeconomic imbalances, real long-term rates will at some
point be high enough to finally balance demand with supply at the
economy's potential in both the financial and product markets.
Other things equal, this condition will involve equity discount factors high enough to bring the rise in asset values into line with
that of household incomes, thereby stemming the impetus to consumption relative to income that has come from rising wealth. This
doesn't necessarily imply a decline in asset values—although that,
of course, can happen at any time for any number of reasons—but
rather that these values will increase no faster than household
incomes.
With foreign economies strengthening and -labor markets already
tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster
can slow to a sustainable pace, without destabilizing the economy
in the process.
On a broader front, there are few signs to date of slowing in the
pace of innovation and the spread of our newer technologies that,
as I have indicated in previous testimonies, have been at the root
of our extraordinarily impressive productivity improvement.
What is uncertain is the future pace of the application of these
innovations, because it is this pace that governs the rate of change
in productivity and economic potential.
Monetary policy, of course, did not produce the intellectual insights behind the many technological advances which have been
responsible for the recent phenomenal reshaping of our economic
landscape. It has, however, been instrumental, we trust, in establishing a stable financial and economic environment with low inflation that is conducive to the investments that have exploited these
innovative technologies.
Federal budget policy has also played a pivotal role. The emergence of surpluses in the unified budget and of the associated increase in Government saving over the past few years has been ex-
ceptionally important to the balance of the expansion, because the
surpluses have been absorbing a portion of the potential excess of
demand over sustainable supply associated partly with the wealth
effect. Moreover, because the surpluses are augmenting the pool of
domestic saving, they have held interest rates below the levels that
otherwise would have been needed to achieve financial and economic balance during this period of exceptional economic growth.
They have, in effect, helped to finance and sustain the productive
private investment that has been key to capturing the benefits of
the newer technologies that, in turn, have boosted the long-term
growth potential of the U.S. economy.
The recent good news on the budget suggests that our longer-run
prospects for continuing this beneficial process of recycling savings
from the public to the private sectors have improved greatly in recent years. Nonetheless, budget outlays are expected to come under
mounting pressure as the baby boom generation moves into retirement, a process that gets under way a decade from now. Maintaining the surpluses and using them to repay debt over coming years
will continue to be an important way the Federal Government can
encourage productivity-enhancing investment and rising standards
of living. Thus, we cannot afford to be lulled into letting down our
guard on budgetary matters.
Mr. Chairman, although the outlook is clouded by a number of
uncertainties, the central tendencies of the projections of the Board
members and Reserve Bank presidents imply continued good economic performance in the United States. Most of them expect economic growth to slow somewhat this year,
the unemployment rate
to remain in the neighborhood of 4 to 41/6 percent, and the rate of
inflation
for total personal consumption expenditures is expected to
be 13A to 2 percent.
Continued favorable developments in labor productivity are anticipated both to raise the economy's capacity to produce and,
through its supporting effects on real incomes and asset values, to
boost private domestic demand. Strong growth in foreign economic
activity is expected to continue this year, and, other things equal,
the effect of the previous appreciation of the dollar should wane,
augmenting demand on U.S. resources and lessening one source of
downward pressure on our prices.
As a consequence, the necessary alignment of the growth of aggregate demand with the growth of potential aggregate supply may
very well depend on restraint on the domestic demand, which continues to be buoyed by the lagged effects of increases in stock market valuations.
Despite the appreciable increases in both the nominal and the
real intermediate- and long-term interest rates, to date, interestsensitive spending has remained robust, and the Federal Open
Market Committee will have to stay alert for signs that real interest rates have not yet risen enough to bring the growth of demand
into line with that of potential supply, even should the acceleration
of productivity continue.
Achieving that alignment seems more pressing today than it did
earlier, before the effects of imbalances began to cumulate, lessening the depth of our various buffers against inflationary pressures. Labor markets, for example, have tightened in recent years
8
as demand has persistently outstripped even accelerating potential
supply. As I have previously noted, we cannot be sure in an environment with so little historical precedent what degree of labor
market tautness could begin to push unit costs and prices up more
rapidly. We know, however, that there is a limit, and we can be
sure that the smaller the pool of people without jobs willing to take
them, the closer we are to that limit.
As the U.S. economy enters a new century as well as a new year,
the time is opportune to reflect on the basic characteristics of our
economic system that have brought about our success in recent
years. Competitive and open markets, the rule of law, fiscal discipline, and a culture of enterprise and entrepreneurship should
continue to undergird rapid innovation and enhanced productivity
that in turn should foster a sustained further rise in living standards. It would be imprudent, however, to presume that the business cycle has been purged from market economies so long as
human expectations are subject to bouts of euphoria and disillusionment. We can only anticipate that we will readily take such
diversions in stride and trust that beneficent fundamentals will
provide the framework for continued economic progress well into
the new millennium.
Thank you, Mr. Chairman. I request that my full statement be
included in the record.
Chairman GRAMM. Chairman Greenspan, thank you for that excellent and sobering presentation. Hearing your presentation on
these occasions does bring back the point that economics may not
be the dismal science, but it is the science of reality. I appreciate
your comments.
I want to try to touch on a couple of things. One thing that worries me a great deal is that nondefense discretionary spending—
general Government— in the current budget is growing faster than
at any time since Jimmy Carter was President.
We are in the process of seeing a concerted effort —which I believe can be justified on national security grounds — of seeing an increase in defense spending after a decade and a half when defense
spending was cut.
As you know, the President proposes in his budget the largest expansion of Medicare in American history, with a provision that
would not only provide assistance to the roughly 30 percent of seniors who don't have insurance coverage for Pharmaceuticals, but
would provide coverage for everybody, even those who do.
I am beginning to become concerned that the Congress and the
President — and when you combine the two together, you have the
Government — is in the process of beginning a new spending spree.
I would like to get your thoughts on that, Chairman Greenspan,
as to whether you share that concern and what the potential impact of that might be.
Chairman GREENSPAN. Mr. Chairman, in my prepared remarks,
I try to go into a good bit of detail on the whole question of the
budget outlook.
I have concluded that even though we have these significant unified budget surpluses, and indeed the possibility that we might be
underestimating them because ft i«drnd mn ™-n in a pppft^ where
we are about to get, or in the process of getting, still accelerating
productivity, meaning growth in productivity is still rising, it is
very likely that the forecasts that are made both by the OMB and
the CBO, are indeed underestimating the surplus.
On the other hand, if you look at the pattern of forecasts, they
all include a reasonably significant continuation of what I would
call the tax surprise of the 1990's. And that is even after making
adjustment for capital gains taxes, for the incomes which are not
capital gains but related to the stock market, for what we call
bracket creep, you still have a very significant increase in indir
vidual tax revenues relative to taxable incomes.
We don't know, nor does anybody else know, where that is coming from, and we will not until we get full details from the individual tax returns, probably through 1999, to get a full sense of
what is involved and where it's coming from. Pending that, we cannot be sure that this tax surprise cannot turn around just as readily as it has in the past and go in the other direction in the same
magnitude.
It is not very difficult with some reasonable assumptions to take
the unified surplus, or most of it, not to mention the on-budget surplus, and chop it down substantially. I conclude from this, that
until we have a reasonably good sense of where those revenues are
coming from and therefore what is the most likely permanent increase in the surplus based not on guesses on revenues, but on
hard numbers—until we get there, I have argued that we should
allow the surpluses to run and reduce the debt outstanding.
Indeed, as I point out in my prepared remarks, this is not an irrevocable commitment because you can always borrow back Federal debt after you have paid it off for any programs you want. But
I would submit that irrevocable, or almost irrevocable, programs
that are put in place now strike me as risking the possibility that
we may be wrong in this surplus. All I'm asking, in effect, is just
to delay for a while until we have a better grip of what the true
balance in our Federal Government accounts is.
I have not and did not get into, in my prepared remarks, the specifics of either the President's program or anybody else's program,
and I'm hopefully going to try to stay away from that, as I have
over the years.
As you know, my general view is that the first priority is to get
the debt down because there are very major positive economic effects, as well as building up the ability to reborrow, if need be.
That, essentially, is why the ability to keep those surpluses is important. But if it turns out that it is politically infeasible for all
sorts of obvious political reasons, then my choice is that, for longterm fiscal stability, we are far better off cutting taxes than raising
spending.
Chairman GRAMM. Well, Chairman Greenspan, I know it's hard
for you, when we're talking about congressional spending programs
or administration spending programs, to speak up. But I think it's
very important that you follow the spending pattern of the Government and that you not hesitate to blow the whistle when you believe there is a potential danger because I think you have great
credibility on this issue. I'm always concerned about spending.
You talked about the wealth effect of the run-up in equity values.
It is a very natural thing in Congress, when we are running the
10
first surplus in the political career of anyone who is here, in the
old cliche, for the money to burn a hole in your pocket, so I think
your comments are very important.
I have a few more questions, but let me stop, since I have run
over my time. I will come back at the end if we have time.
Senator Sarbanes.
Senator SARBANES. Thank you, Mr. Chairman.
Chairman Greenspan, before I turn to the subject I mentioned in
my opening statement, I just want to ask one quick question on the
Federal Government's economic statistics.
Unfortunately, the budget for this fiscal year required the Bureau of Economic Analysis to impose a hiring freeze, and it didn't
provide monies to examine new developments in the economy in
terms of upgrading our statistical series. It's not a lot of money, but
we make a lot of decisions off the basis of those economic statistics,
and it seems to me you have emphasized the changes that are taking place in the economy, the new economy, so to speak.
It seems to me we need some new surveys and new measures to
try to address these changes in the economy. I wonder what your
view is on the need for at least some additional resources to get
these economic statistics current.
Chairman GREENSPAN. Senator, as you well know, I am extraordinarily reluctant to advocate any increase in spending, so it has
to be either a very small amount or a very formidable argument
that is involved. I find in this case that both conditions are met.
As you point out, we are moving into an economy, the structure
of which none of us has ever seen before. It looks as though it is
emerging in a manner which will set the pace for a goodly part of
the first half of the twenty-first century. This means that a lot of
the things we are looking at, a lot of the things we examine in the
economy, are very poorly represented in our current statistics,
whereas some of the detail that we have on what we call the old
economy is awesome and unnecessary.
It would strike me that, one, we have to move resources away
from some of those measures, but I agree with you that, even having done that, additional funds could probably very effectively be
spent to improve the quality of our statistics both for the private
sector, which is crucial, and for those of us who have to be involved
in governmental economic policy.
Senator SARBANES. Thank you. We will be working on that problem here in the Congress.
I might just note that if we could get some new data, particularly
with respect to the dimensions of the new economy, it should bring
a lot of happiness into your day because it would give you more
data to work with and analyze every day, if I may say so.
Chairman GREENSPAN. Right.
[Laughter.]
Senator SARBANES. Now let me turn to the other subject. I want
to preface it with a story.
Earlier in the week, I attended an event in the inner city of Baltimore marking a Department of Labor grant for a comprehensive
education and training program aimed at school dropouts. There
was a young fellow there who had been a dropout and part of a
pilot program that had drawn him in, in effect, off the streets. He
11
had been counseled, advised, then had finished his GED as part of
this program. He had received important training and moved out
into a job. He is now holding a technical job in the private sector
and doing quite well. He was there as an example of what we are
trying to achieve by these programs.
A critical aspect of this program has been the employers who
have come in, private employers, to participate, and they hold the
promise of a job at the end of the course. They, in effect, say to
these young people, "If you follow this program through, there will
be a job out there for you."
Of course, one of the reasons they have a job out there for them
is because you have a tight labor market. They are searching for
qualified employees, and this program is designed to achieve it.
Now, you say in your statement, "Unit labor costs actually declined in the second half of the year. Indeed, still-preliminary data
indicate that total unit cost increases last year remained extraordinarily low." You are projecting in the economic outlook that the
rate of inflation
is expected for total personal consumption expenditures to be !3/4 to 2 percent, or a bit below the rate in 1999, which
was elevated by rising energy prices, to which my colleague made
reference earlier in his statement.
What is the prospect for these young people? We keep struggling,
we seem to get on a pretty good playing field, then all of a sudden
we discover the goal posts are being moved on us. We are told to
get productivity up. We get productivity up. Unit labor costs are
not rising. The inflationary prediction is very good. Yet, the Fed is
now moving to tighten monetary policy in order to slow down the
economy.
If you slow down the economy, presumably, unemployment will
start to rise. The opportunities for people of the sort that I'm describing will diminish.
Now we're told, we have this problem. We have the wealth effect
of the running up of equity values. We are hearing this morning
how this theory that the increase in productivity, which we had
seen as all good, now has a dismal side to it, because it's going to
lead to this anticipation on the profit levels, the run-up on the equity assets, and then this additional spending.
Well, this young fellow is far removed from the wealth effect. He
is struggling just to try to get into a job situation. What's going to
happen here?
There is a whole new theory being laid out here, as I see it, a
theory that's going to justify raising the rates, curtailing the economy, when there's no inflation, there's no unit labor cost problem,
and it's all being done on the basis of this wealth effect.
Now, I see The New York Times yesterday said, "Mr. Greenspan
was also blunter than normal in suggesting that one of his primary
targets in raising interest rates was the stock market." If the stock
market is a problem, if the activity and the volatility is in the stock
market, we may need to think of some way to try to address that
without slowing down the whole economy and affecting the opportunities for these young people that I talked about in my opening
example.
I note that Reuters said, "Buying on margin, the Street's version
of charging stock purchases on a credit card, went up a heart-
12
pounding pace in January, climbing to a record $243.5 billion, from
$228 billion in December. A decade ago, the debt load amounted to
just $35 billion." Of course, this is something that Senator Schumer
and I spoke with you about during your confirmation hearing.
Where are we going? We have an economy of low inflation. Unit
labor costs are stable. In fact, you anticipate they are going to drop.
We are finally drawing people into the workforce who were never
there before, giving them a chance to share in an opportunity. Now,
all of a sudden, we have this theory, "Well, you are getting this
run-up in the equity assets. That creates a wealth effect. That's
going to stimulate a demand without a supply to respond to it, so
now we have to curtail the economy." The people that will be first
to drop off the table when you curtail the economy are these young
people we are talking about that we are trying to draw into the
labor force.
Chairman GREENSPAN. Senator, implicit in your remarks is the
notion that you are endeavoring to slow the economy to a point at
which you begin to get the significant lay-offs and significant inability of people to move up the ladder of success that I mentioned
in my prepared remarks.
Senator SARBANES. Let me develop it on that point. The economy
doesn't reach this young fellow and people like him until you get
it down to these levels of unemployment.
Chairman GREENSPAN. I agree with that. Our basic purpose is to
keep that process going. The type of economy that we are looking
at, the type that we are dealing with at this particular stage, is,
I would suspect, one that none of us has ever seen before and, indeed, it may be unprecedented in our history. It is characterized by
a really phenomenal change in technologies which are inducing not
only a high rate of growth in productivity, but also an accelerating
productivity.
What this has done is to very sensibly increase the market value
of assets in this economy. It has, accordingly, created what we call
the wealth effect. It is firmly documented that when people have
significant capital gains, a small part of them do induce an increase in consumption. It is in the nature of a capital gain not to
increase supply correspondingly.
The difference between the demand and supply has been, over
the last several years, as I put it in my prepared remarks, met by
goods from abroad and goods produced by people who were previously seeking a job and not having found one, are now coming
into the workforce. If either of those two so-called safety valves
could be projected indefinitely into the future, then there is no inhibition here in growth accelerating fully with the productivity numbers without any imbalances.
But the fact of the matter is we just do not have an unlimited
amount of labor. We have capped our immigration, and having
done so, we are delimited in our workforce largely to those who are
of working-age in the population, and that number continuously
shrinks.
The only point I'm making is that that cannot go on indefinitely,
nor can the other safety valve—imports from abroad—continue indefinitely because the stock of assets owned by foreigners in the
United States becomes increasingly large and the debt servicing of
13
those assets cannot go on indefinitely. What I'm saying is, it's not
a theory, it's merely an analysis of what in fact is happening.
The question I raise is that if the buffers toward imbalances are
shrinking, as they have for the last number of years, and they continue to shrink, then we are like the boat heading toward the dock.
Instead of turning so that we don't go slamming into the dock, we
go straight into the dock and find that we should have turned, at
least partially, in order to come in—to create the triple metaphor,
I guess—for a soft landing.
The issue here is basically the issue of, one, as Senator Bunning
says, there is no evidence right now of inflation. I cannot find it,
no matter where I look, with the exception of oil prices and some
commodity prices rising. But the major part of costs, unit labor
cost, is, if anything, improving, going down.
The problem is that we are caught with a conceptual evaluation
of this economy, which is not a theory, it's an evaluation of facts.
Even though our data is not as good as we would like, there is
enough to make this an unequivocal explanation of what's going on.
If that is indeed the case, it is essentially saying that so long as
immigration is capped, the wealth effect cannot persist indefinitely
because it relies on two safety valves, both of which are limited.
That is the basis of our analysis. I grant you that we do not
know exactly when we reach these triggering points. But it has
been the judgment of the Federal Open Market Committee that it
is far better to have buffers there adequate to ensure that this
prosperity we are going through can continue at a pace somewhat
below that of the second half of last year, because that cannot be
sustained because the safety valves won't allow it.
But we are in no way arguing that the growth in this economy
should not continue robust, that unemployment should not continue very low, and that prosperity should not continue as far out
as we can manage to induce it.
Senator SARBANES. Mr. Chairman, I see my time has expired.
Thank you.
Chairman GRAMM. Senator Bunning.
Senator BUNNING. Thank you, Mr. Chairman.
I would like to follow up on this just a bit. Chairman Greenspan,
are you telling me and this Committee that we can't sustain a 4to 5-percent economic growth rate?
Chairman GREENSPAN. No, I'm not, Senator, because
Senator BUNNING. It seems to me that's what I'm hearing.
Chairman GREENSPAN. No, let me explain to you why not. I don't
know what the potential growth rate of this economy is. It depends
wholly on the trend in productivity growth. As I pointed out in my
testimony earlier
Senator BUNNING. But your monetary policy would indicate to
us, or at least to me, that you don't believe a 4- to 5-percent economic growth rate in this country is sustainable without inflation,
without what you call the wealth effect being contained.
I didn't know the Federal Open Market Committee had a job of—
this is on your own testimony—making sure the current wealth effect is finally contained.
Why do we want to contain the growth and wealth effect in this
country?
14
Chairman GREENSPAN. The point at issue is that we don't want
to contain the growth. The problem that I and my colleagues have
is that you cannot continue to get accelerating productivity and the
wealth effect with the safety valves limited.
What I'm saying
Senator BUNNING. Well
Chairman GREENSPAN. Senator, I do understand where you are
coming from because I have been in the same place and I think I
have convinced myself. Let me see if I can try to indicate to you
why I believe as I do on this issue.
The question of how fast this economy grows is not something
the central bank should be involved in.
Senator BUNNING. I'm convinced of that, yes.
Chairman GREENSPAN. So am I. The issue really relates to inflationary imbalances. What we are looking at is basically the indications that demand chronically exceeds supply for an intermediate
period. The best way to measure that is to look at what is happening to the total number of people who, one, are unemployed or,
two, are not in the labor force but want a job, from which we are
getting increased production.
Senator BUNNING. But you brought up in your testimony the unbelievable increase in productivity due to the many technological
advances that we have had. And you have no idea how to measure
that yet.
Chairman GREENSPAN. No, I disagree with that. We do know
how to measure it well enough to know that what it is that we are
concerned about is not the rate of increase in demand or the rate
of increase in supply, but only the difference between the two. The
difference between the two is measurable by the extent to which
net imports of goods and services are rising as a share of the gross
domestic product and the amount of goods that are produced as a
consequence of the unemployment rate falling or a decline in the
general pool of workers.
In other words, we don't need to know whether the growth rate
is 4, 5, 6, 8 percent. What we need to focus on as the central bank
is solely the difference between the two, without reference to where
they are. That's where our problem lies.
Senator BUNNING. Then you believe, by setting monetary policy,
you will be able to dictate the difference of those two things to the
point that by raising interest rates from the central bank, it will
allow you to regulate or to dictate the amount of people that are
employed and the amount of wealth that's being created, no matter
where it's being created—particularly on the stock market.
My problem is if we get prime interest rates at double digits, we
are going to stop this economy in its tracks. I don't want to see that
happen on your watch, and I surely don't want to see it happen on
my watch.
Chairman GREENSPAN. I appreciate that, Senator. I have the
same view.
First of all, let me just say that the crucial element in here is
not what the central bank is doing, it's what the market is doing.
Senator BUNNING. It's how the market reacts to the central bank.
Chairman GREENSPAN. Well, the market is far bigger than the
central bank. For example, what the market has been doing in the
15
last year, recognizing the excess demand for funds relative to savings in the system—exactly these imbalances I'm talking about—
is to move average corporate long-term interest rates up by more
than a full percentage point in real terms. That is a significant
change.
Senator RUNNING. May I ask you what the 30-year bond is at
today? Is it at 6.2 percent?
Chairman GREENSPAN. No, the 30-year bond—you are referring
to Government bonds. I'm talking about corporate bonds.
Senator RUNNING. Are you telling me that corporate borrowing
is at 7.5, 7.2, or what? What is it?
Chairman GREENSPAN. The BBB corporate rate is, in essence, the
Standard & Poor's BBB that is essentially the average cost; that
is, it's a good proxy for the average cost of corporate
borrowing.
That number at this stage in real terms is about 53/4 percent and
has about a 2V4 percent inflation expectation. In total, we are basically talking about close to 8 percent nominal rates.
Senator BUNNING. My time has expired. I will wait for the second
round. I have some more questions to ask.
Chairman GREENSPAN. Let me make one quick statement. When
the rate on the U.S. Treasury 30-year bond went down sharply, the
rate on corporate bonds did not.
Senator BUNNING. The rate on corporate bonds did not go down.
Chairman GRAMM. Senator Allard.
Senator ALLARD. Chairman Greenspan, I was heartened in your
testimony when you noted that there was some difficulty with the
fiscal discipline last year because I felt like I had made the same
observation.
I'm wondering if perhaps you have some suggestions on how we
can shore up our fiscal discipline so that we don't fall over the cliff
with some of our spending patterns. I have thought at times about
a biennial budget. It may bring forth a little more fiscal discipline.
I would like to have you comment on that idea, too.
Chairman GREENSPAN. Senator, the most important fiscal action
that has been taken in the last couple of years, or maybe the last
year, is the quite remarkable agreement between the Administration and the Congress that the Social Security surplus is off-budget
and out of bounds for being employed to finance any Government
expenditure. That is an exceptionally wise decision, and it's gotten
very little publicity, largely because it occurred with remarkably
little contention. That in and of itself is a crucial issue.
On the issue of creating a biennial budget, I agree with you. I
think it is probably a good idea considering the process that has
been evident and the complexity of the budgets that we go through.
I think that in itself is useful.
I do think that even though the caps have been so effective for
so many years, surprisingly, because, as you know, they can be
challenged very easily by a majority, the notion of fiscal discipline
so captured the Congress that it became very difficult to break the
caps, except very recently when the pressures became exceptional
and the problems that we are aware of in the last year or so became evident.
I'm not arguing for sustaining the old caps, although I would like
to see them there, if it were possible. I recognize that it is not.
16
What I think would be important would basically be to reestablish caps because they do turn out to be effective, or at least have
in the past, and there's no reason to believe they would not be in
the future, but to be sure that they are set at realistic levels and
are adhered to. That, in my judgment, would be crucial.
I also argue in my prepared remarks that moving toward the onbudget balance as the crucial determinant of budget policy is moving us toward accrual accounting, which is the private sector norm.
That, of course, is a change, were we to go in that direction. And
I don't perceive it as feasible in the immediate short run. But were
we to go toward that in the short run, it would be a very important
move toward having Government focus on its longer-term commitments, as well as shorter-term commitments.
Senator ALLARD. We also have had some debate about extension
of the research and experimentation tax credit on a permanent
basis. Do you think this would help prolong increased productivity?
Chairman GREENSPAN. Senator, I have no real judgment on that
because it depends on the very specific cases.
Senator ALLARD. Let's take the high-tech side of the economy and
maybe apply that because they seem most concerned about it.
Chairman GREENSPAN. What has been really quite remarkable in
this country is our ability to create a level of technology which is
the envy of the rest of the world. We have done it basically not so
much from tax subsidies or other subsidies from Government, but
essentially from having an entrepreneur-based system in which
people could see very large rewards from successful endeavors.
I can't say I know very much about the impact of a tax credit
on what is going on in Silicon Valley as such, but I am reasonably
certain that the vast proportion of the success that our high-tech
industry has created has nothing to do with Government.
Senator ALLARD. Chairman Greenspan, with your indulgence, I
would like to ask one more question. It has to do with the natural
resource area. In our economy, even though we have had unprecedented sustained growth over the years, the one area that has been
particularly down has been farm prices and that's been unusual.
Not only has it been grain prices, but also livestock prices. Usually,
they are countercyclical. In addition, a lot of our other natural resources, oil and gas, for example, and minerals, have had unusually low prices.
Would you comment on what you see as the impact of what's
happening with energy prices right now? hi my part of the country,
it's a welcome sign because oil and gas prices have been unprecedentedly low and a lot of people have been suffering with no jobs.
Now we have some parts of the country complaining about the high
price of energy. I wondered if you would comment about that.
Chairman GREENSPAN. Well, it is no big secret why crude oil
prices are up. The inventories at refineries in the United States
and, indeed, pretty much throughout the rest of the world, have
been drawn down very significantly. Indeed, in some areas of our
petroleum industry, we are running almost on fumes.
The crucial importance of this, as with all commodities, is when
inventories reach exceptionally low levels, there is no buffer. If you
get an unexpected surge in demand, you don't get an incremental
price increase—you get a huge surge.
17
One of the things we have seen in the United States, even as we
have experienced a very dramatic reduction in the importance of oil
in our economic production, is that it's still a large enough and pervasive enough force within our economy that should we get one
of these very severe spikes, it would have a major negative impact
on economic growth. As a consequence of that, an endeavor to set
prices, as indeed the cartel endeavors to do—and cartels are not
my favorite type of institution—but even from their point of view,
for the longer-run viability of the crude oil reserves, numbers significantly under $30 a barrel for West Texas Intermediate is clearly
in their interest and, needless to say, for consumers as well.
In the agriculture area, the problem we have had clearly is twofold. First, we have had an extraordinary rise in productivity. We
talk about the awesome increases in productivity in the nonfarm
area. In the agriculture area, they are even more impressive. Since
we in the United States consume a good deal less than half of a
number of the products we produce, we depend on export markets
to keep production up.
Second, clearly the Asian crisis in 1998 had a major negative effect on agricultural supplies and it's had an obvious major impact
on crop prices.
The longer-term outlook for agriculture, in my judgment, is export markets. The more we can open up markets abroad—and
there's a lot of room to do that on a lot of different continents—it
strikes me as the most important thing we can do to keep a viable,
very productive agricultural sector, which we have experienced for
so many generations.
Senator ALLARD. Thank you.
Chairman GRAMM. Senator Bayh.
Senator BAYH. Thank you, Mr. Chairman.
Chairman Greenspan, you have a difficult job and you do it well.
I thank you for that and for your appearance today.
I sensed in your opening remarks a greater sense of urgency
about the waning of some of the buffers that ameliorate the adverse consequences of the imbalances between supply and demand
that you outlined. You mentioned, in particular, immigration. You
also mentioned the need for continued fiscal constraint here on the
Hill in terms of Government spending. We haven't mentioned yet
today free trade, but I know you believe very strongly that that's
another buffer.
My first two questions to you are: It seems to me implicit in your
remarks that reasonable immigration policies, policies promoting
both free trade and fiscal discipline, will allow our economy to grow
faster with lower inflation, maybe maintaining some of the buffers
that put pressure on monetary policy. First, is that correct?
Second, are there other buffers that I didn't mention here that
we should be aware of that have also deteriorated recently?
Chairman GREENSPAN. As best we can judge, there are really two
fundamental buffers, meaning the two safety valves which have
met the excess of demand over supply—in other words, filled the
gap—basically imports and people coming out of the pool of available workers seeking jobs in the workforce and producing goods.
Those are the two major elements which have absorbed the gap between supply and demand.
18
To reiterate, the gap has been engendered by a major wealth effect. It was not a problem 3 or 4 years ago, basically because the
size of the safety valves, or I should say the buffers in the safety
valves—I want to be sure that's the correct way to phrase it—were
quite large. Year after year, those buffers continued to shrink.
Even so, we have seen no evidence of inflation accelerating as that
happened.
The question we have to confront is: Is it remotely conceivable
that both of those buffers can continue on down to zero without
pressures on the general price level?
I know of no way that can happen unless we get into a centrallyplanned economy, price controls, or a variety of other things. It
would be wholly alien to human nature, and, at the root, a denial
of the law of supply and demand.
The problem that we have is that, having not experienced this
type of phenomenon previously, we are not able to judge how big
these buffers are relative to the ultimate pressure valve. What we
do know is that if we misjudge this particular period and inadvertently, as I used the analogy before, instead of turning before we hit
the dock, go straight into the dock, then I think we do very severe
damage to this economy.
The basic purpose of what we are trying to do is to sustain this
extraordinary recovery, this extraordinary acceleration in growth,
and a vibrant labor market in a manner which continues to absorb
the new people coming into the workforce seeking and getting jobs
and training on the job.
Senator BAYH. Chairman Greenspan, let me follow up on that
and ask you about our efforts to sustain this remarkable economic
growth that we have been experiencing and the human nature you
mentioned. Specifically, I would like to ask about the wealth effect
and human psychology.
There was an interesting piece in The Wall Street Journal yesterday pointing out that the psychology of markets can move in both
directions. Accepting, for the sake of argument, that the wealth
effect does have some potential problems at this point in the economic cycle that we have to deal with, how do we deal with that
without running the risk of, I guess in a nutshell, irrational exuberance which might be followed by irrational pessimism?
How do we deal with the potential harmful effects without perhaps tipping over in the other direction?
Chairman GREENSPAN. Senator, let me emphasize that I am not
making any judgments as to whether in fact the wealth effect is
overdone or whether the values are overdone or not. It's just not
relevant to the argument that I'm making very specifically. It has
secondary effects.
I am essentially saying that if you are getting accelerating productivity in an economy, the value of your capital assets should be
going up. They are actually worth more. The prospective earnings
they can generate are indeed greater. I'm not commenting on the
secondary question as to whether the rise that has occurred is
more than it should have been. As I have argued previously, it is
very difficult to make a judgment on whether we have a bubble,
which is really what that would be, except after the fact.
19
I am not raising the issue in this context of there being an irrational surge in stock prices or a speculative imbalance which is
threatening the economy. That's a different type of argument. It is
not the one I am making.
Senator BAYH. Thank you very much.
Chairman GRAMM. Senator Mack.
OPENING COMMENTS OF SENATOR CONNIE MACK
Senator MACK. Thank you very much, Mr. Chairman. I want to
continue with this line of discussion.
If there is a sense of frustration on the part of some of the Members of the Committee, I think it's that for the first time, we are
hearing about possibly another gauge of evaluating or controlling
money supply. I was really surprised when I read your comments
of last week about, as I recall, tying asset values to household income or income levels.
My first reaction to that was that there was a new component.
Fifteen or 20 years ago, we used to talk about M-l and M-2 and
try to observe a range in which this M-l and M-2 grew. It almost
seems like, with your discussion, you have added a new component
now to saying that one of the things you are looking at is the
growth in asset values, and it needs to be within a certain range.
Am I wrong to draw that conclusion?
Chairman GREENSPAN. Yes and no, Senator.
First of all, let me emphasize that the issue of the relationship
between household net worth and household income is only a measure of the extent of the wealth effect. Household income has nothing whatsoever to do with the determination of what the proper
values of stocks are or the general wealth. That is determined by
earnings expectations and so-called discount factors.
Senator MACK. Yes, but didn't you tie those two?
Chairman GREENSPAN. I did, but in a different context. It is a
statistical way of evaluating whether you have a wealth effect. It
is not an issue of what is causing the wealth effect. It is merely
a diagnostic tool to make a judgment as to whether a wealth effect
is indeed functioning in the economy.
Senator MACK. May I ask you one other question in the middle
of your thought there? We went back and compared asset growth
to income growth to see if you had a situation where asset growth
was growing significantly compared to income growth, whether
there was any relationship to inflation. We couldn't find any.
Chairman GREENSPAN. There is none.
Senator MACK. This raises the question if the objective, which I
have said for years that the Fed should be engaged in, is price stability, why then would there be this focus on asset growth?
Chairman GREENSPAN. First of all, let me go back and indicate
the role of wealth or net assets in the household sector, very specifically, on the economy. If you take the ratio of net worth to
household income back as far as we can get reasonably good data,
which is to the early 1920's, the ratio is reasonably low and did not
materially break out of the range that it had until well into the
1990*8. In short, the wealth effect, to the extent that it worked—
and it did on the margin—was a relatively minor factor in the
economy and, therefore, in any inflation expectations.
20
What has happened in the last several years is a very major acceleration in the ratio of household net assets to income. All of the
evaluations we have made of that huge increase in wealth is that
even though its relationship to consumption expenditures is about
what it's been in the years past, because wealth was so low and
its changes were so small, it never had any real relevance to what
was happening in either investment or in consumption.
It is a new world we are dealing with. The characteristic of this
dramatic acceleration in productivity and the extraordinary behavior of our economy in the last 5 years is wholly novel, in my experience. And one of the key characteristics of this type of economy is
the wealth effect. The only reason I tie the wealth effect to household income is it is a measure of trying to relate it to consumption
because consumption comes out of income and wealth.
Senator MACK. Right. Let me see; you have indicated that asset
values may not be out of line as a result of the dramatic acceleration in productivity.
Chairman GREENSPAN. That's correct.
Senator MACK, But it also sounds like what you are saying is you
want to restrain asset growth because of your interpretation now
that the wealth effect has a greater impact on our economy than
it has had in the past.
Chairman GREENSPAN. I believe that would be a view that is
generally held by the economics profession. Let me give you an example of when the wealth effect would not have an impact. I was
looking at a chart which had the ratio of wealth to income, and
what that chart shows very dramatically is that from 1922, which
is the earliest data we have, it's relatively flat, and then all of a
sudden it spikes.
The reason I raise the immigration question is basically because
it gives an insight into where the safety valves are or are not. This
type of economy, which is creating a huge surge in wealth, could
create a huge surge in consumption and growth if there were the
people to produce the goods to meet the demand. The point at issue
is there is not.
It is even credible to argue that as large as our current account
deficit is, as large as our net debt to foreigners has become, the
rates of return off the new technologies are high enough to create
an inflow of capital into the United States, in both direct investment and in portfolio investment, to finance these net imports or
current account deficits indefinitely in the future, so that there is
nothing implicit in the issue of wealth per se creating a problem.
There is a problem if the safety valves, meaning those sources of
goods and services which satisfy the excess of demand over supply,
the excess being caused by the wealth effect, are limited.
If in fact the wealth effect had no impact on consumption, if all
that happened when stock prices went up was that the market
value of assets in households went up and the market value of the
assets on the books of corporations went up, but it had no effect
on consumption, if all consumption was related to income and not
wealth, then the wealth effect would not exist. The problem of imbalances would not exist. And they wouldn't exist if we had the
ability to expand output indefinitely.
21
The argument that I am making is we don't have that capability
and we are blocked essentially because we have limits on how the
demand created by the wealth effect can be supplied. I'm arguing
that, as a consequence of this, the market forces, not the Federal
Reserve, are driving up interest rates to close the gap between the
supply and demand for funds, which is a counterpart to goods and
services.
We at the Federal Reserve are acting in conjunction with the
market and responding to it. The best I can say to you is that it
is certainly true that we have a new economy. It is different. It is
behaving differently. It requires a different type of monetary policy
to maintain its stability and growth than we have had in the past.
That is the essential issue that we are confronted with, as best we
can see it.
Senator MACK. Thank you, Mr. Chairman.
Chairman GRAMM. Senator Grams.
OPENING COMMENTS OF SENATOR ROD GRAMS
Senator GRAMS. Thank you, Mr. Chairman.
Chairman Greenspan, thank you for being here.
I would like to ask you to focus on another area. I think Senator
Allard touched on it slightly. That is the impact of current monetary and fiscal policies on our agricultural sector of the economy.
As you know, the sector is very important, not only ui Minnesota,
but nationwide. Agriculture and agricultural commodities are very
important.
There is a growing concern, I believe, in the ag sector that the
very robust national economy that so many have enjoyed, has in
fact been bypassing rural parts of our country. While we all support efforts in monetary policy which would squeeze out the inflationary expectations from the current expansion, I think there are
many of us that are also concerned that these anti-inflationary efforts may in fact exacerbate what is already a difficult economic
scenario for our Nation's fanners.
As we know, the ag sector is very capital-intensive. The need to
replace and maintain some very expensive machinery is an important aspect of farm management. The acquisition of additional land
is also very expensive. Should borrowing costs increase by even 25
to 50 basis points, I think the impact on the average farmer would
be significant.
On the sell side of the economic equation, there is little evidence
of improving market conditions or any inflationary premiums in
the future markets. The current increase in fuel costs, I think, only
adds to an already bleak picture for many of our farmers. I have
a couple of questions relating to that.
Earlier, you mentioned that cartels were not your favorite
Chairman GREENSPAN. Cartels are not my favorite institutions.
Senator GRAMS. Cartels are not your favorite institutions. When
looking at agriculture and dairy, would you say that the dairy cartel known as the Northeast Dairy Compact would be one of your
supportive institutions?
Chairman GREENSPAN. Senator, I have been in Government long
enough to know that's the type of question you don't answer.
[Laughter.]
22
Senator GRAMS. OK. I appreciate that.
But first, Chairman Greenspan, in your analysis, how is the Nation's agricultural sector faring relative to other segments of the
economy? In sum, is agriculture sharing in the current boom economy that we are having?
Chairman GREENSPAN. Yes and no. Some parts are; most are not.
The problem, as I indicated to your colleague, is that productivity
has become really quite extraordinary. Yields on crops are moving
up in an awesome manner. The ability to produce is multiples of
what it was 30, 40 years ago.
Lef s take spring wheat, which you have a great interest in. My
recollection is only about a third of hard spring wheat is consumed
in the United States, and it is essentially inelastic. In other words,
the demand for bread and bread products, which essentially is
what the hard wheat goes to, is not sensitive to what is going on
in the economy, so that what you have is a third of your markets
which don't really get impacted by the huge increase in incomes in
the United States.
We are left essentially with the rest of the world market. The
weakening of export demand, especially as a consequence of the
Asian crisis, has clearly created subnormal incomes for agriculture
generally, and for wheat farmers particularly, as prices went down.
It wasn't that many months ago that wheat, soybeans, corn, were
all flat on the bottom of any chart that you could imagine.
Indeed, I agree with you that the agricultural area is lagging.
The only beneficent part of it is the productivity has really been
impressive. If we can get the huge part of demand opened up—that
is, the export markets—I think we will find that that extraordinary
productivity will finally flow down to the bottom line in a much
more impressive way than we have seen to date.
Senator GRAMS. I think a lot of the problem is the research that
we have done and the technologies we have improved, that we have
shared with the rest of the world. We are not the only country seeing much larger harvests from the same, so the competition is even
heavier out there.
Just quickly, and finally, do monetary policy adjustments, such
as changes in the discount or the Fed fund rates themselves, reflect
the economic realities for the agricultural communities, knowing
the pressures that they are up against?
To follow up on that, would monetary policy adjustments aimed
at assuring mat our current expansion not overheat, have unintended consequences on the agricultural community?
Chairman GREENSPAN. Well, first of all, we have problems in the
United States in that there are many different segments of industry and areas, but we have a central financial system, unlike what
existed 50, 60 years ago when you had different financial systems
in different parts of the country and different interest rates. Early
on in the Fed's history, we had different discount rates at different
Reserve Banks. But we now have a very effective central monetary
system in which interest rates are the same everywhere in the
economy.
The consequence of that is there is only one interest rate, and
it must be, in a sense, the average of all aspects of our economy,
so there can't be a special interest rate for agricultural loans in the
23
sense that it is not affected by the supply and demand for money
since money will basically flow to wherever the demand is. In that
regard, it's very difficult to envisage how monetary policy can adjust to the facts of agriculture, which are indeed as you portray
them, Senator.
Senator GRAMS. Thank you, Mr. Chairman.
Chairman GRAMM. Senator Reed.
OPENING COMMENTS OF SENATOR JACK REED
Senator REED. Thank you, Mr. Chairman.
Chairman Greenspan, the Treasury Department is embarking on
a very aggressive policy of reducing the publicly-held debt, which
is causing some concerns, at least thoughts in the debt markets.
Does this in any way complicate your ability to implement monetary policy through the raising and lowering of interest rates?
Chairman GREENSPAN. Not really. There has been a lot of commentary that the gradual elimination of the Treasury debt, to the
extent that that happens, would create major problems for the Federal Reserve. The reason it would not is that our policy is essentially based on accumulating assets on the balance sheet of the
Federal Reserve Banks or reducing them, and accordingly, creating
reserves for the banks.
At the moment, we are restricted essentially to a relatively few
Government-related and Government issues. But should the decline in available U.S. Treasury securities get to be so substantial
that it affects our ability to have adequate securities, Government
securities, in our portfolio, should that happen, we could very readily find many other ways to implement policy by certain types of
other assets we could hold.
The crucial issue is that if you are going to reduce the debt outstanding, which we believe is very important to this country, then
you either have to take the excess of receipts over outlays and cumulate assets for the Government, or use the funds to pay down
debt. I much prefer the second. In so doing, you create avenues for
the private sector to create new instruments which substitute
themselves as so-called benchmarks for the Treasury securities.
You will find that if these riskless instruments become extremely
scarce, there will be very strong incentives in the marketplace to
create AAA-plus private credits to substitute for these types of
instruments.
I think the complexity and flexibility of the private financial system is such that the elements of particular benchmark securities
that are created through Government issues are very readily, in
my judgment, replaced by comparable private sector issues.
Senator REED. Many proponents of this policy, Chairman Greenspan,, have suggested that by retiring publicly-held debt, you will
effectively pull down interest rates because there will be less Government intrusion into the private debt markets. If your policy, as
it is now, and for the foreseeable future, is to raise interest rates,
will you have to, in effect, overcompensate for this other effect?
Chairman GREENSPAN. Well, first of all, remember that to the extent that Government debt goes down, over the long run, long-term
interest rates will be lower than they otherwise would be. We are
not talking about huge changes and we are certainly not talking
24
about the notion of cyclical or countercyclical monetary policy because we are talking about a broad trend.
If you are asking me in a strictly technical sense, are there a few
basis points which probably have to be overcome because of this,
probably, but they are very few and, really, of no real relevance to
the development of what is going on in the economy.
Senator REED. Finally, Chairman Greenspan, you point out that
we are in a new economy. I wonder if there is any, to your mind,
other historical periods in which a new economy emerged that you
can draw lessons from or look to for insights as to what is happening now, or is this so new, so novel, that it's sui generis?
Chairman GREENSPAN. Senator, a lot of people look back to the
major technological changes at the latter part of the 19th century
as a clue to the type of things that are going on. I used to think
that could fully explain what's happening today. In the last year
or so, I have concluded that we appear to be moving beyond that.
I know of nothing that even remotely looks like what we are experiencing today. The relationships are different. A fundamental
root of this extraordinarily successful economy that we have is, one,
the synergies of a number of new technologies that have come together, coupled with a financial system and an economic system
which has enabled those particular new technologies to be developed in a manner to very markedly enhance standards of living of
the American people. This is new.
The type of policy that we have to devise has to reflect the nature of how the new economy is working. A number of the old tools
which we relied upon don't have relevance to this.
It may be that we are going through a short-term period and it
will be back to where we were in a few years, in which case this
will be a novel period. It will be a period in which monetary policy
is novel, and then we go back to the old techniques in a few years.
That may very well be the case. All I know at the moment is the
endeavor to apply the usual policies that we have employed over
the years to what is going on today is misunderstanding the nature
of the forces that are at play here.
Senator REED. Thank you, Mr. Chairman.
Chairman GRAMM. Senator Bennett.
OPENING COMMENTS OF SENATOR ROBERT F. BENNETT
Senator BENNETT. Thank you, Mr. Chairman.
Chairman Greenspan, I apologize for being late. I was presiding
over a hearing of the Joint Economic Committee on the issue of
critical infrastructure protection, and out of that hearing came a
line that I want to apply here. One of the witnesses likened the
Internet to a neighborhood where all of the houses are in a circle
and all of the backyards are the same backyard. He said if any one
of the householders doesn't lock his front door, every one of the
householders is at risk because the individual can go through that
one house and through the backyard, gaining availability to every
house simultaneously. This is the line he used, he said, "A national
solution is no solution. It must be an international solution to the
question of Internet vulnerability and security."
I think I'm hearing you say that the same thing is applying to
the economy. Not to the exact same extent here, because you don't
25
have the technological connection that you have on the Internet,
but we are in an interdependent economy and a purely national solution ultimately becomes no solution.
I associate with my friend from Florida on thinking that the primary function of the Fed should be to maintain price stability, but
you have raised this issue of inadequate labor to provide us with
the kind of productivity increases that we need to meet the demand
that we are getting, and that raises the whole question of H-1B
visas, for example. In this room we had testimony, Chairman Mack
was presiding, of a witness who said, "This work will get done,"
speaking of particular high-tech work. He said, "This work will be
done and it will be done by these people, because they are the only
people available to do it." The question is, will it be done in the
United States or will it be done in their countries of origin?
If you don't give us H-1B visas to bring these people to the
United States, the work will be done by these people overseas.
America will be the loser in terms of not having those people live
here, not having them pay taxes here, not having them raise their
families here and provide the kind of workforce that you referred
to. It is not just immigration at the lower level, it is immigration
generally, in terms of an internationally mobile labor force.
Now, could you comment on what you see in that general area
about labor, labor availability across national lines?
Chairman GREENSPAN. It is not an accident that I present the
safety valves as being goods from abroad or people from abroad.
What that is suggestive of is exactly the point you are making,
Senator, namely that there is an internationalization taking place
here.
It's a very difficult problem because, while I can hold forth on the
economic benefits of immigration or visas or what are implicit in
an economic argument, that's not the only relevance that immigration raises. There are many issues, cultural questions, issues that
have bedeviled the United States for 100 years in this area.
But speaking as an economist and evaluating the type of economy which we are currently experiencing, the benefits of bringing
in those people to do the work here, rather than doing the work
elsewhere, to me, should be pretty much self-evident.
Senator BENNETT. We are talking about a form of protectionist
mentality. I find the same people that do not like international
trade, at least to the degree that I do—people who have opposed
NAFTA, have opposed GATT, who have opposed Fast Track—are
the same people who are opposing the H—IB visas and other forms
of immigration reform to allow the transfer not only of individuals,
but also of goods and services across international lines.
Could this wave of protectionism mentality, wherever it is applied, ultimately bring down the economy, or at least significantly
slow the kind of growth we are all luxuriating in right now?
Chairman GREENSPAN. I have always worried about that. And I
have become increasingly concerned about it as the rate of growth
and productivity rises. It seems like an unrelated issue, but as
we are creating an ever more complex, sophisticated, accelerating
economy, the necessity to have the ability to bring in resources and
people from abroad to keep it functioning in the most effective
manner increasingly strikes me as relevant elements of policy.
26
Senator BENNETT. So the mentality we saw in Seattle could in
fact, in a variety of areas, ultimately kill this current golden goose?
Chairman GREENSPAN. There is a certain sadness involved in
this because one of the characteristics of very rapidly changing
technology is it creates a real deep-seated fear of job skill obsolescence. People no longer have the sense that, once they graduate
from high school or college, they have the tools for the rest of their
working lives. There is a general rising sense of uncertainty which
is manifested, incidentally, in the very dramatic increase in community college enrollment—people going back essentially for refurbishing skills they had not received in their original education.
My own judgment, as indeed, I suspect is yours, is that they are
mistaken. But I do understand where it is coming from. It would
be a mistake for us not to recognize what that is, where it's coming
from, and to try to find a way to remove the uncertainty and the
fear which is deep in many people. That is why the whole educational issue interfaces with the economic outlook. Unless we can
resolve this issue, I do think the forces against globalization can
significantly undercut this remarkable surge in prosperity that we
are observing.
Senator BENNETT. Thank you.
Chairman GRAMM. Senator Edwards.
OPENING COMMENTS OF SENATOR JOHN EDWARDS
Senator EDWARDS. Thank you, Mr. Chairman.
Good morning, Chairman Greenspan.
Can you tell us on a scale from one to ten, with one being no concern at all, to ten being a great deal of concern, how concerned the
American people should be about the possibility that this year, inflation could rise to 6 or 7 percent?
Chairman GREENSPAN. Can I go below one?
[Laughter.]
My own judgment is that inflation, at this stage, is very well contained. If the markets function properly and the central bank functions properly, it should stay that way.
Senator EDWARDS. Good. That's very encouraging.
Senator Bennett, in his questioning, talked about the Internet
and Internet security. I wonder about all of this hacking we have
seen recently reported in the news, particularly on some of the
major Web sites. I'm curious as to whether you have any feelings
about the potential impact that hacking, if it's not brought under
control by law enforcement, could have on the economy.
Chairman GREENSPAN. Do you mean encryption generally?
Senator EDWARDS. Yes.
Chairman GREENSPAN. One of the most alluring problems that
mathematicians have these days is whether somebody can create
an encryption which another mathematician cannot break. The result of this is that we are getting ever more complex mechanisms
to secure various different transactions and transmissions. With
the major acceleration in capacity that we are getting in our systems for data crunching, one would think that you could create an
encryption which just cannot be broken in a finite period of time.
My impression basically is that the technology hopefully should
be able to resolve this. But I cannot say to you that I know enough
27
about it to feel comfortable as to how that will work out. I do know
that if we struggle a great deal and try to find governmental mechanisms, such as restricting exports of encrypted types of materials
and the like, we cannot be sure it's going to work.
What we have to do is look to the private sector to find the most
effective means of encryption, recognizing that the life expectancy
of any particular complex encryption is limited, and ultimately it
will be overwhelmed by the capacity to unwind the code. It is a
continuous process where you never get the ultimate solution, but
you are constantly trying to keep ahead of those who want to pirate
the systems.
Senator EDWARDS. Let me change gears. I know you are aware
of the fact that a House committee passed out last week legislation
that would eliminate the Social Security earnings test.
I'm curious what effect, if that legislation actually became law,
it would have, if any, on the labor markets.
Chairman GREENSPAN. Well, it has two effects. One, clearly it
has an effect on the Social Security trust funds and the whole Social Security system. The effects there, I might add, are to create
a reduction in the receipts of Social Security, or I should say to increase benefits actually.
The presumption, oif course, is that you will get an increase in
the number of retired people coming back into the workforce. I
don't know what the orders of magnitude are, but clearly, to the
extent that happens, that is a positive effect.
How one balances the increased issue of benefits and strain on
the Social Security system, on the one hand, and increased labor
force availability, on the other, is something I can't make a judgment on. But it does strike me that the general notion of looking
at the average age of retirement and the average age at which one
obtains full benefits has always been one that I thought appropriate in any discussion on Social Security.
Senator EDWARDS. Let me ask you a two-part question.
In this period of extraordinary prosperity that we are enjoying,
can you define for us as clearly as you can your view of what demographic group is benefiting most from this prosperity?
Second, I noticed you commented last week in your testimony
about raising the minimum wage. I wondered if you had any views
about what, if anything, we could do to address the income disparity that we are facing in this country today?
Chairman GREENSPAN. As best I can judge, Senator, everybody
is benefiting to a greater or lesser extent from this extraordinary
prosperity. In a relative sense, when compared to recent history,
it's clearly those at the lower income levels which are benefiting
the most.
But let me characterize that in a somewhat different sense. The
lower 20 percent of households characterized by income had a flat
real average household income for about 15 years, from 1980 to
1995, whereas most of the rest of the households were showing significant gains.
Starting in the last 4 or 5 years, that group has all of a sudden
taken off. It's growing about the same as everybody else, so that
it is not as though it is improving faster.
Senator EDWARDS. Why is that happening?
28
Chairman GREENSPAN. It's happening because the labor markets
are getting ever tighter and the demand for every type of skill, low
skill to high skill, has gone up very dramatically. The demand for
labor has gone up to a point where the spectrum across income
groups has now been pretty much obliterated. The so-called college
premium, the extent to which people with college educations have
been able to increase their income relative to high school graduates, the gap that had been opening up mainly because of the
technological nature of the economy we have, that increase has
stopped. The prosperity seems spread evenly everywhere. The distribution of income which had become increasingly
skewed to the
upper income groups through most of the 1980ls and 1990's stopped
in the middle of the decade, and everyone's income has been growing roughly about the same amount, meaning that the concentration of income hasn't changed much in the last 5 years. It is not
that the lower income groups have improved. It's that they stopped
losing ground.
When you look at the distribution of wealth, clearly with the
heavy concentration of stock holdings in upper income groups, in
the last 4 or 5 years it has been materially shifting upward toward
upper income groups.
Senator EDWARDS. I thank you, Chairman Greenspan.
Thank you, Mr. Chairman.
Chairman GRAMM. Senator Schumer.
OPENING COMMENTS OF SENATOR CHARLES E. SCHUMER
Senator SCHUMER. Thank you, Mr. Chan-man.
Chairman Greenspan, I would like to return to the subject we
talked about a couple of weeks ago in this room, which is margin
requirements.
First, let me say the economy is in great shape, as you know and
deserve much of the credit for. Productivity continues to grow at
a rate almost unforeseen. Inflation is extremely low. You almost
couldn't ask for more.
The one real concern that you brought up and mentioned today,
of course, is the wealth effect, which is that more spending will
come about because people have more wealth. I think you noted
last week that about 80 percent of the wealth effect comes from the
equity markets. Even within those equity markets, it com^s from
a certain group of stocks—I believe the Dow Jones has gone up
about 15 percent over the last year. I don't own any stock, so I
might be off, at little peril to myself, at least financially. The
Nasdaq has also gone up rather dramatically.
All of that leads me to wonder, and you have talked about raising interest rates, the possibility of raising interest rates to deal
with this wealth effect, if not immediately, perhaps down the road.
All of this leads me to ask the question that jumps out, at least
at me, which is: Given the relative stability of our economy overall,
isn't raising interest rates too blunt an instrument, a meat cleaver
rather than a scalpel, whereas dealing with margin requirements
or some other alternative that focuses on this dramatic rise in the
equity markets that some, at least, feel in certain instances, not in
every instance, is a little overheated or overstated, wouldn't that be
a better way to go?
29
That's the first question.
The second is, in general, related to that. That is, if this wealth
effect continues, do you mean to say that, as the stock market goes
up, you will continue to raise interest rates—of course, depending
on how much it goes up?
Chairman GREENSPAN. Let me just emphasize, Senator, that we
are not focusing monetary policy on the stock market. We are focusing it on the economy. To the extent that the stock market affects the economy, we respond to that. But it doesn't necessarily
follow that as stock prices go up or go down, it will have an effect
on the economy which requires us to respond, so that we don't look
at stock prices and say, stock prices are rising; we have to raise
interest rates.
Senator SCHUMER. But you look at the wealth effect, which is
basically
Chairman GREENSPAN. We do look at the wealth effect, but the
wealth effect is not that closely tied to the stock market. It is a
broad thing, but we cannot argue that there is a direct relationship
between what's happening in the stock market and what's happening to monetary policy. That is not our interest.
Leaving that aside, I am going to go back to the question of if
it were our interest, which is what you are implying in the first
question.
Senator SCHUMER. Correct.
Chairman GREENSPAN. Would not increasing margins be better?
If the evidence indicated that raising margins would affect stock
prices, then the answer to that hypothetical question would be yes.
But the evidence that we have, going back a long period of time,
is that margin requirements, per se, do not affect stock prices.
They do affect borrowing patterns, and they affect the prudential
safety of brokers and dealers and banks and others, but they don't
affect stock prices.
Senator SCHUMER. Is the trend the type of jump trend we saw
in November and December, with margin borrowing continuing as
we move into the new year?
Chairman GREENSPAN. It moved up in January.
Senator SCHUMER. It did?
Chairman GREENSPAN. It did.
Senator SCHUMER. Did it move a similar amount?
Chairman GREENSPAN. My recollection is that it was somewhat
smaller, but yes, it is still rising to a significant extent.
As a consequence of that, however, there have been at least some
anecdotal discussions on Wall Street which suggest that a number
of broker-dealers are looking at their extensions of credit to be
sure that they are not overextending themselves. And there have
almost surely been some marked increases in maintenance margins
on the part of individual broker-dealers who are looking at what
some of their customers are buying, and they don't like it because
they are trying to protect themselves.
that, in our judgment, is the major use of margins, not our margin authority, which is strictly the minimums, but what individual
firms do to protect themselves, as they should. My impression is
that, having looked at the dramatic surge in margins and the fact
that it's become a public issue—and, Senator, you have been very
30
instrumental in putting it on the table—is itself beginning to have
some effect in creating a bit more sensibility in that process.
Senator SCHUMER. Thank you, Chairman Greenspan.
Mr. Chairman, may I ask one more question, or are we going to
have a second round?
Chairman GRAMM. We are going to have a second round.
Senator SCHUMER. Thank you, Mr. Chairman.
Chairman GRAMM. Chairman Greenspan, there are a couple of
things I want to touch on, and I will try to be brief.
First of all, I would like to throw out that my guess is that 20
years from now, when we have a much better fix on contemporary
history than we do now, the progress of the people in the bottom
quartile of income will have been produced not only by the strong
recovery, but also by the dramatic reform in welfare.
I would argue that for the previous 15 years, they have been
largely detached from the economy and its performance by the fact
that welfare was the dominant Government program, not just welfare as we narrowly define it, but basically payments that are
made based on income, that that has been the dominant factor in
any income measure in that quartile, and that reforming welfare
produced the push and the economic growth produced the pull that
have generated what is obviously a wonderful thing. I wanted to
throw that out.
We have an H-1B proposal now before the Congress. As you
know, the allowable level of immigration of high-tech workers is in
decline under current law, down over the next 2 years to 65,000.
We have a bill to raise it to 195,000 for the next 3 years, and also
to exempt—with a focus on people who are educated in America,
the logic being, as you are probably aware, about half of all the
graduate students in America today are foreign-born. That is even
more pronounced in technical areas, and they are among our best
students. The idea is to give them a preference in staying here,
and, in fact, we exempt from the 195,000 those with advanced degrees in technical areas.
I wanted to give you an opportunity, given what you have said
about immigration, to comment on whether or not you think that
passage of such a bill—I'm not claiming you have knowledge of the
details—but whether the basic thrust of such a bill would be a
good thing for the economy today or not.
Chairman GREENSPAN. Mr. Chairman, as you point out, I am not
familiar with the details of the bill, but certainly the principle that
you are putting on the table is something which I could and would
fully support.
Chairman GRAMM. Let me go back to equity values, because I
think people hear what you are saving and conclude that you believe that equities are overvalued. I have tried to look at the stock
market today and have tried to reach my own internal conclusion.
A little like Senator Schumer, I invest in groceries and tuition, and
I'm doing well on the groceries.
[Laughter.]
I'm hoping to do much better on the tuition in the relatively near
future.
[Laughter.]
31
I guess if somebody forced me to bet good money, I would bet
that equity values, given what's going on, are not only not overvalued, but may still be undervalued. I don't know that.
But the wealth effect that you are talking about is easy for me
to understand. When I came to Congress, I had taught for 12 years,
and my little TIAA-CREF investment, after you paid taxes on it,
might have bought a tractor. Today, it would buy a farm. People
can't help but be affected by that kind of change. I think when you
have a change in equity values in a year, 20 percent or 25 percent,
that has to create a wealth effect.
Some of our colleagues are concerned about consumer debt. Well,
if you are a white-collar worker and the value of your financial
wealth is rising by more than your income, when you take into account your 401(k) and your IRA's, you have to be affected or you
are irrational.
The wealth effect is easy for me to understand, and it seems to
me that it is a very relevant factor because financial wealth is so
widely dispersed. It is my understanding that we have passed the
point where the average family now has more financial wealth
than the equity value of their home. When equity values go up by
20 percent in a year, it has to effect the economy.
I wanted to run back over that trail one more time and give you
a chance to comment on it.
Chairman GREENSPAN. Mr. Chairman, to reiterate what I said
earlier, the issue of stock prices and equity values generally going
up as a consequence of the accelerating productivity is a perfectly
understandable and appropriate thing to happen. That is, the real
value of assets has indeed increased. And remember that all value
is future value. It's an endeavor to infer what capabilities there are
in the future essentially discounted to a present value.
That that has happened is, in my judgment, unquestioned. That
alone is enough to raise a wealth effect and the related type of
demand/supply imbalance without any advertence to the question
as to whether or not stock prices are undervalued, appropriately
valued, or overvalued. All you need to know is that they went up,
The issue of whether they are undervalued or not depends, as I
just indicated, on how one views the future. It is a crucial question
as to what the future will look like, which is, in the deepest sense,
not forecastable.
The problem that we therefore have is when we look back in retrospect, we will know whether we had a bubble in there which was
essentially that part of the increase in stock prices—not all of it,
but part of it—which was not appropriately valuating what the
technologies could truly do. We will know that only in retrospect
because we cannot project the future.
As I have said previously before this Committee, bubbles are visible only in retrospect. If we could actually identify a stock market
bubble in advance, we would have to be willing to say that there
is a very high probability that in the very near term, values will
fall by, say, 40 percent.
We also have to be able to say that all of the pension funds, all
of the sophisticated people who are involved in pricing stocks, don't
know what they are doing. Now, that may well be the case. I'm
merely saying that the hurdle to argue that there is a bubble is an
32
important hurdle. There are lots of people who have very strong
views on this, one way or the other, and the basis of the evidence
which they adduce I do not find persuasive in one way or the other.
I have my own views and they are just as valid as everybody
else's, which isn't very much.
Chairman GRAMM. Senator Sarbanes.
Senator SARBANES. Thank you, Mr. Chairman.
I have two subjects I want to cover, Chairman Greenspan. Before
I turn to the first, I want to make this observation. I don't think
the example of bringing the ship into the dock is an apt example
because you never dock the economy. One of your challenges is to
keep sailing the ship, as it were, on course. But the notion that
somehow, at some point, it comes to a terminus and the voyage is
over
Chairman GREENSPAN. All analogies are awful, Senator.
Senator SARBANES. All right. Now, I have heard you speak in the
past with some feeling about this problem of income and wealth
disparity in this country and its significance. The top 1 percent of
Americans, which is 2.7 million people, take home as much aftertax income as the lowest 38 percent, which is 100 million people
combined. The trend has worsened over the years. In 1977, the top
1 percent of Americans received 7.3 percent of all national aftertax income. In 1999, it is expected to be just under 13 percent. It
is not too far from having doubled in that 22-year period, and that
is for the top 1 percent.
I set that out because I'm very concerned about this wealth effect
notion that has come forth now as a basis for raising interest rates.
Because you have a wealth effect, you get, as I understand it, additional consumption which outstrips the available supply. You feel
that there will be an inflationary problem and, therefore, you need
to start raising the interest rates in order to dampen the economy.
I want to go back to the example that I used at the outset of this
education and training program which is drawing these at-risk
youth, school dropouts, into the labor force. I talked to a couple of
employers, as I said, about this program because the employers are
important. They promise a job at the end of the line. They said to
me, "Well, we are doing this because we think we are performing
a service and doing some good, but the fact of the matter is, we
also have an economic interest in doing this because, with the
tightening labor market, we are looking for ways to bring people
in, develop their skills, make them part of the trained workforce,
and therefore, it serves our economic interest to participate in this
program, to hold out a job at the end of the day."
One reason they are in it is because we have had this rapidlygrowing economy. These additional strains have, in effect, made it
to their interest to participate and help to develop this workforce.
Now we hear about this wealth effect. Well, if you slow down the
economy, they are not going to be so interested in participating.
In effect, the wealth effect, which I am struggling still to understand, I perceive would affect really a minority of our population.
About half of our population have no stocks at all. The other half,
a large portion of them have only very small holdings. Others are
counted because they participate through pension activities, so they
are setting it aside for their retirement.
33
If you talk about who gets this wealth effect that leads them to
consume, which gets you worried about overheating the economy,
it is going to be a relatively small part of the population. Yet, to
deal with the situation that they are creating, we, in effect, are
going to curtail the movement of the economy that's going to have
a dramatic impact on our efforts to bring people into the workforce.
I have a very deep concern about that circle.
Since the yellow light is on, let me put my other concern to you.
You spoke about the waning of the buffers that would enable us
to continue this fast-paced economy, and you mentioned immigration and imports. I take it, on the import side, since the current
account deficit has risen by a tremendous amount—it's at record
highs—that the growth in the current account deficit is a problem
that we need to look at.
Now, you have said, conceivably, the return on investment in the
high-tech sector would be sufficient to continue to draw in capital
which would cover the gap created by the trade deficit.
Chairman GREENSPAN. I think I said it might be.
Senator SARBANES. It might be. So we are getting closer to those
parameters. In other words, I take it that that's a statistic about
which we should have some concern—a very large run-up in the
current account deficit. Would you agree with that?
Chairman GREENSPAN. I agree with that, Senator.
Senator SARBANES. Now if we could address the first issue.
Chairman GREENSPAN. Yes. Senator
Senator SARBANES. And I assume we agree about the boat and
its voyage and so forth. I have you on a perpetual voyage, trying
to sail this economic ship of state around. I don't think it's going
to come in to dock yet.
Chairman GRAMM. Well, maybe the wind blowing the ship into
a rock is a better analogy.
[Laughter.]
Senator SARBANES. All right.
Chairman GRAMM. He has to tack around the rock.
[Laughter.]
Chairman GREENSPAN. The problem with analogies is that they
are always subject to qualifications which, if you keep working at
them, have no value whatsoever.
Senator SCHUMER. Welcome to the Merchant Marine Committee,
Chairman Greenspan.
[Laughter.]
Senator SARBANES. The advantage, though, is you don't really
have to explain anything.
Chairman GRAMM. People know what you are talking about.
Chairman GREENSPAN. Let me put it this way. You cannot substitute an anecdote for a syllogism.
[Laughter.]
Senator SARBANES. All right.
Chairman GREENSPAN. Senator, first of all, as I envisage what is
essentially the policy of the Federal Reserve, it is to recognize that
the rate of growth of the economy has to phase down to a level
which is capable of being continued essentially indefinitely.
That particular trend still envisages a major inflow of workers
from those with high school educations or less into the market.
34
I do not perceive that what we are talking about is some form
of monetary policy which squeezes the economy down into a subnormal rate of growth. My own view is that the economy should
and will grow at the rate of increase in productivity plus, over the
long run, the rate of increase in the working-age population. Nothing that I envisage as far as monetary policy is concerned in any
way suggests that what the Federal Reserve has in the back of its
mind is some form of putting brakes on the system which brings
the economy to a roaring halt.
That is not what the overall markets are doing or what we perceive to be our function. Our function is to create stability and to
maintain a noninflationary financial system. It is not consistent
with the view that says that what we wish to do is to slow the
economy down in a dramatic fashion because I do not believe that
that is what our overall policy has been over the years, nor is it,
as best I can judge, in the future.
I indicated before the House Banking Committee last week that
we perceive that the optimum monetary policy, if it is feasible, is
to move incrementally. Incremental does not imply slamming on
the brakes. You slam on the brakes only when there are no other
alternatives to restore stability in our economy.
We needed to do that back in 1979, when inflation was running
into a dangerous loop. We needed it on occasion in the past where
things looked to be on the edge of instability.
What I have tried to argue today is not that we are on the edge
of instability, but that we have an extraordinary economy which is
growing at a pace which is somewhat above the level which is sustainable over the long term. That does not mean the productivity
growth cannot continue to grow and, indeed, create a long-term
level of growth higher than what we experience now.
But what we consider to be important is not to allow the safety
buffers to shrink to a point where they are no longer capable of absorbing an excess of demand over supply, which invariably occurs
in the normal state of affairs.
Senator SARBANES. Well, let me just make this observation. We
have needed the economy to move at this pace in order to finally
reach the point where we are drawing this heretofore, in a sense,
neglected population into the labor market and into the economic
mainstream. For the first time, unemployment amongst AfricanAmericans and unemployment amongst Hispanics is the lowest on
record, and I regard that as a very important and a very significant
development.
If we needed the economy moving this way to get to that point,
and then we start slowing the economy down, it carries with it the
real risk of receding from the advances that we have been making
hi this regard.
I'm not arguing that you should push the economy even more or
intensify it, but I am concerned about trying to pull it back and
what impact that's going to have.
Chairman GREENSPAN. Senator, it certainly is not my expectation. But clearly, we are confronted with a situation which cannot
continue to exist indefinitely in the future. It is on a track, whether
or not we talk in terms of running into the dock or whether we talk
in other types of analogies. The underlying fact at this point is that
35
we have a system which is creating continuous reductions in the
safety buffers which cannot continue indefinitely at the pace that
it is going and maintain the degree of prosperity that we have.
That is not to say that if we get to balance, that that in any way
is going to create a retardation of the tremendous benefits that
have occurred which you have cited. I think there's no question, I
agree with you, they have been very formidable, positive factors in
our economy and in our society.
Senator SARBANES. Thank you, Mr. Chairman.
Chairman GRAMM. Senator Schumer.
Senator SCHUMER. Thank you, Mr. Chairman.
I have three questions. First, following up on the recent discussion we had, I think, again, I share your view. You have always
stated, over your years, that you want to avoid slamming on the
brakes, and sometimes incremental changes are made in order to
avoid doing that. I think you have always said, once the genie of
inflation is out of the bottle, you can't get it back in, and I think
that has served us well for a long time.
On the other hand—and this relates both to what we were talking about before and what has been discussed here today—if productivity should be even higher than what we think it is today, and
continue to grow that way—productivity is almost the magic and
core number here—it seems to me it may well mean that we could
continue to grow at the same level that we are growing without
much change.
In addition, I think my constituents in New York were very glad
to hear what you said in answer to the question before, that you
are not going to base monetary policy on the stock market. Obviously, there is an intermediary factor, which is the wealth effect,
which may or may not be directly related. But if an accurate guess
of increased productivity accounts for both an increase in the stock
market—and, as you mentioned, we can't predict bubbles—but at
the same time accounts for the relatively good shape that the economy is in, and keeps us on keel that way, then, again, we may be
in such good shape that neither a tightening in a narrower way,
in a small way, in an incremental way, or a tightening in a larger
interest rate way may be necessary. Is that fair to say?
Chairman GREENSPAN. It depends. It depends on whether the acceleration in productivity carries with it further increase in stock
prices. If it does not, then what you said is accurate.
The problem has to be an evaluation of whether in fact the acceleration hi productivity does or does not create a wealth effect
which opens up the gap between demand and supply. If it does not,
then
Senator SCHUMER. We could keep going.
Chairman GREENSPAN. —what we will experience is just an acceleration of economic growth and no increases in imbalances from
that source.
Senator SCHUMER. Right. I agree with that. We just don't know,
I guess, is the answer to that.
Chairman GREENSPAN. No.
Senator SCHUMER. I have two other questions. Now that we have
had a good deal of success in reigning in the deficit, there is a lot
of talk that the good old benchmark of the 30-year Government
36
bond is not going to be there if we keep going on the track we
are—I guess it's 2013 now, which is 13 years away, not 30—and
that something has to come and take its place. Who knows what
it will be?
We are already seeing the effect of that. Could you comment on
the problems, or the transition of the benchmark?
Chairman GREENSPAN. Senator, benchmarks are made by the
markets themselves.
Senator SCHUMER. Correct.
Chairman GREENSPAN. It's not something which is promulgated
by Government.
Senator SCHUMER. Right.
Chairman GREENSPAN. The U.S. Treasury 30-year bond has been
an extraordinary instrument in that it's the longest-term, risk free
instrument that we have, and all sorts of transactions have been
posited against that particular base.
Should it disappear, and it certainly will if we eliminate the debt
by 2013 or any time, something else will substitute because it is
necessary. At the moment, there is talk in the marketplace that socalled swap spreads are becoming enticing.
But what will happen is that something else will end up as the
benchmark. It may very well be that some financial institution or
a group of them would get together and create AAA-plus private
instruments, and that would serve as a benchmark.
I'm not concerned about the problem. The financial market and
the sophistication of the system is such that if there is a demand
for a benchmark, it will be created.
Senator SCHUMER. Right. And it doesn't affect the economy much
if that benchmark is either shorter-term or private, rather than a
public instrument.
Chairman GREENSPAN. It does not. It will certainly affect a number of people on Wall Street and how they function, but as far as
the economy is concerned, it will have no effect that I can see.
Senator SCHUMER. Just one final question, if I might, Chairman
Greenspan. Today, I believe the SEC is going to issue a concept
release on fragmentation of the markets. There are all of these new
ways to trade stocks, and they are all being practiced in different
corners of the financial markets. There's good news to that. That
creates competition and probably a more efficient system.
But there are many people who worry that fragmentation of the
markets is not only producing competition, but also inefficiencies
and disparities in prices. The depth and the transparency of our
markets might not inspire the same level of confidence that it does
today.
Would you comment on fragmentation? Are you worried about it?
Is there any guidance in the debate that will partially involve this
Committee?
Chairman Gramm, in his wisdom, has arranged for us to hold a
hearing in New York on this. I guess it will be held next week.
Chairman GRAMM. It will be held next Monday and Tuesday.
Senator SCHUMER. Just some thoughts on this issue, which is an
issue that I find nobody has a really good paradigm or role model
for at this point.
37
Chairman GREENSPAN. Well, I think, in principle, what we know
about auction markets or any type of market in which there is bid
and ask system determining prices is that there tends to be a natural monopoly in the sense that the institution, the trading institution, whether it be a floor or ECN or what have you, tends to have
a competitive edge if the bid-ask spread in volume is narrower
than any competition.
Senator SCHUMER. Right.
Chairman GREENSPAN. To the extent that occurs, the trading will
automatically flow toward the institution with the smaller spread.
The competitive capability of everyone else will decline, and all of
the business will converge, other things equal, to a central market.
We saw that happen, for example, with the New York Cotton Exchange and the New Orleans Cotton Exchange, which I believe I
may have mentioned to you at one time.
Senator SCHUMER. You did.
Chairman GREENSPAN. That is what is happening here. With the
huge advances in technology and communication, the capacity to
have all trades of a specific type struck in a central marketplace
in real time has increased vastly. Back 20, 30 years ago, you could
not do that, and we did have disparate markets and we did have
trading of the same stock and the same commodity in a lot of different places.
The question really occurs here as to what extent Government
has a role here, or should we just let the private sector create what
it needs to create? My judgment is, definitely, let's do that because
the technologies are not going to be easily forecastable and the selfinterest of the traders is going to largely create that sort of instrument, that sort of exchange, that sort of entity which they find
gives them the lowest cost and the greatest liquidity.
Senator SCHUMER. I have one followup question. Would certain
values that the Government has, through the SEC, instilled in the
market—transparency, the availability of the "price" of the buy
and sell—which some are arguing shouldn't happen now—I guess
Schwab is one of those that has argued against it as a barrier to
competition—should that be a value that we should continue to
pursue as we let the private sector choose the most efficient?
Chairman GREENSPAN. Senator, it is a value. The question, I believe, that has to be focused on as far as governmental policy is
concerned, is will the market create it by itself? In other words, if
it is a value, will it happen automatically or is there anything that
Government should or could do?
Clearly, the one thing that Government has to do is to prevent
fraud. The issue of adherence to law and law of contracts and all
various different types of governmental-associated characteristics of
markets can only be done by Government. It is crucially important
that the issue of the sanctity of contracts and fraud be emphasized
in governmental policy.
But I think it is important to try to distinguish which types of
values will get created because they are of value to the marketplace by themselves, and in which Government should not have a
role. That's where I think the debate has to be.
Senator SCHUMER. Thank you, Chairman Greenspan.
Thank you, Mr. Chairman.
38
Chairman GRAMM. Well, Chairman Greenspan, let me say this
has been a very good hearing. I envy your ability to sit here for
such long periods of time.
We have covered a lot of subjects today. I don't know whether
this will be the last Humphrey-Hawkins hearing we ever have, but
if it is, it was good one. There are many things that end without
ever reaching a high point.
I want to thank you for your testimony,
The Committee stands in adjournment.
[Whereupon, at 12:38 p.m., Wednesday, February 23, 2000, the
hearing was adjourned.]
[Prepared statements and additional material supplied for the
record follow:]
39
PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I would like to join Chairman Gramm and my colleagues in welcoming Federal
Reserve Board Chairman Alan Greenspan to this hearing. I always look forward to
the opportunity to hear from Chairman Greenspan concerning monetary policy and
other economic issues. It is a particular pleasure to have you, Mr. Chairman, before
this Committee knowing that we will continue to have the benefit of your service
as Chairman for 4 more years.
Our Nation continues to enjoy unprecedented growth, with remarkable productivity increases fueling much of the growth. As a result, we are experiencing low
unemployment, increased real wages, and remarkable price stability. The members
of the Board of Governors and the Federal Reserve Bank presidents see good prospects for sustained economic expansion through the year.
Congress must take advantage of these times of prosperity to plan for the future.
I share the belief that the wisest use of our current surpluses is to pay down the
debt. Only through fiscal discipline can Congress ensure that future generations -will
enjoy the same opportunities that we now have.
During the previous two decades, the United States has pursued a policy of low
taxation, limited Federal regulation, free trade, and sound monetary policy. This has
resulted in a tremendous economic expansion. The expansion which began in 1983
has been interrupted by only a very modest downturn in 1991. Obviously, we should
continue these policies of limited Government.
In contrast to the United States, maay of our competitors in Europe and Asia
have resorted to greater Government intervention. With the benefit of hindsight, it
is clear that the American model has produced the greatest benefits.
Certainly, Alan Greenspan deserves much of the credit for the current strong
economy. His watchful eye and careful policies have created economic opportunities
for all Americans.
Chairman Greenspan, I look forward to your testimony.
PREPARED STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
FEBRUARY 23, 2000
Introduction
I appreciate this opportunity to present the Federal Reserve's semiannual report
on the economy and monetary policy.
There is little evidence that the American economy, which grew more than 4 percent in 1999 and surged forward at an even faster pace in the second half of the
year, is slowing appreciably. At the same time, inflation has remained largely contained. An increase in the overall rate of inflation in 1999 was mainly a result of
higher energy prices. Importantly, unit labor costs actually declined in the second
half of the year. Indeed, still-preliminary data indicate that total unit cost increases
last year remained extraordinarily low, even as the business expansion approached
a record 9 years. Domestic operating profit margins, after sagging for 18 months,
apparently turned up again in the fourth quarter, and profit expectations for major
corporations for the first quarter have been undergoing upward revisions since the
beginning of the year—scarcely an indication of imminent economic weakness.
The Economic Forces at Work
Underlying this performance, unprecedented in my half-century of observing the
American economy, is a continuing acceleration in productivity. Nonfarm business
output per workhour increased 3V4 percent during the past year—likely more than
4 percent when measured by nonfarm business income. Security analysts' projections of long-term earnings, an indicator of expectations of company productivity,
continued to be revised upward in January, extending a string of upward revisions
that began in early 1995. One result of this remarkable economic performance has
been a pronounced increase in living standards for the majority of Americans. Another has been a labor market that has provided job opportunities for large numbers
of people previously struggling to get on the first rung of a ladder leading to training, skills, and permanent employment.
Yet those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained,
threaten our continuing prosperity. Accelerating productivity entails a matching acceleration in the potential output of goods and services and a corresponding rise in
real incomes available to purcnase the new output. The problem is that the pickup
40
in productivity tends to create even greater increases in aggregate demand than in
potential aggregate supply. This occurs principally because a rise in structural productivity growth has its counterpart in higher expectations for long-term corporate
earnings. This, in turn, not only spurs business investment but also increases stock
prices and the market value of assets held by households, creating additional purchasing power for which no additional goods or services have yet been produced.
Historical evidence suggests that perhaps 3 to 4 cents out of every additional dollar of stock market wealth eventually is reflected in increased consumer purchases.
The sharp rise in the amount of consumer outlays relative to disposable incomes in
recent years, and the corresponding fait in the saving rate, has been consistent with
this so-called wealth effect on household purchases. Moreover, higher stock prices,
by lowering the cost of equity capital, have helped to support the boom in capital
spending.
Outlays prompted by capital gains in excess of increases in income, as best we
can judge, have added about 1 percentage point to annual growth of gross domestic
purchases, on average, over the past 5 years. The additional growth in spending of
recent years that has accompanied these wealth gains as well as other supporting
influences on the economy appears to have been met in about equal measure from
increased net imports and from goods and services produced by the net increase in
newly hired workers over and above the normal growth of the workforce, including
a substantial net inflow of workers from abroad.
But these safety valves that have been supplying goods and services to meet the
recent increments to purchasing power largely generated by capital gains cannot
be expected to absorb an excess of demand over supply indefinitely. First, growing
net imports and a widening current account deficit require ever larger portfolio and
direct foreign investments in the United States, an outcome that cannot continue
without limit.
Imbalances in the labor markets perhaps may have even more serious implications for inflation pressures. While the pool of officially unemployed and those otherwise willing to work may continue to shrink, as it has persistently over the past
7 years, there is an effective limit to new hiring, unless immigration is uncapped.
At some point in the continuous reduction in the number of available workers willing to take jobs, short of the repeal of the law of supply and demand, wage increases
must rise above even impressive gains in productivity. This would intensify inflationary pressures or squeeze profit margins, with either outcome capable of bringing
our growing prosperity to an end.
As would be expected, imbalances between demand and potential supply in markets for goods and services are being mirrored in the financial markets by an excess
in the demand for funds. As a consequence, market interest rates are already moving in the direction of containing the excess of demand in financial markets and
therefore in product markets as well. For example, BBB corporate bond rates adjusted for inflation expectations have risen by more than 1 percentage point during
the past 2 years. However, to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this increase, propelling equity prices and the wealth effect even higher. Should this process continue,
however, with the assistance of a monetary policy vigilant against emerging macroeconomic imbalances, real long-term rates will at some point be high enough to finally balance demand with supply at the economy's potential in both the financial
and product markets. Other things equal, this condition will involve equity discount
factors high enough to bring the rise in asset values into line with that of household
incomes, thereby stemming the impetus to consumption relative to income that has
come from rising wealth. This does not necessarily imply a decline in asset values—
although that, of course, can happen at any time for any number of reasons—but
rather that these values will increase no faster than household incomes.
Because there are limits to the amount of goods and services that can be supplied
from increasing net imports and by drawing on a limited pool of persons willing to
work, it necessarily follows that consumption cannot keep rising faster than income.
Moreover, outsized increases in wealth cannot persist indefinitely either. For so long
as the levels of consumption and investment are sensitive to asset values, equity
values increasing at a pace faster than income, other things equal, will induce a rise
in overall demand in excess of potential supply. But that situation cannot persist
without limit because the supply safety valves are themselves limited.
With foreign economies strengthening and labor markets already tight, how the
current wealth effect is finally contained will determine whether the extraordinary
expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.
41
Technological Change Continues Apace
On a broader front, there are few signs to date of slowing in the pace of innovation and the spread of our newer technologies that, as I have indicated in previous
testimonies, have been at the root of our extraordinary productivity improvement.
Indeed, some analysts conjecture that we still may be in the earlier stages of the
rapid adoption of new technologies and not yet in sight of the stage when this wave
of innovation will crest. With so few examples in our history, there is very little
basis for determining the particular stage of development through which we are currently passing.
Without doubt, the synergies of the microprocessor, laser, fiber-optic glass, and
satellite technologies have brought quantum advances in information availability.
These advances, in turn, have dramatically decreased business operational uncertainties and risk premiums and, thereby, have engendered major cost reductions
and productivity advances. There seems little question that further major advances
lie ahead. What is uncertain is the nature pace of the application of these innovations, because it is this pace that governs the rate of change in productivity and
economic potential.
Monetary policy, of course, did not produce the intellectual insights behind the
technological advances that have been responsible for the recent phenomenal reshaping of our economic landscape. It has, however, been instrumental, we trust,
in establishing a stable financial and economic environment with low inflation that
is conducive to the investments that have exploited these innovative technologies.
Federal budget policy has also played a pivotal role. The emergence of surpluses
in the unified budget and of the associated increase in Government saving over the
past few years has been exceptionally important to the balance of the expansion,
because the surpluses have been absorbing a portion of the potential excess of demand over sustainable supply associated partly with the wealth effect. Moreover,
because the surpluses are augmenting the pool of domestic saving, they have held
interest rates below the levels that otherwise would have been needed to achieve
financial and economic balance during this period of exceptional economic growth.
They have, in effect, helped to finance and sustain the productive private investment that has been key to capturing the benefits of the newer technologies that,
in turn, have boosted the long-term growth potential of the UJ-L economy.
The recent good news on the budget suggests that our longer-run prospects for
continuing this beneficial process of recycling savings from the public to the private
sectors have improved greatly in recent years. Nonetheless, budget outlays are expected to come under mounting pressure as the baby boom generation moves into
retirement, a process that will get under way a decade from now. Maintaining the
surpluses and using them to repay debt over coming years will continue to be an
important way the Federal Government can encourage productivity-enhancing investment and rising standards of living. Thus, we cannot afford to be lulled into letting down our guard on budgetary matters, an issue to which I shall return later
in this testimony.
The Economic Outlook
Although the outlook is clouded by a number of uncertainties, the central tendencies of the projections of the Board members and Reserve Bank presidents imply
continued good economic performance in the United States. Most of them
expect economic growth to slow somewhat this year, easing into the 3Vfc to 33A percent area.
The unemployment rate would remain in the neighborhood of 4 to 4Vi percent. The
rate of inflation for total personal consumption expenditures is expected to be !3/4
to 2 percent, at or a bit below the rate in 1999, which was elevated by rising energy
prices.
In preparing the forecasts, the Federal Open Market Committee members had to
consider several of the crucial demand- and supply-side forces I referred to earlier.
Continued favorable developments in labor productivity are anticipated both to raise
the economy's capacity to produce and, through its supporting effects on real incomes and asset values, to boost private domestic demand. When productivity-driven
wealth increases were spurring demand a few years ago, the effects on resource utilization and inflation pressures were offset in part by the effects of weakening foreign economies and a rising foreign exchange value of the dollar, which depressed
exports and encouraged imports. Last year, with the welcome recovery of foreign
economies and with the leveling out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign
economic activity is expected to continue this year, and, other things equal, the effect of the previous appreciation of the dollar should wane, augmenting demand on
U.S. resources and lessening one source of downward pressure on our prices.
42
As a consequence, the necessary alignment of the growth of aggregate demand
with the growth of potential aggregate supply may well depend on restraint on
domestic demand, which continues to be buoyed by the lagged effects of increases
in stock market valuations. Accordingly, the appreciable increases in both nominal
and real intermediate* and long-term interest rates over the last 2 years should act
as a needed restraining influence in the period ahead. However, to date, interestsensitive spending has remained robust, and the FOMC will have to stay alert for
signs that real interest rates have not yet risen enough to bring the growth of demand into line with that of potential supply, even should the acceleration of productivity continue.
Achieving that alignment seems more pressing today than it did earlier, before
the effects of imbalances began to cumulate, lessening the depth of our various buffers against inflationary pressures. Labor markets, for example, have tightened in
recent years as demand has persistently outstripped even accelerating potential
supply. As I have previously noted, we cannot be sure in an environment with so
little historical precedent what degree of labor market tautness could begin to push
unit costs and prices up more rapidly. We know however, that there is a limit, and
we can be sure that the smaller the pool of people without jobs willing to take them,
the closer we are to that limit. As the FOMC indicated after its last meeting, the
risks still seem to be weighted on the side of building inflation pressures.
A central bank can best contribute to economic growth and rising standards of
living by fostering a financial environment that promotes overall balance in the
economy and price stability. Maintaining an environment of effective price stability
is essential, because the experience in the United States and abroad has underscored that low and stable inflation is a prerequisite for healthy, balanced, economic
expansion. Both sustained expansion and price stability provide a backdrop against
which workers and businesses can respond to signals from the marketplace in ways
that make most efficient use of the evolving technologies.
Federal Budget Policy Issues
Before closing, I should like to revisit some issues of Federal budget policy that
I have addressed in previous congressional testimony. Some modest erosion in fiscal
discipline resulted last year through the use of the "emergency" spending initiatives
and some "creative accounting." Although somewhat disappointing, that erosion was
small relative to the influence of the wise choice of the Administration and the Congress to allow the bulk of the unified budget surpluses projected for the next several
years to build and retire debt to the public. The idea that we should stop borrowing
from the Social Security trust fund to finance other outlays has gained surprising—
and welcome—traction, and it establishes, in effect, a new budgetary framework
that is centered on the on-budget surplus and how it should be used.
This new framework is extremely useful because it offers a very clear objective
that should strengthen budgetary discipline. It moves the budget process closer to
accrual accounting, the private sector norm, and—I would hope—the ultimate objective of Federal budget accounting.
The new budget projections from the Congressional Budget Office and the Administration generally look reasonable. But, as many analysts have stressed, these estimates represent a midrange of possible outcomes for the economy and the budget,
and actual budgetary results could deviate quite significantly from current expectations. Some of the uncertainty centers on the likelihood that the recent spectacular
growth of labor productivity will persist over the years ahead. Like many private
forecasters, the CBO and the Office of Management and Budget assume that productivity growth will drop back somewhat from the recent stepped-up pace. But a
distinct possibility, as I pointed out earlier, is that the development and diffusion
of new technologies in the current wave of innovation may still be at a relatively
early stage and that the scope for further acceleration of productivity is thus greater
than is embodied in these budget projections. If so, the outlook for budget surpluses
would be even brighter than is now anticipated.
But there are significant downside risks to the budget outlook as well. One is our
limited knowledge of the forces driving the surge in tax revenues in recent years.
Of course, a good part of that surge is due to the extraordinary rise in the market
value of assets which, as I noted earlier, cannot be sustained at the pace of recent
years. But that is not the entire story. These relationships are complex, and until
we have detailed tabulations compiled from actual tax returns, we shall not really
know why individual tax revenues, relative to income, have been even higher than
would have been predicted from rising asset values and bracket creep. Thus, we
cannot rule out the possibility that this so-called "tax surprise," which has figured
so prominently in the improved budget picture of recent years, will dissipate or reverse. If this were to happen, the projected surpluses, even with current economic
43
assumptions, would shrink appreciably and perhaps disappear. Such an outcome
would be especially likely if adverse developments occurred in other parts of the
budget as well—for example, if the recent slowdown in health care spending were
to be followed by a sharper pickup than is assumed in current budget projections.
Another consideration that argues for letting the unified surpluses build is that
the budget is still significantly short of balance when measured on an accrual basis.
If Social Security, for example, were measured on such a basis, counting benefits
when they are earned by workers rather than when they are paid out, that program
would have shown a substantial deficit last year. The deficit would have been large
enough to push the total Federal budget into the red, and an accrual-based budget
measure could conceivably record noticeable deficits over the next few years, rather
than the surpluses now indicated by the official projections for either the total unified budget or the on-budget accounts. Such accruals take account of still growing
contingent liabilities that, under most reasonable sets of actuarial assumptions, currently amount to many trillions of dollars for Social Security benefits alone.
Even if accrual accounting is set aside, it might still be prudent to eschew new
longer-term, potentially irreversible commitments until we are assured that the onbudget surplus projections are less conjectural than they are, of necessity, today.
Allowing surpluses to reduce the debt to the public, rather than for all practical
purposes irrevocably committing to their disposition in advance, can be viewed as
a holding action pending the clarification of the true underlying budget outcomes
of the next few years. Debt repaid can very readily be reborrowed to fund delayed
initiatives.
More fundamentally, the growth potential of our economy under current circumstances is best served, in my judgment, by allowing the unified budget surpluses
presently in train to materialize and thereby reduce the Treasury debt held by the
public.
Yet I recognize that growing budget surpluses may be politically infeasible to defend. If this proves to be the case, as I have also testified previously, the likelihood
of maintaining a still satisfactory overall budget position over the longer run is
greater, I believe, if surpluses are used to lower tax rates rather than to embark
on new spending programs. History illustrates the difficulties of keeping spending
in check, especially in programs that are open-ended commitments, which too often
have led to larger outlays than initially envisioned. Decisions to reduce taxes, however, are more likely to be contained by the need to maintain an adequate revenue
base to finance necessary Government services. Moreover, especially if designed to
lower marginal rates, tax reductions can offer very favorable incentives for economic
performance.
Conclusion
As the U.S. economy enters a new century as well as a new year, the time is opportune to reflect on the basic characteristics of pur economic system that have
Drought about our success in recent years. Competitive and open markets, the rule
of law, fiscal discipline, and a culture of enterprise and entrepreneurship should
continue to undergird rapid innovation and enhanced productivity that in turn
should foster a sustained further rise in living standards. It would be imprudent,
however, to presume that the business cycle has been purged from market economies so long as human expectations are subject to bouts of euphoria and disillusionment. We can only anticipate that we will readily take such diversions in stride and
trust that beneficent fundamentals will provide the framework for continued economic progress well into the new millennium.
44
For use at 10:00 a.m., EST
Thursday
February 17, 2000
Board of Governors of the Federal Reserve System
/"iiSllfe'-
Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 17, 2000
45
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 17, 2000
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the
Full Employment and Balanced Growth Act of 1978.
Sincerely,
Alan Greenspan, Chairmai
46
Table of Contents
Page
Monetary Policy iind the Economic Outlook
Economic and Financial Developments in 1999 and Early 2000
1
47
Monetary Policy Report to the Congress
Report submitted to the Cungress on February 17,
2UOO, pursuant to ihe Full Employment and Balanced
Growth Act of 1978
MONETARY POLICY .AND THE
ECONOMIC OUTLOOK
The U.S. economy posted another exceptional performance in 1999. The ongoing expansion appears to
have maintained strength into early 2000 as it set a
record for longevity, and—aside from ihe direct
effects of higher crude oil prices—inflation has
remained subdued, in marked contrast to the typical
experience during previous expansions. The past year
brought additional evidence that productivity growth
has improved substantially since the mid-1990s,
boosting living standards while helping to hold down
increases in costs and prices despite very light labor
markets.
The Federal Open Market Committee's pursuit of
linancial conditions consistent with sustained expansion and low inflation has required some adjustments
to the sellings of moneiary policy instruments over
the past two years. In late 1998, lo cushion the U.S.
economy from the effects of disruptions in world
financial markets and to ameliorate some of the
resulting strains, money market conditions were
eased. By the middle of last year, however, wilh
financial markets resuming normal functioning, foreign economies recovering, and domestic demand
continuing to outpace increases m productive potential, the Committee began to reverse that easing.
As ihe year progressed, foreign economies, in
general, recovered more quickly and displayed
greater vigor than had seemed likely at the start of
ihe year. Domestically, the rapid productivity growth
raised expectations of future incomes and profits and
thereby helped keep spending moving up at a faster
clip than current productive capacity. Meanwhile,
prices of most internationally traded materials
rebounded from their earlier declines; this turnaround, together with a flattening of the exchange
value of the dollar after its earlier appreciation, translated into an easing of downward pressure on the
prices of imports in general. Core inflation measures
generally remained low, but with the labor market at
its tightest in three decades and becoming tighter, the
risk that pressures on costs and prices would eventually emerge mounted over the course of the year. To
maintain the low-inflation environment that has been
so important to the sustained health of the current
expansion, the FOMC ultimately implemented four
quarter-point increases in the intended federal funds
rate, the most recent of which came at the beginning
of this month. In total, the federal funds rale has been
raised 1 percentage point, although, at 5V* percent, it
stands only Vt point above its level just before the
autumn-1998 linancial market turmoil. At its most
recent meeting, the FOMC indicated that risks appear
to remain on the side of heightened inflation pressures, so it will need to remain especially attentive to
developments in this regard.
Moneiary Policy, Financial Markets,
and (he Economy over 1999 and Early 2000
The first quarter of 1999 saw a further unwinding of
ihe heightened levels of perceived risk and risk aversion that had afflicted financial markets in the autumn
of 1998: investors became much more willing lo
advance funds, securities issuance picked up, and risk
spreads fell further—though not back to the unusually low levels of ihe first half of 1998. At the same
time, domestic demand remained quite strong, and
foreign economies showed signs of rebounding. The
FOMC concluded at its February and March meetings that, if these trends were to persist, the risks of
the eventual emergence of somewhai greater inflation
pressures would increase, and it noted lhat a case
could be made tor unwinding pan of the easing
actions of the preceding fall. However, the Committee hesitated to adjust policy before having greater
assurance that the recoveries in domestic financial
markets and foreign economies were on tirm footing.
By the May meeting, these recoveries were solidifying, and the pace of domestic spending appeared to
be outstripping the growth of the economy's potential, even allowing for an appreciable acceleration
in productivity. The Committee still expected some
slowing in the expansion of aggregate demand, but
the timing and extent of any moderation remained
uncertain. Against this backdrop, the FOMC main-
48
2
Monetary Policy Report LO me Congress Q February 2000
tained an unchanged policy stance bui announced
immediately after the meeting that it had chosen a
directive tilted toward the possibility of a firming of
rales. This announcement implemented the disclosure
policy adopted in December 1998, whereby major
shifts in the Committee's views about the balance of
risks or the likely direciion of future policy would be
made public immediately. Members expected that, by
making the FOMC's concerns public earlier, such
announcements would encourage financial market
reactions to subsequent information that would help
stabilize the economy. In practice, however, ihose
reactions seemed to be exaggerated and lo focus even
more than usual on possible near-term Committee
action.
Over subsequent weeks, economic activity continued to expand vigorously, labor markets remained
very tight, and oil and other commodity prices rose
further. In this environment, the FOMC saw an
updrift in inflation as a significant risk in the absence
of some policy firming, and at the June meeting it
raised the intended level of the federal funds rate
'/4 percentage point. The Committee also announced
a symmetric directive, noting that the marked degree
of uncertainty about the extent and timing of prospective inflationary pressures meant that further finning
of policy might not be undertaken in the near term,
but that the Committee would need to be especially
alert to emerging inflation pressures. Markets rallied
on the symmetric-directive announcement, and the
strength of this response together with market commeniary suggested uncertainty about the interpretation of the language used to characterize possible
future developments and about the time period to
which the directive applied.
In [he period between the June and August meetings, the ongoing strength of domestic demand and
further expansion abroad suggested that at least part
of the remaining easing put in place the previous fall
to deal with financial market stresses was no longer
needed. Consequently, at the August meeting the
FOMC raised the intended level of the federal funds
rate a further Vi percentage point, to 5'/t percent. The
Committee agreed that this action, along with that
taken in June, would substantially reduce inflation
risks and again announced a symmetric directive. In a
related action, the Board of Governors approved an
increase in the discount rate to 43/i percent. At this
meeting the Committee also established a working
group lo assess the FOMC's approach to disclosing
its view about prospective developments and to propose procedural modifications.
At its August meeting, the FOMC took a number
of actions lhat were aimed at enhancing the ability of
the Manager of the System Open Market Account to
counter potential liquidity strains in the period around
the century date change and that would also help
ensure the effective implementation of the Committee's monetary policy objectives. Although members
believed that efforts to prepare computer systems for
the century date change had made the probability of
significant disruptions quite small, some aversion to
Y2K risk exposure was already evident in the markets, and the costs thai might stem from a dysfunctional financing market at year-end were deemed to
be unacceptably high. The FOMC agreed to authorize, temporarily, (l)a widening of the pool of collateral lhat could be accepted in System open market
transactions, (2) the use of reverse repurchase agreement accounting in addition to the currently available matched sale-purchase transactions to absorb
reserves temporarily, and (3) the auction of options
on repurchase agreements, reverse repurchase agreements, and matched sale-purchase transactions that
could be exercised in the period around year-end.
The Committee also authorized a permanent extension of the maximum maturity on regular repurchase
and matched sale-purchase transactions from sixty to
ninely days.
The broader range of collateral approved for repurchase transactions—-mainly pass-through mortgage
securities of government-sponsored enterprises and
STRIP securities of the U.S. Treasury—would facilitate the Manager's task of addressing what could be
very large needs to supply reserves in the succeeding
months, primarily in response to rapid increases in
the demand for currency, at a time of potentially
heightened demand in various markets for U.S. government securities. The standby financing facility,
authorizing the Federal Reserve Bank of New York
to auction the above-mentioned options to the government securities dealers lhat are regular counterpanics in the System's open market operations,
would encourage marketmaking and the maintenance
of liquid financing markets essential to effective open
market operations. The standby facility was also
viewed as a useful complement to the special liquidity facility, which was lo provide sound depository
institutions with unrestricted access to the discount
window, at a penally rate, between October 1999 and
April 2000. Finally, the decision to extend the maximum maturity on repurchase and matched salepurchase transactions was intended to bring the terms
of such transactions into conformance with market
practice and to enhance [he Manager's ability over
ihe following months to implement the unusually
large reserve operations expected to be required
around the turn of the year.
49
Board of Governors of the Federal Reserve System
3
Selected interest rales
Ncm The dau air daily Veitical Line; intficaiF ihe days on which the
Feueraf Reserve announced 3 moneury policy ocnon "The dates on Ihe nonwn-
Incoming information during the period leading up
to the FOMC's October meeting suggested that the
growth of domestic economic activity had picked up
from the second quarter's pace, and foreign economies appeared lo be strengthening more than had
been anticipated, potentially adding pressure to
already-taut labor markets and possibly creating
inflationary imbalances that would undermine economic performance. Bui the FOMC viewed the risk
of a significant increase in inflation in the near term
as small and decided to await more evidence on how
the economy was responding to its previous tightenings before changing its poiicy stance. HOWCVCT, the
Committee anticipated thai the evidence might well
signal the need for additional tightening, and it again
announced a directive thai was biased toward
restraint.
Information available through mid-November
pointed toward robust growth in overall economic
activity and a further depletion of the pool of unemployed workers willing to take a job. Although higher
real interest rales appeared to have induced some
softening in interest-sensitive sectors of the economy,
the anticipated moderation in the growth of aggregate
demand did not appear sufficient to avoid added
pressures on resources, predominantly labor. These
conditions, along with further increases in oil and
other commodity prices, suggested a significant risk
that inflation would pick up overtime, given prevailing financial conditions. Against this backdrop, the
FOMC raised the target for the federal funds rate an
additional '/* percentage point in November. Ai that
lime, a symmetric directive was adopted, consistent
with the Committee's expectation that no further
policy move was likely to be considered before the
February meeting. In a related action, the Board of
those on which either rtK FOMC held a .scheduled meeting <
U wns announced Losi observations are lor Sebiuary 11.2000
Governors approved an increase in the discount rate
of '/4 percentage point, lo 5 percent.
At the December meeting, FOMC members held
the stance of policy unchanged and, to avoid any
misinterpretation of policy intentions that might
unsettle financial markets around the century date
change, announced a symmetric directive. But the
statement issued after the meeting also highlighted
members' continuing concern about inflation risks
going forward and indicated the Committee's intention to evaluate, as soon as its next meeting, whether
those risks suggested that further tightening was
appropriate.
The FOMC also decided on some modifications
to its disclosure procedures at the December meeting, at which the working group mentioned above
transmitted its final report and proposals. These
modifications, announced in January 2000, consisted
primarily of a plan to issue a statemenl after every
FOMC meeting that not only would convey the
current stance of policy but also would categorize
risks to the outlook as either weighted mainly toward
conditions that may generate heightened inflation
pressures, weighted mainly toward conditions that
may generate economic weakness, or balanced with
respect to the goals of maximum employment and
stable prices over the foreseeable future. The changes
eliminated uncertainty about the circumstances
under which an announcement would be made;
they clarified that the Committee's statement about
future prospects extended beyond the mtermeeting
period; and they characterized the Commitlee' s views
about future developments in a way that reflected
policy discussions and that members hoped would
be more helpful to the public and to financial
markets.
50
4
Monetary Policy Report to the Congress D February 2000
Financial markets and ihe economy came through
the century date change smoothly. By the February
2000 meeting, there was littJe evidence that demand
was coming inlo line with potential supply, and the
risks of inflationary imbalances appeared to have
risen. At the meeting, the FOMC raised its target
for the federal funds rale 'A percentage point to
53/4 percent, and characterized the risks as remaining on the side of higher inflation pressures. In a
related action, the Board of Governors approved a
'/4 percentage point increase in the discount rate, to
5 'A percent.
Economic Projections for 2000
The members of the Board of Governors and the
Federal Reserve Bank presidents, all of whom participate in the deliberations of the FOMC, expect to see
another year of favorable economic performance in
2000, although the risk of higher inflation will need
to be watched especially carefully. The central tendency of the FOMC participants' forecasts of real
GDP growth from the fourth quarler of 1999 to the
founh quarter of 2000 is 31/: percent to 33/4 percent. A substantial pan of the gain in output will
likely come from further increases in productivity.
Nonetheless, economic expansion at the pace that is
anticipated should create enough new jobs to keep
the unemployment rate in a range of 4 percent
to 4% percent, close to its recent average. The central
tendency of the FOMC participants' inflation forecasts for 2000—as measured by the chain-type price
index for personal consumption expenditures—is
J-Vi percent to 2 percent, a range that runs a little to
the low side of the energy-led 2 percent rise posted in
1999.' Even though futures markets suggest that
energy prices may turn down lacer this year, prices
elsewhere in the economy could be pushed upward
I In past Monetary Policy Reports ID the Congress, [he FOMC has
framed its inflation forecasts in terms of the consumer price index.
The chain-Eype pn« index for PCE tiraws extensively on dasa from
Ihe consumer price index hut, while not entirely fife of measurement
problems, lias several advantages relative to the CPI. The PCE chaintype index is constructed from a formula that reflects ihe changing
composition of spending and thereby avoids some at the upward bias
associated with Ihe fixed-weight nature of the CPI. In addition, the
weights are based on a more comprehensive measure of expenditures.
Finally, historical data used in the PCE price index can be revised to
account for newly available information and lor improvements in
measurement techniques, including those that alfect source data from
[he CPI. the result is a more consistent series over time. This switch in
presentation notwithstanding, the FOMC will continue 10 rely on a
variety of aggregate price measures, us well as other information an
prices and costs, in assessing the path of inflauon.
economic projections for 2000
Central
tendency
1 Change from average lot fourth qua
auarwr of 2000.
2 Chain-weighted.
by a combination of factors, including reduced
restraint from non-oil import prices, wage and price
pressures associated with lagged effects of ihe pasl
year's oil price rise, and larger increases in costs thai
might be forthcoming in another year of tight labor
markets.
The performance of the economy—both the rale of
real growth and the rale of inflaiion—wil] depend
importantly on ihe course of productivity. Typically,
in past business expansions, gains in labor productivity eventually slowed as rising demand placed
increased pressure on plant capacity and on the workforce, and a similar slowdown from the recent rapid
pace of productivity gain cannot be ruted out. But
with many firms still in the process of implementing
technologies that have proved effeclive in reorganizing internal operations or in gaining speedier access
to outside resources and markets, and with the technologies themselves, still advancing rapidly, a further
rise in productivity growth from the average pace of
receni years also is possible. To the extent thai rapid
productivity growth can be maintained, aggregate
supply can grow Taster ihan would otherwise be
possible.
However, ihe economic processes thai are giving
rise 10 faster productivity growth not only are lifting
aggregate supply but also are influencing the growth
»i aggregate spending. With firms perceiving aburtdani profit opportunities in productivity-enhancing
high-lech applications, investment in new equipment
has been surging and could well continue to rise
rapidly for some time. Moreover, expectations that
the investment in new technologies will generate
high returns have been lifting the stock market and,
in turn, helping to maintain consumer spending at a
pace in excess of the current growth of real disposable income. Impetus to demand from this source
also could persist for a while longer, given the current
51
Board of Governors of the Federal Reserve System
high levels of consumer confidence and the likely
lagged effects of the large increments to household
wealth registered to date. The boost to aggregate
demand from the marked pickup in productivity
growth implies that the level of interest rates needed
to align demand wiih potential supply may have
increased substantially. Although the recent rise in
interest rates may lead to some slowing of spending,
aggregate demand may wefl continue to outpace
gains in potential output over the near term, an imbalance that contains the seeds of rising inflationary
and financial pressures thai could undermine the
expansion.
In recent years, domestic spending has been able to
grow faster than production without engendering
inflation partly because the external sector has provided a safety valve, helping to relieve the pressures
on domestic resources. In particular, the rapid growth
of demand has been met in part by huge increases in
imports of goods and services, and sluggishness in
foreign economies has restrained the growth of
exports. However, foreign economies have been firming, and if recovery of these economies stays on
course, U.S. exports should increase faster than they
have in the past couple of years. Moreover, the rapid
rise of the real exchange value of the dollar through
mid-1998 has since given way to greater stability, cm
average, and the tendency of the earlier appreciation
to It mi I export growth and boost import growth is
now diminishing. From one perspective, these external adjustments are welcome because they will help
slow the recent rapid rates of decline in net exports
and the current account. They also should give a
boost 10 industries that have been hurt by the export
slump, such as agriculture and some parts of
manufacturing. At the same time, however, the
adjustments are likely to add to the risk of an upturn
in the inflation trend, because a strengthening of
exports will add to the pressures on U.S. resources
and a firming of the prices of non-oil imports
will raise costs directly and also reduce to some
degree the competitive restraints on the prices of U.S.
producers.
Domestically, substantial plant capacity is still
available in some manufacturing industries and could
continue to exert restraint on firms' pricing decisions,
even with a diminution of competitive pressures from
abroad. However, an already light domestic labor
market has tightened still further in recent months,
and bidding for workers, together with further
increases in health insurance costs that appear to be
coming, seems likely to keep nominal hourly compensation costs moving up at a relatively brisk pace.
To date, the increases in compensation have not had
5
serious inflationary consequences because they have
been offset by the advances in labor productivity,
which have held unit labor costs in check. But the
pool of available workers cannot continue to shrink
without at some point touching off cost pressures thai
even a favorable productivity trend might not be able
to counter. Although the governors and Reserve Bank
presidents expect productivity gains to be substantial
again this year, incoming data on costs, prices, and
price expectations will be examined carefully to make
sure a pickup of inflation does not start to become
embedded in the economy.
The FOMC forecasts are more optimistic than the
economic predictions that the Administration recently
released, but the Administration has noted that it is
being conservative in regard to its assumptions about
productivity growth and the potential expansion of
the economy. Relative to the Administration's forecast, the FOMC is predicting a somewhat larger rise
in real GDP in 2000 and a slightly lower unemployment rale. The inflation forecasts are fairly similar,
once account is taken of the tendency for the consumer price index to rise more rapidly than the
chain-type price index for personal consumption
expenditures.
Money and Debt Ranges for 2000
At its most recent meeting, the FOMC reaffirmed the
monetary growth ranges for 2000 that were chosen
on a provisional basis last July: 1 percent to 5 percent
for M2, and 2 percent 10 6 percent for M3. As has
been the case for some time, these ranges were
chosen lo encompass money growth under conditions
of price stability and historical velocity relationships,
rather than to center on the expected growth of money
over the coming year or 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 still has little
confidence thai money growth within any particular
range selected for the year would be associated with
the economic performance i! expected or desired.
2.
Ranges tor growth of monetary und debt aggregates
Percenl
A8grej.lt
M2
M3
199B
(999
2000
1-3
2-6
l-i
2-6
1-5
2-6
Nof t Change trom average for Fount) quarter of preceding y
52
6
Monetary Policy Report to the Congress D February 2000
Nonetheless, the Commiltee believes that money
growih has some value as an economic indicator, and
it will continue to monitor the monetary aggregates
among a wide variety of economic and financial data
to inform its policy deliberations.
M2 increased 6'A percent last year. With nominaf
GDP rising 6 percent, M2 velocity fell a bit overall,
although it rose in the tinal Iwo quarters of the year as
market interest rates climbed relative to yields on M2
assets. Further increases in market interest rates early
this year could continue to elevate M2 velocity. Nevertheless, given the Commitlce's expectations for
nominal GDP growth, M2 could still be above the
upper end of its range in 2000.
M3 expanded 71/; percent last year, and its velocity
fell about IV* percent, a much smaller drop than in
the previous year. Non-M2 components again exhibited double-digit growth, with some of the strength
attributable to long-term trends and some to precautionary buildups of liquidity in advance of the
century date change. One important trend is the shift
by nontinancial businesses from direct holdings
of money market instruments to indirect holdings
through institution-only money funds; such shifts
boost M3 at the same time they enhance liquidity for
businesses. Money market funds and large certificates of deposit also ballooned late in the year as a
result ol a substantial demand for liquidity around the
century iJate change. Adjustments from the temporarily elevated level of M3 at the end of 1999 are
likely to trim that aggregate's fourth-quarter-tofourth-quarter growth this year, but not sufficiently to
offset the downward trend in velocity. That trend,
together with the Committee's expectation for nominal GDP growth, will probably keep M3 above the
top end of its range again this year.
Domestic nonfinaneial debt grew 6'/j percent in
1999, near the upper end of the 3 percent to 7 percent
growih range the Committee established last February. This robust growth reflected large increases
in the debt of businesses and households that were
due to substantial advances in spending as well as to
debt-financed mergers and acquisitions. However, the
increase m private-sector debt was partly offset by a
substantial decline in federal debt. The Committee
left (he range for debt growth m 2000 unchanged at
3 perceni to 7 percent. Alter an aberrant period in the
1980s during which debt expanded much more rapidly ihari nominal GDP, the growih of debt has
relumed to its historical pattern of about matching
the growth of nominal GDP over the past decade, and
the Committee members expect debt to remain within
its range again this year.
ECONOMIC AND FINANCIAL DEVELOPMENTS
IN 1999 AND EARLY 2000
The U.S. economy retained considerable strength
in 1999. According to the Commerce Department's
advance estimate, the rise in real gross domesticproduct over the tour quarters of the year exceeded
4 percent for the fourth consecutive year. The growth
of household expenditures was bolstered by further
substantial gains in real income, favorable borrowing
terms, and a soaring stock market. Businesses seeking to maintain their competitiveness and profitability
continued 10 invest heavily in high-tech equipment;
external financing conditions in both debt and equity
markets were quite supportive. In the public sector,
further strong growth of revenues was accompanied
by a step-up in the growth of government consumption and investment expenditures, the part of government spending that enters directly into real GDP.
The rapid growth of domestic demand gave rise to a
further huge increase in real imports of goods and
services in 1999. Exports picked up as foreign economies strengthened, but the gain feil short of that for
imports by a large margin. Available economic indicators for January of this year show the U.S. economy
continuing lo expand, with labor demand robust and
the unemployment rate edging down to its lowest
level in thirty years.
The combination of a strong US. economy and
improving economic conditions abroad led to firmer
prices in some markets this past year. Industrial commodity prices turned up—sharply in some cases-—
after having dropped appreciably in 1998. Oil prices,
responding both to OPEC production restraint and to
the growth of world demand, more than doubled over
the course of the year, and the prices of non-oil
imports declined less rapidly than in previous years.
Change in real GDP
,1,1,1111
53
Board of Governors of the Federal Reserve System
Change in PCE chain-type price index
7
Change in real income and consumption
Illlllhl
when a rising dollar, as well as sluggish conditions
abroad, had pulled them lower. The higher oil prices
of 1999 translated into sharp increases in retail energy
prices and gave a noticeable boost to consumer prices
overall; ihe chain-type price index for personal
consumption expenditures rose 2 percent, double the
increase of 1998. Outside the energy sector, however,
consumer prices increased at about the same low rate
as in the previous year, even as the unemployment
rate continued to edge down. Rapid gains in productivity enabled businesses to offset 3 substantial
portion of the increases in nominal compensation,
thereby holding the rise of unit labor costs in check,
and business pricing policies continued to be driven
to a large extent by the desire to maintain or increase
market share at the expense of some slippage in unit
profits, albeit from a high level.
The Household Sector
Personal consumption expenditures increased about
5Vi percent in real terms in 1999, a second year of
exceptionally rapid advance. As in other recent years,
the strength of consumption in 1999 reflected sustained increases in employment and real hourly pay,
which bolstered the growth of real disposable personal income. Added impetus came from another
year of rapid growth in net worth, which, coming on
lop of the big gains of previous years, led households
in the aggregate to spend a targer portion of their
current income than they would have otherwise. The
personal saving rate, as measured in the national
income and product accounts, dropped further, to an
average of about 2 percent in the final quarter of
1999; ii has fallen about 4'/> percentage points over
the past five years, a period during which yearly
gains in household net worth have averaged more
than 10 percent in nominal terms and the ratio of
household wealth lo disposable personal income has
moved up sharply.
The strength of consumer spending this past
year extended across a broad front. Appreciable gains
were reported for most types of durable goods.
Spending on motor vehicles, which had surged about
\31A percent in 1998, moved up another 51/: percent in 1999. The inflation-adjusted increases for
furniture, appliances, electronic equipment, and other
household durables also were quite large, supported
in part by a strong housing market. Spending on services advanced about 4'/z percent in real terms, led by
sizable increases tor recreation and personal business
services. Outlays for nondurabies, such as food and
clothing, also rose rapidly. Exceptional strength in
Wealth and saving
. Ratio or n« wonh of households 10 disposable pen
nd through 1999Q3
The data eilendlnroiifh 1999 Q4
54
8
Monetary Policy Report to the Congress D February 2CXX)
Change in real residential investmem
M..I.I.
the purchases of some nondurables toward the end
of the year may have reflected precautionary buying
by consumer; m anticipation of the century date
change; it is notable in this regard that grocery store
sales were up sharply in December and then fell back
\n January, according to the latest report on retail
sales.
Households also continued to boost their expenditures on residential structures. After having surged
11 percent in 1998. residential investment rose about
3'Xt percent over the four quarters of 1999, according
to the advance estimate from the Commerce Department. Moderate declines in investmem in the second
half of the year offset only pan of the increases
recorded in the first half. As with consumption expenditures, investment in housing was supported by the
sizable advances in real income and household net
worth, hul this spending category was also tempered
a little by a rise in mortgage inieresi rales, which
likely was an important factor in the second-half
downturn.
Nearly all the indicators of housing activity showed
upbeat results for the year. Annual sales of new and
existing homes reached new peaks in 1999. ^urpassing the previous highs set in 1998. Although sales
dropped back a touch in the second half ot' the year,
their level through year-end remained quite high by
historical .standards. Builders' backlogs also were Jt
high levels and helped support new construction activity even as sales eased. Late in the year, reports
that shortages of skilled workers were delaying construction became less frequent as building activity
wound down seasonally, but builders also continued
to express concern about potential worker shortages
in 2000. For 1999 in total, construction began on
more than 1.3 million single-family dwellings, the
mosi •since the late 1970s: approximately 330.000
multifamily units also were started, about the same
number as in each of the two previous years. House
prices rose appreciably and, together with the new
investment, further boosted household net worth in
residential real estate.
The increases in consumption and residential
investment in 1999 were, in pan, financed by an
expansion of household debt estimated at 9Vi percent, the largest increase in more than a decade.
Mortgage debt, which includes the borrowing against
owner equity that may be used for purposes other
than residential investment, grew a whopping
!fl'/4 percent. Higher interest rales led to a sharp drop
in refinancing activity and prompted a shift toward
the use of adjustable-rate mortgages, which over the
year rose from 10 percent to 30 percent of originations. Consumer credit advanced 71/* percent, boosted
by heavy demand for consumer durables and other
big-ticket purchases. Credit supply conditions were
also favorable; commercial banks reported in Federal
Reserve surveys that they were more willing than in
;he previous year or two 10 mal<e consumer installment loans and that they remained quite willing to
make mortgage loans.
The household sector's debt-service burden edged
up to its highest level since the lale 1980s; however,
with employment rising rapidly and asset values
escalating, measures of credit quality for household
debl generally improved in 1999. Delinquency rates
on home mortgages and credit cards declined a bit,
and tho;.e on auto loans tell more noticeably. Personal bankruptcy tilings fell sharply after having
risen for several years to 1997 and remaining elevated in 1998.
55
Board of Governors of t/ie Federal Reserve Svsiem
The Business Sector
Private nonresidential fixed investment increased
7 percent during 1999, extending by another year a
long run of rapid growth in real investment outlays.
Sirengih in capital investment has been underpinned
in recent years by the vigor of the business expansion, by the advance and spread of computer technologies, and by the ability of most businesses to
readily obtain funding through the credit and equity
miirkcls.
Investment in high-tech equipment continued to
soar in 1999. Outlays for communications equipment
rose about 25 percent over the course of the year,
boosted hy a number of factors, including the expansion of wireless communications, competition in telephone markets, the continued .spread of the Internet.
and the demand of Internet users for faster access to
u. Computer outlays rose nearly 40 percent in real
terms, and the purchases of computer software, which
in the national accounts are now counted as pan of
private lixed investment, rose about 13 percent; for
both computers and software the increases were
roughly in line with the annuai average gains during
previous years of the expansion.
The timing of investment in high-tech equipment
over the past couple of years was likely affected to
=ome degree by business preparations for the century
date change. Many large businesses reportedly invested must heavily in new computer equipment before the siart of 1999 to leave sufficient time for their
systems to be tested well before the start of 2000; a
very steep nse in computer investment in 1998—
roughly 60 percent in real terms—is consistent with
those reports. Some of the purchases in preparation
for Y2K most likely spilled over into 1999, but the
past year also brought numerous reports of busiCtiangc in ical nonresident) al lixoJ inveilmc:ni
9
nesses wanting to stand pat with existing systems
until after the turn of the year. Growth in computer
investment in the final quarter of 1999, just before the
century rollover, was the smallest in several quarters.
Spending on other types of equipment rose moderately, on balance, in 1999, Outlays for transportation
equipment increased substantially, led by advances
in business purchases of motor vehicles and aircraft.
By contrast, a sharp decline in spending on industrial
machinery early in the year held the yearly gain for
[hat category to about 2 percent; over the final three
quarters of the year, however, outlays picked up
sharply as industrial production strengthened.
Private investment in nonresidential structures fell
5 percent in 1999 according to the advance estimate
from the Commerce Department. Spending on structures had increased in each of the previous seven
years, rather briskly at times, and the level of investment, though down this past year, remained relatively
high and likely raised the real stock of capital
invested in structures appreciably further. Real expenditures on office buildings, which have been climbing
rapidly for several years, moved up further in 1999,
to the highest level since the peak of the building
boom of the 1980s. In contrast, investment in other
types of commercial structures, which had already
regained its earlier peak, slipped back a little, on net,
this past year. Spending on industrial structures,
which accounts for roughly 10 percent of total real
outlays on structures, fell for a third consecutive year.
Outlays for the main types of institutional structures
also were down, according to the initial estimates.
Revisions to the data on nonresidential structures
often are sizable, and the estimates for each of the
three years preceding 1999 have eventually shown a
good bit more strength than was initially reported.
After increasing for two years at a rate of about
6 percent, ncmfarm business inventories expanded
more slowly this past year—about 3'/a percent
according to the advance GDP report. During the
year, some businesses indicated that they planned to
carry heavier stocks toward year-end to protect themselves against possible Y2K disruptions, and the rate
of accumulation did in fact pick up appreciably in the
fall. But business Sinai sales remained strong, and the
ratio of nonl'arm stocks to final sales changed little,
holding toward the lower end of [he range of the past
decade. With the ratio so low, businesses likely did
not enter the new year with excess stocks.
After slowing to a I percent rise in 1998, the
economic profits of U.S. corporations—that is. book
profits with inventory valuation and capital consumption adjustments—picked up in 1999. Economic profits over the first three quarters of the year averaged
56
10
Monetary Polity Report lo the Congress D February 2000
Before-lax protits 2* a share of GDP
Change m real private nonfarm inventories
.ih.lli
about y/i percent above the level of a year curlier.
The earnings of corporations from ihcir operations
outside the United Slates rebounded in 1999 from a
brief but steep decline m [he second half of 1998,
when financial market disruptions were affecting the
world economy. The profits earned by financial corporations on their domestic operations also picked up
after having been slowed in 1998 by the financial
turmoil; growth of these profits in 1999 would have
been greater but for a large payoui by insurance
companies to cover damage from Hurricane Floyd.
The profits that nonfinancial corporations earned on
their domestic operations in the first three quarters of
1999 were about 2'/3 percent above the level of a year
earlier; growth of these earnings, which account for
about two-thirds of all economic profits, had slowed
to jusi over 2 percent in 1998 alter averaging 13 percent at a compound annual rate in the previous sis
years. Nontinancial corporations have boosted vol-
ume substantially further over the past two years, but
profits per unit of output have dropped back somewhat from iheir 1997 peak. As of the third quarter
of lasi year, economic profits of nonfinancial corporations amounted to slightly less than 11'/; percent
of the nominal output of these companies, compared
with a quarterly peak of about 12V<i percent two years
earlier.
The borrowing needs of nonfinancial corporations
remained sizable in 1999. Capital spending outstripped internal cash flow, and equity retirements
that resulted from stock repurchases and a blockbuster pace of merger activity more than offset record
volumes of both seasoned and initial public equity
offerings. Overall, the debt of nonfinancial businesses
grew 101/? percent, down only a touch from its
decade-high 1998 pace.
Gross wrporali; bond issuance
D High yield
]
1
A
S
O
N
D
J
F
M
A
M
J
I
A
S
O
N
D
1
57
Board of Governors of the Federal Reserve System
The strength in business borrowing was widespread across funding sources. Corporate bond
issuance was robust, particularly in the tirst half of
the year, though the markets' increased preference
for liquidity and quality, amid an appreciable rise
in defaults on junk bonds, left issuance ot' belowin vestment-grade securities dawn more than a quartet
from their record pace in 1998. The receptiveness of
the capital markets helped firms to pay down loans at
banks—which had been boosied lo an 11 Vt perceni
gain in I99K by the financial market turmoil that
year—and growth in these loans slowed to a more
moderate 514 perceni pace in 1999. The commercial
paper markel continued to expand rapidly, with
domestic nonfinancial outsiandings rising 18 perceni
on top of the 14 percent gain in 1998.
Commercial mortgage borrowing was strong again
as well, as real estate prices generally continued
to rise, albeit at a slower pace than in 1998, and
vacancy rates generally remained near historical
lows. The mix ot lending shifted back to banks and
life insurance companies from commercial morlgagebacked securities, as conditions in the CMBS market,
especially investor appetites for lower-rated tranches,
remained less favorable than they had been before the
credit market disruptions in the fall ot" 1998.
Risk spreads on corporate bonds seesawed during
1999. Over the early part of the year, spreads reversed
pan of the 1998 run-up as markets recovered. During
the summer, they rose again in response to concerns
about market liquidity, expectations of a surge in
financing before the ceniury date change, and
anticipated firming of monetary policy. Swap spreads.
in particular, exhibited upward pressure at this time.
The likelihood of year-end difficulties seemed to
diminish in tiie Fall, and spreads again relreaied,
ending the year down on balance but generally above
the levels lhai had prevailed over the several years up
to mid-1998.
Federal Receive surveys indicated thai banks
firmed terms and standards for commercial and industrial bans a bit further, on balance, in 1999. In the
syndicated loan market, spreads for lower-rated borrowers also ended the year higher, on balance, after
rising substantially in 199R. Spreads for higher-rated
borrowers were fairly steady through 1998 and early
1999, widened a bit around midyear, and then fell
back to end the year about where they had started.
The ratio of nei interest payments to cash flow for
nonfinancial firms remained in the low range it has
occupied for the past few years, bul many measures
of credit quality nonetheless deteriorated in 1999.
Moody's Investors Service downgraded more nonfinancial debt issuers than it upgraded over the year,
affecting a nei $78 billion of debt. The problems dial
emerged in the bond market were concentrated
mostly among borrowers in the junk sector, and partly
reflected a fallout from the large volume of issuance
and Ihe generous terms available in 1997 and early
1998: defaull rates on junk bonds rose to levels not
seen since the recession of 1990-91. Delinquency
rates on C&I loans at commercial banks ticked up in
1999, albeit from very low levels, while the chargeotT rale for those loans continued on its upward trend
of the past several years. Business failures edged up
last year but remained in a historically !ow range.
Spread 01 corporate bond yields
over Treasury security yields
Net mieresi payments of nonfmancial corporations
relative ro cash flow
NOTI The Jaia jjc doily The spread i»i high-yield bondi compares the yield
in the Memll Lyrah I "^5 in<fc* with thai on o seven-year Tieuury. ibc odief
wo ^pitil^i compare yieJOs *in [he appiapnqie Memll Lynch indcAti wiih ihai
m aien-^u lirasury Lasi itbservaliens orp Iw K-ctmary 11. 2000
I1
The doia art quarterly andfxicnd Ehmugh I999Q3
58
12
Monetary Policy Report lo die Congress Q February 2000
Annual change in real government expenditures
on consumption and investment
n Federal
— • Stare and local
The Government Sector
Buoyed by rapid increases m receipts and favorable
budgel balances, the combined real expenditures of
federal, slate, and local governments on consumption
and investment rose about 4'/j percent from the fourth
quarter of 1998 to the fourth quarter of 1999. Annual
data, which smooth through some of the quarterly
noise ihat is often evident in government outlays,
showed a gain in real spending of more than 3'/2 perceni ihis past year, the Jargesi increase of the expansion. Federal expenditures on consumption and
investment were up nearly 3 percent in annual terms;
real defense expenditures, which had trended lower
through most of the 1990s, rose moderately, and
outlays for nondefense consumption and investment
increased sharply. Meanwhile, the consumption and
investment expenditures of slate and local governments rose more than 4 percent in annual terms;
Federal receipts and expenditures
UK unified budget anil are lor UK
growth of these outlays has picked up appreciably as
the expansion has lengthened.
At the federal level, expenditures in [he unified
budget rose 3 percent in fiscal 1999, just a touch less
than the 3'/4 percent rise of the preceding fiscal year.
Faster growth of nominal spending on items Ihat are
included in consumption and investment was offset in
the most recent fiscal year by a deceleration in other
categories. Net interest outlays fell more than 5 percent—enough to trim toial spending growth about
Vi percentage point—and only small increases were
recorded in expenditures for social insurance and
income security, categories that together accoum for
nearly half of total federal outlays. In contrast, federal expenditures on Medicaid, after having slowed
in 19% and 1997, picked up again in the past two
fiscal years. Spending on agriculture doubled in fiscal
1999; the increase resulted both from a step-up in
payments under farm safety net programs that were
retained in the "freedom to farm" legislation of 1996
and From more recent emergency farm legislation.
Federal receipts grew 6 percent in fiscal 1999 after
increases that averaged close to 9 percent in the two
previous fiscal years. Net receipts from taxes on
individuals continued to outpace the growth of personal income, but by less than in other recent years,
and receipts from corporate income taxes fell moderately. Nonetheless, with total receipts growing faster
than spending, the surplus in the unified budget continued to rise, moving from $69 billion in fiscal 1998
to $124 billion this past fiscal year. Excluding net
interest payments—a charge resulting from past
deficits—the federal government recorded a surplus
of more than S350 billion in fiscal 1999.
Federal saving, a measure that results from a translation of the federal budget surplus into terms consistent with the national income and product accounts,
amounted to 21/4 percent of nominal GDP in the first
three quarters of 1999, up from I'/i? percent in 1998
and '/i percent in 1997. Before 1997, federal saving
had been negative for seventeen consecutive years,
by amounts exceeding 3 percent of nominal GDP in
several years—most recently in 1992. The change in
the fcderai government's saving position from t992
to 1999 more than offset the sharp drop in the personal saving rate and helped lift national saving from
less than 16 percent of nominal GDP in 1992 and
1993 to a range of about IS'/? percent to 19 percent
over the past several quarters.
Federal debt growth has mirrored the turnabout in
the government's saving position. In the 1980s and
early 1990s, borrowing resulted in large additions
to the volume of outstanding government debt. In
contrast, with the budget in surplus the past two
59
Board of Governors of the Federal Reserve System
National saving
years, the Treasury has been paying down debt. Without [he rise in federal saving and the reversal in
borrowing, imeresi rales in recent years likely would
have been higher than they have been, and private
capital Formation, a key element in the vigorous
economic expansion, would have been lower, perhaps appreciably.
The Treasury responded lo its lower borrowing
requirements in 1999 primarily by reducing the number of auctions of thirty-year bonds from three to two
and by trimming auciion sizes for notes and Treasury
inflation-indexed securities (TIIS). Weekly bill volumes were increased from 1998 levels, however, to
help build up cash holdings as a Y2K precaution. For
2000, the Treasury plans major changes in debt management in an attempt to keep down the average
maturity of the debt and maintain sufficient auction
sizes to support the liquidity and benchmark status of
its most recently issued securities, while still retiring
Federal government debl held by the public
13
large volumes of debt. Alternate quarterly refunding
auctions of live- and ten-year notes and semiannual
auctions of thirty-year bonds will now be smaller
reopenings of existing issues rather than new issues.
Thirty-year TIIS will now be auctioned once a year
rather than twice, and the two auctions of ten-year
TIIS will be modestly reduced. Auctions of one-year
Treasury bills will drop from thirteen a year to four,
while weekly bill volumes will rise somewhat.
Finally, the Treasury plans to enter the market to buy
back in "reverse auctions" as much as $30 billion of
outstanding securities this year, beginning in March
or April.
State and local government debt expanded 4V* percent in 1999, well off last year's elevated pace.
Borrowing for new capital investment edged up, but
the roughly full-percentage-point rise in municipal
bond yields over the year led to a sharp drop in
advance refundings, which in turn pulled gross issuance below last year's level. Tax revenues continued
to grow at a robust rate, improving the financial
condition of states and localities, as reflected in a
ratio of debt rating upgrades to downgrades of more
than three to one over the year. The surplus in the
current account of state and local governments in the
first three quarters of 1999 amounted to about'/: percent of nominal GDP, about the same as in 1998 but
otherwise the largest of the past several years.
The External Sector
Trade and the Current Account
U.S. external balances deteriorated in 1999 largely
because of continued declines in net exports of goods
and services and some further weakening of net
investment income. The nominal trade deficit for
goods and services widened more than $100 billion
in 1999, to an estimated $270 billion, as imports
expanded faster than exports. For the first three quarters of the year, the current account deficit increased
more than one-third, reaching $320 billion ai an
annual rate, or 3'/3 percent of GDP. In 1998, the
current account deficit was 21/; percent of GDP.
Real imports of goods and services expanded
strongly in 1999—about 13 percent according to
preliminary estimates—as the rapid import growth
during the first half of the year was extended through
the second half. The expansion of real imports was
fueled by the continued strong growth of U.S. domestic expenditures. Declines in non-oil import prices
through most of the year, partly reflecting previous
dollar appreciation, contributed as well. All major
60
14
Monetary Policy Report to the Congress D February 2000
U.S. current account
I
I9SI 1983 1985 1987 1989 1991 1993 1995 1997 1999
it. The observation for 1999 li Ihe awrage far Iht firs! three qua
import categories other than aircraft and oil recorded
strong increases. While U.S. consumption of oil rose
about 4 percent in 1999, the quantity of oil imported
was about unchanged, and inventories were drawn
down.
Real exports of goods and services rose an estimated 4 percent in 1999, a somewhat faster puce lhan
in 1998. Economic activity abroad picked up, particularly in Canada, Mexico, and Asian developing
economies. However, the lagged effects of relative
prices owing to past dollar appreciation held down
exports. An upturn in U.S. exports io Canada,
Mexico, and key Asian emerging markets contrasted
with a much (latter pace of exports to Europe, Japan,
and South America. Capital equipment composed
about 45 percent of U.S. goods exports, industrial
supplies were 20 percent, and agricultural, automotive, and consumer goods were each roughly
10 percent.
Change in real imports and exports ol goods and services
Capital Account
U.S. capital flows in 1999 reflected the relatively
strong cyclical position of the U.S. economy and the
global wave of corporate mergers. Foreign purchases
of U.S. securities remained brisk—near the level of
the previous two years, in which they had been
elevated by the global financial unrest. The composition of foreign securities purchases in 1999 showed a
continued shift away from Treasuries, in part because
o!" the U.S. budget surplus anc! the decline in the
supply of Treasuries relative io other securities and,
perhaps, to a general increased tolerance of foreign
investors for risk as markets calmed after their turmoil of late 1998. Available data indicate that private
foreigners sold on net about $20 billion in Treasuries, compared with net purchases of $50 billion in
1998 and $150 billion in 1997. These sales of Treasuries were more than offset by a pickup in foreign
purchases of their nearest substitute—government
agency bonds—as well as corporate bonds and
equities.
Foreign direct investment flows into the United
Stales were also robust in 1999, with the pace of
inflows in the first three quarters only slightly below
the record inflow set in 1998. As in 1998, direct
investment inflows last year were elevated by several
large mergers, which (eft their imprint on other parts
of the capital account as well. In the past two years,
many of the largest mergers have been financed by
a swap of equity in the foreign acquiring firm for
equity in the U.S. firm being acquired. The Bureau
of Economic Analysis estimates that U.S. residenis
acquired more than $100 billion of foreign equity
through this mechanism in the first three quarters of
1999, Separate data on market transactions indicate
that U.S. residents made net purchases of Japanese
equities. They also sold European equities, probably
in an attempt to rebalance portfolios in light of the
equity acquired through stock swaps. U.S. residents
on net purchased a small volume of foreign bonds in
1999. U.S. direct investment in foreign economies
also reflected the global wave of merger activity in
1999 and will likely total something near its record
level of 1998.
Available data indicate a return to sizable capital
inflows from foreign official sources in 1999. following a modest outflow in 1998, The decline in foreign
official assets in the United States in 1998 was fairly
widespread, as many countries found their currencies
under unwanted downward pressure during the turmoil. By contrast, the increase in foreign official
reserves in the United Slates in 1999 was fairly
concentrated in a relatively few countries that experi-
61
Board oj Governors of (he Federal Reserve System
enced unwanted upward pressure on their currencies
vis-a-vis the U.S. dollar.
The Labor Marker
As in other recent years, the rapid growth of aggregate output in 1999 was associated with both strong
growth of productivity and brisk gains in employment. According lo the initial estimate for 1999,
output per hour in the nonfarm business secior rose
3'/4 percent over the four quarters of the year, and
historical data were revised this past year to show
stronger gains than previously reported in ihe years
preceding 1999. As the data stand currently, the average rate of rise in output per hour over the past four
y:irs is about 2H percent—up from an average of
\Vi percent from the mid-1970s to the end of 3995.
Some of ihe step-up in productivity growth since
!995 can be traced to high levels of capital spending
and an accompanying faster rate of increase in the
amount of capital per worker. Beyond that, the causes
are more difficult to pin down quantitatively but
are apparently related lo increased technologies!
and organizational efficiencies. Firms are not only
expanding the stock of capital but are also discovering many new uses for the technologies embodied in
that capita!, and workers arc becoming more skilled
at employing the new technologies.
The number of jobs on nonfarm payrolls rose
slightly more than 2 percent from the end of 1998 to
the end of 1999, a net increase of 2.7 million. Annual
job gains had ranged between 2V* percent and
2H percent over the 1996-98 period. Once again in
1999, the private service-producing sector accounted
for most of the total rise in payroll employment, led
15
Change in payroll employ men!
.iliiin
1995
\<f>1
1099
by many of the same categories that had been strong
in previous years—transportation and communications, computer services, engineering and management, recreation, and personnel supply. In the construction sector, employment growth remained quite
brisk—more than 4 percent from the final quarter of
f998 to the final quarter of 1999. Manufacturing
employment, influenced by spillover from the disruptions in foreign economies, continued to decline
sharply in the first half of the year, but losses thereafter were small as factory production strengthened.
Since the start of the expansion in 1991, the job count
in manufacturing has changed little, on net, but with
factory productivity rising rapidly, manufacturing
output has trended up at a brisk pace.
Measures of labor utilization
Change in uutpul per hour
iLmi
Nm'i Fhe augmented uneniployjiKni i
s [he number of unemployed plus
ihose who are no) m (he labor lurcc and w
job. dmded by ihe civilian tabor
force plus those ivta are rxfl tn the labor fi
M January 1*34 marts the minxluciiOP o
poini on JTC m>[ Jinxc.y cotnparabie wrih ihow of earlier pcntxls 1'hi
62
16
Monetary Policy Report to ihe Congress D February 2000
In 1999, employers continued lo face a tight labor
market. Some increase in the workforce came from
the pool of ihe unemployed, and the jobless rale
declined to an average of 4.1 percent in the fourth
quarter. In January 2000, the rate edged down to
4,0 percent, the lowest monthly reading since the
siari of the 1970s. Because the unemployment rate
is a reflection only of the number of persons who
are available for work and actively looking, it does
not capture potential labor supply lhal is one step
removed—namely those individuals who are interested in working but are not actively seeking work at
the current time. However, like the unemployment
rate itself, an augmented rate thai includes these
interested nonparticipants also has declined to a low
level, as more individuals have taken advantage
of expanding opportunities lo work.
Although the supply-demand balance in the labor
market tightened further in 1999, ihe added pressure
did not translate into bigger increases in nominal
hourly compensation. The employment cost index for
hourly compensation of workers in private nonfarm
industries rose 3.4 percent in nominal terms during
1999, little changed from the increase of the previous
year, and an alternative measure of hourly compensation from the nonfarm productivity and cost data
slowed from a 5Vi percent increase in 1998 to a
4!/2 percent rise this past year. Compensation gains in
1999 probably were influenced, in part, by the very
low inflation rate of 1998, which resulted in unexpectedly large increases in inflation-aiJiusied pay in
thai year and probably damped wage increments last
year. According to the employment cost index, the
hourly wages of workers in private industry rose
3V: percent in nominal terms alter having increased
Change in employment cosl index
Change in uml labor costs
LlilJii
about 4 percent in each of the Iwo previous years.
The hourly cost to employers of the nonwage benefits
provided to employees also rose 3'/z percent in 1999,
but this increase was considerably larger than those
of the past few years. Much of the pickup in benefit
costs came from a faster rate of rise in the costs of
health insurance, which were reportedly driven up by
several factors: a moderate acceleration in the price
of medical care, the efforts of some insurers to rebuild
profit margins, and the recognition by employers that
an attractive health benefits package was helpful
in hiring and retaining workers in a tight labor
market.
Because the employment cost index does not capture some forms of compensation that employers
have been using more extensively—for example,
stock options, signing bonuses, and employee price
discounts on in-store purchases—it has likely been
understating the true size of workers' gains. The
productivity and cost measure of hourly compensation captures at least some of the labor costs that the
employment cost index omits, and this broader coverage may explain why the productivity and cost
measure has been rising faster. However, it, too. is
affected by problems of measurement, some of which
would lead to overstatement of ihe rate of rise in
hourly compensation.
With the rise in output per hour in the nonfarm
business sector in !999 offsetting about three-fourths
of the rise in the productivity and cost measure of
nominal hourly compensation, nonfarm unit labor
costs were up just a shade more ihan 1 percent. Unil
labor costs had increased slightly more than 2 percent
in both 1997 and 1998 and less than I percent in
1996. Because labor costs are by far the most important item in total unit costs, these small increases
have been crucial to keeping inflation low.
63
Board of Governors of the Federal Reserve System
3.
Alternative measures ol price change
Prices
Rates of increase in the broader measures of' aggregate prices in 1999 were somewhat larger than those
ol 1998. The chain-type price index for GDP—which
measures inflation tor goods and services produced
domestically—moved up about 1 V~ percent, a pickup
of '/2 percentage point from the increase of 1998. In
comparison, acceleration in various price measures
lor goods and services purchased amounted to 1 percentage point or more: The chain-type price index for
personal consumption expenditures increased 2 percent, twice as much as in the previous year, and the
chain-type price index for gruss domestic purchases,
which measures prices of ihe aggregate purchases of
consumers, businesses, and governments, moved up
close to 2 percent after an increase of just !/4 percent
m 1998. The consumer price index rose more than
21/? percent over the four quarters of the year after
having increased \Vi percent in 1998,
The acceleration in the prices of goods and services purchased was driven in pan by a reversal in
import prices. In 1998, the chain-type price index for
imports of goods and services had fallen 5 percent.
Change in consumer prices
r price index lor all urban £
17
but it rose 3 percent in 1999. A big swing in oil
prices—down in 1998 but up sharply in 1999—
accounted for a large part of this turnaround. Excluding oil. the prices of imported goods continued to fall
in 1999 but, according to the initial estimate, less
rapidly than over the three previous years, when
downward pressure from appreciation of the dollar
had been considerable. The prices of imported materials and supplies rebounded, but the prices of imported capital goods fell sharply further. Meanwhile,
the chain-type price index for exports increased 1 percent in the latest year, reversing a portion of the
2'/2 percent drop of 1998, when the sluggishness of
foreign economies and the strength of the dollar had
pressured U.S. producers to mark down the prices
charged to foreign buyers.
Prices of domestically produced primary materials,
which tend lo be especially sensitive to developments
in world markets, rebounded sharply in 1999. The
producer price index for crude materials excluding
food and energy advanced about 10 percent after
having fallen about 15 percent in 1998, and the PPI
for intermediate materials excluding food and energy
increased about 1 'A percent, reversing a 1998 decline
of about that same size. But further along in the chain
of processing and distribution, the effects of these
increases were not very visible. The producer pnee
index for finished goods excluding food and energy
rose slightly less rapidly in 1999 than in 1998. and
the consumer price index for goods excluding food
and energy rose at about the same low rale thai it had
in 1998. Large gains in productivity and a margin of
excess capacity in the industrial sector helped keep
prices of goods in check, even as growth of domestic
demand remained exceptionally strong,
"Core" inflation at the consumer level—which
takes account of the prices of services as well as the
prices of goods and excludes food and energy
prices—changed little in 1999. The increase in the
core index for personal consumption expenditures,
I '/• percent over the four quarters of the year, was
ahoui the same as the increase in 1998. As measured
by the CPI. core inflation was 2 percent this past year,
about '/j percentage point lower than in 1998, but the
deceleration was a reflection of a change in CPI
methodology that had taken place at the stun of last
year: on a methodologically consistent basis, the rise
in the core CPI was about the same in both years.
In the national accounts, the chain-type price index
for private fixed investment edged up '/4 percent in
1999 after having fallen about -% perccni in 1998.
With construction costs rising, the index for residential invesimeni increased 3Vj percent, its largest
advance in several years. By comrast. the price index
64
18
Monetary Policy Repon to the Congress D February 2000
Change in consumer prices excluding loud and energy
Selected Treasury rales, daily data
ions arc lor February I I >(IK>
lor nonrcsidentia) investment declined moderately, as
u result of another drop in the index for equipment
and software. Falling equipment prices are one channel through which faster productivity gains have been
reshaping the economy in recent years; the drop in
prices has contributed to high levels of investment,
rapid expansion of the capital stock, and a step-up in
the growth of potential output.
U.S. Financial Markets
Financial markets were somewhat unsettled as 1999
began, with ihe disruptions of the previous autumn
still unwinding and the devaluation of the Brazilian
real causing some jitters around mid-January. However, market conditions improved into the spring,
evidenced in part by increased trading volumes and
narrowed bid-asked and credii spreads, as it became
increasingly evident that strong growth was continuing in ihe United Slates, and that economies abroad
were rebounding. In this environment, market participants began to anticipate that the Federal Reserve
would reverse the policy easings of the preceding
fall, and interest rates rose. Nevertheless, improved
profit expectations apparently more than offset the
interest rate increases, and equity prices continued to
climb until late spring. From May into the fall, both
equity prices and longer-ierrn interest rales moved in
a choppy fashion, while short-term interest rates
moved up with monetary policy tightenings in June.
August, and November. Worries about Y^K became
pronounced after midyear, and expectations of an
acceleration of borrowing ahead of the fourth quarter
prompted a resurgence in liquidity and credit premiums. In the closing months of the year, however, the
likelihood of outsizcd demands lor credit and liquidity over the year-end subsided, causing spreads io
narrow, and stock prices surged once again. After
ihe century date change passed without disruptions,
l i q u i d i t y improved and trading volumes grew,
although both bond and equity prices have remained
quite volatile so far this year.
Interest Rales
Over the first tew monihs of 1999, short-ierm Treasury rales moved in a narrow range, anchored by
an unchanged stance of monetary policy. Yields on
intermediate- and long-term Treasury securities rose,
however, as the flight to quality and liquidity of the
preceding fall unwound, and incoming data pointed
Select Treasury rales, quarterly datu
65
Board of Governors of the Federal Reserve System
10 continued robusi economic growth and likely Federal Reserve tightening. Over most of the rest of the
year, short-term Treasury rates moved broadly in line
with the three quarter-point increases in the target
lederal funds rate; longer-term yields rose less, as
markets had already anticipated some of those policy
actions.
Bond and note yields moved sharply higher from
early November 1999 to mid-January 2000, as Y2K
fears diminished, incoming data indicated surprising
economic vitality, and the century date change was
negotiated without significant technical problems.
In recent weeks, long-term Treasury yields have
retraced a good portion of that rise on expectations
of reduced supply stemming from the Treasury's new
buyback program and reductions in the amount of
bonds to be auctioned. This rally has been mostly
confined to the long end of the Treasury market;
long-term corporate bond yields have fallen only
slightly, and yields are largely unchanged or have
risen a little further ai maturities of ten years or less,
where most private borrowing is concentrated.
Concerns about liquidity and credit risk around the
century dale change led to large premiums in private
money market rates in the second half of 1999.
During the summer, this "safe haven" demand held
down rates on Treasury bills maturing early in the
new year, until the announcement in August that the
Treasury was targeting an unusually large year-end
cash balance, implying that it would issue a substantial volume of January-dated cash management bills.
Year-end premiums in eurodollar, commercial paper,
term federal funds, and other money markets—
Eurodollar deposit forward premium over year-end
measured as the implied forward rate for a monthlong
period spanning the turn relative to the rate for a
neighboring period—rose earlier and reached much
higher levels than in recent years.
Those year-end premiums peaked in late October
and then declined substantially, as markets reflected
increased confidence in technical readiness and special assurances from central banks that sufficient
liquidity would be available around the century date
change. Important among these assurances were several of the Federal Reserve initiatives described in the
first section of this report. Securities dealers took
particular advantage of the widened pools of acceptable collateral for open market operations and used
large volumes of federal agency debt and mortgagebacked securities in repurchase agreements with the
Open Market Desk in the closing weeks of the year,
which helped to relieve a potential scarcity of Treasury collateral over the turn. Market participants also
purchased options on nearly $500 billion worth of
repurchase agreements under the standby financing
facility and pledged more than S650 billion of collateral for borrowing at the discount window. With the
smooth rollover, however, none of the RP options
were exercised, and borrowing at the discount window turned out to be fairly light.
Equity Prices
Nearly all major stock indexes ended 1999 in record
territory. The Nasdaq composite index paced the
advance by soaring 86 percent over the year, and the
S&P 500 and Dow Jones Industrial Average posted
still-impressive gains of 20 percent and 25 percent.
Major slock price indexes
NOTE The Jala are daily For Ociober thf forward premiums air on
•word rates l»o monta abend lest one-morKh lorward rates one inomh ahead
• November Ihey are one-monlti forwird rales one month ahead less unemth deposit ram: and for December Ihey are thra-werk forward raits one
•ek ahead ICM one-week deposit raits The December forward premium'
Bixl into the third week or December
19
J FMAMi IASONDJ FMAMJ IASOHDJ F
i<m
NOIL. The data are doily UBI observance
i»w
2000
t ror Ft omarv I I 2000
66
20
Monetary Policy Report to ihe Congress D ftbruary 2000
Equity valuation and long-iemi real imeresi
E. The daia ure Fnomhly and etunil through January 3300. The eanungsauo is baud on rhe E/B/E/S Iniprnauonal. Inc. consensus esom£e at"
LS OVQ Ufc coming fwerve nwmte The real mieie&i rtwc is [he yield cm U»
i Treasury w« lesi Ihc wn-ycar uiflnnon tifucianoiii from [he Federal
: Bant of Plu]aifc!ptiia Survey of Professional Rutcaifcrs
Last year was ihe fifth consecutive year that all three
indexes posted double-digit returns. Most stock
indexes moved up sharply over the first few months
of the year and were about flat on net from May
through August; they then declined into October
before surging in the final months of the year. The
Nasdaq index, in particular, achieved most of its
annual gains in November and December. Stock price
advances in 1999 were not very broad-based, however: More than baJf of the S&P 500 issues lost value
over (he vear. So far in 2000. stock prices have been
volatile and mixed; major indexes currently span a
range from the Dow's nearly 10 percent drop to ihe
Nasdaq's 8 percent advance.
Almost all key industry groups performed well.
One exception was shares of financial firms, which
were flat, on balance. Investor perceptions that rising
interest rates would hurt earnings and, possibly, concern over loan quality apparently offset the boost
resulting from passage in the fall of legislation
reforming the depression-era Glass-Steagall constraints on combining commercial banking with
insurance and investment banking. Small-cap stocks,
which had lagged in 1998. also performed well; the
Russell 2000 index climbed 20 percent over the year
and finally surpassed its April 1998 peak in late
December.
At large firms, stock price gains about kept pace
with expected earnings growth in 1999, and the
S&P 500 one-year-ahead earnings-price ratio fluctuated around the historically low level of 4 percent even as real interest rates rose. Meanwhile, the
Nasdaq composite index's earnings--price ratio (using
actual twelve-month trailing earnings) plummeted
Domestic nonfinancial dctH: Annual range and actual level
from an already-slim 1 '/4 percent to '/J percent, suggesting that investors arc pricing in expectations of
tremendous earnings growth at technology firms relative to historical norms.
Debt and the Monetary Aggregates
Debt and Depository Intermediation
The debt of domestic nonrinancial sectors is estimated to have grown 6'/2 percent in 1999 on a
fourth-quarter-to-fourth-qiiaiier basis, near the upper
end of the FOMC's 3 percent to 7 percent range and
about a percentage point faster than nominal GDP. As
was the case in 1998, robust outlays on consumer
durable goods, housing, and business investment,
as well as substantial net equity retirements, helped
sustain nonfederal sector debt growth at rates above
Domeslic nonlinandal deb! as a percentage of nominal GDP
Non-federal
1989
1991
1993
1995
1997
— I3J
1999
67
Board of Governors of the Federal Reserve Svsiem
9 percent. Meanwhile, the dramatically increased
federal budget surplus allowed the Treasury to reduce
its outstanding debt about 2 percent. These movements follow the pattern of recent years whereby
increases in the debt of households, businesses, and
state and local governments relative to GDP have
come close to matching declines in the federal government share, consistent with reduced pressure on
available savings from the federal sector facilitating
private borrowing.
After increasing for several years, the share of total
credit accounied for by depository institutions leveled out in 1999. Growth in credit extended by those
institutions edged down to W-L percent from 6V* percent in 1998. Adjusted for mark-to-market accounting rules, bank credit growth retreated from I01/* percent in 1998 lo 51/: percent last year, with j considerable portion of the slowdown attributable lo
an unwinding of the surge in holdings of non-U.S.
government securities, business loans, and security
loans that had been built up during the market disruptions in the fall of 1998. Real estate loans constituted
one of the few categories of bank credit that accelerated in 1999. By contrast, thrift credit swelled 9 percent, up from a 41/: percent gam in 1998, as rising
mortgage interest rates ied borrowers lo opl mote
frequently for adjustable-rate mortgages, which
thrifts tend to keep on iheir books. The trend toward
sec utilization of consumer loans continued in 1999:
Bank originations of consumer loans were up about
5 percent, while holdings ran off at a !3/4 percent
pace.
4
21
M3; Annual range and actual If-'vel
The Monetary Aggregates
Growth of the broad monetary aggregates moderated
significantly iasi year. Nevertheless, as was expected
by the FOMC last February and July, both M2
and M3 finished the year above their annual pricesiability ranges. M3 rose TV? percent in 1999, somewhat outside the Committee's range of 2 percent
10 6 percent but far below the nearly 11 percent
pace of 1998. M3 growth retreated early in 1999, as
the surge in depository credit in the final quarter of
\998 unwound and depository institutions curbed
their issuance of the managed liabilities included
in that aggregate. At thai time, the expansion of
Growth of money and detii
Period
Ml
Amuul'
\WI
[
M2
i
Ml
DnmesBC
nonnnancial debt
0
57
4 [
1 S
4.2
79
42
11
19
1 1
ft?
1941
1992
I4.J
1S
ft
199^
10.6
14
6
1 7
4S
4.5
41
49
39
61
<j
1990
1994
2.5
1995
-1 5
1996
-4.5
45
1997
1998
-1 .2
11
19
56
85
6.2
iy
75
0.0
55
)•*»
Qua,ttrt< famaul rate!*1999 I
2
}
4
•> •>
-2.0
s.i
Nim. Ml Consists ol currency, travelers checks, demand deposit] and other
checkable deposm Ml consists of M 1 plus savings deposits (including n»ney
market ileposu accounts!. snuU-denomi nation time deposits, and balances in
retail money market luilds M3 consists 01 M2 plus luge-denomination time
deposits, balances in institutional DKXKV nuirtel fcn&. RP Uabtitaes 1a<rcnngta
and rerml jnd eurodollars jEivemp^hf and term) Debt consists of the oul
5*
1 0
6»
89
109
;s
51
6.0
5 1
10 O
5.4
52
67
66
67
f> 9
ft.O
*-
standing credit market debt of the U.S government- state and local governrneftE. households and rtclopron1! organizations, ncHI financial businesses. alKl
lanw
f From average for [b
rth quarter ol pfecedinp vear 10 average for fourth
quarter 01' year indicraed.
2 From average for prr ceding L|uditer lo average lor omncr mdicaied
68
22
Monetary Policy Report to the Congress n February 2000
M2; Annual ranee and actual levei
Tnlln«i> nl Jollai
M
1 I
o N o i
1999
2000
institution-only money funds also slowed with the
ebbing of" heightened preferences ("or liquid assets.
However, M3 bulged again in the fourth quarter
of 1999, as loan growth picked up and banks
funded the increase mainly with large lime deposits
and other managed liabilities in M3. U.S. branches and agencies of foreign banks stepped up issuance of large certificates of deposit, in part lo augment the liquidity of their head offices over the
century dale change, apparently because it was
cheaper to fund in U.S. markets. Domestic banks
needed the additional funding because of strong loan
growth and a buildup in vault cash for Y2K contingencies. Corporation's apparently built up year-end
precautionary liquidity in institution-only money
funds, which provided a further boost to M3 late
Ml velocity and the opportunity cost nf holding M2
in the year. Early in 2000, these effects began lo
Unwind.
M2 increased 6'/4 percent in 1999, somewhat above
the FOMC's range of 1 percent io 5 percent. Both the
easing of elevated demands for liquid assets that had
boosted M2 in the fourth quarter of 1998 and a rise
in its opportunity cost (the difference between interest rates on short-term market instruments and the
rales available on M2 assetsl tended to bring down
M2 growth in 1999. That rise in opportunity cost also
helped to halt the decline in M2 velocity that had
begun in mid-1997, although the P/4 percent (annual
rale) rise in velocity over the second half or' 1999 was
not enough to offset the drop in the first half of the
year. Within M2, currency demand grew briskly over
the year as a whole, reflecting booming retail sales
and, late in the year, some precautionary buildup for
Y2K. Money stock currency grew at an annualized
rale of 28 percent in December and then ran off in the
weeks after the turn of the year.
In anticipation of a surge in the public's demand
for currency, depository institutions vastly expanded
their holdings of vault cash, beginning in the fall
to avoid potential constraints in the ability of the
armored car industry to accommodate large currency
shipments late in the year. Depositories' cash drawings reduced their Federal Reserve balances and
drained substantial volumes of reserves, and, in midDecember, large precautionary increasas in the Treasury's cash balance and in foreign central banks'
liquid investments at the Federal Reserve did as well.
The magnitude of these flows was largely anticipated
by the System, and, to replace the lost reserves,
during the fourth quarter ihe Desk entered into a
number of longer-maturity repurchase agreements
timed to mature early in 2000. The Desk also
executed a large number of short-term repurchase
transactions for over the turn of the year, including
some in the forward market, to provide sufficient
reserves and support markei liquidity.
The public's demand for currency ihrough yearend, though appreciable, remained well below the
level for which the banking system was prepared, and
vault cash at the beginning of January stood about
$38 billion above its year-ago level. This excess vault
tush, and other century date change effects in money
and reserve markets, unwound quietly after the
smooth transition into the new year.
1979
No IE Tin daia art Himntrly jnd eiiend through 1W9 O4 The velocuy ol
Ml ii the rauo of nominal gross demesne product ID OB slock of M2. The
opportunity cost of M2 is j twn-quattcr moving average ol the difference
beiw«n the tfiire-monch neaiury Qi'H rate and ihe weighted average rcram on
ap*I! included in M2.
International Developments
Global economic conditions improved in 1999 alter a
year of depressed growth and heightened financial
69
Board of Governors of the Federal Reserve System
market instability. Financial markets in developing
countries, which had been hit hard by crises in Asia
and Russia in recent years, recovered last year. The
pace of activity in developing countries increased,
with Asian emerging-market economies in particular
bouncing hack strongly from the output declines of
the preceding year. Real growth improved in almost
all the major industrial economies as well. This
strengthening of aclivity contributed to a general rise
in equity prices and a widespread increase in inlerest
rates. Despite stronger activity and higher prices for
oil and other commodities, average foreign inflation
was lower in 1999 than in 1998. as output remained
below potential in most countries.
Although the general theme in emerging hnancial
markets in 1999 was a return to stability, the year
began with heightened tension as a result of a financial crisis in Brazil. With the effects of the August
1998 collapse of the ruble and the default on Russian
government debt still reverberating, Brazil was
forced to abandon its exchange-rate-based stabilization program in January 1999. The real, allowed to
float, soon fell nearly 5(1 percent against ihe dollar,
generating fears of a depreciation-inflation spiral that
could return Brazil to its high-inflation past. In addition, there were concerns that the government might
default on its domestic-currency and do liar-indexed
debt, the latter totaling more than $50 billion. In the
event, these fears proved unfounded. The turning
point appears to have come in March when a new
central bank governor announced that fighting inflation was a lop priority and interest rates were substantially raised to support the real. Over the remainder
of the year. Brazilian financial markets stabilized
on balance, despite continuing concerns about the
government's ability to reduce the fiscal deficit, inflation, although accelerating from the previous year,
remained under 10 percent. Brazilian economic activity also recovered somewhat in 1999, after declining
in I99S, us the return of confidence allowed officials
to lower short-term interest rates substantially from
their crisis-related peak levels of early in ihe year.
The Brazilian crisis triggered some renewed financial stress in other Latin American economies, and
domestic interest rates and Brady bond yield spreads
increased sharply from levels already elevated by
the Russian crisis. However, as the situation in
Brazil improved, financial conditions in the rest of
the region stabilized relatively rapidly. Even so. the
combination of elevated risk premiums and diminished access :o international credit markets tended to
depress activity in much of the region in the first half
of 1999. Probably the most strongly affected was
Argentina, where the exchange rate peg to the dollar
23
was maintained only at the cost of continued high
real interest rales that contributed to the decline in
real GDP in 1999. In contrast, real GDP in Mexico
rose an estimated 6 percent in 1999, aided by higher
oil prices and strong export growth to the United
States. The peso appreciated against the dollar for the
year as a whole, despite a Mexican inflation rate
about 10 percentage points higher than in the United
States.
The recovery of activity last year in Asian developing countries was earlier, more widespread, and
sharper than in Latin America, just as the downturn
had been the previous year. After a steep drop in
activity in the immediate wake of the financial crises
that hit several Asian emerging-market economies in
laie 1997, the preconditions for a revival in aclivity
were set by measures initialed to stabilize shaky
financial markets and banking sectors, often in conjunction with International Monetary Fund programs
that provided financial support. Once financial conditions had been stabilized, monetary policies turned
accommodative in 1998, and this stimulus, along
with the shift toward fiscal deficits and an ongoing
boost to net exports provided by the sharp depreciations of their currencies, laid the foundation for last
year's strong revival in activity. Korea's recovery
was the most robust, with real GDP estimated Co have
increased more than 10 percent in 1999 after falling
5 percent the previous year. The government continued to make progress toward needed financial and
corporate sector reform. However, significant weaknesses remained, as evidenced by the near collapse of
Daewoo, Korea's second largest conglomerate. Other
Asian developing countries that experienced financial
difficulties in late 1997 (Thailand, Malaysia. Indonesia, and the Philippines) also recorded increases in
real GDP in 1999 after declines the previous year.
Indonesian financial markets were buffeted severely
at times during 1999 by concerns about political
instability, but the rupiah ended the year with a
modest net appreciation against the dollar. The other
former crisis countries also saw their currencies stabilize or slightly appreciate against the dollar. Inflation
rates in these countries generally declined, despite the
pickup in activity and higher prices for oil and other
commodities. Inflation was held down by the elevated, it diminishing, levels of excess capacity and
unemployment and by a waning of the inflationary
impact of previous exchange rate depreciations.
In China, real growth slowed moderately in 199°.
Given China's exchange rate peg to the dollar, the
sizable depreciations elsewhere in Asia in 1997 and
1998 led to a sharp appreciation of China's real
effective exchange rale, and ihere was speculation
70
24
Monetary Policy Report 10 the Congress D February 2000
last year that the renminbi might be devalued. However, wiih China's irade balance continuing in substantial, though reduced, surplus, Chinese officials
maintained the exchange rate peg to ihe dollar last
year and staled their intention of extending it through
at least this year. After the onset of (he Asian financial crisis, continuance of Hong Kong's currencyhoard-maintained peg to the U.S. dollar was also
questioned. In the event, the tie to the dollar was
sustained, but oniy a! the cost of high real interest
rates, which contributed to a decrease in output in
Hong Kong in 1998 and early 1999 and a decline of
consumer prices over this period. However, real GDP
started to move up again later in the year, reflecting in
pan the strong revival of activity in the rest of Asia.
In Russia, economic activity increased last year
despite persistent and severe structural problems.
Real GDP, which had dropped nearly 10 percent in
1998 as a result ot" the domestic financial crisis,
recovered about half the loss last year. Net exports
rose strongly, boosted by the lagged effect of the
substantial real depreciation of the ruble in late 1998
and by higher oil prices. The inflation rale moderated
to about 50 percent, somewhat greaier than the depreciation of the ruble over the course of the year.
The dollar's average foreign exchange value, measured on a trade-weighted basis against the currencies
of a broad group of important U.S. trading partners,
ended 1999 litlle changed from its level af the beginning of the year. There appeared to be two main,
roughly offsetting, pressures on the dollar last year.
On the one hand, the continued very strong growth of
the U.S. economy relative to foreign economies
tended to support the dollar. On the other hand, the
Nominal dollar exchange rale indexes
further rise in U.S. external deficits—with the U.S.
current account deficit moving up toward 4 percent of
GDP by the end of the year—may have tended to
hold down the dollar because of investor concerns
that the associated strong net demand for dollar assets
might prove unsustainable. So far this year, the dollar's average exchange value has increased slightly,
boosted by new evidence of strong U.S. growth.
Against the currencies of the major foreign industrial
countries, the dollar's most notable movements in
1999 were a substantial depreciation against the Japanese yen and a significant appreciation relative to the
euro.
The dollar depredated 10 percent on balance
against Ihe yen over the course of 1999. In the firsl
half of the year, the dollar strengthened slightly relative to the yen, as growth in Japan appeared to remain
sluggish and Japanese moneiary authorities reduced
short-term interest rates to near zero in an effort to
jumpstart the economy. However, around mid-year,
several signs of a revival of activity—particularly the
announcement of unanticipated strong growth in real
GDP in the first quarter—triggered a depreciation of
the dollar relative to the yen amid reports of large
inflows of foreign capital into the Japanese slock
market. Data releases showing that the U.S. current
account deficit had reached record levels in both the
second and third quarters of the year also appeared to
be associated with depreciations of the dollar against
the yen. Concerned that a stronger yen could harm
the lledgling recovery, Japanese monetary authorities
intervened heavily to weaken ihe yen on numerous
occasions. So far ihis year, the dollar has tinned
L'.i. dollar etchunge tale against ihe Japanese yen
and the euro
71
Board of Governors of the Federal Reserve System
about 7 percent against the yen. Japanese real GDP
increased somewhat in 1999, following two consecutive years ol" decline. Growth was concentrated in the
first half of the year, when domestic demand surged,
led by fiscal stimulus. Later in the year, domestic
demand slumped, as the pace of fiscal expansion
flagged. Net exports made virtually no contribution
to growth for the year as a whole. Japanese consumer
prices declined slightly on balance over the course of
the year.
The new European currency, the euro, came into
operation at the start of 1999, marking the beginning
of stage three of European economic and monetary
union. The rales of exchange between the euro and
the currencies of the eleven countries adopting the
new currency were set at the end of 1998: based on
these rates, the value of the euro at its creation was
just under Si.17. From a technical perspective, the
introduction of the euro wem smoothly, and on its
tirsi day of trading its value moved higher. However,
the euro soon started to weaken against [he dollar,
influenced by indications that euro-area growth
would remain very slow. After approaching parity
with the dollar in early July, ihe euro rebounded,
partly on gathering signs of European recovery. However, the currency weakened again in the fall, and in
early December it reached parity with the dollar,
about where it closed the year. The euro's weakness
late in the year was attributed in part to concerns
about the pace of market-on en ted structural reforms
in continental Europe and to a political wrangle over
the proposed imposition of a withholding tax on
investment income. On balance, the dollar appreciated 16 percent relative to the euro over 1999. So
far this year, the dollar has strengthened 2 percent
further againsf the euro. Although the euro's foreign exchange value weakened in its first year
of operation, the volume of euro-denominated
transactions—particularly the issuance of debt
securities—expanded rapidly.
In the eleven European countries that now fix their
currencies to the euro, real GDP growth remained
weak early in 1999 but strengthened subsequently
and averaged an estimated 3 percent rate for the year
as a whole. Net exports made a significant positive
contribution to growth, supported by a revival of
demand in Asia and Eastern Europe and by the
effects of the euro's depreciation. The areawide
unemployment rate declined, albeit to a still-high rate
of nearly 10 percent. In the spring, the European
central bank lowered its policy rate 50 basis points, to
2Vi percent. This decline was reversed later in the
year in reaction to accumulating evidence of a pickup
in activity, and the rate was raised an additional
25
25 basis points earlier this month. The euro-area
inflation rate edged up in 1999, boosted by higher oil
prices, but still remained below the 2 percent target
ceiling.
Growth in the United Kingdom also moved higher
on balance in 1999, with growth picking up over the
course of the year. Along with the strengthening of
global demand, the recovery was stimulated by a
series of official interest rate reductions, totaling
250 basis points, undertaken by the Bank of England
over the last half of 1998 and the first half of 1999.
Later in 1999 and early this year, the policy rate was
raised ("our times for a total of 100 basis points, with
officials citing the need to keep inflation below its
2'/2 percent target level in light of the strength of
consumption and the housing market and continuing
tight conditions in the labor market. On balance, the
dollar appreciated slightly against the pound over the
course of 1999.
In Canada, real growth recovered in 1999 after
slumping the previous year in response to the global
slowdown and the related drop in the prices of Canadian commodity exports. Last year, strong demand
from the United States spurred Canadian exports
while rising consumer and business confidence supported domestic demand. In the spring, ihe Bank of
Canada lowered its official interest rate twice for a
total ol' 50 basis points in an effort to stimulate
activity in the context of a rising Canadian dollar.
This decline was reversed by 25-basis-point increases
near ihe end of the year and earlier this month, as
Canadian inflation moved above the midpoint of its
targei range, the pace of output growth increased, and
U.S. interest rates moved higher. Over the course of
1999, the U.S. dollar depreciated 6 percent on balance against the Canadian dollar.
Concerns about liquidity and credit risk related to
the century date change generated a temporary bulge
in year-end premiums in money market rates in the
second half of the year in some countries. For the
euro, borrowing costs for short-term interbank funding over the year changeover—as measured by the
interest rate implied by the forward market for a
one-month loan spanning the year-end relative to the
rates for neighboring months-—started to rise in late
summer but then reversed nearly aJl of this increase
in late October and early November before moving up more moderately in December. The sharp
October-November decline in the year-changeover
funding premium came in response to a series of
announcements by major central banks that outlined
and clarified the measures these institutions were
prepared to undertake to alleviate potential liquidity
problems related to the century date change. For yen
72
26
Monetary Policy Repon to the Congress D February 2000
Forward premium for deposus over year-end
Foreign len-year interest rales
NOIF. The <Uo
Febnury 2000
ing monins Laa obstrvanon is lui December 29. I<W
funding, ihe century dale change premium moved in
a different pattern, fluctuating around a relatively low
level before spiking sharply for several days just
before the year-end. The I ate-December jump in the
yen funding premium was partly in response to date
change-related illiquidity in ihe Japanese government
bond repo market that emerged in early December
and persisted into early January. To counter these
conditions, toward ihe end of the year the Bank of
Japan infused huge amounts of liquidity into its
domestic banking system, which soon brought shortterm yen funding costs back down to near zero.
Bond yields in ihe major foreign industrial countries generally moved higher on balance in 1999.
Long-term interest rates were boosted by mounting
evidence that economic recovery' was taking hold
abroad and by rising expectations of monetary lightening in the United States and, later, in other industrial countries. Over the course of the year, long-term
interest rates increased on balance by more than
100 basts points in nearly all the major industrial
countries. The notable exception was Japan, where
Ions-term rales were little changed.
Equity prices showed strong and widespread
increases in 1999. us ihe pace of global activity
quickened and [he threat from emerging-market
financial crises appeared to recede. In the industrial
countries equity prices on average rose sharply,
extending the general upward trend of recent years.
The average percenlage increase of equity prices in
developing countries was even larger, as prices recovered from their crisis-related declines of the previous year. The fact that emerging Latin American and
Asian equity markets outperformed those in industrial countries lends some support to the view thai
global investors increased their risk tolerance, especially during the last months of the year.
Oil prices increased dramatically during 1999, fully
reversing the declines in the previous iwo years. The
average spot price for West Texas intermediate, the
Foreign equity indexes
73
Bvard of Governors of the Federal Keserve System
U.S. benchmark crude, more than doubled, from
around $12 per barrel at the beginning of the year to
more ihan S26 per barrel in December. This rebound
in oil prices was driven by a combination of strengthening world demand and constrained world supply.
The strong U.S. economy, combined with a recovery
of economic activity abroad and a somewhat more
normal weather paitern, led to a 2 percent increase
in world oil consumption. Oil production, on the
other hand, declined 2 percent, primarily because of
reduced supplies from OPEC and other key producers. Starting last spring, OPEC consistently held production near targeted levels, in marked contrast to the
widespread lack of compliance that characterized earlier agreements. So far this year, oil prices have risen
21
further on speculation over D possible extension of
current OPEC produciion targets and the onset of
unexpectedly cold weather in key consuming regions.
The price of gold fluctuated substantially in 1999.
The price declined to near a twenty-year low of about
$250 per ounce at mid-year as several central banks,
including the Bank of England and the Swiss
National Bank, announced plans to sell a sizable
portion of iheir reserves. The September announcement that fifteen European central banks, including
the two jusl mentioned, would limit their aggregate
sales of bullion and curtail leasing activities, saw the
price of gold briefly rise above $320 per ounce before
turning down later in the year. Recently, the price has
moved back up, to above $300 per ounce.
@FedFRASER