Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's Second Monetary Policy Report for 1990 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundred First Congress, Second Session

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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1990

HEARING
BEFORE THE

COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FIRST CONGRESS
SECOND SESSION

ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF

1978
JULY 18, 1990

Printed for the use of the Committee on Banking, Housing, and Urban Affairs




U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON '. 1990
For sale by vhe SuperintendPnt of Documents, Congressional Sales Office
U.S. Government 1'rinting Office, Washington, DC 20402

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
DONALD W. RIEGLE, JR., Michigan, Chairman
ALAN CRANSTON, California
JAKE GARN, Utah
PAUL S. SARBANES, Maryland
JOHN HEINZ, Pennsylvania
CHRISTOPHER J. DODD, Connecticut
ALFONSE M. D'AMATO, New York
ALAN J. DIXQN, Illinois
PHIL GRAMM, Texas
JIM SASSER, Tennessee
CHRISTOPHER S. BOND, Missouri
TERRY SANFORD, North Carolina
CONNIE MACK, Florida
RICHARD C. SHELBY, Alabama
WILLIAM V. ROTH, JR., Delaware
BOB GRAHAM, Florida
NANCY LANDON KASSEBAUM, Kansas
TIMOTHY E. WIRTH, Colorado
LARRY PRESSLER. South Dakota
JOHN F. KERRY, Massachusetts
RICHARD H. BRYAN, Nevada
STEVEN B. HAHRIS, Staff Director and Chief Counsel
W. LAMAR SMITH, Republican Staff Director and Economist
RAYMOND NATTER, Republican General Counsel
PATRICK J. LAWLER, Chief Economist




(III

CONTENTS
WEDNESDAY, JULY 18, 1990
Page

Opening statement of Chairman Riegle
Opening statements of:
Senator Garn
Senator Sasser.
Prepared statement
Senator Heinz
Senator Sarbanes
Senator Gramm
Senator Bond
Senator Shelby
Senator D'Amato

1
2
3
4
6
7
8
S*
10
11

WITNESSES
Alan Greenspan, Chairman, Board of Governors, Federal Reserve System,
Washington, DC
Economic and financial developments thus far in 1990
Credit conditions
Ranges for money and debt growth in 1990 and 1991
Fiscal and monetary policy interaction...
Monetary policy report to Congress
Response to written questions of:
Senator Riegle
Senator Heinz
Senator Sasser
Witness discussion:
Effects of not achieving a budget package
Risks of not reducing the Federal deficit
Risks of inflation and economic downturn

12
13
15
18
19
21
80
93
95
49
51
56

Savings and loan problem

57

Need to increase savings
Suggestions to increase savings
Condition of insurance fund for commercial banks
Employment deceleration
Increased productivity

60
64
66
74
75




(HI*

FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1990
WEDNESDAY, JULY 18, 1990

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10:04 a.m., in room SD-538 of the Dirksen
Senate Office Building, Senator Donald W, Riegle, Jr. (chairman of
the committee) presiding.
Present: Senators Riegle, Sasser, Sarbanes, Sanford, Shelby,
Kerry, Graham, Garn, Heinz, D'Amato, Bond, and Gramm.
OPENING STATEMENT OF CHAIRMAN RIEGLE

The CHAIRMAN. The committee will come to order.
Let me welcome all those in attendance this morning, and particularly our very distinguished Chairman of the Federal Reserve
Board, Alan Greenspan.
Our purpose in meeting is for the semiannual monetary policy
report which the Fed will be presenting today to the Congress.
As we know, this is the second appearance here for Chairman
Greenspan within a week's time. I think we had a very interesting
discussion and a newsworthy discussion last week, and we'll have
the chance to elaborate on that some today.
Since the Fed's last report in February, the economy has continued to grow and the current expansion now is over 7*/2 years. But I
think it is fair to say that the growth has been quite slow and inflation, especially after this morning's report, seems certain to accelerate this year for the fourth
year in a row.
The June CPI increase of 5/io of a percent gives us an annual
rate through 6 months of roughly 5.9 percent in CPI increase.
That's a fairly healthy inflationary factor, and we'll be interested
in knowing what your thoughts are on that and where you see that
going through the remainder of the year.
The New York Times has just done an analysis that was published on Monday, which indicate that 16 States are either in or
close to being in recessions at the present time. Obviously, that depends on the economic definition being used, but it's obvious that
there are some serious economic soft spots across the country.
Also, when you were here last week, our discussion made a reference to your earlier testimony here with respect to whether or not
we're experiencing a credit crunch in the economy. That testimony
was some 4 weeks ago. Your feeling was at that time that there
(1)




was not evidence that convinced you that there was a credit crunch
taking place.
Your testimony last week I think presented some different information, that some new data was emerging that was indicating that
bank credit contraction might well be taking place and that monetary policy would have to be adjusted to offset that.
And we had some discussion on that and I think all the members
of the committee will want to pursue that with you further today.
Also, because the RTC is accelerating its rate of spending with
respect to the savings and loan clean-up effort, there's a question,
too, as to whether that rather substantial flow of money might be
otherwise distorting normal patterns of financial flows. I don't
know to what extent you feel that has affected our measures of the
money supply, as well, and in what ways that has to be taken into
account.
Finally—and I know that this will come up in the course of the
discussion today—we've been at the budget summit now for some
weeks. It's not clear exactly when or if that process will yield a
result. There's been plenty of public indication that pressure has
been applied by people who think that the Fed should be lowering
interest rates either to deal with the softness in the economy or in
anticipation of a budget summit agreement.
So we would be interested in knowing as well your thoughts as to
how the Fed might respond if there is a major deficit reduction
agreement that's worked out. What might be both the market reactions to that and what policy adjustments might the Fed itself
think are appropriate?
So, these will be issues that we'll want to discuss with you this
morning, and we're very pleased that you're here.
Let me just start down the table here.
Senator Garn.
OPENING STATEMENT OF SENATOR GARN

Senator GARN. Thank you very much, Mr. Chairman.
Last week, when Chairman Greenspan was before this committee
to talk about financial modernization, the big news item came from
his comments on the relationship between, on the one hand, financial health of the banking industry, and on the other hand, monetary policy and the condition of the overall economy.
Aside from the understandable focus on the Chairman's comments as they relate to near-term outlook for interest rates, what
I'd like to do is emphasize the broader impact of what you said last
week, Mr. Chairman.
The broader impact is that there is a fundamental relationship
between the health of the Nation's financial institutions and the
health of the Nation's economy.
It is because I am concerned about this broader consequence of
financial institution health, when this committee recently held
hearings on the possibility of a credit crunch, I said that I gave the
benefit of the doubt to the expertise of the regulators when it
comes to evaluating loan quality. It is because of the importance of
financial institution health that I believe the committee should not
ignore, as we did yesterday, a direct legislative request from the




Chairman of the Federal Reserve Board of Governors when he is
concerned about the danger of fraud against financial institutions.
It was close—11 to 10. But nevertheless, we lost.
Finally, it is because of the importance of financial institution
health that I applaud the chairman of the committee for his efforts
through exhaustive hearings to continue to lay the groundwork for
responsible legislative restructuring.
With that, Mr. Chairman, I look forward to your testimony.
The CHAIRMAN. Very good. Senator Sasser, chairman of the
Budget Committee, and budget summiteer.
OPENING STATEMENT OF SENATOR SASSER

Senator SASSER. Yes; well, I'm surviving, is about all I can say,
Mr. Chairman.
I'm pleased to see Dr. Greenspan, the Chairman of the Federal
Reserve Board, here this morning. I want to welcome you, Dr.
Greenspan, before the committee.
We always benefit from your economic wisdom and I'm confident
that that will be the case today.
Dr. Greenspan, I want to commend you for the Fed going
through a bit of easing just this past week. You stated, I believe,
when you appeared before the committee just a few days ago something contrary to what the banking regulators had told the committee 1 month before. They were saying that there was no credit
crunch.
The Fed, as I understand it, took the position that banks were
tightening their lending standards and that the markets were
tightening independently of the Fed's action. You took the action of
easing somewhat, and I want to commend you for that, commend
the Fed for it.
And as you know, traditionally, I've been one that's urged the
Federal Reserve to ease on interest rates. But there are some
things that cause me some concern, and perhaps we can pursue
those a little further this morning, Mr. Chairman, when we get to
the question period.
But I am concerned. The Japanese interest rates are now getting
to the point where they're comparable with interest rates here in
the United States. We find that West German long-term interest
rates now are similar to the 8.45 percent Treasury bond rate here.
And we're still in the posture of borrowing a substantial amount
of funds from abroad to finance our deficit.
So when we get to my turn to question, I'll be interested in hearing from Chairman Greenspan as to just how the problem of foreign interest rates, particularly Japanese and West German interest rates, interact with his ability to ease rates here in the United
States and how that might impact on, or how the summit budget
negotiations might give him a little more leeway there if we could
reduce the necessity for Federal borrowing from foreign capital
markets.
Thank you, Mr. Chairman.
[The complete prepared statement of Senator Sasser follows:]




Statement of Senator Jim Sasser, Senate Banking Committee,
July 18, 1990
Thank you Mr. Chairman.

I would like to welcome Dr.

Greenspan before the committee for his semiannual Monetary Policy
Report.

As always, I am sure that the committee will benefit

from Dr. Greenspan's economic wisdom.

Certainly, it was of great

interest last week when Dr. Greenspan indicated in his testimony
before this committee that the Federal Reserve would likely ease
the federal funds rate.

While I am pleased that the Fed did ease

its policy last week, I am concerned that this easing may not
continue.
Last year, the Fed followed a progressive policy of easing
the federal funds rate for seven months.
to 8.25 percent.

The rate fell from 9.75

The recent action by the Fed brought the rate

down to 8.0 percent.
It appears to me that economic conditions today are more
serious than they were last year.

Contrary to what we were told

by the other banking regulators only one month ago, Dr. Greenspan
has now stated that there is, in fact, a credit crunch.

Banks

are tightening their lending standards such that "markets are
tightening independently" of the Fed's regulatory activities.
Moreover, housing starts are at their lowest level since
1982 during the depths of the Reagan recession.

Last month I met

with a group of business leaders in Nashville, many of whom are
connected with real estate, who told woeful tales like those of
eight years ago.
Mr. Chairman, looking back to the seven months in 1989, it's




apparent that the Fed can ease monetary policy.

I think economic

conditions call for an easing of rates more today than they did
last year.




Thank you.

The CHAIRMAN. Thank you, Senator Sasser.
Senator Heinz.
OPENING STATEMENT OF SENATOR HEINZ

Senator HEINZ. Mr. Chairman, I want to join you and the other
members of the committee in welcoming Alan Greenspan back to
our committee for the second report on monetary policy in 1990.
Alan, I believe this is the third time you've testified before this
committee in 4 weeks, most recently on Wednesday, when there
was, in response to something that you said, a rush to the exit, a
littered room of broken chairs.
But I just want you to know that the fact that you have been
here three times in 4 weeks means that we're going to continue to
invite you back—until you get it right. [Laughter.]
Quite seriously, Mr. Chairman, there are a number of things we
need to look at today. One of those is the question of our economic
expansion.
It does continue—not as strongly as before. It is setting a new
record each month. But the question is, in part, whether or not
that expansion will be slowed, or even curtailed by the credit
crunch that Chairman Greenspan referred to last Wednesday.
I think we also need to examine what the uncertainty over the
budget summit may be exacting on our economy, just as much as
we need to examine what a $50 billion budget package of spending
reductions and/or revenue enhancements might mean to decelerating the economy.
And most important of all, we must examine what happens—
speaking of people getting it right—if people don't get it at all in
the next several months and the budget summit drags on into October, November, and December. What are the consequences of
that for us all.
Finally, I want, at the appropriate time, to raise the question
that Senator Garn and others have referred to about the various
kinds of other risks in our system. For example, the risks to banks
because of what might be the inability of some banks to know
whether a check is good before funds must be made available.
Other risks were exposed in a recent Price-Waterhouse study of
the Federal Housing Administration insurance program, which is
not in very good shape. We should also be concerned about Bill
Seidman's and the FDIC's recent revelation that they are at an alltime low in terms of coverage of their insurance fund relative to
assets.
We should also look at the other kinds of failings that we've
seen. There was a news article on a student loan guarantee system
which is federally insured.
The question, in other words, is whether there are some systemic
problems that we in this committee, and you, as our central banker
need to be taking a more comprehensive and thoughtful look at so
that we don't go through the kind of trauma that we've been going
through with respect to the moral hazards and risks associated
with the S&L crisis.




Mr. Chairman, as I say, I welcome Chairman Greenspan back to
the Senate, and who knows how many more times we'll have to
call him back.
The CHAIRMAN. Thank you.
Senator Sarbanes.
OPENING STATEMENT OF SENATOR SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman.
Chairman Greenspan, I join my colleagues in welcoming you
here this morning.
I'd be interested in the course of your testimony, and if you don't
cover it there, subsequently in the question period, to get some
reading from you of what you think the risks are of a down-turn
and, indeed, a recession. And if it were to occur, how severe and
extended you would expect it to be.
Second, I note that in your statement, in your testimony, you do
discuss at some length the credit crunch issue.
It wasn't very long ago, less than a month, you testified before
this committee on the credit crunch. And at that time, you indicated, and I quote:
To date, we have found that lenders have tightened their standards in certain sectors and locales, but there has not, so far at least, been a broad-based squeeze on
credit. And lenders are generally not retreating from lending opportunities.

Now, that was on June 21.
Just last week, in testimony before this committee, and now in
your submitted testimony this morning, you've apparently shifted
your view on this issue. In fact, your testimony states, and I quote:
The weakness in the monetary aggregates in part signals a change in the behavior of depository institutions with potential for affecting overall credit provision.

And you go on to state:
It is difficult to discern the dividing line between lending standards that are still
healthy and those that are so restrictive as to be inconsistent with the borrower's
status and the best interests of the lender in the long-run. In recent weeks, however,
we have slipped over that line.

And you go on to point out that the change in credit standards
has its roots in part in the excesses of the 1980's, stating:
The weaker credits extended during that decade have come home to roost, and in
so doing, have impinged to varying degrees on the current availability.

Now, this has been an issue that has been of concern to members
of this committee and, in fact, we were inquiring about and sending warning signals about a credit crunch for some period of time,
even prior to the June 21 testimony.
I'd be interested in whether something dramatic occurred between June 21 and last week, and then today, to cause this shift in
your view, or whether there was a trend going on, developments
going on that weren't fully perceived, but were perhaps even
sensed by members of this committee responding as they were, of
course, to anecdotal statements about a credit crunch which constituents were experiencing.
I hope to explore that with you in the question period.
Thank you very much, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Sarbanes.




Another budget summiteer, Senator Gramm.
OPENING STATEMENT OF SENATOR GRAMM

Senator GRAMM. Thank you, Mr. Chairman.
Chairman Greenspan, let me try to sort of flesh out the question
that I know everybody today would like you to answer because we
would like to jump-start the summit, which responding to some law
of political behavior, set out long before American Government
came into existence, which is the greater the crisis, the more likely
politicians are up to some point to sit down and do nothing.
Since the sequester order came out, I've seen no movement on
the summit whatsoever, a lot of grunts and moans, but no action.
I'd just like to get you at some point, if you will, to give your
response as to how you believe you could change monetary policy if
the fiscal policy of the Nation were changed as follows.
If we had a real deficit reduction package in terms of permanent
policy changes, of a minimum of a $50 billion reduction in the deficit this year, if, by changes in permanent law enacted this year, we
reduced the deficit over the next 5 years by the actions taken this
year alone by a minimum of $450 billion, possibly as much as $500
billion.
Gramm-Rudman is set to expire October 1992. If we extended
Gramm-Rudman a minimum of 3 years, with iron-clad enforcement
of this agreement, including potential of the President having limited rescission powers if spending went above the cap set out in the
bill.
I'd be interested in knowing what you believe that change in
fiscal policy would do in terms of your capacity to ease monetary
policy in light of that overall change.
The second question that I have and the thing that I've been
more and more concerned about is the nature of the transaction
that is occurring in the savings and loan industry.
Now, I know it's good politics in Congress to talk about all this
wealth transfer. But in reality, we have a transaction that is fairly
unusual in terms of financial transaction. That is, we are going out
and borrowing tens of billions of dollars. We are then using that
money to make deposits good that the deposit-holder never felt
were in jeopardy.
So our transaction basically is Aunt Sarah in Tyler had $25,000,
her nest egg, in the local savings and loan. That savings and loan
went broke, but Aunt Sarah was never worried because she had
confidence in the Federal Government and its insurance fund. So
she never changed her behavior.
And what happens is if we go out and borrow money and then
we use that money to fill the hole that exists in the reserves of the
financial structure, Aunt Sarah's deposit is good. She doesn't
change her behavior because she never thought it was bad.
And so, I am concerned about what we are doing to the overall
financial structure of the country when we're borrowing capital, at
least temporarily pre-empting it from other uses. We're using it to
fill a hole in reserves and we're not changing behavior on the other
end.




9

Those are the two concerns I'd like to raise and I hope at some
point in your comments, you can address them.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you.
Senator Sanford.
Senator SANFORD. I have got to go preside and Mr. Byrd is in the
chair, so I can't be late.
I do want to comment—that's the most fascinating question I
have ever heard, with all of those assumptions. I think the question
is, if we continue to, as this budget agreement apparently will do, if
we continue over the next 5 years to add close to another trillion
dollars to the debt, if you'd work that into your answer, too, and
what would that do to monetary policy, I think that would be very
helpful to us.
And I'm sorry, Mr. Chairman, that time's run out on me.
The CHAIRMAN. Thank you, Senator Sanford.
Senator Bond.
Senator BOND. Thank you, Mr. Chairman.
I want to keep my comments short because I usually find the answers much more interesting than our comments here.
Senator GRAMM. I thought mine was fascinating. [Laughter.]
Senator SANFORD. Absolutely.
OPENING STATEMENT OF SENATOR BOND

Senator BOND. Well, I'll tell you what. Once in a while you get
lucky, Phil. [Laughter.]
With all the comments you make, something's bound to be fascinating. [Laughter.]
But I find the Chairman's comments generally much more interesting.
But I would say that I just happened to meet early again this
morning the same economist who gave me the question that I
asked you last week and you answered. But we discussed something further today, and that's the fact that long-term interest
rates don't seem to have gone down too much as a result. There
has been some favorable impact in the stock market.
We discussed why it was that the Federal Reserve's new move
hadn't really affected long-term interest rates. And I suggested
that perhaps the fact that—I see that you have set out in your testimony today that we have for too long financed the deficit, that
we don't have enough savings to finance here. By borrowing
abroad, now our debt is held in the international market.
Frankly, on the long-term interest rates, they're going to be set
by the international markets. And unless and until we get serious
about reducing the deficit and make fiscal policy coordinate with
monetary policy, it doesn't matter what the Federal Reserve does
in the long term.
As long as our creditors in other countries see a lack of will to
bring down the substantial budget deficit, we're not going to get a
very significant reduction in long-term interest rates. And without
those, the Federal Reserve has its hands tied.
I would suggest that your prepared statement certainly reflects
it, that unless we get serious and have a long-term budget agree-




10
ment, that we also implement, that we cannot expect the Federal
Reserve to be the whipping boy and the one to blame for high interest rates.
We're going to have to get serious on the fiscal side and then perhaps the long-term interest rates and other factors will enable the
Fed and its monetary policy to bring interest rates down.
I believe you touch on it. I would welcome any additional comments you have as you discuss that portion of your report.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Bond.
Senator Shelby.
Senator SHELBY. Mr. Chairman, I have a written statement that
I'd ask that it be made part of the record, and then I'll just have
one brief comment to the Chairman. And he'll probably touch on
it, anyway, either in his opening statement or by questions.
But what's bothering me is bothering a lot of Senators, Mr.
Chairman, and that is how are we going to finance this deficit and
continuing debt service that we have? And we're looking at these
numbers. We all know what's going on in the so-called budget
summit, but we haven't gotten to the summit yet, I don't believe
the White House or the Congress.
And I just see us borrowing more and more money from overseas, as iSenator Bond just alluded to, and what is that going to do
to our monetary system?
Last week, in some testimony, you certainly sent a good signal,
or it was interpreted as such, to the market, and they reacted accordingly on interest rates. I don't know what's going to happen
there.
But some of the banks seem to be confused at tunes by signals
coming from the Fed or coming from the press interpreting your
remarks.
Maybe that's more accurate.
I hope today that you will try to—I wouldn't say straighten out
those banks or those remarks, but perhaps make a signal that we
can all understand forthrightly.
[The complete prepared statement of Senator Shelby follows:]
STATEMENT BY SENATOR RICHARD SHELBY

Senator SHELBY. Mr. Chairman, I am glad that you scheduled
this morning's hearing because I am glad to have the opportunity
to hear more on what Chairman Greenspan only hinted at last
week. I would urge members of the audience to be careful about
standing near the door, lest they be trampled by members of the
press corps in their race to the telephone.
Chairman Greenspan, at last week's hearing, you hinted that interest rates may ease in the near future, in response to a credit
crunch. It is also true that we have increasing evidence that we
have entered a "rolling recession"; that is, with recessionary effects
differing by industry and region. Job growth is slow in many areas,
and very slow in some areas. My State of Alabama is well behind
the national average in job growth [Alabama 1 percent job growth
per year vs. national average of 1.8 percent] with no real apparent
cause.




11
Last week you testified that "loan rates are moving up relative
to the cost of money in the commercial banking industry, which is
suggestive of the fact that markets are tightening independently of
our actions" [as reported by the Washington Post]. Thus it is my
understanding that by lowering interest rates, you mean to make
credit more accessible to borrowers, while not deterring banks from
being more careful about their lending criteria. I hope in your testimony you will address in more detail just what course you would
like to see banks follow. I believe that banks are still receiving
mixed signals and a little more guidance from you could help eliminate the confusion.
Mr. Chairman, I look forward to the question and answer period.
Thank you, Mr. Chairman.
The CHAIRMAN. Very good.
Senator D'Amato.
Senator D'AMATO. Thank you, Mr. Chairman.
Mr. Chairman, as you know, Mr. Greenspan has been in the forefront over the years, saying that the one great problem that we
have to overcome, in addition to the deficit, is that of capital formation, that of savings.
And he's been saying this for a long, long time now, even before
his tenure as Chairman of the Federal Reserve,
And I'd like to try to maybe put him on the spot a little bit and
ask him and suggest to him if in the course of his testimony, or at
some point in time, he might suggest to us the avenues available to
encourage that savings. Not just the IRA, if that's a way, but what
can we do? What can Congress do?
Should we try to bring about some incentives to bring about that
kind of savings pool which is so desperately needed here in the
United States?
Second, in our quest for revenues to deal with the deficit, it
seems to me that we've got to be rather careful because if we raise
revenues in the wrong way, in the wrong manner, we can actually
do damage to capital formation and really bring about the recession that so many people are concerned about.
And one of the areas, and I admit, it may sound parochial and
there are parochial overtones to it, is the proposition put forth relative to a stock transfer tax. I believe that would be devastating, not
only to Wall Street, but I think as it relates to the investor, as it
relates to capital formation, and as it relates to driving the marketplace from the shores of this country.
We talk about the ability of markets to move today. Not only can
they move across State boundaries—and so while there is obviously
a concern as it relates to New York. I think there's a much bigger
concern that we should have as it relates to what problems could
that possibly create.
And I'd ask the Chairman if he might speak to that issue as well.
[The complete prepared statement of Senator D'Amato follows:]
OPENING STATEMENT OF SENATOR ALFONSE M. D'AMATO

Senator D'AMATO. Mr. Chairman, I join you in welcoming Federal
Reserve Board Chairman Greenspan. I also welcome the Fed's report
on monetary policy. Chairman Greenspan's recent comments before




12
this committee have been cited as an optimistic sign that the Fed is
prepared to ensure that appropriate credit opportunities are available in the national economy.
Mr. Greenspan told us last week that the Federal Reserve may
"have to consider offsetting monetary policy" to react to the potential damage to the economy of tighter lending practices. This action
may alleviate the "credit crunch ' that the New England region appears to be suffering right now. I look forward to hearing Mr.
Greenspan amplify these remarks during his testimony today.
The Federal Reserve Board, under Mr. Greenspan's effective
leadership, has succeeded in maintaining price stability and providing a healthy economic environment. However, there are many
economic potholes in the road ahead that the Federal Reserve
Board must avoid or fix to pave the way for the economy to move
forward without a recessionary accident.
Although Mr. Greenspan has indicated that there may be a need
for moderate offsetting changes to react to the "credit crunch," he
also tells us that fundamental economic factors have not changed
in a way that will allow the Fed to lower interest rates. The latest
inflation and unemployment data suggest that the economy continues to teeter along a knife's edge between healthy growth and significant decline. In addition, economic and political developments
in Europe and Japan continue to threaten our ability to effect significant interest rate reduction and economic growth.
Despite these obstacles, many people are hoping that the ongoing budget summit will lead to a deficit-reduction plan that will
reduce interest rates and promote growth. In what I am sure will
be his economy, I hope that Mr. Greenspan will identify today
what a deficit reduction plan must entail to convince him that it
would be appropriate to loosen Federal monetary policy.
The CHAIRMAN. Chairman Greenspan, we'll make your full statement a part of the record.
This is a very important report in and of itself, and particularly
at this time. We'd be pleased now to hear your comments about it.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM, WASHINGTON, DC

Chairman GREENSPAN. Thank you, Mr. Chairman.
If the chair doesn't mind, I would like to read the whole statement into the record.
The CHAIRMAN. Very good.
Chairman GREENSPAN. I think it's important that I try to.
The CHAIRMAN. Fine.
Chairman GREENSPAN. Because it is in response to a number of
the questions which the committee has raised.
The CHAIRMAN. Very good. May I ask that you pull the mike a
little closer so those in the back of the room can hear a little
better? Thank you.
Chairman GREENSPAN. As usual, Mr. Chairman, I am pleased to
be here today, and in this connection, to testify on our semiannual
Monetary Policy Report to the Congress.
In my prepared remarks this morning, I shall discuss, as is customary on such occasions, current and prospective economic condi-




13

tions and the Federal Reserve's objectives for money and credit
growth over the period ahead.
Two areas of particular note at present, with potential implications for the conduct of monetary policy, are the ongoing restructuring of credit flows in the U.S. economy and the prospects for a
significant cut in the Federal budget deficit. I shall pay special attention to these topics in my statement.
ECONOMIC AND FINANCIAL DEVELOPMENTS THUS FAR IN 1990

When I came before this committee in February, I characterized
the economy as poised for continued moderate expansion in 1990,
and, in large measure, developments so far this year appear to
have borne that statement out. Real GNP grew at a 2-percent
annual rate in the first quarter, and indicators of economic activity
for the second quarter suggest a further rise, though perhaps at a
somewhat slower rate. Within this whole, however, the various sectors have moved along at fairly different paces.
On the distinctly positive side, exports have shown solid gains,
buoyed by expanding markets abroad. The impetus from international trade has been important in the pick-up in industrial production this year.
In contrast, the news coming from the household sector in recent
months has had a softer cast to it. Consumers appear to have
pulled back a bit, as the slower overall pace of expansion and the
more pronounced weakness in certain parts of the country—especially the northeast—seem to have taken some toll on confidence in
the economic outlook. Moreover, having accumulated large stocks
of automobiles and other consumer durables earlier in the expansion, consumers could be more selective about when to purchase replacements. Sales of new homes have also weakened, deterring
building activity.
There are other pluses and minuses, as well, in the economic picture—by sector and by region. But, on balance, the economy still
appears to be growing and the likelihood of a near-term recession
seems low, in part because businesses have been working hard to
keep their inventories in line with sales trends.
Although output overall grew rather modestly over the first half,
the unemployment rate remained at its lowest level in almost 20
years. Over the past year, as employment has decelerated, so too
has the labor force, in part reflecting a surprising decline in labor
force participation rates for young people. Some flattening in the
aggregate participation rate would be consistent with evidence that
many individuals now perceive job opportunities as less abundant.
Differences from past cyclical experiences, however, suggest that
other factors also must be at work—if, in fact, the current pattern
represents something more than noise in the data. This development certainly bears watching, for it may have implications for potential output growth.
Be that as it may, with hiring proceeding at a less rapid pace,
the rate of increase in wages appears to have leveled out from its
earlier upward trend. The core rate of inflation in consumer prices,
proxied by abstracting from movements in food and energy prices,
picked up sharply in the first quarter, but has moderated in recent




14

months. This moderation has been concentrated in the prices of
goods, perhaps reflecting the ebbing of capacity pressures in a
number of industries, while service price inflation has shown little
sign of abating.
While the figures that were released today, Mr. Chairman, were
higher than one would like to see, they don't, in my judgment,
really
fundamentally affect the underlying trends. In fact, Vio of
5
/io percent increase in the CPI resulted from a sharp increase in
owner's equivalent rent, which is a technical evaluation of the cost
of owning a home. And, with gasoline prices presumably flattening
out this month, and I would assume that owner's equivalent rent
will also slip back, I would be surprised if we did not get some reduction in the rate of increase in the CPI reported a month from
today, for the month of July.
In 1990, Federal Reserve policy has continued to be directed at
sustaining the economic expansion while making progress toward
price stability. Ultimately, the two go hand-in-hand: A stable price
level sets the stage for the economy to operate at its peak efficiency, while high inflation inevitably sows the seeds of recession and
wrenching readjustment. In the short-run, however, the risks of inflation on the one hand, and of an economic downturn on the
other, must be weighed in the policy-making process. The Federal
Reserve saw those risks about evenly balanced over the first half of
the year and made no adjustments in monetary policy.
Throughout this period, which has been marked by dramatic
changes in the flow of funds through depository institutions, the
Federal Reserve has been paying particularly close attention to
conditions in credit markets. Evidence of a tightening of terms and
reduced availability of credit has gradually accumulated, to the
point where it became apparent in recent days that some action by
the monetary authority was warranted. A number of indicators
have been pointing in this direction, including the behavior of the
monetary aggregates. Growth in M2, for example, which stalled out
in the spring, has failed to strengthen materially, suggesting that
the degree of financial restraint in train might be greater than anticipated or than appropriate to the evolving economic situation.
This restraint is a function of developments in the credit markets,
independent of monetary policy. The recent decline in the Federal
funds rate to 8 percent, as a consequence of our action to reduce
slightly the pressures in the reserve markets, represents an effort
to offset the effects of greater stringency in credit markets.
Other market interest rates generally rose early in 1990, as it
became apparent that the economy was not as weak as many had
thought. Long-term yields were most affected, increasing a full percentage point by early May. Subsequently, however, signs of a softening of activity prompted a reversal of much of that run-up. Rates
on long-term securities remain about a half percentage point above
their year-end levels, but money market quotes are now little
changed on balance. Throughout this period, rates on Treasury
bills have remained somewhat higher than usual relative to those
on private instruments, probably in part reflecting the large
amount of bill issuance necessary to fund working capital for the
RTC.




15

The run-up in market interest rates early in the year was one
factor behind the sharp slowing in money growth over the first half
of 1990. M2, which had been running close to the top of its target
range in February, posted no net increase between March and
June. This weakness, which moved the aggregate close to the
bottom of its range, was too abrupt to be accounted for fully by the
rise in market rates, however. Another of the factors at work was
the restructuring of financial flows. One aspect of this restructuring was the closing of insolvent thrifts by the ETC and sale of their
deposit bases. Although the RTC's activities do not directly affect
M2, the availability of huge blocks of deposits to the remaining
thrifts and banks lessened their need to raise rates to draw in
funds. In combination with the more cautious attitude depositories
have exhibited toward expanding their balance sheets, the deposit
transfers contributed to an unusual degree of inertia in the pricing
of retail deposits. Households responded to the relatively low returns on deposits by looking elsewhere, as suggested by heavy flows
into stock and bond mutual funds and sizable noncompetitive
tenders at Treasury auctions. Nevertheless, while the movements
in yield spreads can account for a good share of the slump in M2
growth, a portion of it still requires explanation.
The cause of the meager growth this year in the broader monetary aggregate, M3, is clearer: The RTC closed down a very large
number of S&L's, taking many of those institutions' assets onto the
Government's balance sheet and thereby effectively reducing the
overall funding needs of the depository system. In addition, increased loan losses and the phasing-in of tighter capital requirements circumscribed the expansion of credit at many other thrifts
and banks. With depository credit growth limited, M3—which contains much of the associated funding—essentially stalled. By June,
M3 growth was well below the 2Vz percent lower bound of the
target range the FOMC had set in February.
That range had itself been reduced a full percentage point from
the target provisionally set last July in recognition of the potential
effects of the ongoing contraction of the thrift industry. Lacking
historical experience with a financial restructuring like the current
one, however, it was unclear exactly how the flows would end up
being redirected through the financial system and, in particular,
how much of the thrift lending would be picked up by commercial
banks. While the economy more broadly is about where we expected it to be, the configuration of the financial system is somewhat
different, leading to less M3 growth than had been anticipated.
CREDIT CONDITIONS

The weakness in the monetary aggregates in part signals a
change in the behavior of depository institutions, with potential for
affecting overall credit provision. The conservative pricing of retail
and wholesale deposits represents one aspect of their efforts to
widen profit margins. In light of concerns about their capital positions, banks and thrifts also have reined in lending activity and imposed stiffer terms on loans.
The change in credit supply conditions may have significant implications for borrowing, spending, and policy. I would not call this




16

change technically a "credit crunch," as those words connote a contraction of lending on a major scale, with many borrowers effectively shut out of credit markets, regardless of their qualifications.
We are not seeing symptoms of that kind of widespread, classic
crunch, as in the past when deposit rate ceilings or usury ceilings
limited the market's ability to adjust and forced cut-offs of credit.
But I can well appreciate that my view on this topic may be perceived as a semantic nicety by a borrower who today is suddenly
unable to get a loan on the terms formerly available. To the borrower, it makes little difference why the lender is pulling back or
how pervasive the change in credit conditions is.
From a policymaker's perspective, however, it is essential to sort
the issues out. This means discerning the breadth and depth of the
shift in credit conditions, its causes, its effects, and the extent to
which it may ultimately be a desirable development. Clearly, the
verdict is not yet in on the current episode; in economics, we are
seldom able to make a definitive diagnosis until well after the fact,
but to do our job, we must hazard some answers.
First, what do we observe? The evidence on this score continues
to grow; numerous reports indicate that depository institutions and
other lenders have become more selective in extending credit. In
addition, Federal Reserve surveys of large banks support this sense
that terms have been tightened in particular parts of the country
and on certain types of loans. Especially hard-hit have been financings for mergers and LBO's, commercial real estate, and construction and development. There also is evidence that small and
medium-size companies, as well as the poorer quality credits among
the larger firms, have faced some tightening of credit availability.
The change in credit conditions has taken various forms, including
tougher standards for credit approval, higher collateral requirements, increases in interest rates, and, in some cases, loans have
been simply unavailable. Even investment-grade corporations
appear to be facing slightly higher costs in accessing bank credit
facilities. At the same time, a huge widening of spreads on lessthan- investment-grade bonds has effectively shut down that
market to most new issues.
But on a number of other types of credit, changes in prices and
non-price terms appear to have been relatively minor. For example, the rates on residential mortgages, consumer loans, and the
debt of investment-grade corporations have remained about in
their usual alignment with other market interest rate. Because
these credits may trade on securities markets and thereby access a
broad range of investors, the interest of banks and thrifts in holding the obligations in portfolio has little, if any, effect on the cost
to borrowers. These obligations account for a major share of the
credit extended in the economy, and hence, the slowing of depository credit and the sluggish behavior of the monetary aggregates—
while indicative of some tightening of credit—likely overstate the
impact of the depositories' behavior on economic activity.
No doubt a sizable portion of lenders' increased reluctance to
commit funds for certain purposes reflects a natural and healthy
reaction to a slowdown in growth as the economy moves closer to
capacity restraints. Prospects for continued strong production and
sales increases fade, and the odds rise that some borrowers will




17

prove unable to meet their obligations. In other words, part of the
ongoing shift in credit conditions is what amounts to a regular cyclical event. But there is more to it than that. Through one avenue
or another, the change in credit standards has its roots in part in
the excesses of the 1980's. The weaker credits extended through
that decade have come home to roost, and in so doing, have impinged to varying degrees on the current availability of credit.
Perhaps the clearest example is the real estate sector and its
principal lender, the thrift industry. Those S&L's that were the
freest with their funds exist no longer, having been closed by the
RTC, and the remaining S&L's face tighter regulations constraining their lending. The resulting void has been filled quite effectively for home mortgage borrowers, with highly developed secondary
markets drawing funds in from elsewhere. For these borrowers, the
shrinkage of the thrift industry does not represent a significant decline in intermediation services. But many other clients of thrifts,
whose debt is less easily securitized, have been hard-pressed to find
alternative sources of funds. Moreover, lax lending standards by
both thrifts and banks contributed to overbuilding in commercial
real estate, which has added to problems for lenders to this industry.
Rising capital requirements for banks and thrifts have interacted
with large losses on soured loans and the financial market's distaste for providing additional capital to the institutions taking
these losses. This interaction has resulted in strong incentives for
depository institutions to conserve capital. Their efforts to build
larger capital cushions, in turn, have been manifest in a somewhat
more cautious approach to lending, as well as a stepped-up effort to
sell off assets by, for example, securitizing loans. Partly as a result
tighter credit conditions, the growth of credit, as measured by the
change in the debt of domestic nonfinancial sectors, has come down
into closer alignment with the expansion of nominal GNP. This
process, which reflects a somewhat more cautious approach on the
part of borrowers as well, is not an aberrant restrictive phase in
the life of the financial system, but rather, a return to what had
been the norm prior to the 1980's.
To be sure, when you go from excess credit creation to normal, it
can feel like a tightening. And in that sense, credit conditions have
tightened. Many of the loans made during the 1980's should not, by
historical standards of creditworthiness, have been made. As standards reverted closer to normal, those weaker borrowers have been
finding it far more difficult to access credit.
In addition, however, depository institutions appear more recently to be lending with greater caution in general. As a result, even
creditworthy borrowers may have to look harder for a loan, put up
more collateral, or pay a somewhat higher spread. For the Nation
as a whole, the tightening of credit standards will leave the financial system on a sounder footing and contribute to economic stability in the long run. Nevertheless, in the here and now, the tightening is beginning to have very real, unwelcome effects. Diminished
credit availability can constrain Firms' spending, for example, limiting more of them to internally generated funds. It is difficult to discern the dividing line between lending standards that are still
healthy and those that are so restrictive as to be inconsistent with




18

the borrower's status and the best interests of the lender in the
long run. In recent weeks, however, in my judgment, we may have
slipped over that line. Such developments can, and do, occur independently of central bank actions, and can have important influences on spending and output. Thus, the Federal Reserve must
remain alert to the possibility that an adjustment to its posture in
reserve markets might be needed to maintain stable overall financial conditions.
As best we can judge, the change in credit conditions currently is
exerting a slight additional degree of restraint on the economy.
The process of credit restraint may not have reached completion
and some of its effects may not yet have been felt; hence it will
require continued scrutiny. However, the tightening should eventually unwind as displaced borrowers find alternative sources of
funds and as the banking system rebuilds its capital.
This restraint has implications for monetary policy at present,
and the ongoing restructuring of the financial system has implications for the conduct of policy over the foreseeable future. It is
clear that the financial restructuring will affect the channels
through which policy actions are transmitted ultimately to economic growth and inflation; some will be diminished and others augmented. In these circumstances, the Federal Reserve has emphasized a flexible approach to policymaking, which includes attention
to a wide range of economic and financial indicators.
RANGES FOR MONEY AND DEBT GROWTH IN 1990 AND 1991

At its meeting earlier this month, the Federal Open Market
Committee reaffirmed the 1990 range of 3 to 7 percent it had set
for the growth of M2. With the thrift industry likely to continue to
shrink at a good clip and commercial banks expanding more circumspectly, depository institutions are not expected to be bidding
aggressively for funds. As a result, although banks may replace
more of their managed liabilities with retail deposits, M2 could
well remain in the lower half of its target range through yearend.
In view of changing credit flows, a slow rate of expansion in M2
seems consistent with continued moderate growth in output, but
any pronounced weakness in the aggregate that drops it below its
current range might represent greater monetary restraint than is
desirable this year.
Looking ahead to 1991, the committee lowered the M2 range by
percentage point on a provisional basis. We believe that this range
is consistent with the continuation of measured restraint on aggregate demand—a necessity in the containment, and ultimate elimination, of inflation. Such restraint need not be a barrier to sustained growth. Indeed, it is a crucial requirement. As I suggested
earlier, one thing that surely would jeopardize the current expansion would be for inflation to move upward, rather than downward,
from the recent plateau.
FOMC members and other Reserve Bank Presidents generally
foresee the policy embodied in the money ranges as leading to both
sustained growth and diminished inflation in the period ahead. For
1990, their expectations center on an inflation rate in the 4% to 5
percent range, with real GNP growth of about 1% to 2 percent. But




19

with this year's slow growth helping to relieve pressures on resources, expectations for 1991 incorporate both somewhat lower inflation and somewhat higher real growth, at a rate closer to that of
growth in potential output.
The path of M3 consistent with these projections has been heavily affected by changes in financial intermediation in recent quarters. Taking into account the current lending posture of the commercial banks and remaining thrifts, we now expect the closures of
insolvent thrifts to show through in very subdued growth in M3.
Accordingly, the FOMC voted to lower the 1990 range for growth
of this aggregate to 1 to 5 percent. This action does not signal a
tighter policy stance, but rather our recognition that financial markets have been adjusting to the RTC's activities in a somewhat different manner than we had anticipated, making the lower M3
target appropriate. In view of the considerable uncertainties about
both the scale of RTC activities next year, and the speed with
which the banking industry will approach a more comfortable capital position, the new 1990 range was carried forward unchanged
into 1991 on a tentative basis.
Overall debt growth during the rest of this year is expected to
remain around the midpoint of its reaffirmed 5 to 9 percent monitoring range. The non-Federal sectors now appear to be increasing
their debt about in line with nominal income growth, with the
rapid pace of mortgage borrowing in recent years slowing into the
single digits and corporate leveraging activity slackening. Growth
of total debt in 1990 is likely to exceed that of nominal GNP, however, as the Federal Government's borrowing to fund RTC activities is expected to boost the total by roughly three-quarters of a
percentage point.
For 1991, the FOMC has provisionally reduced the monitoring
range for domestic nonfinancial sector debt to 4V2 to 8l/2 percent.
Debt growth in this range should be adequate to support continued
economic expansion, while avoiding the excessive leveraging that
characterized much of the 1980's.
A number of uncertainties come into play in the process of judging the outlook for the economy over the next year-and-a-half. Of
particular concern in the context of monetary policy are the likely
extent and persistence of the tightening of credit terms, the prospective path of potential output growth—especially in view of the
recent slowing in the labor force—and the outlook for fiscal policy.
It is the last of these that is the focus of the remainder of my comments today.
FISCAL AND MONETARY POLICY INTERACTION

The determination displayed by the Congress and the administration in their efforts to come to an agreement on cutting the deficit has been enormously heartening to all who are concerned about
the long-term health of the U.S. economy. As a nation, we have
been saving too little and borrowing too much; significant progress
on the Federal deficit would be an important step in rectifying this
situation. As you know, I favor not only eliminating the deficit, but
also ultimately bringing the Government's accounts into surplus
over time to compensate for the private sector's tendency to save




20

relatively little. In the long run, the Nation's saving and investment behavior is crucial in determining its productivity and hence,
its standard of living.
Major, substantive, credible cuts in the budget deficit would
present the Federal Reserve with a situation that would call for a
careful reconsideration of its policy stance. What adjustment might
be necessary, and how it might be timed, cannot be spelled out
before the fact. The actions required will depend on the constellation of other influences on the economy, the nature and magnitude
of the fiscal policy package, and the likely timing of its effects. I
can only offer the assurance that the Federal Reserve will act, as it
has in the past, to endeavor to keep the economy expansion on
track.
Concerns that the Federal Reserve would be able to offset undesirable macroeconomic effects of a budget pact are, I believe, largely unfounded. It is true that, in general, monetary policy cannot be
calibrated extremely finely in response to economic developments,
as we are all subject to imperfect data and an imperfect understanding of the myriad economic interrelationships of the real
world.
However, some doubts seem to focus on whether the various lags
involved permit monetary policy to catch up to a change in the
fiscal stance. I am less concerned, Mr, Chairman, on this point. We
can decide that a policy adjustment is appropriate and implement
it fully, all in the same morning, if need be, and the effects of the
change will show through to interest rates and financial asset
prices almost immediately. Granted, the impact on economic
growth and inflation will be spread out over several quarters, but
this is true of changes in fiscal policy as well.
In the final analysis, no one can guarantee that growth in the
economy will proceed smoothly, without a hitch on a quarter-toquarter basis. Nevertheless, a major cut in the budget is unquestionably the right thing to do. Because the Federal Government
has been borrowing too much for too long, it is well past time to
reduce the Government's draw on credit markets and to free up
more resources for enhancing investment and production by the
private sector. In this way, fiscal policy, by augmenting national
saving, will be doing its part to promote maximum sustainable economic growth. With monetary policy similarly keeping sight of its
long-run goal of price stability, the two together will have set a favorable backdrop for vibrant and enduring economic growth.
Thank you very much, Mr. Chairman.




21
For use at 9:45 a.m., E.D.T.
Wednesday
July 18,1990

Board of Governors of the Federal Reserve System

sj&
*w?rrm)2-

:

Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 18, 1990




22

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 18, 1990
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, Chairman

Table of Contents
Page
Section 1:

Monetary Policy and the Economic Outlook for 1990 and 1991

1

Section!:

The Performance of the Economy During the First Half of 1990

6

Section 3:

Monetary and Financial Developments During the First Half of 1990




17

23
Section 1: Monetary Policy and the Economic Outlook for 1990 and 1991
The Federal Reserve delivered its initial HumphreyHawkins report of 1990 to the Congress in Febniaiy,
and the period since then has been an especially
challenging one for monetary policy decisionmaking.
The already difficult task of moving a quite fully
employed economy toward price stability without contractionary mishap has been complicated by a variety
of disturbances to business activity and financial markets-among them developments thai distorted some
of the basic indicators of me Federal Reserve's influence on ihe economic system.
On the whole, events in the economy have been
broadly in line with the projections for 1990 contained
in the February monetary policy report. Inflation has
been somewhat greater on average than most members
of the Federal Open Market Committee and other
Reserve Bank presidents expected in February; however, this mainly reflected the influence of transitory
factors early in the year, and price increases recently
have been more moderate. Meanwhile, the economy
has continued to expand, but apparently rather sluggishly overall since the winter.
While these aspects of the economic situation were
important elements in the FOMC's review of its policy
plans earlier this monlh, the Committee also gave
careful attention to developments in financial markets.
Although market interest rates had changed little on net
since February, slow growth of the monetary stock and
other evidence in hand pointed toasmall but significant
tightening of credit supplies. This implied greater
effective restraint on aggregate demand in the months
ahead than was thought desirable, and in the past wee):
the System shifted lo a slightly more accommodative
stance in the provision of reserves to depository institutions. As a result, the overnight federal funds rate,
which had fluctuated narrowly around 8W percent
throughout the first half of the year, has declined to
about 8 percent, and other market rates of interest also
have eased a bit in recent days.

Developments Thus Far in 1990
In the early part of 1990, economic activity appeared
to be regaining momentum, a development that reduced previous concerns about recessionary risks. Ai
the same time, even discounting weather-related spurts
in food and energy prices and an unusual bunching of
price increases for some other items, there appeared to
be no abatement in underlying inflationary pressures.
Through the first quarter, M2 remained near the top of
the annual range set by the FOMC, and although M3
was near the lower bound of its range, this weakness




-Appeared consistent with the anticipated effects of the
restructuring of the thrift industry.
The Federal Reserve maintained a steady pressure
on reserve positions during the first quarter, rather than
extending the sequence of easing steps that had fostered
a drop in the federal funds rate of 1V4 percentage points
between June and December of 1989. However, in
keeping with the tenor of most of the economic data
released during the quarter, other interest rates generally moved higher, particularly at the long end of the
yield curve. This shift suggested that market participants had reevaluated the prospects for moderating
inflation and a further easing of monetary policy. Early
in the year, bond yields in the United States rose along
with rates in Japan and Western Europe, as developments in Eastern Europe suggested a further spur to
worldwide economic activity, carrying the potential
for greater inflation and heightened pressures on a
limited international pool of savings.
In the second quarter, some of the weather-related
increases in food and energy prices that had caused
inflation to pick up earlier in the year were reversed,
and price increases for many other goods and services
moderated. Inflation trends remained in Ihe range
prevailing over the previous three years, though price
pressures in die industrial sector gave signs of some
easing. The incoming information pointed to a sluggish
pace of economic expansion; most notably, growth in
private sector employment slackened,consumer spending flattened, and real estate markets weakened. Moreover, advance indicators in some sectors—particularly
durable goods orders and construction contracts—gave
no evidence of a significant pickup in the second half.
With ihe economy appearing somewhat less buoyant,
over May and June bond yields in the United States
retraced some of their earlier increases. Long-term
rates in Japan and West Germany also declined, but by
much less, with the result that yields in those countries
have risen appreciably this year relative to those in the
United States.
In foreign exchange markets, the dollar has depreciated somewhat on balance thus far this year, under the
influence of a diverse set of economic, financial, and
political developments around the world. The dollar
has appreciated slightly in terms of Ihe yen, while
depreciating somewhat in terms of the German mark
and other currencies of the EMS exchange rate mechanism and somewhat more hi terms of the Swiss franc
and pound sterling.
The monetary aggregates flattened out during the
second quarter, and by midyear M2 was in the lower

24
half of its annual range and M3 had fallen below the
lower bound of its annual range. The weakness in the
monetary aggregates mainly, though not wholly, reflected a rechannelling of credit flows away from
depository institutions. Total borrowing by domestic
nonfinancial sectors moderated only a little in the first
half of 1990 from the pace of 1989, and growth in the
aggregate debt of these sectors was in the middle of the
FOMCs monitoring range. However, the proportion
of lending accounted for by depositories was down
substantially. Much of the decrease related to the
shrinkage of savings and loan associations: Marginal
institutions continued to retrench, and the Resolution
Trust Corporation transferred large volumes of assets
to banks and onto its own books in the course of closing
failed thrift institutions. Meanwhile, concerns about
credit quality and pressures on capital positions led
banks to adopt more cautious lending postures and to
hold down asset growth.
The weakness in lending by depositories was reflected dramatically in the behavior of M3; this aggregate, encompassing managed liabilities as well as M2
deposits, comprises most of the liabilities used by these
institutions to fund credit extensions. With depository
credit damped, not only were managed liabilities weak,
but banks and thrifts did not bid aggressively for retail
funds—thereby contributing to reduced growth of M2.
In addition, increases in expected returns on stocks and
bonds may have restrained expansion of this aggregate, although some portion of the slowdown in M2
remains unexplained by changes in relative yields or
income. The weakness in depository credit and the
monetary aggregates likely has had, to date, only
limited effects on spending: The bulk of the credit
formerly supplied by depositories has been provided
by other lenders, in part through the securities markets, with little change in the terms to most borrowers,

Monetary Objectives for 1990 and 1991
In reevaluating its ranges for money and credil for
1990 and in establishing tentative ranges for 1991, the
FOMC had to take account of the redirection of credit
flows away from depository institutions and the result*
ing effect on the growth of the financial aggregates
relative to spending and prices. In February, the Committee expected that the continued shrinkage of the
thrift industry would damp growth in M3; to take
account of this, it lowered the M3 range for 1990 to2Vi
to 6'A percent, one percentage point below the range
set tentatively in July 1989. However, the contraction
of thrift assets has been faster than anticipated, in pan
because of the step-up in RTC activity, and bank credit
has expanded less rapidly. As a consequence, through




June, M3 grew at an annual rate of only 1W percent
from its fourth-quarter 1989 base.
Barring a marked slowdown in RTC activity or a
significant strengthening in bank credit, M3 growth is
likely to remain sluggish over the balance of the year.
As in the first half, the weakness in M3 growth is
expected to be associated with a further substantial
increase in velocity—the ratio of nominal GNP to
money—rather than with substantial restraint on overall credit supplies. Recognizing this unusual behavior
of M3 velocity, the FOMC voted in early July to
reduce the M3 range for 1990 to 1 to 5 percent. At the
same time, the Committee reaffirmed its range of 5 to
9 percent for total growth in the debt of domestic
nonfinancial sectors. The Committee seeks to ensure
that credit will remain available in amounts and at
terms compatible with moderate expansion of the
economy, and it will continue to assess the implications
of developments at depositories for credit conditions
more generally.
As noted above, the contraction of the thrift industry
and the moderate growth in bank credit also has
affected the growth of M2, as potential inflows of retail
deposits have outpaced the needs of depository institutions for such funds. The velocity of this aggregate has
risen, unexpectedly, but less than that of M3: Growth
of M2 from its fourth-quarter base through June was at
a 314 percent annual rate, within its annual range,
though in the lower half. M2 velocity is likely to
increase further over the second half of the year;
however, a substantial slowing of M2 could suggest
more restraint than would be consistent with sustained
upward momentum of the economy, and thus the
Committee reaffirmed the established range for M2
growth for 1990.
In setting tentative ranges for 1991, the Committee
faced more than the usual uncertainty about the growth
of money that would foster its objectives of sustained
expansion and a gradual abatement of inflation, Developments in credit markets will be shaped not only by
the special factors that have altered patterns of intermediation thus far this year, but also by the outcomeof the
current deliberations regarding the federal budget. At
this point, the forces that recently have diminished the
role of depository credit seem likely to persist for some
time, and they may foster further upward shifts in
monetary velocities, albeit probably smaller ones than
now appear in train for 1990. To be sure, though,
subsequent events may dictate adjustments to the ranges
next February, when they are reexamined in light of
developments over the second half of this year.
For growth in M2, the Committee tentatively adopted
a range of 2W to 6W percent—one-half percentage

25
Ranges tor Growth of Monetary and Credit Aggregates
Parcsrtt change,
fourth warier ID
fourth quarter

1990

1989

Adopted In
February 1990

Adopted in
July 1990

M2

3to 7

3to7

3to7

2V4 to 61A

M3

3<A to 7Vi

2Vi to 6%

1 to 5

1 to 5

Debt

e'Ato 101A

5 to 9

5to9

«*kM

point below the 1990 range. The adjustment is consistent with the Committee's intention to move over time
toward the low trend rates of monetary expansion that
would be consistent with price stability. At the same
time, the range is expected to allow for sufficient
expansion of money to sustain moderate growth in the
economy. There may be sortie further upward shift in
velocity, but the range should be wide enough to
accommodate considerable variation in credit market
conditions.
The range for growth of M3 was tentatively set al
1 to 5 percent, the same as that now in effect for 1990,
Growth of this aggregate is especially sensitive to the
pattern of credit flows. Thus, the continuing downsizing of the thrift industry is likely to result in slower
growth of M3 than of M2 again next year, as managed
liabilities in the broader aggregate run off. It also is
likely to mean a substantial further increase in M3
velocity. Given that growth of this aggregate currently
is running along the lower bound of the new range for
1990, even if the pace of credit flows at banks and
thrifts were to pick up somewhat, M3 growth between
1 and 5 percent should be consistent with the Committee's basic objectives.
For debt, the FOMC adopted a lenlalive monitoring
range of 4V4 to 8V4 percent, a half percentage point
below the range for 1990. The Committee viewed
slower growth of debt, more inline with the expansion
of nominal income, as a healthy development for the
economy. The rapid expansion of debt over the past
decade, relative to the ability to service it, occasioned
many of the difficulties with asset quality now facing
our lending institutions.

Economic Projections for 1990 and 1991
The members of the FOMC and the Reserve Bank
presidents not currently serving as members believe
that the monetary ranges for 1990 and 1991 are consistent with achievement of sustainable economic growth




Provlelonal for 1991

and a reduction of inflation over time. Most of them
expect that the pace of expansion will be moderate over
the remainder of 1990 and through next year, with the
central tendency of their forecasts of real GNP growth
being 1 'A to 2 percent over the four quarters of 1990
and 134 to 2 !A percent over the course of 1991.
Demand from abroad is likely to provide support for
continued growth in U.S. production and employment.
At current exchange rates, U. S. producers appear to be
in a position to compete effectively in most international markets, and economic activity is growing relatively rapidly on average in other major industrial
countries. In time, export demand should be bolstered
b> ihe shift toward more open, market-based economic
systems in Eastern Europe; although the continental
European nations may be most immediately affected by
these developments, given the high rates of capacity
utilization in those economies, the United States is
likely to benefit both directly and indirectly from the
increased demand for consumer and capital goods.
In the aggregate, demands from sectors outside of
exports are unlikely to provide much impetus to manufacturing activity. Defense procurement is declining
in real terms. And there is little prospect of a substantial resurgence in motor vehicle production: High
levels of auto sales in the past several years appear to
have satisfied demands that were pent up during the
deep economic slump of the early 1980s. Demand for
construction materials and equipment probably also
will remain subdued, because building activity will be
damped by the current overhang of vacant residential
and commercial space. That overhang, more than any
disruption of credit flows, explains the current weakness in construction, and, especially in the case of
office building, it will take some time for existing space
to be absorbed and to lay the base (or a solid upturn in
activity.
In sum, the growth of total output projected for 1990
and 1991 probably will involve rather slow gains for

26
Economic Projections for 1990 and 1991
FOMC Members and Other FRB Presidents

Administration

Range

Centra) Tendency

5 to 6'A
1to2

SVfetoBVfe
1Vito2

4 to 5

4Vtto5

6.8
2.2
4.8'

SVfe to 5V4

5.6'

1 % to 2Vt

7.2
2.9

1990
Percent change,
fourth quarter to fourth quarter

Nominal GNP
Real GNP
Consumer price Index
Average level In the
fourth quarter, percent

Civilian unemployment rate
19flt
Percent change,
fourth quarter to fourth quarter

Nominal QNP
Real GNP
Consumer price index

3V4 to 7
Oto3
3Vato5

1

4.2

Average level In the
fourth quarter, percent
Civilian unemployment rate

2

5V4 to 7

5.6

1. CPI-W.FOMCfor*ca!tsaretorCPI-U.
2. Percent ol total labor force, including armed (of cm redding in the Unilvd Stals

the goods-producing sectors of the economy. The
service-producing industries are likely to continue to
be the locus of important increases in output and,
especially, employment. Demands for a wide range of
services have remained robust thus far this year, and
demographic trends suggest that such sectors as medical care and education will continue to experience
appreciable growth.
.The overall growth in economic activity forecast by
the Board members and Bank presidents for the period
ahead is expected to be consistent with a slight easing of
pressures on resources and a diminution of inflation.
With respect to the labor market, the central tendency
of the forecasts for the civilian unemployment rate is
5 W to 5 M percent in the fourth quarter of this year and
5W to 6 percent in the final quarter of 1991; the jobJess rate has fluctuated narrowly at a little below
5'A percent since late 1988. Moderate growth in
demands on industrial capacity should be conducive to
an extension of the recent more favorable trends in




producer prices for intermediate and finished goods,
which were, respectively, virtually unchanged and up
just 3 percent in the past twelve months.
Inflation at the retail level also should be damped
over the remainder of this year by favorable developments in the energy sector. Despite the very recent
upturn in crude oil prices, gasoline prices are widely
expected to decline in coming months, as the return of
refinery output to normal levels alleviates the tightness
that has characterized the product market. With inflation for other goods and services expected to remain
below the first-quarter pace, the central tendency
of the policymakers' forecasts of the overall consumer
price index is for an increase of between 4W and
5 percent over me four quarters of 1990—compared
with the 534 percent annual rate of increase recorded
during the first five months of the year. The lower
trajectory of the CPI is projected to be sustained in
1991, with forecasts for the year centering on the 3 H to
4Vi percent range.

27
The Administration's economic projections, presented in connection with its mid-session update of the
budget, indicate similar expectations about inflation
trends but a more favorable outlook for real GNP. As a
result, the Administration's projection of nominal GNP
growth is somewhat above the central tendency of
those of the FOMC participants, and might imply the
need for faster monetary growth than is currently
contemplated by the Committee. These differences
must be regarded as small, however, relative to the




degree of uncertainty that attaches to any prediction of
the economy-and, in particular, of the short-run
relation between growth in GNP and money stockMore important, the differences do not signal any basic
inconsistency between the goals of the Federal Reserve
and the Administration, for the Federal Reserve would
welcome a more rapid expansion of output that occurred in the context of solid progress toward price
stability.

28
Section 2: The Performance of the Economy During the First Half of 1990
Activity in many sectors of the economy followed an
erratic course during the first half of the year, in part
because of transitory factors, such as last winter's
unusual weather. On balance, production expanded
further during ihe first half of 1990, but evidently no
faster than the reduced pace of 1989. The comparatively slow rate of growth largely reflected weaker
spending by domestic businesses and households, while
merchandise exports apparently remained on a fairly
strong growth path. Although job creation in the
private sector of the economy has slowed this year,
ihe civilian unemployment rale has remained near
5 L A percent, the lowest level in nearly twenty years.
Prices rose sharply early in the year, but the increases moderated this spring. In the first quarter, there
were large weather-related surges in food and energy
prices and a bunching of increases in prices of some
other goods and services. Given the character of the
spurt, most analysts—and policymakers in the Federal
Reserve—judged that the runup in aggregate price
indexes overstated underlying inflation trends. In the
event, some of the transitory elements of the earlier
spurt were reversed in the spring and inflation moved
down. Despite the recent slowing, however, the twelvemonth change in the CPI as of May, at 4.4 percent, was
about the same as that recorded for each of the past
three years. In part, the persistence of inflation during a
period of slower economic growth reflects continued
cost pressures from relatively tight labor markets and
weak productivity performance. However, there have
been encouraging signs, particularly at the earlier
stages of processing, that an easing of resource constraints in the manufacturing sector is reducing someof
the pressures that had boosted prices from 1987 to
early 1989.

The Household Sector
Total personal consumption expenditures were buffeted this winter by large swings in outlays for energy
items and motor vehicles. Expenditures for home
healing declined sharply in me first quarter as unseasonably warm temperatures in January and February
followed a December that had been colder than usual.
This influence was largely offset by a rise in motor
vehicle sales. In late 1989 sales of cars and light trucks
had been depressed by a scaling back of incentives and
by large price increases for new model-year vehicles.
Around the turn of the year, enriched incentive programs revived these sales. To date this year, sales of
cars and light trucks have averaged 14 million units
(annual rate)—a pace not far below the total for




1989—and seem largely to reflect replacement demand
and growth in the driving age population.
Abstracting from the swings in outlays on home
heating and motor vehicles, consumption spending
appears to have stagnated this spring after posting a
moderate gain in the first quarter of 1990. The recent
sluggishness in spending reflects declines in outlays for
a wide variety of consumer goods, including furniture
and other household durables. In contrast, spending
for services other than energy, especially medical
services, continues to outpace real income growth.
Growth of consumption has slowed this year against
a backdrop of somewhat smaller gains in real disposable personal income. But consumption has slowed
even more than income, and the personal saving rate
rose above 6 percent in the spring. Consumers may be
spending more cautiously as they reassess their income
and wealth prospects in light of the slower growth of
the economy and a softening of residential property
values in many parts of the country. These factors
probably have been particularly important in the Northeast, where consumer sentiment has deteriorated markedly. However, other indicators, such as delinquency
rates on consumer loans, do not reveal broad pressure
on household finances. Nor are there signs that credit
availability has been reduced: Federal Reserve surveys
of bank lending officers suggest no change in the
willingness to lend to consumers.
Residential investment spending also was affected
by unusual weather patterns this winter. Housing starts
were strong in the first two months of the year, as mild
temperatures allowed builders to catch up on work
delayed by cold weather in late 1989 and to begin
projects that normally would have been started later in
the year. Then starts slumped this spring, in part
reflecting a "payback" for the winter activity. Averaging over this period, residential construction appears to
have weakened; in the first five months of the year,
housing starts totaled 1.36 million units (annual rate),
somewhat below the pace of activity in 1989. By
region, housing markets have been very weak in the
Northeast, while homebuilding has been better maintained, albeit at moderate levels, in the North Centra!
and Western regions of the country.
Both demand and supply factors have contributed to
the recent weakness in housing construction. Sales of
new and existing homes generally have been moving
lower for more than a year; in part, demand may have
been restrained by slower growth in income and reduced investment motivation for home purchase because of softening bouse prices. Demand also may

29
Real GNP

Percent change from and ot previous period, annual rate

Drought-Adjusted

Q1

I
1984

1985

198G

I
1987

1988

Industrial Production

1989

1990

Index 1987 -100
120

110

100

90

I

I

I

19B4

19B5

1986

I

1987

80

1988

1989

1990

Implicit Deflator for QNP
Percent change from and ot previous period, annual rate




1984

1985

1986

1987

1988

1989

1990

30

Real Income and Consumption
Percent change from end of previous period, annual rate
|

| Real Disposable Personal Income

[""] Real Personal Consumption Expenditures

Q1

L
1984

_ I
1985

198G

1987

1988

Personal Saving

1989

1990

Percent of disposable Income

AprilMay
Average

1984

1985

1986

Private Housing Starts




1967

1988

1989

1990

Annual rate, millions of unite, quarterly average

Hi;
1984

1985

1986

1987

1988

1989

1990

31
have been tempered ihis spring by some edging up in
mortgage rates. Since early May, however, mortgage
rates have moved down about Vi percentage point, and
there is no evidence that access to home loans has been
curtailed.
On the supply side, building is being deterred in
some parts of the country by an overhang of unsold or
unreined housing units. In addition, it appears that a
reduction in credit availability for construction may be
playing some role in damping building activity. To a
degree, this less favorable credil climate is attributable
to the cutback in financing supplied by thrift institutions owing to the closure of savings and loans as well
as the more stringent capital requirements and lending
limits mandated by the Financial Institutions Reform,
Recovery, and Enforcement Act. At the same time,
other institutions do not appear to be filling the void
completely. In part, the shift in credit availability
reflects the elimination of the imprudently aggressive
lending that capsized so many thrift institutions. A
number of commercial banks also have recently experienced reductions in their lending capacity as they
have written off, or reserved against, bad loans. But, in
addition, the number of sound lending opportunities
undoubtedly has shrunk as a consequence of economic
weakness and soft property values in specific locales.
The Business Sector

The financial position of the business sector deteriorated further during the early part of 1990. Before-lax
profits from current operations of nonfinancial corporations edged down in the first quarter after falling
nearly 18 percent over the four quarters of 1989,
Profits have been squeezed by a combination of marked
increases in wages and benefits during aperiod of weak
growth in productivity, competitive pressures from
both home and abroad that have prevented firms from
completely passing increases in labor costs through to
prices, and higher debt-servicing costs associated in
part with increased leverage.
Shrinking profits, which have reduced the availability of internal funds, along with the slower growth of
final sales and easing of capacity pressures over the
past year, have muted the demand for new plant and
equipment. Reflecting these developments, real business fixed investment has decelerated considerably
since the first half of 1989.
Although total real spending on producers' durable
equipment rose at an annual rate of about 7 percent in
the first quarter, spending was boosted by a rebound in
outlays for motor vehicles and a resurgence in aircraft
shipments following the settlement of the strike lasi




November at Boeing. Excluding these transitory
swings, real equipment spending slowed further in the
first quarter, and shipments of most types of capital
goods—especially industrial machinery—remained soft
in April and May. One bright spot in the equipment
picture, however, has been the growth in outlays for
computers and other information-processing equipment, after some slowing during the second half of
1989.
Nonresidential construction was boosted by favorable weadier early in the year, but most of the gain has
since been reversed. The weakness is most evident in
office and commercial real estate, for which vacancy
rates are high and dataon. contracts and permits suggest
the outlook for building remains decidedly negative. In
some areas, this reflects sluggish growth in the regional
economies. However, activity also may be hindered by
the shift in the credit climate, as more speculative
projects that previously might have been financed no
longer qualify. An exception to the weakness in business construction has been in the industrial sector; lead
times can be quite long for these projects, however, and
much of the continued strength undoubtedly reflects in
large part decisions made when capacity pressures
were mounting in 1988 and early 1989. Indeed, contracts and permits for new industrial construction have
been Wending down for about a year.
The emergence of uncomfortably high inventories
in some sectors in late 1989 led to corrective actions in
the first part of this year. Most prominently, manufacturers of motor vehicles cut production sharply and
reinstated widespread sales incentives to eliminate an
overhang of stocks on dealer lots, lu roost other
sectors, stocks have been trimmed or have been increased only modestly this year, and they appear to be
in good alignment with sales trends. Among the possible exceptions are wholesale distributors of machinery
and nonauto retailers, where some mild overhangs
appear to have developed this spring; these could
precipitate further adjustments, probably affecting both
domestic and foreign producers.
The Government Sector
The federal budget deficit over the first eight months
of the fiscal year was$l52 billion, up from $113billion
in the year earlier period. About 515 billion of this
increase resulted from spending by the Resolution
Trust Corporation, and further RTC outlays during
June imply that the year-to-year increase in the deficit
is likely to widen. Most of the RTC spending reflects
financial transactions in which existing federal insurance obligations to thrift depositors are being recognized in the government's budget outlay and public

32
Real Business Fixed Investment
Percent change from end of previous period, annual rate
1 ~| Structures

Q Producers' Durable Equipment
20

r
1984

Q1

Jl
1985

1986

1987

1988

1989

1990

Changes in Real Nonfarm Business Inventories
Annual rate, billions of 1982 dollars

50

1984

1985

1986

1987

1988

1989

After-tax Profit Share of Gross Domestic Product *




1990

Percent

Nonflnanclaf Corporations

O1

1984

1985

1986

1987

1988

1989

—

1990

Ratio of profits from domestic operations with inventory valuation and capital
consumption adjustments to gross domestic product of nonfinancial corporate sector
10

33
debt accounts. The RTCs borrowing and spending
thus should have little effect on real economic activity
or interest rates.
However, several other budget components have
contributed to the higher deficit. Spending on Medicare and other health care programs, and some discretionary spending for Che space and other programs, has
surged. During the same period, revenue growth has
lagged as weak corporate profils have cut into receipts
and last year's surprisingly large personal income tax
collections have not been sustained. The latter suggests
thai some of lasi year's receipts reflected special factors, such as the deferral of tax liabilities in response to
the phased reduction of income tax rates under the Tax
Reform Act of 1986, and the capital gains realized
during sharp movements in financial markets.
Federal purchases of goods and services, the part of
expenditures that is included directly in GNP, fell in
real terms over 1988 and 1989, owing mainly to
declines in defense spending. Real defense purchases
continued to move lower in the first quarter of 1990;
however, the downtrend in total purchases was interrupted by a pickup in nondefense spending, mainly a
transitory surge in space expenditures. In the second
quarter, compensation for temporary Census workers
added to federal purchases.
Real state and local government purchases increased
at an annual rate of 4W percent in the first quarter,
compared with the 3 to 3 '^ percent pace recorded over
the past three years. Revenue growth generally has not
kept up with gains in spending, however, and an
increasing number of state and local governments face
significant budgetary difficulties; indeed, the overall
deficit of the sector (excluding social insurance funds)
was about $45 billion (annual rate) in the first quarter of
1990, almost $11 billion greater than the deficit recorded in the 1989 calendar year. These difficulties are
compounded by growing spending requirements in
several important areas. An increase in the number of
school-age children has boosted public school enrollments, the number of medicaid recipients has increased, and prison populations have risen rapidly.
Meanwhile, legislatures have been reluctant to increase personal income taxes, and federal grants and
increases in state excise taxes have failed to prevent the
widening of the gap between spending and revenues.

The External Sector
Movements in the exchange rate have been smaller
than those in 1989, when the dollar appreciated about
12 percent in terms of the other G-10 currencies over
the first half of the year and then depreciated by a




similar amount between last summer and this past
February. The dollar appreciated approximately 2 percent between February and March this year, but has
since declined about 4 percent, partly in response to
publication of weaker data on U.S. economic activity
and the associated washing out of expected increases in
interest rates.
While the value of the dollar has not changed
dramatically on a trade-weighted average basis against
the other G-10 currencies this year, there have been
some divergences in bilateral exchange rates. On
balance, the dollar has depreciated significantly against
sterling and the Swiss franc, and somewhat less against
the German mark and related currencies. In contrast,
the dollar has appreciated against the yen, despite
exchange market intervention by the Bank of Japan and
other central banks to support the value of the yen early
in the year. Against the currencies of our other major
trading partners in the Pacific Basin, the dollar has
depreciated against the Singapore dollar, but appreciated in terms of the South Korean won and the new
Taiwan dollar.
Prices of non-oil imports, which fell at about a
3 percent annual rate between the first and third
quarters of last year, rose at a similar pace between the
third quarter of 1989 and the first quarter of 1990,
partly in response to the drop in the dollar between last
summer and the early part of this year. Prices of
imported oil surged around the turn of the year, moving
above $20 per barrel in January, but since then they
have more than retraced this runup. On the export side,
prices rose at an annual rate of just 134 percent in the
first quarter of 1990 after recording little change, on
balance, over 1989 as a whole. In the first quarter,
prices for agricultural exports fell somewhat, but there
was an acceleration in prices for exported consumer
and capita) goods that appears to have been related to
some pickup in prices for these items in domestic
markets around the turn of the year.
Merchandise exports continue to provide an important impetus to growth in the domestic economy,
although the increases in exports have slowed somewhat from the very rapid advances recorded in the
latter part of the 1980s. So far this year, exports have
been boosted by strong shipments of aircraft with the
rebound in activity at Boeing, as well as by notable
increases in other classes of machinery, agricultural
products, industrial supplies, and consumer goods.
Two factors have contributed to further large gains
in the quantity of U.S. exports: Many of our major
trading partners abroad have continued to register
strong economic growth, and the average dollar prices
of U.S. exports have declined somewhat relative to

34
Foreign Exchange Value of the U.S. Dollar *

lixtox.Mwoh1B73.100

ire

150

125

JUlW

100

75

1984

1985

1986

1987

U.S. Real Merchandise Trade

1988

1909

1900

Annual rats, Nitons of 1982 dollars

600

475

Imports
/

•
350

Exports

225

100
1984

1985

1086

1987

1988

U.S. Current Account




1989

1990

Annual rate, billions of dollars

Q1

180
1984

1985

1986

1987

1989

1989

1990

Index of weighted average foreign exchange value of U.S. dollar in terms of
currencies of other G-10 countries. Weights are 1972-76 global trade of each of the
10counlrieK.

35
average prices abroad. Movements in nominal exchange rates do not appear to have contributed significantly to either export growth or overall U.S. external
adjustment in recent quarters; the effects of the large
depreciation of the dollar through 1987 have waned,
and any residual positive effects probably have been
offset by die average strengthening of the dollar last
year. However, the depreciation of the dollar since last
summer should lend some stimulus lo external adjustment in coming quarters.

Census; private payrolls have increased less than 20,000
per month. Manufacturing employment has continued
to shrink this year at about the same rate as in the
second half of 1989, and construction payrolls also
have declined since the winter. Meanwhile, job growth
in the service-producing industries has slowed in recent months. Although hiring gains have continued
strong for health services, growth in jobs in business
services has moderated, and there have been only small
gains in employment at retail establishments.

Meanwhile, slower import growth has accompanied
the slackening pace of activity in the United States.
Total imports were boosted by a surge in oil imports in
the firs! quarter, but, on balance, non-oil merchandise
imports have edged down this year. The slowdown in
imports has been pronounced in automotive products
and consumer goods, reflecting both weaker domestic
final demands and the inventory adjustments in these
sectors of the U.S. economy.

Growth in the labor force also has been subdued in
recent months. To an extent, this reflects longer-run
demographic trends; but it may also reflect a tendency
for fewer people to seek jobs when the growth of
employment opportunities is perceived to have slackened . Survey data suggest that individuals have increasingly viewed jobs as harder to find.

Together, the continued growth in exports and the
slowdown in imports narrowed the merchandise trade
balance to $105 billion at an annual rate in the first
quarter of 1990, its lowest rate since early 1985. The
current account deficit was reduced to S92 billion at an
annual rate.
Net private capital inflows, and a large statistical
discrepancy, provided the counterpart to the current
account deficit in the first quarter of 1990, as they did
for 1989 as a whole. Most of the private capital inflow
in the first quarter came through the banking sector.
Private foreign investors continued to acquire U.S.
corporate bonds in the first quarter; however, they
sold a small amount of U.S. Treasury securities, and
they continued to sell U.S. corporate stocks as they
have since last October. Foreign direct investment
flows into the United States slowed markedly in the
first quarter to a rate well below that recorded in
recent years. Official capital showed a net outflow in
the first quarter, as it did throughout most of 1989,
reflecting the net sale of dollars in exchange market
intervention.

Labor Markets
Job growth was strong early in the year, but has
softened recently. In January and February, increases
in nonfarm payroll employment averaged more than
350,000, fueled by large increases in service-producing
industries as well as by robust hiring in construction
during the warmer than normal winter weather. Since
March, however, job growth has averaged about
125,000 per month, despite the net addition of about
300,000 temporary workers to help carry out the 1990




The slower rates of growth in employment and the
labor force have been roughly matching, and the
civilian unemployment rate has remained near 5 !4 percent throughout the year. While unemployment rates
have risen noticeably in the Northeast and moved up in
some Midwestern states, jobless rales in other regions
of the country either have changed little or have edged
down.
With labor markets remaining relatively tight by
historical standards, pressures on labor costs have not
abated. Although the rate of increase in straight-time
wages has changed little over the past year and a half,
benefit costs, which currently constitute roughly onefourth of compensation, have picked up markedly. In
part, this increase reflected the higher social security
taxes that went into effect in January, but benefits also
have been boosted by the continued rise of health
insurance costs and an acceleration of lump-sum payments and bonuses. All told, employee compensation
in private nonfarm industry rose 5 W percent over the
twelve months ended in March, a bit above the pace
recorded in the year ended last December.
In addition to gains in hourly compensation, unit
labor costs have been boosted by a poor performance in
labor productivity, as output per hour in the nonfarm
business sector rose just W percent between the first
quarter of 1989 and the first quarter of 1990. While
productivity has remained strong in the manufacturing
sector, rising almost 5 percent at an annual rate in the
first quarter, productivity performance outside of manufacturing has been quite weak. As aconsequence, unit
labor costs in the first quarter of 1990 were 5 percent
above their level a year earlier, about the same increase
as recorded over 1989 as a whole, but well above the
rates that prevailed earlier in the expansion.

36
Nonfarm Payroll Employment
Net change, millions of persona, annual rate

Manufacturing

HI

I

1984

1985

1986

1987

I

1988

Civilian Unemployment Rate

I
1984

1969

1990

Quarterly average, percent

I
1985

1986

1987

1968

Employment Cost Index *




_

1989

1990

12-monlti percent change

Total Compensation

1984

1985

1986

1967

1986

1969

1990

Employment cost index for private industry, excluding (arm and household workers.
Percent change from Q1 1989 to O1 1990.
14

37
Price Developments
After surging in the first quarter of 1990, price
increases moderated this spring. Food and energy
prices were boosted early in the year by weatherrelated developments, and prices for a wide range of
other goods and services also picked up sharply.
However, by May, the transitory effects of the weather
on inflation largely had been reversed, and price
increases for many other items slowed significantly.
Energy prices surged this past winter, as a result of
demand pressures from the unseasonably cold weather
in December and supply disruptions at U.S. refineries
and in Eastern Europe. The posted price of West Texas
Intermediate oil, the benchmark for U.S. crude prices,
rose about S3 per barrel to a peak of $22 in January.
Since early February, on balance, the posted price for
WTI has moved down substantially, in large part
reflecting the effects on crude markets of increased
output by OPEC nations. Movements in energy prices
at the consumer level normally follow developments in
crude oil prices. Gasoline prices, however, remain
higher than in December. In pan, pump prices have
been boosted by the additional costs to refiners of
complying with environmental standards. In addition,
inventories of gasoline were relatively low during the
first half of the year as a result of a variety of supply
disruptions at refineries.
Overall, consumer food prices were boosted by
sharp increases in prices for fresh fruits and vegetables
after the freeze in December, but during the spring
these prices retraced most of their earlier climb. The
prices for other foods for home consumption have
continued on an upward course. In addition, the prices
of foods and beverages purchased at restaurants
have risen at a 6 percent annual rate so far this year,
about 1V4 percentage points above the average rate
of increase over the past two years; these prices
probably have reflected a dwindling supply of entrylevel workers and related increases in labor costs,
and perhaps in some regions by the higher federal
minimum wage.




The CPI excluding food and energy rose about
454 percent over the twelve months ending in May,
near the upper end of the range experienced during the
current expansion. Price increases for consumer goods,
particularly apparel, rose sharply early in the year.
However, the burst in prices did not carry through to
the second quarter, as prices for commodities excluding food and energy changed little in April and May.
In the service sector, inflation rose markedly in the
first quarter, in part reflecting some bunching of increases for items whose prices tend to change in
irregular jumps, such as public transportation fares and
auto registration fees. Although inflation in service
prices moderated in the spring, there was little retracing of the earlier increases; indeed, in May, the CPI for
nonenergy services was 5L/i percent above its level
twelve months earlier, the upper end of Ihe range of
increases seen over the past three and a half years. As in
1989, increases in prices of rents and medical services
contributed importantly to the rise in overall service
prices so far this year. However, there also have been
widespread pickups in prices for a variety of laborintensive services, and it is likely that, in addition to
strong consumer demands, higher labor costs have
boosted service prices.
The signs of moderating inflation for goods at earlier
stages of processing, which had surfaced as capacity
utilization rates moved down during 1989, appear to
have continued into 1990. After rising 4 W percent in
1989, the PPI for finished goods excluding food and
energy has increased at an annual rate of about 354 percent during the first six months of 1990. Producer
prices for intermediate materials excluding food and
energy increased at an annual rate of just W percent
between December and June, roughly the same rate of
increase as recorded over 1989 as a whole. The
moderation of inflation for goods at the producer level
is perhaps one indication that earlier moves toward
monetary restraint and the slower pace of economic
activity have worked to ease Ihe resource constraints
that had pushed up materials prices between 1987 and
early 1989.

38
Consumer Prices

1984

12-montti percent change

1985

1986

1987

1988

1989

Consumer Prices Excluding Food and Energy

1990

12-month percent change

Services less Energy

s

\

-\

\/
1984

1985

1986

J

Commodities less Food and Energy

~*
1987

1988

Producer Prices for Intermediate Materials
Excluding Food and Energy




I
1964

1885

I
1966

1989

12-month percent change

I
1987

1990

I
1088

1989

1990

39
Section 3: Monetary and Financial Developments During the First Half of 1990
Shifts in financial intermediation and credit flows,
stemming from the continued restructuring of the thrift
industry and a more cautious attitude of banks toward
certain credit extensions, exerted a major influence on
the monetary aggregates and their relation to economic
activity during the first half of 1990. In anticipation of
further contraction in the thrift industry, and its associated effects on depository intermediation, the Committee reduced the annual growth range for M3 by a full
percentage point in February, In the event, M3 has
slowed even more dramatically than had been anticipated, leaving this aggregate below the lower bound of
its reduced range. Not only has the Ihrift industry
contracted more rapidly than expected, but commercial banks have picked up little of the lending forgone
by thrifts and, in fact, have curtailed their own lending
in some sectors, thus further depressing depository
credit. With little need to fund asset growth, banks and
thrifts have pursued retail deposits less aggressively,
leading to the opening of a sizable gap between yields
available in the open market and those on such deposits. Partly as a result, M2 also has slowed, moving
down into the lower portion of its annual growth range.
The deceleration of the monetary aggregates mainly
reflects a reduction in the share of credit provided by
depositories, rather than a sharp slowing of income or
total credit flows. The velocities of both M2 and M3
posted sizable increases, particularly in the second
quarter. Total debt of domestic nonfinancial sectors
grew at an annual rate of 7 percent over the first half of
the year—down only slightly from its pace in the latter
half of 1989 and in the middle of its monitoring range.
However, growth of total debt was boosted by federal
government borrowing to support thrift resolutions;
the debt of nonfederal sectors grew somewhat less
rapidly than it did last year. Uncertainty about the
effects of the restructuring of credit flows, and about
the reasons for the extent of the slowdown in money
growth, underlined the need for the FOMC to assess
the behavior of the aggregates in light of information
on spending and prices and the likely course of monetary velocities.
The somewhat more cautious lending posture that
commercial banks have recently adopted is mainly a
response to heightened credit risks caused by the more
moderate pace of economic expansion overall and a
downturn in several sectors. The resulting loan writeoffs and pressures on capital positions may also have
induced some tightening of standards. Growing markets for securitized loans largely have filled the vacuum created by the retrenchment of thrifts in the area of




mortgage lending, with little attendant effect on the
cost or availability of residential mortgage credit to
households. Both banks and thrifts have cut back on
other types of lending that can less easily be rechannelled, however, including construction and nonresidential real estate loans, loans to highly leveraged
borrowers, and loans to small and medium-sized businesses. To offset tighter credit market conditions,
which could exert undue restraint on aggregate demand, the Federal Reserve has recently adopted a
slightly more accommodative stance with regard to
reserve provision, fostering a small decline in market
interest rates.

The Implementation of Monetary Policy
The FOMC maintained a steady degree of pressure
in reserve markets during the first six months of the
year. Policy had been eased in the second half of 1989
amid concerns that the economic slowdown might
cumulate and thereby threaten the expansion. In the
first half of 1990, however, the Committee viewed the
balance of evidence as suggesting that underlying
trends were generally consistent with its objectives of
sustaining economic growth while containing and eventually reducing inflationary pressures.
In the opening months of the year, incoming information on spending and prices caused markets to
reevaluate the prospects for a near-term reduction of
inflationary pressures and further easing of monetary
policy. As a result, market interest rates rose, despite a
steady federal funds rate. The rise was most pronounced at the longer end of the maturity spectrum,
and it restored the usual upward tilt to the yield curve
that had been absent much of last year. Developments
in Eastern Europe, which portended increases in demands on the world's limited pool of savings, also
contributed to increases in long-term rales in me
United States and abroad. By late April, market participants expected a near-term tightening of U.S. monetary policy.
In early May, the pendulum of market opinion began
to swing away from the view that a tightening of U.S.
monetary policy was in the offing. Beginning with a
lackluster employment report on May 4, economic
data have pointed to a somewhat slower pace of activity
and reduced price pressures. In addition, apronounced
slowdown in the monetary aggregates began in April,
followed by outright declines in May. Although both
M2 and M3 recovered a little in June, they remained
below the midpoint and the lower bound, respectively,

40
Short-Term Interest Rates

Percent

Monthly

Three-month Treasury bill >- -,>
Coupon equivalent

1982

1983

1984

1985

1966

1987

1988

1989

1990

1989

1990

Long-Term Interest Rates
Monthly

Thirty-year Treasury bond

I
1982

1983

1984

Obeervalona are monthly avuragas at daily data,
last observation for June, f S9O.




I
1935

I
1966

I
1987

1968

41
M2 and M3: Target Ranges Adopted in February and Actual Growth

Billions of dollars
Rate of growth

Q4 1989 to Q2 1990
A. 2 percent
Q4 1989 to June
3.6 percent

I

O

I

N

I

D

I

J

I

F

I

M

I

A

I

M

I

J

1989

J

A

S

O

N

D

1990

Billions at dollars
Rate of growth

Q4 1989 to 02 1990
1.6 percent

Q4 1989 to June
1.2 percent

J
O

L
N

1989




J
O

J

I
F

I
M

I
A

I
M

I
J
1990

\
J

I
A

I
S

I
O

L
N

D

42
to decelerate in the first quarter, slowing to a pace of
less than 4 percent from the 5 54 percent rate seen in the
fourth quarter of 1989. The effects of this slowdown on
M2 were partially masked, however, by a surge in
currency growth -apparently owing in pan to increased demand from overseas—and a bulge in some of
M2's wholesale components, mainly overnight RPs
and Eurodollars. By the second quarter, a steep runoff
in retail money market mutual fund (MMMF) shares
and a sharp decline in demand deposits reinforced
weakness in core deposits in damping growth in aggregate M2.

of their annual ranges at midyear. Evidence also suggested that restricted credit availability, in part the
result of tightened credit standards, may have spread
beyond commercial real estate, construction, and
merger-related lending. In response to this finning of
credit conditions, the Federal Reserve began providing
reserves slightly more generously through open market operations in mid-July.
Market interest rates, which already had receded
somewhat from their early spring highs, declined
further with the Federal Reserve's recent easing, though
intermediate and long-term rates remained above the
levels seen last December. Lower interest rates also
bolstered the stock market, and some share price
indexes reached record highs this month.
Spreads between high-quality private instruments
and Treasury issues narrowed slightly over the first
half of 1989. This narrowing reflected the continued
availability of funds for investment-grade borrowing
as well as increases in the borrowing needs of the RTC,
which are met partly through the Treasury. The pickup
in Treasury borrowing for the RTC was necessitated
by the faster pace of thrift resolutions, which require
the government to carry thrift assets on its own balance
sheet pending their disposition. The market for
investment-grade issues continued to function reasonably well, with stable rate spreads between quality tiers
and generally well-maintained issuance volumes. On
average, however, the business sector faced somewhat
higher borrowing costs, largely as the result of numerous downgradings of debt issues. The collapse of
Drexel Burnham Lambert had a marginal impact on an
already debilitated market for below-in vestmenl-grade
issues, widening spreads somewhat more between
yields on such bonds and those on other long-term
securities.

Increases in the opportunity costs of holding M2
balances—that is, the rise in other interest rates relative
to those on M2—retarded growth in this aggregate
during the first half of die year. This was particularly
evident for retail MMMFs. Through much of 1989, the
yield curve was inverted, and MMMFs, whose portfolios typically average about 30 to 40 days in maturity,
had historically large yield advantages relative to
longer-term Treasury bills and short-dated Treasury
notes. As a result, MMMFs expanded briskly. As the
yield curve began to flatten towards year-end, flows
into MMMFs ebbed, diough they remained a key
element of overall M2 growth. With the steepening of
the yield curve in the early part of 1990, MMMF
growth stopped in March. The recent rally in the stock
market also may have depressed MMMFs, as data
through May indicate strong inflows to equity mutual
funds, a substantial portion of which may have been
transferred from MMMFs.
When yield curves have become more steeply upward sloping in the past, the effect on M2 of weakness
in MMMFs and other liquid balances often has been
partially offset by strength in retail time deposits, as
households lengthen the maturity of their assets. This
year, however, retail CD rates were unusually slow to
respond to the rise in market rates through April,
contributing to unexpected weakness in M2. The reluctance of banks to raise deposit rates in response to
rising market rates was particularly evident in die
intermediate-term area where, for example, the rise of
100 basis poinls in the yield on the three-year Treasury
note during the first four months of die year elicited an
increase of less than 20 basis points in rates on bank
retail CDs of comparable maturity. Evidence of the
rising opportunity cost of holding M2 can be seen in die
unusually heavy volume of noncompetitive tenders in
Treasury bill and note auctions, which suggest a shift
oui of M2 balances.

Monetary and Credit Plows
Growth of the monetary aggregates was sluggish
over the first half of 1990, with M2 and M3 expanding
at annual rates of only 3 '/4 percent and 1W percent,
respectively, from the fourth quarter of 1989 through
June. The weakness in money growth primarily reflected a redirection of credit extensions away from
depository institutions owing to the continued downsizing of the thrift industry and a mo re cautious lending
posture of commercial banks.
The deceleration of M2 growth did not begin until
the second quarter of 1990, when growth slowed to a
2 'A percent annual rate from the 6 to 7 percent range
seen in the previous three quarters. Retail deposits
(which include NOW accounts as well as savings,
small time deposits, and similar instruments) had begun




The unwillingness of banks to price their deposits as
aggressively as in the past is partly an indirect result
of the contraction of die thrift industry. During the

20

43

Growth of Money and Debt (Percentage change)

M1

M2

M3

Debt of
domestic
nonfinancial
sectors

Fourth quarter to fourth quarter
1980

7.4

8.9

1981

5.4(2,5)'

9.3

12.3

10.2

1982

8.8

9.1

9.9

9.1

9.8

11.2

1983

10.4

1984

5.4

12.2

9.5

9.5

7.9

10.6

14.2

1985

12.0

8.9

7.8

13.1

1986

15.5

9.3

9.1

13.2

1987

6.3

4.3

5.8

9.9

1988

4.3

5.2

6.3

9.1

1989

0.6

4.5

3.3

8.1

4.8

6.0

2.7

6.9

3.6

2.3

0.4

7.0«

4.2

4.2

1.6

7.0

Quarterly
(annual rate)
1990

Q1
02

Semiannuaily
(annual rats)
1990

H1

'Figure in parentheses is adjusted (or shifts to NOW accounts In 1981.
e - estimated




44

3-year Treasury Mote and 2.5-year Commercial Bank CD Rates

Monthly

3-year Treasury Note

NOTE: Haltut*sri on coupon aquvaionl, 365-day basisPrallriinry data lor June. 1990 CO We
M2 Velocity

Ratio scale

Quarterly

I
1960

1965

1970

I

I

1975

NOTE: M2 Q21990 vstocity based on projected GNP lor O2 1990.




22

I

45
first six months of 1990, commercial banks enjoyed
$62 billion in retail deposit inflows—about a 10 percent
increase at an annual rate— while thrifts were shedding
$28 billion in retail deposits - about a 5 percent annual
rate of contraction. Much of this deflection of deposits
toward commercial banks was the direct result of RTC
resolutions. In ihe first half of the year, the RTC
resolved 170 thrifts holding $32 billion of nonbrokered retail deposits, much of which was immediately assumed by commercial banks.
Although deposit transfers do not directly depress
M2, they may have contributed to the weakness in this
aggregate by reducing banks' need to raise their offering rates to attract additional deposits at a time when
growth in bank credit was slow. Through the first half
of 1990, commercial banks were able to fund nearly
80 percent of their total credit growth with retail
deposits—almost double the proportion seen in recent
years—even though they allowed spreads between
market rates and their retail offering rates to widen
substantially.
Widening opportunity costs of holding M2 can
explain only some of the moderation in mis aggregate
in the first half of 1990, however. M2 may also have
been responding to slower spending, and other factors,
some of which may have been associated with deposit
restructuring under the RTC. Brokered deposits
formerly attracted to thrifts by relatively high yields
may have been particularly sensitive to the recent
sluggishness in deposit pricing; about $7 billion of
brokered deposits were held at thrifts that were resolved in the first six months of the year, and many of
these high- rate contracts were subsequently abrogated
or not rolled over by the acquiring institutions. Evidence also suggests that, in light of large deposit
inflows from thrifts, banks have curtailed marketing
and promotional activity designed to attract retail
deposits. Finally, the issuance of short-ierm Treasury
paper to fund RTC holdings of former thrift assets has
boosted the supply of, and raised the rates on, a close
M2 substitute just when depositories were becoming
less aggressive in seeking retail deposits. The rise in
opportunity costs and these other factors contributed to
an increase in the velocity of M2 in the first half of
1990, though some of this increase remains difficult to
explain.
The link between changes in depository intermedialion and M3 is somewhat more direct. This aggregate
encompasses managed liabilities, as well as deposits
and other sources of funds in M2, and is thus a better
barometer of the overall funding needs of banks and
thrifts. As has been evident since last summer, the
contraction of the thrift industry and the failure of




banks fully to pickup the slack has already resulted in a
significant slowdown in growth of depository credit
relative to that of aggregate nonfinancial sector debt
and a concomitant increase in M3 velocity. This trend
continued into the first half of 1990, as growth in
depository credit all but ceased—though overall debt
growth continued at a moderate pace - and M3 fell well
below the lower bound of its annual growth cone.
Although the FOMC foresaw some significant damping effects on M3 growth in 1990 in association with
the continued shrinkage of the thrift industry, the actual
weakness in M3 so far this year has been more pronounced than anticipated. In setting out its expectations
for M3 in 1990, the Committee recognized that considerable uncertainties surrounded the thrift industry contraction in terms of the pace of RTC resolutions, the
extent of asset shrinkage at capital-impaired thrifts,
and the desire of commercial banks to step into the
breach. To this point, a faster-than-expected shrinkage
of thrift assets has been manifested not only in weaker
M2 deposit inflows, but also in faster runoffs of large
time deposits and other M3 managed liabilities at
thrifts. In addition, commercial banks apparently have
filled less of the void left by thrifts than was originally
anticipated. As a result, they too have pared their M3
managed liabilities, further depressing this aggregate.
Rates on large lime deposits, like those on retail
deposits, have remained low relative to yields on
Treasury bills. Facing a substantial deterioration in the
quality of their assets and constraints on capital, banks
apparently have attempted to bolster profit margins and
have not aggressively pursued new lending opportunities. Not only have deposit rates been held down, but
loan rales also appear to have been raised slightly
relative to market rates and non-price terms have
tightened for certain types of credits.
The pullback in credit supplies, together with some
levelling out of demands for credit, likely contributed
to a deceleration of bank asset growth. Over the second
quarter, growth of bank credit slowed to a 5 % percent
pace from the near 7 percent rate of growth seen over
the first quarter of 1990 and the second half of 1989,
with much of the deceleration centered in real estate
and consumer lending. Although the slowdown in real
estate lending has been especially pronounced in New
England, this type of lending remains sluggish in
several other regions as well. Some of the deceleration
in consumer Sending represents sales of loans by banks
attempting to bolster capital-asset ratios. Even adjusted for these sales, however, growth of consumer
loans at banks slowed further in the second quarter
from an already reduced first-quarter pace. The weakness in consumer borrowing this year is due primarily

46
Weakness in Depository Credit
Domestic Nonlinancial Debt and Depository Credit
Four-Quarter Percent Change

Domestic fJontrnancfal Debt

1970

M3 Velocity

1975

Ratio scale

Quarterly

1961

1968

1980

1985

Debt Velocity
Quarterly

1975

1982

1989

1961

1968

1975

NOTES: Q2 1990 valodttes based on projected GNP for O2 1990. Debt lor Q2 1990 partially sstirnated.




1990

1982

1989

47
to sluggish retail sales, particularly of automobiles and
other durable goods; banks evidently have remained
willing lenders to households, and interest rates on
consumer loans have changed little.
Bank lending to businesses also has been depressed
this year. Surveys of commercial bank lending officers
through early May suggest that the slowdown in bank
credit largely reflects diminished demand for credit
and deteriorating conditions in the real estate market,
although tighter lending terms and more stringent
credit standards were frequently cited for borrowers
below investment grade, including many small businesses. Batiks seem to have raised lending rates somewhat to small firms, judging from the slight increase in
the spread between rateson small business loans and on
federal funds. Separate surveys in which small businesses were queried about general credit availability
have pointed to some recent increases in the difficulty
these firms face in obtaining credit, though on balance
they found credit availability little changed from mid] 989. The slowdown in bank business lending this year
has mainly reflected reduced merger activity. Bank
retrenchment in this area is consistent with other
private credit judgments, as evidenced by the major
slump in me market for bonds below investment grade.
The reduced volume of corporate restructurings,
coupled with a diminished household demand for
credit, has slowed the growth of the aggregate debt of
domestic nonfinancial sectors to a 7 percent annual rate
from the fourth quarter of 1989 through May of this
year, compared with the 8 percent rate seen last year.
Debt growth is currently in the middle of its monitoring
range and broadly consistent with growth in nominal
GNP. With the increasing leverage and the attendant
dramatic declines in debt velocity witnessed in the
1980s apparently ending, the Committee reduced the
1990 monitoring range for debt by VA percentage
points in February.
Debt growth decelerated in the first half of the year
despite a spike in U.S. government borrowing, which
owed primarily to the growing working capital needs
of the RTC. RTC spending, net of capital raised
off-budget by the Resolution Funding Corporation,
j amped to S31 billion in the second quarter, up from the
$4 to $5 billion levels of the previous two quarters.
This spending is financed through the Treasury and is
therefore included in the debt aggregate.
The pace of household borrowing slowed considerably in the first six months of 1990, reflecting decelerations in both mortgage and consumer credit. The
recent slowing of home mortgage borrowing appears




to be largely the result of reduced demand, owing to
increases it> interest rates earlier in the year and
weakening economic activity in some regions of the
country. Although banks have picked up only some of
the slack for thrifts in the area of mortgage lending, the
expanding market for securitized mortgages has facilitated an orderly flow of mortgage credit. In fact,
spreads of mortgage-backed securities over comparable Treasury issues remain low by historical standards
and rates on home loans have not risen noticeably
relative to other long-term rates.
Consistent with households' sluggish spending,
overall consumer installment credit has risen at a
234 percent rate from the fourth quarter of 1989
through May of this year, well below the 5 'A percent
clip in 1989. Some of this deceleration reflects substitution of home equity loans for previously existing
consumer indebtedness; households apparently continue to recognize the lower relative after-tax cost of
mortgage debt since the 1986 tax reform, which phased
out the interest deducibility of non-mortgage household indebtedness. The slowdown in consumer loans
an the books of depositories has been even more pronounced, reflecting a marked pickup in securitizations.
The trend toward securitization of consumer loans,
which has been evident in the last few years, appears to
have accelerated in 1990, possibly because depositories are making efforts to reduce assets in order to meet
the new risk-based capital requirements.
Through the first half of the year, the total borrowing
of nonfinancial firms has been maintained at about the
same pace as in the last half of 1989 despite a sharp
drop in equity retirements. Although business lending
by banks has slowed, commercial paper issuance picked
up the slack, particularly in the first few months of the
year. More recently, in light of declines in bond yields,
firms have stepped up their issuance of bonds and
slowed their use of commercial paper. Despite a recent
slight narrowing of spreads relative to investmentgrade securities, issuance of below-investment-grade
bonds has remained in the doldrums. Spreads between
investment-grade paper and Treasury issues are still
low by historical standards, held down in part by
supply pressures in the Treasury market.
In the municipal market, the increase in market
interest rates and the downgradings of a number of key
issuers during the first half of 1990 combined to slow
refunding issuance to a crawl. As a result, the total debt
of state and local governments expanded at only an
annual rate of 3 percent in the second quarter, compared with 4W percent in 1989.

Debt: Monitoring Range Adopted in February and Actual Growth
Debt

Billions of dollars
Rate of growth

O4l989toQ21990
7.0 percent

Q4 1989 to May
6.9 percent

5%

9500

O

N

D

J

F

M

A

M

1939

J
J
1990

A

S

O

N

D

M1: Actual Growth
M1

Billions ol dollare
Rate of growth
Q41989toQ21990
4.2 percent

Q4 1989 to June
4.1 percent

780

760

O
1969

N




D

J

F

M

A

M

J
J
1990

A

S

O

N

D

49

The CHAIRMAN. Thank you, Mr. Chairman. That is a very detailed statement and I appreciate the fact that you read the entire
statement into the record.
Let me start with a blunt question, and I'd like as frank an
answer as you can give.
You make it clear that we need to have a budget package, and it
needs to be substantial in terms of a deficit reduction. Everyone on
this committee agrees with that as a goal.
You talk about some positive effects that will come from that, assuming that's achieved. I want to ask the opposite question.
EFFECTS OF NOT ACHIEVING A BUDGET PACKAGE

There's not much progress that's discernible yet. Should we not
get a budget package, if there's a stalemate and we don't get one,
what does that mean for your ability or the Fed's ability to maintain a stable and balanced monetary policy?
Chairman GREENSPAN. Well, I think the question answers itself,
Mr. Chairman. It obviously makes it more difficult for us.
The CHAIRMAN. How much more difficult?
Chairman GREENSPAN. It depends on what is going on in the
economy. It depends on basically what is going on in the budget
itself and what the borrowing requirements
The CHAIRMAN. Wouldn't it give a pretty serious jolt? In other
words, haven't expectations now been raised, not just here, but
around the world? If we were to have the budget summit come to a
dead end, I would think that you'd have quite an effect in terms of
monetary reaction and financial market reaction, or do you not
agree with that?
Chairman GREENSPAN. Well, Mr. Chairman, that depends on
whether the markets have discounted it or altered their stance
with the expectation that a significant budget action will be implemented by the United States.
I still sense a very large element of skepticism in the markets.
Were that not the case, I think we would have seen a fairly major
action in the bond market already, as this summit process began to
evolve. I think there is a deep-seated skepticism which is encumbent upon us to dissipate because I think it does us no good.
I can't say to you what I think will evolve with respect to monetary policy or with respect to the markets because there are so
many elements involved in answering that question that I'm not
sure I could do adequate justice to it in a realistic manner.
The CHAIRMAN. Very good. Let me move to something that relates to that.
When you were here last week, you indicated the need to adjust
the money supply and Fed policy to try to offset this credit-tightening that you've elaborated on today.
Is that credit-tightening, if it were not offset, sufficient by itself
to nudge us over into a recession? Does it offer that kind of a
threat?
Obviously, you're going to try to offset it. You've already made a
policy decision to do that. But how material a threat would that be
to the health of the economy as a whole if it isn't dealt with?




50

Chairman GREENSPAN. It's very difficult to say. In our judgment,
looking at the economy as it has evolved over the last 6 months, we
think that the economy of the United States, its growth, its inflation prospects, the levels of unemployment, would all be best
served at this stage, on balance, if the degree of credit-tightening
or—put it this way—the degree of credit-availability in the economy from whatever source remained relatively stable.
In our judgment, a tightening is not an appropriate response, or
put it this way, a tightening is not something that we would like to
see happen. I can't tell you what the consequences are. It clearly
does raise the risks of tilting us over into recession. I don't know
whether it would be adequate to do that, but it raises the risks
more than we would like.
And so, as we view our actions, it is not an easing; it is basically
an offset to independent market tightening.
The CHAIRMAN. All right. Now, when you do that, and you've explained it, I think, clearly last week and today, when you make
that offsetting adjustment, is it your intention to try to hold interest rates where they are, or is it your intention to try to nudge interest rates down somewhat from where they are?
Chairman GREENSPAN. It's our intention to keep credit conditions
about where they are.
The CHAIRMAN. Well, but I want to
Chairman GREENSPAN. That's an important distinction, Mr.
Chairman.
The CHAIRMAN. Well, that's what I want to get clarified because
Chairman GREENSPAN. Maybe I can explain something which I
think might help in this respect.
The CHAIRMAN. Yes.
Chairman GREENSPAN. There's a general view that we in the
Federal Reserve fully control the state of credit conditions. And it's
presumed that if we fix the Federal funds rate, that that would
freeze the state of credit conditions in the short end of the money
market.
That is not, in fact, the case because there are other forces which
impinge upon the market, either pushing credit conditions to a
tighter or an easier stance. And it is that which affects the economy, not necessarily what we do.
So we are often required to move to counter market forces if we
perceive that they are having undesirable effects.
The CHAIRMAN. So the bottom line of that is that you're not
really aiming here with this policy adjustment that you're in the
process of making to move interest rates as such. You're making a
policy adjustment to make sure that credit availability in the aggregate is in the amount that you think we need to have.
Is that right?
Chairman GREENSPAN. That is correct, Mr. Chairman.
The CHAIRMAN. I want to ask you one other question and that's
with respect to our reliance on international borrowing.
The sense that I've had as we've had these discussions over now
some years is that our maneuvering room in terms of monetary
policy and fiscal policy is very directly connected with how the rest
of the world views our financial situation and their willingness to




51
continue to lend us money and the rates of interest at which
they're willing to lend us money.
If we were to veer off course very far here from what the international community viewed to be an unsound financial and economic condition and strategy, wouldn't that have the effect of driving up interest rates in the sense that the international community
would want a higher rate of interest generally in order to lend us
the large amounts that they do every day?
Chairman GREENSPAN. Certainly, if they perceive that our policies are becoming irresponsible, there is greater risk, and that risk
is reflected in higher rates.
The CHAIRMAN. If the Fed tried in some artificial way to drive
down domestic interest rates, that the rest of the world viewed as
being irresponsible and unsound and unsustainable, might it not
then in fact actually have the reverse effect and drive up interest
rates because foreigners would not be willing to lend us money?
Chairman GREENSPAN. I think the effect would be to take what
has been a very moderate growth in the money supply in recent
years to a much sharper degree of acceleration as we endeavored to
push interest rates down by flooding the market. The money
supply would accelerate. Inflation would not be that far behind, inflation premiums would rapidly embody themselves in interest
rates, and we would be worse off.
The CHAIRMAN. Thank you.
Senator Heinz.
Senator HEINZ. Mr. Chairman, I think you and the Chairman already talked about one of the questions I wanted to ask, which is
what happens if the budget summit ends up over the next 2 or 3
months in a period of procrastination and nothing happens?
The answer to that question was it would make Alan Greenspan's job a lot tougher than it is, and I don't know anybody who
volunteers, on this committee certainly, to have his particular
burden of responsibility.
Chairman GREENSPAN. I might say, that is a minor issue. What
concerns me, far more, obviously, is what it does to the American
economy.
Senator HEINZ. Exactly. The question is could the uncertainty of
postponing a resolution of this issue—and I say "could" advisedly—
create such uncertainty that not only would it be difficult for the
Fed to manage it, but it might tilt what is already a fragile economy into a recession?
Chairman GREENSPAN. Senator, I don't think any of us can look
into the future and come up with a scenario, one which anyone has
any confidence in.
All I would say to you is that I don't think we should position
ourselves to take the types of risks that we would if you don't resolve this problem.
RISKS OF NOT REDUCING THE FEDERAL DEFICIT

Senator HEINZ. Among the kinds of risks, I assume there are a
variety of them, there's high inflation, high interest rates, and recession.
Are those some of the risks?




52

Chairman GREENSPAN. At the moment, the major risk is not a
crisis, as such. The basic problem with the Federal deficit is that it
has reduced domestic saving in this economy for a number of years
and has had a corrosive, virtually invisible effect in undermining
our net capital investment and productivity advances.
Senator HEINZ. You make that point very clearly on page 14 of
your statement, which I want to refer to specifically.
I think most of the members of the committee would agree with
you that we have a very serious lack of savings in this country and
we all talked about that.
I would like to ask you to focus for a moment on the other side of
the equation—namely, investment.
Now, I know, to an economist, saying tends to equal investment,
in the old simplistic macroeconomic models that we all got in
school, Economics 1.
But you know that's not the case because we know that if there
are a lot of savings, there tends to be more investment. But by the
same token, if there aren't adequate opportunities for people to
earn good returns on their investment, if it's more attractive to
invest abroad than in the United States, as lots of companies have
been doing for a very long time, for 10 or 15 years, for a variety of
reasons, if other countries create, either fairly or unfairly, rules of
the game that give their economies an edge, and we don't, that depresses returns to investment in this country.
If our tax system unfairly penalizes returns to equity investors,
and I think you believe it does, obviously, that has an impact.
My question to you is, in a time period where clearly, particularly in the manufacturing sector, product life cycles are shorter, the
requirements for investment, retooling, new investment, are accelerating all the time in order to account for the rapidity of change
and obsolescence, is the United States lacking a sufficient return to
new investment, such that people think it better to consume rather
than to invest?
Chairman GREENSPAN. I think the evidence, Senator, certainly
leans in that direction. The major reason why I think we have to
address the budget problem is not because there is a dawning crisis
in front of us.
In fact, since there may not be, it's all the more urgent that we
attack the issue because it's very easy to go from month to month
and say nothing has happened, while the corrosive undermining of
the saving and investment process continues over the long term,
creating the type of problem, Senator, which you raise.
Senator HEINZ. My question actually went beyond the budget
deficit, because, while that can lower the overall cost of capital in
an economy, if the overall return to investment is higher some
place else, or differentially low in the United States, people will go
some place else, irrespective of whether their cost of capital is 3
percent, 6 percent, or 9 percent. You may get a lower cost of capital overall, but they'll go where they can get the biggest return.
So my question really reached out beyond the budget issue. But I
don't have time to pursue it.
Chairman GREENSPAN. Well, let me just say quickly, the reason I
raised the budget issue is that I think it is critical to the issue you
raised.




53

Senator HEINZ. I don't disagree, but I was trying to get beyond it.
Obviously, time is not going to permit us to do that.
I note on page 11 of your statement that you indicate that restraint, talking about restraint and how it's clear, and I quote,
"that the financial restructuring," which you discuss at length,
"will affect the channels through which policy actions are transmitted, ultimately to economic growth and inflation. Some will be
diminished, others augmented."
As we look back on the last 10 years, which you identified as a
period of excessive credit growth, and we look at specific failures
such as the S&L failure, and as we look at all of the other areas
where Government is exposed, which total an estimated $6 trillion
from existing deposit insurance programs, loan and pension guarantees, direct loans, implied Government guarantees of debt issued
by Government-sponsored enterprises, and all the rest, does it seem
to you that Congress needs to do a better job of examining and understanding the weaknesses and, indeed, the failures, as well as the
prospective problems in the current system, and to implement
much more comprehensively, thoughtfully, and aggressively than
before, reforms necessary in other areas—I'm going beyond the
S&L problem—to ensure the protection of the Federal Government
from other types or even levels of financial risk?
Chairman GREENSPAN. Senator, I think we all have to increase
our knowledge of that whole structure of risks, and, hopefully, we
are rapidly moving in that direction.
To address the type of problem implicit in your question, we developed the statement that I delivered here last week on our philosophy toward banking regulation and changing banking structure
changes, specifically emphasizing the question of capital.
In a sense, all of the problems that we perceive are reflective in
one way or another of the fact that we probably have capital cushions that are too low throughout the system.
Senator HEINZ. Mr. Chairman, thank you. My time has expired.
The CHAIRMAN. Thank you, Senator Heinz.

Before yielding to Senator Sarbanes for his questioning period,
Senator Graham, do you have a brief opening comment that you
want to make?
Senator GRAHAM. Mr. Chairman, I appreciate the Chairman appearing again with us today. I do not have an opening statement.
The CHAIRMAN. Very good.
Senator Sarbanes.
Senator SARBANES. Thank you, Mr. Chairman.
Chairman Greenspan, I first want to ask about a statement on
page 4 of your testimony.
Throughout this period, rates on Treasury bills have remained somewhat higher
than usual relative to those on private instruments, probably in part reflecting the
large amount of bill issuance necessary to fund working capital for the ETC.

My question is how much higher as a consequence of funding
working capital for the ETC?
Chairman GREENSPAN. It's obviously significantly less than a
hundred basis points and maybe less than fifty.
My guess, without looking at the numbers, is 20 to 40.
Senator SARBANES. Twenty to 40 basis points?




54

Chairman GREENSPAN. My more thoughtful colleagues say a
quarter of a percentage point.
Senator SARBANES. Now, I'm interested in the ranges for growth
of monetary and credit aggregates which you've set out in the
report.
Are these ranges as wide as they've been in any report submitted
by the Federal Reserve?
Chairman GREENSPAN. Yes.
Senator SARBANES. Four-point range?
Chairman GREENSPAN. Yes.
Senator SARBANES. That's as wide as it's ever been?
Chairman GREENSPAN. I don't think they have been wider than
that.
Senator SARBANES. At what point does it become so wide that it's
meaningless?
Chairman GREENSPAN. I would say much beyond four points.
Senator SARBANES. We're at that point right now, in effect. Are
we now being given by the Fed a range that is so wide, that it's
really a meaningless exercise?
Chairman GREENSPAN. No, on the contrary. In fact, one of the
issues that you raised in your opening remarks, Senator, with respect to what has been happening in recent weeks, is the fact that
money supply growth has stalled out again. It appeared in June to
be coming out of what was a very sharply depressed May level, and
looked as though it was going to be on track, but then it stalled
out—in the context of the ranges which we are contemplating.
As I've indicated in my prepared testimony, we use those ranges
as a meaningful measure of how we think the various aggregates
ought to grow consistent with our view of the appropriate policy
stance.
So I'm saying to you that they are quite meaningful.
Senator SARBANES. Well, suppose it was a 6 point range. Would
that mean anything, to lay out a 6 point range?
Chairman GREENSPAN. I think that you set a range to correspond
to where a specific monetary aggregate is likely to fluctuate without significantly altering the thrust of one's policy stance.
In my judgment, a 6 point range is unlikely to capture that.
Senator SARBANES. In other words, if it fluctuates that much, it's
outside the policy range.
Is that right?
Chairman GREENSPAN. I would say if it fluctuates that much and
has no impact upon the economy, one has to raise a serious question as to whether it is a useful monetary aggregate on which to
focus policy.
Senator SARBANES. Well, this is one item I want to keep an eye
on.
When the chairman asked you about interest rates and whether
you were expecting to have a policy that would lower interest
rates, you used a different phrase in response to that and made a
point of it.
Was that phrase, "credit availability"?
Chairman GREENSPAN. "Credit conditions."




55

Senator SARBANES. Credit conditions. And I take it that what you
were saying by that is that you do not anticipate a monetary policy
that would result in the lowering of interest rates.
Chairman GREENSPAN. At present our policy is as I stipulated it
in my prepared testimony.
In other words, pur policy is contingent: We would do certain
things under certain conditions. Of course, when we meet at an
FOMC meeting we may make a very specific change to policy.
Senator SARBANES. Well, you want to keep credit conditions as
they are, as I understand it.
Is that correct?
Chairman GREENSPAN. I would say in the current context, in the
judgment of the committee, and one to which I fully subscribe,
stable credit market conditions at this stage would be appropriate
for the best performance of the economy.
Senator SARBANES. And I take it, since you made such a point of
the distinction, that that would therefore encompass interest rates
at about their current level.
Chairman GREENSPAN. I very purposefully discussed the distinction between short-term interest rates, the Federal funds rate, and
credit conditions.
Most of the time, the vast majority of the time, they're indistinguishable. But not all the time. And it is in this specific period that
they have deviated sufficiently to induce an offsetting action on the
part of the Federal Reserve, and that's the reason why we moved
as we did on Friday.
Senator SARBANES. Now in your statement, on page 3, you say,
In the short run, however, the risks of inflation, on the one hand, and of an economic downturn on the other, must be weighed in the policy-making process. The
Federal Reserve saw those risks as about evenly balanced over the first half of the
year and made no adjustments in monetary policy.

I take it you're now making adjustments in monetary policy.
Is that correct?
Chairman GREENSPAN. I think that's a semantic question. It depends on whether or not you are
Senator SARBANES. You mean the question as to whether you're
making adjustments in monetary policy?
Chairman GREENSPAN. No. If you're defining policy in the
narrow sense, obviously, we have changed. If you're defining policy
in a broader sense, meaning that we are endeavoring to maintain
stable credit conditions, then the answer is we have not.
Senator SARBANES. I see. So, on the one hand, you've adjusted
policy, and on the other hand, you've not adjusted policy.
Chairman GREENSPAN. It depends on the way you define it.
Senator SARBANES. That's why Truman always wanted a onehanded economist. [Laughter.]
Chairman GREENSPAN. Now, let me be very specific, Senator, so
it's clear.
Senator SARBANES. President Truman, he said he wanted a onearmed economist so he didn't get these "on the one hand" and "on
the other hand" answers. [Laughter.]
Let me ask you this question.
The CHAIRMAN. You wanted to clarify.
Chairman GREENSPAN. Yes.




56

Senator SARBANES. I don't want to deny you your other hand,
please.
Chairman GREENSPAN. The only thing I don't want to leave unclear is that what we do is policy, but let's define exactly what it is
that we're doing and why we are doing it. That's a very important
issue in understanding how the Federal Reserve interacts with the
system.
Senator SARBANES. Let me ask just one final question on that
point, Mr. Chairman. I understand that.
The CHAIRMAN. All right. I'm sensitive to the time limits. If we
could make it short.
RISKS OF INFLATION AND ECONOMIC DOWNTURN

Senator SARBANES. You say the Federal Reserve saw those risks
as about evenly balanced over the first half of the year. That was
the risk of inflation, the risk of economic downturn.
I take it you now see those risks differently. Is that correct?
Chairman GREENSPAN. I would say that we probably view the
risks of a recession and inflation us about the same, but we feel
uncomfortable with that way of looking at it, if for no other reason
than the surest way to get a recession going in this country is to
allow inflation to take hold.
In other words, I'm uncomfortable with that distinction if we
fine-tune it too much.
Senator SARBANES. Well, no, let me put the question to you.
You've stated in your statement that you saw the risks as about
evenly balanced over the first half of the year.
How do you now see the risks? Evenly balanced? Moreso on the
recession side? Moreso on the inflation side?
Chairman GREENSPAN. I would say at the moment they're still
generally evenly balanced, though perhaps a shade more toward recession than they were earlier in the year.
Senator SARBANES. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Thank you, Mr. Chairman.

Alan, you said
The CHAIRMAN. If you'll suspend for a minute, I want to just describe for the home viewing audience the noise they hear in the
background.
Whenever the Chairman of the Fed is here and says something
that some at the press table think is in the immediate news category, there's a burst of reporters out the door, and chairs are often
tipped over.
In fact, we now have in the budget of the Banking Committee a
"broken chair allowance" that we have to factor in on those occasions when the Chairman of the Federal Reserve is here because so
much importance is attached to his comments and the speed of reporting those comments.
The noise that often occurs in the background is the sudden exit
of reporters who are running for telephones to inform the world as
to what has been said.




57

I won't trespass on your time in saying that, but I just want to
help people understand what the commotion is when they hear it
on their television set and yet, can't see it.
Senator D'AMATO. And a 60-point drop in the stock market.
Senator GRAMM. Well, Mr. Chairman, I guess it simply shows the
importance of a shade of difference. Whether the observer is capable of making a judgment about that shade of difference, we don't
know, but at least they'll read about it tomorrow.
Alan, let me ask you a question. I want to go back to your comment about how you believe the market has really discounted a
major deficit reduction, the likelihood of a major deficit reduction
action by Congress.
I see that as good news for two reasons. One, it shows the market
has not lost touch with reality, and that always encourages me.
Second, I think it shows that the rewards are big if, with the
economy getting a little softer, a shade of softening, if that were
occurring with expectations already built up that we were about to
dramatically reduce the deficit and change the fiscal policy of the
Nation, then I think the rewards of that action, on the positive
side, would be relatively small, they having already been discounted. The reaction on the negative side, if we didn't do it, might be
big.
But I think the fact that the markets clearly have discounted
any affirmative action substantially means that if we do something
and it's dramatic, the reaction is likely to be large and positive.
Do you agree with that?
Chairman GREENSPAN. On the size of the budget cut?
Senator GRAMM. Yes.
Chairman GREENSPAN. I would say so, yes. Let me say this in the
context of what these words mean.
I think it's important to define what the forces are out there. At
this particular stage, as I've said in my testimony, I don't see any
cumulative evidence that is working toward a recession. In fact, inventories are in reasonably good shape.
If further credit-tightening does not occur in the markets, we
should not expect to go off the track that we are currently on.
And so, when we are dealing with this issue of what's more important—inflation or recession, and what the balance is—I think
that's too simple an approach. I think we have to keep in mind
that we are endeavoring to keep the economy on an even keel as
best we can.
SAVINGS AND LOAN PROBLEM

Senator GRAMM. Let me ask you a question about the S&L bailout, both working capital and the bail-out cost itself.
Obviously, we are now past the situation where a private entity
is guaranteeing the payment of principal with a zero-coupon Treasury bond. That was the case we were in last year, and there was a
legitimate debate about whether that should be on-budget or offbudget.
I think we're past that point. I think, clearly, now, the working
capital, in my opinion, should not be on-budget until we get an as-




58

sessment of the loss. But once we've got the loss, that's an onbudget loss.
The question is, though, with the great uncertainties about it
and with it actually, with asset disposal in the out-years potentially
lowering the deficit as assets are sold, do you believe that the capital cost of the S&L bail-out should be built into the GrammRudman targets or just isolated from it?
Chairman GREENSPAN. I would think they should be isolated.
Senator GRAMM. I agree with you because I think, No. 1, they
create a potential mischief in terms of manipulation, where you
would borrow money at the end of one fiscal year and dispose of
assets in another.
And I think also, by creating tremendous uncertainty, you create
the potential that our ability to meet the targets is affected by the
gods and not by us.
Let's assume that we get a worst-case scenario and we don't get
an agreement and the sequester goes into effect on October 1. A
little over $100 billion. Current services spending is up $70 billion,
$75 billion. So we're cutting $25 billion below the level we spent at
last year. Bad public policy. Across-the-board cuts make no sense.
But at that point, if it really came down to a choice between suspending the sequester and, in essence, giving up on the GrammRudman process, or leaving it in effect, at least until Congress did
something, and if they didn't, leaving it in effect for the fiscal year,
what would be your fiscal prescription?
Chairman GREENSPAN. That is an extremely tough question. I
just would want to say that I hope that the Congress doesn't allow
itself to get to that point.
I think that the presumption of a $50 billion or $60 billion cut
strikes me as the right order of magnitude for the first year. And I
see no reason why proper policy cannot be implemented.
Senator GRAMM. You know, we have a bad habit of the stock
market collapsing in October. In 1987, we had the 508 points and
then we had the budget summit agreement in effect in 1988, such
as it was. And then in 1989, we had the 100 point drop.
Are you concerned that if we get to October and the sequester's
triggered, we've got the uncertainty as to whether Congress is
going to detrigger it, whether they're going to take action, that we
might have another slump in the stock market?
Chairman GREENSPAN. I could answer that question as a private
citizen, Senator, but I would like to suggest to you that it would
not be appropriate for me to address that question one way or the
other.
In all seriousness, there's no way that I could know the answer
to that question.
Senator GRAMM. Well, I would think, though, Alan, that you
would suspect that if, in fact, we had fiscal chaos in October, which
we had in 1987 and we had in 1989, that that would not be good for
the equity markets.
Chairman GREENSPAN. Fiscal chaos would not be good in September or November or December. [Laughter.]
Senator GRAMM. Well, October is where the law creates the
chaos.
But if you don't want to answer, that's fine.




59

Chairman GREENSPAN. Senator, there are so many hypothetical
outcomes here. You can spin all different types of scenarios, which
I don't think really are all that useful.
I think what we ought to do is focus on getting an agreement
going, getting the budget deficit problem under control, and getting
it behind us once and for all.
The rewards of getting that budget problem behind us are extremely large. While I understand the very difficult problems that
the Congress and the administration are going through, the pay-off
is so large, that it strikes me that we should not be trying to figure
out what would happen under a variety of different conditions.
Senator GRAMM. Thank you, Mr. Chairman.
The CHAIRMAN. Before yielding to Senator Shelby, I want to put
an important fact into the record that we've just recently been
given,
You serve as a member of the RTC Oversight Board which must
try to figure out how to resolve the problems in the savings and
loan industry, I want to say for Senator Gramm's benefit, before he
leaves, we have recently gotten an analysis from the RTC through
June 12 of this year, on the dollar value of all of the assets that
have been taken back from failed thrifts. That's everything from
golf courses to residential properties to land, what have you.
That's everything from golf courses to residential properties to
land, what have you.
And of all of the properties now in possession that have been
taken in by the RTC, 69 percent of the total asset value represents
assets within the State of Texas. That is an interesting, I think, illustration of the fact that, while it's a huge national problem, at
least in terms of what there is on the junk pile, fully 69 percent of
the dollar value of the assets are found within a single State.
That relates very importantly to the State-chartered powers
problem, which is a critical part of the overall thrift problem.
Senator GRAMM. Mr. Chairman, could we at this point put the
number on the screen that you call if you want to buy any of these
assets? [Laughter.]
The CHAIRMAN. Unfortunately, we already own them. [Laughter.]
We own them as the public and now we need to try to sell them.
But it's a very interesting fact.
Let me also say, Senator Kerry, you've joined us. Did you have
any brief opening comment? If not, Senator Shelby.
Senator KERRY. Thank you, Mr. Chairman, I don't.
The CHAIRMAN- Senator Shelby.
Senator SHELBY. Thank you. Thank you, Mr. Chairman.
I don't want to get into hypothetical, Mr. Chairman, not too
many, anyway. But let's just suppose, knowing your background
and knowing your knowledge of what the financial markets look
forward to us in Washington to do, not to say. They discount what
we say, but they really watch what we do.
If, in fact, in the next several months, we make real, not imagined, deficit reductions here, that would be profound, would it not?
It would be the right signal or a good signal to send to the Fed?
Chairman GREENSPAN. Yes, it would. It certainly would, Senator.




60

Senator SHELBY. Would it be better for us to make multiyear outlooks in the deficit rather than just we're going to do a quick-fix for
this year?
Chairman GREENSPAN. I would say it's not just better; it's essential.
Senator SHELBY. It's essential.
Having said that, so I would assume that any real reduction in
interest rates in the market, real, real big, would be linked to the
reduction in the deficit of what the Congress really does, not what
it says.
Chairman GREENSPAN. That's correct, Senator.
Senator SHELBY. OK. Now, you mentioned earlier that other
forces other than the Fed, you know, the Fed, and you're the Chairman of the Fed for many years, set out monetary policy and we
thought, so many people still do, I think, think that you as the
Chairman can just set it without regard to anything other than
what goes on in the United States of America.
Well, we know that's not true.
But isn't it a fact that as we have become more and more dependent on our ability to borrow internationally from the Japanese
and the Germans and the Swiss and others that will come forward,
that they sort of have a leash on our economy, in a sense.
In other words, what happens in Europe, what happens in
Frankfurt, what happens in Tokyo, is a leash on what you do at
the Fed, just like a lot of domestic things that happen.
Is that a fair statement? Is a leash too strong?
Chairman GREENSPAN. A leash is a little strong. I think it's clear
that
Senator SHELBY. A rope?
Chairman GREENSPAN. No, no, those are factors that we have to
consider, and it does have an effect on what we do.
Senator SHELBY. OK. But it is a burden, isn't it, a sense of
burden that we
Chairman GREENSPAN. It makes it more difficult, certainly.
NEED TO INCREASE SAVINGS

Senator SHELBY. OK. So that ties in, does it not, Mr. Chairman,
to our low savings rate; in other words, our savings pool has not
grown as our appetite for money has grown.
And when you talk about here at the table, and you've done this
for years now before this committee, and you're speaking as the
Chairman of the Fed, you're talking about a low interest rate and
so forth in this country. It's just about essential to the future of our
economy to up that savings rate in this country, isn't it?
Chairman GREENSPAN. I think that's the most important domestic economic policy issue.
Senator SHELBY. No. 1. Would that be your No. 1 priority?
Chairman GREENSPAN. Yes.
Senator SHELBY. That, and what would be your second? Cutting
the deficit?
Chairman GREENSPAN. Well, no. Cutting the deficit is part of
that.
Senator SHELBY. Or would they be simultaneous?




61

Chairman GREENSPAN. No. Cutting the deficit is part of the strategy to enhance domestic saving in the United States.
Senator SHELBY. How much, Mr. Chairman, of the domestic savings is the Fed eating up in the borrowing each year?
In other words, the savings pool out there, domestically in the
United States?
Chairman GREENSPAN. How much do we, the Fed?
Senator SHELBY. Yes. No, not the Fed; the Government.
Chairman GREENSPAN. The Government.
Senator SHELBY. Oh, not you. I knew you didn't borrow it; you
create it. [Laughter.]
Go ahead. In other words, roughly, what is the percentage of our
domestic savings pool that is eaten up by the Federal Government's borrowing each year?
And if you don't have that figure, if you could furnish it for the
record.
Chairman GREENSPAN. I do have the figures here, but I'd like to
submit them for the record because that's an important number
which I want to make certain I get correct.
[Chairman Greenspan subsequently submitted the following:]




62
Federal Budget Deficit and Domestic Saving
Fiscal Years

Net Domestic
Nonfederal Savina

Federal Budget
Deficit
(I)
DJ.J.XJ.UUB

(2)
UJ-

UWXJ.aj.0

Deficit as Share
of Saving
(3)
— Percent —

2.8
23,.0
23..4
14..9
6 .1

74.,7
86..4
98..7
125..9
138..2

3.8
26,.7
23,.7
11,.8
4,.4

1975
1976
1977
1978
1979

53.,2

128,.1
155.,8

40,.2

214..3

41.,5
47..3
31.,3
29,.4
18,.7

1980
1981
1982
1983
1984

73..8
78 .9
127..9
207..8
185 .3

195..3
229,.6
221.,2
220..2
314,.2

37,.8
34..4
57..8
94 .4
59..0

1985

212 .3
221 .2

302..2
286 .4
217 .4
278..3
279,.7

70 .2
77 .2
68 .9
55..7
54..3

1970
1971

1972
1973
1974

1986
1987
1988
1989

73..7
53,,6
59..2

149 .7
155,.2
151..9

171,.5
201..0

1. The federal budget deficit, recorded as a positive number, is on a
unified budget basis.
2. Net domestic nonfederal saving is drawn from the national income and
product accounts, table 5.1; it is the sum of personal saving,
undistributed corporate profits (with inventory valuation and capital
consumption adjustments), and the state and local government budget
surplus or deficit (-).
3.-Entries in the third column equal the corresponding entries in column
(1) divided by those in column (2), with the result multiplied by 100.




63

Senator SHELBY. And have our borrowings internationally continue to go up almost vertically? Or have they ebbed some?
Chairman GREENSPAN. Net borrowings abroad, which are best
measured by the current account deficit, have come down a bit.
Senator SHELBY. And that's good news.
Chairman GREENSPAN. It's good news, but if we can get the
budget deficit down further, we're likely also to bring the current
account deficit down with it.
Senator SHELBY. Last, I want to get onto something that you
mentioned, availability of credit, the tightening of credit.
We had a hearing and you were here several weeks ago, Secretary Kemp was here, and others. A lot of the builders in the country, especially in my area of the south and Alabama and so forth,
they feel like they've been squeezed too much by the credit agencies, by their banks. Even if they've got good credit, they're solvent,
they're doing well, especially in the area of home construction and
land development.
Do you see any easing of this or any of your studies showed this
to be true? Or does it depend on region to region?
Chairman GREENSPAN. It depends on the region. But there's no
question that there are problems in real estate virtually across the
country.
Senator SHELBY. Is most of the overexpansion in real estate in
commercial real estate?
Chairman GREENSPAN. Yes, very substantially so. There are
fairly high vacancy rates in commercial real estate pretty much
across the country. It differs region by region, but it's generally
high almost everywhere, especially for office buildings.
Senator SHELBY. Is that concentrated a lot in the East? I know
it's everywhere, but
Chairman GREENSPAN. No, I would say it's across the country.
Senator SHELBY. Spread across.
Chairman GREENSPAN. There are differing problems in the East,
the issues are more severe in the East, obviously, but it's a problem
which, as far as vacancies are concerned, is a nationwide phenomenon.
That is not obviously true in residential real estate to anywhere
near the extent that it is with
Senator SHELBY. But you've got a different market there with the
secondary market, have you not?
Chairman GREENSPAN. Yes.
Senator SHELBY. Mr. Chairman, my time has expired.
The CHAIRMAN. Thank you, Senator Shelby.
Senator D'Amato.
Senator D'AMATO. Thank you, Mr. Chairman.
Alan, in February of this year, you went and spoke about your
favorite topic, or at least the area that you identified with, one as
being in need of treatment, and that is savings.
At that time, we talked and you said that you thought, and I'm
reading, that the double taxation of dividends was an area—you
picked it out—as one of the structural problems, and that if we
eliminated double taxation on dividends, that that would enhance
savings.




64

Chairman GREENSPAN. It would certainly improve the financial
structure.
SUGGESTIONS TO INCREASE SAVING

Senator D'AMATO. What other suggestions do you have for us as
it relates to methodology to attempt to enhance savings, understanding the importance of reducing the deficit, putting that
aside—we all agree with that.
Chairman GREENSPAN. Senator, I think the first thing that we've
got to be clear on is that when you reduce savings—I'm sorry—
when you increase savings, you have to reduce consumption.
Any incentive, any tax incentive, any policy incentive, always
has to be looked at in terms of, does it actually reduce consumption
relative to income or is it merely a transference from one savings
vehicle to another?
In that regard, we are having great difficulty finding policies
other than endeavoring to bring the budget deficit down to zero
and, as I indicated in my prepared text, hopefully, to surplus to increase saving in significant amounts.
There's no question that there are small, marginal types of programs which probably help in minor ways.
Senator D'AMATO. IRA, for example.
Chairman GREENSPAN. Exactly.
Senator D'AMATO. That would be a marginal increase?
Chairman GREENSPAN. Yes. The evidence there is mixed, and if
there is a net increase in saving from IRA's, and there may be, it's
relatively small.
Senator D'AMATO. So you do list the double taxation of dividends,
the elimination of that, as a positive step.
Chairman GREENSPAN. That is unquestionably desirable, yes.
Senator D'AMATO. Some form of IRA as a marginal improvement.
Chairman GREENSPAN. Yes. Well, let me just say that it depends
on the form of it.
I have not come across a program or a policy to increase saving
significantly in this country other than, at this stage, going toward
a budget surplus.
I wish it were otherwise. I do not like the notion of having to
look to the Government to supply savings to the private sector.
But there is no question at this stage that we need that. We need
the savings. And hence, rather than look to a variety of different
gimmicks, of which I've seen too many over the years, it's far more
important that we look to getting the budget deficit issue behind
us, moving toward surplus, and then looking for other means to
augment saving at that time.
Senator D'AMATO. Let me touch on—I was going to do a no-no
and talk about a broad-based energy tax as a way of reducing the
deficit.
What is your feeling in regard to that?
Chairman GREENSPAN. Senator, I realize that there are a lot of
new items that will be going on the table in these budget negotiations.




65

I would prefer that I not be requested to comment on any of
these. I think it would just muddy the waters, and I would prefer
to stand aside on this one.
Senator D'AMATO. So if I were to then propose to you what would
be the most beneficial in terms of reducing the deficit, a hypothetical if you had to choose your poison, would it be a stock transfer
tax, or would it be a broad-based energy tax?
You would decline to answer. You would not like to answer
which way you would choose your death.
Chairman GREENSPAN. I would just as soon refrain at this stage,
if you wouldn't mind.
Senator D'AMATO. Do you believe, if you care to answer, the
stock transfer tax would be in the best interest of dealing with the
problems?
Chairman GREENSPAN. I repeat, Senator—I would just as soon
not get involved at this stage.
Senator D'AMATO. OK. And I respect that. But I have to say, for
the record, that I honestly believe, Mr. Chairman, and Chairman
Greenspan, that the stock transfer tax would absolutely do total violence to the principle of attempting to bring about capital formation, that it would all but eliminate and push the small investor,
who already today treats the market with great skepticism, and I
believe, based upon programmed trading, this business of coming in
to say that the SEC should regulate Chicago and the margins,
maybe they should, maybe they shouldn't. But if they come in and
regulate the margins and you don't have programmed trading
under control, you re not going to do anything.
And I'm afraid that Senator Gramm s comment as it related to
October coming and hitting one of these points in time when we
have 100 or 200 plus drop in the market, is going to take place. It
will absolutely take place.
And we're talking about nothing but greed. It's just greed that
powers the Wall Street houses to undertake this.
Again, I spoke to a number of the operators of the investment
banking community. They all suspended. They all got out. But then
when they saw their best friends back in making moneys, how do
they say to their management people, why, X, Y, and Z firm are
back in and we're not going to do it?
And I think to date, there's only one—I think it's Dean Whitter
is the only major firm that's not back in. Maybe I'll get a call from
someone else who will say, no, we're not back in. Well, fine.
But everybody else is back in there, and they're doing it at, I believe, the detriment of shareholders, the average shareholder.
They're doing it to incur their own profit advantage for the trading
houses themselves. And I think that they're helping to destroy a
great system and it's going to ultimately, we're going to lose confidence in this and then we're going to get the kind of overregulation
that we all abhor.
I've gone past my time. I certainly recognize that the Chairman
is in a difficult position, given the negotiations. I'd like to free him
from that restraint.
Chairman GREENSPAN. I thank you, Senator.
Senator D'AMATO. All right, thank you. Thank you.
The CHAIRMAN. Very good.




66

Senator Graham.
Senator GKAHAM. Thank you, Mr. Chairman.
Mr. Chairman, on one of the Sunday morning programs, it's been
reported extensively in Monday's press, the Chairman of the Federal Deposit Insurance Corporation, Mr. Seidman, made some observations about the solidity of the commercial banking system.
He commented that he felt that the insurance fund was adequate
to handle a mild recession, but that if economic conditions should
deteriorate beyond that, that he had some serious concerns.
As I read those articles, I had a sense of recall of similar statements being made back in 1987 relative to the savings insurance
fund.
CONDITION OF INSURANCE FUND FOR COMMERCIAL BANKS

What is your assessment of the state of the insurance fund for
commercial banks? And second, based on that assessment, what, if
any, recommendations would you make for congressional action?
Chairman GREENSPAN. Well, Senator, I can't go beyond what Bill
Seidman has said. He's obviously in charge of it. He's far more
knowledgeable about the specific elements within his system that
would change under various economic conditions.
Clearly, I respect his judgments on that.
With respect to the broader question, as I indicated here earlier
and as I indicated here last week, the reason we need more capital
in our depository institutions is because we have to make certain
that our depository institutions maintain an adequate capital
buffer so that questions about the adequacy of the FDIC funds just
don't arise.
The basic thrust of my remarks here last week—enhanced capital and prompt resolution—was directed at insulating the insurance funds.
Senator GRAHAM. So is the answer that you do not have any recommendations beyond those initiatives that are already in place
for Congress relative to the security of FDIC?
Chairman GREENSPAN. I would assume if there are any recommendations, they will evolve in the context of the FIRREA-mandated study which the Treasury is involved with and to which we at
the Fed are contributing.
Senator GRAHAM. The reason I'm emphasizing this is because,
during the period, 1987 and 1988, we had a number of persons who
represented various S&L regulatory agencies who came before the
committee, and when asked, what should Congress do, essentially
said nothing. We have the situation under control. We don't need
any steps at this point
In fact, a representative of the Treasury almost said it would be
unpatriotic if we were to do anything because that would create a
false fear in the public when no such fear was justified.
So I want to be clear that your recommendation at the present
time is that no congressional action is called for pending the studies that are currently underway as to the deposit insurance system.
Chairman GREENSPAN. Well, remember, Senator, that FIRREA
mandates that the fund go to IVz percent of deposits from the 0.7 it
is at today.




67
I would hope that these studies will be forthcoming reasonably
quickly and, to the extent that any actions are required or any suggestions are appropriate, that they would be made in an expeditious fashion.
Senator GRAHAM. And I would like to conclude this set of questions with this request.
If there are any circumstances that come to your very advantaged perspective that would alter your sense of urgency and congressional action, that you would alert us to that change in position at the earliest moment.
Chairman GREENSPAN. We certainly will.
The CHAIRMAN. Senator Graham, would you yield at that point
on my time, because this is, I think, an extremely important issue.
I think Bill Seidman has given an important warning signal in his
public comments.
As I understand it, we now have about $12 billion left in the
bank insurance fund and it's protecting a total of about $2.5 trillion dollars in total deposits, of which $1,9 billion are explicity insured.
Obviously, you've also got bank capital in the balance sheets,
however one values that, as partial protection. But there is a very
small balance hi the bank insurance fund.
With that in mind and Chairman Seidman's expressed concern, I
think a look needs to be taken at that fund now and not just in the
context of the FIRREA-mandated studies and other adjustments.
Given the fact that we are seeing the economic softening in various areas of the country, and softening in real estate values and
stated bank balance sheet numbers and so forth. I think we have to
assure ourselves that we don't have a problem there that we're not
alert to.
So I would ask you and the Fed to take a fresh look, not in any
crisis sense, at that now, if you would. I want you to indicate to us
if the Fed independently sees anything out there.
Chairman GREENSPAN. We shall do so, Mr. Chairman.
The CHAIRMAN. Very good. I thank you for yielding.
Senator GRAHAM. Yes. A collateral question which caused me to
read Mr. Seidman's remarks with special alarm is that economic
conditions seem to be moving so rapidly and in many cases, in a
negative way.
It was almost exactly 23 months ago that one of the most wellpositioned persons in the country, the then Vice President of the
United States, made a statement that his economic assessemnt of
the future was such that he felt we could achieve our Nation's economic and fiscal goals solely within spending reduction strategies.
That position was reasserted 7 months ago in the State of the
Union address.
This week, we've had a report from the President's budget advisers that if we were to follow that strategy, that very serious negative occurrences would be the result.
What do you think has happened in the 23 months since August
1988, and the 7 months since January 1990, that have caused the
assessments of some of the most knowledgeable and best informed
people in the Federal Government to now be so wildly out of touch
with what current economic circumstances are?




68

Chairman GREENSPAN. Well, there are a lot of technical differences that have emerged with respect to estimating the budget deficit and specifically, receipts. The effects of the Tax Reform Act of
1986 were not clearly evident until fairly recently. In other words,
we were getting receipts data coming in under the new statutes,
the nature of which was not sufficiently clear to the estimators. So
that I think for a while, there was a presumption that as an aftermath of the 1986 Reform Act, the ratio of tax receipts to taxable
incomes was actually higher than it has ultimately turned out to
be with respect to liabilities.
Senator GRAHAM. And that was not a circumstance that was
foreseeable either in August 1988 or January 1990?
Chairman GREENSPAN. I think not, but I don't know the answer
to that. My impression is a lot was learned in the April tax receipt
period, specifially with respect to final settlements.
That was certainly one element. There were clearly other elements involved. There were estimates of the rate of growth of
nominal, taxable income which were higher than has turned out to
be the case, and their interest rate assumptions turned out to be
lower than has turned out to be the case.
What we're seeing in this particular process is that when you try
to estimate the difference between two totals, both of which are of
the trillion-dollar order of magnitude, relatively small percentage
changes have fairly significant impacts on the deficit that we calculate.
Senator GRAHAM. I guess, if those types of circumstances in a relatively short period of time, 23 or 7 months, could have caused
such an extreme difference in the end result
Chairman GREENSPAN. Excuse me. Let me introduce one additional issue which is relevant.
The way in which the budget is forecast by the administration is
to assume that the requests of the President are fully implemented
by the Congress.
And depending on what those requests are, you can get a very
significantly different budget forecast than from what we've called
baseline, or what we used to call current services.
I think that the numbers we're looking at today are on a current
services basis, whereas, those in the two cases you were raising
were, I believe, the administration's forecasts which assume policy
implementation in full.
Senator GRAHAM. I can understand that, to some degree, starting
in August 1988. But in January 1990, making projections for the
fiscal year that will begin October 1, 1990, what deviations from
the
Chairman GREENSPAN. Is that 1990? OK. The fiscal 1991 period.
Senator GRAHAM. I'm talking about the State of the Union address that was delivered in January 1990 and the statements that
were made about the economy at that time, in contrast to the
statements that were made Monday by Mr. Darman, Mr. Brady,
and other representatives of the administration as to the state of
the economy at that point.
And I'm trying to understand how there could have been such a
variation, since the Congress has not taken action on the President's budget request in any definitive form for the fiscal year that




69

will begin October 1. I don't see how that could have been a factor
in causing such a dramatic shift over the 7 months' period.
Chairman GREENSPAN. I would have to look at the full details,
which I have not as yet had a chance to look at, but I do think you
can explain a very substantial part of that strictly by the issue of
whether you consider the President's policies to be fully implemented or not.
There were unquestionably technical differences with respect to
the economic forecasts which are relevant, but only partly so.
Senator GRAHAM. Mr. Chairman, my concern, which, as I indicated, was elevated by the statements of Mr. Seidman, is we seem to
be in a period of tremendous economic flux. If circumstances can
change as dramatically in 7 months as they have, if the shifts can
occur in just a matter of weeks, almost dated by your testimony
before this committee, I think that it behooves us all to have a very
highly elevated antennae in terms of observing these events that
are occurring with increasing rapidity so that we can understand
them and attempt to take actions that will be in the Nation's benefit.
The CHAIRMAN. Thank you very much, Senator Graham.
Senator Kerry.
Senator KERRY. Thank you, Mr. Chairman. Mr. Chairman, thank
you. I appreciate the opportunity to visit with you yet again.
I want to pick up—I had wanted to ask a number of questions.
Some of them were asked by the Senator from Florida. But I
shared his concern about the comments on "Face the Nation" on
Sunday, and the reports thereafter.
I want to ask a number of questions about that, if I may, as well
as a couple of others.
I understand we have about $13.2 billion or so in the FDIC fund
now, with $2 billion of losses expected this year, bringing it down
to $11 billion, which means about 60 cents in the fund for every
$100 of insured deposits, which is about half what the Congress intended and what people have determined is sound business.
On the other side of the ledger, against that seemingly somewhat
impoverished fund, is an increasing series of reports from various
people around the country—Stanford economist, among others,
Dan Brombaugh, who is widely reputed to have been one of the
early forecasters of the S&L crisis—he is now suggesting that we're
at the point at which, in a short period of time, taxpayers are going
to have to make a contribution to the closure of insolvent banks,
that either we're going to have to contribute additional money to
pick up the tab for these bank failures on the commercial side,
and, in addition, that there may be additional money needed
simply through the premiums that banks are going to pay for insurance and so forth.
Now, it has been asserted by some others, let me quote them,
that once you subtract the expected losses from FDIC assets, the
net reserves are probably around zero.
Mr. Brombaugh himself says, I quote;
We're in the midst of reliving the S&L crisis in the commercial banks. The stage
we are in is about the same as 1984 and 1985 with the thrifts, when the problems at
many savings and loan associations were far more serious than their financial reports revealed.




70

We are moving down the same road as the thrifts," another economist said, "but the road is not so steep and we're not so far along.
Can you comment on that because I think it has an enormous
implication?
You know, our citizens are not only angry, but they're now hearing these reports and they're scared. That's having, I think, something of an effect on their use of money. Certainly, retail is feeling
that, I think to a degree. But more importantly, some people are
even questioning whether they ought to put their money into some
banks and how safe it's going to be down the road if this scenario
plays out.
Chairman GREENSPAN. I think that that report which you cited is
an exaggeration.
I must tell you that I don't have those types of concerns. The
types of concerns I have focus more on making certain that we
build up our competitive capabilities as a banking system and that
we improve the structure of the entire financial system.
I would scarcely argue that we're in a position where the situation is about to unwind. I think that's just an issue which comes up
periodically, and there's no real basis for it,
We do have to raise capital in our commercial banking system.
Lenders do have to be somewhat more prudential, relative to the
type of lending that occurred in the mid and latter part of the
1980's, but those are readily resolvable issues, in my judgment, and
not something to create any really serious concern.
Senator KERRY. Now, if we are augmenting the amount of capital
that these institutions are holding, while simultaneously dealing
with the credit issues that you have talked about, therefore, as you
have called it—I mean, you've suggested the semantical problems
in your own articulation of the credit problem and what some call
a credit crunch is for you a shift in credit bases, but to the consumer it has the same effect.
But if you have that, coupled with the increased capitalization
requirements for these institutions, coupled with the earlier comments in your testimony which I read concerning the diminishing
labor force, plus the prospect that we are sitting on here of increasing taxes while simultaneously reducing spending, that seems like
a monumental conglomerate of simultaneous drag on your economy that's going to have an enormous impact on your forecasting, I
would think.
Chairman GREENSPAN. Senator, some of those things I think are
quite healthy. In fact, I believe that, even though it has been quite
painful to have the rate of increase in credit slow down, it is very
important for it to come back to a more normal trend. This slowdown includes not only the money supply elements that are proxies
for overall credit, but also the expansion in mortgages, in corporate
debt, in consumer credit, all of which had been adding to a very
high rate of total expansion, especially with the mergers and acquisitions and LBO's.
But the process by which the deceleration occurs makes it feel as
though it is harmful to the system, when the truth of the matter is,
it is not.
I'll put it this way: It probably doesn't feel any different to the
average potential borrower whether or not we are coming down




71

from an abnormal level of expansion of credit back to normal, or
whether we are going from normal to too restrictive.
It is a continuum, in a sense, so far as he is concerned. But it
matters very much to the overall system.
I feel somewhat more secure about the soundness of the system
today than I would have, say, 2 or 3 years ago.
Senator KERRY. And is that because we're dealing with it?
Chairman GREENSPAN. Well, basically, because the rate of credit
expansion, which I've found rather disturbing, has come down, and
because we are dealing with it. Whatever concerns one may have
about the system, they have to be less now than they were, say, 3
years ago. Capital has actually increased. The rate of borrowing
has come down. The credit standards, if anything, have improved.
Those strike me as plusses, not negatives.
Senator KERRY. And unemployment is up.
Chairman GREENSPAN. No, unemployment is down.
Senator KERRY. Not in New England.
Chairman GREENSPAN. Well, I certainly grant you that unemployment is up in New England from a very low level and you are
experiencing the worst part of the problems that we are confronted
with.
But if you think of it in terms of the national figures, including
New England, the unemployment rate is still at the lowest level in
approximately 15 years,
Senator KERRY. Well, now, in the course of the current revision
of the estimates of the deficit, now at $168 billion, and then the
S&L on top of that, we're looking at an enormous contraction this
year under Gramm-Rudman, and it depends obviously on whether
we start talking about moving the dates or what happens, and
that's not on the table at this point in time.
Looking at the kind of deficit reduction that we're now looking
at, and recognizing the President has now said, I think we need
taxes and we're going to need some revenue to do it, I know you
don't want to deal in specifics, and I'm not asking you in specifics,
But is there a range of revenue to reduce that deficit that begins to
become excessive and, in your view, have a negative impact on the
economy?
What is the balance between cuts in revenue that, in your view,
that
Chairman GREENSPAN. Senator, there are differences between
spending and taxes in the way one balances or brings the budget
deficit down.
The differences do affect the economy in certain different ways
because, obviously, different types of taxes and different types of
program changes have different types of effects within the economy. I would suspect, however, that, overall, it doesn't matter that
much. That is, it is the total size of the deficit reduction that is crucial. And rather than worry about the effect of the composition on
the economy, I think we ought to focus very clearly on getting a
cut in the area of $50 or $60 billion. That strikes me in today's context as the magnitude of deficit reduction which could be implemented without undercutting the growth in the economy.
Senator KERRY. Now, if I could, and I don't want to abuse the
time too much here, but I'd like to just ask another question.




72

The CHAIRMAN. All right. If you're going to move off that subject,
I'd like you to just yield for a minute I'm not totally clear on this
and it may be that I just didn't hear it right or there may have
been a word left out here or there.
But are you saying, in a package of that size, $50 to $60 billion,
that the exact component that might be new revenue as opposed to
spending cuts really isn't the key question in your mind. The key
question is what is the size of the total package.
Chairman GREENSPAN. It's basically the total package and
whether it is credible, and whether it has subsequent wedge effects.
In other words, as we discussed earlier, the first year number is
really a proxy for a much broader program.
The CHAIRMAN. Right.
Chairman GREENSPAN. But it's the total program which is the
crucial issue and its composition is of a lower order of importance.
I'm not saving that the composition has no effect. I have expressed before this committee many of my views on the balance of
taxes versus spending, and I certainly don't retract those.
The CHAIRMAN, I understand.
Chairman GREENSPAN. But I think the crucial issue by far is the
overall program. And I must say to you, Mr. Chairman, when you
look at including the types of problems that we have been discussing, the economy has been behaving much better than a lot of
people had feared.
We have been confronted with scare stories now for about what
was going to happen to the economy now for 2 or 3 years, ever
since the 1987 stock market crash.
I think we must say, in retrospect, that things are not going all
that badly. We are comfortable that we've been able to keep money
supply growth at a relatively low, stable pace, which, in our judgment, ultimately will pay off with a lower rate of inflation and,
with greater stability. In part because of the fact that inventories
have been brought under control, we are not subject to the degree
of instability that we had gone through.
I grant you that the rate of growth is slow, and whenever the
rate of growth is slow, you're closer to the edge, clearly, than you
are when the growth rate is higher. But the point at issue is that,
having said all of that, I think things are not too bad. And I must
say, I'm rather pleased with the way the system is working.
We've got a huge problem with respect to the resolution of the
savings and loans, which has a very material effect on how we do
our business. But having gone through a period where there were
very rapid resolutions in June, for example, without a significant
impact on interest rates or a significant distortion in the system,
we ought to be somewhat aware that this is suggestive of an economy which is not on the edge of either falling into a recession, or
taking on highly inflationary characteristics.
I think that we've done better than I think we probably could
have forecast as a reasonable judgment after the 1987 crash.
The CHAIRMAN. Well, I appreciate your saying that. If you'll
yield just for another minute, I want to try to nail down, the point
that I also thought I heard being made in response to your question, Senator Kerry.




73

I hear you saying that if we could get a deficit reduction package
that is in the $50 to $60 billion range, and that is built in so that
you get the out-year wedge effects then whether that were split 507
50 between revenues and spending cuts or somewhat more or somewhat less either way, the macroeconomic effect of that package, as
you would see it, would be much the same.
The big deal, as you see it, is to get the package with whatever
blend between revenue and spending cuts—as long as it adds up to
that kind of a total, and it's real and it goes into the out-years.
Is that right?
Chairman GREENSPAN. If it's real and enforceable.
The CHAIRMAN. Well, that's a very important point because
you're in effect saying here that the macroeconomic effect of the
package is really dependent upon having the package, and that if
we end up fighting endlessly on the composition and a little bit
more of this or a little bit more of that, we may well be missing the
point.
Chairman GREENSPAN. Yes. But let me say this: Obviously, I'm
not talking at the extremes.
The CHAIRMAN. No, I understand. I'm not posing the question
that way.
Chairman GREENSPAN. As I've said to this committee before, if
we were to do it all on the tax side, to be very honest, I don't think
it would ultimately function.
The CHAIRMAN. No, I'm not saying that.
Chairman GREENSPAN. But the answer is yes. Within a range,
the differential macroeconomic impact cannot be large enough for
us to be concerned with.
This issue of resolving the budget deficit problem is so difficult
that to add additional difficulties, when they don't matter all that
much, strikes me as inappropriate.
The CHAIRMAN. Well, and it's an important, refreshing comment
by you. And I think it helps the debate.
This being said at 12:20 in the afternoon, and I don't know
whether it will make its way out of here the way I think it ought
to. But I think the questions that Senator Kerry has posed and the
answers that you've given are important and I think they put this
debate in a somewhat new and clearer light. I think it's helpful.
Senator Kerry, why don't you finish up?
Senator KERRY. Thank you very much, Mr. Chairman. I thank
you for drawing that out further.
I had thought I had understood it as that, but I am happy that
you've focused more on it, and I think it's helpful.
Mr. Chairman, assuming we get the package, is it your view that
the Fed should move to interpret the results of that package or
that the credit markets should do so on their own with the risk
that they might bid the interest rates down too low or not enough.
Chairman GREENSPAN. I think that at the end of the day, it's the
credit markets that count. We obviously will be focusing very closely on how the markets respond and how the markets evaluate the
package.




74
EMPLOYMENT DECELERATION

Senator KERRY. Now, beyond—well, let me hold off on those
questions. I don't need to do those now.
I do want to ask you this, though. I was struck in your testimony
about the employment deceleration, but the labor force, also. And
you talk about some of the aspects of the labor force.
I wondered if you weren't underplaying the impact and the problem we face in this country of now having seen many, many
women brought into the labor force, considerable minorities
brought into the labor force, the birth rate being such that the
bubble is over on the baby boom, and that we face a serious problem in terms of growth.
I know that we're increasingly feeling this in New England.
I wonder if it is not underplayed somewhat in your testimony
and in the importance for this country's ability to be able to "get
moving again, and to really see the kind of growth that we want.
Do we have the capacity for growth in the labor force that will
permit that at this point in time?
Chairman GREENSPAN. Well, Senator, we've had an odd slowing
in labor force growth, really since the beginning of the year. It is
reflected to a large extent in the participation rates of females, age
20 to 24, and of teenagers. But even in the rate of growth in the
participation of adult women, which had been such a major factor
adding to our labor force, we've seen some slowing down.
Now, it is quite possible that this is merely a statistical aberration. Data often do that. They often give you mixed signals. I think,
however, that we do know that the trend growth rate of the labor
force must have slowed down because we have independent estimates of slowed employment growth and our insured unemployment system essentially confirms that the unemployment rate has
also remained very low. So the arithmetic of the system is confirming that there is a slowdown out there in the labor force.
What we do not know is whether it is a temporary 6-month
oddity, which we've seen many times in the past, or whether
there's something more fundamental here. I don't think we will
know that for a number of months, maybe not for a number of
years. But it's something that has happened, and it is clearly not
all the result of the slowing down in economic growth. What its
full implications are, we do not yet know.
Senator KERRY. I'd like to ask you just a last sort of generic question, if I may.
There was a period in this country when Franklin Roosevelt
talked about fear being the only thing that we had to fear. And I
find in New England, speaking for New England, but I think for a
lot of parts of this country right now, if you look at the polls, the
most significant figure that pollsters are now focused on is the perception by Americans that they don't know what the future is
going to be. They don't believe it's going to be as good, for some
reason.
I think it's something of great concern when you measure what's
happening in housing and homelessness, in education, the functional literacy of 20 percent of our high school graduates and so forth,
other problems in the work force.




75

I think people are feeling these things. And now the S&L crisis,
the comments of Seidman and so forth.
I'd just like to ask you as this principal figure in the structure of
our country on economic matters, if you might speak to that sense
of fear for a moment and to the question people have, which I
think is restraining economic activity and slowing us down to a
degree.
And I wonder if that is of concern to you, do you perceive that?
And if, in any way, you do, what is your prescription?
INCREASED PRODUCTIVITY

Chairman GREENSPAN. Well, Senator, what we do perceive is that
the economy, and more importantly, productivity, has slowed its
growth. This is not an issue of the last few years; it's really an
issue which differentiates the early post-World War II period from,
say, the last 20 years.
I think it is certainly the case that the slowed growth in living
standards which we've experienced in this country has changed the
level of optimism, if one could put it that way, that one sensed earlier in the post-World War II period. My working life really starts
right at the end of World War II and goes through this period, so
I'm aware that there was a discontinuity out there somewhere 20
years ago.
The 1980's have actually been something of an improvement
from the 1970's. I think there were increased senses of optimism,
and I think they still carry over. You're quite right that the S&L
issue has created a problem as far as the economic outlook is concerned and the difficulty of getting our Federal budget deficit down
has been a problem. The trade issues also have created some particular problems. But overall, we probably were in our worst
stages, if you want to put it that way, in the latter part of the
1970's. In other words, that's when inflation was beginning to take
hold, and a degree of instability and concern about the future of
the country, got to very severe levels.
We are still growing more slowly than I think we should be
growing. And I do think, to come to the ultimate answer to your
question, that the bottom line to all of this is that we have got to
get productivity increasing at a faster pace. The only way I can see
that occurring is by resolving the investment and saving issue,
which is the reason I said earlier to one of your colleagues that I
thought the highest domestic economic priority in this country is
increasing the saving rate.
Improving the rate of growth in the economy would change a
number of the problems which you identified. However, referring
to my earlier statement, I think it's very easy to exaggerate the
negatives. Nevertheless in many respects we underestimate a lot of
the positives. Things are not as good as they could be and I think
it's fairly evident that were we able to pick up our growth rates,
the attitudes as you identified them—and I sense them as everyone
does—would change.
Senator KERRY. I thank you very much, Mr. Chairman. Thank
you.




76

The CHAIRMAN. Thank you. You know, I would just like to add to
that, and ask you one more question, then we'll finish here. You're
been very patient.
In my own mind, I think our overriding national goal has to be
getting the productivity growth rate up. We're doing about 1 to 2
percent a year in recent years, on the average. We need to try to
double that.
I believe you can actually lay out a pretty clear-cut set of strategy options that can increase national savings and investment in
private and public physical capital as well as human capital to beef
up productivity growth to those rates.
But if we can do that, we can solve our other problems. If we
don't get that done, I think our problems are going to increase.
Let me take you to page 10 of your testimony, and this is the one
item I want to finish with.
On page 10, with respect to what you see happening in terms of
the tightening of credit standards and what's going on in some
form of a credit contraction, you made this statement:
Nevertheless, in the here and now, the tightening is beginning to have very real
unwelcome effects.

And then down about 6 lines you say:
In recent weeks, however, we may have slipped over that line.

In terms of the tightening down process going beyond what
would seem to be sound from the point of view of at least the monetary policy impact that you would like.
Tell me what the data is. What are you hanging your hat on that
is causing you to make that kind of definitive statement here?
Chairman GREENSPAN. First of all
The CHAIRMAN. I'd like you to summarize it, and then I want to
know if it's something we can have so that we can take a look at it
ourselves.
Chairman GREENSPAN. First of all, we see in the aggregate data a
significant slowing down in the rate of growth in the various credit
aggregates from levels which we had always perceived in our analysis to be excessive relative to the needs of financing a certain level
of nominal GNP. It's clear in the early stages and, in fact, I would
say up until recently, that it was not only desirable, but very
healthy for the financial system. We began to see evidence of that
as we, for example, looked at the balance sheets of the financial
intermediaries and the income statements, of the depository intermediaries. What you could see at that particular point was a gradual deceleration.
The question basically then arises, is there a point at which it
becomes too restrictive? In other words, do you get to a point where
commercial banks in particular are beginning to pull back to
where it looks as though the commitments being made will then
start to flatten out significantly, effectively, creating a tightening
in the credit markets?
What we were looking for and did not see in any reasonable way,
say in the spring, was a widening of margins in banking, meaning
that commercial banks were seeking to increase their margins because they were fearful of the threats to their capital or to the
quality of their loan portfolios.




77

We began to see very early stages of that, which were not consequential. It's only very recently when, in talking to, for example, a
lot of bankers about their loan policies and spreads, that we're beginning to get indications, although no hard evidence because the
hard evidence won't be available for months. You won't see it for a
while. But it is enough to see that the indications are credible, especially if you're getting the type of responses we are in, for example, the money supply data.
The money supply looked as though, after it had dipped down in
May, and had started back up, it was really going to move, but it
has since slowed down again rather substantially. The money
supply is growing but it is growing at a relatively modest level indicative of the type of phenomenon which would exist if we are
slipping over the line.
And while, obviously, I don't want to make too much of the specific line, there is enough, in my judgment, out there to suggest
that the pressures on the economy were increasing.
That's one of the reasons why the probability of recession increased a shade, not much, and I think we have probably offset
most of that in the action that we have taken.
The CHAIRMAN. Just last week, the action that you announced.
Chairman GREENSPAN. Yes. But I will tell you this—that when
you get into this type of information, it is very important to try to
collect it from a wide variety of sources. And this is one of the reasons why I think the Federal Reserve has an exceptional real time
information processing system.
In other words, if you're waiting until you get the published
number, with the rare exception of data that are published on a
weekly basis, you'll always be acting much too late. You'll always
be looking at the last war. We have no alternative but to try to
anticipate what we think is happening. In that context it began to
appear, when, for example, the money supply growth stalled out,
that there was more here than we had originally appreciated.
In my judgment, had we done nothing, we would have increased
the probability of the credit system beginning to crush the economy's growth. As best I can judge, we have alleviated that pressure
at this particular stage, and that's why I remain hopeful that the
economic growth that we're envisaging, which is not robust, but
nonetheless, there, will continue.
The CHAIRMAN. Now, is my memory correct that about, oh, maybe
3 months ago, you and other bank regulators met with representatives of the largest banks of the country?
Chairman GREENSPAN. No, we met with representatives of the
American Bankers Association, which includes both large and
small banks.
The CHAIRMAN. Let me make that correction—representatives of a
mixture of American banks. That session, as I understood it, was a—
my word—"jawboning" session or a session to try to talk to the
bankers about now being too restrictive, to tighten down to a
prudent point, but not overdo it. And that's the general characterization that was made of that.
It sounds to me, if that is an accurate description of what happened, that in the time since you have not become convinced that




78

you were getting the effect that you wanted, and so you now have
had to insert an element of monetary policy adjustment to deal
with it.
Chairman GREENSPAN. Well, let me just rephrase the way you
put it. What we were concerned about at that meeting at the ABA
was that it not be perceived that the regulators and the examiners
were suggesting to the bankers that they pull in their horns.
In a sense, there is a related issue here. We were concerned that
they would, in fact, do what apparently has in part happened. But
it was not clear at that time that it was going to become a general
problem, and we surely hoped that it would not.
Up until recent weeks, I had every reason to hope that we would
avoid that sort of phenomenon and that it was just a temporary
phenomenon which we go through all the time. That did not turn
out to be the case, but it's not something that you can know for
sure or forecast with great definitiveness.
The CHAIRMAN. Well, I take it from what you said a moment ago
that your data are still fragmentary. In other words, part of it is
data that are coming in, part of it's your feel, and part of it is anecdotal, I would assume.
Chairman GREENSPAN. Well, I hope it's not feel. Feel is not very
useful. I hope that it's real information. We don't just take summaries of comments from banks or something.
The point is that when you get evidence about what is going on
in the lending and fee process within commercial banks—in the
smaller banks, in the medium banks and in syndications—certain
patterns begin to emerge that look more than random. And it's
when you can draw that conclusion, then you're reasonably sure
that certain fundamental things are going on, even if you don't
have the exact numbers to verify it.
The CHAIRMAN. Well, I understood you to be saying a moment
ago that the policy adjustment you made last week was matched to
what your data suggest to you is the size of the problem.
I don't want to have it read back, but, in essence
Chairman GREENSPAN. The rough order of magnitude. That is
correct.
The CHAIRMAN. And so, it sounds as me, based on the data that
you do have and the analysis that you have done, you feel you have
now made the full policy adjustment.
You're not in the middle of six or eight different adjustment
steps that you anticipate, of which and you've only made one, but
rather that you've tried to make the full adjustment that fits the
problem as you see it.
Is that fair?
Chairman GREENSPAN. Up to this date, I would say that is correct.
But as I indicated to you in my prepared text, we think this process is still moving. Whether it will move enough to make any further material difference, I frankly don't know. I hope not. It may
well not. At this particular stage, I would say we are watching it
very closely.
The main thing I think we have to emphasize about this, and the
reason why I hesitate to call this whole thing a credit crunch, is
that we are dealing with relatively small changes. I think they're




79

important enough to respond to, but if we had a real credit crunch
of the type we used to have in the past, we are talking about a fundamentally different type of phenomenon.
The reason I tend to be somewhat resistant to responding to the
contraction of credit growth that has been going on is that I perceive it as something healthy, something which will be advantageous to the long-term financial stability of our system. I think it is
crucially important from a policy perspective to make that distinction.
The CHAIRMAN. Well, I agree with you. And I think you've made it
clear today that this was fine-tuning. This was not—and you tell me
if you don't agree—this was not a major policy adjustment. This was,
you said it several different ways, was a fine-tuning adjustment.
And further you've said today that it was not designed to drive
down interest rates. It was, in a sense, to hold interest rates
Chairman GREENSPAN. To hold credit conditions the same.
The CHAIRMAN. Level.
Chairman GREENSPAN. And, in general, to keep the markets
stable.
It was an action that directly related to a specific credit problem
that we perceived, and what we did was to offset it. We were not
looking to fundamentally change the underlying credit conditions
in the economy, which is what policy would do if, for example, we
were looking at a more profoundly important change in either economic activity or inflationary pressures, because when we react to
either of those, it's a major change in policy which tends to be progressive.
And as I've tried to convey, we do not view this in that manner.
The CHAIRMAN, I'm going to just finish with this comment. As
things change further, and that can happen—obviously no one can
read the future
Chairman GREENSPAN. They can change in either direction.
The CHAIRMAN. Yes. I understand. But if you find that they do
change in the next several weeks, next 2 or 3 months, and another
policy adjustment is needed, whether or not we've got an official
hearing such as this scheduled, I will certainly, and I know the
committee will want to meet again with you if there's going to be
any kind of a consequential policy adjustment over that kind of a
timeframe.
I'm not saying that anyone foresees that or you foresee it, but if
things are changing further to an extent that requires a further
adjustment, I think that that would be something that we would
want to at least have you illuminate for us.
Chairman GREENSPAN. Certainly.
The CHAIRMAN. Very good. We thank you very much. You've
been very patient and very straightforward, as always.
The committee stands in recess.
[Whereupon, at 12:55 p.m., the committee was recessed.]
[Response to written questions follow:]




80
RESPONSE TO WRITTEN QUESTIONS OF SENATOR RIEGLE FROM

Alan Greenspan

Q.I.

In your testimony, you referred to bank surveys as an
important part of the evidence suggesting a tightening
of credit conditions. some of these may be informal,
but, if possible, please provide us with the recent
results of those that are more formally and regularly
conducted. When will these be updated, and how
reliable do you think they are?

A.I.

Information on the recent pullback in credit supplies
has been obtained from a variety of sources, including
formal surveys, analyses of economic and financial
data, and anecdotal information. The relevant formal
surveys included the Senior Loan Officer Opinion survey
of Bank Lending Practices and the Survey of Terms of
Bank Lending. These surveys of course take time to
compile. As a consequence for rapidly changing market
conditions, we are often required to engage in quick
informal surveys to update the state of knowledge. Our
most recent appraisal of credit tightening was based
primarily on informal surveys, which have only recently
been confirmed by a formal survey.
Senior Loan Officer Opinion Survey
The Senior Loan Officer Opinion Survey covers 60 of
the nation's largest domestically chartered banks.
Commencing with the most recent (August) survey,
18 U.S. branches and agencies of foreign banks have
been added as respondents.) The format of the survey
is not fixed, but rather asks questions on topics of
current interest to the Federal Reserve. The survey
is conducted 4 to 6 times a year.
In the Senior Loan Officer Survey for January 1990,
many respondents reported tightening their standards
for business loans to riskier borrowers and for
merger-related loans to all borrowers. Standards for
nonmerger-related loans to investment-grade borrowers
«ere not significantly changed. Most respondents also
reported less willingness to make real estate loans for
acquisition, land development, and construction (ADC).
Only one-third of the respondents said that their ADC
loans were higher because of the thrift crisis, and
several of these banks reported that they lent only to
the higher-quality former customers of thrifts.
The Senior Loan Officer survey for May 1990 asked
questions about recent weakness in nonmerger-related




81

business loans. The responses suggested that weak loan
growth was mainly the result of reduced funding needs
of large and medium-sized customers. At the same time,
however, over half the respondents reported that they
had tightened credit standards and loan terms to both
medium-sized and small borrowers. The May survey
also found that a large majority of respondents had
tightened lending standards for approving commercial
real estate loans.
The Federal Reserve conducted another Senior Loan
Officer Survey at the beginning of August, which
collected additional information on credit conditions.
A substantial minority of respondents indicated that,
since the May survey, they had further tightened lending standards and terms on nonmerger-related business
loans. The tightening was most noticeable for mediumsized businesses but extended as well to large and
smaller firms. The greater stringency encompassed some
widening of spreads of loan rates over base rates and
increased costs for credit lines as well as tighter
nonprice terms. As in the May survey, about threequarters of respondent banks reported tighter lending
standards to approve loans to finance office buildings
and other types of commercial real estate. A substantial majority of branches and agencies of foreign
banks, surveyed for the first time, indicated that in
the last 6 months they too had tightened their lending
standards both for business loans and for commercial
real estate loans.
We believe that the Senior Loan Officer Opinion Survey
is a reliable indicator of current thinking at large
commercial banks. However, the questions in this
survey are usually qualitative rather than quantitative. It is difficult, therefore, to infer other than
very broadly the size of the impact of a change in
lending practices from the responses to this survey.
Survey of Terms of Bank Lending
The Survey of Terms of Bank Lending to Businesses
(STBL), is conducted during the first full business
week of February, May, August, and November. It
collects information from a sample of 340 banks of all
sizes about quantities and prices of all business loans
made during the survey week. Results of the August
survey will be available in mid-September.
Unpublished data obtained from the STBL for May 1990
gave some evidence that banks had tightened terms on




82

business loans. Pricing and collateralization
requirements for loans to smaller borrowers were
tightened. For loans to larger borrowers the spreads
over funding costs of prime-based loans made under
commitment did not change much, but the same spreads
on loans with pricing based on market rates widened.
The STBL is believed to be a fairly reliable indicator
of lending terms. However, the survey covers only a
sample of commercial banks and, consequently, universe
estimates obtained from the survey are subject to
sampling error. In addition, information about the
size and industry of borrowers is not collected, so
that, for instance, loans of small amounts or loans
made under small commitments must be used as a proxy
for loans to small borrowers.
Q.2.

On page 12 of your statement you say that if M2 drops
below its current range you may need to lower interest
rates. Should we infer that the Fed may be planning to
place more weight on M2 in policy decisions than it has
in recent years?

A.2.

M2 is one of several key indicators that figures
importantly in monetary policy deliberations. The
Federal Reserve sets annual ranges for M2, along with
ranges for M3 and debt, that are believed to be consistent with its objectives for economic growth and progress toward price stability. Growth of these aggregates outside of their ranges would in any case signal
a need to consider whether the stance of monetary
policy was consistent with achievement of these goals.
In the period ahead, H2 could be useful as a barometer
of depository institutions' attitudes toward credit
provision. Should banks and thrifts pull back further
in the lending area, their reduced demand for funds
probably would show through to a smaller appetite for
deposit funding and a reduction in M2 growth. Under
such circumstances, the Federal Reserve might find it
appropriate to adjust policy to offset any significant
additional reduction in aggregate credit availability.
Therefore, the Federal Reserve will continue to
scrutinize growth in M2 relative to its annual target
range to assess what it is telling us about conditions
in credit markets.
Nonetheless, we will continue to interpret movements
in M2 in light of other information about financial
markets and the economy. Monetary velocity has fluctuated widely in recent years, and the recent contraction in the thrift industry has amplified uncertainty
about short-term relationships of money to spending and




83

prices. For that reason, a policy response would not
be automatic should H2 stray below its target range,'
nor would the Federal Reserve refrain from taking
action while M2 remained within its range should other
factors warrant action.
Q.3.

At earlier hearings, you said that you planned to
virtually eliminate inflation without recession by
getting the economy to grow slowly enough that some
slack in resource utilization would develop. We've had
slow growth, but so far the unemployment rate has
actually fallen and the Federal open Market Committee
has had to raise its forecast for inflation this year
to a number that would be the highest in 9 years. Do
you still think it is realistic to expect that we can
really stop inflation relatively painlessly?

A.3.

Economic theory and experience both suggest that
ultimately disinflation requires a reduction in inflation expectations. The question is, what policies
will cause the necessary lowering of inflation expectations? Certainly, monetary and fiscal policies that
are responsible and prudent would help to achieve a
reduction of inflation expectations. Accordingly, it
is the intention of Federal Reserve policy to move
over time toward the low trend rates of monetary expansion that would be consistent with price stability.
For a time, such a policy might involve some slack
in resource utilization. Indeed, since the recent
peak in early 1989, capacity utilization in the industrial economy has dropped a little more than 1 percentage point to about 83-1/2 percent. To be sure the
unemployment rate remains relatively low by historical
standards, even though it edged up to 5-1/2 percent in
July. Part of the continued tightness in some labor
markets in the context of sluggish economic growth
reflects the unexpected slowdown in the growth of the
labor force this year. We are still of the conviction
that the rate of inflation should decline over time,
but progress may only be apparent over a multi-year
time horizon.




84

Q.4.

The East and West Germans have just started a monetary
union and the European Community as a whole appears to
be moving fairly rapidly toward a continent-wide union.
What kind of competition would such a European currency
provide for the dollar as an international reserve
currency? What would be the cost of losing our
dominant status?

A.4.

The eventual adoption of a single currency by the
European Community might be expected to reduce somewhat
the international demand for the dollar as an official
international reserve asset. This substitution out
of the dollar as a reserve currency would be by nonCommunity countries, though most of these countries'
demand for the new European currency would probably be
satisfied by exchanging their holdings of existing
European currencies (marks and sterling). The demand
for dollar reserves by European Community members taken
together, may be little changed. There could be some
economies of scale which would reduce their total
demand for reserves, but much of this reduction would
be satisfied by eliminating their existing holdings of
other members' currencies (mainly marks) which would
become domestic currency and therefore not usable as
international reserve assets.
Any net reduction in international demand for dollar
reserves is likely to be small and probably would occur
slowly. The "cost" of any reduced demand would come
through a depreciation of the dollar's exchange value
and higher U.S. net exports. In a sense, we would have
to redeem the excess supply of dollars for goods and
services which, other things equal, means lower living
standards than would otherwise be the case for U.S.
residents. On balance, the effects in this regard are
likely to be very small.
Any reduction in the demand for dollar reserves due
to the establishment of European monetary union
could well be offset, at least to some degree, by an
increased demand for dollar reserves from East Europe
and the Soviet Union. These countries have held relatively modest amounts of dollars in the past due to
their limited trade with the west. As the economies
of these countries are opened to trade with the west,
their demand for western currency, both dollars and
other "hard" currencies, will probably increase.




85
- 6-

Q.5.

Recent trade data have shown decreasing deficits. In
the absence of a major budget agreement, what are. the
prospects for future trade deficits?

A.5.

it is difficult to quantify changes in the U.S. trade
deficit associated with different levels of budget
restraint. However, most econometric models suggest
that it would take a major budget agreement to bring
about a sustained further improvement in the U.S. trade
deficit. With only a small package, the U.S. trade
deficit may continue to improve slowly or it might
deteriorate; without a substantial increase in savings
from the U.S. private sector, the federal government
deficit will continue to put pressure on the low level
of private savings, requiring inflows from abroad (and
associated trade and current account deficits) to
sustain even modest levels of domestic investment.

Q.6.

You have referred to the weakness in money growth as a
confirming sign of credit tightening, saying that not
all the weakness can be accounted for by the thrift
cleanup process. Do you have a quantitative estimate
of the effect of thrift closings and downsizings of
weak thrifts on M2?

A.6.

We do not have a quantitative estimate of the extent to
which the thrift restructuring is depressing M2, but
there is sufficient circumstantial evidence to lead us
to believe that it explains some, though not all, of
its weakness. Based on relationships that have been
relatively successful in explaining M2 growth before
this .year, the recent growth rates of M2 have been far
below those consistent with interest rates and with
available information on the pace of growth of the
economy. This aberrant behavior has coincided with the
massive expenditures by the RTC to resolve insolvent
thrifts. These expenditures, fay shifting a sizeable
volume of cash to banks at a time when bank lending has
been weak, apparently have caused banks to offer less
generous terms on deposits. In addition, the closing
of a number of aggressive, insolvent s&Ls has greatly
reduced the availability of high interest rates in that
sector. Both have acted to reduce the quantity of
M2-type assets demanded by the public.




86

Q.7

At the hearing, you indicated that federal borrowing
to raise working capital funds for the RTC appears to
have raised Treasury bill yields relative to those on
private instruments by about a quarter percentage
point. Do you expect these wider spreads to persist?
If the wider spreads were caused entirely by the RTC's
needs, what would be the implied size of this secondary
cost of the thrift cleanup?

A. 7.

Any upward pressure on bill rates stemming from RTC
working capital needs is likely to persist as long
as those needs represent a significant addition to
the amount of bills outstanding. However, estimating
the absolute effect of the RTC's activities on bill
rates is difficult. The 25 basis points cited above
refers to the spread between bill rates and private
rates, rather than to the absolute level of bill rates,
which is more relevant for assessing the impact on the
cost of the thrift cleanup. The narrowing would come
about partly as a result of lower private rates. For
example, interest rates in the CD market probably have
fallen somewhat in response to the transfer of a sizeable volume of assets from the thrift sector, which
formerly had been bidding aggressively for funding
for those assets. The considerations outlined above
suggest that the additional cost caused by higher bill
rates might be on the order of several hundred million
dollars at an annual rate while the additional borrowing is outstanding. When the RTC's holdings of assets
begin to decline, the amount of bills outstanding will
start to return to normal, and the upward pressure on
bill rates should diminish. It might also be noted
that no matter which segment of the capital markets
provided the financing for the RTC's working capital
needs, some upward pressure on rates in that sector
would have been likely.

Q.8.

The chart on page 24 of your report is impressive. The
gap between total debt growth and growth of depository
credit is enormous. The former has eased only slightly
while the latter has slowed to a stop. What other
sources of credit have taken up the slack and by how
much?

A.8.

In 1988 depository institutions accounted for more than
35 percent of the net increase in credit market funds
supplied to domestic nonfinancial borrowers. (See
Table.) In the period since then, their share has been
a little more than 10 percent. The drop in the growth
of depository credit is more than accounted for by the
contraction of the thrift industry's balance sheet;
commercial bank credit continued to expand, but at a




87

moderate pace given concerns about borrower
creditworthiness and pressures on bank capital.
Because thrifts' primary lending activity is home
mortgage loans, the reduction in thrift lending has
been concentrated in this sector.
There are two aspects of the replacement of thrift
institutions in the supply of credit to the economy.
First, other lenders have stepped up to acquire
mortgage assets shed by thrift institutions, and to
provide the mortgage credit that has been foregone by
thrifts. These include commercial banks, insurance
companies, and, through direct lending in the
securities markets, the household sector (which
includes nonprofit organizations). Much of the
increased mortgage lending by these sectors has been
done through the acquisition of mortgage-backed
securities, whose issuance has ballooned since the
start of the thrift crisis.
However, for the most part, these sectors have not
stepped up their overall provision of credit to
nonfinancial borrowers by the full amount of their
increased mortgage lending. Instead, their enlarged
purchases of mortgage assets have been at least partly
at the expense of decreased lending to other borrowers.
For example, insurance companies' share of the growth
of domestic nonfinancial debt is little changed since
1988, while commercial banks and households—included
in the "Other" line—increased their share by less than
the decline in thrift lending. The largest increases
in lending shares have been recorded by mutual funds
and securities brokers and dealers. Some of the
'increase in credit extended by these intermediaries
probably represents acquisitions of mortgage-related
securities, but it also includes the purchase of other
securities displaced by the increased absorption of
mortgage assets by commercial banks and the household
sector.




Shares of Changes in Domestic Nonfinancial Debt
(By percent)
1985
Depository Institutions

1989

199_0-H1

38

12

Commercial banks

22

24

25

Thrift institutions

17

-12

-14

17

17

17

Pension Funds

8

9

12

Finance Companies

5

4

4

Money Market Funds

- 1

1

6

Other Mutual Funds

0

4

6

- 1

13

8

5

0

2

41

33

Insurance Companies

Securities Brokers & Dealers
Government Agencies
**
Other

28

11

Source: Flow-of-funds statistics.
* - Preliminary estimates.
** - Computed as a residual. Largely consists of direct
lending by the household, foreign, and government sectors.




89

Q.9

A.9.

-The Congressional Budget Office estimates that the RTC
will need to resolve a total of 925 thrifts which are
or will be insolvent by August of 1992. They estimate
that an additional 792 institutions are now insolvent
if their assets are measured on a market value basis
and that most will fail within a few years after that
time. The OTS, however, estimates the RTC caseload at
722 to 1037 and describes the rest of the industry as
either "meeting or expected to meet the new capital
standards" (621 thrifts) or "well capitalized and
profitable" (1267 thrifts). To reach CBO's total of
1817 economically insolvent thrifts, one would have to
include at least 159 of the thrifts that OTS describes
as well capitalized and profitable in addition to all
of those rated lower. If the CBO's analysis is
correct, the new capital standards would certainly
appear to be inadequate. How many thrifts do you
estimate would be solvent and how many insolvent if
their assets were measured on a market value basis?
As you well know, neither generally accepted accounting
principles or regulatory accounting rules require
financial institutions to adjust their balance sheet
to market values. Absent such information, any
estimate of the number of "true" insolvents would be
largely speculative. The most recent information
available to us from the office of Thrift Supervision
indicates that as of March 31, 1990, 310 thrifts with
assets of $194.6 billion were in a weakened or insolvent condition and were scheduled for transfer to RTC
conservatorship. At the time, the RTC was already
operating 257 conservatorship with assets of $120.4
billion. In addition, the OTS also identified 311
institutions with assets of $148.6 billion as undercapitalized and not expected to meet regulatory capital
minimums.
The best proxy for mark-to-market asset valuations
would likely be the asset quality information collected
and analyzed by the OTS as part of their examination
process. Our access to such information is limited to
select institutions in which we have a direct supervisory interest (e.g. applications approval). We would
advise you to contact the OTS directly concerning such
information.
But even with detailed examination information, a
meaningful estimate of market values would have to
incorporate a wide range of institution-specific and
macroeconomic variables, and in the end would not
likely produce a result in which we could place a
great deal of confidence. A further complicating
factor which the government must always contend with is




90

the discounted values associated with assets being sold
in "firesale" or "liquidation" scenarios. When assets
can be sold in market-based transactions between willing buyers and sellers not acting under duress, the
buyers and sellers add value to the transaction as
"on-going" concerns. Hence, even an accurate portrayal
of asset market values on the books of an ongoing,
operating thrift would not accurately reflect the
government's likely costs of having to liquidate the
institution.
As I have discussed several times in the past, knowing
the ultimate cost of the bailout is only of real significance if it would materially affect the manner in
which we are addressing the problem. I believe that we
are taking forthright measures to resolve this crisis,
and that we are moving forward with appropriate vigor,
whatever the ultimate cost.
Q.10.

If the Treasury's proposal to require governmentsponsored enterprises to attain triple-A ratings
(abstracting from implicit federal guarantees) were
enacted how many basis points do you think mortgage
rates paid by homebuyers would have to rise relative to
market yields to enable these agencies to provide an
adequate return on new equity? What effect would that
have on homebuilding?

A.10.

It is very difficult to gauge the effect of the
Treasury's proposal to, in essence, substitute investor
capital for implicit taxpayer guarantees on residential
mortgage rates and housing activity. For one thing, it
is unclear how much of the current subsidy of the perceived implicit federal guarantee to FNMA and FHLMC,
the two principal housing agencies, gets passed along
to homebuyers and how much goes to shareholders in
these organizations. However, as proposals to limit
the subsidy have gained force, stock prices of FNMA
and FHLMC have fallen, suggesting that a significant
portion of the subsidy may have been going to shareholders. Efforts to measure the influence on mortgage
rates are plagued by the difficulties of separating
liquidity effects associated with the large scale of
the FNMA and FHLMC programs from the credit enhancement
effects that are linked to the subsidy. Although
empirical studies of the credit enhancement effects
vary on the amount of the impact, they generally agree
that it is relatively small.




91
- 12 -

Q.ll.

The switch to risk-based capital standards makes
lending to consumers and businesses relatively less
attractive; those activities receive a higher riskweighting than other assets. This is a positive step
in terms of bank regulation because it rewards safety.
But what are the broader macroeconomic implications of
the shifts in credit allocation that may result?

A.11.

At the margin, risk-based capital requirements tend
to make loans to businesses and consumers less
attractive. Whether this will have much, if any,
effect on the availability or cost of such credit
depends on the extent to which the securitization
process can be effective in transferring such credits
to unconstrained investors, either other banks for
which capital constraints are not binding or other
investors.
The recent experience in the mortgage
market, as the thrift holdings of mortgage assets have
contracted sharply, suggests that it is possible for
credit demands to be readily met by new investors as
traditional lenders cut back or withdraw. Nevertheless, this is a matter that requires continued monitoring to determine whether any reluctance by some banks
to make credit available to businesses or consumers is
adversely affecting these borrowers.

Q.12.

The cost to banks of raising second tier capital
through the sale of subordinated debt rose by 40 basis
points in the first half of this year. At the same
time, bank stocks are down and in many cases are
selling below book value. How much do you think this
increased cost of capital will affect growth in loan
volume?

A.12.

While bank access to capital markets already has
deteriorated, the strong inflow of retail deposits
from the contracting thrift industry has been putting
downward pressure on these deposit rates and offsetting, at least to a degree, the effect of higher
costs of capital on the overall cost of funds to banks.
Nonetheless, many banking organizations may have
reacted to their less favorable access to the capital
markets by adopting a more cautious approach to lending
and expansion of their balance sheets. We at the
Federal Reserve have been and will continue to monitor
this situation carefully.




92

Q.13.

The financial health of the insurance industry is
currently being called into question. Issues are being
raised about some of their assets, including holdings
in low-grade bonds and real estate-related activities.
If the problems are as serious as feared by many, how
much effect might there be on real estate lending?

A.13.

In addition to the insurance industry's holdings of
certain problem assets, concerns have been voiced about
pressures on profit positions from intensified
competition, especially in the guaranteed investment
contract products area, and some erosion in recent
years of capital positions. For the industry as a
whole, it would appear that capital and reserves are
adequate to withstand their present asset quality
problems, although some individual institutions, of
course, could experience pronounced difficulties. in
light of these considerations, one could reasonably
expect that the insurance industry will take a more
cautious approach to lending, avoiding more risky
credits. This could favor the residential mortgage
market as solid mortgage assets—mortgage securities as
well as whole loans—become more attractive.




93
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HEINZ FROM

Alan Greenspan

Q.I.

Savings and investment are critical components of
economic growth. Increased savings through reductions in the federal budget deficit would increase the
amount of funds available for investment and reduce
the cost of capital. However, some observers noted
that increased savings and a lower cost of capital
alone may not result in additional investment in the
United States. They assert that returns on equity
are the major determinant in investment decisions.
Consequently, investment in the United States may not
increase if investments in other countries offer higher
rates of return.
Do you agree that increased savings may not result in
increased investment in the United States if other
countries provide opportunities for higher rates of
return on investments? If so, what steps should the
United States take to increase rates of return for our
industries relative to returns available in other
countries?

A.l.

A marked reduction in the federal budget deficit likely
would boost the level of plant and equipment spending
in the United States, although there is considerable
uncertainty about the size of such an investment
response. It is important to keep in mind that two
independent factors determine the level of investment
spending. The first is the cost of capital, which
represents the price of the assets, interest rates,
depreciation, and taxes. The second factor is the
marginal value of capital, which represents the value
of the output produced by the new plant or equipment,
net of labor and other non-capital costs incurred to
run the facility.
Cutting the budget deficit would lower interest rates
in the United states, by reducing the demand for
savings relative to its supply. Moreover, given
international linkages in the capital market, interest
rates abroad might fall somewhat as well. As a result
of the lower rates, the cost of capital would be
reduced, and firms would find it profitable to undertake projects that previously had been uneconomic.
Thus, cutting the deficit would be expected to raise
investment spending.
Because firms can choose to locate new facilities in
the United States or abroad, some of the new spending
could be done on foreign soil. The choice of location
depends on the expected marginal value of capital for




- 14 -

94
- 15 -

new facilities in the United States relative to the
marginal value at new facilities abroad. Reducing the
budget deficit would.-have.no immediate effect on this
comparison, which depends heavily on such things as
exchange rates, relative labor costs, and transportation costs. However, to the extent that interest rates
in the United States fall relative to rates abroad, the
value of the dollar would be expected to'depreciate.
All else equal, a lower dollar would reduce the costs
of producing in the United States relative to producing
abroad. Over time, this shift in costs would reduce
the number of U.S.-owned plants located abroad and
increase the number of foreign-owned plants located in
the United States. Hence, a reduction in the deficit
would tend, in the long run, to raise the amount of
business investment worldwide and, all else equal, to
increase the share of that investment located in the
United States.




95
RESPONSE TO WRITTKN QUESTIONS OF SENATOR SASRER FROM
Alan Greenspan

1.

Due to the failure of certain savings and loans, the
Resolution Trust Corporation (RTC), in essence the U.S.
taxpayer, is now the largest holder of junk bonds in
America. According to securities analysts, some $4 to
$6 billion worth of these securities are now in government hands. It is expected that the amount could climb
to $10 billion.

i.

What is your best estimate of the amount of junk bonds
that the RTC holds?

b.

What's the risk, if any, posed to the taxpayer?

c.

How likely is it that the face value of these bonds will
be recovered?

.l.

On October 17, 1990, the RTC published the portfolio of
junk bonds it held at that date. The list of the
439 issues, with a face value of $3.3 billion at that
date, is attached, as v/ell as a copy of the press release
that accompanied the list. The RTC anticipates publishing an updated list y£ its junk bond portfolio on a
quarterly basis to reflect changes due to 1) sales or
2) new acquisitions.
High yield securities, by their very nature, contain a
significant amount of risk to the investor. An additional risk to the taxpayer is that in times of a
volatile market the disposal of the junk bond portfolio
may be done in such a way as to not achieve maximum
value. While market conditions may directly impact the
value of the portfolio, they arc entirely outside the
control of the RTC.
On some issues, less than face value has been and will
be achieved; on others, a premium to face has been and
will be realized. The prices achieved may be impacted
by events not within control of the RTC.




96

Q.2-

There has been much speculation that in the event there
is a successful budget summit agreement, the Federal
Reserve will ease its monetary policy to keep the economy
growing. Without this type of response from the Fed,
cutting the budget deficit at the magnitude that's being
discussed could cause a major contraction in fiscal
policy that could trigger a serious economic downturn.
I think most economists would say that the effect of
monetary policy is felt more slowly than the effect of
fiscal policy. so it's possible that waiting until after
a budget agreement has been reached could cause a recession. Many economists think that the Fed should be
easing rates in anticipation of budget summit agreement.
If we move into a recession, the deficit will only widen
further -- revenues would decrease, demand for social
services would increase, and the cost of the savings and
loan bailout would multiply by untold amounts.

a.

Do you believe that monetary policy can work quickly
enough to counter the fiscal contraction?

D.

Should the Fed be relaxing in anticipation of a budget
agreement?

A.2.

Should Congress and the Administration come to agreement
on a credible package instituting a major and lasting
cut in the federal deficit, the Federal Reserve certainly
would need to reconsider its policy stance. The appropriate response would depend on the composition and
timing of the fiscal action, as well as the economic
landscape at tho time. An anticipatory adjustment to
monetary policy could end up adding volatility to the
economy, if the actual fiscal change were to turn out
much different from what had been expected by the Federal
Reserve. Consequently, a monetary policy change predicated on a forthcoming budget pact might well not be in
the best interests of the economy.
Moreover, the lags in monetary policy are not so long
as to make it ineffective in offsetting the effects of
any likely fiscal restraint. Although it is commonly
assumed that monetary policy effects work their way
through the economy with considerable lags, while fiscal
policy impacts are immediate, this characterization does
not take into account some important features of the two
types of policy. In particular, monetary policy changes
can be suggested, debated, decided, and implemented in a




97

very short span of time, if need be. And financial market: quotes and asset prices adjust to changes in monetary
or fiscal policy very quickly, sending out signals to the
rest of the economy. As with monetary policy, the economy's response to changes in fiscal policy also tends to
be spread out over several quarters, and any shift in the
budget stance is likely to be phased in over a period of
quarters or years. To be sure, no one can guarantee that
monetary policy will be able to counteract any effects of
a deficit cut on a quarter-to-quarter basis, but on the
whole, monetary policy lias the ability to act quickly
enough to support economic expansion.
3.

As a member of the RTC Oversight Board, could you inform
the Committee as to the short-term spending needs of the
RTC. Treasury Secretary Brady has indicated that the RTC
could run out of money this year.

a.

Does Secretary Brady mean this calendar year or this
fiscal year?

3.

At the rate that the RTC is spending, and given the
ambitious plans of the Oversight Board, when do you
anticipate the need for funds, and how much will be
needed?

3.

Treasury Secretary Brady has stated that the RTC faces
two limitations on resources: the overall $50 billion
limitation on losses and the obligation limitation (or
"note cap"). Based on the RTC's calculation, it will use
almost all of its borrowing capacity under the note cap
in the first 2 months of FY 91. At that point, it would
still have about $12 billion in loss funds available. If
the RTC were unconstrained by the note cap, we would
expect it to exhaust almost all of its remaining loss
funds by the end of this calendar year.
To address the anticipated resolutions in fiscal 1991,
the RTC will need an additional $40 billion in new loss
funds beyond the loss funds remaining from the original
appropriation. New working capital borrowings could be
as much as an estimated 360 billion in fiscal 1991,
depending upon the pace of asset sales. These
projections indicate that the RTC will need additional
resources before the end of the calendar year to keep the
cleanup process going.




98

Q.-J.

As the financing arm of the savings and loan bailout,
REFCORP is deemed to be off-budget. It borrows in the
capital markets and turns over the proceeds to the RTC,
which then uses the money to resolve insolvent savings
and loans. This funding mechanism is expensive; it is
30 to 40 basis points over comparable Treasury securities. Now that the Administration has admitted that it
will need enormous Treasury financing anyway to pay for
S&L losses, does it make sense to do away with REFCORP,
and instead, borrow directly from the Treasury? Would
this save some money?

.4.

The primary reason for financing the RTC off-budget
through REFCORP--the concern about undermining GrammRudman-Hollings (GRH) budgetary discipline—is not
applicable in the current situation. At the time FIRREA
was being considered, there was a real risk that an ad
hoc budgetary exemption for Treasury financing of RTC
would set a precedent that would be extended to other
large spending programs and threaten the discipline of
the GRH process. Since that time, two developments have
undercut justification for any further off-budget financing of the RTC. First, the RTC has decided to borrow
working capital through the Federal Financing Bank;
hence, substantial RTC outlays are already being recorded
on-budget. Secondly, the GRH procedures are in the process of being revised by representatives of Congress and
the Administration in the budget negotiations. In my
view, the financing of RTC in the Treasury securities
market would be appropriate in the context of a credible,
substantial and enforceable budget agreement to reduce
and, within a few years, eliminate our fiscal deficits.
Not only would RTC outlays be financed at the more
favorable rate on Treasury securities, but the overall
structure of interest rates would decline as investors
were convinced that pressures on our financial markets
were being lessened.

Q.5.

In your testimony last week before this same committee,
you engaged in an interesting colloquy with Senator Wirth
about the economic origins of the thrift crisis. You
said that if Regulation Q had not been repealed, and the
thrifts had not been permitted to pay market rates of
interest, there would have been a "tremendous flood from
thrift deposits" into treasuries or money market funds.

a.

Had there been similar outflows of deposits from S&Ls and
banks before 1980 during periods of high interest rates?

o.

What was different in 1980 that convinced everyone that
Reg Q had to be repealed? Was it that interest rates had
never been this high before -- 20 percent? Or was it




99

that there were no competitors to banks, like money
market funds, available to attract deposits?
If Reg Q had not been repealed, would S&Ls have lost
all their deposits?
Would they have retained their
core or pass book deposits? And would the industry
have recovered when interest rates finally declined in
1982-83?
The savings and loan industry grew at 20 percent per year
in the 1980s. What would have been the cost of resolving
the thrift problem in 1980 presuming that Reg Q wa.s not
repealed? Would it have been much smaller because the
savings and loan industry v/ould have been much smaller?
In earlier periods of high market rates relative to
deposit rates there had been outflows or sharply
reduced inflows of retail deposits at thrifts resulting
in curtailed mortgage lending. During the 1970s, public awareness of alternatives to such deposits, most
importantly money market mutual funds, exacerbated
disintermediation problems. To lessen these problems,
regulators responded by ra ising certain deposit rate
ceilings and introducing new types of accounts.
There had developed a growing recognition that
Regulation Q ceilings had contributed to swings in
retail deposits at thrifts and thereby to that sector
of the economy most dependent on thrift credit, residential housing. Moreover, pa;~t regulatory responses
to maintain deposit flow through selected adjustments
in rate ceilings cind the croation of new accounts had
created a complex structure and to some degree aggravated the mismatch of asset and liability maturities.
Moreover, thrift profitability continued to vary
inversely with market interest rates.
It is worth noting that deposit rate ceilings were
not removed in 1980 but instead a procedure was
established for nn orderly phase out of those ceilings
over a 6-year period. Ceilings on savings deposits,
for example, were not eliminated unti] 1986, Nevertheless, these accounts declined only moderately; they
fell about 13 percent over the period from April 1980
to April 1986 when the ceiling was removed, with much
of this decline occurring when the money market deposit
account was authorized in late 1982. Thus, it seems
evident that thrifts would not have lost all their
deposits had rate ceilings remained. However, they
would have had nore d i f f i c u l t y funding their assets
and likely would have relied more on high cost
short-tern liabilities: that v/ould have preserved the




100

mismatch of asset and liability maturities, and
pressures on earnings would have continued.
A.5d.

Q.6.

While the ability of thrifts to attract federally
insured deposits at rates not governed by ceilings
was a factor contributing to the thrift crisis, others,
such as inadequate supervision, also played an important
role. It is impossible to say what the cost of resolving the thrift problem would have been in 1980, or
how much smaller the cost would have been if deposits
had not been deregulated, as it is uncertain how
regulatory ceiling would have been administered in
response to unfolding events. In 1980 itself, the
industry had a relatively strong capital-asset
position--5-l/4 percent measured on a book-value
basis—and the number of troubled institutions was
small. The difficulties encountered by the industry
arose in the following years. In the absence of deposit
rate deregulation, it would seem that the insurance fund
still would have had to deal with a sizable number of
troubled institutions. While the types of problems
faced by the regulators probably would have been
different, resolution costs likely would nave been
lower.
The Fed eased its monetary policy for 7 months in 1989,
but then held a steady course this year, until just last
week. You yourself indicated that the Fed has found that
the money supply isn't increasing at a very great rate;
there is a credit crunch — banks are tightening on their
own; and housing starts are at their lowest level since
the 1982 recession.

a.

Does the Fed need to be sending a strong and continued
signal to the markets that it will avoid recession?

b.

What justified the 7 months of easing last year versus
today?

:.

Can you make a case that there is no recession in the
offing?

A.6.

The message the market should be receiving from the
Federal Reserve is that monetary policy will be adjusted
as needed in an effort to keep the economic expansion on
track. However, this policy stance includes importantly
attention to inflation pressures, for one of the surest
ways to derail economic growth is to allow inflation to
accelerate. High inflation inevitably brings in its wake
recession and wrenching readjustment, while price




101

stability allows the economy to operate at its peak
efficiency. Developments in world oil markets since the
Humphrey-Hawkins hearings have not altered these basic
facts, although they do have the potential to make it
significantly more difficult in coming quarters for the
Federal Reserve to attain its goals of simultaneously
sustaining expansion and damping inflation.
Last year, the Federal Reserve eased pressures on reserve
markets in a series of measured steps as the balance of
risks appear to tip more in the direction of recession
than of a pickup in inflation. Even with the adjustment
in monetary policy, economic growth was quite sluggish
late last year. Early in 1990, economic activity
appeared to be regaining momentum and there seemed to be
no abatement in underlying inflation pressures. In these
circumstances, the Federal Reserve made no further
changes in its reserve stance until July when it became
apparent that credit stringency was threatening to impose
an inappropriate degree of restraint on the economy.
.7.

One of the leading contributors to inflation today is the
escalation of health care costs. Indeed, the consumer
price index figures released today show that health care
is running at approximately double the rate of inflation
at 9 percentage points above a year ago, rising 0.7 in
June.
I am concerned that we may be destroying the interest
sensitive sectors, like housing, but not even touching
those that aren't interest sensitive, like health care.
Is health care a key component of inflation? How does
the Fed's high interest rate policy affect inflation in
health care costs?

.7.

Price increases for the medical care component of the CPI
have for some time run above the overall inflation rate.
For the 1980s as a whole, medical care costs rose about
3 percentage points per year faster than overall
inflation.
To an important extent, the rise in medical care costs
reflects supply and demand conditions specific to the
health care area. For example, in the past 2 years,
hourly compensation for private sector health services
workers as measured by the employment cost index) has
been rising at about a 6-3/4 percent annual rate,
compared with a less than 5 percent pace for all private
industry workers, likely reflecting shortages in some
localities for nurses and other health care workers as
this sector of the economy continues to expand.




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However, inflation in medical service costs is not
immutable. During the early 1980s, when the overall CPI
inflation rate came down 9-1/2 percentage points, medical
inflation fell 6 percentage points.
Monetary policy affects inflation in the medical care
area through its influence on the degree of resource
utilization in the economy more generally. In particular, a lessening of resource pressure helps bring down
costs of various materials used in the medical area, such
as chemicals and paper, and helps hold down labor costs
in the medical care area, as workers need smaller nominal
wage increases to keep up with overall inflation.