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S. HRG. 105-247
IAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR1997
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
JULY 23, W97
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
45-218 CC
WASHINGTON : 1997
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
ISBN 0-16-055895-6
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
ALFONSE M. D'AMATO, New York, Chairman
PAUL S. SARBANES, Maryland
PHIL GRAMM, Texas
CHRISTOPHER J. DODD, Connecticut
RICHARD C. SHELBY, Alabama
JOHN F. KERRY, Massachusetts
CONNIE MACK, Florida
RICHARD H. BRYAN, Nevada
LAUCH FAIRCLOTH, North Carolina
ROBERT F. BENNETT, Utah
BARBARA BOXER, California
CAROL MOSELEY-BRAUN, Illinois
ROD GRAMS, Minnesota
WAYNE ALLARD, Colorado
TIM JOHNSON, South Dakota
MICHAEL B. ENZI, Wyoming
JACK REED, Rhode Island
CHUCK HAGEL, Nebraska
HOWARD A. MENELL, Staff Director
STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel
PHILIP E. BECHTEL, Chief Counsel
PEGGY KUHN, Financial Analyst
LENDELL PORTERFIELD, Financial Economist
MARTIN J. GRUENBERG, Democratic Senior Counsel
GEORGE E. WHITTLE, Editor
(ID
CONTENTS
WEDNESDAY, JULY 23, 1997
Page
Opening statement of Chairman D'Amata,
Prepared statement
Opening statements, comments, or prepared statements of:
Senator Shelby
Senator Hagel
Prepared statement
Senator Allard
Senator Sarbanes
Senator Gramm
Senator Kerry
Senator Mack
Senator Grams
Senator Faircloth
Prepared statement
1
27
2
2
27
2
9
10
12
14
18
22
27
WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC
Prepared statement
Inflation, Output, and Technological Change in the 1990's
Labor Markets
The Economic Outlook
Growth of Money and Credit
Concluding Comment
Response to written questions of Senator Shelby
3
28
29
31
32
34
34
35
ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Letter from Alan Greenspan, Chairman, Board of Governors of the Federal
Reserve System to Senator Alfonse M. D'Amato, dated July 14, 1997
Attachment 1
Attachment 2
Attachments
Monetary Policy Report to the Congress, July 22, 1997
37
39
46
48
49
(III)
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1997
WEDNESDAY, JULY 23, 1997
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Committee met at 10:05 a.m., in room SD-538 of the Dirksen Senate Office Building, Senator Alfonse M. D'Amato (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN ALFONSE M. D'AMATO
The CHAIRMAN. The Committee will come to order.
The Committee is pleased to welcome Chairman Greenspan this
morning to hear the Federal Reserve's semiannual report to Congress on our Nation's economy.
Chairman Greenspan, Money magazine reports that there was a
story circulating on Wall Street, and I think it illustrates the magnificent gift that you have at times with respect to obfuscation. Apparently, the report goes that you actually proposed marriage to
your wife, Andrea Mitchell, early on when you first met her. I will
remind those who are not aware of the fact that you actually dated
your wife for a number of years, and the actual marriage didn't
occur until a few months ago. It seems that it took Andrea all those
years to decipher that you had, in fact, proposed marriage.
[Laughter.]
I think it takes a number of us quite awhile to analyze and to
fully appreciate the extent of your remarks.
But let me say this, if I might. I think there is one thing that
is very clear and one thing that you have never wavered on, and
that is that the Congress of the United States has its job to do, as
it relates to getting spending under control and to seeing to it that
we work to achieve a balanced budget. We must put our house in
order not only for the short term but also for the long term, and
that the markets do look at that.
Mr. Chairman, under your stewardship, I believe that you have
brought equanimity to the marketplace, as it relates to the policies
and the programs that you have implemented.
There have been those who over the years have been rather critical and have been ready to assail you and the Federal Reserve's
policy whenever they disagreed with respect to interest rates thinking that that was the panacea for everything.
You have had a steady hand at the tiller, you have navigated
through some very difficult seas and we are deeply appreciative.
(l)
And I think all of my colleagues share that opinion of your continued leadership.
Mr. Chairman, I am going to ask all of my colleagues to try to
keep their remarks to a minimum so we can hear from you because
usually it is about 2 hours of listening to ourselves, and we never
get to really hear from you.
But we are deeply appreciative of your being here.
Senator Shelby.
OPENING COMMENTS OF SENATOR RICHARD C. SHELBY
Senator SHELBY. Mr. Chairman, heeding your request, I will be
short in my remarks.
Chairman Greenspan, I want to again welcome you to the Committee and I want to thank you and the members of the Federal
Reserve Board for your diligent pursuit of price stability.
I am very pleased to know, and Fve always thought this, that the
Board is very aware of the economic conditions and price pressures,
and I am concerned with the potential effects of efforts to publicly
question and criticize the Federal Reserve Board on its recent increase in the Federal funds rate of 25 basis points.
The Chairman alluded to that.
Such efforts, I believe, set a dangerous precedent and only serve
to politicize the Federal Reserve which we should never, never do.
I believe price stability is dependent on central bank independence. I can only hope, Chairman Greenspan, that critics of the
recent rate increase realize that the yield on the long bond has decreased almost 50 basis points since the Fed funds hike, increasing
the opportunities for families to purchase homes in America as well
as existing homeowners to refinance, among other things.
I am convinced, Mr. Chairman, that the only reason we are witnessing the current economic expansion of 76 months and counting
is because inflation has been held in check. After all, history has
proven time and time again that the best way to truly encourage
growth and output in the long run is to provide a monetary environment of low inflation.
That being said, Chairman Greenspan, I wish the Board continued success and we welcome you.
The CHAIRMAN. Thank you, Senator.
Senator Hagel.
OPENING COMMENTS OF SENATOR CHUCK HAGEL
Senator HAGEL. Mr. Chairman, thank you.
Chairman Greenspan, good morning, welcome. I do have a brief
statement that I will submit for the record, Mr. Chairman, and add
only that we once again welcome you and look forward to your testimony.
The CHAIRMAN. Thank you, Senator.
Senator Allard.
OPENING COMMENTS OF SENATOR WAYNE ALLARD
Senator ALLARD. Thank you, Mr. Chairman.
I just want to say that I am also looking forward to the Chairman's comments.
The CHAIRMAN. Thanks so much. This is an all-time record, just
10 minutes.
Senator Greenspan.
[Laughter.]
OPENING STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Chairman GREENSPAN. In light of that, I have a very extended
written presentation which I will
The CHAIRMAN. Mr. Chairman, let me say this to you. We really
want you to take your time because we have saved an hour plus.
[Laughter.]
I want you to take as much time as you want and to stress the
points that you think are important. I mean that very sincerely.
Chairman GREENSPAN. Thank you.
I have excerpted significantly from my prepared remarks and I
request that the full remarks be inserted in the record.
The CHAIRMAN. So ordered.
Chairman GREENSPAN. Mr. Chairman and Members of the Committee, it's always a pleasure to appear here periodically to present
the Federal Reserve's report on the economic situation and monetary policy.
The recent performance of the economy, characterized by strong
growth and low inflation, has been exceptional—and better than
most had anticipated.
Moreover, our Federal Reserve Banks indicate that economic activity is on the rise, and at a relatively high level, in virtually every
geographic area and community of the Nation.
This strong expansion has produced a remarkable increase in
work opportunities for Americans. A net of more than 13 million
jobs has been created since the current period of growth began in
the spring of 1991. As a consequence, the unemployment rate has
fallen to 5 percent—its lowest level in almost a quarter century. To
be sure, not all segments of our population are fully sharing in the
economic improvement. Some Americans still have trouble finding
jobs, and for part of our workforce real wage stagnation persists.
In contrast to the typical post-war business cycle, measured price
inflation is lower now than when the expansion began and has
shown little tendency to rebound of late, despite high rates of resource utilization.
With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial
cycles fade with time. Soaring prices in the stock market have been
fueled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady,
or even increase further, in a relatively stable, low-inflation environment.
The key questions facing financial markets and policymakers are
what is behind the good performance of the economy, and will it
persist. Many observers, including us, have been puzzled about
how an economy, operating at high levels and drawing into employment increasingly less experienced workers, can still produce subdued and, by some measures even falling, inflation rates.
Certainly, public policy has played an important role. Administration and Congressional actions to curtail budget deficits have
enabled long-term interest rates to move lower. Deregulation in a
number of industries has fostered competition and has held down
prices. Finally, the preemptive actions of the Federal Reserve in
1994 contained a potentially destabilizing surge in demand. But
the fuller explanation of the recent extraordinary performance
may, indeed, lie deeper.
In February 1996, I raised before this Committee the hypothesis
tying together technological change and cost pressures that could
explain what was even then a puzzling quiescence of inflation. The
new information received in the last 18 months remains consistent
with those earlier notions, but some additional pieces of the puzzle
appear to be falling into place.
The surge in capital investment in high-tech equipment that
began in early 1993 has since strengthened. Presumably companies
have come to perceive a significant increase in profit opportunities
from exploiting the improved productivity of the new technologies.
It is premature to judge definitively whether these business perceptions are the harbinger of a more general and persistent improvement in productivity. Although the anecdotal evidence is
ample and manufacturing productivity has picked up, a change in
the underlying trend is not yet reflected in our conventional data
for the whole economy.
But even if the perceived quicker pace of application of our newer
technologies turns out to be mere wheel-spinning rather than true
productivity advance, it has brought with it a heightened sense of
job insecurity and, as a consequence, subdued wage gains. As I
pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers
in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent in 1996.
To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number
of voluntary job leavers has edged up. But the increases in the Employment Cost Index still trail behind what previous relationships
to tight labor markets would have suggested, and a lingering sense
of fear or uncertainty seems still to pervade the job market.
The combination in recent years of subdued compensation per
hour and solid productivity advances has meant that unit labor
costs of nonfinancial corporations have barely moved, damping inflationary pressures.
While accelerated technological change may well be an important
element in solving the current economic puzzle, there have been
other influences at play as well in restraining price increases at
high levels of resource utilization, including the strong dollar, increasing globalization, deregulation, and changes in the health care
industry.
Many of these forces are limited or temporary, and their effects
can be expected to diminish, at which time cost and price pressures
would tend to reemerge. The effects of an increased rate of technological change, however, might be more persistent.
When I discuss greater technological change, I am not referring
primarily to a particular new invention. Instead, I have in mind
the increasingly successful and pervasive application of recent technological advances. Many of these technologies have been around
for quite some time. Why might they be having a more pronounced
effect now?
What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to
create significant new opportunities for value creation. For example, the applications of the laser were modest until the later development of fiber optics engendered a revolution in telecommunications. Broad advances in software have enabled us to capitalize
on the prodigious gains in hardware capacity. The interaction of
both of these has created the Internet.
The accelerated synergies of the various technologies may be
what has been creating the apparent significant new profit opportunities that presumably lie at the root of the recent boom in
high-tech investment.
We do not now know, nor do I suspect can anyone know, whether
current developments are part of a once or twice in a century phenomenon that will carry productivity trends nationally and globally
to a new higher track, or whether we are merely observing some
unusual variation within the context of an otherwise generally conventional business cycle expansion.
But whatever the trend in productivity and, by extension, overall
sustainable economic growth, from the Federal Reserve's point of
view, the faster the better. We see our job as fostering the degree
of liquidity that will best support the most effective platform for
growth to flourish. We believe a noninflationary environment is
such a platform.
The Federal Reserve's policy problem is not with growth, but
with maintaining an effective platform. To do so, we endeavor to
prevent strains from developing in our economic system, which
long experience tells us produce bottlenecks, shortages, and inefficiencies. In gauging the potential for oncoming strains, it is the effective capacity of the economy to produce that is important to us.
Capacity itself, however, is a complex concept which requires a
separate evaluation of its two components, capital and labor. It
appears that capital can adapt and expand more expeditiously than
in the past to meet demands. Hence, capital capacity is now a considerably less rigid constrain than it once was.
In recent years, technology has engendered a significant compression of lead times between order and delivery for production
facilities. This has enabled output to respond increasingly faster to
an upsurge in demand, thereby decreasing the incidence of strains
on capital capacity and shortages so evident in earlier business
expansions.
Even so, today's economy as a whole still can face capacity constraints from its facilities. Indeed, just 3 years ago, bottlenecks in
industrial production were putting significant upward pressures on
prices at earlier stages of production. Although further strides
toward greater facilities flexibility have occurred since 1994, this is
clearly an evolutionary, not a revolutionary, process.
Moreover, technology and management changes have had only a
limited effect on the ability of labor supply to respond to changes
in demand. To be sure, individual firms have acquired additional
flexibility by increased use of out-sourcing and temporary workers.
While these techniques put the right workers in the right spots to
reduce bottlenecks, they do not increase the aggregate supply of
labor. Labor capacity for an individual country is constrained by
the size of the working-age population, which, except for immigration, is basically determined several decades in the past.
Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes that despite
significant increases in capital equipment in recent years, additions
to labor supply have been inadequate to meet the demand for labor.
As a consequence, the recent period has been one of significant reduction in labor market slack.
The key point is that continuously digging ever deeper into the
available work-age population is not a sustainable trajectory for job
creation. The rise in the average work week since early 1996 suggests employers are having increasingly greater difficulty fitting
the millions who want a job into available job slots. If the pace of
job creation continues, the pressures on wages and other costs of
hiring increasing numbers of such individuals could escalate more
rapidly.
Thus, there would seem to be emerging constraints on potential
labor input. Even before we reach the ultimate limit of sustainable
labor supply growth, the economy's ability to expand employment
at the recent rate should rapidly diminish.
Fortunately, the very rapid growth of demand over the winter
has eased recently and monetary policymakers forecast a continuation of less rapid growth in coming quarters. The pace of expansion is expected to keep the unemployment rate close to its current
low level.
We anticipate that consumer prices will rise only 2Y4 to 2Y2 percent this year. The central tendency of the projections is that CPI
inflation will be 2 ¥2 to 3 percent in 1998—a little above the expectation for this year. However, much of this increase is presumed to
result from the absence of temporary factors that are holding down
inflation this year.
I have no doubt that the current stance of policy—characterized
by a nominal Federal funds rate around 5Vb percent—will need to
be changed at some point to foster sustainable growth and low
inflation. Adjustments in the policy instrument in response to new
information are a necessary and, I should like to emphasize, routine aspect of responsible policymaking. For the present, as I have
indicated, demand growth does appear to have moderated, but
whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With considerable momentum behind the expansion and labor market utilization
rates unusually high, the Federal Reserve must be alert to the possibility that additional action might be called for to forestall excessive credit creation.
The Federal Reserve is intent on gearing its policy to facilitate
the maximum sustainable growth of the economy, but it is not, as
some commentators have suggested, involved in an experiment
that deliberately prods the economy to see how far and fast it will
grow. The costs of a failed experiment would be too much of a burden for too many of our citizens.
The key question is how monetary policy can best foster the
highest rate of sustainable growth and avoid amplifying swings in
output, employment, and prices. The historical evidence is unambiguous that excessive creation of credit and liquidity contributes
nothing to the long-term growth of our productive potential and
much to costly shorter-term fluctuations.
Our objective has never been to contain inflation as an end in itself, but rather as a precondition for the highest possible long-run
growth of output and income—the ultimate goal of macroeconomic
policy.
The Federal Reserve recognizes, of course, that monetary policy
does not determine the economy's potential. All that it can do is
help establish sound money and a stable financial environment in
which the inherent vitality of a market economy can flourish and
promote the capital investment that, in the long run, is the basis
for vigorous economic growth.
Similarly, other Government policies also have a major role to
play in contributing to economic growth. A continued emphasis on
market mechanisms through deregulation will help sharpen incentives to work, save, invest, and innovate. Also, a fiscal policy
oriented toward limited growth and Government expenditures, producing smaller budget deficits and even budget surpluses, would
tend to lower interest rates even further, also promoting capital investment. The recent experience provides striking evidence of the
potential for the continuation and extension of monetary, fiscal,
and structural policies to enhance our economy's performance in
the period ahead.
Thank you, Mr. Chairman. Fm available for questions.
The CHAIRMAN. Thank you, Mr. Chairman.
Indeed, I want to say that performance far outstrips rhetoric,
and the performance of the economy, the performance of real interest rates as it relates to the steps that the Federal Reserve has
taken, demonstrates that you and the Federal Reserve have moved
decisively in the right direction in demonstrating the very real concern for inflation. People understand it or are beginning to get the
message.
I am going to ask everyone to please attempt to hold their questions to 5 minutes, so that everyone has an opportunity, and the
Chairman will also operate under that.
Chairman Greenspan, in your last appearance here before this
Committee, you and I discussed the possibility of permitting the
Federal Reserve to pay interest on banks' required reserves. Last
week, I received a letter and the background of that was the concern that banks were increasingly using retail sweep accounts designed to get around reserve requirements. Since banks do not earn
any interest on reserves, the letter from the Federal Reserve said
that required reserve balances had fallen by about $19 billion as
a result of the sweep accounts with reserves now only at $9 billion.
I am pleased that your response expressed the Fed's support for
legislation for authorizing the payment of interest on reserves.
Your response further recommends allowing depository institutions
to pay interest on demand deposits.
I would like to distribute this letter to my colleagues and indicate
to them that hopefully we can move forward. I look forward to and
8
anticipate having hearings and working with you and the Federal
Reserve in developing a legislative package.
As you say in your next to the last paragraph, "Allowing the Federal Reserve to pay interest on reserve balances would be a useful
step, which we support." You go on to say, "To this end, we would
support providing the Federal Reserve the ability to pay interest on
required and excess reserve balances, at possibly differential rates
to be set by the Federal Reserve. We would also recommend allowing depository institutions to pay interest on demand deposits,
which would eliminate a price distortion and the wasteful use of
resources to circumvent it."
That is very welcome news. I think it's going to be reflected in
terms of banks not taking these extraordinary measures to attempt
to maximize their incomes. In the long run, this will result in some
very beneficial factors for consumers and others.
Let me ask you this. Why would it be desirable to pay interest
on excess reserves? And would you expect to see any significant
changes in the level of excess reserves, now averaging about a billion dollars, if the payment of interest is permitted?
Chairman GREENSPAN. It would give us greater control over
monetary policy, and it is an effective tool which, in my judgment,
while not a major issue, is something which would be helpful.
The CHAIRMAN. Do you anticipate that consumers and small
businesses would benefit by permitting the payment of interest on
reserves?
Chairman GREENSPAN. I would certainly say yes. First of all, let's
remember that what we are discussing now is endeavoring to put
into statute, something, which for all practical purposes, is moving
into existence in any event. The sweep accounts technologies are so
pervasive that within a short period of time, transaction balances
that create the need for required reserves will be so pared as to
mean that, for practical purposes, required reserves don't really
exist. That would then require us to alter our monetary policy
regime, which would enable us to function, but would create
discontinuities in how we handle our whole function. While we obviously can do it if necessary, it is far better approached by recognizing what the nature of the problem is.
If we were to pay interest on required reserves, we clearly significantly alter the desire for individual institutions to create
sweeps. If we also recognize that interest on demand deposits or
transaction deposits, generally, is, in effect, being paid to many corporations, the other side of the sweep issue is technologies which
enable all people to have interest-earning transaction deposits.
If you extend the number of checks which can be drawn on a
nontransaction account, you eventually create a demand deposit.
Indeed, the American Bankers Association very recently raised the
numbers question and related issues, which emphasize that the
technologies are changing. It is important to recognize that we,
ourselves, in our regulations should not foster endeavors to go
around obsolescent statutes.
I would very strongly urge the Congress to implement the legislation which you are contemplating, Mr. Chairman.
The CHAIRMAN. Let me thank you, Chairman Greenspan, for
your responsiveness in providing such detail, because your letter is
over 20 pages of very thoughtful commentary as to how we should
attempt to arrive at that position.
We look forward to working with you and your staff and the staff
on both sides of the Committee. Hopefully in early September when
we come back, we can hold hearings and see if we can't get some
legislative action to deal with this, an action that would benefit the
consumers, and, as you say, do away with this outmoded process.
The yellow light is on. I am going to hold all of our colleagues,
including the Chairman, to that 5-minute rule, so that we can all
get an opportunity to raise our questions with you.
Senator Sarbanes.
OPENING COMMENTS OF SENATOR PAUL S. SARBANES
Senator SARBANES. Thank you, Mr. Chairman.
Let me just pursue this subject for a minute. How much would
it cost the Fed to pay interest on a reserve balance?
Chairman GREENSPAN. It depends on how one scores this, in the
sense that as we see it at this stage, if nothing is done and, if we
continue the existing process, there will be a continued erosion of
reserve balances, so that the amount of revenues that will be
achieved
Senator SARBANES. Let's leave the erosion aside and use a static
analysis. How much would it cost?
Chairman GREENSPAN. It's $300 million now, and if we project—
I don't know whether you want to call it a dynamic analysis—it
gets down to about $150 million annually.
Senator SARBANES. Does the Fed make a payment annually into
the Treasury?
Chairman GREENSPAN. Yes, it makes a payment far more often
than annually.
Senator SARBANES. Well, annually, how much do you pay into
the Treasury?
Chairman GREENSPAN. It's roughly $20 billion in total.
Senator SARBANES. Twenty billion?
Chairman GREENSPAN. I have forgotten the latest year, but that's
what it's been averaging.
Senator SARBANES. Mr. Chairman, obviously, we need to hear
from the Treasury about this.
The CHAIRMAN. Sure. OMB as well as the CBO in terms of the
scoring.
Senator SARBANES. Chairman Greenspan, we are pleased to have
you here again before the Committee.
Business Week, on May 19th, had an article, "How Long Can This
Last?" Then it said, "Strong growth with little unemployment and
low inflation doesn't have to peter out, here's why." And they then
develop the case. Of course, 3 years ago, in fact, they had a whole
issue devoted to why are we so afraid of growth? You and I have
discussed that.
Then I notice that just last week, you're on the cover of Business
Week. Actually, I must say that it's a very nice picture.
[Laughter.]
It's talking about how the Fed Chairman sees the new economy.
Now, I assume that everything that was going to be said was said
10
yesterday, so people won't go tearing out of the room in order to
get to the telephone to effect the market.
I guess we've done the market-effecting as of yesterday. There's
certainly a lot of exuberance. Whether it's rational or irrational, I'll
forebear from asking here this morning.
I want to pursue this question, though, of real interest. First,
producer prices continue to decline; is that correct? In fact, we have
had 6 consecutive months of decline in the Producer Price Index,
something that's not been seen since 1949. Isn't it reasonable to
assume that these declines in producer prices will feed into slower
inflation at the consumer level?
Chairman GREENSPAN. Only in part. Remember, producer prices
for finished goods, and they comprise both consumer goods and capital goods, among a number of other miscellaneous things. It's only
the consumer goods part of that which tends to reflect itself in the
goods part of the Consumer Price Index.
As you know, there's a rather significant services element within
the Consumer Price Index. Indeed, the prices of services have been
rising at a somewhat faster pace, albeit a relatively slow pace, than
goods price inflation. So a goodly part of that PPI decline is the
declining prices in capital goods which have become increasingly
more computer-related, and as a consequence, are subject to the
price declines which have so characterized the high-tech industries
of this country.
Senator SARBANES. It won't be a straight pass-through, but there
will be some impact, I take it?
Chairman GREENSPAN. Yes, that's correct.
Senator SARBANES. Now, I'm just curious; if inflation continues
to slow, which has been the case—is that not right?
Chairman GREENSPAN. That is correct.
Senator SARBANES. Won't real short-term interest rates rise, even
if the Federal funds rate stays the same?
Let me show you a chart here. This is what's happening to the
real Fed funds rate. I mean, there's a tendency, obviously, since the
Fed doesn't take any action, and you have taken only one action
in recent times to take the rates up, but the real fund rates have
moved quite sharply over the last year by a full point as a consequence of the drop in inflation; is that not correct?
Chairman GREENSPAN. I wouldn't necessarily use the 12-month
change, but you are quite correct that the real Federal funds rate
has risen inversely to the fall in the GDP deflator or the CPI,
which we would use to calculate it.
Senator SARBANES. So if the Fed leaves the nominal rate where
it is, but inflation continues to drop, you will get an increase in the
real interest rates; would you not?
Chairman GREENSPAN. Of course, you would.
Senator SARBANES. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gramm.
OPENING COMMENTS OF SENATOR PHIL GRAMM
Senator GRAMM. Thank you, Mr. Chairman.
Chairman Greenspan, first of all, let me congratulate you on our
economic expansion, on the steadiness of our growth.
11
I am sure there are school teachers and truck drivers all over
America who looked at their retirement account in the last quarter—TIAA CREF rose in value by 10 percent in the last quarter—
and they wondered, who should I give credit for this? In a town
where there are so many people who want to claim credit, I would
like to bestow at least, on my own behalf, the bulk of the credit
on you.
I think more than any other institution in our Federal Government, the Federal Reserve Bank, through its policy, being criticized
by both Democrats and Republicans at various times for not accommodating their political agenda, I think your institution's policies
under your leadership are probably more responsible for the economic growth we're experiencing, for the steadiness of that growth,
for the run-up in equity values, than any other institution or any
other individual in our Federal Government.
I wanted to take this opportunity to, at least on my behalf, say
thank you, and for the millions of people, because they're busy with
their own individual lives and may never know your name, who
have been beneficiaries of the policies that you have instituted.
I think it has made a great deal of difference. I think you have
already written your name on the pages of the monetary history of
this country, as probably the greatest central banker in the history
of the United States of America.
I wanted to get a chance today to say that, and I don't have any
questions, Mr. Chairman.
Chairman GREENSPAN. I very much appreciate those remarks,
Senator.
The CHAIRMAN. Thank you.
With the balance of your time, I am going to move to Senator
Shelby and then to Senator Kerry.
Senator Shelby.
Senator SHELBY. Thank you, Mr. Chairman.
Chairman Greenspan, some of your written statement spends
time explaining the significant capacity and the utilization of that
capacity in our economy. Given technology, a strong dollar, increased trade activity, is it unreasonable to believe the denominator in that equation should not be limited to production capacity,
only within our borders?
Chairman GREENSPAN. As I tried to outline in my prepared remarks, there is a significant distinction between facilities, the
physical facilities themselves, and the labor input. And one of the
really fascinating characteristics of the data of the last several
years is in the order books for capital equipment where unfilled
orders are falling quite dramatically relative to shipments, meaning that the lead times between orders and delivery are becoming
rapidly narrower. This means that when demand changes and you
need new facilities, your ability to put physical things in place has
obviously increased quite measurably.
In addition, the expansion of trade throughout the world and
globalization have added to that ability to respond to demand, so
that the actual physical ability to produce from our capital stock
has clearly improved and the response time falling means that restraints from the physical lack of production flexibility has dropped
—for example, from when we ran at 100 percent steel output in our
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open-hearth furnaces 50 years ago. Until we got oxygen lances in
there and other means to just gradually expand it, we were really
rigidified.
At that time, much of American capacity was of that nature. But
today it's changed, and the combination of the globalization and the
improved technology that removes the length of lead times on deliveries has effectively reduced the impact of previous shortages
from facilities that occurred in the past.
It's labor which, because of biology, cannot respond in an increasingly effective way. That is where the ultimate limits are beginning
to emerge in the capacity or the potential of this economy.
Senator SHELBY. Chairman Greenspan, how does that change the
way that you or we interpret capacity utilization data?
Chairman GREENSPAN. The figures that we publish for capacity
utilization do not change. They are, in effect, stipulating what is
the amount of gap between production and capacity as it is perceived at that time by the managers of those establishments, because ultimately that's where we get our data.
The difference is not in the measurement of the size of the gap,
but in the ability to change that gap, which has changed so dramatically. That's what's important in the whole notion of capacity
—it's a different degree of flexibility.
Senator SHELBY. Thank you.
The CHAIRMAN. Senator Kerry.
OPENING COMMENTS OF SENATOR JOHN F. KERRY
Senator KERRY. Thank you very much, Mr. Chairman.
Chairman Greenspan, welcome. I'm glad to have you here. I join
my colleague, Senator Gramm, in applauding your extraordinary
stewardship these past few years.
I think we should remember the difficulties of the credit crunch
and the banking industry at the beginning of this decade. You
made some tough choices then which were absolutely instrumental
in making up for Congress' unwillingness to act, and you did it in
a most creative and important way. I think much is owed you with
respect to monetary policy.
I will not hold my breath, however, and wait for my colleague
from Texas to laud the fiscal decisions made in 1993, which I think
also contributed to the good economic story we hear today.
Senator GRAMM. You are going to get awfully purple in the face
if you do.
[Laughter.]
Senator KERRY. That's why I say I wouldn't even venture to try.
Let me ask you this, Mr. Chairman. I have raised this issue with
you before. The trend lines on consumer debt seem to continue in
a way that seems to be disturbing. I don't know if it is, but I just
want to ask you about it. Even as we see this extraordinary expansion and growth and strong market, et cetera, we continue to see
consumer debt increasing.
Consumer debt is now running at record levels, as are personal
bankruptcies. My concern is that while in 1995 and 1996, the commercial banks earned a record high profit—and I don't begrudge
them that; that's part of the growth in the economy—but at the
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same time, consumer debt soared 39 percent in the last 5 years,
and it now exceeds $1 trillion.
Much of the higher growth figures of the last quarter, the nearly
6 percent growth that has been praised, are due to larger than anticipated consumer spending. Personal bankruptcies rose by 6 percent in mid-1995 from the prior year. Consumers owe $360 billion
on their credit cards, which is double the 1990 level. The average
household has four credit cards with balances of around $4,800,
which is up from two cards and a balance of $2,340 2 years ago.
Consumer loans comprised 45 percent of bank lending, up from 33
percent in 1986, and nearly 5 percent of credit loans were written
off as losses last year, which is up from 3.8 percent a year earlier.
We see people making purchases today with plastic that they did
not previously make. You go to the dentist, grocery store, take cab
rides, eat at McDonald's, and you pay with credit cards. Master
Card has told us that Government transactions like paying taxes
and traffic fines with credit cards is one of its fastest growing markets now. The average creditworthy American family receives 30
independent credit card solicitations each year.
Now in a theoretical sense, there's a paradox here.
Generally, we haven't seen a rise in consumer delinquencies until
there has been a rise in the unemployment rate. But now the unemployment rate has been static, yet we have seen a rapid rise in
consumer delinquencies over the last 6 to 9 months.
So, I would like to ask you just two questions. First, how do you
explain this phenomenon, if it is that? Second, are you concerned?
Should we be concerned about this level of consumer debt, and
what might be embraced in that if there were some downturn and
rise in unemployment?
Chairman GREENSPAN. Senator, first, let me describe the process
which has engendered this very significant rise in debt to which
you allude.
For the purposes of analysis, we create crude estimates of gross
extensions of installment or consumer credit to be able to disaggregate the extension versus the repayment and to be able to interrelate it to retail sales. And what we have found is, as I recall the
numbers, that the ratio of extensions to sales was rising fairly dramatically for a number of years in the early part of the 1990's
which was when most of this debt began to accumulate.
However, in the last year or so, that ratio of extensions to new
purchases has flattened out, so that the cumulative process seems
to have simmered down considerably in the aggregate sense.
We nonetheless do see, as you have pointed out, some fairly pronounced evidence of delinquencies showing up in credit cards.
The new phenomenon is the home equity loans, which are
increasingly being used as a consolidating consumer credit vehicle,
and a lot of these loans are fairly highly leveraged against the
value of the home. Indeed, there are even some loans which are
being made at 125 to 130 percent of the value of the home. In effect, these are character, that is, noncollateralized loans, which are
perfectly legitimate to make, if the person's credit standing is good.
But clearly what is occurring is a general movement up in certain areas of the consumer credit markets. Overall, however, there
does not seem to be a problem which is creating any concern on our
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part. The reason is that if you look at the debt service payments
as a percent of income, while they have moved up, it's not by any
means clear that they are in a territory which creates particular
concern.
In the mortgage market, which has to be interrelated with the
consumer credit market, because in many instances they are the
same people who are borrowing, if you look at the delinquencies in
non-credit card and non-lower quality home equity loans, the default rates and the rates of delinquencies are really remaining
quite low.
As a consequence of that, I would say that there is no material
concern that raises an issue, with the exception of the localized
issues of delinquencies and the very sharp increase in personal
bankruptcies, which is unquestionably triggering a number of these
delinquencies.
The real problem will occur when, as inevitably will be the case,
consumer income growth slows down, and you get a backing-up of
credit problems and the usual problems that will invariably exist,
or, at least, have existed in the past when incomes have flattened
out or fallen.
I see nothing in the current pattern which essentially creates a
significant deviation from those expectations. If I had time, I would
go into the income distribution effects which are also relevant here,
namely, that obviously the significant part of the middle-income
and upper-income groups, which are large parts of this consumer
credit market, have much larger assets available than they have
debts. It is true that in the lower quintiles of household balance
sheets you do see some pressures in some groups. There are undoubtedly numbers of families who are in some difficulty. But from
a total point of view, one does not yet see the elements of considerable concern.
Senator KERRY. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Mack.
OPENING COMMENTS OF SENATOR CONNIE MACK
Senator MACK. I, too, want to express my welcome to you, Mr.
Chairman, and follow along on the remarks of Senator Gramm and
Senator Kerry.
The accomplishments of the Fed—and when I say that, it is to
you, to the other members of the Board, and to the staff—I think
are remarkable, and so I compliment you on that.
I really only have one question to pursue, and it's probably more
academic than it is anything else at this point. But we've had this
conversation before about the various commissions that have reported that the CPI overstates inflation. Those numbers can be
from .8 to 1.5 percent. We're now seeing inflation as gauged by CPI
running at about 1.4 percent for the first 6 months of this year. I
guess my question is, are we moving from a time of disinflation to
deflation, and what are the risks inherent in that?
Chairman GREENSPAN. I would say that while it is certainly the
case that the measured inflation rate has come down, and, indeed,
if you adjust it to take the bias out of the data, the inflation rate
is down still more. However, there are none of the characteristics
15
in this economic structure which leads us to conclude that we are
moving in a direction of deflation.
Deflation is clearly something we should avoid as well, but I see
no evidence that is happening. You have to be a little careful about
the problem of price measurement. An increasing part of the prices
that we are currently publishing are reflecting the very marked declines in prices in an increasingly high-tech arena.
Measuring what prices really mean for a personal computer, for
example, or for some significant advance in a microchip is a very
interesting technical exercise. We generally tend to measure the
unit of output in terms of the power of calculation. And as you
know, the technology is advancing at such a pace that that power
is moving up exponentially.
We are getting very dramatic declines in price. Even though the
price of a PC has not changed all that much over the years, the
power that is put into it has made the implicit price, correctly
measured by the value of its power, go down dramatically.
The reason I raise this issue is that it is not clear to me that
everyone uses all of that power, and that when one is trying to ask,
what is the real price change of a particular piece of equipment,
it's not self-evident to me that everyone would agree that the value
increases that they see that are implicit in the prices that we publish, reflect the improvements that they are able to get out of the
machine.
The bottom line of all of this is that some of the ways in which
we measure price are increasingly complex and have ranges of
error in them. The more we shift toward the increased technology
types of equipment, the greater the pressure for prices to decline
in a measured form.
This is the reason why, though we've had previous discussions
about this and the various indexing of Federal programs, and gotten judgments about what the biases are, there is another issue
which we have always discussed, namely increasing difficulty of defining what we mean by price.
So, I want to be careful here that when we talk about deflation,
we do not assume that because we are shifting toward the types
of equipment in which prices are falling, that therefore we have
what would be called financial deflation. That is a different type of
concept, and something that we don't yet fully understand.
Senator MACK. What would be the indicators that you would look
for that would signal to you that we may be moving or could be
moving into a time of deflation?
Chairman GREENSPAN. I would be more concerned about deflation as it reflects asset values as well as prices. In other words, the
whole process of what historically we've looked at as deflation has
been characterized not only by falling product prices, but also by
falling asset prices. And that is a much different type of environment. A period of stable or declining product prices in a period of
stable asset prices, does not create the types of disruptions that are
inimical to economic growth.
We've seen innumerable cases in our history where prices have
actually been falling while asset prices, in fact, are rising and economic growth is quite impressive.
16
I think it is very important to think in terms, not of deflation as
price deflation, per se, but as a process which is inimical to economic growth.
Senator GRAMM. Mr. Chairman, I didn't use all my time, could
I just take 1 minute on this subject?
The CHAIRMAN. Yes.
Senator GRAMM. I think an example of what you're talking about,
Mr. Chairman, is that from 1865 to 1879 in the specie resumption
period, as monetary historians call it, we actually had a decline in
prices. The cost of most products declined on average about 1 percent. And yet while we had two major recessions during the period,
we had very, very impressive economic growth.
But the thing that was driving that was not any underlying economic force it was that the Federal Government decided that they
wanted to go back on the gold standard at the price of gold prior
to the Civil War, which was $20.67 an ounce. They were able, from
1865 to 1879, to run a surplus in the budget. And as greenbacks
came in, they burned them, and then as they paid off Government
bonds—Government bonds were the assets that were held to issue
National Bank Notes which were money—and in all this period
where you have actually a debate in the House of Representatives
about a surplus policy, it has actually happened before. It was a
period where real interest rates were almost negative and where
you had fairly substantial economic growth.
Chairman GREENSPAN. It was a period in which the United
States moved out of an agrarian society to become in the early part
of the 20th century, the major economy in the world.
Senator GRAMM. Twenty million people came here looking for opportunity and freedom and found it.
Chairman GREENSPAN. And they found them.
The CHAIRMAN. With that, we are now going to Senator Hagel.
Chairman GREENSPAN. This is called a short-term monetary policy discussion.
[Laughter.]
Senator HAGEL. Dr. Gramm, thank you. That was enlightening.
Mr. Chairman, I am incapable of offering any new compliments
that haven't already been offered this morning, so I would just like
to associate myself with all the flattering compliments that have
come your way. In fact, much of your reign has produced this kind
of stability.
I would like to get to a couple of points that you made in your
testimony, to talk about where we go from here and some of the
long-term challenges that are out there. I would refer back to your
last statement in your testimony. I would just read it back to you
very quickly so you have some frame of reference.
You said, "The recent experience provides striking evidence of
potential for the continuation and extension of monetary, fiscal,
and structural policies to enhance our economy's performance in
the period ahead."
I would like to tie to that, your point about the two most important components, ingredients, of capacity in our economy, capital
and labor, especially in light of our ongoing tax and budget negotiations, hopefully, our final ongoing negotiations.
17
I ask you, if you would, to elaborate a little bit, especially on the
fiscal and structural policies that we are going to have to deal with,
labor, for example, immigration policy. Obviously, we are going to
be confronted with a real problem one of these days. I suspect it's
seeping in now. But if you wouldn't mind elaborating a little bit on
what you see ahead that we are going to have to deal with, and
especially in fiscal and structural policies.
Chairman GREENSPAN. There are very few things that economists, sociologists, demographers, or others can forecast with some
degree of accuracy.
One thing that I think everybody agrees on is that there's going
to be a major shock in the fiscal situation as we move toward 2010,
when the very dramatic rise in the birth rate of the period of the
end of World War II begins to feed into the various programs which
relate to the elderly, which as you know, are a very large part of
our expenditure side of the budget, outside of what is devoted to
defense spending.
That has very major effects as we look at both the Social Security and Medicare programs. There are others, obviously, civilian
retirement and military retirement are also relevant in those contexts as well.
But we see a very large set of pressures impacting the Federal
budget. While I obviously strongly supported efforts to move toward a balanced budget, and hopefully a surplus in the short run,
we should recognize that the virtual certainty of the impact of the
Baby Boom generation on the budget is crucial to the way things
develop. Therefore, it strikes me that in the context of reviewing
budget policy, even in the short run, that that issue be in the back
of everybody's mind, knowing that there is a path there which is
going to have to be somehow addressed.
Merely getting to balance by the year 2002, while it is a necessary condition to address the 2010 and beyond period, it is also
important to recognize that after 2002, the deficit starts to drift up
again, and becomes a significant problem as you move into the second decade of the 21st century.
Because of the very substantial increase in the proportion of the
budget which is entitlements or what we used to call uncontrollable
spending, it's a new type of budget. It's not the standard annual
appropriations of discretionary programs which so dominated the
budget many years ago and enabled the Congress, really, to deal
year-by-year. Then, if things got out of hand, you could just make
a number of changes and correct the problem. But you can't do that
anymore.
What the current fiscal policy should have in mind is what types
of acts ought to be passed by the Congress which become effective
in the year 2008, 2012, 2015?
Those are going to be the types of legislative endeavors which
will be, if you wait too long, virtually impossible to enact. It is far
easier to enact laws today which become effective in 15 years so
that the people affected will have time to plan. It would be unfair
to wait until the last minute and say: There is no more money in
the cash box; we have to change our programs; too bad. I don't
think that's fair.
18
If there are going to be changes—and, indeed, if you look at the
economics of the budget, there have to be because the arithmetic
doesn't work—it's incumbent upon the Congress to give those who
are affected by those programs the maximum lead time to adjust
their own personal accounts in order that they don't find themselves in impossible situations at retirement.
Senator HAGEL. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Grams.
OPENING COMMENTS OF SENATOR ROD GRAMS
Senator GRAMS. Thank you very much, Mr. Chairman.
Chairman Greenspan, welcome. It's great to see you again. As
everybody here, I want to add my compliments to the job and the
decisions that you have made. But in saying that, I know the economy is strong today, and I hate to be the pessimist at this sunny
day picnic who says it's going to rain.
We know that if we have a picnic every day, one of these days,
it is going to rain. I grew up on a small dairy farm in Minnesota,
and we always had a philosophy that you had to have enough in
reserves in case the crops failed this year to be able to plant next
year and survive. We have some good times, and in the good times,
it's a better opportunity to plan for tomorrow in case it does rain.
So, I would just like to ask you, while we are enjoying this strong
economy today, is there something that we should be concerned
about or at least planning for, for the downside of tomorrow?
Chairman GREENSPAN. Let me just say what the Federal Reserve
is doing. We recognize that while things are doing exceptionally
well today, we can't assume it's going to happen indefinitely. As a
consequence, because we see such exceptional value in maintaining
this expansion, we think it's incumbent upon us, as we have discussed over the years, and as I discuss at length in these prepared
remarks, to remember that the policy of the central bank doesn't
impact the economy and prices until a year or so after we implement it. So, we are continuously focusing on the longer term, not
as long a term as I was mentioning to Senator Hagel with respect
to fiscal policy, but we too have this long-term focus. Because if we
are going to maintain the stable platform which keeps this expansion going as long as it can physically continue, we have to have
long-term planning ourselves.
Indeed, the reason why we moved in March was to tighten up
the system ever so slightly because we believed that the risks in
the longer term were increasing. Unless policy, both in the fiscal
and the monetary areas, recognizes that the timeframe in which we
are enacting policy is lengthy, we will find ourselves running out
of seed grain, as you put it, at some point because we had failed
to look forward into the future.
I would suggest that the major thrust of Congressional action, as
it responds to the economy, in my judgment, really gets to two
areas: one, the fiscal policy area, which is explained, I hope, in
some detail in the question that Senator Hagel raised; and two, we
ought to recognize the extraordinary benefits that are coming out
of the deregulatory policies that the Congress and the regulatory
agencies have embarked upon.
19
We are seeing already significant values in deregulating a number of controls in the agricultural area. We are beginning to see the
ability of farmers to plant fence-to-fence without acreage controls
which are an anachronism from a period gone in our history with
very dubious potential advantages. And when one talks about economic growth, let's remember that the gross farm product is part
of the gross domestic product.
The more we can produce in all of the areas of the economy, the
greater off our society will be, the greater our ability to address the
problems of an increasing, up until recent years, unequal income
distribution, questions of welfare, which I think Congress has very
courageously addressed very recently and other issues.
I think we are focusing on the right things. The question is do
we have the political will to do what is required. Stage one is focus,
stage two is understanding, and hopefully, stage three is action.
Senator GRAMS. As we look ahead, it looks like with the increasing revenues that we could balance the budget earlier than we even
expect. When we reach that point the question is, is it smart to
carry the debt that we have and the interest payments that go
along with it once the budget is balanced, and then spend all future increases in revenue? Or would it be better to begin paying
down the debt to have a structure in there that says you have to
keep spending at a limit but take care of the debt we have as well?
Chairman GREENSPAN. Let me just say that one of the immediate
aspects of a surplus, if it looks as though it's a structural surplus,
which would be very difficult to do beyond the year 2008 or 2009,
but even for the intermediate period, it would do two things.
First, it would indicate that Congress is moving in a direction in
which the big bulge in potential deficits for the second decade of
the next century and beyond are not likely to occur because you are
addressing it in advance.
Second, nominal long-term interest rates have come down considerably from their peaks in the early 1980's but we are still above
where we were in the 1950's and the 1960's because there's still a
significant inflation premium built into long-term interest rates.
That's because there is still a belief that the American Government
is not going to be able to handle inflation in a manner which one
can presume a noninflationary environment is here to stay.
Back in the early 1950's and early 1960's, there was a general
view in this country that inflation was not something indigenous
to the United States except during times of war. The great shock
of the 1970's and the stagflation and the big surge of inflation has
left a residue of inflation expectations embodied in long-term interest rates. While significantly less than it was say 15 years ago, it
is nonetheless still appreciably above where it had been in the
early post-World War II period. That means that there is a capability of getting lower rates and if we do, it means much greater capital investment, much more intensive use of our resources, and
much lower mortgage interest rates for homeownership.
There are an awful lot of positives which spill out that gives you
a sense of a virtuous economic cycle where you get lower long-term
interest rates, you get increased capital investment, increased productivity, increased growth, and lower inflation. It is a process
which we should endeavor to foster. And the major way of doing
20
it is to recognize that passing the zero budget deficit line doesn't
mean you should stop there. There's nothing that says that.
On the contrary, the benefits that are achieved from going from
high-budget deficits to low-budget deficits to balance continue as
you move over that line into surpluses. I would think that understanding that process and fostering that process would be something of considerable value to the future of the country.
Senator GRAMS. Thank you very much, Mr. Chairman.
The CHAIRMAN. Senator Sarbanes.
Senator SARBANES. Thank you, Mr. Chairman.
Of course, that is assuming that the economy is continuing to
function at or near full employment.
Chairman GREENSPAN. That is correct.
Senator SARBANES. Otherwise you run the risk of moving the
economy downward. Then actually not only would you not run surpluses, you would start running deficits again.
Chairman GREENSPAN. True. But what I'm saying is that our old
notions of fiscal drag are not applicable to this situation because
we still have a substantial element of inflation expectations embodied in long-term rates.
It's only when you get down to very low rates, which existed back
in the 1960's, that a notion of fiscal drag as being something which
could slow the rate of the economy will function. In today's environment, that's not the model that's working.
Senator SARBANES. Mr. Chairman, I have four subjects I want to
cover very quickly as time runs.
First of all, you have repeatedly come before us and said we have
to get the deficit down, that's very important to the workings of the
economy. That it is easier to have sort of a responsive monetary
policy if fiscal policy is on the right course.
I wonder if you would redistribute some of this praise which has
come to you this morning, which I don't really quarrel with, but
recognizing that we brought the deficit down from $290 billion to
I think this year less than $50 billion, it is also an important contributor to the state of the economy.
Chairman GREENSPAN. In my written comments, I state exactly
that, and there's no question in my mind, as I have said over the
years, that the decline in the deficit, which is the result of both the
Administration's and Congress' actions, has been very helpful to
this country.
Senator SARBANES. I just want to underscore the perception that
I think is in your statement on the first page where you note that
"The expansion has enabled many in the working-age population,
a large number of whom would have otherwise remained out of the
labor force or among the longer-term unemployed, to acquire work
experience and improved skills."
I think this is a very important point. We need this good sustained period of growth and this low unemployment to sort of reach
that population. Also to reach into the inner cities.
We are getting anecdotal evidence at least now that the economy
is picking up in the inner cities and I think it is a very important
dimension of having the kind of economy that we are dealing with
right now.
21
That is just a comment but I appreciate the sensitivity that is
reflected here in the statement.
Now let me turn to this real interest rate question.
Fm struck by all these articles that are being written about you,
one way or another, and they all seem to take the view that unless
you raise interest rates, the open market community is somehow
falling down on the job.
I take that back, not all, a lot accept where we are and think it's
working pretty well and want to stay the course. But some Cassandras keep crying the fact of the matter is, with inflation dropping,
just by keeping the Fed fund right where it is, nominally you in
effect are raising the real Federal funds rate. Is that not the case?
Chairman GREENSPAN. That is correct, Senator.
Senator SARBANES. So, I think those who are sort of trying to undercut you on this inflation question need to take a look at what's
happening to this Federal funds rate which is now the highest it
has been, well, that's 1994.
Actually, I understand that we have to go back to 1989, 1990, to
find a time when the Fed funds rate, the real Fed funds rate was
up at this level. That is what I regard as a constraining action on
the economy having some impact. I understand that leading economic sectors like autos and housing are down for the first 6
months of this year. Durable goods manufacturing are flat, as I understand it.
So, I think it is very important that there be an understanding
that with inflation dropping, even keeping the Fed funds rate right
where it is raises the real Fed funds rate, and therefore is a constraining action with respect to the economy.
Chairman GREENSPAN. Senator, if I could just interject in there.
Senator SARBANES. Just so I get to my fourth point, yes, sure.
Chairman GREENSPAN. That's the reason why I mentioned in my
prepared remarks that movements in the nominal Federal funds
rates are routine aspects of monetary policy. We are, in effect, making monetary policy every day by what we do and what we do not
do, and we are aware of the process by which the elements of various structures of rates are affected by what we do or what we do
not do.
Obviously, our awareness of the Federal funds rate in real terms
rising is something which is part of our general policy understanding, so, the notion that the only time that monetary policy changes
is when we change the Federal funds rate or the discount rate is
not correct.
There's a continuous process. And one of the reasons why it is
important to recognize that what we do is routine in a sense is that
we are doing it all the time, and that's why it's the fundamental
outcome of the policy that matters, not every particular move of the
real rate or the nominal rate that we think is important.
Senator SARBANES. I think this is an important point because
some writers are writing this as though just holding a position does
not reflect a policy when circumstances are changing. For instance,
the one I'm addressing, when inflation goes down.
Mr. Chairman, can I just put one final question?
The CHAIRMAN. Yes.
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Senator SARBANES. Chairman Greenspan, I would like to draw
you out a bit. I mean, this is off of this subject but just to get some
of your thinking on what you expect the impact on the international monetary system to be of the European Monetary Union,
assuming the EU is able to move toward a common currency.
I guess that really should be the subject of its own hearing but
how significant is that and its potential impact on the entire international monetary scene?
Chairman GREENSPAN. It is fairly obvious that a single currency
in the European Community will enhance their ability to function
in the same manner that the single currency within the 50 States
of the United States enables us to function.
It is going to create differences, obviously, in the elements of the
adjustment process within Europe, and all I can say to you is that
to the extent that it enhances Europe's ability to become an effective world competitor, it's going to help us, not hinder us, because
what all the post-World War II evidence, not to mention the earlier
pre-war evidence, clearly suggests is the greater the real growth in
trade, the greater the ability of globalization and integration of the
various major elements within the international financial system,
the better it is for everybody.
So, we hope that the struggles that they are making, which are
obviously considerable, bring fruition and success because it will be
to everybody's advantage if that happens.
The CHAIRMAN. Senator Faircloth.
OPENING COMMENTS OF SENATOR LAUCH FAIRCLOTH
Senator FAIRCLOTH. Thank you, Mr. Chairman.
Thank you, Chairman Greenspan, for being here and I thank you
for the service you've rendered to the country.
I think your policies have absolutely proven to have been correct,
although there has been criticism of them. Certainly there always
will be, but I think you have done an excellent job of staying the
course with the economy. We are proud of what you have done.
I am concerned that there might be more leverage in the market
than we might be led to believe. I would like your opinion. I understand that home equity loans, some of those have risen pretty rapidly with the possible effect that the proceeds of the loans were
going into fueling the market.
The next thing I wonder, I heard that the State of New Jersey
had issued bonds and they were to be invested in the stock market.
Is that right? And what is your opinion of the concerns I have?
Chairman GREENSPAN. I discussed the issue of home equity loans
just before you came in.
Senator FAIRCLOTH. I'm sorry I was late.
Chairman GREENSPAN. It's an important question. It's the one interesting area where, as you point out, the loans are all of a sudden
expanding rapidly and some of them are changing in nature from
standard, old-fashioned home equity loans where you just dip a little bit into your equity, to now where there are a lot of loans which
are becoming huge parts of equity value and, in certain instances,
more than the total equity value.
There's some problems that are starting to emerge in there. It's
still a very small part of the consumer markets and not something
23
that we are, at this particular stage, particularly concerned about,
but you are raising an issue which we have to keep an eye on, and
we are looking at that.
Fm not familiar with these Jersey issues.
Senator FAIRCLOTH. I might not be correct.
Chairman GREENSPAN. Now, I see what it is. It is a taxable bond
issue to fund a pension plan. Borrowing to fund pension plans is
an interesting issue in public pension finance and private pension
finance. I don't know enough about it to make any particular comment on it.
Senator FAIRCLOTH. Do you have any concern that there is more
leverage in the market than you might feel comfortable with?
Chairman GREENSPAN. You mean overall?
Senator FAIRCLOTH. In the stock market, yes.
Chairman GREENSPAN. Oh, the stock market. It is very difficult
to know what the degree of financing is. If you are referring to the
issue of stock market credit, so-called margin credit, there is no
question that in the last couple of months margin credit has risen
very substantially. It is well over $100 billion now. But when you
take it as a percent of the market value of the stocks to which they
apply, the ratio is still below where it was, for example, in early
1995. So as a ratio to the value of stocks, to be sure it has increased recently but it is still low relative to the overall values, just
a little over 1 percent actually of $10 trillion.
Senator FAIRCLOTH. But it has increased in the last month or
two?
Chairman GREENSPAN. Yes, that's correct. The absolute amount
of the margin did increase substantially in May and June.
Senator FAIRCLOTH. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you.
Senator Kerry.
Senator KERRY. Mr. Chairman, thank you.
Chairman Greenspan, in your answer to Senator Hagel, you commented on the need for Congress to pass remedies that would be
taking effect in 2007, 2008, 2012 in order to deal with this problem
of the arithmetic, the fact that the arithmetic just doesn't add up.
And we agree it doesn't add up.
But aren't those the very years in which the current Republican
tax cut plan explodes in terms of cost? If the arithmetic doesn't add
up today, and Congress puts plans in place to deal with that, isn't
there a contradiction in what Congress is about to do with respect
to the back-end of those taxes beyond the year 2002?
Chairman GREENSPAN. Senator, I haven't looked at the data in
sufficient detail to make a judgment on that, but as I understand
it, there is a dispute as to exactly how those numbers will unfold,
and I have not had a chance to look to make a judgment.
Senator KERRY. I assume you would agree that if, in fact, the
numbers were scored in a way that show that they do enlarge at
the back end?
Chairman GREENSPAN. The question of how the scoring is done
is a real crucial question and I haven't looked at the specific procedures in a manner which would give me any confidence to give a
judgment.
24
Senator SARBANES. If the Senator would yield. It has always
been my understanding that you have always put deficit reduction
ahead of tax cuts?
Chairman GREENSPAN. That is correct, Senator.
Senator KERRY. But you did say that the deficit will increase as
of 2002, the deficit itself goes up.
Chairman GREENSPAN. It will surely increase in a current services context so to speak, as we move into the latter part of the first
decade of the next century and into the second decade.
Senator KERRY. So there would be an inherent contradiction if
the deficit goes up in a plan that, in fact, increases the capacity of
the deficit to go up?
Chairman GREENSPAN. The only thing that could be a factor
here, which we are not terribly sure of, is the question of the longterm growth rate of the economy.
In my prepared remarks, I raised the question of whether there's
a change in the process and I conclude that we don't know yet.
That's an issue which I would suspect will be relevant to this discussion but for fiscal policy purposes, I think it's far more prudent
to assume that it will not happen in a material way that will affect
the overall projection of the current services deficit.
Senator KERRY. I was also struck by your prepared testimony
where you say that, 'There would seem to be emerging constraints
on potential labor input. Even before we reach the ultimate limit
of sustainable labor supply growth, the economy's ability to expand
employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree of slack in physical facilities at the time."
Then you say, "Simply adding new facilities will not increase production unless output per worker improves. Such improvements
are possible if worker's skills increase, but such gains come slowly
through improved education and on the job training."
I take it from your testimony, which I read, that we are fast
reaching this point where the gains that we get appropriately come
through that advance in technology that you talk about. I would assume that again you would also place a significant premium on our
ability to provide that education, our ability to provide the on-thejob education and our investments in technology. In education we
are increasing some aspects of availability, but on-the-job training
and the technology investments we are reducing on the fiscal side.
Do you have any comment about that, and sort of when we have
reached that point and how critical this is to the continued growth?
Chairman GREENSPAN. The experience that analysts have had
with respect to looking at various different types of training programs more often than not shows that on-the-job training or closely
related job training is far more effective than any other type of
training that one can get.
The advantage of this particular expansion, by effectively absorbing inexperienced people into the job market, people in fact who
have no experience, has given them the best type of training you
can get, which is on-the-job training, because it does two things.
It gives you the skills, and it also gives you the self-esteem that
you need to recognize that you can go further. Unless we recognize
that process, especially with our educational system generally, then
25
we are going to find that as we move into the 21st century, where
technology becomes an increasingly important aspect of value creation, we are going to leave a significant part of our population behind. That would be a great tragedy which we can avoid with forward planning and an understanding of how to get people to obtain
the skills that are going to be necessary for the workforce of the
21st century.
Senator KERRY. Just a final question, if I may, Mr. Chairman.
You also talk about the obvious relationship of immigration to
the economy. Are we reaching the point where immigration may be
more important to the capacity to sustain growth than it has been
because of this apex of technology and its relationship to the labor
market?
Chairman GREENSPAN. As I conclude in my prepared remarks, as
you get into the 21st century, the ability to put up facilities is increasingly going to create far less problems of restraint from the
physical parts of the system.
But we have a working-age population, 16 to 64, which is demographically determined at a much earlier stage and is not subject
to significant alteration with the exception of immigration.
And as I point out in the prepared remarks, in the period from
early 1994 to the current period, a little more than a third of the
growth in the working-age population is the result of net immigration, both legal and illegal.
Senator KERRY. Thank you very much.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Grams.
Senator GRAMS. Thank you, Mr. Chairman. I have just a couple
of quick questions.
Mr. Greenspan, talking about the budget, and I know your job
is to make decisions on economic policy for the country, but in making those decisions you have to look to Capitol Hill to see what the
budgets are doing. Looking at this current budget deal, which does
have ramifications for 5 years, and in some implications, up to 10
years, would you look at the spending levels and say they were acceptable? They're too high or too low? Would you look at the tax
cuts? Are the tax cuts too high, too low, or sufficient, especially in
the area for consumers for one thing to spur economic growth, but
also for investment of capital, either reinvestment or new investment? How would you size up this budget looking at the decisions
you have to make on economic policy?
Chairman GREENSPAN. As I've indicated to this Committee many
times in the past, as a technical matter, you cannot balance budgets over the long run by raising taxes because the very process itself will inhibit income growth, reduce revenues, and, indeed, end
up being counterproductive.
The only way to address a long-term structural budget deficit
problem is through the expenditure side. It's the only way that you
will succeed or can succeed in a permanent manner.
I don't want to get involved with the specific elements that are
currently involved, but merely indicate to you that you can't avoid
coming to grips with the expenditure side because of the entitlement structure as now stated in law. It strikes me that short of a
surprising increase in the underlying tax base, spending is running
26
faster than the revenues that will come out of a growing tax base
with the projected demographics that we're currently looking at.
Senator GRAMS. One final question. You mentioned earlier about
deregulation, how it's helped to improve the economy in many
ways. One thing this Committee will be dealing with is, of course,
the benefits of financial modernization. How do you view that as
being an important step in adding to future economic growth?
Chairman GREENSPAN. There is no question that we have anachronistic legislation enacted in the thirties which still significantly
affects our regulatory structures and the financial system. I have
testified many times that the Glass-Steagall Act is one of those
anachronisms and the sooner it is repealed, the better.
There is, as you know, considerable discussion going on in the
House of Representatives on potential new regulation in this area
and I have testified at length on this, and I would like to send you
a copy of my testimony if you wouldn't mind, so you could get a
broader notion of what we're responding.
Senator GRAMS. I'd appreciate that. Thank you very much.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Faircloth, do you have any further questions?
Senator FAIRCLOTH. No, I do not.
The CHAIRMAN. Senator Sarbanes.
[No response.]
Mr. Chairman, I want to thank you for your graciousness for
being here again with us today. I look forward to working with you.
You know that the Senate has heretofore passed Glass-Steagall
reform so it will be interesting if the House can pass a bill. Then
it would be my intent to take that up, but I'm not going to take
it up unless or until we see that they really can give us a product
and get it over here. Then we can work out whatever the differences are. But I think it's long overdue. We passed it heretofore,
and I think your words today are very, very encouraging.
Thank you for coming today. We look forward to working with
you in the future on a number of the projects that we've discussed,
and I want you to have a good summer.
Chairman GREENSPAN. Thank you very much, Senator.
The CHAIRMAN. We stand in recess.
[Whereupon, at 11:45 a.m., the Committee was recessed.]
[Prepared statements, response to written questions, and additional material supplied for the record follow:]
27
PREPARED STATEMENT OF SENATOR ALFONSE M. D'AMATO
The Committee is pleased to welcome Chairman Greenspan this morning to hear
the Federal Reserve's semiannual report to the Congress on our Nation's economy.
Chairman Greenspan, Money magazine reports that there is a joke circulating on
Wall Street that I think well illustrates your gift for obfuscation. Apparently, the
report goes that you actually proposed marriage to your wife, Andrea Mitchell, when
you first started dating—which I will remind everyone was many years ago. The actual marriage did not occur until a few months ago. Apparently, it took Andrea all
those years to decipher that you had, in fact, made a marriage proposal. Andrea is
not alone. It takes awhile for many of us to analyze and understand your remarks.
Chairman Greenspan, clearly the financial markets understood the message you
delivered to the Congress yesterday and look forward to your elaborating on your
comments today. Yesterday, the Dow Jones Industrial Average closed up 155 points
—above 8,000 points for the second time this year and a new record high (8,062),
following your testimony. This Committee awaits an encore performance today although we would also appreciate your insights as to whether yesterday's reaction
was what you anticipated.
Chairman Greenspan, as many have noted on countless occasions, the Fed has
done a remarkable job under your tenure. Our economic expansion is in its 7th year,
making it the third longest in the post-World War II period. Thirteen million new
jobs have been created. Continued low-interest rates have allowed thousands of
businesses to expand and millions of families to buy homes. This is good news for
the American worker, whose wages haven't been eaten away by high inflation. It
is good news for American business which relies on stable growth for marketplace
success. It is also good news for the American people who continue to enjoy one of
the highest standards of living in the world.
With the economic boom continuing, I believe now is a good time for us to look
more carefully at those areas and those people who may have been left behind. I
am increasingly concerned about local communities who face economic disruptions
because of businesses or Government facilities closing shop. Also, as you will note
in your remarks, workers continue to worry about their job security despite one of
the lowest unemployment rates since the 1970's. I would appreciate your insights
as to whether this means enough is being done to educate our workers to use new
technologies. Finally, I am also concerned about whether some consumers may have
too easy access to credit and are being taken advantage of by financial institutions.
I know that you will touch on these concerns in your remarks and we can have
a fuller discussion. We look forward to hearing your comments this morning about
the state of our economy and our markets.
PREPARED STATEMENT OF SENATOR CHUCK HAGEL
Good morning and welcome to you, Chairman Greenspan. Today our economy is
in good condition and that is, in part, due to your deft handling of monetary policy.
We are enjoying a combination of economic factors that many think are incompatible-—low inflation and low unemployment. I will be interested to hear from the
Chairman as to what conditions have made this possible and what we, as legislators, can do to help extend the length of the expansion.
Congress is currently engaged in a debate on tax and spending reconciliation bills.
While no one is going to be completely satisfied with the end product, I believe we
are moving in the right direction—less taxes and less spending. Just as the markets
will micro-analyze every word the Chairman utters today, the markets will also
react to our commitment to balancing the budget. This is a goal I hope we are all
committed to.
I look forward to hearing Chairman Greenspan's testimony.
PREPARED STATEMENT OF SENATOR LAUCH FA1RCLOTH
Mr. Chairman, I want to thank Mr. Greenspan for being here.
I have said this before, I think the robust economy we have is due to his steady
hand at the Federal Reserve Board.
Some Members of Congress have not always been happy with his interest rate
policies, but I think his policies have proven to be the reasonable course of action.
Further, I don't think it should be overlooked that for the last 3 years this Congress has tried to cut spending and reduce regulatory interference in the private
28
sector. I think these two factors are fueling a lot of this growth, particularly in the
high-tech sector of the economy. We need to keep these policies in place—and I
think we will keep the economy growing.
Thank you, Mr. Chairman.
PREPARED STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
JULY 23, 1997
I am pleased to appear before this Committee to present the Federal Reserve's
report on the economic situation and monetary policy.
The recent performance of the economy, characterized by strong growth and low
inflation, has been exceptional—and better than most anticipated. During the first
quarter of 1997, real gross domestic product expanded at nearly a 6 percent annual
rate, after posting a 3 percent increase over 1996. Activity apparently continued to
expand in the second quarter, albeit at a more moderate pace. The economy is now
in the seventh consecutive year of expansion, making it the third longest post-World
War II cyclical upswing to date.
Moreover, our Federal Reserve Banks indicate that economic activity is on the
rise, and at a relatively high level, in virtually every geographic region and community of the Nation. The expansion has been balanced, in that inventories, as well
as stocks of business capital and other durable assets, have been kept closely in line
with spending, so overhangs have been small and readily corrected.
This strong expansion has produced a remarkable increase in work opportunities
for Americans. A net of more than 13 million jobs has been created since the current
period of growth began in the spring of 1991. As a consequence, the unemployment
rate has fallen to 5 percent—its lowest level in almost a quarter century. The expansion has enabled many in the working-age population, a large number of whom
would have otherwise remained out of the labor force or among the longer-term unemployed, to acquire work experience and improved skills. Our whole economy will
benefit from their greater productivity. To be sure, not all segments of our population are fully sharing in the economic improvement. Some Americans still have
trouble finding jobs, and for part of our workforce real wage stagnation persists.
In contrast to the typical post-war business cycle, measured price inflation is
lower now than when the expansion began and has shown little tendency to rebound
of late, despite high rates of resource utilization. In the business sector, producer
prices have fallen in each of the past 6 months. Consumers also are enjoying low
inflation. The Consumer Price Index rose at less than a 2 percent annual rate over
the first half of the year, down from a little over 3 percent in 1996.
With the economy performing so well for so long, financial markets have been
buoyant, as memories of past business and financial cycles fade with time. Soaring
prices in the stock market have been fueled by moderate long-term interest rates
and expectations of investors that profit margins and earnings growth will hold
steady, or even increase further, in a relatively stable, low-inflation environment.
Credit spreads at depository institutions and in the open market have remained
extremely narrow by historical standards, suggesting a high degree of confidence
among lenders regarding the prospects for credit repayment.
The key questions facing financial markets and policymakers are what is behind
the good performance of the economy, and will it persist. Without question, the
exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information,
while just suggestive at this point, could be read as indicating basic improvements
in the longer-term efficiency of our economy. The Federal Reserve has been aware
of this possibility in our monetary policy deliberations and, as always, has operated
with a view to supplying adequate liquidity to allow the economy to reach its highest potential on a sustainable basis.
Nonetheless, we also recognize that the capacity of our economy to produce goods
and services is not without limit. If demand were to outrun supply, inflationary imbalances would eventually develop that would tend to undermine the current expansion and inhibit the long-run growth potential of the economy. Because monetary
policy works with a significant lag, policy actions are directed at a future that may
not be clearly evident in current experience. This leads to policy judgments that are
by their nature calibrated to the relative probabilities of differing outcomes. We
moved the Federal funds rate higher in March because we perceived the probability
of demand outstripping supply to have increased to a point where inaction would
29
have put at risk the solid elements of support that have sustained this expansion
and made it so beneficial.
In making such judgments in March and in the future, we need to analyze carefully the various forces that may be affecting the balance of supply and demand in
the economy, including those that may be responsible for its exceptional recent behavior. The remainder of my testimony will address the various possibilities.
Inflation, Output, and Technological Change in the 1990's
Many observers, including us, have been puzzled about how an economy, operating at nigh levels and drawing into employment increasingly less experienced workers, can still produce subduea and, by some measures even falling, inflation rates.
It will, doubtless, be several years before we know with any conviction the full story
of the surprisingly benign combination of output and prices that has marked the
business expansion of the last 6 years.
Certainly, public policy has played an important role. Administration and Congressional actions to curtail budget deficits have enabled long-term interest rates to
move lower, encouraging private efficiency-enhancing capital investment. Deregulation in a number of industries has fostered competition and held down prices. Finally, the preemptive actions of the Federal Reserve in 1994 contained a potentially
destabilizing surge in demand, short-circuiting a boom-bust business cycle in the
making and keeping inflation low to encourage business innovation. But the fuller
explanation of the recent extraordinary performance may well lie deeper.
In February 1996, I raised before this Committee a hypothesis tying together
technological change and cost pressures that could explain what was even then a
puzzling quiescence of inflation. The new information received in the last 18 months
remains consistent with those earlier notions; indeed, some additional pieces of the
puzzle appear to be falling into place.
A surge in capital investment in high-tech equipment that began in early 1993
has since strengthened. Purchases of computer and telecommunications equipment
have risen at a more than 14 percent annual rate since early 1993 in nominal
terms, and at an astonishing rate of nearly 25 percent in real terms, reflecting the
fall in the prices of this equipment. Presumably companies have come to perceive
a significant increase in profit opportunities from exploiting the improved productivity of these new technologies.
It is premature to judge definitively whether these business perceptions are the
harbinger of a more general and persistent improvement in productivity. Supporting
this possibility, productivity growth, which often suffers as business expansions mature, has not followed that pattern. In addition, profit margins remain high in the
face of pickups in compensation growth, suggesting that businesses continue to find
new ways to enhance their efficiency. Nonetheless, although the anecdotal evidence
is ample and manufacturing productivity has picked up, a change in the underlying
trend is not yet reflected in our conventional data for the whole economy.
But even if the perceived quicker pace of application of our newer technologies
turns out to be mere wheel-spinning rather than true productivity advance, it has
brought with it a heightened sense of job insecurity and, as a consequence, subdued
wage gains. As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996.
It should not have been surprising then that strike activity in the 1990's has been
lower than it has been in decades and that new labor union contracts have been
longer and have given greater emphasis to job security. Nor should it have been
unexpected that the number of workers voluntarily leaving their jobs to seek other
employment has not risen in this period of tight labor markets.
To be sure, since last year, surveys have indicated that the proportion of workers
fearful of layoff has stabilized and the number of voluntary job leavers has edged
up. And perhaps as a consequence, wage gains have accelerated some. But increases
in the Employment Cost Index still trail behind what previous relationships to tight
labor markets would have suggested, and a lingering sense of fear or uncertainty
seems still to pervade the job market, though to a somewhat lesser extent.
Consumer surveys do indicate greater optimism about the economy. However, it
is one thing to believe that the economy, indeed, the job market, will do well overall,
but quite another to feel secure about one's individual situation, given the accelerated pace of corporate restructuring and the heightened fear of skill obsolescence
that has apparently characterized this expansion. Persisting insecurity would help
explain why measured personal saving rates have not declined as would have been
expected from the huge increase in stock market wealth. We will, however, have a
better fix on savings rates after the coming benchmark revisions to the national
income and product accounts.
30
The combination in recent years of subdued compensation per hour and solid productivity advances has meant that unit labor costs of nonfinancial corporations have
barely moved. Moreover, when you combine unit labor costs with nonlabor costs—
which account for one-quarter of the total costs on a consolidated basis—total unit
costs for the year ended in the first quarter of 1997 rose only about half a percent.
Hence, a significant part of the measured price increase over that period was attributable to a rise in profit margins, unusual well into a business expansion. Rising
margins are further evidence suggesting that productivity gains have been unexpectedly strong; in these situations, real labor compensation usually catches up only
with a lag.
While accelerated technological change may well be an important element in unraveling the current economic puzzle, there have been other influences at play as
well in restraining price increases at high levels of resource utilization. The strong
dollar of the last 2 years has pared import prices and constrained the pricing behavior of domestic firms facing import competition. Increasing globalization has enabled
greater specialization over a wider array of goods and services, in effect allowing
comparative advantage to hold down costs and enhance efficiencies. Increased deregulation of telecommunications, motor and rail transport, utilities, and finance
doubtless has been a factor restraining prices, as perhaps has the reduced market
power of labor unions. Certainly, changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost
of benefits, and hence overall labor compensation.
Many of these forces are limited or temporary, and their effects can be expected
to diminish, at which time cost and price pressures would tend to reemerge. The
effects of an increased rate of technological change might be more persistent, but
they too could not permanently hold down inflation if the Federal Reserve allows
excess liquidity to flood financial markets. I have noted to you before the likelihood
that at some point workers might no longer be willing to restrain wage gains for
added security, at which time accelerating unit labor costs could begin to press on
profit margins and prices, should monetary policy be too accommodative.
When I discuss greater technological change, I am not referring primarily to a
particular new invention. Instead, I have in mind the increasingly successful and
pervasive application of recent technological advances, especially in telecommunications and computers, to enhance efficiencies in production processes throughout the
economy. Many of these technologies have been around for some time. Why might
they be having a more pronounced effect now?
In an intriguing paper prepared for a conference last year sponsored by the Federal Reserve Bank of Boston, Professor Nathan Rosenberg of Stanford documented
how, in the past, it often took a considerable period of time for the necessary
synergies to develop between different forms of capital and technologies. One example is the invention of the dynamo in the mid-1800's. Rosenberg's colleague Professor Paul David had noted a number of years ago that it wasn't until the 1920's that
critical complementary technologies of the dynamo—for example, the electric motor
as the primary source of mechanical drive in factories and central generating stations—were developed and in place and that production processes had fully adapted
to these inventions.
What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to create significant new opportunities Tor value creation. For example, the applications for the laser were modest until
the later development of fiber optics engendered a revolution in telecommunications.
Broad advances in software have enabled us to capitalize on the prodigious gains
in hardware capacity. The interaction of both of these has created the Internet.
The accelerated synergies of the various technologies may be what have been
creating the apparent significant new profit opportunities that presumably lie at the
root of the recent boom in high-tech investment. An expected result of the widespread and effective application of information and other technologies would be a
significant increase in productivity and reduction in business costs.
We do not now know, nor do I suspect can anyone know, whether the current
developments are part of a once or twice in a century phenomenon that will carry
productivity trends nationally and globally to a new higher track, or whether we are
merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion. The recent improvement in productivity could be just transitory, an artifact of a temporary surge in demand and output
growth. In view of the slowing in growth in the second quarter and the more moderate expansion widely expected going forward, data for profit margins on domestic
operations and productivity from the second quarter on will be especially relevant
in assessing whether recent improvements are structural or cyclical.
31
Whatever the trend in productivity and, by extension, overall sustainable economic growth, from the Federal Reserve's point of view, the faster the better. We
see our job as fostering the degree of liquidity that will best support the most effective platform for growth to flourish. We beh'eve a noninflationary environment is
such a platform because it promotes long-term planning and capital investment and
keeps the pressure on businesses to contain costs and enhance efficiency.
The Federal Reserve's policy problem is not with growth, but with maintaining
an effective platform. To do so, we endeavor to prevent strains from developing in
our economic system, which long experience tells us produce bottlenecks, shortages,
and inefficiencies. These eventually create more inflation, which undermines economic expansion and limits the longer-term potential of the economy.
In gauging the potential for oncoming strains, it is the effective capacity of the
economy to produce that is important to us. An economy operating at a high level
of utilization and growing 5 percent a year is in little difficulty if capacity is growing
at least that fast. But a fully utilized economy growing at 1 percent will eventually
get into trouble if capacity is growing less than mat.
Capacity itself, however, is a complex concept, which requires a separate evaluation of its two components, capital and labor. It appears that capital, that is, plant
and equipment, can adapt and expand more expeoitiously than in the past to meet
demands. Hence, capital capacity is now a considerably less rigid constraint than
it once was. In recent years, technology has engendered a significant compression
of lead times between order and delivery for production facilities. This has enabled
output to respond increasingly faster to an upsurge in demand, thereby decreasing
the incidence of strains on capital capacity and shortages so evident in earlier business expansions.
Reflecting progressively shorter lead times for capital equipment, unfilled orders
to shipment ratios for nondefense capital goods have declined by 30 percent in the
last 6 years. Not only do producers have quicker access to equipment that embodies
the most recent advances, but they have been able to adjust their overall capital
stock more rapidly to increases in demand.
The current lack of material shortages and bottlenecks, despite the high level and
recent robust expansion of demand, is striking. The effective capacity of production
facilities has increased substantially in recent years in response to strong final demands and the influence of cost reductions possible with the newer technologies. Increased flexibility is particularly evident in the computer, telecommunications, and
related industries, a segment of our economy that seems far less subject to physical
capacity constraints than many older-line establishments, and one that is assuming
greater importance in our overall output. But the shortening of lags has been pervasive even in more mature industries, owing in part to the application of advanced
technologies to production methods.
At the extreme, if all capital goods could be produced at constant cost and on demand, the size of our Nation's capital stock would never pose a restraint on production. We are obviously very far from that nirvana, but it is important to note that
we are also far from the situation a half-century ago when our production processes
were dominated by equipment such as open hearth steel furnaces, which had very
exacting limits on how much they could produce in a fixed timeframe and which required huge lead times to expand their capacity.
Even so, today's economy as a whole still can face capacity constraints from its
facilities. Indeed, just 3 years ago, bottlenecks in industrial production—though less
extensive than in years past at high levels of measured capacity utilization—were
nonetheless putting significant upward pressures on prices at earlier stages of production. More recently vendor performance has deteriorated somewhat, indicating
that flexibility to meet demands still has limits. Although further strides toward
greater facilities flexibility have occurred since 1994, this is clearly an evolutionary,
not a revolutionary, process.
Labor Markets
Moreover, technology and management changes have had only a limited effect on
the ability of labor supply to respond to changes in demand. To be sure, individual
firms have acquired additional flexibility by increased use of outsourcing and temporary workers. In addition, smaller work teams can adapt more readily to variations in order flows. While these techniques put the right workers at the right
spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That
supply is sensitive to changes in demand, but to a far more limited extent than for
facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except
for immigration, is basically determined several decades in the past.
32
Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes, and slack in one market can offset tightness
in another. For example, additional work shifts can expand output without significant addition to facilities, and similarly more labor-displacing equipment can permit
production to be increased with the same level of employment.
Yet despite significant increases in capital equipment in recent years, new additions to labor supply have been inadequate to meet the demand for labor. And as
a consequence, the recent period has been one of significant reduction in labor marOf the more than 2 million net new hires at an annual rate since early 1994, only
about half have come from an expansion in the population aged 16-64 who wanted
a job, and more than a third of those were net new immigrants. The remaining 1
million plus per year increase in employment has been pulled from those who had
been reported as unemployed (600 thousand annually) and those who wanted, but
had not actively sought, a iob (more than 400 thousand annually). The latter, of
course, are not in the official unemployment count.
Hie key point is that continuously digging ever deeper into the available workage population is not a sustainable trajectory for job creation. The unemployment
rate has a downside limit if for no other reason than unemployment, in part, reflects
voluntary periods of job search and other frictional unemployment. There is also a
limit on how many of the additional 5 million who wanted a job last quarter but
were not actively seeking one could be readily absorbed into jobs—in particular, the
large number enrolled in school, and those who may lack the necessary skills or face
other barriers to taking jobs. The rise in the average work week since early 1996
suggests employers are having increasingly greater difficulty fitting the millions
who want a job into available job slots. If the pace of job creation continues, the
pressures on wages and other costs of hiring increasing numbers of such individuals
could escalate more rapidly.
To be sure, there remain an additional 34 million in the working-age population
(age 16-64) who say they do not want a job. Presumably, some of these early retirees, students, or homemakers might be attracted to the job market if it became sufficiently rewarding. However, making it attractive enough could also involve upward
pressures in real wages that would trigger renewed price pressures, undermining
the expansion.
Thus, there would seem to be emerging constraints on potential labor input. Even
before we reach the ultimate limit of sustainable labor supply growth, the economy's
ability to expand employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree
of slack in physical facilities at that time. Simply adding new facilities will not
increase production unless output per worker improves. Such improvements are possible if worker's skills increase, but such gains come slowly through improved education and on-the-job training. They are also possible as capital substitutes for
labor, but are limited by the state of technology. More significant advances require
technological breakthroughs. At the cutting edge of technology, where America finds
itself, major improvements cannot be produced on demand. New ideas that matter
are hard won.
The Economic Outlook
As I previously noted, the recent performance of the labor markets suggests that
the economy was on an unsustainable track. Unless aggregate demand increases
more slowly than it has in recent years—more in line with trends in the supply of
labor and productivity—imbalances will emerge. We do not know, however, at what
point pressures would develop—or, indeed, whether the economy is already close to
Fortunately, the very rapid growth of demand over the winter has eased recently.
To an extent this easing seems to reflect some falloff in growth of demand for
consumer durables and for inventories to a pace more in line with moderate expansion in income. But some of the recent slower growth could simply be a product of
abnormal weather patterns, which contributed to a first-quarter surge in output and
weakened the second quarter, in which case the underlying trend could be somewhat higher than suggested by the second-quarter data alone. Certainly, business
and consumer confidence remains high and financial conditions are supportive of
growth. Particularly notable is the run-up in stock market wealth, the full effects
of which apparently have not been reflected in overall demand, but might yet be.
Monetary policymakers, balancing these various forces, forecast a continuation of
less rapid growth in coming quarters. For 1997 as a whole, the central tendency of
their forecasts has real GDP growing 3 to 3V4 percent. This would be much more
brisk than was anticipated in February, and the upward revision to this estimate
33
largely reflects the unexpectedly strong first quarter. The central tendency of monetary policymakers' projections is that real GDP will expand 2 to 2Vfe percent in 1998.
This pace of expansion is expected to keep the unemployment rate close to its current low level.
We are reasonably confident that inflation will be quite modest for 1997 as a
whole. The central tendency of the forecasts is that consumer prices will rise only
2V4
to 2V2 percent this year. This would be a significantly better outcome than the
23/4 to 3 percent CPI inflation foreseen in February.
Federal Open Market Committee members do see higher rates of inflation next
year. The central tendency of the projections is that CPI inflation will be 2 ¥2 to 3
percent in 1998—a little above the expectation for this year. However, much of this
increase is presumed to result from the absence of temporary factors that are holding down inflation this year. In particular, the favorable movements in food and energy prices of 1997 are unlikely to be repeated, and non-oil import prices may not
continue to decline. While it is possible that better productivity trends and subdued
wage growth will continue to help damp the increases in business costs associated
with tight labor markets, this is a situation that the Federal Reserve plans to monitor closely.
I have no doubt that the current stance of policy—characterized by a nominal
Federal funds rate around 5Vfe percent—will need to be changed at some point to
foster sustainable growth and low inflation. Adjustments in the policy instrument
in response to new information are a necessary and, I should like to emphasize, routine aspect of responsible policymaking. For the present, as I indicated, demand
growth does appear to have moderated, but whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With
considerable momentum behind the expansion and labor market utilization rates
unusually high, the Federal Reserve must be alert to the possibility that additional
action might be called for to forestall excessive credit creation.
The Federal Reserve is intent on gearing its policy to facilitate the maximum sustainable growth of the economy, but it is not, as some commentators have suggested,
involved in an experiment that deliberately prods the economy to see how far and
fast it can grow. The costs of a failed experiment would be much too burdensome
for too many of our citizens.
Clearly, in considering issues of monetary policy we need to distinguish carefully
between sustainable economic growth and unsustainable accelerations of activity.
Sustainable growth reflects the increased capacity of the economic system to produce goods and services over the longer run. It is largely the sum of increases in
productivity and in the labor force. That growth contrasts with a second type, a
more transitory growth. An economy producing near capacity can expand faster for
a short time, often through unsustainably low short-term interest rates and excess
credit creation. But this is not growth that promotes lasting increases in standards
of living and in jobs for our Nation. Rather, it is a growth that creates instability
and thereby inhibits the achievement of our Nation's economic goals.
The key question is how monetary policy can best foster the highest rate of sustainable growth and avoid amplifying swings in output, employment, and prices.
The historical evidence is unambiguous that excessive creation of credit and liquidity contributes nothing to the long-run growth of our productive potential and much
to costly shorter-term fluctuations. Moreover, it promotes inflation, impairing the
economy's longer-term potential output.
Our objective has never been to contain inflation as an end in itself, but rather
as a precondition for the highest possible long-run growth of output and income—
the ultimate goal of macroeconomic policy.
In considering possible adjustments of policy to achieve that goal, the issue of lags
in the effects of monetary policy is crucial. The evidence clearly demonstrates that
monetary policy affects the financial markets immediately but works with significant lags on output, employment, and prices. Thus, as I pointed out earlier, policy
needs to be made today on the basis of likely economic conditions in the future. As
a consequence, and in the absence of once-reliable monetary guides to policy, there
is no alternative to formulating policy using risk-reward tradeoffs based on what
are, unavoidably, uncertain forecasts.
Operating on uncertain forecasts, of course, is not unusual. People do it every day,
consciously or subconsciously. A driver might tap the brakes to make sure not to
be hit by a truck coming down the street, even if he thinks the chances of such an
event are relatively low; the costs of being wrong are simply too high. Similarly, in
conducting monetary policy the Federal Reserve needs constantly to look down the
road to gauge the future risks to the economy and act accordingly.
34
Growth of Money and Credit
The view that the Federal Reserve's best contribution to growth is to foster price
stability has informed both our tactical decisions on the stance of monetary policy
and our longer-run judgments on appropriate rates of liquidity provision. To be sure,
growth rates of monetary and credit aggregates have become less reliable as guides
for monetary policy as a result of rapid change in our financial system. As I have
reported to you previously, the current uncertainties regarding the behavior of the
monetary aggregates have implied that we have been unable to employ them as
guides to short-run policy decisions. Accordingly, in recent years we have reported
annual ranges for money growth that serve as benchmarks under conditions of price
stability and a return to historically stable patterns of velocity.
Over the past several years, the monetary aggregates—M2 in particular—have
shown some signs of reestablishing such stable patterns. The velocity of M2 has
fluctuated in a relatively narrow range, and some of its variation within that range
has been explained by interest rate movements, in a relationship similar to that established over earlier decades. We find this an encouraging development, and it is
possible that at some point the FOMC might elect to put more weight on such monetary quantities in the conduct of policy. But in our view, sufficient evidence has
not yet accumulated to support such a judgment.
Consequently, we have decided to keep the existing ranges of growth for money
and credit for 1997 and carry them over to next year, retaining the interpretation
of the money ranges as benchmarks for the achievement of price stability. With
nominal income growth strong relative to the rate that would likely prevail under
conditions of price stability, the growth of M2 is likely to run in the upper part of
its range both this year and next, while M3 could run a little above its cone. Domestic nonfinancial sector debt is likely to remain well within its range, with private
debt growth brisk and Federal debt growth subdued. Although any tendency for the
aggregates to exceed their ranges would not, in the event, necessarily call for an
examination of whether a policy adjustment was needed, the Federal Reserve will
be closely examining financial market prices and flows in the context of a broad
range of economic and price indicators for evidence that the sustainability of the
economic expansion may be in jeopardy.
Concluding Comment
The Federal Reserve recognizes, of course, that monetary policy does not determine the economy's potential. All that it can do is help establish sound money and
a stable financial environment in which the inherent vitality of a market economy
can flourish and promote the capital investment that in the long run is the basis
for vigorous economic growth. Similarly, other Government policies also have a
major role to play in contributing to economic growth. A continued emphasis on
market mechanisms through deregulation will help sharpen incentives to work,
save, invest, and innovate. Similarly, a fiscal policy oriented toward limited growth
in Government expenditures, producing smaller budget deficits and even budget
surpluses, would tend to lower real interest rates even further, also promoting
capital investment. The recent experience provides striking evidence of the potential
for the continuation and extension of monetary, fiscal, and structural policies to enhance our economy's performance in the period, ahead.
35
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM ALAN GREENSPAN
Q.I. According to the minutes from the May 20, 1997, Federal
Open Market Committee Meeting, it was stated that ". . . recent
developments have underscored the fact that historical experience
was not a fully reliable guide to the prospective behavior of prices;
accordingly, the inflation outlook remained subject to considerable
uncertainty." In addition, your testimony spoke of the "absence of
once-reliable monetary guides to policy." What historical relationships are now in question besides NAIRU? Is capacity utilization
still a good predictor for the Producer Price Index? Are gold and
commodities still reliable leading indicators of the PPI inflation?
A.1. The degree of wage and price inflation that has accompanied
the tightening of labor markets over the past few years has fallen
short of what would have been expected based on most simple
econometric relations derived from historical data. Many of those
models involve, implicitly, a "NAIRU" concept, and the level of unemployment
at which inflatic
____ jr —„
Elation is predicted to pick up is ,^F
„
well above the 5 percent area we have seen in recent months. One
can readily identify factors, such as the dollar's appreciation on
exchange markets or the unusual degree of insecurity people feel
with respect to their jobs, that have disturbed the traditional relationships of late, but the residual uncertainty about the dynamics
of the inflation process in today's economy is significant.
Considerable uncertainty also attends the relations between
monetary aggregate behavior and the performance of the economy.
However, as we have noted, there are nints of a return in the past
couple of years to more "normal" patterns in the demand for
money. This is reflected in the chart (on page 21) in the Monetary
Policy Report, where one can see that the velocity of M2 and the
so-called opportunity cost of holding M2 assets have been moving
in parallel of late, after a major break with the historical pattern
in the early 1990's. The pace of innovation in financial markets
remains rapid though, and a period of renewed predictability in the
behavior of velocity has been relatively brief, so there is the clear
possibility of anotner disturbance in the money demand relation.
We're watching closely in the hope that monetary aggregates might
become a more useful guide for policy. As regards other policy relevant relations, we do continue to monitor the behavior of industrial
capacity utilization for information about current or potential inflationary pressures. Through heavy investment in plant and, especially, equipment, manufacturers have expanded capacity rapidly,
and the level of capacity utilization has not been very high in the
recent period—consistent with the subdued behavior of producer
prices. When capacity utilization rose to levels appreciably above
historical averages earlier in the expansion, we did see an acceleration of producer prices—confirming the continuing importance of
this variable as an indicator of inflationary pressures.
The price of gold generally is a broad measure of inflationary
expectations and movements in commodities prices certainly are
mirrored in the PPI—especially in the crude and intermediate
goods sub-indexes—and they may be indicative of whether bottlenecks are developing that could be the precursor of more general
strains on production capabilities. We continue to find value in
36
tracking these developments at earlier stages of processing, but it
is important to remember that basic commodities constitute only a
small part of the cost of producing most goods, so that even rather
noticeable movements in commodities prices may have only a faint
echo in the prices of finished goods.
Q.2. The real Federal funds rate currently stands above its longterm average, and even the level required to slow the economy in
1994. Has the real Federal funds rate necessary to slow the economy changed over time? If so, to what degree?
A.2. As I emphasized in my testimony, the Federal Reserve has no
intention of fostering any slower growth of economic activity than
the pace that can be sustained, and from our perspective the faster
that pace, the better. In assessing what stance of monetary policy
would be consistent with sustainable economic growth, the FOMC
is continuously attempting to answer a question similar to the one
that you posed.
The answer to that question does vary over time, depending on
what else is happening in financial markets and the economy. For
example, in the early 1990's the real Federal funds rate had to be
kept unusually low for a long time to counter the effects of the
credit crunch. It does appear currently that the level of real shortterm interest rates consistent with continued good macroeconomic
performance is higher than on average over the last four decades
or so. This phenomenon may well be a consequence of the recent
evidently improved profit opportunities, mentioned in my testimony, resulting from higher returns on capital investment projects,
especially those associated with taking advantage of newer technologies. Perceptions of enhanced profitability have been reflected
in high and rising equity prices, despite relatively elevated real
short-term interest rates. Whether higher real returns across the
maturity spectrum will prove to be lasting or not is now unknowable, and will bear special monitoring as time passes.
37
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 30551
ALAN GREENSPAN
CHAIRMAN
July 14, 1997
The Honorable Alfonse M. D'Amato
Chairman
Committee on Banking, Housing,
and Urban Affairs
United States Senate
Washington D.C. 20510
Dear Mr. Chairman:
I appreciate the opportunity to respond to the important issues raised in
your letter of April 28 regarding the payment of interest on reserves.
As you note, the lack of interest on reserve balances at the Federal Reserve
is in effect a tax on depository institutions. Naturally, banks and their customers try to
minimize such tax liabilities, using resources and incurring expenses in the process.
Efforts to avoid reserve taxes on business transaction accounts have been widespread for
many years, and movements out of transaction deposits have been spurred as well by the
prohibition of interest payments on demand deposits. In recent years, technological
advances have facilitated the spread of "tax avoidance" into consumer checking accounts.
In the process, required reserve balances possibly could be reduced to a point that would
complicate the implementation of monetary policy. Should this occur, the Federal
Reserve would need to adapt its monetary policy instruments, which could involve
disruption and cost to private parties as well as to the Federal Reserve.
Payment of interest on reserves would address these potential complications, reducing the need, or easing the way, for any such adaptations. Reduced costs for
banks-both the direct costs of the tax and the indirect cost of tax avoidance-would over
time tend to get passed through to customers.
You have asked a number of specific questions related to these and other
important issues regarding the payment of interest on reserves, and our responses are
enclosed.
38
The Honorable Alfonse M. D'Amato
Page 2
I hope these comments and the responses to your questions will be helpful
to you in formulating legislation to pay interest on reserves. Allowing the Federal
Reserve to pay interest on reserve balances would be a useful step, which we support.
We would farther recommend that any legislation incorporate an adequate measure of
flexibility so that the central bank could adapt the tools of monetary policy to potential
future financial market developments. To this end, we would support providing the
Federal Reserve the ability to pay interest on required and excess reserve balances, at
possibly differential rates to be set by the Federal Reserve. We would also recommend
allowing depository institutions to pay interest on demand deposits, which would
eliminate a price distortion and the wasteful use of resources to circumvent it.
A more fundamental change-eliminating reserve requirements and the tax it
implies-could also be considered, but it might well require significant adjustments in the
implementation of monetary policy, including the adoption of procedures to control
volatility in overnight interest rates that have not been tested in our financial sector. If
Congress intended to move in this direction, statutory authority to pay explicit interest on
the remaining balances held at the Federal Reserve would be especially useful for
monetary policy purposes.
Enclosures
39
ATTACHMENT 1—SPECIFIC QUESTIONS
Q.I. If the Fed were permitted to pay interest on reserves, what
would be the impact on reserve levels?
A.1. The impact on reserve levels would depend in part on the type
of reserves on which interest would be paid. Interest could be paid
on required reserve balances at the Federal Reserve (that is, required reserves less vault cash), on excess reserve balances, or on
both. If interest were paid on required reserve balances, then some
depositories would likely discontinue their existing programs to
sweep retail deposits into non-reservable accounts, and others
would decline to implement new sweep programs. (Retail sweep
programs, which employ computer-assisted procedures to sweep
checking and demand deposit balances into savings deposits, have
reduced transaction deposits by over $210 billion since they began
to be implemented in early 1994.) The net effect would be a higher
level of both transaction deposits and required reserve balances
than would prevail in the absence of interest on reserves.
We estimate that required reserve balances have fallen by about
$19 billion as a result of the implementation of retail sweep programs, and they are now around $9 billion. Over the next couple
of years, absent interest payments on reserves, required reserve
balances could decline by perhaps another $5 billion as retail
sweep programs reach saturation levels. (Based on the behavior of
banks that have already instituted sweep programs, we expect that
a residual of around $3 billion to $5 billion of required reserve balances would remain. A number of banks—especially those with a
large volume of business demand deposits and little vault cash—
would be unlikely to reduce their required reserve balances to zero
with retail sweep programs.)
The proportion of sweeps that would be unwound with the payment of interest on reserves is uncertain. Most of the expense of
sweeps for depositories is incurred in the design and implementation stage, and once installed, maintenance costs are probably low,
so incentives to discontinue the programs are small. But maintenance costs are not zero, and might be considerable if computer
systems are changed—for example, in the course of a merger. In
our survey of large banks undertaken in the spring of 1996, about
two-thirds of the banks then sweeping indicated that they would
unwind sweeps if interest were paid on reserves at the Federal
funds rate. After accounting for the additional sweeps that would
be implemented if interest were not paid on reserves, and for trend
growth, the total effect of paying interest on required reserve balances would be to boost the level of such balances by roughly $17
billion to $19 billion, once depository institutions have adjusted.
Allowing the payment of interest on excess reserves would also
be helpful under certain circumstances. The rate of remuneration
on excess reserves would act as a floor under the Federal funds
rate, and such a floor would be a useful element in limiting variability of the funds rate if interest were not to be paid on required
reserve balances, or if, despite such interest payments, required reserve balances did not remain high enough. The payment of interest on excess reserves could stimulate an increase in the demand
40
for excess reserves relative to the current average level of about $1
billion. The extent of the increase would depend in part on the
level of required reserve balances—with lower or no required balances, the demand for excess reserves would be larger. The demand
would also depend on the rate paid on excess reserves; it could be
large if the rate were only slightly below the FOMC's expected Federal funds rate, but much smaller if the rate were set well under
the expected funds rate. (The interest rate on excess reserves could
not be above the Federal funds rate, because lenders would not
accept both the private credit risk on Federal funds and a lower interest rate than that offered by the Federal Reserve.)
Q.2. What impact would eliminating the restriction on payment of
interest on demand deposits have on the level of required reserves?
A.2. Allowing explicit interest payments should stimulate an increase in demand deposits and hence in required reserves. For demand deposits held by households, there would be little effect, as
depositories are already allowed to offer interest-bearing checking
accounts to households. However, partly because of the prohibition
against interest on demand deposits, businesses hold a substantial
proportion of their liquid assets outside such deposits, in instruments such as money market mutual fund shares, repurchase
agreements, and Eurodollar deposits. Banks have long offered their
business customers, especially the larger ones, cash management
facilities to sweep demand deposit balances at the end of each day
into these investments. And there are reports that some money
market mutual funds are beginning to solicit small businesses for
transactions-oriented accounts that would substitute for demand
deposits. A number of firms might shift funds out of these instruments and into checking accounts, if such accounts were to pay
explicit interest.
However, several factors should limit the magnitude of the response to the payment of interest on demand deposits. First, according to our last survey on this topic, in 1992, perhaps one-third
to one-half of total demand deposits are held in compensating balance accounts, on which corporations gain "earnings credits" that
are used to offset charges for bank services. As this is a form of
implicit interest, the payment of explicit interest might provide
rather little stimulus to the demand deposits of such corporations.
Furthermore, banks can already offer businesses an interestearning money market deposit account, a product that competes
with money fund shares. Although such accounts have restricted
transaction facilities, they are likely to have higher offering rates
than interest-bearing demand deposits, limiting the attractiveness
of the latter. Finally, perceptions of the relative risk of demand
deposits, which are uninsured above $100,000, versus some of the
alternative investments might also be a restraining influence.
On balance, if the banks could pay explicit interest on demand
deposits, we imagine that they would likely gain a modest fraction
of market share away from institutional money funds, while a substantial amount of the daily sweeping into bank repurchase agreements and Eurodollar deposits might be curtailed, and the potential for further shifts of transactions accounts to money funds
would be reduced. It is impossible to predict with any confidence
41
the effects of removing a restriction that has been in place for more
than half a century. But it seems reasonable to suppose that the
payment of interest on demand deposits could boost the level of
such deposits by several tens of billions of dollars, depending on
how banks chose to position interest-bearing business transaction
accounts against their own alternative products and competing
market instruments. Of course, if no interest were paid on required
reserve balances, the response to the payment of interest on demand deposits would be more limited because of the continued reserve tax.
Q.3. What would be an appropriate rate for the Fed to pay on
bank reserves?
A.3. If the Federal Reserve were granted the power to pay interest
on reserves, the actual rate paid, and any differential between
rates on required reserve balances and excess reserves, would best
be left to the Federal Reserve. The rate or rates paid on reserves
would have to be allowed to vary with the general level of shortterm interest rates. Under current procedures, the rate paid on required reserve balances would likely be set very close to the
FOMC's expected Federal funds rate. The funds rate is the rate at
which depositories trade reserves among themselves. The rate on
excess reserves could be set either slightly or more noticeably below
this rate. However, if the FOMC shifted its focus away from the
Federal funds rate as an instrument, toward other market interest
rates, or toward other instruments for monetary policy, an alternative procedure for setting the interest rates on reserves might
need to be employed.
Q.4. Would you anticipate that the average consumer would see a
benefit from lifting the statutory prohibition of paying interest on
reserves?
A.4. Yes, we would expect that, over time, the competitive forces
of the marketplace would impel depositories to pass along to their
depositors or borrowers much of the reduced intermediation costs
from paying interest on reserves. An immediate pass-through
would be likely on the earnings credit rates on compensating balances of businesses, which typically have been explicitly reduced by
the cost to banks of reserve requirements. For many bank customers, however, it may take some time before aiiy benefits are
visible. For example, what limited information we have suggests
very little returns to bank customers so far from the reduction in
reserve taxes associated with the implementation of retail sweep
programs.
Q.5. Would the implementation of monetary policy be adversely
affected by eliminating reserve requirements?
A.5. Elimination of reserve requirements would reduce the costs
of financial intermediation for depositories through a number of
channels. It would remove the reserve tax and the costly efforts of
depositories to avoid it. It would also remove a complex area of regulation of depositories, which is not needed for safety and soundness purposes.
However, unless we were to change our operating procedures, the
elimination of reserve requirements could have adverse implica-
42
tions for the implementation of monetary policy, assuming no other
legislative changes. Depositories must meet reserve requirements
that exceed their vault cash by holding a specified average balance
at Reserve Banks over a 2-week maintenance period. Banks and
thrifts can arbitrage across the days of the maintenance period,
holding smaller balances when overnight interest rates are high,
and larger balances when rates are low. This arbitrage helps to
stabilize overnight interest rates. In addition, the demand for the
2-week average reserve balances can be readily estimated by the
Federal Reserve when it assesses the need to supply reserves
through open market operations. In the absence of reserve requirements, the demand for balances at Reserve Banks would be based
on the daily need of the depositories for balances to cover the clearing of customer payments through their reserve accounts, which
depositories themselves have a hard time predicting because of
possible large unexpected customer transactions flows late in the
business day. Consequently, the Federal Reserve also would have
difficulty predicting the demand for reserve balances and determining the appropriate size of daily open market operations. In the
absence of interday arbitrage of the Federal funds rate by banks,
and with highly uncertain daily demands for reserves, overnight interest rates could become quite volatile.
Required clearing balances could help to mitigate such effects,
but would not likely be a sufficient stabilizing influence. (Required
clearing balances allow depositories to earn implicit interest to offset charges for the use of Federal Reserve services—an analog of
the compensating balances banks offer to businesses. They are
called "required" because a depository must precommit to holding
a certain average amount over a 2-week maintenance period.) If
reserve requirements were eliminated, required clearing balances
would increase, thereby helping to provide a stable 2-week average
demand for balances at Reserve Banks. The volume of required
clearing balances on which an institution can obtain earnings credits is limited, however, by the charges for the Federal Reserve services it uses and by the level of interest rates. If the Federal Reserve
began to provide a lower volume of services, the level of feasible
required clearing balances could decline. In addition, when interest
rates rise, earnings credit rates rise as well, and the level of clearing balances needed to pay for a given level of services from the
Federal Reserve falls.
If the level of feasible required clearing balances for an institution were less than the balances needed as a cushion against unexpected payment flows late in the day, then the institution's daily
demand for balances could be quite variable in the absence of
reserve requirements. If numerous large depositories were in this
position, then required clearing balances would not represent the
marginal demand for balances, and the benefits of interday arbitrage and relatively predictable 2-week average demands would be
lost. In the event, required clearing balances would be of little help
in mitigating the volatility in short-term market rates.
The Federal Reserve could nevertheless manage to implement
monetary policy effectively without reserve requirements, and several industrialized countries already do so—as noted below in the
response to your last question. However, we would have to make
43
a number of changes in our operating procedures, and banks and
other market participants would need to adapt to the new structure. Several of these changes are discussed in answer to your next
question.
Q.6. If the continued decline of reserves would produce greater interest rate volatility, what options would the Federal Reserve have
to counteract this effect?
A*6. With the decline in reserves experienced so far, interest rate
volatility has increased only slightly. A moderate rise in the volatility of overnight interest rates would not likely be transmitted
significantly to longer-term rates, nor have noticeable adverse macroeconomic effects. Even a more sizable increase in the volatility of
overnight interest rates might not have serious effects on overall
financial stability, although we have not experienced such an eventuality. However, a moderate—and certainly a severe—rise in volatility would increase the unanticipated gains and losses of money
market participants, and the heightened uncertainty might induce
them to incur greater expenses in reserve and cash management.
Under current legislation, the Federal Reserve has some options
for stabilizing—or at least putting bounds on—short-term interest
rates if volatility were to rise significantly in an environment of low
or no required reserves. For example, more active use of the discount window by depositories when reserve markets are under
pressure could help to limit upward movements in the Federal
funds rate. While depositories have been less inclined to turn to the
discount window for temporary adjustment credit in recent years,
we might be able to find ways to encourage greater use of this facility. An alternative, employed in many European countries, would
involve a more thorough overhaul of our credit facilities, with less
administrative restraint on use of the discount window, and a setting for the discount rate above the usual overnight market rates.
This type of "Lombard" facility would prove useful in restraining
upward spikes of the funds rate, if the reluctance of depositories
to use discount window credit could be overcome. We would still
need to control borrowing by troubled institutions for whom even
a penalty rate might be below market. Also, this facility could affect the institutional arrangements involving the role of Reserve
Banks' Boards of Directors in establishing discount rates, especially
if such a rate were based on a fixed spread above the FOMC's expected Federal funds rate.
Moreover, the Federal Reserve could add reserves on a more
flexible basis throughout the day to help cap the funds rate, although there are limits to such operations, as discussed later. To
prevent the funds rate from dropping too low, we could consider arranging sweeps of our own—rolling the excess reserve balances of
depositories into matched sale/purchase agreements with us late in
the day. The interest rate we paid on such contracts would act as
a floor for the Federal funds rate. However, an innovation of this
nature might involve significant administrative costs in developing
the system and related software, and in operating it, including
making assignments of collateral, opening a special securities wire
late in the business day, and administering any limitations on the
amounts or frequency of such sweeps for individual depositories.
44
These costs could be largely avoided if the Federal Reserve were
allowed to pay interest on excess reserves. The payment of interest
on excess reserves might also allow other alternatives for controlling the Federal funds rate. For example, we could conceivably
follow a procedure of setting the rate on excess reserves very close
to our intended Federal funds rate and then ensuring an overabundant supply of reserves through occasional outright purchases of
securities, so that the funds rate would tend to be stabilized around
its intended level, without the need for a Lombard facility, and
with a reduced need for daily adjustments in reserve levels through
temporary open market operations.
In addition, the Federal Reserve could contemplate other types
of changes in its procedures for implementing monetary policy on
a daily basis. For instance, we might consider moving away from
the current procedure of conducting discrete, auction-like, quantitybased open market operations, usually only once per day. Instead,
we could enter the market regularly several times each day. Alternatively, we could post buy and sell rates for overnight repurchase
agreements during an extended period of trading each day and let
the market determine the net quantity of additions to reserves.
However, in either of these cases, we are unlikely to be able to add
sizable quantities of reserves with open market operations near the
end of the day, when much of the funds rate volatility occurs; collateral for repurchase agreements is quite limited then because
dealers have already obtained all the financing they need.
One other option would be for the Federal Reserve to look for
ways to increase the demand for required clearing balances. One
suggestion has been for us to allow the earnings credits on such
balances to be traded among depositories. However, as mentioned
above, it would be ill-advised to rely exclusively on required clearing balances to stabilize interest rates, given the sensitivity of such
balances to the level of interest rates and to the usage of Federal
Reserve services.
In sum, as you can see, we have a number of possible means of
reducing volatility in the Federal funds market, should that become necessary, and other alternatives could be made available
with further legislation. Nevertheless, there are drawbacks to
many of these possibilities, and in some cases further study would
be needed before we could select the precise features to be implemented.
Q.7. Would the Federal Reserve's reliance on only the required
clearing balances pose any concerns relative to the payment system?
A.7. If the Federal Reserve relied solely on the required clearing
balances, the overall balances available for effecting payments
would be substantially reduced, and both daylight and overnight
overdrafts of accounts at Reserve Banks could become larger and
more frequent. Such effects could increase the risks borne by the
Federal Reserve, but since payments through us are almost always
considered final, systemic risks in the payment system would not
be increased. Reserve Banks would be able to offset the risks they
would bear through collateralization, and their existing administrative procedures and penalty charges would tend to encourage more
45
efficient account management and hence discourage the overdrafts
from occurring to some extent.
Q.8. When the Federal Reserve began its series of interpretative
letters authorizing sweep accounts, was there any analysis or discussion of the likely level of bank usage of these accounts and/or
the effect on reserves?
A.8. Enclosed as Attachment 2 is a staff memo to the Board, dated
March 3, 1993, regarding the original proposal to establish a retail
sweep program. It shows that the Federal Reserve was fully aware
of the possibility of substantial reductions in transaction accounts
and reserves following the implementation of retail sweep programs. Although the implications of the drop in reserves were not
discussed in the memo, the Board was well aware of the possible
increase in reserve market volatility from a drop in reserves, since
this subject was considered thoroughly about a year before when
the Board reduced the reserve requirement on transactions deposits from 12 to 10 percent. Nevertheless, the sweep proposal was not
in violation of our regulations. Retail sweep programs are in essence an extension to the household sector of a financial innovation
that became widespread for business accounts in the mid-1970's.
Improvements in computer technology and software over the years
have made it possible for such programs to be implemented even
for the small accounts of numerous households.
Q.9. How does our reserve policy, including the level of reserves
required and the nonpayment of interest on reserves, compare to
that of the central banks in other industrialized countries?
A.9. Among the foreign G-10 countries, Canada, Belgium, and
Sweden effectively have no reserve requirements at present. In
other foreign G-10 countries, required reserve ratios vary considerably, as do the base of deposits against which these requirements
are applied. Many countries have reduced required reserve ratios
to quite low levels. Interest is paid on reserves in Italy, the Netherlands, and Switzerland. A table of data is being provided for your
reference in Attachment 3.
46
ATTACHMENT 2
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
DIVISION OF MONETARY AFFAIRS
Date:
March 3 . 1993
To:
Board of Governors
From:
Division of Monetary Afipairs (David Linclsey)
Legal Division (Olive/jfllreland)
Subject:
First Union's Proposea Money Management Service
First Union has proposed to institute a new money
management service directed at households.
The proposal
apparently has been formulated in response to the Board's recent
interpretation of Regulation D that prohibited an earlier
practice by First Union, which involved sweeping funds from NOW
accounts into large time deposits.
The new arrangement would sweep balances above a
prespecified maximum level from the depositor's NOW account into
his or her MMDA.
When NOW account balances fall below a
prespecified minimum level, funds would be -moved from the MMDA to
the NOW account.
The maximum and minimum levels for each
individual NOW account would be set based on an analysis of the
historical pattern of activity in the account.
If a sixth
transfer from the MMDA occurred within a one-month period, all
remaining balances in the depositor's MMDA would be swept into
the NOW account, to prevent violations of the limit of six
automatic transfers per month from MMDAs.
The proposed sweep arrangement differs from the recently
prohibited practice of sweeping NOW account funds into large time
deposits.
That arrangement commingled depositors' funds,
allowing an individual depositor to rely on other depositors'
47
funds to prevent overdrafts should his or her portion of the
maturing CD be insufficient to cover NOW-account debits.
The new plan will allow more of a depositor's balances to
be maintained in MMDAs than at present: hence, the bank will be
able to lower its reserve requirements.
Potentially, the
depositor and the bank both could benefit, assuming the bank
passes along part of the reduction in its funding costs to the
depositor.
The extent of the reduction will depend in part on
First Union's ability to predict debits and credits to individual
customers' NOW accounts.
In proposing the program. First Union
seems to be signalling that it believes an appreciable reduction
is possible.
If First Union successfully implements the program,
it is likely that other banks will emulate it. and a significant
erosion of the reserve base could occur.
The proposal does not appear to violate Regulation D as
currently formulated: in effect, it would simply extend to
households the benefits of sweep accounts that have been enjoyed
by corporations for many years.
First Union plans to proceed
with this arrangement in the absence of a prohibition from the
Board.
Please let Mr. Lindsey or Mr. Ireland know if you have
any comments on or objections to this proposal by March 8. 1993.
1. First Union's proposal would reduce Ml. but would have no effect
on M2. as both NOW accounts and MMDAs are included in M2.
Required Reserve Ratios (%) and Types ot
Liabilities Subject to Them
France
Germany
0.5 on some passbook savings accounts,
CDs, repos, and some off-balance-sheet
liabilities
1.0 on transaction and sight deposits, and
large time deposits
1.5 on savings deposits
2.0 on sight deposits defined as less than 1month maturity, time deposits, CDs, and
repos
Remuneration on
Reserves
Calculation and Maintainence Periods and
Time Lag Betweem Them
None
Required reserves computed on the last
day of the previous month, maintained for
1 month ending on the 15th of the current
month, 15-day lag
None
Calculation is averaged over calendar
month ending on the 15th of the month,
maintained for 1 month through monthend, 15-day lag
Calculation is averaged over the month
prior to the previous calendar month,
maintainence period is 1 month ending on
the 14th day of the current month, 45-day
lag
Italy
15.0 on transaction and sight deposits, time
and savings deposits, and CDs, applied to
the change in eligible liabilities
Required reserves
are remunerated at
5.5 %, excess
reserves at 0,5%
japan
0.05 - 1.3 on transactions and sight deposits'
0.05 - 1.2 on time and savings deposits1
0.05- 1. 8 on CDs'
0.1 - 0.15 on other liabilities
None
Netherlands
variable on transaction and sight deposits,
time and savings deposits, CDs, repos, and
other liabilities
Remunerated at
nearly market
rates2 .
Switzerland
25 on transaction and sight deposits, and
about 20 percent of various forms of savings
deposits
Most reserves are
not remunerated3
035 on most domestic-currencydenominated liabilities plus any foreign
currency liability (as part of the netting of
foreign currency positions)
None
United
Kingdom
Calculation is averaged over previous
month, maintainence period is 1 month
ending on the 15th day of the current
month, 15-day lag
Calculation is averaged over previous 3
months, maintainence period is 7-10 days.
variable lag
Calculation is averaged over previous 3
months, maintainence period is 1 month
ending on the 17th day of the current
month, 51 -day lag
Calculated in April and October on average
liabilities reported at the end of the 6
previous months, lag and maintainence
period are 6 months
frlotes: No reserve requirement* are in place in Belgium and Sweden. In Canada banks must maintain a non-negative balance before overdrafts on their account with the Bank of Canada only on
average during 1-month periods. 'Ratio varies with size of the corresponding liability category. 'Weighted average of the rate on ordinary and special advances. 'Postal checking deposits are pai.i
.25%.
i. BIS Conference Papers Vol. 3, March 1997, pp. 312-321. various publications of foreign central banks, and ,
Monetary Institute. April 1995, pp. 128-131 and 353-354
. Europe
49
For use at 2:00 p.m., E.D.T.
Tuesday
July 22,1997
Board of Governors of the Federal Reserve System
Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 22,1997
50
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 22, 1997
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
51
Table of Contents
Page
Section 1: Monetary Policy and the Economic Outlook
1
Section 2: Economic and Financial Developments in 1997
A
52
Section 1: Monetary Policy and the Economic Outlook
The economy continued to perform exceptionally
well in the first half of 1997. Real output grew
briskly, while inflation ebbed. Sizable further
increases in payrolls pushed the unemployment rate
below 5 percent for the first time in nearly twentyfive years. Although growth in real gross domestic
product appears to have slowed in the spring, this
slackening came on the heels of a dramatic surge in
the opening months of the year, all indications are
that the expansion remains well intact. The members
of the Board of Governors and the Reserve Bank
presidents anticipate that the economy will grow at a
moderate pace in the second half of this year and in
1998 and that inflation will remain low. Conditions in
financial markets are supportive of continued growth:
Longer-term interest rates are in the lower portion of
the range observed in this decade, the stock market
has registered all-time highs, and credit remains
readily available to private borrowers.
Since the February report on monetary policy. Federal Reserve policymakers have revised upward their
expectations for growth of real activity in 1997 and
trimmed their forecasts of inflation. This combination of revisions highlights the extraordinarily positive condition, still prevailing more than six years
into the current economic expansion. In part, the
recent confluence of higher-than-expected output and
lower inflation has reflected the favorable influences
on prices of retreating oil prices and a strong dollar.
But it may also be attributable to more durable
changes in our economy, notably a greater flexibility and competitiveness in labor and product
markets and more rapid, technology-driven gains in
efficiency. In essence, the economy may be experiencing an upward shift in its longer-range output
potential.
To the extent that aggregate supply is expanding
more rapidly, monetary policy can accommodate
extra growth in demand without fostering increased
inflationary pressures. In late March, however, the
Federal Open Market Committee concluded that there
was a significant risk that aggregate demand would
grow faster in the coming quarters than available
supply, which, with utilization already at a very
high level, would place the economy's resources
under increasing strain. If such unsustainable
growth persisted, the resulting inflationary imbalances would eventually undermine the health of the
expansion—the all too frequent pattern of past business cycles. To protect against the possibility of such
an outcome, the Committee tightened policy slightly.
With the softening of demand in the spring, the Committee was able to maintain a steady posture in the
money market while closely monitoring economic
developments. The ongoing objective of monetary
policy is to help the nation achieve maximum sustainable economic growth and the highest average living standards. The Federal Reserve recognizes that it
can best accomplish this objective by keeping inflation in check, because an environment of price stability is most conducive to sound, long-term planning by
households and businesses.
Monetary Policy, Financial Markets, and
the Economy over the First Half of 1997
The rapid economic growth observed in the closing months of 1996 continued in the first quarter of
this year, with real GDP advancing almost 6 percent
at an annual rate. Consumer spending surged, fueled
by a significant increase in income, upbeat consumer
attitudes, and the effects of the huge run-up in equity
prices over the past couple of years on household net
worth. Business fixed investment was strong, and
companies restocked inventories that had become thin
as sales soared. The advance in real output provided
support for considerable new hiring; rising pay and
greater job availability drew additional people into
the workforce, lifting the labor force participation rate
to a new high during the first quarter of the year. The
underlying trend in consumer price inflation was still
subdued. Inflation pressures were held in check by
smaller food price increases, declining prices for nonoil imports, the marked expansion of industrial capacity in recent years, and continuing efforts by businesses to boost efficiency.
At their meeting in late March, Federal Open
Market Committee (FOMC) members expected that
the growth of economic activity would ease in the
coming months, but they were uncertain about the
likely extent of that slowing. Although the firstquarter burst in production had owed importantly
to a number of temporary factors, many of the
fundamentals underlying consumer and business
demand remained quite positive. The Committee was
concerned about the risk that if outsized gains in real
output continued, pressures on costs and prices would
emerge that could eventually undermine the expansion. Therefore, to help foster more sustainable trends
in output and guard against potential inflationary
imbalances, the Committee firmed policy slightly by
53
Selected Interest Rates
Percent
3/25
5/20
7/2
1997
Note. Dotted vertical lines indicate days on which the Federal
Open Market Committee (FOMC) announced a monetary policy
action. The dates on the horizontal axis are those on which
the FOMC nek) meetings, last observations are for July 18, 1997.
raising the expected federal finds rate from around
5V4 percent to around 5Yi percent
Despite high levels of employment and production
through the first half of the year, there were few signs
that inflation was deviating significantly from recent
trends. Although overall consumer price inflation
dipped in the second quarter as energy prices
declined, consumer prices excluding food and energy
increased at about the same pace in the first half of
the year as in 1996.
The unsustainably strong pace of economic growth
in the first quarter weighed on financial markets.
Interest rates rose substantially, even before the
System's action, despite favorable news on inflau'oa Because the policy tightening was widely
anticipated, rates were little affected by the announcement, but they moved up a little more in the following weeks as incoming data suggested persistent
strength in economic activity. Equity prices rose early
in the first quarter and then declined, changing
relatively little on net. The trade-weighted value of
the dollar in terms of the other G-10 currencies
increased about 7 percent in the firs, quarter, reflecting the unexpectedly strong economic growth in the
United States and market uncertainty about economic performance abroad.
As the second quarter progressed, it became
increasingly evident that economic activity had
indeed decelerated. The expansion of consumer
spending eased considerably, while business fixed
investment remained strong. Employment continued
to climb rapidly, pushing the unemployment rate
down below 5 percent on average in the second
quarter-—the lowest level since the early 1970s.
Continued favorable price movements and the
slowing of economic growth suggested to financial
market participants that inflation might remain
damped without a further tightening of financial
conditions, and this belief prompted a substantial drop
in interest rates from late April to mid-July, reversing the earlier advance. With resource utilization still
at very high levels, and with economic and financial
conditions conducive to robust increases in spending, the FOMC at its May meeting continued to view
the risks as skewed toward the re-emergence of
inflationary pressures. But the moderation in aggregate demand and uncertainty about the relationship
between utilization rates and inflation led the Committee to leave reserve conditions unchanged in May
and again in July. The drop in market interest rates in
the second quarter may also have been encouraged by
favorable news about this year's federal budget
54
deficit and by the agreement between the President
and the Congress to balance the budget in fiscal year
2002. Spurred by lower rates and greater optimism
about the long-term outlook for earnings, the stock
market surged in the second quarter and into July.
The value of the dollar rose somewhat further in
foreign-exchange markets, on balance, an increase
more than accounted for by an appreciation against
continental European currencies.
During the first half of the year, credit remained
available on favorable terms to most households and
businesses. High delinquency rates for consumer
loans encouraged many banks to tighten standards,
but consumer loan rates generally stayed fairly low
relative to benchmark Treasury rates, and consumer
credit continued to grow faster than income and only
a little below the pace of 19%. Home mortgage debt
advanced at a moderate rate, with home equity loans
expanding especially rapidly in the spring. Businesses continued to have access to ample external
funding both directly in capital markets and through
financial intermediaries. The spreads between yields
on corporate bonds and Treasury securities stayed
low or fell further, and. relative to market rates, bank
business loan rates held near the lower end of the
range seen in the current expansion.
Total domestic nonfinancial debt expanded more
slowly in the first half of 1997 than in 1996. mainly
because of a reduced pace of federal borrowing.
Trends in the monetary aggregates during the first
half of 1997 were similar to those in 1996, with M2
near the upper end of the range set by the FOMC and
M3 somewhat above its range. This outcome was in
line with FOMC expectations, because the ranges had
been set to be consistent with conditions of price
stability, and inflation, while damped, remained above
this level. The behavior of M2 in the first part of the
year was again reasonably well explained by changes
in nominal GDP and interest rates.
Economic Projections for 1997 and 1998
After growing swiftly on balance over the first half
of the year, economic activity is expected to .expand
more moderately in the second half of 1997 and in
1998. For this year, the central tendency of the GDP
growth forecasts put forth by members of the Board
of Governors and the Reserve Bank presidents is
3 percent to 3V* percent, measured as the change in
real output between the final quarter of 1996 and the
final quarter of 1997. For 1998, most of the forecasts
anticipate growth of real GDP within a range of
2 percent to 2>/2 percent. With this pace of continued
economic expansion over the next six quarters, the
central tendency of forecasts for the civilian
unemployment rate remains a little under 5 percent
through 1998, about the average for the second
quaner of this year.
Economic activity appears to have entered the
second half with considerable positive momentum.
Households have experienced hefty gains in employment, income, and wealth, and their optimism about
the future is quite high. These factors seem likely to
outweigh any drag on consumer demand that might
be associated with the debt-servicing problems that
some households have experienced. Lower mortgage rates are buttressing demand for homes. In the
business sector, healthy balance sheets and profits and
a moderate cost of external funds, along with a
continuing desire to install new technology, are
providing support and impetus for investment in
equipment Meanwhile, investment in structures
should follow last year's strong performance with
further increases, because of declining vacancy rates
in some sectors and ready access to financing.
Notwithstanding the economy's positive momentum, growth is expected to be more moderate in the
next year and a half than in the first half of 1997. In
part, this deceleration is likely to reflect the influence on demand of the substantial buildup of stocks
of household durables and business plant and equipment thus far in the expansion. As well, the pace of
inventory investment will need to slacken considerably relative to that observed in the first part of this
year, lest stock-to-sales ratios become uncomfortably high. In the external sector, the strength of the
dollar on exchange markets since last year could
damp export sales and encourage US. firms and
households to purchase foreign-produced goods and
services.
Federal Reserve policymakers believe that this
year's rise in the CPI will be smaller than that of
1996, mostly because of favorable developments in
the food and, especially, energy sectors. After last
year's run-up, crude oil prices have dropped back
significantly, pulling down the prices of petroleum
products. Food price increases also have been
subdued this year, as the decline in grain prices that
began in the middle of last year has been working its
way through to the retail level. Looking ahead to next
year, the governors and Reserve Bank presidents
expect larger increases in the CPI. with a central
tendency from 2V6 percent to 3 percent. Food and
energy prices are not expected to repeat this year's
55
Economic Projections for 1997 and 1998
Percent
Federal Reserve governors
and Reserve Bank presidents
Indicator
Range
Central
tendency
1997
Change, fourth quarter
to fourth quarter*
5 to 6
Nominal GOP
Real GDP
Consumer price index2
3 to 31/2
2 to 2%
5 to 5V2
3 to 31A
2V4 to 2V2
Average level in the
fourth quarter
Civilian unemployment rate
4% to 51/4
4% to 5
1998
Change, fourth quarter
to fourth quarter*
Nominal GDP
Real GDP
Consumer price index2
1
4 /4 to 5%
4V2 to 5
2 to 3
2te to 3
2 to 21/2
2V2 to 3
4Vz to 51/4
4% to 5
Average level in the
fourth quarter
Civilian unemployment rate
1. Change from average for fourth quarter of previous year
to average for fourth quarter of year indicated.
salutary performance, and non-oil import prices may
be less of a restraining influence than in 1997, absent
a continued uptrend in the dollar. Moreover, there is a
risk that high levels of resource utilization could
begin putting upward pressure on business costs.
As noted in past monetary policy reports, the
CPI forecasts of Federal Reserve policymakers
incorporate the technical improvements that the
Bureau of Labor Statistics is making to the CPI in
1997 and 1998. A series of technical changes is
estimated to have trimmed reported rates of CPI inflation slightly in recent years, and the additional
changes will affect the index this year and next In
light of the challenges of accurately measuring price
changes in a complex and dynamic economy, the
governors and Reserve Bank presidents will continue
2. All urban consumers.
placing substantial weight on other price indexes,
along with the CPI. in gauging progress toward the
long-run goal of price stability.
The Administration has not yet released an update
of the economic projections contained in the February Economic Report of the President. The earlier
Administration forecasts were broadly similar to
those in the Federal Reserve's February report, with
Administration forecasts for growth and inflation
within or near the range anticipated by Federal
Reserve policymakers in February. Because of
developments in the economy since that time, the
central tendency of forecasts for real GDP growth put
forth by the members of the Board of Governors
andthe Reserve Bank presidents has moved higher,
while their forecasts for the CPI have moved down.
56
Ranges for Growth of Monetary and Debt Aggregates
Percent
Aggregate
1996
1997
Provisional for 1998
M2
1 to 5
1 to 5
1 to 5
2 to 6
2to6
2 to 6
3 to 7
3 to 7
3 to 7
Debt
Note. Change from average for fourth quarter of preceding year to average for fourth quarter of year indicated.
Money and Debt Ranges
for 1997 and 1998
At its meeting earlier this month, the Committee
reaffirmed the ranges for 1997 growth of money and
debt that it had established in February: 1 percent to
5 percent for M2. 2 percent to 6 percent for M3. and
3 percent to 7 percent for the debt of the domestic
nonfinancial sectors. The Committee also set
provisional ranges for 1998 at the same levels as for
1997.
In choosing the ranges for M2 and M3. the Committee recognized the continuing uncertainty about
the future behavior of the velocities of the two aggregates. For several decades until the 1990s, these
aggregates exhibited fairly stable trends relative to
nominal spending, and variations in M2 growth
around its trend were reasonably closely related to
changes in the spread between market rates and
yields on the assets in M2. These relationships were
disrupted in the first pan of this decade. Between
1991 and early 1994, the velocities of M2 and M3
climbed well above the levels that were predicted by
past experience, as households shifted substantial
amounts out of lower-yielding deposits into higheryielding stock and bond mutual funds, and as banks
and thrift institutions sharply curtailed their lending
to focus on rebuilding capital. Since mid-1994, the
velocities have been moving more nearly in line
with their historical patterns with respect to changes
in opportunity costs—.albeit at higher levels. This
recent period of renewed stability is still brief, however, and has occurred at a time of relatively stable
financial and economic conditions, leaving open the
important question of whether the stability would be
sustained in the future under a wider variety of
circumstances.
In light of this uncertainty, the Committee again
decided to view the r-nges as benchmarks for monetary growth rates that would be consistent with
approximate price stability and historical velocity
relationships. If velocities change little over the next
year and a half. Committee members' expectations of
nominal GDP growth in 1997 and 1998 imply that
M2 and M3 will likely finish around the upper
boundaries of their respective ranges each year. The
debt of the domestic nonfinancial sectors is expected
to remain near the middle of its range this year and
next The Committee will continue to monitor the
behavior of the monetary aggregates and domestic
nonfinancial debt—as well as a wide range of other
data—for information about economic and financial
developments.
57
Section 2: Economic and Financial Developments in 1997
The economy has continued to perform exceptionally well this year. Real gross domestic product
surged almost 6 percent at an annual rate in the first
quarter of 1997. and available data point to a healthy,
though smaller, increase in the second quarter. Financial conditions remained supportive of spending.
Despite a modest tightening of money market conditions by the System, most interest rates were little
changed or declined a bit on net during the first half
of the year, and equity prices surged ahead. With
relatively few exceptions, credit remained readily
available from both intermediaries and financial markets on generally favorable terms. The rapid increases
in output led to a further tightening of labor markets in the first six months of 1997, and labor costs
accelerated a little from the pace of a year earlier.
Price inflation has been subdued, held down in part
by declines in energy prices, smaller increases in food
prices, and lower prices for non-oil imports that have
followed in the wake of the appreciation of the dollar. In addition, intense competition, adequate plant
capacity, and ongoing efficiency gains have helped to
restrain inflation pressures in the face of rising wages.
Change in Real GDP
Percent, annual rate
Q1
1L11Lii
1992
1993 1994 1995 1996 1997
The Household Sector
Spending, Income, and Saving. After posting a sizable increase in 19%, real personal consumption expenditures jumped 5V2 percent at an annual
rate in the first quarter of 1997. Although the advance
in spending slowed thereafter—partly because of
unusually cool weather in late spring—underlying
fundamentals for the household sector remain favor-
Change in Real Income and Consumption
Percent, annual rate
Disposable personal income
Personal consumption expenditures
I
1992
1993
1994
I
1995
I
l_
1996 1997
able to further solid gains: notably, real incomes have
continued to rise, and many consumers have
benefited from sizable gains in wealth. With this
good news in hand, consumers have become extraordinarily upbeat about the economy's prospects.
Indexes of consumer sentiment—such as those compiled by the Survey Research Center 2: the University
of Michigan and the Conference Board—have soared
to some of the highest readings since the 1960s.
Despite this generally healthy picture, some households still face difficulties meeting debt obligations,
and delinquency rates for consumer loans have
remained at high levels.
Real outlays for consumer durables surged
183/4 percent (annual rate) in the first quarter of
this year but apparently slowed considerably in the
second quarter. After changing little, on net, last year,
consumer purchases of motor vehicles increased
rapidly early in the year, a result of sound
fundamentals, a bounceback from the strikedepressed fourth quarter, and enlarged incentives
offered by auto makers. In the second quarter, sales
were once again held down noticeably by strikerelated supply constraints, as well as by some payback from the elevated first-quarter pace. Smoothing
through the ups and downs, the underlying pace of
demand in the first half of the year likely remained
reasonably close to the IS million unit rate that has
prevailed since the second half of 1995. Purchases of
durable goods other than motor vehicles also took off
in the first quarter, computers and other electronic
equipment were an area of notable strength, as house-
58
holds took advantage of rapidly falling prices to
acquire the latest technology. According to available
monthly data, purchases of durables other than motor
vehicles and electronic equipment moderated in the
second quarter. Although a pause in the growth of
spending is not surprising after the strong first quarter,
unusually cool spring weather, leading to the postponement of purchases of some seasonal items, may
also have contributed to the moderatioa
Growth of real spending for nondurables also
appears to have slowed considerably from a strong
first-quarter pace. Within services, weather conditions held down growth of real outlays for energy services in the first quarter and boosted them in the
second. Growth of real outlays for other services—
typically the steadiest component of consumptionpicked up at the end of 1996 and appears to have
stayed ahead of last year's 2Yz percent pace in the
first half of 1997.
Consumer spending continued to draw support
from healthy advances in income this year, as gains in
wages and salaries boosted personal disposable
income. These gains translated into a 4 percent annual
rate advance in real disposable income in the first
quarter, after a significant 23/4 percent advance last
year. Although month-to-month movements were affected by unevenness in the timing of tax payments,
the underlying trend in real disposable income
remained strong into the second quarter.
On top of rising incomes, further increases in net
worth—primarily related to the soaring stock
market—have given many households the financial
wherewithal to spend. In light of the very large gains
in wealth, the impetus to consumption appears to
have been smaller than might have been anticipated
on the basis of historical relationships, suggesting
that other factors may be offsetting the effect of
higher net worth. One such factor could be a greater
focus on retirement savings, particularly among the
large cohort of the population reaching middle age.
Concerns about the adequacy of saving for retirement have likely been heightened by increased public
discussion of the financial problems of social security and federal health programs. In addition, debt
problems may be restraining the spending of some
households.
Residential Investment The underlying pace
of housing activity has remained at a high level this
year, even though some indicators suggest that activity has edged off a bit from last year's pace. In the
single-family sector, housing starts through June aver-
Private Housing Starts
Millions of units, annual rate
1987
1989
1991
1993
1995
1997
aged 1.14 million units at an annual rate, a shade
below the pace of starts in 1996. Although starts
dipped in the second quarter, the decline was from a
first-quarter level that, doubtless, was boosted by mild
weather. Mortgage rates have zig-zagged moderately
this year, the average level has differed little from that
in 1996. With mortgage rates low and income growth
strong, a relatively large proportion of families has
been able to afford the monthly cost of purchasing
a home. Home sales have remained strong, helping
to keep inventories of unsold new units relatively
lean—a favorable factor for prospective building
activity. Other indicators of demand remain quite
positive. According to the latest survey by the
National Association of Homebuilders, builders'
ratings of new home sales strengthened in recent
months to the highest level since last August.
Moreover, consumers' assessments of conditions for
homebuying, as reported by the Survey Research
Center at the University of Michigan, remained very
favorable into July. In addition, the volume of applications for mortgages to purchase homes has moved
up recently to a high level.
The pace of multifamily starts has been well
maintained. These starts averaged close to 320,000
units at an annual rate from January to June, a little
above last year's figure for starts. Even so, the pace of
multifamily construction remains well below peaks in
the 1970s and 1980s, partly because of changes in the
nation's demographic composition as the bulge of
tenters in the 1980s has moved on to home ownership. Another factor that has restrained multifamily
construction is the growing popularity of manufactured housing ("mobile homes"), which provides an
alternative to rental housing for some households. In
particular, the price of a typical manufactured unit
59
is considerably less than that of a new single-family
house, making manufactured homes especially attractive to first-time buyers and to people purchasing
second houses or retirement homes. Shipments of
these homes trended up through last fall and then flattened out at a relatively high level.
Household Finance. Household balance sheets
strengthened in the aggregate during the first half of
1997, but debt-payment problems continued at a high
level in several market segments. Indebtedness grew
less rapidly than it had in 1996, and further gains in
equity markets pushed up the ratio of household net
worth to disposable personal income to its highest
mark in recent decades. Consumer credit increased at
a 6Vt percent annual rate between December 1996
and May 1997, compared with 814 percent in 1996.
The growth of mortgage debt was somewhat slower
in the first quarter than in 1996 and, according to
available indicators, probably stayed at roughly the
same rate during the second quarter.
15
i i i i i i i i i t
1982
1987
1997
1992
13
Note. Debt service » the estimated sum of required interest
and principal payments on consumer and household-sector mortgage debt.
Delinquency Rates on Household Loans
475
400
Quarterly
1995
The estimated ratio of required payments of loan
principal and interest to disposable personal income
remained high in the first quarter, after climbing
rapidly between early 1994 and early 1996 and rising more slowly in the second half of last year. This
measure of the debt-service burden of households has
nearly returned to the peak reached toward the end of
the last business cycle expansion. Adding estimated
payments on auto leases to households' scheduled
monthly debt payments boosts the ratio a little more
than 1 percentage point and places it just above its
previous peak.
16
425
500
1985
17
450
Percent of disposable personal income
Four-quarter moving average
1975
Percent of disposable personal income
Quarterly
Indicators of households' ability to service their
debt have been mixed. The delinquency rate for mortgage loans past due sixty days or more is at its lowest level in two decades, but delinquency rates for
consumer loans are relatively high. According to data
from the Report of Condition and Income filed by
banks (the Call Report), the delinquency rate for
credit card loans was roughly unchanged in the first
quarter of 1997, remaining at its highest value since
late 1992, when the economy was in the midst of a
sluggish recovery and the unemployment rate was
more than 2 percentage points higher than today. For
Household Net Worth
1965
Household Debt-Service Burden
1987
1989
1991
1993
1995
1997
Note. Data on credit-card delinquencies are from the CaH
Report; data on mortgage deinquencies are from the Mortgage
Bankers Association.
60
auto loans at the finance companies affiliated with the
major manufacturers, the delinquency rate rose again
in the first quarter, continuing the steady run-up in
this measure over the past three years.
Anecdotal evidence suggests that the recent
increases m consumer credit delinquency rates had
been partly anticipated by lenders, reflecting the
normal seasoning of loans as well as banks' efforts to
stimulate borrowing by making credit more broadly
available and automakers' attempts to stimulate sales
using the same approach. During the past several
years, lenders have aggressively sought business from
people who might not have been granted credit previously, in part because of lenders' confidence in
new "credit scoring" models that statistically evaluate an individual's credirworthiness. Despite these
new tools, banks evidently have been surprised by the
extent of the deterioration of their consumer loans
and have tightened lending standards as a result
Nearly half the banks responding to the Federal
Reserve's May survey on bank lending practices had
imposed more stringent standards for new credit card
accounts over the preceding three months, with a
smaller fraction reining in other consumer loans.
About one-third more of the responding banks
expected charge-off rates on consumer loans to
increase further over the remainder of the year than
expected charge-off rates to decrease; many of those
expecting an increase cited consumers' growing
willingness to declare bankruptcy. Rising delinquency
rates have also put pressure on firms specializing in
subprime auto loans, with some reporting reduced
profits and acute liquidity problems.
According to the most recently available data,
personal bankruptcies surged again in the first quarter
of the year after rising 30 percent in 19%. The rapid
increases of late are partly related to the same
increase in financial stress evident in the delinquency
statistics, but they may also be tied to more widespread use of bankruptcy as a means of dealing with
such stress. Changes in federal bankruptcy law effective at the start of 1995 increased the value of assets
that may be protected from liquidation, and there may
also be a secular trend toward less stigma being
associated with declaring bankruptcy.
sizable increases in cash flow, and a favorable cost of
capital, especially for high-tech equipment. To be
sure, a significant portion of this investment has been
required to update and replace depreciated plant and
equipment: nevertheless, the current pace of investment implies an appreciable expansion of the capital
stock.
Real outlays for producers' durable equipment
jumped at an annual rate of 123/4 percent in the first
quarter of this year after rising 93/t percent last year.
As in recent years, purchases of computers and
other information processing equipment contributed
importantly to this gaia The computer sector has
been propelled by declining prices of new and more
powerful products and by a drive in the business sector to improve efficiency with these latest technological developments. Real purchases of communications equipment also have been robust, boosted by
rapidly growing demand for wireless phone services
and Internet connections as well as by upgrades to
telephone switching and transmission equipment in
anticipation of eventual deregulation of local phone
markets. In addition, purchases of aircraft by domestic airlines moved higher on net in 1995 and 1996
and—on the basis of orders and production plans of
aircraft makers—are expected to rise considerably
further this year. For the second quarter, data on
orders and shipments of nondefense capital goods in
April and May imply that healthy increases in equipment investment have continued.
Real business spending for nonresidential structures posted another sizable increase in the first
quarter after advancing a hefty 9 percent in 1996.
Although the latest data suggest a slowing of the pace
Change in Real Business Fixed Investment
Percent annual rate
The Business Sector
Investment Expenditures. Following a fifth
year of sizable increases in 1996, real business fixed
investment rose at an annual rate of 11 percent in the
first quarter. The underlying determinants of investment spending remain solid: strong business sales,
1992
1993
1994
1995
1996
1997
61
of advance in the second quarter, the economic
factors underlying this sector point to continued
increases. Vacancy rates have been falling and rents
have been improving. Financing for commercial
construction reportedly is in abundant supply, especially with substantial amounts of capital flowing to
real estate investment trusts (REITs).
Trends in construction continue to differ among
sectors. Increases in office construction were especially robust in recent quarters, as vacancy rates fell
for both downtown and suburban properties. With
office-based employment expanding, this sector has
continued to recover from the severe slump of the late
1980s and early 1990s; even so. the level of construction activity is barely more than half that of the mid1980s. Construction of other commercial buildings
has increased steadily during the past five years, and
the gain in the first quarter of this year was sizable.
Since the current expansion began, the non-office
commercial sector has provided a large contribution
to overall construction spending. Industrial construction dropped back in the first quarter after jumping at
the end of last year, the trend for this sector has been
relatively flat on balance in recent years.
During 1996, investment in real nonfarm business
inventories was modest compared with the growth of
sales, and the year ended with lean inventories in
many sectors. In the first quarter of this year, businesses moved to rebuild stocks, and inventory investment picked up substantially. Outside of motor vehicles, stocks rose in the first quarter, with particularly
sizable increases coming from a continued ramp-up
in production of aircraft and from a restocking of
petroleum products during a period when prices
Change in Real Nonfarm Business Inventories
Percent annual rate
i
1992
i
i
i
i
1993 1994 1995 1996 1997
Before-Tax Profit Share of GDP
Percent
Nonfinancial corporations
12
i i i i i i i i i i i i i i
1987
1992
1982
1977
6
1997
Note. Profits from domestic operations with inventory valuation and capital consumption adjustments, dK/ided by gross
domestic product of the nonfinancial corporate sector.
eased. Nevertheless, with extraordinarily strong sales,
inventory-sales ratios still moved down further in
the major sectors. Available monthly data suggest
that vigorous inventory investment outside of motor
vehicles continued through mid-spring, as firms
responded to strength in current and prospective sales.
For motor vehicles, inventories moved up some in the
first quarter of this year, after strike-related reductions in the fourth quarter. In the second quarter, the
monthly pattern of motor vehicles stocks was
bounced around somewhat by strikes; cutting through
the noise, inventories of light vehicles still appear to
be in balance.
Corporate Profits and Business Finance.
The continued rapid advance of business investment
this year has been financed through both strong cash
flow and substantial borrowing at relatively favorable terms. Economic profits (book profits after
inventory valuation and capital consumption adjustments) in the first quarter were 7% percent higher
than a year earlier. For the nonfinancial sector,
domestic profits were more than 9 percent higher,
reaching their highest snare of those firms' domestic
output in the current expansion. Despite abundant
profits, the financing gap for these companies—the
excess of capital expenditures (including inventory
investment) over internally generated funds—has
widened somewhat since the middle of 1996. To fund
that gap, and the ongoing net retirement of equity
shares, nonfinancial corporations increased their debt
6V2 percent at an annual rate in the first quarter,
compared with 5V* percent during 1996.
62
External funding has remained readily available to
businesses on favorable terms. The spreads between
yields on investment-grade bonds and yields on
Treasury securities have stayed low since the beginning of the year, while the spreads on high-yield
bonds have declined further to historically narrow
levels. Price-earnings ratios are high, implying a
low cost of equity financing. Further, banks remain
accommodative lenders to businesses. According to
the Federal Reserve's most recent survey of business lending, the spreads between loan rates and
market rates have held about steady for borrowers of
all sizes, with rate spreads for large loans near the
lower end of the range seen over the past decade.
Moreover, surveys by the National Federation of
Independent Business indicate that small businesses
have not had difficulty obtaining credit.
Spreads Between Yields on
Private and Treasury Securities
Percent
Monthly
10
1987
1989
1991
1993
i i
1995
i i
1997
Note. Yield on Merrill Lynch Master II Index of high-yield bonds
is compared with that on a severvyear Treasury note; yield on
Moooys index of A-rated investment-grade bonds is compared
with that on a ten-year Treasury note.
Moreover, delinquency rates for business loans at
banks have stayed extremely low, as has the default
rate on speculative-grade debt.
The increase in the pace of business borrowing in
the first half of 1997 was widespread across sources
of finance. Nonfinancial corporations stepped up their
borrowing from banks. The outstanding commercial
paper of these corporations also increased on net from
December through June, after declining a little in
1996. Meanwhile, these businesses' net issuance of
long-term bonds in the first half of the year exceeded
last year's pace, with speculative-grade offerings
accounting for the highest share of gross issuance on
record.
At the same time, the pace of gross equity issuance by nonfinancial corporations dropped considerably in the first half of this year. In particular, the
market for initial public offerings has been cooler
than in 1996, despite some pickup of late; new issues
have been priced below the intended range more
often than above it, and first-day trading returns have
been relatively low. Net equity issuance has been
deeply negative again this year, as gross issuance has
been more than offset by retirements through share
repurchases and mergers. The bulk of merger activity in the 1980s involved share retirements financed
by borrowing, but the recent surge—which largely
involves friendly intra-industry mergers—has been
financed about equally through borrowing and stock
swaps. Structuring deals as stock swaps can reduce
shareholders' tax liabilities and enable the combined
firm to use a more advantageous method of financial accounting. The dollar value of nonfinancial
mergers in which the target firm was worth more than
a billion dollars set a record in 1996, and merger
activity appears to be on a very strong track this year
as well.
The Government Sector
The plentiful supply of credit probably stems from
several factors. Most banks are well positioned to
lend: Their profits are strong, races of return on equity
and on assets are high, and capital is ample. In addition, continued substantial inflows into stock and
high-yield bond mutual funds suggest that investors
may now perceive less risk in these areas or may be
more willing to accept risk. In fact, businesses generally are in very good financial condition, with the
estimated ratio of operating cash flow to interest
expense for the median nonfinancial corporation
remaining quite high in the first part of the year.
Federal. The federal budget deficit has come
down considerably in recent years and should
register another substantial decline this fiscal year.
Over the first eight months of fiscal year 1997—the
period October through May—the deficit in the unified budget was $65 billion, down $43 billion from
the comparable period of fiscal 1996. The recent
reduction in the deficit primarily reflected extremely
rapid growth of receipts for the second year in a
row, although a continuation of subdued growth in
outlays also contributed to the improvement. Given
recent developments, the budget deficit as a share
63
of nominal GDP this fiscal year is likely to be at its
lowest level since 1974.
Federal receipts were almost 8l/2 percent higher in
the first eight months of fiscal year 1997 than in the
year-earlier period and apparently are on track to
outpace the growth of nominal GDP for the fifth
year in a row. Individual income tax payments have
risen sharply this fiscal year—on top of a hefty
increase last year—reflecting strong increases in
households' taxable labor and capital income;
preliminary data from the Daily Treasury Statement
indicate that individual income tax revenues remained
strong in June. Moreover, corporate tax payments
posted another sizable advance through May of this
fiscal year.
Federal outlays during the first eight months of
the fiscal year rose 3l/z percent in nominal terms
from the comparable period last year. Although this
increase is up from the restrained rate of growth in
fiscal 1996—which was held down by the government shutdown—spending growth remained subdued across most catgones. Outlays for income
security programs rose modestly in the first eight
months of the fiscal year, partly as a result of the
continued strong economy, and spending on the
major health programs grew somewhat more slowly
than their average pace in recent years. Although
still restrained, outlays for defense have ticked up
this fiscal year after trending down for several
years.
Change in Real Federal Expenditures
on Consumption and Investment
As for the part of federal spending that is included
directly in GDP. real federal expenditures on consumption and gross investment declined 3V4 percent
in the first quarter of 1997. a shade more than the
average rate of decline in recent years. An increase in
real nondefense spending was more than offset by a
decline in real defense outlays.
The substantial drop in the unified budget deficit
reduced federal borrowing in the first half of 1997
compared with the first half of 1996. The Treasury
responded to the smaller-than-expected borrowing
need by reducing sales of bills: this traditional
strategy of allowing borrowing swings to be absorbed
primarily by variation in bill issuance enables the
Treasury to have predictable coupon auctions and
to issue sufficient quantities of coupon securities to
maintain their liquidity. The result this past spring
was an unusually large net redemption of bills, which
pushed yields on short-term bills down relative to
yields on other Treasury securities and on shortterm private paper.
The issuance of inflation-indexed securities at
several maturities has been a major innovation in federal debt management this year. The Treasury sold
indexed ten-year notes in January and April and
added five-year notes earlier this month. A small
number of agency and other borrowers issued their
own inflation-indexed debt immediately after the first
Treasury auction, and the Chicago Board of Trade
recently introduced futures and options contracts
based on inflation-indexed securities. As one would
expect at this stage, however, the market for indexed
debt has not yet fully matured: Trading volume as a
share of the outstanding amount is much smaller than
for nominal debt, and a market for stripped securities has yet to emerge.
Percent. Q4 to Q4
10
1992
1993
1994
1995
1996
1997
Note. Value for 1997:01 » a quarterly percent change at an
annual rate.
State and Local. The fiscal condition of state and
local governments has remained positive over the
past year, as the surplus of receipts over current
expenditures has been stable at a relatively high level.
Strong growth in sales and incomes has led to robust
growth in revenues, despite numerous small tax cuts,
and many states have held the line on spending in the
past several years. Additionally, the welfare reform
legislation passed in August 1996, while presenting
long-term challenges to state and local governments,
actually has eased fiscal pressures in recent quarters:
Block grants to states are based largely on 1992-94
grant levels, but caseloads more recently have been
falling. Overall, at the state level, accumulated
surpluses—current surpluses plus those from past
years—were on track to end fiscal year 1997 at a
64
Change in Real State and Local Expenditures
on Consumption and Investment
Percent, Q4 to Q4
The pace of gross issuance of state and local debt
was roughly the same in the first half of the year as in
1996. Net issuance turned up noticeably, however, as
retirements of debt that had been pre-refunded in the
early 1990s waned.
The External Sector
1992
1993
1994
1995
1996
1997
Note. Value for 1997:Q1 '» a quarterly percent change at an
annual rate.
healthy level, according to a survey by the National
Association of State Budget Officers taken shortly
before the end of most states' fiscal years.
Real expenditures for consumption and gross
investment by state and local governments increased
moderately in the first quarter of this year, about the
same as the pace of advance in the past two years. For
construction, the average level of real outlays during the first five months of the year was a little higher
than in the fourth quarter. Hiring by state and local
governments over the first half of the year was
somewhat above last year's pace, with most of the
increase at the local level.
U.S. Current Account
Billions of dollars, annual rate
1992
1993
1994
1995
1996
1997
Trade and the Current Account The nominal
deficit on trade in goods and services was $116 billion at an annual rate in the first quarter, somewhat
larger than the $105 billion in the fourth quarter
of last year. The current account deficit of $164 billion (annual rate) in the first quarter exceeded the
$148 billion deficit for 1996 as a whole because
of the widening of the trade deficit and further
declines in net investment income. In April and May,
the trade deficit was slightly narrower than in the
first quarter.
Change in Real Imports and Exports
of Goods and Services
Percent, Q4 to Q4
[] Imports
| Exports
Q1
Uka
20
10
1992
1993
1994
1995
1996
1997
Note. Value for 1997:Q1 is a quarterly percent change at an
annual rate.
The quantity of U.S. imports of goods and services surged in the first quarter at an annual rate of
about 20 percent Continued strength in the pace of
US. economic activity largely accounted for the rapid
growth, but a rebound in automotive imports from
Canada from their strike-depressed fourth-quarter
level boosted imports as well. Preliminary data for
April and May suggest that strong real import growth
continued. Non-oil import prices fell through the
second quarter, extending the generally downward
trend that began in mid-1995.
65
The quantity of US. exports of goods and services expanded at an annual rate a bit above
10 percent in the first quarter, about the same rapid
pace as during the second half of last year. Growth of
output in our major trading partners, particularly the
industrial countries, helped to sustain the growth of
exports, as did increased deliveries of civilian aircraft.
Exports to western Europe and to Canada grew
strongly while those to the Asian developing
countries declined somewhat. Preliminary data for
April and May suggest that real exports rose
moderately.
Capital Flows. Large gross capital inflows and
outflows continued during the first quarter of 1997.
reflecting the continued trend toward globalization of
financial and product markets. Both foreign direct
investment in the United States and US. direct investment abroad were very strong, swelled by mergers
and acquisitions.
Private foreign net purchases of U.S. securities
amounted to S85 billion in the first quarter, down
somewhat from the very high figure in the previous
quarter but still above the record pace for 1996 as a
whole. Net purchases of US. Treasury securities were
particularly robust. Private foreigners also showed
increased interest in the US. stock market in the first
quarter of 1997. US. net purchase of foreign securities amounted to $15 billion in the first quarter, down
from the strong pace of 1996. Private foreigners
continued to add to their holdings of US. paper currency in the first quarter, but at a rate substantially
below earlier peaks.
Foreign official assets in the United States, which
rose a record $122 billion in 1996, increased another
$28 billion in the first quarter of 1997. Apart from
the oil-producing countries, which benefited from
high oil prices, significant increases in holdings were
associated with efforts by some emerging-market
countries to temper the impact of large private capital
inflows on their economies. Information for April and
May suggests that official inflows have abated.
Foreign Economies. Economic activity in the
major foreign industrial countries has generally
strengthened so far this year from the pace in the
second half of last year. In Japaa real GDP accelerated to a 6Vz percent annual growth rate in the first
quarter, boosted by extremely strong growth of
consumer spending ahead of an increase in the
consumption tax on April l. Activity appears to have
fallen in the second quarter, but continued improvement in business sentiment suggests that the current
weakness is only temporary. In Canada, growth of
teal output increased to 3l/z percent at an annual rate
in the first quarter. Final domestic demand more than
accounted for this expansion, as business investment, consumption, and residential construction all
provided significant contributions. Indicators suggest
that output growth remained healthy in the second
quarter.
Economic activity has remained vigorous so far
this year in the United Kingdom and appears to have
strengthened in Germany and France. In the first
quarter. U.K. real GDP grew at an annual rate of
3¥z percent as domestic demand, particularly investment, accelerated from its already strong pace in the
fourth quarter. Strong household consumption spending supported demand in the second quarter. Weak
demand for exports, associated with the appreciation
of the pound since mid-1996, and some tightening of
monetary conditions should moderate growth in the
current quarter. In Germany, economic expansion
revived in the first quarter and appears to have finned
in the second quarter. After growing very little in the
fourth quarter of last year, German real GDP rose at
an annual rate of 13A percent in the first quarter, led
by government consumption, equipment investment,
and exports. Manufacturing orders and indicators
of business sentiment suggest additional gains in
the second quarter. French real GDP grew only threequarters percent at an annual rate in the first quarter,
as declines in investment offset strong export growth,
but data on manufacturing output and consumption
suggest a pick up in activity during the second
quarter.
In most major Latin American countries, real
output growth remained vigorous. In Mexico, real
economic expansion slowed some in the first quarter
from its very rapid pace in the second half of last year
but remained robust. The industrial sector continued
to be the source of strength, while the service sector
lagged. A pickup in import growth has resulted in a
narrowing of the trade surplus; through May, the trade
balance of $134 billion was about half the size it was
in the same period last year. In Argentina, continued
healthy economic growth in the first quarter has
brought real GDP back to its level before the recession induced by the Mexican crisis of 1995. In Brazil,
real output declined in the first quarter after three
quarters of strong expansion.
Economic growth in our major Asian trading
partners other than Japan slowed a bit on average in
the first quarter but appears to have rebounded in the
second quarter. Nationwide labor strikes in Korea
66
affected many of the country's key export industries
and were partly responsible for weakness in firstquarter output and a ballooning of the current account
deficit. Data for April and May show recovery in
industrial production, and the trade balance improved
in the second quarter. Real output growth in Taiwan
remains strong so far this year, though not quite so
vigorous as during the second half of 1996. In China,
real GDP continues to expand at an annual rate of
nearly 10 percent, about the same brisk pace as last
year.
Despite the pickup in growth, considerable excess
capacity remains in the major foreign industrial
countries. As a consequence, inflation has generally
remained quiescent. The increase in the Japanese
consumption tax lifted the twelve-month change in
the consumer price index to about 1V2 percent, but
elevation of the inflation rate should be temporary.
CPI inflation remains less than 2 percent in Germany,
France. Canada, and Italy. Only in the United Kingdom, where output growth has resulted in tight labor
markets and consumer prices are rising at an annual
rate of more than 2Vz percent, are inflation pressures currently a concern.
In most major countries in Latin America, inflation either is falling or is already low. Mexican inflation continues to improve: The monthly inflation
rate was below 1 percent in May and June, the
lowest monthly rates since the 1994 devaluation.
In Argentina, consumer prices were essentially flat
through the second quarter after almost no increase
last year. Brazilian inflation has declined to historically low rates. In contrast, Venezuelan inflation,
though it has come down from its 1996 rate of more
than 100 percent per year, remains near 50 percent.
Consumer price inflation remains generally low in
Asia, including in China, where it fell to less than
3 percent in the twelve months through May.
Net Change in Payroll Employment
Thousands of jobs, average monthly change
Total nonfarm
400
200
200
1992
1993
1994
1995
1996
1997
Employment gains in the private serviceproducing sector, in which nearly two-thirds of all
nonfarm workers are employed, accounted for much
of the expansion in payrolls through June of this year.
Within this sector, higher employment in services,
transportation, and retail trade contributed importantly to the gain. After advancing substantially for
several years, payrolls in the personnel supply
industry—a category that includes temporary help
agencies—actually turned down in the second
quarter: anecdotal reports suggest that some
temporary help firms are having difficulty finding
workers, especially for highly skilled and technical
positions.
Civilian Unemployment Rate
Percent
The Labor Market
Payroll employment continued to expand solidly
during the first half of 1997. The growth in nonfarm
payrolls averaged about 230,000 per month; this
figure may overstate slightly the underlying rate of
employment growth in the first half because technical factors boosted payroll figures in April. The
strength in labor demand drew additional people into
the job market, raising the labor force participation
rate to historical highs during the first half. Nevertheless, the civilian unemployment rate moved down to
4.9 percent, on average, in the second quarter.
i
1987
1989
1991
1993
1995
1997
Note. The break in data at January 1984 maifcs (he introduction of a redesigned survey; the data from that point on are not
dhectty comparable with the data of earlier periods.
67
Employment gains were also posted in the goodsproducing sector. In the construction industry, payrolls increased substantially between December and
June. Factory employment moved somewhat higher
in the first pan of the year after declining a little
during 1996, and manufacturing overtime hours
remained at a high level. Producers of durable goods
increased employment further between December and
June, while makers of nondurable goods continued
to reduce payrolls. Since the end of 1994, factory
employment and total hours worked in manufacturing have changed little. Even so, manufacturers have
boosted output considerably over this period, primarily through ongoing improvements in worker
productivity.
Although productivity for the broader nonfarm
business sector rose substantially in the first quarter, it
was just 1 percent above its value a year earlier.
Moreover, output per hour changed little from the end
of 1992 to the last quarter of 1995. The average rate
of measured productivity growth in the 1990s is still
somewhat below that of the 1980s and is even further
below the average gains realized in the twenty-five
years after World War II. The slower reported productivity growth during this expansion could partly
reflect measurement problems. Productivity is the
ratio of real output to hours worked, and official
productivity indexes rely on a measure of teal output
based on expenditures. In theory, a matching measure
of real output should be derivable by summing labor
and capital inputs on the "income side" of the
national accounts. However, the income-side measure
Change in Output per Hour,
Nonfarm Business Sector
Percent Q4 to 04
ll
Q1
t
1990
1992
i
1994
l
l
1996
Note. Vekie for 1907:01 fe the percent change from 1996:01
to 1997:01.
of real output has increased considerably faster than
the expenditure-side measure in recent years, raising
the possibility that productivity growth has been
somewhat better than reported in the official indexes.
Measurement difficulties may also affect estimates
of the longer-term trajectory of productivity growth.
In particular, if inflation were overstated by official
measures—as a considerable amount of recent
research suggests it is—then real output growth
would be understated. This understatement would
arise because too much inflation would be removed
from nominal output growth in the calculation of
real output growth. Indeed, productivity growth for
nonfinancial corporations—a sector for which output
growth arguably is measured more accurately than
in broader sectors—has been more rapid than for
nonfarm business overall. In particular, productivity
for nonfinancial corporations increased at an average annual pace of about ivi percent between 1990
and 1996, while productivity in the nonfarm business sector rose a little less than 1 percent per
year over the same period. This difference—which
implies very weak measured productivity growth
outside of the nonfinancial corporate sector—raises
the possibility that overall productivity growth is
stronger than indicated by official indexes for
nonfarm business.1 Of course, a critical—and still
unanswered—question is the extent to which any
understatement of productivity growth has become
larger over time. If productivity growth were more
rapid than indicated by official statistics, then the
economy's capacity to produce goods and services
would be increasing faster than indicated by current
official statistics. But if the amount of mismeasurement has not increased over time, then the economy's
productive capacity also increased more rapidly
in earlier years than shown by published measures.
In this case, the official statistics on productivity
growth—though perhaps understated—would not
give a misleading impression about changes in productivity trends.
After changing little, on net, since the late 1980s,
the labor force participation rate turned up early
last year, it reached a record high 67.3 percent in
March of this year and remained at an elevated
67.1 percent in the second quarter. Better employment opportunities have drawn additional people into
the workforce. Although the recent welfare reform
1. Mote detail is provided in • paper by Lawrence Slifinu end
Carol Conado. "Decomposition of Productivity end Unit Costs,"
Board of Governed of the Federal Reserve System. November 18,
1996.
68
Labor Force Participation Rate
63
60
I I I I I 1 I I I I I I I I I I I 1 I I I I I I I I I M
1972
1977
1982
1987
1992
57
1997
Note. Data before 1994 have been adjusted for the redesign of
the household survey.
legislation probably has not yet had a large effect on
aggregate labor force dynamics, it may generate an
additional, albeit small, boost to labor force participation rates over the next few years. Since the beginning of 1996, the increases in the labor force associated with a higher participation rate have eased
pressures on labor markets, as additional workers
have stepped in to satisfy continuing strong demand
for labor. Nevertheless, hiring was sufficiently brisk
during the first half of this year to pull the unemployment rate down about one-quarter percentage point
between December and June.
Just as the low unemployment rate points to tightness in labor markets, anecdotal reports from many
Change in Employment Cost Index
Percent, Dec. to Dec.
Hourly compensation
Q1
1990
1992
Illi
1994
1996
Note. Data are for private industry, excluding farm and household workers. The value for 1997:Q1 is measured from March
1996 to March 1997.
regions and industries mention the difficulties firms
are having hiring workers, especially workers with
specialized skills. With this tightness, labor compensation costs have accelerated slightly. Although
hourly labor costs, as measured by the employment
cost index (ECI). increased only 2.5 percent at an
annual rate during the first three months of this year,
they were up 3.0 percent over the twelve months
ended in March, compared with 2.7 percent over
the preceding twelve months. These increases are
smaller than might have been expected based on
historical relationships, perhaps partly reflecting
persistent worker concerns about job security. In
addition, modest increases in employer-paid benefits
have partly offset faster increases in wages and
salaries in the past couple of years. With smaller
increases in health care costs than earlier in the
decade, shifts of employees into managed care plans,
and requirements that employees assume a greater
share of health care costs, employer costs for healthrelated benefits have been well contained. However,
growth in employer health care costs may be in the
process of bottoming out, as reports of rising
premiums for health insurance have become more
common. Moreover, the wages and salaries component of the ECI has continued to accelerate, rising 3.4 percent during the twelve months ending in
March 1997, about one-quarter percentage point
faster than during the previous twelve months and
roughly half a percentage point faster than in 1994
and 1995.
Prices
The underlying trend of price inflation has
remained favorable this year. In particular, the CPI
excluding food and energy—often referred to as
the "core" CPI—increased at an annual rate of
2l/2 percent over the first two quarters of the year,
about the same pace as in 1996. The overall CPI
registered a smaller increase than the core CPI during the first half of this year. Boih the overall CPI and
the core CPI have been affected by a series of technical changes implemented by the Bureau of Labor
Statistics over the past two and one-half years to
obtain a more accurate measure of price changes. If
not for these changes, increases in the CPI since 1994
would be marginally larger.
Other measures of prices also suggest that favorable inflation trends continued into 1997. Measured
from the first quarter of last year to the first quarter of
this year, the chain price index for personal consumption expenditures excluding food and energy rose
69
Change in Consumer Prices Excluding
Food and Energy
Percent, Q4 to Q4
and reduce unit costs, upward pressure on prices may
be reduced. Finally, an extended period of relatively
low and steady inflation has reinforced a belief
among households and businesses that the trend of
inflation should remain muted, and consequently
helped to hold down inflation expectations.
Change in Consumer Prices
Percent. Q4 to Q4
1990
lllM
1992
1994
1996
Note. Consumer price index (or all urban consumers. Value for
1997:H1 is the percent change from 1996:04 to 1997:02 at an
annual rate.
2 percent, the same as in the four-quarter period a
year earlier.2 Similarly, the chain price index for
overall GDP—which covers prices of all goods and
services produced in the United States—and the chain
measure for gross domestic purchases—which covers prices of all goods purchased in the United
States—increased the same amount over the year ending in the first quarter of 1997 as during the previous four quarters.
All of these price measures indicate that inflation
remains muted, despite high levels of resource utilization. Several factors have contributed to the recent
favorable performance of price inflation. Energy
prices have declined this year. Non-oil import prices
also have fallen significantly, reducing input costs for
some domestic companies and likely restraining the
prices charged by domestic businesses that compete
with foreign producers. Besides being restrained
by some price competition from imported materials
and supplies, prices of manufactured goods at earlier
stages of processing have been held in check by an
expansion of industrial capacity that has been rapid
enough to restrain increases in utilization rates over
the past year. Also, to the extent that firms have succeeded in their efforts to realize large efficiency gains
2. The price measure for personal consumption expenditures
(PCE) is closely related to the CPI because components of the CPI
are key inputs in the construction of the PCE price measure.
Nevertheless, the PCE price measure has the advantage that by
using chain weighting rather than fixed weights it avoids some of
the substitution bias that affects the CPI.
Mini
1990
1992
1994
1996
Note. Consumer price index for all urban consumers. Value for
1997:H1 is the percent change from 1996:Q4 to 1997:Q2 at an
annual rate.
Developments in the food and energy sectors were
favorable to consumers in the first half of 1997.
Consumer energy prices declined in the first half of
the year as the price of crude oil dropped back following last year's run-up. In 1996, the price of crude
oil was boosted by refinery disruptions, uncertainty
about the timing of Iraqi oil sales, and unusual
weather patterns that increased energy demand for
heating and cooling. As these factors receded this
year, crude oil prices fell. Although the downward
trend was interrupted by some transitory spikes in
prices—as in May when tensions in the Middle East
flared up—the price of crude is now roughly back to
the range that prevailed before last year's run-up.
Since December, gasoline prices have tumbled more
than 16 percent at an annual rate, and heating oil
prices have fallen significantly. Natural gas prices
also fell as stocks, which had dwindled over the
winter, were replenished. Reflecting the declines in
fuel prices, the CPI for energy fell about 9 percent at
an annual rate between December 1996 and June
1997.
Consumer food prices increased at an annual rate
of only about 1 percent in the first half of the year.
70
Alternative Measures of Price Change
Percent
1995:Q1
to
1996:Q1
1996-.Q1
to
1997:Q1
Fixed weight
Consumer price index
Excluding food and energy
2.7
2.9
2.9
2.5
Chain type
Personal consumption expenditures
Excluding food and energy
Gross domestic purchases
Gross domestic product
2.0
2.0
2.2
2.2
2.5
2.0
2.2
2.2
2.1
1.8
Price measure
Deflator
Gross domestic product
Note. Changes are based on quarterly averages.
Although coffee prices jumped, the prices of many
other food items were flat or edged lower. Most
notably, declines in grain prices that began in mid1996 have been working their way to the retail level
and have held down prices for a variety of graindependent foods, such as beef, poultry, and dairy
products. Prices of foods that depend more heavily on
labor costs have been rising modestly this year.
Consumer prices for goods other than food and
energy rose a restrained three-quarters percent at an
annual rate between December and June of this year,
a touch below last year's pace. Declining prices for
non-oil imports helped contain prices of goods in the
CPI in the first half of the year, in part by constraining U.S. businesses in competition with importers.
For example, prices of new and used passenger cars
declined in the first six months of the year, and prices
of light trucks were essentially flat. Also, prices of
house furnishings were about unchanged, on balance, in the first half of the year, although apparel
prices moved up after declining in recent years.
The CPI for non-energy services rose about
3 percent at an annual rate between December and
June, a touch below last year's pace. After rising
markedly last year, airfares declined, on net, in the
first half of this year. Fares fell substantially early in
the year when the excise tax on tickets expired, and
even with the reimposition of the tax in March, ticket
prices were still lower in June than in December.
Increases in prices of medical services also continued
to slow somewhat this year.3 In addition, the CPI for
auto finance fell in May and June as automakers
sweetened incentives. In contrast, price increases in
the first half of the year picked up in some other
areas; shelter prices rose a bit more rapidly than
last year, as did tuition and prices for personal care
services.
Credit and the Monetary Aggregates
Credit and Depository Intermediation. The
total debt of domestic nonnnanciaJ sectors increased
at an annual rate of about 4V* percent from the fourth
quarter of 1996 through May of this year, placing the
aggregate near the middle of the range for 1997
established by the FOMC. This pace is more than half
a percentage point below that for 1996, reflecting
significantly slower growth of borrowing by the federal government. The total debt of the other sectors
has risen at a roughly constant pace over the past few
years, even though the growth rate of nominal output
has been increasing.
eda
3. In January 1997, the Bureau of Labor Su
e of the prices of hospital services—which account for
roughly one-third of the CPI for medical services—and this new
measure should, over time, provide a more accurate gauge of price
movements in this area.
71
Debt: Annual Range and Actual Level
Billions of dollars
Domestic nonfinanaal sectors
15,200
15,000
14,800
14,600
O
N
0
1996
M
A
14,400
1997
Credit on the books of depository institutions rose
more rapidly than total debt in the first half of 1997,
indicating that their share of total debt outstanding
increased. Credit growth at thrift institutions eased
late last year and early this year after increasing
moderately in the first three quarters of 1996. However, commercial bank credit grew at a brisk pace in
the first half of the year, with both securities and loans
increasing more rapidly than they did last year. Real
estate lending at banks rose about 9 percent at an
annual rate between the fourth quarter of 1996 and
June of this year, compared with 4 percent in 1996. In
contrast, outstanding home mortgages at thrift institutions grew litde in the first part of the year after a
large run-up in 19%. Home equity credit lines from
banks expanded especially rapidly in the spring, as
some banks promoted these loans as a substitute for
consumer loans. The growth of consumer loans at
banks (including loans that were securitized as well
as loans still on banks' books) fell from about
11 percent in 1996 to 3V* percent at an annual rate
between the fourth quarter of 1996 and June of this
year.
The Monetary Aggregates. Growth of the
monetary aggregates during the first half of 1997 was
similar to growth in 1996. Between the fourth quarter
of last year and June, M2 expanded at an annual rate
of almost 5 percent; as the Committee had anticipated, the aggregate was running close to the upper
bound of its growth cone, which had been chosen to
be consistent with price stability. The behavior of M2
over this period can be reasonably well explained by
changes in nominal GDP and interest rates, using
historical velocity relationships. In the first quarter.
the velocity of M2 (defined as the ratio of nominal
GDP to M2) increased a little more than might have
been anticipated from its recent relationship to the
opportunity cost of holding M2—the interest earnings forgone by owning M2 assets rather than market
instruments such as Treasury bills. M2 may have
been held down a bit by savers' preferences for equity
market funds, for which inflows were quite strong.
Growth of M2 was much slower in the second quarter
than in the first quarter (4Vi percent compared with
6 percent at an annual rate), consistent with the slowing of the economy and almost unchanged M2
opportunity cost. The monthly pattern of M2 growth
in the second quarter was heavily influenced by
unusually high individual non-withheld tax payments. M2 surged in April, as households apparently accumulated additional liquid balances in order
to make the larger tax payments, and was about
unchanged on a seasonally adjusted basis in May as
payments cleared and balances returned to normal.
M2: Annual Range and Actual Level
Billions of dollars
3,950
3,900
3,850
3,800
O
N
1996
O
J
F
M
A
M
J
3,750
1997
The correspondence between changes in M2 velocity and in opportunity cost during recent years may
represent a return to the roughly stable relationship
observed for several decades until 1990—albeit at
a higher level of velocity. The relationship was
disturbed in the early 1990s by households' apparent decisions to shift funds out of lower-yielding
deposits into higher-yielding stock and bond mutual
funds. On one hand, the "credit crunch" at banks and
the resolution of troubled thrifts curbed the eagerness of these institutions to attract retail deposits,
holding down the rates of return offered on brokered
deposits and similar accounts relative to the average
72
deposit rates used in constructing measures of
opportunity cost. At the same time, the appeal of
longer-term assets was enhanced temporarily by the
steeply sloped yield curve and more permanently by
the greater variety and lower cost of mutual fund
products available to investors. More recently, robust
inflows into stock funds apparently have substituted
to only a limited extent for holdings of M2 assets, and
M2 velocity and opportunity cost have again been
moving roughly together since mid-1994. although
velocity has continued to drift up slightly. However,
the period of renewed stability in the behavior of
M2—three years—is still fairly short, and whether
the stability will persist is unclear. Variations in
opportunity cost and income growth during this
period have been rather small, leaving considerable
doubt about how M2 would respond to more
significant changes in the financial and economic
environment.
M2 Velocity and the Opportunity Cost
of Holding M2
Ratio
Percentage points, ratio scale
Quarterly
2.0
1.9
1.8
1.7
1.6
1978
1982
1986
1990
1994
Note. M2 opportunity cost is a two-quarter moving average of
the three-month Treasury bill rate less the weighted average rate
paid on M2 components.
M3 rose about 7 percent at an annual rate between
the fourth quarter of 1996 and June of this year. This
pace is a little faster than last year's and again left M3
above the upper end of its growth cone, which, like
the growth cone for M2, was set to be consistent with
price stability. Large time deposits, which are not
included in M2. continued to increase much more
rapidly than other deposits. Banks have been funding their asset growth disproportionately through
wholesale deposits, leaving interest rates on retail
deposits further below market rates than they have
M3: Annual Range and Actual Level
Billions of dollars
5,100
5,000
2%
4,900
O
N
1996
0
M
A
4,800
1997
been historically. Growth of institution-only money
market funds eased just a little from last year's torrid
pace, as the role of these funds in corporate cash
management continued to increase.
Ml contracted at a 2'/2 percent annual rate between
the fourth quarter of 1996 and June of this year.
Growth of this aggregate was again depressed by the
spread of so-called sweep programs, whereby balances in transactions accounts, which are subject
to reserve requirements, are "swept" into savings
accounts, which are not. Sweep programs benefit
depositories by reducing their required holdings of
reserves, which cam no interest. At the same time,
they do not restrict depositors' access to their funds
for transactions purposes, because the funds are swept
back into transactions accounts when needed. Until
late last year, most retail sweep programs were
limited to NOW accounts, but demand-deposit
sweeps have expanded markedly since then. Adjusted
for the estimated total of balances swept owing to the
introduction of new sweep programs. Ml expanded at
a 434 percent annual rate between the fourth quarter
of 1996 and June 1997, a little below its sweepadjusted growth rate in 1996.
The drop in the amount of deposits held in transactions accounts in the first half of 1997 caused required
reserves to fall about 10 percent at an annual rate,
close to the rate of decline last year. Nonetheless, the
monetary base has expanded at a moderate pace so far
in 1997, because the runoff in required reserves has
been more than offset—as it was also last year—by
an increase in the demand for currency. Currency
growth has been a little higher this year than last, as
the effects of strong domestic spending more than
73
Growth of Money and Debt
Percent
Period
M1
M2
M3
Domestic
nonfinancial
debt
Annual*
1987
1988
1989
6.3
4.3
0.5
4.2
5.7
5.2
5.8
6.3
4.0
1990
1991
1992
1993
1994
4.1
7.9
2.5
4.1
3.1
1.8
1.3
0.6
1.8
1.2
0.6
1.1
1.7
52
52
-1.6
-4.6
4.0
4.7
6.2
6.8
5.5
5.4
-0.7
-5.4
6.1
4.3
8.2
6.8
4.5
-2.6
4.9
7.1
4.8
14.4
10.6
1995
1996
10.0
9.0
7.9
6.9
4.6
4.7
Quarterly
(annual rate)2
1997
Q1
02
n.a.
Year-to-date3
1997
1. From average for fourth quarter of preceding year to
average for fourth quarter of year indicated.
2. From average for preceding quarter to average for
quarter indicated
3. From average for fourth quarter of 1996 to average for
June (May in the case of domestic nonfinancial debt).
offset a slight drop in net shipments of US. currency abroad in the first four months of the year.
ances would become more linked to banks' desire to
avoid overnight overdrafts when conducting transactions through their accounts at Reserve Banks.
Demand from this source is mote variable than is
requirement-related demand, and it also cannot be
substituted across days: both factors would tend, all
else equal, to increase the volatility of the federal
funds rate.
Further reductions in required reserves have the
potential to diminish the Federal Reserve's ability to
control the federal funds rate closely on a day-today basis. Traditionally, the daily demand for balances at the Federal Reserve largely reflected banks'
needs for required reserves, which are fairly predictable. As a result, the Federal Reserve has generally
been able to supply the quantity of balances that satisfies this demand at the intended funds rate. Moreover,
reserve requirements are specified in terms of an
average level of balances over a two-week period, so
if the funds rate on a particular day moves above the
level expected to prevail on ensuing days, banks can
trim their balances and thereby relieve some of the
upward pressure on the funds rate. If required
reserves were to fall quite low. the demand for bal-
The decline in required reserves over the past
several years has not created serious problems in the
federal funds market, but funds-rate volatility has
risen a little, and the risk of much greater volatility
would increase if required reserves were to fall
substantially further. One factor mitigating an
increase in funds-rate volatility has been an increase
in required clearing balances. These balances, which
banks can precommit to hold on a two-week average basis, earn credits that banks use to pay for Fed-
74
eral Reserve priced services. Like required reserve
balances, required clearing balances are predictable
by the Federal Reserve and can be substituted across
days within the two-week maintenance period. Fundsrate volatility has also been damped by banks1
improved management of their balances at Reserve
Banks, which in part reflects the improved real-time
access to account information now provided by
the Federal Reserve. Whether these factors could
continue to restrain funds-rate volatility if required
reserve balances were to become much smaller is as
yet unclear. Also unclear is whether a moderate
increase in funds-rate volatility would have any serious adverse consequences for interest rates farther out
on the yield curve or for the macroeconomy. The Federal Reserve continues to monitor the situation
closely.
Interest Rates, Equity Prices, and
Exchange Rates
Interest Rates. Interest rates on Treasury securities were little changed or declined a bit, on balance, between the end of 19% and mid-July. Yields
rose substantially in the first quarter as evidence
mounted that the robust economic activity observed
in the closing months of 1996 had continued into
1997. By the time of the March FOMC meeting, most
participants in financial markets were anticipating
some tightening of monetary policy, and rates moved
little when the increase in the intended federal funds
rate was announced. Beginning in late April, key data
pointed to continued low inflation and a slowing of
Selected Treasury Rates
Quarterly
15
Thirty-year
bond
1965
1975
1985
10
1995
Note. The twenty-year Treasury bond rate is shown until the
first issuance of the thirty-year Treasury bond, in the first quarter
o»1977.
economic growth in the second quarter, and interest
rates retraced their earlier advance.
The yield on the inflation-indexed ten-year
Treasury note was little changed between mid-April
and mid-July, suggesting that at least part of the
roughly 60-basis-point drop in the nominal ten-year
yield over that period reflected a reduction in
expected inflation or in uncertainty about future inflation, or both. Yet, relative movements in these two
yields should be interpreted carefully, as the market's
experience in trading indexed debt is relatively brief,
making its prices potentially vulnerable to small shifts
in market sentiment. Moreover, the Treasury announced this spring a reduction in the frequency of
nominal ten-year note auctions, perhaps putting downward pressure on their nominal yields, and some investors may have paid renewed attention to upcoming
technical adjustments to the CPI. which will reduce
measured inflation. Survey-based measures of expected
inflation showed little change in the second quarter.
The interest rate on the three-month Treasury bill
was held down in recent months by the reduced supply of bills associated with the smaller federal deficit
Between mid-March and mid-July, the spread
between the federal funds rate and the three-month
yield averaged about 15 basis points above the average spread in 1996. Interest rates on private shortterm instruments increased a little in the second
quarter after the small System tightening in March.
Equity Prices. Equity markets have advanced
dramatically again this year. Through mid-July, most
broad measures of US. stock prices had climbed
between 20 percent and 25 percent since year-end.
Stocks began the year strongly, with the major
indexes reaching then-record levels in late January or February. Significant selloffs ensued, partly
occasioned by the backup in interest rates, and by
early April the NASDAQ index was well below its
year-end mark and the SAP 500 composite index was
barely above its. Equity prices began rebounding in
late April, however, soon pushing these indexes to
new highs. Stock prices have been somewhat more
volatile this year than last.
The run-up in stock prices in the spring was
bolstered by unexpectedly strong corporate profits for
the first quarter. Still, the ratio of prices in the
SAP 500 to consensus estimates of earnings over the
coming twelve months has risen further from levels
that were already unusually high. Changes in this
ratio have often been inversely related to changes in
long-term Treasury yields, but this year's stock price
75
Major Stock Price Indexes
Index (December 31. 1996=100)
J F M A M J
J A S O N D J F M A M J J
1996
Exchange Rates. The weighted average foreign exchange value of the dollar in terms of the other
G-10 currencies rose sharply in the first quarter from
its level in December and has moved up somewhat
further since then. On balance, the nominal dollar
is more than 10 percent above its level at the end
of December. A broader measure of the dollar
that includes currencies from additional U.S. trading
partners and adjusts for changes in relative consumer
prices shows appreciation of about 7 percent. After
rising nearly 10 percent in terms of the Japanese yen
to a recent peak in late April, the dollar retreated: it is
currently about unchanged from its value in terms of
yen at the end of December. In contrast, the dollar has
risen about 17 percent in terms of the German mark
since the end of last year.
1997
Note. Last observations are for Jury 18, 1997.
gains were not matched by a significant net decline in
interest rates. As a result, the yield on ten-year
Treasury notes now exceeds the ratio of twelvemonth-ahead earnings to prices by the largest amount
since 1991, when earnings were depressed by the
economic slowdown. One important factor behind the
increase in stock prices this year appears to be a
further rise in analysts' reported expectations of earnings growth over the next three to five years. The
average of these expectations has risen fairly steadily
since early 1995 and currently stands at a level not
seen since the steep recession of the early 1980s,
when earnings were expected to bounce back from
levels that were quite low.
Equity Valuation and Long-Term Interest Rate
Percent
Weighted Average Exchange Value
of the U.S. Dollar
Index, March 1973 = 100
Monthly
95
85
75
1992
1993 1994 1995 1996 1997
Note. Nominal value in terms of the currencies of the other
G-10 countries. Weights are based on the 1972-76 global trade
of each of the ten countries.
14
Ten-year Treasury note yield
10
SAP 500 earnings-price ratio
1982
1987
1992
Jl 2
1997
Note. Earnings-proa ratio to baaed onthe I/B/E/S international. Inc., consensus estimate of earnings over the coming
twelve months. Al observations reflect prices at mid-month.
Early in the year, data showing continued
strengthening of US. economic activity surprised
market participants, raised their expectations of some
tightening of US. monetary policy, and contributed to
upward pressure on the dollar. In light of the FOMC
action in late March and the tendency for subsequent
economic indicators to suggest a slowing of the
growth of US. real output, pressure for dollar appreciation abated. While robust economic activity in the
United States generated a rise in US. long-term interest rates through April, market uncertainty about the
strength of output growth in several foreign industrial countries led to little change, on balance, in aver-
76
U.S. and Foreign Interest Rates
age long-term (ten-year) rates in other G-10 countries.
Since then, U.S. rates have returned to near yearend levels, while rates abroad have moved dowa
Accordingly, the long-term interest differential, on
balance, has shifted further in favor of dollar assets
since December, consistent with the net appreciation
of the dollar this year.
Three-month
Percent
Monthly
Despite indications of further recovery of output in
Japaa the dollar rose against the yen early in the year
as planned fiscal policy in Japan appeared to be more
restrictive than had been expected, and Japanese
long-term interest rates declined in response. Statements by G-7 officials at their meeting in Berlin
in February and on subsequent occasions suggested
some concern that the dollar's strength and the yen's
weakness not become excessive. The dollar moved
back down in terms of the yen in May and has since
fluctuated narrowly. The yen has been supported
by data showing a widening of Japanese external
surpluses and by a partial retracing by Japanese longterm rates of their earlier decline, as indicators have
suggested that the fiscal measures may not be as
contractionary as previously expected.
Ten-year
Monthly
Average foreign
The dollar also rose sharply early in the year in
terms of the German mark and other continental
European currencies. Market participants have been
disappointed that the pace of economic activity has
not strengthened further in continental European
countries. In addition, uncertainties about the prospects for European Monetary Union, including the
possibility of delay and the question of which
countries will be in the first group proceeding to
Stage Three, have resulted in fluctuations in the mark
and, on balance, appear to have strengthened the dollar. German long-term interest rates have declined
somewhat on balance this year.
U.S. Treasury
i
Short-term market interest rates in most of the
major foreign industrial countries have changed little
on average since the end of last year. Rates in the
United Kingdom have risen somewhat as the new
government increased the official lending rate onequarter percentage point in May and the Bank of
England raised it by the same amount in June and
again in July. Short-term rates in Italy and Switzerland have eased. Stock prices have risen sharply so
far this year in the major foreign industrial countries,
particularly in continental Europe.
i
The trend in Mexican inflation has declined this year,
nevertheless, the excess of Mexican inflation over
US. inflation implies about a 7 percent real appreciation of the peso since December;
Since mid-May, financial pressures in Thailand,
which caused authorities there to raise interest rates
and have led to depreciation of the currency, have
spilled over to influence financial markets in some of
our Asian trading partners, particularly the Philippines and Malaysia. Interest rates in both of these
countries rose sharply. Philippine officials relaxed
their informal peg of the peso in terms of the dollar,
and the currency declined significantly; the Malaysian
ringgit and Indonesian rupiah have also depreciated.
The dollar has changed little on balance in terms of
the Mexican peso since December, as improved
investor sentiment toward Mexico, reflected in narrowing yield spreads between Mexican and US.
dollar-denominated bonds, has supported the peso.
i
1992 1993 1994 1995 1996
1997
Note. Average foreign rates are the global trade-weighted
average, for the other G-10 countries, of yields on instruments
comparable to the U.S. instruments shown.
25
O
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