Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's Second Monetary Policy Report for 1999 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundred Sixth Congress, First Session

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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1999

HEARING
BEFORE THE

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

ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
JULY 28, 1999
Printed for the use of the Committee on Banking, Housing, and Urban Affairs

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2000

For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
I S B N 0-16-060055-3




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




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C O N T E N T S
WEDNESDAY, JULY 28, 1999
Page

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

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WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC
Prepared statement

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Monetary Policy Report to the Congress, July 22, 1999




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48

FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1999
WEDNESDAY, JULY 28, 1999

U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The Committee met at 10:05 a.m., in room SH-216 of the Hart
Senate Office Building, Senator Phil Gramm (Chairman of the
Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PHIL GRAMM

Chairman GRAMM. Let me call our Committee to order.
We are in the process of voting. Our Members will be coming in
as they finish making their vote.
I thought, however, that since one of our distinguished colleagues
was obviously organized—was there when the vote started, voted
early, and like his fastball in days of old, zoomed over here—we
would start now. While I thought that it might be advisable to
limit opening statements to the Chairman and Ranking Member,
since Senator Bunning is here, I will recognize him for an opening
statement.
OPENING STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman. It's always a little
nerve-wracking to participate in a congressional hearing when you
know that Alan Greenspan is going to testify. When Mr. Greenspan
talks, people listen. Whenever he appears before a congressional
committee, the stock market usually reacts in a matter of minutes,
depending on whether he frowns or smiles. I hope today is a good
day. I hope he smiles on the period of economic growth that we
have been blessed with recently and which continues the longestrunning period of uninterrupted growth in our national economy.
It appears that the U.S. economy is growing faster than predicted by the Fed in February. The unemployment rates remain at
historical lows, at about 4.3 percent, and 1.25 million jobs have
been created in the first 6 months of this year.
One of the reasons people pay so much attention to Chairman
Greenspan is that everyone knows he is no Pollyanna when it
comes to economic growth. He has always balanced his optimism
with concern about the potential reawakening of inflation. Hopefully, today, Chairman Greenspan can tell us that low unemployment rates, such as we are experiencing now, can be sustained,
can even be improved upon, without automatically signaling any
dangerous inflationary pressures.
(l)




When the Humphrey-Hawkins bill was passed back in 1978, unemployment was around 6 percent and headed up, and inflation
was pushing double digits and heading up. Only recently have we
approached the national goals that the bill originally established in
1978, unemployment of 4 percent and inflation under 3 percent.
Hopefully we can maintain that progress, and I'm looking forward to Chairman Greenspan's thoughts on the subject.
Chairman GRAMM. Thank you, Senator Running.
We are hosting today our semiannual Humphrey-Hawkins presentation. Under existing law, this is the last mandated hearing of
Humphrey-Hawkins.
As I have said, we get an opportunity to hear from Alan Greenspan on a regular basis. He has not been selfish with his time with
regard to the Congress. In fact, he probably spends more time up
here than he should in terms of any kind of efficient allocation of
his time.
I do not see any great necessity in continuing the HumphreyHawkins hearings. Some of my colleagues feel differently. Obviously, while I'm Chairman, I'm going to be guided by the will of
the majority of the Committee. But whether this is the last of the
Humphrey—Hawkins hearings, or whether this is just one in a continuing series, I want to welcome Alan Greenspan, Chairman of the
Board of Governors of the Federal Reserve System.
Alan Greenspan is the greatest central banker in the history of
the United States and therefore, by definition, is the greatest central banker in the history of the world. It is an amazing thing to
me, as I travel around the world and meet other central bankers,
how clear it is that Alan Greenspan has become the world's standard for central banking. To the degree that imitation is the highest
form of flattery, almost no matter where you go, no matter which
central bankers you visit with, they tend to act and sound like Alan
Greenspan. It seems to me, Mr. Greenspan, that is a great compliment to you.
We have spent many hours—far more than the debate actually
deserves—debating about who is responsible for the golden economic era we find ourselves in. I don't ever remember the economy
being better than it is today; I don't ever remember prosperity
being as broadly based as it is today. In my hometown, we have
unemployment of less than 1 percent. If you go into any store in
America, you find high-quality goods, many of them imports, at the
lowest price, in any kind of real measure, that we have seen in the
history of the country.
Last year, our economy not only had strong economic growth, but
probably over the last 3 years the average white-collar worker in
America, certainly above the age of 50, has seen the value of their
financial assets grow by more than their annual income. For the
first time ever last year, Americans had more financial wealth than
they had in the equity value of their homes.
We have debated endlessly as to who is responsible. I give a lot
of credit to Ronald Reagan in terms of planting the seeds of modernization and efficiency, holding back the forces of protectionism.
In the 1980's, when General Motors was questioning whether it
could stay in the automobile industry, the unions and the automakers came to Washington and met with Ronald Reagan. He gave




them a prescription, which I think is the proper Government prescription: "Compete or die." They competed.
There are many people deserving of credit for the current golden
economic age we live in, but if there is any person currently in office who could lay a claim to having done more than any other person on the planet to produce this record level of prosperity, it is
Alan Greenspan. I want to thank you, Chairman Greenspan, for
the great job you have done. I want to thank you for the great service you have provided.
Your utterances have become somewhat like the Bible in the
sense that everybody quotes you to prove their point, even though
their quote may be counter to the quote that someone else is using
to prove exactly the opposite point. I am sure that much of your
time today will be spent deciding the exact meaning of Deuteronomy, or at least that section of Alan Greenspan's utterances.
In any case, we appreciate the great job you have done, and we
appreciate the sacrifice you have made in keeping this position. I
have tried now for several years to raise your pay. I know that
you're not missing any meals, and you don't necessarily need it, but
I don't want it so that you have to be rich to be the Chairman of
the Board of Governors of the Federal Reserve System. I intend to
continue to work until we get salaries at the Fed comparable to
what they are in other areas of the Government. I want to thank
you for being here.
I would like to recognize the Ranking Member of the Committee,
Senator Sarbanes.
OPENING STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I join
in welcoming Chairman Greenspan before the Committee. I have
listened carefully to your effusive praise of Chairman Greenspan
and I'm reminded of an event I was at a couple of weeks ago when
I had the opportunity to introduce Secretary Rubin, now former
Secretary Rubin. I said the big debate that was going on in Washington was whether Secretary Rubin was the best Secretary of the
Treasury since Alexander Hamilton or the best Secretary of the
Treasury including Alexander Hamilton.
When Secretary Rubin got up to speak, he said he appreciated
that, but he was reminded of the fact that in 1928, they were saying much the same thing about Andrew Mellon, who was then the
Secretary of the Treasury, and a year later they were calling for
his immediate ouster from the post. These things have a way of
going up and down, as we are well aware.
I also listened to Chairman Gramm when he talked about the
fact that you are quoted by Members for supporting positions that
are 180 degrees opposite to one another because of the opaqueness
with which you make your remarks. I see where The New York
Times, just last Friday, labeled you. They said you are widely considered an expert in opacity. We will try to work through that here
this morning.
Let me just say, Chairman Greenspan, I hope we continue the
Humphrey-Hawkins requirements for these semiannual monetary
policy reports to the Congress by the Federal Reserve. I think it
serves the Nation well. I think, in fact, the economic and financial




community has now come to, in effect, not only look forward to
these sessions, but expects this opportunity to have laid before the
country the thinking of the Federal Reserve and its view on economic circumstances. I think that is highly desirable, and I believe
it is preferable to have a clear requirement. We may have a Chairman who is quite prepared to follow that pattern, but we may not,
and I believe it's better to get it into place. It then becomes a regular part of the landscape, and everyone can work accordingly. I
hope we can discuss that issue further.
I wanted to comment a bit this morning about the June 30 Federal Open Market Committee vote to raise interest rates a quarter
of a point. The statement of the FOMC on the rationale for this
action said:
Last fall, the Federal Open Market Committee reduced interest rates to counter
a significant seizing-up of financial markets in the United States. Since then, much
of the financial strain nas eased, foreign economies have firmed, and economic activity in the United States has moved forward at a brisk rate. Accordingly, the full
degree of adjustment was judged no longer necessary.

The FOMC statement acknowledged that:
Labor markets have continued to tighten over recent quarters, but strengthening
productivity growth has contained inflationary pressures.

It went on to say:
Owing to the uncertain resolution of the balance of conflicting forces in the economy going forward, the FOMC has chosen to adopt a directive that includes no predilection about near-term policy action.

That, of course, has everyone wondering what it means. I saw
one commentator who said, "Well, you know, eventually we'll find
out." That seems to me about as perceptive a comment as was
made on that.
But let me, in any event, begin by commending the Federal Open
Market Committee, whether one agrees with the substance of its
decisions or not, for following through on its new policy announced
last year of making public a decision to shift the bias of monetary
policy when it is deemed to be of significant consequence. That was
the announcement, as 1 recall, that the FOMC made.
I think this policy substantially adds to the transparency of the
FOMC's decisionmaking process, and I'm frank to say I believe that
it's to the benefit of all participants in the economy for the FOMC
to really be as open as it can about its policy directions.
As you know, Chairman Greenspan, I had urged the FOMC prior
to that meeting not to adopt the so-called preemptive strategy of
raising interest rates.
I agree that the FOMC needs to be alert to developments that
might indicate that financial conditions may no longer be consistent with containing inflation, but it's my view that current conditions are consistent with containing inflation. Therefore, I did not
think a rate increase was advisable.
Now, I want to lay out some parameters, and hopefully in the
discussion period we'll have a chance to address them. Perhaps you
address them in your statement. It seems to me that economic developments over the 4 weeks since the meeting of the Federal Open
Market Committee have reinforced the view that current conditions
are consistent with containing inflation. The Labor Department reported in June that for the second consecutive month there was no




change in the consumer price index. Only twice before in the postWorld War II period have there been back-to-back months with no
increase in the CPI.
In addition, the core inflation rate, which excludes the volatile
food and energy prices, increased just one-tenth of 1 percent for the
second consecutive month. All of this, I think, reinforces the view
that the seven-tenths of 1 percent increase in April was aberrational and not reflective of deeper inflationary pressures developing
in the economy.
In fact, core inflation has fallen over the past 5 years. In 1994,
when unemployment was last at 6 percent, core CPI rose 2.6 percent. It rose only 2.1 percent over the past 12 months. For the first
6 months of this year, core CPI rose at a 1.6 percent annual rate.
I think this is absolutely a terrific development. We were told when
we were at 6 percent unemployment that if we drove the unemployment rate down below that level, we would set the inflation
rate escalating upward. In fact, we're now down to 4.3 percent unemployment, and the inflation rate is down to around 2 percent.
When we were at 6 percent unemployment, the inflation rate was
at 2.6 percent.
Producer prices have fallen. The core rate of inflation, as measured by the PPI, fell two-tenths of 1 percent.
If we go beyond these prices at consumer and producer levels, it's
difficult to find evidence of inflation elsewhere in the economy. The
Commerce Department said retail sales rose only slightly in June,
suggesting a moderation in consumer spending.
The trade deficit, unfortunately, continued to deteriorate in May,
thereby placing a drag on economic growth. As an aside, I'm increasingly concerned about the size of this trade deficit. I don't
know how long we can go on digging this hole for ourselves. It is
the one economic statistic that gives me serious pause and concern
at the moment. I, for one, do not think we can go on running these
very large trade deficits year after year. Fortunately, the Congress
has appointed a commission to look into the causes of the trade
deficit and what might be done about it. Murray Weidenbaum is
chairing that commission, and Apa Demetrio from Bard College is
the Vice Chairman.
Some assert that low unemployment is going to cause labor cost
pressures, but in the last year, growth rates for both wages and
benefits have declined, even as productivity has accelerated. The
unemployment cost index for private industry rose 3.3 percent last
year, compared to 3.5 percent the year before. Average hourly earnings give the same picture. I won't go into the figures for the sake
of time.
But rising productivity gains mean that cost pressure from the
labor side has been easing even more than the wage data suggest.
Productivity in the nonfinancial corporate sector, a measure that
the Chairman often refers to, is up 3.7 percent in the last year, the
highest in more than a decade.
Labor costs and productivity, taken together, give us unit labor
costs. They have increased only six-tenths of 1 percent in the last
year. Unit labor costs have actually had a downward pressure on
inflation.




Another indicator that's often referred to is capacity utilization.
High rates of capacity utilization have been correlated with rising
inflation, lower utilization rates correlated with falling inflation.
This expansion has been marked by a very substantial increase in
manufacturing capacity. It has risen more than 5 percent per year
for the first time since the 1960's. With manufacturing output
growing less than 5 percent, capacity utilization has been declining
for the last several years. In fact, the Fed reported in June that
the manufacturing sector was using only 79.4 percent of its capacity. That's less than the average utilization of 81.1 percent for the
last 31 years.
Now, as I indicated, economists earner on—there were even a
number of people actually within the Federal Reserve System, fortunately not the Chairman—established this kind of theory that if
unemployment went below a certain level, the so-called NAIRU,
then inflation would go upward. We were told that if the economy
grew fast enough to drive unemployment below some magic figure,
6 percent was often put forward, we would get inflation. Well, as
I said, we have had unemployment below 6 percent for almost 5
years and no real evidence of inflation.
A recent issue of Business Week pointed out that in the absence
of strong evidence of inflation, a policy of raising rates preemptively can do enormous damage. In fact, they estimated that if
rates had been raised enough to keep unemployment at 6 percent,
the United States would have lost about $1 trillion worth of gross
domestic product and 2.5 million people would be without jobs
today.
Unemployment now has been below 5 percent for 2 years. For a
year, it's not gone above 4.5 percent, and the people at the bottom
finally are beginning to catch up. According to the Labor Department, black unemployment fell to 7.3 percent last month, which is
the lowest rate since separate statistics were first collected in 1973.
Teenage unemployment rates are down substantially. The unemployment rate for adult women stands at 3.9 percent, among the
lowest rates in 30 years.
Chairman Greenspan, I know that you're sensitive to this aspect
of the benefits of sustained economic growth. You're sensitive to the
fact that it begins to reach into geographic and demographic areas
that previously have not experienced a lift as the economy moves
ahead. We very much hope that the Federal Open Market Committee will keep this dimension in mind as it formulates monetary
policy over the coming years.
I am anxious to hear the indicators that lead you to believe that
we may be beginning to approach the need to constrain or dampen
down the economy. We obviously don't want to do that needlessly,
and we don't want to give up the growth and the jobs and all of
the benefits that flow from that to address preemptively a problem
that may, in fact, not be there. I'm searching for the kind of indicators that seem to you to warrant the movement which the Fed took
in June. I have tried to list some of the indicators to which the Fed
has referred to in the past, on occasion, as being guides or signals
they have used. None of those, it seems to me, have indicated the
necessity to tighten policy.




I very much hope that the Fed will think long and hard about
further preemptive actions, because we have a very virtuous economy right now. Obviously, we all want to keep it.
I think Chairman Greenspan wants to keep it as much as any
of us, and I'm trying to search here for an analysis that gives us
the basis to make that judgment. I'm also trying to get the Chairman to undercut this article that sought to label him as an expert
in opacity.
Thank you very much, Mr. Chairman.
Chairman GRAMM. Thank you. Let me make it very clear that
you were talking about that Chairman.
Senator SARBANES. I have accused you of a lot, Mr. Chairman,
but not opacity.
[Laughter.]
Chairman GRAMM. Thank you.
I had intended to try to go to Chairman Greenspan after our two
opening statements, but I'm afraid that I and our distinguished
Ranking Member, being somewhat old, have rambled on, so I feel
a little guilty not to give people an opportunity at least to say a
word.
What I would like to do is set the little green light
OPENING COMMENTS OF SENATOR CHRISTOPHER J. DODD

Senator DODD. I think we should go to Chairman Greenspan. We
are all looking forward to hearing what he has to say.
[Laughter.]
Chairman GRAMM. Thank you. You have heard enough and it's
time to move on.
[Laughter.]
The distinguished Chairman of the Board of Governors of the
Federal Reserve System, Alan Greenspan. Thank you very much
for being here.
OPENING STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Thank you very much, Mr. Chairman.
I very much appreciate your opening comments, but I would like
to emphasize that the Central Bank of the United States is a very
substantial institution. I just happen to be sitting at the top, but
what's underneath there is formidable, and were that not there, I
would scarcely suggest you would be making the types of comments
you're making.
Chairman GRAMM. I wish I believed that. As my grandmother
used to say, the graveyards are full of indispensable men, everyone
eventually has to leave the scene. I wish it were the System making these good policies and not you, Chairman Greenspan.
Go ahead.
Chairman GREENSPAN. Mr. Chairman, I have rather extended
written remarks and would request that they be included for the
record, and I will partially excerpt from them.
I very much appreciate, Mr. Chairman and Members of the Committee, this opportunity .to^ oresent the Federal Reserve's semiannual report on monetary policy."" ~




8

To date, 1999 has been an exceptional year for the American
economy, but a very challenging one for American monetary policy.
Through the first 6 months of this year, the U.S. economy has further extended its remarkable performance. Almost IVi million jobs
were added to payrolls on net, and gross domestic product apparently expanded at a brisk pace, perhaps near that of the prior 3
years.
At the root of this impressive expansion of economic activity has
been a marked acceleration in the productivity of our Nation's
workforce. This productivity growth has allowed further healthy
advances in real wages, and has permitted activity to expand at a
robust clip while helping to foster price stability.
Last fall, the Federal Open Market Committee (FOMC) eased
monetary policy to counter a seizing-up of financial markets that
threatened to disrupt economic activity significantly. As those markets recovered, the FOMC had to assess whether that policy stance
remained appropriate. By late last month, when it became apparent that much of the financial strain of last fall had eased, that
foreign economies were firming, and that demand in the United
States was growing at an unsustainable pace, the FOMC raised its
intended Federal funds rate V\ percentage point, to 5 percent. To
have refrained from doing so, in our judgment, would have put the
U.S. economy's expansion at risk.
If nothing else, the experience of the last decade has reinforced
earlier evidence that a necessary condition for maximum sustainable economic growth is price stability. While product prices have
remained remarkably restrained in the face of exceptionally strong
demand and expanding potential supply, it is imperative that we
do not become complacent.
The already shrunken pool of job-seekers and the considerable
strength of aggregate demand suggest that the Federal Reserve
will need to be especially alert to inflation risks. Should productivity fail to continue to accelerate and demand growth persist or
strengthen, the economy could overheat. That would engender inflationary pressures and put the sustainability of this unprecedented period of remarkable growth in jeopardy. One indication
that inflation risks were rising would be a tendency for labor markets to tighten further, but the FOMC also needs to continue to assess whether the existing degree of pressure in these markets is
consistent with sustaining our low-inflation environment. If new
data suggest it is likely that the pace of cost and price increases
will be picking up, the Federal Reserve will have to act promptly
and forcefully so as to preclude imbalances from arising that would
only require a more disruptive adjustment later—one that could
impair the expansion and bring into question whether the many
gains already made can be sustained.
Data becoming available this year have tended to confirm that
productivity growth has stepped up. It is this acceleration of productivity over recent years that has explained much of the surprising combination of a slowing in inflation and sustained rapid
real growth. Increased labor productivity has directly limited the
rise of unit labor costs and accordingly dampett preesuiespn prices.
This good inflation perform a ri/^ rpftrxfiigaaa.-. i I i fflffHLr import
prices, in turn has fostered ^further declines in inflation expecta-




tions over recent years that bode well for pressures on costs and
prices going forward.
In testimony before this Committee several years ago, I raised
the possibility that we were entering a period of technological innovation which occurs perhaps once every 50 or 100 years. The
evidence then was only marginal and inconclusive. Of course, tremendous advances in computing and in telecommunications were
apparent, but their translations into improved overall economic efficiency and rising national productivity were conjectural at best.
That American productivity growth has picked up over the past
5 years or so has become increasingly evident. Nonfarm business
productivity grew at an average rate of a bit over 1 percent per
year in the 1980's. In recent years, productivity growth has picked
up to more than 2 percent, with the past year averaging around
2Vz percent.
To gauge the potential for similar, if not larger, gains in productivity going forward, we need to attempt to arrive at some understanding of what has occurred to date. A good deal of the acceleration in output per hour has reflected the sizable increase in the
stock of labor-saving equipment. But that is not the whole story.
Output has grown beyond what normally would have been expected
from increased inputs of labor and capital alone. Business restructuring and the synergies of the new technologies have enhanced
productive efficiencies. They have given businesses greater ability
to pare costs, increase production flexibility, and expand capacity
that are arguably the major reasons why inflationary pressures
have been held in check in recent years.
Other factors contributing to subdued inflation have included the
one-time fall in the prices of oil, other commodities, and imports
more generally. In addition, a breaking down of barriers to crossborder trade and the reduction of Government restrictions on trade
have intensified the pressures of competition, helping to contain
prices. Coupled with the decline in military spending worldwide,
this has freed up resources for more productive endeavors, especially in a number of previously nonmarket economies.
Despite the remarkable progress witnessed to date, history counsels us to be quite modest about our ability to project the future
path and pace of technology and its implications for productivity
and economic growth. We must remember that the pickup in productivity is relatively recent, and a key question is whether that
growth will persist at a high rate, drop back toward the slower
standard of much of the last 25 years, or climb even more. By the
last I do not just mean that productivity will continue to grow, but
that it will grow at an increasingly faster pace through a continuation of the process that has so successfully contained inflation and
supported economic growth in recent years.
The business and financial community does not as yet appear to
sense a pending flattening in this process of increasing productivity
growth. This is certainly the widespread impression imparted by
corporate executives, and it is further evidenced by the earnings
forecasts of more than a thousand securities analysts who regularly
follow S&P 500 companies on a firm-by-firm basis. Except for a
short hiatus in the latter part of 1998, analysts' expectations of 5year earnings growth have been revised up continually since early




10

1995. If anything, the pace of those upward revisions has quickened of late. Analysts and the company executives they talk to appear to be expecting that unit costs will be held in check, or even
lowered, as sales expand. Hence, implicit in upward revisions of
their forecasts is higher expected national productivity growth.
That said, we must also understand the limits to this process of
productivity-driven growth. To be sure, the recent acceleration in
productivity has provided an offset to our taut labor markets by
holding unit costs in check and by adding to the competitive pressures that have contained prices. But once output-per-hour growth
stabilizes, even if at a higher rate, any pickup in the growth of
nominal compensation per hour will translate directly into a more
rapid rate of increase in unit labor costs, heightening the pressure
on firms to raise the prices of the goods and services they sell.
Thus, should the increments of gains in technology that have fostered productivity slow, any extant pressures in the labor market
should ultimately show through to product prices.
Meanwhile, the impressive productivity growth of recent years
also has had important implications for the growth of aggregate demand. If productivity is driving up real incomes and profits—and,
hence, gross domestic income—then gross domestic product must
mirror this rise with some combination of higher sales of motor vehicles, other consumer goods, new homes, capital equipment, and
net exports. By themselves, surges in economic growth are not necessarily unsustainable—provided they do not exceed the sum of the
rate of growth in the labor force and productivity for a protracted
period. However, when productivity is accelerating, it is very difficult to gauge when an economy is in the process of overheating.
In such circumstances, assessing conditions in the labor market
can be helpful in forming those judgments. Employment growth
has exceeded the growth in working-age population this past year
by almost Vz percentage point. This implies that real gross domestic product is growing faster than its potential. To an important extent, this excess of the growth of demand over supply owes to the
wealth effect as consumers increasingly perceive their capital gains
in the stock and housing markets as permanent and, evidently as
a consequence, spend part of them.
There can be little doubt that, if the pool of job-seekers shrinks
sufficiently, upward pressures on wage costs are inevitable, short—
as I have put it previously—of a repeal of the law of supply and
demand. Such cost increases have invariably presaged rising inflation in the past, and presumably would in the future, which would
threaten the economic expansion.
By themselves, neither rising wages nor swelling employment
rolls pose a risk to sustained economic growth. Indeed, the Federal
Reserve welcomes such developments and has attempted to gauge
its policy in recent years to allow the economy to realize its full,
enhanced potential. In doing so, however, we must remain concerned with evolving shorter-run imbalances that can constrain
long-term economic expansion and job growth.
In its deliberations this year, the FOMC has had to wrestle with
the issue of what policy setting has the capacity to sustain this remarkable expansion, now in its ninth year. For monetary policy to
foster maximum sustainable economic growth, it is useful to pre-




11
empt forces of imbalance before they threaten economic stability.
But this may not always be possible—the future at times can be
too opaque to penetrate. When we can be preemptive, we should be,
because modest preemptive actions can obviate more drastic actions at a later date that could destabilize the economy.
Preemptive policymaking is equally applicable in both directions,
as has been evident over the years both in our inclination to raise
the interest rates when the potential for inflationary pressures
emerged, as in the spring of 1994, or to lower rates when the more
palpable risk was economic weakness, as in the fall of last year.
This evenhandedness is necessary because emerging adverse trends
may fall on either side of our long-run objective of price stability.
In the face of uncertainty, the Federal Reserve at times has been
willing to move monetary policy based on an assessment that risks
to the outlook were disproportionately skewed in one direction or
the other, rather than on a firm conviction that, absent action, the
economy would develop imbalances. For instance, both the modest
policy tightening of the spring of 1997 and some portion of the easing of last fall could be viewed as insurance against potential adverse economic outcomes.
As I have already indicated, by its June meeting the FOMC was
of the view that the full extent of this insurance was no longer
needed. It also did not believe that its recent modest tightening
would put the risks of inflation going forward completely into balance. However, given the many uncertainties surrounding developments on both the supply and demand side of the economy, the
FOMC did not want to foster the impression that it was committed
in short order to tighten further. Rather, it judged that it would
need to evaluate the incoming data for more signs that further imbalances were likely to develop.
Mr. Chairman, as a result of our Nation's ongoing favorable economic performance, not only has the broad majority of our people
moved to a higher standard of living, but a strong economy also
has managed to bring into the productive workforce many who had
for too long been at its periphery. The unemployment rate for those
with less than a high school education has declined from 10% percent in early 1994 to 6% percent today, twice the percentage point
decline in the overall unemployment rate. These gains have enabled large segments of our society to obtain skills on the job and
the self-esteem associated with work.
The questions before us today are what macroeconomic policy
settings can best extend this favorable performance. No doubt, a
monetary policy focused on promoting price stability over the long
run and a fiscal policy focused on enhancing national saving by accumulating budget surpluses have been key elements in creating
an environment fostering the capital investment that has driven
the gains to productivity and living standards. I am confident that
by maintaining this discipline, policymakers in the Congress, in the
Executive branch, and at the Federal Reserve will give our vital
U.S. economy its best chance of continuing its remarkable progress.
Thank you very much.
Chairman GRAMM. Thank you, Chairman Greenspan.




12

Let me see if I can get three or four questions into my 5 minutes.
I would like to try to hold everybody to 5 minutes, and then we can
go back for a second round if we need to.
First of all, I am sure you are aware, Chairman Greenspan, that
if you take "emergency" designations of spending that we have
adopted this year and the impact in the year 2000 of "emergency"
designated spending last year, we are currently spending $21 billion more than our budget cap, as a projection, for the year 2000.
If you look at the new "emergency" designations for spending in the
House, if they were adopted by the Senate, we would be $30 billion
over our spending cap this year.
We have an active discussion in both parties of adding a major
new Medicare benefit. The President has proposed allowing nonelderly onto Medicare and providing pharmaceutical benefits for
everybody. The bipartisan commission proposed making reforms
and taking some of the savings to pay for pharmaceutical benefits
for moderate-income people. But by any definition, this would be
the biggest new entitlement since Medicare.
When you look at that pattern, does that worry you about the future of price stability?
Chairman GREENSPAN. It certainly worries me about the future
of surpluses.
There is little question that, implicit in the surplus projections
we are looking at are presumptions of significant constraint on expenditures other than those mandated under entitlement laws. The
overages you are referring to at the moment are obviously reflective in that area, and it is difficult to make a judgment as to exactly how that alters the path of discretionary outlays that are implicit in the CBO projections, and, indeed, in the OMB projections.
I do think that it is important for the Congress to be aware of
precisely what it plans to do in that regard, because this is one,
but not the only, area which raises questions about the viability of
those projections of surpluses.
The other area is that even though both the OMB's projections
and the CBO's projections about the economy and a number of the
translations of the economy into outlays seem reasonable, what you
don't see is the range of error that is implicit in those forecasts. We
have had a very dramatic increase in the ratio of individual income
tax receipts relative to the GDP, or taxable incomes, a significant
part of which we cannot explain in terms of capital gains taxation,
a number of standard elements in income, or changes in the distributions of income. Things are happening which we call "technical
factors," which is another way of saying we don't have a clue, and
tax receipts can just as readily go in the other direction. If you
start to simulate a number of these things that could go wrong,
those surpluses evaporate fairly rapidly, at least the size of them
shrinks dramatically.
Chairman GRAMM. Let me pose this question, which is inevitable
on the day we're taking up the tax cut. Let me just posit some information. Then I would like to pose a question and get your response to it.
If you accept the current estimates that we're $30 billion over the
spending caps, if you accept the CBO's analysis of the President's
budget that he would spend $1,033,000,000 on 81 new programs if




13

his budget proposal were adopted over the next 10 years, so that
you came to conclude that we are in the process of spending the
surplus; if you believe that to be the case, would you support a
tax cut?
Chairman GREENSPAN. Mr. Chairman, as I have said previously,
there are two sides to this surplus forecast; namely, the one that
you raise, which very significantly questions whether it will be
there, but there's a range of error on both sides. It is conceivable—
I don't say that it's the most likely by any means—but I can perceive of a situation in which productivity continues to accelerate
beyond our expectations, and that would engender significantly
higher taxable incomes, and we may end up with offsets of that
sort.
It is precisely that imprecision and the uncertainty that is involved which has led me to conclude that we probably will be better
off holding off on a tax cut immediately, largely because of the fact
that it is apparent that the surpluses are doing a great deal of positive good to the economy in terms of long-term interest rates, in
terms of the cost of capital, and the ability effectively of the American Government to borrow when it has to. As we reduce the
amount of debt outstanding, the borrowing capacity of the Federal
Government rises, which is a very important long-term issue relevant to the question of inflation, especially when we have such
large contingent liabilities overhanging us because of unfunded liabilities in the Social Security, Medicare, and, in addition, the Civil
Service Retirement Fund. I conclude, as a consequence of this, that
we should be cautious in the beginning, and I think there is no
problem in delay.
I have also said, however, that should it appear that effectively
what is occurring is an endeavor to build up irrevocable spending
programs financed by a surplus which is dubious, I think that is
the worst of all possible outcomes because we have very large expenditure projections that will occur in the 10-year time frame as
we get a dramatic increase in the number of retirees and an aged
population.
Caution is very important in this area, and, while I certainly
support tax cuts if it looks as though the surplus will be spent, it
is far better to remove that tinder, if I may put it that way, by cutting taxes fairly quickly, but I hope that that's not what the ultimate conclusion will be.
Chairman GRAMM. Senator Sarbanes.
Senator SARBANES. Chairman Greenspan, if I were to urge you
to urge the Fed to cut interest rates in the current circumstances,
presumably you would tell me that I would be running the risk of
overstimulating the economy, since we are now at 4.3 percent unemployment, and, therefore, moving us into an inflationary problem. Would I be correct in that presumption?
Chairman GREENSPAN. Yes, Senator.
Senator SARBANES. If I were to say to you, "Well, I'm in favor of
a major spending buildup, a large expansion in programs," I take
it that you would have the same view as the possible macroeconomic effects of that kind of stimulation in an economy that's
working where we're worried about whether the labor markets are
going to tighten and so forth. Would that be correct?




14
Chairman GREENSPAN. That is correct.
Senator SARBANES. Now, if I were to come along and say, "Well,
I think we should have a major, very substantial tax cut," would
that not also be open to the same response that we would run the
risk of overstimulating the economy and again confronting an inflation problem?
Chairman GREENSPAN. That would certainly be the case, Senator. I would note, however, that the various tax cut proposals, because they're locked into the on-budget surplus projections, almost
all are phased in at a very slow pace. So, while I would certainly
argue that were we to cut taxes sharply right now we are creating
a risk, which I don't think we need, I don't think that any of the
programs that I have seen rise to that limit.
Senator SARBANES. How would you know, since even if I concede
that point, they involve very large cuts later on? How would you
know that the circumstances later on would accommodate such
large cuts and not raise, again, inflation problems, particularly
when the projections on which all of this is based assume an economy that's going to continue to work at pretty high levels in terms
of the use of its resources?
Chairman GREENSPAN. I agree with that, Senator, and, therefore,
if the Congress decides to move forward and put into place significant tax cuts in future years, I think it also has to be prepared to
cut spending significantly in the event that the forecasts on which
the surpluses are based are proved wrong.
Senator SARBANES. Or not to do the tax cuts.
Chairman GREENSPAN. That cle'arly is the alternative. What I'm
trying to say, however, is that implicit in moving forward with tax
cuts when there is a question with respect to the sustainability of
the budget surpluses, I would submit that the Congress has to be
prepared to cut spending and not raise taxes back. The reason I
say that is that, if we're looking at the issue of the sustainability
of long-term economic growth, the one thing we don't want to do
is create tax patterns which are uncertain and variable.
Senator SARBANES. Wouldn't prudence, therefore, suggest that
the best thing is to be cautious in all of these fields, now that we,
for the first time, are confronting the question of what to do with
the surplus?
Chairman GREENSPAN. That is precisely what I am arguing.
Senator SARBANES. We should tread lightly.
Chairman GREENSPAN. Senator, I have been saying that for 9
months, and the words I have been choosing vary little from one
testimony to the other.
Senator SARBANES. Let me ask you this question. If we cannot
reduce the national debt when we have unemployment down to 4.3
percent, when will we be able to reduce the national debt?
Presumably, if unemployment were to rise, we would confront assertions that we have to do something stimulative in order to bring
down the unemployment, which, of course, would presumably mean
draining off some of the surplus or running into a deficit, depending on what our situation is.
Isn't this the moment, in a sense, if we are concerned about
working down the national debt—which I think everyone agrees,




15

certainly in current circumstances, would strengthen the national
economy—isn't this the time to try to do that?
Chairman GREENSPAN. Absolutely. This is the ideal time to do it,
and I would certainly agree that if you can't do it in a significant
way now, I can't imagine other circumstances being more favorable
to debt reduction at this point.
Senator SARBANES. Thank you very much, Mr. Chairman.
Chairman GRAMM. Senator Mack.
OPENING COMMENTS OF SENATOR CONNIE MACK

Senator MACK. Thank you, Mr. Chairman. I, top, welcome Chairman Greenspan this morning. This follows on with the discussion
about this whole debate that we're having, but it's a little bit more
focused in the sense that you said you prefer debt reduction to tax
cuts. But I believe, if I remember correctly, the budget plan that
was put forward earlier this year, that called for the $792 billion
in tax reductions, also acknowledges and sets up a $2 trillion reduction in our Nation's debt.
It seems like the discussion very seldom mentions that, while
we're talking about tax cuts, there is debt reduction that's going to
be taking place.
Chairman GREENSPAN. If, indeed, the Social Security trust fund
is not touched, in the way that you're arguing, the debt to the public will fall by $2 trillion which is a very positive phenomenon.
Senator MACK. I'm just laying out here that, while we are talking
about tax cuts, we're also making the commitment. In fact, we have
even proposed that there be some lockbox mechanism to try to see
that the Social Security trust fund is not touched.
Chairman GREENSPAN. Which requires that the on-budget accounts do not go into deficit.
Senator MACK. I understand. But you have also said that the
best tax rate for capital gains is zero. On one hand, you talk about
the need for debt reduction, but on the other, you have said that
the best tax rate for capital gains is zero. I would like you to reconcile these two positions.
Do you prefer debt reduction to all kinds of tax cuts, or do you
prefer debt reduction only to the kinds of tax cuts that do not have
strong supply-side effects?
Chairman GREENSPAN. Over the longer run, I am strongly in
favor of eliminating the capital gains tax on the grounds that I
think it is a very poor means of raising revenue. I would favor cuts
in marginal tax rates somewhere out in the future as we find that
this particular economic expansion, which must inevitably slow,
runs into some difficulty.
I don't distinguish the issue of the types of tax cuts we may need
when this economy slows down. My impression would be we probably will need both significant capital gains tax cuts and marginal
tax rate cuts to assist monetary policy in stabilizing an economy
which, having run a long way, will very likely, when it finally retrenches, run into some difficulty. Having the availability of significant tax cuts at that point, in my judgment, will be very useful.
I am by no means against cutting taxes. On the contrary, I think
that reducing the aggregate level of taxation in this country would
be extremely effective in maintaining the type of technology-driven




16

growth that we have. My discussion and argument at this particular point refers solely to this immediate period, a period in
which something very unusual is going on and one in which we
have the capability of reducing the debt to the public very significantly. In my judgment, if we can do that, what that will do for
the issue of economic growth, for savings, in the first decade of the
twenty-first century is very important.
Because we have this huge projected increase in entitlement
spending, it's crucially important, in my judgment, to get a very
strong fiscal structure in place as we run into what is an inevitable
major acceleration in entitlement costs.
Senator MACK. Senator Sarbanes talked about the HumphreyHawkins reporting requirements. I, too, think it is helpful—and I
believe you do as well—that the Federal Reserve Chairman come
to the Congress, on a periodic basis, reporting about monetary policy and responding to other questions with respect to the economic
conditions of the country. I suspect that there may very well be an
effort legislatively to reenact that reporting requirement.
But I just want everyone to be on notice, as Chairman Greenspan and Chairman Gramm know, over the last several years I
have talked about legislation that would amend the HumphreyHawkins Act, because I find it to be totally out of place.
First of all, I don't believe it ever should have been passed. I will
raise just one point here. The Humphrey-Hawkins Act states the
unemployment rate has to be 4 percent or less. Actually, if you
read it, you will find places where reducing the rate of unemployment is set forth in this section to not more than 3 percent among
individuals aged 20 and over.
It's ludicrous, I think, but I guess, maybe to make the point, by
law the Federal Reserve is supposed to be pursuing a policy of reducing the unemployment rate to 4 percent or less.
Is the Federal Reserve engaged today in trying to push the unemployment rate to 4 percent or less?
Chairman GREENSPAN. I don't think that the law requires that
the Federal Reserve specifically do that. Indeed, I think it's a national economic policy which is set as a goal by the Administration.
I have forgotten whether that particular segment has lapsed in
time, but there has not been particular discussion of that goal for
a long while.
Focusing on a specific unemployment rate as an economic goal,
in my judgment, is very shortsighted. I think what you try to do
is to get maximum sustainable growth, which is what our policy is.
What unemployment rate falls out as a consequence of that policy,
in my judgment, would be the appropriate unemployment rate.
Senator MACK. And sustaining maximum economic growth over
a long period of time comes primarily from price stability?
Chairman GREENSPAN. That's what we have concluded over the
years, and I suspect that that was a view, which is fairly general
now, which was not held at the time the Humphrey-Hawkins Act
was passed.
Senator MACK. Mr. Chairman, my last point would be, as much
as I would like for Chairman Greenspan to be there forever, I recognize that he won't. It seems to me that it would be appropriate
to change the Humphrey-Hawkins law to make price stability the




17

number one goal of the Fed, as opposed to giving it multiple goals
as far as economic growth, unemployment, et cetera.
Thank you.
Chairman GRAMM. Thank you, Senator Mack.
Humphrey-Hawkins passed a year before I came to Congress. It
was set up as a naive notion that we could pass a law and force,
through inflationary policies, the Federal Reserve to drive down
unemployment, as if you could really do that.
Fortunately, the Congress knocked the teeth out of it, because
none of this stuff was binding. But I think the point you make,
Senator Mack, that we should decide to rewrite the law, is certainly correct. We're not as ignorant now as we were in 1978, and
it should be reflected in public policy.
Senator Bryan is here, so we will hear from him next.
OPENING COMMENTS OF SENATOR RICHARD H. BRYAN

Senator BRYAN. Thank you very much, Mr. Chairman.
Chairman Greenspan, given our current economic conditions—
and I understand from your testimony that you believe it to be desirable at some point in time to reduce the marginal rate and to
eliminate, if possible, the capital gains rate—but, given our current
economic circumstances today, as we find ourselves today, what
would your priority be, given these three options: pay down the national debt, give a large tax cut, or increase domestic discretionary
spending?
Chairman GREENSPAN. Senator, my first choice, as I indicated
previously, is to reduce the debt. My second choice is to reduce
taxes, basically because if we find that we cannot prevent ourselves
in one form or another from spending the surplus, we are going to
end up with rising spending which will require rising taxes as a
percent of taxable income. There is a limit to how far that can go
before it impedes economic growth, so I very strongly would argue
against using the surplus for new expenditure programs.
If that, indeed, appears to be forthcoming, I would favor tax cuts,
even in the short term, because there would be far less a concern
on what would happen to the economy over the longer run than
were we to go the expenditure route. But my first preference is,
indeed, to reduce the debt as much as we can and in as short a
period as we can.
Senator BRYAN. Chairman Greenspan, I think you have provided
an extraordinary service, not only to the Congress, but also to the
American people. You have said it in many different ways, but this
morning you say again to us, history reminds us to be cautious.
In that context, we are projecting a surplus, an on-budget nonSocial Security surplus over 10 years, of approximately $1 trillion.
Is that being cautious in the sense that, as a layman not as an
economist, my experience has taught me that no one, no matter
how erudite, no matter how well-intentioned, whatever his or her
philosophical moorings may be, no one can predict with certainty
what the economy is going to be like next year, much less a decade
ahead.
My question is, actions taken upon a projection that's 10 years
out there indeed may not occur—whether we have Democrats or
Republicans in the Congress or the White House, or whether the




18

Whig Party comes back and assumes the leadership in any one of
these distinguished bodies—is that "cautious" to make our policy
actions today based upon projections over that period of time?
Chairman GREENSPAN. Senator, you raise a very important question, and I would state first that if you are required to make a best
judgment projection of the surpluses, the economists at the OMB
and CBO have probably done as good a job as you can do.
But as you quite correctly point out, history suggests that in retrospect, looking back from 10 years from today to the period that
just preceded, the probability that the path of the economy and the
budget will proceed precisely as forecast is extraordinarily low.
Senator BRYAN. My last question, if I may, Chairman Greenspan.
I would like to get your reaction in terms of the credibility that the
markets would have.
As you know, the proposal before the Senate contemplates a $792
billion tax cut over the 10-year period that we have just talked
about. One of the assumptions—and you talked about that, I think,
somewhat indirectly—is that, with respect to discretionary spending, we will not only observe the caps in place this year, we will
observe the more restrictive caps of next year and the more restrictive caps of the year thereafter.
As Chairman Gramm pointed out, our colleagues in the House,
this year, to avoid those caps, are contemplating expenditures in
fiscal year 2000 that would exceed the current caps by $30 billion.
What kind of credibility does this plan have, if in this year we're
talking about exceeding the caps by $30 billion, in terms of the
probability that that surplus is actually going to materialize over
the 10-year period?
Chairman GREENSPAN. Senator, that's the reason why, if the
Senate, and the Congress generally, decides to go forward with a
significant tax cut which has long-term positive implications for the
size of the Government which, if we could do it, is very favorable,
but if that is done, I would very strongly suggest that the Congress
be prepared to cut spending to the extent necessary to make the
forecasts of the surplus, that are implicit currently, achievable.
That means that, if you're going to introduce very significant tax
cuts, it is quite conceivable—and indeed I would not rule it out—
that the so-called ex ante surplus, as economists like to call it, will
indeed emerge. It will turn out to be an optimum policy, but I do
think that contingencies are required in the event that that fails.
I do not think, as I said before, that it is viable to raise taxes
back up without having significant negative effects on incentives in
the system. Consequently, in order to adjust for the fact that we
have an uncertain forecast of the surplus and what appears to be
a fairly exact change in tax rates, I think you have to square the
circle by making tax cuts in such a way that in the event that the
surplus turns out to be far less than is projected, there is an implicit action to which the Congress commits. I don't necessarily say
it has to be in the law; I don't see how it can be. But something
should be added that implies that further curtailments in expenditures occur, and that could be both in discretionary or in entitlement outlays.
Senator BRYAN. Thank you very much, Mr. Chairman.
Chairman GRAMM. Senator Bunning.




19

Senator BUNNING. Thank you, Mr. Chairman.
In your testimony, you talked about the unpredictability of continued growth due to the explosion we have had in technology, and
the ability of our workforce to produce more goods and services because of that explosion.
It's my understanding that, over the next 5 years, particularly as
far as the Internet, computerization, and things of that sort go, we
are going to have an even bigger explosion in the next 5 years than
we had in the prior 5 years.
Looking forward, if we do have that type of explosion in computer technology, the Internet, and those things, do you see that
as a reasonable assumption that the pressures you spoke about will
not be as bad in the future as they are now?
Chairman GREENSPAN. Senator, you are raising the crucial question which we have to confront. This relates not only to monetary
policy, but also fiscal policy and a lot of other things with which
we're dealing.
There's virtually no chance that these advances in productivity
that we have been observing hi recent years will somehow stop.
There are synergies which have already developed which invariably
imply significant new applications, the Internet being one of them.
A number of analysts, a number of people in the high-tech area,
are saying that the so-called major technological change—which essentially goes back to the integrated circuit and, before that, to the
transistor—the evolution of that is still in front of us.
In other words, we like to say we have an S-curve, the run in
the S-curve, and nobody yet sees this flattening out.
The crucial question is not whether very significant further advances will occur. The question, so far as policy is concerned, is the
pace of that change because it is perfectly credible that we can go
from, say, a very modest Internet interface with the economy to a
very significant interface. But how fast that happens is very crucial
to the rate of change in technology growth and, therefore, the rate
of change in productivity. Over the last 4 or 5 years—5 years—we
have seen the rate of productivity growth go from roughly a little
over 1 percent per annum to well over 2 percent. Implicit in this
technological advance that a number of those in the financial community are projecting is that that rate will continue to rise. Indeed,
if it does rise, then, as I mentioned earlier, I think our tax receipts
are going to be higher than they otherwise would be, and there will
be lots of other positive fallout.
The crucial question, which I try to address in my prepared remarks, is that if the rate of growth of productivity ceases to grow
itself and flattens out—I don't want to give a number because
everybody's going to think that's exactly the number I believe—but
let's say some number just flattens out, what that does is it creates
pressures on the economy, and inflationary pressure potentially. So
what is crucial to the outlook—indeed, crucial to the budget discussion as well, as far as I'm concerned—is whether the forecasts implicit in the earnings per share growth, which have continuously
been rising, imply that productivity growth will continue to rise.
Both the business community and the security analysts with whom
they discuss issues seem at this stage to still be forecasting that
this rate of increase of productivity growth will continue.




20

We have no evidence at this stage that they are wrong, but what
we are very closely watching is not whether technology will continue to grow—there's no question in my mind that it will grow,
and it will grow very impressively—it's to try to factor in the pace
at which that is changing because it is that which is crucial to the
economic outlook.
Senator BUNNING. But nobody would have predicted what has
happened in the last 5 years, going from 1 to 2 percent. What is
to say that it won't go from 2 to 4 percent in the next 5 years?
In projecting and trying to figure out what you're going to do, it's
going to be very difficult, whether it be fiscal or monetary policy,
to make those projections. The same thing happens with our $3.2
billion projected surplus over the next 10 years. They are trying to
figure that out too, which makes it extremely difficult for the OMB
and the CBO. What we have to do, as a Congress, is try to figure
out what is conservative and what would work if certain sets of
factors fit.
I thank you for your testimony.
Chairman GRAMM. Senator Schumer.
OPENING COMMENTS OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman.
I want to thank you, Chairman Greenspan, for your testimony.
I guess on this issue of tax cuts, which is the issue of the day, I'm
trying to put in a sentence what you're saying, which is very hard
to do. You're basically saying, "Yes, but not now."
Is that unfair?
Chairman GREENSPAN. I would say that if you forced me to be
nonopaque, I guess that's where I would come out.
Senator SCHUMER. Maybe another way to put it—and I will try
again since I had that success—is it's better to be safe than sorry,
which is how you have conducted monetary policy, very brilliantly,
in my judgment, for the last however many years you have been
Chairman.
Do you think we should conduct fiscal policy in the same cautious way?
Chairman GREENSPAN. As I have been saying since late last year
as the surpluses began to evolve, I said that these are exceptionally
beneficial to the economy, to economic growth, price stability; that
the longer we can allow them to run and run down the debt outstanding to the public, the better off we will be. Obviously, at some
point, significant tax cuts would be in order, and I said that I
would hope that we would move to marginal tax rates and capital
gains tax reduction.
But it is a very tough call as to exactly how that works out. The
one issue I would just throw into the hopper is that I do think that,
despite the fact that we may be looking at a far more extended
period of prosperity than any of us imagined, and if we go to this
4 percent that you are suggesting as possible, and I can't deny
that—no one can, and shouldn't—then we will be looking at something which goes on for quite a significant period of time.
I think the more appropriate posture is to be cautious and recognize that history says that when you have been expanding for
9 years, somewhere out there is a slowdown, an adjustment which




21

can occur wholly independently of the question of whether these
structural, long-term productivities are continuing. At that point,
to have the capability of a very major cut in marginal tax rates I
think would be a useful tool for the economy; so that, if indeed you
do pass a tax bill, I hope that there will be room, indeed I'm sure
there will be room, to move in a manner which would be helpful
in the event the economy did slow down.
Senator SCHUMER. As you know, it's much easier to pass a tax
cut than a tax increase. You have always said that you err on the
side of preventing inflation because, "Once the genie is out of the
bottle, it's hard to get it back." I think those are almost your exact
words.
I think the same is true of fiscal policy. If we go too far on the
tax cut side, it's going to be hard to get the genie back in the bottle,
whereas if we proceed cautiously and we need to do more later, it's
a lot easier to do that.
Is that a fair statement?
Chairman GREENSPAN. I think it's self-defining.
Senator SCHUMER. I'll translate "self-defining" to be "fair" for the
moment, if you won't.
[Laughter.]
Let me go to another area where I have great concern and ask
for your opinion. We have just read in the last few days about the
New York Stock Exchange and Nasdaq talking about going public.
This has been brought about, again, because of the amazing technological changes that have occurred. One rule of the SEC, that
Nasdaq had to list all trades, let the genie out of the bottle, so to
speak.
We now hear talk of many markets, these so-called ECN's, as opposed to two markets, two major markets. I have a concern about
these ECN's. I am concerned the market will become fragmented,
that it may not be as deep and wide as it might be. I'm concerned
we may run into problems in terms of regulation. I worry that, basically, the great thing about American markets—that they are not
opaque, they are visible to all, they are deep, and tremendously
flexible—could be lost if we see the markets broken up into lots of
these ECN's. We may see a skimming, if you will, where some people can trade in these ECN's and other people can't, certainly with
the information available.
Do you worry about this?
If you could, give us some of your views on how the equity markets and all markets are changing because of technology. Are there
things we have to look out for, or should we just let it proceed
apace?
Chairman GREENSPAN. Senator, I am not overly concerned because one of the things about markets is that they converge toward
natural monopolies in the sense that it is very difficult to have
fragmented markets operating efficiently. What history has demonstrated to us is that when you have markets selling the same
product in different places, unless communication is lacking between the two, they will ultimately converge into one. One or the
other will disappear because there is the standard issue that the
liquidity in a market is essentially the bid-ask spread.




22

If the smaller market has a wider bid-ask spread, the business
will move to the larger market, and it's a continuous process until
the smaller market disappears.
That's what happened to the New Orleans Cotton Exchange. It
had a contract very similar to the New York Cotton Exchange, and
when communication wasn't very significant, you could run two
separate markets. But as the telephone and telegraph emerged, it
was inevitable that that would not happen and, therefore, I'm not
concerned particularly about this type of fragmentation. It probably
will occur in the early stages, but there is a tendency toward convergence, and I would hope that those who are regulating these
markets are structuring the regulation in a manner to foster that
because it is very obvious that you don't want a lot of markets
trading in the same commodity or in the same stock.
You want the people who are trading to have access to the total
market and the only way that can happen effectively is if there are
single markets for these types of commodities or stocks.
Senator SCHUMER. Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator.

Senator Santorum.

OPENING COMMENTS OF SENATOR RICK SANTORUM

Senator SANTORUM. Thank you, Mr. Chairman.
Chairman Greenspan, it's good to have you with us. I want to
take one more stab at this issue of tax cuts, and look at it in the
sense of history, recent history.
Last October, we came forward with "emergency spending," new
spending of $22 billion, this past spring $12 billion. Yesterday, the
Democratic leader came forward with a plan for agriculture of $10
billion. This week, the House has come forward with yet another
$10 billion. I think what Chairman Gramm was trying to get at is,
don't we see a pattern here that is a little cause for concern?
What I'm concerned about is what I hear from you, Chairman
Greenspan, which says, well, ideally I would like to spend down the
debt. I think anyone who looks at what's going on in this Congress
would see it's fairly apparent that if there's money sitting here in
this town, it ain't going to be spent on debt. About 90 percent of
the people who walk in my office ask me for more money for something, and I would suspect the percentage may be higher in other
places.
I guess what I'm trying to get at, I appreciate the philosophical
context from which you're giving these answers, but we are here
in a very real arena where the answer is going to be we either
spend it or we give it to the American public for them to spend.
That's what I see happening here.
Given that analysis of some real politique, what would you prefer
to have happen?
Chairman GREENSPAN. Senator, as I've been saying for the last,
I guess, 7, 8, or 9 months, if it turns out to be infeasible to apply
the surplus to reducing the debt, and it turns out that instead it
is being spent, then I very strongly support tax cuts.
Senator SANTORUM. Thank you, Chairman Greenspan.
We have a couple of sectors in my State that are hurting during
a very robust time in our economy, and that is the agricultural




23

sector, which is the number one industry in Pennsylvania, and
what we are known for in Pennsylvania, our steel industry. Both
are related, for different reasons, to what's going on in the foreign
markets. One is steel dumping. The other is the inability to get agricultural products outside of the United States.
I guess I would just like your comments as to those two sectors
and what, in particular, we can be doing to address those problems.
There is apparent prosperity everywhere, but if you go to a lot of
areas in my State, and in other States across the country, we see
real problems continuing.
Chairman GREENSPAN. Senator, in the agricultural area we are
confounded with an extraordinary set of circumstances; namely,
productivity is growing far faster than it is anyplace else in the
economy. Over the last 30 years as I recall, productivity growth in
agriculture broadly, and this includes crops, livestock, and dairy, is
about three times the rate of increase in the nonfarm area. What
that means is that we're creating very large surpluses because our
ability to consume all of this domestically is limited because there
are only so many people that we have, so we depend very crucially
on export markets.
When Asia ran into trouble last year, there was a very dramatic
drop in agricultural exports. In fact, my recollection is that maybe
four-fifths of the drop was attributable to the declines in exports
to Asia, which created a very substantial backing up of products
and a very major weakening in prices. In soybean prices, close to
$4 a bushel is something I haven't seen for who knows how long.
We're confronted with what really amounts to a necessity on our
part of reinvigorating export markets. I do not believe that if we
go back to some of our old practices we will find that it's to the advantage of American farming. I do not think so. It is crucial that
we endeavor to find a means of expanding agricultural exports, because our ability to produce is truly awesome.
Steel is a tricky problem. As you know, we increasingly have two
steel industries in this country. One is based on the old technologies of coke ovens, blast furnaces, and oxygen furnaces, and the
other is the minimills which are evolving at a very dramatic pace.
Indeed, the largest minimill company has the prospective of being
the largest steel company in the country at some point soon.
I don't know what to do in this regard. It's a very tough problem.
I would hope that we could find easy solutions to it, but I have very
mixed feelings here. I used to work as a steel consultant many,
many years ago, and I used to go visit the huge Homestead Works
which are awesome. In fact, the whole Pittsburgh District was
Senator SANTORUM. I understand that the Homestead Works is
now a vacant lot.
Chairman GREENSPAN. That's exactly what I remember, and that
is very distressing. Yet, we have to make sure that technologies
continuously move forward for standards of living to rise. And the
issue that I'm concerned about is that if we endeavor to try to impede trade in the process, everyone loses. As I said in a speech recently, what we really have to do is to find a means to help those
people who work in industries which are technologically retreating,
and through no fault of their own find themselves caught up in
very large economic events.




24

We ought to direct our efforts to try to find how we can help
those people best. I do not believe that trade protection works. The
reason is that, yes, there is no question that you are likely to keep
jobs in place longer, but what that does is basically prevent individuals in their 20's, their 30's, or even their 40's, from changing jobs.
If you keep them in place until they are 50, they have no place to
go when, inevitably, the economic forces will create significant further contraction, so I believe it is crucially important that we not
use trade restrictions as a means to resolve what are very difficult
issues because I don't think it helps the workers. I think it prevents them from moving when they should be moving.
Capital, which is earning less than the required rate of return,
should move into higher tech areas or more productive areas because that's what's made America great. That is why our standard
of living is by far the highest of any place in the world.
Our ability to have that flexibility to move capital and workers
is crucial and impeding the flow of capital and workers from job to
job, from industry to industry, is not to our long-term advantage
and, indeed, I suspect it's not to our short-term advantage, either.
Senator SANTORUM. Thank you, Mr. Chairman.
Chairman GRAMM. Senator Bayh.
OPENING COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Chairman Gramm.
Chairman Greenspan, it's a pleasure to have you with us once
again, and I should say it's refreshing to have someone who does
not have to stand for office offering some common sense to those
of us who do.
I have listened to some of the comments of my colleagues here
today, and am in more sympathy with them in some respects than
they might imagine. But I do hope that the justification for at least
one of the very large tax proposals that's moving its way through
Congress is not that we cannot restrain ourselves from engaging in
irresponsible spending, and therefore we should engage in irresponsible tax cuts. If paying down the debt is the right thing to do, we
need to have the fortitude to do that, and I hope those of us in this
Congress will summon ourselves to the correct priorities, not just
the path of least resistance.
I have a few very quick questions I would like to pose. You have
already addressed the first two, at least in part. The first deals
with contingent revenues and contingent liabilities.
Being a former governor, we used to have 2-year budget cycles,
and invariably our forecasts were in error. It seems to me that in
forecasting out 10 years, what we are really doing is engaging in
guesswork disguised, in some respects, as science.
Are you aware, Chairman Greenspan, of any 19-year period in
our Nation's history of uninterrupted economic growth? Do the assumptions of 2.5 percent average annual GDP growth implicit in
the projections we get sound reasonable?
Chairman GREENSPAN. The answer is clearly we have not. Indeed, we are on the edge of the longest expansion in American history, 9 years into it.
In fairness to the people doing the estimating, however, they try
to adjust the level of their long-term growth to capture the fact




25

that there are going to be periods when it's going to be higher than
trend and lower. Effectively, the cumulative impact of the budgetary policies are supposed to capture periodic recessions without
knowing in advance where they will be, so it is true that you can't
forecast a long period of time without a recession credibly. I would
say that the procedures the CBO and OMB use probably eliminate
most of the bias that would be created in the system.
Senator BAYH. With regard to the contingent liabilities, I think
you raised an excellent point. You mentioned it a couple of times,
and that is the need for long-term entitlements reform.
As you may be aware, the subject of Medicare is squarely on the
table in the context of this budget debate, and I think it's important for everyone here today to understand that every one of the
proposals which has been put forward merely postpones the day of
reckoning with regard to Medicare. Even the President's proposal
only extends the solvency out to 2028.
Would you feel more comfortable with some of the tax proposals
that were put forward if they were combined, at the end of the day,
with some meaningful systemic restructuring of entitlements?
Chairman GREENSPAN. I'm delighted to hear that, Senator.
The issue has never been on the table, but implicit in any discussion on taxes is clearly that if you bring down spending proportionately with the tax reductions, you can do it any time. Because were
you to do that right now, surplus balances are not affected and I
would very strongly suggest that if that were in fact the case, the
markets would like it immensely. I just don't sense that that is an
issue which is on the table. It was for a while.
Senator BAYH. There are some, Chairman Greenspan, who are
suggesting that as a part of the so-called compromise at the end,
perhaps some Medicare systemic reform would be combined with a
more aggressive tax approach than some would favor.
Chairman GREENSPAN. I would say that if that is feasible, it
would be very useful.
Senator BAYH. Thank you. Your comment was very helpful in
that regard.

I'm fascinated. We have discussed previously this wonderful escalation of productivity growth rates that has taken place in the private sector. We're having a debate up here about how much to set
aside for nondefense discretionary spending over the next 10 years.
I realize that a lot of the Federal budget is comprised of transfer
payments that are not exactly analogous to the private economy,
but is it not possible that some of the same trends that are taking place in the private sector might not also lend themselves to
greater productivity in the public sector, thereby giving us a little
extra flexibility in terms of discretionary funding, even if the nominal levels are a little lower than some people might want?
Chairman GREENSPAN. I assume that's happening, Senator.
I know within the Federal Reserve, where we can see it directly,
there are very dramatic changes in the productivity of our system.
We have computerized substantial parts of our operation and it has
created a very large change, as far as I can judge, in certain areas
of output parameters.
Senator BAYH. I agree. Some people suggest if we don't build in
an automatic cost of living escalator in Government spending, that




26

somehow or other a real cut is taking place. But I think they're
missing, among other things, the possibility for increased productivity gains.
My last question—and I see I'm on the yellow light—changes the
subject, which you may appreciate. We are now running balance of
trade deficits on a monthly basis about, I think, at the level that
we used to have on an annual basis.
I would be interested in just your very brief thoughts about what
the long-term consequences of this are for our economy, perhaps
with regard to our currency value, and what that might mean for
inflation rates somewhere out beyond the horizon.
Chairman GREENSPAN. Senator, I tried to address that in my
prepared remarks, not in full detail, but in some.
What we know about the current account deficit, which is the
broader definition, including income payments as well, is that it is
rising for two reasons. One, our propensity to import goods and
services, relative to our incomes, is higher than our trading partners, and that, other things equal, will induce a trade deficit in the
United States and a trade surplus elsewhere.
Of considerable significance recently, however, is that the very
technology boom we have been discussing has raised the rates of
return on prospective capital investment in the United States to
a point where a great deal of investment is taking place either
through securities or through direct investment here. That has
the consequence of increasing the so-called capital surplus, which
means that the obverse, the current account deficit, which is exactly the same size with the sign changed, is also widening.
The way you tell whether in fact the accumulation of capital is
driving the current account deficit is to look at the exchange rate.
The strength of the dollar over the last several years is indicative
of the fact that a substantial part of the opening up in our accounts
is coming from the capital investment side, but clearly not all, because import sensitivity is there. I discuss that in greater detail in
my prepared remarks, and would hope you might have a chance to
get to read them.
Senator BAYH. Thank you very much, Mr. Chairman.
Senator BENNETT [presiding]. Senator Allard.
OPENING COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman.
Chairman Greenspan, welcome to the Committee. I want to keep
my reputation going, so I'm going to ask a question on the debt.
We have recently begun to divide out the debt from a policy standpoint. You referred to it in your comments as "the debt outstanding
to the public." We also have the total debt out there where we have
a transfer from the general fund, from Social Security, and other
funds.
When you look in terms of total debt now, and the balance of
that over and above what's outstanding to the public, do you view
that as of any significance to you as an economist, or is it pretty
much in your view just a bookkeeping issue with the Congress?
Chairman GREENSPAN. Senator, we have found—in fact, economists generally have found—that the unified budget balance, which
is essentially the net measure of savings or dissavings from the




27

Federal Government in the economy, has been one we find for economic analytical purposes most useful.
But there's no question that from a budgetary point of view, for
determining what to do with Federal resources in the years ahead,
that something which picks up the trust funds or, even more generally, accrued liabilities, is far more useful for projecting the distribution of resources of the American Government. In that sense,
as a first approximation, looking at the deficit on-budget would be
a preferable means because what that does is to recognize that
there are long-term commitments to Social Security beneficiaries
out there, and that you ought to build up a fund the same way you
would do it in the private sector, and that, therefore, it should be
a separate set of accounts.
But it's important to recognize that as important as that is in improving the way we look at the longer term, it still does not pick
up the full funding of Social Security, Medicare, or civilian or military retirement, for all of which we have trust funds. It's certainly
a very good approximation and having two budgets out there is
quite useful: one to look at the analytical short-term impact on the
economy, and the other to get a far better handle on what the obligations are of the Government to the American public with respect
to retirement benefits. What we have in the past been doing is
looking solely at the unified budget and have effectively been looking at the retirement benefits on a pay-as-you-go basis.
I suspect that we can create a major advance in budgetary policy
were we to move toward two budgets, which indeed is what we
have today. If future budget agreements and indeed all of the various caps which have served us so well are seen as applicable to
on-budget items, I believe that would be a major improvement in
budgeting for the Federal Government.
Senator ALLARD. Thank you for your comments.
In reading over your testimony, I made note of the fact that you
commented that the CPI was greater this year, 1999, than it was
in 1998. You recognized, in conjunction with that, what had happened to energy prices. Oil has gone from historic lows up to about
$20 a barrel now.
Are you concerned about energy prices and how that might be
influencing potential inflationary pressures?
Chairman GREENSPAN. The answer, Senator, is of course yes. But
having said that, it's far less important than it was 20, 30, 40 years
ago because, as you go back and look at the impact of energy costs
on the gross domestic products say in the 1960's or 70's, it was a
far greater force for both economic growth or contraction and inflation than it is today. While there is no doubt that we have seen
a significant pickup as a consequence of increases in gasoline and
home heating oil prices in the CPI, they have a slightly higher
weight than they probably should have. Looking at the impact in
the personal consumption expenditure deflator, in which they have
a smaller share, is probably a better view of the impact.
But the answer to your question is, and I hopefully said it appropriately in my testimony, that the decline in energy prices when
crude went to $10 a barrel had a fairly pronounced effect on measured inflation, and it reversed in this year. But the impact is far
less than it used to be and our concerns about major breakdowns




28

in the flows of crude oil, which really gave us considerable concern
say in the mid-1970's, is far less a concern now than it was then.
Senator ALLARD. I see that my time has expired. Thank you very
much, Mr. Chairman.
Chairman GRAMM. Senator Bennett.
OPENING COMMENTS OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you, Mr. Chairman.
I can't resist being in this gentile tax cut debate that has been
going on back and forth in the form of asking questions. I want to
address the issue of the "huge" tax cut, to quote one of my colleagues, that Congress is talking about. Let me run through some
numbers and see if I'm right.
Our current GDP is in excess of $8 trillion. If we expect the
growth rate that is being talked about here, that means by the end
of a decade, it will be over $11 trillion, or we will generate $100
trillion worth of economic activity.
Chairman GREENSPAN. In nominal dollars.
Senator BENNETT. In nominal dollars, that's correct.
The tax cut which is being attacked out of the White House as
excessive is, over that same period where we are generating $100
trillion worth of economic activity, about $800 billion, or less than
1 percent. Are those numbers correct?
Chairman GREENSPAN. Yes, they sound approximately correct,
Senator.
Senator BENNETT. So we are currently taking, as a percentage of
GDP, the highest percentage. We're taking something like 22 percent of GDP in Federal taxes, and we're talking about cutting that
from 22 percent of GDP down to 21 percent of GDP, which would
still be higher than the tax take when the marginal rate was 70
percent following World War II. Is that correct?
Chairman GREENSPAN. That is correct, Senator.
Senator BENNETT. I want to make the point that we are not necessarily talking about a "huge" tax cut in view of the projections
that have been made. I want to say on the record that I agree with
your priorities. If we could control this as a board of directors of
a responsible business, I would say that before we make a dividend
to the shareholders, which is basically what the tax cut is, we
should pay down the corporate debt. When we have paid down the
corporate debt and we still have some left over, we should pay out
a dividend to the shareholders.
The only reason you don't pay a dividend to the shareholders is
that you assume the management of the business can make that
money grow better than the shareholders themselves can make it
grow. If the shareholders can invest it for 6 percent and you think
keeping that money in the company can make it grow at 8 or 10
percent, you're doing the shareholders a favor by hanging on to it.
In this case, I don't think the Federal Government does the shareholders a favor by hanging on to it, and I'm willing to take the risk
of having a less than 1 percent of GDP tax cut.
Now, having made that speech, let me go to another subject
that will surprise you not at all. I want to talk to you about Y2K.
Coming before the Special Committee on Y2K, which I chair, last
Thursday the State Department's Inspector General told our Com-




29

mittee, "Y2K-related disruptions in the international flow of goods
and services are likely."
I believe we have the Y2K problem under control in this country
to a degree that I would not have anticipated when the Special
Committee was created. We have done a better job of getting that
under control than I thought we would. But overseas, we are seeing
some of the challenges that we had feared.
The aggregate data that she shared with our Committee showed
that nine of the 39 industrialized nations surveyed were at medium
to high risk of experiencing failure in telcom, energy, and water
sectors, and 52 of the 68 developing nations had a similarly high
level of risk in breakdowns in these sectors.
You have talked here about the impact on the United States of
the "Asian flu" in our agricultural sector. I want to use that as the
analogy to talk about the impact in the financial sector of a Y2K
problem of this kind. I refer you to the latest Merrill Lynch study,
where they talk about a major liquidity problem arising in certain
parts of the world because of Y2K.
I share with you and take every opportunity I can to tell people,
"Don't take your money out of the bank in the United States in anticipation of Y2K." That would be a foolish thing to do. But international investors are withholding liquidity in the international
areas because of Y2K concerns.
Have you had any focus in that area, and do you have any information you can share with us?
Chairman GREENSPAN. Senator, as we have discussed before, we
are confronted with what is truly a unique event. Nothing of this
nature has ever happened before. And we are starting from scratch
in trying to understand all of the potential.
Nonetheless, I agree with your conclusion regarding the United
States. We have picked up the rate of pace to adjust for the possibilities of problems, and I feel far more comfortable now than I did
6 months ago.
It is also true, as I recall in the presentation to your Committee,
that financial areas were perceived to be doing a good deal better
than some of the other areas of the foreign economies. That's important to us because while we are acutely aware of all of the problems that can arise, including the liquidity type of issue which
Merrill Lynch is raising, we think we're sufficiently in position to
address those issues.
Indeed, one of the things we follow very closely is the implicit interest rate that's being charged over the new year, because that is
not a bad measure of the extent of financial stress that the markets are perceiving as likely to emerge as a consequence of that.
Indeed, we do see some of what we call butterfly effects where the
interest rates go up and down. They have not yet reached a point
where there is evident real stress in the system. We can conjecture
a good deal about all sorts of problems, but people in the marketplace are feeling increasingly more comfortable, as best I can judge.
That should not mean that we become complacent on this issue,
but I do think that a remarkable amount of effort has been put in
to assure the systems in the United States, certainly in the financial areas.




30

And I would reiterate what you just said with respect to banks,
Senator. The most risky activity that people can take is to take all
the currency out of their banks because there will be a new industry that will emerge as a consequence of that, which will be millennium thievery, and I think you have a far greater chance of losing
your money if you take it out than if you leave it in.
There is going to be a fairly general set of procedures where accounts are going to be made available to everybody so that in the
very, very remote chance that computers break down and wipe out
the evidence of people's deposits, there is physical material there.
That is a concern which is being very fully addressed, and I see the
concerns that a lot of people have about what's going to happen to
their banks to be, at this stage, far more adverse than I think even
remotely is going to be the case. I suspect, as some of the evidence
shows, that the amount that a number of surveys suggest people
are going to want to draw out in cash is beginning to move downward, and that's a very good sign.
Chairman GRAMM. It seems to me we should be encouraged. In
the year 1000, they had to add a new digit, and yet there was no
evidence of economic disruption. A millennium before, we had dates
going down, and they started going up.
[Laughter.]
Yet, there was no evidence of disruption or chaos in the economy.
If they could do it then, surely we can deal with it now, it seems
to me.
Senator BENNETT. I have a relative, Mr. Chairman, if you will indulge me, who has a tombstone that is not Y2K-compliant. When
her husband died, they carved the date of his birth and death in
the tombstone and included the date of her birth, but for the date
of her death they prematurely carved "19." She has outfoxed them
by living into the next century, and they're going to have to replace
it with "20" when she finally dies.
Chairman GRAMM. She still has another 6 months.
[Laughter.]
Senator Reed.
OPENING COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman.
Chairman Greenspan, I note that at page 10 of your report, you
indicate the positive role that the Federal Government is now playing in contributing to national savings.
In the context of the proposed significant tax cuts, how would
that contribution be affected?
I guess, again, I'm not being an economist, but households have
increased a little in their savings rate. Nevertheless, it's still lagging far below other countries.
Chairman GREENSPAN. Actually, Senator, the latest numbers we
have show the savings rate is still negative.
Senator REED. So, essentially, one could analyze this as taking
money from the Federal Government, which is, because of our policies, saving in the national context, and giving it to households who
have net savings, which would seem to imply increased consumption, a hotter economy, and the Federal Reserve stepping in even
more dramatically to cool it off.




31

Is that a fair analysis of the possible consequences of tax cuts?
Chairman GREENSPAN. Senator, it would be a fair analysis if the
cuts were to occur immediately because, indeed, exactly what you
suggest is the way it would probably start to emerge. That's not in
any of the bills which I think have been thrown into the hopper.
They are all working against the on-budget surplus which evolves
rather slowly in the context of the projections that are being made.
It's sufficiently far out that I don't particularly have that concern.
My concerns have to do with the long-term fiscal structure. I'm not
unduly concerned by any of the bills that I've seen creating problems. If there were significant corporate tax changes in place, even
projected 5, 7, 8 years out, that could have an effect, because longterm capital investment would be impacted. But it is not likely,
with the heavy emphasis on consumers in these tax bills, that that
is a problem which creates difficulty for me.
Senator REED. Your major concern, Chairman Greenspan, is,
over time, the mismatch between the accumulating tax cuts and
the accumulating obligations we have to Social Security, to Medicare, to funding the Government?
Chairman GREENSPAN. I am not against cutting taxes. I would
hope that we would put in significant cuts as we see the surplus
developing, or if we were to see the surplus being dissipated by the
expenditures.
Senator REED. I think, Chairman Greenspan, that your concerns
are my concerns. It's a lot easier to cut taxes than it is to raise
them, and cutting taxes now and then discovering a shortfall in
revenues or a change in economic conditions puts us in the position
of either haying to dramatically cut expenditures, which is also difficult, or raise taxes. Those are not easy things to do, and I think
the temptation, particularly now because of these rosy projections,
is to do something which is generally pretty easy to do, cut taxes.
But in the hard times that might emerge, I don't think we would
have the same enthusiasm to do what you suggest must be done:
significant reductions in expenditures or increasing taxes to once
again balance the budget.
Thank you very much, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Reed.
Senator Grams.
OPENING COMMENTS OF SENATOR ROD GRAMS

Senator GRAMS. Thank you very much, Mr. Chairman.
I just had to talk a little bit about what Senator Reed was just
talking about, saying it's easy to cut taxes, hard to raise them.
That's not true at all. In the last 18 years, there have been 15 tax
bills; only three have dealt with tax cuts; two had no net result in
the revenues; 10 were tax increases, and those ten went back and
undid any tax cuts that were out there.
When they say that it's easy to cut taxes, it's the hardest thing
in Washington to do. It only has to be relevant by looking at the
gross domestic product and what share the Government is taking.
It is a larger bite today than ever before. This fallacy that's out
there and this argument that they continue to throw on the floor
that, "Oh, my goodness, it's easy to cut taxes, but we don't want
to do it now," is ridiculous.




32

Also, as Senator Bennett was saying, a $100 trillion gross economy over the next 10 years and an $800 billion tax cut is by no
means huge or large. It's puny in many respects.
I think about Senator Bayh of Indiana who was asking about
Government productivity. We should expect productivity like we
have seen in the private sector, but not one Government budget is
being cut; they are growing twice as fast as workers' wages. I'm reminded of a small computer-parts manufacturing company located
in Hibbing, Minnesota. They told me that in 20 years of business,
they have never raised their prices once. In fact, every year in the
bidding process they have had to cut prices in order to remain competitive. That's the private sector, not double-digit increases as in
the Government.
I hear these arguments all the time. This is not even a tax cut,
per se; it's just giving back. We have more people paying taxes and
the taxes are larger, so everybody should feel that they should get
a little back or share the burden, rather than paying so much.
I'm not trying to preach to you, Chairman Greenspan. I know
you know this.
One thing I wanted to talk about is the claim or the argument
that we need to put some of this money aside for Social Security
and Medicare. We have agreed that all the surplus in Social Security should be set aside to pay down the debt, to help make sure
that Social Security is going to be solvent. Medicare is another
question.
I know that I've talked to you about this before, and that is the
big debate over whether general revenue sources should be used to
supplement these trust funds. If we open the door, which is being
proposed now by the President and the Democrats, to open this
door and stick the hand into the general revenue cookie jar to support a trust fund without reforms—there have been no reforms proposed in either Social Security or Medicare—where do you come
down? Should general revenues be used to prop up the system, or
should we have genuine reform in Medicare and Social Security?
Chairman GREENSPAN. Senator, we confronted this problem in
the 1983 Social Security Commission. I was impressed by the fact
that a bipartisan Commission was very strongly opposed to the use
of general revenues on the grounds that social insurance funds
should be self-financing, fundamentally,
I would very much prefer that we did not move in the direction
of general revenues because, in effect, once you do that, you have
opened up the system completely, and the issue of what Social Security taxes are becomes utterly irrelevant. Clearly, if you don't
change either the tax structure or the benefit structure of either
Social Security or Medicare, and you improve the trust funds, it
could only have come from general revenues. There is no other possibility. And I am not terribly certain that serves our budgetary
processes in a manner which I think is appropriate.
I understand and I recognize that there are arguments to go to
general revenues in the context of significant changes, but I would
be cautious in that direction, and I guess I may be increasingly one
of the last holdouts on this issue.
Senator GRAMS. I think the proposal is to use general revenue
funds. That's what we see, I think, on the table today. But if they




33

want to promise these benefits through these trust funds, then
maybe we should get the tax reserves from those programs. I heard
people say that we want to spend the money, but we're not willing
to tax for it. In other words, if we need to make Medicare solvent,
it should come from Medicare withholding taxes, and the same
with Social Security. I hope we can take a look at that. I agree with
you, I think if we open that door to general revenues, they become
entitlements and the withholding taxes become irrelevant and we
are just going to put them all into one pie.
I have one more question on taxes. The question, do you view tax
relief as basically investment in the economy? I think it helps the
economy grow because if you have more money available to either
business, in the form of capital, or consumers, that's an investment
in the economy and it can help the economy continue to grow. I
look at it this way. If you reduce taxes, there is less money to the
Government, but you keep more in the private sector.
Chairman GREENSPAN. I'm of, I guess, the old fiscal school that
you raise revenue for basic Government purposes, and that if you
don't have those purposes, you give the money back or you don't
tax it. I don't consider that you raise taxes and invest them in Government programs to get higher rates of return. If that were indeed
the case, I probably would be supportive of that, but my experience
is that the private sector's rates of return tend to be significantly
higher than the Government's rates of return.
That is actually the analogy that Senator Bennett raised about
business, which maybe a lot of people think is a little simplistic,
but it's not altogether off-track.
Senator GRAMS. I think we have a President that has no faith
in the private sector, no faith in the American worker, but more
faith in the Government to do this.
Thank you, Mr. Chairman.
Chairman GBAMM. Thank you, Senator Grams.
Senator Edwards.
OPENING COMMENTS OF SENATOR JOHN EDWARDS

Senator EDWARDS. Thank you, Mr. Chairman.
Good morning, Chairman Greenspan. I have to say I agree with
what you just said, and it didn't seem particularly oversimplistic to
me. I believe Senator Bennett's analogy actually made a great deal
of sense.
I have been listening to your testimony this morning, although
I have not been here. As someone who is really not partisan in
terms of this tax cut issue, because I have struggled with this question tremendously and have looked at all the proposals, I start with
some fundamental things that bother me. I would like to have you
help me with this process that I'm going through.
One is that I think most Americans believe that there's a lot of
hocus-pocus in these 10-year projections, that they're not reliable.
If they\e not reliable for 1 or 2 years, they're certainly not reliable
for 10.
You compound that problem with the fact that we're not meeting
the caps that have already been imposed. The Congress has shown
we have not, at least until now, been fiscally disciplined enough to




34

meet those caps, and I do believe that Government spending needs
to be kept down.
I thought I heard you say earlier today, and I would like for you
to tell me if this is right, that tax cuts, over the long haul, create
incentives to keep Government spending down. I believe that's a
very positive thing. I believe we very badly need to pay down the
debt. I think that's a high priority.
My problem with all of this is, I think, in essence, that we're
dealing with it with numbers that I have no confidence in, or a low
level of confidence in, particularly over the period of time that
we're talking about.
I would like to see a tax cut. This money belongs to the American
people, and we need to give it back to them, but I would like to
give it back to them in a real world where it makes sense to give
it back to them, and not in some fantasy land.
I would like to get some comment from you about whether you
have ideas about ways that we can do this where we're imposing
these tax cuts, some of which I agree with some of my colleagues,
even on the other side of the aisle, but we're making these tax cuts
in the real world, when we know that there is a surplus, when we
know that the money is really there, when we know that we have
done what we need to do fiscally to pay down the debt.
I hope that question makes some sense, but I would love some
comment in response from you about that.
Chairman GREENSPAN. Is it the question of whether we're giving
the taxes back, in a sense?
Senator EDWARDS. Or is there a way to do it other than the way
we're doing it?
Chairman GREENSPAN. There is an interesting issue here. We
have a little more than $3.5 trillion in debt to the public, which
means, cumulatively, over a period of generations, we have spent
that much more than we have received in revenues. When you're
running a surplus, there's an interesting question as to whether,
in fact, you perceive that the monies that are employed there are
being used to pay off previous debt, which is essentially financing
deficit spending, or you're returning taxes which are excess in the
process. Clearly if the debt is zero, then I would say that if you're
running a surplus, it should all go back in tax cuts because, in effect, you have raised more taxes than you need for the programs
that you have, and because you have more money doesn't mean you
should spend it.
But I think it's a very tricky question to make a judgment as to
what part of excess, meaning the surplus, goes back to the taxpayer, and what part goes back to reduce the debt. In a sense, it's
the same sort of analogy that Senator Bennett was raising with respect to that same particular process.
Senator EDWARDS. From your perspective, personally, is there
someplace in this spectrum, either timewise or some other way,
where your confidence level would be such that you would feel comfortable saying that we have done what we need to do, we have
been fiscally disciplined, we have paid down enough of the debt, or
we have paid down the debt, and it's now time for a tax cut?
That's what I'm trying to get a sense of.




35
Chairman GREENSPAN. I would say the words "several years"
strike me. In other words, 1 year, 2 years; as far as I'm concerned,
the more we can do, the better. I recognize that it is very difficult
to sit with a surplus without doing something with it. My preference is to go as far as we can in paying down the debt because,
in the process, we increase the debt-raising capacity of the Federal
Government as well, and merely delaying what we're bound to do
doesn't eliminate it.
In other words
Senator EDWARDS. Excuse me for interrupting you, but I assume
in that process of several years, as you describe it, you would anticipate, if these projections turn out to be at least roughly accurate, that there would be a place at that point in time where we
have done what we need to do with the national debt, and it's time
to give taxpayers back their money?
Chairman GREENSPAN. Absolutely. And, indeed, many of the programs that we're now looking at do just that. It's a matter of their
being enacted now, rather than a little later. I'm not terribly certain that a number of the bills that you're confronted with are the
wrong bills; that is, even with the time frame they have, it is a
question of when do you put them into law?
Senator EDWARDS. Absolutely. 1 agree with that completely.
Chairman Greenspan, if I could ask just one last question, which
is really a very practical question, and it goes to the paying down
the debt issue. All of us have to go back home and talk to our constituents. I will be talking to a lot of North Carolina families, who
may be saying to me, for example, around the kitchen table: "Well,
a tax cut was proposed that would give us back $600 a year in our
taxes, and that's money we could use. It would really help out our
family." What should I say to them?
Let's assume, at least for the moment, that I don't believe a tax
cut is the right thing to do. What should I say to them about why
it makes sense to do the kinds of things you have been talking
about; using the money, for example, to pay down the national
debt? How does it affect their lives is what I'm really asking?
Chairman GREENSPAN. It affects their lives because, if we pay
down the national debt, mortgage interest rates would be lower
than they otherwise would be, the cost of capital generally for capital investment or job-producing investments is likely to be lower
than it would otherwise be, and, as I said before, the debt-raising
capacity of the Federal Government improves so that in the event
that we run into the necessity where significant funds are required,
for tax cuts or anything else, that capacity is there.
Senator EDWARDS. Could you honestly say to them that it also
increases the likelihood that they will hold their jobs, that they will
have pay raises, those kinds of things?
Chairman GREENSPAN. I think that's stretching it a bit. You can
promise a lot of thingsSenator EDWARDS. But you want to tell them the truth.
Chairman GREENSPAN. I would say, theoretically, you can go in
that direction, but I wouldn't press it.
[Laughter.]
Senator EDWARDS. Thank you very much, Mr. Chairman.




36

Chairman GRAMM. I note that Senators Hagel, Crapo, and Kerry
are here, but have not yet had the opportunity to make an opening
statement. Senator Hagel, are there any observations you would
like to make?
OPENING COMMENTS OF SENATOR CHUCK HAGEL

Senator HAGEL. Thank you, Chairman Gramm.
Chairman Greenspan, thank you for your testimony, and also for
your leadership. Today, our economy is in good condition. This is,
in large part, due to your deft handling of the country's monetary
policy. I am very appreciative of that and I thank you.
Mr. Chairman, I am going to ask that my full statement be included in the record.
Thank you.
Chairman GRAMM. Senator Crapo.
OPENING COMMENTS OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you, Mr. Chairman.
I will join the remarks of those who have gone before me. Chairman Greenspan, for the great work you have done, I would like to
add my praise. Thank you for your enlightening testimony.
Thank you, Mr. Chairman.
Chairman GRAMM. Senator Kerry,
OPENING COMMENTS OF SENATOR JOHN F. KERRY

Senator KERRY. Thank you, Mr. Chairman.
Chairman Greenspan, I join with everybody in thanking you for
a very extraordinary job. Your stewardship is obvious to all, and
I think is gaining the recognition that it appropriately deserves.
Thank you very much, Mr. Chairman.
Chairman GRAMM. Chairman Greenspan, I have a couple more
questions. Senator Schumer promises me he has just one more
question, and then we will end the hearing.
I would like to begin by saying that if you're going to tell the
American people that you're paying down the debt and you're not
going to vote for a tax cut, you had better vote against all these
spending increases, or you're not telling them the truth.
Chairman GREENSPAN. Absolutely.
Chairman GRAMM. Where I'm coming from on this whole issue,
if I believe we could hold the line on spending, I would much prefer
to do nothing now, run down the debt for 16 months, have a Presidential election, let the issue in that election be what we do with
the surplus, let the American people decide in the congressional
races and the Presidential race, and make the decision. That would
be my preference.
Unfortunately, I see a buildup of what could become the most
rapid growth in Government spending since the 1970's. And I am
concerned that we could wait around for 16 months and end up
with another massive, unfunded entitlement—because all that the
President's giving Medicare, as you know, is an IOU that would be
cashed in 15 years from now when there's no money. The Treasury
is no better off with the IOU in terms of paying the benefits than
they are without it, as you, of all people, know.




37

I am simply driven to the tax cut now, believing the money won't
be there when we elect a new President if we don't do it now. I
don't have any doubt we would pass a better tax cut with the next
President than we're going to pass with this one, because I know
who this President is, and I think I know who the next President
will be. But that, basically, is the dilemma I find myself in.
Let me give you my two questions. As you know, the House will
probably name conferees today, at long last, on the Financial Services Modernization Act. As you are also aware, the Treasury has
taken the extraordinary position of saying that unless we allow
the banks to provide these expanded financial services within the
bank structure itself, rather than outside the bank in the holding
company—which is the position that you have taken—they would
consider vetoing the bill.
Number one, I don't know that I believe they would veto the bill;
number two, there may be some ability to compromise here. But I
want to be sure I get a simple answer to this question.
As the Chairman of this Committee, and obviously the Chairman
of the Senate side of the Conference, I am faced by this Administration with a choice, and the choice is either no Financial Services
Modernization bill, or having the banks exercise these new powers
within the bank itself, with the safety and soundness concerns and
with the potential subsidy for banks in competing with other economic entities in those areas.
If I had to make the choice, no bill or allowing the so-called
op-sub, if you were me, which choice would you make?
Chairman GREENSPAN. Well, Senator, I testified before the House
Banking Committee—I believe it was House Banking or House
Commerce—that as important as it is to get the Glass-Steagall Act
repealed, it's far more important that it be done correctly. I have
argued that it is a potentially destabilizing structure that would
occur with the subsidies within the bank were we to have full powers in the subsidiaries of the banks because I think, with the extraordinary change in technology that is occurring and the rapid
change in financial instruments that are proliferating throughout
this economy and the world, that we have to be cautious when we
have a significant subsidy in a financial institution to be sure that
is appropriately contained.
Allowing significant powers in the subsidiary of the bank, in my
judgment, would not do that.
Chairman GRAMM. I think you were sufficiently clear, but I want
to be absolutely sure no one is confused. If the choice were op-subs
or no bill, you would say no bill?
Chairman GREENSPAN. That is correct, Senator.
Chairman GRAMM. I hope it's not that choice, because I come
down on the same side that you do on this issue. I'll ask my final
question, and then turn to Senator Schumer.
I'm really worried about what we're doing in farm policy, because
I look at the data. I read your speech to the independent bankers,
and I have asked all of our people interested in agricultural policy
to read the speech. But basically, the productivity which is driving the current economic expansion is at work in agriculture with
greater focus than it is in the economy as a whole.




38

Productivity growth in agriculture, in the last 30 years, has outstripped productivity growth in the economy by roughly a two-toone margin. In fact, their costs are going down in agriculture, and
this rapid growth in technology, both here and worldwide, together
with the loss of markets because of the Asian financial crisis and
some other minor factors, has produced a decline in farm prices.
The point is that to the extent that this decline is due to technological breakthroughs, it's not going away. The bottom line is, as
hard as it sounds for us, we have a proposal from Senator Daschle
that we give $9.9 billion of payments to farmers to offset a decline
in farm income of approximately $4 billion. The net result would
be a $5 billion increase over what would have happened had prices
not gone down.
The problem, it seems to me, with that proposal is that if this
technological expansion continues with its downward pressure—as
technological improvements produce downward pressure on prices,
which is why society benefits—we are literally, through our policy,
encouraging more people to go into production and driving prices
down further.
Do you share those concerns? I ask this as a Senator whose State
is the largest beneficiary of Federal farm payments.
Chairman GREENSPAN. I do share your concern, Senator, because
the agricultural productivity revolution is even more remarkable,
as you pointed out, than we see in the nonfarm area. Crop yields
have gone up in the major crops extraordinarily. Herds of cattle
and hogs have not changed materially, but the output of beef, pork,
milk, and especially chickens and poultry has been just unbelievable. The improvements in agriculture are truly awesome.
Chairman GRAMM. And you can probably make a case that we
have more of it coming than we might have in the economy as a
whole.
Chairman GREENSPAN. I don't know that, but what has occurred
to date shows no evidence that I'm aware of that the rate of productivity has slowed down. Indeed, in the last year or two, productivity has moved up even faster.
Chairman GRAMM. Well, the remarkable thing is when you have
these farms with 275,000 pigs and the cost of production has fallen
right through the floor, and they're producing more pork with fewer
pigs, which is incredible, to be subsidizing people to stay in hog
production just seems suicidal to me, even though I have hog producers who, because of these technological breakthroughs, will end
up being driven out of business almost without regard to what we
ultimately do. It's a very difficult thing to deal with.
Senator Schumer.
Senator SCHUMER. Thank you. I was tempted to say something
about producing more pork with fewer pigs, but I'm going to let it
drop. I thank the Chairman for his indulgence and for his always
excellent questions. I have one final question which I didn't have
time to ask before. It also relates to our international relationships,
although not in the area of agriculture.
Since 1994, private ownership of the U.S. Government debt has
remained stable. I think it's gone from $3.2 trillion to $3.3 trillion.
But over the same period, foreign private ownership has increased
dramatically. The numbers I have here go from $667 billion—which




39

was about 21 percent of outstanding debt—to $1.3 trillion, which
is 39 percent. Over only a 4- to 5-year period, that's a pretty big
increase.
At the same time, we have seen in recent weeks that the value
of our dollar, of the U.S. dollar, is dropping vis-a-vis other currencies. I think the Japanese are now actually doing the inverse of
what they and we were doing several years ago, which was trying
to support the dollar. We haven't been terribly successful in that
support.
My question is if foreign investor attitudes about whether to hold
dollars change, if they're less likely to hold dollars as they become
weaker, what effect would that have on our economy? Isn't it the
same as raising interest rates?
What would the effect on the bond market be? Is it reasonable
to assume that capital would flee? What can we do to prevent this,
if anything? How great a danger is this? What are the possible
solutions?
Chairman GREENSPAN. Senator, in my prepared remarks, one of
the imbalances that I discuss is precisely this question, and I do
raise the issue that the expanding current account deficit is being
financed, obviously, by an ever-increasing amount of ownership of
claims against the United States by foreigners, both governments
and private citizens. Should that propensity to hold dollars fade,
then clearly one of the things that will occur is that market interest rates will tend to rise.
Indeed, a goodly part of the holdings of foreigners are in coupon
issues, as I'm sure you know. The consequence of this is that, if
there is a significant withdrawal—which I must say I don't really
perceive; I think there's a tendency every time markets go up and
down for a few weeks that it becomes a long-term trend and I think
that, frankly, it's being overdone, but let's leave that aside for the
moment.
Talking in the abstract, clearly, as I say in my prepared remarks,
you get higher market interest rates, interest-sensitive areas of
the economy under some pressure, and you bring down the rate of
growth as a consequence.
I can't say I have seen anything of that amplitude or dimension
even remotely pending, but it is clearly one of the issues which
we at the Federal Reserve and our colleagues at the Treasury are
watching very closely.
Senator SCHUMER. Right now, you're not terribly worried?
Chairman GREENSPAN. No, I'm not.
Senator SCHUMER. Thank you, Mr. Chairman.
Chairman GRAMM. Chairman Greenspan, thank you very much
for coming. We appreciate your patience in being here. The market
is up 10 points today, so you have said nothing that has in any way
encouraged or discouraged anybody.
Perhaps that's the way it should be. Thank you very much for
coming today.
The hearing is adjourned.
[Whereupon, at 12:40 p.m., Wednesday, July 28, 1999, the hearing was adjourned.]
[Prepared statements and additional material supplied for the
record follow:]




40
PREPARED STATEMENT OF SENATOR PHIL GRAMM
Under existing law, this is the last mandated Humphrey-Hawkins hearing. As
I have said, we get an opportunity to hear from Alan Greenspan on a regular basis,
and he has not oeen selfish with his time with regard to the Congress. In fact, he
probably spends more time up here than he should.
I don't see any great necessity in continuing the Humphrey-Hawkins hearings.
Other of my colleagues feel differently. Obviously, while I'm Chairman, I'm going
to be guided by the will of the majority of the Committee. But whether this is the
last of the Humphrey-Hawkins hearings, or whether this is just one in a continuing
series, I want to welcome Alan Greenspan, Chairman of the Board of Governors of
the Federal Reserve System.
Alan Greenspan is the greatest central banker in the history of the United States
and therefore, by definition, is the greatest central banker in the history of the
world. It is an amazing thing to me, as I travel around the world and meet other
central bankers, how clear it is that Alan Greenspan has become the world's standard for central banking. To the degree that imitation is the highest form of flattery,
almost no matter where you go, no matter which central bankers you visit with,
they tend to act and sound like Alan Greenspan. It seems to me, Mr. Greenspan,
that is a great compliment to you.
Now, we have spent many hours—far more than the debate deserves—debating
about who is responsible for the golden economic era we find ourselves in. I don't
ever remember the economy being better than it is today; I don't ever remember
the prosperity being as broadly based as it is today.
Last year, our economy not only had strong economic growth, but probably over
the last 3 years the average white-collar worker in America, certainly above the age
of 50, has seen the value of their financial assets grow by more than their annual
income. For the first time ever last year, Americans had more financial wealth than
they had in the equity value of their homes.
We have debated endlessly as to who is responsible. I give a lot of credit to Ronald
Reagan in terms of planting the seeds of modernization and efficiency, holding back
the forces of protectionism. In the 1980's, when General Motors was questioning
whether it could stay in the automobile industry, the unions and automakers came
to Washington and met with Ronald Reagan. He gave them the prescription "compete or die," and they competed.
There are many people deserving of credit for the current golden economic age we
live in, but I think if there is any person currently in office who could lay a claim
to having done more than any other person on the planet to produce this record
level of prosperity, it ia Alan Greenspan. I want to thank you, Chairman Greenspan,
for the great job you have done. I want to thank you for the great service you have
provided.
Your utterances have become somewhat like the Bible in the sense that everybody
quotes you to prove their point, even though their quote may be counter to the quote
tnat someone else is using to prove exactly the opposite point. I am sure that much
of your time today will be spent deciding the exact meaning of Deuteronomy, or at
least that section of Alan Greenspan's utterances.
In any case, we appreciate the great job you have done, and we appreciate the
sacrifice you have made in keeping this position. I have tried now for several years
to raise your pay. I know that you're not missing any meals, and you don't necessarily need it, but I don't want it so that you have to be rich to be the Chairman
of the Board of Governors of the Federal Reserve System. I intend to continue to
work until we get salaries that are comparable to what they are in other areas of
the Government.
PREPARED STATEMENT OF SENATOR CONNIE MACK
Since 1982, the United States has had only 9 months of recession. This is the
longest we have gone with only 9 months of recession since at least the 1850's.
Besides the great reduction in marginal tax rates in the 1980's, price stability has
been one of the key reasons for this record-setting performance. During the past 17
years, inflation has been less volatile than during any other 17-year period since at
least the 1820's.
With Chairman Greenspan in charge, I remain confident the Fed will keep prices
stable. However, Mr. Greenspan will not be running the Federal Reserve forever.
That's why I intend to reintroduce legislation that will make it explicit that longterm price stability is the Fed's primary goal. This legislation will also continue the
tradition of semiannual hearings before the Banking Committee.
As always, Chairman Greenspan, I look forward to your comments.




41
PREPARED STATEMENT OF SENATOR CHUCK HAGEL
Today, our economy is in good condition. This is, in large part, due to Chairman
Greenspan's deft handling of the country's monetary policy. We are now enjoying
a combination of positive economic factors that many thought were incompatible—
low inflation and low unemployment. I think that says a great deal about Chairman
Greenspan's time at the Federal Reserve System.
Unfortunately, there is an important segment of our society that isn't enjoying the
benefits of this economic expansion. Farmers and ranchers are suffering from low
commodity prices. Some people are trying to make the Freedom to Farm Act the
scapegoat for the current crisis in agriculture. I see it differently.
In large part, the problems in the agriculture economy are the result of the Government's failure to provide the open markets promised when the Freedom to Farm
Act was enacted. In addition, the Government has been too slow in reforming our
patchwork of unilateral sanctions and other restrictions on the free flow of agricultural products. We should be more aggressive in creating opportunities for free and
fair trade—giving our farmers and ranchers new markets for their goods. We need
to fulfill our promises to America's agricultural producers.
Another area I hope to engage Chairman Greenspan in deals with the issue of
tax cuts. Congress is considering options for the projected surplus. Those opposed
to tax cuts are arguing that if Congress enacts tax cuts, the Federal Reserve will
be forced to raise interest rates in order to cool off the economy. I would like to hear
from Chairman Greenspan on what he thinks we should do with the surplus, if in
fact the projections are correct.
Finally, members of the Conference Committee are beginning the task of working
out many of the difficult details encompassed in the Financial Modernization bill.
Today, the United States is the global leader in financial services. We must not
jeopardize this position through congressional inaction or bad choices. I would appreciate any advice Chairman Greenspan chooses to give as we navigate the tough
issues during conference.
I look forward to Chairman Greenspan's testimony and thank him for appearing
here today.
PREPARED STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
JULY 28, 1999
Introduction
Thank you, Mr. Chairman and Members of the Committee, for this opportunity
to present the Federal Reserve's semiannual report on monetary policy.
To date, 1999 has been an exceptional year for the American economy, but a very
challenging one for American monetary policy. Through the first 6 months of this
year, the U.S. economy has further extended its remarkable performance. Almost
1V4 million jobs were added to payrolls on net, and gross domestic product apparently expanded at a brisk pace, perhaps near that of the prior 3 years.
At the root of this impressive expansion of economic activity has been a marked
acceleration in the productivity of our Nation's workforce. This productivity growth
has allowed further healthy advances in real wages, and has permitted activity to
expand at a robust clip while helping to foster price stability.
Last fall, the Federal Open Market Committee (FOMC) eased monetary policy to
counter a seizing-up of financial markets that threatened to disrupt economic activity significantly. As those markets recovered, the FOMC had to assess whether that
policy stance remained appropriate. By late last month, when it became apparent
that much of the financial strain of last fall had eased, that foreign economies were
firming, and that demand in the United States was growing at an unsustainable
pace, the FOMC raised its intended Federal funds rate 1A percentage point, to 5 percent. To have refrained from doing so, in our judgment, would have put the U.S.
economy's expansion at risk.
If nothing else, the experience of the last decade has reinforced earlier evidence
that a necessary condition for maximum sustainable economic growth is price stability. While product prices have remained remarkably restrained in the face of exceptionally strong demand and expanding potential supply, it is imperative that we
do not become complacent.
The already shrunken pool of job-seekers and considerable strength of aggregate
demand suggest that the Federal Reserve will need to be especially alert to inflation
risks. Should productivity fail to continue to accelerate and demand growth persist




42
or strengthen, the economy could overheat. That would engender inflationary pressures and put the sustainability of this unprecedented period of remarkable growth
in jeopardy. One indication that inflation risks were rising would be a tendency for
labor markets to tighten further, but the FOMC also needs to continue to assess
whether the existing degree of pressure in these markets is consistent with sustaining our low-inflation environment. If new data suggest it is likely that the pace
of cost and price increases will be picking up, the Federal Reserve will have to act
promptly and forcefully so as to preclude imbalances from arising that would only
require a more disruptive adjustment later—one that could impair the expansion
and bring into question whether the many gains already made can be sustained.
Recent Developments
A number of important forces have been shaping recent developments in the U.S.
economy. One has been a recovery of financial markets from the disruptions of last
fall. By the end of 1998, the extreme withdrawal from risk-taking and consequent
seizing-up of markets had largely dissipated. This year, risk spreads have narrowed
further—though generally not to the unrealistically low levels of a year ago—and
a heavy volume of issuance in credit markets has signaled a return to their more
normal functioning. Equity prices have risen to new highs and, in the process, have
elevated price-earnings ratios to historic levels.
Abroad, many financial markets and economies also have improved. Brazil weathered a depreciation of its currency with limited fallout on its neighbors. In Asia, a
number of the emerging-market economies seemed to be reviving after the trying
adjustments of the previous year or so. Progress has not been universal, and in
many economies prospects remain clouded, depending importantly on the persistence of efforts to make fundamental reforms whose necessity had been made so
painfully obvious in the crises those economies endured. Nonetheless, the risks of
further major disruptions to financial and trade flows that had concerned the FOMC
when it eased policy last fall have clearly diminished. Improving global prospects
also mean that the U.S. economy will no longer be experiencing declines in basic
commodity and import prices that held down inflation in recent years.
In the domestic economy, data becoming available this year have tended to confirm that productivity growth has stepped up. It is this acceleration of productivity
over recent years that nas explained much of the surprising combination of a slowing in inflation and sustained rapid real growth. Increased labor productivity has
directly limited the rise of unit labor costs and accordingly damped pressures on
prices. This good inflation performance, reinforced also by falling import prices, in
turn has fostered further declines in inflation expectations over recent years that
. bode well for pressures on costs and prices going forward.
In testimony before this Committee several years ago, I raised the possibility that
we were entering a period of technological innovation which occurs perhaps once
every 50 or 100 years. The evidence then was only marginal and inconclusive. Of
course, tremendous advances in computing and telecommunications were apparent,
but their translations into improved overall economic efficiency and rising national
productivity were conjectural at best. While the growth of output per hour had
shown some signs of quickening, the normal variations exhibited by such data in
the past were quite large. More intriguing was the remarkable surge in capital investment after 1993, particularly in high-tech goods, a full 2 years after a general
recovery was under way. This suggested a marked increase in the perceived prospective rates of return on the newer technologies.
That American productivity growth has picked up over the past 5 years or so has
become increasingly evident. Nonfarm business productivity (on a methodologically
consistent basis) grew at an average rate of a bit over 1 percent per year in the
1980's. In recent years, productivity growth has picked up to more than 2 percent,
with the past year averaging about 2Vz percent.
To gauge the potential for similar, if not larger, gains in productivity going forward, we need to attempt to arrive at some understanding of what has occurred to
date. A good deal of the acceleration in output per hour has reflected the sizable
increase in the stock of labor-saving equipment. But that is not the whole story.
Output has grown beyond what normally would have been expected from increased
inputs of labor and capital alone. Business restructuring and the synergies of the
new technologies have enhanced productive efficiencies. American industry quite
generally has shared an improved level of efficiency and cost containment through
high-tech capital investment, not solely newer industries at the cutting edge of innovation. Our century-old motor vehicle industry, for example, has raised output per
hour by a dramatic 4?/2 percent annually on average in the past 2 years, compared
with a lackluster IVi percent on average earlier this decade. Much the same is true
of many other mature industries, such as steel, textiles, and other stalwarts of an




43
earlier age. This has confirmed the earlier indications of an underlying improvement
in rates of return on the newer technologies and their profitable synergies with the
existing capital stock.
These developments have created a broad range of potential innovations that have
granted firms greater ability to profitably displace costly factors of production whenever profit margins have been threatened. Moreover, the accelerating use of newer
technologies has markedly enhanced the flexibility of our productive facilities. It has
dramatically reduced the lead times on the acquisition of new equipment and enabled firms to adjust quickly to changing market demands. This has indirectly increased productive capacity and effectively, at least for now, eliminated production
bottlenecks and the shortages and price pressures they inevitably breed.
This greater ability to pare costs, increase production flexibility, and expand capacity are arguably the major reasons why inflationary pressures have been held
m check in recent years. Others have included the one-time fall in the prices of oil,
other commodities, and imports more generally. In addition, a breaking down of barriers to cross-border trade, owing both to the new technologies and to the reduction
of Government restrictions on trade, has intensified the pressures of competition,
helping to contain prices. Coupled with the decline in military spending worldwide,
this has freed up resources for more productive endeavors, especially in a number
of previously nonmarket economies.
More generally, the consequent erosion of pricing power has imparted an important imperative to hold down costs. The availability of new technology to each company and its rivals affords both the opportunity and the competitive necessity of
taking steps to reduce costs, which translates on a consolidated basis into increased
national productivity.
The acceleration in productivity owes importantly to these new information technologies. Prior to this IT revolution, most of twentieth-century business decisionmaking had been hampered by limited information. Owing to the paucity of timely
knowledge of customers' needs, the location of inventories, and the status of material flows throughout complex production systems, businesses built in substantial
redundancies.
Doubling up on materials and staffing was essential as a cushion against the inevitable misjudgments made in real time when decisions were based on information
that was hours, days, or even weeks old. While businesspeonle must still operate
in an uncertain world, the recent years' remarkable surge in the availability of realtime information has enabled them to remove large swaths of inventory safety
stocks, redundant capital equipment, and layers of workers, while arming them with
detailed data to fine-tune specifications to most individual customer needs.
Despite the remarkable progress witnessed to date, history counsels us to be quite
modest about our ability to project the future path and pace of technology and its
implications for productivity and for economic growth. We must keep in mind that
the pickup in productivity is relatively recent, and a key question is whether that
growth will persist at a high rate, drop back toward the slower standard of much
of the last 25 years, or climb even more. By the last I do not just mean that productivity will continue to grow, but that it will grow at an increasingly faster pace
through a continuation of the process that has so successfully contained inflation
and supported economic growth in recent years.
The business and financial community does not as yet appear to sense a pending
flattening in this process of increasing productivity growth. This is certainly the
widespread impression imparted by corporate executives, and it is further evidenced
by the earnings forecasts of more than a thousand securities analysts who regularly
follow S&P 500 companies on a firm-by-firm basis, which presumably embody what
corporate executives are telling them. While the level of these estimates is no doubt
upwardly biased, unless these biases have significantly changed over time, the revisions of these estimates should be suggestive of changes in underlying economic
forces. Except for a short hiatus in the latter part of 1998, analysts' expectations
of 5-year earnings growth have been revised up continually since early 1995. If anything, the pace of those upward revisions has quickened of late. True, some of that
may reflect a pickup in expected earnings of foreign affiliates, especially in Europe,
Japan, and the rest of Asia, but most of this yea?s increase almost surely owes to
domestic influences.
There are only a limited number of ways that the expected long-term growth of
domestic profits can increase, and some we can reasonably rule out. There is little
evidence that company executives or security analysts have significantly changed
their views in recent months of the longer-term outlook for continued price containment, the share of profits relative to wages, or anticipated growth of hours worked.
Rather, analysts and the company executives they talk to appear to be expecting
that unit costs will be held in check, or even lowered, as sales expand. Hence, im-




44
plicit in upward revisions of their forecasts, when consolidated, is higher expected
national productivity growth.
Independent data on costs and prices in recent years tend to confirm what aggregate data on output and hours worked indicate: that productivity growth has risen.
With price inflation stable and domestic operating profit margins rising, the rate of
increase in total consolidated unit costs must have been falling.
Even taking into account the evidence of declining unit interest costs of nonfinancial corporations, unit labor cost increases (which constitute three-quarters of
total unit costs) must also be slowing. Because until very recently growth of compensation per hour has been rising, albeit modestly, it follows then that productivity
growth must have been rising these past 5 years, as well. Accelerating productivity
is thus evident in underlying consolidated income statements of nonfinancial corporations, as well as in our more direct, though doubtless partly flawed, measures
of output and input.
With that said, we must also understand the limits to this process of productivitydriven growth. To be sure, the recent acceleration in productivity has provided an
offset to pur taut labor markets by holding unit costs in check and by adding to the
competitive pressures that have contained prices. But once output-per-hour growth
stabilizes, even if at a higher rate, any pickup in the growth of nominal compensation per hour will translate directly into a more rapid rate of increase in unit labor
costs, heightening the pressure on firms to raise the prices of the goods and services
they sell. Thus, should the increments of gains in technology that nave fostered productivity slow, any extant pressures in the labor market should ultimately show
through to product prices.
Meanwhile, the impressive productivity growth of recent years also has had important implications for the growth of aggregate demand. If productivity is driving
up real incomes and profits—and, hence, gross domestic income—then gross domestic product must mirror this rise with some combination of higher sales of motor
vehicles, other consumer goods, new homes, capital equipment, and net exports. By
themselves, surges in economic growth are not necessarily unsustainable—provided
they do not exceed the sum of the rate of growth in the labor force and productivity
for a protracted period. However, when productivity is accelerating, it is very difficult to gauge when an economy is in the process of overheating.
In such circumstances, assessing conditions in the labor market can be helpful in
forming those judgments. Employment growth has exceeded the growth in workingage population this past year by almost ¥2 percentage point. While somewhat less
than the spread between these growth rates over much of the past few years, this
excess is still large enough to continue the further tightening of labor markets. It
implies that real GDP is growing faster than its potential. To an important extent,
this excess of the growth of demand over supply owes to the wealth effect as consumers increasingly perceive their capital gains in the stock and housing markets
as permanent and, evidently as a consequence, spend part of them, an issue to
which I shall return shortly.
There can be little doubt that, if the pool of job-seekers shrinks sufficiently, upward pressures on wage costs are inevitable, snort—as I have put it previously—
of a repeal of the law of supply and demand. Such cost increases have invariably
presaged rising inflation in the past, and presumably would in the future, which
would threaten the economic expansion.
By themselves, neither rising wages nor swelling employment rolls pose a risk to
sustained economic growth. Indeed, the Federal Reserve welcomes such developments and has attempted to gauge its policy in recent years to allow the economy
to realize its full, enhanced potential. In doing so, we must remain concerned with
evolving shorter-run imbalances that can constrain long-term economic expansion
and job growth.
With productivity growth boosting both aggregate demand and aggregate supply,
the implications for the real market interest rates that are consistent with sustainable economic growth are not obvious. In fact, current real rates, although somewhat high by our historical standards, have been consistent with continuing rapid
growth in an environment where, as a consequence of greater productivity growth,
capital gains and high returns on investment give both households and businesses
enhanced incentives to spend.
Other Considerations
Even if labor supply and demand were in balance, however, other aspects of the
economic environment may exhibit imbalances that could have important implications for future developments. For example, in recent years, as a number of analysts
have pointed out, a significant shortfall has emerged in the private saving with
which to finance domestic investment in plant and equipment and houses.




45
One offset to the decline in household saving out of income has been a major shift
of the Federal budget to surplus. Of course, an important part of that budgetary
improvement, in turn, owes to augmented revenues from capital gains and other
taxes that have flowed from the rising market value of assets. Still, the budget surpluses have helped to hold down interest rates and facilitate private spending.
The remaining gap between private saving and domestic investment has been
filled by a sizable increase in saving invested from abroad, largely a consequence
of the technologically-driven marked increase in rates of return on U.S. investments.
Moreover, in recent years, with many foreign economies faltering, U.S. investments
have looked particularly attractive. As the U.S. international indebtedness mounts,
however, and foreign economies revive, capital inflows from abroad that enable domestic investment to exceed domestic saving may be difficult to sustain. Any resulting decline in demand for dollar assets could well be associated with higher market
interest rates, unless domestic saving rebounds.
Near-Term Outlook
Going forward, the Members of the Federal Reserve Board and Presidents of the
Federal Reserve Banks believe there are mechanisms in place that should help to
slow the growth of spending to a pace more consistent with that of potential output
growth. Consumption growth should slow some, if, as seems most likely, outsized
gains in share values are not repeated. In that event, businesses may trim their
capital spending plans, a tendency that would be reinforced by the higher level of
market interest rates that borrowers now face. But with large unexploited long-term
profit opportunities stemming from still-burgeoning innovations and falling prices of
many capital goods, the typical cyclical retrenchment could be muted.
Working to offset somewhat this anticipated slowing of the growth of domestic demand, our export markets can be expected to be more buoyant because of the revival
in growth in many of our important trading partners.
After considering the various forces at work in the near term, most of the Federal
Reserve Governors 3and Bank Presidents expect the growth rate of real GDP to be
between 3Vz and 3 A percent over the four quarters of 1999 and IVz to 3 percent
in 2000. The unemployment rate is expected to remain in the range of the past 18
months.
Inflation, as measured by the four-quarter percent change in the consumer price
index, is expected to be 2Vi to 2Va percent over the four quarters of this year. CPI
increases thus far in 1999 have been greater than the average in 1998, but the Federal Reserve Governors and Bank Presidents do not anticipate a further pickup in
inflation going forward. An abatement of the recent run-up in energy prices would
contribute to such a pattern, but the policymakers' forecasts also reflect their determination to hold the line on inflation, through policy actions l if necessary. The central tendency of their CPI inflation forecasts for 2000 is 2 to 2 /2 percent.
Preemptive Policymaking
In its deliberations this year, the FOMC has had to wrestle with the issue of what
policy setting has the capacity to sustain this remarkable expansion, now in its
ninth year. For monetary policy to foster maximum sustainable economic growth,
it is useful to preempt forces of imbalance before they threaten economic stability.
But this may not always be possible—the future at times can be too opaque to penetrate. When we are able to be preemptive, we should be, because modest preemptive
actions can obviate more drastic actions at a later date that could destabilize the
economy.
I should emphasize that preemptive policymaking is equally applicable in both directions, ?s has been evident over the years both in our inclination to raise interest
rates when the potential for inflationary pressures emerged, such as in the spring
of 1994, or to lower rates when the more palpable risk was economic weakness, as
in the fall of last year. This evenhandedness is necessary because emerging adverse
trends may fall on either side of our long-run objective of price stability. Stable
prices allow households and firms to concentrate their efforts on what they do best:
consuming, producing, saving, and investing. A rapidly rising or a falling general
price level would confound market signals and place strains on the system that ultimately may throttle economic expansion.
In the face of uncertainty, the Federal Reserve at times has been willing to move
policy based on an assessment that risks to the outlook were disproportionately
skewed in one direction or the other, rather than on a firm conviction that, absent
action, the economy would develop imbalances. For instance, both the modest policy
tightening of the spring of 1997 and some portion of the easing of last fall could
be viewea as insurance against potential adverse economic outcomes.




46
As I have already indicated, by its June meeting the FOMC was of the view that
the full extent of this insurance was no longer needed. It also did not believe that
its recent modest tightening would put the risks of inflation going forward completely into balance. However, given the many uncertainties surrounding developments on both the supply and demand side of the economy, the FOMC did not want
to foster the impression that it was committed in short order to tighten further.
Rather, it judged that it would need to evaluate the incoming data for more signs
that further imbalances were likely to develop.
Preemptive policymaking requires that the Federal Reserve continually monitor
economic conditions, update forecasts, and appraise the setting of its policy instrument. Equity prices figure importantly in that forecasting process because equity
prices influence aggregate demand. As I testified last month, the central bank cannot effectively directly target stock or other asset prices. Should an asset bubble
arise, or even if one is already in train, monetary policy properly calibrated can
doubtless mitigate at least part of the impact on the economy. And, obviously, if we
could find a way to prevent or deflate emerging bubbles, we would be better off. But
identifying a bubble in the process of inflating may be among the most formidable
challenges confronting a central bank, pitting its own assessment of fundamentals
against the combined judgment of millions of investors.
By itself, the interpretation that we are currently enjoying productivity acceleration does not ensure that equity prices are not overextended. There can be little
doubt that if the Nation's productivity growth has stepped up, the level of profits
and their future potential would be elevated. That prospect has supported higher
stock prices. The danger is that in these circumstances, an unwarranted, perhaps
euphoric, extension of recent developments can drive equity prices to levels that are
unsupportable even if risks in the future become relatively small. Such straying
above fundamentals could create problems for our economy when the inevitable adjustment occurs. It is the job of economic policymakers to mitigate the fallout when
it occurs and, hopefully, ease the transition to the next expansion.
Century Date Change Preparations
I would be remiss in this overview of near-term economic developments if I did
not relay the ongoing efforts of the Federal Reserve, other financial regulators, and
the private sector to come to grips with the rollover of their computer systems at
the start of the upcoming century. While I have been in this business too long to
promise that 2000 will open on an entirely trouble-free note, the efforts to address
potential problems in the banking and financial system have been exhaustive. For
our part, the Federal Reserve System has completed remediation and testing of all
its mission-critical applications, including testing its securities and funds-transfer
systems with our thousands of financial institution customers.
As we have said previously, while we do not believe consumers need to hold excess cash because we expect the full array of payment options to work, we have
taken precautions to ensure that ample currency is available. Further, the Federal
Reserve established a special liquidity facility at which sound depository institutions
with good collateral can readily borrow at a slight penalty rate in the months surrounding the rollover. The availability of this back-stop funding should make depository institutions more wilting to provide loans and lines of credit to other financial
institutions and businesses and to meet any deposit withdrawals as this century
closes.
The banking industry is also working hard, and with evident success, to prepare
for the event. By the end of May, 98 percent of the Nation's depository institutions
that were examined by Federal Financial Institutions Examination Council agencies
were making satisfactory progress on their Year 2000 preparations. The agencies
are now in the process of examining supervised institutions for compliance with the
June 30 milestone date for completing testing and implementation of remediated
mission-critical systems. Supervisors also expect institutions to prepare business resumption contingency plans and to maintain open lines of communication with customers and counterparties about their own readiness. The few remaining laggards
among financial institutions in Year 2000 preparedness have been targeted for additional followup and, as necessary, will be subject to formal enforcement actions.
Conclusion
As a result of our Nation's ongoing favorable economic performance, not only has
the broad majority of our people moved to a higher standard of living, but a strong
economy also has managed to bring into the productive workforce many who had
for too long been at its periphery. The unemployment rate for those with less than
a high school education has declined from 10% percent in early 1994 to 6% percent
today, twice the percentage point decline in the overall unemployment rate. These




47
gains have enabled large segments of our society to obtain skills on the job and the
self-esteem associated with work.
The questions before us today are what macroeconomic policy settings can best
extend this favorable performance. No doubt, a monetary policy that is focused on
promoting price stability over the long run and a fiscal policy focused on enhancing
national saving by accumulating budget surpluses have been key elements in creating an environment fostering the capital investment that has driven the gains to
productivity and living standards. I am confident that by maintaining this discipline, policymakers in the Congress, in the Executive branch, and at the Federal
Reserve will give our vital U.S. economy its best chance of continuing its remarkable
progress.




48
For use at 11:00 a.m., E.D.T.
Thursday
July 22, 1999

Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978

July 22, 1999




49

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C.. July 22. 1999
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased lo submit its Monetary Policy Report to the Congress, pursuant to the
Full Employment and Balanced Growth Act ot 1978.
Sincerely,

Alan Greenspan, Chairman




50

Table of Contents
Page
Monetary Policy and the Economic Outlook
Economic and Financial Developments in 1999




I

51

Monetary Policy Report to the Congress
Report submitted In the Congress on Julv 22. I9W.
l»irxuattt in the Fall Einpitmnent and Balanced
Growth Act of 1978

MONETARY POLICY AND THE ECONOMIC
OUTLOOK
The U.S. economy has continued to perform well in
1999. The ongoing economic expansion has moved
into a near-record ninth year, with real output expanding vigorously, the unemployment rate hovering
around lows lasl seen in 1970. and underlying [rends
in inflation remaining subdued. Responding lo the
availability of new technologies at increasingly
attractive prices, firms have been investing heavily in
new capital equipment; this investment has boosted
productivity and living standards while holding down
the rise in costs and prices.
Two of the major threats faced by the economy in
lale 1998—economic downturns in many foreign
nations and turmoil in financial markets around the
world—receded over the first half of this year. Economic conditions overseas improved on a broad front.
In Asia, activity picked up in the emerging-market
economies that had been battered by the financial
crises of 1997. The Brazilian economy—Latin
America's largest—exhibited a great deal of resilience with support from the international community,
in the wake of the devaluation and subsequent floating of the real in January. These developments, along
with the considerable easing of monetary policy in
late 1998 and early 1999 in a number of regions,
including Europe. Japan, and the United Stales, fostered a markedly better tone in the world's financial
markets. On balance. U.S. equity prices rose substantially, and in credit markets, risk spreads receded
toward more iypical levels. Issuance of private debt
securities ballooned in late 1998 and early 1999, in
part making up for borrowing that was postponed
when markets were disrupted.
As these potentially contractionary forces dissipated, the risk of higher inflation in the United Slates
resurfaced as the greatest concern for monetary policy. Although underlying inflation trends generally
remained quiescent, oil prices rose sharply, other
commodity prices trended up, and prices of non-oil




imports fell less rapidly, raising overall inflation rates.
Despite improvements in technology and business
processes ihat have yielded striking gains in efficiency, the robust growth nf ag^rcgaie demand,
fueled by rising equity wealth and readily available
credit, produced even lighter labor markets in the lirsi
half of 1999 ihan in (he second half of I99S. If t h i s
trend were to continue, labor compensation would
begin climbing increasingly faster ihan warranted by
productivity growth and pul upward pressure on
prices. Moreover, the Federal Open Market Committee (FOMC] was concerned thai as economic activity
abroad strengthened, ihe firming of commodity and
other prices might also foster a less favorable inflation environment. To gain some greater assurance
that the good inflation performance of the economy
would continue, the Committee decided ai its June
meeting to reverse a portion of the easing undertaken
iast fall when global financial markets were disrupted; the Committee's target for the overnighi federal funds rate, a key indicator of money market
conditions, was raised from 4'/j percent to 5 percent.

Monetary Policy, Financial Markets, and the
Economy aver {he First Half of 1999
The FOMC met in February and March againsi the
backdrop of continued rapid expansion of the U.S.
economy. Demand was strong, employment growth
was brisk, and labor markets were tight. Nonetheless,
price inflation was still low. held in check by a substantial gain in productivity, ample manufacturing
capacity, and low inflation expectations.
Activity was supported by a further settling down
of financial markets in the first quarter alter a period
of considerable turmoil in the laie summer and fall of
1998. In that earlier period, which followed Russia's
moratorium on a substantial portion of its debt payments in mid-August, the normal functioning of U.S.
financial markets had been impaired as investors cut
back sharply their credit risk exposures and market
liquidity dried up. The Federal Reserve responded
to these developments by irimming its target for the
overnight federal funds rale by 75 basis points in
three steps. In early 1999, the devaluation and subsequent floating of the Brazilian real in mid-January

52
2

Monetary Policy Report to the Congress D July I9W

Sektlwl i merest rale:,

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M
IWK

«l*

IfJJIIIIf IMI7 133:

II
I

VII

VI*
IVW

Sun Il ' Jjci :nc daih Vertical lines indicate il* Ja.« 1x1 which ihv
'l
tafcnil Kcwue jninninml a numeiarv p»licy jcuon IT* ikuei on Bit himiun-

ul uiis jre ihiv* MI ahH-h either ihe KOMC held .1 scheduled media;: i
olk-v jiiion Wai ;uinoun«d LIBI oHetvauuni are for July 14. IW*

heightened concerns for a while, but market conditions overall improved considerably.
At its February and March meetings, the FOMC
left the stance of monetary policy unchanged. The
Committee expected that ihe growth of output might
well slow sufficiently to bring production into close
enough alignment with the economy's enhanced
potential to forestall the emergence of a trend of rising inflation. Although domestic demand was still
increasing rapidly, it was anticipated to moderate
over time in response to the buildup of large stocks
of business equipment, housing units, and durable
goods and more restrained expansion in wealth in the
absence of appreciable further increases in equity
prices. Furthermore, the FOMC, after taking account
of the near-term effects of the rise in crude oil prices.
saw few signs that cost and price inflation was in the
process of picking up. The unusual combination of
very high labor resource utilization and sustained low
inflation suggested considerable uncertainty about the
relationship between output and prices. In this environment, the Committee concluded that it could wait
for additional information about (he balance of risks
to the economic expansion.
By the lime of the May FOMC meeting, demand
was still showing considerable forward momentum.
and growth in economic activity still appeared to
be running in excess of the rate of increase of the
economy's long-run capacity to expand output. Borrowers' heavy demands for credit were being met on
relatively favorable terms, and wealth was further
boosted by rapidly rising equity prices. Also, the
economic and financial outlook for many emergingmarket countries was brighter. Trends in inflation
were still subdued, although consumer prices—even

apsr rrom a big jump in energy prices—were
, e ported to have registered a sizable rise in April.
At its May meeting, the FOMC believed that these
developments tilled the risks toward further robust
growth thai would exert additional pressure on
already taut labor markets and ultimately show
through lo inflation. Moreover, a turnaround in oil
and other commodiiy markets meant that prices of
these goods would no longer be holding down inflation, as they had over the past year. Yet. the economy
to dale had shown a remarkable abiliiy 10 accommodate increases in demand without generating greater
underlying inflation trends, as the continued growth
of labor productivity had helped to contain cosi pressures. The uncertainty about the prospects for prices.
demand pressures, and productivity was large, and
the Committee decided to defer any policy action.
However, in light of its increased concern about
the outlook for inflation, the Com mi I tee adopted
an asymmetric directive tilted toward a passible firming of policy. The Committee also wanted to inform
the public of ihis significant revision in its view, and
it announced a change in the directive immediately
after the meeting. The announcement was the first
under the Committee's policy of announcing changes
in the tilt of the domestic directive when ii wants to
communicate a major shift in its view about ihe
balance of risks to the economy or the likely direction
of its future actions.
In the time leading up to the FOMC's June meeting, economic activity in the United States continued
to move forward at a brisk pace, and prospects in a
number of foreign economies showed additional
improvement. Labor markets tightened slightly further. The federal funds rate, however, remained at




53
Hoard nf Gfvtrnurx iif the Federal Reser.-e System

the lower level established in November 1998. when
ihe Com mil tee look its lusi of three steps In counter
severe financial market strains. With those strains
largely gone, the Com mil tee believed that the time
had come to reverse some of that accommodation.
and it raised the targeted overnight federal funds rule
25 basis points, to 5 percent. Looking ahead, the
Committee expected demand to remain strong, but
it also noted the possibility that a further pickup in
productivity could allow the economy to accommodate this demand for some time without added inflationary pressure. In light of these conflicting forces
in ihe economy, the FOMC returned to a symmetric
directive. Nonetheless, with labor markets already
tight, the Committee recogni/ed that it needed to stay
especially alert to signs that inflationary forces were
emerging lhat could prove inimical to the economic
expansion.

Economic Projections for 1999 and 2000
The members of (he Board of Governors and the
Federal Reserve Bank presidents see good prospects
for sustained, solid economic expansion through next
year. For this year. \he central tendency of iheir
forecasts of growth of real gross domestic product is
3Vi percent to 3Vt percent, measured as the change
I.

Economic projections for 1999 and 2000
FeOeml HeMf\e governors j
and Reserve Bank preiidenu ,
Inttacaior
D»«
Rln e
*

Central
tendency
1494

Ctianst- Jritntt yaner
NoiraiBl GDf " . .
Rrnl GOT
Coraiunei pnct in** '

J'.,-^:
J>.-,_4

5-5'*
3V?-?V,

4.8
13

H-rraic Intl.
/IJUft* awi/rrr
Civilian unemployment
4-1':

4-1V4

2000

the Mid-S«*ioo Rtvitw ol ihc buUjwi.
TP avtfMi IDT fwmri yoancr ol pievings yea
xirrh qiuner nt y*a indiraHil




43

between the fourth quarters of 199H and 1999. For
2WK). ihe forecasts of real GDP are mainly in
the 21/: percent to 3 percent range. With this puce
of expansion, the civilian unemployment rule is
expected to remain close 10 the recent 4'/j percent
level OVCT ihe ncxi si* quarters.
The increases in income and wealth that have
bolstered consumer demand over the lirst half of this
year and the desire to invest in new high-technology
equipment that has boosted business demand during
the same period should continue to stimulate spending over the quarters ahead. However, several factors
ate expected to exert some restraint on the economy's
momentum by next year. With purchases of durable
goods by both consumers and businesses having
risen still further and running at high levels, the
slocks of such goods probably are rising more rapidly
than is likely to he desired in the longer run. and
the growth of spending should moderate. The
increase in market interest rates should help to damp
spending as well. And unless the extraordinary gains
in equity prices of the past lew years are extended,
ihe impetus to spending from increases in wealth will
diminish.
Federal Reserve policymakers believe that this
year's rise in the consumer price index |CP1) will he
larger than that in 1998. largely because of the
rebound in retail energy prices that has already
occurred. Crude oil prices have moved up sharply,
reversing ihe decline posted in 1998 and leading to a
jump in the CP1 this spring. For next year, the FOMC
participants expect the increase in the CPI to remain
around this year's pace, with a central tendency of
2 percent to 2'/> percent. Futures market quotes suggest that the prevailing expectation is that the rebound
in oil prices has run its course now, and ample
industrial capacity and productivity gains may help
limit inflationary pressures in coming months as well.
With labor utilization very. high, though, and demand
still strong, significant risks remain even after the
recent policy firming that economic and financial
conditions may turn out to be inconsistent with keeping costs and prices from escalating.
Although interest rates currently are a bit higher
than anticipated in the economic assumptions underlying the budget projections in the Administration's
Mid-Session Review, there is no apparent tension
between the Administration's plans and the Federal Reserve policymakers' views. In fact. Federal
Reserve officials project somewhat faster growth in
real GDP and slightly lower unemployment rates into
2000 than the Administration does, while [he Administration's projections for inflation arc within the
Federal Reserve's central tendencies.

54
4

Monetary Policy Report to the Congress D July 1999

Ranges Tor growth of monetary und ih-'hi
Paeau
AfpVfilK

I'NN

I1W

IY<"i*"i(*jl In*
21 HI

rage 1<* fourth tjuuiii:

Money and Debt Ranges for 1999 and 2000
At its meeting in law June, (he FOMC reaffirmed (he
ranges 1'or 1999 growth tit' money arid debt that it had
established in February: I percent to 5 perccm Tor
M2, 2 percent lo 6 percent tor M3. und 3 percent to
7 percent tor debt of the domestic nnnlinanciat sectors. The FOMC set the same ranges tor 200(1 on a
provisional basis.
As has heen the case since the mid-1990s, ihe
FOMC views the ranges for money growth as benchmarks for growth under conditions of price stability
and the historically typical relationship between
money and nominal income. The disruption of ihe
historically typical pattern of the velocities of M2
and M3 (the ratio of nominal GDP to the aggregates)
during the 1990s implies that the Committee cannot
establish, with any confidence, specific target ranges
for expected money growth for a given year that will
be consistent with the economic performance that
it desires. However, persistently fast or slow money
growth can accompany, or even precede, deviations
from desirable economic outcomes. Thus, the behavior of the monetary aggregates, evaluated in the context of other financial and nonfinancial indicators,
will continue to be of interest to Committee members
in their policy deliberations.
The velocities of M2 and M3 declined again in (he
first half of this year, albeit more slowly than in 1998.
The Committee's easing of monetary policy in the
fall of 1998 contributed to the decline, but only to a
modest extent. It is not clear what other factors led lo
the drop, although the considerable increase in wealth
relative to income resulting from the substantial gains
in equity prices over (he pasi lew years may have
played a role. Investors could be rebalancing their
portfolios, which have become skewed toward equities, by reallocating some wealth to other assets,
including those in M2.
Even if the velocities of M2 and M3 were to return
to their historically typical patterns over the balance
ol 1999 and in 2000, M2 and M3 likely would be
at the upper bounds of, or above, their longer-term
price-stability ranges in both years, given the Com-




mittee's projections nf nominal GDP growth. This
relatively rapid expansion in nominal income reflects
faster expected growth in productivity ihan when the
price-stability ranges were established in the midIStyOs and inflation that is still in excess of price
Muhiliiy. The more rapid incrcaitc in pniduciiviiy. iJ' ii
persists tor u while and is sullkicntly large, miyht in
the future suggest an upward adjustment to the money
ranges consistent with price stability. However, considerable uncertainty attends the trend in productivity, and the Committee chose noi to adjust the ranges
ut ils most recent meeting.
Dehi of ibe nwn/inanciaJ Majors has expanded at
roughly the same pace as nominal income this year—
its typical pattern. Given the stability of this relationship, the Committee selected a growth range for the
debt aggregate that encompasses its expeclations for
tlebt growth in both years. The Committee expects
growth in nominal income to slow in 2000. and with
ii. debi growth. Noneiheless. growth of this aggregate
is projected to remain within the range of 3 percent to
7 percent.

ECONOMIC AND FINANCIAL DEVELOPMENTS
IN 1999
The economy has continued to grow rapidly so far
this year. Real gross domestic product rose more than
4 percent at an annual rate in the first quarter of 1999.
and available data point to another significant gain
in the second quarter.1 The rise in activity has been
J. All JJSUJES from [be national income and produci accou
here are subject 10 change in ihe quinquennial benchmark i
staled Tot this fall.
ChanEe in real GDP

ll,
Nmi- In this ttiait jnd in sub«t|oeni chani rhui ihow ihe component* c
real GDP. change* JIT matured from the Einal quarur ol the ITCVUHU period i
ihe tinaJ quarter nl' the period indicated

55
Roafd of Gin-emnrx nf f/ic Federal Reserve Sy.ttem

5

The Household Sector

as measured, for example, by the University of
Michigan Survey Research Center (SRC) and Conference Board surveys—has remained quite upbeat in
ihis envirwnmenv.
Growth of consumer spending in the lirst quarter
was strong in all expenditure categories. Outlays
for durable goods rose sharply, retleaing M«iMc
increases in spending on electronic equipment (especially computers) and on a wide range of other gooils.
including household furnishings. Purchases nf curs
and light trucks remained at a high level, supported
by declining relative prices as well us hy the fundamentals that have buoyed consumer spending more
generally. Outlays for nondurable goods were also
robust, reflecting in part a sharp increase in expenditures lor apparel. Finally, spending on services
climbed steeply as well early ihis year, pateil by
sizable increases in spending on recreation and brokerage services. In the second quarter, consumers
apparently boosted their purchases of motor vehicles
Further. In all. real personal consumption expenditures rose at more ihan a 4 percent annual rate in
April and May, an increase that is below the tirstquarter pace hut is still quite rapid hy historical
standards.

Consumer Spending

Wealih and saving

brisk enough Hi produce further substantial growth of
employment und a reduction In the unemployment
rate 10 4'/j percent. Growth in output has been driven
by strong domestic dcmiind. which in turn has been
supported by further increases in equity prices, by the
continuing salutary effects of government saving and
inflows of foreign investment on the oosi nf capital,
and by more smoothly functioning financial markets
as the turbulence that marked the latter part of I9VN
subsided. Against the background of the easing of
monetary policy lust fall and continuing robust
economic activity, investors became more willing 10
advance funds to businesses: risk spreads have
receded und corporate dcfa issuance has been brisk.
Inflation developments were mixed over the lirst
half of the year. The consumer price index increased
more rapidly owing to a sharp rebound in energy
prices. Nevertheless, price inflation outside of the
energy area generally remained subdued despite the
slight further tightening of labor markets, us sizable
gains in labor productivity and ample industrial
capacity held down price increases.

Real personal consumption expenditures surged
6'/i percent at an annual rate in the first quarter, and
more recent data point to a sizable further advance in
the second quarter. The underlying fundamentals for
the household sector have remained extremely favorable. Real incomes have continued to rise briskly
with strong growth of employment and real wages,
and consumers have benefited from substantial gains
in wealth. Not surprisingly, consumer confidence—
Change in real income and consumption

Q Disposable personal income




disposable personal income

Real disposable income increased at an annual rate
of 3'/2 percent in the first quarter, with the strong
labor market generating marked increases in wages
and salaries. Even so. income grew less rapidly than
expenditures, and the personal saving rate declined
further; indeed, by May the saving rate had moved
below negative 1 percent. Much of the decline in the
saving rate in recent years can be explained by the
sharp rise in household net worth relative 10 disposable income that is associated with the appreciation

56
Monetary Policy Report 10 the Congress D July

Pnvme housing suns

of households' slock market assets since 1995. This
rise in wealth has given households [he wherewithal
10 spend at levels beyond what current incomes
would otherwise allow. As share values moved up
further in the first half of this year, the wealth-ioincome ratio continued to edge higher despite the
absence of saving out of disposable income.

Residential Investment
Housing activity remained robust in the first half of
this year, la the single-family sector, positive fundamentals and unseasonably good weather helped boost
starts to a pace of 1.39 million units in the first
quarter—the highest level of activity in twenty years.
This extremely strong level of building activity
strained the availability of labor and some materials;
as a result, builders had trouble achieving the usual
seasonal increase in the second quarter, and siarts
edged off to a still-high pace of 1-31 million units.
Home sales moderated in the spring: Sales of boih
new and existing homes were off some in May from
their earlier peaks, and consumers' perceptions of
homebuying conditions as measured by the Michigan
SRC survey have declined from the very high marks
recorded in late 1998 and early this year. Nonetheless, demand has remained quite robust, even in ihe
face of a backup in mortgage interest rates: Builders'
evaluations ot new home sales remained very high at
mid-year, and mortgage applications for home purchases showed strength into July.
With strong demand pushing up against limited
capacity, home prices have risen substantially,
although evidence is mixed as to whether ihe rate of
increase is picking up. The quality-adjusted price of
new homes rose 5 percent over the four quarters




ended in CWrQt, up from 3'A percent aver Ihe
preceding four-quarter period. The repeat sales index
of existing home prices also rose about 5 percent
between 199X.QI and J999:Ql- hul this series posted
even larger increases in the year-earlier period. On
the cost side, tight supplies have led to rising prices
for some building materials: prices of plywood, lumber, gypsum wall board, and insulation have all moved
up sharply over the past twelve months. In addition,
hourly compensation costs have been rising rclaiivcly
rapidly in the construction sector.
Starts of mu II family units surged to .184,000 at an
I
annual rate m the lirst quarter and ran at a pace a hit
under 3(H).IH)0 unils in ihe second quarter As in ihe
single-family sector, demand has been supported by
strong fundamentals, builders have been faced with
light supplies of some materials, and prices have
been rising briskly: Indeed, apartment property values
have been increasing at around a 10 percent annual
raie for three years now.

Household Finance
In addition 10 rising wealth and rapid income growth.
the strong expenditures of households on housing and
consumer goods over the first half of 1999 were
encouraged by the decline in interest rates in the
latter pan of I99S. Households borrowed heavily to
finance spending. Their debt expanded at a 91/: percent annual rate in the lint quarter, up from the
8'/4 percent pace over 1998, and preliminary data for
the second quarter indicate continued robust growth.
Mortgage borrowing, fueled by the vigorous housing
market and favorable mortgage interest rates, was
particularly brisk in the first quarter, with mortgage
debt rising at an annual rate of 10 percent. In the
second quarter, mortgage rates moved up considerably, but preliminary data indicate that borrowing
was still substantial.
Consumer credit growth accelerated in the first half
of 1999. It expanded at about an 8 percent annual rate
compared with 51/: percent for all of 1998. The
growth of nonrevolving credit picked up. reflecting
brisk sales and attractive financing rates for automobiles and other consumer durable goods. The expansion of revolving credit, which includes credit card
loans, slowed a bit from its pace in 1998.
Households apparently have not encountered added
difficulties meeting the payments associated with
their greater indebtedness, as measures of household
financial stress improved a bit on balance in the first
quarter. Personal bankruptcies dropped off considerably, although part of the decline may reflect

57
Hoard uf Gtn'fnmrx iif llie Federal Reserre S\:ticin

ralu's on hmi.wh»liJ Inuns

SIKH fhc daca art qgjrttr!>
•uii'Ki I Dan on^rcdu i-ard itlimjuctun's ;ire Irortlhont. Cjll Mq>">ni. ilua
£i£t tWhiajwriciej arc tram the Monpage Banker* Assignation

[he aftermath of A surge in tilings in late I99K that
occurred in response 10 pending legislation ihat
would limit the ability of certain debtors to obtain
forgiveness of their obligations. Delinquency rates on
several lypes of household loans edged lower. Delinquency and charge-off raies on credit card debt
moved down from their 1997 peaks but remained at
historically high rates. A number of banks continued
to tighten credit card lending standards this year, as
indicated by banks' responses to Federal Reserve
surveys.
The Business Sector
Fixed Investment
Real business fixed investment appears 10 have
posted another huge increase over the fir si half of
Change in real business fixed invesimcm




1

1999. Investment spending continued to ho driven
by buoyant expectations uf sulcs pro^psas us wtl!
as by rapidly declining prices of computers and
iHhcr high-fcch equipment. In reccm quarters, spendin" also may have been bixisiecl by the desire to
upgrade uicnpuicr equiptneni in advance t>V ihe rollover Lo the year 2(KM), Real investment has been
rising rapidly lor 'icveral year* now; indeed, ihe
average increase of 10 percent annually over the past
live years represents the mosi rapid ><uslamed expansion of investment in more than thirty years.
Although a growing portion of this investment has
gone to cover depreciation on purchases nf shortliveii equipmem. ihe investment boom has led to j
notable upgrading and expansion of the capital slock
and in many cases has embodied new technologies.
These factors likely have been important in the nalion'-i improved productivity performance over the
past few years.
Real outlays for producers' durable equipment
increased at an annual rate of 91/; percent in the first
quarter of the year, after having surged nearly 17 percent iasi year, and may well have re-accelerated
in the second quarter. Outlays on communications
equipment were especially robust in the first quarter,
driven by the ongoing effort by telecommunications
companies to upgrade iheir networks to provide a
full range of voice and data transmission services.
Purchases of computers and. oihet information processing equipment were also up notably in the first
quarter, albeit below last year's phenomenal spending
pace, and shipments of computers surged again in
April and May. Shipments of aircraft to domestic
carriers apparently soared in the second quarter, and
business spending on motor vehicles, including
medium and heavy trucks as well as light vehicles.
has remained extremely strong as well.
Real business spending for nonresidential structures has been much less robust [han for equipmem.
and spending trends have varied greatly across sectors of ihe market. Real spending on office buildings
and lodging facilities has been increasing impressively, while spending on institutional and industrial
structures has been declining—the last reflecting
ample capacity in the manufacluring sector. In the
first quarter of this year, overall spending on structures was reported in the national income and product
accounts to have moved up at a solid 5V-i percent
annual rate, reflecting a further sharp increase in
spending on office buildings and lodging facilities.
However, revised source dam indicate a somewhat
smaller first-quarter increase in nonresidential construction and also point to a slowing in activity in
April and May from the first-quarter pace.

58
Monetary Policy Report lo the Congress D July I<W9

Clianuu in nonlurm husiniiss inventories

Before-lax prolils of nunlinunciJl airporaljons

JS j .durt i:t GDP

IIL.ill ill
L_L

Proliis ntm Mm

Inventory Investment
Invemory-!.ales ratios in many industn'es dropped
considerably curly this year, as the pace of slockbuilding hy mint arm businesses, which had slowed
notably over 1998. remained well below the surge of
consumer and business spending in the nrsi quarter.
Although production picked up some in the spring,
final demand remained quite strong, and available
monthly data suggest that businesses accumulated
inventories in April and May at a rate not much
different from the modest first-quarter pace.
In the motor vehicle sector, makers geared up
production in ihe latter pan of 1998 to boost inventories from their low levels after last summer's
strikes. Nevertheless, as with the business sector
overall, moior vehicle inventories remained on the
lean side by historical standards in the early part of
this year as a result of surprisingly strong vehicle
sales. As a consequence, manufacturers boosted the
pace of assemblies in the second quarter to the high-

est level in twenty years. With no noticeable signs uf
a slowing in demand, producers have scheduled thirdquarter (JUipui 10 remain at ihe lofty heights o!' ihe
second quarter.

Corporate Protiis and Business Finance
The economic profits of nonfinancial US. corporations rose considerably in the first quarter, even alter
allowing for the depressing effect in the fourth
quarter of payments associated with the settlement
between the tobacco companies and the states.
Despite the growth of profits, capital expenditures by
nonfinancial businesses continued to outstrip internal
cash flow. Moreover, borrowing requirements were
enlarged by the net reduction in equity outstanding,
as the substantial volume of retirements from merger

Gross corporate bond issuance

I

F




M

A

M

J

J

A

S

O

N

D

J

F

M

A

M

I

59
Board of Governors I'f ihe Federal Resene S\:iieni

Spreads of corrxinili; hunt! yidds
DVI.T Treasury icfuriiv vieWs

1WH

Nmi-. (W daa jre &n\\ The ^pnrud IEV helo*-invFsimcEil-?nkJt: bonds
mparts [he yieU ,.n HwMemll LiiX-h Ma>i« II high-yield hand inJei
mposiie wuh ihe viild from ilw seven-vtar Treasure conHanr-nsicuiiiy icrtes;
e Lther [wo spreads compare yields <m ihe aopiDpnW Memlt L^nch mdcus

activity and share repurchase programs exceeded the
considerable volume of gross issuance of both initial
and seasoned public equities. As a result, businesses
continued to borrow j| a brisk pace: Aggregate debt
of the nonfinancial business sector expanded at a
91/: percent annual rate in the firsi quarter. As financial market conditions improved after Ihe turmoil of
the fall, businesses returned to the corporate bond
and commercial paper markets for funding, and corporate bond issuance reached a record high in March.
Some of the proceeds were used to pay off hank
loans, which had soared in the fall, and these repayments curbed the expansion of business loans at
banks. Partial daia for the second quarter indicate
that borrowing by nonlinancial businesses slowed
somewhat.
Risk spreads have receded on balance this year
from their elevated levels in the latter pan of 1998.
From the end of December 1998 through mid-July,
investment-grade corporate bond yields moved up
(Vow historically low levels, hut by less than yields
on comparable Treasury securities, and the spread
between these yields narrowed to a level somewhat
above that prevailing before the Russian crisis. The
rise in in vest men I-grade corporate bond yields was
restrained by investors' apparently increased willingness to hold such debt, as growing optimism about
ihe economy and favorable earnings reports gave
investors more confidence about the prospective
financial health of private borrowers. Yield spreads
on below-invesiment-grade corporate debt over comparable Treasury securities, which had risen consider-




ably in ihe latter pan of iWS, also retreated. But in
mid-July, these spreads were still well above the ihin
levels prevailing before the period of (inaner.il turmoil but in line with (heir historical averages.
In contrast to securities market participants, hanks'
attitudes toward business lending apparently became
somewhat more cautious over the lirst half of the
year, according tn Federal Reserve surveys. The average spread of bank lending rales over the FOMC's
intended federal funds rale remained elevated. On
net. hanks continued to lighten lending terms and
standards this year, although the percentage Lhai
reported tightening was much smaller than in the
fall.
The overall financial condition of nonlinancial
businesses was strong over the first half of the year.
nkhuiLgh, u lew indicators suggested a slight deterioration. In the lirst quarter, the ratio of net interest
payments to corporate cash tlow remained close to
the modest levels of 1998. as low interest rates continued to hold down interest payments. Delinquency
rates for commercial and industrial loans from banks
ticked up. bu( they were still modest by historical
standards. Similarly, over the first half of the year,
business failures—measured as the ratio of liabilities
of failed businesses to total liabilities—stepped up
from the record low in 1998. The default rate on
he low-in vestment-grade bonds rose to its highest
level in several years, an increase stemming in part
from defaults by companies whose earnings were
impaired by the drop in oil and other commodity
prices last year. The total volume of business debt
that was downgraded exceeded slightly the volume of
debt that was upgraded.

The Government Sector
Federal Government
The incoming news on the federal budget continues
to be quite favorable. Over the first eight months of
fiscal year 1999—the period from October through
May—the unified budget registered a surplus of about
$Al billion, compared with S16 billion during the
comparable period of fiscal 1998. If the latest projections from the Office of Management and Budget and
the Congressional Budget Office are realized, the
unified budget for fiscal 1999 as a whole will show a
surplus of around $100 billion to $120 billion, or
more than I percent of GDP—a striking turnaround
from ihe outsizeil budget deficits of previous years,
which approached 5 percent of GDP in the early
1990s.

60
10

Monetary Policy Report 10 the Congress O.luly

Feilorul roceipix and expenditures js j share nt nominal GDP

NnlK. Dam on receipt .UMl L-^pcildlTurvs jn
• ItV) are CHI macs tram 0* CBO - JuK I I

illn; umlwil tnidp:i

As a result of ihis turnaround, the federal government is now contributing positively to the pool of
national saving. In ["act. despite the recent drop in ihe
personal savins rate, gross saving by households.
businesses, and governments has remained above
17 percent of GDP in recent quarters—up from the
14 percent range that prevailed in the early 1990s.
This we 11-maintained pool of national savings,
together with the continued willingness of foreigners
to finance our current account deficits, has helped
hold down the cost of capital, thus contributing to our
nation's investment boom.
This year's increase in ihe federal surplus has
reflected continued rapid growth of receipts in combination with a modest increase in outlays. Federal
receipts were 5 percent higher in the first eight
months of fiscal 1999 than in the year-earlier period.
Wilh profits leveling off from last year, receipts of
corporate taxes have stagnated so far this fiscal year.

However, individual income tax paymenis arc up
appreciably, rellccling the solid gains in household
incomes and perhaps also a rise in capital gains
realizations large enough to offset last year's reduction in capital gains lax rates. At the same nmc.
federal outlays increased only 21/; percent in nominal
terms and barely at all in real terms during ihe iirst
eight months of (he fiscal year, relative to ihe comparable year-earlier period. Spending growth has been
rcsiraincd in major portions of both the discretionary
(notably, defense) and nondiscrctionury (notably, nei
interest, social security, and Medicare) categoric*—
ahhdugn (his year's emergency supplemental spending hill, at about $14 billion, was somewhat larger
ihan similar hills in recent years.
As for the pan of federal spending that is counted
in GDP. real federal outlays for consumption and
gross investment, which had changed little over the
past few years, declined at a 2 percent annual rate
in the first quaner of 1999. A drop in real defense
outlays more than offset a rise in nondgt'cnsc expenditures in the first quarter. And despite the military
action in the Balkans and the recent emergency
spending bill, defense spending appears to have
declined in the second quaner as well.
Federal dehi held by private investors as a share
of nominal GOP

NalfonaJ saving as a share of nominal GDP

1978

IWJJ

I9SB

IW

IW8

Nun Federal del* held hy private invoiw, „ jnw federal delx kudehi
held by federal 8ov«n™iu Kccum and Kie ftatral Rom* Smtnj Tbt
value lor 199915 an tinman bated oo ihe CBO'i July I economc and budget
updnc

National savjn; iinnpnv; ihe gn




ng of houichokb. busir

The budget surpluses of the past two years have
led 10 a notable decline in the stock of federal debt
held by private investors as a share of GDP. Sinee
its peak in March 1997. the total volume of Treasury
debt held by private investors has fallen by nearly
S130 billion. The Treasury has reduced its issuance
of interest-bearing marketable debt infiscal1999.

61
Rtiard nf GowriKirs «f ilir Federal Restnt Sv.wm

The decrease has been concentrated in nominal coupon issues: in I99K, by contrast, the Treasury retired
both hill und coupon issues in roughly equal measure. Offerings of in 11 ation-indexed securities have
remained an important part of the Treasury's overall
borrowing program: Since the beginning of fiscal
1999, the Treasury has sold nearly $31 billion of such
securities.
State and Local Governments
The liscal condition of state and local governments
has remained quite posiiuc us well. Revenues have
been boosted by increases in tax collections due
to strong growth of private-sector incomes und
expenditures—increases thut were enough to offset
an ongoing trend of tax cuts. Meanwhile, outlays
have continued to be restrained. In ull. at the slate
levei, fiscal 1999 looks to have been the seventh
consecutive year of improving liscal positions; of the
forty-six stales whose liscal years ended on June 30,
all appear to have run surpluses in their general
funds.
Real expenditures for consumption and gross
investment by slates und localities, which had been
rising only moderately through most of 1998, jumped
at a 7'/j percent annual rate in the first quarter of this
year. This increase was driven by a surge in construction expenditures that was helped along by unseasonably favorable weather, and spending data for April
and May suggest that much of this rise in construction spending was offset in the second quarter. As for
employment, state and local governments added jobs
over the first half of the year at about the same pace
as they did last year.
Debt of state and local governments expanded at a
51/: percent rate in the first quarter. The low interest
rate environment and strong economy encouraged the
financing of new projects and the refunding of outstanding higher-rate debt. Borrowing slowed to a
more modest pace in the second quarter, as yields on
long-daled municipal bonds moved up, but by less
than those on comparable Treasury securities. The
credit quality of municipal securities improved further over the first half of the year, with more issues
being upgraded than downgraded.

External Sector
Trade and the Current Account
The current account deficit reached 527^ billion at an
annual rale in the first quarter of 1999. a hit more
than 3 percent of GDP, compared with $221 billion




|'M7

1'KJH

I'BJ-I

and 2'/: percent of GDP for I99K. A widening of the
deficit on trade in goods and services, to $215 billion
at an annual rate in the first quarter from $17? billion
in the fourth quarter of 1998. accounted for the
deterioration in the current account balance. Data for
April and May indicate that the trade deficit increased
further in the second quarter.
The quantity of imports of goods and services
again grew vigorously in the first quarter. The annual
rate of growth of imports, at 1 3'/^ percent, continued
the rapid pace seen over 1998 and reflected the
strength of U.S. domestic demand and the effects of
past dollar appreciation. Imports of consumer goods,
automotive products, computers, and semiconductors
were particularly robust. Preliminary data for April
and May suggest that real import growth remained
strong, as nominal imports rose steadily and non-oil
import prices posted a moderate decline.
The volume of exports of goods and services
declined at an annual rate of 5 percent in the first
quarter. The decline partially reversed the strong
increase in the fourth quarter of last year. The weakChange in real imports and exports ol'^oods anil services

62
12

Monetary Polity Report to the Congress D July 1999

ness of economic activity in a number of U.S. trading
partner* and the strength ol' fhe dollar damned
demand for U.S. exports. Declines were registered in
aircraft, machinery, industrial supplies, and agricultural products. Exports to Asia generally turned down
in the first quaner from the elevated levels recorded
in ihe fourth quarter, when they were boosifd by
record deliveries ol' aircraft lo the region. Preliminary
dua lor April anil May suggest (hal real exports
advanced slightly.

suix-s D| Ijhor ulili/yimn

Capital Account

Foreign direct investment in the United Slates and
U.S. direct investment abroad remained robust in the
lirst quarter, reflecting brisk cross-border merger and
acquisition activity. On balance, net capital Hows
through direct investment registered a modes! outflow in the first quaner compared with a huge net
inflow in the fourth quaner. Fourth-quarter inflows
were swollen hy several large mergers. Net foreign
purchases ol U.S. securities also continued to be quite
sizable but again were well below the extraordinary
pace of ihe fourth quarter. Most of the slowdown in
the first quaner is attributable to a reduced demand
for Treasury securities on the pan of private investors
abroad. But capital inflows from foreign official
sources also slowed in the tirst quaner. U.S. residents
on net sold foreign securities in the first quaner, but
at a slower rate than in the previous quaner.
The Labor Market
Employment and Labor Supply
Labor demand remained very strong during ihe first
half of 1999. Payroll employment increased about
Change in iota! nonfarm payroll employment




IWT

!ffi

-LI I I I

N u l l , riv .lutinvnkrj unempkwnKfii r.lie is Ihe nunibci nl unempk>ycLl
ihme »*H' ore noun i*r lafcThint jndwjiK jp^t. <hvnkilh? jfh.'m'j£ujLi
lun.1 pliHilH« »ho.»t IHH in (he labor limn- jiujwuiu J iuh ihchKak m
X iJOfUy 1144 nurlj ihe inBi«Ju.'Lioti ill j reiksigneil lurx-Y. dju \nxn l
pant an me MH JiiAiK comparahlr wuhilkHmk carluf perrnds

200.000 per monih on average, which, although less
rapid than the 244.000 pace registered over 1998. is
faster than the growth of the working-age population.
With the labor force participation rate remaining
about flat at just over 67 percent, the unemployment
rate edged down funher from an average of 4'/- percent in 1998 to 4l/» percent in the first half of this
year—the lowest unemployment rate seen in the
United Slates in almost thirty years. Furthermore, the
pool of potential workers, including not just the
unemployed but also individuals who are out of the
labor force hul report thai they want a job, declined
late last year to the lowest share of the labor force
since collection of these data began in 1970—and ii
has remained near lhat low this year. Not surprisingly, businesses in many parts of the country have
perceived workers to be in very short supply, as
evidenced by high levels of help-wanted advertising
and surveys showing substantial difficulties in filling
job openings.
Employment gains in the private service-producing
sector remained sizable in the first six months of the
year and more than accounted for the rise in nonfarm
payrolls over this period. Payrolls continued to rise
briskly in the services industry, with firms providing
business services (such as help supply services and
computer services) adding jobs especially rapidly.
Job gains were quile sizable in retail trade as well.
Within ihe service-producing sector, only the finance,
insurance, and real estate industry has slowed the
pace of net hiring from last year's rale, reflecting,
in pan, a slower rate of job gains iti the mortgage
banking industry as the refinancing wave has ebbed.
Within the goods-producing sector, the boom in

63

construction activity pushed payrolls in ihjt industry
higher m the first iix month.1. "I ihis year. Bui in
manufacturing, where employment began declining
more than a year j«ii in (he wake ol a drop in export
demand, payrolls continued to fall in the lirsi half of
I9V9: in all. nearly halt" j m i l l i o n factory jobs have
been shed since March 1*WX. Despite these job losses,
manufacturing output continued to rise in the lirsi
half of ihis year, rcllccung large gains in labor
productivity.

Labor Cusis Jnd Productivity
Growth in hourly compensation, which had been on
an upward trend since 1995, appears to have leveled
off and. by some measures, lias slowed in ihe past
year. According 10 the employment cost index (ECI).
hourly compensation costs increased 3 percent over
the twelve months ended in March, down from
31/: percent over the preceding iwelve-mcmth period..
Part of both (he earlier acceleration and more reeent
deceleration in the ECI apparently reflected swings in
commissions, bonuses, and other types of "variable"
compensation, especially in the finance, insurance,
and real estate industry. But in addition, pan of the
recent deceleration probably reflects the influence o1"
restrained price inflation in tempering nominal wage
increases. Although down from earlier increases, the
3 percent vise in ihe ECI over the twelve months
ended in March was well above the rise in prices over
this period and therefore was enough to generate
solid gains in workers' real pay.
The deceleration in the ECI through March has
been most pronounced in the wages and salaries
Measures ol the change in hourly cum pen sail on




component, whose twelve-month change slowed
'/j percentage point from a year earlier. Mure
recently, daia on average hourly earnings »l produelion or nonsupervisory workers may poml 10 a leveling off. hui no further slowing, ol wage growih: This
scries wus up al about j 4 percent annual rate over ihe
lirsi six months of (his year, about ihc same as the
increase over I99K. Growth in the bencliis component ol ihe ECI slowed somewhat as well in ihe year
ended in March. 10 a 2'Xt percent increase. However,
employers' awls for health insurance arc one componcm of benetiis ihat has been rising mure rapidly ol
late. Alter showing essentially no change from I994
through I996. the EC! for health insurance accelerated to a ."iVi percent pace over the twelve months
ended in March.
A second measure of hourly compensation—ihe
Bareau of Labor Statistics' measure «f compensation
per hour in ihe noniarm business sector, which is
derived from compensation information Irom the
national accounts—has been rising more rapidly ihan
ihe EC! in ihe past few years and has also decelerated
less so far this year. Non farm compensation per hour
increased -V percent over the four quarters ended in
the tirst quarter of 1999, I percentage poim more
lhan the rise in ihe ECI over this period. One reason
these two compensation measures may diverge is thai
the ECI does not capture certain forms of compensation, such as stock options and hiring, retention, and
referral bonuses, whereas nontarm compensation per
hour does measure these payments.- Although the
Iwo compensation measures differ in numerous other
respects as well, the series' divergence may lend
support to anecdotal evidence that ihese alternative
forms of compensation have been increasing especially rapidly in recent years. However, because nonfarm compensation per hour can be revised substantially, one must be caulious in putting much weight
on the mosi recent quarterly figures from this series.
Rapid productivity growth has made it possible
lo sustain these increases in workers' compensation
without placing great pressure on businesses' costs.
Labor productivity in ihe noni'arm business sector
posted another sizable gain in the first quarter ol
1999. and the increase over the four quarters ended in
the first quarter of 1999 was 21/: percent. Indeed,
productivity has increased at a, 2 percent pace since
1995—well above the trend of roughly I percent per

64
14

Monetary Polity Report 10 the Congress D July I9W

Change in tiulrjul per

Ckunev in uni

iLiii

Hull

1

NI»I.. Nonfcrm IXHIH.-.U WL-IUC IV value it* I*N(JI i-ihi.-peri.Vfii ,-h.in
tnim IW« 01 In IWJ'IJI

year thai had prevailed over the preceding two
decades.1 This recent producliviiy performance is all
the more impressive given that businesses are
reported 10 have had to divert considerable resources
loward avoiding computer problems associated with
the century date change, and given as well that businesses may have had to hire less-skilled workers than
were available earlier in the expansion when the pool
of potential workers was not so shallow. Pan of the
strength in productivity growth over :hg past few
years may have been a cyclical response to the rapid
growth of output over ihis period. But productivity
may also be reaping a more persistent payoff from the
boom in business investment and the accompanying
introduction of" newer technologies that have occurred over the past several years.
Even these impressive gains in labor productivity
may noi have kepi up fully with increases in firms'
real compensation costs of late. Over the past two
years, real compensation, measured by the ECI relative to the price of nonfarm business output, has
increased the same hefty 2V- percent per year as labor
productivity; however, measured instead using nonfarm compensation per hour, real compensation has
increased somewhai more than productivity over this
period, implying a rising share of" compensation in
total national income. A persistent period of real
com pert saiion increases in excess of productivity

1 ABoul >'» percentage point or the improvement in productivity
growth since IW can be attributed to changes in pace measurement.
The measure at red outpuf underlying ihe productivity figures since
IW is deflated using CPI components that have been constructed
using j geonxtnc-means formula: ihese components tend to nse less
rapidly than The CPI components r^GHhad^wn a*e<l itt the ouipoj .and
productivity data he tore 144?. These i mallet CPI increases tiaiulate
inio more rapid growth of ouipul and productivity in Ihe later period.




growth would reduce tirms' capacity to absorb further wage gains without putting upward pressure on
prices.

Prices
Price inflation moved up in early 1999 from a level
in 1998 thai was depressed by a transitory drop in
energy and oihcr commodity prices. After increasing
only about 1!/; percent over 1998. the consumer price
index rose at a 2'/j percent annual rate over the first
six months of this year, driven by a sharp turnaround
in prices of gasoline and heating oil. However, the
so-cailed "core" CPI, which excludes food and
energy items, rose al an annual rate of only 1.6 percent over this period—a somewhat smaller increase
than that registered over 1998 once adjustment is
Change in consumer prices

• Published
D Research s,

—

rMllliml

J_J

!*krit CtHuuwtr pnff 'Ate* lot ^ill urban consumers The reiearLh sei
* h«n ciicndal into IW usm? trr pubhWied CPI Vaiuc( Int 19"W HI
rccni chancei Irwn Dcctmbei IWWioluK I Wai an annual rate

65
tttiartl of Gin-emiirs of lite Federal Krsen-f System

ntiu in L'lmsunicr prices ux

u l l (. IUIMHIKT pniv imlci IIH .ill iirtian niiHunttr, I'lk- [UMMrcri •>•'
twn eircnJttl inn. tVW iivmr ite puWi.neJ Cl'l V.ilucs (ur I ' W H I
riic cKaopcv Imm IMttmlwr I W K n . J u n t I ftl M jfl jnnual rait

made tor the effects of changes in CPI methodology:
According to a new research series Iron ihe Bureau
of Labor Statistics (BLS). the core CPI would have
increased 2.2 percent over 1998 had 1999 methods
been in place in that year.J
The moderation of the core CPI in recent years has
reflected a variety of factors that have helped hold
inflation in check despite what has been by all
accounts a very tight labor market. Price increases
have been damned by substantial growth in manufacturing capacity, which has held plant utilization rates
in most industries at moderate (and in some cases
suhpar) levels, thereby reinforcing competitive pressures in product markets. Furthermore, rapid productivity growth helped hold increases in unit labor costs
to low levels even as compensation growth was picking up last year. The rise in compensation itself has
been constrained by moderate expectations of infla>rding
tion, which have been relatively stable. According
to the Michigan SRC survey, the median of oneoneyear-ahead inflation expectations, which was aboui
about
21/: percent late last year, averaged 2'/4 percent in the
the
first half of this year.
The quiescence of inflation expectations, at least
through the early pan of this year, in mm may have
come in part from the downward movement in Overoverall inflation last year resulting from declines in prices
of imports and of oil and other commodities. These
4 The most important change ihis year was the iniroducnon of rhe
^eomeirii;-means formula 10 aggreg&re puce quotes within inost of Ihe
detailed "em categoncs. (The Laspevres lormula continues to be usrd
in constructing higher-level aggregates.) Although these geotnemi:ineans CPIs were introduced inlo iM olticial CPt only in January of
ihis year- ihe BLS generaied the series tin an experimental basis going
back «veial years, allowing them 10 t>e buili into ine nalionul income
and product accounis back to !*)9^.




15

price declines have not been repeated more recently.
This year's rise in energy prices i.i the clearest example, but commodity prices mure generally have been
turning up of late. The Journal ot Commerce industrial price index hus moved up about h percent so far
this year alter having declined about 10 percent last
year, with especially larjic increases posted for prices
ol lumber, plywood, und steel. These price movements are starting 10 he seen at later stages ot processing as well: The pnxJuccr price index for intermediate materials excluding food and energy, which
gradually declined about 2 percent over the fifteen
months through February 1999. retraced about hall of
that decrease by June. Furthermore, non-oil import
prices, although continuing to lull this year, have
moved down at a slower rale than that of the pasl
couple of years when the dollar was rising sharply in
foreign exchange markets. Non-oil import prices
declined at a I'/» percent annual rate over the h'rst
halt'of 1999. alter having fallen ii A 3 percent ia\e. on
average, over 1997 and 1998.
Some other broad measures of prices also showed
evidence of acceleration early this year. The chainlype price index for GDP—which covers prices oi' all
goods and services produced in the United Slates—
rose at about a !'/: percent annual rate in the first
quarter, up from an increase of about I percent last
year. A portion of this acceleration reflected movements in the chain-type price index for personal
consumption expenditures IPCE) that differed from
movements in the CPI.

3. Alternative measures of price change
Perctm. annual rate
,*«V

Price measure
Ffn*M>Mj>*r
tonsumer price ande*
.
ExcLiKlin? rood and energy
G™« domcsuc product
Grots dome&iic purchases
E*ctwtan£ ^wjj ami ctper^\

IWQ4

I*J8Q4

I197O4

1*98 O-t

I99»OI

't

1f
24

15
] 6

1 7
j .1

9
4
7

1 t>

i.:

16

i.:
1 2

1?

^MII-. A hxed-v-fi^hl indet u^'' quamily wei^n from ihe base year 10
aggregate pn^s ^rf>m each diifinci irctn cawgoi> A cKoin-iype iiuVi is ihe
^mneinc jverape ol iwo h^rd-wci^hl tnd»ts and allowi the wri^his lochanpe
tfpch year Changes AK bated on quWrly averages

Although the components of the CPI are key inputs
into the PCE price index, the two price measures
differ in. a variety of respects: They use difieyeitt
aggregation formulas; ihe weights are derived from
different sources; the PCE measure does not utilize
all components of the CPI; and the PCE measure is

66
Ifi

Monetary Policy Report to the Congress D July 1999

broader in scope, including not just the out-of-pocket
expenditures hy households thai arc captured by the
CPI, but also ihe portion of expenditures nn items
such us medical cure and education that are paid hy
insurers or governments, consumption of items such
as hanks' checking services that arc provided without
explicit charge, and expenditures made hy nonprofit
institutions. Although PCE prices typically rise a hi!
less rapidly than the CPI. the PCE price measure was
unusually restrained relative to the CP! in the tew
years through 1998. reflecting a combination of the
above I actors.
Last year's sharp drop in retail energy prices and
ihe subsequent rebound this spring reflected movements in the pnce at crude oil. The spot price of Wesi
TC'X;IN intermediate IWT1) crude oil. which had stood
ai about $20 per barrel through most of 1997.
dropped sharply over 1998 and reached $11 per barrel by (he end ol' ihe year, reflecting in pan a weakening in demand for oil I'rom the distressed Asian
nations and increases in supply from Iraq and other
countries. Bui uil prices jumped this year as ihe
OPEC nations agreed on production restraints aimed
at firming prices, and the WTI spot price reached $18
per barrel in April and has moved still higher more
recently. As a result, gasoline prices, which dropped
15 percent over 1998. reversed almost all of that
decline over the first six months of this year. Prices of
healing fuel also rebounded after dropping in 1998.
In all. the CPI for energy rose at a 10 percent annual
rate over the December-to-June period.
Consumer food prices increased moderately over
the first six months of the year, rising at a 1 '/j percent
annual rate. Despite the upturn in commodity prices
generally, farm prices have remained quite low and
have helped to hold down food price increases. Spot
prices of wheat, soybeans, and sugar have moved
down further this year from already depressed levels
at the end of 1998. and prices of com and coffee have
remained low as well.
The CPI for goods other than food and energy
declined at about a 16 percent annual rate over the
first six months of 1999. alter having risen I V-t percent over 1998. The 1998 increase reflected a sharp
rise in tobacco prices in December associated with
the settlement of litigation between the tobacco companies and the states; excluding tobacco, the CPI for
core goods was about flat last year. The decline in the
first half of this year was concentrated in durable
goods, where prices softened for a wide range of
items, including motor vehicles. The CPI for nonenergy services increased about IV?. percent at an
annual rate in the lira half, down a little from ihe
increase over 1998. Increases in the CPI JOT rem




Domestic turn financial ijofn: Annual range and actual level

o

N
I9VX

O

I

1-

M

A

M

J

\<ff*

of shelter have slowed ihu.s far in 1999. rising at a
2Vi percent annual rate versus a 3'/J percent rise last
year. However, airfares and prices of medical services both have been rising more rapidly so far this
year.

Debt and Ihe Monetary Aggregates
Debt and Depository Intermediation
The total debt of the U.S. household, government,
and nonfinancial business sectors increased at about a
6 percent annual rate from the fourth quarter of 1998
through May, a little above the midpoint of its growth
range of 3 percent to 7 percent. Nonfederal debt
expanded briskly at about a 9 percent annual pace, in
association with continued strong private domestic
spending on consumer durable goods, housing, and
business investment. By contrast, federal debt contracted at a 3 percent annual rate, as budget surpluses
reined in federal government financing needs.
Credit extended hy depository institutions slumped
over the first half of 1999. after having expanded
quite briskly in 1998. A fair-sized portion of the
expansion in 1998 came in the fourth quarter and
stemmed from the turmoil in financial markets. In
that turbulent environment, depository institutions
postponed securitization of mortgages, and businesses shifted lheir funding demand from securities
markets to depository institutions, where borrowing
costs in some cases were governed hy pre-existing
lending commitments. Depository institutions also
acquired mortgage-hacked securities and other private debt instruments in volume, as their yields evidently rose relative to depository funding costs. As

67
Hiiunl nfGovertwrx nf iht Federal Kfsen-c S\siein

M.V Annujl ranai1 unJ uuiuul

financial stresses unwound, securittzaiion resumed,
business borrowers relumed to securilies markets,
and net purchases of securities slowed. From the
fourth quarter of 1998 through June, hank credit rose
al a 3 percent annualized pace, after adjusting for the
estimated effects of mark-to-market accounting rules.

Monetary Aggregates
The growth of M3. the broadest monetary aggregate,
slowed appreciably over the first half of" 1999. M3
expanded at a 6 percent annual pace from the fourth
quarter of 199& through June of this year, placing this
aggregate at the top of the 2 percent 10 6 percent
price-stability growth range set by the FOMC at ics
February meeting. With depository credit growing
modestly, depository institutions trimmed the managed liabilities included in M3, such as large time

17

deposits. Growth of insiiiutUtnul nwwey market
mutual funds also moderated from il.s rapid pace in
I99H. Rales on money market funds lend to lag the
movements in market rates because Ihc average rate
of return on ihe portfolio of securities held by the
turn! changes more slowly than market rules. In the
fall, rales »n institutional money market funds did mil
decline as fast uu. market rates after ihc Federal
Reserve eased monetary policy, and ihc growth of
these funds soured. As rates on these funds moved
buck into alignment with market rates ihis year,
growth of these funds ebbed.
M2 advanced at a fi'/j percent annual rale from the
fourth t|uartcr of I99S through June, M2 growth had
been elevated in tale I99K rw unsettled financial
conditions, which raised the demand for liquid money
balances, and by the easing of monetary policy, which
reduced the opportunity costs of holding the assets
included in the monetary aggregates. M2 growth
moderated over the first half of 1999. as the heightened demand for money waned: in June this aggregate was above «s 1 percent 10 5 percent pricestability growth range. The growth in M2 over ihe
first half of the year again outpaced thai Q( nominal
income, although the decline in M2 velocity—the
ratio of nominal income to M2—was at a slower rate
than in 1998. The decline this year reflected in pan
a continuing lagged response to the policy easing in
the fall; however, the drop in M2 velocity was again
larger than predicted on the basis of ihe historical
relationship between (he velocity of M2 and the
opportunity costs of holding M2—measured as the
difference between the rate on three-month Treasury
bills and the average return on M2 assets. The reasons for the decline of M2 velocity this year are not
M2 velocity and the opportunity cosi of holding M2

M2; Annual range and aciual level




I97B

IVBH

Ni 11 h The dHa jrv quarterly The <rcloi:riy of Ml is Ihe ncia ut amw
frou domeiuc product la itte nock nf M2. The opportunity nw or M2 i
iwo-quaner moving average ol die JrlfncBce between (he ihrce-moiKh Treat
bill me and (he weieMed-dvn^t nmrn on auen included in M2.

68
18

4.

Monetary Polity Report 10 the Congress D July

Growl h of money afltl JcM
Krornl

10

Swi-. Ml cofwtt* ofcurneiKy. travtftrs charts, domed Jepowif. dadudw
ctvukuMf dcpwu. M; ittwili of Ml pku uvinp <itptMiu uwludiBf maaey
mortei ikfKKit account!). innM-ikiioiniiiau« tune Jepouu. aid Mami n
icoil nuaey market Iwji M3 consMi oi MJ plot ! ( i*'»iiiinmii« me
•!
itepuuu. bBlanco in inuinnioml money martei fimtb. MP liabihua loremifti
a»d wmL wd EwatoHan imcni^l and BtrnK Drti comnu of *» ra«wmliA| cndn market debt of die U.S. govcnmnL nwe

mmtinuii nrfanuauoiB. nunnmiicml
metis.
fann.
1 From average Tnr Nwlh <|oanef at'
tfiidvler iU' ^c* indicated.
1 Fmm avoap tor pRVEdillf fans w averafc l« i^uner i
3 From AVCI^C lew NMrdi qvnrr oT I94H inawemfv for Jm* (May IB the

clear; 'he drop extends a trend in velocity evident
since mid-1997 and may in pan owe to households'
efforts to allocate some wealth to the assets included
in M2. such as deposits and money market mutual
fund shares, after several years of substantial gains in
eqtiiiy prices that greatly raised the share of wealth
held in equities.
MI increased a a 2 percent annualized pace from
the fourth quarter of 1998 through June, in line with
rls advance in 1998. The currency component of Ml
expanded quite rapidly. The strength appeared to
stem from domestic, rather than foreign, demand,
perhaps reflecting vigorous consumer spending,
although currency growth was more robust than
might be expected for the rise in spending. The
deposits in MI—demand deposits and other checkable deposits—contracted further, as retail sweep programs continued 10 be introduced. These programs,
which first began in 1994. shift funds from a depositor's checking account, which is subject to reserve
requirements, to a special-purpose money market
deposrl account, which is not. Funds arc then shifted
back to the checking account when the depositor's
account balance Falls below a given level. The
depository institution benefits from a retail sweep
program because (he program cms its reserve requirement and thus the amount of non-inierest-bearing
reserve balances thai it must hold at its Federal
Reserve Bank. New sweep programs depressed the
growth of MI by about S'A percentage points over
the first half of 1999. somewhat less than in previous

years because most of the depository institutions that
would benefit from such programs had already implemented them.
As a consequence of retail sweep programs, the
balances that depository institutions are required to
hold at the Federal Reserve have fallen about 60 percent since 1994. This development has the potential
to complicate reserve management by the Federal
Reserve and depository institutions and thus raise the
volatility of the federal funds rate. It would do so
by making the demand for balances at the Federal
Reserve more variable and less predictable. Before
the introduction of sweeps, the demand for balances
was high and stable because reserve balance requirements were large, and the requirements were satisfied by the average of daily balances held over a
maintenance period. With sweep programs reducing
required balances to low levels, depository institutions have found that they target balances in excess of
their required balances in order to gain sufficient
protection against unanticipated debits that could
leave their accounts overdrawn at the end of the day.
This payment-related demand for balances varies
more from day to day than the requirement-related
demand. Thus far, the greater variation in the demand
for balances has not made the federal funds rate
appreciably more volatile, in part reflecting the successful efforts of depository institutions and the Federal Reserve to adapt to lower balances. For its part,
the Federal Reserve has conducted more open market
operations that mature the next business day to bet-




cue tf Ja»uc nnMiniKial dcbil.

69
ftnanl of Governors of the Federal Reserve Svxiem

ter align daily supply with demand. Nonetheless.
required balances at the Federal Reserve could drop
to levels ill which the volatility of the funds rate
becomes pronounced. One way 10 address ihc problem of declining required balances would he to permit (he Federal Reserve lo pay interest on ihe reserve
balances [hai depository institutions hold. Paying
interest on reserve balances wnild reduce considerably the incentives of depository institutions to develop reserve-avoidance practices that may complicate the implementation of monetary policy.

Implied v ill ali U tic

U.S. Financial Markets
Yields on Treasury securities have risen this year in
response to the ebbing of ihc financial market strains
«1 taw 199K. surprisingly strong economic activity.
concerns about the potential for increasing inflation,
and the consequent anticipation of tighter monetary
policy. In January, yields on Treasury securities
moved in a narrow range, as lingering safe-haven
demands for dollar-denominated assets, owing in part
to the devaluation and subsequent floating of the
Brazilian i-eal, about offset the effect on yields of
•itronger-than-expected economic data. Over subsequent months, however, yields on Treasury securities,
especially at intermediate and long maturities, moved
up substantially. The demand for the safest and most
liquid assets, which had pulled down Treasury yields
in the fall, abated as the strength in economic activity
and favorable earnings reports engendered optimism
about the financial condition of private borrowers and
encouraged investors to buy private securities- In
addition, rising commodity prices, tight labor markets, and robust economic activity led market participants to conclude that monetary policy would need to
be tightened, perhaps in a series of steps. This view.
accentuated by the FOMC's announcement after its
May meeting that it had adopted a directive tilled
toward tightening policy, also boosted yields.
Between the end of 1998 and mid-July. Treasury
yields added about 80 basis points to 110 basis points,
on balance, with the larger increases in the intermediate maturities. The rise in Treasury bill rates,
anchored by the modest upward move in the FOMC's
target federal funds rate, was much less, about
10 basis points to >W) basis points.
The recovery in fixed-income markets over the first
half of the year was evident in a number of indicators
of market conditions. Market liquidity was generally
better, and volatility was lower. The relative demand
for the most liquid Treasury securities—the most
recently auctioned security at each maturity—was




rhc iUll,i ore Jailv Implml %i,lull lili
jsHih-m.uiun- j« In lull 19. I1***

not so acute, and yields on these securities were in
somewhat closer alignment with yields on issues that
hati been wuistanding longer. Dealers were more willing to put capital at risk to make markets, and bidasked spreads in Treasury securities narrowed somewhat, though, in June they were still a bit wider than
had been typical. Market expectations of asset price
volatility, as reflected in prices on Treasury bond
options contracts, receded on balance. The implied
volatility of bond prices dropped off until April and
then turned back up. as uncertainty about the timing
and extent of a possible tightening of monetary policy increased.
Yields on inflation-indexed Treasury securities
have only edged up this year, and the spreads between
yields on nominal Treasury securities and those on
comparable inflation-indexed securities have widened considerably. Yields on inflation-indexed securities did not decline in late 1998 like those of their
nominal counterparts, in part because these securities
were not perceived as being as liquid as nominal
Treasury securities. Thus, as the safe-haven demand
Vor nominal Treasury securities unwound and nominal yields rose, yields on inflation-indexed securities
did not move up concomitantly. Moreover, these
yields were held down by some improvement in
the liquidity of the market for inflation-indexed
securities, as suggested by reports of narrower bidasked spreads, which provided additional impetus
for investors to acquire these securities. Because of
such considerations, the value of the yield spread
between nominal and inflation-indexed Treasury
securities us an indicator of inflation expectations is
limited. Nonetheless, the widening of the spread
this year may have reflected some rise in inflation
expectations.

70
20

Monetary Policy Report 10 the Congress O July

KI prices, as measured by ihe S&P 5(X) index, was
nuar the record l<»w cstMistKit in May. Meanwhile,
real interest rates, measured as ihe UilVcrencc hciwccn
(he yield on ihe nominal len-year Treasury note and
u \urvcy-hased measure nt inflation expectations,
moved up. Cun-scgucnilv. ihe risk premium lor hulding equities remained i|uitc small by historical
standards.

n-k prki;

Yeur 2000 Pr

Equity prices have climbed this year. Major equity
price indexes posted gains of 10 percent 10 31 percent, on balance, between the end of" I9V8 amj
July 16. when most ol'them established record highs.
The lift lo prices from mronger-ihan-aniicipated economic activity and corporate profits apparently has
offset ihe damping efteci of rising bond yields. Prices
of technology issues, especially Internet stocks, have
risen considerably on net. despite some wide swings
in sentiment. Share prices of firms producing primary
commodities, which tumbled in the fall, rebounded to
post large price gains, perhaps because of the firming
of commodity prices amid perceptions that Asian
economies were improving. Consensus estimates of
earnings over ihe coming twelve months have
strengthened, but in June the ratio of these estimates
Equity valuation and ihe len-year real in tore si rate

I<MO

IW*

SniK The claui anf monthly rhe catninjs-pncK raf ro u twd on ihe U&&JS
Inicrnalional. Inc . tomtmus tinman; ol earnings n-er the t.imnf i»rlve
mnnitll Tlir real inWtsI rale ii Ihe yield on IlK !en->far TreiBury new less Ihe
measure or Ten-year mftafnHI enpet-larnutt Imnt iftc FtOfjat Kravnr Bank ol
Philadelphia Survey nl Pioleluonal FCHECIHCTS




The Federal Reserve and ihe hanking system have
largely completed preparing technical systems to
ensure thai ihcy will Itmcrmn at (he ccniury Uiiic
change and arc taking steps lo deal with potential
continjiencies. The Federal Reserve «JccL'>vJully
completed testing all of its mission-critical computer
systems ("or year 2001) enmpliance, including its securities and funds transfer systems. As a precaution to
assure ihe public that sufficient cash will be available
in the event that demand for U.S. currency rises
in advance of the century date change, the Federal
Reserve will increase considerably its inventory of
currency by late 1999. In addition, the Federal
Reserve established a Century Dale Change Special
Liquidity Facility to supply collateralized credit
freely to depository institutions at a modest penalty co
market interest rates in the months surrounding the
rollover. This funding should help financially sound
depository institutions commit more confidently to
supplytftg loans to other financial institutions and
businesses in the closing months ol" 1999 and early
monihsof'2000.
All depository institutions have been subject to
special year 2000 examinations by their banking
supervisors to ensure their readiness. Banks, in turn,
have worked with their customers to encourage
year 2000 preparedness by including a review of a
customer's year 2000 preparedness in their underwriting or loan-review standards and documental ion.
According to ihe Federal Reserve's May 1999 Senior
Loan Officer Opinion Survey, a substantial majority
of the respondent banks have largely completed
year 2000 preparedness reviews of their material
customers. Most banks reported that only a small
portion of their customers have not made satisfactory
progress.
Banks in the Federal Reserve's survey reported
little demand from their clients for special contingency lines of credit related to the century date
change, although many expect demand for such lines
to increase somewhat as the year progresses. Almost
all domestic respondents reported that (hey are will-

71
tif GovtriHiii "/ llu Federal Reserve Svxtent

ing to extend such credit lines, although in some
cases wiih lighter standards or terms.

/memutirmal Developments
Global economic prospects look considerably
brighter ihun they did only a lew monihs ago. To
an important degree, this improvement owes to the
rebound in ihe Brazilian economy from ihe turmoil
experienced in January and February and LO the Tact
thai ihe i'allout from Bra/il on other countries wa.s
much less than it mighi have been. The tear was that
the co I lapse ui' the Brazilian reul last January would
unleash a spiral of inflation and further devaluation
and lead to a default on government domestic debt,
destabilizing financial markets and triggering an
intensified flight of capital from Brazil. In light of
event?, following the Russian debt moratorium and
collapse of the ruble last year, concern existed that a
collapse of the real could also have negative repercussions in Latin America more broadly, and possibly even in global financial markets.
Developments in Brazil turned out better than
expected over the weeks after the floating of the real
in January. Between mid-January and early March,
the real lost 45 percent of its value against the dollar,
reaching a low of 2.2 per dollar, but then started to
recover after the Brazilian central bank raised the
overnight interest rate Vrom ?9 percent to 45 percent
and made clear that it gave a high priority to fighting
inflation. By mid-May, the real had strengthened
to 1.65 per dollar, even while the overnight rate had

Brazilian financial indicators




1\

been cut. in .steps, from its March high. The overnight
rate was reduced further, to 21 percent by the end ol
June, hut the reul let I back only modestly and stood
at about 1.80 pcr dollar in mid-July. Bra/il's stock
market also rose sharply and was up by about h5 percent in the year to date.
Several favorable development.1, have worked to
support ihe real and equity prices over the past lew
months. Inflation has been lower than expected, with
consumer price inflation at an annual rate of around
S percent I'or ihe tirst half of the year. Creater-ihunexpeclcd real GDP growth in the lirst quarter, though
attributable in part to temporary factors, provided
some evidence of a hotloming i>ui, and possible
recovery, in economic activity over the first part of
this year. And in the fiscal arena, the government
posted a primary surplus of more than 4 percent ol
GDP in the lirst quarter—well above the goal in ihe
International Monetary Fund program. The positive
turn of events has facilitated a return of the Brazilian
government and private-sec tor borrowers lo international bond markets, albeit on more restrictive terms
than those of a year ago.
Since the middle of May. however, the road to
recovery in Brazil has become bumpier. The central
government posted a fiscal deficit in May that was
bigger than had been expected. In addition, court
challenges have called into question fiscal reforms
enacted earlier this year that were expected to
improve the government's fiscal balance by about
! percent of GDP. In May. the rise in U.S. interest
rates associated with the anticipated tightening in the
stance of U.S. monetary policy helped push Brady
bond yield spreads up more than 200 basis points.
Although they narrowed some in June they widened
recently on concerns about Argentina's economic
situation.
The Brazilian crisis did trigger renewed financial
stress throughout Latin America, as domestic interest
rates and Brady bond yield spreads increased sharply
in January from levels that had already been elevated
by the Russian crisis. Nonetheless, ihese increases
were generally smaller than those that had followed
the Russian crisis, and as developments in Brazil
proved more positive than expected, financial conditions tn the rest of the region stabilized rapidly. Even
so. the combination of elevated risk premiums and
diminished access to international, credit markets,
as well as sharp declines in the prices at' commodity exports, had significant consequences for GDP
growth, which began to slow or turn negative
throughout the region in late 1998 and early 1999.
Mexico appears to have experienced the least diminution in economic growth, likely because of its

72
22

Monetary Policy RcptiR (o (he Congress D July J999

strong trade links wiifi the United States, wncrc
growth has been robust. A Ibticning in Mexican
GDP in ihc final quarter of 1998 has given way to
renewed, btti moderate, growih rmve rccenily. and
the Mexican peso lias appreciated by about 51/; percent relative to (he dollar since the start of ihe year.
By contrast, economic activity in Argentina declined
••harply in the first quarter, in part because ol' the
devaluation and relatively weak economic activity
in Bra/il. Argentina's major trading partner. More
recently the earlier recover)1 in Argentina's financial
markets appears to have backtracked as concern has
increased about the medium- to long-run viability ol'
the currency peg to the dollar Several countries in
the region, including Venezuela, Chile, and Colombia, also experienced sharp declines in output in the
firM quarter, stemming in pan from earlier declines in
oil and other commodity prices.
In emerging Asia, sigm ul' recovery in financial
markets and in real activity are visible in most ol" the
countries that experienced linancial crises in late
1997. However, the pace und extent of recovery is
uneven across countries. The strongest recovery has
been in Korea. In 199K. the Korean won reversed
nearly hall" of its sharp depreciation of late 1997.
It has been little changed on balance this year, as
Korean monetary authorities have intervened to moderate its further appreciation. Korean stock prices
have also staged an impressive recovery—moving up
about 75 percent so far in 1999. In the wake of its
financial crisis, output in Korea tell sharply, with
industrial production down about 15 percent by the
middle of last year. Since then, however, production
has bounced back.. With the pace of the recovery
accelerating this year, all ol" the post-crisis drop
in production has been reversed. This turnaround
reflects both ihe improvement in Korea's external
position, as the trade balance has swung into substantial surplus, and the government's progress in
addressing the structural problems in the financial
and corporate sectors that contributed to the crisis.
Financial markets in the Southeast Asian countries
that experienced crises in 1997 (Thailand, Singapore.
Malaysia. Indonesia, and the Philippines) apparently
were little affected by spillover from Brazil's troubles
earlier this year and have recovered on balance over
the past year, with exchange rates stabilizing and
stock prices moving higher. Financial conditions have
been weakest m Indonesia, in large pan a result of
political uncertainty; but even so, domestic interest
rates have dropped sharply, and the stock market has
Staged an impressive rebound since April. The recovery of economic activity in these countries has been
slower and less robust than in Korea, possibly reflect-




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Ink*. Unun ''"I- I

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\m> The ibu .ire hw )ht Ij-l nailing Jay ol the riKMIfl The July uhscr
»J Jrt Mr lab II Imttci .vr rapMjJwifuiit-waitJMrfl .iwnifr' "i jJJ Jiv

ing slower progress in addressing structural weaknesses in the financial and corporate sectors. However, activity appears to have bottomed out and has
recently shown signs of staning to move up in these
countries.
Financial markets in China and Hong Kong experienced some turbulence at the start of the year when
Chinese authorities put the Guangdong International
Trust and Investment Corporation (GITIC) into bankruptcy, leading to rating downgrades for some Chinese financial institutions, including the major state
commercial banks. The GITIC bankruptcy also raised
concerns about Hong Kong linancial institutions.
which are heavy creditors to Chinese entities. These
concerns contributed to a substantial increase in yield
spreads between Hong Kong government debt and
U.S. Treasury securities and to a fall in the Hong
Kong stock market of about 15 percent. Spreads have
narrowed since, falling from about 330 basts points
on one-year debt in late January to about 80 basis
points by mid-May, and have remained relatively
stable since then. Equity prices also rebounded
sharply, rising nearly 50 percent between midFebruary and early May. Despite sizable volatility in
May and June, ihey are now roughly unchanged from
early May levels.
In Japan, a few indicators suggest that recovery
from a prolonged recession may be occurring. Principally, first-quarter GDP growth at an annual rate ol"
7.9 percent was recorded—the tirst positive growth
in six quarters. This improvement reflects in part a
shift toward mare stimulative fiscal and monetary
policies. On the fiscal front, the government
announced a set of measures at the end of last year
chal were slated for impte mental km during (999 and

73
Hnanl <>f Gm-rmiin uf she Federal Reserve System

included permanent ems in personal and corporate
income taxes, various investment incentive*, and
increases in public expenditures. The large-scale fiscal expansion and concern ohuut increases in ihc
supply ol' government bonds caused bond yields in
more lhan double laic last year and early ihis year, to
a level iH' ahoul 2 percent on ihe icn-year bond.
In mid-February, primarily because ol' concern
about the prolonged weakness in economic activity
ami pronounced deflationary pressures but also in
response in ihe rising bond yields, the Bank ol" Japan
announced a reduction in ihe target for ihe overnight
cull-money rule and subsequently guided ihe rate lo
ils present level of 3 hasis points hy curly March.
This easing ol' monetary policy had a simulative
effect on Japanese h'nancial markets, with ihe yield
on ihe ten-year government bond [ailing more than
75 hasis points. 10 1.25 percent by mid-May. More
recently, ihe yield has risen to about 1.8 percent,
partially in response to ihe release of unexpectedly
strong hrsi-quarter GDP growth. Supportive monetary conditions, coupled with restructuring announcements from a number ol' large Japanese firms and
growing optimism about the economic outlook, have
fueled a rise in the Nikkei from around 14,400 over
the first two months of the year to over 18.500 in
mid-July.
The improved economic performance in Japan also
reflects some progress on addressing persistent problems in the financial sector. In March the authorities
injected 7V: trillion yen of public funds into large
financial institutions and began to require increased
provisioning against bad loans as well as improved
financial disclosure. Although much remains to be
done, these actions appear to have stabilized conditions, at least temporarily, in the banking system, and
the premium on borrowing rates paid by leading
Japanese banks declined to zero by March.
The yen strengthened in early January, supported
by the runup in long-term Japanese interest rates,
reaching about 110 per dollar—its highest level in
more than two years. However, amid apparent intervention by the Japanese authorities, the yen retreated
to a level above 116 per dollar, and it remained near
that level until the mid-February easing of monetary
policy and the subsequent decline of interest rates
when it depreciated to about 120 per dollar. In midJune, the Japanese authorities intervened in the foreign exchange market in an effort to limit appreciation or' the yen alter the surprisingly strong firstquarter GDP release increased market enthusiasm for
that currency. The authorities noted that a premature
strengthening ol' the yen was undesirable and would
weigh adversely on economic recovery.




23

In the other major industrial countries, ihe pace
nl'economic growth this year has been mixed. Economic developments in Canada have been quite
t'iivwjMc. GDP rose 4l/» perecm al an annual rale in
the lirsi quarter aflcr a fourth -quarter gain of 41/. pero:nt, with production fueled by strong demand for
Canadian products from the United Stales. Cure inllation remains low. near the lower end of ihe Bank
(if Canada'N target range of I percent lo 3 percent,
although overall inflation rose some in April and
May. Oil prices and other commodity prices have
risen, and the current account dclicil has narrowed
considerably. These factors have helped (he Canadian
dollar appreciate relative to ihe U.S. dollar by ahoul
4 percent ihis year and have facilitated a cut in
short-term interest rates <il' 50 basis points by the
Bank of Canada. Along with rising lung-term interest
rates elsewhere, long rates have increased in Canada
by about 30 basis points over the course of ihis year.
Even so. equity prices have risen about 12 percent
since the start of the year, although the rise in longterm rates has undercut some of the momentum in the
stock market.
In ihe United Kingdom, output was flat in the first
quarter, coming oft" a year in which GDP growth had
already slowed markedly. However, the effects ol'
aggressive interest rale reductions undertaken by the
Bank of England in late 1998 and earlier this year
appear to have emerged in the second quarter, with
gains in industrial production, retail sales volume,
and business confidence. Inflationary pressures have
been well contained, benefiting in part from the continued strength in sterling: the Bank of England cut
interest rates, most recently in June, to reduce the
likelihood of inflation undershooting its target of
2'/i percent. Consistent with expectations of an
upturn in growth, equity prices have risen more than
15 percent, and long-term bond yields have climbed
nearly 80 basis points since the end of last year.
First-quarter growth in the European countries that
have adopted a common currency (euro area)
regained some momentum from its slow pace in late
1998 but was nevertheless below potential, as production continued to react to Ihe decline in export
orders registered over the course of 1998 and in early
1999. Still, ihe drag on overall production from weak
export demand from Asia and eastern Europe appears
lo have lifted a bit in the past few months, although
the signs of a pickup in growth were both tentative
and uneven across the euro area. In Germany, industrial production was higher in April and May than in
the preceding iwo months, and export orders were
markedly higher in those months than they had been
al any lime since the spring of 1998. Bui in France.

74
24

Monetary Policy Report to the Congress D July

which had been the strongest of the three largest
euro-area economies in 1998, GDP growth was a
meager \V> percent at an annual rate in the lirst
quarter, and industrial production slipped in April.
On average in the uuro area, inflation has remained
quite lame, even as rising oil prices, a declining euro.
am], M kttm in Germany, an acceleration in wage
rates have raised intlujionary pressures this year. The
low average rate of inflation as well us the still
sluggish pate of real activity in some of the euro-area
countries led the European Central Bank to lower the
overnight policy rate by 50 basis points in April, on
lop of cuts in shon-ierm policy rates made hy the
national central hanks lute luM year that, on average.
were worth about 60 basis points.
Notwithstanding the easing of the policy stance,
long-term government hond yields have risen substantially from iheir January lows in the largest
economies of the euro area. Ten-year rates spiked in
curly March along with U.S. rates, fell hack some
through mid-May, and then resumed an upward
course around the time [he FOMC adopted a tightening bias in mid-May. Since the middle of June, a
relatively sharp increase in yields has pushed them to
about 100 basis points above their values at the start
ol the year and has narrowed what had been a growing interest rate differential between U.S. and European bonds. In addition to the pressure provided by
the increase in U.S. rates, the runup in European
yields likcJy reflects the belief that short-term rates
have troughed. as the incipient recovery in Asia not
only reduces the drag on European exports but also
attenuates deflationary pressures on European import
prices. Concern about the fall in the exchange value
of the euro may also have contributed to an assessment that the next move in short-term rates would be
up. Gains in equity prices so far (his year—averaging
about 121/! percent—are also suggestive of the belief
that economic activity may be picking up, although
the range in share price movements is fairly broad,
even considering only the largest economies: French
equity prices have risen about 20 percent. German
prices arc up 13 percent, and Italian prices are up
only 5 percent.
The new European currency, the euro, came into
operation at the start of the year, marking the beginning of Stage Three of European Economic and
Monetary Union. The rates of exchange between the




Numiiiuf ilollar cu'hanm: rale iru

u l K The liala JJI monthly Jitr-iit.. The illlu-,inM ewta
aied German mart, heime Janiur> IfM Die maiw i-um
fc->wifti«il average ul Ihe eichanjii! value of ilw Jnllu

euro and the currencies of the eleven countries adopting the euro were set on December 31: based on these
rales, the value of the euro at the moment of its
creation was $1.16675. Trading in (he euro opened
on January 4. and after jumping on the first trading
day. its value has declined relative to the dollar
almost steadily and is now about 13 percent below its
initial value. The course of the euro-dollar exchange
rate likely has reflected in part the growing divergence in both the cyclical positions and. until
recently, long-term bond yields of the euro-area
economies and the United States. Concerns about
fiscal discipline in Italy—the government raised
its (999 deficit-to-GDP target from 2.0 percent
to 2.4 percent—and about progress on structural
reforms in Germany and France have also been cited
35 contributing to weakness in the euro, with the
European Central Bank recently characterizing
national governments' fiscal policy plans as
"unambitious."
On balance the dollar has appreciated more than
4'/i percent against an index of the major currencies
since the end of last year, owing mainly to its
strengthening relative to the euro. Nevertheless, ii
remains below its recent peak in August of last year
when the Russian debt moratorium and subsequent
financial market turmoil sent the dollar on a twomonth downward slide.

o