Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's Second Monetary Policy Report for 2000 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundred Sixth Congress, Second Session

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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 2000

HEARING
BEFORE THE

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

OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

JULY 20, 2000

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

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2000
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PHIL GRAMM, Texas, Chairman
RICHARD C. SHELBY, Alabama
PAUL S. SARBANES, Mainland
CONNIE MACK, Florida
CHRISTOPHER J. DODD, Connwticu
ROBERT F. BENNETT, Utah
JOHN F. KERRY? MaBStwfowtts
ROD GRAMS, Minnesota
RICHARD H. BRYAN, Nevwur
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
JOHN E. SILVIA, Chief Economist
MARTIN J. GRUENBERG, Democratic Senior Counsel
GEORGE E. WHITTLE, Editor
(ID

C O N T E N T S
THURSDAY, JULY 20, 2000
Page

Opening statement of Chairman Gramm
Opening statements, comments, or prepared statements of:
Senator Sarbanes
Senator Shelby
Senator Mack
Senator Grams
Senator Bayh
Senator Bennett
Senator Reed
Senator Schumer
Senator Sunning

1
2
3
4
4
5
6
25
27
30

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

7
30

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD
Monetary Policy Report to the Congress, July 20, 2000
(III)

34

FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 2000
THURSDAY, JULY 20, 2000

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

Chairman GRAMM. Let me call the Committee to order.
Today we begin our semiannual report from the Chairman of the
Federal Reserve System, Alan Greenspan, on the state of the economy and monetary policy. As many of you know, we have worked
out a bipartisan consensus as to how to proceed in the future as
we move away from the Humphrey-Hawkins report toward a report that more meets the needs of the era that we are blessed to
live in.
We were unable to pass permanent legislation to annualize this
meeting, not because of a dispute about the nature of Chairman
Greenspan's testimony, but basically because of a dispute about
how many reports to Congress we want to continue. There tends
to be, in some hearts, a love of reports and bureaucrats and dust.
But, in any case, this is a free country, and if people feel they need
more reports, I'm sure we have the people in those two great big
buildings at the Federal Reserve who are ready and willing to give
us all the reports we need.
We are very glad to have you here again, Chairman Greenspan.
You have become a national phenomenon. We are told Wall Street
is waiting for a big day today, and so are we. We are blessed with
the strongest, most vibrant economy that I can remember in my
study of American economic history.
There are many who would be quick to take credit, but I think
if you had to narrow it down to who deserves more credit than anybody else on the planet, that person is sitting before us today, and
his name is Alan Greenspan.
We are very proud to have you here, Chairman Greenspan, and
we are eager to hear from you. We're eager to begin our new set
of hearings based on the state of the economy and monetary policy,
and we welcome you this morning.
With that, let me recognize our Ranking Democratic Member,
Senator Sarbanes.
(l)

OPENING STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. First
of all, I'm pleased to join you in welcoming Chairman Greenspan
before the Committee this morning to give the Federal Reserve's
Monetary Policy Report to the Congress.
I join with you in the observation concerning the statutory requirement that the Fed submit its semiannual report on monetary
policy to Congress, which expired, actually, earlier this year. As we
know, the House has passed the bill reauthorizing those reports, as
well as a number of other reports that have been sunsetted. I believe there's a general consensus that some reports were dropped
that should have been kept. Our staffs are working together now,
and I hope we can work out an understanding with respect to those
reports.
As you note, there's no controversy over the Monetary Policy Report to the Congress. In fact, to its credit, the Federal Reserve has
supported making the monetary policy reports, and we are pleased
that they are here this morning.
I want to take just a moment or two to address this monetary
policy question. When the Fed's Open Market Committee last met
on June 28 and announced its decision not to raise rates, it issued
the following statement, and I must say, as an aside, I think the
increased transparency which the Fed has brought to its decisionmaking is all to the good. I welcome the fact that they announce
the decisions and give some rationale for them, although I guess
some of us feel they could give some additional rationale and sometimes that it shouldn't be quite as opaque as it is. But, nevertheless, at their last meeting they said:
Recent data suggests that the expansion of aggregate demand may be moderating
toward a pace closer to the rate of growth of the economy's potential to produce.
Although core measures of prices are rising slightly faster than a year ago, continuing rapid advances in productivity have been containing costs and holding down
underlying pressures.

I hope that kind of analysis will lead to the conclusion that we
do not need to go back on the path of raising rates. I don't believe
there has been a significant change in the economy since the last
meeting of the Federal Open Market Committee that would justify
a rate hike.
I think it's important to keep in mind that the Federal Reserve
has already raised rates six times over the past year, including a
half-point hike just 8 weeks ago. The Federal funds rate is now 2
percentage points higher than it was a year ago. The low core rate
of underlying inflation means that rising nominal rates have translated directly into higher real interest rates. In fact, real interest
rates now are at their highest level since 1989, just before the last
recession.
Not surprisingly, interest-sensitive sectors of the economy now
show declines. Just this morning, the Commerce Department released the June numbers on housing starts and housing permits.
Housing starts in June are at their lowest point since May 1998.
Over the last 4 months of this year, housing starts have fallen 15
percent. Housing permits in June are at their lowest point since
December 1997.

Even with last month's rise in durable goods orders, they now
stand at the same level they were at in the beginning of the year.
Sales of domestic cars and light trucks have fallen for 4 consecutive
months, with a total decline of 13 percent over that period.
Obviously, this slackening of demand has resulted in some weakening of employment opportunities. In fact, the private sector over
the last 3 months has added just over 330,000 jobs, the poorest 3months' performance in 4V2 years. And the unemployment rate for
blacks and Hispanics has started to rise again, after having, fortunately, come down in an impressive manner.
I should note, Mr. Chairman, that Chairman Greenspan, in my
judgment, to his credit, has been sensitive to these concerns. In
fact, he concluded his statement before the Banking Committee at
this time last year with the following comment:
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 with3 less than
a high school education has declined from 10% percent in early 1994 to 6 /4 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.

It is important to note, I believe, that the rate hikes have taken
place in an economy that is showing virtually no evidence of inflation. The core rate stands at about the same pace as it's been over
the 4 preceding years. The same thing is true for producer prices.
And, of course, this is all coupled with a sustained strong level of
improvement in productivity, up 3.7 percent over the last year.
This has kept unit labor costs down—in fact, those costs have decelerated. They are actually pulling inflation down.
I believe there is strong evidence that the FOMC's increase in interest rates over this past year has slowed the economy, and I'm
very much hopeful that at its next FOMC meeting, the Fed will not
raise rates again. Hopefully, the current slowing in the economy is
a move toward the soft landing that many economic observers have
been talking about. We certainly don't want a hard landing, and I
hope the Fed will not contribute to that possibility.
I join in welcoming Chairman Greenspan once again before the
Committee. I look forward to hearing his testimony and the opportunity to put questions to him.
Thank you very much.
Chairman GRAMM. Thank you, Senator Sarbanes.
Senator Shelby.
OPENING COMMENTS OF SENATOR RICHARD C. SHELBY

Senator SHELBY. Chairman Greenspan, I want to join in welcoming you. We all have deep respect for you and appreciate your
coming before this Committee again to talk with us about monetary policy, at least the current status of it.
We all like low interest rates, but I think what we want is sound
monetary policy first. The Federal Reserve was created as a central
bank to be independent, and it will be, should be, up to you and
your colleagues to determine issues such as that. You see things
about the economy that perhaps we don't see every day. That is
something that is incumbent upon you.

I would love to see interest rates drop a couple of points, but at
the same time, monetary policy, sound monetary policy, I believe,
is more important than anything.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Shelby.
Senator Mack.
OPENING COMMENTS OF SENATOR CONNIE MACK

Senator MACK. Thank you, Mr. Chairman. Welcome, Chairman
Greenspan. This is the last time I will have the opportunity as a
Member of the Senate to listen to your testimony. I want to personally commend and thank you for your stewardship at the Fed.
I think you have proven, I hope for the last time, that the most
important contribution that the Fed can make to this country is a
commitment to price stability. That is the underlying foundation
for long-term growth, job creation, and improved quality of life for
all Americans. Again, I commend you for your hard work and for
your effort.
To continue on with what Senator Shelby said, everyone would
like to see lower interest rates, but the commitment, the continued
commitment to price stability is what I want to see the Fed pursuing. That is something that I believe you have done throughout
your career at the Fed and, again, I commend you for that.
I would like to raise an additional issue. Yesterday, I believe the
Domestic and International Monetary Policy Subcommittee of the
House Banking Committee defeated legislation with respect to dollarization on a vote of 11 to 10. This is just the beginning of this
debate. Obviously, I am disappointed in that, but I take this opportunity to raise the issue with respect to the relationship between
the United States and Latin America.
In the past, almost all bonds issued by Latin American countries
were denominated in dollars. Today, the percentage issued in euros
is approaching 25 percent. The failure of the Congress to provide
the President with fast-track authority for trading negotiations has
sent a message, I believe, to the Latin American leaders that their
economic future may be tied to Europe, not to the United States.
I believe yesterday's decision by the Banking Committee on the
House side is regrettable, and I take this opportunity to try to remind my colleagues of the significance of Latin America to our future. Today, there is less trade that takes place with 500 million
Latin Americans than with 30 million Canadians, and if we don't
wake up and become more engaged in our relationships with Latin
America, I think we're making a tragic mistake.
Mr. Chairman, I appreciate the opportunity to raise that issue.
Chairman GRAMM. Senator Grams.
OPENING COMMENTS OF SENATOR ROD GRAMS

Senator GRAMS. Thank you very much, Mr. Chairman. Welcome,
Chairman Greenspan. It is nice to see you again. As always, we
welcome the opportunity to hear your analysis of our current economic conditions and also your expectations for any of the nearterm changes.
In previous visits with our Committee, we had some discussion
of a "soft landing" for our economy. The timing of that landing

seemed to be an indeterminate time in the future, but the financial
press is now suggesting that our economy may be on a glidepath
and may even be ready to request landing clearance. I believe the
possibility of a soft landing is now more of an immediate interest,
and I look forward to your comments this morning and your current evaluation.
On one other matter, I'm sure that you recall during the passage
of the Gramm-Leach-Bliley bill last fall that several of the Members of this Committee, myself included, expressed our belief that
a bill of the magnitude of GLB would require extensive followup
oversight hearings to assure that the congressional intent of the
bill was being followed in its implementation.
As Chairman of the Securities Subcommittee, I have called two
such oversight hearings. The first hearing concerned the so-called
NARAB provisions impacting the insurance industry. The second
hearing, held jointly with the Financial Institutions Subcommittee,
on June 13, concerned the interim rules and proposed regulations
for merchant banking activities. Governor Meyer testified on behalf
of the Fed. After the hearing, eight Senators, Members of the Financial Institutions and Securities Subcommittees, joined on a followup letter to Governor Meyer. We have expressed our concerns
that the regulations, in some instances, go beyond the intent of
GLB. That letter was sent to Governor Meyer yesterday.
Chairman Greenspan, I am aware that the Fed is still in the
comment period with respect to the merchant banking rules. I mention this letter this morning only to alert you to its existence and
just to ask that the letter, which is a bipartisan letter, come to
your attention as well. It would be premature, of course, to ask this
morning for any reaction from you at this time.
But please know that the merchant banking rules have caused
great consternation in some sectors of the financial industry and
among several Members of this Committee. I mention that because
we hope the Fed will consider making the appropriate changes in
issuing the final regulations. Again, thank you very much for your
attention to this matter.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Grams.
Senator Bayh.
OPENING COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Mr. Chairman. I find myself in the
unusual position here today of being all alone on the right, which,
Chairman Gramm, is not very often the case when you and I are
together.
[Laughter.]
But I am pleased to be here today.
Chairman GRAMM. We should be together more.
[Laughter.]
Senator BAYH. That's right. We are together from time to time,
and that's a good thing.
Chairman Greenspan, we are here today to hear from you, not
to hear from each other. I would just like to comment; I could not
help but to notice in the popular press yesterday, I see there's one
candidate for the Presidency, not representing either of the two

major political parties, who has suggested that, if elected, he would
like to "reeducate" you.
[Laughter.]
I hope today we can educate the American people about the difficult job you have.
We have seen 20 million new jobs created over the last several
years, 2 million new businesses created. The unemployment rate is
at about a 30-year low, and the incidence of homeownership is at
an all-time high. It is my understanding of your purposes that you
would like to contain inflationary pressure so that this expansion
might continue and we might add to those numbers. Since there
will be a great many Americans watching, I hope we can focus on
the relationship between containing inflationary pressures and expanding this wonderful period of prosperity we have had.
I believe that to be your intention, and I hope that we can educate the American people, and perhaps a few of the candidates, to
that fact. Thank you for joining us today. I look forward to hearing
from you.
Chairman GRAMM. Senator Bennett.
OPENING COMMENTS OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Maybe we need to educate that candidate in
the way the law is structured. As President, he has no ability to
fire the Chairman of the Federal Reserve System. But then, that
candidate has trouble understanding a great number of things.
[Laughter.!
Chairman Greenspan, with the rest of the Committee, I welcome
you and congratulate you on your performance. Your stewardship
over the economy has been remarkable.
I signal in advance one issue that I hope you will deal with, if
not in your opening statement, at least in the question and answer
period. That is, the difference between nominal interest rates and
real interest rates, real interest rates being calculated on the gap
between inflation and interest rates, so that if interest rates are at,
illustratively, 6 percent and inflation is at 6 percent, real interest
rates are at zero. We have had that situation during your time at
the Fed, where real interest rates were very close to zero. Now,
while the nominal interest rate is not particularly high, with inflation well under control, the real interest rate is approaching some
historic highs, and the impact of that on the real estate industry
is beginning to concern me a little. I would appreciate it if you
would address that.
I think, as the stock market has demonstrated, they are able to
shrug off almost anything, but some of the folks in both the private
housing real estate market and the commercial real estate market
are beginning to complain a little, at least to me, about the impact
of real interest rates, and the sense that there is a slowdown in the
real estate sector. Coming from one of the fastest-growing States
in the Union, where people need to be housed as they move in or
as our birthrate continues, that scenario is of some concern to me.
I would like to hear about that in your opening statement, and if
not, I hope we can get into it in the question period.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.

When the ancient Greeks journeyed to Delphi, they passed
through two gates. One said, "Know thyself." The other said, "Moderation in all things." With those two warnings, let the oracle
speak.
[Laughter.]
Chairman GREENSPAN. The oracle is temporarily speechless.
[Laughter.]
Chairman GRAMM. But never for long.
[Laughter.]
Chairman GREENSPAN. The big problem with oracularness is that
words come from deep depths of thought which are indescribable,
unprovable, and rarely correct.
OPENING STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Mr. Chairman and other Members of the
Committee, I appreciate, as always, this opportunity to present the
Federal Reserve's report on monetary policy.
The Federal Reserve has been confronting a complex set of challenges in judging the stance of policy that will best contribute to
sustaining the strong and long-running expansion of our economy.
The challenges will be no less in the coming months as we judge
whether ongoing adjustments in supply and demand will be sufficient to prevent distortions that would undermine the economy's
extraordinary performance.
For a while now, the growth of aggregate demand has exceeded
the expansion of production potential. Technological innovations
have boosted the growth rate of potential, but as I noted in my testimony last February, the effects of this process also have spurred
aggregate demand. It has been clear to us that, with labor markets
already quite tight, a continuing disparity between the growth of
demand and potential supply would produce disruptive imbalances.
A key element in this disparity has been the very rapid growth
of consumption resulting from the effects on spending of the remarkable rise in household wealth. However, the growth in household spending has slowed noticeably this spring from the unusually
rapid pace observed late in 1999 and early this year. Some argue
that this slowing is a pause following the surge in demand through
the warmer-than-normal winter months and hence a reacceleration
can be expected later this year. Certainly, we have seen slowdowns
in spending during this near-decade-long expansion which have
proven temporary, with aggregate demand growth subsequently rebounding to an unsustainable pace.
But other analysts point to a number of factors that may be exerting more persistent restraint on spending. One factor they cite
is the flattening in equity prices, on net, this year. They attribute
much of the slowing of consumer spending to this diminution of
the wealth effect through the spring and early summer. This view
looks to equity markets as a key influence on the trend in consumer spending over the rest of this year and next.
Another factor said by some to account for the spending slowdown is the quickly rising debt burden of households. Interest and
amortization as a percent of disposable income have risen materi-

8

ally during the past 6 years, as consumer and especially mortgage
debt has climbed and, more recently, as interest rates have moved
higher.
In addition, the past year's rise in the price of oil has amounted
to an annual $75 billion levy by foreign producers on domestic consumers of imported oil, the equivalent of a tax of roughly 1 percent
of disposable income. This burden is another conceivable source of
the slowed growth in real consumption outlays in recent months,
though one that may prove to be largely transitory.
Mentioned less prominently have been the effects of the faster
increase in the stock of consumer durable assets—both household
durable goods and houses—in the last several years, a rate of increase that history tells us is usually followed by a pause. Stocks
of household durable goods, including motor vehicles, are estimated
to have increased at nearly a 6 percent annual rate over the past
3 years, a marked acceleration from the growth rate of the previous
10 years. The number of cars and light trucks owned or leased by
households, for example, apparently has continued to rise in recent
years despite having reached nearly 194 vehicles per household by
the mid-1990's. Notwithstanding their recent slowing, the sales of
new homes continue at extraordinarily high levels relative to new
household formations. While we will not know for sure until the
2000 census is tabulated, the surge in new home sales is strong
evidence that the growth of owner-occupied homes has accelerated
during the past 5 years.
Those who focus on the high and rising stocks of durable assets
point out that even without the rise in interest rates, an eventual
leveling out or some tapering off of purchases of durable goods and
construction of single-family housing would be expected. Reflecting
both higher interest rates and higher stocks of housing, starts of
new housing units have fallen off of late. If that slowing were to
persist, some reduction in the rapid pace of accumulation of household appliances across our more than 100 million households would
not come as a surprise, nor would a slowdown in vehicle demand
so often historically associated with declines in housing demand.
Inventories of durable assets in households are just as formidable a factor in new production as inventories at manufacturing
and trade establishments. The notion that consumer spending and
housing construction may be slowing because the stock of consumer
durables and houses may be running into upside resistance is a
credible addition to the possible explanations of current consumer
trends. This effect on spending would be reinforced by the waning
effects of gains in wealth.
Because the softness in outlay growth is so recent, all of the
aforementioned hypotheses, of course, must be provisional. It is certainly premature to make a definitive assessment of either the recent trends in household spending or what they mean. But it is
clear that, for the time being at least, the increase in spending on
consumer goods and houses has come down several notches, albeit
from very high levels.
In one sense, the more important question for the longer-term
economic outlook is the extent of anv oroductivity slowdown that
might accompany a more subdued pace~oTproduction and consumer
spending, should it persist. Therhekayiawrf nroductivitv. mnder such

9

circumstances will be a revealing test of just how much of the rapid
growth of productivity in recent years has represented structural
change as distinct from cyclical aberrations and, hence, how truly
different the developments of the past 5 years have been. At issue
is how much of the current downshift in our overall economic
growth rate can be accounted for by reduced growth in output per
hour and how much by slowed increases in hours.
So far there is little evidence to undermine the notion that most
of the productivity increase of recent years has been structural and
that structural productivity may still be accelerating. New orders
for capital equipment continue quite strong—so strong that the
rise in unfilled orders has actually steepened in recent months.
Capital-deepening investment in a very broad range of equipment
embodying the newer productivity-enhancing technologies remains
brisk.
To be sure, if current personal consumption outlays slow significantly further than the pattern now in train suggests, profit and
sales expectations might be scaled back, possibly inducing some
hesitancy in moving forward even with capital projects that appear
quite profitable over the longer run. In addition, the direct negative
effects of the sharp recent run up in energy prices on profits as
well as on sales expectations may temporarily damp capital spending. Despite the marked decline over the past decades in the energy requirements per dollar of GDP, energy inputs are still a large
element in the cost structure of many American businesses.
For the moment, the drop-off in overall economic growth to date
appears about matched by reduced growth in hours, suggesting
continued strength in growth in output per hour. The increase of
production worker hours from March through June, for example,
was at an annual rate of Vz percent compared with SVi percent the
previous 3 months. Of course, we do not have comprehensive measures of output on a monthly basis, but available data suggest a
roughly comparable deceleration.
A lower overall rate of economic growth that did not carry with
it a significant deterioration in productivity growth obviously would
be a desirable outcome. It could conceivably slow or even bring to
a halt the deterioration in the balance of overall demand and potential supply in our economy.
As I testified before this Committee in February, domestic demand growth, influenced importantly by the wealth effect on consumer spending, has been running \Yz to 2 percentage points at
an annual rate in excess of even the higher, productivity-driven
growth in potential supply since late 1997. That gap has been filled
both by a marked rise in imports as a percent of GDP and by a
marked increase in domestic production resulting both from significant immigration and from the employment of previously unutilized labor resources.
I also pointed out in February that there are limits to how far
net imports—or the broader measure, our current account deficit—
can rise, or our pool of unemployed labor resources can fall. As a
consequence, the excess of the growth of domestic demand over potential supply must be closed before the resulting strains and imbalances undermine the economic expansion that now has reached
112 months, a record for peace or war.

10

The current account deficit is a proxy for the increase in net
claims against U.S. residents held by foreigners, mainly as debt,
but increasingly as equities. So long as foreigners continue to seek
to hold ever-increasing quantities of dollar investments in their
portfolios, as they obviously have been, the exchange rate for the
dollar will remain firm. Indeed, the same sharp rise in potential
rates of return on new American investments that has been driving
capital accumulation and accelerating productivity in the United
States has also been inducing foreigners to expand their portfolios
of American securities and direct investment. The latest data published by the Department of Commerce indicate that the annual
pace of direct plus portfolio investment by foreigners in the U.S.
economy during the first quarter was more than 2Vi times its rate
in 1995.
There has to be a limit as to how much of the world's savings
our residents can borrow at close to prevailing interest and exchange rates. And a narrowing of disparities among global growth
rates could induce a narrowing of rates of return here relative to
those abroad that could adversely affect the propensity of foreigners to invest in the United States. But, obviously, so long as
our rates of return appear to be unusually high, if not rising, balance of payments trends are less likely to pose a threat to our prosperity. In addition, our burgeoning budget surpluses have clearly
contributed to a fending off, if only temporarily, of some of the
pressures on our balance of payments. The stresses on the global
savings pool resulting from the excess of domestic private investment demands over domestic private saving have been mitigated
by the large Federal budget surpluses that have developed of late.
In addition, by substantially augmenting national saving, these
budget surpluses have kept real interest rates at levels lower than
would have been the case otherwise. This development has helped
foster the investment boom that in recent years has contributed
greatly to the strengthening of U.S. productivity and economic
growth. The Congress and the Administration have wisely avoided
steps that would materially reduce these budget surpluses. Continued fiscal discipline will contribute to maintaining robust expansion of the American economy in the future.
Just as there is a limit to our reliance on foreign saving, so is
there a limit to the continuing drain on our unused labor resources.
Despite the ever-tightening labor market, as yet, gains in compensation per hour are not significantly outstripping gains in productivity. But as I have argued previously, should labor markets
continue to tighten, short of a repeal of the law of supply and demand, labor costs eventually would have to accelerate to levels
threatening price stability and our continuing economic expansion.
The more modest pace of increase in domestic final spending in
recent months suggests that aggregate demand may be moving
closer into line with the rate of advance in the economy's potential,
given our continued impressive productivity growth. Should these
trends toward supply and demand balance persist, the ongoing
need for ever-rising imports and for a further draining of our limited labor resources should ease or perhaps even end. Should this
favorable outcome prevail, the immediate threat to our prosperity
from growing imbalances in our economy would abate.

11
But as I indicated earlier, it is too soon to conclude that these
concerns are behind us. We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and
potential supply move into better balance, there is still uncertainty
about whether the current level of labor resource utilization can be
maintained without generating increased cost and price pressures.
As I have already noted, to date costs have been held in check
by productivity gains. But at the same time, inflation has picked
up—even the core measures that do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect
effects of energy prices, but the Federal Reserve will need to be
alert to the risks that high levels of resource utilization may put
upward pressure on inflation.
Furthermore, energy prices may pose a challenge to containing
inflation. Energy price changes represent a one-time shift in a set
of important prices, but by themselves generally cannot drive an
ongoing inflation process. The key to whether such a process could
get underway is inflation expectations. To date, survey evidence, as
well as readings from the Treasury's inflation-indexed securities,
suggests that households and investors do not view the current
energy price surge as affecting longer-term inflation. But any deterioration in such expectations would pose a risk to the economic
outlook.
As the financing requirements for our ever-rising capital investment needs mounted in recent years—beyond forthcoming domestic
saving—real long-term interest rates rose to address this gap. We
at the Federal Reserve, responding to the same economic forces,
have moved the overnight Federal funds rate up !3/4 percentage
points over the past year. To have held to the Federal funds rate
of June 1999 would have required a massive increase in liquidity
that would presumably have underwritten an acceleration of prices
and, hence, an eventual curbing of economic growth.
By our meeting this June, the appraisal of all the foregoing
issues led the Federal Open Market Committee to conclude that,
while some signs of slower growth were evident and justified standing pat at least for the time being, they were not sufficiently compelling to alter our view that the risks remained more on the side
of higher inflation.
The last decade has been a remarkable period of expansion for
our economy. Federal Reserve policy through this period has been
required to react to a constantly evolving set of economic forces,
often at variance with historical relationships, changing Federal
funds rates when events appeared to threaten our prosperity, and
refraining from action when that appeared warranted. Early in the
expansion, for example, we kept rates unusually low for an extended period, when financial sector fragility held back the economy. Most recently we have needed to raise rates to relatively high
levels in real terms in response to the side effects of accelerating
growth and related demand-supply imbalances. Variations in the
stance of policy—or keeping it the same—in response to evolving
forces are made in the framework of an unchanging objective—to
foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate possible.

12

Maximum sustainable growth, as history so amply demonstrates,
requires price stability. Irrespective of the complexities of economic
change, our primary goal is to find those policies that best contribute to a noninflationary environment and hence to growth. The
Federal Reserve, I trust, will always remain vigilant in pursuit of
that goal.
Mr. Chairman, I request that my full statement be included in
the record.
Thank you.
Chairman GRAMM. Chairman Greenspan, let me thank you. It
has been my privilege to hear every report that you have given to
the Senate since you have been Chairman. And I would have to say
I believe this is the finest report that you have ever delivered.
I also think it's very instructive that it was a sobering report,
and yet the reactions in the market are positive—the Dow is up
141 points—which says to me that what American investors want
is not cheerleading, not instant gratification, but a steady hand on
the wheel. As I always say to those who are critical of your policies
and who wonder why I'm not more critical, I don't criticize success.
When something's working, I believe you should stay with it.
I have a couple of questions I want to ask. We have started a
vote, so it would be my intention to ask my questions, then to recognize Senator Sarbanes. When we get to the point that we have
to go vote, it would be my objective to temporarily adjourn the
hearing. That will give you a moment to relax and have a glass of
water.
Senator SARBANES. Or something stronger.
[Laughter.]
Senator SHELBY. Coffee.
[Laughter.]

Chairman GRAMM. When we return from the vote, we will continue with the hearing.
First of all, Chairman Greenspan, as you are well aware, we
have spent years battling the effort by American Government to
use trade as a tool of foreign policy. Hardly anything is more denounced than export controls in terms of limiting the ability of our
farmers to sell agricultural products or our manufacturers to sell
manufactured products based upon our approval or disapproval of
potential customers. Except for those pariah states where we have
virtually a state of war in terms of our conflicts in foreign policy,
we have moved away from using economic trade as a tool of foreign
policy.
We now have a new proposal, as I'm sure you are aware, called
the China Nonproliferation Act, which was introduced by Senator
Thompson, that seeks for the first time to use access to our capital
market and access to our banking system as an instrument of
American foreign policy.
The objectives of the bill are goals that no one would disagree
with, that we would like nations not to proliferate in terms of
weapons sales.
But the tools that are being used represent, in my opinion, a very
real threat to our prosperity and finally, in posing the question, a
paradox, in the sense that we bargained harder in our relations
with China, in the normal trade relation agreements and the Chi-

13

nese accession to the WTO—we bargained harder to open the access that our banking system and our investment system has to the
Chinese market than in almost any other area.
Having looked at this proposal, I wanted to give you an opportunity to respond to it.
Chairman GREENSPAN. Mr. Chairman, I certainly agree with the
comments you have made and I clearly understand the motives underlying Senator Thompson's bringing this amendment forward.
As you know, my own view is that our gradual increase in engagement commercially with China is undermining many of the
types of structures which I think lead to the problems we have. I
believe, contrary to engaging them in less commercial activities, it
is very much to our advantage to significantly increase involving
them in free trade, open-market economics, and basically the type
of dynamics which raise standards of living, and ultimately create
significant changes in societies.
In addition to questioning the value of this amendment, there's
a very serious question as to whether it will produce, indeed, what
is suggested it will produce. First, let me say that the remarkable
evolution of the American financial system, especially in recent
years, has undoubtedly been a major factor in the extraordinary
economy we have experienced. It is the openness and the lack of
political pressures within the system which has made it such an
effective component of our economy and, indeed, has drawn foreigners generally to the American markets for financing as being
the most efficient place in many cases where they can raise funds.
But it is a mistake to believe that the rest of the world is without
similar resources. Indeed, there are huge dollar markets all over
the world to lend dollars. And because of the arbitrage that exists
on a very sophisticated level throughout the world, the interest
rates and the availability of funds are not materially different
abroad than here. We do have certain advantages, certain techniques which probably give us a competitive advantage, but they
are relatively minor. Most importantly, to the extent that we block
foreigners from investing, from raising funds in the United States,
we probably undercut the viability of our own system.
But far more important is, I am not even sure how such a law
would be effectively implemented, because there is a huge amount
of transfer of funds around the world. For example, if we were to
block China, or anybody else for that matter, from borrowing in the
United States, they could readily borrow in London and be financed
by American investors. If London were not financed by American
investors, London could be financed, for example, by Paris investors, and we finance the Paris investors.
In other words, there are all sorts of mechanisms that are involved here, and the presumption that somehow we can block the
capability of China or anybody else from borrowing at essentially
identical terms abroad as here, in my judgment, is a mistake.
My most fundamental concern about this particular amendment
is it doesn't have any capacity, of which I am aware, to work. But
being put into effect, the only thing that strikes me as a reasonable
expectation is it can harm us more than it would harm others.
Therefore, I must say, Mr. Chairman, I join you in your concerns
about that amendment and I trust it would not move forward, even

14

though I respect the motives of Senator Thompson and understand
where he's coming from, but I trust that he will try to achieve his
ends in a somewhat different manner and a more effective way.
Chairman GRAMM. I thank you, Chairman Greenspan. Let me
ask one more question. Maybe I'm like the old cold war warrior
that has not discovered that the cold war is over, but it makes me
nervous that we are in the midst of the greatest spending spree in
discretionary programs since Jimmy Carter was President. There is
the real possibility that by the end of this year we will have exceeded the Carter Presidency, and you would have to go back to the
Johnson Presidency to find a period where real spending in discretionary programs would exceed what is happening this year.
We are spending at a rate where, if it continues, discretionary
spending growth will eat up probably $1 trillion of the surplus in
a decade. We have Medicare proposals that are misleading in the
sense that we hear dollar figures quoted, but the programs don't
go into effect for 3 years, so that when you look at them fully implemented, you are looking at proposals that, realistically, would
cost $350 billion over a 10-year period.
Now, quite aside from all of the benefits of spending this money
or the benefits from adding to the services that people get through
very popular programs, and justifiably so, such as Medicare, sitting
where you're sitting, looking at the big picture, does this spending
concern you?
Chairman GREENSPAN. Very much, Mr. Chairman, and the reason is not the nature of spending per se, but the rapid dissipation
of the projected surpluses. Let us understand that what we are observing at this particular point is a very extraordinary and, as you
point out, quite unprecedented economic prosperity that we're now
experiencing.
It stems, to a large extent, from a remarkable change in technology that started at the end of World War II and finally became
operationally effective on output-per-hour in the mid-1990's. It essentially drove the economy upward at a remarkable pace, but like
all such rapidly changing vehicles, there is a degree of instability
that occurs when you move at that pace, and, as a consequence,
a free-market economy such as ours develops a series of buffers
which prevent the economy from going off the rails.
I have mentioned two directly as a means by which we supply
the excess of demand over production, or potential supply, but I
think we are missing an understanding of the fact that the increasing surplus—not its level—but the fact that it has been continuously increasing has been a very major stabilizing force in keeping
the savings-investment imbalances and their relationship to our
current account deficit within limits that allow the economy to
move forward at this very dramatic pace, with all the wonderful
consequences that have derived from that.
I'm not saying that if we now turn the deficit down, even if it
continues as a positive number, that that is going to necessarily derail the recovery, but it certainly removes some of the buttress and
buffer in this rapid economic expansion.
What my concern is, is that in the endeavor to employ all of
these deficits for various different projects, whether they are spending initiatives or tax cut initiatives, we are removing part of that

15

valuable buffer. From an economic point of view, I submit to you
that it is increasing the risks in this economy. I am hopeful that,
despite the fact that we have all of these various recommendations
out there in various different stages of initiatives, at the end of the
day, we will allow most of this still-rising surplus to act in the
manner which it is acting. Only when we achieve balance, finally,
and we are out of danger, if I may put it that way, can one more
readily look at a rational approach to this particular problem.
But I do acknowledge the fact that some of the numbers you
have cited and a number of the potential programs, both expenditure and tax cuts, in the pipeline do give me some concern.
Chairman GRAMM. You haven't changed your relative priorities.
Your first objective would be to keep the money in the surplus; if
you are not going to do that, you should cut taxes; but the last,
least desirable thing would be to spend it.
Chairman GREENSPAN. I still hold to that view, Mr. Chairman.
Chairman GRAMM. Senator Bennett has voted. Let me recognize
Senator Sarbanes. I think he wanted to make a comment.
Would you prefer to take a break, or would you rather go on?
Chairman GREENSPAN. Let's keep going, Mr. Chairman.
Chairman GRAMM. OK.
Senator SARBANES. Mr. Chairman, Fm going to leave to vote. The
only comment I wanted to make was to commend Chairman Greenspan on his very well-balanced statement before the Committee.
I am reminded of the story of President Truman who said he
wanted a one-armed economist. They asked him why he wanted a
one-armed economist and he said, because I have these economists
and when I ask them for advice, they say, "On the one hand, and
then on the other hand."
[Laughter.]
Your statement certainly did that here today, and I just wanted
to say that I was reminded of that Truman story.
But I will be back with my questions.
Chairman GRAMM. Chairman Greenspan, I will be glad to take
a break if you would like.
Senator BENNETT. I would prefer the opportunity of questioning
you unencumbered.
[Laughter.]
Chairman GREENSPAN. I knew I had gotten myself into trouble.
[Laughter.]
Senator BENNETT [presiding]. I timed it. It took me 12 minutes;
6 minutes to go over and 6 minutes to come back. If it takes them
the same amount of time, I will have more time than I ever get
at one of these hearings. I'm not going to pass up that opportunity.
Let's go back and talk about your discussion with Chairman
Gramm with respect to what to do with the surpluses. At the risk
of sounding heretical, I am one who believes that a little bit of
debt, properly managed, is not necessarily a bad thing. I look at
the national debt not in total terms, but in relative terms. The national debt is now falling as a percentage of GDP, and falling as
a percentage of the economy as the economy grows more rapidly
than the debt does. The debt may be going up in nominal terms.
I believe it is, is it not?

16

Chairman GREENSPAN. It's true the public debt, which includes
the issues to the Social Security trust fund, is still going up, but
the debt to the public has been going down for quite a number of
quarters.
Senator BENNETT. Yes, the debt held outside of the Government.
Chairman GREENSPAN. We are included outside of the Government in those calculations. But it's true either way, whether the
Federal Reserve is included or not.
Senator BENNETT. So it is outside of the debt owed to Federal
trust funds that the nominal debt is coming down?
Chairman GREENSPAN. Yes.
Senator BENNETT. And as a percentage of the economy, of course,
it is coming down dramatically because the economy is going up.
Let's talk philosophically about whether it would be desirable to
bring that to absolute zero. I don't know of very many businesses
who bring their debt load to absolute zero. They always have some
bonds outstanding to pay for capital improvements, acquisitions,
or so forth by debt, and use debt, properly managed, as a tool for
growth.
Does that same principle apply to the Federal Government, or
should we have as our "holy grail" the reduction of the debt to
zero?
Chairman GREENSPAN. First of all, I would say that the analogy
is somewhat different in the sense that a private corporation endeavors to achieve a certain optimum degree of leverage which
minimizes risk in the context of maximizing rate of return. It is
very rarely the case that the optimum debt level in a business is
zero.
We, of course, in the Federal Government, are not created in that
context. I think you are correct, certainly in the sense that there
are certain advantages to having a risk-free asset out there for people to invest in. There is no question that U.S. Treasury instruments have become, in a sense, the primary vehicle for investment
for, not only U.S. investors, but a very substantial part of the rest
of the world. It has become a particular security against which all
others tend, in one form or another, to be measured. If that were
the only consideration, there is no question that having a substantial amount of U.S. Treasury debt outstanding to fill the investment requirements of the rest of the world would in and of itself
be of value.
But there is the extraordinary value of having a large surplus
currently, and presumably in the intermediate future, which necessitates the level of the debt going down, with the possible exception of the Government investing in private securities, which raises
other complications. We are confronted with the trade-off between
the advantages of very large surpluses, which are acting as a buffer
to keep this recovery in check, but of necessity implies that the
level of the Treasury debt goes down. I think we have to balance
those particular views. In my judgment, it is not a close call. I
believe the advantages of having that surplus in there, hopefully
rising, are extraordinarily greater than the loss that occurs to our
economy and to the rest of the world of having a reduced supply
of risk-free U.S. treasuries.

17

My judgment is, and I suspect this is already happening, that
having a decreasing supply of U.S. treasuries, whose scarcity value
is lowering their interest rates relative to other securities, has
made them less attractive. There is evidence that a number of portfolio managers are shifting out of U.S. treasuries and into higheryielding, but still high-grade, private securities. That process will
doubtless continue, and as is now scheduled, we reduce our outstanding debt quite considerably.
It is a very interesting trade-off that we have. I must say to you,
it's one of those better trade-offs in life to have. It's a "good" versus
another "good." It's a question of which is the more valuable.
I would conclude that, while there are unquestionably losses and
problems that emerge as a consequence of reducing the supply of
U.S. treasuries to the public, the benefits of the surplus which creates that problem far exceed the costs.
Senator BENNETT. I tend to agree with you, at least for now.
Does there come a point at which you say, OK, we have gone far
enough, and now we level out and the benefits of having some public debt are such that we can do other things with the surplus, or
should we let it continue to run until we get to absolute zero?
Chairman GREENSPAN. No, I don't believe the issue really rests
on the goal of eliminating the debt. I think the goal should be, from
an economic point of view, to have high or rising surpluses, so long
as they contribute to long-term economic growth.
I would presume at some point this extraordinarily accelerating
path of technology and productivity growth is going to flatten out
or slow down. That's not to say it's in any way going back to where
we were, but the rate of change almost surely will slow down.
It's conceivable to me, at that particular point, that we have returned to the type of balances, for example, on the current account
or savings-investment balance, that the need to have the surpluses
is not still there. It is quite conceivable to me that the balance of
this trade-off at some point down the road can shift in the other
direction; that it is conceivable that the need to have surpluses—
which, remember, essentially is the employment of resources for
purposes other than what the American public may want—is no
longer there.
They may want a very large tax cut, or they may want some
major expenditure programs. It is conceivable to me at that point
that all of the various balances may suggest that eliminating the
surplus may not be a bad idea. It would stop the decline in the
issuance of U.S. Treasury securities, and I could conceive of the fact
that that might be the optimum position. I would certainly never
conclude that in and of itself, without any qualifications, zero debt
should be our irrevocable goal. I think it's very useful if we reach
that. It has a lot of advantages. But I would scarcely argue that
it is the primary economic goal of this Government.
Senator BENNETT. As is everything that you have outlined in
your prepared statement, it is a matter of balancing and picking
and choosing and trying to find your way through the maze. If
there were shining goals that were clear and absolute that we
should always reach for, your job would be a whole lot easier, and
so would ours.
Chairman GREENSPAN. Indeed.

18

Senator BENNETT. Thank you for the seminar on that particular
issue. It's one that I have been interested in, and I think we need,
as politicians, to pay more attention to it, instead of simply grabbing for the headlines that say, "Let's reduce the debt to zero by
a date certain," or "Let's return the money to the taxpayer of a certain amount by a date certain." Those simple headline-grabbing
statements by politicians obscure the subtleties that you have explored here, and I thank you for that.
Let's return to the issue that I talked about in my opening statement and talk about the real estate market and what you see
there. You referred to it in your prepared statement to a certain
degree, but let's talk about it a little more.
I gather from your statement that you're not as concerned about
it as some of the real estate people in my State are. Is that because
you're dealing with national statistics and I'm dealing with a local
situation? Are they being unduly parochial, or are there other aspects here that you deal with when you talk about the impact of
interest rates on both commercial and residential real estate?
Chairman GREENSPAN. No, I think there's clear evidence of concern on their part. I think it's one of the problems that we have
with the industry, in the sense that housing is a very crucial and
very large part of our economy, but one which, by its nature, is sensitive to interest rates. We have had over the years—and I think,
in my judgment, detrimentally—far too many big cycles in housing.
It has created big problems for builders, for people in the real estate business, and for mortgage lenders. That has not been good.
I think all of the goals that I perceive for housing should try to stabilize longer-term housing as best one can.
The difficulty is, of all of the major sectors of the economy, it is
by far the most interest-sensitive, for obvious reasons. Long-term
debt financed and small changes in interest rates for long-term
debt have significant effects on the amounts of monthly payments
that are involved in financing a home.
I think there is no way to avoid the fact that we have ups and
downs. When we had low mortgage interest rates in recent years,
we had an extraordinary expansion in both new and existing home
sales. As I pointed out in my prepared remarks, the effect of that
was to very dramatically increase the stock of single-family dwellings which are mainly owner-occupied, but not wholly. At some
point, that rate of increase, being much faster than the rate of increase in household formations, obviously had to slow down. It
would have slowed down whether interest rates were high or low.
But clearly, with mortgage interest rates going up as much as they
have in the last number of quarters, it was inevitable, in my judgment, for housing to quite significantly slow down.
Are the builders and the real estate people in your State being,
in a sense, unduly concerned? No, I believe that their business, as
best we can judge, is going down. That is, the starts numbers, especially the numbers, for example, that were published this morning,
do indicate that we are coming off those extraordinary highs of recent years. But we are still at reasonably good levels.
There are indeed many builders who said, "We are delighted by
the fact that the intensity of the market has come down," because
they had been unable to meet the demand and, as a consequence,

19

have probably behaved in a manner relative to their markets which
was not optimum for their long-term profitability.
It is a problem, I think, that has always existed in housing. From
the point of view of the Federal Reserve, we hope and endeavor to
find ways in which the fluctuations in that cycle can be smoothed
in some respect, but there is no way to prevent it from occurring
so long as that market is as interest-sensitive as it is. The only way
to avoid that would be going wholly to a cash market, and that is
just not credible. In fact, it is not desirable.
I should think that one of the problems that we all face is how
to narrow the fluctuations in the cycle. I do not think we can eliminate them. But I do believe it's the proper goal of people in the real
estate business and in the financial business to try to find vehicles
which smooth out that cycle.
Senator BENNETT. Thank you.
Senator Sarbanes.
Senator SARBANES. Thank you very much, Mr. Chairman.
Chairman Greenspan, the FDIC, in its national edition Regional
Outlook for the second quarter for 2000, said the following:
During 1999, the FDIC reported the first annual loss for the Bank Insurance Fund
since 1991. This loss primarily resulted from an uptick in unanticipated and highcost bank failures. Some of these failures were associated with high-risk activities,
such as subprime lending, and some were related to operational weaknesses and
fraud. The emergence of these problems in the midst of a strong economic environment raises concerns about how the condition of the banking industry might change
if economic conditions deteriorate.

Do you share those concerns? What's your reaction to this report
from the FDIC?
Chairman GREENSPAN. I believe that is a balanced appraisal.
There is no question that if you look at the banking system overall,
as of today, all of the various measures of current activity and relationships and risk indicate a fairly strong system. In other words,
delinquency rates are very low, charge-off rates are exceptionally
low, losses overall are very small to the banks. The number of
bankruptcies have been rather few, but in the cases that they have
arisen, there have been very large losses to the FDIC.
But I believe the issue I have discussed previously, and I know
my colleagues in the other agencies have also commented upon, is
the fact that when you have an extended period of expansion,
which now, as I indicated in my prepared remarks, is 112 months,
invariably you are going to find that there is a tendency to reach
for types of loans which shouldn't be reached for, if I may put it
that way, because there are lots of companies which look better
than they should, if for no other reason than they have not confronted a recession for more than a decade. They look creditworthy
as a consequence.
It has been everybody's experience that bad loans are made essentially at the top of the business cycle or after a very extended
period of expansion, and I have no doubt that the long period of
expansion that we have seen has induced a number of loans which,
in retrospect, will appear to have been mistakenly made.
In that regard, there are basic concerns, and there should be.
And in this context, it is, I must say, gratifying that there has been
some tightening up within the banking system. Our senior loan officer survey, the last one, did indicate that there is a general rec-

20

ognition that lending standards had to be tightened and, indeed,
that's occurring.
But I do find that the statement of the FDIC is reasonably balanced and, I think, one to which I would subscribe.
Senator SARBANES. Would you expect us to have serious banking
problems if we had an economic downturn, on the basis that this
kind of looseness had entered into the system?
Chairman GREENSPAN. I think individual banks will have trouble. I must say that the overall state of the banking system is in
reasonably good shape, and I would say that it could resist fairly
significant economic disruption without a major problem within the
banking industry. But remember that loan losses are exceptionally
low, that bankruptcies of banks are exceptionally low, and if we
run into a recession, I have no doubt that some form of rise in
bankruptcies and liquidations will occur, that some increase in the
underlying quality of the measured risks at the time will also take
place.
I believe the new technologies that have evolved in the banking
industry, the extraordinary capacities that they now have to hedge
risks, has put them in a position where they are extraordinarily resistant, in my judgment, to being upended by any type of economic
problem that I can perceive.
Senator SARBANES. Let me ask a question on the Fed's figures
on industrial production, because I want to go behind the general
figure. Your figures indicate a growth of manufacturing output at
about 7 percent for each of the last three quarters. At first glance,
that would suggest that raising the interest rates and monetary
policy has not had much effect yet on industrial production.
I understand, though, that these aggregate numbers disguise a
dramatic slowdown in manufacturing outside of the information
technology sector. That sector, which makes up only 10 percent of
total manufacturing output, has been growing at, I guess, what one
might call an incredible rate—31 percent, 60 percent, figures of
that sort, year to year.
The growth in output for the other 90 percent of manufacturing,
according to the figures I'm given, has dropped from a 4V2 percent
rate in the last quarter of 1999, down to a mere ¥2 percent rate
for the quarter just ended. The pace of consumer goods production
has also skidded from a near 3 percent rate last year to a ^10 of
a percent rate last quarter.
Would you agree that interest rate hikes are having a serious effect on manufacturing output outside of the information technology
sector?
Chairman GREENSPAN. Yes, I would. I think it's the rise in real
long-term corporate rates which has been quite a major factor in
basically slowing some aspects of the nontechnology part of the
economy.
But remember that another reason for that is there has been a
shift of capital out of the so-called old economy into the new economy, so that, in a sense, you can't merely say that if the new technology part of the economy were gone or disappeared, somehow we
would be left with an economy which was extremely sluggish and
scarcely rising at all. Indeed, as my recollection serves me, outside

21

of the high-tech area, manufacturing production had zero change
since the beginning of the year.
Part of that is an issue of merely observing resources going into
those areas where the potential rates of return are higher. Indeed,
you will always find that if you subtract at any time in history
those areas of industrial production which are rising inordinately,
the remainder, I can assure you, will be either negative or flat.
That, in itself, doesn't tell you very much.
Are you asking me, is the process such that the combination of
the differential rates of return plus the significant rise in real longterm corporate rates had an effect on what we now call the older
economy? I would say definitely that is the case. It is the type of
thing which we try to understand and evaluate as best we can.
Senator SARBANES. Mr. Chairman, I see my time has expired.
Senator SHELBY [presiding]. Chairman Greenspan, recently, the
Securities Subcommittee on the Banking Committee conducted a
hearing and they called it, "Adapting a 1930's Financial Reporting
Model to the 21st Century."
At the hearing, accounting experts testified that current financial
reporting models do not sufficiently capture significant sources of
value, specifically intangible assets like knowledge and innovation,
on which new business models rely. The lack of appropriate measurement can cause distortions in economic reporting, as well as
risk to business leaders who make decisions based on insufficient
and sometimes even misleading information.
It was stated at the hearing that "Government also tracks economic indices based on an industrial age economy." My question is,
what indicators do you believe best track the economic health of
the new economy, as well as prominent players in the economy like
Schwab, America Online, Cisco, et cetera?
What is being done to ensure, Chairman Greenspan, that the
economic data Government collects is reflective of today's economy,
and how do you do it?
Chairman GREENSPAN. The issue arises most directly in our GDP
accounts by what we capitalize and what we don't. In years past,
the Department of Commerce used to write off all software outlays
as expensed. To the extent that there was value-added created
there, even other than intermediate product, it was mismeasured.
As a consequence, an awareness on the part of the Department of
Commerce that it was underestimating the GDP induced them a
year or two ago to measure final output software and include it as
a capitalized item.
Remember that in accounting terms, you should capitalize any
outlay which increases the long-term value of the firm. As a consequence, you would presumably in today's environment take a
number of the types of outlays which we write off and capitalize
them. But because of our tax system, we are induced essentially to
write them all off. In a sense, a large amount of outlay—for example, just in organizing a high-tech firm—is expensed. Yet the book
value of the firm because of that is negligible; the market value is
huge. What that is saying is the accounting is inappropriate and
that if one were endeavoring to catch the true value of the firm and
using the concept of what outlays enhance its value, you would capitalize them.

22

Now, if they were capitalized and appeared in the same sense
that software appears, as capitalized expenditures, the GDP would
increase immeasurably. I might add that the net domestic product,
which is a more technically complex term which takes depreciation
out of the system, would not go up nearly as much. But the gross
domestic product would very much increase.
I must say there are a number of academics who argue that we
are significantly underestimating the extent of measured GDP, although it gets to be an important argument of whether, in that
case, you depreciate immediately, which is what happens when you
write it off, or depreciate in 6 months, 1 year, 2 years, 3 years, or
whether that really matters. But it is an issue.
Senator SHELBY. Is the Federal Reserve presently working with
the FASB and the SEC to address these accounting problems or insufficiencies? Are you working with them at all?
Chairman GREENSPAN. The issues we are addressing with them
relate more to technical questions of essentially banking accounting
issues, specifically with respect to appropriate reserving or the like.
The other issue is a different issue. We are not involved with the
FASB or the American Institute of Certified Public Accountants on
that issue. We have other issues with them. But we do believe the
issue that you raised originally is a very important question, and
I think that goes to the root of a much broader question of how one
appropriately keeps accounts for value-added in this new economy,
so to speak.
Senator SHELBY. Mr. Chairman, may I quickly ask one additional
question?
Chairman GRAMM. Sure.
Senator SHELBY. Last month, Chairman Greenspan, in a speech
before the New York Association for Business Economics, you spoke
about what you call "multifactor productivity," which you stated
is "that portion of labor productivity that cannot be explained by
other identifiable inputs in the production process." I wonder if you
could elaborate on that briefly for the Committee?
Chairman GREENSPAN. Obviously, we have direct measures of
output per hour of input, and clearly, output per hour is the most
crucial determinant of standards of living because it moves closely
with real income per capita and all of the various relationships
that are involved in it.
Economists endeavor to try to determine what causes that to
happen, and if you are looking at output per labor hour of input,
it is obvious that the amount of capital investment per worker is
a critical determinant of that. In the broader sense, the aggregate
GDP has essentially capital input and labor input.
But we have the capacity to so evaluate those inputs to determine what proportion of the output they both reflect, and what we
find, over the years, over the generations, is that there is a significant what we call "multifactor productivity residual," which cannot
be explained by the amount of capital investment, on the one hand,
or labor input on the other. We infer that it is a measure of technological advancement or managerial improvement. It could be anything which improves output without labor or capital input, which
encompasses many things, but technology and managerial restructuring are the main issues which do that. That's a very important

23

measure of whether technology is being applied and what rates of
return are on the facilities.
Senator SHELBY. What's been the trend in the last year regarding this?
Chairman GREENSPAN. It's been going up, especially if we measure the gross domestic product as gross domestic income. Remember that gross domestic income is conceptually identical to gross
domestic product, but they are measured differently and there is a
statistical discrepancy. Gross domestic income has been rising far
faster than gross domestic product, and as a consequence, shows a
much larger unexplained residual, if I may put it that way, what
we call "multifactor productivity," than would the product side, but
both are showing an increase in that residual.
Senator SHELBY. Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Shelby.
Let me announce that for some reason that has absolutely nothing to do with this hearing, someone has objected to committees
meeting. As a result, we are going to be out of business at about
11:45 a.m.
Let me apologize to my colleagues. As you know, from time to
time, this happens. What I am going to try to do is go quickly to
our remaining Members. I would like to ask you to try to hold your
statement to under 5 minutes. Chairman Greenspan, if you would
speed up without lowering the quality, we would appreciate it.
Senator Bayh.
Senator BAYH. Thank you, Chairman Gramm.
Senator SARBANES. Just say "maybe" as an answer.
[Laughter.]
Senator BAYH. Chairman Greenspan, you said something in your
testimony I found myself in complete agreement with. When you
said, in praising Congress, that Congress has wisely avoided the
steps that would materially reduce our surpluses, I couldn't agree
more. Chairman Gramm mentioned something that I also agreed
with when he said, "Americans don't want instant gratification, but
a steady hand at the wheel," in praising you.
I'm having difficulty reconciling these statements with Congress'
current attempts to set fiscal policy, not just for this year, but for
the next 10 years, in a highly politicized environment which has
led normally prudent, responsible people, in my opinion, to behave
otherwise and to propose things that would materially reduce the
surplus, apparently in pursuit of instant gratification, political or
otherwise.
I would like to ask, very briefly, three questions designed to deal
with the surplus and the timing of the kind of action that we are
taking here and elicit your views on these things.
First, I understood your testimony to say that if the economy is
in fact softening a little here, we may be about to get a test of
whether the increases in the rate of productivity growth that we
have experienced over the last several years have been aberrational
or, in fact, are more enduring in character. My question is, if we
are about to have such a test, wouldn't it be prudent to wait and
see before we make major fiscal decisions?
Chairman GREENSPAN. Yes, Senator.
[Laughter.!

24

Senator BAYH. Thank you.
[Laughter.]
Chairman GRAMM. Good.
Senator BAYH. He is not only brilliant, but follows instructions.
This is a wonderful thing.
[Laughter.]
Second, the estimates of the size of the surplus have varied by
more than $1 trillion in just the last few months. Since tax cute
or spending increases tend to be more permanent in nature, while
the size of the surplus seems to fluctuate dramatically, wouldn't
that also argue for the prudent course of action being to wait a
while longer to make such important decisions that will affect our
country for the next decade?
Chairman GREENSPAN. I hate to repeat myself, Senator Bayh,
but, again, yes.
[Laughter.]
Senator BAYH. This is wonderful. I have one last question. Chairman Gramm, maybe I can go three for three.
You mentioned that our goal here is to bring supply and demand
into balance. My question to you, Chairman Greenspan, is that if
the Congress, if the elected branches of Government decide to pursue a more stimulative fiscal policy, we would give the appearance
of having the Federal Reserve pursuing a more cautious monetary
policy while the elected branches of Government were pursuing a
more stimulative policy. What impact would that have on the kind
of decisions you would have to make, again, perhaps arguing to see
if we didn't create an equilibrium before taking action?
Chairman GREENSPAN. Senator, it would depend, obviously, on
what impacts changing fiscal policy had on the economy, because
it's that to which we respond, not fiscal policy directly itself.
Senator BAYH. Thank you, Chairman Greenspan.
I would wrap up, Chairman Gramm, by saying that, Chairman
Greenspan, I, too, favor tax cuts, but I think the question here is
timing rather than the long-term desirability. I take it that's your
position as well.
Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Mack.
Senator MACK. That was a rather remarkable set of exchanges.
I want to focus on the issue that I always seem to focus on, and
that's the issue of price stability and inflation. Some people believe
that the unemployment rate needs to go to 5 percent in order to
prevent inflation. I suppose that is what is referred to as the socalled "NAIRU" theory. We are presently at 4 percent, which would
mean we would have to, over time, see the unemployment rate rise
back to 5 percent. I have gone back and looked since the 1940's,
and every single time that we have had an unemployment rate go
up by 1 percent, whether that was over a 1-year period, 2-year period, 3-year period, or 4-year period, we have had a recession. That
theory concerns me.
My question is, in you view, can we achieve price stability with
unemployment at 4 percent, or do we need to move the unemployment rate higher in order to achieve price stability?

25

Chairman GREENSPAN. In my judgment, the evidence indicating
that we need to raise the unemployment rate to stabilize prices is
unpersuasive. It's a major issue in the economics profession, under
significant debate. My forecast is that the NAIRU, which served as
a very useful statistical procedure to evaluate how the economy
was behaving over a number of years, like so many types of temporary models which worked, is probably going to fail in the years
ahead as a useful indicator, at least an anywhere near as useful
indicator as it was through perhaps a 20-year period up until fairly
recently.
Senator SARBANES. Are the question and answer sessions of the
Chairman with the Congress made available to the other members
of the Federal Open Market Committee?
Chairman GREENSPAN. They are in the public record.
Senator SARBANES. I would think it would be helpful if they were
made available to the other members of the Federal Open Market
Committee.
Senator MACK. Let me be more specific. I think at the beginning
you started to address the question, and I gathered from your response to the earlier part of the question, you believe that you can
maintain price stability with unemployment at 4 percent.
Chairman GREENSPAN. I don't know that for sure. Indeed, in my
prepared remarks, I did indicate that is an open question. I suspect
the answer is yes, but I must say that the evidence on either side
of this question is not yet of sufficient persuasiveness to convince
everybody.
Senator MACK. Thank you, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Reed.
OPENING COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman.
Chairman Greenspan, from your colloquy with Chairman Gramm,
someone could, I believe, deduce the impression that you have a
hierarchy of policy: First, save the surplus; second, cut taxes; and
third, increase spending. My sense is that both cutting taxes and
increasing spending would have virtually the same effect on the
economy. They would both stimulate the economy and dissipate the
surplus. From your position, both would be objectionable. Is that
correct?
Chairman GREENSPAN. Senator, in that context, you are quite
correct. The reason why I would prefer, if necessary, dissipating
the surplus through tax cuts is because I believe it is much more
difficult to maintain a continuous expansionary imbalance in fiscal
affairs if you reduce taxes because there is a downside limit to how
far you can go, but the issue of producing long-term entitlement
programs is virtually without limit. As a consequence, I think there
is a bias in the system over the longer term which suggests to me
that we are fiscally safe if we have to get rid of surpluses, to get
rid of them on the tax side rather than on the expenditure side.
Senator REED. The experience in 1993 was that we made quite
significant cuts in discretionary programs and also increased taxes,
equally arduous votes. Some would argue that sometimes it's much
harder to reverse tax cuts than it is to cut back programs.

26

Chairman GREENSPAN. Senator, I am talking in the context, not
of the most recent period, but over the last half-century. I think,
should that indeed turn out to be the new trend, then I would
change my view.
Senator REED. I have an unrelated question, Chairman Greenspan. The trade deficit continues to explode. Do you sense that you
have both the predictive tools to anticipate a meltdown, if you will,
as a result of the trade deficit, and the policy levers, both in the
Federal Reserve and within the Federal Government, to deal with
the potentialities of that threat to our economy?
Chairman GREENSPAN. Senator, the trade deficit or the current
account deficit, which is a somewhat broader definition of the same
problem, is an issue to which we have addressed a very considerable amount of research resources to endeavor to evaluate, project,
and understand. As I have indicated in the past, and indeed in my
prepared remarks, we have more than financed in some sense the
trade deficit by the extraordinary inclination on the part of foreigners to invest in the United States. If we were in trouble on this
issue, our exchange rate would be falling, and indeed it is not.
But over the longer run, we have certain structural differences
in our trade accounts which induce us to import at a faster pace,
relative to our income, than our trading partners. If everybody is
growing at their potential, we would be chronically increasing our
deficits. That would mean that foreigners would be increasing indefinitely the size of their portfolio of claims against American residents. Clearly, there is a limit to how far that can go.
We have been endeavoring to fully understand the process, to see
what various different types of measures could be addressed in the
event of problems emerging, and we are looking to do more work
on that.
However, for the moment, it's quite remarkable: the same forces
that are engendering the huge increase in capital investment—that
is, the high rates of return—are attracting very large investments
from foreigners into the United States, and that's been keeping our
system in balance.
Senator REED. Thank you, Mr. Chairman.
Chairman GRAMM. Thank you, Senator Reed.
I want the record to show that at this point, we ended the hearing and embarked on a short period for an informal briefing.
[Whereupon, at 11:45 a.m., the hearing was adjourned, and an
informal Committee briefing convened, the transcript of which is as
follows:]

INFORMAL COMMITTEE BRIEFING
Federal Reserve's Second Monetary Policy Report for 2000

Chairman GRAMM. We are going to end this briefing in 10 minutes. I want to recognize Senator Grams for 5 minutes, then I will
recognize Senator Schumer, and then we will end the briefing.
Senator GRAMS. Thank you very much, Mr. Chairman.
Chairman Greenspan, I will be very brief. We have talked about
heavy industry and the new economy, about electronics, a big part
of the economy, and about agriculture. Where does agriculture fit
in right now? What is the state of our ag economy? We are facing
emergency bills to help farmers. Where is our agricultural economy
compared to productivity of our competitors around the world?
Chairman GREENSPAN. First, let me state that productivity in
agriculture has actually been rising at a pace faster than in the
nonfarm area—that is, the extraordinary rise in yields has been
nothing short of awesome over the last 50 years, after a remarkably stable period of flat yields for corn and wheat, even before we
used to plant soybeans.
But that plus productivity in the livestock area of our economy
has really in a sense outstripped what we are capable of doing in
industry. What that has done is created a huge capacity to produce
for which we must find demand. As you know better than anybody,
Senator, the proportion of agriculture produced domestically which
is consumed in the United States is a good deal less than half. For
many of our crops it is substantially less than half, requiring that
we find export markets to meet the demand for our output, which
is the reason I believe it's crucial for us to keep opening up markets abroad, for agriculture especially, the issues in Europe and in
Asia. I think the fixture of American agriculture depends vitally on
our ability to continuously increase our export capabilities, because
we produce far beyond the capability of the needs of the American
people, even as our consumption per capita continues to rise.
I believe that, in one sense, we are confronted with a really quite
remarkable industry. What we have been able to do in agriculture
is something which we should be exceptionally proud of. But it does
make it incumbent upon us to ensure that the new production we
are turning out has markets into which it can be sold.
Senator GRAMS. Thank you very much, Mr. Chairman.
Chairman GRAMM. Thank you.
Senator Schumer.
OPENING COMMENTS OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman.
I have two questions. My first relates to Congress. My good friend
and colleague, Senator Gramm, talked about the contrast of discretionary spending versus tax cuts. I have a different perspective, because we are not increasing discretionary spending too much. Yet
(27)

28

in the last few weeks, in either the House or Senate, and in some
cases both, we have voted for a $750 billion estate tax cut and a
$750 billion, over a 20-year period, marriage tax reduction.
There is talk now of lowering the marginal rate to 14 percent
from 15 percent. That's $300 billion over the first 10 years and $1
trillion over the next 20 years. There is talk of other tax reduction
as well.
I'm worried we are entering a phase of Voodoo II tax cuts—not
targeted tax cuts, not limited tax cuts, but cut after cut after cut
that jeopardize the balanced budget life that both Democrats and
Republicans in recent years have come to accept as a consensus.
Let's say this year we were to spend the entire projected surplus
of $1.7 trillion on tax cuts. Would that throw a monkey wrench into
the prosperity that we have been seeing, just as that amount of discretionary spending might do the same?
Chairman GREENSPAN. Senator, in response to that, and the related questions earlier, I indicated that my major concern is a dissipation of the surplus, irrespective of how, because it's been fairly
clear to me and my colleagues that the dramatic rise in the surplus
has been an extraordinarily important buffer to the potential volatility that would occur in an economy such as ours which is being
driven sharply higher by remarkable changes in technology.
One of the major elements which has kept our expansion stable
has been the growing surplus—not even the level of the surplus,
but the fact that it is growing. I indicated earlier that were we able
to continue that until we finally achieved some balance and stability in this expansion, it would be very much to our interest.
Senator SCHUMER. So there's a danger. Let's not label how much,
but there is a danger that too many tax cuts could jeopardize the
continued growth of expansion.
Chairman GREENSPAN. I would say that anything, whether it is
tax cuts or expenditure increases, which significantly slows the rise
in surpluses or eventually eliminates them, would put the economy
at greater risk than I would like to see it exposed to.
Senator SCHUMER. I agree with you on both sides of the ledger.
My second question deals with energy prices. We have seen an increase in the price of oil. We have also seen that natural gas is
higher than it has been, I think, on record. I believe it was $4.43
for a million cubic—I guess it's feet they measure it in, not yards.
Electricity prices are going up. We face some electricity shortages
in different parts of the country. Do you worry that the general
shortages we face in the face of increasing demand could create
problems for our economy on the inflation front?
I have not witnessed all three major sources of energy used in
this country—oil, gas, and electricity—being in such short supply,
or at least demand pushing things up on all three fronts as much
as it has in a pretty long time, 20 years. Do you worry about this?
What should we be doing about it?
Chairman GREENSPAN. I do worry about it, Senator, and I worry
about it largely despite the fact that the proportion of energy per
dollar of GDP has come down very dramatically over the years, and
our reliance on energy and supply of energy is, accordingly, significantly less. But it is still substantial and still capable of having
fairly dramatic negative effects on the economy.

29

The major problem that we confront in all these areas is the fact
that our ability to control our supply has been undercut. Clearly,
in the oil markets, American crude production, despite remarkable
technological advances, still trends downward. The Alaska North
Slope peaked a number of years ago and has been coming down.
We have offset it in part in drilling in the Gulf. But we are ever
decreasing the amount of crude that we can produce domestically,
and that means we are increasingly reliant on others.
We have also run into a problem where the propensity to build
new electric power facilities is being disincentivized. I'm not aware
of all of the various ramifications of the problems that are involved
in building a new electric utility plant, but my impression is that
whatever they may be, they have succeeded in slowing down the
rate of expansion materially,
As a consequence of that, I'm not worried as much on the issue
of inflation because you can contain that. I'm worried about the instability that creates within the economy and the difficulties that
might emerge as a consequence of that. While I don't want to say
I'm not concerned about the inflationary implications, obviously I
am, I don't want to leave the impression that's the only thing that
is involved. It is an issue that we need to address.
Senator SCHUMER. I want to make one more point. I believe the
sleeper in all of this is the price of natural gas, which had always
stayed low, even when oil went up. Now it is at record highs, for
reasons I'm not clear on. Does that concern you, too?
Chairman GREENSPAN. What happened was that there's a cyclical storage in natural gas where we build up at certain times and
we bring levels of inventories down, and in the last year or so, we
have slipped below the normal trend, and we are now looking at
marginally lower levels of shut-in storage for natural gas than we
typically need at this time of the year. As a consequence of that,
pressures are beginning to build, and we are getting the types of
price expansions which you would expect.
Unlike crude oil, our ability to find new gas is there. It's the fact
that we are not drilling in the way that we had been. Eventually,
that is likely to improve, but it takes a long while to get wells in
place and to bring up the level of inventories of natural gas to a
level which will bring prices off the huge spike which we have perceived recently.
Senator SCHUMER. Thank you, Mr. Chairman.
Chairman GRAMM. Chairman Greenspan, thank you for a great
hearing. Take care of yourself. We will see you next year.
Chairman GREENSPAN. Thank you, Mr. Chairman.
[Whereupon, at 12 noon, Thursday, July 20, 2000, the briefing
was concluded.]
[Prepared statements and additional material supplied for the
record follow:]

30
PREPARED STATEMENT OF SENATOR JIM SUNNING
Mr. Chairman, I would like to thank Alan Greenspan, Chairman of the Federal
Reserve System, for testifying today.
I am very interested in hearing Chairman Greenspan's semiannual comments on
monetary policy. As the Chairman knows, productivity has continued to grow, quarter after quarter. Much of this can be attributed to the information revolution. I believe these continuing productivity increases have effectively mitigated the potential
inflationary impact of our tight labor markets. I also believe the increase in information technology has led to not just a temporary spike in productivity, but instead
reflects a fundamental structural change.
The latest CPI figures do not indicate any disturbing signs of inflationary pressures growing. If you remove the spike caused by the aurge in energy prices, the
CPI is very stable. Additionally, it appears that the higher interest rates imposed
in the last year or so have started slowing parts of the economy, such as the housing
market.
I hope Chairman Greenspan has come to the same conclusion I have—that there
is no need to raise interest rates again. Chairman Greenspan has achieved his goal,
although it is one I do not share. The economy has slowed.
I still fear that the further raising of rates by the Fed could slow the economy
so much that we fall into a recession. I will repeat what I said to you the last time
you came up here, Chairman Greenspan. I do not believe you want a recession on
your watch, and I know I don't want one on mine. Please do not raise rates again,
Chairman Greenspan. Our economy does not need a monetary policy designed to
eliminate inflation that does not exist.
Thank you very much, Mr. Chairman.

PREPARED STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD op GOVERNORS OF THE FEDERAL RESERVE SYSTEM
JULY 20, 2000
Introduction

Mr. Chairman and other Members of the Committee, I appreciate this opportunity
to present the Federal Reserve's report on monetary policy.
The Federal Reserve has been confronting a complex set of challenges in judging
the stance of policy that will best contribute to sustaining the extremely strong and
long-running expansion of our economy. The challenges will be no less in the coming
months as we judge whether ongoing adjustments in supply and demand will be sufficient to prevent distortions that would undermine the economy's extraordinary
performance.
For some time now, the growth of aggregate demand has exceeded the expansion
of production potential. Technological innovations have boosted the growth rate of
potential, but as I noted in my testimony last February, the effects of this process
also have spurred aggregate demand. It has been clear to us that, with labor markets already quite tight, a continuing disparity between the growth of demand and
potential supply would produce disruptive imbalances.
A key element in this disparity has been the very rapid growth of consumption
resulting from the effects on spending of the remarkable rise in household wealth.
However, the growth in household spending has slowed noticeably this spring from
the unusually rapid pace observed late in 1999 and early this year. Some argue that
this slowing is a pause following the surge in demand through the warmer-thannormal winter months and hence a reacceleration can be expected later this year.
Certainly, we have seen slowdowns in spending during this near-decade-long expansion that have proven only temporary, with aggregate demand growth subsequently
rebounding to an unsustainable pace.
But other analysts point to a number of factors that may be exerting more persistent restraint on spending. One they cite is the flattening in equity prices, on net,
this year. They attribute much of the slowing of consumer spending to this diminution of the wealth effect through the spring and early summer. This view looks to
equity markets as a key influence on the trend in consumer spending over the rest
of this year and next.
Another factor said by some to account for the spending slowdown is the rising
debt burden of households. Interest and amortization as a percent of disposable income have risen materially during the past 6 years, as consumer and particularly
mortgage debt has climbed and, more recently, as interest rates have moved higher.

31
In addition, the past year's rise in the price of oil has amounted to an annual $75
billion levy by foreign producers on domestic consumers of imported oil, the equivalent of a tax of roughly 1 percent of disposable income. This burden is another likely
source of the slowed growth in real consumption outlays in recent months, though
one that may prove to be largely transitory.
Mentioned much less prominently have been the effects of the faster increase in
the stock of consumer durable assets—both household durable goods and houses—
in the last several years, a rate of increase that history tells us is usually followed
by a pause. Stocks of household durable goods, including motor vehicles, are estimated to have increased at nearly a 6 percent annual rate over the past 3 years,
a marked acceleration from the growth rate of the previous 10 years. The number
of cars and light trucks owned or leased by households, for example, apparently has
continued to rise in recent years despite having reached nearly 1% vehicles per
household by the mid-1990's. Notwithstanding their recent slowing, sales of new
homes continue at extraordinarily high levels relative to new household formations.
While we will not know for sure until the 2000 census is tabulated, the surge in
new home sales is strong evidence that the growth of owner-occupied homes has accelerated during the past 5 years.
Those who focus on the nigh and rising stocks of durable assets point out that
even without the rise in interest rates, an eventual leveling out or some tapering
off of purchases of durable goods and construction of single-family housing would
be expected. Reflecting both the higher interest rates and higher stocks of Housing,
starts of new housing units have fallen off of late. If that slowing were to persist,
some reduction in the rapid pace of accumulation of household appliances across our
more than 100 million households would not come as a surprise, nor would a slowdown in vehicle demand which so often is historically associated with declines in
housing demand.
Inventories of durable assets in households are just as formidable a factor in new
production as inventories at manufacturing and trade establishments. The notion
that consumer spending and housing construction may be slowing because the stock
of consumer durables and houses may be running into upside resistance is a credible addition to the possible explanations of current consumer trends. This effect on
spending would be reinforced by the waning effects of gains in wealth.
Because the softness in outlay growth is so very recent, all of the aforementioned
hypotheses, of course, must be provisional. It is certainly premature to make a definitive assessment of either the recent trends in household spending or what they
mean. But it is clear that, for the time being at least, the increase in spending on
consumer goods and houses has come down several notches, albeit from very high
levels.
In one sense, the more important question for the longer-term economic outlook
is the extent of any productivity slowdown that might accompany a more subdued
pace of production and consumer spending, should it persist. The behavior of productivity under such circumstances will be a revealing test of just how much of the
rapid growth of productivity in recent years has represented structural change as
distinct from cyclical aberrations and, hence, how truly different the developments
of the past 5 years have been. At issue is how much of the current downshift in
our overall economic growth rate can be accounted for by reduced growth in output
per hour and how much by slowed increases in hours-.
So far there is little evidence to undermine the notion that most of the productivity increase of recent years has been structural and that structural productivity
may still be accelerating. New orders for capital equipment continue quite strong—
so strong that the rise in unfilled orders has actually steepened in recent months.
Capital-deepening investment in a broad range of equipment embodying the newer
productivity-enhancing technologies remains brisk.
To be sure, if current personal consumption outlays slow significantly further than
the pattern now in train suggests, both profit and sales expectations may be scaled
back, possibly inducing somehesitancy in moving forward even with capital projects
that appear quite profitable over the longer run. In addition, the direct negative effects of the sharp recent run up in energy prices on profits as well as on sales expectations may temporarily damp capital spending. Despite the marked decline over
the past decades in the energy requirements per dollar of GDP, energy inputs are
still a significant element in the cost structure of many American businesses.
For the moment, the drop-off in overall economic growth to date appears about
matched by reduced growth in hours, suggesting continued strength in growth in
output per hour. The increase of production worker hours from March through June,
for example, was at an annual rate of Va percent compared with 3V4 percent the
previous 3 months. Of course, we do not have comprehensive measures of output
on a monthly basis, but available data suggest a roughly comparable deceleration.

32
A lower overall rate of economic growth that did not carry with it a significant
deterioration in productivity growth obviously would be a very desirable outcome.
It could conceivably slow or even bring to a halt the deterioration in the balance
of overall demand and potential supply in our economy.
As I testified before this Committee in February, domestic demand growth, influenced importantly by the wealth effect on consumer spending, has been running 1 '/2
to 2 percentage points at an annual rate in excess of even the higher, productivitydriven growth in potential supply since late 1997. That gap has been filled both by
a marked rise in imports as a percent of GDP and by a marked increase in domestic
production resulting both from significant immigration and from the employment of
previously unutilized labor resources.
I also pointed out in February that there are limits to how far net imports—or
the much broader measure, our current account deficit—can rise, or our pool of unemployed labor resources can fall. As a consequence, the excess of the growth of domestic demand over potential supply must be closed before the resulting strains and
imbalances undermine the economic expansion that now has reached 112 months,
a record for peace or war.
The current account deficit is a proxy for the increase in net claims against U.S.
residents held by foreigners, mainly as debt, but increasingly as equities. So long
as foreigners continue to seek to hold ever-increasing quantities of dollar investments in their portfolios, as they obviously have been, the exchange rate for the dollar will remain firm. Indeed, the same sharp rise in potential rates of return on new
American investments that has been driving capital accumulation and accelerating
productivity in the United States has also been inducing foreigners to expand their
portfolios of American securities and direct investment. The latest data published
by the U.S. Department of Commerce indicate that the annual pace of direct plus
portfolio investment by foreigners in the U.S. economy during the first quarter was
more than 2Va times its rate in 1995.
There has to be a limit as to how much of the world's savings our residents can
borrow at close to prevailing interest and exchange rates. And a narrowing of disparities among global growth rates could induce a narrowing of rates of return here
relative to those abroad that could adversely affect the propensity of foreigners to
invest in the United States. But, obviously, so long as our rates of return appear
to be unusually high, if not rising, balance of payments trends are less likely to pose
a threat to our prosperity. In addition, our burgeoning budget surpluses have clearly
contributed to a fending off, if only temporarily, of some of the pressures on our balance of payments. The stresses on the global savings pool resulting from the excess
of domestic private investment demands over domestic private saving have been
mitigated by the large Federal budget surpluses that have developed of late.
In addition, by substantially augmenting national saving, these budget surpluses
have kept real interest rates at levels lower than they would have been otherwise.
This development has helped foster the investment boom that in recent years has
contributed greatly to the strengthening of U.S. productivity and economic growth.
The Congress and the Administration have very wisely avoided steps that would
materially reduce these budget surpluses. Continued fiscal discipline will contribute
to maintaining robust expansion of the American economy in the future.
Just as there is a limit to our reliance on foreign saving, so too is there a limit
to the continuing drain on our unused labor resources. Despite the ever-tightening
labor market, as yet, gains in compensation per hour are not significantly outstripping gains in productivity. But as I have argued previously, should labor markets
continue to tighten, short of a repeal of the law or supply and demand, Jabor costs
eventually would have to accelerate to levels threatening price stability and our continuing economic expansion.
The more modest pace of increase in domestic final spending in recent months
suggests that aggregate demand may be moving closer into line with the rate of
advance in the economy's potential, given our continued impressive productivity
growth. Should these trends toward supply and demand balance persist, the ongoing
need for ever-rising imports and for a further draining of our limited labor resources
should ease or perhaps even end. Should this favorable outcome prevail, the immediate threat to our prosperity from growing imbalances in our economy would abate.
But as I indicated earlier, it is much too soon to conclude that these concerns are
behind us. We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth
rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures.
As I have already noted, to date costs have been held in check by productivity
gains. But at the same time, inflation has picked up—even the core measures that

33
do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be
alert to the risks that high levels of resource utilization may put upward pressure
on inflation.
Moreover, energy prices may pose a challenge to containing inflation. Energy price
changes represent a one-time shift in a set of crucial prices, but by themselves generally cannot drive an ongoing inflation process. The key to whether such a process
could get underway is inflation expectations. To date, survey evidence, as well as
readings from the Treasury's inflation-indexed securities, suggests that households
and investors do not view the current energy price surge as affecting longer-term
inflation. But any deterioration in such expectations would pose a risk to the economic outlook.
As the financing requirements for our constantly rising capital investment needs
mounted in recent years—beyond forthcoming domestic saving—real long-term interest rates rose to address this gap. We at the Federal Reserve, responding to the
same economic forces, have moved the overnight Federal funds rate up 1% percentage points over the past year. To have held to the Federal funds rate of June 1999
would have required a massive increase in liquidity that would presumably have
underwritten an acceleration of prices and, hence, an eventual curbing of economic
growth.
By our meeting this June, the appraisal of all the foregoing issues led the Federal
Open Market Committee to conclude that, while some signs of slower growth were
evident and justified standing pat at least for the time being, they were not sufficiently compelling to alter our view that the risks remained more on the side of
higher inflation.
As indicated in their forecasts, FOMC members and nonvoting presidents expect
that the long period of continuous economic expansion will be extended over the
next l¥z years, but with growth at a somewhat slower pace than that over the past
several years. For the current year, the central tendency of Board members' and Reserve Bank presidents' forecasts is for real GDP to increase 4 to 4Vz percent, suggesting a noticeable deceleration over the second half of 2000 from its likely pace
over the first half. The unemployment rate is projected to remain close to 4 percent.
This outlook is a little stronger than that anticipated last February, no doubt owing
primarily to the unexpectedly strong jump in output in the first quarter. Mainly reflecting higher prices of energy products than had been foreseen, the central tendency for inflation this year in prices for personal consumption
expenditures also has
been revised up somewhat, to the vicinity of 2Va to 23/4 percent.
Given the much firmer financial conditions which have developed over the past
18 months, the Committee expects economic growth to moderate somewhat next
year. Real output is anticipated to expand 314 to 3% percent, somewhat less rapidly
than in recent years. The unemployment rate is likely to remain close to its recent
very low levels. Energy prices could ease somewhat, helping to trim PCE inflation
next year to around 2 to 21/2 percent, somewhat above the average of recent years.
Conclusion
The last decade has been a remarkable period of expansion for our economy. Federal Reserve policy through this period has been required to react to a constantly
evolving set of economic forces, very often at variance with historical relationships,
changing Federal funds rates when events appeared to threaten our prosperity, and
refraining from action when that appeared warranted. Early in the expansion, for
example, we kept the rates unusually low for an extended period, when financial
sector fragility held back the economy. Most recently we have needed to raise rates
to relatively high levels in real terms in response to the side effects of accelerating
growth and related demand-supply imbalances. Variations in the stance of policy—
or keeping it the same—in response to evolving forces are made in the framework
of an unchanging objective—to foster as best we can those financial conditions that
are most likely to promote sustained economic expansion at the highest rate possible. Maximum sustainable growth, as history amply demonstrates, requires price
stability. Irrespective of the complexities of economic change, our primary goal is to
find those policies that best contribute to a noninflationary environment and hence
to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of
that goal.

34

For use at 10:00 a.m., EOT
Thursday
July 20, 2000

Board of Governors of the Federal Reserve System

Monetary Policy Report to the Congress

July 20, 2000

35

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington. D.C., July 20, 2000
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased to forward its Monetary Policy Report to the Congress.
Strwerely,

Alan Greenspan, Chairm

36

Table of Contents
Page
Monetary Policy and the Economic: Outlook

I

Economic and Financial Developments in 2000

4

37

Monetary Policy Report to the Congress
Report forwarded to ike Congress on Jul\ 20. 2000

MONETARY PQUCY Mb THE
ECONOMIC OUTLOOK
The impressive performance of the U.S. economy
persisted in the firs! half of 2000 with economic
activity expanding at a rapid pace. Overall rates of
inflation were noticeably higher, largely as a result
of steep increases in energy prices. The remarkable
wave of new technologies and the associated surge in
capital investment have continued to boost potential
supply and to help contain price pressures at high
levels of labor resource use. At the same time, rising
productivity growth—working through its effects
on wealth and consumption, as well as on investment
spending—has been one of Ihc important factors
contributing to rapid increases in aggregate demand
that have exceeded even the stepped-up increases
in potential supply. Under such circumstances, and
with the pool of available labor already at an unusually low level, Ihc continued expansion of aggregate
demand in excess of the growth in potential supply
increasingly threatened to set off greater price pressures. Because price stability is essential to achieving
maximum sustainable economic growth, heading off
these pressures has been critical to extending the
extraordinary performance of the U.S. economy.
To promote balance between aggregate demand
and potential supply and to contain inflation pressures, the Federal Open Market Committee (FOMC)
took additional firming actions this year, raising the
benchmark federal funds rate I percentage point
between February and May. The tighter stance of
monetary policy, along with the ongoing strength of
credit demands, has led to less accommodative financial conditions: On balance, since the beginning of the
year, real interest rates have increased, equity prices
have changed little after a sizable run-up in 1999, and
tenders have become more cautious about emending
credit, especially to marginal borrowers. Still, households and businesses have continued to borrow at a
rapid pace, and the growth of M2 remained relatively
robust, despite the rise in market interest rates. The
favorable outlook for the U.S. economy has contributed to a further strengthening of the dollar, despite

tighter monetary policy and rising interest rates in
most other industrial countries.
Perhaps partly reflecting firmer financial conditions, Ihe incoming economic data since May have
suggested some moderation in the growth of aggregate demand. Nonetheless, labor markets remained
light at the lime of the FOMC meeting in June, and it
was unclear whether Ihe slowdown represented a
decisive shift to more sustainable growth or just a
pause. The Committee left the stance of policy
unchanged but saw the balance of risks to the economic oullook as stil! weighted toward rising
inflation.

Monetary Policy, Financial Markets.
and the Economy over the First Half of 2000
When the FOMC convened for its first two meetings
of Ihe year, in February and March, economic conditions in the Uniied Stales were pointing toward an
increasingly lam labor market as a consequence of
a persistent imbalance between the growth rates of
aggregate demand and potential aggregate supply.
Reflecting the underlying strength m spending and
expectations of tighter monetary policy, market interest rates were rising, especially after the century date
change passed without incident. But, at the same
time, equity prices were still posting appreciable
gains on nel. Knowing thai the iwo safety valves that
had been keeping underlying inflation from picking
up until then—Ihe economy's ability to draw on the
pool of available workers and !o expand its trade
deficit on reasonable terms—could not be counted on
indefinitely, the FOMC voted for a further tightening
in monetary policy at both its February and its March
meetings, raising the target for the overnight federal
funds rate 25 basis points on each occasion. In related
actions, the Board of Governors also approved
quarter-point increases in Ihe discount rate in both
February and March.
The FOMC considered larger policy moves at its
first two meetings of 2000 but concluded thai significant uncertainty about the outlook for the expansion
of aggregate demand in relation to that of aggregate
supply, including the liming and strength of ihe
economy's response to earlier monetary policy tight-

38

2

Monetary Policy Report to (he Congress D July 2000

Selected interest i

N<m. The dou MT daily Venial lines lockout ihc days on which the
Federal Rcsovr umnunced a chancre m Ihe inunded runtta rak The daiei on the

enings, warranted a more limited policy aciion. Still,
noting thai there had been few signs that the rise in
interest, rates over recent quarters had begun to bring
demand in line with potential supply, the Committee
decided in both instances thai the balance of risks
going forward was weighted mainly in the direction
of rising inflation pressures. In particular, il was
becoming increasingly clear that the Committee
would need to move more aggressively at a later
meeting if imbalances continued to build and inflation and inflation expectations, which had remained
relatively subdued until ihen. began 10 pick up.1
Some readings between the March and May meetings of the FOMC on labor costs and prices suggested a possible increase of inflation pressures.
Moreover, aggregate demand had continued to grow
at a fast clip, and markets for labor and other
resources were showing signs of further tightening.
Financial market conditions had firmed in response to
these developments; the substantial rise in private
borrowing rales between March and May had been
influenced by (he buildup in expectations of more
policy tightening as market participants recognized
the need for higher short-term interest rates. Given all
these circumstances, the FQMC decided in May to
raise the target for the overnight federal funds rate
SO basis points, to 6Y* percent. The Committee saw
little risk in the more forceful aciion given the strong
momentum of (he economic expansion and wide-

1. At its March ond May m«nii(s, the FOMC took a number of
actions ihv vert ami • adjuring the imptementaiWm of moocary
policy lo actual md prospective reductions in ihe Hock of Treasury
deni ncyriiitt. These octiont are described in the disunion or U S.
financia

spread market expectations of such an aciion. Even
after taking into account its latest action, however,
the FOMC saw the strength in spending and pressures in labor markets as indicating that the balance
of risks remained tilted toward rising inflation.
By the June FOMC meeting, the incoming data
were suggesting that the expansion of aggregate demand might be moderating toward a more sustainable
pace: Consumers had increased their outlays for
goods modestly during the spring; home purchases
and starts appeared to have softened; and readings on
the labor market suggested that the pace of hiring
might be cooling off. Moreover, much of the effects
on demand of previous policy firmings, including the
50 basis point tighten ing in May, had not yet been
fully realized. Financial market participants interpreted signs of economic slowing as suggesting that
the Federal Reserve probably would be able to hold
inflation in check without much additional policy
firming. However, whether aggregate demand had
moved decisively onto a more moderate expansion
track was not yet clear, and labor resource utilization
remained unusually elevated. Thus, although the
FOMC decided to defer any policy aciion in June, it
indicated that the balance of risks was still on the side
of rising in Ration in the foreseeable future.2

2 M hs June meeting. Ihe FOMC rW rax establish ranges for
jrawh of money and deW in 3000 and 2001. The legal requirement to
establish ml TO announce nicti ranges lad expired and owing m
nnmtainitts abota the behavior of The velocities of (kin and money,
these raflfcs for many years tint not provided useful benchmark! for
the conduct of monetary policy. Nevertheless, the FOMC believes Uui
the behavior of money and ciedii will continue 10 have value for
gauging canonic end financial omdiikms. am) inis report discuss**
recent developmenK in money and ciedM in mine detail.

39
Board of Governors of the Federal Reserve System

Economic Projections for 2000 and 2001
The members of the Board of Governors and [he
Federal Reserve Bank presidents expect the current
economic expansion to continue through next year,
but tU a more moderate pace than the average over
recent quarters. For 2000 as a whole, the central
tendency of their forecasts for the rate of increase
in real gross domestic product (GDP) is 4 percent to
4!£ percent, measured as the change between the
fourth quarter of 1999 and the fourth quarter of 2000.
Over the four quarters of 2001. the central tendency
forecasts of real GDP are in the 3Vi percent lo
3% percent range. With this pace of expansion, the
civilian unemployment rate should remain near its
recent level of 4 percent. Even with the moderation in
the pace of economic activity, the Committee members and nonvoting Bank presidents expect that inflation may be higher in 2001 than in 1999, and the
Committee will need to be alert to the possibility that
financial conditions may need to be adjusted further
to balance aggregate demand and potential supply
and to keep inflation tow.
Considerable uncertainties attend estimates of
potential supply—both the rate of growth and the
level of the economy's ability to produce on a sustained non-inflationary basis. Business investment in
new equipment and software has been exceptionally
1.

Economic projections for 2000 and 2001

-~

l-ederal Mucne povewrt
and Reicrvc B*n* peiidHHi
B™,
""f

Ctn0
^
tnriwy

«—

MOO

Hamiwt OCT
Red GDI"

rce pm»

1. Ounce hod ivcn^c K» founh quWf oi pitvinu yev to i
f«rnh (pincr at fttt nt&csteA

3

high, and given the rapid pace of technological
change, firms will continue u> exploit opportunities to
implement more-efficient processes and to speed the
Row of information across markets. In such an environment, a further pickup in productivity growth is a
distinct possibility. However, a portion of the very
rapid rise in measured productivity in recent quarters
may be a result of the cyclical characteristics of ibis
expansion rather than an indication of structural rates
of increase consistent with holding the level of
resource utilization unchanged. Current levels of
labor resource utilization are already unusually high.
To date, this has not led to escalating unit labor costs,
but whether such a favorable performance in the
labor market can be sustained is one of the important
uncertainties in the outlook.
On the demand side, the adjustments in financial
markets that have accompanied expected and actual
tighter monetary conditions may be beginning to
moderate the rise in domestic demand. As thai process evolves, the substantial impetus that household
spending has received in recent years from rapid
gains in equity wealth should subside. The higher
cost of business borrowing and more-restrictive credit
supply conditions probably will not exert substantial
restraint on investment decisions, particularly as long
as the costs and potential productivity payoffs of new
equipment and software remain attractive. The slowing in domestic spending will not be fully reflected in
a more moderate expansion of domestic production.
Some of the slowing will be absorbed in smaller
increases in imports of goods and services, and given
continued recovery in economic activity abroad,
domestic firms are expected to continue seeing a
boost to demand and to production from rising
exports.
Regarding inflation. FOMC participants believe
that the rise in consumer prices will be noticeably
larger this year than in 1999 and that inflation will
ihen drop bacV somewhat in 2001. The central tendency of their forecasts for the irwrease in the chaintype index for personal consumption expenditures
is 2Vi percent to 2-V-i percent over the four quarters
of 2000 and 2 percent lo 2'A percent during 2001.
Shaping the contour of this inflation forecast is the
expectation that the direct and indirect effects of the
boos! to domestic inflation this year from the rise in
the price of world crude oil will be partly reversed
next year if, as futures markets suggest, crude oil
prices retrace this year's run-up by next year. Nonetheless, these forecasts show consumer price inflation
in 2001 lo have moved above the rates that prevailed
over the 1997-93 period. Such a trend, were it not to
show signs of quickly stabilizing or reversing, would

40

pose a considerable risk to the continuation of the
extraordinary economic performance of reccni years.
The economic forecasts of ihe FOMC are similar
to those recently released by ihc Administration In its
Mid-Session Review of the Budget. Compared with
the forecasts available in February, the Administration raised its projections for the increase in real GDP
in 2000 and 2001 to rates thai lie at the low end of the
current range of central tendencies of Federal Reserve
policymakers. The Administration also expects that
the unemployment rale will remain close to 4 percent. Like the FOMC, the Administration sees consumer price inflation rising this year and failing back
in 2001. After accounting for the differences in ihe
construction of the alternative measures of consumer
prices, the Administration's projections of increases
in the consumer price index (CPI) of 3.2 percent in
2000 and 2.5 percent in 2001 are broadly consistent
with the Committee's expectations for the chain-type
price index for personal consumption cxpcndilures.

ECONOMIC AND FINANCIAL DEVELOPMENTS
IN 2000
The expansion of U.S. economic activity maintained
considerable momentum through the early months of
2000 despite the tinning in credit markets that has
occurred over the past year. Only recently has the
pace of real activity shown signs of having moderated from the extremely rapid rate of increase that
prevailed during the second half of 1999 and the
first quarter of 2000. Real GDP increased at an annual
rate of 5W percent in the first quarter of 2000. Privale
domestic final sales, which hud accelerated in the

Change in real GDP

LW7

IWS

1W9

MOO

Change in PCS chain-iypL' price inde<

IlilJ
IWI

IW

IW6

1907

1WS

\WP>

J!X»1

second half of 1999, were particularly robust, rising
at an annual rale of almost 10 percent in the first
quarter. Underlying that surge in domestic spending
were many of the same faciors that had contributed
to the considerable strength of outlays in the second
half of 1999. The ongoing influence of substantial
increases in real income and wealth continued to fuel
consumer spending, and business investment, which
continues to be undergirded by the desire to take
advantage of new. cost-saving technologies, was further buoyed by an acceleration in sales and profits
late last year. Export demand posted a solid gain
during the first quarter while imports rose even more
rapidly to meet booming domestic demand. The
available data, on balance, point to another solid
increase in real GDP in the second quarter, although
ihey suggest thai private household and business
fixed investment spending likely slowed noticeably
from the extraordinary first-quarter pace. Through
June, the expansion remained brisk enough to keep
labor utilisation near the very high levels reached at
the end of 1999 and to raise the factory utilization
rate to close to its long-run average by early spring.
Inflation rates over the lirsl half of 2000 were
elevated by an additional increase in the price of
imported crude oil. which led to sharp hikes in retail
energy prices early in the year and again around
midyear. Apart from energy, consumer price inflation so far this year has been somewhat higher than
during 1999, and some of thai acceleration may be
attributable to the indirect effects of higher energy
costs on the prices ot' core goods and services.
Sustained strong gaim in worker productivity
have kept increases in unit labor costs minimal
despite the persistence of a historically low rate of
unemployment.

41
Board of Goifmon of the Federal Restrvt System

Change in reai income and consumption

IN6

tWT

1W8

IW

JOOO

'ousehold Sector
Consumer Spending
Consumer spending was exceptionally vigorous during the first quarter of 2000. Real personal consumption expenditures rose at an annual rate of 73/4 percent, the sharpest increase since early 1983. At that
time, the economy was rebounding from a deep
recession during which households had deferred
discretionary purchases. In contrast, the first-quarter
surge in consumption came on the heels of two years
of very robust spending during which real outlays
increased at an annual rate of more than 5 percent,
and the personal saving rate dropped sharply.
Outlays for durable goods, which rose at a very
fasi pace in 1998 and 1999, accelerated during the
first quarter lo an annual rate of more than 24 percent.
Most notably, spending on motor vehicles, which had
climbed to a new high in 1999, jumped even further
in the first quarter of 2000 as unit sales of light moior
vehicles soared to a record rale of IB.l million units.
In addition, households' spending on computing
equipment and software rebounded after the turn of
the year; some consumers apparently had postponed
their purchases of these goods in laic 1999 before the
century dale change. Outlays for nondurable goods
posted a solid increase of 5Vi percent in the first
quarter, marked by a sharp upturn in spending on
clothing and shoes. Spending for consumer services
also picked up in the first quarter, rising at an annual
rate of 5'/> percent. Spending was quite brisk for a
number of non-energy consumer services, ranging
from recreation and telephone use to brokerage fees.
Also contributing to the acceleration was a rebound
in outlays for energy services, which had declined in
late 1999. when weather was unseasonably warm.

5

In recent months, the rise in consumer spending
has moderated considerably from the phenomenal
pace of the first quarter, with much of the slowdown
in outlays for goods. At an annual rate of 17 V* million units in the second quarter, light motor vehicles
sold at a rate well below their first-quarter pace.
Nonetheless, (hat level of sales is still historically
high, and wilh prices remaining damped and automakers continuing to use incentives, consumers'
assessments of the motor vehicle market continue to
be positive. The information on retail sales for the
ApriWf-Iune period iiwlicale thai consumer expenditures for other goods rose markedly slower in the
second Quarter than in the first quarter, at a pace well
below the average rate of increase during the preceding two years. In contrast, personal consumption
expendilures for consumer services continued lo rise
relatively briskly in April and May.
Real disposable personal income increased at an
annual rale of about 3 percent between December
and May—slightly below (he 1999 pace of 3'/i percent. However, Ihe impetus to spending from the
rapid rise in household net worth was still considerable, labor markets remained tight, and confidence
was still high. As a result, households continued to
aliow their spending to outpace their How of current
income, and Ihe personal saving rate, as measured in
the national income and product accounts, dropped
further, averaging less than I percent during the fim
five months of the year.
After having boosted the ratio of household net
worth to disposable income to a record high in the
first quarter, stock prices have fallen hack, suggesting
less impetus lo consumer spending going forward. In
addition, smaller employment gains and the pickup in

Wealth and saving

tVJV

IW3

l«t>

IWO

IfU

1998

42

6

Monetary Policy Repon 10 UK Congress D My 2000

energy prices have moderated the rise in real income
of lale. Although these developments left some
imprint on consumer attitudes in June, households
remained relatively upbeat about their prospective
financial situation, according to [he results of tfie
University of Michigan Survey Research Center
(SRC) survey. However, ihey became a bil less positive about the outlook for business conditions and
saw a somewhat greater likelihood of a rise in unemployment over Ihe coming year.

Residential Investment
Housing activity stayed at a high level during the firsi
half of this year. Hume builders began the year with a
considerable backlog of projects thai had developed
as the exceptionally strong demand of the previous
year strained capacity. As a result, they maintained
starts of new single-family homes at an annual rate of
1.33 million units, on average, through April—
matching 1999's robust pace. Households' demand
for single-family homes was supported early in the
year by ongoing gains in jobs and income and the
earlier run-up in wealth; those forces apparently were
sufficient to offset the effects that higher mortgage
interest rates had on the affoniabfljly of new homes.
Sales of new homes were particularly robust, setting
a new record by March; but sales of existing units
slipped below their 1999 high. As a result of the
continued strength in sales, the home-ownership rate
reached a new high in the first quarter.
By the spring, higher mortgage interest rates were
leaving a clearer mark on the altitudes of both consumers and builders. The Michigan SRC survey
reported that households' assessments of homebuying conditions dropped between April and June to ihe
Private bousing starts

lowest level in more than nine years. Survey respondents noted that, besides higher financing costs,
higher prices of homes were becoming a factor in
iheir less positive assessment of market conditions.
Purchases of existing homes were little changed,
on balance, in April and May from the firsi-quarter
average; however, because these sales arc recorded &
the time of closing, they tend to be a lagging indicator of demand. Sates of new homes—a more current
indicator—fell hack in April and May, and homebuilders reported thai sales dropped further in June.
Perhaps a sign that softer demand has begun to affect
con struct i on, suns of new single-family homes
slipped to a rale of I Vi million units in May. That
level of new homebuilding, although noticeably
slower than the robust pace thai characterized the fall
and winter period, is only a bit below the elevated
leve! that prevailed throughout much of 1998. when
single-family starts reached their highest le%'el in
twenty years. Starts lit" mullifamify housing unils,
which also had stepped up sharply in the first quarter
of the year, to an annual rate of 390.000 units, settled
back to a 340,0(10 unit rate in April and May.

Household Finance
Fueled by robust spending, especially early in the
year, the expansion of household debt remained brisk
during the first half of 2000. although below the very
strong 1999 growth rale. Apparently, a favorable
outlook for income and employment, along with rising wealth, made households feel confident enough
to continue to spend and take on debt. Despite rising
mortgage and consumer ioan rates, household debt
increased at an annual rale of nearly 8 percent in the
firsi quarter, and preliminary data point to a similar
increase in the second quarter.
Mortgage debt expanded at an annual rate of 7 percent in the first quarter, boosted by the high level
of housing activity. Household debt not secured by
real estale—including credit card balances and auto
loans—posted an impressive 10 percent gain in the
firsi quarter !o help finance a large expansion in
outlays for consumer durables, especially motor vehicles. The moderaiion in the growth of household debt
this year has been driven primarily by ils mortgage
component: Preliminary data for the second quarter
suggest that, although consumer credit likely decelerated from the first quarter, it still grew faster than in

1999.
Debt in margin accounts, which is largely a household liability and is not included in reported measures
of credit market debt, has declined, on net, in recent

43

Board of Governors of the Federal Resent Syittm

Delinquency tales on household loans

7

Change in real business tiled investment

Ifl4

i«9;t

1996

WJ

I99B

1W»

3)00

<nr Djla « mdH c*rt delmomoe* art from ton* Call Rtvwtrdare on
loan dchBquciicica are Irom Iht fl>( Thme waiflBfcers. ilflia <v> mflgoge
nquencifs a* noni the Mortgage Bnnki

months, following a surge from late in the third
quarter of 1999 through the end of March 2000.
There has been no evidence that recent downdrafts in
share prices this year caused serious repayment problems ai the aggregate level that might pose broader
systemic concerns.
The combination of rapid debt growth and rising
interest rales has pushed (he household debt-service
burden to levels not reached since the 'ale 1980s.
Nonetheless, with household income and net worth
both having grown, rapidly, and employment prospects favorable, very few signs of worsening credit
problems in the household sector have emerged, and
commercial banks have reported in recent Federal
Reserve surveys that they remain favorably disposed
to make consumer installment and mortgage loans.
Indeed, financial indicators of [he household sector
have remained mostly positive: The rale of personal
bankruptcy filings fel! in the first quarter 10 its lowest
level since 1996; delinquency rates on home mortgages and auto loans remained low; and the delinquency rale on credit cards edged down further,
although it remained in the higher range that has
prevailed since the mid-1990s. However, delinquency
rates may be held down, tn some ex lent, by the surge
in new loan originations in recent quarters because
newly originated loans are less likely to be delinquent
than seasoned ones.
The Business Sector
Fixed Investment
The boom in capital spending extended into we first
half of 2000 with few indications that businesses'

desire to take advantage of more-efficient technologies is diminishing. Real business fixed investment
surged at an annual rate of almost 24 percent in the
first quarter of the yeat, rebounding sharply from its
lull at the end of 1999. when firms apparently postponed some projects because of the century date
change. In recent months, the trends in new orders
and shipments of nondefense capital goods suggest
that demand has remained solid.
Sustained high rates of investment spending have
been a key feature shaping the current economic
expansion. Business spending on new equipment and
software has been propelled importantly by ongoing
advances in computer and information technologies
that can be applied to a widening range of business
processes. The ability of firms to take advantage of
these emerging de.vekipmeiw.5 has been supjxmed by
the strength of domestic demand and by generally
favorable conditions in credit and equity markets. In
addition, because these high-technology goods can be
produced increasingly efficiently, their prices have
continued to decline steeply, providing additional
incentive for rapid investment. The result has been a
significant rise in the stock of capital in use by
businesses and an acceleration in the flow of services
from that capital as more-advanced vintages of equipment replace older ones. The payoff from the prolonged period during which firms have upgraded
their plant and equipment has increasingly shown
through in the economy's itnpvoved productivity
performance.
Real outlays for business equipment and software
shot up at an annual rate of nearly 25 percent in the
first quarter of this year. That jump followed a modest increase in the final quarter of 1999 and put
spending for business equipment and software back
on the double-digil uptrend that has prevailed

44

H

Monetary Policy Report to the Congress D July 2000

throughout the current economic recovery. Concerns
about potential problems with the century dale
change bad ibe most noticeable effect on the patterns
(if spending for computers and peripherals and for
communications equipment in ihe fourth and first
quarters; expenditures for software were also
affected, although less so. For these categories of
goods overall, the impressive resurgence in business
purchases early this year left little doubt that the
underlying strength in demand for high-tech capital
goods had been only temporarily intermpied by the
century date change. Indeed, nominal shipments of
office and computing equipment and of communication devices registered sizable increases over the
April-May period.
In the first quarter, business spending on computers
and peripheral equipment was up almost 40 percent
from a year earlier—a pace in line with the trend of
the current expansion. Outlays for communications
equipment, however, accelerated; the first-quarter
surge brought the year-over-year increase in spending to 35 percent, twice the pace that prevailed a year
earlier. Expanding Internet usage has been driving
the need for new network architectures. In addition,
cable companies have been investing heavily in
preparation for their planned entry into ihe markets
for residential and commercial telephony and broadband Internet services,
Demand for business equipment outside of the
high-tech area was also strong at the beginning of the
year. In (he first quarter, outlays for industrial equipment rose at a brisk pace for a third consecutive
quarter as the recovery of the manufacturing sector
from the effects of Ihe Asian crisis gained momentum. In addition, investment in farm and construction
machinery, which had fallen steadily during most of
1999, turned up. and shipments of civilian aircraft to
domestic customers increased. More recent data show
a further rise in the backlog of unfilled orders placed
with domestic firms for equipment and machinery
(other than high-tech items and transportation equipment), suggesting that demand for these items has
been well maintained. However, business purchases
of motor vehicles are likely to drop back in the
second quarter from the very high level recorded at
the beginning of the year. In particular, demand for
heavy trucks appears to have been adversely affected
by higher costs of fuel and shortages of drivers.
Real investment in private nonresidemial structures jumped at an annual rate of more than 20 percent in the first quarter of the year after having
declined in 1999. Both last year's weakness and this
year's sudden and widespread revival are difficult lo
explain fully. Nonetheless, the higher levels of spend-

ing on office buildings, other commercial facilities,
and industrial buildings recorded early this year
would seem to accord well with the overall strength
in aggregate demand. However, the fundamentals in
this sector of the economy are mixed. Available information suggests that property values for offices, retail
space, and warehouses have been rising more slowly
than they were several years ago. However, office
vacancy rates have come down, which suggests that,
at least at an aggregate level, the office sector is not
overbuilt. The vacancy rate for industrial buildings
has also fallen, but in only a few industries, such as
semiconductors and other electronic components, are
capacity pressures sufficiently intense to induce significant expansion of production facilities.

Inventory Investment
The ratio of inventories to sales in many nonfarm
industries moved lower early this year. Those firms
that had accumulated some additional stocks toward
the end of 1999 as a precaution against disruptions
related to ihe century date change seemed lo have
little difficulty working off those inventories after
the smooth transition to the new year. Moreover, the
first-quarter surge in final demand may have, to some
extent, exceeded businesses* expectations. In currentcost terms, non-auto manufacturing and trade establishments built inventories in April and May at a
somewhat faster rate than in the first quarter but still
roughly in line with the rise in their sales. As a result,
the ratio of inventories to sates, at current cost, for
these businesses was roughly unchanged from the
first quarter. Overall, the ongoing downtrend in the
ratios of inventories 10 sales during the past several
years suggests that businesses increasingly are taking

Change in real nonfarm business invenlorie

nii.iiu

J

1

l»4

1

19W

1

19%

I

1*97

I

199S

I

\VH

2WO

UJ

45
Board of Cowmen of ihe Federal Reserve System

advantage of new technologies and software to implement better inventory management.
The swing in inventory investment in the motor
vehicle industry has been more pronounced recently.
Dealer stocks of new cars and tight trucks were
drawn down during the first quarter as sales climbed
to record levels. Accordingly, auto and truck makers
kept assemblies ai a high level through June in order
to maintain ready supplies of popular models. Even
though demand appears to have softened and inventories of a few models have hacked up, scheduled
assemblies for the third quarter arc above the elevated
level of the first half.

BefonHax profits of nonfinancial cciporalkms
at a share of GDP

I9SU

Business Finance
The economic profits of nonfinancial U.S. corporalions posted another solid increase in the firs) quarter
The profits that nonftnracia! cwpwaiions earned on
their domestic operations were 10 percent above the
level of a year earlier the rise lifted the share of
profits in this sector's nominal output close to its
1997 peak. Nonetheless, with investment expanding
rapidly, businesses' external financing requirements,
measured as the difference between capita) expenditures and internally generated funds, stayed ai a high
level in the first half of this year. Businesses' credit
demands were also supported by cash-financed
merger and acquisition activity. Total debt of nonfinancial businesses increased at a 10!* percent clip
in the first quarter, close to the brisk pace of 1999,
and available information suggests that borrowing
remained strong into the second quarter.
On balance, businesses have altered the composition of their funding this year to rely more on shorter-

IM.1

I TO 1991

14X6

1W8 2000

Null-. Pnjfltt froa tkrneibf ofVimDOir wilhtfitaoiy valuation M«Jc*ral
tt*onv*HNi H^OCIIHV divided b> pro domenf product of norritawcial

term sources of credit and less on the bond market,
although the funding mix has fluctuated widely
in response to changing market conditions. After the
passing of year-end, corporate borrowers returned to
the bond market in volume in February and March,
but subsequent volatility in the capital market in
April and May prompted a pullback. In addition.
corporate bond investors have been less receptive to
smaller, less liquid offerings, as has been true for
sometime.
In the investment-grade market, bond issuers have
responded to investors' concents about the interest
rate and credit outlook by shortening the maturities of
their offerings and by issuing more Boating-rate securities. In the below-investment-grade market, many
of the borrowers who did tap the band market in

Cross corporate bond issuance

1

J

A

S

Niilt. Eiclinfc! unnuM r

Q

N

D

J

F

M

A

M

J

J

A

S

O

N

O

J

F

M

A

M

J

46

10

Monetary Policy Report In the Congress D July 2000

SpreaJs of corporate bond yields
over the ten-year swap rate

Default rates on outstanding junk bonds

1 1

• ••••III

I I A S O N D J KM AM I ] A 5 O N I 1 J T M A M I J

iw*

iwi

rooo

N t m . The iota jic dwl>- The sprKhll "Hnpare U* yiultb 01 Ibt Mcrntt
Ljnth J.A. BBS ml 175 mdnci until Ihe ten-yen iw<u> on tram BloombciJ
l.mi Miisi.aioni are lot July 17. '(CO

February and March did so hy issuing convertible
bonds and other equity-related debt instruments. Subsequently, amid increased equity market volatility
and growing investor uncertainty abou! the outlook
for prospective borrowers, credit spreads in the corporate bond market widened, and issuance in the
below-invest menl-grade market dropped sharply in
April and May. Conditions in the corporate bond
market calmed in iaie May and June, and issuance
recovered 10 close to its first -quarter pace.
As the bond market became less hospitable in the
spring, many businesses evidently turned to banks
and to the commercial paper market for financing.
Partly as & result, commercial and industrial loans al
Ratio of liabilities of failed nonfinancial firms
to liabilities of jll non financial firm>

111

lllllllllll

banks have expanded briskly, even as a larger percentage of banks have reported in Federal Reserve
surveys thai they have been tightening standards and
terms on such loans.
Underscoring lenders' concerns about the creditwon hincss of borrowers, the ratio of liabilities of
failed businesses to total liabilities has increased further so far this year, and the default rate on outstanding junk bonds has risen further from the relatively
elevated level reached in 1999. Through midyear,
Moody's Investors Service has downgraded, on net,
more debt in the non financial business sector than it
has upgraded, although it has placed more dent on
watch for future upgrades than downgrades.
Commercial mortgage borrowing has also
expanded at a robust pace over the first half of 2000.
as investment in office and other commercial building
strengthened. Emending lasi year's ircnd. borrowers
have tapped banks and life insurance companies as
the financing sources of choice. Banks, in particular,
have reported stronger demand for commercial real
estate loans this year even as they have lighlened
standards a bii for approving such loans. In ihe market foi commercial mortgage-backed securities,
yields have edged higher since the beginning ol the
year.
The Government Sector
Federal Govern mem
The incoming information regarding the federal hudgel suggests that Ihe surplus in (he current fiscal year
will surpass last year's hy a considerable amount.
Over ihe first eight months of fiscal year 2000—the

47

Board of Governors ofihf Federal Reserve System

National saving at a share of nominal GNP

period from October lo May—the unified budget
recorded a surplus of about SI 20 billion, compared
with $41 billion during ihe comparable period of
fiscal 1999. The Office of Management and Budget
and the Congressional Budget Office are now forecasting thai, when the fiscal year closes, the unified
surplus will be around $225 billion to $230 billion,
$100 billion higher than in the preceding year. That
oulcome would likely place the surplus at more lhan
2V* percent of GDP, which would exceed the most
recent high of 1.9 percent, which occurred in 1951.
The swing in [he federal budget from deficit to
surplus has been an important factor in maintaining
national saving. The rise in federal saving as a percentage of gross national product from -3.5 percent
in 1992 to 3.1 percent in the first quarter of this year
has been sufficient (o offset the drop in personal
Federal receipts and ospenditures as a share at nominal GDP

tor Men uc cumi
Butft:),, the Qftc

11

saving chat occurred over the same period. As a
result, gross saving by households, businesses, and
governments has stayed above 18 percent of GNP
since 1997. compared with t6'A percent over (he
preceding seven years. The deeper pool of national
saving, along with the continued willingness of foreign investors to finance our current account deficit,
remains an important factor in containing increases in
the cost of capital and sustaining the rapid expansion
of domestic investment. With longer-run projections
showing a rising federal government surplus over the
next decade. Ihis source of national saving could
continue to expand.
The reccn! good news on the federal budget has
been primarily on the receipts side of the ledger.
Nonwithheld tax receipts were very robust this
spring. Both final payments, on personal income lax
liabilities for 1999 and final corporate tax payments
for 1999 were up substantially. So far this year, the
withheld tax and social insurance contributions on
\his year's earnings of individuals have also been
strong. As a result, federal receipts during the first
eight months of the fiscal year were almost 12 percent higher than they were during the year-earlier
period.
While receipts have accelerated, federal expenditures have been rising only a little faster than during
fiscal 1999 and continue to decline as a share of
nominal GDP. Nominal outlays for the first eight
months of the current fiscal year were W* percent
above the year-earlier period. Increases in discretionary spending have picked up a bit so rai this yew. In
particular, defense spending has been running higher
in the wake of ihe increase in budget authority
enacted last year. The Congress has also boosted
agricultural subsidies in response to the weakness in
farm income. While nondiscretionary spending continues to be held down by declines in net interest
payments, categories such as Medicaid and other
health programs have been rising more rapidly of
late.
As measured by the national income and product
accounts, real federal expenditures for consumption
and gross investment dropped sharply early (his year
after having surged in the fourth quarter of 1999.
These wide quarter-to-quarter swings in federal
spending appear to have occurred because. the Department of Defense speeded up iis payments to vendors
before the century date change; actual deliveries of
defense goods and services were likely smoother. On
average, teal defense spending in the fourth and first
quarters was up moderately from (he average level in
fiscal 1999. Real nondefense outlays continued to
rise slowly.

48

12

Monetary Policy Report 10 ihe Congress D July 2000

Federal government debt held by the public

IW9

!*>n Tht dam « annual and titentl IlKWifh 2000. Fuferal M* held t)
p^Die inveMcn is giva* federal d*W feu itbi IwU b> frdeial Fowrnmeil
ati-iHHM *Tj MK fedrutl Rfseiw Syuen Thr vatef /« 3000 is an cwiiruih-bated «i ihf A*ruD«nuiuB'.lii« St MiASMHion RC.KH nl*t Budjln

With current hadget surpluses coming in above
expectations and large surpluses projected 10 continue for the foreseeable future, the federal government has taken additional steps aimed at preserving a
high level of liquidity in the market for its securities.
Expandirig on efforts to concentrate its declining dent
issuance in fewer highly liquid securities, the Treasury announced in February its intention to issue only
iwo new five- and ten-year notes and only one new
thirty-year bond each year. The auctions of five- and
len-year notes will remain quarterly, alternating
between new issues and smaller reopemngs. and the
bond auctions will be semiannual, also alternating
between new and smaller reopened offerings. The
Treasury also announced that it was reducing the
frequency of its one-year bill auctions from monthly
to quarterly and cutting the size of the monthly
two-year note auctions. In addition, the Treasury
eliminated the April auction of the thirty-year
inflation-indexed bond and indicated that the size of
the ten-year in nation-indexed note offerings would
be modestly reduced. Meanwhile, anticipation of
even larger surpluses in the wake of the surprising
strength of incoming tax receipts so far in 2000 led
the Treasury to announce, in May, that it was again
catling ihe size of Ihe roonlhly two-year note auclions. The Treasury also noted thai it is considering
additional changes in its auction schedule, including
ihe possible elimination of ihe one-year bill auctions
and a reduction in the frequency of its two-year note
auctions.
Early in the year, the Treasury urtt'eited (he doails
of its previously announced re verse-auction, or debt
huyhack, program, whereby it intends lo retire sea-

soned, less liquid, deb! securities with surplus cash,
enabling it to issue more "on-the-run" securities.
The Treasury noted that it would buy hack as much
as $30 billion this year. The first operation took place
in March, and in May the Treasury announced a
schedufc of two operations per mnrtth through
the end of July of this year. Through midyear, the
Treasury has conducted eight buyback operations,
redeeming a total of S15 billion. Because an important goal Ot" the buyback program is to help forestall
further increases in the average maturity of the Treasury's publicly heid debt, the entire amount redeemed
so far has corresponded to securities with remaining
maturities at the long end of the yield curve (at least
fifteen years].

State and Local Governments
In the state and local sector, real consumption and
investment expenditures registered another strong
quarter at the beginning of this year. In part, the
unseasonably good weather appears to have accommodated more construction spending than usually
occurs over the winter. However, some of the recent
rise is an extension of the step-up in spending that
emerged last year, when real outlays rose 5 percent
after having averaged around 3 percent for the preceding three years. Higher fedcrai grams for highway
construction have contributed to the pickup in spending. In addition, many of these jurisdictions have
experienced solid improvements in their fiscal conditions, which may be allowing them to undertake new
spending initiatives.
The improving fiscal outiook for slate and local
governments has affected both ihe issuance and the
quality of state and local debt. Borrowing by slates
and municipalities expanded sluggishly in the first
half of this year. In addition to ihe favorable budgetary picture, rising interest rates have reduced the
demand for new capital financing and substantially
limited refunding issuance. Credit upgrades have outnumbered downgrades hy a substantial margin in the
stale and local sector.

The External Sector
Trade and Current Account
The deficits in U.S. external balances have conlinued
to get even larger Ihis year. The current account
deficit reached an annual rate of $409 billion in the
first quarter of 2000, or 4 h /t percent of GDP. com-

49

Board of Governors of Ihf Federal Reserve S\sttm

1904

|W<

11%

IWV

ms

TW9

pared with $372 billion and 4 percent in the second
half of 1999. Ncl payments of investment income
were a hit less in the firsc quarter than in the second
hall' of last year owing to a sizable increase in income
receiptsi from direct iftvestmenl abroad. Most of the
expansion in the current account deficit occurred in
trade in goods and services. In the first quarter, (he
deficit in trade in goods and services widened to an
annual rate of $345 billion, a considerable expansion
from ihc deficit of $298 billion retorted in the second half of 1999. Trade data for April suggest that
the deficit may have increased further in the second
quarter.
U.S. exports of real goods and services rose at an
annual rate of 6Vi percent in the first quarter, following a strong increase in exports in the second half of
last year. The pickup in economic activity abroad that
began in 1999 continued (o support export demand
dSid partly offset negative effects on price competitiveness of U.S. products from the dollar's past appre-

Change in real imports anil exports or" goods and service1

ciation. By market destination, U.S. exports to Canada, Mexico, and Europe increased the most. By
product group, export expansion was concentrated in
capita! equipment, industrial supplies, and consumer
goods. Preliminary data for April suggest that growth
of real exports remained strong.
The quantity of imported goods and services continued [o expand rapidly in the first quarter. The
increase in imports, at an annual rale of 11 y> percent,
was the same in the first quarter as in the second haif
of 1999 and reflected both the continuing strength of
U.S. domestic demand and the effects of past dollar
appreciation on price competitiveness. Imports of
consumer goods, automotive products, semiconductors, telecommunications equipment, and other
machinery were particularly robust. Data for April
suggest that the second quarter got off to a sirong
start. The price of non-oil goods imports rose at an
annual rate of l*/4 percent in the first nuarier, the
second consecutive quarter of sizable price increases
following four years of price declines; non-oil import
prices in the second quarter posted only moderate
increases.
A number of developments affecting world oil
demand and supply led to a further step-up in the spot
price of Wesi Texas intermediate (WTI| crude this
year, along with considerable volatility. In the wake
of the plunge of world oil prices during 1998, the
Organization of Petroleum Exporting Countries
(OPEC] agreed in early 1999 to production rcstramts
that, by late in the year, restored prices to their 1997
level of about t20 per barrel. Subsequently, continued recovery of world demand, combined with some

Prices for oil and older commodities

50

14

Monetary Policy Report 10 ihe Congress D July 2000

supply disruptions, caused the WTI spol price to
spike above $34 per barrel during March of this year,
the highest level since the Gulf War more than nine
years earlier. Oil prices dropped back temporarily in
April, hut in May and June (he price of crude oi!
moved back up again, as demand was boosted further
by strong global economic activity and by rebuilding
of oil stocks. In late June, despite an announcement
by OPEC that it would boost production, the WTI
spot price reached a new high of almost $35 per
barrel, hul by early July the price had settled back to
ahoul $30 per barrel.

investment was associated with cross-border merger
activity.
Capita] inflows from foreign official sources in the
first quarter of this year were sizable—$20 billion,
compared with .$43 billion for all of 1999. As was the
case last year, the increase in foreign official reserves
in the United Stales in the first quarter was concentrated in a relatively few countries. Partial data for
ihe second quarter of 2000 show a small official
out tow.
The labor Markei

Financial Account

Employment and Labor Supply

Capital flows in the first quarter of 2000 continued to
reflect the relatively strong performance of the U.S.
economy and transactions associated with global
corporate mergers. Foreign private purchases of U.S.
securities remained brisk—well above the record
pace set last year. In addition, the mix of U.S. securities purchased by foreigners in the [irsl quarter
showed a continuation of last year's trend toward
smaller holdings of U.S. Treasury securities and
larger holdings of U.S. agency and corporate securities. Private-sector foreigners sold more than $9 billion in Treasury securities in the first quarter while
purchasing more than $26 billion in agency bonds.
Despite a miied performance of U.S. stock prices,
foreign portfolio purchases of U.S. equities exceeded
$60 billion in the first quarter, more lhan half of Ihe
record annual total set last year. U.S. purchases of
foreign securities remained strong in ihe firsl quarter
of 2000.
Foreign direct investment flows into the United
States were robust in the first quarter of this year as
well. As in the past (wo years, direct investment
inflows have been elevated by the extraordinary 'evel
of cross-border merger and acquisition activity. Portfolio flows have also been affected by this activity.
For example, in recent years, many of the largest
acquisitions have been financed by swaps of equity
in the foreign acquiring firm for equity in the U.S.
firm being acquired. The Bureau of Economic Analysis estimates that U.S. residents acquired $123 billion
of foreign equities in this way last year. Separate data
on market transactions indicate that U.S. residents
made net purchases of Japanese equities but sold
European equities. The latter sales likely reflect a
rebalancing of portfolios after stock swaps. U.S.
direct investment in foreign economies has also
remained sirong, exceeding $.10 billion in the first
quarter of 2000. Again, a significant portion of this

The labor market in early 2000 continued to be
characterized by substantial job creation, a historically low level of unemployment, and sizable
advances in productivity thai have held labor costs in
check. The rise in overall nonfarm payroll employment, which totaled more lhan 1 '/• million over the
first half of the year, was swelled by the federal
government's hiring of intermittent workers to conduct the decennial census. Apart from that temporary
boosi. which accounted for about one-fourth of the
net gain in jobs between December and June, nonfarm payroll employment increased an average of
190,000 per month, somewhat below the robust pace
of the preceding four yean.
Monthly changes in private payrolls were uneven
at times during the first half the year, but, on balance,
the pace of hiring, while still solid, appears to have
modcraled between the first arid second quarters. In
some industries, such as construction, the pattern
appears to have been exaggerated by unseasonably
high levels of aciiviiy during the winter that accelerctiango in liMal noritarm payroll employ mem

.llllllll
l«9l CWJ 199.' IWJ 1W IS% IW7 tWS ITO9 2001)

51
Board of Governors af the Federal Reserve System

ated hiring [hat typically would have occurred in
the spring. After a robust first quarter, construction
employment declined between April and June; on
average, hiring in this industry over the first half of
the year was only a bit slower than [he rapid pace that
prevailed from 1996 to 1999. However, employment
gains in the services industry, particularly in business
and heaiih services, were smaller in the second quarter than in the first while job cutbacks occurred
in finance, insurance, and real estate after four and
one-half years of steady expansion. Nonetheless,
strong domestic demand far consumer durables and
business equipment, along with support for exports
from Ihe pickup in economic activity abroad, led lo a
leveling off in manufacturing employment over ihe
first half of 2000 after almost iwo years of decline.
And. with consumer spending brisk, employment
at retail establishments, although fluctuating widely
from month to month, remained generally on a solid
uptrend over the first half.
The supply of labor increased slowly in recent
years relative to the demand for workers. The labor
force participation rate was unchanged, on average,
at 67.1 percent from 1997 to 1999; that level was just
0.6 percentage point higher than al the beginning of
the expansion in 1990. The stability of the participation rale over ihe 1997-99 period was somewhat
surprising because ihe incentives to enter the workforce seemed powerful: Hiring was strong, real wages
were rising more rapidly than earlier in the expansion, and individuals perceived that jobs were plentiful. However, the robust demand for new workers
instead led to a substantial decline in unemployment,
and the civilian jobless rate fell from 5W percent ai
Measures of tabor utiiizalinn

2000
. The augmented antmploynvnT rftis Ihe number of anenntioY«t frius
o are iwi in ihc gator force and ware a ron. ibvEded ty Ihe civilian labor
those who we FKH tn rht labor for" and HW a fob. The break jn daia
cy ]*** marks die introduction of a redesigned survey, dalo from iliu
rciiOEuirctf^ comparable w»h rtwscol earlier period;

15

the beginning of 1997 !o just over 4 percent at the
end of 1999.
This year, the labor force participation rale ratcheted up sharply over the first four months of the year
before dropping back in recent months as employment slowed. The spike in participation early this
year may have been a response to ready availability
of job opportunities, but Census hiring may also have
temporarily attracted some individuals into the workforce. On net, growth of labor demand and supply
have been more balanced so far this year, and the
unemployment tale has held near its ihirt^-yeaT low
of 4 percent. At midyear, very few signs of a significant easing in labor market pressures have surfaced.
Employers responding to various private surveys of
business conditions report lhat they have been unable
to hire as many workers as they would like because
skilled workers are in short supply and competition
from other firms is keen. Those concerns about hiring
have persisted even as new claims for unemployment
insurance have drifted up from very low levels in the
past several months, suggesting that some employers
may be making workforce adjustments in response to
slower economic activity.

Labor Costs and Productivity
Reports by businesses that workers are in short supply and that ihey are under pressure lo increase
compensation to be competitive in hiring and retaining employees became more intense early this year.
However, the available statistical indicators are providing somewhat raised and inconsistent signals of
whether a broad acceleration in wage and benefit
costs is emerging. Hourly compensation, as measured
by the employment cost index (EC1) for private nonfarm businesses, increased sharply during the first
quarter to a level more than 4Vi percent above a year
earlier. Before that jump, year-ovcr-year changes in
the ECI compensation series had remained close io
3'/j percent for three years. However, an alternative
measure of compensation per hour, calculated as pan
of the productivity and cost series, which has shown
higher rales of increase than the ECI in recent years,
slowed in the first quarter of this year. For the nonfarm business sector, compensation per hour in the
first quarter was 4'/i percent higher than a year earlier; in the first quarter of 1999, the four-quarter
change was 51/* percent.'
3 The figures for compensation pet hour in [he nonfiaancial corporate sector arc similar, an increase nf nboin 4 peirenl for ihe year
ending in [he fits! quarter of this year compared wilh almas! s1/; percent fm (he year ending in the tint quarter of IW9.

52
16

Monetary Policy Report 10 the Congress D July 2000

Measures of Ihc change in hourly compensation

Change in output per hour for the nonfurm business sector

iL.iill
JWI

industry eul
eulufcikg farm and hometa
Won-,. the ECI is for pnvnc imJuory

Part of ihe acceleration in the EG in the first
quarter was Ihe result of a sharp step-up in ihe wage
and salary component of eompensalion change.
While higher rales of straight-time pay were widespread across industry and occupational groups, (he
most striking increase occurred in the finance, insurance, and real estate industry where the year-overyear change in wages and salaries jumped from about
4 percent for the period ending in December 1999 to
almost &'A percent for the period ending in March of
this year The sudden spike in wages in that sector
could be related to commission; that are lied directly
to activity levels in the industry and, thus, would not
represent a lasting influence on wage inflation. For
other industries, wages and salaries accelerated moderately, which might appear plausible in light of
reports that employers are experiencing shortages of
some types of skilled workers. However, the uptrend
in wage inflation that surfaced in the ftrsl-quarlet ECI
has not been so readily apparent in the monthly data
on average hourly earnings of production or nonsupervisory workers, which are available through June.
Although average hourly earnings increased at an
annual rate of 4 percent between December and/one.
the June level of hourly wages siood 3^4 percent
higher than a year earlier, the same as the increase
between June 1998 and June 199V.
While employers in many industries appear to have
kept wage increases moderate, they may be facing
greater pressures from rising costs of employee benefits. The ECI measure of benefit costs rose close to
3'/3 percent during 1999, a pea-entage point faster
than during 1998; these costs accelerated sharply
further in the fir.w quarter of this year 10 a level
51/: percent above a year earlier. Much of last year's

IW2 IW

I9W

1907 ]*M 1999 20011

ThevstatotJUOOQI is ihc p

pickup in benefit costs was associated with faster
rales of increase in employer contributions to health
insurance, and the first-quarter ECI figures indicated
another step-up in this component of costs. Private
survey information and available measures of prices
in Ihe health care industry suggest that the upturn in
the employer costs of health care benefits is associated with both higher costs of health care and
employers' willingness to offer attractive benefit
packages in order to compete for workers in a tight
labor market. Indeed, employers have been reporting
that they are enhancing compensation packages with
a variety of benefits in order to hire and retain
employees. Some of these offerings are included in
the ECI; for instance, the ECI report for the first
quarter nofed a pickup in supplemental forms of pay,
such as overtime and nonproduclion bonuses, and in
paid leave. However, other benefits cited by employers, including stock options, hiring and retention
bonuses, and discounts on store purchases, are not
measured in the ECI.* The productivity and costs
measure of hourly compensation may capture more
of the non-wage costs that employers incur, but even
for that series, the best estimates of employer compensation costs are available only after business
reports for unemployment insurance and tax records
are tabulated and folded into the annual revisions of
the national income and product accounts.
Because businesses have realized si7^ble gains in
worker productivity, compensation increases have
4. Beginning *ift publication of ihe ECL fix June 2000, ihe Bureau
ol Lubor itali^lic-. plans (o exp^nt ihc Lklinmon of notir^odkiction
honusfi in ihc ETt 10 irurlmie hmng and relenlion bonuses, Thew
payment^ are already intruded in rhe wage and ulary rneustn-t ondcriying rhe tiafj tut campens-ar™ prr Aoor

53

Board of Governors of rhe Federal Keserve System

Chartge in unit labor cons forihe nonfarm business sector

2.

Alternative measures of [Mice change

r«««

Grou dmpeflic iwrbuc*
fenoiu} canwtfKiail tKpcntftum . .
Ejiclwdt&f lood vtd energy . . . .
Friftt-tixit'"
CoHunKf pntt inks
&ctwfi*c 1cx>d Vld tnHBy

till Illi

M

IWTQI

I998.C4

IW80J

I«M'Q4

MWM)!

1.0

1.*

.Ill

30

15
1*

7

22
I.J

26
2.1

40

. A Aud-wcifte tndt* vm qwnury wcijbU from ihe ha*e year 10
c p**«i Front auh dioinci Uenx cftt^nrj- A. c^uia-iy^u iadu i» **
b year. Qw»(*i *re bawd CHI qoanerlj awnfc«

HM 199° MM

Niir> Tht value ftn KIOU QltilM pert

not generated significam pressure on overall costs of
production, Outpui per houi in ihe nonfarm business
sector posted another solid advance in the first quarter, rising to a level 3Y* percent above a year earlier
and offsetting much of the rise in hourly compensation over Ihe period. For nonfinancial corporations,
the subset of the nonfarm business sector that
excludes types of businesses for which output is
measured tess directly, the 4 percent year-overyear increase in productivity held unit labor costs
unchanged.
With the further robust increases in labor productivity recently, the average rise in output per hour in
the nonfarm business sector since early IW7 has
stepped up further (O 3 percent from the 2 percent
pace of the 1995-97 period. What has been particularfy impressive is that the acceleration of productivity in the past several years has exceeded the
pickup in output growth over the period and, thus,
does not appear to be simply a cyclical response to
more rapidly rising demand, Raiher, businesses are
likely realizing substantial and lasting payoffs from
their investment in equipment and processes that
embody the techno logical advances of the past several years.

goods and services purchased by consumers, businesses, and governments has been somewhat greaier:
The chain-type price index for gross domestic purchases rtse ai an annual rate of 3'/: percent in the first
quarter after having increased aboul 2 percent during
!999 and just V* percent during 1998.
The pass-through of the sleep rise in the cost of
imported crude oil that began in early 1999 and
continued into the first half of this year has been the
principal factor in the acceleration of (he prices of
goods and services purchased. The effect of higher
energy costs on domestic prices has been most apparent in indexes of prices paid by consumers. After
having risen 12 percent during 1999, the chain-type
price index for energy items in the price index for
personal consumer expenditures (PCEJ jumped at an
annual rale of 35 percent in the first quarter of 2000;
ihe firsi-ijuarter rise in the energy component of the
CPI was similar.
Swings in energy prices continued to have a noticeable effect on overall measures of consumer prices
Change in consumer prices

Prices
Rates of increase in the broader measures of prices
moved up further in early 2000. After having accelerated from 1 percent owing 1998 to l x ^ percent last
year, the chain-type price index for GDP—prices of
goods and services that are produced domestically—
increased at an annual rate of 3 percent in the first
quarter of this year. The upswing in inflation for

IWI IW 19W IW5 IW6 19-»I !99B IW9 20I»

54

18

Monetary Policy Report to the Congress D July 2000

in the second quarter. After world oil prices dropped
back temporarily in the spring, ihe domestic price of
motor fuel dropped in April and May, and consumer
prices for energy, as measured by the CPI. retraced
some of the firsi-quaner increase. As a result, the
overall CPI was little changed over the two months.
However, with prices of crude oil having climbed
again, the bounceback in prices of motor fuel led to
a sharp increase in the CPI for energy in June. In
addition, with strong demand pressing against available supplies, consumer prices of natural gas continued in rise rapidly in the second quarter. In contrast to
the steep rise in energy prices, Ihe CM for food has
risen slightly less than other non-energy prices so far
this year.
Higher petroleum costs also fed through into higher
producer cosis for a number of intermediate materials. Rising prices for inputs such as chemicals and
paints contributed importantly to the acceleration in
the producer price index for intermediate materials
excluding food and energy from about IVj percent
during 1999 to an annual rate of 3'f^ percent over t)x
first half of this year. Upward pressure on input prices
was also apparent for construction materials, although
these have eased more recently. Prices of imported
industrial supplies also picked up early this year
owing to higher costs of petroleum inputs.
Core consumer price inflation has also been running a little higher so far this year. The chain-type
price index for personal consumption expenditures
other than food and energy increased at an annual
rate of 214 percent in the first quarter compared with
an increase of 1W percent during 1999. Based on the
monthly estimates of PCE prices in April and May,
core PCE price inflation looks to have been just a

Change in consumer prices excluding food and energy

ChaiiMypo pnct md(i for PCE

r pri« indt* tot all uttan omsun
and QJ m pert

Voluti for 20110 01

little below its first-quarter rate. After having risen
just over 2 percent between the fourth quarter of 1998
and the fourth quarter of 1999, the CPI excluding
food and energy increased at an annual rate of
2'A percent in ihe first quarter of 2000 and at a
2% percent rate in the second quarter. In pan, Ihe rise
in core inflation likely reflects the indirect effects of
higher energy costs on the prices of a variety of
goods and services, although these effects are difficult to quantify with precision. Moreover, prices of
non-oil imported goods, which had been declining
from fare I99S through the middle of last year, continued to trend up early this year.
The pickup in core inflation, as measured by the
CPI, has occurred for both consumer goods and services. Although price increases for nondurable goods
excluding food and energy moderated, prices of consumer durables, which had fallen between 19% and
1999, were Hide changed, on balance, over the first
half of this year. The CPI continued to register steep
declines for household electronic goods and computers, hoi prices of other types of consumer durables
have increased, on net, so far this year. The rate of
increase in the prices of non-energy consumer services has also been somewhat faster; the CPI for
these items increased at an annual rate of 3'/3 percent
during the first two quarters of this year compared
with a rise of 2Vj percent in 1999. Larger increases
in the CPI measures of rent and of medical services
have contributed Importantly to this acceleration.
Another factor has been a steeper rise in airfares,
which have been boosted in part to cover the higher
cost of fuel.
In addition to slightly higher core consumer price
inflation, the national income and product accounts
measure of prices for private fixed investment goods
shows that the downtrend in prices for business
fixed investment items has been interrupted. Most
notably, declines in the prices of computing equipment became much smaller in the final quarter of last
year and the first quarter of this year. A series of disruptions to the supply of component inputs to computing equipment has combined with exceptionally
strong demand to cut the rate of price decline
for computers, as measured by the chain-type price
index, to an annual rate of 12 percent late lust year
and early this year—half the pace of the preceding
three and one-half years. At the same time, prices of
other types of equipment and software continued to
be little changed, and the chain-type index for nonresidential structures investment remained on a moderaie uptrend. In contrast, the further upward pressure
on construction costs at the beginning of the year
continued to push the price index for residential

55

Board of Governors of ike Federal Keierve System

construction higher; after having accelerated from
3 percent to 3'/i percent between 1998 and 1999, this
index increased at an annual rate of 4'A percent in the
first quarter of 2000.
Although actual inflation moved a bit higher over
the first half of 2000, inflation expectations have been
tittle changed. Households responding to the Michigan SRC survey in June were sensitive to the adverse
effect of higher energy prices on their real income but
seemed to believe that the inflationary shock would
be short-lived. The median of (heir expected change
in CPI inflation over the coming twelve months was
2.9 percent. Moreover, they remained optimistic that
inflation would remain at about that rate over
the longer run, reporting a 2.8 percent median of
expected inflation during the next live to ten years. In
both instances, their expectations are essentially the
same as at the end of 1999, although the year-ahead
expectations are above the lower levels thai had
prevailed in 1997 and early 1998.

US. Financial Markets
Conditions in markets for private credit firmed on
balance since the end of 1999. Against a backdrop of
continued economic vitality in the United States and
a tighter monetary policy stance, private borrowing
rates are higher, on net. particularly those charged to
riskier borrowers. In addition, banks have tightened
terms and standards on most types of loans. Higher
real interest rates—as measured based on inflation
expectations derived from surveys and from yields
on the Treasury's inflation-indexed securities—
account for the bulk of the increase in interest rates

Selected Treasury rates, daily data

F M AM I J 1 5 O N D J F M AM ) I AS O N D I F M A M J J
I4M
l*«
2000

19

Selected Treasury rates, quarterly data

Treuury

iiny
J-VM-V

\^J
^

I I I I r I M M j I I I J_)j. j_)J4J I I I I I 1 N I I I M I 1 I
1%4
IW
IOTJ
1»T9
JW
JW»
l»»4
IfW
Nijih. The iwenty.rev Tnuury bond rjK it tftown gnirl Ihr bM >nu.
of the ihiify-ycar Timuiy bond ID Ftbniry l1'^ tul o^"Boons a?
MO«K»

this year, with short-term real rales having increased
the most. Rising market interest rates and heightened
uncertainties about corporate prospects, especially
with regard to the high-tech sector, have occasionally
dampened flows in the corporate bond market and
have weighed on the equity market, which has, at
limes, experienced considerable volatility. Through
mid-July, the broad-based Wilshire 5000 equity index
was up approximately 3 percent for the year.

Interest Rues
As the year began, with worries related to the century
date change out of the way, participants in the rixedincome market turned their attention to the signs of
continued strength in domestic labor and product
markets, and they quickly priced in the possibility of
a more aggressive tightening of monetary policy.
Both private and Treasury yields rose considerably.
In the latter part of January, however. Treasury yields
plummeted, especially those on longer-dated securities, as the announced details of the Treasury's debt
buyback program and upwardly revised forecasts of
federal budget surpluses led investors to focus
increasingly on the prospects for a diminishing supply of Treasury securities. A rise in both nominal and
inflation-indexed Treasury yields in response to
strong economic daia and tighter monetary policy in
April and May was partly offset by supply factors and
by occasional safe haven flows from the volatile
equity market. Since late May, market interest rates
have declined as market participants have interpreted
the incoming economic data as evidence that mone-

56

20

Monetary Policy Reporl to ihe Congress D July 2000

Selecied yield corves. July 17. 2000

tary policy might not have to be tightened as much as
had been previously expected On balance, while
Treasury bill rales and yields on shorter-dated notes
have risen 15 to 80 basis points since the beginning
of Ihe year, intermediate- and long-term Treasury
yields have declined 5 lo 55 basis points. In the
corporate debt market, by contrast, bond yields have
risen 10 to 70 basis points so far this year.
Forecasts of steep declines in the supply of longerdated Treasuries have combined with tighter monetary policy conditions to produce an inverted Treasury yield curve, starting with the two-year maturity.
In contrast, yield curves elsewhere in Ihe U.S. fixedincome market generally have not inverted. In the
interest rate swap market, for instance, the yield
curve has remained flat lo upward sloping for maturities as long as ten years, and the same has been inie
for yield curves for the most actively traded corporate
bonds.5 Nonetheless, private yield curves are flatter
than usual, suggesting that, although supply considerations have played a potentially important role in the
inversion of the Treasury yield curve this year, investors' forecasts of future economic conditions have
also been a contributing factor. In particular, private
yield curves are consistent with forecasts of a mod-

5. A lypial iMeretl rate twap it an acreement between l»o panto
lo enchante fined tad varubk twit* THE payments an a nntonal
principal amMni over a pndttenMned period ranging dan OK to
Urinyyeui. The notional amount BuUit never nrtrapj). Typically,
me variable inures! IMC is ibe London InuifcMk Offered Hut
(LIBOR). and Ihe hied nMnsI me—caltad Ihe >«p me—is dcttrnincd in die ivan mfkel. The overall craft qaaliiy of nfta
participants B tiiin. lypicilty A or above: lho« emitiet
with cmltt
nunjs of BBB « kmer arc generally eitherrejectee1or reqwtd la
adupt cradtr-nih»cia| mechannnn. typically by poumj collHenl.

Spread of BBB corporate yields

eration in economic growth and expectations that the
economy will be on a sustainable, non-inflationary
track, with little further monetary policy lightening.
The disconnect between longer-term Treasury and
private yields as a consequence of supply factors
in the Treasury market is distorting readings from
yield spreads. For instance, taken at face value, the
spread of BBB corporate yields over Ihe yield on the
ten-year Treasury note would suggest Ihat conditions
in the corporate bond market so far in 2000 are worse
than those during the financial market turmoil of
(998. In contrast, the spread of the BBB yield over
the ten-year swap rate paints a very different picture,
with spreads up this year but below iheir peaks in
1998. Although the swap market is still not as liquid
as the Treasury securities market, and swap rates are
occasionally subject to supply-driven distortions,
such distortions have been less pronounced and more
short-lived than those affecting Ihe Treasury securities market of late, making swap rales a better benchmark for judging the behavior of other corporate
yields.
Aware thai distortions to Treasury yields are likely
to become more pronounced as more federal debt is
paid down, market participants have had lo look for
alternatives to Ihe pricing and hedging roles traditionally played by Treasuries in U.S. financial markets. In
addition to interest rate swaps, which have featured
prominently in the list of alternatives to Treasuries,
debt securities issued by ihe three governmenisponsored housing agencies—Fannie Mae, Freddie
Mac, and the Federal Home Loan Banks—have been
used in both pricing and hedging. The three housing
agencies have continued to issue a substantial volume
of debt this year in an attempt to capture benchmark
status, and the introduction in March of futures and

57

Board of Caff mars of the federal Restive System

options contracts based on five- and ten-year notes
issued by Fannie Mae and Freddie Mac may help
enhance the liquidity of (he agency securities market.
Nonetheless, the market for agency debl has been
affected by some uncertainty this year regarding the
agencies' special relationship with the government.
Both the Treasury and the Federal Reserve have
suggested that it would he appropriate for the Congress 10 consider whether the special standing of
ihese institutions continues to promote the public
interest, and pending legislation would, among other
things, restructure the oversight of these agencies and
reexamine iheir lines of credit with the U.S. Treasury.
The implementation of monetary policy, too, has
had to adapt to the anticipated paydowns of marketable federal debt. Recognizing thai there may be
limitations on ils ability to rely as much as previously
on transactions in Treasury securities to meet the
reserve needs of depositories and to expand (he supply of currency, the FOMC decided at ils March 2000
meeting to facilitate umil its first meeting in 2001 the
Trading Desk's abilily to continue to accept a broader
range of collateral in its repurchase transactions. The
initial approvals to help expand the collateral pool
were granted in August I9*W as part of the Federal
Reserve's efforts lo better manage possible disruptions 10 financial markets related lo the century dale
change.
At the March 2000 meeting, (he Committee also
initiated a study to consider alternative asset classes
and selection crileria that could he appropriate for the
System Open Market Account (SOMA) should the
si?* of the Treasury securities market continue to
decline. For the period before ihe completion and
review of such a study, the Committee discussed, a!
its May meeting, some changes in the management of
the System's portfolio of Treasury securities in an
environment of decreasing Treasury debt. The
changes aim to prevent the System from coming to
hold high and rising proportions of new Treasury
lichl issues. They will alsn help the SOMA to limit
any Further lengthening of the average maturity of ils
portfolio while continuing to meet long-run reserve
needs to the greatest extent possible through outright
purchases ol Treasury securities.1' The SOMA will
cap the rollover of its existing holdings at Treasury
auctions and will engage in secondary market purchases according to a schedule thai effectively will
h The FOMC i*tler> a ponfoilo with J shnri average mammy
because ihe higher lumiivvr rate of such u (KMtlblfO givis it preaitr
fte*to|jiiy IQ irffeem sccuriil*A in times of financial market sires4;whirl, ™y ^.nre^nlj;il ilecre&tts In the securities poirfolio

21

Major siock price indexes

result in a greater percentage of holdings of shorterterm security issues than of longer-dated ones. The
schedule ranges from 35 percent of an individual
on July 5, replacing a procedure in which alt maturing holdings were rolled over and in which coupon
purchases were spread evenly across the yield curve.
Equity f>rices
Major equity indexes have posted small gains so far
this year amid considerable volatility. Fluctuations in
technology stocks have been particularly pronounced:
After having reached a record high in March—
24 percent above its 1999 year-end value—the
Nasdaq composite index, which is heavily weighted
toward technology shares, swung widely and by midJuly was up 5 percent for the year. Given its surge in
the second half of 1999, the mid-July level of the
Nasdaq was about 60 percent above its mid-1999
reading, The broader S&P 500 and Wilshire 5000
indexes have risen close to 3 percent since the beginning of the year and are up about 10 percent and
13 percent, respectively, from mid-1999.
Corporate earnings reports have, for the mosl pan,
exceeded expectations, and projections of future
earnings continue to be revised higher. However, the
increase in interest rates since ihe beginning of the
year likely has restrained ihe rise in equity prices. In
addition, growing unease about ihe lofty valuations
reached by technology1 shares and rising default rates
in Ihe corporate sector may have given some investors a belter appreciation of the risks of holding

58

22

Monetary Pnlicy Report lo the Congress D July 2000

stocks in general. Reflecting the uncertainty about
the future course of Ihe equity market, expected and
acitial volatilities of slock returns rose substantially
in the spring, A( that lime, volatility implied by
options on the Nasdaq 100 index surpassed even the
elevated levels reached during the financial markel
turmoil of 1998.
Higher volatility and greater investor caution had
a marked effect on public equity offerings. The pace
of initial public offerings has fallen off considerably
in recen! months from as brisk first-quarter rate, with
some offerings being canceled or postponed and others Doing priced well short of earlier expectations. On
the other hand, households' enthusiasm for equity
mutual funds, especially those funds that invest in the
technology and international sectors, remains relatively high, although it appears to have faded some
after the run-up in stock market volatility in the
spnng. Following a first-quarter surge, net inflows
ID slock funds moderated substantially in the second
quarter but still were above last year's average pace.
Debt and the Monetary Aggregates
Debt and Depository Intermediation
The total debt of the U.S. household, government,
and nonfinancia! business sectors is estimated to have
increased at close to a SW percent annual rale in the
first half of 2000. Outside the federal government
sector, debt expanded at an annual rate of roughly
y'/? percent, buoyed by strength in Household and
business borrowing. Continued declines in federal

nf domestic nonlinancial Jebi

debt have helped lo ease the pressure on available
savings and have facilitated tne rapid expansion of
nonfederal debt outstanding; The federal government
paid down 5218 billion of debt over the ftrsl hall of
2000, compared with paydowns of $56 billion and
$101 billion in the first six months of calendar years
I99S and 1999 respectively.
Depository institutions have continued to play an
important role in meeting the strong demands for
credit by businesses and households. Adjusted for
mark-to-market accounting rules, credit extended by
commercial banks rose 11'/: percent in the first hall
of 2000. This advance was paced by a brisk expansion of loans, which grew at an annual rate of nearly
13 percent over this period. Bank credit increased in
part because some businesses sought hank loans as an
alternative to a less receptive corporate bond market.
In addition, (he underlying strength of household
spending helped boos* the demand for consumer and
mortgage loans. Banks' holdings of consumer and
mortgage loans were also supported by a slower pace
of sccuritizations this year. In the housing sector, for
instance, the rising interest rate environment has kept
the demand for adjustable-rale mortgages relatively
elevated, and banks tend to hold these securities on
their books rather than securitize them.
Banks have tightened lerms and standards on Itians
further this year, especially in the business sector,
where some lenders have expressed concerns about a
more uncertain corporate outlook. Bank regulators
have noted that depository institutions need to take
particular care in evaluating lending risks to account
for possible changes in the overall macroecanaimc
environment and in conditions in securities markets.

59

Board of Governors of the Federal Reserve System

M2 erowth rale

Ilii.Ill
The Monetary Aggregates
Growth of the monetary aggregates over (he first half
of 2000 has been buffeted hy several special factors.
The unwinding of ihe buildups in liquidity thai
occurred in late ] 999 before the century date change
depressed growth m (he aggregates early this year.
Subsequently, M2 rebounded sharply in anticipation
of ouisized tax payments in the spring and then ran
off as those payments cleared. On nei, despiie the
cumulative finning of monetary policy since June
199°, M2 expanded a! a relatively robust. 6 percent,
annual rate during the (irsi half of 2000—ihe same

M2 velocity and IlK opportunity cosi of holding M2

Norh ThedBtJwqHMierlyiinilmcihiou(h?CCKHJI The \tl«ityof M? i
ihf in in of nominal RTOU dnnvsirc prudufi 'nihc *l«k pf M- The E^pofTuifr
ihrw-irionch Trea^ur> Iwll faie and rt* wnphted n-,cmp: niuin un <i»sei
nicLBded in Ml

23

M3 growth rale

1WO 1901 1992 [993 |yyj m$s ]*•* I9y? J99K )9W MOO

pace as in 1999—supported by the rapid expansion of
nominal spending and income.
M2 velocity—the ratio of nominal income tci M2—
has increased over the rirsi half of this year, consistent with its historical relationship with the interest
forgone ("opportunity cost") from holding M2. As
usual, rales offered on many of Ihe components of
M2 have not tracked the upward movement in market
interest rales, and the opportunity cost of holding M2
has risen. In response, investors have reallocated
some of their funds within M2 toward those components whose rales adjust more quickly—such as small
time depoiits—and have restrained flows into M2 in
favor ot longer-term mutual funds and direct holdings of market instruments,
M3 expanded at an annual rate of 9 percent in the
first half of 2000, up from 7W percent for all of 1999.
The robust expansion of bank credit underlies much
of the acceleration in M3 ihis year. Depository institutions have issued large time deposits and other
managed liabilities in volume to help fund the expansion of their loan and securities portfolios. In contrast, flows to institutional money funds slowed from
the rapid pace of late 1999 after the heightened
preference for liquid assets ahead of the century date
change ebbed.
As has been the case since 1994. depository institutions have continued to implement new retail sweep
programs over the fiist half of 2000 in order to avoid
having to hold non-inierest-bearing reserve balances with the Federal Reserve System. As a result,
required reserve balances are still declining gradually, adding to concerns (hit, under current procedures., low balances might adversely aft'eei the imple-

60

24

Monetary Policy Report to the Congress D July 2000

menlalion of monetary policy hy eventually leading
to increased volatility in the federal funds market,
The pending legislation that would allow the Federal
Reserve to pay interest on balances held at Reserve
Banks would likely lend to a partial unwinding over
lime of the ongoing trend in retail sweep programs.
International Developments
In the first half of 2000, economic activity in foreign
economies continued The strong overall performance
thai was registered hat year. W/iJ? a few excepfions,
most emerging-market countries continued to show
signs of solid recoveries from earlier recessions, supported hy favorable financial market conditions.
Average real GDP in (he foreign industrial countries
accelerated noticeably in the first half of this year
after a mild slowdown in late 1999. The pickup
reflected in large part better performance ol Japanese
domestic demand (although its sustainabilily has been
questioned) and further robust increases in Europe
and Canada. In many countries, economic slack
diminished, heightening concern about inflation risks.
Foreign interest rales

Higher oil prices bumped up broad measures of inflation almost everywhere, but measures of core inflation edged up only modestly, if at all.
Monetary conditions generally were tightened in
foreign industrial countries, as authorities removed
stimulus by raising official rates. Yield curves in
several key industrial countries tended to flatten, as
interest rates on foreign long-term government securities declined on balance after January, reversing an
upward trend seen since the second quarter of 1999.
Yields on Japanese governmenl long-term bonds
edged upward slightly, but at midyear stilt were only
aboiii 1W percent.
Concerns in financial markets at the end of last
year about potential disruptions during the century
date change dissipated quickly, and global markets in
the early months of this year returned to the comparatively placid conditions seen during most of 1999.
Starting in mid-March, however, global financial
markets were jolted by several episodes of increased
volatility set off typically by sudden dowodrafts in
US. Nasdaq prices. At that time, measures of market
risk for some emerging -market countries widened,
but they later retraced most of these increases. The
performances of broad stock market indexes in the
industrial countries were mixed, but they generally
tended to reflect their respective cyclical positions.
Slocks in Canada. France, and Italy, for example,
continued to make good gains, German stocks did
(ess well, and UK. stocks slipped. Japanese shares
also were down substantially, even though the domestic economy showed some signs of firmer activity. In
general, price volatility of foreign high-tech slocks or
stock indexes weighted toward technology-intensive
sectors was quite high and exceeded that of corresponding broader indexes.
The dollar continued to strengthen during most of
the first half of the year. It appeared to be supported
mainly by continuing positive news on the performance of the U.S. economy, higher U.S. short-term
interest rates, and for much of (he first half, expectations of further tightening of monetary policy. Early
in the year, the attraction of high rates of return on
U.S. equities may have been an additional supporting
factor, but the dollar maintained its upward trend
even after U.S. stoek prices leveled off near the end
of the first quarter and then declined for a while. In
June, the dollar eased hack a bit against the currencies of some industrial countries amid signs lhai U.S.
growth was slowing. Nevertheless, for the year so far,
the dollar is up on balance about 5'/i percent against
the major currencies; against a broader index of
trading-partner currencies, the dollar has appreciated
aboul 3V» percent on balance.

61

Board of Governors of ihe Federal Reserve System

Nominal U.S. dollar exchange rales

NUTP.. Thif dra me weekly, Indexes io lh* upper panel are (nfe-v
*vprape$ 5< Ihe exctnoge value o! the dollar agtunu nu|or ninCM
agunsr the cumpctas of a hood frour>of imponam t" 5 truing porfn
obwrvMkms uc [or UK week emUnj July I !. 2000

The dollar has experienced a particularly large
swing againsi the euro. The euro started this year
already down more lhan ! 3 percent from its value
against the dollar at the time when the new European
currency was introduced in January 1999, and ii
continued to depreciate during most of the first hall'
of 2000, reaching a record low in May. During this
period, the euro seemed to he especially sensitive to
news and public commentary by officials about the
strength of the expansion in the euro area, the pace of
economic reform, and the appropriate macroeconomic policy mix. Despite a modest recovery in
recent weeks, the euro still is down against the dollar
almosi 7 percent on balance for the year so far and
about y/t percent on a trade-weighted basis.
The euro's persistent weakness posed a challenge
for authorities at the European Central Bank as they
sought to implement a policy stance consistent with
their official inflation objective (2 percent or less for
harmonized consumer prices) without threatening the
euro area's economic expansion. Supported in part
by euro depreciation, economic growth in the euro

25

area in the first half of 2000 was somewhat stronger
lhan the brisk 3 percent pace recorded last year.
Investment was robust, and indexes of both business
and consumer sentiment registered record highs. The
average unemployment rate in the area continued to
move down to nearly 9 percent, almost a full percent.
age point lower than a year earlier. At the end of the
first half, the euro-area broad measure of inflation,
partly affected by higher oil prices, was above 2 percent, while core inflation had edged up to IVt percent. Variations in the pace of economic expansion
and the intensity of inflation pressures across the
region added to (he complexity of the situation confronting ECB policymakers even though Germany
and Italy, two countries that had lagged the euro-area
average expansion of activity in recent years, showed
signs that they were beginning to move ahead more
rapidly. After having raised its refinancing rate
50 basis points in November 1999, Ihe ECB followed
with three 25-point increases in the first quarter and
another 50-point increase in June. The ECB pointed
to price pressures and rapid expansion of monetary
aggregates as important consrderaiions behind the
moves.
Compared with its fluctuations against the euro,
the dollar's value was more stable against the Japanese yen (luring the first half of 2000- In late 1999.
private domestic demand in Japan slumped badly,
even though the Bank of Japan continued to hold
its key policy rate at essentially zero. Several times
during the first half of this year, the yen experienced
strong upward pressure, often associated with market
perceptions that activity was reviving and with speculation that the Bank of Japan soon might abandon its
zero-interest-rate policy. This upward pressure was
resisted vigorously by Japanese authorities on several
occasions with sales of yen in foreign exchange markets. The Bank of Japan continued to hold overnight
interest rates near zero through the first half of 2000.
The Japanese economy, in fact, did show signs of
stronger performance in the first half. GDP rose at an
annual rate of 10 percent in the first quarter, with
particular strength in private consumption and investment. Industrial production, which had made solid
gains last year, continued to expand at a healthy pace,
and surveys indicated that business confidence had
picked up. Demand from the household sector was
less robust, however, as consumer confidence was
held back by historically high unemployment. A large
and growing outstanding stock of public debt (estimated at more than 110 percent of GDP) cast increasing doubt about the extent to which authorities might
be willing to use additional fiscal stimulus to boost
demand. Even though some additional government

62

26

Monetary Policy Report in Ihe Congress D July 1000

expenditure for coming quarters was approved in laK
1999, government spending did not supply stimulus
in the first quarter. With coie consumer prices moving down at an annual rate thai reached elmost I percent at midyear, deflation also remained a concern.
Economic activity in Canada so fat this yeai
stowed a bi( from its very strong performance in the
second half of 1999, but it still was quile robust,
generating strong gains in employment and reducing
the remaining slack in the economy. The expansion
was supported by both domestic demand and spillovers from the U.S. economy. Higher energy prices
pushed headline inflation to near the top of the Bank
of Canada's 1 percent to 3 percent target range; core
inflation remained jus! below !>/• percent. The Canadian dollar weakened somewhat againsi the U.S. dollar in the first half of ihe year even though ihe Bank
of Canada raised policy interest rales 100 basis
points, matching increases in U.S. rales. !n ihe United
Kingdom, the Bank of England continued a round of
tightening that started in mid-1999 by raising official
rates 25 basis points twice in the first quarter. After
March, indications that Ihe economy was slowing
and thai inflationary pressures might be ebbing under
the effect of the tighter monetary stance and strength
of sterling—especially against the euro—allowed the
Bank 10 hold rales constant. In recent months, sterling has depreciated on balance as official interest
rates have been raised in other major industrial
countries.
In developing countries, the strong recovery of
economic activity last year ro both developing Asia
and Latin America generally continued inio (he tirsi
half of 2000. However, after a fairly placid period
ihai extended into the firsi few months of this year,
financial market conditions in some developing countries became more unsettled in the April-May period.
In some countries, exchange rates and equity prices
weakened and risk spreads widened, as increased
political uncertainty interacted with heightened financial maiket volatility and rising interest rales in
the industrial countries. In general, financial markets
now appear to be identifying and distinguishing those
emerging-market countries with problems more
effectively than they did several years ago.
In emerging Asia, the strong bounceback of activity last year from the crisis-related declines of 1998
continued into the first half of this year. Korea, which
recorded Ihe strongest recovery in the region last year
with real GDP rising at double-digit rates in every
quarter, has seen some moderation so far in 2000.
However, with inventories slill being rebuilt, unemployment declining rapidly, and inflation showing
no signs of accelerating, macroeconomic conditions

Emerging maikets

I<i7*. The d«a arc vcckly. EMBI- (t P Morgan cnErgjn? rarkri bold
*) spreads (Of Hnpped Braty-tond yield spifcKb °*w U.S, ^n
TvMHiiH m fnt Uic *n;k tndins lul, I i 2000

remained generally favorable, and Ihe won came
under upward pressure periodically in the first half of
this year. Nonetheless, the acute financial difficulties
of Hyundai, Korea's largest industrial conglomerate,
highlighted the lingering effect on the corporate
and financial sectors of the earlier crisis and the need
for further restructuring. Economic activity in other
Asian developing countries that experienced difficulties in 1997 and 1998 (Thailand, Indonesia, Malaysia, Singapore, and the Philippines) also continued
to firm this year, but at varying rales. Nonetheless,
financial market condnions have deteriorated in
receni months fot some countries in the region.
In Indonesia and the Philippines, declines in equity
prices and weakness in exchange rates appear to have
stemmed from heightened market concerns over
political instability and prospects for economic
reform. Output in China increased at near doubledigit annual rates in the second half of last year and
remained strong in the first half of this year, boosted
mainly by surging exports. In Hong Kong, real GDP
rose at an annual rale of more than 20 percent in the

63
Board of Governors of the Federal Reserve System

firsi quarter of this year after a strong second half in
1999. Higher consumer confidence appears to have
boosted private consumption, and trade flows through
Hong Kong, especially to and from China, have
increased.
The general recovery seen last year in Latift
America from effects of the emerging-market financial crisis extended inlo the first pan of this year.
In Brazil, inflation was remarkably well contained,
and imcresi rales were towered, bul unemployment
has remained high. An improved financial situation
allowed the Brazilian government to repay most of
the funds obtained under its December 1998 international support package. However, Brazilian financial
markets showed continued volatility this year, especially at times of heightened market concerns over
ihe stains of fiscal reforms, and risk premiums widened in the first half of 2000 on balance. In Mexico.
activity has been strong so far this year. In the first
quarter, real GDP surged ai an annual rate of 11 per

27

cent, boosted by strong exports to the United Slates,
soaring private investment, and increased consumer spending. Mexican equity prices and the
peso encountered some downward pressure in the
approach of the July 2 national election, but once the
election was perceived to be fail and ihe transition of
power was under way, both recovered substantially,
In Argentina, ihe pace of recovery appears to have
slackened in the early pan of ihis year, as the government's fiscal position and. in particular, iis ability to
meet the targets of its International Monetary Fund
program remained a focus of market concern- Heightened political uncertainly id Venezuela, Peru, Colombia, and Ecuador sparked financial market pressures
in recent months in those countries, too. In January,
authorities in Ecuador announced a program of "dollarizalion," in which the domestic currency would be
entirely replaced by U.S. dollars. The program, now
in the process of implementation, appears to have
helped stabilize financial conditions there.