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S. HRG. 108–769 FEDERAL RESERVE’S SECOND MONETARY POLICY REPORT FOR 2004 HEARING BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED EIGHTH 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, 2004 Printed for the use of the Committee on Banking, Housing, and Urban Affairs ( U.S. GOVERNMENT PRINTING OFFICE WASHINGTON 98–356 PDF : 2004 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001 VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00001 Fmt 5011 Sfmt 5011 98356.TXT BANK1 PsN: BANK1 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS RICHARD C. SHELBY, Alabama, Chairman ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota CHUCK HAGEL, Nebraska JACK REED, Rhode Island RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky EVAN BAYH, Indiana MIKE CRAPO, Idaho ZELL MILLER, Georgia JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey KATHLEEN L. CASEY, Staff Director and Counsel STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel PEGGY R. KUHN, Senior Financial Economist MARTIN J. GRUENBERG, Democratic Senior Counsel JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator GEORGE E. WHITTLE, Editor (II) VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00002 Fmt 0486 Sfmt 0486 98356.TXT BANK1 PsN: BANK1 C O N T E N T S TUESDAY, JULY 20, 2004 Page Opening statement of Chairman Shelby ................................................................ Opening statements, comments, or prepared statements of: Senator Dole ...................................................................................................... Senator Bunning ............................................................................................... Senator Carper ................................................................................................. Senator Reed ..................................................................................................... Senator Crapo ................................................................................................... Senator Bayh .................................................................................................... Senator Sununu ................................................................................................ Senator Sarbanes .............................................................................................. Senator Hagel ................................................................................................... Senator Dodd .................................................................................................... Senator Allard ................................................................................................... Prepared statement ................................................................................... Senator Schumer .............................................................................................. Senator Corzine ................................................................................................ Senator Bennett ................................................................................................ 1 2 2 3 4 4 4 5 5 6 6 6 36 7 7 26 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... Prepared statement .......................................................................................... Response to written questions of: Senator Shelby ........................................................................................... Senator Bunning ....................................................................................... Senator Crapo ............................................................................................ Senator Sununu ......................................................................................... Senator Stabenow ...................................................................................... ADDITIONAL MATERIAL SUPPLIED FOR THE (III) 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00003 Fmt 5904 Sfmt 5904 40 42 43 44 46 RECORD Foreign Official Assets in the United States chart, submitted by Senator Paul S. Sarbanes .................................................................................................. Monetary Policy Report to the Congress, July 20, 2004 ....................................... VerDate 11-MAY-2000 7 36 98356.TXT BANK1 PsN: BANK1 48 49 VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00004 Fmt 5904 Sfmt 5904 98356.TXT BANK1 PsN: BANK1 FEDERAL RESERVE’S SECOND MONETARY POLICY REPORT FOR 2004 TUESDAY, JULY 20, 2004 U.S. SENATE, URBAN AFFAIRS, Washington, DC. The Committee met, at 2:31 p.m., in room SH–216 of the Hart Senate Office Building, Senator Richard C. Shelby (Chairman of the Committee) presiding. COMMITTEE ON BANKING, HOUSING, AND OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY Chairman SHELBY. The hearing will come to order. I am very pleased this afternoon to welcome Chairman Greenspan before the Committee on Banking, Housing, and Urban Affairs, to testify on the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress. Chairman Greenspan, the U.S. economy is continuing its expansion with real GDP increasing 3.9 percent in the first quarter of 2004. I hope we can now also point to strong job growth with payroll employment increasing for 10 straight months with an average of 200,000 jobs per month in the first half of this year. I think overall this is good news for the American worker and we hope to see even better numbers on jobs and wages in the months ahead. When this Committee heard from you in February of this year, the Federal Open Market Committee had just stated that the Committee could be ‘‘patient’’ in changing its accommodative monetary policy. The FOMC then indicated in May that changes in its policy were ‘‘likely to be measured.’’ At its June meeting, the Federal Open Market Committee raised its target for the Federal funds rate by 25 basis points to 11⁄4 percent—the first increase since May 2000. This move was widely anticipated by financial markets, and I think overall it has helped ease inflationary fears. Some Fed watchers have expressed the concern that the FOMC waited too long to increase its target Federal funds rate target. However, last week’s report on retail sales and industrial production seemed to indicate that the Fed’s actions have been prudent. Also, since the FOMC’s June action, the markets have responded by a reduction, as you well know, in the long-term interest rate. This afternoon, I think we will have ample opportunity to discuss the Federal Reserve’s views on the economy and how we might interpret the FOMC statement on changes in monetary policy which are ‘‘likely to be measured.’’ And, perhaps we will even garner some insight as to the FOMC’s consideration at its upcoming August meeting. (1) VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 2 Mr. Chairman, as I had indicated to you a minute ago, there is a vote going on. Some of us voted early, and we will have a lot of Members to join us. We look forward to your remarks, but first, Senator Dole, any statement? STATEMENT OF SENATOR ELIZABETH DOLE Senator DOLE. Thank you, Chairman Shelby. Today, we welcome Chairman Greenspan back to this Committee for our fourth and final Semi-Annual Monetary Policy Report of the Federal Reserve for this Congress. I appreciate the Chairman’s willingness to visit with us so often, and explore areas of concerns with regard to our economy and monetary policy. Last month, Chairman Greenspan assured us that he has observed real wages increasing for Americans in the past 4 months. This, in turn, has helped increase disposable income, a trend that I understand Chairman Greenspan expects to continue as the natural course of the recovery and growing strength of our economy. I cannot overstate the importance of this trend for our men and women in the workforce, and appreciate Chairman Greenspan’s continued optimism in the American economy. I was very pleased with the release last week of the June industrial production data, indicating the growing strength in the manufacture of durable capital goods. North Carolina has been hit very hard by the loss of manufacturing jobs over the past years. Any reversal of this trend is indeed welcome news. There have been some excellent numbers for North Carolina—according to figures released today from the Bureau of Labor Statistics—North Carolina has created 35,400 new jobs in the month of June. This positive news highlights the transition which is occurring in North Carolina with the loss of low-skilled manufacturing jobs and the creation of jobs in service sectors which require a good education with a demand on computer skills. Continuing education must continue to be a top priority for us to respond to this demand. I have spoken before about the work that Senators Enzi, Alexander, and I are undertaking to write the Higher Education Access, Affordability, and Opportunity Act of 2004. It will provide additional assistance to our community colleges and other institutions of higher learning for training and retraining students in highgrowth job markets. We hope to introduce this bill shortly. In addition, I remain concerned about a number of factors such as high energy prices, the rise in steel prices, and the size of our trade deficit. Despite these concerns though, I am confident that through increased trade, hard work, global communications, and continuing education of our workforce, we will achieve new levels of opportunity for all Americans and global security. I, again, thank Chairman Greenspan for joining us here today, and I will look forward to his testimony. Thank you, Mr. Chairman. Chairman SHELBY. Senator Bunning. STATEMENT OF SENATOR JIM BUNNING Senator BUNNING. Thank you, Mr. Chairman. I am glad that we get you first this time, Chairman Greenspan— the House usually shares that opportunity with us—because given VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 3 the June economic figures, especially the housing figures that came out today, I know many want to know what you make of these figures, and that is especially true of this Committee. When the FOMC raised rates 25 basis points on June 30, it was a move that was largely expected. Many in the economic talking heads class said the market had already built in this rate adjustment. However, since that raise, as of last night’s close, the Nasdaq market has lost 164 points, and the Dow has lost 341 points. It has not been a very good 3 weeks for our stock markets. I am not sure the June economic figures were what the FOMC had in mind when it made its decision to raise rates. I do not think any of us like the figures we have seen. We can do better on all fronts. We did have another jobs increase, but I still think we can do better. We need to make sure those who want a job can find one. I am also concerned with some of the recent corporate earnings that have been reported, especially in the airlines industry. Delta Airlines has been a major presence in Northern Kentucky and in Kentucky in general. Their Northern Kentucky hub has been an economic engine for all of Kentucky. It is a major reason why companies such as Toyota, Fidelity, Citigroup, to name a few, have built facilities in Kentucky. Delta also has a great many employees in my State, about 8,000 in the Northern Kentucky area. Delta’s health is a very large concern to my State. I do not know what the answer is, but I know other Members of this Committee have similar concerns about airlines with major operations in their States. I also think many are concerned about the new housing starts figures that were released today. As you know, the housing sector helped carry our economy during the last recession. Obviously, at some point this would have to cool down, just a little I hope, but it was a pretty dramatic drop both in May and in June. That came as a surprise to me. I would like to hear your take on this. Is this so-called housing bubble bursting? Is it something we need to be concerned with, or was it inevitable that the housing market would have to slow some? I am concerned with how our economy is faring right now, especially with the June figures coming in. Energy prices were falling, but they are back on the rise. The stock market is down and housing is down. It seems that our recovery had a definite hiccup in June. I guess the $64,000 question, was it a hiccup or something that we should be more concerned about? Also, as I mentioned earlier, most of the economic talking heads stated that the FOMC rate raise was built into the market. They seem to have been proven wrong. They also stated that a second rate increase was pretty much a done deal for August. I hope the Fed is not on automatic pilot. I would like you to look closely at the June figures, and I know you will, before a decision is made in August. I do not want a hiccup to turn into the flu. Thank you, Mr. Chairman. Chairman SHELBY. Senator Carper. COMMENT OF SENATOR THOMAS R. CARPER Senator CARPER. I have no prepared remarks, Mr. Chairman. Chairman Greenspan, welcome. I look forward to hearing your testimony. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 4 Chairman SHELBY. Senator Reed. COMMENTS OF SENATOR JACK REED Senator REED. Thank you, Mr. Chairman. Thank you, Chairman Greenspan, for attending. It does look like we are recovering jobs, but those jobs seem to not have the same wages and earnings of previous jobs that were lost, and that is a significant issue. We have had a chance to talk about this before, but until we can really establish wage and earning growth among a broad sector of American workers, I do not think we are going to see a robust economic recovery, and we are going to continue to have families that are trying to make ends meet by borrowing. And as interest rates go up—and you have already raised them and you might contemplate raising again—that will put additional pressure on families. So there is perhaps some encouraging news, but there is also a very different reality we have to cope with, and I am looking forward to your testimony. Thank you. Chairman SHELBY. Senator Crapo. COMMENTS OF SENATOR MIKE CRAPO Senator CRAPO. Thank you very much, Mr. Chairman. Chairman Greenspan, it is a pleasure to welcome you back here. I am going to say at the outset my duty is to preside over the floor in about 18 minutes, so I will not be here too far into your testimony. In fact, I may miss your testimony. I am going to read it very carefully, however, and I do share some of the questions that you have already heard. The main question, of course, that we want to see, is whether the expansion that we are now seeing is capable of sustaining itself, what the numbers from June meant, and how we can look forward now in terms of gauging the strength of the expansion and what is going to happen with inflation. I do appreciate your careful attention to the inflation in our economy. I do want to pose one question for you to consider either during your testimony or perhaps in follow up if it does not come up there. That is, as you know, a divided SEC voted 3 to 2 last Wednesday to seek comments on a proposal for mandatory registration of hedge funds advisers with the SEC. My question is whether you are concerned with this SEC proposal for mandatory registration of hedge fund advisers with the SEC, and whether you think it would be advisable for the President’s Working Group on Financial Markets to become involved in issues relating to the regulation of the hedge fund industry. With that, again, I welcome you here, and I look forward to your testimony. Chairman SHELBY. Senator Bayh. COMMENT OF SENATOR EVAN BAYH Senator BAYH. Thank you, Mr. Chairman. I look forward to hearing from Chairman Greenspan, and I will reserve other comments until the question period. Chairman SHELBY. Senator Sununu. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 5 COMMENT OF SENATOR JOHN E. SUNUNU Senator SUNUNU. I have no opening statement. Welcome, Mr. Chairman. Chairman SHELBY. Senator Sarbanes. STATEMENT OF SENATOR PAUL S. SARBANES Senator SARBANES. Mr. Chairman, thank you very much. I am pleased to welcome Chairman Greenspan back before our Committee to testify on the Federal Reserve’s Semi-Annual Monetary Policy Report to Congress. This was a requirement put into law by this Committee with actually the support of the Fed, and I think it has worked very well over the years. As we all know, of course, at the last meeting of the Federal Open Market Committee, they decided to raise the target for the Federal funds rate by 25 basis points to 11⁄4 percent, the first change in interest rates by the Fed in about a year’s time. In a statement released after the meeting—and I want to commend Chairman Greenspan and his colleagues for this shift in practice, whereby after the FOMC makes decisions, they seek to explain them, however briefly, to the public. The FOMC said they ‘‘perceive the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters are roughly equal. With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.’’ The final sentence of that paragraph has generally been read to suggest that the FOMC will take a more aggressive stance toward monetary policy if economic conditions warrant. But, I would just like to note, in light of the recent economic indicators that have been released, that the sentence could also be read to suggest that the FOMC may tilt in the other direction if, in fact, it is necessary. While the outlook for economic growth remains positive, most forecasts are being revised downward. GDP growth for the first quarter of the year was revised downward to 3.9 percent. Last week, the Commerce Department reported an unexpectedly large decline in retail sales for June of 1.1 percent. The Fed reported a 0.3 percent decline in industrial production. And just this morning, the Commerce Department reported that housing construction fell 81⁄2 percent in June, the sharpest drop since February 2003. While these are all just monthly numbers, they raise questions about the strength of the economic outlook. That is particularly true when taken together with a continuing weakness in the labor market. Job growth in May declined from the 300,000 figure of March and April to 250,000, and in June was cut in half to 112,000. As a result of the prolonged labor market weakness, the economy remains 1.2 million jobs below the level when the recession began 39 months ago. Compared to the average economic recovery of the post-war era, today’s economy is nearly 6 million jobs short. Further, in June, 1.7 million of the unemployed, 21.6 percent of the total, had been unemployed an average duration of 20 weeks. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 6 The long-term unemployed have made up over 20 percent of the unemployed for the past 21 months, surpassing the record set from 1982 to 1984. As The New York Times reported on Sunday, the slack labor market is resulting in the failure of hourly pay in the United States to keep pace with inflation. The article points out that the Bureau of Labor Statistics reported last Friday, that hourly earnings of production workers fell 1.1 percent over the past 12 months, after accounting for inflation. The decline is the steepest since the recession of 1991. And only this morning, The Wall Street Journal had an article entitled, ‘‘So Far, Economic Recovery Tilts to Highest-Income Americans,’’ and goes on to note that, ‘‘The recovery’s primary beneficiaries have been upper-income households.’’ Finally, Mr. Chairman, in closing I simply want to take note that Virgil Mattingly, who had served as General Counsel for the Federal Reserve Board and the Federal Open Market Committee for the past 15 years, and who served a total of 30 years at the Federal Reserve, just retired on June 30. Virgil Mattingly worked closely with the Members and staff of this Committee on every major piece of banking legislation enacted over the past 20 years. He always provided not only exceptionally intelligent and competent technical assistance to the work of this Committee, but also wise counsel and wise advice. He was, in my view, an extraordinarily able and dedicated public servant, and upheld, and indeed in some measure helped to define, the tradition at the Federal Reserve of an outstanding career of service. He made very significant contributions to our Nation and to the formulation of public policy. I simply wanted to take this opportunity to wish him well in his retirement, and to express appreciation for the fine work he did over the years. I also want to take this opportunity to congratulate Scott Alvarez, who has been Associate General Counsel for the Federal Reserve, and has been appointed to succeed Virgil Mattingly as the Fed’s General Counsel. Scott Alvarez is also well known and highly regarded by the Members and staff of this Committee, and we look forward to continuing to work closely with him in his new capacity. Thank you, Mr. Chairman. Chairman SHELBY. Senator Hagel. COMMENT OF SENATOR CHUCK HAGEL Senator HAGEL. I have no statement, Mr. Chairman. Chairman SHELBY. Senator Dodd. COMMENT OF SENATOR CHRISTOPHER J. DODD Senator DODD. Mr. Chairman, I will wait, and I will just ask unanimous consent that my statement be included in the record. Chairman SHELBY. Without objection, so ordered. Chairman SHELBY. Senator Allard. COMMENT OF SENATOR WAYNE ALLARD Senator ALLARD. Mr. Chairman, I would like to thank you for holding this hearing, and I always look forward to hearing from the Chairman, and I will submit my full statement to the record. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 7 Chairman SHELBY. Without objection, it will be made part of the record. Chairman SHELBY. Senator Schumer. COMMENTS OF SENATOR CHARLES E. SCHUMER Senator SCHUMER. Thank you, Mr. Chairman. I would ask that my full statement be submitted to the record. Chairman SHELBY. Without objection, so ordered. Senator SCHUMER. The only observation I would make is there are two wings to our economic policy here. There is fiscal policy and monetary policy. The thing you are here to report on and the thing you are in charge of, monetary policy, I think you are doing a superb job. I think the quarter-inch steps that you have made is just about perfect for our situation. But I do worry about our fiscal policy, and sometimes, as you well know, much of the time, lower interest rates are better for the economy than lower taxes, and that will be the line of my questions. Chairman SHELBY. Thank you, Senator Schumer. Senator Corzine. COMMENTS OF SENATOR JON S. CORZINE Senator CORZINE. I will submit a statement for the record. Chairman SHELBY. Without objection, your opening statement will be made part of the record. Chairman Greenspan, if you will abide us a few minutes, we have established a quorum and would like to move the Committee to Executive Session and ask for a vote on our nomination for the Department of the Treasury and the Department of Housing and Urban Development. Chairman Greenspan, you proceed as you wish. Thank you. STATEMENT OF ALAN GREENSPAN, CHAIRMAN BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Mr. Chairman, if I may before I start, I would like to thank the Senator for his very thoughtful remarks with respect to Virgil Mattingly’s tenure at the Federal Reserve. We will miss him, and we certainly concur in how you evaluated his service and his contributions, I must say, to this Committee, and assisting in innumerable pieces of legislation, for which, for some reason or other, he always had the right balanced insight. We know Scott Alvarez, who worked closely with him over the years, will not become a Virgil clone, but we would not mind if he did. Mr. Chairman, with respect to Federal Reserve’s Monetary Policy Report to the Congress, I cannot remember how many times I have been here, but it is always a fascinating experience because it gives us a chance, in this requirement, to review every 6 months what is going on in the economy and our interfacing with it. As Senator Sarbanes said, it has probably been a major element in our generalized communications policy, and I know that we always look forward to meeting with this Committee. Economic developments in the United States have generally been quite favorable in 2004, lending increasing support to the view that the expansion is self-sustaining. Not only has economic activity VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 8 quickened, but the expansion also has become more broad-based and has produced notable gains in employment. The evident strengthening in demand that underlies this improved performance doubtless has been a factor contributing to the rise in inflation this year. But inflation also seems to have been boosted by transitory factors such as the surge in energy prices. Those higher prices, by eroding households’ disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived. When I testified before this Committee in February, many of the signs of the step-up in economic activity were already evident. Capital spending had increased markedly in the second half of last year, no doubt spurred by significantly improving profits, a low cost of capital, and the investment tax incentives enacted in 2002 and enhanced in 2003. The renewed strength in capital spending carried over into the first half of 2004. Orders and shipments of nondefense capital goods have been on the rise, and backlogs of unfilled orders for new equipment continue to build. A key element of the expansion that was still lacking in February, however, was evidence that businesses were willing to ramp up hiring to meet the stepped-up pace of sales and production. Businesses’ ability to boost output without adding appreciably to their workforces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment, which was an apparent outgrowth of the capital goods boom of the 1990’s. Indeed, over much of the previous 3 years, managers had seemed to pursue every avenue to avoid new hiring despite rising business sales. Their hesitancy to assume risks and expand employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the decline in stock prices and also, of course, by the environment of heightened geopolitical tensions. Even now, following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cashflow. The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape. That said, there have been much clearer indications over recent months that conditions in the labor market are improving. Most notably, gains in private nonfarm payroll employment have averaged about 200,000 per month over the past 6 months, up sharply from the pace of roughly 60,000 per month registered over the fourth quarter of 2003. The improvements in labor market conditions will doubtless have important follow-on effects for household spending. Expanding employment should provide a lift to personal disposable income, adding to the cuts in personal income taxes over the past year. In addition, the low interest rates of recent years have allowed many households to lower the burdens of their financial obligations. Although mortgage rates are up from recent lows, they remain quite attractive from a longer-term perspective and are providing solid support to home sales. Despite the softness of recent retail sales, the combination of higher current and anticipated future income, VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 9 strengthened balance sheets, and still-low interest rates, bodes well for consumer spending. Consumer prices excluding food and energy, so-called core prices, have been rising more rapidly this year than in 2003. For example, the 12-month change in the core personal consumption expenditures price index stood at 0.8 percent in December of last year and climbed to 1.6 percent by May of this year. Core inflation, of course, has been elevated by the indirect effects of higher energy prices on business costs and by increases in non-oil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities. But the acceleration of core prices has been augmented by a marked rise in profit margins, even excluding domestic energy companies. This surge in profits reflects, at least in part, the recent recovery of demand after a couple of years during which weak demand led to relatively heavy price discounting by businesses. Profits of nonfinancial corporations, as a share of sector output, after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent in the first quarter of 2004, a pace of advance not experienced since 1983. Half of this rise in profit share occurred between the first quarter of 2003 and the first quarter of 2004, a period during which costs were unusually subdued. In fact, consolidated unit costs of business for the nonfinancial corporate business sector actually declined during this period. The increase in output per hour in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline in unit costs. The remainder was due to the effects of rising output in reducing nonlabor fixed costs per unit of output. Hence, at least from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004, all of the 1.1 percent increase in prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than rising cost pressures. However, businesses are limited in the degree to which they can raise margins by raising prices. An increase in margins should affect mainly the level of prices associated with any given level of unit costs but, by itself, should not prompt a sustained pickup in the rate of inflation going forward. In a market economy, any tendency for profit margins to continue to rise is countered largely by the entry of new competitors willing to undercut prices and by increased labor costs as more firms attempt to exploit the opportunity for outsized profits by expanding employment and output. That increase in competitive pressure, as history has amply demonstrated, with time, returns markups to more normal levels. The profit share in the first quarter of this year, at about 12 percent, was well above normal. The gap suggested that the growth of unit profits would eventually slow relative to increased unit costs. This outlook had accorded with analysts’ expectations for earnings growth over the next year, which are substantially below the realized profit growth of profit in recent quarters. Indeed, some leveling or downward pressure on profit margins may already be in train, owing to a pickup in unit labor costs. And, although advances in productivity are continuing at a rate above the long-term average, they have slowed from the extraordinary VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 10 pace of last summer and are now running below increases in hourly compensation. The available information suggests that hourly compensation has been increasing at an annual rate of about 41⁄2 percent in the first half of the year. To be sure, the increases in average hourly earnings of nonsupervisory workers have been subdued in recent months and barely budged in June. But other compensation has accelerated this year, reflecting continued sizable increases in health insurance costs, a sharp increase in business contributions to pension funds, and an apparently more robust rate of growth of hourly earnings of supervisory workers. The larger wage gains for supervisory workers together with anecdotal reports of growing skill shortages are consistent with earlier evidence of rising wage premiums for skilled workers relative to less-skilled workers. For the moment, the modest upward path of unit labor costs does not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more intense competitive pressures at home and from abroad. Although some signs of protectionist sentiment have emerged, there is little evidence that the price-containing forces of ever widening global competition have ebbed. In addition, the economy is not yet operating at its productive capacity, which should help to contain cost pressures. But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation. Accordingly, in assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially on costs and prices. As always, considerable uncertainties remain about the pace of the expansion and the path of inflation. Some of those uncertainties, especially ones associated with potential terrorism, both here and abroad, are difficult to quantify. Such possibilities have threatened the balance of world supply and demand in oil markets in recent months, especially as demand has risen with the pace of world economic growth. Yet aside from energy, markets exhibit little evidence of heightened perceptions of risk. Credit spreads remain low, and market-based indicators of inflation expectations, after rising earlier this year, have receded. With growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary. If economic developments are such that monetary policy neutrality can be restored at a measured pace, as the FOMC expects, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. Of course, considerably more uncertainty and hence risk surrounds the behavior of an economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. In either scenario, individual instances of financial strain cannot be ruled out. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 11 The protracted period of low interest rates has facilitated a restructuring of household and business balance sheets. Businesses have been able to fund longer-term debt at highly favorable interest rates, and by extending the maturity of their liabilities, have rendered net earnings and capital values less exposed to destabilizing interest rate spikes. Households have made similar adjustments. Financial intermediaries are profitable, well-capitalized, and appear to be well-positioned to manage in a rising rate environment. In short, Mr. Chairman, financial markets along with households and businesses seem to be reasonably well-prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed, in our judgment, by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment. Although many factors affect inflation in the short-run, inflation in the long-run, it is important to remind ourselves, is a monetary phenomenon. As we attempt to assess and manage these risks, we need, as always, to be prepared for the unexpected and to respond promptly and flexibly as situations warrant. But although our actions need to be flexible, our objectives are not. For 25 years, the Federal Reserve has worked to reestablish price stability on a sustained basis. An environment of price stability allows households and businesses to make decisions that best promote the longer-term growth of our economy and with it our Nation’s continuing prosperity. Thank you very much, Mr. Chairman. I have excerpted from my prepared remarks and request that they be included in the record in full, and I look forward to your questions. Chairman SHELBY. Without objection, it will be. Thank you, Mr. Chairman. Chairman Greenspan, your testimony, among other things, indicates that the economic expansion is self-sustaining, and that it has become broad based with strengthened demand and employment gains. You also indicate that financial markets, along with households and businesses, seem to be reasonably well prepared to cope with a transition to a more neutral sense of monetary policy. Can we interpret those comments as indicating that the Federal Open Market Committee, FOMC, will be inclined to raise the Federal funds target by an additional 25 basis points in August, and would this be a measured pace? Chairman GREENSPAN. I think we have very purposely refrained from defining what we mean by that term. Obviously, I try to raise two general scenarios as to how we would ultimately restore the Federal funds rate to neutrality, where we believe it will need to go. One is measured, which I guess the dictionary says means gradual; and the other is one which we do not perceive is the most likely, but still we are prepared for if necessary, if the economy shows signs of exhibiting significant inflationary pressures, in order to maintain the mandate which the Congress has given us to create price stability mainly for the purpose of maintaining and fostering maximum, sustainable long-term growth. Because that is our objective, we will do what is required to achieve that objective. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 12 Chairman SHELBY. In February, the Fed’s forecast for growth was between 4.5 and 5 percent for 2004. Today’s forecast gives a range of 4.5 to 4.75 percent, or a slight reduction. It is close. At the same time we have seen evidence of higher inflation in recent months. Others argue that the economy does not have as much excess capacity as utilization data would imply, with the implication there that the inflation threat may be stronger in the Fed’s view. What is your assessment, Mr. Chairman, of whether the economy is in any danger of moving into a slowdown characterized by higher inflation? Chairman GREENSPAN. Mr. Chairman, this is always our concern. I should say most of us lived through the stagflation of the 1970’s, and it was a very, I would say, disconcerting experience. Chairman SHELBY. A bad situation. Chairman GREENSPAN. And the concern that we have, obviously, in this context, is something that obviously occurred in that period, namely a sharp rise in oil prices. Now, obviously, the levels of oil prices in real terms are nowhere near today where they were back then. But we will always be confronted with issues of trying to maintain an economy in which low inflation exists in the context of strong growth in the economy and in employment. We try to calibrate our policies to achieve that end as best we can. Sometimes the real world does not offer us the opportunities that we would like, but we work as expeditiously as we can to calibrate policy to achieve those ends. Chairman SHELBY. Chairman, how comfortable are you with the data being gathered on production capacity, which seems to imply that there is still room to absorb additional production without generating significant inflation? You alluded to that earlier. Chairman GREENSPAN. Mr. Chairman, these data are collected through surveys of plant managers who were asked at what level in their judgment at a certain period of time their plant is operating. And what we do is essentially collect, reweigh, and process those data and make a judgment as to what the facility’s capacity and excess capacity is, recognizing that this is not necessarily the same thing as saying, what is the capability of these plants, because there may be shortages of skilled workers or surpluses of skilled workers, and obviously, capacity in any meaningful sense is an integration of the physical facilities and a workforce capable of effectively operating those facilities. Chairman SHELBY. Chairman Greenspan, the House has been considering a bill that effectively blocks FASB from requiring the expensing of all employee stock options. Some of us here have grave concerns about the Congress becoming involved in such technical accounting issues. What message would the Congress send by intervening in FASB’s rulemaking process? What would the implications have for the current standard-setting process? Chairman GREENSPAN. I would be most concerned if the Congress intervened. Accounting, remember, is for the purpose of trying to get records which tell companies whether their strategies for success are succeeding or not. Accounting is difficult because a lot of it requires forecasts. FASB endeavors to obtain all of the various differing views on the way certain particular accounting procedures VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 13 should be implemented, and I think that they do a good job. It is a tough job. And if the Congress dictates what they can do or should do, I think it undercuts the ability of the business community to effectively measure what it is doing. Chairman SHELBY. Thank you. Senator Carper. Senator CARPER. Thank you, Mr. Chairman. Chairman Greenspan, this past weekend I flew out to Kentucky to visit my mother. Senator Bunning, she lives over in Ashland, Kentucky, real close to Huntington, West Virginia. While traveling there and back to Delaware I had some down time because our planes were delayed, and I had a chance to catch up on some of my reading. Among the things that I read about were the competitive disadvantage that a lot of our manufacturers face because of the rising, still-high cost of natural gas compared with natural gas costs for a lot of our competitors around the world. I read about the competitive disadvantage that a number of our employers face in this county—I will call them legacy costs—which relate to pension costs for pensions that you are attempting to fund, and pension costs for those that are already retired. I read about the health care cost that we face in this country, double digit increases again in health care costs for employees and for those who are retired. And I read about the disadvantages that we face with respect to legal costs. We tried mightily earlier this month to pass class action reform legislation in the Senate, have not yet been successful, although I certainly hope we are not giving up. And another is with respect to costs growing out of asbestos, and the question whether or not we are going to be able to come to grips with a more rational approach for compensating those who have been damaged by exposure to asbestos. I am going to ask you to maybe address a couple of those. First of all, if you will, just maybe a minute or two with respect to natural gas prices. I did not fully appreciate earlier how much higher our natural gas prices are to those in other parts of the world and how regionalized the prices are and what that means to us. If you could just dwell on that a little bit. As you know, we are supposed to be in conference with the House on a FISC ETI bill, so-called the Jobs Bill or Tax Bill. There are provisions in that legislation for energy conservation and production. Just a thought, if you will, to start off on natural gas prices and what these are doing to our competitiveness. Chairman GREENSPAN. Senator, I think you are raising a very critical issue which I have addressed before this Committee in the past, and regrettably, things have not changed or improved much. Our basic problem is that natural gas is essentially unlike crude oil or all of the oil products, where because we have a significant world trade, when we run into shortages here as we do, and indeed we are always short in the sense we are importing a very significant amount of our oil in this country, we have the capability from almost any part of the world to draw in additional supplies of crude oil and petroleum products. As a consequence, our prices tend to be, at least domestically, fairly close to those amongst our competitors around the world. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 14 That is not true, as you point out, with natural gas. The basic reason is that as our demand for natural gas in this country has increased year-by-year in part because it is obviously the preferred fuel in so many applications, we have begun to run out of the ability to supply that from domestic sources or from Canada, which has historically supplied us with about a sixth of our needs. Because trade in natural gas is about half the size, relative to total consumption worldwide that oil is, we have very considerable difficulty importing. One of the reasons is that while we do import from Canada, we can no longer expand Canadian imports. What we have to do is very markedly increase our supplies of liquified natural gas, which means what we have to do is get gas which is put in liquified form for transport in a cryogenic state, and bring it in to terminals in the United States. Our terminal capacity is not at this stage large enough to fill our import needs, and I trust we will be moving fairly rapidly to increase our capacity to bring in foreign gas, but until that occurs, I am fearful, as I suspect you are from the remarks you were making, that we are going to erode our competitive advantage where natural gas is a key input into the production process. And I trust we can expedite our ability to raise our import capabilities and bring gas prices, which now are close to $6 per million BTU, well above the world competitive level, back to levels which enable our companies to be far more competitive. Senator CARPER. Mr. Chairman, I mentioned earlier that we have been unsuccessful, at least this month, in passing class action reform legislation. Later today or maybe tomorrow Senator Frist is expected to meet with Senator Daschle and make a counter-proposal, if you will, to the offer Senator Daschle made maybe 4 weeks ago on asbestos litigation reform. We have about 70 to 75 companies that have gone bankrupt in this country. A number of others are threatened at this point in time. Could you take a minute and share with us your views of the importance of our trying to reach an accommodation in this area? Chairman GREENSPAN. I am not someone who has looked at the details of the legislation, or in fact, the depth of the problem. In my early years, asbestos was something that was considered an exceptionally valuable product and—— Senator CARPER. Times have changed. Chairman GREENSPAN. Times have definitely changed. And I cannot add terribly much to this, but hope that the obvious business uncertainty which the lack of a resolution of this question is creating can be expeditiously resolved. Senator CARPER. Thank you, sir. Chairman SHELBY. Senator Dole. Senator DOLE. Mr. Chairman, I am concerned about how movement in the Chinese economy could affect us, and I would like to ask you about this. The Chinese, of course, have a very weak banking sector. Half of their loans are bad. There are signs of a growing bubble in their commercial real estate sector, a growing U.S. currency reserve at $415 billion as of January. Chairman Greenspan, while the Chinese economy is small compared to ours, how concerned are you about these and other potential problems in the Chinese economy? Recently, China appeared to VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 15 have realized that their growth is not sustainable, and have taken steps to slow down their rapid growth. One of the areas where they have pulled back is with steel production. Recently, I have been contacted by our transit authorities, both in Charlotte and Raleigh, North Carolina, because they are going to be starting soon on construction, and they have expressed deep concern on how this rise in steel prices is presenting real problems to their cost projections. I have to imagine that commercial real estate and other industries will be impacted and will suffer because of these cost increases. Could these steps by the Chinese Government to slow down their economy potentially trigger inflation in the United States with continued globalization? Can China, in combination with other countries with high growth, export inflation to the United States, and if so, do we have any monetary tools to combat such a problem? Chairman GREENSPAN. Senator, the Chinese economy is slowing down, and it is a deliberate effort on the part of what is a partial, centrally planned economy with an ever-growing market segment, and it is a very tricky policy that they have to implement to get it right. The rate of increase in investment has gone down very materially on a year over year basis, and clearly through the second quarter, where their quarter-by-quarter rate of growth really slowed virtually to a halt, they exhibited considerable removal of very major elements of growth. However, they do not seem to be sinking much further. In fact, their exports look, frankly, a little bit better in June, and overall, it is very likely that, largely because of the nature of the central planning, they will try to calibrate it in a way which improves the outlook. But their economy, as you point out, is still relatively small in the areas which impact directly on us. I find it most unlikely that their contraction of steel product, as large a producer as they are, will induce any significant rise in steel prices. There has been, as you know, some significant decline in steel prices in the United States, but judging from the scrap prices in recent weeks, it has come back a bit in part because the demand is still reasonably strong. I do not believe that the Chinese can export inflation to us. It is extremely difficult to do that, and they are not the type of economy which so interfaces with us that would create such a problem. It is important that they move as quickly as they can to a market economy, and I think that they are trying to move in that direction. But until they have succeeded, they will still have the types of problems that you suggest. Senator DOLE. The Bureau of Labor Statistics reported that in June that the U.S. economy created about 112,000 new jobs nationwide. I have been amazed that some have stated that since this number was less than half of that projected for new jobs, that somehow this is an indication that our economy is headed back into recession again. For the record, how do you view these lower-than-expected job figures? Chairman GREENSPAN. Senator, we have approximately 130 million people on payrolls in this country, and I am surprised that we VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 16 can estimate the change from month to month as accurately as we do. The range is really quite large. I know a number of people looked at those data and took it as some indication that there is some significant weakness developing. If that were the case, I think we would have seen it in a marked pickup in initial claims for unemployment insurance, which of course we have not, and all of the other qualitative indicators we have currently in the third quarter suggest that employment is continuing to expand. And indeed, while there has been weakness in June, and a number of your colleagues mentioned this, I might say that July seems to be somewhat better, even though we are going through a soft patch. Motor vehicle sales, which for example, were an important part of the weakness in the June retail sales data, as least so far as the first 10 days were concerned, shows a very significant snap-back largely because discounts have been expanded again. Our anecdotal data on new orders arriving during the month of July showed that the system is holding up. There is no real underlying evidence of any cumulative weakness here. It is nonetheless the case that the little bulge in inflationary pressure seems to have created a soft patch here, and it is something obviously we are watching very closely. Senator DOLE. Just one final question. Recently, some have suggested that most of the new jobs being created in the last year are paying an average $1,500 to $9,000 less than those jobs lost over the past few years. Obviously, often an unemployed person that finds a new job, they may be at a lower salary for a short time. But does your analysis show that the current jobs being created are basically lower-wage jobs with little or no benefits? Chairman GREENSPAN. The answer is no. But let me say that there are several different statistics that I think are important. The one that you cite is an important fact, namely, that people who do lose their jobs tend to have difficulty restoring the level of their original wage for quite a while. And that is part of the process which goes on in the very significant churning in the labor market. We have looked at this question in the broader sense of are we essentially downgrading the types of jobs that are being created, say, over the past year, and the answer is we find very little evidence of that. There are essentially two ways to interpret how one should evaluate this. One, is to look at the question as to whether the growth in jobs is disproportionately in industries where the average wage rate is higher than average for the economy as a whole. There seems to be a slight indication of a decline in that regard, meaning more workers going into industries with slightly below nationwide average earnings. And two, when we look at it in the context of occupation, where clearly one gets a sense of what is happening to particular types of job slots, the answer is exactly in the opposite direction. Now, these are not contradictory. In other words, you can have an increasing spread within industries where there is a greater skill dispersion while still having the average of the industry go down. But the bottom line in all of this is these data are so marginal that the conclusion that there is anything going on other than VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 17 just average expectation of changes in jobs does not seem, in our judgment, to be supported by the underlying data which is broadly available. Senator DOLE. Thank you, Mr. Chairman. Chairman SHELBY. Senator Sarbanes. Senator SARBANES. Thank you very much, Mr. Chairman. Actually, Senator Dole touched on a couple of issues I wanted to address. One is the current account deficit, which is now at about 5.5 percent of GDP, the highest level, as I understand it, in U.S. economic history, at least according to Pete Peterson, who said in an article in The Washington Post on Sunday, ‘‘This deficit requires us Americans to borrow about $2 billion from foreigners every working day. No expert I know believes that this is sustainable.’’ And, Chairman Greenspan, if I recall correctly, you have stated before this Committee in the past that a current account deficit of this magnitude is not sustainable, as I recall. Chairman GREENSPAN. That is correct, Senator. Senator SARBANES. Now, I am concerned not only about the deficit but that the source of the foreign borrowing has shifted. In its February report, the Fed found, ‘‘The financing counterpart to the current account deficit experienced a sizable shift in 2003 as net private inflows fell while foreign official inflows increased. Foreign official purchases of U.S. assets surged to record levels in 2003, with the accumulation of dollar reserves particular high in China and Japan.’’ I have a chart here that I want to show this surge and which I think highlights that our dependence on foreign capital has increasingly been supplied by foreign governments, specifically, according to the Fed, China and Japan. And this is the foreign official assets in the United States. This is 1976. This is 1993. And then we see the steady pace—and then it is almost going up at a perpendicular rate now. I find this troubling. I guess I find any chart that all of a sudden seems to leap out in some different direction from what we have generally been experiencing a matter of concern. What is happening here and what are its implications? Are China and Japan doing this to manipulate the currency in order to gain a trade advantage and help their export position? And what are the potential consequences for us in this scenario, particularly assuming it might continue? Chairman GREENSPAN. Well, let me answer the second part of your question first. We have obviously been monitoring these flows very closely for precisely the reasons that you indicate. It is turning out that the impact on the international markets on the value of the dollar and, hence, on the value of the United States’ internal economic system from these shifts between foreign private funding of our current account deficit to last year’s very significant public funding, it is turning out that in 2004 we are beginning to see a reversal of that without any serious consequences, meaning that the shift between foreign public financing of the deficit and private financing is not a significantly large issue. The Japanese, for example, stopped intervening to accumulate American dollars in March of this year, after very heavy purchases earlier this year, and the Chinese purchases have flattened out. We see very little evidence VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 18 that the shift of that official financing to private financing is impacting on the economy in general. Nonetheless, there is no question that, as I am sure you are aware, almost half of Federal marketable debt outstanding that we issue, is held abroad. And these trends are significant, and they do raise serious questions. But so far, the flexibility of our international financial system has been such that we have had very little problem in financing these very large deficits. Now, as I have testified before this Committee on innumerable occasions, this cannot go on indefinitely because at some point we are going to reach a status where our net debt to foreigners—currently a little under a fourth of GDP—will get exceptionally large, and the holding of dollar assets as reserves for both the private and public sectors abroad will become abnormally large relative to their needs and they will stop purchasing dollars. That will have an obvious significant impact on us when it occurs. I do not know when that date is. I know at some point in the future something of that nature has to occur, unless there are shifts in the world economy such that our trade deficit and, therefore, our current account deficit falls measurably. If that does not happen, then we are going to see a clear indication on the part of foreign investors in the United States to start to hold back and diversify, even if the rates of return here remain high. Since we are at unprecedented levels—and it could conceivably be higher, as I indicated in a speech earlier this year—at some point it has to shift. Senator SARBANES. I want to touch on one other subject that Senator Dole raised, and that is the weakness of the labor market. The participation rate between the first quarter of 2001 and the second quarter of 2004 dropped to such an extent that actually we would have 2.5 percent more people in the labor force today if the participation rate was what it was just 3 years ago. In June, 21.6 percent of the total of unemployed have been unemployed over 20 weeks. This is quite a change, as we can see here, in terms of having crossed above the 20-percent line and staying up there, which actually now it has been there for 21 months. It surpassed the record set from 1982 to 1984. Finally, the job growth, although we have had some job growth in recent months, we still remain below where we were in the level of jobs 39 months ago when the recession began. In every economic recovery since the Depression, the economy has recaptured all of the jobs it lost well within the 39 months. So this is the longest job loss recovery. And, in fact, there is a very marked contrast between the current recovery and the average of post-war recessions. If we just match the average, we would have about 6 million more jobs currently. Now, looking at all of this, and, of course, you know, we are getting a lot of comment in the newspapers and in the magazines about this very difficult problem, it seems to me we have not been able to bring jobs back online in a way that gives us encouragement in terms of putting people back to work. We still have this job gap, this slack in the labor market. How do we explain it? I mean, it is a very marked contrast—— Chairman GREENSPAN. It is. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 19 Senator SARBANES. —where we are today with previous recoveries. Chairman GREENSPAN. Senator, I think there are two basic forces at play here. The first is that productivity growth over this period has been extraordinarily large, far in excess of the rate of increase in output per hour that was experienced during other periods that you draw on the average of your chart. And so as production picked up, we were not hiring, basically for reasons which I indicate in my prepared remarks, and that has continued, not to the extent that it existed last year, but productivity is still running above the averages of a goodly part of the period which you have on your chart. Second, we have had an exceptionally shallow recession—in fact, the shallowest recession in the post-World War II period—so that the normal rebound that we experienced in a lot of the recoveries which are part of the average that you show on your chart was not possible. If, as I suspect is the case, the growth rate of productivity will slow down from the extraordinary levels of last year, growth will continue in payrolls, and at a fairly significant pace. I do not know that I can pinpoint the actual number. It will depend crucially on every tenth of a percent in the productivity numbers and obviously in the GDP. But it does not look as though the growth in employment is stalling, though there is no question that it is moving up at a pace far less rapid than you point out has been our history. Chairman SHELBY. Senator Bunning. Senator BUNNING. Thank you, Mr. Chairman. Chairman Greenspan, how concerned should we be about the June housing figures, 8.4-percent reduction following a 3.5-percent reduction in May? Chairman GREENSPAN. Senator, the figures for June came out below where we would have expected them to be, but not appreciably. The reason essentially is that as mortgage rates began to move up several months ago, we began to see a significant pick-up in housing sales, people endeavoring to get in under the wire, so to speak. The result was clearly a borrowing of housing starts from the future. And that I think is part of the June experience. If that is the case, then we would expect some short-term recovery from the June decline, and, indeed, that is suggested in the detail that we get along with housing starts, which tries to measure the permit data that go along with the starts data, coupled with backlogs of unused permits. And those data indicate that a significant part of the drop, almost half, is not reflected in the decline in so-called adjusted permits, meaning for single-family dwellings it would be permits of single-family dwellings plus the number of starts in nonpermitted issuing areas. Those numbers are down roughly half what the actual starts figure is. So the number is weak, there is no question about that, and definitely below where our expectations are. But we do not believe it is a cause for concern. Our general forecast, as it has been for quite a while, is that housing starts which have come up at an extraordinary pace in recent years are very likely to shade lower over the next couple of years. It is hard to maintain the pace that we are maintaining, but we do not expect that the fall-off will be abrupt VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 20 or significant. And as a consequence of that, we do not perceive the June figure to be a harbinger of worse to come. Senator BUNNING. Does the June producer price index drop make you feel better about inflation or not? Chairman GREENSPAN. Obviously somewhat better, but still, a number of the prices that are built into that index were rising recently at a somewhat faster pace than we expect in the context of maintaining long-term price stability. But it is the case that the modest slowdown in the inflation rate was welcome. Senator BUNNING. Let me ask you, you talked productivity and how important it was for the job market and other things. What is the Fed’s view as far as additional productivity gains as we look down through the third and fourth quarter of this year? Do you see an average gain of productivity? Or where are we? Chairman GREENSPAN. It is one of the most difficult statistics to forecast, Senator. We can forecast aggregative demand reasonably well, plus or minus a half a percentage point annual rate, most of the time. We know that when we have profit margins at the levels they are now, there are very significant incentives on the part of business to expand their workforces and in the process be less focused on cost reduction, which is the major component of productivity growth. So it is difficult for us to make judgments as to the path of productivity or exactly how the increase in the GDP will be distributed between that produced by increased employment and that produced by increased productivity. Our general judgment is that it is probably going to be average, but the truth of the matter is we have very little experience in dealing with productivity numbers as high as they have been, and our forecasting success in the last year or two in trying to judge where these numbers were likely to go has been one of our poorer set of projections. Senator BUNNING. The last question, and this has to do with energy costs, the cost of crude oil, the cost of natural gas, and everything. How much more cost increase can this economy stand before it becomes a very significant factor in the overall well-being of the economy? Chairman GREENSPAN. Senator, that is one of the most important questions that we focus on. It depends in part on what these oil prices or gas prices are going to rise from here. Their impact on the economy will depend on how fast they are moving, because what our data show, especially for oil, is that over the longer run, say a series of years, the elasticity of demand for oil with respect to price is pretty high. In other words, if prices stay high, after several years we will shift the structure of our economy to less oil-intensive structures. The nature of our light motor vehicle stock, for example, will shift significantly to types of cars and trucks which consume far less motor gasoline. And the same will hold true in lots of other areas of the economy. If, however, prices spike in the short run, where those adjustments are not possible, then history tells us it has significant impacts. And, indeed, that is what happened to us in the latter part of the 1970’s. So it depends very critically, if we are to run into a problem, whether it is a gradual change in price or whether it is a short-term change. But as I indicated earlier, even though we are VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 21 approaching record nominal prices of crude oil in the world, we obviously are well below where we were, for example, in 1979 in real terms. Senator BUNNING. Thank you. Chairman SHELBY. Senator Reed. Senator REED. Thank you, Mr. Chairman. Chairman Greenspan, one of the issues we have talked about on several occasions is this lack of growth in wages and earnings for workers, and that is a critical issue. Increases are necessary to meet increased obligations of housing, education, health care, but also there is a distributional effect which you have pointed out, where higher-skilled workers seem to do okay and lower-skilled workers seem to be falling behind, creating social tensions. Senator REED. Looking at the numbers I have, over the last year average hourly earnings decline 1.1 percent in real terms. Average weekly earnings declined 1.4 percent. This is in a situation where the economy is recovering. We are seeing GDP growth and, as you point out, where productivity has been growing significantly, allowing, one presumes, increases of wages. Can you explain the apparent contradiction between these falling wages and increased productivity and expansion? Chairman GREENSPAN. Senator, I believe—I think it was the last time I was here—we had a fairly extensive discussion in the question-and-answer period on the issue of education. I believe you were participating in that. Senator REED. That is right, and can I say, I think this is a slightly different question, because we are not talking about people entering the workforce with different skills. We are talking about apparently workers that are already employed within a year. I would think that factor would not be the most critical. Chairman GREENSPAN. In a way it is, and the reason I say that is that, as I tried to define the problem back then, what has been happening to our labor force is that we have not been able to keep up the average skill level in our workforce to match the required increases of increasing technology. And what that has meant has been that rather than getting an ever increasing number of college graduates at a far faster rate than we have been getting them and, hence, higher skills, to create a surplus or at least a significantly large supply of skilled workers relative to the demand in order to keep skilled wages down and because you move up people from the lesser skilled areas to the skilled, you lower the number of surplus workers in those markets for lesser skilled and, hence, remove the downside pressure on wages. In other words, this is an issue which has been regrettably going on for 15 years, or thereabouts, creating an ever increasing opening up of the skilled versus lesser-skilled gap. And as you point out, if you put the wage changes in nominal terms, for the lesser-skilled they have been growing in many parts of the last 15 years at less than the increase in the Consumer Price Index. That is, of course, not true for wages and salaries as a whole. Indeed, the ratio of average hourly earnings for supervisory workers that one can infer from the data systems that we have, have been rising relative to average hourly earnings, which you cite, for quite a considerable period of time, and they account for 40 percent of the aggregate VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 22 wage and salary totals. So we are getting a problem here which I think has got to be addressed, and as I had indicated last month, I think the effective increase in the concentration of incomes here, which is implicit in this, is not desirable in a democratic society. Senator REED. We have several problems. One problem is training and retraining individuals and, you know, if you are starting off with high school or elementary children, you maybe can have an effect. That is 5 or 10 years out. The situation is: What do we do in this year, next year, and the following years to raise the wages of people whose skills cannot be—— Chairman GREENSPAN. I think the way you raise those wages is you remove the large number of younger people whose skills should be upgraded significantly from being an overhang on the job markets in which we have got, from as best I can see, an excess of supply over demand, and that has got to be changed. Senator REED. I do not see a ready policy there, but I see a concept. Chairman GREENSPAN. Whether you have a policy or not, I think it is right to get the analysis right. Because if we do not understand what is causing this, our policies are not going to address what is a significant problem. Senator REED. What specific policies should we adopt today? Chairman GREENSPAN. Well, I mean, if we can move—— Senator REED. Because that helps us understand. Chairman GREENSPAN. First of all, we know that from the fourth grade to the twelth grade, our children somehow are falling behind international standards. Senator REED. Mr. Chairman, I accept that, but policies that are applied to people currently in the workforce today, adults who are working hard, they are seeing corporate profits go up dramatically. They are getting very little share of those corporate profits as the data indicates. Chairman GREENSPAN. I think what you are going to find is that that share will now start to increase. Senator REED. Now, one of the places that this share increases is labor costs, because employers will spend more for health care and for other benefits, which workers appreciate. That still does not increase the take-home. Chairman GREENSPAN. I agree with that, and what I am saying is that, as I indicated I think the last time I was here, virtually all of the increase in productivity during the year starting in the first quarter of 2003 shows up not as real wages, but as increased profitability. That stopped some time in the last several months, and what history tells us is that the shift now goes in the other direction, and you get, with a delayed effect, the increased productivity showing up as real wages overall, and I would think that while certainly supervisory workers are going to contribute or share significantly, it will also be true of the 80 percent of payrolls which are nonsupervisory workers as well. Senator REED. My time has expired. Thank you, Mr. Chairman. Chairman SHELBY. Senator Allard. Senator ALLARD. Thank you, Mr. Chairman. I want to pose a housing question to Chairman Greenspan. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 23 Low mortgage rates I think for the last year have probably contributed substantially to increased sales of existing residences, helping to boost the national homeownership rate to the highest level ever. Could you please discuss your views on what lies in store for housing, particularly in terms of other factors such as consumer confidence, unemployment rates, as well as wage rate? And what trends do you see for the homeownership rate? Chairman GREENSPAN. Senator, as you know, the homeownership rate in the United States has risen quite materially in the last decade. We went from about 64 percent to probably around 69 percent now. We are seeing that household growth is holding up reasonably, and indeed a significant part of that is actually the result of immigration. And with household growth holding up, and the inclination of renters to move into an owner-occupied status, we still seem to be getting a fairly pronounced growth in homeownership, and indeed the broad policies and effectiveness of our mortgage markets are clearly working in that direction. To the extent, obviously, that homeownership becomes a critical continuing factor, it creates big demand for single-family dwellings, and that is the reason why we have had approximately a million and a half plus single-family dwellings annually for a number of years as homeownership has moved forward. Now, obviously, as we get into ever higher numbers, there is some amount of desire to be a renter, not an owner. So at some point we will slow down, but I see no evidence at this stage that slowdown is occurring, and as a consequence I think the underlying demand for housing is going to remain reasonably solid, although presumably less than the peaks that we have seen in recent months. Senator ALLARD. I also understand that the number of jobs coming from—to change the subject—other countries to the United States is growing at a faster rate than jobs lost overseas. According to the Organization for International Investment over the last 15 years, the numbers of manufactured jobs insourced, coming into the United States, have grown by 82 percent, while the number outsourced overseas grew by only 23 percent. This study indicated that these insourced jobs are offering higher pay than those outsourced. Furthermore, last month the Labor Department released the first official Government study that revealed only 2.5 percent of the 182,456 workers who lost their jobs in the first quarter of this year were due to jobs being sent abroad. Would you please share your thoughts on these numbers, and is outsourcing really taking away as many American jobs as people are claiming it is? Chairman GREENSPAN. Senator, I have not checked the specific numbers, but it does not seem different from what I am generally aware of, depending on how you define a lot of these categories. We are in a global economy, and increasingly so, and it has been to the advantage of the United States to be in this global economy, and indeed in the position of leadership, which we have been in, and it has contributed, in my judgment, to a very significant increase in standards of living of the average American. As the world becomes ever more complex and as we find we go to ever increasingly more sophisticated levels of specialization in VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 24 the division of labor, it necessarily means that we reach out to engage in trade with the rest of the world at an increasing rate, and indeed, the aggregate amount of trade worldwide has been growing almost every year relative to world GDP for the last half century. This means that you are getting imports as a share of domestic GNP’s, on average, rising. And as a consequence of this, we are engaged in ever more insourcing and outsourcing, depending how you want to define it, and while it is certainly the case that outsourcing as estimated for the current period is quite small, I think it is going to be rising, and I do not think that is bad. I think that is going to be part of a broader expansion which will lead to higher standards of living in this country and an ability for our expertise to be most effectively applied in international markets. Senator ALLARD. Mr. Chairman, may I follow with a question on protectionism? Chairman SHELBY. Go ahead. Senator ALLARD. You have cautioned repeatedly about the danger of protectionism, and that it could provide a barrier to the economic growth that has picked up in recent months. Could you elaborate on that for us, please? Chairman GREENSPAN. Looking back at the post-World War II period, this very expansion of globalization which I have referred to is also capable of being viewed as an ever wider degree of international stimulus to the United States, and indeed, I think that our ability to engage the international community has significantly enhanced our standard of living, as I just indicated. But it depends on that expansion continuing, because it is the rate of change in expansion which creates the level of economic growth here, and I think that what one requires to recognize is that if the Doha Round, for example, fails to be completed—and there is some concern, as you know, about how that is evolving, especially this month—I would have a concern that we would find that losing this stimulus from the international system will work negatively on economic growth in the United States, and I, accordingly therefore, hope that we can continue our efforts to make sure that globalization continues if we are to reap the benefits of it. Senator ALLARD. Thank you, Mr. Chairman. Chairman SHELBY. Senator Bayh. Senator BAYH. Thank you, Mr. Chairman. Chairman Greenspan, I would like to follow up on Senator Sarbanes first line of questioning with regard to our growing dependence upon foreign borrowing and the consequences for our domestic economy. I think you indicated that at some point we will reach a position where the rest of the world’s appetite for U.S. denominated assets has been satiated. We do not know when that point will arrive. Are there any studies under way to try and determine, using portfolio theory or other types of analysis, when that point might be reached? Chairman GREENSPAN. Senator, it is very interesting because there has been a very considerable amount of work endeavoring to unearth where those points are. We do know that in developing countries in the past, as individual countries have gotten up to ever higher current account deficits, they turned around. In some cases they got to double digits before they turned around. But they usu- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 25 ally, if the economies were flexible, adjusted without any real crisis occurring. But a number of us have been trying to figure out whether there are leading indicators as to when this type of thing turns. What has been examined are all the various different types of flows, private flows, equity flows, debt flows, flows of governments. What we find is that none of them work. What that says is that the markets internationally are so efficient that the substitutability of various different instruments to finance, for example, our current account deficit, is extraordinarily high, and while it clearly affects prices of bonds and stocks and exchange rates in the process, the adjustments continue in a way which it is very difficult to determine when certain types of flows are occurring and when the aggregate deficit is about to turn around. Senator BAYH. Let me follow up. I was concerned about part of your response to Senator Sarbanes, where I believe you indicated that when the satiation point arrives, that even a higher rate of return on U.S. denominated assets would not lead them to acquire more of our assets, which means that if the deficit has to be financed entirely domestically, the increase in interest rates and other adjustments that might flow from that would have to be even more severe. I find that potential to be rather alarming. Chairman GREENSPAN. I think the way I put it, I said that even if rates of return stay high. I did not say necessarily ‘‘increase.’’ The reason I put it that way, Senator, is that if you think about rates of retutn being high in the United States, and people therefore continually wish to invest here, you can conceive of a situation in which even though the rate of return does not change, they will eventually say, ‘‘I am over committed. I have too much. I want to diversify, even though I will get a lower rate of return.’’ Senator BAYH. Does that not imply more adverse consequences for us domestically? Chairman GREENSPAN. If we get to the point where there is a cliff effect, obviously, it would, but I think we are so flexible and the markets are so flexible, and I assume we will keep them flexible, that the international system does not work that way. It works incrementally. But you are quite right. I mean ultimately if we cannot continue to attract investment at current interest rates or current rates of return, and we still are running very large trade, and therefore capital account deficits, all economic theory says that rates have to rise. I am a little suspicious of that conclusion largely because of a lot of those conclusions are based on the way the markets functioned 30, 40, 50 years ago, when remember, they were not flexible. We had all sorts of capital controls and all sorts of rigidities. But I do not think we can readily dismiss it out of hand as a possibility. Senator BAYH. Our focus as policymakers, when we are concerned about this issue, should be on maintaining the flexibility of the international financial system and hoping there is not an exogenous shock of some kind that would lead to a rapid readjustment. Chairman GREENSPAN. Senator, I would generalize that. I say the experience we have had in the last decade has indicated that the most important thing we can do with respect to policy, both domestically and internationally, is to create flexibility, because it ob- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 26 viously is a factor in the resilience of an economy to respond to shocks, and indeed, I do not think that we could have successfully gotten through September 11, for example, unless we had an exceptionally flexible financial and economic system domestically. Senator BAYH. My final question, Mr. Chairman, and thank you for this discussion, it is something I am concerned about. I hope that the flexible nature of the markets will enable us to make a gradual adjustment but I am somewhat concerned. I would like to just change the topic and ask my final question. A recent Fed study entitled ‘‘The Price and Quantity of Residential Land in the United States’’ was just completed, and concluded that over the next 3 years in the aggregate, housing prices on a cumulative basis, will go up, they predict, 2.6 percent, which is the lowest increase on record according to the report. Given the role that real estate values played in getting us through the recent softness and sustaining consumer demand, is that not the source of some concern? Chairman GREENSPAN. It would be if it were an abrupt change. Remember that we have had a fairly significant rise in real residential prices in recent years, and historically if you look back, that is not unusual. But what does tend to happen is that we go up for quite a while, and then we flatten out, and I do not know what the actual number is. I have not read the details of the study, nor do I know whether the data are accurate in that regard, but I certainly do not—— Senator BAYH. If you are having a restless night and have trouble nodding off, I recommend it. Chairman GREENSPAN. I find the best thing to do if I run into that occasion is to read some of my speeches. [Laughter.] Senator BAYH. Thank you, Mr. Chairman. The reason for my question was simply—by the way, that has been said about mine as well—is your sanguine view about the sustainability of the recovery, and it seems one of the legs that we have relied upon recently is—I may perhaps be ameliorating a little bit here going forward, but you think that will be more than offset by other things. Chairman GREENSPAN. Yes, that is our forecast. Senator BAYH. Thank you. Chairman SHELBY. Senator Bennett. STATEMENT OF SENATOR ROBERT F. BENNETT Senator BENNETT. Thank you very much, Mr. Chairman. One of the advantages of coming a little bit late is that you get to hear all of your colleagues ask your own brilliant questions before you can get to them, but you can also take notes on the things that people say. You said in response to Senator Shelby, when he was talking about where interest rates should be, and you very appropriately and predictably did not give us a number. But you said you were hoping we could get back to neutrality. So let me take one more stab at it and ask what number is neutrality? Chairman GREENSPAN. I knew you were going to ask that question, Senator. Actually, we do not know what neutrality is until we get there. The reason I say that is the notion of stability, or a state VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 27 where the financial markets are in some form of equilibrium, depends on a number of things. You can tell whether you are below or above, but until you are there, you are not quite sure you are there. We know at this stage that at 11⁄4 percent Federal funds rate, are below neutral. When we arrive at neutral, we will know it, and we can take whatever actions we consider desirable or not desirable at that time, but I think that estimates that people try to make as to where that so-called neutrality is, fall in a fairly broad range, and I would just choose not to speculate where it is. Senator BENNETT. You said to Senator Allard that outsourcing is rising and that is good. Chairman GREENSPAN. It is very low at this stage, but what I was saying is, as part of the globalization process, which I think is good for the American economy, and probably an inevitable component is increasing trade of all sorts, and therefore, outsourcing both into the United States and out is likely to rise. And as Senator Allard suggests, a number of studies say at this stage that the outsourcing into the United States may very well be larger than the outsourcing. I do not think this is a critical issue. I am really quite surprised at how big an issue this has become. I fully understand the real and serious problems that individuals have who lose their jobs in this process, and indeed, we should do whatever is required to make their lives better, but shutting off international trade as a means of doing that is essentially very counterproductive to everybody’s standard of living. Senator BENNETT. I happen to feel the same way. When you made the statement ‘‘that is good,’’ I thought it is a good thing he is not Chairman of the Council of Economic Advisers, because if you were, tomorrow morning there would be calls for his resignation and attempts on the part of the political arm of White House to distance themselves from your testimony, because that is exactly what Greg Mankiw said to the Joint Economic Committee, and that is what happened when he said that. Chairman GREENSPAN. I think the response to Greg Mankiw’s remark was unfortunate. Senator BENNETT. Yes, and you are not going to be invited to Lou Dobbs’ show any time soon. [Laughter.] Let us talk for just a little bit about oil prices. Oil is traded in dollars. The dollar is losing its value vis-à-vis the euro, the British pound, and some other currencies. Is there a temptation therefore on the part of OPEC to get their real return back up to what it might have been by raising the denomination of a barrel of oil in dollars? In other words, is it in their interest to try to take the price of oil in dollars up to the point where they are getting as much real income as they used to get when the dollar and the euro were in parity? Chairman GREENSPAN. Senator, I do not think that the particular denomination in which oil is priced affects the overall price. In other words, the way I would put it is we could trace oil prices in euros, for example, or in dollars or in yen, and while there are certain technical issues which are a slight problem here, if we were to officially switch the unit in which oil was denominated, I do not VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 28 think it would change the price patterns in dollars, yen or euros in any significant manner. Senator BENNETT. I do not think it would either at the moment the switch were made, but if a dollar is seen as continuing to depreciate with respect to other world currencies, is there an incentive over time for an OPEC country—— Chairman GREENSPAN. Oh, I see. There obviously is a sense in which if a dollar purchases less in other currencies, that one could conceive that they might try to raise prices in order to offset that. Senator BENNETT. Offset the declining value of the dollar. Do you see that in OPEC strategy? Chairman GREENSPAN. Well, they are certainly not doing it now. They essentially have opened up the taps as best one can judge. Supply is increasing, but demand overall is increasing more, and that is what the difficulty is. I cannot say to you that I see any evidence that OPEC is constraining production for the purpose of raising price at this particular time. Senator BENNETT. My observation of the current increase of the price of oil has more to do with uncertainty over the situation in Russia than it does with OPEC strategy. Do you have a reaction to that? Chairman GREENSPAN. Let me say this. I am talking about shortterm strategy obviously. There is a long-term strategy about the capacity of crude oil in OPEC producing countries, which is a different issue, but clearly, the problems in Russia involve a significant concern about a curtailment of crude oil production if Yukos went into bankruptcy and it was dismembered or something like that. That was clearly in the marketplace. But also in the marketplace is something which is disturbing in the sense that the very long-term futures, that is, those for 2010, for example, have risen very substantially in recent years, which is unusual because in years past the so-called long-term supply price of crude oil in dollars was about $20 a barrel, and irrespective of what the spot price was, the long-term price stabilized somewhere in that $20 area. In the last several years, the long-term price has gone up very substantially, and it is not because of cost. It is basically fear of long-term supply in a number of the areas of the world where geopolitical concerns have risen. Senator BENNETT. Thank you. Chairman SHELBY. Senator Dodd. Senator DODD. Thank you very much, Mr. Chairman. Thank you, Mr. Chairman, for being here today. I was not here for your confirmation hearing, but let me once again say I think of how fortunate we are in this country that you are the Chairman of the Federal Reserve, and you have done a tremendous job over the past 16 years. Chairman GREENSPAN. Thank you very much. Senator DODD. I suspect the next 16 years are going to be difficult ones, and in your contribution to this discussion, debate is very much appreciated. Let me begin with those comments. Senator Schumer, when he was speaking a little while ago, mentioned that these two wings, like a wonderful physical analogy, talking about monetary policy and fiscal policy. I know you are here to give a monetary policy report, but I cannot resist the oppor- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 29 tunity to raise issues with you involving fiscal policy. We are policy setters up here. We have about 20 working days by my calculations, between now and the adjournment of this Congress, which is not a great deal of time left. Two issues that I would like to raise with you, both of which you have commented on in the past. In fact, you did again today in part. One has to do with the growing and dangerous gap between those who are more affluent and those who are not in the country. The second issue has to do with the Federal deficit. I recall sitting here, it was about 42 months ago, when you were sitting in that very chair in January 2001, and we had this incredible conversation, that is, you did with the Committee, about the potential effects of eliminating the national debt and how we should respond to it, a conversation I suspect many of us only a few years earlier never would have imagined occurring. Chairman GREENSPAN. Nor I. Senator DODD. All of us have in our minds those clocks, whether it was in New York or Washington, that would tick off every nanosecond the accumulation of debt, and here we were, only 42 months ago, literally talking about the implications of eliminating the national debt. You spoke at that time about realistically getting to the level of Federal debt that is an effective irreducible minimum. I am quoting you from your testimony on that day in January 2001. Let me begin if I can with the gap question and wealth, because some of the things we have heard today and some of the statistics you point to, indicate that that is going on. I do not know if you had the opportunity this morning to read an article in The Wall Street Journal entitled ‘‘So Far Economic Recovery Tilts to the Highest-Income Americans.’’ The article quotes Dan Maki, M-a-ki, a former member of the staff of the Federal Reserve and currently an economist. Chairman GREENSPAN. Dean Maki, I believe. Senator DODD. What is it? Chairman GREENSPAN. Dean. Senator DODD. Dean, yes. He is an economist today with JPMorgan. He says, ‘‘Today the recovery’s primary beneficiaries have been upper-income households.’’ Your own testimony of course mentions a similar point when you find that increases in average hourly earnings of nonsupervisory workers have been subdued in recent months and barely budged in June, while also find an apparently more robust rate of growth for hourly earnings of supervisory workers. I wonder if I can conclude from your testimony here today that you would in general agree with Dean Maki’s findings, that the primary beneficiaries of this recovery have been upper-income households? He goes on, by the way, in the article, to compare purchases that are occurring in some of the high end value stores. Nieman Marcus sales are up 131⁄2 percent, whereas Payless Shoe Stores have seen sales fall by 1 percent, of low cost product. Putting that together, have we seen the wealthy, who were given huge tax cuts over the past 3 years, turn around and spend their tax cuts on these luxury items, while average workers of course have seen their wages stagnate? What are the implications? It worries me deeply. I think it VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 30 does you as well. If these trendlines continue, what happens to the social fabric of a country where those kind of gaps exist? Chairman GREENSPAN. I am not concerned about what people spend money on. That is not an issue so much. But it is the resource issue. Senator DODD. But as an evidentiary piece. Chairman GREENSPAN. Yes. I agree with Dean Maki’s conclusions. That is what our data show as well. That is the reason why I think, as I indicated earlier, that is very important to understand the process that is going on here and find a way to have public policy address it. My own judgment, and I think the data strongly support the underlying forces, is that the problem is essentially an educational issue, plus I would suspect it may have something to do with immigration policy as well. But we have been unable to create a level of skills which would enable a significant part of our population to earn skilled wages. Unless we can do that, I am not sure how we get out of this bind. Obviously, we could slow down the growth of the economy, stabilize our technology, try not to be innovative, and that will actually create a stabilization in the income shares. But that is scarcely an acceptable way to come at this. Rather than try to essentially curtail economic growth, we should determine why it is that the skills of our schoolchildren, which in the fourth grade internationally are above average, somehow deteriorate by the time they get to the twelfth grade to well in the lower echelons of children around the world. It cannot be that our children are somehow inferior. The fourth graders are not. And if they are not interior in the fourth grade, I do not know how they become inferior thereafter. So it is not the quality of the students. It is something we do wrong. I am not knowledgeable enough to know, but this is a crucial issue. Senator DODD. It would be worthwhile to have maybe a longer conversation. One of the factors I think is we—I think the high rate at one point in the Nixon Administration is we were spending something close to 6 percent of the Federal budget on secondary and elementary education in this country, the Federal Government was. Today, I think the figure is less than 2 percent. And when you look at disparities that exist within school systems, even adjoining ones or neighboring ones where I think the average of a noncertified teacher in a poor rural and urban school is hovering around 35 percent of the teachers not certified to teach the classes they are teaching, class sizes being huge, there are factors there that make it difficult for students to learn. I think we should look at our choices. We can come down to where we allocate resources and how we make choices between the issue of tax cuts for the top 1 percent of income earners versus investing in a No Child Left Behind bill, or special education funds and so forth that I think could contribute to that. But it is an interesting point and I appreciation your observation because I think it does contribute to it. Let me jump to the deficit issue, because my colleague from New York is here and I suspect he may want to talk about the same subject matter. I want you to use a little bit if you can here the VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 31 bully pulpit of this chair have you. Again, we are here from monetary policy. We have no budget. Not likely to get one. Maybe we will, but I doubt it at this point. We are going to be asked later this week to vote for a tax cut which we are going to be asked not to pay for. No matter how much you may find it attractive politically to be for it, there is no provision apparently to accommodate for the cost of it. We may be asked to vote for an omnibus appropriations bill, because we have only passed one appropriations bills, the Department of Defense appropriation bill. Otherwise, 12 appropriations bills have not been enacted. The House has done more, but nonetheless, not likely to reach some common agreement between the two. We are going to be asked to increase the debt ceiling by some $680 billion, therefore getting near $8 trillion in debt figures. That is in 42 months going from a projected, I think it was in excess of $3 trillion, surplus over 10 years to now $8 trillion in deficit. I know you feel strongly about this and it just seems to me we need to hear your voice again on this subject matter. That our fiscal policies are out of control here and we need some voices of discipline warning members. Again, I am not suggesting you come up with a policy solution, but I think we need to hear from you as often as we can. Along with the trend lines in the gap in wealth in this country are disturbing, the trend lines on Federal deficits are deeply alarming. And our inability or unwillingness to come to terms with them is a growing concern, it should be to all of us. I wonder if you might take a few minutes and express your views on this subject matter once again. Chairman GREENSPAN. Senator, let me just say that I think we are, at the moment, reaping some of the consequence of the failure to extend PAYGO and discretionary cap legislation in September 2002. You are dealing with long-term budgets, which has been something novel in this country in the last 20 years. It was not all that long ago, in the 1960’s and certainly in the 1950’s, that there were very few long-term programs. The F–4, for example, was a project which took a number of years in the military, and we had certain agricultural programs which extended, but we did not have very long-term commitments as we have today. The problem is that our ability to forecast what the budget will look like 15 years from today is extremely limited. We can estimate within a reasonable degree of accuracy where, for example, Social Security, a defined-benefit program, will ultimately come out because it is a defined benefit and forecasting only a limited number of variables will tell us where we are going to be. In contrast, we have extraordinarily limited understanding of the forces that are going to drive Medicare 15 to 20 years from now. We know that the recipient population is going to rise very sharply. But if we try to determine what benefit outlay per recipient is going to be, we would have a long list of things we needed to forecast. But the variance in every one of them is very large. As a consequence, the product of those variances creates huge uncertainty. Unless we have a process which, for example, has a means to control the long-term projections, for example, to have triggers in the programs, both taxes and outlays, which go off, so to speak, VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 32 when a program is significantly off the originally expected path. We clearly should be looking at the issue of sunset legislation, automatically requiring reevaluations of programs. The vast majority of programs will probably be extended by voice vote on the floor. But there would be an awfully large number of individual programs which really should be looked at. And if you look at them, some of them require major change, or elimination. We at the Federal Reserve, for example, have a process where every 5 years we scrub all of the regulations that we have built up over the years to determine which of them still are applicable. Had we not done that we would have had a huge number of regulations. So, I think what is wrong at the moment is that we do not have process. It is very difficult to vote on individual bills without the context of everything else. And 30, 40 years ago we did not need triggers. We did not need PAYGO. We did not need sunset legislation, largely because the vast majority of what the Congress voted on was relatively short term and you could make some reasonably good forecasts and reasonably good judgments. We can no longer do that. Unless we find that we can address process first and get the Budget Committees back in play and get the process by which the overall budget is constructed in the way we did prior to September 2002, I do not know how you figure out how to go forward. I do not think you can construct a Medicare program, or any amendments to Medicare, without some advertence to what the long-term fiscal outlook is, and I do not know how you do it without process. Senator DODD. Thank you for that. I guess I can conclude, at least in the short term here, your view would be that on the various proposals we have before us in the budget that PAYGO at the very least is something the Congress to endorse; is that correct? Chairman GREENSPAN. Indeed. Senator DODD. Thank you, Mr. Chairman. Chairman SHELBY. Thank you, Senator Dodd. Senator Schumer. Senator SCHUMER. Thank you, Mr. Chairman. And thank you, Chairman Greenspan, as well. Hearing the summary of your statement and your answers to questions, I guess if I had to summarize it I would say, the recovery is sustainable. That seems to be the tone. The disparity I think some of us face as we go around our States and our country is there does not seem to be a tremendous amount of confidence about that. You can look at two measures. One, consumer confidence has been relatively flat. We have the oil prices, which you mentioned. And for the higher income people, since we have talked a lot about disparities, the stock market has actually gone down since the good numbers have started going up. I guess the question I have, the first question I have is, why do you think that is? Does it have an effect on the economy? You mentioned terrorism in your statement. Obviously, that is something that is out there that is hard to quantify. Do disparate incomes create that? Does the deficit help create lower confidence? And how much effect, if this lower confidence that is not as optimistic—it does not seem that average people, the consumer end, whether it is higher end or lower end seem to have that kind of confidence. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 33 Businesses seem to have a little more confidence these days. But even they are saying that profitability, which was enormously high in the last few quarters, is going to decline some. Could you just talk a little bit about this phenomenon which is confusing in certain ways? Particularly the stock market. I am puzzled how the stock market has gone down. The Dow Jones has gone down 400 points as all these numbers are good. Chairman GREENSPAN. Senator, this is not atypical of a recovery. If you go back historically and read the records of the time when you know that subsequently things got extraordinarily positive, people were glum. You have to put it in context. With regard to today’s environment, for example, the June figures, and this soft patch we are going through, I do not recall a recovery in which there were not several soft patches. It’s the way the markets work. There is something different here, in a sense as you point out, that the level of confidence is less. The way we know that, or the way I would suggest is a indication of it, is we have for the first time in a quarter-century, or more than that I think, the aggregate of capital investment and inventory investment running less than cashflow. The typical pattern is that businesses when they are confident are expanding. They are borrowing, and capital investment expands way beyond cashflow. If you look at the debt markets, the corporate debt markets, they are barely moving. In fact, I think in June, the preliminary estimate is that corporate debt on balance declined. In other words, repayments were greater than new extensions because cashflow is so high. I think the reasons for that are largely the aftermath of terrorism. I still think there are concerns out there. Corporate scandals have created a really serious issue of caution on the part of business who are terribly fearful of doing things which are perceived to be inappropriate. So that there is this sense of general lack of charging ahead, which clearly was the case in the latter part of the 1990’s. It is likely that the mere aftermath of the 1990’s themselves had some effect. But it does not appear to be enough to hold back the gradual broadening we perceive to be going on. Some things go down, some things go up, but the markets and the economy continues to grow. The stock market does not always respond to good news positively, and in fact in most instances where the perception is that a rising economy or a booming economy will somehow create increased interest rates in the context where long-term or short-term profitability no longer has the upside to move as fast as it has, markets will go down under those conditions. So, I would say that the weakness in the stock market is a perfectly typical type of pattern that one sees over the years, and more generally that the way this economy is behaving with its obvious idiosyncratic characteristics, as all recoveries have, is nothing that we perceive at the Fed as particularly surprising. Senator SCHUMER. One more question, if I might, Mr. Chairman. Chairman SHELBY. Go ahead. Senator SCHUMER. Although I would just make a comment I made in my opening statement, sometimes maybe for the stock market and maybe for the economy, lower interest rates are better than lower taxes. That is a debate on the fiscal side that we have VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 34 been having here, although it affects you. I take it you would not disagree with that necessarily as long as underline—— Chairman GREENSPAN. I can conceive of situations in which you could be accurate. Senator SCHUMER. How about now? [Laughter.] Here is my other question. This is a bit off the topic but I had wanted to ask you this before. Last week, we had a very interesting hearing that the Chairman led on hedge funds. It was an interesting discussion and I, for one, have not made up my mind on this thing. I have a bent that regulation, if it is not heavy-handed, has been good for the markets. People complain about it, but it works, and it has led people’s view that our markets are on the level. The proposal made by Chairman Donaldson, who I know is your friend and whom I know you disagree with on this issue, he made a pretty good argument in saying, first of all, that 40 to 50 percent of the funds register now and there does not seem to be too many complaints. In fact, they voluntarily register. That he thought registration might increase because pension funds and other types of funds that are dealing with consumers and others might feel better with the registration. He mentioned that the financial cost was quite low. I think he said it would cost about $45,000 or $50,000 to do the registration, which for a large pension fund is a drop in the bucket, particularly given their profitability. And he seemed to feel that the act of registering would not create any kind of systemic risk—sorry, you said the systemic risk. But he felt that the act of registering would not get in the way of any kind of thing that a hedge fund wanted to do in terms of its entrepreneurial zest, activity, risk taking, et cetera. I am wrestling with issue and I think some of us on the Committee are, could you give us your views on this, particularly on the aspect of, does required registration cause—oh, one other point he mentioned, which made a difference to me since hedge funds are based in New York and I try to make sure businesses come to New York and not run away, that you would not have people go overseas. I had heard from some hedge funds, well, we will just go overseas. He said, it does not matter. If they had U.S. investors they would still have to be through the same—they would meet the same legal requirements and have to register anyway. Could you comment on the issue in general, and specifically your view about how required registration would affect the entrepreneurial zeal and zest, risk-taking of the hedge funds? Chairman GREENSPAN. Senator, I actually was writing down a few comments on this particular issue, not sure where I would use it, just to get my own thoughts. It will take a couple of minutes for me to read it. Let me read it to you, if you do not mind. Senator SCHUMER. That would be great. Chairman GREENSPAN. If you do not mind, with the Chairman’s acceptance. Chairman SHELBY. Yes, sir, go ahead. Chairman GREENSPAN. Hedge funds have become major contributors to the flexibility of our financial system; an issue I raised earlier. That development proved essential to our ability to absorb so many economic shocks in recent years. Hedge funds seek out the VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 35 abnormal rates of profit often found where markets are otherwise inefficient. Taking positions in volume, as hedge funds do, tends to eliminate the abnormal profits and the inefficiencies by aligning prices across markets and provides liquidity to markets. Successful or not, when those profit opportunities are perceived to be eliminated, individual funds move on to address other inefficiencies. But these above-normal profits have attracted a large number of new entrants seeking to exploit a possibly narrowing field of inefficiencies. Not surprising, the rate of return in this activity is reportedly declining. I would not be surprised if, with time, many of the new entrants exited, some presumably following large losses. Chairman Donaldson, who as you mentioned has been a good friend of mine for 45 years, is certainly right in wanting to eliminate fraud by hedge funds and other financial institutions. Fraud undermines markets and the efficient functioning of our economy. My problem with the SEC’s current initiative is that the initiative cannot accomplish what it seeks to accomplish. Fraud and market manipulation will be very difficult to detect from the information provided by registration under the 1940 Act. Fraud is almost always uncovered through complaints of counterparties or by accident, such as our uncovering millions of dollars of the new U.S. currency in Federal Reserve wrappings in Iraq. This is certainly true, namely the uncovering of fraud, in banking as we experience it, and I assume is also true for regulated broker-dealers as well. Even should SEC’s proposed risk evaluation surveillance of hedge funds detect possible trading irregularities, which I doubt, those irregularities will likely be idiosyncratic and of mainly historic interest because by the time of detection hedge funds would have long since moved on to different strategies. Should the existing proposal fail in achieving its goal, pressure will become irresistible to expand SEC’s regulatory reach in an endeavor to accomplish it set out to do. Hedge fund arbitragers are required to move flexibly and expeditiously if they are to succeed. If placed under increasing restrictions, many will be leave the industry to the significant detriment of our economy. Senator SCHUMER. So in other words, if I might, and I appreciate your statement. As I said, I am grappling with this issue and have not made up my mind, but you are saying registration in itself would not be detrimental. It might not accomplish what its advocates say, but could leave to other things that would become detrimental. Is that a fair summation? Chairman GREENSPAN. That is correct. Senator SCHUMER. Without the erudition that you have. Thank you, Mr. Chairman. Chairman SHELBY. Chairman Greenspan, it has been a long afternoon. I have a number of questions I am going to submit for the record. We appreciate your candor, your appearance as always, and we will be watching you and praying for our economy. It is doing well. Thank you. Chairman GREENSPAN. Thank you, sir. Chairman SHELBY. The hearing is adjourned. [Whereupon, at 4:55 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and additional material supplied for the record follow:] VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 98356.TXT BANK1 PsN: BANK1 36 PREPARED STATEMENT OF SENATOR WAYNE ALLARD Thank you, Chairman Shelby, for convening this important hearing. I always look forward to the opportunity to hear from Chairman Greenspan. I believe that the U.S. economy is on the right track. The economy is growing, payroll employment is up, and new and existing home sales set new record highs in May. This is good news. However, we cannot take the positive economic news for granted; Congress needs to do more to continue to promote a healthy economy. First, we need to address the looming problems in the various entitlement programs. Second, we need to continue to provide economic incentives through tax cuts, including making the previous tax cuts permanent. Finally, I believe the most important way that we can ensure the long-term economic vitality of our country is to control Government growth and spending. Congress will not spend the Nation into prosperity. Chairman Greenspan, you and I have discussed this point a number of times during your previous appearances before the Banking Committee, and I have always appreciated your comments in favor of Government restraint. Chairman Greenspan, I know that you have a very busy schedule, so I appreciate you taking the time to appear before the Committee today. I look forward to your report and the opportunity to raise several questions with you. ————— PREPARED STATEMENT OF ALAN GREENSPAN CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM JULY 20, 2004 Mr. Chairman and Members of the Committee, I am pleased to be here today to present the Federal Reserve’s Monetary Policy Report to the Congress. Economic developments in the United States have generally been quite favorable in 2004, lending increasing support to the view that the expansion is self-sustaining. Not only has economic activity quickened, but the expansion has also become more broad-based and has produced notable gains in employment. The evident strengthening in demand that underlies this improved performance doubtless has been a factor contributing to the rise in inflation this year. But inflation also seems to have been boosted by transitory factors such as the surge in energy prices. Those higher prices, by eroding households’ disposable income, have accounted for at least some of the observed softness in consumer spending of late, a softness which should prove short-lived. When I testified before this Committee in February, many of the signs of the stepup in economic activity were already evident. Capital spending had increased markedly in the second half of last year, no doubt spurred by significantly improving profits, a low cost of capital, and the investment tax incentives enacted in 2002 and enhanced in 2003. The renewed strength in capital spending carried over into the first half of 2004. Orders and shipments of nondefense capital goods have been on the rise, and backlogs of unfilled orders for new equipment continue to build. A key element of the expansion that was still lacking in February, however, was evidence that businesses were willing to ramp up hiring to meet the stepped-up pace of sales and production. Businesses’ ability to boost output without adding appreciably to their workforces likely resulted from a backlog of unexploited capabilities for enhancing productivity with minimal capital investment, which was an apparent outgrowth of the capital goods boom of the 1990’s. Indeed, over much of the previous 3 years, managers had seemed to pursue every avenue to avoid new hiring despite rising business sales. Their hesitancy to assume risks and expand employment was accentuated and extended by the corporate accounting and governance scandals that surfaced in the aftermath of the decline in stock prices and also, of course, by the environment of heightened geopolitical tensions. Even now, following the pattern of recent quarters, corporate investment in fixed capital and inventories apparently continues to fall short of cashflow. The protracted nature of this shortfall is unprecedented over the past three decades. Moreover, the proportion of temporary hires relative to total employment continues to rise, underscoring that business caution remains a feature of the economic landscape. That said, there have been much clearer indications over recent months that conditions in the labor market are improving. Most notably, gains in private nonfarm payroll employment have averaged about 200,000 per month over the past 6 months, up sharply from the pace of roughly 60,000 per month registered over the fourth quarter of 2003. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6621 98356.TXT BANK1 PsN: BANK1 37 The improvement in labor market conditions will doubtless have important followon effects for household spending. Expanding employment should provide a lift to personal disposable income, adding to the support stemming from cuts in personal income taxes over the past year. In addition, the low interest rates of recent years have allowed many households to lower the burdens of their financial obligations. Although mortgage rates are up from recent lows, they remain quite attractive from a longer-run perspective and are providing solid support to home sales. Despite the softness of recent retail sales, the combination of higher current and anticipated future income, strengthened balance sheets, and still-low interest rates bodes well for consumer spending. Consumer prices excluding food and energy—so-called core prices—have been rising more rapidly this year than in 2003. For example, the 12-month change in the core personal consumption expenditures price index stood at 0.8 percent in December of last year and climbed to 1.6 percent by May of this year. Core inflation, of course, has been elevated by the indirect effects of higher energy prices on business costs and by increases in non-oil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities. But the acceleration of core prices has been augmented by a marked rise in profit margins, even excluding domestic energy corporations. This surge in profits reflects, at least in part, the recent recovery of demand after a couple of years during which weak demand led to relatively heavy price discounting by businesses. Profits of nonfinancial corporations as a share of sector output, after falling to 7 percent in the third quarter of 2001, rebounded to 12 percent in the first quarter of 2004, a pace of advance not experienced since 1983. Half of this rise in the profit share occurred between the first quarter of 2003 and the first quarter of 2004, a period during which business costs were unusually subdued. In fact, consolidated unit costs for the nonfinancial corporate business sector actually declined during this period. The increase in output per hour in the nonfinancial corporate business sector of more than 6 percent accounted for much of the net decline in unit costs. The remainder was due to the effects of rising output in reducing nonlabor fixed costs per unit of output. Hence, at least from an accounting perspective, between the first quarter of 2003 and the first quarter of 2004, all of the 1.1 percent increase in the prices of final goods and services produced in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than rising cost pressures. However, businesses are limited in the degree to which they can raise margins by raising prices. An increase in margins should affect mainly the level of prices associated with any given level of unit costs but, by itself, should not prompt a sustained pickup in the rate of inflation going forward. In a market economy, any tendency for profit margins to continue to rise is countered largely by the entry of new competitors willing to undercut prices and by increased labor costs as more firms attempt to exploit the opportunity for outsized profits by expanding employment and output. That increase in competitive pressure, as history has amply demonstrated, with time, returns markups to more normal levels. Over the past three decades, the share of the profits of nonfinancial corporations in the total nominal income of that sector has fluctuated around a longer-run average of roughly 101⁄2 percent. The profit share in the first quarter of this year, at about 12 percent, was well above that level. The gap suggested that the growth of unit profits would eventually slow relative to increases in unit costs. This outlook had accorded with analysts’ expectations for earnings growth over the next year, which are substantially below the realized growth of profits in recent quarters. Indeed, some leveling or downward pressure on profit margins may already be in train, owing to a pickup in unit labor costs. Although advances in productivity are continuing at a rate above the long-term average, they have slowed from the extraordinary pace of last summer and are now running below increases in hourly compensation. The available information suggests that hourly compensation has been increasing at an annual rate of about 41⁄2 percent in the first half of the year. To be sure, the increases in average hourly earnings of nonsupervisory workers have been subdued in recent months and barely budged in June. But other compensation has accelerated this year, reflecting continued sizable increases in health insurance costs, a sharp increase in business contributions to pension funds, and an apparently more robust rate of growth of hourly earnings of supervisory workers. The larger wage gains for supervisory workers together with anecdotal reports of growing skill shortages are consistent with earlier evidence of rising wage premiums for skilled workers relative to less-skilled workers. For the moment, the modest upward path of unit labor costs does not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more intense competitive pressures at home and from VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6621 98356.TXT BANK1 PsN: BANK1 38 abroad. Although some signs of protectionist sentiment have emerged, there is little evidence that the price-containing forces of ever-widening global competition have ebbed. In addition, the economy is not yet operating at its productive capacity, which should help to contain cost pressures. But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation. Accordingly, in assessing the appropriateness of the stance of policy, the Federal Reserve will pay close attention to incoming data, especially on costs and prices. What does seem clear is that the concerns about the remote possibility of deflation that had been critical in the deliberations of the Federal Open Market Committee (FOMC) last year can now be safely set aside. Those deflationary pressures were largely a consequence of the stock market slump, the capital goods contraction that commenced in 2000, and, as I noted earlier, the extreme business caution that followed from these events as well as from terrorist attacks, corporate scandals, and the lead-up to the war in Iraq. Both equity prices and capital goods spending have turned up over the past year, and the probability that economic activity might stagnate has receded. As always, considerable uncertainties remain about the pace of the expansion and the path of inflation. Some of those uncertainties, especially ones associated with potential terrorism both here and abroad, are difficult to quantify. Such possibilities have threatened the balance of world supply and demand in oil markets in recent months, especially as demand has risen with the pace of world economic growth. Yet aside from energy, markets exhibit little evidence of heightened perceptions of risk. Credit spreads remain low, and market-based indicators of inflation expectations, after rising earlier this year, have receded. With the growth of aggregate demand looking more sustainable and with employment expanding broadly, the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary. In May, the FOMC believed that policy accommodation needed to be removed and that removal could be accomplished at a pace that is likely to be measured. At our meeting last month, the FOMC raised the target Federal funds rate from 1 percent to 11⁄4 percent, and the discount rate was raised commensurately. Policymakers reiterated that, based on our current outlook, the removal of accommodation would likely proceed at a measured pace. But in light of the considerable uncertainty surrounding the anticipated evolution of price pressures, the FOMC emphasized that it will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability. If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. Of course, considerably more uncertainty and hence risk surrounds the behavior of the economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. In either scenario, individual instances of financial strain cannot be ruled out. The protracted period of low interest rates has facilitated a restructuring of household and business balance sheets. Businesses have been able to fund longerterm debt at highly favorable interest rates and, by extending the maturity of their liabilities, have rendered net earnings and capital values less exposed to destabilizing interest rate spikes. Households have made similar adjustments. Between mid-2002 and mid-2003, homeowners were able to refinance at lower interest rates almost half of total outstanding home mortgage debt and thereby to substantially reduce monthly debt service payments. Households also substituted mortgage debt for more-expensive consumer credit. Moreover, those households and businesses that held long-term investment-grade bonds in that year accumulated realized and unrealized capital gains as long-term rates declined. The FOMC judged this extended period of exceptionally low interest rates to have been helpful in assisting the economy in recovering from a string of adverse shocks. But in the process of returning the stance of policy to a more neutral setting, at least some of the capital gains on debt instruments registered in recent years will inevitably be reversed. Prices in financial markets have already adjusted in anticipation of a significant amount of policy tightening, engendering additional alteration of balance sheets in recent months. An unwinding of carry trades—that is, market positions premised on low short-term financing costs—seems to be under way, at least judging from a pronounced shift in the trading portfolios of primary dealers. In addition, investors classified as noncommercial have established net short positions in 10-year Treasury note futures in recent months. Indeed, the swing toward a net short position on 10- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00042 Fmt 6633 Sfmt 6621 98356.TXT BANK1 PsN: BANK1 39 year Treasury note futures has been the largest since the inception of the contract in the 1980’s, likely offsetting a significant portion of the interest rate exposure of previously established carry trade positions. Moreover, the recent increase in market interest rates has slowed the pace of mortgage refinancing and reportedly has precipitated some winding down of leveraged positions among major mortgage market participants. These circumstances are quite different from the situation prevailing at this time last summer. Then, record levels of refinancing in the second half of 2002 and the first half of 2003 had pushed the duration of mortgage-backed securities (a measure of the price sensitivity of fixed-income instruments to changes in interest rates) to exceptionally low levels. As mortgage and other long-term rates rebounded last summer, a consequence of rapidly improving economic conditions and the fading of deflationary concerns, refinancing fell sharply, removing most downward pressure on duration. Holders of mortgage-backed securities endeavoring to hedge the resulting shifts in interest rate gaps moved rapidly to shed Treasuries and receive—fixed interest rate swaps, and these actions magnified last summer’s upturn in long-term interest rates. In the current environment, by contrast, it appears that the scope for such mortgage hedging effects to greatly amplify an increase in long-term rates is much diminished given the decline in the pace of refinancing and the associated increase in mortgage durations that have already occurred. Last, very large fractions of the total outstanding obligations of businesses and households are long-term, fixed-rate debt. As a result, rising market interest rates will not have much immediate direct effect on business and household debt service burdens. Indeed, from early 1999 through early 2000, a period when interest rates on new home mortgage originations rose more than 150 basis points, the average interest rate on the total of home mortgage debt outstanding barely moved. Nonetheless, despite the lock-in of low interest rate costs on a substantial share of household and business liabilities, recent higher market interest rates will, in time, show through into increased charges against household and business income. To be sure, financial intermediaries and other creditors that extended loans or purchased securities in recent years at relatively low long-term interest rates will sustain capital losses as rates rise. In general, however, financial intermediaries are profitable, well-capitalized, and appear to be well-positioned to manage in a rising rate environment. In short, financial markets along with households and businesses seem to be reasonably well-prepared to cope with a transition to a more neutral stance of monetary policy. Some risks necessarily attend this transition, but they are outweighed in our judgment by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment. Although many factors may affect inflation in the short-run, inflation in the long-run, it is important to remind ourselves, is a monetary phenomenon. As we attempt to assess and manage these risks, we need, as always, to be prepared for the unexpected and to respond promptly and flexibly as situations warrant. But although our actions need to be flexible, our objectives are not. For 25 years, the Federal Reserve has worked to reestablish price stability on a sustained basis. An environment of price stability allows households and businesses to make decisions that best promote the longer-term growth of our economy and with it our Nation’s continuing prosperity. VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6621 98356.TXT BANK1 PsN: BANK1 40 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM ALAN GREENSPAN The Housing Sector Q.1. The semi-annual written report refers to activity in the housing sector remaining ‘‘torrid’’ in the first half of 2004. There have been some concerns expressed about a potential bubble in housing prices. Your report indicates that house price increases have outstripped gains in incomes as well as rents in recent years. In a recent speech, one member of the Board of Governors, Governor Kohn, indicated that ‘‘the odds have risen that these prices could be out of line with fundamentals.’’ Governor Kohn also indicated that ‘‘we still cannot be very confident about whether a significant misalignment exists, however.’’ What is your assessment of the continued rise in housing prices? Are there any particular geographic sectors that you are more concerned about than others? A.1. As you note, the most recent Monetary Policy Report to the Congress indicated that house price increases have outstripped gains in income as well as rents in recent years. This observation raises the possibility that real estate prices, at least in some markets, could be out of alignment with the fundamentals. But as Governor Kohn notes, that conclusion cannot be reached with any confidence. For example, the rise in house prices relative to rents and incomes has, no doubt, been influenced by the low level of mortgage interest rates in recent years in ways that cannot be gauged precisely. Moreover, the available data are not fully adequate for a complete analysis of the issue; house prices are difficult to measure given the enormous heterogeneity of the U.S. housing stock—both within and across geographic regions—and available measures of residential rents do not match precisely with the units for which we have prices. Although taking a firm stand on the appropriateness of real estate prices is not possible, policymakers do need to take account of their influence on economic activity. As is the case with other asset prices, we monitor real estate prices closely in developing our economic outlook. The data limitations that prevent a complete analysis of housing price developments at the national level are even more binding at the local level, making it especially difficult to detect asset price misalignments for specific markets. Improvements in the World Economy Q.2. The semi-annual report comments on solid gains in U.S. exports since mid-2003 due to the strong economic performance of many of the major trading partners. What is your view as to the continued economic strength of our trading partners? In particular, do you believe the improvements in Japan will continue? A.2. Over the past year, the global economic recovery has become both stronger and more sustainable. Growth has strengthened in every major region compared with the sluggish performance during the first half of 2003, and recent indicators suggest that the foreign economies continue to put in a favorable performance. To be sure, average growth in emerging Asia appears to have braked sharply in recent months, as policy measures muffled the boom in the Chinese economy. However, continued strong export growth and recent VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00044 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 41 signs of an acceleration in consumer spending suggest that Chinese GDP growth will rebound in the second half of this year. Recovery in Canada and in Latin America also appears to be on track, and economic expansion in the United Kingdom continues unabated. The pace of recovery in the euro area has been sluggish, however, with particularly weak activity in Germany. In Japan, the rebound that began last year has continued to broaden. Japanese exports have grown rapidly over the past couple of years, as exports to China and other emerging Asian economies have surged. The expansion in exports has contributed to a snapback in corporate profits in the export-related manufacturing sector, and the revival in profits appears to be spreading to the more domestic-oriented nonmanufacturing sector. Rising profitability along with improving conditions in the corporate sector more generally have allowed investment to rebound from its recent trough. Labor markets have also revived, with employment rising and the unemployment rate declining from a peak of 5.5 percent early last year to 4.6 percent at present. Against this backdrop of strengthening activity, consumer price deflation has eased markedly since early 2002. These positive developments suggest that Japan may finally be on its way to a self-sustaining recovery. However, there are several risks to the outlook. In particular, the recent run-up in oil prices, if sustained, may exert a significant drag on Japanese economic activity. Moreover, Japanese consumption has risen sharply over recent quarters, while employee compensation has fallen. The result has been a marked decline in the household saving rate. Most analysts expect the saving rate to move up as economic conditions improve. If this happens abruptly, consumption might lag the recovery even if compensation begins to rise. Also, the possibility of a hard landing in China carries significant risks for Japan as well as for other Asian economies. Finally, bank lending in Japan continues to contract, and more aggressive financial sector restructuring remains important for Japan’s long-term growth prospects. The President’s Working Group & Hedge Funds Q.3.a. In 1999, the President’s Working Group concluded that ‘‘requiring hedge fund managers to register as investment advisers would not seem to be an appropriate method to monitor hedge fund activity.’’ In the intervening 5 years, have market conditions changed in order to justify a different conclusion? A.3.a. No. The Working Group’s report made two arguments in support of this conclusion. First, it argued that the provision of the Investment Advisers Act that exempts hedge fund managers from registration (Section 203(b)(3)) evidences a Congressional determination that clients of an adviser that has relatively few clients do not need the substantive protections of the Investment Advisers Act. Congress has not repealed Section 203(b)(3). Second, it argued that the sophisticated investors that typically invest in hedge funds are in a position to protect their own interests. There is no evidence that investors in hedge funds today are less sophisticated than they were in 1999. Indeed, institutional investors have accounted for a growing share of hedge fund investments, and they can and should protect their own interests rather than rely on the VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00045 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 42 limited regulatory protections that would be provided as a result of a registration requirement. Q.3.b. What, if any, mechanism would be the appropriate method for monitoring hedge fund activity in light of their growth in recent years and the increased investor involvement while at the same time being mindful of liquidity concerns? A.3.b. The case for monitoring hedge fund activity has not been made. Some have argued that monitoring of hedge funds is necessary to detect and deter market manipulation. However, the data collected from registered advisers is limited to total assets under management, which would provide no insight into any manipulative activities. Concerns about market manipulation, whether by hedge funds or others, can best be addressed by enhanced market surveillance. If there were a public policy reason to monitor hedge fund activity, the best method of doing so without raising liquidity concerns would be indirectly through oversight of those brokerdealers (so-called prime brokers) that clear, settle, and finance trades for hedge funds. Although the use of multiple prime brokers by the largest funds would complicate the monitoring of individual funds by this method, such monitoring could provide much useful information on the hedge fund sector as a whole. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ALAN GREENSPAN Q.1. The Securities and Exchange Commission (SEC) has recently issued a proposed rule on the Gramm-Leach-Bliley push-outs provisions governing bank securities activities. It is this Senator’s recollection that Congress intended to allow banks to continue their existing, limited securities activities that are part of their banking business, such as trust, fiduciary, and custodial activities. Do you believe that the SEC proposal accomplishes Congressional intent? Also, do you believe that this SEC proposal has complied with the intent of Congress not to impose unnecessary regulatory burdens on banks? A.1. Prior to the Gramm-Leach-Bliley Act of 1999 (GLB Act), banks enjoyed a blanket exception from the definitions of ‘‘broker’’ and ‘‘dealer’’ in the Securities Exchange Act of 1934 (1934 Act). As part of the GLB Act, Congress replaced this blanket exception for banks with a series of 15 exceptions designed to allow banks to continue to conduct securities activities that are part of normal bank activities. When these activity-focused exceptions go into effect, a bank may avoid registration as a broker-dealer under the 1934 Act only if the bank limits its securities activities to those covered by one or more of the new activity-focused exceptions. Because banks cannot as a practical matter register as a broker-dealer, securities brokerage and dealer activities that do not fit within one of these activity-focused exceptions would have to be ‘‘pushed-out’’ of the bank to an SEC-registered broker-dealer. The activity-focused exceptions that Congress adopted for banks in the GLB Act are broad and were intended to allow banks to continue to provide their customers securities services in connection with their normal banking activities without significant disruption. For example, Congress adopted important statutory exceptions for VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 43 the trust, fiduciary, and custodial activities of banks. In adopting these exceptions, Congress recognized that banks have long provided their customers securities services in connection with their trust, fiduciary, and custodial activities. Furthermore, Congress recognized that banks had provided these services for decades prior to the GLB Act without significant securities-related problems and under the effective supervision of the Federal and State banking agencies. The new activity focused exceptions were designed to complement the new authority granted by the GLB Act, which allowed banks to affiliate with full-service securities firms without the restrictions embodied in the Glass-Steagall Act, by restricting the ability of banks to significantly expand their securities services. In particular, these targeted exceptions were intended to prevent banks from operating a distinct retail brokerage business within the bank. The Board and the other Federal banking agencies previously expressed concern that earlier SEC proposals to implement the securities provisions of the GLB Act were not consistent with the express terms or the Congressional purpose of the GLB Act. In June, the SEC requested comment on new rules to implement the ‘‘broker’’ exceptions for banks in the GLB Act, including the important exceptions for bank trust, fiduciary, and custodial activities. The public comment period on these rules currently is scheduled to expire on September 1, 2004. Board staff, in conjunction with the staffs of the other Federal banking agencies, currently is reviewing and analyzing the SEC’s proposed rules to determine whether these rules, consistent with Congress’s intent, would permit banks to continue to effect securities transactions in connection with their traditional bank activities and without significant disruption. The Board will provide you a copy of any comment letter that the Board decides to file with the SEC on the proposed rules. RESPONSE TO A WRITTEN QUESTION OF SENATOR CRAPO FROM ALAN GREENSPAN Q.1. A divided SEC voted 3–2 last Wednesday to seek comments on a proposal for mandatory registration of hedge fund advisers with the SEC. Are you concerned with the divided SEC’s proposal for mandatory registration of hedge fund advisers with the SEC? Do you think the President’s Working Group on Financial Markets should be involved in issues related to regulation of the hedge fund industry? A.1. I am concerned with the proposal. The proposal seeks to deter fraud and market manipulation, but it is unlikely to accomplish those objectives. The information reported to the SEC by registered advisers is very limited and would be of little value for these purposes. Nor are examinations of advisers likely to uncover much fraud. Our experience with bank examinations indicates that examiners have great difficulty uncovering fraud. Most often it is uncovered through complaints by customers or disaffected employees rather than through exams. I believe this was also the case with the recent scandals in the regulated mutual fund industry. Should registration fail to achieve the intended objectives, pressure may well become irresistible to expand the SEC’s regulatory reach from hedge fund advisers to hedge funds themselves. The application of VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 44 the Investment Company Act to hedge funds would greatly impede their important contributions to the flexibility and resiliency of our financial system. Because of the critical role that hedge funds have come to play in our financial system, all of the members of the President’s Working Group have an interest in what regulations, if any, apply to their activities. It was this shared interest that motivated the Working Group’s April 1999 report on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. More recently, it has motivated discussions within the Working Group of the SEC’s adviser registration proposal. In that sense, the Working Group should be and has been involved in issues related to the regulation of the hedge fund industry. But decisions about the application of the Investment Advisers Act to hedge fund advisers fall squarely within the SEC’s jurisdiction and must be made by the SEC. RESPONSE TO WRITTEN QUESTIONS OF SENATOR SUNUNU FROM ALAN GREENSPAN Q.1. I understand that in August 2003, the Federal Reserve proposed a rule to loosen the tying restrictions on bank holding companies—the proposal and the subsequent supervisory guidance would entail an interpretation of Section 106 of the Bank Holding Company Act Amendments of 1970. Can you describe the intent of the Fed proposal and comment on the status of the rule? Also, does the Federal Reserve Board view tying as a problem in large financial institutions? A.1. The special antitying restrictions established by Section 106 of the Bank Holding Company Act Amendments of 1970 are quite complex. For example, these restrictions apply only to banks and do not apply to the nonbank affiliates of a bank or other nonbank entities. In addition, while Section 106 prohibits banks from imposing certain types of tying arrangements on their customers, there are several important exceptions to the statute. These exceptions, among other things, expressly allow a bank to condition the availability or price of a product on a requirement that the customer also obtain a ‘‘loan, discount, deposit, or trust service’’ from the bank or an affiliate. These exceptions and the statute’s complex structure can make applying the statute a challenging and fact-intensive process. In recent years, the Board has received a number of inquiries concerning the antitying prohibitions in Section 106 and the compliance of banking organizations with these restrictions. These inquiries indicated that there was some uncertainty, both among bankers and their customers, as to what types of bank actions are prohibited by Section 106. To help address this uncertainty, the Board in 2003 requested public comment on a formal interpretation of the statute and related supervisory guidance. The interpretation was intended to provide banks and their customers a comprehensive guide to the statute and, thus, improve the public’s understanding of the statute’s restrictions. The proposed interpretation, for example, discusses the necessary elements of a prohibited tying arrangement, describes the statutory and regulatory exceptions to the statute’s prohibitions, and provides examples of the types of bank actions VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 45 that are prohibited and permissible under the statute. The related supervisory guidance describes the types of internal controls that should help banks comply with the antitying restrictions in Section 106. The Board has received approximately 40 comments on the proposed interpretation and related supervisory guidance and we hope to finalize these documents in the near future. Federal Reserve examiners review the antitying programs of bank holding companies and State member banks as part of the regular compliance reviews of these organizations. In 2002, examiners from the Federal Reserve and the Office of the Comptroller of the Currency also conducted targeted antitying examinations at several large banking organizations. The targeted exams indicated that the banking organizations reviewed generally have adequate policies and procedures to ensure compliance with the antitying restrictions of Section 106, and the agencies generally did not uncover unlawful tying arrangements in these examinations. The Government Accountability Office also recently conducted a review of bank compliance with Section 106 and found that the available evidence does not substantiate claims that banks are tying the availability or price of credit to the purchase of debt underwriting services from a securities affiliate of the bank. Based on our supervisory experience, it appears that banking organizations generally have adequate internal controls to help prevent illegal tying. The Board, however, will take appropriate supervisory action against a bank within our supervisory jurisdiction if information developed through the supervisory process or provided by a customer indicates that the bank has imposed a tie on a customer in violation of Section 106. For example, in 2003, the Board took enforcement action against a foreign bank for violations of Section 106 after investigating a tying complaint received from one of the bank’s customers. Q.2. In November 2003, the DOJ’s Antitrust Division submitted a comment letter to the Fed on its proposal to address tying. The letter stated that the prohibitions on tying within Section 106 are much broader than those found in Federal antitrust laws and that the Fed’s proposed interpretation and supervisory guidance might continue to prohibit some pro-competitive practices, such as multiproduct discounting. The DOJ expressed concern that Section 106 disadvantages banks as competitors in markets in which banks and nonbanks compete—lessening competition and ultimately harming consumers. The DOJ recommended that the Fed’s interpretation of Section 106 be consistent with, and not broader than, the Federal antitrust laws. It would appear that Section 106 was designed to protect small business customers or individual consumers from being forced to buy products they do not wish to purchase. The Division’s letter further recommends that, at a minimum, Section 106 should be limited to ties involving small businesses and individual consumers. What are your views regarding the DOJ’s Antitrust Division’s recommendations that Section 106 not be interpreted to prohibit conduct that is not found to be anticompetitive under the Federal antitrust laws? Also, what are your views on applying general anti- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00049 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 46 trust standards when banks are dealing with large, sophisticated customers? A.2. As you note, the Antitrust Division of the Department of Justice has submitted a comment letter to the Board concerning the Board’s proposed interpretation of Section 106. In the letter, the Antitrust Division supported the Board’s efforts to clarify that Section 106 does not prohibit banks from entering into tying arrangements with their customers when these arrangements are voluntarily entered into or sought by the bank’s customer (so-called ‘‘voluntary ties’’). The Division’s letter also expressed concern that Section 106 may itself harm competition and consumers by limiting the ability of banks to provide their customers discounts on packaged offerings and by placing banks at a disadvantage in markets where both banks and nonbank entities compete. Accordingly, the Division recommended that the Board seek to interpret the antitying restrictions in Section 106 in a manner that is consistent with the tying restrictions that apply to all companies, including banks, under the Sherman and Clayton Acts. However, the Antitrust Division’s letter also recognizes that the courts historically have interpreted Section 106 as imposing significantly more stringent antitying prohibitions on banks than apply to companies generally under the Sherman and Clayton Acts and that these precedents may constrain the ability of the Board to interpret Section 106 to be coterminous with the general antitrust laws. The Board will carefully consider the views of the Antitrust Division as the Board moves forward with the proposed interpretation and related matters. RESPONSE TO A WRITTEN QUESTION OF SENATOR STABENOW FROM ALAN GREENSPAN Currency Manipulation Q.1. As you are aware, there has been a lot of concern in the Senate with both China and Japan’s monetary policy actions, particularly related to Japan’s huge interventions in international currency markets to maintain an artificially weak yen, as well as China’s dollar peg. The last time you and I discussed this, you referred to it as a ‘‘problem’’—something the Bush Administration has been unwilling to do. I would argue that it has been an ongoing problem and requires Government action to end this unfair currency manipulation tax placed on American products. I believe that Japan’s long-standing and successful efforts in maintaining an artificially weak yen have been a major factor in the ongoing weakness of our manufacturing sector. It also has a very negative impact on the automotive sector. Although, as you and I discussed recently, Japan had stopped its interventions in the last several months after spending over $138 billion in the first quarter of this year and over $330 billion since 2003, I would note that significant sums of money, perhaps as much as $50 billion per month, have been budgeted for such future actions in Japan’s current fiscal year budget. Financial markets are also clearly wary of statements from senior officials from Japan’s Ministry of Finance that the government is not ruling out inter- VerDate 11-MAY-2000 15:14 Feb 22, 2005 Jkt 000000 PO 00000 Frm 00050 Fmt 6633 Sfmt 6601 98356.TXT BANK1 PsN: BANK1 47 vening again in massive amounts again if they so choose. And this threat alone seems to be putting an artificial ceiling on the yen’s move toward its appropriate value. Given on-going concerns over Japan’s currency actions in our last hearing and the ever-present threat of further massive interventions, should the United States and the G–7 make very clear to Japan that a resumption of such interventions would be unwelcome and disruptive to the global economy? Also, can you provide an analysis of the impact to our economy of Japan’s successful efforts to weaken its yen? Has it undermined the Federal Reserve’s efforts to stimulate U.S. economic growth and create jobs, particularly in the manufacturing sector? A.1. U.S. policy regarding the foreign exchange value of the dollar—against the yen or any other currency—is the province of the Secretary of the Treasury, who is also the chief spokesperson for the U.S. Government on these matters. I defer to the Secretary on any official U.S. response to the concerns you raise about Japanese policy operations with respect to the dollar’s exchange value against the yen. G–7 finance ministers, central bank governors, and their respective deputies meet frequently to discuss exchange rates and related foreign exchange operations, such as those conducted earlier this year by Japan. Japan’s official intervention operations, in which the Japanese government purchased dollars in foreign exchange markets and sold yen, may have influenced some U.S. asset prices. One effect could have been on the foreign exchange value of the dollar against the yen. In principle, the Japanese operations would have weakened the yen against the dollar, and it is possible that the operations did so, although the size and persistence of any effects are difficult to judge. However, one should keep in mind that, despite the large scale of the Japanese operations in 2003 and 2004, the yen has strengthened against the dollar on balance, rising roughly 20 percent from its low point against the dollar in early 2002. Because the Japanese authorities invested the proceeds of their dollar purchases in interest-earning, dollar-denominated assets, another effect of their operations on U.S. asset prices could have come through the potential effect of these operations on U.S. interest rates. In principle, the operations would have resulted in increased demand for U.S. securities and somewhat lower U.S. interest rates. While it is possible that these operations did have such an effect, the magnitude of any effect is likely to have been quite small. U.S. securities markets are the deepest and most liquid of any in the world, and the scale of the Japanese operations, while large by some standards, was arguably too small to have had a substantial effect on the general level of U.S. interest rates. In any event, the operations of the Japanese have not hampered the Federal Reserve in its efforts to conduct monetary policy to achieve price stability and maximum sustainable growth for the U.S. economy. 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