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1UCT OF MONETARY POLICY
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC MONETAEY POLICY
OF THE
COMMITTEE ON BANKING, FINANCE AND
UEBAN AFFAIES
HOUSE OF REPEESENTATIVES
ONE HUNDRED FIRST CONGRESS
FIRST SESSION
JULY 20, AND AUGUST 2, 1989
Printed for the use of the Committee on Banking, Finance and Urban Affairs
Serial No. 101-44
U.S. GOVERNMENT PRINTING OFFICE
19658 ±*
WASHINGTON : 1989
For sale by the Superintendent of Documents, Congressional Sales Office
U.S. Government Printing Office, Washington, DC 20402
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
HENRY B. GONZALEZ, Texas, Chairman
CHALMERS P. WYLIE, Ohio
FRANK ANNUNZIO, Illinois
WALTER E. FAUNTROY, District of
JIM LEACH, Iowa
NORMAN D. SHUMWAY, California
Columbia
STEPHEN L. NEAL, North Carolina
STAN PARRIS, Virginia
CARROLL HUBBARD, JR., Kentucky
BILL McCOLLUM, Florida
JOHN J. L A F A L C E , New York
MARGE ROUKEMA, New Jersey
MARY ROSE OAKAR, Ohio
DOUG BEREUTER, Nebraska
BRUCE F. VENTO, Minnesota
DAVID DREIER, California
DOUG BARNARD, JR., Georgia
JOHN HILER, Indiana
ROBERT GARCIA, New York
THOMAS J. RIDGE, Pennsylvania
CHARLES E. SCHUMER, New York
STEVE BARTLETT, Texas
BARNEY FRANK, Massachusetts
TOBY ROTH, Wisconsin
RICHARD H. LEHMAN, California
ALFRED A. (Al) McCANDLESS, California
BRUCE A. MORRISON, Connecticut
JIM SAXTON, New Jersey
MARCY KAPTUR, Ohio
PATRICIA F. SAIKI, Hawaii
BEN ERDREICH, Alabama
JIM BUNNING, Kentucky
THOMAS R. CARPER, Delaware
RICHARD H. BAKER, Louisiana
ESTEBAN EDWARD TORRES, California
CLIFF STEARNS, Florida
GERALD D. KLECZKA, Wisconsin
PAUL E. GILLMOR, Ohio
BILL NELSON, Florida
BILL PAXON, New York
PAUL E. KANJORSKI, Pennsylvania
ELIZABETH J. PATTERSON, South Carolina
C. THOMAS McMILLEN, Maryland
JOSEPH P. KENNEDY II, Massachusetts
FLOYD H. FLAKE, New York
KWEISI MFUME, Maryland
DAVID E. PRICE, North Carolina
NANCY PELOSI, California
JIM McDERMOTT. Washing™
PETER
RICH/
CONTENTS
Hearings held on:
July 20, 1989
August 2, 1989
Appendixes:
July 20, 1989
1
*m3£
,
IP
August 2, 1989
117
WITNESS
THURSDAY, JULY 20,
1989
FEDERAL RESERVE BOARD'S SEMI-ANNUAL MONETARY POLICY REPORT TO CONGRESS
Greenspan, Hon. Alan, Chairman, Board of Governors of the Federal Reserve
System
APPENDIX
Prepared statement:
Greenspan, Hon. Alan.
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Monetary Policy Report to Congress Pursuant to the Full Employment and
Balanced Growth Act of 1978, dated July 20, 1989
73
Questions asked by Hon. Henry Gonzalez, and response from Mr. Greenspan...
100
WITNESSES
WEDNESDAY, AUGUST 2, 1989
MONETARY POLICY AND THE STATE OF THE ECONOMY
Benderly, Jason, co-director of Economic Research, Goldman Sachs Economic
Research Group
DePrince, Albert, chief economist, Marine Midland Bank
Levy, Mickey, chief economist, First Fidelity Bancorporation, Philadelphia
APPENDIX
Prepared statements:
Benderly, Jason, with miscellaneous charts
DePrince, Albert, with miscellaneous charts and tables
Levy, Mickey, with miscellaneous charts and tables
37
43
49
118
127
154
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
DePrince, Albert, submitted paper entitled, "The Federal Budget Deficit:
What Should Be Done and Politically Realistic Tax Options for the Next
Administration
(in)
189
FEDERAL RESERVE BOARD'S SEMI-ANNUAL
MONETARY POLICY REPORT TO CONGRESS
Thursday, July 20, 1989
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, DC.
The subcommittee met at 10:05 a.m., pursuant to notice, in room
2128, Rayburn House Office Building, Hon. Stephen L. Neal, (chairman of the subcommittee) presiding.
Present: Chairman Neal, Representatives Barnard, Gonzalez,
Hoagland, McCollum, Leach, and Bunning.
Also present: Kaptur, Wylie, Hiler, Roth, and McCandless.
Chairman NEAL. Let me call the subcommittee to order at this
time.
This morning I am pleased to welcome the distinguished Chairman of the Federal Reserve Board who will present the Board's
Semi-annual Monetary Policy Report to Congress.
At our last monetary policy hearing, in February, Chairman
Greenspan confirmed his support for zero inflation as the dominant
objective of monetary policy. I strongly share his commitment to
zero inflation. No other economic attainment could be as beneficial
to the American people. Zero inflation is the necessary prerequisite
for low interest rates. It provides the optimal environment for sustaining high employment and real growth, for encouraging savings
and promoting investment, and for enhancing productivity. It provides the only firm ground on which businesses and investors can
plan for the long term, secure against the risks of excessive price
volatility. It minimizes the occurrence and moderates the severity
of recessions. It enables the economy to provide the American
people with the highest standard of living attainable by virtue of
our natural resources, technological skills and hard work.
We should never forget that lowering inflation to zero with the
resultant low interest rates is the best possible policy for the working people, middle- and low-income people of America. By definition these are the people that must borrow and therefore will benefit from low interest rates. These are the folks least able to deal
with the uncertainties caused by inflation.
Almost no one denies that zero inflation will bring these benefits
in some abstract, long run. The problem has always been to make
zero inflation an operational objective, attainable in real time.
Characterizing a policy goal as long run usually implies that the
outcome would be desirable, if it ever happens, but we really don't
(1)
want to make hard policy choices here and now to ensure that it is
eventually achieved.
Chairman Greenspan made it clear that he regarded zero inflation as a serious objective, to be attained by policies actually taken
with that goal in mind, and to be reached within a relatively short
period of time—5 years at most and preferably sooner. That was a
very welcome statement, one of the most definitive and positive
statements ever to come out of these semi-annual hearings on monetary policy.
We all know, however, that statements and rhetoric are the easy
part of policy-making. Monetary policy is reflected in numbers and
not words. Whatever monetary officials may say, what they actually do is reflected in the numbers that count—numbers on the
money supply, on interest rates and, with a lag, numbers on inflation. In judging monetary policy we should pay more attention to
the numbers and less attention to the words.
That is no easy task, since the numbers must be interpreted.
Their impact on the economy is often ambiguous, and may not
become clear for some time. Nonetheless, the primary focus should
always be on the numbers: the numbers that measure inflation,
and the numbers that indicate, however ambiguously, whether
policy is moving toward zero inflation, or away from it.
Judging policy by the numbers, it seems to me clear that the
Federal Open Market Committee has indeed been acting consistently to reinforce Chairman Greenspan's rhetorical commitment to
zero inflation. To be sure, the inflation numbers are still too high,
and will probably remain high for some time yet, though the very
latest reports are encouraging. We cannot, however, judge policy
solely on the basis of the latest inflation numbers. Monetary policy
operates on inflation with a substantial lag, perhaps as long as 2
years. Judged by virtually all the numbers generally taken to indicate the direction of policy, monetary policy has been consistently
tight through most of this year—a continuation of the tightening of
1988. A dramatic example is the behavior of M2. As revealed on
the chart on the wall, the path of M2 through the first half of the
year is well below the Fed's target ranges.
[The chart with information on M2, can be found in the appendix.]
This tightening will likely restrain inflation and, sooner or later,
begin moving it toward zero. The Fed's own so-called "P Star,"—an
indicator of future inflationary pressures based on the behavior of
M2—signals a future decline in inflation, though the timing and
extent remain uncertain.
So I want to congratulate Chairman Greenspan this morning for
delivering a policy that promises to back up his words. I am fully
aware that some analysts and forecasters think policy has been so
tight it will cause a serious economic slowdown, perhaps even a recession. We do see concrete signs of slowdown underway. I am not
going to try to judge whether the Fed has tightened a little too
much, not quite enough, or just right. I applaud the general direction, given the serious inflationary pressures that were arising, and
the overwhelming importance we must attach to the ultimate objective of zero inflation. We should never forget that we can not
avoid recession by inflating, we just postpone it.
If the economy turns very weak, the Fed will have some running
room for moderate easing, without compromising progress toward
zero inflation over the next 5 years. I only urge, once again, that
the Fed keep that paramount goal in sight, whatever short-run turbulence the economy may experience in the near term. Zero inflation, the low interest rates, low unemployment, increased savings,
investment and productivity, maximum sustainable growth and improved living standards that will accompany it is an outstanding
goal that we all can share and be proud of, and I certainly commend Chairman Greenspan for his dedication to fighting inflation.
I want to welcome the Chairman this morning. I would first like
to yield to our distinguished ranking minority Member, Mr. McCollum, for his comments.
Mr. MCCOLLUM. Thank you very much, Mr. Chairman, and I, too,
want to welcome Chairman Greenspan this morning. It's certainly
good to see you back with us, and we are looking forward very
much to hearing from you on your report on the state of the affairs
down in your shop.
I guess I am always reminded when you appear that despite the
emphasis that is always focused on this particular set of hearings
because of the Open Market Committee's actions and the monetary
policy concerns we all have, that the Federal Reserve does a great
deal more than this particular function, and yet the attention obviously is there because what you do with regard to influencing the
course of our country's economy in terms of inflation and in terms
of steadiness and in terms of avoiding recessions where possible is
of paramount concern to the business community and to the welfare of Americans as a whole.
So this morning I think that it's interesting to have your testimony in light of the fact that it seems as though the economists in
general and the market projectors as well always breathe in and
out heavily on every little movement that is made in the Open
Market Committee whenever they guess it or whenever they figure
it out.
Yet the important thing is what you point out in your testimony,
not only this time, but you've done it with us before, is where we
are going over a longer period of time. It seems to me that the past
few months, while they may have appeared a little rocky at time,
have so far in this year at least proven, as Mr. Neal has indicated,
that the wisdom is there in your efforts and in the tremendous
amount of time and effort consumed by the members of the Board
and Policy Committee.
I think your efforts at a so-called soft landing and a smooth sail
through these times when inflation looked like it could get out of
hand so far this year appear to be working, and I do want to commend not only yourself, but of course all the members of the Board
and the Open Market Committee for so far agilely doing extremely
well and doing better than your critics would have anticipated, and
that often is the case. Critics like to be out front, you know.
The second thing though that concerns me that Mr. Neal didn't
mention, and I hope you will comment on this morning beyond the
issue of where we are going as you see it now, is the question of
this trade deficit figure. It was a blip perhaps, or was it more significant?
As we begin to reign in inflation here and the dollar value has
fluctuated abroad, are we going to go back into trouble on the
trade balance and will that be a major factor, or was this an aberration in the last few days when the report came out for the measurement of the current period?
I know these are tough questions to balance, but I would be very
curious in particular as to your thinking with regard to that as
well as to the overall questions that you'll normally answer on the
state of the economy and inflation and so on.
Again thank you for coming. We appreciate it very much.
I yield back.
Chairman NEAL. Mr. Barnard.
Mr. BARNARD. NO.
Chairman NEAL. Let
me recognize our distinguished ranking
Member of the full committee, Mr. Wylie.
Mr. WYLIE. Thank you very much, Mr. Chairman.
May I also welcome you, Chairman Greenspan, and I, too, am
looking forward very much to your report this morning.
I would observe that the Federal Reserve is now feeing a very
challenging situation as I observe it. Inflation this year has been
higher than we would like, but at the same time economic growth
seems to be slowing down some. But these recent developments
have taken place against the backdrop of a tremendous successful
U.S. economy in the last several years, and the economic expansion
is now well into it's seventh year. Employment gains have been impressive, and underlying inflation tendencies have not picked up as
much in the last few years.
The Fed, as Mr. McCollum suggested, gets discredited when the
economy is bad. So I will at least give some of the credit to the Fed
for the strong economic performance over the past few months. I
believe you and your colleagues ought to be commended generally
for artfully conducting monetary policy, and that you have done an
admirable job under what appeared to be very difficult circumstances earlier in the year.
The recent easing of monetary policy that you engineered demonstrated the need for flexibility to policy-making and you have
enunciated that policy in the past and it has proved to be appropriate in the face of very changing conditions.
So your recent actions and the positive reactions lead me to be
optimistic about the economic expansion in the future, and we look
forward to your assessment of the current situation and any
thoughts you have for the future.
Thank you very much, Mr. Chairman.
Chairman NEAL. Mr. Hoagland.
Mr. HOAGLAND. I have no opening statement, Mr. Chairman.
Chairman NEAL. Mr. Roth.
Mr. ROTH. I just have a short opening comment. I welcome Chairman Greenspan's optimism. When I read his statements I think we
share a lot of that optimism. The last time you were here we had a
lot of gloom and doom saying that the roof is going to cave in. Yet
our economy keeps on roaring down the track like a Japanese
bullet train. This economy is strong and it's going to remain
strong.
But I am concerned about a couple of things. I think all the
Members on this panel, Chairman Greenspan, serve on the conference on the S&L bill that is working its way through the House,
and when I consider that problem, I get nervous about what could
happen. Is this the only black hole we are going to see, or are we
going to see other black holes like this.
So I think this hearing today is far more than a routine semiannual update, Mr. Chairman. I think the current reports all indicate that we are entering a new stage in this economic cycle and
we should be concerned about an economic slowdown, unemployment and the trade deficit and the like.
I am particularly concerned about the debt burden. The debt
problem we're facing in America today is really our Achilles' heel,
and I would like to have your views on that. I hope the S&L problem is the only black hole that we are facing. I hope that with farm
credit, mortgage guarantees, and small business loans, we don't
face similar problems.
So, Mr. Chairman, you come before us at a critical juncture, and
while I feel that this economy can remain strong, I think that we
have to take a good assessment of the risks we face so that we take
the right steps for the economy to remain stronger into the future.
Thank you, Mr. Chairman.
Chairman NEAL. Are there others who would like to make opening comments?
[No response.]
If not, I would like to welcome the distinguished Federal Reserve
Board Chairman. We will put your entire report and statement
into the record, Mr. Chairman. Please proceed as you will.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. GREENSPAN. Thank you very much.
Mr. Chairman and Members of the committee, I appreciate this
opportunity to appear before you in connection with the Federal
Reserve's semiannual Monetary Policy Report to the Congress. In
my prepared remarks today I will adhere closely to the matter at
hand, that is, monetary policy and the state of the Nation's economy.
Over the course of this year, the contours of the broad economic
setting have changed. As a consequence, the stance of monetary
policy also has shifted somewhat, although the fundamental objective of our policy has not. That objective remains to maximize sustainable economic growth which in turn requires the achievement
of price stability over time.
At our report to the Congress in February of this year I characterized the economy as strong with the risks on the side of a further intensifying of price pressures.
In view of the dimensions of the inflation threat, the Federal Reserve tightened policy further early this year. Additional reserve
restraint was applied through open market operations, and the discount rate was raised V2 a percentage point. The determination to
resist any pickup in inflation also motivated the decision of the
Federal Open Market Committee at its February meeting to lower
the ranges for money and credit growth for 1989.
Reflecting the economy's apparent strength and the tighter
stance of policy, interest rates rose during the first quarter. Shortterm market rates increased around 1 percentage point over the
quarter leaving them up more than 3 points from a year earlier,
but long-term rates held relatively steady.
By the beginning of the second quarter, the outlook for spending
and prices was becoming more mixed. Scattered indications of an
emerging softening in economic activity began to appear, prompting market interest rates to pull back. Rates continued to fall as a
variety of factors pointed to some lessening of price pressures in
the period ahead. In particular, money growth weakened further,
the underlying trend in inflation appeared to be less severe than
markets had feared, the dollar continued to climb and domestic
demand slackened. Against this background, the Federal Reserve
eased reserve conditions, first in early June and again in early
July. By mid-July, most short-term market rates had fallen to a bit
below their year-end levels, and long-term interest rates were down
as much as a full point, to their lowest levels in more than 2 years.
Economic activity apparently grew in the first half of this year
at a rate somewhat below that of potential GNP. This stands in
sharp contrast to the performance of the preceding 2 years during
which growth proceeded at a pace that placed increasing pressures
on labor and capital resources.
Prices did accelerate in the first 6 months of this year, but most
of the increase may be transitory, related to supply conditions in
food and petroleum markets. After a gradual pickup over the preceding 2 years, price inflation outside of food and energy held near
its 1988 pace.
The strength of the potential inflationary pressures in 1988 and
into 1989 was, of course, the motive for the progressive tightening
of policy that the Federal Reserve undertook over that period. And
the outlook for some reduction in these pressures owes in part to
that policy restraint. The associated rise in market interest rates,
beginning early last year, opened up wide "opportunity" costs of
holding money assets and resulted in a sharp slowing of money
growth.
In addition to the effect of interest rates, several special factors
played a role in slowing money growth and boosting velocity—that
is, the ratio of nominal GNP to money. Probably the most important of these was the unexpectedly large size of personal tax liabilities in April. Many individuals evidently were surprised by the
size of their liabilities, and drew down their money balances below
normal levels to make the required payments.
The difficulties of the thrift industry also may have affected M2
growth. Late last year, as public attention increasingly focused on
the financial condition of the industry and its insurance fund,
FSLIC-insured institutions began to lose deposits at a significant
rate. While most of the funds apparently were redeposited within
M2 at commercial banks or money funds, this factor likely also had
some dampening effect on that aggregate.
More recently, growth of the broader monetary aggregates has
picked up markedly. The restraint imposed by the earlier rise in
market interest rates is fading, and households appear to be rebuilding their tax depleted balances. As of May, M2 had risen at
just a 1 percent rate from its fourth-quarter base, but the 6% percent rate of growth in June lifted the year-to-date increase to
around a 2 percent rate, still somewhat below its 3 to 7 percent
annual target cone. M3 rose at a SV2 rate through June, at the
lower end of its range. The latest data on these aggregates suggests
that relatively rapid expansion has continued into July.
Looking ahead at the remainder of 1989 and into 1990, recent developments suggest that the balance of risks may have shifted
somewhat away from greater inflation. Even so, inflation remains
high—clearly above our objective. Any inflation that persists will
hinder the economy's ability to perform at peak efficiency and
create jobs. Consequently, monetary policy will need to continue to
focus on laying the groundwork for gradual progress toward price
stability. Such an outcome need not imply a marked downturn in
the economy, and policy will have to be alert to any emerging indications of a cumulative weakening of activity. However, progress
on inflation and optimum growth over time also require that our
productive resources not be under such pressures that their prices
continue to rise without abating. In light of historical patterns of
labor and capital growth and productivity, this progress very likely
will be associated with a more moderate, and hence sustainable, expansion in demand than we experienced in 1987 and 1988.
At its meeting earlier this month, the Federal Open Market
Committee determined that a combination of continued economic
growth and reduced pressures on prices would be promoted by
growth of money and debt in 1989 within the annual ranges that
were set in February. Moreover, it tentatively decided to maintain
these same ranges through 1990.
The specified ranges, both for this year and next, retain the 4
percentage-point width first instituted for the broader aggregates
in 1988. Considerable uncertainties about the behavior of money
and credit remain, and the greater breadth allows for a range of
paths for these aggregates as financial and economic developments
may warrant. In view of the apparent variability, particularly over
the short run, in relationships between the monetary aggregates
and the economy, policy will continue to be carried out with attention to a wide range of economic and financial indicators. The complex nature of the economy and the chance of false signals demand
that we cast our net broadly—gathering information on prices, real
activity, financial and foreign exchange markets, and related data.
Although M2 remains below its 1989 target cone, the decline in
interest rates in recent months, along with the continued growth of
income, should provide support for that aggregate over the rest of
this year, helping to lift it into the lower part of its target range.
We also expect M3 to strengthen from its rate of growth over the
first half of the year moving up into the middle of its target range
by year-end.
Growth of money and debt within the 1989 ranges is expected to
be consistent with nominal GNP rising this year at a pace not too
far from last year's increase, according to the projections of the
FOMC members and other presidents of Reserve Banks. These projections, however, incorporate somewhat more inflation and less
real growth than we experienced in 1988. The central tendency of
the projections of 2 to 2Vfe percent real GNP growth over the four
quarters of this year implies continued moderate economic growth
throughout the year. For the year as a whole, these projections anticipate that growth is likely to be strongest in the investment and
export sectors of the economy, with expansion of consumer expenditures and Government purchases rather subdued.
A sectoral pattern of growth such as this would in fact serve the
Nation's longer-term needs by contributing to a better external balance. Fundamentally, improvement in our international payments
position requires productivity-enhancing investment and a higher
national savings rate. In this regard the Federal Government can
play a significant positive role by reducing the budget deficit.
The outlook for inflation this year, as reflected in the central
tendency of the projections expressed at the FOMC meeting, is for
a 5 to 5V2 percent increase in the consumer price index. A figure in
this range would represent the highest annual inflation rate in the
United States since 1981. This is source of concern to the Federal
Reserve. Yet this rate is below that experienced in the first 6
months. This implies a considerable slowing over the remainder of
the year, reflecting earlier monetary policy restraint and a perspective moderation in food and energy prices.
Federal Reserve policy is focused on laying the groundwork for
more definite progress in reducing inflation pressures in 1990,
while continuing support for the economic expansion. The ranges
provisionally established for growth of money and debt next year
are consistent with these intentions.
Thus, although the 1990 ranges do not represent another step in
the gradual, multi-year lowering of the ranges, the Federal Reserve's intent to make further progress against inflation remains
intact. Uncertainties about the outlook suggested a pause in the
process of reducing the ranges; however, the Committee recognizes
that our goal of price stability will require additional downward adjustments in these ranges over time. Of course, as we draw closer
to 1990, the economic and financial conditions prevailing will
become clearer, allowing us to approach our decisions on the
ranges with more confidence. Hence, the current ranges for money
and credit growth in 1990 should be viewed as very preliminary.
The economic projections for 1990 made by the Governors and
the Reserve Bank presidents center in a range of lVfe to 2 percent
real GNP growth and 4Vfe to 5 percent inflation for next year. Naturally, as I have already noted, there are considerable uncertainties surrounding forecasts for 1990.
The Federal Reserve is committed to doing its utmost to ensure
prosperity and rising standards of living over the long run. Given
the powers and responsibilities of the central bank, that means
most importantly maintaining confidence in our currency by maintaining its purchasing power.
The principal role of monetary policy is to provide a stable backdrop against which economic decisions can be made. A stable, predictable price environment is essential to ensure that resources can
be put to their best use and ample investment for the future can be
made.
In the long run, the link between money and prices is unassailable. That link is central to the mission of the Federal Reserve, for
it reminds us that without the acquiescence of the central bank, inflation cannot take root. Ultimately, the monetary authorities
must face the responsibility for lasting price trends. While oil price
shocks, droughts, higher taxes or new Government regulations may
boost broad price indexes at one time or another, sustained inflation requires at least the forbearance of the central bank. Moreover, as many nations have learned, inflation can be corrosive. As
it accelerates, the signals of the market system lose their value, financial assets lose their worth, and economic progress becomes impossible.
Thankfully, this bleak scenario is not one that we in the United
States are confronting. We do, however, face a difficult balancing
act. The economy has prospered in recent years; the economic expansion has proven exceptionally durable, employment has surpassed all but the most optimistic expectations, and the underlying
inflation rate after coming down quickly in the early 1980's, has accelerated only modestly. But now signs of softness in the economy
have shown up.
Accordingly, it is prudent for the Federal Reserve to recognize
the risk that such softness conceivably could cumulate and deepen,
resulting in a substantial downturn in activity. We also recognize,
however, that a degree of slack in labor and product markets will
ease the inflationary pressures that have built up. So our policy,
under current circumstances, is not oriented toward avoiding a
slow-down in demand, for a slowing from the unsustainable rates of
1987 and 1988 is probably unavoidable. Rather what we seek to
avoid is an unnecessary and destructive recession.
The balance that we must strike is to support moderate growth
of demand in the near term, while concurrently progressing toward
our longer-term goal of a stable price level. Admittedly, the balance we are seeking is a delicate one. I wish I could say that the
business cycle has been repealed. But some day, some event will
end the extraordinary string of economic advances that has prevailed since late 1982. For example, an inadvertent, excess accumulation of inventories or an external supply shock could lead to a
significant retrenchment in economic activity.
Moreover, I cannot rule out a policy mistake as a trigger for a
downturn. We at the Federal Reserve, for example, might fail to
restrain a speculative surge in the economy or fail to recognize
that we were holding reserves too tight for too long. Given the lags
in the effects of policy, forecasts inevitably are involved and thus
errors inevitably arise. Our job is to keep such errors to an absolute minimum. An efficient policy is one that doesn't lose its bearings, that hones in on price stability over time, but that copes with
and makes allowances for any unforeseen weakness in economic activity. It is such a policy that the Federal Reserve will endeavor to
pursue.
Thank you, Mr. Chairman.
[The prepared statement of Alan Greenspan can be found in the
appendix.]
Chairman NEAL. Thank you, Mr. Chairman. On the first page of
your statement you assert that maximizing sustainable economic
10
growth requires the achievement of price stability over time. It
seems to me that this is a very important point. I think it underscores the need to achieve zero inflation. Would you elaborate on
that point. Why is zero inflation a prerequisite for maximizing sustainable economic growth?
Mr. GREENSPAN. Mr. Chairman, I think we have observed over
the years, and very specifically during the 1970's, that the most destabilizing force that we can engender in our economy is price inflation. Indeed, I think we can find most of the fluctuations that
occurred in economic activity resulting directly or indirectly from
the inflation pressures which emerged at that time.
Conversely, the period of the 1950's and especially the first half
of the 1960's prior to the onset of the Vietnam War was a period of
price and economic stability, and I think it was not an accident. I
think it's built into the nature of the type of economy which prevails in this country and in the Western World, and it clearly signals to us that if we seek to achieve maximum long-term economic
growth, the lowest potential unemployment rate and the maximum
use of resources, both capital and labor, in this country, if we
choose to do that as a goal, then zero inflation should be a key element in trying to create a base for such a benevolent environment.
Chairman NEAL. Thank you.
Mr. Chairman, your projected target ranges for 1990 for M2 were
not lowered, as you testified, but were kept the same as this year
by 3 percent to 7 percent. I presume this is just a pause in your
progressive lowering of M2 target ranges. Isn't it true that to
attain and maintain zero inflation we will need M2 growth at a
much lower level, at around the rate of real growth in the economy
of say 2V2 to 3 percent compared to the midpoint of the ranges for
this year and next year, which is 5 percent? Doesn't your research
on "P Star" indicate that in the long run M2 should grow no faster
than the real economy grows in order to attain zero inflation?
Mr. GREENSPAN. That is certainly correct, Mr. Chairman, and
indeed our evaluation of the interrelationships between money
supply, the economy and prices does suggest, as you indicate, that
over the longer run a zero inflation rate would be consistent with
M2 annual growth of approximately 2Vfe to 3 percent.
As I stipulated in my opening remarks, we recognize that the
1990 preliminary targets are only a pause, and that in order to
pursue a goal of zero inflation over the longrun, implicit in such a
goal is a further lowering of our target range.
Chairman NEAL. Thank you, sir. I want to underscore what you
said a minute ago. It seems to me so important for us as a country
to understand clearly the enormous economic benefits that flow
from zero inflation. Zero inflation provides the opportunity for
maximum employment, for maximum savings, for maximum productivity, for the lowest possible interest rates, for our being the
most competitive we can possibly be in international trade. The
benefits that flow from zero inflation are enormous. I think that
we should not miss any opportunity to point them out and, hopefully > get a good broad consensus that we ought to move our economy
toward zero inflation and keep it there from now on.
Let me yield at this time to Mr. McCollum.
Mr. MCCOLLUM. Thank you, Mr. Chairman.
11
Chairman Greenspan, listening to your testimony this morning,
do I correctly interpret it as saying to us that you were generally
pleased with the producer price index and the consumer price
index this past week and that we would read into what you're
saying that you would anticipate, hopefully at least, that that
trend will continue this fall?
Mr. GREENSPAN. Well, we certainly found both indexes gratifying
and in line with the general expectation that inflation pressures
are easing. It's clearly premature with 1 month's data to say that
in fact the inflation pressures are behind us. Obviously they are
not, but it's certainly helpful to find one's basic view of the overall
environment essentially underscored by data of that sort.
Mr. MCCOLLUM. In the same week we had a somewhat disturbing
1-month trade deficit report. How do you read that in light of all of
this?
Mr. GREENSPAN. Well, I think it's clear that we had a very dramatic decline in our trade deficit in the early part of 1988, and it
has drifted up somewhat, but still a slight downward drift is clearly perceivable over the last 1 or IV2 years.
I do think that exports still have a way to go, and perhaps a significant way to go on the upside for the United States. We still do,
incidentally, have, despite the easing of the order patterns of
recent months, export orders in excess of exports, in effect implying that the unfilled orders are rising and the trend is still in tact
on the export side. I think that we don't fully yet know how far
that will carry, but so far the numbers do look encouraging.
The gradual slowing in underlying inflation pressures probably
still has not yet impacted on imports as much as it is likely to do,
and so I still think that there is a downward trend perceivable in
our trade deficit in the period ahead.
Mr. MCCOLLUM. In your statement you've stated a number of different ways, but on page 8 you said "Monetary policy will need to
continue to focus on laying the groundwork for gradual progress
toward price stability," which all of us of course concur in.
You follow that by making the statement "Such an outcome need
not imply a marked downturn in the economy, and policy will have
to be alert to any emerging indications of a cumulative weakening
of activity."
What would those indications be of a cumulative weakening?
Mr. GREENSPAN. Well, first of all, let me just follow up a bit on
the trade outlook.
Mr. MCCOLLUM. Certainly.
Mr. GREENSPAN. We have to be a little careful in analyzing these
numbers of being overly concerned with an individual month's
data. I mean, it is quite possible for these trends to go off for a
month or for several months and then reassert themselves. It's a
highly unstable statistical series, and I don't want to try to give
you a forecast other than the long-term drift because it is quite
possible that the trend in the trade data could be quite stable for a
while and go up and then go down. But I do think that we still
have a way to go on the down side so far as the trends are basically
concerned.
Not only will we be looking carefully at those data with respect
to the emerging forces, but basically what we are looking at is the
12
balance of the way the economy is moving forward—whether or
not we see slight inventory backup occurring, whether we see a significant and unexpected deterioration in new orders, for example—
anything which suggests that what has been a slow pace and has
yet not shown any really significant signs of cumulative downturn.
What we would be looking for is evidence that the moderate,
slowed pace begins to accelerate on the downside. We do not see
that at this moment. It is sluggish, but not cumulative. There is
some very mild backing up of inventories, but nothing near what is
usually a precondition for economic downturns.
One thing which I might say would concern me is an acceleration of inflation. Should that occur, I think that would, in and of
itself, create the type of structural imbalances which could tilt us
down.
I must say to you I don't see that at the moment, but obviously
when the economy is running slow, one has to keep that in mind,
as I commented in my opening remarks.
Mr. MCCOLLUM. Thank you very much, Mr. Chairman.
Thank you, Chairman Neal.
Chairman NEAL. Thank you, sir. Let me say to my colleagues,
that it is my intention to stick with the 5-minute rule so everyone
will have an opportunity to speak. We will have time for as many
rounds as Members who wish to speak.
Mr. Barnard.
Mr. BARNARD. Thank you, Mr. Chairman.
Welcome, Mr. Greenspan, to our mid-year evaluation of the economy.
In an earlier week's edition of the Economist Magazine they outlined what the growth rates and inflation rates would be for the 12
OCED countries, and they seemed to be somewhat in line with
your projections as far as growth and inflation is concerned.
But they do indicate that they feel like the attitude of the public
or businesses is going to be that more is going to have to be done
than the Fed anticipates doing to stimulate this growth, and I don't
envy you the job of trying to anticipate growth and prices and employment to the degree that we are trying to get down to zero inflation.
Of course I don't guess you expect that the reaction to your decisions are going to be wholeheartedly accepted, but do you think
that there is going to be a demand to, in view of the projection, a
greater demand to reduce interest rates?
Mr. GREENSPAN. It's difficult for me to make that judgment, Mr.
Barnard. The reason I say that is clearly interest rates are down
quite significantly. We have had a fairly dramatic decline, and especially in long-term interest rates, which have gone down over a
percentage point in the most recent period. The Treasury bill rate
is down well over a percentage point, and the whole rate structure
is coming down, including mortgage rates.
At this particular stage I would think that the effects of that are
beginning to emerge clearly in the various different types of markets, and while obviously, other things equal, lower real interest
rates are always better than higher real interest rates, I do think
what we have to be very careful about is acting in a manner which
reflates the economy very quickly by flooding the market with re-
13
serves, which, in turn, may bring short-term rates down. In fact, I
can guarantee it will bring short-term rates down, but it will not
bring long-term rates down.
Mr. BARNARD. A further question I have is while we have seen
inflation increase from SV2 percent to its present since 1988, and
what you're saying is it is really unreasonable and unworkable to
see that inflation be reduced that fast over the next 2 years?
Mr. GREENSPAN. Well, I think that the path we are on now probably is as good a path as one could be on, granted all of the other
problems that we have in the world, in the economy, and the various different types of imbalances. I think it's much too premature
to say that we will succeed in diffusing the inflationary pressures
in a manner which basically will create the type of environment
which the chairman has been discussing. That obviously is where
we are heading. It's a longer-term goal and it's not something
which I think one can rush.
In other words, if you try to rush it one way or the other, either
side, you probably dislodge the economy from its path.
Mr. BARNARD. Mr. Greenspan, I was impressed with what you
said on page 16. It says here that "I wish I could say that the business cycle has been repealed, but some day some event will end the
extraordinary string of economic advances that has prevailed since
late 1982."
Now that combined with the fact that our best weapon, the Government's best weapon to fight inflation is its credibility, as I understand it.
Now this brings me to this question. Couldn't that event be the
fact that we continue not to be able to balance the budget and the
fact that we are facing problems like the savings and loan bailout,
cleanup of nuclear waste and other tremendous costly matters,
couldn't that be the event that would put us into what you might
could say is an unnecessary and destructive recession?
Mr. GREENSPAN. Well, clearly there are a number of things that
could do it, and one would be a disillusionment in the financial
markets with the progress that is being made on deficit reduction,
and that could conceivably drive long-term interest rates higher,
which would tilt us over.
I must say, however, that usually Murphy's Law works such that
anything that can go wrong does go wrong, and I must say so far as
the Federal budget is concerned, it hasn't been working. The deficit
has been coming down and things have been better than I would
have forecast. I think that the Congress and the administration
should sort of grab that event and use it as a vehicle which could
very readily bring the problem of the budget deficit down to insignificant dimensions.
Mr. BARNARD. Well, let me just say in closing, because my time
has expired, as we face this very controversial decision as to whether or not the sayings and loan bailout will be on budget or off
budget, that decision could very well trigger the fact that GrammRudman in the future will not be as important to us as it has been
in the past, and when that dike is first cracked, we may then find
that we are off and running toward a different circumstance.
I'm pleased with what we've done in bring the deficit down to
what it is, but I think that some very interesting decisions are
14
looming right now that would disturb that Gramm-Rudman would
continue to be our goal.
Mr. GREENSPAN. Well, I must say, Congressman, that despite the
fact that Gramm-Rudman is scarcely the type of fiscal vehicle
which, as I have said to others, I would consider ideal as an example in a course in Public Finance 101, it really does look to me as
the crucial structure which the Congress and the administration
can work with to bring the deficit down, and anything which undercuts Gramm-Rudman, in my view, is clearly detrimental that
process.
One of the reasons why I, in fact, very early on before this committee, supported the administration's recommendations with respect to financing was that I considered that its recommendation
created less of a threat to the Gramm-Rudman process than alternate means of financing, and specifically the many which suggested to do it on-budget with an exemption. It's the exemption issue,
not the on-budget issue which is the crucial question.
Mr. BARNARD. Thank you, sir.
Chairman NEAL. Mr. Wylie.
Mr. WYLIE. Mr. Chairman, I want to follow up on that question. I
thought that might be extraneous to your report this morning, and
I do appreciate the very rosy report which you have made as far as
the state of our economy.
But one of the issues which is about to hang us up on the savings
and loan bill perhaps, I'm not sure, is the issue of on budget/off
budget financing. You mentioned on page 6 that "As public attention increasingly focused on the financial condition of the industry
and its insurance fund, institutions began to lose deposits at a significant rate/' and then you point out that our national savings
rate is not high enough and we need to do something to enhance it.
So I think we need to restore confidence quickly in the savings
and loans and in the depository institutions system.
You also point out that some of the disintermediation from the
savings and loans went into banks and money market funds. So it
in effect was counted as savings.
But where I'm coming from is this. I agree with you, well I took
it from you partly that the psychological effect of waiving GrammRudman at this time might have a bad impact on the state of our
economy and on our trading partners who think we are serious
about reducing the deficit, and I think we need to be serious about
reducing the deficit.
One plan calls for $50 billion of Ref Corp bonds, which would be
off budget. Another plan calls for $50 billion of Treasury borrowing, which would be on budget, and I hope it's appropriate as a
part of monetary policy discussions here to ask you this question.
What if we put $25 billion off budget for the next 2 fiscal years,
and then for fiscal year 1991 we would put the other $25 billion on
budget, the point being that we might be able to save a little bit of
money, but also we would not have to waive Gramm-Rudman for
fiscal year 1989 or fiscal year 1990.
Mr. GREENSPAN. Well that's the first time I've heard that suggestion, Mr. Wylie. Let me just say with respect to saving money, as I
have also indicated earlier, that really shouldn't be a part of the
decision. I don't consider the issue of the spread between off-budget
15
and on-budget to be the crucial question so far as financing is concerned because the actual up-front costs to fund that difference is
just something over $1 billion which, in my judgment, is a small
insurance premium to be paid for the purposes of doing it offbudget.
I think the crucial question at this particular stage really gets to
the issue of which of the two vehicles essentially would undercut
Gramm-Rudman most, and that is not an easy call. I mean neither
one has zero damage, and both clearly have a negative effect.
I would not want to comment on your particular suggestion, because I frankly would want to give it a good deal more thought.
Mr. WYLIE. I was going to suggest that you might prefer not to
comment just now, but please give it some thought. It's an attempt
on my part to come up with some compromise because I don't want
us to be at loggerheads over this issue. I think we need to get the
whole issue of the savings and loan crisis behind us before the
August recess and, as I have pointed out on many occasions, we are
losing $10 to $20 million every day we don't solve that problem. It
seemed to me as if it might be a compromise which would give us
an out, and I use the word "out" advisedly.
Mr. Barnard also pointed out that you have a very rosy report
here this morning, and we appreciate it.
On page 16 you said "Moreover, I cannot rule out a policy mistake as a trigger for a downturn," and some observers are concerned about the economy moving into a recession, as I pointed
out, and others are worried about inflation picking up further. You
say that you think there will be a soft landing and that most members of the FOMC are expecting a soft landing.
But I think I might have detected during your answer to a question from Chairman Neal that the Federal Reserve is probably not
going to consider bringing down interest rates very much in the
immediate future, and when I say that, that's not related I don't
suppose to the statement that you made that you can't rule out a
policy mistake as a trigger for a downturn.
Mr. GREENSPAN. Well, all I can say to you, Mr. Wylie, is this
morning I'm going out of my way to avoid implying one way or the
other what the Federal Open Market Committee is going to do, and
the only way you could get such an impression I would suspect is
through inadvertence on my part.
Mr. WYLIE. YOU don't anticipate any mistakes.
Thank you very much, Mr. Chairman.
Chairman NEAL. Mr. Hoagland.
Mr. HOAGLAND. Let me defer to the chairman of the full committee, if I might, Mr. Chairman, because he is so busy with the savings and loan work right now.
Mr. GONZALEZ. NO, no, go ahead, Mr. Hoagland. We have time.
Go ahead, please. Follow the regular order.
Mr. HOAGLAND. NO, please go ahead.
Mr. GONZALEZ. I really appreciate it. [Laughter.]
Well, that should remove any doubt about the all-powerfulness of
a chairman.
I thank you very much, Mr. Hoagland.
Actually I apologize for coming in late, but as we all have, we
have our district obligations.
16
I wanted to welcome the Chairman.
Mr. GREENSPAN. Thank you. I was hoping that you would be
spending your time elsewhere where you have been doing so much
good, Mr. Chairman.
Mr. GONZALEZ. Well, I'm not a party to the detailed processes at
this point. We have delegated that with the knowledge that some
of the issues are not staff level decisions, but we are trying to iron
out to point where we can come in and have one final session and
dispose of the matter on hand. But I'm not party to the daily work.
We delegated it, both the Senate as well as the House.
Mr. GREENSPAN. Let me just say I wish you well because I think
it is a very tough job that you are engaged in.
Mr. GONZALEZ. Well, it's complicated.
Mr. GREENSPAN. That I understand.
Mr. GONZALEZ. I think a lot of headway has been made and continues to be made, and we'll have a happy resolution, maybe not as
soon as some of us want it, but pretty quick. But thank you very
much for your good wishes.
I just wanted to say that I had to meet with the new Commanding General at the most historic Air Force Base in the United
States, Kelly Air Force Base, which is in the my district and has
been all along, and that's the only reason I wasn't here at the
outset.
I think some of the newer Members here may not realize why we
are here. We are here because of the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978, which I was one of the
co-sponsoring authors. The public reporting requirement stipulated
in the Act have two important purposes.
Of course I always welcome the Chairman, and particularly this
one that I think at a very critical junction in our national development is a very pragmatic captain at the helm of the Nation's monetary ship.
The reason for these semiannual hearings was a result of many
years of effort because the Congress believed that economic policy
making should be better coordinated between the Federal Reserve
Board and the rest of the Federal Government. Essentially that
was the major objective.
Second, the reporting requirements of the act provide the public
with a rare glimpse of the Federal Reserve's intentions regarding
the future course of economic activity.
The fact that you're here today, Mr. Chairman, is a result of the
Congress' insistence that the Federal Reserve lay its cards on the
table and be more open about its intentions. It was not long ago
that the release of meaningful monetary policy data was measured
in terms of years and not months or weeks.
While Congress had made progress in requiring the timely release of monetary policy data, I believe more needs to be done. For
example, this hearing is being broadcast live to millions of viewers,
and yet none of us know the results of the most recent Federal
Open Market Committee meeting held several weeks ago.
In fact, the Federal Reserve will not release the official results of
that meeting until after its next meeting, which is a lag of 6 weeks.
We live in the most open republic in the world, but our central
bank, arguable the single most powerful economic agent within our
17
society, has determined that the public should not have access to
the results of its policy actions for 6 weeks. I believe there is no
justification for this information lag. The President of the United
States would not get away with releasing such critically important
information 6 weeks after the fact.
The Federal Reserve should take the initiative and alter this
needlessly secretive approach to policymaking. The results of the
FOMC meeting should be released the same day the meetings are
held. The public has a right to all this information in a timely fashion.
This hearing is being held at a time when the outlook for the
economy is mixed. Economists are split as to whether or not the
Federal Reserve has gone too far in its quest to cool off economic
activity in order to keep inflation in check.
The unexpected rise in the exchange value of the dollar has dramatically increased our merchandise trade deficit which jumped 23
percent in May. While the trade news was disappointing, yesterday's inflation news was unexpectedly good. Consumer prices registered their2 smallest increase in more than a year as the June CPI
rose only Aoths of 1 percent. The favorable inflation news should
provide the impetus for the Federal Reserve to further loosen its
stranglehold on economic activity.
At this time, in my opinion, the overriding goal of the Federal
Reserve should be to concentrate on keeping unemployment at its
recent low levels. Inflation may distort the value of economic aggregates, but unemployment degrades the value of human existence.
Again, I say we are very fortunate though at this time to have
such a person as you, at the helm Mr. Chairman. As you know, I
thoroughly respect you, and I have expressed these views before.
Mindful that progress has been made over the course of years but
it wasn't until the 1970's that we even had such a thing as the
Humphrey-Hawkins Act.
But I want to thank you very much for the great work you're
doing.
Mr. GREENSPAN. Thank you very much, Mr. Chairman.
Mr. GONZALEZ. AS we have said before, we will do everything we
can to be creative and constructive in our criticism.
Thank you, Mr. Chairman, and thank you again, Peter. I deeply
appreciate it.
Chairman NEAL. Mr. Roth.
Mr. ROTH. Thank you, Mr. Chairman.
I appreciate you allowing me to ask these questions because I am
not on their panel. So I appreciate your allowing me to join the
panel this morning.
I'll be very brief. I just need a favor, Mr. Chairman, and two
pieces of advice, and then I'll be finished.
The Fed is not only our central bank, but it's also the principal
regulator of our banks. With the experience that all of us here on
this panel have gone through with the savings and loan, we don't
want to go through anything like it again. When everything is said
and done, the General Accounting Office now tells us it's going to
cost $284 billion. That's $1,000 for every person in this room and
every American. I checked my billfold this morning and I don't
18
even have $10 in it. So $1,000 is going to mean a lot I think to
every person in the United States.
In 1987 we had more than 180 bank failures in this country, and
last year nearly 200 bank failures, and the GAO has told us, Mr.
Chairman, that in every single case they studied these bank failures were categorized by bad management to a great degree. GAO
requests independent audits of the banks in this country. So in this
S&L Bill we have a provision for an independent audit.
Mr. Chairman, the favor I would like to ask is that you join us in
promoting that good concept.
Mr. GREENSPAN. Well, I'm not sure about the specific amendment involved. My recollection is that we have not been enthusiastic about any forms of duplication that would be involved, and we
don't want to load the smaller banks with unnecessary audits, but
we certainly agree with your general thrust, namely, that in the
context of keeping unnecessary audits off the agenda, that there is
certainly a crucial requirement on all of our parts to make certain
that individual banks are thoroughly looked at and that the reports that they make are correct.
Mr. ROTH. Well, thank you, Mr. Chairman. I appreciate that vote
of confidence because in this legislation we have taken care of your
concern because any bank with less than $150 million in assets
would be subject to an FDIC special rule, largely exempting them.
GAO also found that 800 banks, for example, had no audits at all
in 1987. I think it's very unfair for the American taxpayer to have
to stand behind these banks when these banks aren't even required
to have an independent annual audit.
We have 13 banks, Mr. Chairman, in this country that have $1
billion in assets and they do not have audits. I think that's very
unfair. So I appreciate your, as I interpret it, endorsement. Thank
you.
The advice I would have from you is regarding the $284 billion
bill. A dead rat has been pulled here to Capitol Hill by the S&L
industry. How can we balance a budget with that type of a bill now
facing the Congress?
Mr. GREENSPAN. Well first of all, let's remember that the vast
proportion of that number is interest payments, and that the
actual true underlying cost of the savings and loan losses, if you
take the $40 billion obligated prior to this most recent endeavor
which is estimated to cost some $50 billion is something still probably under $100 billion, and that's not exactly a small number.
But the point at issue here is that the $284 billion is essentially
the $50 billion with the interest that is involved, and I think it's
important to distinguish between true costs and costs which are financed. In other words, if we were to finance all of the S&L costs
through direct taxes in a one-shot tax on the American people,
then the total cost would have been the $40 billion plus the $50 billion, which is the current request. There would be no interest. So
that the difference between the $50 and whatever figure one uses,
depending on how many years of interest you put on, is the interest cost, and it's not directly, as far as I see, related to the hole
that we have to fill in the S&L cost. It's the fact that we're borrowing the money to do it is what is generating that cost.
19
Mr. ROTH. But still in the final analysis it's still going to cost the
$284 billion.
Mr. GREENSPAN. Oh, sure. In the end that's quite correct.
Mr. ROTH. You're a person that looks into the future and looks at
what is taking place in our financial markets. How about farm
credit for example? Are we going to be faced with any problems in
that area?
Mr. GREENSPAN. Well, fortunately, the problems in farm credit
have very clearly eased. That is, we were having some very significant delinquencies in the farm credit area, and these have come
down quite appreciably.
I trust that with the farm real estate values now beginning to
rise again, and hopefully the crops coming back to normal yields,
that the financial state of the farm community will stabilize and
that we will not be looking at anything remotely resembling the
type problem we ended up with with the S&Ls.
Mr. ROTH. Well, I certainly hope, Mr. Chairman, that you are
correct. I have just been handed a note that my time is up, but I
appreciate your indulgence in answering the questions.
Thank you, Mr. Chairman.
Chairman NEAL. Chairman Gonzalez raised a question and I believe it would be accurate to say that Chairman Gonzalez recommended the immediate release of the decisions made by the Open
Market Committee as opposed to releasing it with a delay following
the next meeting. Would you like to comment on that?
Mr. GREENSPAN. Yes. First of all, let me just say that when we
make definitive judgments with respect to monetary policy, it is reported immediately. When we change the discount rate, it is reported immediately. When in the past reserve requirements
changed, it was reported immediately.
The reason why we choose not to publish our minutes until they
are replaced at a subsequent time is that the form of the decisions
that are made at the FOMC meeting are a variety of contingencies.
By that I mean, as those of you who have read these minutes
know, what we basically agree on is that if "A" happens, we will
do "B", and if "C" happens, we will do "D", and in a sense what
we are doing is not saying we are going to do something very specifically at that particular time, but rather it is a series of contingent actions.
Our concern is that if we were to publish that at the point at
which the FOMC set forth the various options, the markets would
behave on the basis, or react to our expected contingencies, without
the actual events occurring, and we think that is probably more destabilizing than the markets reacting to specific actions taken by
the Federal Reserve.
Now what happens when we actually move, Mr. Chairman, is
that the markets know it pretty quickly, and in fact we try to communicate to the markets that we have changed policy. And I just
say that there is scarcely a difference between the actions we take
in which policy is actually changed and the markets' knowledge of
that. The difference is almost negligible.
So I say to you that the reason that we don't publish our minutes
is a technical problem in the way we function with respect to open
market policy.
20
My own judgment is that we would not be conveying anything
new to the markets as to what we're actually doing, but merely
just conveying a whole series of what we might do under various
different types of contingencies, and I think that's probably more
destabilizing to the markets than the way we behave now. Frankly,
I think that the procedure which we have is essentially the best so
far as tactical month-by-month actions are concerned.
I think tactically we do convey every action we take fully and
completely to the market, and obviously the very broadest policy
issues are those which we present here in our semiannual meeting,
which are our target ranges, and we report them at the point at
which those initiations are made.
So I would say that our general purpose is basically in fact to
make our actions immediately available to the public because that
works most effectively.
It's only because of this very specific contingency question, which
is caused by the fact that we cannot meet every day and make decisions every day, that we endeavor to delay the minutes, but do publish them as soon as those minutes become supplemented by a new
set of minutes, which occurs approximately every 6 to 7 weeks.
Chairman NEAL. Mr. Hoagland.
Mr. GREENSPAN. I must say, Mr. Chairman, I will be glad, and in
fact I would like to go into this in considerable detail and try to
explain specifically to you why it is in order to try to make it clear
why we think that is superior, and hopefully we would get your
judgments as well as a consequence of that type of a discussion.
Mr. GONZALEZ. NOW you're talking to this Chairman. Well, I appreciate that very much, Mr. Chairman, and we will get together.
Mr. GREENSPAN. Good.
Mr. HOAGLAND. I know I have told you this story before, Mr.
Chairman, but I think it bears repeating. Last January when you
first testified before the Banking Committee when Chairman Gonzalez was presiding, you made a couple of remarks that resulted in
the market going up 28 or 30 points, and I got a call from my
mother that night about how pleased she was. I promised her and
my father that whenever I had a chance I would give you a chance
to make some comments that might make the market go up.
[Laughter.]
I wonder if there is anything you would like to say in that connection today? [Laughter.]
Mr. BARNARD. That gentleman had better get out of the door because there would be a stampede. [Laughter.]
Mr. GREENSPAN. Mr. Hoagland, I am most appreciative of your
invitation, and I trust I may be able to decline, if you don't mind,
and express my apologies to your mother. [Laughter.]
Mr. HOAGLAND. Well, I will ask you again in 6 months. [Laughter.]
Let me ask you first, Mr. Chairman, after more than a year now
of progressive tightening, while you have recently eased monetary
policy slightly, and I wonder if this represents a beginning of a
trend that is likely to last for a number of months as was the case
with the tightening, or are you attempting a fine-tuning maneuver
that you may soon reverse?
21
Mr. GREENSPAN. It's very difficult for me to answer that particular question because we don't know the answer.
The basic thrust of policy is essentially to diffuse the inflation
pressures in a manner which does not tilt the economy over into a
severe recession. It's much too soon to make a judgment as to what
the consequences of our actions late last year or even earlier this
year and most recently are.
There are lags in the implementation of monetary policy and its
impact and, as I indicated in my prepared remarks, inevitably
every monetary policy action presupposes a forecast, and a forecast
can be wrong. In fact, if we are right two times out of three, that's
a fairly good record. But because you're wrong on occasion, it is not
desirable to do too many wiggles because what you then do is to set
up a set of potential imbalances in the system which would induce
much greater volatility in the market.
So what is wrong basically with so-called fine-tuning is that we
can't. That does not mean that we don't endeavor to make adjustments along the way because that is appropriate, but we do it in
the context of how confident we are about certain aspects of the
economy's future, and at this particular stage, it's fairly clear that
we've got a fairly complex situation with which we're dealing, and
we tend, I think, to be cautious, and rightfully so.
Mr. HOAGLAND. So when you begin heading in a direction then
you're likely to continue in that direction.
Mr. GREENSPAN. Well, actually it's hard to answer that question
because events may emerge which make that an inappropriate
action. It's very difficult to project monetary policy because what
you're essentially trying to do is to project forecasts, in other
words, you're forecasting forecasts, and that gets, I think, pretty
difficult to handle.
I could give you a long series of potential alternative policy paths
which the Federal Reserve could pursue, but I'm not sure that is
very helpful because I frankly don't know on which ultimately we
will find ourselves.
Mr. HOAGLAND. Let me get you on a different subject briefly. Do
you have regular meetings with the President to discuss economic
and monetary policy matters to try and develop a coherent strategy to keep the economy on a strong course, or do the contacts take
place only on an ad hoc basis, and I'm wondering
Mr. GREENSPAN. You're talking with the President?
Mr. HOAGLAND. Yes, sir, with the President or with members of
his staff.
Mr. GREENSPAN. Well, I have periodic meetings with the President in the so-called quadrate configuration, meaning with the
Chairman of the Council of Economic Advisers, the Secretary of
the Treasury and the Director of the Office of Management and
Budget and myself. That's the so-called quadrate.
We don't have scheduled meetings, but we have them periodically. I meet with all of these people one-on-one frankly quite often—
often several times a week and sometimes several times a day—
and I do on occasion run into the President and we will chat.
So I feel that there is no lack of appropriate coordination. I mean
there is, remember, only one American Government, and there is
only one American economic policy, and while we are independent
22
of the administration, that does not mean that we would have a
policy which we consider to be at variance with the national policy.
What we try to do is coordinate as best we can in the context of
what the Treasury and the President are doing, and that's one of
the reasons that we have these periodic meetings, which I would
say are more than adequate discussion with the other major policymakers within the administration.
Mr. HOAGLAND. Well, my time is up, Mr. Chairman, and thank
you for yours today.
Chairman NEAL. Mr. Leach.
Mr. LEACH. Thank you, Mr. Chairman.
First, let me compliment you on a remarkable statement. I think
it's very modest in indicating that the Federal Reserve might make
mistakes once in a while and very genteel in saying that the business cycle has not been repealed and that some unkown event
might change the direction of the economy.
And genteel I would say to the gentleman from Georgia because
the clear message was that some day we might have a change in
the political cycle and a Democrat might get elected President. I
can understand that this great expansion we've had underway for
8 or 9 years might decline.
Let me just turn briefly, I meant that with some facetiousness,
Mr. Barnard
Mr. BARNARD. We never know, Mr. Leach, with you.
Mr. LEACH. Fair enough [Laughter.]
But it strikes me that even though you've made a definitive
statement, you don't want to be inadvertent about making a view
known on the direction of policy. You have made a very substantial
shift in philosophical attitude in this statement compared to the
last one you've given. Your last statement was very tough on shortterm concerns for inflation. This statement maintains a firm longterm concern for inflation, but has put forth a very clear signal
that short-term accommodation with money supply growth is appropriate.
You pointed out in June that we had a 6% percent growth in
M2, and that rapid rate is continuing in July. It strikes me that
this represents a very significant shift in Federal Reserve policy. Is
that valid or not?
Mr. GREENSPAN. I would say that the words that are in my opening statement were chosen very carefully.
Mr. LEACH. Well I appreciate that. Now there has been some indication about rosy forecasts. It strikes me that the economic projections of the Governors and the presidents of the banks are not
that rosy, but instead, they indicate stagnation. One and a half percent to 2 percent real GNP growth next year, and 4Vfe to 5 percent
inflation doesn't strike me as a standard that we should be ecstatic
about, with the exception that there may be in these kinds of turbulent times something reassuring about stagnancy.
But in the long term are those the kinds of numbers that the
Federal Reserve Board is aiming at, or are those on the low side of
economic growth and on the high side of inflation?
Mr. GREENSPAN. I would say, one, they were on the low side of
economic growth and the high side of inflation.
Mr. LEACH. Fair enough.
23
Finally, let me just ask one question relating to the value of the
dollar. As you know, it has appreciated somewhat. We're back at
about the February 1987 levels at a point where Secretary Baker
played such a crucial role in precipitating a downward valuation of
the dollar relative to some other currencies.
Is your view that the basic kinds of structural personal and Government relations are such that this is where the value of the
dollar is going to be pegged, or do you look for it to be lowered or
increased in the near future?
Mr. GREENSPAN. Well, I think, as has been stated in the various
communiques of the G7 Finance Ministers and Governors, that fundamentally we all perceive that stable exchange rates are better
than unstable exchange rates. The way that can be achieved over
the longer run is bringing domestic inflation down. In other words,
if all of the G7 had very low inflation rates, then, inevitably, exchange rates, bilateral exchange rates amongst the G7 would tend
to stabilize.
We don't, however, tend to try to override market forces that we
perceive as being fundamental, and there has been no judgment
within the G7 to so-called peg the rate, which is implicit in any
sort of a fixed rate exchange. But we do overwhelmingly value the
issue of stability of exchange rates, and most of the focus is to try
to make those rates as stable as we can.
The essential focus over the last year or so has been to do that,
and in large measure I would say that we have succeeded. Certainly there has been a considerable amount of cooperation, coordination and considerable efforts jointly and bilaterally, and I must say
I'm satisfied with the process.
Mr. LEACH. I appreciate that. I've got a note that my time has
expired.
But I would just like to express my appreciation for the flexibility that I think you've indicated in the Federal Reserve policy. I
don't know if you were hinting that maybe a mistake in too much
tightening had occurred, but clearly a little bit of easing at this
time appears to be warranted and the Federal Reserve Board appears to be moving in that direction.
Thank you.
Chairman NEAL. MS. Kaptur.
Ms. KAPTUR. Mr. Chairman, as you know, I'm not a Member of
this subcommittee, but I appreciate t lle opportunity to attend.
Would I be stepping on another Membe: 's rights if I asked a question?
Chairman NEAL. NO, we have been goi lg from side to side.
Ms. KAPTUR. All right, Mr. Chairman. I'll make it very brief.
I just want to welcome Chairman Greenspan and thank him for
his courtesy to Members of this Commi|ttee always and the members of his staff as well.
I just wanted to ask you in the context of the world economy how
good is a real growth of 2 percent per y ear in GNP in view of our
trade competitors, some of the growth rates that we see around the
world and our productivity? Could you put it in a global context for
us, please.
Mr. GREENSPAN. Well, it's clear that when we have international
imbalances, meaning we have large current account deficits and
24
our trading partners have large surpluses, if we wish to bring those
down, then clearly our domestic demand should rise at a slower
pace and, hence, absorb fewer imports than they. In other words,
what we want to do is to set up a situation in which their growth
and demand is faster than ours so that our exports would rise relative to our imports in a way which would close the gap.
So what we are looking at is a somewhat slower rate of growth
in the United States than abroad, and while clearly that's not
something which we would like to perceive as permanent by any
means, in the short run it does have advantages in bringing the
international imbalance down.
Ms. KAPTUR. But the recent trade figures suggest that whatever
is supposed to take hold hasn't taken hold yet, don't they?
Mr. GREENSPAN. Well, no, that's not quite right. I think that, as I
indicated earlier, the trend in our trade deficit is down, but I do
believe there have been and will continue to be pauses. In other
words, we come down and we pause, we go down and we pause
some more. I think that process is a very jagged one, and I think
that if we continuously focus on any individual month or any
short-term series of months, I think that's probably not a good
enough set of information to track the trend.
Ms. KAPTUR. I thank the gentleman, and yield back the remainder of my time.
Chairman NEAL. Mr. Bunning.
Mr. BUNNING. Thank you, Mr. Chairman.
Welcome, Chairman Greenspan.
I would like to touch on something you said in your statement,
particularly in lieu of the fact that the Ways and Means Committee is now about to bring a new tax increase of approximately $50
to $60 billion under consideration presently, and approximately $30
to $35 billion in new spending.
Is this the type of catastrophic occurrence that you are speaking
about in your statement? I don't believe they read the President's
lips too well during the campaign, no new taxes, and the current
Ways and Means Committee has under consideration approximately $50 to $60 billion dollars in new tax revenues.
I don't believe that the Federal Reserve and the policy of the
Federal Reserve has taken that into consideration.
Mr. GREENSPAN. Well, Congressman, I think that we read the
newspapers and we do have other reports as to what is happening,
and we try basically to take into consideration pretty much everything that is going to affect markets because it clearly affects what
it is we do and the economy as a whole.
The types of adjustments that I was talking about in my prepared remarks mean supply shocks, for example, macro-global effects like the huge increase in oil prices which were very debilitating to the American economy. There is a long potential list of disasters that could emerge, and I'm just not prepared at this stage to
put them into the record.
Mr. BUNNING. Well, all right. Let's follow that up a little bit. The
fact of the matter is that you have with your policies and with the
other members of the Open Market Committee have been able to
restrain our inflation at 5.9 at the max this year, or a little over 6
percent, and how we seem to be trending down.
25
Do you look for a loosening of interests to continue that trending
down, or is the policy of the Federal Reserve going to be maintained at the current level? In other words, the handle that you
have on the economy presently seems to be a very effective
method. Are you going to loosen or do you project loosening in the
future?
Mr. GREENSPAN. Well, Congressman, as I indicated, we eased in
early June and early July, and we are under continuous discussions with respect to policy. I can't forecast what it is we will do
because it will depend on a events as they emerge.
Mr. BUNNING. What I'm trying to get at is our commercial bankers seem to be reluctant to follow your lead, and the commercial
banks seem to be reluctant to lower their prime interest rate even
though the Fed has lowered and
Mr. GREENSPAN. They have lowered it once.
Mr. BUNNING. Yes, and one other or two major banks have lowered it another V± of 1 percent or V2 percent, but I'm looking at an
overall picture in the next 6 months. Can we look for a continuing
lowering or softening of the long- and short-term interest rates?
Mr. GREENSPAN. I can't answer that because I don't have the authority to answer in the sense that I don't have in front of me the
Federal Open Market Committee instructions of the next 6 months.
But I will say to you that what it is that we will be doing is essentially to monitor very closely what is going on in the economy and
in the financial markets and craft our monetary policy essentially
to meet what our longer-term goal is, namely, to maintain maximum potential economic growth and, as I indicated very early on,
that presupposes continuous restraint on inflationary pressures.
The combination of that and how we will emerge in particular is
something which I really can't forecast.
Mr. BUNNING. HOW much impact do you believe that a sequestration might have on our economy?
Mr. GREENSPAN. YOU mean in a negative sense or in a positive
sense?
Mr. BUNNING. Negative.
Mr. GREENSPAN. It depends on the size of the sequestration. I'm
not of a view that sequestration necessarily has a negative economic impact because clearly if the budget deficit is not coming down
because agreements cannot be reached, while I would not argue
that sequestration is something which I find particularly desirable,
the alternative of doing nothing is worse. I would conclude under
those conditions that if we were forced into sequestration, which I
certainly hope we are not, it basically means that we are not bringing the deficit down in a manner which is appropriate to balancing
this economy, and sequestration, as bad a tool as it is, is better
than doing nothing.
Mr. BUNNING. Thank you. My time has expired. I appreciate you
coming before our subcommittee. Thank you.
Mr. GREENSPAN. Thank you very much.
Chairman NEAL. Mr. Chairman, I would like to return briefly to
the question of the coordination of policy between the Fed and the
administration. I believe that it depends on what you mean by the
word coordination as to whether it is a good idea or not. It seemed
to me if the word means to harmonize in some way, in other words,
26
to have the policies, fiscal and monetary policies heading down precisely the same path, that that could often be quite disastrous and
not a goal to be desired.
Mr. GREENSPAN. YOU mean if we're both wrong.
Chairman NEAL. Yes, that is exactly right. It seemed to me if you
look back over at the 1980's, they provide a good example. You
could fairly characterize fiscal policy as having been very loose,
and it was only a relatively tight monetary policy, it seems to me,
that saved this country from an absolute disaster. If we had coordinated in the sense that a lot of people use that word—or harmonized those policies—our economy would look more like that of Argentina, Brazil, or Mexico. Monetary policy would not have followed the rather sensible course that we have come to eventually.
Thus I hope that was not what you meant when you said you
thought it was a good idea to coordinate.
Mr. GREENSPAN. I do think it's a good idea to coordinate. That
does not necessarily mean that you come to an agreement. Inevitably we have to coordinate. For example, we are the fiscal agent of
the Treasury and we do a great number of things which are required to be done in the monetary sphere for them.
But what we do try to do is to tell them what it is we are doing,
how we view the outlook and what consequences we think that has,
and we do comment on all other aspects of policy and endeavor to
make certain that if there are disagreements, that it is not merely
because we failed to communicate the reasons for our particular
positions.
Fortunately, at this stage in the near 2 years that I have been at
the Federal Reserve I have not found myself in the position where
I considered that administration policy was moving in a dramatically different direction than I thought the implications of Federal
Reserve policy was.
Chairman NEAL. I assume you in no way mean to imply that you
would yield any Fed policy-making decisions to the administration.
Mr. GREENSPAN. That is correct. We are independent and behave
in that manner, hopefully.
Chairman NEAL. I don't think we have a difference of opinion
here. There is a bill floating around that has language to the effect
of having the Fed and the administration coordinate policy. I think
what the authors of the bill mean by that is something that I believe would be damaging to the economy. I think what they have in
mind is that if the fiscal side is on an expansive course, then I
think they would like to see the Fed fall in line and pursue expansive policies also. It is in that sense that it seemed to me that it
would be a terrible mistake for any kind of coordination.
Mr. GREENSPAN. I would certainly agree with that. I must say to
you, Mr. Chairman, that the general philosophy of this administration with respect to fiscal and monetary affairs I find myself comfortable with.
Chairman NEAL. Well, I find that interesting, but that is not the
question I asked however. It seems to me it is important, as I said
in my opening statement, for us as a subcommittee to independently look at the numbers regarding inflation and other economic indicators that show where we are heading. It is a responsibility that
we have and should take seriously. It seems to me that we would
27
have the same responsibility when looking at fiscal policy. That is
to say, if we have people from the administration saying that their
goal is to balance the budget, but in practice the result of the
policy that is followed is to triple the national debt in 8 years, then
there is clearly a little difference between the rhetoric and the outcome.
It is the outcome—the numbers—that I am interested in. Thus, if
the Fed's policy during the 1980's had been expansive, as fiscal
policy clearly was, it seems to me we would have experienced a
great disaster.
Mr. GREENSPAN. I couldn't agree with you more, Mr. Chairman.
Chairman NEAL. Thank you, Mr. Chairman. My time has expired. Mr. Barnard.
Mr. BARNARD. Mr. Chairman, at this time when we are going
through a period of reduced economic growth, and hopefully that
we will further reduce inflation, aren't we experiencing a pretty
high rate of production capacity, the utilization of production capacity?
Mr. GREENSPAN. Yes, we are, Mr. Barnard.
Mr. BARNARD. SO if we continue then to slow the economy, or if
the economy continues to slow and interest rates slow, then all of
the sudden we start to—well, if we start to have good economic
growth, more demand, and here we are right now with a high production capacity, wouldn't that fuel the fires for larger increases in
inflation?
Mr. GREENSPAN. Yes, it would, Mr. Barnard. In other words, if
the economy would unexpectedly turn at this stage and begin to accelerate, we clearly would have difficulties on that score. I don't
expect that to happen, but clearly it is not something with a zero
probability.
Mr. BARNARD. Sometimes we sort of feel like those who sort of
preach the possibility of a significant recession, and I don't mean a
big depression, but a real dip that we're off base, and I know that's
what you all are trying to prevent, but it is a delicate balancing
mechanism, isn't it?
Mr. GREENSPAN. It certainly is.
Mr. BARNARD. You've got a hard job.
Did you attend the meeting in Europe with the G7?
Mr. GREENSPAN. NO, I did not. I don't believe that Federal Reserve Chairmen have ever been in those meetings.
Mr. BARNARD. The reason I was going to ask is because it's still a
lot of interest to some of us, the progress that Mr. Delora is making
in Europe with his organization of his 12 European countries and
the so-called Economic Community-1992. I think even at the last
meeting they decided to go forth with the possibility of a European
currency.
How do you see that affecting some decisions in this country at
this point?
Mr. GREENSPAN. I don't think it's anything immediate. I mean
clearly the very first issue, the first stage of the report, the socalled Delors report, is further integration of the European monetary system, and that is not going to have any material impact on
American monetary policy.
28
Clearly we audit the EMS on a daily basis, and we are quite
aware of the various pressures that are emerging between and
among the various members of the EMS, and to a certain extent it
does affect our policies in the context of the G7, especially on the
issue of intervention.
But I see no really major impact on the United States. In fact, I
would probably see no detrimental impact even were they to go to
the next stage and that is a European central bank, or even finally
to a single currency.
Obviously, some of our policies would be different tactically from
the way we implement them at this particular stage, but I don't
consider that it serves as a major alteration of the international
monetary system in a manner which fundamentally affects us and
our actions.
Mr. BARNARD. What about other factors though, what about
trade, or maybe even the competition of international banks, how
do you see that?
Mr. GREENSPAN. Well, we did have some concern early on when
the preliminary version of the so-called Second Banking Directive
was issued, and it at least suggested a the form of reciprocity by
which their banking regulations and ours would interface that
would create some problems for American banks.
That has turned out not to be the case at least up to now. Significant revisions have occurred, or more exactly, clarifications have
occurred which suggests that American banks will not do poorly as
the EC develops.
Mr. BARNARD. My time has expired, Mr. Chairman. Again, and
I've been pondering how I'm going to ask this next question. It's a
very simple question. But in view of Mr. Heller's resignation,
would you like to comment whether or not the members of the
Board of Governors are adequately paid or underpaid or should
their salaries be increased?
Mr. GREENSPAN. DO you mean would I like to answer that question? [Laughter.]
Mr. BARNARD. I think in view of the situation
Mr. GREENSPAN. Let me say this, that I think that I would pretty
much subscribe to my predecessor's remarks before the Congress
relevant to the Commission that he headed.
My concern is that we at the Federal Reserve should not become,
at least the Board of Governors, a group of Governors who are
either independently wealthy when they emerge on the scene, such
as myself and a few others and hence the salary is not a relevant
consideration, or those who have to struggle with their finances—
those who have children in school and have to finance a number of
things. Despite the fact that it appears to be a very high salary,
and unquestionably is a very large salary relative to the average
American family income, it has turned out in too many cases to require Federal Reserve Governors to leave because they could not
afford to stay, and I think that does not serve the national interest.
While I scarcely feel comfortable lobbying for salary increases,
my own concern is not so much with the few of us who don't need
a salary increase, and I certainly do not, I am concerned about the
future of the System because I know some of the members do
struggle, and I am very much aggrieved to see Dr. Heller leave,
29
and not because he wanted to, but because he was in a financial
bind.
Mr. BARNARD. Thank you.
Chairman NEAL. Mr. Chairman, I think you are absolutely correct. It just seems absurd to me that here we are trying to find the
very best people for these jobs—jobs making among the most important decisions that are made on behalf of the American people
that affect every aspect of our economic lives—yet we pay them
less than a mid-level officer in a big "corporation or the head of a
small company. It does not make sense. Somehow we must come to
the understanding that these top-level jobs in our Government, including the Fed, are critically important to the future of this country.
Every time a subject like this comes up I think of Paul Volker.
Chairman Volker I think saved this country from disaster. He
should have been Man of the Year many times over, and he should
have gotten a Nobel Prize for practical economics,
Mr. GREENSPAN. I agree with that.
Chairman NEAL. He literally did so much for this country.
Coming from the Federal Reserve Bank in New York he took a
salary cut of about half, as I recall, to be Chairman of the Federal
Reserve Board, and he could have made many times as much
money in the private sector. It is ridiculous.
Mr. BARNARD. Would the chairman yield?
Chairman NEAL. Yes, I yield.
Mr. BARNARD. Let me say I don't apologize for bringing up this
subject. The fact is I brought it up, and I certainly want to associate myself with the comments of my chairman, because I think it's
something that needs to be discussed, and I think the American
people and the Government should realize, and I appreciate your
comments this morning.
I didn't intend to embarrass you, but I really think that it's a
subject that we need to take under serious consideration.
Chairman NEAL. I quite agree.
Mr. McCollum.
Mr. MCCOLLUM. Thank you. I tend to agree with both of the gentlemen, and yet it's sort of one of those inflation factors I guess
that's out there. We really do need to increase some of the salaries
at executive levels around here.
I just happened to have the occasion to have the new Secretary
of Health and Human Services before a group yesterday in which
he was discussing once again the problems of the lack of being able
to hire the professionals at NIH to do the studies there, and it goes
on and on and on. So it's not surprising that we have this problem
at the Fed, too.
I would like to bring the subject over to just one or two quick
concluding thoughts and ask you about them if I could, Mr. Greenspan.
In an early week issue or two of the Wall Street Journal Gary
Shilling wrote a column that you may have seen that's entitled
"What If We Are Not In For A Soft Landing," and it's one of many
that have been out there recently worry about this or worrying
about that.
30
He says, "With weakness in spending, inventories have been
climbing in relation to sales in normal pre-recession fashion. True
inventories aren't yet thought to be out of hand, but they never are
until the recession is underway and stocks in manufacturers' and
retailers' hands soar as sales fall faster than production can be
cut." And essentially he goes on to warn the business community
about their inventory problem.
Is he correct in that? I don't expect you to have read the article.
Mr. GREENSPAN. I think I glanced through it. No, I think that's
basically correct in the sense that we have to be careful when one
looks at inventory data to understand that what seems to be very
low levels of inventories when purchasing managers are desirous of
continuously building them because they perceive of expanding
business and production all of the sudden seem excessive if demand
turns around.
It is true, however, that the absolute level of inventories is not
particularly excessive. On the contrary, they appear to be in somewhat the subnormal area, but there is no question that if, all of the
sudden, we had a rapid slowing of demand, inventories would be
perceived of at that point as being excessive, and we would have
downward pressure occurring on the economy as people endeavored
to liquidate what they perceived of as excess stocks.
Mr. MCCOLLUM. So businesses are prudent to be observant of
this.
Mr. GREENSPAN. I think they have been. I think having said all
of that with respect to concern about backing up and the effects,
the levels of inventory are not particularly worrisome.
Mr. MCCOLLUM. I would also like to take this occasion to put
something in perspective that I think you and I agree on, but so
often when people watch or listen and hear you testify or anyone
who is in your position, Mr. Volker and others in the past, they do
not appreciate the subtleties of the policies of the Open Market
Committee and how you carry out the decisions that you make,
and just for the purposes of clarification, I believe I am correct that
in recent times most of the activities have been in the area of if
you want to affect the economy of using either Federal funds rate
or the tightening or loosening of the monetary reserves through
your selling activities or purchasing activities.
Yet the public things of the discount rate as a big deal, and occasionally you do exercise that function, but I'm impressed when you
said in your testimony today that you had actually loosened a little
bit in June and July. They didn't see a discount rate change, and a
lot of them seem to think that that's what it is.
Could you elaborate, and I mean I think I'm right about this, but
we always think we're talking sometimes to economists or the business community, and yet people who watch this at home are not
always in tune with this sort of thing and they think I think of the
discount rate.
Mr. GREENSPAN. Yes. That's a very good point, Congressman. I
think that what is useful to point out is that where we have an
effect is basically by altering our balance sheet, that is the consolidated balance sheet of the 12 Federal Reserve Banks. And as we
alter that balance sheet, no matter what it is we do, whether we
31
buy or sell securities or a number of other things, we affect the reserve balances of the commercial banks and others.
The extent to which the demand for reserves varies relative to
the supply, which we create, will affect the Federal funds rate because the Federal funds rate is by definition the price which banks
pay or exchange with each other to obtain reserve balances.
To the extent that we squeeze down the availability of reserves,
obviously we will tend, other things equal, to move the Federal
funds rate up, and to the extent that we add reserves to the
system, we will tend to move the Federal funds rate down. That
will tend to impact a number of other short-term interest rates, the
Treasury bill rate and obviously all^of the various different CD
rates and the like to some extent or another, although our effect on
long-term rates is basically through a different channel.
Mr. MCCOLLUM. You don't even need to get to the discount rates
with that.
Mr. GREENSPAN. What I was about to say is that the discount
rate does not enter in the calculation, except as something which
we generally use to emphasize a significant change in economic
policy. In other words, what we will tend to do is to move the discount rate and engage in complementary policy with respect to reserve balances.
But the discount rate in and of itself does not affect the level of
reserves, and need not affect the Federal funds rate or any other
interest rates. It is far more of a symbolic announcement of Federal Reserve policy than the Federal funds rate.
Mr. MCCOLLUM. In other words, if you need a punctuation mark
and the message isn't getting through, then the discount rate is the
vehicle for doing that.
Mr. GREENSPAN. That's correct. It is often used, and has been
used historically as, as you would put it, an exclamation point.
Mr. MCCOLLUM. Sometimes you don't need to do that and sometimes your movements occur regardless of that.
Mr. GREENSPAN. That's correct.
Mr. MCCOLLUM. SO the public does not need to focus on it perhaps as much as they have.
Mr. GREENSPAN. Not only that, but sometimes it is not desirable.
Sometimes we don't want to be as emphatic, we want to be more
gradual, and the discount rate does not lend itself to a gradualist
approach.
Mr. MCCOLLUM. Well I thank you for that perspective because
again I think we often overlook up here sitting on this committee
how much this is observed by people who just are not students of
this.
In fact, one of the great problems I've thought since I have been
ranking Member on this subcommittee has been the absence of
working knowledge by most Americans of the system of the Federal Reserve and it's very helpful, in my judgment, to have that explanation. I thank you and I think the indulgence of the Chairman.
We really appreciate your coming down today.
Mr. GREENSPAN. Thank you very much, Congressman.
Chairman NEAL. Mr. Hoagland.
32
Mr. HOAGLAND. I would like to ask you a couple of questions, Mr.
Chairman, about this goal of zero inflation if I might. The Chairman referred to it in his opening statement.
Let me ask you, first of all, what is zero inflation? What do you
actually mean by that? Do you mean literally zero, or do you mean
something close to zero?
Mr. GREENSPAN. Well, I think when you talk about zero inflation
you mean literally zero. But for practical purposes, you get the full
economic effects of zero inflation if the inflation rate plus or minus
is not something which business decision-makers take into consideration when they make the economic decisions.
What we are trying to do is to remove the expectation of price
instability or price change from economic decision-making and
thereby reduce risk, and by reducing risk, you lower real interest
rates and you make for a far more stable economic environment,
high productivity and higher standards of living and significantly
improved job creation.
Mr. HOAGLAND. NOW historically looking back at the Eisenhower
years and before and since, what is that level that you have to
reach so that business leaders are not concerned about inflation?
Mr. GREENSPAN. Looking back in history, my recollection is that
when the consumer price index was say IV2 percent, and had been
that way for quite a while, it was probably indistinguishable at
that point from zero as far as economic effects were concerned.
But I do think that when you're aiming at an inflation rate over
the longer run, you can't count on anything other than zero as
working, and clearly zero is probably better than IV2 percent in
any event if you can implement it. But it is not the case that an
actual zero number has got some magic characteristic to it because,
as you are acutely aware, very few people can tell you what the
actual inflation rate is. If you took a survey out there, you would
be surprised how far off the answers were that you got.
Mr. HOAGLAND. They would be in favor of repealing the Fourth
Amendment probably, too.
What other desirable economic goals, however, are inconsistent
with that?
Mr. GREENSPAN. Inconsistent?
Mr. HOAGLAND. Yes, inconsistent. I mean, for instance, is the unemployment rate?
Mr. GREENSPAN. NO. I would say that over the long run a necessary condition for minimum unemployment is negligible inflation,
or more exactly, inflation which does not create risk premiums in
the system. So I consider there is no trade off between inflation
and unemployment. I think the long-term goals are symmetrical.
Mr. HOAGLAND. Are there any other long-term goals that are inconsistent with that, or is it totally positive?
Mr. GREENSPAN. Well, it depends. If you are a commodity speculator, I would say you would not be satisfied with that because that
probably would be mean the volume of hedging and speculative
business would go down. But if one is looking at the average American, the status of our society and the stability of our economy, I
would be hard pressed to find anything which says that inflation is
a good thing.
33
Mr. HOAGLAND. So it's an absolute sincere goal as far as the Fed
is concerned. I mean it's not something you're putting out for consumption by the financial markets, but something that you genuinely believe in or genuinely
Mr. GREENSPAN. There is another question, which is in the process of getting there, you essentially are tending effectively to move
the time preference of political decision-making from the short run
to the longer run, and that's not always easy to do. I mean it is not
easy to implement a zero inflation rate in a democratic society.
It is one of the extraordinary characteristics of our society that
we have been able to have low inflation as a politically desirable
goal.
I recall in the 1970's that as soon as the inflation rate got above
a certain number, it was a highly corrosive political event, and I
think that is very fortunate in our society because it has enabled
us, that is, we the central bank, to move in a direction where zero
inflation is a value to be achieved.
Mr. HOAGLAND. Well, let me ask you about a similar issue in
terms of political desirability. Back in Nebraska next to drugs the
deficit is clearly what's on people's minds the most, and I wonder
how comfortable you are with a long-term strategy that we're
trying to implement here in terms of deficit reduction?
Mr. GREENSPAN. Well, the Gramm-Rudman targets I find quite
desirable. One of the reasons why I have been strongly supportive
of the Gramm-Rudman process and very concerned about exemptions and any variations from it is that I think if we allow that
path toward negligible Federal budget deficit to be in any way altered, I think we will pay a cost eventually.
Mr. HOAGLAND. NOW do you think that can be done with cuts
alone? I mean do you think we can gore ourselves out of it in the
next couple of years?
Mr. GREENSPAN. DO you mean on the expenditure side alone?
Mr. HOAGLAND. On the expenditure side.
Mr. GREENSPAN. If you ask me technically, certainly. It's a political question. It's not an economic question.
Mr. HOAGLAND. Thank you, Mr. Chairman.
Chairman NEAL. Mr. Bunning.
Mr. BUNNING. Thank you, Mr. Chairman.
I just want to follow up on Mr. Hoagland. Early this year we had
a budget agreement between the administration and the Congress
that, in my opinion, was really a budget agreement only in words
and not really in substance, and there were a lot of things in the
budget agreement that really avoided meeting the GrammRudman-Hollings goal, particularly when you look at what was included in the budget, the Social Security Trust Fund, the Highway
Trust Fund and the Airport Trust Fund as an offset to some of the
figures on the budgetary area.
How much input would the Federal Reserve have in making that
budget agreement, or did OMB and Treasury and the leadership
both on the Democratic and Republican side? Did the Federal Reserve have some input in that budget agreement?
Mr. GREENSPAN. Not specifically, Mr. Bunning. It is certainly the
case that I was kept informed of what was going on, and indicated
our priorities, but I was not directly involved in making those types
34
of political choices, which frankly I thought would probably not
have been appropriate in any event.
Mr. BUNNING. Does it concern you as the central banker that the
things that are in the agreement were not really of substance other
than the fact that we were going to get under a set number that
Gramm-Rudman said we must get under or we would have sequestration?
Mr. GREENSPAN. I think that it is inevitable in the GrammRudman process that part of it will be a sham. So long as that proportion of it is kept to a minimum, I find the real net changes to be
where it's important. I mean we have always had that problem.
My view of Gramm-Rudman is to always expect that by the way
we set it up, somebody is going to try to play the books in one way
or another. I take that as a given, and I don't think it's all that
relevant an issue so long as there are real substantive changes that
are going on which are adequate to bring the path of the budget
deficit down.
I think that one of the reasons why I feel myself, academically I
might say, uncomfortable with Gramm-Rudman and the reason
why I would not consider it in Public Finance 101 as being an ideal
vehicle is exactly because it is set up in a manner in which fun and
games are involved in the process.
But when you cut through all of that, it has been an extraordinarily helpful vehicle, and in fact the only vehicle of which I am
aware that has enabled us to find a means to bring the budget deficit down. I think it would be a great tragedy if that process were
lost somewhere along the line.
I do agree that the fiscal 1990 process had some aspects to it
which clearly were not really fundamental reductions, but there is
no way that I can see that the fiscal 1991 agreement can be
reached without real basic reductions occurring in the deficit.
There is a limit to what can be done even in this process in the
bookkeeping of Gramm-Rudman.
Mr. BUNNING. In the creative accounting and the movement of
pay days and the things that allow those numbers to be met under
the 1990 Gramm-Rudman are not as important as the message
you're saying?
Mr. GREENSPAN. NO, it's not the message. It's the real cuts that
evolve as a consequence. There were $2.7 billion switches and pay
dates and a variety of other things, but after you've done all that,
it's still real, and it's the real which I think is what is important
and why it is crucial that that process continue.
I recognize and I don't look appreciatively at some of the
Gramm-Rudman processes that have occurred since the initiation
of that bill, but I think it is a mistake to look at that and say it is
flawed and therefore let's get rid of it. On the contrary, I would say
despite all of that, it has been a major contribution and I think will
continue to be in getting our budget deficit down.
Mr. BUNNING. Thank you, Mr. Chairman.
Chairman NEAL. Mr. Barnard.
Mr. BARNARD. One more question, Mr. Chairman.
Mr. Chairman, one of what I would say is one of the sleeper
issues for the U.S. banks in the European Community's proposed
Second Directive is Japan. While the reciprocity issue may have
35
been resolved to the satisfaction of U.S. banks, the Second Directive can be used as a lever to liberalize the Japanese financial services industry. Up until now the Japanese have been waiting for us
to liberalize.
If their hand is forced by the European Community and they feel
compelled to adopt a universal bank structure, given the capitalization of the Japanese banks recently, wouldn't that pose serious
competitive problems for even our largest banks?
Mr. GREENSPAN. I think it's too soon draw any conclusions as to
precisely how our bank relationships with the EC are going to
emerge.
I had a very constructive meeting with Sir Leon Brittan a couple
of months ago who is in fact the senior officer involved in the EC
process, and I must admit I found his responses to my concerns,
which reflected American banks' concerns, quite encouraging.
So I'm not at all, I must say to you, basically concerned about
how the process will emerge.
Mr. BARNARD. But the attractiveness of the Japanese banks as
far as increasing their capital is concerned, isn't that going to have
an effect on the ability of our banks to raise money?
Mr. GREENSPAN. It won't affect our ability to raise money. I
mean it's certainly the case that their low cost of capital will
enable them to raise money in the end easier than we raise money
in dollars, but the fact that they have a lower cost of capital does
not affect us.
Remember, they are competing in a worldwide market, not only
for bank capital, but for worldwide capital as we are, and the
amount of aggregate bank capital, if one wants to put it that way,
in the total scheme of things is very small. Most of the competition
that American banks have are not against the Japanese banks for
capital, but by American corporations or the U.S. Government.
That's where the central competition occurs.
I think there is no evidence that the ability of the Japanese
banks to raise capital easier than for our banks to raise it inhibits
our banks from raising funds.
Mr. BARNARD. Thank you.
Chairman NEAL. Mr. Chairman, thank you very much for joining
us this morning. Keep up the good fight.
Mr. GREENSPAN. Thank you very much.
Chairman NEAL. The subcommittee stands adjourned.
[Whereupon, at 12:30 p.m., the hearing adjourned, subject to the
call of the Chair.]
MONETARY POLICY AND THE STATE OF THE
ECONOMY
Wednesday, August 2, 1989
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, DC.
The subcommittee met, pursuant to call, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman of the subcommittee] presiding.
Present: Chairman Neal, Representative Bunning.
Chairman NEAL. We call the hearing to order at this time. Today
we are very fortunate to have before us a panel of prominent
economists and forecasters who have been asked to testify on monetary policy and the state of the economy. Their testimony will
help the subcommittee evaluate the Federal Reserve's July 20
report on monetary policy. At that hearing—at which Chairman
Greenspan presented a report—I carried on at some length and
tried to make the point concerning what I think are the enormous
benefits that our economy would gain by following a policy to
achieve zero inflation over a reasonably short period of time and to
then maintain a policy to keep inflation at zero.
Our witnesses are Mr. Jason Benderly, co-director of Economic
Research for Goldman Sachs, Mr. Albert DePrince, chief economist,
Marine Midland Bank, and Mr. Mickey Levy, chief economist, First
Fidelity Bancorporation, Philadelphia. Gentlemen, welcome, thank
you very much for coming this morning. We will put your entire
statements in the record and if you would summarize it would give
us a little more time for discussion. If it is all right with you, we
will proceed in the order in which I read your names. Is there any
objection to that? Are there any opening statements?
Mr. BUNNING. Mr. Chairman, I have no statement. I will be
happy to hear what these gentlemen have to say.
Chairman NEAL. At this time we will hear from Mr. Jason Benderly.
STATEMENT OF JASON BENDERLY, CO-DIRECTOR OF ECONOMIC
RESEARCH, GOLDMAN SACHS ECONOMIC RESEARCH GROUP
Mr. BENDERLY. Mr. Chairman and Members of the subcommittee,
thank you for the opportunity to appear before you today to
present my assessment of the current economic outlook and environment and the conduct of monetary policy.
(37)
38
To start with, our general forecast for the U.S. economy is that
real GNP growth will slow further in the second half of 1989, to
about 1 percent growth, down from what was slightly over a 1.5
percent rate during the first half of the year.
Inflation as measured by the Consumers Price Index, we think
will slow sharply during the second half from the first half s 6 percent pace. This is mainly because of a reversal in energy prices, not
because the underlying trend of cost is likely to decelerate significantly so soon. We think that something like a 4 or 4.5 rate of CPI
inflation for the second half of the year is most likely.
For 1990 we think economic growth will pick up a little from
1989's pace but probably to not much above something like a 2 percent rate. On the inflation front, if energy and food prices remain
stable, which is a risky assumption to make, we expect a Consumer
Price Index inflation of about 4.5 percent. The fact that inflation in
1990 is likely to be up a little from what we think it will be during
the second half of 1989 is a little deceiving because the underlying
trend of inflation will be improving some, we think, as 1990 unfolds. All in all, this assessment is not too different from the Federal Reserve's projections presented to you by Chairman Greenspan.
We appear to be slightly more optimistic about economic growth
and inflation for 1990 but not by a large amount.
The sources of the economic slowdown in the economy during the
first half of 1989 certainly included the effects of tighter monetary
policy but other factors were at work as well. They included rising
inflation squeezing consumer purchasing power, satiated demand
for housing and consumer durable goods; more subdued net export
growth since mid 1988, and a slowdown in the pace of inventory
acceleration.
But whatever is the right list of factors or the appropriate important assign to each of these in terms of what caused the slowdown
in the first half of the year, this slowdown has lasted long enough
by this time to set in motion a perpetuation of slower growth
through the second half of 1989 into 1990. This operates via the socalled multiplier effect. These refer to the second round effects that
are set in motion once a change in economic movement has occurred.
One very important element of this process is becoming quite
visible now, a sharp slowdown in personal income growth. This is
because the building blocks of the key wage and salary component
for personal income growth, employment, the average work week
and hourly earnings, are not providing the wherewithal for rapid
growth in pay checks.
As a result, sluggish consumer spending and a slow growth economy are likely to persist until some positive force enters the picture. An additional element that should keep growth slow into 1990
is that capital spending plans are apt to be pared back as corporations find their projections for sales turn out to be too optimistic
and their assessment of capacity shortages turn out to be too pessimistic.
The main prop to the economy should continue to be net export
growth, albeit at a lessened pace. U.S. goods are still competitive in
world markets so long as the dollar does not rise on a sustained
basis. And demands abroad should continue growing more rapidly
39
than in the United States thus providing more lift to exports than
imports.
With very visible and widespread signs of economic weaknesses
unfolding in recent months, the warning flag of recession has been
raised by an increasing number of economists. While the risk of recession should certainly not be ruled out, we think opposite reaction to the slowdown seems more appropriate, that is, the first half
weakening of the economy was precisely the antidote required to
prevent a recession from developing later.
Most forecasts that early anticipated a recession developing
sometime in 1989 or 1990 had as an essential ingredient an overheating economy with intensifying inflation pressures in early
1989. This has clearly not occurred. Economic weaknesses have
quickly steamed upward pressures on inflation, particularly from
the manufacturing sector of the economy.
Even wages have stopped accelerating with the rate of change
seemingly stuck at something like a 4 percent annual rate.
The economic halting of an inflation build up is the key to preventing a recession. Historical episodes of sluggish economic
growth, and there are some in the post-war period, have culminated in recession because of the negative consequences of inflation.
These consequences include an erosion of consumer purchasing
power, sharply declining consumer confidence, speculating and destablilizing inventory building and aggressive monetary tightening.
There are four benefits from the quick containment of inflation
in 1989 that currently reduce the odds of recession. First, the slowing price inflation will ease the squeeze on real wages that hurt the
average consumer during the first half of the year.
Second, consumer confidence should remain at a relatively high
level, thus avoiding a major consumer retrenchment. Historically,
inflation concerns have been the key factor or undermining confidence prior to a recession.
Third, an absence of inflation fears also means an absence of
motive for firms to speculate on their inventory holdings. As a
result, the manufacturing sector seems to be quickly paring schedules rather than building up potential destablilizing inventory excesses.
Four, and most important, a quick easing of inflationary pressures has given the Fed more leeway to ease policy rather than
continuing to clamp down on a weakening economy. In this regard,
the current situation is turning out to be much more like two sluggish growth episodes in the post-war period that did not turn into
recession, 1967 and 1986 than the four sluggish growth episodes
that were followed by recession, 1967, 1969, 1973 and 1979.
In sort with the Fed's focus shifting from fighting inflation to
warding off too much economic weakness, and with consumers and
businesses already being cautious rather than speculating on profits to be made from higher inflation, the excesses that lead to recession should not develop. Unfortunately, there is simply no hard
evidence at this time that recession forces are not accumulating. In
fact the consumer slowdown in the first half of 1989 is of the same
magnitude that preceded recessions in the post-war period.
In general there are very few signs of the imbalances that normally lead to recession, and the downturn in the key housing
40
sector of the economy has been extremely modest compared to the
housing collapses that preceded most recessions.
If recession is the key, what are the prospects? We think they
are quite good. We have the recent purchasing managers survey
which suggests that downward pressure on industrial commodity
prices is building. Vendor performance specifically, which reflects
the percent of companies reporting slower deliveries, has dropped
below the critical 50 percent level in the past 3 months.
This is the first time this happened since early 1985. Vendor performance is the single most reliable indicator of commodity price
trends. Furthermore, an index representing the percent of purchasing agents reporting higher prices has fallen to the lowest level
since 1986. This decline in vendor performance, together with the
generally soft tone of the manufacturing sector, suggest that some
easing of general inflation on the commodity side of the equation is
in store unless offset by more sharply rising wages.
This in turn seems unlikely if the economy is as weak as now
seems likely for the second half of 1989.
The inflation statistics themselves are clearly showing an easing
of pressures in the pipeline. Industrial commodity prices have on
average fallen slightly over the past 6 months. Some prices, copper
and aluminum, this is, have fallen very sharply.
Reflecting this weakness, prices of fabricated manufactured products, as measured by the PPI for intermediate materials, are rising
much more slowly in recent months than they were in the prior
IV2 years. In the finished goods level, prices are reflecting prior increases in costs and as a result are still rising at a 4.5 to 5.0 percent rate.
But this is the tail of the inflation process and so long as pressures are diminishing these prices will increase more slowly. A
wave of declining industrial commodity inflation has replaced the
prior wave of sharply rising commodity prices.
On the labor cost side, wage inflation appears to have stalled out
at about a 4 percent annual rate. There has been a sharp pick up
in the unit labor cost increases which is the result of declining productivity which historically has always accompanied a slowdown in
economic growth.
In the past most of this increase in unit labor costs has tended to
squeeze profit margins rather than being passed through into
larger price increases. The current weakness in corporate earnings
reflects this tendency. Once economic growth stabilizes for several
quarters, even if at a very low level, productivity should resume
growing at its trend 1 percent rate. Unit labor cost increases
should moderated and we should see something like a trend of 4 to
4.5 percent unit labor cost growth.
Even if inflation appears to be under some semblance of control
now, its next step will be very uncertain. This brings me to the
subject of soft landings. A soft landing ought to include both nonrecessionary growth and a sustained reduction of inflation pressures. By this definite situation there have been no soft landings in
the post-war period. Recessions have at times been avoided, but
only at the expense of rising inflation pressures. Inflation has been
brought down but only at the cost of recession.
41
This has led many analysts to conclude that the economy is too
fragile and inflation too stubborn for soft landings to be possible. I
think, however, that a more optimistic conclusion about this issue
can be reached once the behavior of monetary policy is taken into
account in assessing the historical failures at achieving the soft
landing.
A soft landing or non-recessionary subduing of inflation has in
fact never been attempted in the post-war period, hence its possibility has not been tested. History does not suggest that the economy
must inevitably fall off the runway to recession or renewed inflation if the Federal Reserve behaves differently today than it has in
the past under similar circumstances. For purposes of explaining
this interpretation of history, six episodes of a year or so of sluggish economic growth can be identified since the 1950's, none of
which were soft landings. For four of these this is obvious because
they culminated in the recession of 1958, 1970, 1974, and 1980.
For the remaining two episodes of sluggish growth, 1967 and
1986, no recession followed, but they still were not soft landing because strong economic growth brought about a pick up of inflation
pressures that then had to be contained.
In their early states each of these six episodes replicates the conditions that have unfolded over the first 1V2 years or so. First, a
strong economy with rising inflation pressures and tightening monetary policy, then a shift from rapid to sluggish economic growth.
The key point in this analysis is that in not one of the six episodes did the Federal Reserve pursue a moderate course after the
onset of sluggish growth. This is not necessarily a criticism of
policy during these periods because under extreme circumstances
an extreme policy stance can be justified. Such was certainly the
case in 1979 when aggressive tightening was called for because of
extraordinary inflation pressures. But, nonetheless, an aggressively
active change in policy was the norm for these years of sluggish
growth.
A moderate change in the direction of policy and interest rates
has never been tried during periods of sluggish growth and therefore the soft landing waters have not really been tested. Some of
the facts from these episodes are shown in a series of charts attached to my written statement.
These depict the average behavior of several economic and financial variables for the four sluggish growth periods that turned into
recession on the one hand and the two that were followed by an
economic rebound on the other. The current behavior for each of
these variables was also shown for comparison. The similarities
and differences among the six can be summarized as follows: first,
the economy, and interest rates behaved similarly in the year preceding sluggish growth. Growth was strong, utilization rates were
rising, inflation pressures intensifying, and the Federal Reserve
was tightening.
Second, in the ensuing year or so of sluggish growth the behavior
of inflation was the key difference between the four episodes that
culminated in recession and the two that did not. All six were
marked by a similar pace of very sluggish growth, but in the recession episodes, inflation pressures continued to build, while in the
42
other two inflation pressures eased and wage increases remained
under control.
Third and most importantly, the continued build up of inflation
pressures contributed to an aggressive further tightening of credit
conditions in the recession episodes, whereas credit conditions
eases significantly in the two non-recession episodes. Up to the
onset of sluggish growth, interest raters were rising in all instances
and the yield curve became relatively flat. After the onset of sluggish growth the differences between the recession episodes and the
non-recession episodes were very dramatic.
Short term interest rates were either up an additional 200 to 300
basis points, then followed by recession or down by 200 to 300 basis
points and then followed by an economic rebound. This difference
is reflected in the yield curve which either further inverted when
short rates rose or returned to a positive slope when they fell. It
either turned into recession or was followed by a resumption of
strong growth and rising inflation pressures depending on the behavior of inflation and the latitude this presented to the Fed once
sluggish growth began.
It was not the conditions that brought about the sluggish growth
that led to the next step in the economy. For the most part, current conditions are tracking these non-recession episodes. There
are two conclusions about the current situation that we can draw
from this admittedly oversimplified analysis.
First, it is too soon to gauge whether a soft landing of any duration will take place. A gradual further easing of monetary policy
rather than a sharp further reduction of short term interest rates
would, in our view, increase the chances of sustainable growth and
lower inflation.
Second, there is probably more leeway involved in the setting of
policy than the phrase "fine-tuning" suggests there is. There is a
lot of room between the historical precedents of up 300 basis points
in short rates or down 300 basis points that contributed to the soft
landing failures of the past. A gradual easing of rates would not
follow.
Chairman Greenspan's testimony before Congress both directly
and indirectly suggests such a restrained course. Directly from his
stated targets for monetary policy and indirectly from the Fed's
projection of subdued economic growth in 1990.
If an aggressive further easing of policy were being contemplated, faster growth for 1990 would likely be projected. In addition the
slow growth in inflation assumed for 1990 by the Federal Reserve
Board, 4.5 to 5 percent, suggests a strong motive for easing policy
gradually rather than aggressively.
We think if the Federal Reserve reduces interest rates from
where they current are rather than aggressively easing as they
have in the past, we think the extremes of recession can be avoided.
[The prepared statement of Mr. Benderly can be found in the appendix:]
Chairman NEAL. Thank you.
Mr. DePrince, we will hear from you at this time.
43
STATEMENT OF ALBERT DePRINCE, CHIEF ECONOMIST, MARINE
MIDLAND BANK
Mr. DEPRINCE. Thank you. It is a pleasure to be here today to
share with you my views on the state of the U.S. economy and the
conduct of monetary policy.
Presently a "consensus" which thinks the economy has beaten
the inflation cycle and is about to land softly is gathering momentum. That view has been a key factor behind the recent interest
rate plunge. Financial markets have, in turn, gone beyond the
"consensus". They are now positioned for far lower short-term
rates later this year, intimating that severe economic weakness
may be ahead.
My own views differ sharply from that sentiment. First, I believe
the economy is stronger than either the consensus or the financial
markets' views, though admittedly operating on a slower growth
plane than last year. Second, inflation, while likely to be lower
than the first half s pace, is faster that last year's rate. More importantly, this year's slower growth plane will not neutralize persistent pressures for a gradual acceleration in the inflation rate.
Third, the economy is far short of a recession at this point,
though a reversal of the inflation cycle will eventually require the
therapeutic effect of an economic downturn. On this score, the
FOMC's grudging response to the sharp fall in market rates runs a
risk of precipitating that downturn now, though we put a low likelihood on that, since the FOMC is likely to continue to ease its
policy stance.
Nest, the monetary aggregates provide an inadequate yardstick
of monetary conditions; as such, they should not be used in setting
the course of monetary policy. Finally, the FOMC gets good marks
for the speed with which it adapted to changing economic conditions. Because of that, the FOMC has successfully contained the
speed with which inflation accelerated as the economy neared full
utilization of its resources.
Eventually, however, short-term containment will come into conflict with the FOMC's long-term objective of near-zero inflation.
When it does, tensions (the product of either FOMC or marketbased actions) will mount to bring the short-term inflation rate
into closer harmony with the long-term objective of near-zero inflation. Slow growth will not harmonize the short- and long-term inflation objectives. As past history shows, only a recession can bring
the inflation rate down. Thus, the FOMC will some day have no
choice but to accept the blame for the end of this expansion.
Recent economic guideposts in perspective. May's weak economic
performance was summed up in the month's 1.2 percent drop in
the index of leading indicators. Moreover, early data for June is
not much better.
Even so, we must be careful not to overreact to the weak indicators. While the economy has slowed from its 1988 pace, the chances
of it slipping into a recession may not be as high as some notables
think.
First, the weakness in the leading indicators so far this year has
led to a media infatuation with the supposed link between three
successive declines in the leading indicators and the onset of a re-
44
cession. However, the lead time is actually far longer—usually nine
to 12 months.
Second, the recent slowdown in employment growth, while welcomed by most, may be the result of forces other than the FOMC's
tight monetary policy. In particular, with the economy functioning
at full employment, subsequent employment gains must be linked
more closely to increases in the working-age population than in
this expansions earlier years.
Thus, it would be hard or impossible to continue to secure
250,000 to 350,000 gains in payroll employment given the monthly
additions to the working age population, regardless of the FOMC's
policy stance. Gains of around 150,000 per month are the most that
population growth can support.
Next, the consumer is not as depressed as the auto sales data intimates. Its slowdown from 3.5 percent last year to a 2.0 percent
gain over the first half of this year was party the result of a surprising and questionable drop in nondurable goods spending which
will likely be eliminated with this month's benchmark revisions.
Imbalances normally associated with recessions are presently
absent.
Finally, M2's weak, 1.6 percent, growth between 4Q1988 and
2Q1989 might have incorrectly led some to conclude that the
FOMC could be forcing the economy over the brink of a recession.
To us, M2's weakness reflects the deposit pricing strategy, particularly for saving deposits and MMDAs, of banks and thrifts, not the
effect of FOMC policy on credit demands.
Long-term rates are probably near their low point for 1989,
though some prominent forecasters see still lower long-term yields
in the months ahead. At this point, the 30-year bond yield is close
to the level prevailing in 1986—a time when observed inflation was
depressed thanks to the collapse in energy prices, the effects of the
dollar's long appreciation on tradeable goods, and the beneficial effects of sharp productivity gains in the manufacturing sector.
The bigger potential for rate declines lies among short-term
rates. If the economy is as weak as some argue, the chances are
good for far lower short-term rates even if long-term rates show
little further decline. A 30-year bond yield of 8.00 percent is quite
consistent with short-term rates of 6.50 percent to 7.00 percent,
e.g., for Fed funds, 3-month CDs or 3-month Eurodollars—though
so far it appears that the economy is lacking the conditions needed
to produce the rate outcome.
Our view of inflation rests heavily on trends in the growth of
unit labor costs. These are defined as the difference between the
growth in hourly compensation and productivity. Next, the gap between inflation and unit labor costs is viewed as a national, macroeconomic, proxy for profit margins, while the growth in GNP is
considered a national proxy for volume.
Together, inflation unit labor costs and GNP growth from the
basic determination of corporate profits. If unit labor cost rise relative to inflation, profits are squeezed. Eventually, if unit labor cost
growth cannot be curtailed, the narrowed national margin will
trigger faster inflation. The reverse also holds. A drop in unit labor
cost growth will eventually feed through to slower broad-based inflation.
45
Commodity prices do not figure prominently in our formation of
inflation forecasts. First, there is far from a strong relation between basic commodity price movements and broad-based inflation.
Second and more importantly, labor costs are the major expense
faced by U.S. enterprises—particularly in the ever more important
service sector. As a result, labor costs will dominate the broadbased inflation cycle over time.
To begin, 3Q1989 will post a slower rate of inflation than
2Q1989's energy-swollen results. In fact, CPI inflation will likely
dip beneath 5.0 percent this quarter, after pushing towards a 7.0
percent rate last quarter. Only a short time ago, inflation was expected to be above the 5.0 percent rate for the second half.
In addition to less virulent inflation this quarter, the interactions
between saving, both personal and corporate, the public-sector deficit, foreign capital inflows and investment will likely provide from
for marginally lower rates in the second half for any given rate of
inflation.
CPI inflation is expected to average 4.8 percent for the second
half. While a welcomed relief from the first half s blistering 6.1
percent pace, the second half projection is still faster than the 4.4
percent seen during the 1987 to 1988 span. Behind that acceleration stands a slight increase in inflation of services less energy
from 4.9 percent last year to 5.2 percent for the first half to 5.4 percent for the second half. Inflation for goods less food and energy
also shows a slight pick-up.
A mild acceleration in unit labor cost growth stands behind our
expected inflation pick-up. After 2.6 percent increases between
1984 and 1987, unit labor costs advanced 3.6 percent last year and
a 5.0 percent hike is anticipated this year. Next year, unit labor
cost are expected to climb to 6.2 percent.
As compensation gains accelerate in the advanced stage of an expansion, pressure on unit labor costs is intensified due to slower
productivity gains.
Nonfarm productivity growth of 1.6 percent during the 1984 to
1987 span gave way to a 0.9 percent rise last year. This year, only a
0.7 percent advance is seen, with next year's improvement probably slipping to a dismal 0.3 percent.
Prospects for interest rates. Once markets realize that inflation
is in the 4.5 percent to 5.0 percent range, the fall in rates will end.
In fact, we are likely at that point for long-term yields now. Unless
a recession is at hand, yields beneath 8.00 percent for the 30-year
bond is extremely unlikely.
The baseline forecast sees the economy bouncing against capacity
ceilings in the remainder of this year and next year, even though
GNP growth is expected to be slower than in the earlier years of
the expansion.
Thus, pressure on wages and productivity, and hence prices, will
persist and will eventually manifest itself in higher interest rates.
The risk: even lower rates before the cycle bottoms. Interest
rates moved down at an astonishing pace since their March peak.
Admittedly, the upswing since November 1988, when the Treasury
yield curve began to invert, may have been excessive when positioned against the background or core inflation rate. Nonetheless,
rates have systematically moved through each downward revision
46
of our interest rate outlook for the last two months. Moreover,
short-term markets are positioned for still lower short-term rates.
The average yield for the four 1990 contracts is around 7.90 percent. Based on the futures market, there is the implicit assumption
that the Federal funds could be 7.75 percent for most of next year.
Admittedly, the futures market is not more accurate in its prediction of things to come than other forecasting techniques. Nonetheless, it does serve to illustrate the scope of the potential rate decline for which markets are positioned.
Because of the sheer size of that potential drop, it seems prudent
to establish an alternative regime which captures lower short-term
rates during 3Q1989.
An important point should be noted here. While the near-term
state of the economy may cloud the rate outlook in the months
ahead, we feel confident that rates at the end of 1990 will be
higher than at the end of 1989. Any debate could revolve around
the probably year-end rate level and the pace of the 1990 rise.
In retrospect, two forces combined to help keep the inflation rate
within bounds: external shocks and a process we call rolling readjustment.
Three external shocks benefited the U.S. inflation rate since the
last recession's trough. The first was the persistent appreciation of
the dollar from its 3Q1980 low point until its 1Q1985 peak. The
second shock was the early 1986 collapse in oil prices. The third
shock was the October 1987 stock market crash.
The second effect, rolling radjustment, depends upon the rapid
reaction of financial markets to early warning signs of inflation. In
it, the fact reaction is seen choking off budding excesses before
they can become entrenched. Once those excesses are stopped, the
process relies upon an equally fast financial market response
which lowers interest rates before the stress of high rates triggers
a recession.
However, so far in this expansion, rolling radjustment did not reverse the inflation cycle. Rather, it simply kept inflation within
bounds—no mean feat when viewed against the 1970s. In fact, rolling readjustment is probably at least party responsible for the remarkable length of this expansion and the surprising "low" inflation rate given current capacity limits.
Some may see our concept of rolling readjustment as a close
proxy for the term soft landing. However, there is a big difference.
Soft landing proponents seem to think that slow growth can keep
the inflation rate within bounds indefinitely. Rolling readjustment,
in contrast, simply generates a succession of temporary reprieves
from an inevitable outcome: progressively faster inflation.
The outlook for 1990 is based upon an important thread woven
throughout this testimony. Namely, the inflation cycle cannot be
reversed without a recession. It can be held within bounds by the
dual forces of fast responding capital markets and properly reactive monetary policy. But as the economy approaches full employment, inflation will rise. Low points in undulating inflation subcycles, the product of rolling readjustment, should not be confused
with victory over the primary inflation cycle, particularly if each
sub-cycle brings the primary inflation cycle to an ever higher background rate. Failure to recognize this will lead to a repeat of past
47
mistakes; now however, financial markets will have a punishing
effect on the unwary.
Against that background, we feel that an economic downturn is
lurking at some point in the future.
Changes in the financial services industry and the aggregates.
Our own view of the aggregates steps away from econometric
models. Instead of relying upon statistical research, we feel that
identifiable changes in the financial services industry invalidates
the role of the monetary aggregates as a yardstick of monetary tension or stimulus.
Fist, deregulation of retail, personal, deposit rates in the early
1980s altered the relationship between trends in bank deposits and
monetary policy. Second, the adoption of an investment banking
mentality by the larger banks has also played a role. Third, while
often ignored in discussions, more stringent capital requirements
are influencing the aggregates, particularly since 4Q1988. Fourth,
it is becoming ever easier for credit users to avoid banks in satisfying their needs. Fifth, and finally, the definition of money has once
again changed. Several years ago, in an attempt to capture the evolution of financial innovations, money market mutual funds were
added to the definition of M2 and M3.
In particular, the committee "seeks monetary and financial conditions that foster price stability, promote growth in output on a
sustainable basis, and contribute to an improved pattern of international transactions."
The aulaitative objectives are not officially translated into quantitative or numerical objectives. Nonetheless, some sense of the numerical objectives can be gleaned from official statements and
formal testimony. First, the clearest view seems to be on the Ionrun inflation objective. Here, the popular term used by the Federal
Reserve is noninflationary growth—a term that seems to be roughly equivalent to zero, or near-zero, long-run inflation, though admittedly, the term zero inflation has not been used in policy statements.
In fact, however, the FOMC pursues its strategic objectives
within a context of short-run conditions. These conditions also determine what I call the FOMC's tactical objectives. These objectives
bridge, in turn, the long-run objectives and the FOMC's day-to-day
actions, i.e., the "degree of reserve restraint" the FOMC creates in
money markets. The tactical objectives have two parts: one, the priority attached to the FOMC's short-run objectives and, two, the balance of the directive issued to the manager of its open market activities.
The priority of the short-run objectives vary depending on prevailing economic conditions. Presently they are ranked as inflation,
economic growth, the monetary aggregates and financial market
conditions. A good amount of judgment goes into the deliberations
which sets the directive's balance.
The expansion has had two big surprises: its length and the persistent failure of inflation to shoot upward. The FOMC's adaptive
policy stance has been an element of that outcome. Nonetheless, it
is equally clear that the low point of the current inflation cycle
was early 1986.
48
Since then, the trend has been admittedly upward; however, its
movement has been systematically beneath expectations. In retrospect, at least three factors account for that. First, fast adaptation
by foreign producers to the dollar's 1985 to 1987 drop had kept
global competition a potent force. Second, monetary policy, as
measured by the level of real interest rates compared with the
1970s, remained taut. Third, markets have responded exceptionally
fast to any hint of accelerating inflation.
However, in reviewing the FOMC's record, it is important to
keep in mind a functional difference between it short- and longterm objectives for inflation. In the short-run, the FOMC seeks to
contain inflation. However, it is important to recognize what that
term means in practice; namely, limiting its inevitable acceleration
as the expansion matures. On this score, the FOMC has been very
successful; inflation's accelerations has been systematically beneath expectations.
The process eventually puts short-term trends in fundamental
conflict with the long-term objective of zero or near-zero inflation,
and at some point, the two must be brought into harmony. To end
the acceleration, even a "contained" acceleration, history shows a
recession plays a critically important role.
Success in containing inflation and sustaining growth has created the illusion in some quarters that the business cycle may be a
thing of the past. There seems to be a notion that monetary policy
can be fine tuned to choke off inflation without a recession—a dangerous and incorrect assumption. If widely believed, economic participants, whether in the product or labor markets, will be less cautious.
Such a development would reduce the efficiency of rolling readjustment and possibly set the stage for more serious economic problems, namely inflation, in the quarters or years ahead.
As noted earlier, with tighter capacity came faster compensation
gains, weaker productivity gains and a notch-up in the inflation
rate. It is a mistake to think that fine-tuning monetary policy can
reverse the pressures as the economy bumps against capacity
limits. Rolling readjustment can extend the life of the expansion,
but not indefinitely. Effects of each rate swing will become less
biting on the underlying inflation cycle, and the pauses in inflation's upward march will become shorter. Eventually, a recession
will be triggered to reverse the inflation cycle. When the recession
materializes, the FOMC will need to accept at least part of the
blame.
[The prepared statement of Mr. DePrince can be found in the appendix:]
Chairman NEAL. Mr. Levy, we have a vote on the House floor.
That vote is on the journal and is a non-controversial. We can cast
our votes quickly and return so we will not have to interrupt your
testimony.
[Recess.]
Chairman NEAL. We call the subcommittee back to order. Mr.
Levy, we would like to hear from you at this time.
49
STATEMENT OF MICKEY LEVY, CHIEF ECONOMIST, FIRST
FIDELITY BANCORPORATION, PHILADELPHIA
Mr. LEVY. Mr. Chairman, I am pleased to present my views on
the outlook for the economy, inflation and the crucial role monetary policy plays in the economy, particularly at this juncture of
the cycle.
I would like to summarize my views with five points. First, my
outlook for economic performance is substantially more pessimistic
than the Fed's, the administration's or the CBO's. I forecast less
than 1 percent GNP growth through year-end 1990, with a better
than even chance of recession.
Second, inflation is plateauing now, it will come down in 1990,
and by the end of 1991 it will be approximately 3 percent. Third,
with this economic forecast, I project Federal budget deficits to be
substantially higher than the official forecasts of the CBO or the
administration, virtually eliminating any chance of achieving
Gramm-Rudman deficit targets in 1991.
Fourth, the Federal Reserve under Chairman Greenspan properly recognizes that low inflation is a necessary condition for sustained maximum economic growth, and in recent testimony has
reaffirmed price stability as its fundamental objective. Contrary to
the common misperception, there is not a tradeoff between anti-inflation efforts and long-run economic growth; they are complements.
Fifth, I would like to make three suggestions: a) immediately end
the year-long trend of declining bank reserves and real (inflationadjusted) money balances, b) continue to pursue the Federal Reserve's low inflation objectives even as the economy weakens. The
anticipated economic weakness is a transition cost of eliminating
earlier excesses and reducing inflation, and c) the Fed must avoid a
dramatic shift to overly expansive monetary policy when economic
growth falls below its desired range. Such policy would arrest the
disinflationary process and create a fragile economic environment
for the early 1990's.
There are really two sources of my pessimistic outlook for real
economic activity.. One is my expectation of sharply slower export
growth. The second is an anticipated sharp slowdown in domestic
demand in response to the Fed's tight monetary policy. In January,
I assigned a 50 percent probability of recession. The reason I mention this is to emphasize that monetary policy is very, very important in my forecast, and it affects the economy and inflation with a
lag.
Since January, my only change has been to increase my probability of recession as the Fed has tightened further. Some of the details of economic weakness both in consumption and industrial production have already been identified in the earlier testimonies.
Particularly, yesterday, the Purchasing Managers Index was
below 50 percent for the third consecutive month. Its declines
below 50 percent suggest that an increasing majority of purchasing
managers are experiencing declining activity.
Keeping in mind monetary policy works with a lag, economic
performance will continue to weaken in response to the Fed's tightness. Presently, no factors point toward a reacceleration in econom-
50
ic growth. With regard to monetary policy, on a year-over-year
basis reserves have been declining at their fastest rate since April
1960 (see chart 3 of my written testimony). In addition, chart 4 illustrates two other measures of monetary polcy that have been
very helpful to me in forecasting shifts in economic growth. On a
year-over-year basis, real M2 has been declining for the first time
since the recessions of the early 1980's. Coincident with that trend,
the spread between the yield on the 30-year bond and the Federal
funds rate has inverted for the first time since 1981.
As the chart illustrates, every time these two monetary indicators have moved dramatically in the same direction, they have
always provided an accurate forecast of shifts in economic performance. I might note that the subcommittee on Monetary Policy has
circulated a similar chart showing how much real M2 influences
the real economy.
Insofar as monetary policy works with a lag, the Fed's recent
tightness virtually guarantees economic weakness.
In contrast, most monetary policymakers and financial market
participants focus on the Federal funds rate as an indicator of monetary policy. However, the funds rate can be a very poor and misleading target for monetary policy because it reflects demand
measures associated with the economy as well as effective changes
in Fed policy.
As an example, from February 1989 until June, the Federal Reserve pegged the funds rate between 9% percent and 97/s percent,
and implied that it was leaving policy "unchanged". But, in fact,
the economy was slowing sharply, and the Fed had to drain reserves to keep the funds rate from falling, effectively tightening
monetary policy further.
The decline in the funds rate since June has been widely interpreted as a monetary easing. This is an incorrect perception. If the
Federal Reserve merely allows the funds rate to recede to reflect
subsiding demand pressures associated with the economy, that does
not constitute a monetary easing. There is no stimulus being provided to the economy. Accordingly, I see a better than even chance
of recession. What if the Fed becomes extraordinarily concerned
about the impact of a recession on S&Ls, LBO debt, LDO debt,
budget deficits and it "throws in the towel" and eases monetary
policy dramatically? That will not prevent a recession since monetary policy works with a lag, although it could mitigate the severity of a downturn.
My optimist outlook for declining inflation stems from the Fed's
restrictive monetary policy and the lagged impact of slower nominal and real GNP growth on unit labor costs. As Chairman Greenspan stated before this committee in February, "Inflation cannot
persist without supporting expansion in money and credit; conversely, price stability requires a moderate growth in money.
Generally, the underlying rate of inflation approaches the extent
to which nominal GNP (product demand) growth exceeds the Nation's long-run capacity to grow. In the late 1970's and in 19871988, the Fed's earlier rapid money growth led to accelerating
nominal GNP growth that generated inflation. If the average firm
experiences sharp increases in product demand, it tends to grant
higher wages not matched by productivity gains because the
51
stronger product demand enables them to pass on those costs into
higher prices and maintain profit margins. The result is higher inflation..
The disinflationary process is initiated by a monetary tightening
which generates slower product demand (nominal GNP) growth.
Because wages have momentum and productivity slumps, unit
labor costs continue to rise temporarily. But with weaker product
demand, businesses find it more difficult to pass on the higher operating costs into higher prices, and the profit margins get
squeezed. That has happened the last 6 months, so far in 1989, corporate operating profits have receded sharply. Eventually, the
profit squeeze restrains the wage inflation. My empirical work
shows that unit labor costs tend to react to nominal and real GNP
with about a four quarter lag. It suggests that unit labor costs and
the core rate of inflation are plateauing, based on what has already
happened to economic growth. Inflation should recede next year
based on actual and expected nominal and real growth. By yearend 1990, unit labor cost increases will be 3V2 percent, and they
should fall further in 1991.
Consistent with this forecast of sharply slower economic growth
and eventual lower inflation, I project significant declines in interest rates. The Federal Reserve can influence the timing of interest
rate fluctuations, but in the long run, interest rates always reflect
economic and inflation fundamentals. Just as interest rates rose in
1987 and 1988 to reflect strong economic performance and higher
inflation, rates will fall back to reflect the economic weakness and
eventually decline in inflation.
By year-end 1990, the funds rate will be down to at least 6% percent, and long-term rates will fall, but not as much.
In my written testimony, I discuss the implications of my economic forecast for the Federal budget deficit. I will not go into
detail now, except to say if the economy slumps or even is as weak
as 1 percent growth, deficits will not decline. There will be virtually no chance of achieving the Gramm-Rudman-Hollings (GRH) deficit target in 1991, and there is a very, very high probability that
the GRH sequestration process will be suspended by fiscal year
1991.
This would not be bothersome. My real concern is that right
now, there is no debate whatsoever in Congress or in the administration regarding what is an appropriate fiscal policy during and
emerging from recession. Merely rebenching the GRH targets and
pushing out this artificial schedule for reducing deficits does not
constitute meaningful fiscal policy reform.
Regarding monetary policy, the Federal Reserve, under Chairman Greenspan, properly recognizes that its ultimate objective is
sustained long-run economic growth and that the Fed's major contribution to this goal is a monetary policy that generates zero inflation.
To quote Chairman Greenspan, 'Trice stability—indeed, even
preventing inflation from accelerating, requires that aggregate
demand be in line with potential aggregate supply. In the long run,
that balance depends critically on monetary policy."
I fully agree with and support these objectives. Unfortunately,
the Fed has not always followed a monetary policy consistent with
52
these stated objectives, and bank reserves and money growth have
swung widely from rapid growth to declines and then back again.
This has generated erratic swings in domestic spending growth and
subsequently, inflation.
Every recent recession has been precipitated by high and/or
rising inflation and the Fed's belated and then heavyhanded monetary tightening in an effort to subdue inflation. And in response to
recession, the Fed has swung to overly-expansive monetary policy,
reinitiating a roller-coster pattern of inflation and economic performance.
What are the sources of these monetary policy mistakes? In the
past, such swings in money growth and economic performance have
stemmed from the tendency of the Federal Reserve to either alter
its desired economic outcomes or the policy instruments used to
achieve these goals. Patterns that the Fed has occasionally fallen
into fall into five categories:
First, a general tendency to target short-term interest rates
rather than to keep money growth within official target bands.
Second, an attempt to fine tune the real economy by focusing on
the funds rate.
Third, the frequent and apparently failure to take account of the
lags between shifts in monetary policy and the impacts on the real
economy and inflation. A recent example occurred in the first half
of 1989. If the Fed truly believed that monetary policy works, it
would not have tightened further by draining reserves and steepining declines in real money balances.
Fourth, the Fed has occasionally attempted to adjust monetary
policy to achieve desired mix of fiscal and monetary policy.
Fifth, the Fed has had a general willingness to adjust monetary
policy to achieve the Treasury's misplaced U.S. dollar management
objectives.
The Fed's typical efforts to fine tune have involved altering its
Federal funds rate target in response to recently released economic
and inflation conditions. In fact, evidence suggests that the Fed occasionally waits until a particular economic release (that is, the
employment number) before it adjusts policy. Since monetary
policy works with a lag, responding to current events cannot do
anything to effect current economic and inflation conditions, but
efforts to fine tune, however well intended, may compound previous mistakes and generate large swings in reserves, money growth,
and domestic spending.
Attempts to manage the dollar have been the primary source of
undesirable wild swings in monetary policy in the last 5 years. The
Federal Reserve and the Treasury must learn a simple rule, that it
is impossible for a single policy instrument, such as monetary
policy, to achieve two desired outcomes. That is, achieving a desired range for the U.S. dollar by adjusting monetary policy cannot
be accomplished without sacrificing the objectives of desired domestic spending and inflation.
In my written testimony, I discuss the highly publicized Federal
Reserve staff study on inflation, commonly referred to as the PStar study. One way to consider the study is as an effort by the
Federal Reserve to investigate or develop a monetary policy framework that would avoid previous mistakes that have led to acceler-
53
ating inflation. I might note that the Federal Reserve staff study
was initiated by Chairman Greenspan and it develops an equation
for the equilibrium price level. As a modified quantity theory, PStar involves potentially useful characteristics as a policy guideline, particularly by focusing on M-2 and normal GNP growth
rather than real economic variables.
On the other hand, it does not preclude the traditional Fed practice of fine tuning. Without going into detail, despite the potential
pitfalls of the P-Star model, such efforts to develop a monetary
policy framework consistent with the Fed's long-run objectives are
constructive and should be encouraged.
Concerning the current context of monetary policy, the Fed has
been very tight by any measure since 1988, and I support the Fed's
pursuit of low inflation. However, we are now at a critical juncture
and I would like to make the following recommendations:
First, the Federal Reserve must take the immediate steps to prevent further declines in bank reserves and real monetary balances.
One might ask, how much does the Fed need to lower the fund rate
to accomplish this recommendation? I don't know. Focusing on the
funds rate as a policy variable, which reflects demand pressures associated with the economy, is a very misleading indicator.
Bank reserves have declined at 3.7 percent over the last year.
Clearly, preventing reserves from declining requires a decline in
the funds rate. Many observers and policymakers may associate
any decline as a monetary easing and a backing-off in the Fed's
fight against inflation. This is a misperception that has led to
major policy mistakes in the past.
Subsiding demand pressures associated with economic weakness
presently are lowering the equilibrium level of the funds rate consistent with any desired reserve and money growth targets. Targeting the funds rate, while only paying lip service to trends in reserves and money, could inadvertently trigger an economic downturn.
My second recommendation is that when economic growth falls
below the Fed's desired range—lMs to 2 percent GNP growth from
fourth quarter 1989 to fourth quarter 1990—the Fed must avoid its
typical mistake of overreacting and swinging monetary policy
toward excessive expansiveness. We must consider a period of sluggish activity as a transition cost of earlier excesses in money
growth and domestic spending growth.
Clearly, the Fed's tight policy is designed to slow nominal
growth. This policy has an immediate impact on financial markets,
and then affects real economic activity with a brief lag. With a
longer lag, inflation declines.
The Fed's recent restrictiveness is now affecting real economic
growth, but not yet inflation. If the Fed responds to extremely
weak economic growth by excessive easing, as it has in the past,
current economic conditions would not be altered. However, it
would interrupt the disinflationary process and establish an undesirable high floor for the underlying rate of inflation. This would
create a fragile environment for economic growth in the 1990's and
perhaps sacrifice the Fed's hard-won credibility.
The direction of monetary policy is particularly important now,
because it will determine not only the extent and duration of the
54
economic weakness, but it will have a profound impact on how
much inflation is reduced and the economic environment in the
early 1990's. Sustained maximum long-term economic growth requires a prudent course of monetary policy that suppresses inflation. Your committee and Congress should encourage the Federal
Reserve to continue to pursue these long-run objectives.
Thank you.
[The prepared statement of Mr. Levy can be found in the appendix:]
Chairman NEAL. Thank you.
Before I ask any questions, would any of you like to comment on
any of the testimony given by any other of your colleagues?
Mr. LEVY. I would like to make two comments on Mr. DePrince's
testimony. One is that I believed that he referred to M2 as "useless".
In the early 1980's, there was a clear shift in M2 velocity in response to financial deregulation and the shift to lower inflationary
expectations and interest rates. However, since then, empirical evidence shows that M2 velocity has stabilized. The chart distributed
by your subcommittee and chart 4 of my written testimony suggest
that M2 is an important economic predictor and should not be neglected.
Second, he referred to the dollar and Black Monday as exogenous
shocks. It is important to point out that interest rates and the U.S.
dollar are jointly determined as endogenous variables. They are not
falling out of the sky. They are not exogenous.
Black Monday was not an exogenous shock. Considering the
dollar as exogenous involves a macroeconomic framework that can
generate policy mistakes.
Chairman NEAL. AS I heard Mr. DePrince, he was suggesting
that Congress might want to review the requirement under Humphrey-Hawkins that the Fed set some targets. My own thinking has
shifted on this subject. I want the Fed to produce a desired effect
and I do not care how they do it. I have my own ideas how they
can do it. I do not think they can do it without decreasing money
growth, but I want to see zero inflation over a reasonable period of
time. I do not want to get bogged down in arguments about the
proper level for M2 growth or the Federal Funds Rate or any other
statistics.
Mr. DePrince, you made a comment, as I recall, that you expect
the longer term rates to stay at current levels. Mr. Levy, I think
you anticipate a significant drop. Can you put a number on it?
Mr. LEVY. I put a number on the Fed funds rate at 6% percent
by the end of 1990. The yield on the long-bond depends crucially on
the dollar and the speed of monetary easing, both of which influence the term structure of interest rates. I expect continued declines in long- and short-term rates to reflect week economic performance and lower inflation.
Chairman NEAL. AS a direct result of inflation. What would you
say, Mr. DePrince?
Mr. DEPRINCE. The two views are probably consistent but they
are separated by about a year. The shorter term interest rates a
year from now—at the point of time in which you have the economic decline Mr. Levy talks about, you will have lower short-term
55
interest rates. The move will take in short term rates which is a
reflection of how the yield curve rate moves over the cycle.
The current rates and the absence of the imminent economic
downturn is I think about as low as they can go, given a background rate of inflation something in the order of 4% to 5 percent
inflation.
Now, if markets are beginning to discount a 3 percent inflation
rate, as Mr. Levy has suggested in his forecast, then there is considerable room for the longer term interest rates to move downward. It hinges on the view of the individual forecasters on the
state of the economy as well as inflation within the general movement of economic activity.
I think what is different is that his economic decline, possible decline, is today. Mine is beginning a year from now with the effects
on the interest rates during the first half of 1991.
I wanted to make my detailed 1991 forecast and superimpose it
on Mickey's, and it will probably be identical. It is a question of
timing.
Chairman NEAL. Mr. Benderly?
Mr. BENDERLY. I think I am somewhere in between the view that
too much economic weakness has already been created and the
view that economic weakness or downturn will start a year from
now.
I tried to emphasize that the buildup in inflation pressures was
stopped soon enough to prevent destabilizing forces that tended in
the past to lead to recession, and that as a result extremes can be
avoided at least for now. If that is correct and we are neither in
recession nor still building up inflation pressures, I think that longterm interest rates have mostly but probably not completely reflected the kind of weakness in growth, but still growth that we
would anticipate.
I don't know whether rates would get down into the 7 or TVz
range, long-term Government rates, or stay between 7% and 8, but
generally speaking I would say the 7Vfe to 8 percent range is what
we would expect to prevail for the next 1V2 years or so.
Chairman NEAL. Mr. Benderly, on page 2 of your testimony you
list "four benefits from a quick containment of inflation that
reduce the odds of recession/' Would you extend that analysis to a
generalization about the relationship between inflation and recession? For instance, would you agree with Mr. Levy that there is not
a tradeoff between anti-inflation efforts and long-run economic
growth, that they are in fact complements?
Mr. BENDERLY. Certainly over the long run, I think economic
growth is maximized when you have a minimum of inflation. So I
think over the long run there is no question but that they are complements, not substitutes.
But on a cyclical basis, I think that if not all, most of the recessions that have occurred in the United States have occurred because of the direct and indirect costs of inflation. Now they are
trying to stop it in terms of very aggressive monetary tightening or
because of the direct effect on consumer confidence or because of
the direct effect on declining purchasing power and so forth and so
on.
56
So over the short run, I think inflation and the buildup of inflation pressures is the primary reason that we have recession over
the long run. You have to contain inflation pressures or you simply
cannot maximize growth.
Chairman NEAL. Let me run something by all three of you and
see if you agree.
It seems to me that we should commit ourselves to three macroeconomic policies in this country. I would not want to try to pinpoint the timing precisely, but generally speaking, say over the
next 5 years and quicker, if possible. First, we would bring inflation to zero; second, we bring Federal spending to no more than 20
percent GNP; and third bring our budget into balance. If we then
keep those as the guidelines for a healthy economy for essentially
now on, it would seem to me that we would maximize the opportunity for interest rates to be at their lowest possible levels. We
would maximize the opportunity for maximum sustainable economic growth or maximize the opportunities for sustainable maximum
employment. That would generate the highest levels of savings possibly, and we would increase the likelihood of our being as productive as possible as a country. The benefits there would improve our
standard of living to the best level that we could expect, and we
would meet our maximum level of competitiveness in the international arena. We would create the most dynamic, healthiest economy imaginable maybe in the history of the world. What would you
say about that?
Mr. BENDERLY. In principle, I think that statement is true. I am
not sure about the specific numbers. I don't know if you need zero
inflation and spending at 20 percent of the GNP and the Federal
budget in absolute balance. There may be a small positive rate of
inflation or a higher or lower rate of Government spending and
some small deficit that would be equally consistent with all of the
goals which you stated. I don't think anyone would disagree with
some kind of statement like that.
The problem is the cost of getting from here to there. I think to
the extent that there is a great deal of inertia to the inflation process, I think there is a cost of getting to zero or 1 or 2 percent inflation. It is difficult to achieve that. I don't think anyone disagrees
with those as goals.
I think it is a matter of how much cost are we willing to pay
over what time period to get there.
Chairman NEAL. Would you say that the costs would be worth it
in getting from here to there over the next 5 years?
Mr. BENDERLY. Yes. I don't know whether it is at 3, 4, 5, or 6 percent inflation where you begin to build again the inflation expectations like we had in the 1970's, but somewhere in there you begin
to build up in a self-sustaining nature to inflation.
To the extent we began to move up to 5 percent inflation again
in the past year, I would say that is in the risky area and that it
will pay in the long run to try to move down from that near 5 percent rate to something substantially lower. Again, I don't know
whether in 5 years zero ought to be the goal or 2 ought to be the
goal, but something well out of this danger zone.
Chairman NEAL. Mr. Levy.
57
Mr. LEVY. I agree with you that zero inflation is consistent with
maximum sustainable economic growth. With regard to the Federal budget, I think we need to qualify your call for a balanced
budget with Federal spending 20 percent of GNP. Presently, Federal spending is about 23 percent of GNP and taxes are a little over
19 percent of GNP. Accordingly, your framework would require a
tax increase and spending cuts.
The key point about the economic effects of fiscal policy is not
the level or change of deficit per se, but instead the level and mix
of Federal spending; that is, the allocation of the Nation's resources. The impact on the economy of imposing a balanced budget
depends crucially on the way in which it is achieved. Even if we
had a balanced budget now, the mix of spending suggests that our
national resources are being allocated toward consumption-oriented
activities rather than investment oriented activities that increase
the Nation's long-run capacity to grow.
We must be careful about how deficits are eliminated. Attempts
to reduce the budget deficit by increasing taxes on capital would
suppress investment and long-run potential economic growth,
reduce U.S. competitiveness internationally, and lower the dollar,
all of which would move you further away from your long-run objective. We should move toward a balanced budget by cutting Federal spending, particularly for nonmeans-tested entitlement programs.
With regard to the cost of achieving these long-run objectives, I
argue that the cost of not adopting the appropriate policies to
achieve them is higher than failing to do so. That is why in my
written testimony I state that monetary policy is now at a critical
juncture.
If the Fed shifts toward overly expansive monetary policy in response to economic weakness, the disinflation process is halted, and
we have the same debate in the early 1990's when the underlying
rate is stuck at 4Vfe percent.
Certainly, the costs of not following your prescription are very,
very high. The real problem is that in the past the Fed has talked
about long-term objectives, but then it gets sucked into the short
run and starts to manage the dollar, or respond to yesterday's
retail sales number, which results in a monetary policy that is inconsistent with its long-term objectives.
Presently, the Fed must continue to pursue its long-term objectives, recognizing that a economic slowdown or maybe a mild recession is a necessary consequence of its previous excesses.
Mr. Benderly mentioned that there is an inertia or a bias in inflation. I would say the Federal Reserve, through its actions and
credibility, creates that inertia. Presently, the Fed is on the verge
of breaking that inertia, and I encourage it to do so.
Chairman NEAL. What is your impression of how the Fed views
this now?
Mr. LEVY. I think there is as much difference of opinion among
the current voting FOMC members as there is among most private
economists, perhaps more. Written statements by different FOMC
members express various focuses and concerns: one is concerned
about employment in the Midwest, another focuses on commodity
prices, and still others focus on certain real economic variables on
58
the yield curve. Recently, a coalition of these "strange bedfellows"
have advocated lower interest rates, but a consistent long-run
framework seems to be missing. I doubt if many FOMC members
would take your long-term objectives and say "that is what I want
to achieve", and stick to a monetary policy consistent with those
goals.
The Fed still has the tendency to lean against the wind. When
economic conditions deviate from desired short-term ranges, the
Fed tends to forget about lags between monetary policy and economic activity, and monetary policies deviate from long-run objectives, at a highcost.
Chairman NEAL. We have also been concerned about the kind of
comments that the Fed Governors and others have made in support of the administration's ideas on maintaining a particular
value for the dollar. It doesn't seem to me that that is a reasonable
objective of monetary policy at all. Mr. DePrince?
Mr. DEPRINCE. I would like to add a bit of urgency at least to the
first item, the rate of inflation. I think when you look at the U.S.
rate of inflation, there may be some debate as to where it will be a
year from now but it is now apparently around AV2 percent.
The German inflation, the European inflation, excluding the
English, prior to the rise in oil prices is up in the order of about
IV2 percent as are the Japanese.
One of the gyrations we see in the fluctuations of the dollar has
stemmed from the fact of trying to balance a different inflation
rate here versus our major trading partners.
We see the same thing in the United Kingdom, which stayed out
of the MS and has its own problems in 1992 in terms of its role in
the European Community and how the pound stacks up against the
European currencies. It has an effect on inflation.
The gyrating United States and English inflation compared with
European, feeding through to the exchange rates, has a simultaneous effect, as Mr. Levy pointed out, in my view, of exchange rates
being an external factor. Part of the movement in stabilizing has to
do with stabilizing inflation. When they are at near zero, we have
no choice but to try to get there.
In the longer term, the trends in population growth today are
not what they were in the 1970's and late 1960's. In my view, some
of the inflation we saw in the 1970's and late 1980's was, in retrospect, needed to drive down the growth in real wages and drive
down the growth in productivity in order to absorb the growth in
productivity.
We have not an excess of growth in employment, but we have a
shortage of growth. High productivity gains become critical, and
that is critical to high growth in wages and low growth in inflation.
In the 1990's, with low population growth, we have no choice but
to drive inflation down to encourage growth in productivity. Otherwise, I think we are well on the verge of becoming a second-rate
economic power. The short-term view, which is necessary for global
stabilization, but the long-term view is that it is necessary to have
the United States maintain itself as a strong economic power but
we have to get on with the business of increasing productivity in
the manufacturing and service sector.
59
The way to do that is by the capacity-generating items Mr. Levy
mentioned in order to enhance the productivity of the economy.
In terms of the budget deficit, I think we have to be very careful
not to shoot ourselves in the foot. I think what we tend to do a lot
of times is ignore the combination of the Federal budget deficit and
the State and local surplus.
While it might be laudatory to aim toward a zero Federal budget
deficit, when a combined public-sector borrowing requirement basis
will put the economy into a severe surplus when you add in the
State and local government, if these are considered part of the
total budget, then the Federal budget puts us into a severe surplus.
I offered suggestions in a paper I gave to a Canadian meeting for
a different formula, which I will be delighted to send down to you,
but I think a zero deficit budget is too severe. We probably should
aim for something in the order of an $80 billion deficit to probably
bring the two into rough balance.
I think you have to approach that balanced budget point of view
on a broader basis. Otherwise, the extent of the fiscal restraint will
be too severe.
Chairman NEAL. I really would like to see your paper on that
subject.
Mr. DEPRINCE. Thank you. I will send it to you.
[The information referred to above can be found in the appendix:]
Chairman NEAL. We are not going to overshoot anytime soon, I
don't think.
Mr. Benderly, Mr. DePrince, you probably recall that Mr. Levy
was a bit critical of the Fed funds rate—the Fed focus on the Fed
funds rate as a cause of serious mistakes in monetary policy. What
would you say about that?
Mr. DEPRINCE. When you approach a monetary policy and the instrument of monetary policy, whether it is interest rates or monetary aggregates, I think it is important to distinguish today's economy from the economy of the 1970's. Today, everything above Ml,
before you get to M3, is virtually excluded from reserve requirements. So the capacity to alter the growth in M2 by altering the
growth in reserves for high-powered money is limited to the effect
on Ml or M3 but not on M2. Very little of M2 is subject to reserves.
Add to that the fact that the interest rate ceilings' automatic
stops have been removed from the economy. One ends up controlling M2, not by controlling reserves. You end up controlling M2. If
you believe in the equation of exchange or MV equals PT, you end
up controlling it by interest rates.
But part of the view that I have toward the monetary aggregate
stems from the fact that in a deregulated environment without the
automatic stops, the relative pricing by commercial banks determine the growth in M2. Money market deposit accounts were yielding 6V2 to 7 percent when CDs were yielding in the order of 10 to
10 V2 percent.
When you look at the growth in M2 between the fourth and
second quarter of this year, there was a massive liquidation of
money market deposit accounts and savings accounts, some of
which migrated to longer dated CDs but some which left the bank-
60
ing system entirely. So there is a lot of movement up, down,
around and sideways.
It is not clear juggling reserves does it. Money market conditions
can be defined by borrowings or the Fed funds rate. One is the
mirror of the other. The Federal Reserve in the short run is using
the rate as a barometer, but I believe Mr. Levy is correct that monetary policy operates with a lag. It is probably shorter than it was
in the 1970's, but there is still a lag in monetary policy. Once
things are put in motion, it is probably hard to reverse them.
I don't think at this point we are in a position where the economy is teetering on the brink of recession, but on the type of environment we are in today, I think the only thing the Federal Reserve has to look at are, in my judgment, interest rates.
This was a subject of debate I think even within the FOMC. Vice
Chairman Johnson has said we ought to look at commodity price
exchange rates in the shape of the yield curve. Governor Angell
has another idea. It is as if they are trying to get a GrammRudman target.
In one section of my paper, I point out it is largely a case of judgment. It is looking at a variative indicator to reach a consensus,
and they do reach a consensus because there is a directive issued.
It is issued in the direction of Fed funds rate.
I think that is the proper directive because the vague and erratic
movements are taking place in M2 as a result of financial changes.
Mr. BENDERLY. I think at times, particularly in the 1970's when
there was an ongoing inflation that began in the late 1960's, there
was an excess of focus on the Fed funds rate and that mistakes
were made because of that focus.
But I think that in today's financial market environment, that
there are too many problems with any single measure of monetary
policy to focus on any single measure over the short run and that
it does take an eclectic collection of indicators to conduct monetary
policy, including some broader measure of money growth, including
short-term interest rates, including the yield curves and perhaps
including some of the more timely and sensitive indicators of economic performance such as some of the figures that come out of
the Burgess survey.
I think they are struggling about that now. I think because there
is not much agreement across the members in the Federal Reserve,
that they are watching the other.
Mr. LEVY. There is convincing evidence that large changes in
bank reserves have been entirely coincident with changes in real
M2 in the 1980's, as well as the 1970's and 1960's (see charts 3 and
4 of my written testimony). These charts illustrate that each recent
recession was preceded by sharply slower growth of bank reserves
and declining real M2. I am baffled by economists and policymakers who ignore these relationships.
The inversion of the yield spread suggests that financial market
participants agree with my forecast that the decline in reserves
and real M2 could be damaging to the economy and the Fed should
focus on it.
I would like to provide a couple of examples of how focusing on
the funds rate has led to policy mistakes in the past. The best
recent example occurred in 1978-1979 when, for a period of time,
61
Federal Reserve Chairman Miller targeted the funds rate below
the rate of inflation. Pegging the funds rate artificially low, as the
economy accelerated, generated tremendous increases in liquidity,
which generated double-digit nominal GNP growth and soaring inflation.
Earlier this expansion, economic growth boomed from late 1982
to mid-1984. The funds rate rose dramatically, from 8V2 to IIV2 percent, to reflect the economic strength.
Beginning in mid-1984 to the end of 1986, the funds rate fell from
IIV2 percent to below 8 percent before the decline in oil prices in
1986. That decline in the funds rate was not a Fed easing that
stimulated economic growth.
Analogously, the rise in the funds rate in 1987 and the first half
of 1988 was not restrictive and did not dampen economic growth,
rather it reflected the strong economic performance.
This year, from February until early June, the Fed kept the
funds rate at 9% percent to 97/s percent. This represented a further
monetary tightening, since pegging the funds rate required draining reserves and reducing money supply.
Most of the recent decline in the funds rate from 9% percent to 9
percent reflects subsiding demand pressures. The decline will not
stimulate the economy.
But while the funds rate reflects short-term economics as well as
Fed actions, it is difficult for any economist or the Federal Reserve
to identify what portion of a change in the funds rate is due to Fed
policy and what portion is due to demand pressures.
Accordingly, the Fed should look at the broader monetary aggregates that have a bettr linkage with economic activity.
Chairman NEAL. What do you think they are doing?
Mr. LEVY. Right now?
Chairman NEAL. Yes.
Mr. LEVY. Right now the Fed is revising downward its forecast of
real economic activity and it is lowering the funds rate, hoping to
avoid a recession. In practice, the Fed lowers the funds rate 25
basis points and then looks at the most recent economic release. If
the release portrays economic weakness, the Fed lowers rates some
more.
A few members of the board are starting to recognize the fact
that reserves and real money balances are declining, which could
push the economy into recession. I applaud the Fed for its disinflationary stance. But what concerns me is that every time in the
1980's when real growth has fallen below the Fed's central tendency forecast range, the Fed has tended to shift dramatically toward
overly expansive monetary policy.
The true test of the Fed has not yet occurred; It will occur when
the economy slumps. Then we see if the Fed really sticks to its disinflationary policy or whether it gives into internal procedures or
mounting pressures from the administration and the Congress to
shift priorities.
Chairman NEAL. M2 has been under their target range since late
January of this year. Based on what you are talking about, what
would be the right path?
Mr. LEVY. I would like to see M2 grow at approximately 4 to 5
percent for the next couple of years, which would generate nominal
62
GNP growth down in the 4 to 5 percent range. This would bring
the underlying rate of inflation down to 2 percent. Subsequently,
the Fed should ratchet the target down further to achieve zero inflation.
I might note that the Fed's targets for money growth, whether
Ml or MIA in the early 1980's or M2 now, were never binding
monetary target variables economic growth or inflation deviating
substantially from the Fed's short-run forecast ranges.
Chairman NEAL. It ought to be easy to find out and know how
they will react by just watching M2, don't you think?
Mr. LEVY. I would look at several measures, particularly bank reserves and real Ml and real M2. When they are all pointing in the
same direction, like they are presently, then heed the message.
Chairman NEAL. Using your own logic here, you recommend that
M2 growth, for example, move higher along with the other aggregates and the other elements of taking control. You are not going
to know, are you, whether the Fed was responding to administration pressure or worrying about recession, or whether they are following a sensible long-range course.
Mr. LEVY. I think we will know when we see a turnaround in
bank reserves. That will determine the general trend in real
money growth. Importantly, we are at the critical juncture when in
the past the Fed has abandoned its money targets because it becomes overly concerned about current economic conditions. Presently, there is a long list of concerns if the economy does go into
recession. I think we will see increased pressure from the administration and the Congress to shift dramatically toward monetary
stimulus.
The true test of the Fed is not whether there is a mild recession,
but whether it continues to follow a disinflationary environment
which creates a healthy environment for sustained economic
growth in the 1990's.
Chairman NEAL. Mr. DePrince, your forecast for 1990 shows a
sharp drop in real growth from 2.9 percent this year to minus .1
percent next year, combined with a sharp rise in inflation from 4.7
percent this year to 5.7 percent next year for the GNP deflator.
That seems contrary to the normal expectation, it seems to me,
that is that a recession will bring inflation down. In simple terms,
how would you support this kind of forecast? I wonder if the other
witnesses would like to comment after you have.
Mr. DEPRINCE. It goes back to the issue of banks. As the pressures build in the labor markets, things are not reversed instantaneously, so compensation gains will continue at an above-trend rate
even as the economy is faltering. These adjustments do not take
place simultaneously.
Simultaneously, as economic growth falters, productivity falters
more so. Unit labor costs remain a problem even in a declining
economy. It is usually not until the early stages of expansion when
you have growth at 7 or 8 percent and productivity at 7 to 8 percent that you have the rapid drop in unit labor costs with the rapid
drop of inflation.
So it is the lags in the process that lead to relatively high inflation next year even though the economy in the second half of the
year is in an economic downturn.
63
I think it is important to keep in mind that wherever the point
of an economic recession may take place, its effect on inflation,
however high inflation may be at the time it takes place, will not
be instantaneous. The big effect, in my judgment, on inflation will
take place as the next expansion gets under way.
It has to do with the same type of lags in the business sector that
Mr. Levy spoke of in terms of the lags in monetary policy from a
policy point of view.
Mr. BENDERLY. I have two points, one specific and one more general.
I think a focus on the unit labor cost increases that tends to
come about because productivity slumps when growth is slowing
puts too much emphasis on the effect of that productivity slump because the historical norm is for 70 or 80 percent or so of such a
slump in productivity and such a slump in rise of unit labor costs
that goes in with that, it goes into increased profits, it is not inflation. Unit labor costs rise more rapidly than inflation when growth
is slowing.
Second and more generally, I think that the economy has already faltered. We have had 1.6 percent GNP in the first half of
the year. I think most signs say the growth will be slower in the
third quarter of 1989. I think that there are signs that the cyclical
pressures on inflation have begun to ease, particularly within the
manufacturing sector.
Manufacturing pricing itself is easing whether pressured at the
raw material stage, the intermediate stage, it doesn't look like it
has yet come through to the finished goods stage, but I think that
is a matter of a few months.
Even on the wage side, there has been a stabilizing of wage gains
at something like 2V2 percent in the manufacturing sector and
something like 4 percent for the economy as a whole. There has
been no pick-up in that pace of wage gain since the third quarter of
1988, almost a year ago.
So I think that process, which involves some lags in systems, the
building up of inflation pressures, is under way already. It is not
going to have to occur in 1990.
Mr. LEVY. I agree with Mr. Benderly that there are lags. Real
and nominal GNP growth have already started to slow down. With
a fourth-quarter lag, according to my estimates, unit labor costs
will roll over and come down.
Let's consider again that mythical firm whose product demands
mirror nominal GNP growth. If you owned the firm, your initial
concerns would be in nominal not real, terms. If revenue growth
began to decelerate while your unit labor costs continued to rise,
thus squeezing your profit margins, your initial reaction may be
that the slowdown in product demand is temporary. Accordingly,
you may grant higher wages. This may explain some of the momentum in wages.
After about four quarters, according to my estimates, businesses
profit margins are squeezed sufficiently to constrain wage increases, and inflation declines.
I might note that too often inflation and corporate profits are
analyzed separately. In reality, they are intertwined. In first quarter 1989, economic profits, that is corporate profits adjusted for in-
64
flation of inventories and the difference between economic and tax
depreciation, declined sharply. Second-quarter data are not yet
available, but I expect further weakness. This squeeze on profits is
crucial to the trend in unit labor cost increases. The tight monetary policy and slower nominal GNP growth require that if unit
labor cost increases roll over, given what the Fed has done, then
something else are not slowed, corporate profits will decline more..
Chairman NEAL. Let me thank you very much.
Mr. Levy, you mentioned another study. I would like to see it. In
fact, I would like to see anything each of you are doing on any of
this. We are constantly trying to follow it, make some sense of it.
We certainly do appreciate your coming this morning to help us
with it. We welcome your thoughts at any time. Thank you again.
The subcommittee is adjourned, subject to the call of the Chair.
[Whereupon, at 12:25 p.m., the hearing adjourned, subject to the
call of the Chair.]
65
APPENDIX
July 20-, 1989
66
1989
MONETARY
POLICY
OBJECTIVES
Testimony of Alan Greenspan, Chairman
Board of Governors of the Federal Reserve System
July 20, 1989
67
Testimony of Alan Greenspan
Chairman, Federal Reserve Board
Mr. Chairman and Members of the
Committee: I appreciate this
opportunity to appear before you in
connection with the Federal Reserve's
semiannual Monetary Policy Report
to Congress. In my prepared remarks
today I will adhere closely to the
matter at hand—that is} monetary
policy and the state of the nation ys
economy.
Economic and Monetary Developments
Thus Far in 1989
Over the course of this year, the contours of the
broad economic setting have changed. As a consequence, the stance of monetary policy also has
shifted somewhat, although the fundamental
objective of our policy has not. That objective
remains to maximize sustainable economic growth,
which in turn requires the achievement of price
stability over time.
Early in the year, the Federal Reserve continued
on the path toward increased restraint upon which it
had embarked in the spring of 1988. At the time of
our report to Congress in February of this year, I
characterized the economy as strong, with the risks
on the side of a further intensifying of price pressures. Labor markets had been tightening noticeably, heightening concerns that inflationary
pressures might be building. Moreover, increases in
food and crude oil prices were raising the major
inflation indexes.
In view of the dimensions of the inflation threat,
the Federal Reserve tightened policy further early
this year. Additional reserve restraint was applied
through open market operations, and the discount
rate was raised Vi percentage point. The determination to resist any pickup in inflation also motivated
the decision of the Federal Open Market Committee
at its February meeting to lower the ranges for
money and credit growth for 1989. This marked the
third consecutive year in which the target ranges
were reduced, and it underscored our commitment
to achieving price stability over time.
Reflecting the economy's apparent strength and
the tighter stance of policy, interest rates rose during
the first quarter. Short-term market rates increased
around 1 percentage point over the quarter, leaving
them up more than 3 points from a year earlier, but
long-term rates held relatively steady. The year-long
rise in short-term rates had a marked impact on
growth of the monetary aggregates, restraining the
demand for money as funds flowed instead into
higher-yielding market instruments.
By the beginning of the second quarter, the
outlook for spending and prices was becoming more
mixed. Scattered indications of an emerging
softening in economic activity began to appear,
prompting market interest rates to pull back. Rates
continued to fall as a variety of factors pointed to
some lessening of price pressures in the period
ahead. In particular, money growth weakened
further, the underlying trend in inflation appeared
to be less severe than markets had feared, the dollar
continued to climb, and domestic demand slackened. Against this background, the Federal Reserve
eased reserve conditions, first in early June and
again in early July. By mid-July, most short-term
market rates had fallen to a bit below their year-end
levels, and long-term interest rates were down as
much as a full point, to their lowest levels in more
than two years.
68
Economic activity apparently grew in the first half
of this year at a rate somewhat below that of
potential GNP. This stands in sharp contrast to the
performance of the preceding two years during
which growth proceeded at a pace that placed
increasing pressures on labor and capital resources.
Job creation has remained the hallmark of the
current expansion, however. Even with the more
moderate pace of economic growth in the first half of
this year, nearly 1 Y2 million new jobs were added to
payrolls. And this occurred apparently without
triggering an acceleration in wages.
Prices did accelerate in the first six months of this
year, but most of the increase may be transitory,
related to supply conditions in food and petroleum
markets. After a gradual pickup over the preceding
two years, price inflation outside of food and energy
held near its 1988 pace.
Excluding food and energy is one traditional way
of estimating the "underlying" rate of inflation.
Although there is some logic in abstracting from
these prices, which are quite volatile and can be
dominated over the short run by supply disturbances, this approach is incomplete. An alternate
picture of near-term price-setting behavior can be
gleaned by examining the components of prices, that
is, the cost pressures facing firms and the behavior of
their profits. Such an analysis reveals that, in
manufacturing, much of the pickup in inflation thus
far in 1989 is accounted for by higher unit energy
and labor costs. The runup in world crude oil prices,
which reflected a series of production accidents this
spring as well as a degree of output restraint on the
part of some OPEC oil producers, is the main
reason for the increase in energy costs.
In contrast, movements in hourly compensation
appear to have been quite moderate in the first half
of this year, and the acceleration in unit labor costs
largely reflected slower growth in productivity. Such
a deceleration in productivity is typical as the pace of
economic activity slows. But, given the relatively
high levels of resource utilization, it also is possible
that firms were forced to draw on less skilled workers
than was the case earlier in the expansion. A
significant moderation in the unit cost of imported
materials, likely reflecting the higher value of the
dollar on foreign exchange markets, provided a
notable offset to these cost pressures. On balance, it
appears that firms have continued to experience
upward pressures on costs. The intensity of these
pressures as related to energy inputs may well
diminish in coming months, but it remains to be
seen how other elements of the cost structure will
evolve.
This approach, while helpful in understanding the
interaction of prices and costs, does not tell us how
an inflation cycle begins or why it may persist.
Short-run inflation impulses can originate from a
variety of sources, on both the demand and the
supply sides of the economy. But over longer periods
of time, inflation cannot persist without at least
passive support from the monetary authorities.
The strength of the inflation pressures in 1988 and
into 1989 was, of course, the motive for the progressive tightening of policy that the Federal Reserve
undertook over that period. And the outlook for
some reduction in these pressures owes in part to
that policy restraint. The associated rise in market
interest rates, beginning early last year, opened up
wide "opportunity" costs of holding money assets
and resulted in a sharp slowing of money growth.
This was especially the case for liquid deposits,
whose rates were adjusted upward only very
sluggishly, providing depositors with strong
incentives to economize on balances.
In addition to the effect of interest rates, several
special factors played a role in slowing money
growth and boosting velocity—that is, the ratio of
nominal GNP to money. Probably the most
important of these was the unexpectedly large size of
personal tax liabilities in April. Many individuals
evidently were surprised by the size of their liabilities, and drew down their money balances below
normal levels to make the required payments. As the
IRS cashed those checks, M2 registered outright
declines.
69
The difficulties of the thrift industry also may
have affected M2 growth. Late last year, as public
attention increasingly focused on the financial
condition of the industry and its insurance fund,
FSLIC-insured institutions began to lose deposits at
a significant rate. These deposit withdrawals were
particularly strong in the first quarter of this year,
and while most of the funds apparently were
repositioned within M2—at commercial banks or
money funds—this factor likely also had some
damping effect on that aggregate.
More recently, growth of the broader monetary
aggregates has picked up markedly. The restraint
imposed by the earlier rise in market interest rates is
fading, and households appear to be rebuilding their
tax-depleted balances. As of May, M2 had risen at
just a 1 percent rate from its fourth-quarter base,
but the 6% percent rate of growth in June lifted the
year-to-date increase to around a 2 percent rate, still
somewhat below its 3 to 7 percent annual target
cone. M3 rose at a 3 Vz percent rate through June, at
the lower end of its range. The latest data on these
aggregates suggest that relatively rapid expansion
has continued into July.
Ml, which is the most interest-sensitive of the
monetary aggregates, declined at a 3 M> percent rate
through June. The unusual drop in Ml stemmed
from sizable declines in NOW accounts and demand
deposits. NOW accounts were reduced both by the
large personal tax payments this spring and by the
high level of interest rates, which drew savings-type
balances instead toward market instruments or other
types of accounts whose offering rates adjusted
upward more quickly. The decline in demand
deposits was related in part to a reduction in
balances that businesses are required to hold to
compensate their banks for various services; for a set
amount of services, higher market rates translate
into lower required balances.
Monetary Policy and the Economy into 1990
Looking ahead at the remainder of 1989 and into
1990, recent developments suggest that the balance
of risks may have shifted somewhat away from
greater inflation. Even so, inflation remains high—
clearly above our objective. Any inflation that
persists will hinder the economy's ability to perform
at peak efficiency and to create jobs. Consequently,
monetary policy will need to continue to focus on
laying the groundwork for gradual progress toward
price stability. Such an outcome need not imply a
marked downturn in the economy, and policy will
have to be alert to any emerging indications of a
cumulative weakening of activity. However,
progress on inflation and optimum growth over time
also require that our productive resources not be
under such pressures that their prices continue to
rise without abating. In light of historical patterns of
labor and capital growth and productivity, this
progress very likely will be associated with a more
moderate, and hence sustainable, expansion in
demand than we experienced in 1987 and 1988.
At its meeting earlier this month, the Federal
Open Market Committee determined that a
combination of continued economic growth and
reduced pressures on prices would be promoted by
growth of money and debt in 1989 within the annual
ranges that were set in February. Moreover, it
tentatively decided to maintain these same ranges
through 1990.
The specified ranges, both for this year and next,
retain the 4-percentage-point width first instituted
for the broader aggregates in 1988. Considerable
uncertainties about the behavior of money and
credit remain, and the greater breadth allows for a
range of paths for these aggregates as financial and
economic developments may warrant. Uncertainties
about the link between the narrow transactions
aggregate, Ml, and the economy have, if anything,
increased, and the Committee once again did not
specify a range for this aggregate.
70
In view of the apparent variability, particularly
over the short run, in the relationships between the
monetary aggregates and the economy, policy will
continue to be carried out with attention to a wide
range of economic and financial indicators. The
complex nature of the economy and the chance of
false signals demand that we cast our net broadly—
gathering information on prices, real activity,
financial and foreign exchange markets, and related
data.
While the monetary aggregates may not be
preeminent on this list, they always receive careful
consideration in our policy decisions. This is
especially true when they exhibit unusual strength
or weakness relative to past patterns and relative to
our announced ranges. Thus, the very sluggish
growth in M2 for the year to date was an important
influence in the decision to ease policy in June and
again in July. Velocity may vary considerably over a
few quarters, but the provision of liquidity, as
measured by one or another of the monetary
aggregates, is an important factor in the performance of the economy over the shorter run and over
the long run broadly determines the rate of price
increase.
Although M2 currently remains below its 1989
target cone, it has picked up substantially. The
decline in interest rates in recent months, along with
the continued growth of income, should provide
support for that aggregate over the rest of the year,
helping to lift it into the lower part of its target
range. Growth in M2 likely will be augmented by a
cessation of the special influences I noted earlier that
depressed it in the first half of the year. In particular,
we expect households to continue to rebuild their
money balances after the tax-related drawdowns in
April and May. Also, deposit withdrawals from
thrift institutions have subsided, and enactment of
legislation that restores full confidence in the
industry would bode well for depositflowsinto
FSLIC-insured institutions.
Further steps in the resolution of the thrift
industry difficulties also have implications for M3.
With deposits flowing in again, thrifts will not have
to rely so heavily on the Federal Home Loan Banks
for their funding as they did earlier this year. Partly
as a result, we expect M3 to strengthen from its rate
of growth over the first half of the year, moving up
into the middle of its target range by year-end.
Our outlook for debt growth foresees little change
from the pace of the first two quarters. The broad
credit measure that we monitor, the debt of domestic
nonfinancial sectors, has grown at about an 8
percent rate this year, near the midpoint of its 6 Vi to
10 Vi percent range. We have little reason to expect
its growth through the end of the year to be very
different, implying some slowing from the pace of
1988. Nevertheless, the expansion of debt is likely to
exceed nominal GNP growth again this year.
Growth of money and debt within the 1989 ranges
is expected to be consistent with nominal GNP
rising this year at a pace not too far from last year's
increase, according to the projections of FOMC
members and other presidents of Reserve Banks.
These projections, however, incorporate somewhat
more inflation and less real growth than we experienced in 1988. The central tendency of the projections of 2 to 2 Vi percent real GNP growth over the
four quarters of this year implies continued moderate economic growth throughout the year. For the
year as a whole, these projections anticipate that
growth is likely to be strongest in the investment and
export sectors of the economy, with expansion of
consumer expenditures and government purchases
rather subdued.
A sectoral pattern of growth such as this would in
fact serve the nation's longer-term needs by
contributing to a better external balance. Fundamentally, improvement in our international
payments position requires productivity-enhancing
investment and a higher national saving rate. In this
regard the federal government can play a significant, positive role by reducing the budget deficit.
71
The outlook for inflation this year, as reflected in
the central tendency of the projections expressed at
the FOMC meeting, is for a 5 to 5 Vz percent
increase in the consumer price index. A figure in
this range would represent the highest annual
inflation rate in the United States since 1981; this is
a source of concern to the Federal Reserve. Yet this
rate is below that experienced in the first six months.
This implies a considerable slowing over the
remainder of the year, reflecting earlier monetary
policy restraint and a prospective moderation in
food and energy prices.
Federal Reserve policy is focused on laying the
groundwork for more definite progress in reducing
inflation pressures in 1990, while continuing
support for the economic expansion. The ranges
provisionally established for growth of money and
debt next year are consistent with these inteations.
They allow for a noticeable pickup in money growth
from that likely to prevail this year, should that be
appropriate. If pressures on prices and in financial
markets are less intense than in recent years,
velocity would not be expected to continue to
increase, and faster money growth, perhaps in the
top half of the range, would be needed for a time to
support economic growth. Conversely, if price
pressures prove intractable, the ranges are low
enough to permit the needed degree of monetary
restraint.
Thus, although the 1990 ranges do not represent
another step in the gradual, multiyear lowering of
ranges, the Federal Reserve's intent to make further
progress against inflation remains intact. Uncertainties about the outlook suggested a pause in the
process of reducing the ranges; however, the
Committee recognizes that our goal of price stability
will require additional downward adjustments in
these ranges over time. Of course, as we draw closer
to 1990, the economic and financial conditions
prevailing will become clearer, allowing us to
approach our decisions on the ranges with more
confidence. Hence, the current ranges for money
and credit growth in 1990 should be viewed as very
preliminary.
The economic projections for 1990 made by the
governors and Reserve Bank presidents center in a
range of 1 ^ to 2 percent real GNP growth and 4 Y2
to 5 percent inflation for next year. Naturally, as I've
already noted, there are considerable uncertainties
surrounding forecasts for 1990. In particular,
developments in the external sector will depend in
part on economic activity abroad, as well as on the
efforts of U.S. firms to become more competitive in
world markets. Domestically, performance will be
affected by a large number of influences, including
importantly the budget deficit.
Monetary Policy in Perspective
The Federal Reserve is committed to doing its
utmost to ensure prosperity and rising standards of
living over the long run. Given the powers and
responsibilities of the central bank, that means most
importantly maintaining confidence in our currency
by maintaining its purchasing power. The principal
role of monetary policy is to provide a stable
backdrop against which economic decisions can be
made. A stable, predictable price environment is
essential to ensure that resources can be put to their
best use and ample investment for the future can be
made.
In the long run, the link between money and
prices is unassailable. That link is central to the
mission of the Federal Reserve, for it reminds us
that without the acquiesence of the central bank,
inflation cannot take root. Ultimately, the monetary
authorities must face the responsibility for lasting
price trends. While oil price shocks, droughts,
higher taxes, or new government regulations may
boost broad price indexes at one time or another,
sustained inflation requires at least the forbearance
of the central bank. Moreover, as many nations have
learned, inflation can be corrosive. As it accelerates,
the signals of the market system lose their value,
financial assets lose their worth, and economic
progress becomes impossible.
72
Thankfully, this bleak scenario is not one that we
in the United States are confronting. We do,
however, face a difficult balancing act. The economy
has prospered in recent years: the economic
expansion has proven exceptionally durable,
employment has surpassed all but the most optimistic expectations, and the underlying inflation rate,
after coming down quickly in the early 1980s, has
accelerated only modestly. But now signs of softness
in the economy have shown up.
Accordingly, it is prudent for the Federal Reserve
to recognize the risk that such softness conceivably
could cumulate and deepen, resulting in a substantial downturn in activity. We also recognize,
however, that a degree of slack in labor and product
markets will ease the inflationary pressures that have
built up. So our policy, under current circumstances, is not oriented toward avoiding a slowdown
in demand, for a slowing from the unsustainable
rates of 1987 and 1988 is probably unavoidable.
Rather what we seek to avoid is an unnecessary and
destructive recession.
The balance that we must strike is to support
moderate growth of demand in the near term, while
concurrently progressing toward our longer-run
goal of a stable price level. Admittedly, the balance
we are seeking is a delicate one. I wish I could say
that the business cycle has been repealed. But some
day, some event will end the extraordinary string of
economic advances that has prevailed since late
1982. For example, an inadvertent, excess accumulation of inventories or an external supply shock
could lead to a significant retrenchment in economic
activity.
Moreover, I cannot rule out a policy mistake as
the trigger for a downturn. We at the Federal
Reserve might fail to restrain a speculative surge in
the economy or fail to recognize that we were
holding reserves too tight for too long. Given the
lags in the effects of policy, forecasts inevitably are
involved and thus errors inevitably arise. Our job is
to keep such errors to an absolute minimum. An
efficient policy is one that doesn't lose its bearings,
that homes in on price stability over time, but that
copes with and makes allowances for any unforeseen
weakness in economic activity. It is such a policy
that the Federal Reserve will endeavor to pursue.
73
Board of Governors of the Federal Reserve System
/si
2
il '
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 20, 1989
74
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 20, 1989
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to the
Full Employment and Balanced Growth Act of 1978.
Sincerely,
Alan Greenspan, Chairman
75
Table of Contents
Page
Section 1:
Monetary Policy and the Economic Outlook for 1989 and 1990
1
Section 2:
The Performance of the Economy during the First Half of 1989
5
Section 3:
Monetary Policy and Financial Developments
during the First Half of 1989
10
76
Section 1: Monetary Policy and the Economic Outlook for 1989 and 1990
As 1989 began, a reduction in inflationary pressures
appeared essential if the ongoing economic expansion
was to be sustained. Monetary policy during 1988 had
been directed toward reducing the risks of an escalation
of inflation and inflation expectations, but at the time of
the Board's report to the Congress in February of this
year, success in that effort seemed far from assured.
Indeed, among the data reported in the early part of
1989 were very large increases in the producer and
consumer price indexes, reflecting not only the effects
of run-ups in oil and agricultural commodity prices,
but also broader inflationary developments, including
unfavorable trends in unit labor costs over the preceding year. Under the circumstances, with pressures on
productive resources still intense, monetary policy was
tightened further. Reserve availability was curtailed
through open market operations, and the discount rate
was raised Vi percentage point in late February. In
response to these policy actions, and to expectations
that additional tightening moves might be needed,
market interest rates climbed throughout the first quarter, and money growth was subdued.
Over the course of the second quarter, a number of
indicators suggested the emergence of conditions that
were more conducive to a future easing of inflationary
pressures. Growth of the monetary aggregates weakened further, with M2 running noticeably below its
target range for the year. Aggregate demand for goods
and services moderated, reducing somewhat the strains
on productive resources, especially in the industrial
sector of the economy. The dollar exhibited considerable strength on the foreign exchange markets, portending a direct reduction in price pressures and slower
growth in demands on domestic production capacity.
Although the unemployment rate remained essentially
unchanged in the neighborhood of 5 V* percent—the
lowest level since the early 1970s—trends in wages and
total compensation showed little, if any, further stepup, reflecting at least in part an awareness among
workers and management of the need to contain costs
in a highly competitive world economy. Meanwhile,
prices of actively traded industrial commodities leveled out, enhancing the prospects of a broader slackening in the pace of inflation.
In this environment, interest rates turned down
during the spring, as financial market participants
responded not only to the better outlook for inflation
but also in anticipation of an easing of monetary
restraint by the Federal Reserve. The System began to
provide reserves slightly more generously through
open market operations at the beginning of June, and
took an additional small easing step in early July. This
helped bring about a further decline in market rates of
interest, which by mid-July generally had more than
retraced the increases that had occurred earlier in the
year. Most short-term interest rates were down about
Vz percentage point from their December levels, while
long-term rates had fallen as much as 1 percentage
point on balance.
Monetary Objectives for 1989 and 1990
In February, the Federal Open Market Committee
specified a range for M2 growth in 1989 that was a full
percentage point below that of 1988 and ranges for M3
and debt that were xh percentage point below those of
the prior year. This was the third consecutive year in
which the ranges had been lowered. At the same time,
the Committee recognized that, in light of the continuing uncertainty regarding the shorter-term relation
between monetary growth and changes in income and
spending, a variety of indicators of inflation pressures
and economic activity as well as the behavior of the
aggregates would have to be considered in determining
policy.
In February, the Committee had anticipated relatively slow money growth over thefirsthalf of the year,
because of the effects of the firming of policy through
late 1988 and into 1989. In addition to the influence of
the higher interest rates on desired holdings of money,
however, several special factors—including the difficulties of the thrift industry and a drawdown of liquid
assets to meet unusually large individual tax payments—appear to have further reduced money balances in the first half. These factors contributed to a
substantial rise in velocity, the ratio of nominal GNP to
the stock of money.
By June, money growth had picked up. Nonetheless,
M2 ended the quarter just 2 percent at an annual rate
above the fourth quarter of last year, compared with its
3 to 7 percent annual growth range. In June, M3 was at
the lower end of its 3V2 to IVi percent annual range.
The rate of expansion of domestic nonfinancial sector
debt also slowed in the first half of this year compared
with 1988, though by less than the monetary aggregates; debt has grown about 8 percent so far this year,
near the middle of its 6V2 to IOV2 percent monitoring
range.
At its meeting earlier this month, the Committee
agreed to retain the current ranges for growth of money
77
Ranges of Growth for Monetary and Credit Aggregates
Percent change,
fourth quarter to fourth quarter
1988
1989
M2
4to8
3to7
3to7
M3
4to8
3V2 to 7V2
3V2 to 7V2
Debt
7to11
6V2to10V2
6V2tOiOV2
and debt in 1989. The Committee anticipates that by
the fourth quarter all three aggregates will be well
within those ranges. The more rapid growth in M2 and
M3 already evident since mid-May is expected to
extend through the second half. The recent declines in
short-term market interest rates have made M2 holdings more attractive, tending to offset the restraining
effects on M2 of previous interest rate increases. With
M2 expansion likely also to be boosted by a further
replenishing of liquid balances depleted by tax payments, this aggregate is expected to grow a little faster
than nominal GNP in the second half, bringing it into
the lower portion of its annual growth range. The faster
growth of M2 should show through at least in part to a
quickening in M3 growth over the second half of the
year, so that this aggregate would move into the middle
part of its range. Domestic nonfinancial debt is likely to
remain in the middle portion of its range through
year-end.
For 1990, the Committee provisionally decided to
use, for all three aggregates, the same growth ranges in
force for 1989. The Committee recognized that the
economic and financial outlook over the next year and a
half is uncertain; in particular, it is unclear at this
juncture whether the velocities of M2 and M3 are more
likely to trend higher or lower next year. Although the
Committee's initial assessment is that growth of money
and credit through 1990 within the bounds of the
reduced ranges of this year likely would foster the
slower inflation and sustained real economic expansion
that it is seeking, it will reevaluate the ranges next
February in light of the unfolding economic and financial situation. The outlook for spending, prices, and
financial markets in 1990 should have clarified somewhat by then, as should the influence on monetary
expansion of tfye ongoing resolution of thrift industry
problems. For the long term, the Committee recognized that ultimate attainment of price stability will
require that the ranges for money and credit growth be
reduced further in future years.
Provisional for 1990
Economic Projections for 1989 and 1990
Voting members of the Committee and other Reserve Bank presidents believe that the monetary ranges
specified are consistent with some progress in reducing
inflation, which likely will be associated in the near
term with continuation of a slower pace of economic
growth. The central tendency of the forecasts is for
increases in real GNP of 2 to 2 xh percent in 1989 and of
Wi to 2 percent in 1990.
The expected easing of pressures on resources should
contribute to a damping of inflation in 1990, although
the Board members and Bank presidents also are
anticipating some near-term relief from the special
problems that boosted prices in the first half of this
year. Larger crops later this year should result in more
favorable behavior of food prices, and the recent
peaking of crude oil prices suggests the likelihood of
some softening in consumer energy prices. Thus, retail
inflation should be considerably slower over the remainder of this year, and the central tendency of CPI
forecasts for 1989 as a whole is 5 to 5Vi percentcompared with the more than 6 percent rate observed,
through May. The forecasts for the CPI in 1990 center
on Ax/i to 5 percent.
The Administration's economic forecast, presented
in connection with its mid-session update of the budget
outlook, does not differ greatly from the projections of
the FOMC members. Nominal GNP is near the upper
ends of the FOMC central-tendency ranges for 1989
and 1990, but with a more favorable mix of real output
versus inflation, especially in 1990. There appears to
be no basic inconsistency between the policy objectives
of the Federal Reserve and the economic forecast of the
Administration; indeed, the Administration has indicated that it shares the view that the maintenance of
anti-inflationary monetary policy is a precondition for
healthy economic expansion.
In an environment of relatively slow overall growth,
such as is expected by the FOMC members, some
78
Economic Projections for 1989 and 1990
FOMC Members and Other FRB Presidents
Administration
Range
Central Tendency
5 to 73/4
1 1 /2t0 23/4
4V2 tO 53/4
6to7
2to2V 2
5to5V2
7.1
2.7
4.91
5to6
Around 51/2
5.32
4V4 tO 7V2
1 to 2V2
3 to 53/4
5V2 tO 63/4
1 1 /2to2
4V2 to 5
6.8
2.6
4.1 1
5to6V2
5V2 to 6
5.42
1989
Percent change,
fourth quarter to fourth quarter
Nominal GNP
Real GNP
Consumer price index
Average level in the
fourth quarter, percent
Civilian unemployment rate
1990
Percent change,
fourth quarter to fourth quarter
Nominal GNP
Real GNP
Consumer price index
Average level in the
fourth quarter, percent
Civilian unemployment rate
1. CPI-W. FOMC forecasts are for CPI-U.
2. Percent of total labor force, including armed forces residing in the United States.
industries and regions are likely to experience setbacks, but major imbalances that could threaten the
continuation of the economic expansion are not anticipated. In the household sector, growth of consumer
purchases has been sluggish and may remain so for a
while. Residential construction activity should pick up
some in coming months, in response to the recent
decline of mortgage rates, although an overhang of
supply in some locales could damp the recovery.
Surveys of business plans suggest that capital spending
will post further gains over the remainder of 1989, but
some moderation from first-half growth rates is to be
expected in light of declining levels of capacity use and
the recent weakening in corporate profits. Spending on
equipment is likely to continue to be buoyed by the
desire to modernize industrial facilities, so as to enhance efficiency and meet intense competition here and
abroad.
The external sector represents an area of considerable uncertainty in the economic outlook for the next
year and a half. Real net exports of goods and services
increased earlier this year, but improvements may be
more difficult to achieve in the period ahead as the
effects of past depreciation of the dollar wear off and
are offset by those associated with the more recent
appreciation. In addition, the path of exports will
depend importantly on economic growth abroad, which
may slow as a result of policy actions taken by some of
our major trading partners to offset mounting inflationary pressures. Ultimately, achievement of the adjustment needed in the external sector will depend not
only on governmental policies that foster macroeconomic stability, but also on the determination of U.S.
firms to meet foreign competition through application
of stringent cost controls and intensified marketing
efforts abroad.
A key ingredient in maintaining a healthy pace of
economic expansion is further progress in reducing the
federal budget deficit. Since 1983, the deficit has fallen
relative to GNP from more than 6 percent to around
79
3 percent, but it remains large by historical standards.
Taking the actions required to meet the GrammRudman-Hollings targets on schedule will foster confidence in the U. S. economy, particularly among financial market participants. At the same time, reduced
demands by the federal government for credit will free
up the available supply to interest-sensitive private
sectors, such as housing and business investment. The
Committee thus views as highly encouraging the commitments expressed by the Congress and the Administration to begin soon to address the problems of
meeting the fiscal 1991 budget target.
80
Section 2: The Performance of the Economy during the First Half of 1989
After two years of rapid expansion, economic activity decelerated substantially in the first half of 1989.
Even at this more moderate pace of growth, however,
job creation was considerable-nearly VA million
between December and June—and the civilian unemployment rate, fluctuating around 514 percent, remained in the lowest range since the early 1970s.
Inflation rose in the first half of 1989, but most of the
increase appears to have resulted from transitory events.
In particular, energy prices increased sharply, as the
rise in crude oil prices between November 1988 and
May 1989 was passed through, and food prices surged
as the agriculture sector continued to experience adverse supply developments. Outside food and energy,
the rate of inflation has, on average, remained at about
its 1988 pace, even in the face of relatively high levels
of resource utilization.
This apparent stability of underlying price trends is
attributable in part to the appreciation of the dollar on
exchange markets. So far in 1989, prices of imported
goods other than oil have been virtually flat on average,
restraining increases in the prices of domestically
produced items. In addition, despite the tightest labor
markets in some time, wage trends have been fairly
stable, helping to limit the acceleration in unit labor
costs during a period in which productivity has
weakened.
The External Sector
Developments in foreign exchange markets have
played an important role in shaping events in the
domestic economy in recent years. After depreciating
over most of the period from 1985 to late 1987, the
foreign exchange value of the dollar in terms of other
G-10 currencies changed little, on net, in 1988, as a
decline in the final few months reversed much of the
increase that had occurred earlier in the year. In
December the dollar began to rebound, and it rose
substantially through mid-June before dropping back
somewhat. The appreciation of the dollar through the
first half of 1989 was frequently met by concerted
intervention sales of dollars by U.S. and foreign
monetary authorities.
During December, and in the first quarter of this
year, the dollar rose in response to perceptions of a
relative tightening of U.S. monetary policy. Reports of
somewhat higher rates of inflation and news about the
strength of the economy contributed to expectations
that Federal Reserve policy would be tightened still
further. There was a brief pause in the dollar's rise after
the Group of Seven finance ministers and central bank
governors stated in April that a further rise in the dollar
that undermined the adjustment process would be
counterproductive.
In May and early June, the dollar appreciated significantly on balance, even though interest rates on
nondollar assets rose relative to those on dollardenominated instruments. Sentiment in favor of the
dollar was, perhaps, partly a response to concerns
about political events abroad, but the data on the U.S.
trade balance, which were better than expected, also
may have played a role. For a while, the dollar's rise
appeared to be associated with expectations of capital
gains on U.S. stocks and bonds. Since mid-June, the
dollar has retraced much of its second-quarter rise,
under the influence of increasing interest rates abroad,
declines in dollar rates, and some easing of demands
for dollar assets after the initial response to political
uncertainties in certain other countries.
Measured in terms of a trade-weighted average of
the other G-10 currencies, the dollar is about 8 percent
higher than in December 1988 and about 12 percent
higher than in December 1987. After adjustment for
changes in relative price levels, the appreciation of the
dollar has been larger, because U.S. inflation has
remained above the average for the other G-10 countries. Meanwhile, the currencies of South Korea and
Taiwan have risen moderately against the dollar so far
in 1989.
In most of the other industrial countries, economic
growth has been strong. The resulting very high rates
of capacity utilization and the diminishing slack in
labor markets, together with higher world oil prices
and special factors, have spurred an appreciable pickup
in inflation abroad in recent quarters. Policymakers in
many foreign industrial countries have responded by
raising official interest rates. Growth of the newly
industrializing economies in Asia has slowed recently,
though the rates remain relatively high. In contrast,
developing countries that are burdened with large
external debts have continued to struggle to achieve
sustained economic growth.
The U.S. merchandise trade deficit in the first
quarter was $110 billion at a seasonally adjusted annual
rate, significantly better than the figure for the fourth
quarter and that for 1988 as a whole. In the first two
months of the second quarter, the trade deficit was
essentially unchanged from the first-quarter pace.
81
Real GNP - Excluding Drought Effects
Percent change from end of previous period, annual rate
1 8
L
_L
1983
J_
1984
_L
1985
_L
1986
J
1987
1988
1989
Industrial Production
Index 1977= 100
150
June
140
130
110
I
1983
1984
I
1985
I
1986
I
1987
I
1988
1989
GNP Prices
Percent change from end of previous period, annual rate
Fixed-weight Price Index
1983
1984
1985
1986
1987
1988
1989
82
Foreign Exchange Value of the U.S. Dollar *
Index, March 1973 - 1 0 0
1 175
150
125
100
J
1983
1984
1985
1986
1987
I
1988
75
1989
U.S. Real Merchandise Trade
Annual rate, billions of 1982 dollars
600
500
Imports
400
300
200
I
1983
100
1984
1985
1986
1987
1988
1989
U.S. Current Account
Annual rate, billions of dollars
—
150
200
1983
1984
1985
1986
1987
1988
1989
Index of weighted average foreign exchange value of U.S. dollar in terms of currencies of other
G-10 countries plus Switzerland. Weights are 1972-76 global trade of each of the 10 countries.
83
Exports have continued to expand this year, although not so rapidly as in 1988. Export gains have
been broadly based, with notable increases for agricultural goods, industrial supplies, capital goods, and
consumer goods. Meanwhile, imports have increased
moderately; in fact, average imports of products other
than petroleum in April and May were less than 1
percent above their fourth-quarter rate. Notable decreases were recorded in imports of consumer goods
and automotive products. So far in 1989, the value of
oil imports has risen sharply, as higher prices for
petroleum and petroleum products were accompanied
by a small increase in physical volume. The further
improvement in the U.S. trade balance in the first five
months of this year reflects a number of factors, most
importantly the strength of economic activity abroad,
the slower growth of U.S. activity, the continuing, if
diminished, benefit for U.S. price competitiveness
from the depreciation of the dollar through the end of
1987, and the restraint that the recent rise in the dollar
placed on prices of non-oil imports.
The current account deficit widened in the first
quarter to $123 billion. The increase from the fourthquarter rate was more than accounted for by capital
losses on assets denominated in foreign currencies
resulting from the dollar's appreciation. Setting aside
those losses, the current account balance in the first
quarter showed a deficit of $108 billion, an improvement of about $22 billion from the previous quarter.
Nearly all of this improvement resulted from the
narrowing of the trade deficit. Preliminary information
on capital transactions in the early months of 1989
suggests an increase in net private foreign purchases of
U.S. Treasury securities and corporate bonds and
substantial foreign direct investment in the United
States.
The improvement in real net exports accounted for
nearly half of the overall rise in the GNP during the first
quarter, more than reversing its negative contribution
in the fourth quarter. The contribution to GNP growth
in the second quarter probably was negligible, however, as real net exports may have begun to be depressed by the loss in U.S. price competitiveness
associated with the cumulative rise in the dollar since
the end of 1987.
The Household Sector
Much of the slowing in overall economic growth in
the first half of 1989 reflected a deceleration in consumer spending. The slump in demand was fairly
broad, encompassing a variety of durable and nondurable goods. Despite the widespread availability of
special financing deals and other incentives, sales of
motor vehicles in the first half were about 6 percent
below the pace of 1988 as a whole. A weakening in
purchases of furniture and appliances likely was related in part to the drop in home sales.
Consumption slowed against a backdrop of strong
income growth in the early part of the year, although
weaker income growth was evident in the spring.
Personal income gains in the first quarter were accentuated by the national income accountants' assumption
that the income of farm proprietors would return to
normal levels over the year, after the drought-induced
reductions in 1988. With hiring down in the spring,
increases in wages and salaries softened noticeably,
showing virtually no growth in real terms. Also,
growth of the nonwage components of personal income
was weaker on balance in the second quarter.
The personal saving rate has been on a distinct
upswing since reaching a forty-year low in mid-1987.
Several explanations have been propounded for the
recent rise, among them the lower level of household
net worth relative to income since the stock market
break of 1987, higher costs of consumer credit (especially in aftertax terms, because of the phase-down of
interest deductibility), and concerns about a potential
softening of the economy. Whatever the cause, households appear to have adopted a more cautious spending
stance, though it also should be noted that the personal
saving rate has remained below the norms of the 1960s
and 1970s.
Residential construction declined over the first half
in response to the rise in interest rates and to earlier
overbuilding in some markets. The more recent drop in
rates, which began in May, likely will be reflected in
some improvement in construction over the summer
and fall. Total housing starts, at an average annual rate
of 1.44 million units through May, were d. *vn 314
percent from their 1988 pace.
Starts in the single-family sector averaged about 1
million units at an annual rate between March and May,
a period relatively free from the weather-related distortions that affected construction in January and February. Interest rates on fixed-rate mortgages rose above
11 percent for the first time since 1985, with part of the
rise attributable to investor concerns about sizable
future liquidations of mortgage assets by troubled thrift
institutions. Also, rates on adjustablefrate mortgages
rose nearly a full percentage point during the early
months of 1989, as discounting of initial interest rates
on ARMs was reduced. In recent years, relatively low
initial terms on ARMs led an increasing number of
households to favor this instrument for home purchases. Since their highs in the spring, interest rates on
ARMs have fallen more than xh of a percentage point,
84
Real Income and Consumption
Percent change from end of previous period, annual rate
|
| Disposable Personal Income
f
\ Personal Consumption Expenditures
1983
1984
1985
1986
Q1
1987
1988
1989
Personal Saving
Percent of disposable income
I
1983
I
1984
I
_L
1985
1986
1987
I
1988
1989
Private Housing Starts
Annual rate, millions of units, quarterly average
2.5
1.5
0.5
1983
1984
1985
1986
1987
1988
1989
85
while fixed-rate mortgage rates have dropped about
1V* percentage points.
Meanwhile, multifamily starts fell further in the first
half of the year from the already low level recorded in
1988. Multifamily housing production has been limited by an overhang of vacant rental units. Moreover,
building in this sector continues to reflect the effects of
the Tax Reform Act of 1986, which, by curtailing
many of thefinancialadvantages associated with investment in rental housing, sharply reduced its aftertax
profitability.
The Business Sector
In contrast to the household sector, business capital
spending strengthened in early 1989, responding in
part to high levels of capacity utilization in the United
States and to international pressures to lower costs. In
the first quarter of 1989, real business fixed investment
rose at an annual rate of 7 Vi percent, and such spending
appears to have increased substantially further in the
second quarter.
The gain in investment has occurred in the equipment category. Particularly noteworthy in the first
quarter was a sharp rise in outlays for industrial
machinery. Increases in that area, which includes
spending for fabricated metal products, engines, turbines, and a variety of other types of industrial apparatus, have been exceptionally strong since mid-1987.
Spending for high-technology equipment also has been
robust. Computer outlays decelerated during the second half of 1988, possibly reflecting some hesitation on
the part of potential purchasers in response to the rapid
pace of new product announcements, but spending was
up considerably in the first quarter, and another gain
appears in train for the second quarter.
High levels of factory utilization apparently have
spurred a rise in industrial building in recent quarters.
Outlays for construction of office and other commercial buildings also rose earlier this year, although the
level of total spending on commercial structures remained below that of the 1985-86 period, depressed by
excess space in many areas. And, while the rise in
energy prices led to some increase in oil and gas
drilling in the spring, the level of activity remained
very low compared with that of the early 1980s.
Inventory investment slowed over the first five
months of 1989, as businesses adjusted with apparent
promptness to the more moderate expansion of final
demand. Inventory buildups by manufacturers have
been concentrated in the aircraft and other capital
goods industries, where production has risen and order
backlogs are large. In contrast, in the retail sector,
automobile inventories rose sharply in the first quarter
and have remained high. In an effort to reduce the
overhang before introducing new models in the fall,
carmakers have lowered factory assembly rates and
have enhanced sales incentives. Qualitative reports
have suggested that stocks at some other retailers also
may have risen above desired levels, although most
firms appear to have been following cautious inventory
policies and problems of excess stocks seem to be
limited.
In the first quarter of 1989, before-tax economic
profits of nonfinancial corporations declined, in part
because unit labor costs increased as sales growth
slowed and productivity deteriorated. The drop in
profits was spread over most types of businesses; the
largest decline was in the manufacturing sector, which
had especially strong gains in both 1987 and 1988.
Meanwhile, corporate tax liabilities edged up in the
first quarter, owing in part to higher profits generated
from the rise in prices of inventories. The combination
of lower operating profits and higher tax liabilities
reduced the internal cash flow of nonfinancial
corporations.
The Government Sector
In the first quarter, real federal purchases of goods
and services, the part of federal outlays that is counted
directly in GNP, were virtually unchanged. Such purchases are dominated by defense; nominal spending
authority in this area has been virtually flat since 1985,
and procurement of some major new weapon systems
is winding down. As a result, real military purchases
have fallen and in thefirstquarter were nearly 5 percent
below the mid-1987 peak. The decline in defense
spending has been partklly offset by increases in other
federal purchases. Inventories held by the Commodity
Credit Corporation edged down further in the first
quarter, but the rate of decline has been slowing (on a
seasonally adjusted basis) since the middle of last year
as the effects of last summer's drought have dissipated.
Spending for the space program and for tax and
immigration enforcement also has risen.
On a unified budget basis, total nominal outlays for
the fiscal year through May were more than 6 percent
above the comparable year-earlier total. Spending
related to the thrift institution problem spiked at yearend 1988 and then dropped sharply in the first half of
this year. On the other hand, growth has continued in
entitlement spending (principally Medicare and Social
Security) and in net interest outlays.
Federal receipts have grown even more rapidly than
outlays, buoyed by increases in employment and in-
86
Real Business Fixed Investment
Percent change from end of previous period, annual rate
|
| Structures
[^Producers 1 Durable Equipment
20
1983
1984
1985
1986
1987
1988
1989
Changes in Real Nonfarm Business Inventories
Annual rate, billions of 1982 dollars
80
60
40
n
I
I
1983
20
1984
I
1985
1986
1987
20
1988
1989
After-tax Profit Share of Gross Domestic Product *
Percent
Nonfinancial Corporations
I
1983
1984
1985
1986
1987
1988
1989
Ratio of profits from domestic operations with inventory valuation and capital consumption
adjustments to gross domestic product of nonfinancial corporate sector.
87
come. In addition, there was an extraordinary spurt in
nonwithheld tax collections in April and May, the
sources of which are at this point uncertain. Some
possible explanations relate to the Tax Reform Act of
1986 and include greater-than-anticipated effects from
its base-broadening provisions and a shifting of income
from earlier years into 1988, when the reduction in
personal tax rates was fully phased in. In addition,
realizations of taxable capital gains may have been
hefty last year because of the large number of corporate
mergers and leveraged buyouts. All told, receipts thus
far in 1989 are 10 percent above year-earlier levels,
and the Administration now projects that the total
budget deficit for FY1989 will be $148 billion, compared with the $155 billion recorded in FY1988.
Real purchases of goods and services by state and
local governments have been on a moderate uptrend
this year. Outlays for personnel and construction in the
education and law enforcement areas have been subject
to considerable upward pressure. Some other expenditures have risen because of federal mandates, especially those in recent health legislation. As in the
federal sector, growth of state and local outlays has
been tempered by budgetary pressures; excluding retirement trust funds, which are running a large surplus,
the sector had a deficit of about $17 billion at an annual
rate in the first quarter. Revenue experience was
favorable this spring, however, as a significant number
of states reported personal income tax receipts that
were larger than expected.
Labor Markets
Job growth was substantial over the first half of
1989, though it slowed in the spring. In the first
quarter, additions to nonfarm payrolls averaged
264,000 a month, about the same pace seen over the
prior two years. By spring, hiring had begun to slow,
and payroll employment growth dropped back to
200,000 per month in the second quarter as a whole.
Even at this reduced rate, however, job gains were
larger than are likely to be sustained, given the underlying trend in labor force growth. Manufacturing
employment declined in the second quarter, while the
number of construction jobs was about unchanged.
Growth of employment moderated in the serviceproducing sectors, where advances have been the
largest over the course of this business expansion.
The moderation in the growth of the demand for
labor in the second quarter did not lead to any appreciable reduction in labor market tightness. The unemployment rate has fluctuated between 5.0 and 5.4
percent thus far this year; in June it stood at 5.3
percent. Although many Americans remain involuntarily unemployed, the difficulty of matching workers
with jobs—given skill and locational considerations—
is much greater than it was earlier in the expansion.
By at least one aggregate measure, the rate of
increase in wages seems to have leveled off in recent
quarters. Average hourly earnings of production and
nonsupervisory workers accelerated from late 1986
through mid-1988; since then the rate of increase has
flattened out, and in June earnings were up 3 % percent
from a year earlier. The employment cost index for
wages and salaries in the private nonfarm sector, a
broader measure of wages that is available only through
March, indicated some easing of wage trends in the
goods-producing sector; however, in the serviceproducing industries, the trend remained sharply upward. The cost of benefits provided to employees in the
goods and services sectors rose slightly faster than
wages over the year ended in March, and total compensation per hour—wages and salaries plus benefits—was
up 4 Vi percent over that period, in the same range as the
12-month increases recorded in the preceding three
quarters.
Productivity performance has deteriorated somewhat in recent quarters. In some instances, higher
levels of production have forced firms to use less
efficient capital and to employ less skilled labor. Output
per hour in the nonfarm business sector was down in
the first quarter, and virtually unchanged on a fourquarter basis. With the sizable increases in compensation over the same period, unit labor costs accelerated
to a 514 percent annual rate, the largest year-over-year
increase since late 1982. In manufacturing, the rise in
unit labor costs in the year ended in thefirstquarter was
about 1 percent; unit costs had declined earlier in the
business expansion. This step-up in unit labor costs
reflects a slackening in the improvement of factory
productivity; compensation increases have remained
moderate.
Price Developments
Inflation increased sharply in early 1989, reflecting
higher costs for food and energy. The consumer price
index for all items, a broad-based measure for finished
goods and services, rose at an annual rate more than 6
percent through May, compared with the 4Vi percent
pace in 1987 and 1988. The producer price index for
finished goods recorded an even more pronounced
acceleration, owing to the greater importance of food
and energy in that index. However, the underlying
inflation trend has not deteriorated: excluding food and
energy, inflation at the retail level has been running at a
rate of around 4% percent, about the same as in 1988.
88
Nonfarm Payroll Employment
Net change, millions of persons, annual rate
•Total
| H Manufacturing
n_n_n_n.n
I
1983
1984
J
1985
1986
L
1987
I
1988
1989
Civilian Unemployment Rate
Quarterly average, percent
1 12
10
J
1983
1984
1985
1986
Employment Cost Index *
1987
I
1988
1989
12-month percent change
Total Compensation
1983
1984
1985
1986
1987
1988
Employment cost index for private industry, excluding farm and household workers.
' Percent change from Q1 1988 to Q1 1989.
1989
89
Consumer Prices *
Percent change from end of previous period, annual rate
1 8
1983
1984
1985
1986
1987
1988
1989
Consumer Prices Excluding Food and Energy *
Percent change from end of previous period, annual rate
Q
Services Less Energy
| H Commodities Less Food and Energy
1984
1983
1985
1987
1986
1988
1989
Producer Prices for Intermediate Materials P e r c 8 n t c h a n g e f r o m e n d o f
Excluding Food and Energy
previous period, annual rate
—
—
n
I
I
1983
I
1984
I
1985
I
1986
* Consumer Price Index for ail urban consumers.
** Percent change from December 1988 to May 1989.
'"Percent change from December 1988 to June 1989.
n
_
I
1987
I
1988
1989
5
90
Energy prices began rising sharply last November,
after the OPEC nations agreed to limit crude oil
production. Subsequently, temporary supply disruptions in Alaska and in the North Sea added to price
pressures. The posted price of West Texas Intermediate, the U.S. benchmark for crude oil, jumped from
about $13 per barrel in November to over $19 in early
May. As a result, energy prices at the producer level
soared, and consumer energy prices rose nearly 25
percent at an annual rate between December and May.
More recently, posted prices of crude oil have remained between $19 and $20 per barrel.
Increases in retail food prices were large in the first
half of 1989, in part reflecting the lingering effects of
last summer's drought and additional damage to some
crops this year. From the beginning of the year through
May, the rise in the CPI for food was close to 8 percent
at an annual rate. Although drought curtailed the
winter wheat crop for 1989, total crop acreage has
expanded, and overall production should rebound this
year, if weather conditions are satisfactory. In addition, meat supplies seem likely to hold fairly steady
over the second half of this year. Thus, pressures from
the supply side should not be a big factor in the food
price outlook.
Excluding food and energy, prices for commodities
at the consumer level have risen at a rate slightly lower
than that recorded for 1988. A marked diminution of
increases in non-oil import prices associated with the
appreciation of the dollar apparently has restrained the
prices of many goods, notably apparel and a variety of
household items. In contrast, inflation in the service
sector has increased, especially in labor-intensive services, such as medical care, entertainment, and public
transportation.
At early stages of processing, prices of goods have
risen little or declined in recent months. Prices for
many crude industrial commodities, which had climbed
sharply in 1987 and 1988 with the expansion of factory
output, have softened this year. This in turn has helped
hold down the increase in prices at the intermediate
level of production; the producer price index for
intermediate materials, excluding foods and energy,
was unchanged on net in the second quarter.
91
Section 3: Monetary Policy and Financial Developments
during the First Half of 1989
In conducting monetary policy over the first half of
the year, the Federal Open Market Committee continued its effort to foster long-run price stability, so as to
build a base for sustainable expansion of the economy.
In again reducing the ranges for money and debt
growth at its February meeting, the Committee recognized that restraint on the expansion of money and
credit would be needed to promote this goal.
rebound from the fourth quarter of 1988, and prices
continued to advance rapidly. But consumer demand
appeared to have moderated, industrial production was
weakening, and the behavior of commo3Tf^5rTces8and
some other indicators of potential price.trends suggested that inflationary momentum migty begin to
wane. In view of the uncertainties surroundings the
outlook, and taking into account the subdued, pace of
money growth, the Committee left reserve market
conditions unchanged through the middle of the second
quarter.
At the same time, the Committee realized that
considerable uncertainty remained about the behavior
of the monetary aggregates. Relatively wide monetary
ranges —4 percentage points in breadth —were retained, in part to take account of the substantial interestrate sensitivity of money demand over horizons of as
long as a year and of the unpredictable effects on money
demand of the resolution of the crisis in the thrift
industry. Moreover, in these circumstances, the Committee recognized that, in addition to the behavior of
the monetary aggregates, a variety of indicators of
inflationary pressures and the course of economic
activity would have to be taken into account in shaping
policy over 1989.
The Implementation of Monetary Policy
As noted previously, developments early in 19.89
suggested that a worrisome risk remained that inflation,
was picking up and could become more deeply embedded in the economy. Wage and benefit costs had
accelerated in 1988, and the readings for the consumer
and producer price indexes were troubling. Extending
[he move toward restraint that began almost a year
earlier, the Federal Reserve increased reserve market
pressures at the start of this year and again in midFebruary. On February 24 the discount rate.was raised
x
k percentage point to 7 percent.
These policy actions were accompanied by marked
increases, of about a percentage point, in most shortterm interest rates. Yields on long-term securities also
moved up, but by considerably less than short-term
rates. The foreign exchange value of the dollar strengthened as interest rates in the United States rose relative
to those abroad. Money growth slowed: Ml was
roughly flat in the first quarter, and M2 and M3
decelerated from already reduced rates in the second
half of 1988.
By spring, the outlook for spending and prices had
become more mixed. Employment growth still looked
strong, indicators of capital spending suggested a
1
Many interest rates began to move offlheir:March
highs early in the second quarter as indicationsmoonted
of moderation in the pace of economic activity and in
underlying price pressures. With the passing weeks, a
considerable weakening in housing activity became
evident, and incoming data showed employment to be
expanding at a noticeably slower rate. Market expectations of some additional tightening of monetary policy
shifted to anticipations of an easing.. The ensuing
decline in interest rates did not, however,, prompt a
drop in the foreign exchange value ai the dollar.
Instead, the dollar appreciated further over this, period,
in part because of political uncertainties abroad and in
part because of data on the U.S. trade balance jhat were
better than expected. The dollar also may .have gained
support for a while from expectations that tfte rallies in
U.S. securities markets would continue. .The.mpnetary
aggregates weakened further in April and early May,
reflecting the drawdown of liquid balances to.make
personal tax payments that were larger than.expected.
In May, M2 fell to the lower edge of the parallel band
associated with its annual target range (see chart), and
M3 slipped just below the bottom of its growth cone.
The FOMC eased policy slightly at the beginning of
June and again in early July. The federal funds rate
moved down about Vi percentage point irrfwcr steps, to
around 9 V* percent. Evidence that the more moderate
pace of economic activity was persisting, indicators of
the behavior of wages and sensitive prices, and the
weakness of the monetary aggregates, all. were consistent with a prospective ebbing of inflationary pressures. Moreover, the dollar was appreciably above
year-end levels, which could be expected to have
favorable effects in restraining inflation. While inflation remained a concern, an intensification of price
pressures did not appear to be a present danger,,.and the
risks &f cumulating weakness in the economy bad
increased.
92
Short-Term Interest Rates
24
Monthly
20
12
3-month Treasury Bill
Coupon Equivalent
I
1980
1982
I
I
i
I
I
Long-Term Interest Rates
Percent
Monthly
15
30-year Treasury Bond
I
1980
I
I
1982
Observations are monthly averages of daily data;
last observation is for June 1989.
I
I
1984
\
I
J
I
1988
93
Ranges and Actual Money Growth
M2
Billions of dollars
3350
3250
3150
I
O
N D
1988
J
F
I
M
I
A
I
M
J
M3
I
I
J A
1989
I
S
O
J
N
Rate of Growth
1988Q4 to 1989 Q2
1.6 Percent
1988 04 to June
1.9 Percent
I
D
Billions of dollars
Rate of Growth
7.5%^
1988Q4to1989Q2
3.4 Percent
3.5%_
1988 Q4 to June
3.5 Percent
— 3950
1
O
1
1
N D J
1988
1
F
1
M
1
A
1
M
1
J
1
1
1
1
1 1
J A S O N D
1989
3650
94
Although the easing steps were largely expected,
most short-term interest rates continued downward in
anticipation of further monetary policy actions, more
than offsetting their first-quarter rise. The bond market
rallied further, leaving long-term rates by mid-July
down V2 to 1 percentage point on balance from late1988 levels. Stock prices continued their brisk upward
movement, reaching post-October 1987 highs. The
value of the dollar also moved down somewhat in late
June and dropped further in early July; it retraced most
of its rise during the second quarter, although remaining well above its level at year-end 1988.
The Behavior of the Monetary
Aggregates
Growth of the monetary aggregates was quite sluggish over the first half of 1989, reflecting the effects of
increases through March in market interest rates relative to returns on monetary assets, some depositor
concern over the problems of the thrift industry, and
large tax payments by individuals. From the fourth
quarter of 1988 through June, M2 edged up at an
annual rate of only 2 percent, markedly below last
year's pace of 5 lA percent. M2 velocity rose sharply
through the second quarter.
The deceleration of M2 in the first quarter stemmed
largely from a combination of continued increases in
market interest rates and unusually slow upward adjustment of rates paid on retail deposits. Yields on NOW
accounts moved up only about 10 basis points over the
year ended in March, while those on other liquid
deposits—savings and Money Market Deposit Accounts (MMDAs)—rose about % and 1 percentage
point, respectively; many short-term mark r ites increased more than 3 percentage points over tne same
period. Rates on small time accounts increased much
more than those on the more liquid retail deposits, but
they too failed to keep up with the rise in market yields.
Some of the sluggishness in the adjustment of returns on retail deposits over this period may have
reflected continued regulatory pressures on thrift institutions to moderate their pricing of deposits, as well as
the closing last year of some insolvent institutions with
aggressive pricing policies. More broadly, the slow
upward adjustment of deposit rates, especially on
accounts without fixed terms—NOW accounts,
MMDAs, and savings deposits—also reflected the
continued evolution of pricing strategies by depository
institutions in the deregulated environment. By concentrating upward rate adjustments in small time deposits
and offering more sophisticated account structures, in
which larger balances receive higher rates, institutions
found that they could retain the bulk of their funds
while minimizing the effects of higher market rates on
their overall interest expense.
Nonetheless, as yields on market instruments became increasingly attractive relative to those on deposits over the first quarter, some funds were redirected to
instruments not included in the monetary aggregates.
Noncompetitive tenders for Treasury bills and notes, a
rough indicator of the extent to which individual
investors are increasing their holdings of Treasury
securities, surged early in the year and remained strong
through March. The increase in demand for Treasury
securities was greater than would have been expected
from interest rate movements alone, suggesting that
depositors' nervousness about the problems of the thrift
industry were playing a role too. Although the President submitted to the Congress a comprehensive plan
for resolving the industry's difficulties early in the year,
and gave assurances that the U.S. government would
back insured deposits fully, FSLIC-insured thrift institutions experienced large outflows of deposits throughout the first quarter. These outflows apparently depressed overall M2 growth somewhat during that
period, but the bulk of the funds likely remained within
the aggregate. Commercial banks experienced relatively strong growth in core deposits, and M2-type
money market mutual funds, whose rates adjust relatively quickly to changes in market interest rates, saw
sizable inflows of funds.
The increased opportunity costs of the first part of
the year continued to damp money growth into the
second quarter, but, in addition, liquid balances were
drawn down to meet large April tax payments. Nonwithheld personal tax payments were $ 16 billion greater
this April than last. The tax-related effect was manifested in a sharp drop in the liquid components of M2 in
late April and into May as the payments continued to
clear. Transaction accounts posted large declines, outflows of savings and MMDA balances accelerated, and
inflows to money market mutual funds paused. Balances began to bounce back in late May, however, as
depositors started to rebuild their holdings of monetary
assets, and in June M2 grew at an annual rate of 6%
percent.
Also contributing to the rebound in holdings of
money balances after mid-May were declines in opportunity costs as market interest rates headed down.
Yields on small time deposits lagged this move, and
returns on these deposits at times exceeded those on
market instruments. Demand for Treasury securities
through noncompetitive tenders fell back, and growth
in small time deposits, already robust, jumped to an
annual rate of more than 20 percent for the quarter.
Yields on small time deposits at thrift institutions
95
Growth of Money and Debt (Percent)
M1
M2
M3
Debt of
domestic
nonfinancial
sectors
Fourth quarter to fourth quarter
1979
7.7
8.2
10.4
12.3
1980
7.4
9.0
9.6
9.6
1981
5.2 (2.5)*
9.3
12.3
10.0
1982
8.7
9.1
9.9
9.0
1983
10.2
12.1
9.8
11.3
1984
5.3
7.7
10.5
14.2
1985
12.0
8.9
7.7
13.2
1986
15.6
9.3
9.1
13.4
1987
6.4
4.2
5.7
9.8
1988
4.3
5.2
6.2
8.9
Q1
-0.4
1.9
3.7
8.2
Q2
-5.5
1.3
3.1
7.4e
Quarterly growth rates
(annual rates)
1989
*M1 figure in parentheses is adjusted for shifts to NOW accounts in 1981.
96
Velocity of Money and Debt
(Quarterly)
M1
Ratio scale
Illlllllllllllllllllllllllll
Illlllllllllllllllllllllllll
1.2
M I N I M III M I N I M M i l l llllll
0 8
11 1 1 1 I I I 1 1 1 1 1 I I 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
04
1989
97
responded somewhat more slowly than those at banks
to the downturn in market interest rates, and growth of
these deposits at thrift institutions surged. Largely
because of this strength in small time accounts, and
because the most anxious depositors probably had
already moved their funds elsewhere, overall deposit
balances at FSLIC-insured thrift institutions stabilized
in the second quarter.
M3 grew at an annual rate of 3 Vi percent from the
fourth quarter of last year to June, placing it at the
lower bound of its target range. In the first quarter,
expansion of M3 was subject to offsetting forces. It was
bolstered somewhat by bank funding needs generated
by strong demand for business loans. Added demand
for commercial and industrial loans stemmed both
from merger-related financings and from shifts to
short-term borrowing by businesses facing rising longterm interest rates and investor concerns about "event
risk"—the possibility that a firm's debt obligations
would be significantly downgraded in a corporate
buyout or restructuring. Acting to damp M3 growth
over the first quarter, however, was heavy reliance by
thrift institutions on Federal Home Loan Bank advances and other borrowings, which are not included in
the money stock. M3 growth edged down a bit in the
second quarter with some easing of bank credit demands and strong growth in government deposits—
also not included in the money stock—resulting from
the large volume of tax payments. By June, however,
M3 had rebounded as tax effects unwound.
Reflecting interest-rate and tax-related effects, Ml
declined at an annual rate of 3Vi percent from the
fourth quarter of 1988 to June. Balances in other
checkable deposits, which had moved down a little
over the first quarter in response to higher opportunity
costs, dropped substantially in late April and early May
as the tax payments cleared. Demand deposits also
declined on balance over the first half of the year,
because opportunity costs increased and because the
balances businesses are required to hold to compensate
their banks for services fell. After changes in market
rates of interest, banks often adjust with a lag the
"earnings credit" rates used to determine the level of
required compensating balances; thus, downward adjustments to compensating balances can continue for
some time after market rates have stopped rising. The
large personal tax payments also affected household
demand-deposit balances. Late in the quarter, however, both demand and other checkable deposits began
to increase, perhaps as some of the earlier influences
started to be reversed with the drop in market interest
rates over the second quarter.
Credit Flows
The aggregate debt of domestic nonfinancial sectors
expanded at an annual rate of close to 8 percent over the
first half of this year, near the midpoint of its monitoring range and down somewhat from its 1988 pace. The
growth of federal sector debt slowed as tax receipts
surged. Expansion of the debt of nonfederal sectors
also moderated, partly in response to higher levels of
market interest rates over much of the first half of the
year. Household borrowing in mortgage markets
slowed as increases in lending rates damped housing
demand, while the pace of consumer borrowing
slackened along with the deceleration in consumption
spending.
Mortgage lending by thrift institutions did not appear to be unusually weak in the first few months of
1989, given the prevailing interest rates. These institutions coped with weak deposit flows by running off
cash and investments and, through the first quarter,
stepping up borrowing from the Federal Home Loan
Banks. Despite signs of a reduction in mortgage lending activity by these institutions in the second quarter,
the overall availability of housing credit did not appear
to be significantly impaired.
Spreads between rates on both fixed-rate mortgages
and mortgage-backed securities and rates on Treasury
instruments of comparable maturity did widen over the
first six months of the year, with some market participants reportedly fearing that large-scale liquidations of
mortgage-backed securities by troubled thrift institutions could adversely affect the market for those instruments. However, the widening also may have reflected
other developments: a general increase in uncertainty
about movements in long-term interest rates (and
therefore about prospective prepayments), and the
flattening of the yield curve, which discouraged issuance of derivative mortgage instruments and thus
reduced demand for the underlying mortgage-backed
securities.
Total borrowing by nonfinancial businesses in the
first half of the year was close to its 1988 pace. Credit
demands continued to be buoyed by sizable mergerrelated financing in the first quarter, and an apparent
pickup in capital expenditures increased business borrowing in the second quarter even as credit demands
related to mergers and restructurings, while still strong,
eased a bit. Because of investor fear of event risk
triggered by the RJR-Nabisco acquisition in late 1988
as well as higher long-term rates through much of the
period, corporate borrowing was concentrated in shortmaturity vehicles. Commercial paper issuance surged
during the first half of the year; businesses also relied
on bank loans, albeit to a lesser extent. In response to
98
Range for Debt and Actual Debt and Money Growth
Debt
Billions of dollars
Rate of Growth
10.5%^
9950
9650
1988 Q4 to 1989 Q 2 e
7.9 Percent
1988Q4 to May
7.9 Percent
9050
O
N D
1988
J
F
M
A
M
J
J A
1989
S
O
N
D
M1
Billions of dollars
840
Rate of Growth
1988Q4to1989Q2
-2.9 Percent
1988Q4 to June
-3.6 Percent
780
740
J I
O
N O
1988
J
F
M
A
M
J
J
1989
A
S
O
N
D
99
investor concerns about event risk, many firms issued
bonds with relatively short maturities of one to five
years, or they brought issues to market with straight
puts or with so-called poison puts, covenants designed
to protect against negative effects on bondholders from
future restructurings. Toward the end of the second
quarter, with the introduction of these protections and
the decline in rates, long-termfinancingin the corporate bond market was on the upswing.
Net issuance of tax-exempt securities by state and
local governments fell sharply over most of the first
half of 1989. Investor demand for tax-exempt securities remained strong and, with diminished supply, the
ratio of tax-exempt to taxable yields fell to its lowest
level since 1984. This ratio rose somewhat late in the
second quarter, when the decline in long-term interest
rates began to bring forth an increase in refunding
activity and a pickup of issuance of bonds to raise new
capital.
100
HENRY B. GONZALEZ TEXAS. CHAIRMAN
CHALMERS P. WYLIE. OHIO
JIM
FRANK ANNUNZIO ILLINOIS
WALTER E. FAUNTROY. DISTRICT OF COLUMBIA
_ „
_,„
LEACH. IOWA
NORMAN D. SHUM
U.S. HOUSE OF REPRESENTATIVES
KESSKST
)G BARNARD! JR.. GEORGIA
IK.^'SIS.IK^EE™™,
JOHN HILER. INDIANA
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
mS^ISm^Sf*
ONE HUNDRED FIRST CONGRESS
J A M E S ^ T O N V E W JERS
J7JBUN\?NTKEHN™CKY
2 1 2 9 RAYBUHN HOUSE OFFICE BUILDING
THOMAS R CARPER DELAWARE
ESTEBAN EDWARD TORRES. CALIFORNIA
WASHINGTON, DC
205
15
GERALD D. KLECZKA. WISCONSIN
BILL NELSON. FLORIDA
PAUL
RICHARD H BAKER LOU (SI/3
CLIFF STEARNS. FLORIDA
GILLMOR. OHIO
BILL PAXON, NEW YORK
PAUL E. KANJORSKI. PENNSYLVANIA
ELIZABETH J. PATTERSON. SOUTH CAROLINA
(202) 2 2 5 - 4 2 4 7
THOMAS McMILLEN. MARYLAND
JOSEPH P. KENNEDY II. MASSACHUSETTS
KWEISIMFUME,MARYLAND
September
DAVID E. PRICE. NORTH CAROUNA
NANCY PELOSI, CALIFORNIA
JIM McDERMOTT. WASHINGTON
C
20,
1989
PETER HOAGLAND. NEBRASKA
RICHARD E. NEAL, MASSACHUSETTS
Mr. Alan Greenspan
Chairman
Board of Governors of
the Federal Reserve System
20th & C Streets, N.W.
Washington, D.C. 20551
Dear Chairman Greenspan:
I want to thank you for appearing before the House Banking
Committee on July 20, 1989 to discuss the Federal Reserve Board's
semi-annual monetary policy report to Congress.
Since I was unable to question you during that hearing, I
respectfully ask you to answer the following questions so that they
may appear in the hearing record.
1)
Moody's recently released a report showing that even a mild
recession could triple the number of junk bond defaults. A
July 20, 1989 Wall Street Journal article reported that so far
this year about $3 billion of different companies junk bonds
have stopped paying interest or are mired in forced
restructuring designed to bail out the companies at the
investors expense.
As you are aware, savings and loans
associations are allowed to invest in junk bonds. Some statechartered thrifts have as much as 40% of their assets invested
in junk bonds. Should S&L's be permitted to invest in junk
bonds? If so, should these investments be limited? Should
these investments be marked-to-market?
How much capital
should be held against these investments?
)
What is the Fed's target for the real GNP growth rate over the
next six months? one year?
•")
The Chairman of the Joint Economic Committee recently
introduced a bill, H.R. 2795, that would place the Secretary
of the Treasury on the Federal Open Market Committee. Do you
think the Executive Branch should have direct representation
on the FOMC? Why or Why not?
101
)
Recent news articles have publicized the Fed's usage of a new
inflation barometer called P-star. Please explain P-star, and
its relative importance as a guide to monetary policy. As a
policy guide, is P-star more important that the GNP growth
rate or unemployment rate? How long has the FED relied on Pstar as a policy guide?
)
Mr. Greenspan, since you were nominated as Chairman of the
Federal Reserve Board, you have come before this Committee and
other Congressional Committees stating that the number one
economic problem facing this country is the huge budget
deficit. On occasion you have voiced a preference that the
deficit be controlled through lower Federal spending rather
than through raising taxes.
Between 1987-88 total Federal Reserve System expenditures
increased 5.8 percent. Between 1988-89 total Federal Reserve
System expenditures increased 5.5 percent. In addition, the
Federal Reserve Board recently implemented a new compensation
structure giving top level employees a pay raise, and during
the monetary policy hearing you appeared to favor a pay raise
for Federal Reserve Board Members. Clearly, Mr. Greenspan,
your own agency has been required to increase expenditures.
It would seem, then, that if you can't cut spending at your
agency, and other equally committed managers cannot do so,
then your prescription for reducing Federal government
spending may not work in practice. In light of this, do you
think taxes should be raised to lower the budget deficit?
)
It is my understanding that in preparation for Federal Open
Market Committee deliberations, a beige book, a blue book and
a green book containing various economic data and policy
options are used to brief FOMC participants.
Would you
explain the function of each book, the information contained
in each, and why these books should not be made public
immediately following FOMC meetings?
In addition, please
justify the Federal Reserve's policy of keeping the FOMC
Policy Directive secret for up to six weeks after the date of
the FOMC meeting.
I appreciate your thoughtful consideration of the questions
and look forward to your timely reply.
With best wishes.
Sincerely,
Henry B. Gonzalez
Chairman
102
B O A R D OF G O V E R N O R S
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 80551
ALAN GREENSPAN
AU9USt
25,
1989
CHAIRMAN
The Honorable Henry B. Gonzalez
Chairman
Committee on Banking, Finance and
Urban Affairs
House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman:
Thank you for your letter of July 20 enclosing
written questions in connection with the hearing held on the
Federal Reserve's monetary policy report. I am pleased to
enclose my responses to your questions for inclusion in the
record of the hearing.
Please let me know if I can be of further
assistance.
Sincerely,
Signed Alan Greenspan
Enclosure
103
Chairman Greenspan subsequently submitted the
following in response to written questions from Chairman
Gonzalez in connection with the hearing held on
July 20, 1989:
Question 1:
Moody's recently released a report showing that
even a mild recession could triple the number of
junk bond defaults. A July 20, 1989 Wall Street
Journal article reported that so far this year
about $3 billion of different companies1 junk
bonds have stopped paying interest or are mired
in forced restructuring designed to bail out the
companies at the investors' expense. As you are
aware, savings and loan associations are allowed
to invest in junk bonds. Some state-chartered
thrifts have as much as 40 percent of their
assets invested in junk bonds. Should S&L's be
permitted to invest in junk bonds? If so, should
these investments be limited? Should these
investments be marked-to-market? How much
capital should be held against these investments?
Answer:
The questions raised concerning whether
savings and loan associations should be permitted to invest in
junk bonds have been addressed by the Financial Institutions
Reform, Recovery and Enforcement Act of 1989 ("FIRREA").
Under section 222, state and federal savings associations may
not directly or through a subsidiary, acquire or retain any
corporate debt securities that are not of investment
grade—i.e., junk bonds.
Under this provision, the FDIC is
authorized to require a savings association or its subsidiary
to divest these securities as quickly as can be done prudently
but not later than July 1, 1994. The legislation permits a
savings association to transfer these securities to a holding
company or holding company affiliate under certain circumstances in exchange for a note, subject to certain conditions.
104
Question 2: What is the Fed's target for the real GNP growth
rate over the next six months? One year?
Answer:
We have no target for real GNP growth.
Our
policy is to maximize long-term sustainable growth through a
tamping down of inflationary pressures.
We have communicated
to the Congress in our monetary policy report the GNP forecasts of Federal Reserve policymakers.
But policy, per se,
is not directed at achieving those particular forecasts.
They are not policy targets.
The successful implementation
of policy goals could engender higher or lower growth rates
than those forecast by the Federal Reserve Governors and
Presidents.
105
Question 3:
The Chairman of the Joint Economic Committee
recently introduced a bill, H.R. 2795, that would
place the Secretary of the Treasury on the
Federal Open Market Committee. Do you think the
Executive Branch should have direct representation on the FOMC? Why or why not?
Answer:
I do not believe the Executive Branch should
be represented on the FOMC or the Board of Governors.
This
could only serve to politicize the decisions of the Federal
Reserve, to the detriment of sound economic policy.
It is true that the original Federal Reserve Act
provided for membership on the Board—the FOMC wasn't created
until 1935—of the Secretary of the Treasury and the
Comptroller of the Currency.
In fact, the Secretary was
designated the ex-officio Chairman of the Board.
Carter Glass
favored this arrangement when he guided the Act through the
House in 1913.
But in 1932, Glass, then a Senator, took the
opposite view.
During debate on the Glass-Steagall Act, Glass
said that he, himself, as Secretary of the Treasury, "had an
undue influence in the activities of the board" and that the
Federal Reserve, as structured in the original Act, had "been
made a doormat of the United States Treasury."
In the Banking Act of 1935, Congress removed the
Secretary and the Comptroller from the Board.
In supporting
the change, Senator Glass said in part:
"With respect to the Secretary of the Treasury, it
was urged--and I know it to be a fact because I was
once Secretary of the Treasury—that he exercised
undue influence over the Board; that he treats it
rather as a bureau of the Treasury instead of as a
board independent of the Government, designed to
respond primarily and altogether to the requirements
of business and industry and agriculture, and not to
106
be used to finance the Federal Government, which was
assumed always to be able to finance itself."
Clearly, the intent of Congress in removing the Secretary and
the Comptroller from ex-officio membership on the Board was to
assure that the Board would be insulated from partisan
political pressure and influence by the Treasury Department
and the Administration.
This is not to say that the Federal Reserve should
operate in isolation from the Treasury.
We enjoy cordial and
close relations with the Secretary and the Treasury generally.
Both staffs are in daily communication with each other and the
Secretary and I meet at least once a week, more often if
necessary.
We are also in daily telephone communication on
issues of mutual concern.
107
Question 4:
Recent news articles have publicized the Fed's
usage of a new inflation barometer called
P-star. Please explain P-star, and its relative
importance as a guide to monetary policy. As a
policy guide, is P-star more important than the
GNP growth rate or unemployment rate? How long
has the Fed relied on P-star as a policy guide?
Answer:
P-star (in symbols, P*) is an approach that
was developed last fall for representing the long-run
relationship between the price level and the outstanding
quantity of the M2 measure of money.
Specifically, it is an
indicator of the average price level that would be established
in the long-run if M2 were maintained at its current level.
As described in more detail in a staff study, the approach was
based on a version of the "equation of exchange" for the
monetary aggregate M2. On the assumptions that in the
long-run velocity settles down to an equilibrium average level
called V*, and that real output attains its potential level
identified by Q*, then according to the equation of exchange,
current M2 holdings would support an implicit GNP deflator
given by the following equation:
M2.t x
V*
P*
Q*
1. See Jeffrey J. Hallman, Richard D. Porter, and David H.
Small, "M2 per Unit of Potential GNP as an Anchor for the
Price Level," Board of Governors of the Federal Reserve
System, Staff Study 157.
108
The staff study showed that since the early 1950s,
inflation tended to accelerate with a lag when the long-run
price measure moved above the current price level, and
conversely, tended to decelerate with a lag when the long-run
price measure moved below the current price level (see chart).
Because of the substantial lags between current
monetary actions and their ultimate effects on prices, a
variety of indicators of the future thrust of policy can
provide information useful in the design of monetary policy.
P-star appears to be one suggestive and comprehensible
indicator of the longer-run consequences of current monetary
developments for the behavior of the average prices of goods
and services.
This experimental measure thus may offer some
guidance to the Federal Reserve in its effort to attain its
long-term goal of price level stability.
It must be remembered, however, that the P* model is
a very simple representation of an actually very complex
process determining average prices in the U.S. economy.
The
simplifying assumptions in the model--such as that velocity
tends to return in the long run to a constant equilibrium
level--have the advantage that the model can highlight
monetary forces that in the long-run emerge as crucial factors
influencing inflation trends.
Still, by intentionally
abstracting from a variety of other influences that clearly
play an important role in shaping the shorter-run dynamics of
price setting, the model does have the disadvantage of not
fully encompassing all the relevant influences in the ongoing
109
process of price determination.
Nor does the model even try
to describe other aspects of overall economic performance with
which policymakers need to be concerned.
Thus, the Federal
Reserve necessarily must place considerable weight on a wide
variety of indications of the current and prospective behavior
of the economy—such as the level of resource use and
conditions in financial markets—in reaching judgments about
the appropriate stance of policy.
Of course, measures of
actual macroeconomic performance, such as GNP, the
unemployment rate of price indexes, are followed closely
because they directly relate to the ultimate goals of maximum
sustainable economic growth with stable prices.
Yet current
readings on these measures need to be supplemented by
forward-looking indicators to more accurately signal
developing trends.
P-star can serve as one cross-check on the
likely implications of M2 growth for future inflation
pressures, and its reliability relative to a number of other
indicators monitored by the Federal Reserve will be assessed,
but these other indicators will continue to play an important
role in formulating monetary policy.
110
Attachment (Question 4)
Inflation Indicator Based on P*
Ratio scale
- Current price level (P)
- Long-run equilibrium price level
given current M2 (P*)
100
I I I I II I I I I I II
I I I 11 M
II
I I II
I I II
Percent change
—i 12
--Inflation
v
t
i i i i M n i i i n l
1959
1964
1969
i I I i i hi i i i M i M i i i
1974
The current price level (P. the solid line in the top panel) Is the Implicit
GNP deflator, which is set to 10G In 1982.
Inflation (bottom panel) Is the percentage change In the implicit GNP
deflator from four quarters earlier.
P* uses the mean of the GNP velocity of M2 from 1955Q1 to 1988Q1.
1979
1984
Ill
Question 5:
Mr. Greenspan, since you were nominated as
Chairman of the Federal Reserve Board, you
have come before this Committee and other
Congressional Committees stating that the number
one economic problem facing this country is the
huge budget deficit. On occasion you have voiced
a preference that the deficit be controlled
through lower Federal spending rather than
through raising taxes.
Between 1987-88 total Federal Reserve System
expenditures increased 5.8 percent. Between
1988-89 total Federal Reserve System expenditures
increased 5.5 percent. In addition, the Federal
Reserve Board recently implemented a new compensation structure giving top level employees a pay
raise, and during the monetary policy hearing you
appeared to favor a pay raise for Federal Reserve
Board Members. Clearly, Mr. Greenspan, your own
agency has been required to increase expenditures. It would seem, then, that if you can't
cut spending at your agency, and other equally
committed managers cannot do so, then your
prescription for reducing Federal government
spending may not work in practice. In light of
this, do you think taxes should be raised to
lower the budget deficit?
Answer:
I believe that our agency has done a highly
creditable job in containing expenditure growth over the
years, in the face of a substantial increase in our
responsibilities, dictated by legislation and the continuing
changes in the economy and financial markets that have added
to our burdens.
The other federal depository regulators also
have faced these pressures, and, indeed, over the past two
years their budgets have expanded by 8 to 13 percent per
annum.
Nonetheless, we continue to work hard at increasing
the efficiency of our operation, and, indeed, the change in
our compensation system promises to yield benefits in that
regard.
112
But as regards your broader question, I recognize
that cutting federal expenditure growth is not an easy matter.
It isn't simply a question of better management; rather, it
involves difficult choices about programs and objectives.
In facing up to those choices, however, we may find that we
actually can maintain or enhance the welfare of our people
without the scale of federal activity in some fields that we
now have.
In any event, it is my belief that the alternative
path to deficit reduction, that is, increased taxes, not only
carries with it the likelihood of losses in incentives and
efficiency but also is likely to prove unreliable:
It is a
great deal to ask a political body, faced with an endless list
of wants from its constituency, to maintain strong spending
discipline over time when revenues are flowing in in
increasing volume.
113
Question. 6:
It is my understanding that in preparation for
Federal Open Market Committee deliberations, a
beige book, a blue book, and a green book
containing various economic data and policy
options are used to brief FOMC participants.
Would you explain the function of each book, the
information contained in each, and why these
books should not be made public immediately
following FOMC meetings? In addition, please
justify the Federal Reserve's policy of keeping
the FOMC Policy Directive secret for up to six
weeks after the date of the FOMC meeting.
Answer:
The Beigebook, Greenbook, and Bluebook are
included among the materials used to brief FOMC members prior
to meetings of the Federal Open Market Committee.
The Beigebook is a compilation of information on
current business conditions in each Federal Reserve District
obtained through informal surveys of Reserve Bank Directors,
as well as business, labor, and community leaders.
Copies of
the Beigebook are made available to the public without delay,
usually ten days or so before FOMC meetings.
The Greenbook and Bluebook are reports prepared by
the staff of the Board of Governors.
The Greenbook contains a
sector-by-sector analysis of recent economic, financial, and
international developments, along with a detailed staff
forecast of key economic variables.
The Bluebook sets out
several monetary policy alternatives, summarizes their
implications for economic and financial developments, and
analyzes technical issues that may arise in the implementation
of policy.
114
It is important to emphasize that these are staff
documents, addressed to the FOMC.
The views of individual
FOMC members, and even consensus views of the Committee,
regarding the economic outlook and monetary policy
alternatives, do not always coincide with those expressed in
the Greenbook and Bluebook.
Committee members have other
sources of data and analysis which they also use in arriving
at policy decisions, including the views and forecasts of a
wide range of institutions and individual contacts outside the
Federal Reserve System, analyses undertaken by the staff of
the twelve district Reserve Banks, and other staff work at the
Board.
Release of the Greenbook and Bluebook could be
misinterpreted by the public.
Participants in financial
markets could over-react to possible outcomes that they read
into those reports, taking them for the views of FOMC members,
and resulting in destabilizing reactions in markets.
Because
the Greenbook includes multi-year forecasts and the Bluebook
discusses contingencies that may apply for several quarters,
release of sensitive material included in these documents
could have far-reaching repercussions for markets.
Moreover, as internal staff documents providing
background for FOMC members' deliberations, they are protected
from disclosure under the Freedom of Information Act.
In that
Act Congress recognized that the prospect of an immediate
public airing of staff analysis would be likely to inhibit the
free flow of information so important to decisionmakers.
This
effect is likely to be especially pronounced for documents
115
like the Greenbook and Bluebook, which have the potential to
affect markets.
A staff conscious of this possibility could
feel constrained in its analyses and projections, making these
documents less useful in preparing Committee members for the
decisions they must make.
For these reasons, the Greenbook and Bluebook are
released to the public only after a suitable delay, taking
account of the sensitive material they convey.
The Directive contains the instructions of the FOMC
to the Federal Reserve Bank of New York concerning open market
operations until the next meeting.
Typically, those
instructions encompass both a statement about the Federal
Reserve's stance in the reserves market in the period
immediately ahead and language conditioning possible policy
responses to new information as it becomes available over the
intermeeting period.
The latter statements are designed to
allow flexibility in monetary policy over the period between
FOMC meetings, but within guidelines set by the Committee.
In
establishing those guidelines, the Committee considers a
number of possible contingencies and in a general way how it
would like policy to respond.
116
The Directive itself is not made public until a
succeeding FOMC Directive has been issued, a practice that
the courts have ruled is consistent with the Freedom of
Information Act.
This is done in part to avoid
over-reactions in financial markets to contingencies or
reserve pressure alternatives mentioned in a Directive that
may not occur or that may be superseded by intermeeting
developments and adjustments. With some knowledge of the
conditional plans of the FOMC, market participants naturally
will try with even more conviction than at present to react in
advance to the likelihood of changes in reserve conditions.
To the extent they anticipate contingencies that never come to
pass, they will be adding unnecessarily to market volatility.
Moreover, earlier release of the Policy Directive
would force the Committee itself to focus more on the market
impact of announcement effects resulting from its choice of
words rather than on the ultimate economic impact of its
actions.
To avoid premature market reaction to only possible
future actions, FOMC decisions could well lose their
conditional character.
Given the uncertainties in economic
forecasts and in the links between monetary policy actions and
economic outcomes, such a loss would lessen the effectiveness
of policy.
2. Merrill v. Federal Open Market Committee, 483 U.S. 340
(1979), on remand, 516 F.Supp. 1028 (D.D.C. 1981).
117
APPENDIX
August 2, 1989
118
TESTIMONY OF
JASON BENDERLY
CO-DIRECTOR OF ECONOMIC RESEARCH
GOLDMAN, SACHS & CO.
NEW YORK, N.Y.
BEFORE THE SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES
JULY 25, 1989
A confluence of events, some anticipated and some not, make me supportive
of the path being followed by the Federal Reserve Board. In general, the
quick slowdown in the U.S. economy during the first half of 1989 has
bought the Fed time over which to gradually reduce the underlying rate of
U.S. inflation. It is true that in the postwar period, inflation's trend
has not been significantly reduced without incurring a recession. But
this is not because a non-recession approach has been tried and failed. A
non-recession approach has never been tried. There is a good chance this
time that the economy will continue to grow very sluggishly and that the
underlying trend of inflation can slowly be reduced over the next few
years.
Before proceeding to the whys and wherefores of this conclusion let me
first present our economic forecast for the U.S. We expect an extended
period of sluggish growth from 2% in the first half of 1989 to 1% in the
second half, then back up to perhaps 2% as we move into 1990. If
realized, this growth rate should lend itself to a gradual paring of the
underlying inflation rate back to a trend of about 4.0%-4.5%. It is clear
that the concern about monetary policy has shifted from its role in
solving the big global problems related to the twin deficits to its role
in a purely cyclical context. This is because a major slowdown in the
economy in the first half of 1989 is now visible for all to see and there
are now fears that too much weakness was created.
Sluggish growth is being signalled by an increasing array of figures.
These include important domestic sectors such as consumer spending and
housing as well as indicators of manufacturing activity such as factory
orders, manufacturing employment and average workweek, various components
of the Purchasing Managers' Survey, and industrial production itself. The
sources of the slowdown were quite diverse and included tighter monetary
policy, reduced consumer purchasing power stemming from rising inflation,
satiated demand for housing and consumer durables, less willingness on the
part of consumers to use credit and savings, more subdued net export
growth since mid-1988, and a slower in pace of inventory growth.
The slowdown in the economy will contribute to continued consumer weakness
because of a so-called "multiplier effect". This simply refers to the
fact that personal income growth tends to slow in response to a slower
119
economy regardless of the source of the initial weakness. Thus, the
initial weakness is perpetuated unless other negative factors are removed
or new positive forces are introduced. There has in fact been a sharp
slowdown in personal income growth in recent months because the building
blocks of the key wage and salary component -- employment, the average
workweek, and hourly earnings -- are no longer providing the support for
rapid growth.
Two props supporting the economy — exports and capital spending -- should
continue to do so, albeit at lesser pace. The rise in the dollar since
late 1987 should weaken export growth some, and anecdotal evidence
suggests that export growth will diminish during the second half of 1989.
But U.S. goods are still competitive in foreign markets and growth abroad
is still much faster than in the U.S. Capital spending is unlikely to
continue increasing rapidly now that economic growth has shifted into a
sluggish mode, but neither is a decline likely so long as net exports keep
expanding. Indeed, orders for nondefense capital goods, machine tool
orders and contract awards for new nonresidential construction spending
point toward a persistently slower but still positive growth rate of
capital spending during the second half of the year.
All in all, the (nonfarm) economy downshifted very quickly in the first
half of 1989 to about a 2% growth rate from 3.5% in 1988 and 5.0% in
1988. With more widespread signs of weakness, the warning flag of
impending recession has been raised. But the opposite view seems more
likely to us. That is, the early-1989 weakening of the economy is an
antidote for a recession developing later. Most forecasts that called for
a recession by 1990 had as a primary ingredient an overheating economy
with intensifying inflation pressures during most of 1989. Economic
weakness has quickly stemmed upward pressures on inflation, particularly
from the manufacturing side. Even wage increases appear to have stopped
accelerating with the ongoing rate of change seemingly stuck at about a 4%
annual rate.
With inflation pressures in the pipeline diminishing, four of the negative
consequences of inflation that historically helped turn episodes of
sluggish growth into recession should be avoided -- eroding consumer
purchasing power, sharply declining consumer confidence, speculative
inventory building and aggressive monetary tightening. Stated conversely,
there are four benefits from a quick containment of inflation that reduce
the odds of recession:
(1) Slowing price inflation will ease the squeeze on real wages that
hurt the average consumer during the first half of the year.
(2) Consumer confidence should remain at a relatively high level,
thus avoiding a major consumer retrenchment. Historically,
inflation concerns have been the key factor undermining
confidence prior to a recession.
(3) An absence of inflation fears also means an absence of a motive
or an opportunity for firms to speculate on their inventory
holdings. As a result, the manufacturing sector appears to be
quickly paring production schedules rather than building up
potentially destabilizing inventory excesses.
120
(4) And finally, a quick easing of inflation pressures (e.g., as
signalled by vendor performance falling under 50% in May and
June) has given the Fed has more leeway to ease policy rather
than continuing to clamp down on a weakening economy. In this
regard, as discussed below, the current period is turning out to
be much more like two sluggish growth episodes in the postwar
period that did not turn into recession (1966-67 and 1985-86)
than four sluggish episodes that were followed by recession
(1956-57,1969,1973 and 1979).
In short, with the Fed's focus quickly shifting from fighting inflation to
warding off too much economic weakness, and with consumers and businesses
already being cautious rather than speculating on profits to be made from
higher inflation, the excesses that lead to recession most should not
develop. Unfortunately, there is no hard evidence that recession forces
are not cumulating. In fact, the consumer slowdown in the first half of
1989 is of the same magnitude that preceded most recessions in the postwar
period. But, there are very few signs of the imbalances that normally
lead to recession, and the downturn in the key housing sector has been
extremely modest compared to the housing collapses that preceded most
recessions.
But what about inflation? A significant easing of inflation pressures in
the pipeline is being signalled from a variety of sources. For one, the
June Purchasing Managers' Survey suggested that downward pressure on
industrial commodity prices is building. Vendor performance (the percent
of companies reporting slower deliveries) dropped to 47.5%, the second
month in a row below the critical 50% level for the first time since
mid-1985, four years ago. Vendor performance is the single most reliable
indicator of commodity price trends. Furthermore, an index representing
the percent of purchasing agents reporting higher prices continued to fall
sharply to the lowest level since 1986. Together with the generally soft
tone of the manufacturing sector, these two indicators suggest that some
easing of general inflation from the commodity side of the equation is in
store unless offset by more sharply rising wages. This in turn seems
unlikely if the economy is as weak (1% or so) as now seems likely for the
second half of 1989.
Inflation statistics themselves are clearly showing an easing of the
pressures in the pipeline. First, industrial commodity prices by any
measure have on average either fallen slightly over the past six months,
or have flattened out. Some prices, copper and aluminum for example, have
in fact fallen sharply. Reflecting this weakness, prices of fabricated
manufactured products as measured by the producer price index for
intermediate materials are rising more slowly. This has become
increasingly apparent in the latest producer price reports. At the
finished goods level, prices are still reflecting prior increases in costs
and as a result are still rising at a 4.5%-5.0% annual rate. But this is
the tail of the inflation process and so long as pressures in the pipeline
remain subdued, these prices will begin increasing more slowly. In
effect, a wave of declining industrial commodity prices (and shrinking
profit margins) has replaced the prior wave of sharply rising commodity
prices (and widening margins).
121
On the labor cost side, wage figures suggest that wage increases have
stalled out at about a 4% annual rate. There has been a sharp pickup in
unit labor cost increases, but this is the result of declining
productivity which historically has always accompanied a slowdown in
economic growth. And in the past, most of such a unit labor cost pickup
has tended to squeeze profit margins rather than being pushed through into
larger price increases. The current weakness in corporate operating
profits reflects this tendency. Once economic growth stabilizes for
several quarters, in say the l%-2% range we expect, productivity should
resume growing at its trend 1% rate. Unit-labor cost increases will then
slow back to an underlying trend rate of about 4.0%-4.5%. This relates
back to the price figures in a straightforward manner. The CPI excluding
food and energy has increased by 4.5% over the most recent twelve months,
and the current spot growth rate also appears to be about 4.5%. This
reflects the underlying trend growth rate of unit-labor costs plus some
passthrough of the productivity slump.
Even if for now inflation appears to be under some semblance of control,
its next step is very uncertain. For that matter, what inflation does
will help determine what is likely to be the next step for the economy.
This brings me back to the introductory comment that soft-landing attempts
to subdue inflation have not really been tried.
Six episodes of a year or so of sluggish growth can be identified since
the 1950s (1956-57, 1966-67, 1969, 1973, 1979, 1985-86), four of which
culminated in recession, two of which were followed by an economic
rebound. Each of the six replicates to a significant degree the
conditions that have unfolded over the past year: rising inflation
pressures, tightening monetary policy, then a shift from rapid to sluggish
economic growth.
The key point is that in not one of the six episodes did the Federal
reserve pursue a moderate course after the onset of sluggish growth. This
is not necessarily a criticism of policy during these periods because
under extreme circumstances an extreme policy stance can be justified.
Such was certainly the case, for instance, in 1979 when aggressive
tightening was called for because of extraordinary inflation pressures, or
in 1985-86 when aggressive easing was justified because of the economic
weakness created by trade deficit deterioration.
But nonetheless, aggressively active policy was the norm. A relatively
stable or unchanged course has never been tried during periods of sluggish
growth, and therefore the soft-landing waters have never really been
tested. This is shown in the sequence of charts at the end of this
testimony which show the average behavior of several economic variables
for the four sluggish growth episodes that culminated in recession
(1956-57, 1969, 1973, 1979) and the two sluggish growth episodes that were
followed by a resumption of relatively strong economic growth and
accelerating inflation (1966-67, 1985-86).
The critical similarities and differences among the six episodes can be
summarized as follows:
*
The economy, inflation and interest rates behaved similarly in
the year immediately preceding sluggish growth: growth was
122
strong, utilization rates were rising, inflation pressures were
building and the Federal Reserve was tightening.
In the ensuing year or so of sluggish growth, the behavior of
inflation was the key difference between the four episodes that
culminated in recession and the two that did not. All six were
marked by a similar pace of sluggish economic growth, but in the
recession episodes, inflation pressures continued to build, while
in the other two they did not.
The continued buildup of inflation caused an aggressive further
tightening in credit market conditions in the recession episodes,
whereas conditions eased significantly in the two nonrecession
instances. That is to say, short-term interest rates rose
consistently by 2-3 percentage points during the years of
sluggish growth that were followed by recession, but fell 2-3
percentage points in the slow growth years that were followed by
an economic rebound.
In short, sluggish growth either turned into recession or was followed by
a resumption of strong growth, depending, apparently, on the behavior of
inflation and the latitude this presented to the Fed once sluggish growth
began, and not simply on the conditions that brought about the sluggish
growth in the first place. For the most part, conditions during the
current episode of sluggish growth are tracking the nonrecession episodes.
The behavior of interest rates, inflation indicators, and inflation are
shown in Charts 1-3 for the six sluggish growth episodes, including the
years immediately preceding and following the year or so of sluggish
growth. For comparison, current figures are shown as if sluggish growth
got underway early in January 1989.
The behavior of interest rates is shown in Chart 1, with short-term rates
in the top panel and the yield curve in the lower panel. Up to the onset
of sluggish growth, interest rates were rising in all instances and the
yield curve became relatively flat. After the onset of sluggish growth,
the differences between the recession and nonrecession episodes are
dramatic -- short-term interest rates either up an additional 200-300
basis points, followed by recession, or down by 200-300 basis points, then
an economic rebound. This difference is reflected in the yield curve -either further inversion when short rates rose or a return to a positive
slope when short rates fell. These aggressive policy changes help explain
why extended periods of sluggish growth have never occurred and why the
economy always seemed to fall off the runway rather than achieving a
sustained soft landing. In principle, there is considerable room in the
middle and therefore no need for the historical precedents to be repeated.
An apparent reason for the two different policy responses was the behavior
of inflation pressures. As shown in Chart 2, there was a sharp contrast
between a weakening in industrial commodity markets during the two
nonrecession slowdowns and continued strong upward pressure during the
four slowdowns that culminated in recession. Vendor performance, a key
manufacturing indicator which measures delays in deliveries, eased
abruptly during the two nonrecession episodes but remained above the
neutral 50% level through the four recession episodes. In response to the
123
easier market conditions signalled by the 1966-67 and 1985-86 declines in
vendor performance, industrial commodity prices fell about 15%, whereas
they rose more than 20% on average in the other four episodes.
Reflecting an easing of inflation pressures in the pipeline, consumer
inflation slowed a bit during the sluggish growth phase of the
nonrecession episodes, whereas the in the four recession periods, consumer
inflation continued to rise (Chart 3). Wage inflation, on the other hand,
is much less sensitive to sluggish growth, and hence, exhibited little
cyclical difference among the six episodes. However, the level of wage
inflation was on average considerably higher during the four periods that
ended in recession than the two which did not.
In addition to a great deal of latitude for the Fed to act in a more
moderate fashion than historically, there are two conjectures that suggest
to us more chance of a soft landing this time. First, there is some
evidence that a restructuring of the labor markets has occurred over the
past ten years or so such that the full employment unemployment rate has
dropped back down again. As a result, wage inflation will be better
behaved with unemployment in the 5%-6% range than is generally expected.
At about 5.3%, the total civilian unemployment rate does look low compared
to the cyclical troughs of the 1970s. But for one key segment of the
labor force which has had a stable participation rate, adult males, the
current 4% unemployment rate looks high compared to the 3% troughs in the
1970s. Furthermore, it can be argued that the labor markets were never
really that tight during the 1970s and that the upward swings of wage
inflation in 1973-74 and 1977-79 were more induced by price shocks. By
pre-1970 standards, current unemployment rates are obviously extremely
high.
Second, and even more conjecturally, I think it can be argued that it is
very difficult to generate a serious inflation, that it takes the
financing of wars, an extended period of extremely tight labor markets,
and/or major price shocks to push inflation upward significantly. This
goes to the heart of the question as to how prone the U.S. economy is to
inflation. The 1970s have conditioned us to believe that inflation is
always ready to rear its ugly head. But, the inflation of the 1970s was
to large extent put in place by the Vietnam War. Four years of extremely
tight labor markets pushed the trend of wage inflation up to 7% before the
1970s even began. Then deteriorating productivity and major price shocks
twice carried the inflation rate to about 10%. Getting rid of an on going
inflation is as difficult as creating it in the first place, and the
tightening to do so did not take place until the early 1980s. George
Perry coined the term "wage norm" to advance the idea that wage inflation
has a great deal of inertia and that it requires extreme circumstances to
significantly shift the wage norm. This is a view to which I am
increasingly sympathetic, and as a result, I conclude that until extreme
conditions bring back very high inflation rates, soft landings are more
likely than hard landings.
124
Economic
Research
Chart 1
Interest Rale Pressures Rise (Fall) During Recession (Nonrecession) Episodes
1-Year Treasury Bills
Yield Curve: Ratio of Long Bonds (10 Years or More) to 1-Year Bills
1988
Note:
Source: Federal Reserve Board.
1989
Average level of short-term rates and average yield
curve ratio tor 4 recession and 2 nonrecession episodes.
125
Economic
Research
IS*-!
I
Chart 2
Rising (Falling) Commodity Price Pressures During Recession (Nonrecession) Episodes
Level of Vendor Performance
Vear-to-Vear Growth Rate of Industrial Commodity Prices
Note:
A w i g « (aval of vandor parformanca and avaraga yaarto-yaar ptretnt changa In Commodity Raaaarch Burtau
•pot induatrlal commodity prlca Indax for 4 racaaalon
and 2 nonracaaalon apiaodaa.
Source National Ataoelatlon of Purchasing Managamant, Commodity Raaaareh Bureau.
126
Economic
Research
Chart 3
Consumer Inflation Rises (Falls) During Recession (Nonrecession) Episodes
Year-to-Year Rate of Consumer Price Inflation
V ear-to-Year Rate of Wage Inflation
Note:
Average year-to-year percent change in the Consumer
Price Index and Compensation per Man-Hour (nonfarm)
for 4 recession and 2 nonrecession episodes.
Source: Bureau of Labor Statistics.
127
TESTIMONY OF
ALBERT E. DEPRINCE, JR.
CHIEF ECONOMIST
MARINE MIDLAND BANK
NEW YORK, NY
ON
THE STATE OF THE ECONOMY AND THE CONDUCT OE MONETARY POLICY
BEFORE THE
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
COMMITTEE ON BANKING, FINANCE AND
URBAN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES
JULY 25, 1989
128
THE STATE OF THE ECONOMY AND THE CONDUCT OF MONETARY POLICY
Good morning! It is a pleasure to be here today to share with you my views on the
state of the U.S. economy and the conduct of monetary policy. The economics
profession is very much a judgmental science; we can each examine the same
economic data and reach different conclusions. Thus, it is useful, as you do here, to
seek opinions from a number of sources in evaluating the state of the economy.
Presently, a "consensus" which thinks the economy has beaten the inflation cycle and
is about to land softly is gathering momentum. That view ha?j been a key factor
behind the recent interest rate plunge. Financial markets have, in turn, gone beyond
the "consensus". They are now positioned for far lower short-term rates later this
year, intimating that severe economic weakness may be ahead.
My own views differ sharply from that sentiment. First, I believe the economy is
stronger than either the consensus or the financial markets' views, though
admittedly operating on a slower growth plane than last year. Second, inflation,
while likely to be lower than the first half's pace, is faster than last year's rate.
More importantly, this year's slower growth plane will not neutralize persistent
pressures for a gradual acceleration in the inflation rate.
Third, the economy is far short of a recession at this point, though a reversal of the
inflation cycle will eventually require the therapeutic effect of an economic
downturn. On this score, the FOMC's grudging response to the sharp fall in market
rates runs a risk of precipitating that downturn now, though we put a low likelihood
on that, since the FOMC is likely to continue to ease its policy stance.
Next, the monetary aggregates provide an inadequate yardstick of monetary
conditions; as such, they should not be used in setting the course of monetary policy.
Finally, the FOMC gets good marks for the speed with which it adapted to changing
economic conditions. Because of that, the FOMC has successfully contained the
speed with which inflation accelerated as the economy neared full utilization of its
resources.
Eventually, however, short-term containment will come into conflict with the
FOMC's long-term objective of near-zero inflation. When it does, tensions (the
product of either FOMC or market-based actions) will mount to bring the short-term
inflation rate into closer harmony with the long-term objective of near-zero
inflation. Slow growth will not harmonize the short- and long-term inflation
objectives. As past history shows, only a recession can bring the inflation rate
down. Thus, the FOMC will some day have no choice but to accept the blame for the
end of this expansion.
RECENT ECONOMIC GUIDEPOSTS IN PERSPECTIVE
The FOMC met on July 5 and 6 amid signs of slow growth compared with last year's
brisk pace. On this score, May's weak economic performance was summed up in the
month's 1.2% drop in the index of leading indicators. Moreover, early data for June
is not much better. Car sales were only 9.9 million units, even with continued
incentives, compared with 10.1 million units for May and 10.6 million units last year.
June's report on payroll employment showed a gain of 180,000 persons, a bit below
market expectations. While revisions to May's earlier results doubled the monthly
129
gain, manufacturing employment remained weak. May's 11,000 drop gave way to a
31,000 plunge for June. Half of June's plunge was attributable to the transportation
sector, presumably reflecting production adjustments by the automobile industry in
response to lackluster demand.
That drop in manufacturing employment quickly translated into widespread
estimates of a drop in industrial production in June, while the overall employment
gain and the drop in car sales pointed to weak retail sales for month. On the positive
side, energy and food prices led to expectations of weak producer price inflation for
the month. Against that backdrop, the bond rally continued.
In response to the widespread signs of less robust growth, the FOMC may be showing
some indirect signs of an easier policy stance. The timing of open market actions in
early July suggested that the FOMC set a 9.25% floor to its short-run Federal funds
rate objective, down from its previous floor of 9.62%. As the apparent easing
registered on financial markets, they began to position other short-term rates as if
there was a high probability of a sizable cut in the Federal funds objective ahead.
Even so, we must be careful not to overreact to the weak indicators. While the
economy has slowed from its 1988 pace, the chances of it slipping into a recession
may not be as high as some notables think.
First, the weakness in the leading indicators so far this year has led to a media
infatuation with the supposed link between three successive declines in the leading
indicators and the onset of a recession. However, the lead time is actually far
longer—usually nine to twelve months. At worst, continuation of the recent
behavior of the leading indicators point to an economic problem sometime late in the
first half of 1990—not in 3Q1989 as some intimate.
Moreover, the leading indicators frequently falsely signalled (as they did, for
example, in late 1966 and mid-1984) a recession's start. In those instances, a sharp
drop in interest rates counteracted the effects of the high rates which had
precipitated the peaking in the leading indicators before irreparable damage was
done. The same may be in store now. As we argue later, the sharp fall in rates since
their March peak will likely have a buoying effect on activity.
Second, the recent slowdown in employment growth, while welcomed by most, may
be the result of forces other than the FOMC's tight monetary policy. In particular,
with the economy functioning at full employment, subsequent employment gains
must be linked more closely to increases in the working-age population than in this
expansion's earlier years. In the earlier years of this expansion, fast employment
gains (Charts 1.1 and 1.2) were met without serious pressure on compensation by the
combination of a lower unemployment rate and an upward ratchet in the labor force
participation rate (the proportion of the working age population in the work force).
Now, the buffer of high unemployment rates is gone, and we are close to the social
limit to upward shifts in the labor force participation rate. Thus, it would be hard or
impossible to continue to secure 250,000 to 350,000 gains in payroll employment
given the monthly additions to the working age population, regardless of the FOMC's
policy stance. Gains of around 150,000 per month are the most that population
growth can support. Because of that, the recent slowdown in payroll employment
growth is unlikely to stop the gradual pick up in wage costs we expect later this year.
Next, the consumer is not as depressed as the auto sales data intimatesL>On this
score, though consumer confidence has zigzagged so far this year, it remains 2.0%
above last year's pace. More importantly, nonautomotive consumer spending is
-2-
130
holding up. Its slowdown from 3.5% last year to a 2.0% gain over the first half of
this year was partly the result of a surprising and questionable drop in nondurable
goods spending which will likely be eliminated with this month's benchmark revisions.
Fourth, imbalances normally associated with recessions are presently absent.
Though demand growth slowed in the first half, production rates quickly responded.
For the period, industrial production advanced only 2.1%, compared with 5.0% last
year. Thus, a recession-producing inventory correction is unlikely at this time.
Finally, M2's weak (1.6%) growth between 4Q1988 and 2Q1989 might have
incorrectly led some to conclude that
the FOMC could be forcing the economy over
the brink of a recession. To us, M2fs weakness reflects the deposit pricing strategy
(particularly for saving deposits and MMDAs) of banks and thrifts, not the effect of
FOMC policy on credit demands. In contrast, commercial bank loans and securities
climbed at an estimated 7.9% rate for the same span, as nondeposit sources of funds
(not captured in the aggregates) offset the effects of slow money growth. Moreover,
the public's ability to avoid banks in satisfying credit needs also lessens the
importance of the aggregates. For the 4Q1988-May span (the latest month of
available credit data), domestic nonfinancial credit advanced 8.1%.
RECENT INTEREST RATE MOVEMENTS IN PERSPECTIVE
As July opened, short-term rates dipped again, as expectations of an eventually
easier FOMC policy stance intensified. Long-term rates, in contrast, showed little
change. As a result, a slight positive slope reappeared in the Treasury yield curve
for maturities between one and seven years. Market rates now seem positioned for a
cut in the FOMC's Fed funds objective to 8.75% or less. Only a few weeks ago, the
short-term market rates seemed to be ready for a 9.12% Fed funds.
Long-term rates are probably near their low point for 1989, though some prominent
forecasters see still lower long-term yields in the months ahead. At this point, the
30-year bond yield is close to the level (Chart 2.2) prevailing in 1986—a time when
observed inflation (Exhibit 1) was depressed thanks to the collapse in energy prices,
the effects of the dollar's long appreciation on tradeable goods, and the beneficial
effects of sharp productivity gains in the manufacturing sector.
The bigger potential for rate declines lies among short-term rates. If the economy
is as weak as some argue, the chances are good for far lower short-term rates even
if long-term rates show little further decline. A 30-year bond yield of 8.00% is
quite consistent with short-term rates of 6.50%-7.00% (e.g., for Fed funds, 3-month
CDs or 3-month Eurodollars)—though so far it appears that the economy is lacking
the conditions needed to produce that rate outcome.
While rates are beneath the March highs, not all rates have benefited equally from
the 2Q1989 rate drop. First, because the FOMC anchored the short-term end of the
yield curve, short-term rates barely outpaced the drop in long-term rates. Usually,
short-term rates move over a much wider range than long-term rates when interest
rates undergo substantial movements. Because of the Fed funds anchor, an upward
slope has only recently returned to the Treasury yield curve.
Second, since markets continue to expect an easier policy stance in the near-term,
the very short-term yield curve (overnight through six months) is downward sloping.
As the FOMC eases later this month and in August, this portion of the yield curve
will likely become positively sloped again. This is captured in our baseline forecast
(Table 3.1 and 3.2).
131
Finally, mortgage rates (Table 3.2) have not fallen as much as Treasury yields. For
example, the ten-year Treasury yield dropped from a high of 9.36% in March to less
than 8.00% in early July. During the same span, the FHLMC mortgage rates
dropped, in turn, only about 100 basis points from March's 11.03%, exacerbating the
spread between mortgage rates and market rates.
Last year, the spread between 10-year Treasury yields and FHLMC rates averaged
149 bp; in 2Q1989, it averaged 190 bp. The wider gap has been ascribed to a heavy
volume of mortgage sales by thrifts. Looking ahead, congestion created by the
ongoing restructuring of the thrifts' balance sheets and FDIC sales of assets seized
from failed thrifts could lead to a wider than usual spread between mortgage rates
and competing market rates.
INFLATION AND THE OUTLOOK FOR INTEREST RATES
...The Inflation Model...
Our view of inflation rests heavily on trends in the growth of unit labor costs (Chart
1.3). These are defined as the difference between the growth in hourly compensation
and productivity (Chart 1.1). Next,
the gap between inflation and unit labor costs is
viewed as a nntinnnl (*TWiT'"''"nn""*j proxy for profit margins, while the growth in
GNP is considered a national proxy foitfvolume.
S7N.65
Together, inflation, unit labor costs and GNP growth form the basic determination of
corporate profits. If unit labor costs rise relative to inflation, profits are squeezed.
Eventually, if unit labor cost growth cannot be curtailed, the narrowed national
margin will trigger faster inflation. The reverse also holds. A drop in unit labor cost
growth will eventually feed through to slower broad-based inflation.
Commodity prices, while considered a harbinger of future broad-based inflation by
many, do not figure prominently in our formation of inflation forecasts. The reasons
are simple. First, there is far from a strong relation between basic commodity price
movements and broad-based inflation. In fact, some extremists hold that every
commodity inflation surge was followed by broad-based inflation, but not every
broad-based inflation surge had an associated commodity price explosion.
At the very least, commodity prices can lead to some distortion in the underlying
background rate of inflation in the short run. For example, the collapse in energy
prices in early 1986 figured prominently in that year's sharp slowdown in
broad-based inflation. More recently, as will be discussed in the next section,
energy commodity prices were the culprit in 2Q1989's inflation surge.
Second and more importantly, labor costs are the major expense faced by U.S.
enterprises—particularly in the ever more important service sector. As a result,
labor costs will dominate the broad-based inflation cycle over time. z.
...The Near-Term...
To begin, 3Q1989 will post a slower rate of inflation than 2Q1989's energy-swollen
results. In fact, CPI inflation will likely dip beneath 5.0% this quarter, after pushing
toward a 7.0% rate last quarter. Only a short time ago, inflation was expected to be
above the 5.0% rate for the second half.
Since short-term rates peaked in March, their fall as inflation surged during 2Q1989
led to a sharp narrowing of the real interest rate which neutralized some of the
burden of the high level of rates. So far this quarter, the rate decline has been short
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of the expected deceleration in the inflation rate. As a result, the projected real
rate ballooned and may be approaching threatening proportions when measured
against the scope of the inflationary threat—a threat which enhances the case for
even lower rates this quarter.
In addition to less virulent inflation this quarter, the interactions between saving
(both personal and corporate), the public-sector deficit, foreign capital inflows and
investment will likely provide room for marginally lower rates in the second half for
any given rate of inflation. In particular, the combination of a higher personal
saving rate, a marginally smaller Federal budget deficit and slower growth in
investment spending experienced so far this year could be creating an excess
availability of funds. If so, that excess would drive down interest rates until either
saving is cut (i.e., consumption growth accelerates) or investment spending
accelerates.
...Inflation through 1990...
With the completion of the feed-through effect of higher crude oil prices, the
fundamental determinant of inflation (labor costs) is again important. When this is
considered in today's full-employment environment, the recent slowdown in
economic growth does not hold much hope for an inflation rate beneath last year's
pace. Instead, that economic slowdown simply helps keep inflation within bounds.
CPI inflation (Exhibit 1 and Table 1.2) is expected to average 4.8% for the second
half. While a welcomed relief from the first half's blistering 6.1% pace, the second
half projection is still faster than the 4.4% seen during the 1987-1988 span. Behind
that acceleration stands a slight increase in inflation of services less energy from
4.9% last year to 5.2% for the first half to 5.4% for the second half. Inflation for
goods less food and energy also shows a slight pick-up.
After a low point of 1.3% in 1986, inflation for this grouping climbed 3.7% for 1987
and 1988. Inflation of 3.8% for the first half of 1989 should be followed by a 4.2%
gain for the second half of 1989. Together, price increases for all items less food
and energy are expected to average 5.0% this half, versus 4.7% for the first half,
4.6% for 1988 and 4.2% for 1987.
Next year, inflation is expected to continue to accelerate, a view contrary to the
mainstream view. For example, the average of 45 forecasters surveyed in the July
1, 1989, issue of Blue Chip Financial Forecasts see inflation slowing from 4.9% this
quarter to 4.7% a year from now. It is important to note that while we expect faster
inflation next year, the acceleration is mild in comparison with the 1970s. That is an
important fact often overlooked in the zeal of inflation forecasting.
A mild acceleration in unit labor cost growth stands behind our expected inflation
pick-up. After 2.6% yearly increases between 1984 and 1987, unit labor costs
advanced 3.6% last year and a 5.0% hike is anticipated4hjs year. Next year, unit
labor cost are expected to climb 6.2%. (S T B T Q ^ y ^
Productivity and hourly compensation developments (also Table 2.2) stand, in turn,
behind that foreseen acceleration in unit labor costs. As business expansions mature,
productivity growth slows and compensation gains accelerate; the current expansion
is no exception, though shifts so far have not been as dramatic as in the 1970s.
Nonetheless, they have been enough to nudge up the growth in unit labor costs in the
last year and a half, and more is expected.
Separately, compensation gains are showing the strains of tight labor market
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conditions. As conditions tightened last year, compensation gains began to tick
upward. After averaging 4.3% between 1984 and 1987 (Table 2.2), compensation
growth accelerated to 4.7% last year, and a 5.5% pace is estimated for the first half.
The slower growth seen so far this year will do very little to alter those trends.
While employment gains of 200,000 are slower than last year's 280,000 monthly gain
in payroll employment, they still exceed the 150,000 monthly gain in the working age
population. With the economy at functionally full employment, it is unlikely that the
gap can be filled with further cuts in the unemployment rate.
As a result, the only other route is further increases in the labor force participation
rate (i.e., an increase in the proportion of the working age population in the work
force). Unfortunately, after sharp increases for much of the last two decades the
participation rate is probably nearing an upper limit. (See Charts 1.2 and 1.4 for
trends in labor market conditions.)
Thus, even modest employment growth will trigger ever faster compensation gains,
both to coax additional workers into the work force and to signal opportunities in
expanding firms/industries. This is reflected in our 1989-1990 forecast. For 1989,
compensation gains (Table 2.2) are placed at 5.7%, followed by 6.5% next year.
As compensation gains accelerate in the advanced stage of an expansion, pressure on
unit labor costs is intensified due to slower productivity gains. Conventional wisdom
holds that current additions to the work force have a lower skill base than additions
earlier in the expansion when the economy had a larger pool to draw upon. Now,
however, the slower growth in the manufacturing sector further erodes national
productivity growth, but thanks to tight labor market conditions, the slower growth
in manufacturing will not likely dent the building pace of compensation settlements.
Nonfarm productivity growth of 1.6% during the 1984-1987 (Table 2.2) span gave
way to a 0.9% rise last year. This year, only a 0.7% advance is seen, with next
year's improvement probably slipping to a dismal 0.3%.
...Prospects for Interest Rates...
Once markets realize that inflation is in the 4.5%-5.0% range/!the fall in rates will
end. In fact, we are likely at that point for long-term yields now. Unless a
recession is at hand, yields beneath 8.00% for the 30-year bond is extremely unlikely.
The fall in short-term rates will, in turn, probably run its course this quarter, given
our view on inflation. Moreover, higher short-term rates will emerge by the fourth
quarter as renewed growth rekindles apprehension over inflation. Since inflation is
expected to continue to inch up later this year and in early 1990, interest rates are
seen rising in tandem. (See Tables 3.1 and 3.2 for details.)
This view contrasts sharply with the growing "consensus" of a soft landing—a
concept in which we do not put much faith. Experience shows that the inflation
cycle can be reversed only by the restraining effect of a recession or a substantial
external shock. The baseline forecast sees the economy bouncing against capacity
ceilings in the remainder of this year and next year, even though GNP growth (Table
2.2) is expected to be slower than in the earlier years of the expansion.
Thus, pressure on wages and productivity, and hence prices, will persist and will
eventually manifest itself in higher interest rates. The eventual recession pulls the
economy far enough away from its capacity ceilings to recalibrate the inflation
cycle at a lower rate. Such a recession is projected for the later part of 1990.
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Because usual excesses which presage a recession are minimal, the next downturn's
duration will be short. Nonetheless, effects on inflation, when combined with
continued intense international competition in tradeable goods, will be dramatic.
...The Risk: Even Lower Rates Before the Rate Cycle Bottoms
Interest rates moved down at an astonishing pace since their March peak.
Admittedly, the upswing since November 1988 (when the Treasury yield curve began
to invert) may have been excessive when positioned against the background or core
inflation rate. Nonetheless, rates have systematically moved through each
downward revision of our interest rate outlook for the last two months. Moreover,
short-term markets are positioned for still lower short-term rates.
For example, the yield curve for short-term debt instruments (e.g., bank CDs,
Eurodollars and commercial paper) is currently downward sloping. That means
markets expect lower short-term interest rates in the future. (See Chart 3.1 for the
"spot" Eurodollar yield curve for overnight through one-year maturities.)
The expectation of lower rates is mirrored in the futures market for short-term debt
instruments. For example, the December Eurodollar contract was priced at a yield
close to 8.00% in July. The average yield for the four 1990 contracts is around
7.90%. Based on the futures market, there is the implicit assumption that the
Federal funds rate could be 7.75% for most of next year.
Admittedly, the futures market is no more accurate in its prediction of things to
come than other forecasting techniques. (See Chart 3.2 for the Eurodollar futures
rates as of 3/13/89). Nonetheless, it does serve to illustrate the scope of the
potential rate decline for which markets are positioned.
Because of the sheer size of that potential drop, it seems prudent to establish an
alternative regime which captures lower short-term rates during 3Q1989. This case
is compared with the baseline in Chart 3.3. In it, short-term rates (Fed funds and
CDs) fall to the 7.87% area by October, a bit ahead of the futures market forecast.
It is important to note that in both the base and the "backup" case, 3Q1989
represents only a temporary interruption in the rising rate channel. By year-end, the
contingency case sees rates rising again.
An important point should be noted here. While the near-term state of the economy
may cloud the rate outlook in the months ahead, we feel confident that rates at the
end of 1990 will be higher than at the end of 1989. Any debate should revolve around
the probable year-end rate level and the pace of the 1990 rise.
...Shocks, Rolling Readjustments and the Inflation Cycle...
In this expansion, forecasters have regularly warned of an imminent acceleration in
the inflation rate ever since commodity prices jumped in early 1984; However, that
acceleration has failed to arrive on cue which admittedly casts some doubt on our
forecast of marginally higher inflation later this year.
In retrospect, two forces combined to help keep the inflation rate within bounds:
external shocks and a process we call rolling readjustment.
Three external shocks benefited the U.S. inflation rate since the last recession's
trough. The first was the persistent appreciation of the dollar from its 3Q1980 low
point until its 1Q1985 peak. This had an obviously beneficial effect on the inflation
rate of tradeable goods, which likely had a lot to do with the gradual deceleration in
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price inflation of goods less food and energy. As can be seen in Exhibit 1, the
inflation rate for that grouping fell from 5.0% in 1983 to 1.3% in 1986.
The second shock was the early 1986 collapse in oil prices. For the four quarters of
1986, prices of energy goods in the CPI plunged 30.1%. That plunge, and the weak
inflation in goods less food and energy, played a major role in the year's slow growth
(1.3%) in the overall CPI.
The third shock was the October 19, 1987 stock market crash. Prior to the crash,
markets were reeling under the fears of higher U.S. inflation which was buffeting the
dollar in exchange markets. After the crash, we hypothesized that it would have a
sobering effect on wage and price decisions but would not have a untoward effect on
growth. As 1988 unfolded, that turned out to be a good forecast. Growth soared and
inflation was about equal to 1987's rate, though we admittedly had a few worrisome
months in Black Monday's aftermath.
Looking ahead, it is unlikely that we can rely upon either a rapid rise in the dollar or
a collapse in energy prices to secure a lower inflation rate in the quarters to come.
The second effect, rolling readjustment, depends upon the rapid reaction of financial
markets to early warning signs of inflation. In it, the fast reaction is seen choking
off budding excesses before they can become entrenched. Once those excesses are
stopped, the process relies upon an equally fast financial market response which
lowers interest rates before the stress of high rates triggers a recession.
The best example of this was the sharp rise in interest rates in the first half of 1984
and their subsequent decline in late 1984. More recently, the sharp run-up in rates
prior to Black Monday, while a causative agent of the crash, probably also had a lot
to do with choking off inflationary excesses that markets feared were building in
mid-1987. The sharp drop in rates after the crash was a big reason we felt the crash
would have no lasting effect on economic activity.
However, so far in this expansion, rolling readjustment did not reverse the inflation
cycle. Rather, it simply kept inflation within bounds—no mean feat when viewed
against the 1970s. In fact, rolling readjustment is probably at least partly
responsible for the remarkable length of this expansion and the surprising "low"
inflation rate given current capacity limits.
Some may see our concept of rolling readjustment as a close proxy for the term soft
landing. However, there is a big difference. Soft landing proponents seem to think
that slow growth can keep the inflation rate within bounds indefinitely. Rolling
readjustment, in contrast, simply generates a succession of temporary reprieves
from an inevitable outcome: progressively faster inflation.
The 1Q1989 jump in rates, for example, pulled the economy back only slightly from
binding capacity limits. As the economy rolled back from the ceiling, inflation fears
subsided; but lower rates associated with those lessened inflation fears will soon
catapult the economy back to the capacity ceilings. With it will come renewed
concern over inflation and an upturn in U.S. rates.
In sum, rolling readjustment has been a significant contributor to this expansion's
length; however, it would be a mistake to believe that it has eliminated the business
cycle. Eventually, a recession will be called upon to reverse the inflation cycle.
136
THE ECONOMIC OUTLOOK FOR THE SECOND HALF OF 1989 AND BEYOND
As noted before, the 2Q1989 rate drop will likely rejuvenate activity in the second
half As a result, GNP growth (Table 1.1) of 2.5%-3.0% may be possible.
Among the separate sectors, auto sales (Table 1.2) will likely show no pick-up
despite the lower interest rates. In comparing 1988 and 1989, it appears that last
year's high volume (10.6 million units) probably came at the expense of 1989fs sales.
Technically, 1988's auto scrappage rate was boosted to an abnormally high level; this
year's scrappage rate is more typical of recent behavior.
Nonautomotive consumption (Table 1.1) rebounds from 2.0% for the first half to
2.8% for the second half. As noted earlier, the first half's results were depressed by
a sharp (and most surprising) decline in spending on nondurable goods for May which
depressed the entire 2Q1989 estimate for nondurable goods. We suspect that this is
related to the procedures used to estimate the early data and will likely be raised
with July's benchmark revisions.
Housing (Table 1.2) will show a marginal revival in the second half. Single family
starts are expected to creep up to 1.05 million units compared with 2Q1989's 1.02
million unit rate. However, the second half rate is still beneath 1988's 1.09 million
units Little improvement is expected in the multi-family sector, as regional
excesses continue to plague that market.
The outlook for 1990 is more complicated and is based upon an important thread
woven throughout this testimony. Namely, the inflation cycle cannot be reversed
without a recession. It can be held within bounds by the dual forces of fast
responding capital markets and properly reactive monetary policy. But as the
economy approaches full employment, inflation will rise. Low points in undulating
inflation sub-cycles (the product of rolling readjustment) should not be confused with
victory over the primary inflation cycle, particularly if each sub-cycle brings the
primary inflation cycle to an ever higher background rate. Failure to recognize this
will lead to a repeat of past mistakes; now however, financial markets will have a
punishing effect on the unwary.
Against that background, we feel that an economic downturn is lurking at some point
in the future. While it may be arbitrary, it is presently projected to begin during the
latter part of 1990. Because imbalances are few and inflation has not been allowed
to become entrenched as it was in the 1970s, the downswing will be brief—probably
no more than two to three quarters.
Effects on cyclically sensitive sectors (autos, housing and capital spending) will be
felt, but not on the scale of the 1970s. Effects on inflation will be faster than in
earlier recessions, again, because it was not allowed to become entrenched.
By early 1991, the new expansion will be underway, thanks to the projected drop in
interest rates as markets respond to a sizeable slash in the perceived background
inflation rate.
The longer-term outlook, while not a subject of this testimony, does highlight a
potential problem. Though the projected recession has the desired therapeutic
effect on inflation, it is short-lived. Because of weak domestic oil drilling activity
and strong demand for crude oil, we fear that the balance will tip toward sharply
higher oil prices by 1992 which leads to a higher inflation rate.
137
THE MONETARY
DELIBERATIONS?
AGGREGATES:
SHOULD
THEY
MATTER
FOR
POLICY
The monetary aggregates have received renewed attention with their surprisingly
slow growth so far this year. The FOMC's principal target variable (M2) rose a scant
1.6% between 4Q1988 and 2Q1989 versus a target growth of 3%-6%. Those of a
monetarist persuasion maintain that tight monetary policy was responsible for the
slowdown, and if it persists, an economic recession is not far off. Aside from the
leading indicators, this may be the only sign of a problem. However, opinions are far
from uniform on this issue. Statistical research is divided on the usefulness of the
aggregates; our view is that changes in the financial service industry in recent years
have rendered the aggregates all but useless in policy deliberations.
...Statistical Support of Ideological Views on the Aggregates...
At one extreme, research at the National Bureau of Economic Research found very
little to support the monetarist view. One study found a negative association
between money growth and both inflation and nominal GNP since the early 1980s.
As a result, the research argues that the monetary aggregates have lost any value as
an "instrument" variable in the conduct of policy deliberations—hardly a rousing
endorsement of the importance of monetary aggregates.
At the other side, recent research by Federal Reserve Board economists may have
breathed new life into the monetarist view and the monetary aggregates. That study
takes a long-run view of the aggregates and distinguishes equilibrium inflation
(termed "P star" by the media) from observed inflation. Equilibrium inflation is
derived from trend velocity, potential GNP growth and observed money growth.
In it, movements in the aggregates account for shifts in the equilibrium inflation
rate—a slight departure from the usual monetarist view where money growth
directly influences price inflation (albeit with a lag). In the Fed model, gaps
between equilibrium inflation and observed inflation are closed, but with a long and
variable lag. If the equilibrium rate is above the observed rate, inflation can be
expected to accelerate and vice versa.
The recent slowdown in money growth has pulled the equilibrium rate beneath the
observed rate, leading some to use this model to justify expectations of slower
inflation. The implication of the Fed's research report for inflation over the second
half of 1989 was one of the factors seized by markets to fuel the bond rally.
...Changes in the Financial Services Industry and the Aggregates...
Our own view of the aggregates steps away from econometric models. Instead of
relying upon statistical research, we feel that identifiable changes in the financial
services industry invalidates the role of the monetary aggregates as a yardstick of
monetary tension or stimulus. If so, their use in FOMC policy deliberations is a
mistake. More importantly, use of the aggregates by Congress as a yardstick of
monetary policy is an equal error.
Since M2 seems to be the FOMC's main monetary target, our analysis focuses on
that variable. This aggregate is composed of saving and small time deposits (which
we later refer to as retail deposits), money market mutual funds, overnight
repurchase agreements and repatriated overnight Eurodollars.
Several facts led us to minimize the economic consequences of M2. First,
deregulation of retail (personal) deposit rates in the early 1980s altered the
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relationship between trends in bank deposits and monetary policy. That process got
underway in mid-1978 with the introduction of the six-month money market
certificate. It was completed in 1983 when the last of the ceilings on personal
saving and time deposits was lifted.
Before ceilings on deposits were lifted, rising rates had devastating effects on bank
deposits. Though the ceilings were periodically adjusted, they never fully reflected
market rates in the late stages of interest rates cycles. The resulting
disintermediation had a fast and dramatic effect on the aggregates as the banking
system literally ran short of personal (retail) deposits. On the asset side, implicit
nonprice rationing was very often the response to the shortage of retail deposits, and
the housing market seemed to bear the brunt of the adjustment.
In understanding the economic process behind the strong statistical appeal of the
monetarist doctrine through the late 1970s, it seems that implicit credit rationing
was an important element in the linkage between the aggregates and activity as
interest rate cycles matured. Alternatively, the excess availability of deposits at
the low point of the interest rate cycle would be reflected in implicit underpricing of
assets to fully utilize the deposit inflows. In sum, the inefficiency of deposit
ceilings found relief in the alternating pattern of implicit rationing and underpricing.
Now, with the exception of demand deposits, depository institutions have complete
control over deposit rates. All other rates are adjusted to reflect the efforts of
depository institutions to minimize net interest expense while satisfying the need to
fund asset levels; personal deposits are but one of a number of funding sources.
So far this year, yields on passbook and MMDA accounts have been sticky, as
depository institutions came to rely upon time deposits to control the growth of
interest expense in the period's rising rate environment. As a result, saving deposits
and MMDAs plunged, while small time deposit growth exploded. In an effort to limit
the hemorrhage of saving deposits and MMDAs, while simultaneously controlling
interest expenses, rates were changed by the introduction of new saving and MMDA
products, not the blanket increase in the rate on all such deposits.
On balance, however, the growth of the aggregates was still lethargic. However,
since banks had control over deposit rates, that weakness reflected factors other
than the effect of the policy stance, not the least of which was the banking system's
demand for personal deposits. That depends, in turn, upon asset growth, which brings
us to the remaining reasons why the aggregates are of little meaning today.
Second, the adoption of an investment banking mentality by the larger banks has also
played a role. In an effort to replace net interest income with fee-based income,
the money center banks have increased the importance of originating loans for sale
or securitization. Not only can this produce a higher return on equity for any given
asset base, but the fee earnings would, hopefully, be more stable than the net
interest income. The consequence, however, is a slower growing asset base of the
banking system. With slower asset growth comes a lessened demand for deposits.
Third, while often ignored in discussions, more stringent capital requirements are
influencing the aggregates, particularly since 4Q1988. At that time, regulatory
pressures to raise equity capital ratios to 4.0% have led to very tough management
of bank balance sheets. However, the tougher capital requirements did not
necessarily limit the role of banks in the credit generation process; they simply
increased the importance of "origination for sale or securitization".
With balance sheet growth tightly managed, deposit generation is also more
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aggressively managed. As fee income becomes more important than net interest
income, the corollary is a lessened need for deposits. Not surprisingly, this process,
helps explain this year's meager growth in M2.
Fourth, it is becoming ever easier for credit users to avoid banks in satisfying their
needs. The corporate community's increasing use of commercial paper and growing
access to the bond market is well documented. More recently, banks have aided the
processes though development of a variety of off-balance sheet products, credit
enhancement products, and an increased presence in direct placements.
However, retail or personal credit is beginning to feel the effects of more efficient
credit markets. E.g., in the mortgage arena, both banks and thrifts have a lessened
role in the day-to-day origination of mortgages as mortgage brokers and bankers
become more active in the origination process. Mortgages originated by those
"brokers" are sold to banks or thrifts which package them for sale as mortgagebacked securities. Such mortgages are not permanently on the banks' balance sheet,
but servicing fees charged by the banks are an important source of income.
Also, home equity loans are issued by finance companies in addition to banks. As
these rise in importance in the credit process (due to tax considerations of the
interest expense) credit growth through nonbank finance companies lessens the need
for deposits at banking institutions.
Fifth and finally, the definition of money has once again changed. Several years ago,
in an attempt to capture the evolution of financial innovations, money market
mutual funds were added to the definition of M2 and M3. Those instruments had a
family resemblance to other forms of nontransaction balances captured in the Ms.
As such, their addition to the money stock definitions was logical.
The type of funds offered has proliferated tremendously since then, and thanks to
flexible rules on transfers, the effective distinction among types of accounts is
blurred. For example, one major firm offers 55 different "no load" funds. Of these,
50 allow telephone transfers between accounts or to a bank account. In addition
telephone redemption via check can be made. These include money market mutual
funds, bond funds and stock funds. In addition to the MMMFs, the bond funds also
allow check writing privileges. The flexibility offered through such "families" of
funds give them all the characteristics of money, but except for the MMMFs, they
are not counted in any of the money stock definitions.
In sum, the monetary aggregates can only be viewed as a grossly incomplete measure
of the monetary tension or stimulus faced by the U.S. economy. Total nonfinancial
credit may be a better yardstick, though I personally feel that any single measure of
monetary tension or stimulus is fraught with problems.
This brings us to the final part of the prepared statement.
THE CONDUCT OF MONETARY POLICY
...Strategic Objectives...
Strategic or long-term objectives are reaffirmed each month in the FOMC
directive. In particular, the Committee "seeks monetary and financial conditions
that foster price stability, promote growth in output on a sustainable basis, and
contribute to an improved pattern of international transactions." As part of the
process, as well as a requirement of the Full Employment and Balanced Growth Act,
the Committee sets annual target bands for the monetary aggregates believed
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consistent with the national objectives. Presently, the principal monetary target is
M2, with a target band of 3%-7%.
The qualitative objectives are not officially translated into quantitative or numerical
objectives. Nonetheless, some sense of the numerical objectives can be gleaned
from official statements and formal testimony. First, the clearest view seems to be
on the long-run inflation objective. Here, the popular term used by the Federal
Reserve is noninflationary growth—a term that seems to be roughly equivalent to
zero, or near-zero, long-run inflation, though admittedly, the term zero inflation has
not been used in policy statements.
Nevertheless, a careful reading of speeches and testimony leaves little doubt that
this is the long-run objective. Such an objective was first articulated in the early
1980s by former Chairman Volcker in a speech to the American Economics
Association. At that time, he argued that there should be no difference between
nominal and real values for long-term business planning purposes. This notion has
been periodically reaffirmed since then.
Next, the numerical estimate of the growth objective is less clear cut. It seems to
be purposefully vague which thus allows for whatever growth rate is viewed as
consistent with price stability. Chairman Greenspan has personally used a 2.5% pace
for the last year, arguing that this is the most that can be achieved without faster
inflation in today's full employment environment. However, that pace has not been
endorsed by other members of the FOMC, preferring generalities instead.
Nonetheless, vagueness has not stopped markets from forming a view on the precise
growth objective. Many practitioners take the FOMC's central tendency forecast
(part of the the Federal Reserve's Humphrey-Hawkins report) as the growth
objective for the coming year.
Finally, international transactions are to be achieved within the context of G-7
coordination. The dollar's exchange value is a key element here. Many feel that the
beneficial effects of the dollar's drop between 1Q1985 and 1Q1987 have been
exhausted. So far this year, the merchandise trade deficit bears out that view. At
the same time, however, the G-7 may be waffling on the importance of reducing the
size of the global imbalances, as the communique from the July economic summit
took a softer stand on this issue.
...Tactical Objectives...
Broadly speaking, the FOMC has pursued its strategic objective of noninflationary
growth by gradually reducing the monetary aggregates' annual target bands. For
example, this year's range for M2 is 3%-6%; for 1985, the range was 6%-9%.
In fact, however, the FOMC pursues its strategic objectives within a context of
short-run conditions. These conditions also determine what I call the FOMC's
tactical objectives. These objectives bridge, in turn, the long-run objectives and the
FOMC's day-to-day actions, i.e., the "degree of reserve restraint" the FOMC
creates in the money markets. The tactical objectives have two parts: (1) the
priority attached to the FOMC's short-run objectives and (2) the balance of the
directive issued to the manager of its open market activities.
The priority of the short-run objectives vary depending on prevailing economic
conditions. Presently they are ranked as inflation, economic growth, the monetary
aggregates and financial market conditions. Inflation has been the number one
priority for the last year and a half; however, in the aftermath of the stock market
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crash, economic growth had top billing at the December 1987 FOMC meeting.
The directive's balance establishes the intensity with which the FOMC intends to
pursue its short-run objectives. It is expressed in terms of allowable inter-meeting
shifts in the degree of reserve restraint in reaction to deviations in economic
conditions from expectations. The directive's balance ostensibly gives the open
market account's manager room to react to changing conditions between meetings.
In fact, it establishes the relative importance of the top objective and the FOMC's
willingness to sacrifice the other objectives in pursuit of the top objective.
For example, during the last year and a half, not only was inflation the FOMC's top
short-run priority, it was also the top priority of the G-7. Containing inflation was
so important that the FOMC directed the open market account manager to exercise
a greater degree of reserve restraint should inflationary pressure warrant. That
directive led to a number of official statements last winter and spring indicating
that policy was set to err on the side of restraint. Presumably, against 1988's fast
growth pace, excess restraint posed little near-term threat to the expansion, while
the threat of faster inflation posed a fundamental threat to its longevity.
At the May 16, 1989 meeting (released July 7th), the directive's balance changed.
Inflation was still the number one priority, but the presence of a slower growth plane
was evident. Moreover, those of a monetarist persuasion pointed to the threat to
growth posed by the weak M2 growth. As a result, the FOMC adopted a "balanced"
directive; i.e., an easier or tighter policy was equally likely. Against that backdrop,
its Federal funds target was eased a bit during June.
...Policy Indicators...
A good amount of judgment goes into the deliberations which sets the directive's
balance. This is not surprising since the economy's position in the inflation cycle is
far from obvious. As a result, most of us seek forward looking guideposts for
short-run policy setting. The members of the FOMC are no different. However, the
perspective of the Board of Governors and the district bank presidents do differ.
The Governors see things on a macro level and, as such, come to rely on broad
national measures. For example, several years ago, Governor Angell proposed an
experimental commodity price index on the assumption that commodity prices are
the leading edge of the inflation cycle.
Soon after his appointment, Vice Chairman Johnson gave some notion of the factors
important to him in the conduct of monetary policy. As with Wayne Angell,
commodity prices were an important harbinger of future inflation. In addition,
however, he believed that important forward-looking information was contained in
financial markets; exchange rates and the shape of the yield curve were considered
particularly important. Basically, he believed that markets, through efficiencies
gained in integrated globalized deregulated markets, contained forward-looking
information which the FOMC could take into account in setting its policy stance.
Chairman Greenspan's statements suggest that the unemployment rate is important
to him, though he has become less doctrinaire on its role this year.
So far, personal preferences for the various indicators have not evolved into fixed
rules for short-run policy settings. Nonetheless, commodity prices seem to be a
common thread among many FOMC members; moreover, it is a theme which has
found some support within the G-7, as they have agreed to at least consider
commodity prices as part of their policy coordination deliberation. I would caution
-14-
142
against a dominant role for commodity prices because they lose sight of the role of
labor costs as expansions mature.
The twelve distinct bank presidents, in contrast, see the economy from a more
micro perspective, i.e., conditions in their own regions. These are summed up before
each FOMC meeting in a document popularly termed the TAN or BEIGE BOOK. As a
result of their limited geographic hegemony, the presidents may have a more
practical sense of the actual efficacy of monetary policy than the Board. If so, it
could explain the supposed division on the FOMC regarding the severity of the
inflation threat between the Board of Governors and the district presidents.
...Inflation and Growth: An FOMC Success Story...
The expansion has had two big surprises: its length and the persistent failure of
inflation to shoot upward. The FOMC's adaptive policy stance has been an element
of that outcome. More importantly, the Committee's policy tone has differed
radically from the 1970s. Simply put, inflation is not now an option for extending
the current economic expansion. Quite the contrary, holding the line on inflation is
considered crucial in sustaining economic growth. If successful, economic actors
believe the policy, so none feel comfortable taking action which assume the
acceptability of inflation in policy circles.
Nonetheless, it is equally clear that the low point of the current inflation cycle was
early 1986. As noted before, the dollar's sharp appreciation through early 1985 and
strong productivity gains in the manufacturing sector in the early years of the
expansion helped drag down inflation among goods excluding food and energy. Tight
policy had a spillover effect on services; although since services did not feel the
effect of global competition, gains were not as significant as in the manufacturing
sector. Still, excluding food and energy, inflation bottomed out at 3.9% in 1986.
Since then, the trend has been admittedly upward; however, its movement has been
systematically beneath expectations. In retrospect, at least three factors account
for that. First, fast adaptation by foreign producers to the dollar's 1985-1987 drop
has kept global competition a potent force. Second, monetary policy, as measured
by the level of real interest rates compared with the 1970s, remained taut. Third,
markets have responded exceptionally fast to any hint of accelerating inflation
However, in reviewing the FOMC's record, it is important to keep in mind a
functional difference between it short- and long-term objectives for inflation. In
the short-run, the FOMC seeks to contain inflation. However, it is important to
recognize what that term means in practice; namely, limiting its inevitable
acceleration as the expansion matures. On this score, the FOMC has been very
successful; inflation's accelerations has been systematically beneath expectations.
That process eventually puts short-term trends in fundamental conflict with the
long-term objective of zero or near-zero inflation, and at some point, the two must
be brought into harmony. To end the acceleration (even a "contained" acceleration),
history shows a recession plays a critically important role.
...Global Markets, Exchange Rates and Inflation....
While the FOMC's commitment to disinflation was an important agent in holding a
line on inflation in this expansion, it was not alone. Global financial markets, with
powerful efficiencies acquired through global integration, enhanced the efficiency of
rolling readjustment in controlling inflation in this expansion. For example,
exchange rate pressure in August and September 1987, the product of a feared
-15-
143
acceleration in U.S. inflation, put tremendous pressure on U.S. interest rates in
general and long-term rates in particular as investors fled dollar-denominated assets.
The resulting global pressure on U.S. rates was probably far greater than could have
been generated from domestic sources alone. Admittedly, those high rates figured
prominently as a causative agent of the stock market correction which began in
early September and ended with Black Monday. Nonetheless, their speed stood as a
stark reminder of the new speed with which financial markets can react to distrust
of monetary policy.
Similarly, the sharp fall in U.S. rates this spring was partly the result of an intense
foreign appetite for dollar-denominated assets. Had foreign interest not appeared,
the rate fall would have been more gradual.
...An Inevitable Cyclical Downturn is Ahead, Eventually...
Success in containing inflation and sustaining growth has created the illusion in some
quarters that the business cycle may be a thing of the oast. There seems to be a
notion that monetary policy can be fine tuned to choke off inflation without a
recession—a dangerous and incorrect assumption. If widely believed, economic
participants (whether in the product or labor markets) will be less cautious.
Such a development would reduce the efficiency of rolling readjustment and possibly
set the stage for more serious economic problems (namely inflation) in the quarters
or years ahead. The 1960s are a good example of that problem. Thanks to the long
expansion (the product of the Vietnam War and "Great Society" fiscal initiatives),
many came to believe that the business cycle was dead, and that period laid the
ground work for the inflation surge of the 1970s.
Throughout this expansion, fast growth moved the economy inexorably toward full
employment. Prior to 1988, there were ample excesses in both labor and industrial
capacities; however, ever since 1986, the economy has moved ever closer to capacity
limits, particularly in the labor markets.
As noted earlier, with tighter capacity came faster compensation gains, weaker
productivity gains and a notch-up in the inflation rate. It is a mistake to think that
fine-tuning monetary policy can reverse the pressures as the economy bumps against
capacity limits. Rolling readjustment can extend the life of the expansion, but not
indefinitely. Effects of each rate swing will become less biting on the underlying
inflation cycle, and the pauses in inflation's upward march will become shorter.
Eventually, a recession will be triggered to reverse the inflation cycle. When the
recession materializes, the FOMC will need to accept at least part of the blame.
Earlier in this testimony, the start of that recession was placed in late 1990.
However, the precise timing of its start is conjecture at best; it is possible that
rolling readjustment could push the expansion out through 1990. Nevertheless, it
would be a mistake to think that inflation could be reduced without a recession,
notwithstanding the FOMC's effort to gradually slow the monetary aggregates'
growth.
IN SUM
The FOMC should be given high marks for creating a credible anti-inflation policy in
this expansion. On only a few occasions did markets doubt the Federal Reserve's
seriousness, and their response (mid-1984 and 3Q1987) quickly pushed the FOMC to
the right course, which could have influenced Vice Chairman Johnson's willingness to
use market information as input into FOMC decisions.
-16-
144
The partnership between efficient, deregulated, global capital markets on the one
hand and the FOMC on the other hand has worked very well in holding inflation
within bounds as the expansion matured. However, as the data show, the background
inflation rate is moving upward, even if it seems to be a glacial rate of acceleration.
Because of that, the FOMC will eventually be called upon to take a decisive stand in
its inflation offensive. If the FOMC responds responsibly, the economy will likely be
pushed into a recession; it came close to one this spring. If it steps aside, financial
markets will do the job for the FOMC—as they almost did in 1984 and again in 1987.
When the test comes, the FOMC will undoubtedly receive much public criticism.
Realistically, however, if the inflation demon is to be put back into the jar, slow
growth will be ineffective. Moreover, slow growth runs the danger of
institutionalizing stagflation because of its detrimental effects on productivity.
Reversal of the inflation cycle will eventually require some economic pain.
The global situation will have a heavy bearing on the speed with which the FOMC
may be forced to act. There is little doubt that the members of the European
Monetary System are committed to low inflation. Germany, which seems to be the
de facto spokesman for the EMS, has systematically raised its interest rates for the
last year in response to its domestic inflation threat and has left little doubt that the
current inflation rate is unacceptable.
Moreover, other EMS members are using the discipline of the relatively fixed
exchange rates imposed by the EMS to wind down their own domestic inflation
rates. Against that background, any question by the global community of the U.S.
anti-inflation commitment will have a fast and severe effect upon the dollar's
exchange rate, and U.S. interest rates will be quick to follow. We have only to look
to August-October 1987 to refresh our memories.
Just as the current decline in U.S. rates probably had its genesis in the foreign
community, the eventual stress point will likely come from that arena. We should be
prepared for that eventuality and not be lulled by the belief that the FOMC is
omniscient and omnipotent enough to fine tune policy enough to drive inflation down
without adverse economic consequences.
-17-
145
CHART 1.1
CHART 1.3
PRODUCTIVITY & COMPENSATION
UNIT LABOR COSTS & INFLATION
r4
re
re
eo
02
90
82
94
SMOOTH!D DATA
CHART 1.2
CHART 1.4
LABOR FORCE PARTICIPATION RATE
& EMPLOYMENT RATIO
CIVILIAN EMPLOYMENT GROWTH
& WORKING AGE POPULATION GROWTH
EXHIBIT 1
CPI INFLATION
(FOURTH-QUARTER TO FOURTH-QUARTER GROWTH)
ALL
ALL ITEMS
LESS FOOD
ALL ITEMS
LESS
1981*
ALL ITEMS
LESS FOOD
& E
ENERGY
&
4.4
5.4
YEAR
#
ENERGY*
GOODS
ENERGY*
SERVICES
5il
3.9
4.2
4.7
5.0
1:1
2:!
ALL
J:J
-30
19
1H1989CF)*
9(F)
0(F)
GOODS
LESS FOOD
& ENERGY
774
5.7
-4.
2H1989(F)*
U
3'.6
3.8
2.4
2.3
5.8
5.9
/0006H
-J:2
-19
3.4
5.3
6.8
5.2
18.6
6.0
5.9
ALL
SERVICES
SERVICES
LESS
4.5
n
U
ti
1:1
•ANNUALIZED RATE
^ENERGY GOODS - MOTOR FUEL, FUEL OIL AND OTHER HOUSEHOLD FUEL$
^ENERGY SERVICES - PIPED GAS AND ELECTRICITY
ENERgY
1.9
5.2
4.2
4.7
3.8
3.9
4.1
4.6
1:1
FOOD
5.4
4.6
4.9
5.3
6.5
146
CHART 2.3
3-MONTH CD RATE
CHART 2.1
SHORT-TERM YIELD CURVE
FEAL
CD ott
•
. O ICHO IM a »i
•.3
s
IFMAMJJASOND
e.g
7.7
J.«
4.1
i.3
M
34
NO*.
At F rES
t.t
3.1
3.0
7.4
7.9
3.t
CHART 2.4
QUARTERLY PATH
CHART 2.2
LONG-TERM YIELD CURVE
O1 Ol OS O4 01 O2 09 O4 0 1 0 2 03 04 01 08 03 O4
CHART 3.2
EURODOLLAR FUTURES VS.
BASELINE EURODOLLARS
CHART 3.1
THE EURODOLLAR YIELD CURVE
CHART 3.3
BASELINE VS. CONTINGENCY VIEW
_
3-MONTH CO RATES
•AMLINI
— CONTINOINOT M M
1160
8.50
\H JAN JAN JAN JAN JAN JAN JAN JAN
I 82 I S3 I 84 I M I Sf I «7 I M I 00 I 90
147
TABLE 1.1
GROSS NATIONAL PRODUCT - QUARTERLY DATA
KA)
IKA)
1988
GROSS NAT'L PRODUCT
CHANGE*
GROSS NAT'L PRODUCT ('82$)
CHANGE*
FINAL SALES ('82$)
CHANGE*
DOMESTIC FINAL SALES ('825)3
CHANGE*
CYCLICAL DEMAND C82$)#
CHANGE*
NONCYCLICAL DEMAND ('82$)&
CHANGE*
PRIVATE FINAL SALES ('82$)**
CHANGE*
PERSONAL CONSUMP. EXP ('82$)
CHANGE*
DURABLE GOODS
AUTO + PARTS
OTHER
NONDURABLE GOODS
SERVICES
GROSS P R I . DOM. INV. ( ' 8 2 $ )
1988
IIKA)
1988
IV(A)
1988
KA)
1989
IKE)
1989
IIKE)
1989
IV(E)
1989
I(£)
1990
II(E)
1990
IIKE) IV(E)
1990 1990
4724.5 4823.8 4909.0 4999.7 5099.0 5206.3 5300.2 5391.4 5488.3 5581.5 5652.5 5697.4
5.4
8.7
7.3
7.6
8.2
8.7
7.4
7.1
7.4
7.0
5.2
3.2
3956.1 3985.2 4009.4 4033.4 4077.5 4103.4 4128.8 4150.9 4171.3 4183.7 4175.7 4148.0
3.4
3.0
2.5
2.4
4.4
2.6
2.5
2.2
2.0
1.2
-0.8 -2.6
3890.1
3949.9
3969.9
4004.4
4042.0
4069.9
4092.8
4112.4
4130.3
4140.2
4147.2
4152.0
3.6
6.3
2.0
3.5
3.8
2.8
2.3
1.9
1.8
1.0
0.7
0.5
4018.4
4059.3
4080.3
4119.1
4132.6
4156.4
4185.4
4209.9
4229.0
4236.2
4230.5
4214.7
3.6
4.1
2.1
1.3
2.3
2.8
2.4
1.8
0.7
1064.0
1090.4
7.4
10.3
1097.0
3.9
1104.5
1107.1
1122.3
5.6
1130.5
1138.5
1142.9
2.4
2.8
0.9
2.9
2.9
1.5
2954.4
2968.9
2983.3
3014.6
3025.5
3034.1
3054.9
3071.4
3086.1
2.3
2.0
2.0
4.3
1.5
1.1
2.8
2.2
-1.7
1123.2
-1.5
1101.2
-5.1
-7.6
3107.3
3113.5
1.9
1.6
1.2
0.8
3113.7
3166.1
3196.4
3208.9
3243.8
3260.9
3280.0
3309.3
3316.2
3322.0
3325.6
6.7
6.9
3.9
1.6
4.4
2.1
2.4
1.9
1.7
0.8
0.7
0.4
2559.8
2579.0
2603.8
2626.2
2634.9
2646.6
2663.8
2677.6
2687.6
2692.8
2696.8
2694.4
4.5
3.0
3.9
3.5
1.3
1.8
2.6
2.1
1.5
0.8
0.6
401.1
410.6
410.4
416.5
412.3
418.0
418.2
420.0
419.0
415.2
411.2
403.8
173.5
179.0
178.7
179.6
172.6
175.3
172.5
171.8
168.8
164.0
160.5
153.6
227.6
231.6
231.7
236.9
892.7
893.6
904.5
907.4
1265.9
1274.8
1288.9
1302.2
239.7
911.5
242.7
904.5
245.7
911.5
3295.1
1138.1
3098.1
-0.5
248.2
250.2
251.2
250.7
-0.4
250.2
914.5
917.5
1311.1
1324.1
1334.1
1343.1
1351.1
1358.1
1364.1
1368.1
919.5
921.5
922.5
728.9
715.1
726.1
717.1
730.2
737.8
748.3
757.1
764.9
766.4
740.4
693.5
662.9
3 ^
679.7
686.6
688.0
694.8
704.3
712.3
718.6
723.9
722.9
711.9
697.5
10 5
4 1
0 8
4 0
5 6
4 6
3 6
3 0
-0 6
-5 9
-7 9
CHANGE*
FIXED PRIVATE INVEST.
CHANGE*
473.4
490.2
495.0
491.4
500.5
511.0
519.5
526.5
532.0
535.5
531.0
519.0
STRUCTURES
124.0
125.0
125.8
125.5
125.9
126.4
126.9
127.4
127.9
128.4
126.4
121.4
PRODUCERS' DURABLE EQ.
FIXED BUS. INVEST.
349.4
365.1
369.2
365.9
374.6
384.6
392.6
399.1
404.1
407.1
404.6
397.6
RESIDENTIAL STRUCTURES
189.5
189.6
191.6
196.6
194.3
193.3
192.8
192.1
191.9
187.4
180.9
178.5
CHG. IN BUS. INVENTORIES
66.0
35.3
39.5
29.1
35.5
33.5
36.0
38.5
41.0
43.5
28.5
-4.0
14.1
5.3
-0.8
-8.5
9.2
1.0
1.0
1.0
1.0
1.0
1.0
1.0
-109.0
-92.6
-93.9
-105.4
-85.9
-89.9
-96.0
-101.1
-102.2
-99.5
-86.8
-66.2
486.2
496.9
514.0
522.1
540.7
546.9
554.5
560.8
565.6
569.2
573.7
581.0
CHG. IN FARM INVENTORIES
NET EXPORTS ( ' 8 2 $ )
EXPORTS
CHANGE*
IMPORTS
CHANGE*
GOVERNMENT PURCHASES ('82$)
25.7
9.1
14.5
6.5
15.0
4.7
5.7
4.6
3.5
2.6
3.2
5.2
595.1
589.5
607.9
627.4
626.6
636.8
650.6
661.8
667.8
668.7
660.5
647.3
6.9
-3.7
13.1
13.5
-0.5
6.7
8.9
7.1
3.6
0.5
-4.8
-7.8
776.4
783.8
773.5
795.5
798.2
809.0
812.8
817.3
821.0
824.0
825.2
826.4
FEDERAL
DEFENSE
327.8
264.6
331.6
320.1
263.6
256.4
335.5
262.5
335.8
256.6
343.1
256.6
343.6
256.6
345.1
258.1
346.1
258.6
347.6
259.1
348.1
259.6
348.6
260.1
OTHER
63.2
67.9
63.7
72.9
79.1
86.5
87.0
87.0
87.5
88.5
88.5
CHG. IN CCC INVENTORIES
STATE + LOCAL
88.5
-19.3
-16.8
-16.5
-9.4
-4.7
3.5
3.5
3.5
3.5
3.5
3.5
3.5
448.7
452.2
453.4
460.0
462.4
465.9
469.2
472.2
474.9
476.4
477.1
477.8
* QUARTER - TO - QUARTER PERCENT CHANGES EXPRESSED AT COMPOUND ANNUAL RATES
A-ACTUAL; E-ESTIMATED; P-PRELIMINARY; R-REVISED
a GNP LESS NET EXPORTS AND CHANGES IN BUSINESS INVENTORIES AND CCC INVENTORIES
# FIXED PRIVATE INVESTMENT, AUTO CONSUMPTION AND OTHER DURABLE CONSUMPTION
& DOMESTIC FINAL SALES LESS CYCLICAL DEMAND
MMB • ECONOMICS GROUP
** FINAL SALES LESS GOVERNMENT SPENDING
JULY 17, 1989
148
TABLE 1.2
RELATED QUARTERLY DATA
191
CORPORATE PROFITS (B.T.)
CORPORATE PROFITS (A.T.)
CHANGE*
INTERNAL FUNDS (A.T.)
CHANGE*
PERSONAL INCOME
CHANGE*
DISPOSABLE INCOME
286.2
149.4
10.6
387.9
3.8
3951.4
III(A)
IV(A)
1988
1988
HA)
1989
320.6
174.5
13.4
409.9
14.4
320.2
172.6
-4.3
388.9
-19.0
319.5
172.0
-1.3
400.9
12.9
315.9
170.1
-4.5
410.7
10.2
4180.5
4315.7
4392.3
4471.7
305.9 313.9
162.7 169.1
40.7
16.7
393.5 396.3
5.9
2.9
4022.4
4094.0
III(E)
1989
IV(E)
1989
III(E)
IV(E)
HE)
IKE)
1990
1990
1990
1990
311.6
167.8
-5.2
414.7
4.0
310.2
305.0
294.3
278.1
4.0
2.1
-0.3
-2.8
4552.6
4635.4
4720.7
4783.4
4846.8
167.0
164.2
158.5
149.7
-1.9
-6.5
-13.3
-20.3
418.8
421.0
420.7
417.7
4.6
7.4
7.3
8.7
13.6
7.3
7.4
7.4
7.5
7.6
5.4
5.4
3375.6
3421.5
3507.5
3582.5
3680.6
3737.8
3830.0
3899.3
3970.3
4043.3
4097.0
4151.3
CHANGE*
7.4
5.6
10.4
8.8
11.4
6.4
10.2
7.4
7.5
7.6
5.4
5.4
SAVINGS RATE
4.4
3.7
4.2
4.3
5.4
4.9
5.4
5.5
5.5
5.7
5.4
5.4
184.0
184.4
184.8
185.3
185.8
186.2
186.6
187.1
187.6
188.0
188.5
0.9
1.0
1.0
1.0
1.0
1.0
118.7
118.4
189.0
1.0
118.1
-1.0
7.2
62.51
CIVILIAN POPULATION (MIL.)
0.9
0.9
2.4
1.9
2.2
1.3
1.2
1.0
5.7
5.5
5.3
5.3
5.4
5.6
5.8
6.5
63.00
63.11
63.14
63.14
62.82
CHANGE*
CIVILIAN EMPLOYMENT (MIL.)
CHANGE*
CIVILIAN UNEMPLOYMENT RATE
62.05
62.20
LABOR PRODUCTIVITY*
3.3
-2.5
HOURLY COMPENSATION*
3.6
4.2
5.8
UNIT LABOR COSTS*
0.2
6.8
3.6
EMPLOYMENT RATIO
62.53
-1.0
1.0
0.6
0.7
5.5
5.6
5.8
6.0
6.5
6.5
6.5
4.1
6.8
4.3
4.5
4.9
5.5
5.9
5.8
-0.6
6.5
7.1
6.0
-1.1
2.2
GNP DEFLATOR ('82=100)*
1.7
5.5
4.7
5.3
3.6
5.8
4.8
4.8
5.3
5.7
6.0
CONSUMER PRICE INDEX *
3.6
4.5
4.7
4.4
5.4
6.9
4.7
4.9
5.5
6.1
6.4
6.4
C.P.I. ENERGY (7.3%)*
-4.1
2.4
2.6
0.3
5.8
33.0
2.5
0.0
3.0
3.0
5.0
5.0
C.P.I. FOOD (16.2%)*
3.2
5.0
8.4
4.4
6.4
7.1
5.0
5.5
5.7
6.0
6.0
6.0
C.P.I. COM. LESS F&E(25.7X)*
2.9
5.0
2.4
4.8
4.0
3.5
4.0
4.4
5.0
5.7
6.5
6.5
PRODUCER PRICE INDEX*
INDEX OF IND. PROD. ('67=100)
CHANGE*
UTILIZATION RATE
NEW CAR SALES (MIL.)
2.4
3.2
4.7
134.5
136.0
138.4
3.5
139.9
9.1
140.7
6.6
5.8
6.2
6.7
7.0
7.0
7.0
141.4
142.4
143.8
144.9
145.2
143.4
141.6
4.0
4.5
7.1
4.5
2.2
2.0
3.0
4.0
3.0
1.0
-5.0
-5.0
82.4
82.9
83.7
84.1
84.0
83.8
83.9
84.1
84.2
84.0
82.4
80.9
10.70
10.46
10.66
10.00
9.90
10.50
9.73
10.25
9.70
9.40
9.20
8.80
30.0
-8.7
7.9
-6.0
-26.2
23.3
-9.5
-3.9
-7.8
-11.8
•8.2
-16.3
DOMESTIC
7.64
7.37
7.60
7.47
6.92
7.27
7.20
7.13
7.03
6.82
6.72
6.42
FOREIGN
3.06
3.09
3.06
3.03
2.81
2.98
2.80
2.77
2.67
2.59
2.48
4.77
4.79
5.01
4.63
4.49
4.66
4.70
4.67
4.58
4.42
4.09
3.71
27.9
1.5
19.4
-26.8
-11.9
16.6
3.4
-2.5
•7.5
-13.3
-27.0
-31.9
1.48
• CHANGE*
NEW LIGHT TRUCK SALES (MIL.)
CHANGE*
PRIVATE HOUSING STARTS (MIL.)
1.48
1.47
1.56
1.52
1.35
1.40
1.42
1.35
1.25
1.20
-12.8
0.1
-2.8
27.5
-10.2
-37.3
15.7
5.8
•18.3
•26.5
•15.1
SINGLE-FAMILY
1.10
1.06
1.06
1.14
1.07
1.02
1.05
1.05
1.00
0.90
0.85
MULT I-FAMILY
0.38
0.42
0.41
0.42
0.33
0.35
0.37
3.30
3.64
3.66
3.77
3.48
3.31
3.37
3.41
-10.2
48.5
2.2
12.2
-27.7
•18.1
7.8
CHANGE*
EXISTING HOME SALES (MIL.)
CHANGE*
0.45
• QUARTER - TO • QUARTER PERCENT CHANGES EXPRESSED AT COMPOUND ANNUAL RATES
A-ACTUAL; E-ESTIMATED; P-PRELIMINARY; R-REVISED
4.5
0.35
0.35
0.35
2.38
1.20
0.0
0.85
0.35
3.32
3.17
3.03
2.92
-10.3
•16.0
-16.5
•14.7
MMB - ECONOMICS GROUP
JULY 17, 1989
149
TABLE 2.1
ECONOMIC, MONETARY AND CREDIT OUTLOOK
FULL YEAR ANNUAL AVERAGES
88(A)
89(E)
90(E)
ABSOLUTE LEVELS
GROSS NATIONAL PRODUCT
4864.3
5249.2
5604.9
GROSS NATIONAL PRODUCT ('82$) 3996.0
4115.2
4169.7
87/84
88/87
6.3
3.2
7.5
3.9
89/88 90/89 91/90 92/91 93/92
ANNUAL PERCENT CHANGE
7.9
3.0
6.8
1.3
7.2
1.8
8.6
4.9
7.4
3.1
94/93
7.0
2.3
3.2
3.8
3.6
2.5
2.6
2.9
FINAL SALES ('82$)
DOMESTIC FINAL SALES ('82$) 3
3953.6
4069.3
4079.3
4171.1
4142.4
4227.6
3.2
.5
2.1
3171.3
3270.0
3318.3
3.5
3.8
3.2
3.7
PRIVATE FINAL SALES C 8 2 $ ) #
4. 1
5. 2
4. 7
PERSONAL INCOME
CORPORATE PROFITS (A.T.)
INTERNAL FUNDS (A.T.)
4062.1
163.9
396.9
4433.1
170.6
403.8
4746.6
159.9
419.6
6.7
-0.7
2.8
7.5
14.7
4.8
9.1
4.1
1.7
7.1
-6.3
3.9
6.3
5.7
8.6
6.6
13.6
10.5
5.3
6.3
-6.2
-11 .2
-3.5
18.2
7.2
-13.0
2.0
-9.4
1.7
-9.4
CIVILIAN EMPLOYMENT (MIL.)
CIVILIAN UNEMPLOYMENT RATE
7.1
7.3
-1.5 -12.2
4.3
1.9
LABOR PRODUCTIVITY
HOURLY COMPENSATION
UNIT LABOR COSTS
110.6
198.1
179.1
111.1
208.9
188.1
112.1
222.0
198.2
1.4
4.1
2.7
1.5
4 .7
3 .1
0.5
5.5
5.0
0.9
6.3
5.4
1.2
5.6
4.4
2.0
3.7
1.7
1.3
4.3
3.0
0.9
5.0
4.1
GNP DEFLATOR ('82=100)
121.7
127.6
134.4
3.0
3.4
4.8
5.4
5.3
3.5
4.2
4.6
CPI ('82=100)
PPI ('82=100)
118.4
108.0
124.6
114.5
131.6
122.1
3.0
0.5
4.1
2.5
5.2
6.0
5.7
6.6
5.6
5.3
3.8
2.5
4.4
4.4
4.7
4.9
INDX. OF IND. PROD. (67=100)
UTILIZATION RATE
137.2
83.3
142.1
84.0
143.8
82.9
2.3
-0.1
5.7
3.2
3.6
0.8
1.2
-1.3
-0.1
-2.4
8.5
5.8
6.0
3.4
4.4
1.9
0.0
92.7
99.4
7.1
-2.8
-6.3
-4.3
-0.1
NEW CAR SALES (MIL.)
DOMESTIC (MIL.)
FRB TRADE-WEIGHTED $ INDEX
10.58
7.52
9.97
7.13
9.28
6.75
-0.3
-3.8
2.9
6.1
-5.8
-5.2
-7.0
-5.3
1.1
4.3
18.0
19.5
6.0
6.0
0.0
1.3
FOREIGN (MIL.)
3.06
2.84
2.53
9.4
-4.2
-7.1
-11.1
-7.4
13.4
6.0
-4.2
NEW LIGHT TRUCK SALES (MIL.)
4.80
4.63
4.20
6.6
4.2
-3.5
-9.3
3.4
31.9
9.9
4.0
PRI. HOUSING STARTS (MIL.)
1.49
3.59
1.42
3.39
1.25
3.11
-2.6
7.9
-8.5
-0.2
-4 .9
-5 .7
-12.1
-8.3
26.0
7.7
10.0
18.0
-4.2
2.4
-10.5
-3.0
776.0
3009.4
2233.4
3818.7
807.9
783.6
3104.0
2320.4
3997.4
893.2
819.4
3280.8
2461.4
4280.7
999.9
7.9
6.8
8.1
8.5
5.1
5.4
6.3
10.9
3 .1
3
4 .7
10.6
5.7
6.9
7.1
7.4
7.1
11.9
7.8
10.7
6.7
5.4
7.2
6.7
7.4
7.0
7.4
7.5
637.7
705.6
752.1
276.7
294.8
315.6
12.8
17.0
8.5
7.7
10.6
6.6
6.6
7.1
4.7
5.3
11.5
11.3
11.5
13.1
10.6
12.9
165.0
26.2
169.9
188.7
24.4
197.7
209.2
24.0
203.2
17.2
3.1
5.8
14.0
-4.2
6.8
14.4
-7.1
16.4
10.9
-1.4
2.8
8.9
0.0
-0.1
15.6
0.0
8.4
13.9
0.0
7.2
12.8
0.0
4.7
EXISTING HOME SALES (MIL.)
SM. DENOM. NONTRANS.(M2 - M1)
M3
LG. DENOM. NONTRANS.(M3 - M2)
CONS. INSTAL. DEBT
AUTO LOANS
REVOLVING CREDIT
MOBIL HOME LOANS
OTHER CONS. CREDIT
96.6
-11.2
-4.3
PRODUCT-SPECIFIC DATA
MORTGAGE DEBT
SINGLE-FAMILY
MULTI-FAMILY
COMMERCIAL
3006.3
2036.7
281.5
3320.1
2264.1
302.7
3680.8
2524.1
325.6
688.1
753.4
SHORT-TERM BUS. BORROWING
1007.9
1132.5
626.5
506.0
C + I LOANS
587.9
COMMERCIAL PAPER
420.0
14.0
10.3
10.4
10.9
11.1
13.7
14.1
13.0
831.2
13.0
14.7
16.7
11.2
5.8
9.6
11.2
7.5
9.5
11.5
7.6
10.3
11.5
9.5
10.4
14.3
13.5
12.0
15.0
13.8
11.5
13.7
12.1
11.1
1238.5
677.8
560.7
10.1
7.2
15.2
11.0
6.2
18.4
9.4
6.6
8.2
20.5
10.8
6.2
5.2
7.4
9.5
8.8
10.5
12.1
12.4
11.9
12.6
13.6
11.4
12.4
A-ACTUAL; E-ESTIMATED; P-PRELIMINARY; R-REVISED
ABSOLUTE LEVELS IN BILLIONS OF DOLLARS UNLESS OTHERWISE NOTED
a GNP LESS NET EXPORTS AND CHANGES IN BUSINESS INVENTORIES AND CCC INVENTORIES
# FINAL SALES LESS GOVERNMENT SPENDING
150
TABLE 1.3
QUARTERLY MONETARY AND CREDIT DATA
KA)
1988
Ml ($ BIL.)
CHANGE
M2 (MIL.)
CHANGE*
760.8
3.2
II(A)
772.9
6.6
III(A) IV(A)
782.9
5.2
787.4
2.4
IKE)
1989
786.7
-0.4
775.8
-5.4
IIKE)
1989
IV(E)
1989
781.4 790.7
2.9
4.8
KE)
1990
IKE)
1990
IIKE)
1990
8(6.8 815.9 825.2
6.8
6.1
4.6
IV(E)
1990
832.5
3.6
2950.2 3001.1 3029.5 3057.0 3071.2 3081.5 3110.6 3152.6 3204.3 3257.2 3307.4 3354.3
6.3
7.1
3.8
3.7
1.9
1.3
3.8
5.5
6.7
6.8
6.3
5.8
SM. DENOM. NONTRANS. DEPOSITS ($ BIL.)
(M2 LESS M1)
2189.4 2228.1 2246.7 2269.5 2284.7 2305.6 2329.2 2362.0 2400.5 2441.3 2482.2 2521.8
3.4
4.1
2.7
3.7
4.2
5.8
6.7
7.0
6.9
6.5
CHANGE*
7.3
7.3
M3 ($BIL.)
CHANGE*
3730.7 3797.5 3850.2 3896.2 3932.3 3962.5 4012.7 4082.2 4159.2 4240.1 4321.6 4402.0
7.0
7.4
5.7
4.9
3.8
3.1
5.2
7.1
7.8
8.0
7.9
7.7
LG. DENOM. NONTRANS. DEPOSITS ($ BIL.)
(M3 LESS M2)
779.1
795.2
819.3
837.9
860.2
881.0
902.1
929.6
954.9
982.9 1014.1 1047.7
CHANGE*
620.2
633.0
643.5
654.4
686.9
697.6
712.3
725.8
738.5
750.1
758.0
761.7
276.6
8.2
162.4
278.8
3.3
166.9
280.0
1.7
172.7
288.0
11.9
179.4
290.5
297.3
303.3
309.0
314.2
318.3
321.0
186.4
191.9
197.3
202.7
208.0
211.9
214.4
MOBIL HOME LOANS ( $ B I L . )
271.2
11.2
158.0
17.1
26.5
26.2
26.2
25.9
25.4
24.0
24.0
24.0
24.0
24.0
24.0
OTHER CONS. CREDIT(S B I L . )
164.4
167.7
171.5
194.1
48.7
196.7
199.0
201.2
202.8
203.9
5.4
4.9
4.5
3.3
2.1
203.8
-0.2
24.0
0.0
202.3
-2.8
22.6
29.4
24.2
30 ?
N.A.
N.A.
N.A.
N.A.
N.A.
N.A.
CONS. INSTAL. DEBT ( $ B I L . )
AUTO LOANS ( $ B I L . )
REVOLVING CREDIT ( $ B I L . )
CHANGE*
HOME EQUITY LOANS ( $ B I L . )
MORTGAGE DEBT ( $ B I L . )
9.3
8.3
9.3
175.8
10.3
17.7
65.8
18.9
29.0
19.8
21.4
21.2
32.3
2896.0 2970.2 3045.2 3113.9 3182.8 3270.9 3367.1 3459.7 3539.3 3639.6 3730.5 3813.7
CHANGE*
SINGLE-FAMILY ( $ B I L . )
CHANGE*
MULTI-FAMILY ( $ B I L . )
CHANGE*
COMMERCIAL (S B I L . )
CHANGE*
SHORT-TERM BUS. BORROWING #
CHANGE*
C. AND I . LOANS ( $ B I L . )
CHANGE*
COMMERCIAL PAPER <$ B I L . )
CHANGE*
FRB TRADE-WEIGHTED S INDEX
CHANGE*
YEN/DOLLAR
CHANGE*
DM/DOLLAR
CHANGE*
1951.4 2012.3 2067.9 2115.2 2162.0 2227.4 2299.8 2367.3 2420.9 2494.7 2560.8 2619.8
9.5
13.6
9.4
5.6
11.5
9.2
12.7
12.3
12.8
11.0
9.5
13.1
278.1 278.9 281.5 287.6 294.3 299.9 305.3 311.2 317.2 323.4 328.3 333.4
6.3
1.1
3.7
9.0
9.6
7.9
7.3
8.0
7.9
8.0
6.3
6.4
666.5
679.0
726.5
743.6
9.1
8.9
9.8
762.1
10.3
781.2
10.4
801.2
10.6
821.5
10.5
841.4
10.0
860.5
7.8
695.8
10.2
711.1
7.0
959.0 1000.6 1025.5 1046.4 1095.7 1120.6 1143.4 1170.4 1199.7 1229.4 1254.5
8.4
8.4
10.4
13.9
18.5
10.3
20.2
9.4
9.8
10.3
8.4
567.7 585.6 598.3 599.9 611.8 621.0 629.9 643.3 658.2 673.4 686.0
8.9
5.9
8.7
9.6
13.2
1.1
8.2
6.1
9.6
7.7
4.3
391.3 415.0 427.2 446.4 483.9 499.6 513.4 527.2 541.5 556.1 568.4
29.7
26.5
12.3
38.0
11.5
11.2
11.3
19.3
13.6
11.2
9.2
1270.6
90.0
-9.4
128.0
-20.7
1.68
-6.0
90.4
1.7
125.7
-6.9
1.71
7.3
97.6
35.6
133.7
27.9
1.87
43.1
93.0
-17.6
125.1
-23.3
1.77
-18.6
96.0
13.5
128.5
11.1
1.85
18.7
100.4
19.7
137.9
32.7
1.93
18.2
* QUARTER-TO-QUARTER PERCENT CHANGES EXPRESSED AT COMPOUND ANNUAL RATES
A-ACTUAL; E-ESTIMATED; P-PRELIMINARY
# C & I LOANS PLUS CP
101.0
2.6
140.0
6.3
1.93
0.0
100.1
-3.6
136.7
-9.0
1.87
-11.7
98.3
-7.2
132.4
-12.0
1.83
-9.5
97.7
-2.5
128.3
-12.0
1.83
0.0
96.0
-6.7
124.2
-12.0
1.78
-9.5
9.4
5.2
693.7
4.5
576.9
6.1
94.4
-6.4
120.3
-12.0
1.74
-9.1
MMB - ECONOMICS GROUP
JULY 17, 1989
151
TABLE 2.2
ECONOMIC, MONETARY AND CREDIT OUTLOOK
YEAR-END (FOURTH QUARTER) DATA
87/84
88/87
89/88
GROSS NATIONAL PRODUCT
GROSS NATIONAL PRODUCT ('82$)
88(A)
4999.7
4033.4
5391.4
4150.9
5697.4
4148.0
6.6
3.5
7.2
2.8
7.8
2.9
5.7
-0.1
9.1
4.4
7.8
4.2
7.4
2.7
6.6
2.0
FINAL SALES ('82$)
DOMESTIC FINAL SALES ('82$) a
PRIVATE FINAL SALES ('82$) #
4004.4
4119.1
3208.9
4112.4
4209.9
3295.1
4152.0
4214.7
3325.6
3.3
3.5
3.0
3.9
3.4
4.8
2.7
2.2
2.7
1.0
3.5
3.7
4.0
3.9
5.0
4.5
2.9
3.2
3.2
2.2
2.2
2.5
PERSONAL INCOME
CORPORATE PROFITS (A.T.)
INTERNAL FUNDS (A.T.)
174.5
409.9
167.8
414.7
149.7
417.7
1.5
2.3
19.8
6.7
-10.8
0.7
22.9
15.3
6.7
5.4
6.4
7.3
7.3
-5.2 -16.2
3.7
1.0
CIVILIAN EMPLOYMENT (MIL.)
CIVILIAN UNEMPLOYMENT RATE
115.8
5.3
118.1
5.4
118.1
7.2
-6.9
-9.6
1.9
1.3
LABOR PRODUCTIVITY
HOURLY COMPENSATION
UNIT LABOR COSTS
110.9
201.9
182.0
111.6
213.4
191.3
112.1
227.3
202.9
1.6
4.3
2.6
0.9
4.7
3.6
0.6
5.7
5.1
GNP DEFLATOR ('82=100)
124.0
129.9
137.4
2.9
4.3
CPI ('82=100)
PPI C82=100)
120.3
109.5
126.9
117.1
134.6
125.2
3.1
0.6
4.3
3.4
INDX. OF IND. PROD. (67=100)
UTILIZATION RATE
139.9
84.1
143.8
84.1
141.6
80.9
2.8
0.5
5.0
2.4
93.0
100.1
10.50
7.47
3.03
4.63
9.90
7.13
2.77
4.67
FRB TRADE-WEIGHTED $ INDEX
NEW CAR SALES (MIL.)
DOMESTIC (MIL.)
FOREIGN (MIL.)
NEW LIGHT TRUCK SALES (MIL.)
89(E)
90(E)
ABSOLUTE LEVELS
94.4
-14.4
0.7
PRODUCT-SPECIFIC DATA
8.80
6.42
2.38
3.71
-0.9
-4.5
7.9
4.7
-2.1
4.7
12.0
-9.7
3.2
90/89 91/90 92/91 93/92
PERCENT CHANGE
0.0
2.1
33.3 -13.9
-8.1 -12.3
0.4
6.5
6.1
2.1
4.6
2.5
1.7
3.6
1.9
4.7
5.7
4.5
5.5
6.9
6.1
6.9
4.8
3.7
2.8
0.0
-1.6
-3.8
7.7
94/93
-4.0
1.1
4.7
3.6
0.7
5.0
4.3
3.5
4.6
4.5
3.7
2.9
4.8
4.9
4.6
5.0
4.8
2.4
7.6
5.0
5.2
2.7
4.1
1.6
-5.7
-6.5
-2.0
0.0
0.0
-5.7 -11.1
-4.6
-9.9
-8.4 -14.3
0.9 -20.5
13.6
18.3
1.0
33.2
15.0
15.0
15.0
22.2
2.2
2.2
2.2
5.9
-0.9
0.5
-5.0
3.2
PRI. HOUSING STARTS (MIL.)
1.56
1.42
1.20
2.0
-8.9
-15.5
-7.5
3.77
3.41
2.92
6.6
11.2
-9.6
-14.4
37.5
24.4
4.8
EXISTING HOME SALES (MIL.)
11.6
-0.7
-11.3
-4.1
11.3
4.3
0.4
5.3
11.2
10.1
9.0
8.3
6.2
7.5
7.7
5.5
6.2
4.1
4.8
6.8
7.8
10.0
10.9
12.7
6.1
7.5
7.9
5.9
6.6
5.5
7.1
7.5
7.2
7.0
7.0
12.4
12.7
11.0
10.4
13.2
12.7
11.9
15.6
13.2
12.7
0.0
2.5
0.0
9.6
0.0
5.8
0.0
4.1
M1
787.4
790.7
832.5
M2
3057.0
3152.6
3354.3
SM. DENOM. NONTRANS.(M2 - M1)
2269.5
2362.0
2521.8
M3
3896.2
837.9
4082.2
929.6
4402.0
1047.7
654.4
280.0
725.8
761.7
11.4
321.0
15.5
8.4
6.0
10.9
303.3
172.7
25.9
197.3
24.0
214.4
24.0
15.6
13.7
-3.8
175.8
201.2
202.3
1.8
4.3
14.3
-7.4
9.3
14.5
4.9
5.8
8.7
0.0
0.6
3113.9
2115.2
287.6
711.1
3459.7
2367.3
311.2
781.2
3813.7
2619.8
333.4
14.1
9.1
11.1
10.2
12.3
14.2
13.8
12.6
860.5
16.0
8.5
9.9
10.1
11.1
12.0
11.2
11.2
11.0
1046.4
1170.4
1270.6
11.9
643.3
527.2
693.7
576.9
8.8
6.1
12.7
599.9
446.4
6.8
7.2
13.5
21.8
18.1
LG. DENOM. NONTRANS.(M3 - M2)
CONS. INSTAL. DEBT
AUTO LOANS
REVOLVING CREDIT
MOBIL HOME LOANS
OTHER CONS. CREDIT
MORTGAGE DEBT
SINGLE-FAMILY
MULTI-FAMILY
COMMERCIAL
SHORT-TERM BUS. BORROWING #
C • I LOANS
COMMERCIAL PAPER
7.3
8.3
A-ACTUAL; E-ESTIMATED; P-PRELIMINARY; R-REVISED
ABSOLUTE LEVELS IN BILLIONS OF DOLLARS UNLESS OTHERWISE NOTED
8 GNP LESS NET EXPORTS AND CHANGES IN BUSINESS INVENTORIES AND CCC INVENTORIES
# FINAL SALES LESS GOVERNMENT SPENDING
8.6
7.8
9.4
6.3
5.2
7.7
6.9
7.3
7.5
11.1
12.4
12.7
10.8
11.6
12.9
11.8
11.2
13.9
152
TABLE
3.1
SELECTED SHORT- TERM INTEREST RATES
FED
1-MO
3-MO EUROS
3-MO CDS
PRIME
FUNDS
CD
SEC
RATE
RATE
RATE
MARKET
JAN 1989
10.50
9.12
9.06
9.20
O/N
RES
ADJ
6-MO
9.57
9.36
8.93
CDS
EUROS
MARKET
9.30
RES
AOJ
6-MO
9.59
9.38
EUROS
1-MO
3-MO
CP
CP
RATE
8.93
9.03
9.04
9.48
3-MO
BAS
POOL
FEB 1989
10.93
9.36
9.33
9.51
9.89
9.71
9.16
9.63
9.93
9.80
9.27
9.29
9.37
9.77
MAR 1989
11.50
9.85
9.92
10.09
10.49
10.40
9.70
10.18
10.49
10.47
9.83
9.89
9.95
10.33
APR
MAY
JUN
JUL
AUG
SEP
OCT
989
989
989
989
989
989
11.50
9.84
9.81
9.94
10.33
10.13
9.69
10.05
10.36
10.23
9.68
9.77
9.81
10.22
11.50
9.81
9.61
9.59
9.97
9.60
9.66
9.64
9.94
9.63
9.35
9.58
9.47
9.97
11.07
9.53
9.35
9.20
9.57
9.09
9.47
9.28
9.57
9.15
8.97
9.34
9.11
9.61
10.75
9.12
8.92
8.80
9.16
8.60
9.20
8.88
9.15
8.80
8.55
8.92
8.65
9.20
10.37
8.65
8.65
8.62
8.97
8.70
8.65
8.70
8.97
8.78
8.50
8.50
8.55
8.92
10.25
8.65
8.55
8.65
9.00
8.73
8.53
8.74
9.01
8.82
8.49
8.52
8.55
8.94
989
10.37
8.76
8.65
8.75
9.11
8.82
8.64
8.85
9.12
8.91
8.59
8.62
8.65
9.05
9.00
989
DEC
989
10.96
9.55
9.39
9.50
9.88
9.52
9.41
9.62
9.92
9.62
9.32
9.35
9.37
9.83
6.97
QUARTERLY DAT/
01 1988
8.59
6.66
6.63
6.72
7.01
6.86
6.58
6.86
7.07
6.99
6.59
6.63
6.69
02 1988
8.78
7.16
7.08
7.22
7.53
7.45
7.04
7.36
7.58
7.55
7.10
7.09
7.18
7.49
04 1988
10.18
8.47
8.65
8.80
9.15
8.86
8.32
8.91
9.18
8.93
8.55
8.60
8.67
9.01
01 1989
10.98
9.44
9.44
9.60
9.98
9.82
9.26
9.70
10.00
9.88
9.34
9.40
9.45
9.86
02 1989
11.36
9.73
9.59
9.58
9.96
9.61
9.61
9.66
9.96
9,67
9.33
9.56
9.46
9.94
03 1989
10.46
8.81
8.71
8.69
9.04
8.68
8.79
8.77
9.04
8.80
8.51
8.65
8.58
9.02
04 1989
10.63
9.15
9.02
9.12
9.49
9.17
9.02
9.23
9.52
9.26
8.96
8.98
9.01
9.43
10.09
9.99
03 1988
01 1990
11.67
10.24
10.05
10.16
10.56
10.14
10.30
10.62
10.24
9.97
10.01
10.51
02 1990
12.40
10.86
10.62
10.75
11.16
10.68
10.69
10.91
11.25
10.80
10.53
10.55
10.57
11.12
03 1990
13.01
11.52
11.24
11.37
11.81
11.26
11.34
11.56
11.92
11.39
11.14
11.16
11.17
11.76
04 1990
13.35
11.78
11.49
11.62
12.07
11.49
11.59
11.82
12.19
11.63
11.38
11.39
11.40
12.02
1984
12.04
10.23
10.17
10.37
10.78
10.68
10.15
10.73
11.06
11.09
10.15
10.05
10.10
10.65
1985
9.93
8.10
7.97
8.05
8.38
8.25
8.03
8.29
8.54
8.54
7.92
7.94
7.95
8.35
1986
8.33
6.81
6.62
6.52
6.81
6.51
6.83
6.71
6.92
6.70
6.39
6.62
6.50
6.86
1957
8.20
6.66
6.74
6.86
7.16
7.00
6.50
7.06
7.28
7.20
6.74
6.73
6.81
7.05
1988
9.32
7.57
7.59
7.73
8.05
7.90
7.43
7.85
8.10
8.00
7.56
7.57
7.66
1989
10.86
9.28
9.19
9.25
9.62
9.32
9.17
9.34
9.63
9.40
9.04
9.15
9.13
9.56
1990
12.61
11.10
10.85
10.98
11.40
10.89
10.93
11.15
11.49
11.02
10.75
10.77
10.79
11.35
1991
8.77
9.18
10.64
8.90
8.78
8.88
9.24
8.95
1993
8.93
7.31
7.29
7.38
7.69
7.54
1994
9.51
7.90
7.85
7.94
8.27
10.17
8.55
8.46
8.55
8.90
9.05
9.33
9.10
8.70
8.70
8.71
6.73
7.04
7.26
7.27
6.75
6.75
6.76
7.15
8.07
7.22
7.80
7.53
8.11
7.76
8.36
7.71
8.24
7.22
7.77
7.22
7.77
7.22
7.77
7.62
8.20
8.64
8.44
8.70
8.97
8.79
8.37
8.39
8.40
8.84
1992
1995-99
MMB ECONOMICS GROUP
JULY 14, 1989
JULY BASED ON PARTIAL DATA
7.97
153
TABLE 3.2
SELECTED LONG-TERM INTEREST RATES
U.S. GOVERNMENT SECURITIES YIELD CURVE
OTHER INTEREST RATES
COUPON ISSUES
T-BILL DISCOUNT RATE
3-MO
6-MO
12-MO
JAN 1989
ONE
TWO
THREE
FIVE
SEVEN
YR
YR
YR
YR
YR
8.27
8.36
8.37
9.27
9.18
9.20
9.15
9.14
9.09
8.93
FEB 1989
8.53
8.55
8.55
9.49
9.37
9.32
9.27
9.23
9.17
9.01
MAR 1989
8.82
8.85
8.82
9.82
9.68
9.61
9.51
9.43
9.36
9.17
APR 1989
8.65
8.65
8.64
9.60
9.45
9.40
9.30
9.24
9.18
9.03
MAY 1989
8.43
8.41
8.31
9.20
9.02
8.98
8.91
8.88
8.86
8.83
JUN 1989
8.15
7.93
7.84
8.63
8.41
8.37
8.29
8.31
8.28
8.27
JUL 1989
7.76
7.55
7.25
7.93
7.75
7.80
7.82
7.90
8.00
8.05
AUG 1989
7.37
7.29
7.08
7.73
7.75
7.80
7.82
7.90
8.00
8.05
SEP 1989
7.25
7.17
6.97
7.60
7.62
7.68
7.76
7.85
7.90
OCT 1989
7.45
7.37
7.15
7.82
7.83
7.90
7.97
8.07
8.12
NOV 1989
7.86
7.75
7.51
8.24
8.26
8.32
8.40
8.49
8.54
DEC 1989
8.26
8.12
7.86
8.66
8.66
8.71
8.77
8.86
8.90
Q1 1988
5.72
6.03
6.34
6.86
7.36
7.58
7.91
8.23
8.42
8.63
02 1988
6.21
6.49
6.82
7.42
7.87
8.10
8.42
8.73
8.91
9.06
03 1988
7.01
7.27
7.45
8.17
8.46
8.59
8.76
8.97
9.10
9.17
04 1988
7.73
7.86
7.91
8.72
8.70
8.75
8.80
8.90
8.96
8.97
01 1989
8.54
8.59
8.58
9.53
9.41
9.38
9.31
9.27
9.21
9.04
02 1989
8.41
8.33
8.26
9.14
8.96
8.92
8.83
8.81
8.77
8.71
AUTO
FHLMC
NEW
MUNI
LOAN
COMMIT
AA
BOND
13.27
13.07
13.07
12.10
11.80
11.68
11.51
11.23
11.09
10.99
11.04
11.23
10.73
10.65
11.03
11.05
10.77
10.20
10.08
10.37
10.50
10.39
10.80
10.67
10.56
11.03
11.40
11.54
9.93
7.35
10.13
10.20
10.07
7.44
9.79
7.25
7.59
7.49
9.28
7.02
9.95
9.05
7.00
9.95
9.05
7.00
9.89
8.88
6.90
9.83
9.12
7.04
10.02
10.41
9.60
7.33
10.00
7.57
9.63
7.64
10.20
10.22
7.83
QUARTERLY DATA
02 1990
9.47
9.26
8.93
9.96
9.89
9.86
9.80
9.81
9.84
9.83
03 1990
10.02
9.78
9.42
10.56
10.43
10.35
10.25
10.22
10.21
10.16
04 1990
10.24
9.99
9.61
10.80
10.65
10.55
10.42
10.37
10.35
10.28
12.23
12.30
12.67
13.18
13.14
11.86
11.28
11.09
11.77
12.43
12.84
13.17
9.93
11.20
11.65
03 1989
7.46
7.34
7.10
7.76
7.71
7.75
7.77
7.85
7.95
8.00
04 1989
7.86
7.75
7.51
8.24
8.25
8.29
8.31
8.38
8.47
8.52
01 1990
8.91
8.73
8.44
9.35
9.32
9.33
9.30
9.34
9.40
9.41
7.74
9.93
7.51
10.09
7.46
9.71
7.25
9.93
8.99
6.97
10.09
11.06
11.66
12.02
12.27
9.57
7.31
7.91
8.19
8.41
8.49
11.89
12.24
12.40
14.62
13.87
13.51
10.11
7.48
7.65
7.81
8.60
9.27
12.44
10.62
12.39
1985
10.79
11.98
12.42
11.84
9.10
1986
5.98
6.03
6.08
6.57
6.87
7.06
7.31
7.55
7.68
7.80
9.44
10.18
9.36
7.32
1987
1984
9.52
9.76
5.78
6.03
6.32
6.85
7.41
7.67
7.94
8.22
8.38
8.58
10.73
10.21
9.72
7.64
1988
6.67
6.91
7.13
7.79
8.10
8.26
8.47
8.71
8.85
8.96
12.60
10.34
10.00
7.68
1989
8.07
8.00
7.86
8.67
8.58
8.59
8.56
8.58
8.60
8.57
11.84
10.37
9.59
7.25
1990
9.66
9.44
9.10
10.17
10.07
10.02
9.95
9.93
9.95
9.92
12.55
11.75
11.13
8.25
1991
7.97
7.82
7.54
8.58
8.64
8.67
8.75
8.86
8.91
12.12
10.92
10.01
7.57
1992
6.33
6.27
6.08
6.57
8.88
6.90
1993
6.72
6.65
6.45
6.99
7.45
7.61
7.72
7.89
8.06
8.18
10.80
9.88
9.20
7.09
1994
7.19
7.10
6.88
7.49
7.92
8.05
8.14
8.28
8.43
8.53
11.15
10.25
9.58
7.32
7.66
7.55
7.32
8.03
8.28
8.36
8.40
8.50
8.61
8.67
11.50
10.46
9.73
7.40
MMB ECONOMICS GROUP
JULY 14, 1989
JULY BASED ON PARTIAL DATA
8.29
7.06
7.24
7.37
7.56
7.76
7.89
10.55
9.58
154
ECONOMIC PERFORMANCE, INFLATION
AND MONETARY POLICY
TESTIMONY OF
MICKEY D. LEVY
CHIEF ECONOMIST
FIRST FIDELITY BANCORPORATION
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES
AUGUST 2,
1989
155
ECONOMIC PERFORMANCE, INFLATION AND MONETARY POLICY
Testimony of
Mickey D. Levy
Chief Economist
First Fidelity Bancorporation
Mr. Chairman and Members of the Committee, I am pleased to have this
opportunity to appear before you today and present my views on the outlook
for economic performance and inflation, and the crucial role monetary
policy plays in the economy, particularly at this critical juncture of the
cycle.
My comments will focus on four issues: 1) the outlook for the
economy, 2) the outlook for inflation, 3) implications for the federal
budget, and 4) monetary policy objectives and an appropriate course of
Federal Reserve action.
A brief summary of my views is:
° The rate of economic growth will continue to decelerate, and a
mild recession is a better than even chance.
I forecast real GNP
growth to average less than 1 percent through year-end 1990.
This
outlook, which is based on the anticipated slowdown of export
growth and the impact of the very tight monetary policy on domestic demand, is more pessimistic than projections of the Federal
Reserve, the Administration, or the Congressional Budget Office.
° Inflation has increased since 1986 in response to the rapid
acceleration in aggregate demand growth.
Restrictive monetary
policy has begun to slow growth, which should constrain
inflationary pressures.
Since the underlying rate of inflation
lags shifts in demand growth, inflation should remain approximately 5 percent in the second half of 1989.
Slower growth in
156
real and nominal GNP growth in 1989-1990 will push inflation below
4 percent by year-end 1990 and lower in 1991.
0
The federal budget deficit will remain far above official
projections as weak economic growth suppresses tax revenues,
eliminating any possibility of achieving the Gramm-Rudman-Hollings
(GRH) deficit targets of $100 billion in Fiscal Year 1990 and $64
billion in FY1991.
It is likely that actual and projected
economic performance will be sufficiently weak to prompt Congress
to vote to suspend the GRH sequestration process.
The debate
about an appropriate fiscal policy in a recessionary environment
is disappointingly absent.
ffhe Federal Reserve under Chairman Greenspan properly recognizes
that low inflation is a necessary condition for sustained maximum
economic growth, and in recent testimony has reaffirmed price
stability as its fundamental objective.
Contrary to the common
misperception, there is not a tradeoff between anti-inflation
efforts and long-run economic growth; they are complements.
0
The Fed has tightened monetary policy in pursuit of its
objectives.
However, the degree of monetary restrictiveness has
been excessive and, if sustained, may prove counterproductive.
On
a year-over-year basis, bank reserves are now declining at their
most rapid rate since 1960, the broader monetary aggregates are
either growing very slowly or declining, and the yield curve has
been inverted since January 1989.
The federal funds rate is a
misleading measure of monetary policy because it reflects demand
pressures associated with economic conditions as well as Federal
157
Reserve actions.
The recent modest decline in the funds rate
reflects primarily subsiding demand pressures, not monetary
easing, and will not reignite economic growth.
The Fed is urged to 1) immediately end the year-long trend of
declining bank reserves which, if sustained, would generate
continued declines in real money balances that would virtually
guarantee recession, and 2) continue to pursue its low inflation
objective even as economic growth weakens.
The anticipated
economic weakness is a transition cost of eliminating earlier
excesses and reducing inflation.
The Fed must avoid a dramatic
shift to overly expansive monetary policy, which would arrest the
disinflation process and create a fragile basis for economic
growth in the early 1990s.
Avoiding attempts to fine-tune the
real economy or to manage the U.S. dollar exchange rate, and
recognizing that monetary policy affects the economy and inflation
with a lag, will help dampen wide swings in monetary policy that
historically have generated undesired volatility in aggregate
demand growth and inflation.
158
I.
The Outlook for Economic Performance.
My assessment is that the economy is fragile, and real GNP growth is
slowing sharply.
Based on the Federal Reserve's tight monetary policy and
other long-run indicators of economic activity, I forecast real GNP growth
to average less than 1 percent through year-end 1990.
There is a better
than even chance of recession unfolding in the next year.
In response to
recent events, the Federal Reserve, the Administration, the Congressional
Budget Office (CBO), and the majority of private forecasters have lowered
their projections of real GNP growth.
My outlook for real GNP growth
remains more pessimistic than these other projections (See Table 1 ) .
Real Indicators of Economic Weakness.
The strong growth of real GNP
in 1987-1988 was driven primarily by two sources: a) accelerating exports,
which pushed up product demand and capacity utilization, and generated a
surge in capital spending, and b) stronger domestic demand in response to
the very stimulative monetary policy of 1985-1986 (See Chart 1 ) .
Those two sources of economic strength have faded, and a period of
sustained economic weakness is unfolding:
export growth has begun to slow,
and domestic demand growth is decelerating sharply in response to the
recent restrictive monetary policy.
Evidence of economic weakness is
mounting, and I see no factors that suggest a reacceleration of growth.
Export growth is forecast to slow sharply, from its 15.7 percent annualized growth from fourth quarter 1986 to second quarter 1989, to an
approximate 5 percent rate through year-end 1990 (See Chart 1 ) . This
slowdown is based on expected weaker demand for U.S. goods in response to
the appreciation in the U.S. dollar since its December 1987 trough and the
acceleration of price increases of U.S. exports, and tighter monetary
policy in other industrialized nations, including some of the largest
159
trading partners of the U.S. (Canada, Japan, and Germany), which should
slow their economic growth.
As growth of exports and product demand have slowed, capacity
utilization in U.S. manufacturing has begun to recede and business capital
spending has softened.
This trend should continue:
I forecast capital
spending to be nearly flat through year-end 1990, compared to its 8.1
percent growth rate since early 1987.
Growth of consumption and domestic demand has begun to slow sharply in
response to the Fed's tight monetary policy.
Real consumption grew at a
1.5 percent rate in the first half of 1989, compared to 3.8 percent from
fourth quarter 1987 to fourth quarter 1988.
Auto sales have been
particularly weak, forcing sizeable cutbacks in auto production.
Both
residential and nonresidential construction activity have been very
sluggish, reflecting the rise in interest rates, slack demand, and large
available stocks.
New housing starts have been in a declining trend, and
residential investment fell sharply in the first half of 1989.
Industrial output has begun to respond to the slowdown in product
demand.
The index of industrial production has flattened and capacity
utilization has declined from its January 1989 peak.
Durable goods orders
have declined, despite the sizeable increases in orders for civilian
aircraft.
Vendor deliveries, which measure the percentage of purchasing
agents who are experiencing slower deliveries, and the purchasing managers
index have fallen sharply from their June 1988 peaks (See Chart 2 ) . The
most recent reading of the purchasing managers index, 48.8 percent, is the
second consecutive month below 50 percent, suggesting that a rising
majority of respondents anticipate activity to decline.
160
Monetary Tightness and Economic Slowdown.
Monetary policy affects
economic activity with a lag, and domestic demand growth is just beginning
to respond to nearly two years of monetary restrictiveness.
Coupled with
slower export growth, the monetary-induced slowdown in domestic demand will
generate a prolonged period of economic weakness.
Some observers question whether monetary policy has been restrictive,
or whether sustained shifts in Fed policy and money supply affect significantly economic growth and inflation.
By almost any measure, monetary
policy has been and remains very restrictive, and the linkages between
money growth, aggregate demand, and inflation, are unmistakable.
Bank reserves are declining at their most rapid rate since 1960, and
growth of the monetary base (reserves plus currency) has slowed to its
lowest year-over-year growth rate since 1967 (See Chart 3 ) . Sharply slower
growth or declines in the broader measures of money, the inverted term
structure of interest rates, declining commodity prices (particularly
gold), and the stronger U.S. dollar, also reflect Fed tightness.
Two widely-followed monetary policy indicators that currently suggest
monetary tightness —
year-over-year change in real M2 and the spread
between the yield on the 30-year Treasury bond and the federal funds rate
—
when combined, have always provided accurate predictions of major shifts
in economic performance (See Chart 4 ) . Every recent recession has been
precipitated by a decline in real M2 and an inversion of the typical
relationship between these short and long-term interest rates.
situation is ominous:
The present
real M2 is declining on a year-over-year basis and
the yield spread is significantly negative for the first time since the
recessionary 1981-1982 period.
Domestic demand growth has begun to respond
to these tight monetary conditions.
In the early 1980s, financial deregulation and a downward shift in
161
inflationary expectations and interest rates caused a one-time shift in the
relationship between money, economic activity, and inflation.
This has led
some observers to argue that the relationship between money growth and
economic activity has permanently broken down.
In search of alternative
indicators of monetary influence, some contend that monetary policy is not
tight because the ratio of nonborrowed-to-required reserves (excluding
extended credit) is above the range normally associated with monetary
tightness.
This argument is invalid.
It is well documented that the ratio
of nonborrowed-to-required reserves is a function of interest rate spreads
and several other factors, and is not always a reliable proxy of monetary
tightness or easiness.
Moreover, the ratio, which has implied a net
borrowed position since late 1988, has been prevented from falling further
by the sharp declines in demand deposits (and their required reserves), not
an excess of reserves.
Another specious argument is that the buoyant stock market suggests
that monetary policy is not tight.
However, the inversion of the yield
curve and the decline in long-term interest rates associated with the
monetary tightness would lift rather than suppress stock prices.
In
addition, the stock market is influenced by factors other than monetary
policy, including actual and expected trends in the level and quality of
corporate profits.
The argument that large swings in money growth have little impact on
aggregate demand growth and inflation, implying a permanent and ongoing
shift in money velocity, is not supported by empirical evidence.
While
there is evidence confirming a one-time downward shift in money velocity in
the early 1980s, the relationship between money and domestic spending has
since stabilized.
One particularly misleading argument used to explain why
velocity is rising and unstable is that recent widespread use of debt
162
securitization increases the amount of credit to finance economic activity.
This argument is based on the misperception that repackaging and reselling
credit creates new credit, when in fact securitization merely redistributes
the ownership of credit, but does not create it.
By properly accounting for the difference between domestic spending
and domestic production, and the lags between monetary policy and economic
activity, money growth provides a powerful guideline to trends in nominal
domestic spending growth.
Even if one allowed that money velocity moves
around a wider range than earlier, the shift in annualized growth of
reserves and M2 from 16.A percent and 9.0 percent fourth quarter 1984 to
fourth quarter 1986 to -2.7 percent and 2.7 percent in the past year
clearly will generate wide swings in aggregate demand growth, economic
performance, and inflation.
Simply put, the recent swing in monetary
policy is too dramatic to ignore.
The dampening impact of the monetary tightening on domestic demand
will persist long after the Fed allows the federal funds rate to recede.
While the funds rate is a policy lever of the Fed, it also reflects demand
pressures associated with the rate and mix of economic growth.
Since early
1989, the shift toward economic weakness and slower capital spending growth
has implied subsiding demand pressures.
As the economic environment has
weakened, the Fed has drained reserves in order to prevent the funds rate
from falling.
Going forward, if the Fed only allows the funds rate to fall
to reflect the subsiding demand pressures associated with the economic
weakness, the Fed's actions will not represent a shift to stimulative
monetary policy that reignites economic growth.
Will economic growth merely slow down, or will the economy fall into
recession?
In official statements, the Federal Reserve envisions a
picture-perfect "soft landing."
While policymakers like to talk about a
163
soft landing, history suggests that they are very difficult to achieve, and
shifting from a period of above average growth to undesirably sluggish
activity is more common.
Concerning the soft landing versus recession debate, the issue is not
so clear-cut; soft landings are in the eyes of the beholder.
Based on the
leading indicators, particularly monetary conditions, there is better than
a 50 percent chance of a recession occurring.
However, any recession would
likely be mild, unlike the economic downturns of the early 1980s, for two
reasons:
1) except in the automobile industry, nonfarm business
inventories are very low, so that any fall-off in product demand would
require less of a correction in production, and 2) the Fed's sensitivity
about the potentially large adverse impact of a recession on the savings
and loan industry, LBO debt, LDC debt, and the federal budget deficit would
lead it to shift quickly toward a stimulative monetary policy.
This may
not prevent recession, but it may lessen its severity.
II.
The Outlook for Inflation.
The trend of rising inflation is ending.
I forecast the core rate of
inflation to be approximately 5 percent in the second half of 1989, slightly
below its first half rate, recede below 4 percent by year-end 1990, and fall
further in 1991 (See Chart 5 ) . My relative optimism stems from the Fed's
restrictive monetary policy, and the expected lagged impact of slower nominal
and real GNP growth on unit labor costs.
Rising inflation is initiated by
overly stimulative macroeconomic policies that generate excessive growth of
product demand relative to long-run output capacity, or economic policies or
other factors that suppress potential growth.
Monetary policy does not
affect long-run capacity, but does influence demand growth.
As Chairman
Greenspan stated in February 1989 and reaffirmed in his Humphrey-Hawkins
164
testimony, "Inflation cannot persist without a supporting expansion in
money and credit; conversely, price stability requires moderate growth in
money."
Persistent excess demand pushes up wages, unit labor costs, and
prices.
As a crude guideline, the core rate of inflation —
that is,
reported inflation excluding any temporary impacts on the general price
level of shifts in certain prices such as oil prices —
approaches the
difference between the longer-term trend of nominal GNP (product demand)
growth and the nation's capacity to grow.
The underlying rate of inflation
recedes in response to restrictive macroeconomic policies that slow demand
growth —
that is, reduce the gap between nominal GNP growth and potential
GNP growth.
A dramatic example of this inflation process began in the late 1970s,
when an overly expansive monetary policy generated nominal GNP growth of
nearly 12 percent.
Wage increases shot up to 10 percent in 1979-1980 and,
with declining productivity, increases in unit labor costs averaged 11
percent.
Reported inflation was temporarily boosted above this level by
the large jump in oil prices.
The severe monetary tightening of 1979-1982
generated a sharp deceleration of nominal GNP growth to 5.6 percent in
1982-1983, which induced a dramatic decline in the core rate of inflation.
Annual compensation increases fell to slightly above 4 percent from 1982 to
1986, and productivity gains helped generate lower increases in unit labor
costs and inflation through 1986.
The present, milder inflation cycle was initiated in the mid-1980s by
Testimonies of Alan Greenspan, Chairman, Board of Governors of the
Federal Reserve System, February 21, 1989 and July 20, 1989.
165
record-breaking money growth that contributed to the reacceleration in real
and nominal GNP growth.
The current monetary-induced economie slowdown,
which will persist during the remainder of 1989 and in 1990, will restrain
the recent acceleration of wages and unit labor costs, and eventually
generate lower inflation.
Historically, trends in unit labor costs have
lagged changes in real and nominal GNP growth.
Based on recent trends and
my projection of slower growth of real and nominal GNP growth through 1990
(nominal GNP is projected to grow approximately 6 percent from fourth
quarter 1988 to fourth quarter 1989 and 5 percent in 1990), unit labor cost
increases will remain approximately 5 percent through year-end 1989, and
then begin receding in early 1990.
By year-end 1990, they should decline
below 3.5 percent and slow further in 1991.
In 1987-1988, businesses incurred more rapid unit labor cost increases
as they allowed wage increases to rise faster than productivity gains, but
strong product demand enabled them to raise product prices more than
operating costs and widen profit margins.
As economic growth and product
demand have slowed, unit labor cost increases have accelerated, reflecting
a combination of lower productivity and wage momentum.
However, in 1989,
weaker demand has lessened the ability of businesses to raise product
prices, and profit margins have been squeezed.
declined so far in 1989.
Corporate profits have
As nominal growth softens further and margins
narrow more, increases in wages and unit labor costs will begin to recede.
This trend should begin in early 1990 and continue into 1991.
Consistent with this forecast of sharply slower economic growth and
eventually lower inflation, I project significant declines in short-term
interest rates through year-end 1990.
While the Federal Reserve influences
the timing of interest rate changes, in the longer term, rates reflect the
economic and inflation fundamentals.
Just as interest rates rose sharply
166
from early 1987 to early 1989 associated with strong economic performance,
rising investment share of GNP, and increasing inflation, I anticipate
short-term interest rates to ratchet down to approximately 6 3/4 percent by
year-end 1990 (See Chart 6 ) .
III.
Implications for the Federal Budget.
Based on this forecast of economic weakness, I project higher federal
budget deficits in Fiscal Years 1990 and 1991 than either the
Administration or the CBO (See Table 2 ) . The sharp slowdown in economic
growth will depress incomes and tax receipts below official current
services estimates.
Even though lower interest rates will reduce net
interest outlays, the Administration already assumes substantial interest
rate declines.
Accordingly, the rate declines will not improve its
current services budget outlook.
Net interest outlays will fall below
earlier CBO baseline projections because they assume smaller rate declines
than the Administration.
However, even if rates decline in line with the
Administration's forecast, the term structure of the U.S. Treasury's
publicly-held debt implies that the favorable impact on net interest
outlays will be gradual, while the impact of the weaker economic growth on
federal tax receipts will be immediate.
This economic weakness will eliminate any possibility of meeting the
Gramm-Rudman-Hollings (GRH) deficit targets of $100 billion in FY1990 and
2
Executive Office of the President, Building a Better America,
February 9, 1989, and Mid-Session Review of the 1990 Budget, July 18,
1989.
Congressional Budget Office, The Economic and Budget Outlook;
Fiscal Years 1990-1994, January 1989, and Statement of Robert D.
Reischauerj Director, Congressional Budget Office, July 20, 1989.
167
$64 billion in FY1991.
In its Mid-Session Review of the 1990 Budget, the
Administration projects deficits of $105.1 billion in FY1990 and $88.0
billion in FY1991, excluding asset sales.
unrealistic.
I consider these forecasts
The Administration's FY1990 deficit projection, which
represents a dramatic cut from FY1989, requires substantial further
deficit-cutting legislation and the seemingly inconsistent assumptions of
continued healthy economic growth and declining real interest rates.
Technical re-estimates by the CBO, based on its January 1989 economic
assumptions, project that the deficit will be $116.8 billion in FY1990 and
$138.1 billion in FY1991 if the costs of the Resolution Financing
Corporation (REFCORP) of the pending legislation to restructure the savings
and loan industry is placed off-budget (S.774), and $140.1 billion in
FY1990 and $150.9 billion in FY1991 if the costs of the REFCORP are
on-budget (H.R.1278).
If real GNP grows 1.7 percent from fourth quarter 1988 to fourth
quarter 1989 and slightly less than 1 percent in 1990, and interest rates
fall sharply in line with the Administration's projection, without
enactment of the Administration's proposed legislation, deficits excluding
the cost of REFCORP would be approximately $122 billion in FY1990 and $150
billion in FY1991.
Deficit projections would be higher if either REFCORP
is included on-budget or there is legislative slippage in the enactment of
the Administration's proposed fiscal policy changes.
There is a high probability that the GRH sequestration process will be
suspended by FY1991.
Under the amended GRH law, if either 1) real GNP
growth is below 1 percent for two consecutive quarters or 2) OMB or CBO
forecast recession, the House and Senate must vote on a joint resolution to
suspend sequestration.
Congress is likely to vote to suspend
168
sequestration.
If deficit projections for FY1991 rise anywhere close to
the levels I forecast, the percentage cuts to sequestered programs
necessary to meet the current GRH deficit targets would be sufficiently
large as to be undesirable economically and intolerable politically.
Presently, neither the Congress nor the Administration is considering
seriously what should be an appropriate fiscal policy during or when
emerging from recession or sharp economic slowdown.
To date, GRH has
provided a deterrent to rising deficit spending, but it has turned the
budget process into a bean-counting game, relying heavily on tax increases
(See Chart 7 ) . GRH T s porous sequestration process has generated a poorly
designed and skewed mix of spending restraints. It has steered attention
away from sorely needed structural changes in certain spending programs,
particularly some of the fastest growing outlay programs that are excluded
from sequestration.
In general, GRH eludes debate about the critical issue
of the optimal allocation of national resources.
Suspending GRH will only postpone addressing these important issues,
and the higher deficits associated with economic weakness may not be an
environment conducive to enacting a rational fiscal policy.
Merely "re-
benching" the GRH deficit targets and stretching-out the artificial deficit
reduction schedule would not constitute meaningful fiscal policy reform.
IV.
Monetary Policy Objectives and Policy.
The ultimate objective of the Federal Reserve and elected economic
policy makers is healthy long-run economic growth.
High and unpredictable
inflation is inconsistent with sustained economic growth because it reduces
economic efficiency, generates uncertainties about expected real rates of
return on investment that dampen capital spending, and induces
misallocations of productive resources.
A credible monetary policy aimed
169
at stable prices, on the other hand, reduces distortions in private
decision making and encourages longer planning horizons and capital
formation.
Low inflation is a necessary ingredient to maximizing long-run
economic growth and job creation.
Unfortunately, there is a widespread misperception that a policy of
anti-inflation implies anti-growth.
This notion has no conceptual basis,
is not supported by historical trends, and is misleading to policymakers
and the public.
The Federal Reserve recognizes that low inflation and
long-run economic growth are complements, and that monetary policy plays a
crucial role in achieving low inflation.
Federal Reserve Chairman
Greenspan began his recent Humphrey-Hawkins testimony by referencing this
"fundamental objective" of money policy:
"That objective remains to
maximize sustainable economic growth, which in turn requires the
achievement of price stability over time."
Chairman Greenspan has established the proper framework for achieving
these objectives:
from accelerating —
"Price stability —
indeed, even preventing inflation
requires that aggregate demand be in line with poten-
tial aggregate supply.
In the long run, that balance depends crucially on
monetary policy."
Historically, the Federal Reserve has not always followed a monetary
policy consistent with these stated objectives.
Bank reserves and money
supply have swung wildly from periods of very rapid growth to declines and
4
Testimony of Alan Greenspan, Chairman, Board of Governors of the
Federal Reserve System, July 20, 1989.
"1989 Monetary Policy Objectives," Testimony of Alan Greenspan,
Chairman, Board of Governors of the Federal Reserve System, February 21,
1989.
170
back again.
This has generated erratic trends in domestic spending growth
and, subsequently, inflation.
Every recent recession has been precipitated
by high and/or rising inflation and the Fed's belated and heavy-handed
monetary tightening in an effort to subdue inflation.
The sharp shift to
monetary restrictiveness beginning October 1979 and the jarring economic
downturns of the early 1980s were necessary costs of the earlier monetary
excesses that generated double-digit demand growth and inflation.
A key factor underlying the sustained economic expansion since late
1982 has been low inflation, which trended down through 1986.
The record-
breaking money growth of 1985-1986, associated with the efforts of the
Treasury to lower the U.S. dollar and the Fed to pump up the economy,
contributed to the 1987-1988 acceleration in demand growth.
The resulting
rise in inflation and the Fed's response to it now threaten this economic
expansion.
Less erratic monetary policy would improve economic
performance.
Sources of Monetary Policy Mistake?.
Such wide swings in money growth
and undesired fluctuations in economic performance have stemmed from the
tendency of the Fed to alter its desired economic outcomes and the policy
instruments it uses to achieve those goals.
occasionally falls into include:
Patterns that the Fed
(a) a general tendency to target short-
term interest rates rather than keep money growth within official target
bands, (b) an attempt to "fine-tune" the real economy, (c) the frequent,
apparent failure to take account of the lags between shifts in monetary
policy and impacts on the real economy and inflation, (d) an attempt to
adjust monetary policy to achieve a desired fiscal policy-monetary policy
mix, and (e) a willingness to use monetary policy to achieve the Treasury's
171
misplaced U.S. dollar management objectives.
The Fed's typical efforts to fine-tune have involved altering its
target for the federal funds rate in response to recently released economic
statistics and inflation conditions.
Since monetary policy works with a
lag, responding to current events cannot affect current economic or
inflation conditions.
Moreover, the linkage between the federal funds rate
and reserve growth varies, depending on demand conditions.
Many such
fine-tuning attempts, however well-intended, have tended to compound
mistakes and generate large swings in money growth whose lagged impacts on
domestic spending have exerted inflation pressures.
Using monetary policy
in an attempt to adjust the industrial mix of growth or.regional disparities in growth is a similarly inappropriate action that has contributed
to unintended consequences.
Attempts to adjust monetary policy in response to fiscal actions in
order to achieve a desired fiscal-monetary policy mix are misguided because
they assume incorrectly that monetary policy and fiscal policy are
substitutes for achieving the objectives of long-run economic growth and
stable prices.
This would require that a shift in fiscal policy would be
capable of generating a permanent shift in aggregate demand, while a shift
toward monetary stimulus would be capable of raising long-run output.
It
is generally recognized that excessively stimulative monetary policy raises
the long-run equilibrium price level, but does not raise long-run potential
output.
Fiscal policy alters the allocation of national resources between
the public and private sectors and influences long-run potential output by
altering incentives to consume, save, and invest, but does not generate a
permanent shift in aggregate demand.
Moreover, attempts to achieve a
desired policy mix require that monetary policymakers understand the
magnitude and timing of the impacts of fiscal policy on economic activity.
172
In light of the disarray of fiscal policy, the general lack of
standing about its impacts, and misperceptions about the substitutability
of fiscal and monetary policy, efforts to adjust monetary policy to fiscal
actions are counterproductive.
Managing the U.S. dollar exchange rate, either independently or in
coordination with foreign central banks, is a seductive course of action
that has been the source of recent monetary policy mistakes.
Such efforts
to manage the dollar involve a subjective judgment about the dollar's
"proper level."
This level or range, which is typically based on some
desired outcome (i.e., reduced trade deficit), may be either inappropriate
for the desired goal, or inconsistent with the level of the dollar
justified by international differences in economic growth, fiscal and
regulatory policy, and expected rates of return on assets denominated in
various currencies.
Sterilized intervention into exchange markets (that
is, intervention matched by offsetting domestic operations) cannot
influence the long-run trend in the dollar.
alter the dollar's value —
Unsterilized intervention does
through changing domestic interest rates and
money supply, which alter expected rates of return on dollar denominated
assets relative to assets denominated in other currencies —
but it does so
through a monetary policy that is inconsistent with domestic demand and
inflation objectives.
Quite simply, despite the allure of managing the
U.S. dollar, common sense suggests that a single policy instrument (i.e.,
monetary policy) by itself is not capable of achieving simultaneously two
conflicting performance outcomes, i.e., desired levels for the dollar and
domestic inflation.
Unfortunately, these obvious limitations have not deterred attempts to
manage the dollar.
For example, the "lower-the-dollar" monetary policy of
mid-1984 to year-end 1986 required steep declines in short-term interest
173
rates and overly excessive money growth.
The Fed abruptly shifted policy
in early 1987 when the U.S. Treasury decided (subjectively) that the dollar
had fallen sufficiently, and further declines would be "damaging."
Un-
sterilized intervention into foreign exchange markets to achieve the new
dollar range agreed upon by the U.S. Treasury and other central banks (the
Louvre Accord, February 1987) required sharply higher interest rates and a
dramatic slowdown in reserve and money growth.
The three month moving
average of bank reserve growth fell from 28 percent in December 1986 to
minus 10.2 percent in June 1989.
Such abrupt shifts in monetary policy not
only fail to achieve desired international objectives, but they generate
undesired large shifts in financial markets conditions, domestic spending
and, with a lag, inflation.
"P-Star" as a Potential Framework for Monetary Policy.
In an effort
to create a monetary policy framework that would avoid mistakes that
previously have led to accelerating inflation, a recent highly publicized
Federal Reserve Board staff study initiated by Chairman Greenspan develops
an equation of the equilibrium price level.
The long-run equilibrium
price level (P ) is determined as M2 times the average long-run velocity of
M2 (V ) divided by potential output (Q ) .
The actual price level (P )
Jeffrey J. Hallman, Richard D. Porter, and David H. Small, "M2 Per
Unit of Potential GNP as an Anchor for the Price Level", Board of
Governors of the Federal Reserve System, April 1989.
7
*
*
*
This equation, P =(M2-V )/Q , is simply a modification of the
classical Quantity Theory of Money, MV=PQ or P=(MV)/Q, using the
long-run price equilibrium Jnstead of the current price level of P; the
average long-run velocity V instead of current velocity V^ and the
Federal Reserve's estimate of long-run potential output (Q ) rather than
current output Q.
174
trends around P , so that inflation (the rate of change of P ) is a
£
function of the gap between P
A
and P .
The model tracks inflationary
developments relatively well over the periods tested.
This model involves potentially useful characteristics as a policy
guideline, but may lead to some of the same mistakes committed in the past.
As a modified Quantity Theory of Money, the equation reinforces long-term
objectives by focusing on M2 as a policy instrument and nominal GNP as a
policy guideline.
However, its effectiveness depends on more detailed
operational procedures not provided in the study.
Although the authors of
the study carefully qualified the model's operational limitations, the way
in which it would be implemented has been misconstrued by many observers.
The model leaves open the issue of the perceived optimal equilibrium
price level and inflation, and it does not preclude the traditional Fed
practice of short-term fine-tuning.
It does not consider the issue of the
lags between monetary policy, economic activity and inflation.
address the Fed's ability to control M2 growth.
It does not
Crucially, it does not
suggest a policy procedure when actual velocity deviates from its long-run
trend line, an opportunity some policymakers would consider prime-time for
"leaning against the wind."
Nor does it prevent the Fed from altering
policy in response to a shift in aggregate supply that involves a change jn
potential output (Q ) . These gaps leave open the potential for traditional
monetary policy mistakes.
Despite these potential pitfalls of the "P-Star" model, such efforts
to construct a monetary policy framework consistent with the Federal
Reserve's long-run objectives are constructive and should be encouraged.
Recommendations for Monetary Policy.
The Fed provided liquidity to
financial markets following the October 1987 stock market collapse, but in
175
response to strong economic growth and rising inflation, it has pursued a
decidedly restrictive monetary policy since early 1988.
Fed's pursuit of low inflation.
I support the
However, monetary policy and this economic
expansion are now at a critical juncture, and I have several suggestions
for an appropriate course of Federal Reserve action.
First, the Fed must take immediate steps to prevent further declines
in bank reserves and money stock.
If sustained, declines in reserves and
money will virtually guarantee recession.
Bank reserves declined 3.7
percent from June 1988 to June 1989, their most rapid year-over-year
decline since April 1960.
Associated, the monetary base (reserves plus
currency), Ml, and M2 have all declined since last year in inflationadjusted terms.
Although technical factors may have contributed to the
steepness of the declines* in Ml and M2 in Spring 1989 and their recent
bounce-back, continued declines in bank reserves are inconsistent with
keeping M2 within its targeted growth band.
Preventing reserves from declining further will require a reduction in
the federal funds rate.
Many observers and policymakers would associate a
decline in the funds rate as a monetary easing and "backing-off" in the
Fed's fight against inflation.
This is a misperception that has led to
major policy mistakes in the past.
While the federal funds rate is a
policy lever of the Federal Reserve, it is also a market rate that is
affected by changing demand pressures associated with the rate and mix of
economic growth.
It is very difficult to distinguish between a change in
the funds rate due to changing market conditions and a change due to an
effective easing or tightening of monetary policy.
Consequently, short-
term interest rates are not an accurate measure of monetary stimulus or
tightness, and should not be the primary targetted policy instrument of the
176
Federal Reserve.
In contrast, growth of bank reserves and money supply,
which are determined directly by the Fed, are more reliable indicators of
the posture of monetary policy, and are more efficient measures for targetting policy.
This has proved particularly true when economic
performance shifts gears.
As an example, in 1987 and the first half of 1988, the federal funds
rate rose due to the strong economic growth and rising investment share of
GNP, as well as a monetary tightening.
Since then, economic performance
has weakened, and demand pressures on short-term rates have subsided.
Consequently, pegging the funds rate at 9 3/4 percent from late-February to
early-June required continually draining bank reserves, effectively a
further monetary tightening.
Although the Fed has allowed the funds rate
to recede modestly since then, further declines in reserves suggest that
monetary policy remains restrictive.
Presently, targetting the funds rate
while only paying lip service to trends in reserves and money could
inadvertently trigger an economic downturn.
Preventing a further decline in reserves by allowing the funds rate to
recede to reflect subsiding demand pressures would not interrupt the Fed's
fight against inflation, and is necessary to avoid a jarring, counterproductive downturn in economic activity.
Announcing the reasons for this
course of action would help avoid the public's misperception about the
Fed's intent.
Second, when economic growth decelerates below the Fed's projection
range, or turns slightly negative, the Fed must avoid overreacting by
swinging monetary policy too far the other way and becoming overly
expansive.
A period of sluggish economic activity is a transition cost of
eliminating earlier monetary excesses and higher inflation.
The Fed has
recently lowered its "central tendency" projection of real GNP growth in
177
1990 to l%-2 percent.
This may signal a willingness of the Fed to accept
this lower growth, and not allow it to sidetrack the pursuit of low
inflation.
This interpretation, however, may be too charitable.
First,
the Fed's central tendency projection of 4^-5 percent inflation for 1990 is
too pessimistic.
The Fed's projection of lower real growth and no change
in the targetted bands for money growth may imply the Fed's acceptance of
too high a level of inflation.
Moreover, if real growth is decidedly weaker than the Fed's projected
range, as I anticipate, the Fed may succumb to its traditional mistake of
shifting to excessive monetary stimulus.
This would not avoid current
economic weakness, but would only interrupt the disinflationary process and
establish an undesirably high floor for the underlying rate of inflation.
This would mean that we would incur weak economic activity without any
compensating reduction in long-term inflation.
Moreover, this would create
a fragile environment for economic growth in the early 1990s.
The Fed's
recent disinflationary policy has generated significant credibility, as
evidenced by the decline in long-term bond yields and the inversion of the
yield curve.
Shifting back to overly expansive monetary policy would
destroy that credibility, which would increase the costs of future
disinflationary monetary policy.
Excessively restrictive monetary policy increases the probability of
shifting to overly stimulative monetary policy.
This is not a necessary
policy outcome, but Chairman Greenspan's recent Humphrey-Hawkins testimony
last week, which recognizes inflation as a lower risk and places a greater
focus on preventing recession, leaves open the possibility of this
occurring.
The Fed must avoid the temptation of responding to current
events that tends to compound mistakes and lead to economically
distabilizing swings in monetary policy.
Instead, it must keep reserves
178
and money growth within bands consistent with longer-term objectives.
The direction of monetary policy is now particularly important because
it will determine not only the extent and duration of economic weakness,
but it will have a profound impact on how much inflation is reduced and the
economic environment of the early 1990s.
Sustained maximum long-run
economic growth requires a prudent course of monetary policy that
suppresses inflation.
Congress should encourage the Federal Reserve to
continue to pursue these long-term objectives.
CHARTS AND TABLES SUPPLEMENTING THE TESTIMONY OF
MICKEY D. LEVY
CHIEF ECONOMIST
FIRST FIDELITY BANCORPORATION
BEFORE THE
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES
AUGUST 2, 198 9
Table 1
COMPARISON OF REAL GNP PROJECTIONS
(% Change, Fourth Quarter to Fourth Quarter)
1_989
1990
a/
Administration-
2.7
2.6
Federal Reserve -1
2-2*$
1^-2
CBO -
2. A
2.0
First Fidelity Bancorporation
1.7
0.9
Blue Chip - '
2.6
1.5
SOURCES:
a/
—
Executive Office of the President, Mid-Session Review of
the 1990 Budget, July 18, 1989.
—
Testimony of Alan Greenspan, Ch<
Chairman, Board of Governors
of the Federal Reserve System, July 20, 1989.
c/
Testimony of
of Robert
Robert D.
D. Reischauer,
Reisch
—
Testimony
Director, Congressional
Budget Office, July 20, 1989
-
Blue Chip Economic Indicators, July 10, 1989.
H-»
CHART 1
THE STRONG ECONOMIC GROWTH
IN 1987-1988 WAS HIGHLIGHTED
BY BOOMING EXPORTS AND
EXPANDED BUSINESS INVESTMENT. REAL GNP GROWTH IS
FORECAST TO SLOW DRAMATICALLY,
AS EXPORT DEMAND AND CAPITAL
SPENDING MODERATE, AND CONSUMPTION FLATTENS.
REAL
I
f
I
'
I l l l l I1
EXRORT
Illll.
I1
GROWTH
...nllllllll Illi.
THE RECENT SLOWDOWN IN EXPORT
GROWTH SHOULD CONTINUE. THE
U.S. DOLLAR HAS APPRECIATED,
PRICES OF U.S. EXPORTS HAVE
ACCELERATED, AND TIGHTER
MONETARY POLICY IN MAJOR
TRADING NATIONS SHOULD
SLOW THE DEMAND FOR U.S.
PRODUCTS.
CONSUMPTION GROWTH HAS
WEAKENED IN RESPONSE TO
TIGHT MONETARY POLICY.
NUMEROUS ECONOMIC
INDICATIONS SUGGEST
THAT THIS TREND
SHOULD CONTINUE.
00
CHART 2
INDICATORS OF INDUSTRIAL OUTPUT
VENDOR
DELIVERIES
NUMEROUS LEADING ECONOMIC
INDICATORS SUGGEST THAT
ECONOMIC ACTIVITY IS
SLOWING DRAMATICALLY.
VENDOR DELIVERIES, WHICH
MEASURE THE PERCENTAGE OF
PURCHASING AGENTS WHO ARE
EXPERIENCING SLOWER DELIVERIES, HAVE FALLEN SHARPLY
FROM THEIR JUNE 1988 PEAK.
PURCHASING
MANAGER'S
INDEX
THE PURCHASING MANAGERS
INDEX HAS FALLEN BELOW
5 0 PERCENT FOR THE FIRST
TIME SINCE MID-1986.
INDEX
OR INDUSTRIAL
PRODUCTION
THE INDEX OF INDUSTRIAL
PRODUCTION HAS FLATTENED
OUT.
00
to
CHART 3
CHANGE IN BANK RESERVES
69
74
79
YEAR-OVER-YEAR CHANGES IN BANK RESERVES ARE DECLINING AT
THEIR MOST RAPID RATE SINCE 19 60, A DRAMATIC REVERSAL
FROM THEIR EXPLOSIVE GROWTH IN 1986. IF THESE DECLINES
CONTINUE, A RECESSION IS VIRTUALLY GUARANTEED.
CHART li
MONETARY POLICY INDICATORS OF- DOMESTIC DEMAND GROWTH
YEAR OVER YEAR
TZ, CHANGE
IN REAL M
REAL (INFLATION-ADJUSTED)
M2 HAS BEEN DECLINING
YEAR-OVER-YEAR SINCE
LATE 198 8.
THE SPREAD BETWEEN THE
LONG-TERM TREASURY BOND
YIELD Aim THE FEDERAL FUNDS
RATE HAS INVERTED FOR THE
FIRST TIME SINCE THE 1981-1982
RECESSION.
A DECLINE IN REAL M2 AND AN
INVERSION OF THE SPREAD HAS
PRECEDED EVERY RECENT RECESSION!
THESE INDICATORS OF
MONETARY POLICY, WHEN
COMBINED, HAVE ALWAYS
PROVIDED AN ACCURATE
PREDICATION OF MAJOR
ECONOMIC SHIFTS. THEY
NOW POINT TOWARD SHARPLY
SLOWER DOMESTIC DOWNWARD
GROWTH.
(REOUalONS
BHAOID)
CHART 5
INFLATION AND UNIT LABOR COSTS
(With Forecast for 89Q2-91Q1)
I
A
1
A\
-
o -
/
a -
K
7 -
L/\ /
/ V
-
6 -
4
1
1
1
\A
/ w
9 -
5
I
1
1
1
1
\ A
1
\\
\
00
3 -
\
\
2 1 -
^^
en
V
•
i
0 -
Unit Labor Cost*
GNP Deflator
UNIT LABOR COST INCREASES AND INFLATION REMAINED LOW
DURING MUCH OF THIS ECONOMIC EXPANSION, BUT THEY HAVE
RISEN SINCE 1987, AND ARE NOW ABOVE DESIRED RANGES.
INFLATION IS FORECAST TO RECEDE IN RESPONSE TO THE
SLOWDOWN IN DEMAND GROWTH.
CHART 6
SELECTED INTEREST RATES
INTEREST RATES ROSE IN
THE 1960s-1970s, BUT
HAVE RATCHETED DOWNWARD
SINCE THE EARLY 198 0s.
RATES ARE FORECAST TO
DECLINE FURTHER IN 198 9
AND 1990.
SELECTED
INFLATION
ADJUSTED
RAT
REAL (INFLATION-ADJUSTED)
RATES HAVE DECLINED FROM
EARLIER PEAKS BUT REMAIN
SUBSTANIALLY ABOVE
HISTORICAL AVERAGES.
REAL
INTEREST
RATES
AND
G N F»
GROWTH
REAL INTEREST RATES TEND TO
RISE AND FALL TO REFLECT
REAL ECONOMIC GROWTH.
CHART 7
FEDERAL SPENDING AND TAXES
(AS A PERCENTAGE OF GNP)
00
SINCE THE 196 0s, FEDERAL TAX RECEIPTS HAVE REMAINED
APPROXIMATELY 19 PERCENT OF GNP, WHILE THE FEDERAL
SPENDING SHARE OF GNP HAS RISEN SUBSTANIALLY.
DEFICIT PROJECTIONS and GRAMM-RUDMAN-HOLLINGS TARGETS
(In Billions of Dollars)
1989 est.
Administration —
Fiscal Years
H90
1991
148 .3
105 .1
88. 0
150 .0
116 .8
138. 1
CBO February 1989 Baseline -
155
141
140
First Fidelity Bancorporation
150
122
150
Gramm-Rudman-Hollings Targets
136
100
64
c/
CBO Technical Re-estimate —
NOTES:
—
Budget projections exclude asset sales and costs of
Resolution Financing Corporation in the pending savings
and loan rescue bill.
—
Executive Office of the President, Mid-Session Review of
the 1990 Budget, July 18, 1989.
c/
—
Testimony of Robert D. Reischc
Testimony of Robert D. Reischauer, Director, Congressional
Budget Office, July 20, 1989.
Congressional Budget Office, 1The Economic and Budget
Outlook: Fiscal Years 1990-1994, January 1989.
188
Table 2
189
THE FEDERAL BUDGET DEFICIT:
WHAT SHOULD BE DONE AND POLITICALLY REALISTIC TAX OPTIONS
FOR THE NEXT ADMINISTRATION
BY
ALBERT E. DEPRINCE, JR
CHIEF ECONOMIST
MARINE MIDLAND BANK
PRESENTED TO
THE BUSINESS OUTLOOK CONFERENCE
THE CONFERENCE BOARD OF CANADA
TORONTO, CANADA
OCTOBER 12, 1988
The views expressed are those of the author and do not
necessarily reflect those of either Marine Midland Bank or
the Conference Board of Canada
190
THE FEDERAL BUDGET DEFICIT:
WHAT SHOULD BE DONE AND POLITICALLY REALISTIC OPTIONS
FOR THE NEXT ADMINISTRATION
The U.S. Federal budget deficit and policy choices to narrow
it are once again in the news. Four reasons account for the
renewed interest in our budget deficit. First, the new
fiscal year began a few days ago, and we missed spending
sequestration under the Gramm-Rudman-Hollings (GRH) targets
by the narrowest of margins. Second, the National Economic
Commission will soon issue its preliminary report on the
subject. Third, both Presidential candidates are bemoaning
the deficit, but have gone out of their way to avoid making
concrete suggestions to deal with its enormity. Finally,
the sheer size of our deficit remains, in the minds of most,
the prime engine of our massive trade imbalance.
Acceptance of draconian solutions to the deficit depend, of
course, on the public's recognition of the seriousness of
the problem. Before GRH was passed in 1985, deficit
projections associated with current service Revels were
headed straight up; a revenue shortfall in* excess of $300
billion was seen for the early 1990's. The budget process
was deemed out of control, and a fixed and binding formula
was viewed as the only way to begin to turn the tide.
Effects were dramatic; in August 1988, the Congressional
Budget Office (CBO) estimated FY 1988's deficit at $155
billion; four years ago, CBO projected a deficit of $254
billion for FY 1988. Whether the success was due to the
discipline of GRH or unexpectedly big revenue flows from the
Social Security Act amendments (passed in 1983) is debated
in some circles. Despite the debate, the situation is
clearly better now than four years ago.
Nevertheless, the deficit is still large by pre-1980 standards; in FY 1988, it was equal to 3.2% of GNP compared with
a 1.7% share in the 1970's. More importantly, its sheer
size remains at the core of discussions on global imbalances, and foreign critics maintain that the solution to
those imbalances is tied to the resolution of our own budget
imbalance. •
Finally, the political process has come to recognize the
enormity of the interest burden of accumulated past and
projected deficits as an incredibly heavy mortgage on future
generations. The servicing of that debt burden could
threaten future U.S. living standards as more and more of
the deficit is owned by foreigners.
191
Whether those forces are enough to move Congress and the
next administration decisively remains to be seen. I
personally do not feel they are awesome enough to force the
political process to move toward a balanced budget.
THE SCOPE OF THE PROBLEM
Before options can be considered, the scope of the problem
needs to be laid out; after that, realistic objectives can
be specified. Those parameters define the scope of
politically acceptable spending cuts or tax increases.
The CBO estimates successive declines in the deficit in the
years ahead. From $155 billion for FY 1988, the deficit is
expected to slip to $148 billion next year and to drift down
to $121 billion by FY 1993. This compares with a GRH
objective of $144 billion for FY 1988 and a balanced budget
for FY 1993.
While the direction is right, the improvement owes much to
the growing annual surplus in trust funds in general and the
Social Security trust fund in particular. For example, the
social security surplus for FY 1988 was $39 billion; it is
expected to climb to $99 billion in FY 1993. Without that
increase, the FY 1993 deficit projection would be at a more
threatening $181 billion.
The social security trust funds should continue to provide a
growing cushion through the year 2010, though the rate of
increase will likely be slower during the 1990's than in the
late 1980's. Beyond 2010, the retirement of the first of
the baby boom generation will begin to nip away at the
surplus; by the year 2015, social security should be running
in a yearly deficit. While a remote date, the effects of
the graying of the baby boom generation stand as a stark
warning of an even more serious budget crisis looming ahead.
As a result, we had best get on with meeting the current
challenge.
THE OPTIMAL OBJECTIVE: A ZERO FEDERAL BUDGET DEFICIT OR
SIMPLY A PROGRESSIVELY NARROWER DEFICIT?
GRH seeks a balanced budget over a fixed time schedule,
though in reality the schedule has been far from fixed. The
original legislation (passed in 1985) set a zero budget
deficit objective for 1991 by narrowing the deficit by $35
billion a year. Only two years later, the interim objective
was violated by such a wide margin that the schedule was
recast—1993 became the zero deficit target point.
The new law also seeks to narrow the deficit by $35 billion
a year, with FY 1993 the year in which a balanced budget is
192
to be achieved. Under the new legislation, it is the Office
of Management and Budget's (OMB) assessment which determines
whether sequestration will be triggered. For FY 1989, the
objective is $136 billion plus a $10 billion margin for
error. OMB's August 1988 estimate placed the FY 1989
deficit at $144 billion, just within the $146 billion target
but beneath CBO's $148 billion CBO estimate. The difference
between the two rests with the economic assumptions for
1989.
Most analysts have concluded that the CBO's estimates are
the more realistic. In addition, legislation passed since
the OMB estimate will almost certainly breech the GRH limit
even with OMB's more optimistic assumptions. When the
probable budget consequences of FSLIC's restructuring of the
S&L industry are fully captured, the deficit will be even
higher. Thus, a $165 billion deficit might be a more
realistic estimate for FY 1989, but even that may not fully
reflect the FSLIC effects.
Should that outcome materialize for 1989, it will likely
have spill-over effects on the FY 1990 deficit. Even
barring a contamination of FY 1990's deficit from FY 1989's
problems, it is most unlikely that the political process
will be able to devise spending cuts or tax increases to hit
the FY 1990 objective of $100 billion, even after adding the
$10 billion margin for error.
As a result, by next April, Congress will probably be forced
to consider GRH-III. Factors blamed for the problem would
be the budget consequences of events viewed as beyond the
control of Congress, e.g. (1) the S&L restructuring, (2) the
impact of the farm drought, (3) net interest expense, and
(4) the fixed formula driving entitlements.
In sum, Congress is not seriously considering a balanced
budget in 1993. Instead, it is using the external
discipline of the GRH timetable to keep a lid on the deficit
and make it smaller in successive years; however, even that
is laudable.
A review of the deficit reduction proposals of both Messrs.
Bush and Dukakis (discussed later) bear this out. Conceptually, both are able to produce close to a zero deficit in
1993, but only with the help of some drastic assumptions.
Based on what details can be gleaned from their public
statements, neither approach would seem to have a wide
political constituency in Congress.
Of the two, Mr. Bush has revealed the cleanest plan, which
calls for a "flexible freeze", line item veto power for the
President, and the balanced budget amendment. Unfortunately, as will be shown later, because the flexible freeze
moves the budget dramatically toward balance, it will
193
severely crimp spending and probably win few constituents in
Congress today. Moreover, the line item veto and the
balanced budget amendment are not realistic political
options today. Here, the experience of states with line
item veto power shows that it is most effective in negotiating and/or controlling the mix of spending and has very
little to do with controlling the level of spending.
While both see the deficit as one of the principle dangers
to the nation, the avoidance of specifics on a cure leads me
to conclude that neither candidate envisions actually
closing the gap. Rather their preference appears to be
simply to assure that (1) at best, the deficits shrink at a
pace that balances the political hostility toward higher
taxes and the public's demand for current programs or (2) at
worst, the deficits do not become any larger in absolute
terms going forward.
THE OPTIONS
There are no shortages of options to narrow the deficit. In
its March 1988 report (Reducing the Deficit: Spending and
Revenue Options), the CBO summarized 105 different spending
cuts and 25 different tax increases. These will likely
serve as the point of departure for the National Economic
Commission's deliberations.
The tax increases are separated into four different
categories.
Increasing Tax Rates
Raise marginal tax rates for individuals and
corporations or impose a surtax on existing schedules
Amend or repeal indexing of income tax schedules
Increase alternative minimum tax
Broaden the Tax Base
Reduce tax credits for rehabilitation of older
buildings
Tax investment income from life insurance products
Tax credit unions like other thrift institutions
Repeal tax preferences for extractive industries
Eliminate private-purpose tax-exempt bonds
194
Further restrict deductions for business meals and
enterta inraent
Tax capital gains at death
Tax 30 percent of capital gains from home sales
Decrease limits in contributions to qualified pensions
and profit-sharing plans
Phase out child and dependent-care credit
Limit mortgage interest deductions
Eliminate or limit deductibility of state and local
taxes
Increase taxation of social security and railroad
retirement benefits
Tax the income-replacement portion of workers'
compensation and black lung benefits
Tax nonretirement fringe benefits
Raise Payroll Taxes
Expand Social Security coverage
Repeal the Medicare taxable maximum
Index the unemployment insurance taxable wage base
Taxes on Consumption
Impose a value-added or national sales tax
Increase energy taxes
Increase excise taxes
Impose pollution charges
ASSESSMENT OF THE CANDIDATES VIEWS
Taxes, however, seem to be the scourge of this Presidential
campaign. Both candidates have gone out of their way to
avoid mention of which taxes they would find acceptable.
Nevertheless, preferences can be surmised from their
respective political philosophies.
Mr. Bush has expressed clear vocal opposition to tax
increases as a means of dealing with the deficit. He even
195
went so far as to sign a pledge to that effect during the
primary campaign. However, his advisors are less committed
to this notion than he; in fact some may recall that Martin
Feldstein broke with the Reagan Administration several years
ago over the issue of tax increases to deal with the
burgeoning budget deficit.
While vocally opposed to tax increases, it is not clear how
deep his commitment runs. Few commentators seem to remember
that eight years ago, it was George Bush who was the most
middle-of-the-road candidate in the Republican primary
campaign, and many political analysts were surprised when he
was chosen as Mr. Reagan's running mate. As a result, Mr.
Bush's policy orientation at that time suggests that he
might find certain tax increases acceptable now, if they
could be camouflaged as something politically palatable and
leave the 1986 marginal tax rates intact.
Taking all this into account, it is likely that (1) Mr. Bush
will be counseled to accept a tax increase if it has bipartisan support, i.e, it is the recommendation of the
National Economic Commission and (2) Mr. Bush would probably
follow that advice if the proposal were truly bi-partisan
and leaves the marginal tax rates unaffected.
In the meantime, his main line of attack on the deficit lies
with the flexible freeze. That freeze will hold the line on
spending growth to the annual inflation rate and allow the
President (and Congress) to sort out priorities.
Mr. Bush sees economic growth, along with lower interest
rates, as necessary elements of any deficit reduction
package. However, his philosophy is one of creating an
environment for growth, not actively managing a governmentbusiness- labor partnership to achieve growth. Mr. Bush's
emphasis on preserving the tax neutrality achieved through
the 1986 tax reform stems from this foundation. His view is
that growth will follow, if the environment is conducive,
and he points to the successes of the last eight years in
term of growth and jobs.
Mr. Dukakis, on the other hand, appears both in terms of
philosophy and personality more of an interventionist in the
day-to-day affairs of the economy. Just as Mr. Bush takes
credit for the spectacular and consistently strong growth in
this expansion, Mr. Dukakis takes credit for the extraordinary performance of the Massachusetts economy in recent
years. He views Massachusetts' success, however, as due to
his efforts to manage the economic scene through active
intervention. Because he wants to manage growth, he puts a
more eloquent emphasis on growth in his campaign than does
Mr. Bush.
196
Finally, as with Mr. Dukakis, Mr. Bush wants better IRS
enforcement, but the latter has not put a dollar magnitude
on the amount that might be recovered nor does it form a
cornerstone of his deficit reduction package. Neither has
offered cost estimates for the stricter enforcement; this is
a bit surprising in the case of Mr. Dukakis, since the
magnitude to be collected ($90 billion over five years) is
so big.
While both candidates have avoided the "T" word, opinions
are nonetheless forming on tax increases that are likely to
be acceptable to each. A survey of 50 prominent financial
economists (reported in the The Blue Chip Financial
Forecasts, September 1, 1988) conducted in late August
revealed the following actions likely-in a Bush
Administration in addition to the flexible freeze:
Higher excise taxes, particularly sin taxes
Higher federal gasoline tax
Higher user fees
Imposition of oil import fee
Reduced growth in defense spending
Cuts in non-means tested entitlement programs
Other: capital gains tax cut; farm subsidies cut.
Either singularly or collectively, the revenue gains from
these tax measures are not significant enough to close the
deficit by 1993. As a result, they would probably be
considered (1) in conjunction with the flexible freeze to
meet a balanced budget objective or (2) more acceptable than
increases in the personal tax rates to meet the "revised"
GRH deficit objective for FY 1990 and to finance new
spending programs promised during the campaign.
Mr. Dukakis is less hostile toward tax increases than Mr.
Bush. However, he has stopped short of endorsement of tax
increases to stem the budget's red ink, arguing instead that
tax increases should be only "a last resort." Despite this
disclaimer, opinions are drawing up on likely tax increases
under a Dukakis Administration. Among the tax choices, the
same 50 Blue Chip analysts considered the following likely
choices under a Dukakis Administration:
Personal tax increases—higher marginal tax rate for
middle and upper incomes
Higher effective corporate tax rates
Impose an oil import fee
Higher federal gasoline tax
VAT—on nonfood items
Other: higher excise and estate taxes; capped home
mortgage deductions.
Taxes aside, the t.op item in Mr. Dukakis' deficit-reduction
arsenal is slowing-the growth or cutting the level of
197
defense spending. Three broad options exist: eliminate
programs, stretch out procurement and/or stretch out
development of selected programs and systems.
Improved tax collection is also part of his agenda with $90
billion frequently mentioned as the possible revenue gain
over a five year period. While an impressive magnitude,
many feel there is little incremental revenue left to be
gained given the progress made in improving enforcement over
the last few years. Nevertheless, most believe it should be
pursued aggressively in the interests of equity, particularly if it can spread the tax net more effectively over the
cash or "gray economy".
Growth and lower interest rates form the third leg on the
Dukakis budget stool. Growth is unquestionably an important
ingredient in any deficit reduction program; however, his
emphasis of it seems to suggest that past growth was
inadequate.
On this score, we had surprisingly strong growth in this
expansion [a 4.3% annualized growth in GNP between the
recession's bottom (4Q1982) and 2Q1988]. Capacity
constraints, however, are biting into more and more
industries; and more and more firms now note labor shortages
in national surveys. Thus, it is improbable that growth can
continue at that pace (let alone a faster pace) in the
coming years without the disruptive effects of rapidly
accelerating inflation.
Indeed, it is questionable whether GNP growth above 3.0%
(our estimate of the long-term trend growth) could be
sustained indefinitely going forward from this point in the
current expansion without tremendous advances in
productivity. The Federal Reserve is concerned with this
issue and sees growth at only 2.0%-2.5% next year, if
inflation is to be contained.
In short, without advances in productivity, above-trend
growth would have severe effects on inflation now that the
economy is approaching capacity. Unfortunately, it is not
likely that productivity can be increased fast enough in the
nonmanufacturing (service) industries to accommodate growth
in the 3.5%-4.0%. The best growth prospect is probably one
of trend growth, but simply maintaining trend growth will
offer no net benefit to the deficit reduction effort beyond
that already captured in the CBO forecast.
Finally, both deficit reduction plans would be affected by
any new program initiatives proposed by either Mr. Bush or
Mr. Dukakis. The Democratic platform contains much more in
the way of new spending than the Republican platform, but
Mr. Bush has not shunned new spending proposals. His child
care proposal and his verbal pledge to upgrade environmental
198
protection programs come to mind. In the end, potential
spending programs heighten the probability of higher taxes
of some form to meet a revised GRH deficit reduction path in
the years ahead.
EVALUATION: THE FLEXIBLE FREEZE SEEMS TO BE THE BEST ROUTE
TO A BALANCED BUDGET
Putting all this in perspective, the most dramatic impact on
the deficit appears to come through Mr. Bush's flexible
freeze. The explanation is simple. If expense growth is
held to the inflation rate and revenues move more closely
with nominal GNP, a gap of 2.0-2.5 percentage points will
emerge between their average growth rates over the 1988-1993
horizon, using CBO inflation estimates.
The original proposal seems to exempt defense spending,
interest payments and social security from the freeze. As
such, the Economist Magazine estimates that applying the
flexible freeze to the remaining components would cut their
FY 1993 spending level by $50 billion. Other things equal,
that would reduce the CBO baseline deficit estimate for FY
1993 from $121 billion to $71 billion, still a hefty number
if a balanced budget is sought.
Applying the flexible freeze to the entire spending package,
does the trick, though Mr. Bush supports the narrow flexible
freeze* Taking the CBO's estimate for the FY 1988 outlay
level and grossing it up by their long-run inflation
assumption (4.5%) produces a spending level in FY 1993 which
is $72 billion less than the CBO baseline estimate. Without
taking account of feed-through effects to the economy via
the resulting lower interest rates or the favorable effects
of lower rates and a smaller deficit on net interest, the FY
1993 deficit is reduced from $121 billion to $49 billion.
Increases in nuisance taxes and excise taxes and lower net
interest expenses would easily push the deficit to zero.
Given the power of the flexible freeze, even his narrowly
defined freeze, it is not surprising that Mr. Bush has
resisted any public consideration of taxes in the campaign.
They are simply not necessary with a sufficiently taunt
spending goal.
The likely taxes mor=;t associated with a Bush Administration
preserve the benefits of the relatively neutral effect of
the marginal rates. They are also very consistent with the
freer-market approach to government that his administration
would pursue.
Among the tax preferences of the two candidates identified
by the 50 Blue Chip analysts, an oil import fee is common to
both. Without doubt, this is an appealing, revenue raiser.
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-10In 1988, the U.S. imported oil at a 2.7 billion barrel
annual rate through August; a $5 per-barrel fee would
generate $13.5 billion. However, it has some very serious
drawbacks.
First, by raising the price of foreign crude, it would
encourage consumption of domestic crude — an obvious
benefit to U.S. oil interests. However, that has the effect
of "draining America first," and without added reserves,
heightens our vulnerability to foreign producers in the
early 1990's. Second, at current world prices, a $5 per
barrel fee would not boost the price of domestic crude
enough to encourage additional domestic exploration. Third,
an oil import fee would increase U.S. production costs and
hurt the global competitiveness of U.S. manufacturing
facilities. Thus, the oil import fee is not really as
attractive as it appears.
The Dukakis proposals offer less progress on the deficit.
The first line of attack is on the defense budget. While
vague on the details, some growth limit is inherent in the
Dukakis agenda. However, the CBO baseline forecast already
limits the growth in defense spending to only 3.5% from FY
1988 through 1993. That's 1.0% less than its inflation
assumption and therefore represents a 1.0% decline in real
terms each year. The CBO baseline budget assumptions move
defense spending from a 6.1% share of GNP this year to 5.2%
by 1994, roughly in line with its share of GNP before the
initiation of the defense buildup.
Some say Mr. Dukakis wants to freeze real defense spending
at FY 1988's level, a proposal more generous than the CBO
assumptions which produce a $121 budget deficit in FY 1993.
This would suggest to some that he would endorse a more
restrictive level of defense spending. His limit on defense
spending could be interpreted as calling for a freeze in
nominal terms at FY 1988's level which would cut defense
spending by 4.5% a year in real terms using the CBO's
inflation estimate. This would diminish defense's share of
GNP even more precipitously than the CBO's assumptions.
Though drastic, a freeze at FY 1988's nominal level, defense
spending in FY 1993 would be $55 billion less than the CBO's
baseline.
Next, regarding the revenue gains from stricter enforcement,
the $90 billion revenue gain Mr. Dukakis espouses translates
into $15 billion per year.
Combining the effects of flat nominal defense spending (a
fall in real spending equal to the inflation rate) and the
bigger revenue collections produces a deficit reduction of
$70 billion in FY .1993, about the same as the broad flexible
freeze.
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-liThe Dukakis agenda, however, places the bulk of the
adjustment in one segment of the budget, with little regard
for Congressional preferences or national needs and a
questionable revenue gain from IRS enforcement. Because
Congress will likely differ with Mr. Dukakis on the
acceptability of a severe cut in real defense spending and
because the $15 billion annual improvement in revenues may
prove fleeting, a Dukakis Administration would need to
consider significant tax increases if it is going to be
serious about the deficit.
The need for taxes will be even more pressing if the
Democratic platform (which has not been discussed in the
campaign) becomes policy initiatives in 1989 and 1990.
Because of the commitment to new programs and limited cuts
available elsewhere, a freeze is impossible in a Dukakis
Administration and the probability of more taxes almost a
certainty even if proclaimed as a last resort for now.
•REALITY: LITTLE POLITICAL APPETITE FOR A DRASTIC REDUCTION
Private discussions with a wide range of individuals leaves
me with the belief that there is little national stomach for
tax increases on the scale needed to reach a balanced
budget. The mention of most of the tax options proposed by
the CBO immediately triggers visions of pressure by special
interest groups which would likely overwhelm any political
enthusiasm for those taxes.
Revenue gains from increases in the personal tax rates or
the imposition of a VAT are enormous. However, these two
revenue raisers are even more contentious than the small
gains generated by taxes on special interest groups. As a
result, it appears that the personal tax rates and a VAT
will not be touched next year unless there is a clear public
mandate to move toward a balanced budget.
The corporate tax structure is probably a tempting plum.
However, little potential exists here. The effective rate
(Federal and state taxes) is already high, averaging 47.3%
during the first half of this year. Moreover, the base is
small. Pre-tax profits were at a $296.1 billion annual
level for the first half, a scant 6.2% of nominal GNP. An
increase of a few percentage points in the effective rate
from here would have a devastating effect on incentives.
However, specific efforts to deal with the remaining
"profitable" firms which pay no taxes would obviously have
broad public endorsement. While important from an equity
perspective, net revenue gains would probably be minor.
In sum, there will likely be no major tax increase in 1989
or 1990, barring a* national or international financial
crisis. Even then-, the experience of the aftermath of Black
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-12Monday indicates that legislative action would be slow in
coining and woefully inadequate to do much on the deficit.
This said, the most significant motivator to the deficit
reduction effort promises to be the National Economic
Commission. The Commission will likely recommend some
combination of spending cuts and tax increases, using the
March 1988 CBO list as a starting point. The options
eventually chosen by Congress depend, however, upon national
objectives. To secure a balanced budget within the GRH time
frame is probably too severe; the nation has repeatedly
demonstrated that it is unwilling to tolerate either the
massive tax increases or the spending cuts needed to achieve
the balanced budget. Otherwise, we would probably be a lot
closer now.
In fact, as I said earlier, we will probably continue to
recast the GRH timetable every few years and postpone the
date of ultimate balance. The problem becomes keeping on a
deficit reduction path of any sort. Since Congress can recast the timetable, the will to control spending is diluted.
AND A BALANCED BUDGET OBJECTIVE TOO RESTRICTIVE
For some time, I have argued that a zero budget deficit is
unduly restrictive when considering the size of net interest
expenses. This year, it will be about $151 billion, roughly
the size of the deficit. In 1993, using CBO economic
assumption and current service levels, net interest will
swell to an estimated $198 billion. That represents roughly
1.6 times the CBO's deficit estimate for 1993.
As such, the remaining budget items must be in surplus by
$77 billion. (For convenience we call that surplus the
operating balance.) To achieve an overall balanced budget
in FY 1993, the year's operating balance would need to be in
surplus by $198 billion—a staggering sum and one that is
probably politically unacceptable, notwithstanding the
upcoming report of the National Economic Commission.
Not only is it dangerously restrictive and politically
unrealistic, but it makes even less sense to chase after a
balanced budget when a more complete measure of "public
sector borrowing requirements" is considered. Most
discussions of the public sector's drain on the nation's
savings ignores the surplus of state and local governments.
This year, they will total around $56 billion when the
surplus from the state and local social insurance funds is
included.
I have, from time to time, suggested that the state and
local surpluses and the Federal deficit should be viewed
collectively as a measure of "public sector borrowing
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requirements," a concept closer to the European measure of
the public sector's drain on an economy's saving.
Thanks to growth in the social insurance trust funds of
states and localities, the state and local surplus (on a
national income account basis) could swell to $70 billion or
more by 1993. If such a surplus materializes, "public
sector (Federal, state and local) borrowing requirements"
would be $51 billion or less (based on the CBO baseline
deficit estimate of $121 billion). That is a far easier gap
to bridge with politically acceptable spending and tax
initiatives.
A NEW AND MORE REALISTIC DEFICIT REDUCTION FORMULA
This criticism of balanced budget efforts must not be
mistaken for uncritical acceptance of deficits. I am quite
concerned about the Federal budget deficit and its implication for both today's global imbalances and tomorrow's
living standards. The problem is, however, to achieve
fiscal discipline without suicidal restraint. More importantly, the formula should be able to withstand the test of
time better than the GRH timetable.
Net interest expense is at the core of today's difficulty in
trimming the deficit. Its size is also the result of a lack
of public concern over the growing deficit after the
Kemp-Roth tax cuts which set the stage for today's problem.
Too much time was allowed to pass before decisive action was
taken in the form of GRH. In the interim, the net interest
bill climbed to a point where it swallowed a significant
portion of the revenue stream each year. In FY 1988, net
interest expense was 14.2% of expenses and 16.6% of
revenues.
The problem, as I see it, is that the GRH deficit reduction
formula is too rigid and doomed to failure. The prospects
of unacceptably large spending cuts or tax increases led to
one restatement of the deficit reduction path last year.
With GRH-II only a year and a half old, we are likely to see
GRH-III within the next six months. That too will be
successful for the first and maybe the second year. But,
before long, GRH-IV will be needed.
What's really needed is a formula which instills the
discipline intended in the original GRH, has the proper
trajectory in the deficit's path, and can remain in place
for some time.
To this end, I have a proposal. The allowable deficit for
each upcoming fiscal year should be expressed in terms of
the net interest expense. The loosest rule would limit the
deficit to no more-than the year's projected net interest
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-14expense. In a sense, it would allow the net interest to be
capitalized through the issuance of debt.
Unfortunately,
this rule is more liberal than the CBO's baseline deficit
projections. Net interest expense will be on the order of
$198 billion in 1993. Thus, limiting the deficit to net
interest expense would be more generous than the $121
billion deficit the CBO expects and violate any sense of
discipline.
Instead, I would suggest that the deficit target be
intensified each year. Beginning in FY 1990, the deficit
would be limited to 87.5% of the year's projected net
interest expense. If the projected deficit is greater than
that, the same rules for sequestration that apply now would
apply, including a $10 billion error margin.
The ratio would be cut by 12.5% in successive years, until
the deficit limit is cut to 50% of net interest expense in
FY 1993. The CBO baseline budget estimates place FY 1993
net interest expense at $198 billion. Half of that would
limit the FY 1993 deficit to $97 billion, before taking
account of the effects of (a) a smaller deficit (versus the
baseline $121 billion deficit) on the outstanding stock of
government debt or (b) lower interest rates due to the
smaller deficit on net interest expenses.
Taking these factors into account could lower net interest
expenses to $170-$180 billion in FY 1993, which in turn
would cut the year's permissible deficit to $85-$90 billion.
That is probably a politically achievable deficit which
would bring combined federal, state and local public sector
borrowing requirements into balance.
If successful in limiting the deficit to 50% of net interest
expenses by FY 1993, the next choice would be whether to
leave the target at 50% of net interest expense or to shrink
the share further in subsequent years.
OPTIONS TO MEET A MORE CREDIBLE DEFICIT REDUCTION PATH
Neither Mr. Bush nor Mr. Dukakis appear to have a program
that can produce a balanced Federal budget by FY 1993 with
politically acceptable options. Part of the problem lies
with the unnecessarily restrictive framework of a balanced
budget. To this end, I have proposed a less restrictive
formula (i:e., tying the allowable deficit to a shrinking
share of the net interest expense in each successive year)
but one that still maintains the discipline of a narrowing
deficit between now and FY 1993. However, even to meet this
less rigorous objective, spending cuts or new taxes will be
needed between now and FY 1993.
204
-15In reality, the choices will likely draw from options
acceptable to both political parties. To this end, I would
like to offer an array of possibilities.
On the spending side, some type of flexible freeze has merit
in defining the limit on total spending allowable in the
coming fiscal year. I personally would favor a broad
flexible freeze that limits the growth in total expenditures
to the CPI. Beyond that broad guideline, the political
process decides spending priorities.
Here, in setting priorities, we cannot ignore an inescapable
reality that future levels of defense spending will need to
be revisited. Mr. Bush's efforts to exclude defense from
his flexible freeze is probably unacceptably generous, just
as a freeze in nominal terms is probably unacceptably
restrictive. The eventual choice will likely lie between
the two extremes. One possible avenue would be to reach the
5.0% share of GNP for defense spending a bit sooner than FY
1994 as assumed in the CBO baseline budget estimates.
Also on the spending side, we will eventually need to deal
with the issue of non-means tested entitlements. These run
the course from Medicare (though premiums are paid they are
woefully inadequate, and the program received a subsidy of
$26 billion in FY 1988) to Social Security. On the latter,
50% of social security benefits are subject to personal
taxes but only when an individual's adjusted gross income is
above $20,000. One means test would be to raise the portion
subject to taxation to 75% or even 100%.
On the revenue side, I would hope either incumbent would
leave the current marginal tax brackets unaltered in the
years to come, though I suspect that Mr. Dukakis is less
wedded to this than Mr. Bush. The current marginal rates
provide us with tremendous international competitive
advantage. More importantly, the current marginal rates
make the tax structure relatively neutral, i.e., the current
tax structure does not encourage tax avoidance activities to
the degree the old marginal rate structure did. Any effort
to raise the marginal tax rates would likely lead to renewed
tax shelter activity as part of the negotiations to secure
political agreement.
However, there is still room for revenue enhancers which
leave the marginal rates unaffected. For starters, it would
be equitable to reopen the issue of mortgage deductibility.
Currently, interest on both first and second homes can be
deducted up to a ceiling based on a complicated formula.
One approach would be to loosen the limit on interest
deduction on the primary home and eliminate entirely the
deduction of interest on second homes.
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Also on the revenue side, the proliferation of home equity
loans since December 1986 goes against the spirit of the
intent of the early tax reform packages. Elimination or
more restrictive allowances for the deductibility of
interest on home equity loans could be considered, but only
if allowance is made for student loans. Currently, home
equity loans are the only avenue available to most families
to secure tax-deductible interest on student loans.
While Mr. Dukakis seeks to restore some of cuts made to the
student loan programs in the past eight years, it is
unlikely that deficit considerations will allow much for
middle and upper-middle class families. For them, the home
equity loan will be the main funding avenue, and their
plight must be recognized in any alteration of the tax
deductibility of interest expenses.
Finally, enhanced excise taxes, particularly sin taxes,
should be considered before any broader taxes are
considered. Higher gasoline taxes should be included in
this category.
User fees must also be considered. In particular, they
should be brought into alignment with the equivalent prices,
including a return on equity, of similar products in the
private sector. In some cases, market-based user fees might
create some personal hardships. Those hardships should not
be used as a excuse for no action; instead, hardship effects
could be neutralized by means-tested offsetting subsidies.
There is some merit to the restoration of a 15% capital
gains tax for all the reasons mentioned by Mr. Bush.
However, Mr. Dukakis' criticisms of that proposal cannot be
ignored. Two suggestions could blunt those criticisms and
should be added to any consideration of a 15% capital gains
tax. First, the definition of capitals gains should be
lengthened from six months to at least a year, if the
objective is to encourage (as proponents of the tax
preference argue) the mobilization of capital for long-term
investments. Second, it might be equitable to consider
taxation of capital gains at death.
Taxes to avoid should include any increase in the effective
corporate tax rate or the establishment of an oil import fee
for reasons mentioned earlier.
Finally, there is the question of a value-added tax which
amounts to a national sales tax. Often criticized as an
unacceptably regressive tax, that shortcoming can be limited
by the exclusion of housing, medical care and food from the
tax. Even with those exclusions, the VAT is a tremendous
revenue raiser; CBO estimates that a 5% VAT would raise
$79.8 billion in FY 1993. If a big revenue raiser is
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needed, I would recommend a VAT (with adequate shielding of
necessities) as opposed to increases in marginal tax rates.
A VAT has several advantages. Its most important is the
fact that it broadens the tax base without affecting
marginal tax rates. In addition, it raises revenues without
adversely affecting the nation's global competitive
position, since the VAT does not apply to exported goods.
The European nations all utilize the VAT and benefit from
its neutral affect on global competition. Were we to
combine a VAT with a slight reduction in corporate tax
rates, the effect could be a tax-induced benefit to our
global competitive position. To succeed, however, any
corporate tax cut would need to be structured in a way to
encourage investment in export-sensitive industries.
The VAT is not without its disadvantages. Beyond the
criticisms of its regressivity, its introduction would cause
an immediate (but one-time) jump in the Consumer Price Index
which would impact all indexed government entitlement
programs as well as private-sector labor agreements with
COLAs. More importantly, because it is a powerful revenue
raiser, its benefits could easily be squandered due to a
lack of discipline in controlling expenses. A firm and
binding budgetary process which controls expenses must be
established prior to enactment of any VAT.
Finally, higher marginal personal tax rates are also a
powerful revenue raiser. A increase from 15%/28% to 16%/3 0%
could raise an additional $35.9 billion in FY 1993 according
to the CBO, while a 5% surtax on existing rates could raise
$2 6.6 billion. Thus, I would hope that any decision to
increase personal income tax rates be similarly coupled to
the establishment of a firm and binding control over
expenses, lest the added revenue fuel politically expedient
spending programs..... In addition, establishment of a 15%
capital gains tax should be part of any proposal to hike
personal tax rates or to place a surtax on existing rates.
IN SUMMARY
The international community has exhibited tremendous
patience with U.S. budget and trade imbalances.
That patience should not be misunderstood as acceptance of
continued big budget or trade deficits. My contacts in both
Europe and Japan consistently warn that the new President
should get on with establishing a credible program of
shrinking the nation's deficit.
Interestingly, in recent meetings with European and Japanese
bankers, I have not heard overwhelming clamoring for the
U.S. to achieve a zero Federal budget deficit. Instead,
they warn that the"path need be only toward a progressively
narrower deficit over coming years and that the options to
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achieve the path be politically realistic.
progress, not a miracle, is the hope.
Credible
In the absence of a credible path with credible policy
options, these same bankers warned that this year's
strengthened dollar could quickly give way to downward
pressure on the dollar. Such a crisis of confidence is the
surest route possible to higher interest rates with their
disabling effect on U.S. activity.
My formula to tie the allowable deficit to a shrinking share
of net interest expenses provides a credible path—it is
doable with a minimum of economic disruption to the national
economy. More importantly, the spending and revenue options
offered earlier probably have the basis of a political
consensus. The proposals soon to be released by the
National Economic Commission offer hope for a broader array
of acceptable options. Together, they provide the credible
path and options sought by financial markets.
O
@FedFRASER