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CONDUCT
OF MONETARY POLICY
(Pursuant to the Full Employment and Balanced
Growth Act of 1978, P.L. 95-523)
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC MONETARY POLICY
OF THE
COMMITTEE ON BANKING, FINANCE AND
UKBAN AFFAIKIS
HOUSE OF EEPRESENTATIVES
ONE-HUNDREDTH CONGRESS
SECOND SESSION
JULY 28, AND SEPTEMBER 8, 1988
Printed for the use of the Committee on Banking, Finance and Urban Affairs
Serial No. 100-82
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1988
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
FERNAND J. ST GERMAIN, Rhode Island, Chairman
HENRY B. GONZALEZ, Texas
CHALMERS P. WYLIE, Ohio
JIM LEACH, Iowa
FRANK ANNUNZIO, Illinois
NORMAN D. SHUMWAY, California
WALTER E. FAUNTROY, District of
STAN PARRIS, Virginia
Columbia
BILL McCOLLUM, Florida
STEPHEN L. NEAL, North Carolina
GEORGE C. WORTLEY, New York
CARROLL HUBBARD, Jr., Kentucky
MARGE ROUKEMA, New Jersey
JOHN J. LAFALCE, New York
DOUG BEREUTER, Nebraska
MARY ROSE OAKAR, Ohio
DAVID DREIER, California
BRUCE F. VENTO, Minnesota
JOHN HILER, Indiana
DOUG BARNARD, JR., Georgia
THOMAS J. RIDGE, Pennsylvania
ROBERT GARCIA, New York
STEVE BARTLETT, Texas
CHARLES E. SCHUMER, New York
TOBY ROTH, Wisconsin
BARNEY FRANK, Massachusetts
AL McCANDLESS, California
RICHARD H. LEHMAN, California
J. ALEX McMILLAN, North Carolina
BRUCE A. MORRISON, Connecticut
H. JAMES SAXTON, New Jersey
MARCY KAPTUR, Ohio
PATRICK L. SWINDALL, Georgia
BEN ERDREICH, Alabama
PATRICIA SAIKI, Hawaii
THOMAS R. CARPER, Delaware
JIM BUNNING, Kentucky
ESTEBAN EDWARD TORRES, California
JOSEPH J. DioGUARDI, New York
GERALD D. KLECZKA Wisconsin
BILL NELSON, Florida
PAUL E. KANJORSKI Pennsylvania
THOMAS J. MANTON, New York
ELIZABETH <f. PATTERSON, South Carolina
THOMAS McMILLEN, Maryland
JOSEPH P. KENNEDY II, Massachusetts
FLOYD H. FLAKE, New York
KWEISI MFUME, Maryland
DAVID E. PRICE, North Carolina
NANCY PELOSI, California
GARY L. ACKERMAN, New York
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
STEPHEN L. NEAL, North Carolina, Chairman
WALTER E. FAUNTROY, District of
BILL McCOLLUM, Florida
Columbia
JIM LEACH, Iowa
DOUG BARNARD, JR., Georgia
H. JAMES SAXTON, New Jersey
CARROLL HUBBARD, JR., Kentucky
BARNEY FRANK, Massachusetts
CONTENTS
Hearings held on:
July 28, 1988
Septembers, 1988
Appendixes:
July 28, 1988
September 8, 1988
Page
1
37
60
123
WITNESS
THURSDAY, JULY 28, 1988
FEDERAL RESERVE'S MONETARY POLICY REPORT To CONGRESS
Greenspan, Alan, Chairman, Board of Governors of the Federal Reserve
System
APPENDIX
Prepared statement:
Greenspan, Alan.
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Graphs submitted by the subcommittee:
M2 and M3 Target Ranges for 1988 and Actual Growth
Monetary Base and Ml Growth Rates for 1988
Federal Reserve Borrowing Versus Interest Rate Differential
Economic Growth and Inflation
83
84
85
86
WITNESSES
THURSDAY, SEPTEMBER 8, 1988
THE CURRENT STATE OF THE ECONOMY
Jasinowski, Jerry, chief economist, National Association of Manufacturers
Paris, Donald G., manager, Economics Department, Caterpillar Co
Pate, James L., senior vice president, Pennzoil Co
Rahn, Richard, chief economist, U.S. Chamber of Commerce
42
38
45
48
APPENDIX
Prepared statements:
Jasinowski, Jerry
Paris, Donald G
Pate, James L
Rahn, Richard
124
142
150
169
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Letter of Invitation to Witnesses, dated July 12, 1988
Federal Reserve System, Board of Governors, submitted Monetary Policy
Report to Congress Pursuant to the Full Employment and Balanced Growth
Act of 1978, dated July 13, 1988
(in)
188
87
FEDERAL RESERVE'S MONETARY POLICY
REPORT TO CONGRESS
Thursday, July 28, 1988
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., in room 2128 of the Rayburn House Office Building, Hon. Stephen L. Neal [chairman of the
subcommittee] presiding.
Present: Chairman Neal, Representatives Barnard, Hubbard,
McCollum, Leach and Saxton.
Also present: Representatives Gonzalez, Flake and Wortley.
Chairman NEAL. I'd like to call this meeting of the subcommittee
to order at this time. This morning, we are pleased to welcome the
Chairman of the Board of Governors of the Federal Reserve
System, Hon. Alan Greenspan, who will present the Federal Reserve's Monetary Report to the Congress.
Today we face an economy that few could have predicted with
great competence last February at the time of the last HumphreyHawkins report on monetary policy. At that time, the potential
fallout of the stock market crash was still awaited with great trepidation and uncertainty. In the intervening months, the economy
has performed beyond any reasonable expectation, to the point
where overheating and the consequent resurgence of inflation are
the dominant concerns.
The Fed has reacted by a noticeable, though modest, tightening
over these months. The main question for the remainder of 1988
seems to be: will the economy slow down a bit on its own or will
the Fed have to induce a slowdown by further tightening? Inflation
is at present more or less stable in the 3 to 4 percent range typical
of the past few years. Whether it is poised to move up to a higher
range is unclear, though indicators of potential inflationary pressures are easy to find. It seems abundantly clear, however, that it
is not poised to move to a lower range. Approaching the zero level,
we all seem to recognize, at least rhetorically, as our long-run objective.
Reasons abound why we cannot at present move quickly to a
zero-range for inflation. We still have a large trade deficit which
might eventually require further dollar depreciation. The decline
in the dollar over the past few years is just now causing major increases in import prices. Moreover, the current drought may cause
a one-time run up in food prices. These temporary obstacles may
(l)
well rule out a move to zero inflation in the immediate future. But
we must not give up the ground we've already won and we must
never waiver from our goal of zero inflation. Stabilizing inflation in
the 3 to 4 percent range should be the minimum we ask and expect
of monetary policy in the near term. If that requires serious further tightening, so be it, and the sooner the better.
Mr. Chairman, I would like to welcome you this morning. Thank
you for joining us. Without objection, we will place your entire
statement in the record and would ask you to proceed with however you would like to summarize that statement.
Are there other Members who would like to make some opening
comments.
If there are no requests for opening statements, Mr. Chairman,
please proceed.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Chairman GREENSPAN. Thank ycm very much Mr. Chairman, and
Members of the committee.
I welcome this opportunity to discuss monetary policy with you.
When I testified last February, the after-effects of the stock
market plunge on spending and financial markets were still unclear. Most Federal Open Market Committee members were forecasting moderate growth. But rapid inventory-building and some
signs of a weakening of labor demand meant that the possibility of
a decline in economic activity could not then be ruled out.
To guard against this outcome, the Federal Reserve undertook a
further modest easing of reserve pressures in late January. In the
event, the economy proved remarkably resilient to the loss of stock
market wealth. Economic growth remained vigorous through the
first half of the year. As the risks of faltering economic expansion
diminished, the dangers of intensified inflationary pressures reemerged. Utilization of labor and capital reached the highest levels
in many years and hints of acceleration began to crop up in wage
and price data.
In these circumstances, the Federal Reserve was well aware that
it should not fall behind in establishing enough monetary restraint
to effectively resist these inflationary tendencies. The system, accordingly, took a succession of restraining steps.
The monetary actions were undertaken so that economic expansion could be maintained. We recognized that to do so, additional
price pressures could not be permitted to build. We do expect economic growth to continue and inflation to be contained.
The central tendency of FOMC members' expectations for real
GNP is for 2% to 3 percent growth over this year and 2 to 2 ¥2 percent over 1989. Although an erratic month-to-month pattern can be
anticipated in our trade deficit, improvement in the external sector
on balance is expected to replace much of the reduced expansion in
domestic demands.
Employment growth is anticipated to be substantial through
1989, though some updrift in the unemployment rate may occur.
Capacity utilization could well top out soon as growth in demands
for manufactured goods slows to match that of capacity.
Considering the already limited slack in available labor and capital resources, a leveling of the unemployment and capacity utilization rates is essential if more intense inflationary pressures are to
be avoided. Otherwise, aggregate demand would continue growing
at an unsustainable pace and would soon begin to create a destabilizing inflationary climate.
Prospective increases in import and agricultural prices also have
accentuated inflation dangers. We must not let these price level adjustments spill over to a sustained higher rate of increase in wages
and prices.
The costs to our economy and society of allowing a more intense
inflationary process to become entrenched are serious. The longrun costs of a return to higher inflation and the risks of this occurring under current circumstances are sufficiently great that Federal Reserve policy at this juncture might be well advised to err more
on the side of restrictiveness than of stimulus.
We believe that monetary policy actions to date, together with
the fiscal restraint embodied in last fall's agreement between the
Congress and the administration, have set the stage for containing
inflation through next year.
The FOMC believes that efforts to contain inflation pressures
and sustain the economic expansion would be fostered by a growth
of M2 and M3 over 1988, well within their reaffirmed 4 to 8 percent annual ranges. The debt of nonfinancial sectors is anticipated
to remain near the midpoint of its reaffirmed 7 to 11 percent monitoring range.
For 1989, the FOMC has underscored its intention to encourage
progress toward price stability over time by lowering its tentative
ranges for money and debt. We have preliminarily reduced the
growth range for M2 by 1 percentage point to 3 to 7 percent. That
is, a range of 3 to 7 percent. We have lowered the tentative 1989
range for M3 by ¥2 a percentage point, a range of 3Va to IVz percent.
The monitoring range l for domestic nonfinancial debt for 1989
also
has been reduced by /2 a percentage point to a tentative GVa to
Wl/2 percent range. The specific ranges chosen for 1989 are, as
usual, provisional. The FOMC will review them carefully next February in light of intervening developments.
Anticipating today how the outlook for the economy in 1989 will
appear next February is obviously difficult. A major reassessment
of that outlook will have implications for appropriate money
growth ranges for that year.
Despite the changes in the economic setting over the last 6
months, massive deficits in our external payments and internal
fiscal accounts remain. As a Nation, we are still living well beyond
our means. Our current account deficit indicates how much more
deeply in debt to the rest of the world we are sliding each year.
As a Nation, we cannot expect our foreign indebtedness to grow
indefinitely relative to our servicing capacity without added inducements to foreigners to acquire dollar assets. These added inducements could take the form of either higher real interest rates
or a cheaper real foreign exchange value for dollar assets, or both.
To be sure, such changes in market incentives would have selfcorrecting effects over time in bringing our domestic spending
more into line with our income.
But simply sitting back and allowing such a self-correction to
take place is not a workable policy alternative. Trying to follow
such a course could have severe drawbacks now that our economy
is operating close to effective capacity and potential inflationary
pressures are on the horizon.
Fortunately, we have a better choice for righting the imbalance
between domestic spending and income, one over which we have
direct control—that is, to resume reducing substantially the still
massive Federal budget deficit. The Federal Government remains
the most important source of dissavings in our economy. The fall in
the dollar we have already experienced over the last few years,
even allowing for the dollar's appreciation this year, has set in
motion forces that should continue to narrow our external deficits.
The associated loss of foreign funds needs to be replaced by
greater domestic savings. A sharp contraction in the Federal deficit
appears to be the only assured source of augmented domestic net
savings. Such a fiscal cutback should help counter future tendencies for future increases in U.S. interest rates and declines in the
dollar. It would instill confidence on the part of international investors in the resolve of the United States to address its economic
problems.
The schedule under the Gramm-Rudman-Hollings law is a good
baseline for a multi-year fiscal strategy. I trust the Congress will
stick with it. But we should go further. Ideally, we should be
aiming ultimately at a Federal budget surplus. Then Government
savings could supplement private domestic savings in financing additional domestic investment.
The strategy for monetary policy needs to be centered on making
further progress toward, and ultimately reaching, stable prices.
Price stability is a prerequisite for achieving the maximum economic expansion consistent with a sustainable external balance
and high employment. Price stability reduces uncertainty and risk
in a critical area of economic decision-making.
By price stability, I mean a situation in which private decisionmakers can safely ignore the possibility of sustained, generalized
price increases or decreases.
In the process of fostering price stability, monetary policy also
would have to bear much of the burden for countering any pronounced cyclical instability in the economy. This is especially true
if fiscal policy is following a program for multi-year reductions in
the Federal budget deficit.
In these circumstances, monetary policy has to remain flexible to
respond to unexpected developments. A perfectly flexible monetary
policy, however, without any guideposts to steer by can risk losing
sight of the ultimate goal of price stability.
Money growth has an undisputed, long-run relation with inflation, but in a shorter-run context, monetary aggregates have drawbacks as rigid guides to monetary policy. Financial innovation and
deregulation in the 1980's have altered the structure of deposits.
They also have made the velocity of money more sensitive to interest rates.
Still, I don't want to leave the impression that the aggregates
have little utility in implementing monetary policy. They have an
important role and it is quite possible that their importance will
grow in the years ahead.
Currently, M2 and M3 are among the indicators influencing
policy adjustments.
At times, in recent years, we have intensively examined the
properties of several alternate measures. An analysis of the monetary base appears as an appendix to the board's Humphrey-Hawkins report. The FOMC's view is that its behavior has not consistently added to the information provided by M2 and M3. The committee, accordingly, has decided not to establish a range for this aggregate.
Because the Federal Reserve cannot rely solely on signals from
the monetary aggregates to guide short-run operations, we have to
interpret the behavior of a variety of economic and financial indicators as well. Judgments about the balance of various risks to the
economic outlook need to adapt over time to the shifting weight of
incoming evidence.
To be sure, we should not overreact to every bit of new information because of the transitory noise in economic statistics. But we
need to be willing to respond to indications of changing underlying
economic trends without losing sight of the ultimate policy objectives.
To the extent that the underlying economic trends are judged to
be deviating from a path consistent with reaching the ultimate objectives, the Federal Reserve would need to make mid-course policy
corrections. Deviations from the appropriate directions for the
economy will be inevitable, since the effects of previous policy actions are delayed and uncertain.
Numerous unforeseen forces not related to monetary policy will
continue to buffet the economy. The limits of monetary policy in
short-run stabilization need to be borne in mind. The business cycle
cannot be repealled. But I believe it can be significantly damped by
appropriate policy action.
Price stability cannot be dictated by fiat. But governmental decision-makers can establish the conditions needed to approach this
goal over the next several years.
Thank you very much, Mr. Chairman.
[The prepared statement of Alan Greenspan can be found in the
appendix.]
Chairman NEAL. Thank you, Mr. Chairman. You headed the
commission that looked into the social security system not too long
ago. I have become increasingly concerned about several things in
this area. One is that we continue to kid ourselves about the level
of the budget deficit because we count the building surpluses and
the social security trust funds into the overall unified budget and
use those surpluses to offset deficits in other aspects of the budget.
This results in statistics that show the real deficit that is considerably higher than it appears because we are using trust funds to
offset part of the real numbers. The social security trust fund surpluses are anticipated to grow dramatically, building, some say, to
a trillion dollars. Wouldn't it be a good idea to remove the social
security fund entirely from the budget, to stop counting it in the
unified budget. I'd like you to comment on this.
Second, we are operating under the assumption that, because of
demographic changes down the road, roughly somewhere after the
turn of the century, the ratio of working people to retired people
will be lower than it is now. Some even suggest that there will be
one retired person for every two working people at that time. We
are building the social security trust funds to meet the requirements of that time.
While that is one way to look at it, it seems to me equally as
valid to think that when the time comes, when this ratio changes,
that there will still be a significant amount of work to be done in
this country and that we will in fact invite people in from other
countries, either as guest workers or under some other agreement,
to do the work. And, if we have people here from other countries
doing work, these people would pay under our social security
system. I would think that it wouldn't be too hard to see how they
could pay in at that time. Wouldn't it be a good idea, less of a
drain on the economy, for us to keep a 7-month, 10-month, or yearsurplus in those trust funds to meet the current needs. We might
want to adjust the social security rate—it could be higher or lower,
maybe once a year—to maintain that 7- to 12-month reserve instead of building massive reserves beyond that point, with the anticipation that we would then fund the retirement of those people
who will be retiring around 2020 from payments made by guest
workers and other American workers.
Chairman GREENSPAN. Well, in answer to your first question, Mr.
Chairman, I think that there is a bit of unwarranted euphoria
about the outlook for the total fiscal accounts of the United States
because of the prospective very large surplus which will surface inevitably under the existing structure in the social security funds.
The Congress, as I understand it, does contemplate eventually—
in a few years—taking social security off budget and, in a sense,
dealing with the remaining budget process excluding the social security trust funds.
The problem I have in evaluating this is that while it is certainly
the case that we will be building, according to plan, a very substantial social security surplus, the longer-term outlook for the nonsocial security trust fund part of the budget is likely to be deteriorating. To balance that segment of the budget is going to be very
difficult to do, and it's going to require very great effort on the part
of the Congress to make certain that that is done in the years
ahead.
As a consequence of that, I think the presumption that we're
somehow going to very readily slip into the unified budget surplus
of the type which I had discussed in my prepared testimony, is, I
think, a bit overdone.
Congress and the next administration are going to have a very
tough problem in restoring fiscal balance, even with the social security trust funds on budget. If we take that surplus off, obviously,
it's going to be very significantly more difficult.
When in the commission we were discussing this question of onbudget, off-budget, there were lots of pluses and minuses.
We should not, in any event, and we will not, completely eliminate the concept of the unified budget deficit because from an economic analysis point of view that is the best statistic that we have
that measures the net claim on the Nation's resources from the
Federal Government.
So that number will continue to be something which the Congress should and will be continuing to focus on and that's the
number which I think we should ultimately have in surplus.
Implicit in that, of course, is that the remaining non-social security trust fund budget will be in deficit to some respect and that it
will be covered by the social security surpluses.
I think that is the appropriate way to look at that. The commission essentially decided to move toward very large surpluses because the alternate procedure of looking at the issue of variable tax
rates induced the types of fluctuations and rates which we on the
commission thought would be too unstable and difficult to deal
with in an economic policy basis. It would also be difficult to deal
with politically because you would be increasing and decreasing
taxes quite often in a way which I don't think would be easy or,
from a long-term fiscal policy point of view, perhaps all that easy
to implement.
We decided in the commission to move away from the historic
pay-as-you-go social security procedure largely for this reason. We
recognize the great difficulty that is created by building up this
huge fund and letting it down, but we consider that the least worst
alternative to this particular problem.
Chairman NEAL. I would like to point out that as the trust fund
builds, there is going to be ever more temptation to spend it. It is
also noteworthy, it seems to me, that we will be financing a huge
portion of our Federal budget with the most regressive of the taxes
that we use anywhere.
Chairman GREENSPAN. Well, Mr. Chairman, I think that that
issue can be redressed in different areas of our tax code. I would be
disinclined to move away from the type of recommendations which
we at the commission made and which the Congress embodied into
law, fully recognizing the issues that you have raised in your earlier remarks.
What we found in endeavoring to find a better solution was that
the alleged better one created even more difficulties in one form or
another.
Chairman NEAL. I thank you. Let me yield to the distinguished
gentleman, Mr. Leach.
Mr. LEACH. Thank you, Mr. Chairman.
First, let me welcome you, sir. You're one of the great, distinguished economists of our age. I think it's interesting that you
began your conversation with a rather revolutionary exhortation,
and that is for Congress to not simply think in terms of a balanced
budget, but to think in terms of surpluses.
Well, from a legislator's perspective, let me turn it back and ask
for some accountability from your position as well.
It strikes me that, and I hesitate to continually pursue one subject, that you are in a position that not only observes the entire
economy, but you are personally accountable for regulating one
aspect of the economy, and that is banking.
The General Accounting Office, which is an arm of the U.S. Congress, recently did an audit of the auditors that did not reflect well
on the Federal Reserve Board or the Office of the Comptroller.
From a basic economic perspective, it suggested that accounting
principles were not adequately carried out. It also suggested that
LDC debt had not been adequately written off. It also suggested
that the law of the United States had not been adequately implemented, particularly the ILSA statute.
These are very serious charges coming from a very serious wing
of the U.S. Congress.
In the response to the GAO study, the Board sent a letter to the
Senate of the United States. Some of the Board's observations were
quite reasonable and understandable. But there's one part of that
letter and one sentence that I'd like to repeat back to you that I
think exemplifies the problem, and I would truly ask for its re-examination.
At one point in the letter, the assertion was made, and I quote:
"Bank management is in the best position to determine the appropriate levels of reserves" that should be taken against LDC debt.
Well, that strikes me as a cop-out of regulatory accountability.
By giving the definitional power to banks of what is a good loan
and what is a bad loan, you're allowing them to regulate themselves. I find this philosophy offensive. It also has certain implications for just how far the regulators want to go.
In any regard, I just think that it's proper for Congress to suggest toughness in regulation from regulators, even though this is a
deregulatory climate. It has enormous implications for the economy. As we found with the LDC debt issue, the only way to save the
economic fabric of the world clearing systems, is to make sure that
the people who have been lent money have the capacity to repay it.
This implies the United States importing more than we export because that's the way you pay back the money center banks.
It skews economic growth and has enormous implications for
some sectors of our economy. It, strangely enough, comes back to
whether regulators at an appropriate period of time demanded adequate capital ratios for the banks involved.
Now, to the credit of the Fed, you've moved in the direction of
the BIS standards. To the credit of the Fed, the national banking
system is stronger today than 4 or 5 years ago.
But I do think that we in the Congress have the obligation to
press on this issue.
But I'd like to turn to a little different direction in terms of regulation. The Fed also has accountability as a lender of last resort. In
another statute, the FSLIC bill passed last year, Congress asserted
that the thrift regulators should have the exact same powers of
regulation that banking regulators do.
I know there have been an increasing number of inter-agency
workings with thrift regulators. This is somewhat new in terms of
its intensity. But my sense is that macro-economics has not been
applied to the subject matter and Fed oversight and coordination
with the thrift regulators have not occurred in a very serious
manner. Let me cite some examples.
We have a circumstance today where net worth certificates are
being used by a bankrupt fund which impels growth in the indus-
9
try and represents a claim on the U.S. taxpayer at some point in
the future.
I would wonder what the Fed position is on the extensive use of
net worth certificates. We have a circumstance in which, thrifts
with negative net worths are allowed to grow. Last year, over 100
thrifts with negative net worths grew more than 10 percent a year.
A few even doubled in size.
What is the position of the Federal Reserve Board on this subject
matter?
We have other circumstances in which "rescued" thrifts are
planning to double in size over a 6- or 7-year time period.
We have another circumstance in which the Chairman of the
Federal Home Loan Bank Board asserts that the thrift industry
should expand by 7 percent a year for the foreseeable future. This
expansion rate is above the inflation rate.
I would like to ask you, as Chairman of the Federal Reserve
Board of the United States, with the prospect of using your resources at some point in time to bail out the thrift industry, whether you and your staff are urging the thrift regulators to hold the
line on growth.
You've urged Congress to develop surpluses, a revolutionary concept.
I would say to you as a regulator, isn't it time that certain aspects of the financial community "shrink." What are you doing to
achieve this objective? And does this objective seem reasonable
given that Congress may be looking at a taxpayer bail-out in the
not too distant future?
Chairman GREENSPAN. Mr. Leach, let me make a few comments
with respect to the issues you have raised.
First of all, let me just say that regulation, per se, does not mean
and should not mean lax supervision. I think that one has got to be
very careful about that issue because it can very easily slip and one
could inappropriately evaluate many problems which currently
confront depository institutions as problems of deregulation when,
in fact, it was lax supervision over the years which basically was a
problem in some areas.
The question with respect to our view that bank management is
best suited to make a determination of the quality of individual
loans really rests on the issue that the first judgment as to the
nature of that loan is best left in the hands of those who have
made the loan and understand it.
That does not mean that there are not overriding supervisory actions taken on occasion which override one way or another what
management views are.
The whole ICERC process, for example, is directed in precisely
that area and enforces certain actions which management may or
may not have taken previously.
But it is a mistake to presume that regulators, irrespective of
their detailed evaluation of the whole process, have the level of
knowledge that management and loan officers have, or the boards
of directors who supervise the loan officers within an individual
bank. It's a mistake to believe that any of us have the information
relevant to making the judgment.
It is required
10
Mr. LEACH. Mr. Chairman, at the risk of presumption.
Chairman GREENSPAN. I'm sorry.
Mr. LEACH. It would be inconceivable for the superintendent of
the State of Iowa banking system to say that about an Iowa rural
bank. They look at regulation and supervision in a very different
way.
I'm thunderstruck by the series of quotes you've just made. They
are in essence saying that you are going to continue to refuse to
write off a higher percentage of LDC bank loans because individual
banks have a better view of the strength of these loans.
It's nuts.
Chairman GREENSPAN. No, I'm not saying
Mr. LEACH. That is not how the Iowa superintendent of banking
would treat a farm loan in a rural bank.
Chairman GREENSPAN. No, I'm not saying that, Mr. Leach. What
I am saying is this. That basically, each individual bank has certain types of loans and I'm saying there is a body of information
that is held in that bank which we do not have a level of access to
that they do. What I'm trying to say is that the initial judgment
should, of necessity, be the individual bank management.
That is not to say that in supervision we don't obviously override
it. That is the purpose of supervision. That's what we do.
But what I don't want us to be doing is to dictate to the bank in
advance of their judgments what we think of particular loans.
What that will do is to undercut the process which is crucial to our
whole credit extension intermediation process in this country
which puts the burden on bank management to the shareholders of
the banks in a manner which enables them to balance risks in a
manner which we cannot do.
Btrt I am not saying that supervision merely automatically accepts whatever management chooses to say about a loan.
On the contrary, the whole purpose of the supervisory process is
to review the previous actions of management and, where desirable, question and, where appropriate, change those decisions.
But the emphasis I want to place here is the appropriate balance
of what supervision should be. It's a combination of appropriate
evaluation of risk and reserving by management with oversight by
supervisory authority.
Mr. LEACH. Could you comment on the thrift issue?
Chairman GREENSPAN. I'm sorry?
Mr. LEACH. Could you comment on the thrift issue?
Chairman GREENSPAN. The thrift issue is a difficult one because
it has emerged in a period as best I can judge, having been in the
private sector at the time—when a number of things happened
which made supervision rather difficult and, in retrospect, clearly
less than would be required and was required at the time.
I, myself, have a periodic breakfast with the other regulators, including the Chairman of the Federal Home Loan Bank Board. And
we discuss a number of the issues, Mr. Leach, which you have
raised and we do comment back and forth and I give my opinions
to him on occasion as they are relevant.
Mr. LEACH. Can you tell us, have you suggested to him that the
industry should grow or shrink?
11
Chairman GREENSPAN. I have not raised that specific issue with
him.
Mr. LEACH. Have you raised the issue of whether institutions
with a negative net worth should increase in size?
Chairman GREENSPAN. Well, no. I think he is aware of that fact
and his view is that they have at this stage controlled the problem.
I certainly would agree with you, as he would, that institutions
with negative net worth should not be growing inordinately.
Mr. LEACH. Mr. Chairman, my time has expired. All I would say
is that this Congress expects the regulators to work together to
constrain the thrift problem to diminish as much as possible public
taxpayer liability.
Chairman GREENSPAN. I couldn't agree with you more, Mr.
Leach.
Mr. LEACH. Fine. Thank you.
Chairman NEAL. Let me explain to my colleagues. I will try to
give everyone the amount of time that they need. At this time, I'll
yield to Mr. Barnard.
Mr. BARNARD. I will yield for a question to Mr. Saxton.
Mr. SAXTON. Thank you very much, Mr. Barnard. I appreciate it
because, I guess as all of us this morning, my time is somewhat
limited and I appreciate going out of turn.
I'm tempted to return to Chairman NeaFs question about social
security because I have recognized, as he has, the direction in
which we're heading with regard to the fact that the social security
trust fund is developing a rather substantial surplus and that it appears to many as though that offset in our unified budget in terms
of the use of that surplus, at least for bookkeeping purposes, gives
a somewhat false impression of where we are with regard to our
budget deficit.
However, I stop short of the position that Mr. Neal seemed to be
heading in with regard to putting social security back on a moneyin, money-out basis. One of the things that he did that was right
was to show the American people that we do have a way to guarantee that long term, or at least medium term, in the social security
trust fund will be in good shape.
We went through the 1972 crisis, the 1977 crisis, the 1983 crisis.
Subsequent to all of that, the surplus makes middle-aged and older
Americans feel good.
I think that, while I understand Mr. Neal's position, I just
wanted to say that there are some of us who appreciate very much
where we are with regard to the trust fund.
The question that I'd like to turn to, however, has to do with a
little bit different subject, with regard to our economic situation
and where we find ourselves with the labor market.
As I travel through New Jersey and the surrounding area, I find
the economy so good that employers are having a very, very difficult time finding people to work.
I've even had situations where I've pulled up to a gas pump at
my favorite gas station. The owner comes out and expresses his
frustration at not being able to find people to work for him, to the
point where he's beginning to wonder if it's a good idea to even
keep his gas station open.
12
I'm wondering what kind of influence, long term, that will have,
that kind of an economic situation will have on labor and on
wages. Won't, in your opinion, there be a tremendous surge, or at
least a tendency to dramatically increase the cost of labor because
of the short supply that we seem to be experiencing currently?
Chairman GREENSPAN. Well, Mr. Saxton, I think that whenever
we get into periods of major business cycle expansion and falling
unemployment rates, there are inevitably areas of the economy in
which labor is perceived of as short. That in many respects is good,
not bad, in that it is implicit in any vigorous economy that one
does run into shortages here and there. It's the extreme case which
we're trying to avoid.
During the second quarter of this year, New Jersey had a 3.6 percent unemployment rate, which was almost 2 full percentage
points under the average for the quarter. And despite a rate in
New Jersey and up through New England that is well below the
current average, we do not yet have any really major, very difficult
shortages of workers nationwide.
In fact, there is a considerable amount of what I would call migration arbitrage going on in this country in which various different areas of the country which have excess and tight labor markets
tend to interract to average out the demand and supply.
That's one of the reasons why, even though there's been some
quickening in the pace of wage increases in recent months, we still
don't have the type of tight accelerating markets which would best
be characterized by really having difficulty finding people and
keeping businesses open.
We don't have that at the moment in any general sense and I
can't imagine that emerging in the period immediately ahead. But
it is unquestionably something which we have to keep an eye on.
Mr. SAXTON. Thank you very much, Mr. Greenspan. Again,
thank you, Doug, for permitting me to go out of turn.
Mr. BARNARD. Mr. Chairman, it's a pleasure to have you with us
today. Certainly, your report is of great interest to us, even though
at this short night that we just spent, it's maybe a little bit difficult to comprehend.
I've got several areas that I'd just like to ask a question.
Number one, since we're on social security this morning, I would
just like to ask, has the Fed given consideration to the increase in
the percentage of debt that's held, Federal debt, that's held by the
social security system and the other Government trust accounts,
and the fact that it's increasing as it is? That along with the fact
that the demographic trends show there is an aging of the baby
boomers which they have forecast there would be increasing savings.
So, therefore, the demographics would be that there would be
less demand on borrowing and probably a greater increase from
that sector on savings.
Now, if those parameters are anywhere at all correct, the question I was asking is what effect is that going to have on some of the
financial institutions if mortgages seem to decline and bond interest rates decline? Is that going to have an ulterior effect on some of
our financial institutions?
13
Chairman GREENSPAN. Well, first, let me say, Congressman, that
the special issues which are held by the social security trust fund,
special treasury issues, are not something which we at the Fed are
particularly concerned about because these are not public issues.
They are not the types of issues which appear in the market and
which we have to keep a close eye on. These are merely the form
in which the surplus is accumulating in the social security trust
fund.
It's an intra-Federal Government transfer and, as a consequence,
it is not something which creates problems for monetary policy.
The shifting demographics, as you point out, does have an effect
on the mortgage market in this sense—as you begin to shift the
population structure, the rate of increase in household formation
begins to slip as a percent of the population and you do get some
downward pressure for net new home demand and net new mortgage credit demand.
However, an increasing part of mortgage credit extensions—in
fact, currently, perhaps the most important part—is the extension's net of mortgages on existing homes. That stock, of course, is
continuing to rise with the population.
It may well be that the net credit demand for existing homes,
which will be continuing to rise, will offset the amounts that are
required on extensions for new homes.
So, overall, I don't expect that the mortgage market, per se, is
going to become a significantly different form or different position
in the overall financial system. As a consequence, it is not likely to
be a significant factor impacting the structure of our financial intermediary institutions.
Mr. BARNARD. Mr. Chairman, in looking at the report and sort of
reviewing the parameters that you suggest on the money aggregates, I don't see that you share the same euphoria that's seemingly being expressed about the economy. On page 6, I was especially
taken with the statement that you made that a more serious longrun threat to price stability could come from Government actions
that introduced structural rigidities and increased cost of protection.
So sometimes I think that the public gets the impression from
the dictum that comes from various sources that we are on a roll,
that a trend has developed. So, therefore, caution and concern
maybe for fiscal policy maybe will go out of the window.
That troubles me because on the heels of that, nobody wants to
talk about taxes and, as a result, it troubles me how we talk about
trying to control the Federal deficit which you continue and I
think rightfully so, try to alarm us about.
So I would just say that it looks like the FMOC is monitoring the
fiscal affairs of Congress, what we're doing, and I think rightfully
we should be.
But I do get the feeling from your statement that you are very
much concerned that we are not on a trend toward economic improvement.
Chairman GREENSPAN. Well, I'm certainly very much concerned
about the fiscal situation. I think that it is a far more difficult
problem to resolve than I think we understand. It is a very deep-
14
seated, political resource allocation problem which is as difficult a
problem that a democratic society has.
I think that we certainly have made considerable progress in the
last several years. I am concerned that we will cease to realize the
need to make certain that the deficit continue down until it ceases
to become a destabilizing force.
The problem with this is that—as you well point out, Congressman—it is very difficult to convince people that we have a problem
when, indeed, we have an unquestionably very vigorous economy,
one which is by most indicators doing exceptionally well. What can
be wrong?
That could very readily lead to a degree of euphoria and unwillingness to come to grips with difficult problems. We will ultimately
find that when the problem hits, it is very late in the game and
very difficult to deal with.
I think that the Gramm-Rudman-Hollings targets have been very
helpful, in retrospect. I understand we've played games with them.
We've done a number of things which, really, one could readily
argue is not quite appropriate. But I think the process has been
working. I think it's very crucial that we resolve the budget issue
while the economy is doing well because the business cycle, as I indicated earlier, is not dead. Sometime it will re-emerge. Fiscal
problems are very difficult to handle under those conditions.
Mr. BARNARD. Of course, I know that you don't want to get into
thfe political aspects of this, but how detrimental would it be if, to
further reduce the deficit, hopefully in 1991 to zero, would an increase in taxes be?
Chairman GREENSPAN. Well, I have always argued that the
major thrust of cutting the Federal deficit has got to be on the expenditure side to be effective over the long run because, ultimately,
the Congress will fund whatever is appropriated for expenditure.
Taxes will ultimately meet the expenditures or we will be running
chronic deficits.
If we are capable of getting expenditure growth down by either
program elimination or program contraction, we have the best capability of resolving the budget deficit problem.
I dislike the issue of moving on the tax side largely because I'm
not certain it's fully effective. I have in this forum and in others
advocated a gasoline tax which could be quite significant, but I advocated that in part largely because I think it has other economic
purposes which are important for long-term energy policy.
But I recognize that at some point taxes have to be part of the
package. It would be a mistake, however, to make it a key and fundamental part of the deficit reduction package because I think, in
the end, we'll find that it doesn't work anywhere near as well as
one which emphasizes cuts in expenditures.
Mr. BARNARD. But don't you think we have had an unusual reduction in revenues in the last 7 years?
Chairman GREENSPAN. Well, as a percent of the gross national
product, they have not changed all that significantly. Those who
argue that the big deficit rise occurred as a rise in expenditures as
a percent of the GNP over the long run, I think have got the better
of the argument in the numerical sense.
Mr. BARNARD. Thank you very much.
15
Chairman NEAL. Thank you, sir. Mr. Hubbard?
Mr. HUBBARD. I would yield to Chairman Gonzalez.
Mr. GONZALEZ. No, no. Go ahead.
Mr. HUBBARD. Thank you, Mr. Chairman. I appreciate your being
with us.
We did meet 15 hours yesterday and this morning to complete a
major banking bill quite different from the Senate version which
passed earlier.
Your recent letter to House Banking Committee Chairman Fernand St Germain was frequently mentioned yesterday during the
discussion of the banking bill.
Let me please mention to you that, as you know, one controversial part of that bill is that 14,000 banks across the United States
of America, if the House version prevails, would be required to
cash Federal, State and local government checks. You mentioned
this provision in your letter to Chairman St Germain.
There would be no exclusions the way the bill finally passed the
House committee this morning at 3 a.m. So the big banks in New
York, Chicago and Los Angeles would be required to cash Federal,
State and local government checks and so would banks in my district, such as the bank of Farmington, the bank at Lowes, and the
bank of Tileen, very small banks, one employee, assets at one of
those banks being less than $1 million.
Could you give us your views on what the effect of this will be
upon the banking community relating what you mentioned in your
letter to Chairman St Germain. But now that the House Banking
Committee has passed that provision with no exemptions, could
you give us your views on how difficult this will be for banks to
abide by this if our version became law?
Chairman GREENSPAN. Well, I haven't had a chance to read the
final version that came out of that extraordinary session earlv this
morning. I do understand, however, that you did lower the $3,000
upper limit to—was it $1,500? So that helps in part.
The major difficulty that we have with that is the potential for
significant increases in fraud. The little I learned about what you
did this morning was that there were some indications of tightening up on that issue.
But I do think that it's going to be quite important, if that eventually prevails, to keep a very close eye on whether or not fraud
accelerates because it can very readily do in a small bank. One bad
check or series of bad checks—fortunately, at the much reduced
level—can eat into resources quite readily.
This is the reason why we advocated either variable fees rather
than the fixed fee that was involved or any of a number of other
methods involved to make certain that the banks, especially the
smaller banks, are protected from any acceleration in counterfeiting or misuse of Government checks.
Chairman NEAL. Would the gentleman yield to me briefly on
that point?
Mr. HUBBARD. Sure.
Chairman NEAL. We ended up with an agreement with a provision that would work as follows: There will be a two-tiered bank
account offered to low income people, including a provision, those
who do not want the regular services of a bank. This is instead of,
16
as the bill originally called for, people going to a bank and registering if they want to use the bank for Government check-cashing.
They now will have the choice of any of the range of the accounts
that the bank has to offer, if they want. But there is also a provision in the bill that requires so-called lifeline account, which many
banks offer now, such as 10 checks a month and a fee of $3 or $4.
In addition, we have added a new kind of bank account, which is
a check-cashing account. People open the account, wait 20 days, in
any case, so that there can be an adequate verification of signature, residence, and so on. From that time on, if a person wanted
just to use the account for cashing a check, they would take the
check to the bank and the maximum charge would be $2 per check.
We used that figure because that was what was in the bill.
The benefit, we think, over the long haul is that we would encourage direct deposit. We do not want to force anyone to do anything they do not want to do. But we would hope that VA, social
security, and other welfare agencies, would put notices in with the
checks suggesting that people could get same-day cash for the
check if they would go for direct deposit.
I believe this would reduce fraud and abuse significantly. It
seems to me we've made a lot of progress in this area.
Mr. HUBBARD. That's all right.
Chairman NEAL. If you do not like the idea, let us know. It seems
to me we have come up with something that is both practicable
and workable.
Chairman GREENSPAN. When we see the print, well take a close
look at it.
Chairman NEAL. We would be interested in your comments on it.
Mr. HUBBARD. Efforts by the banks to go into the insurance and
real estate industries failed yesterday.
Would you comment on current restrictions on banks expending
into insurance and real estate sales, as well as provisions that
would stop banks from underwriting mutual funds?
Chairman GREENSPAN. Well, we basically as a Board reviewed
the whole set of issues related to insurance and security powers,
and real estate powers.
The Board of Governors essentially signed off on, so to speak, S.
1886. All I can say to you is our general position is consistent in
support of the Senate bill in those areas.
Mr. HUBBARD. Last, would you comment about the Senate Banking Bill, which, if our version prevails in the House, then we go to
conference and the Senators come forth with their version, which
only had two votes in opposition.
How do you feel about the Senate Banking Bill that Senator
Proxmire is so proud of and the Senators have almost unanimously
endorsed?
Chairman GREENSPAN. As I said, we at the Board especially reviewed that legislation and concluded that we would unreservedly
support that bill; that is, the Senate print.
Mr. HUBBARD. Thank you, again, Chairman Greenspan, for being
with us today.
Chairman NEAL. Mr. McCollum?
Mr. McCoLLUM. Thank you very much, Mr. Chairman.
17
Chairman Greenspan, I apologize for being a little late this
morning. It was not the hour that we were up last night, though I
know that some of your staff was with us and we appreciate their
staying until the wee hours of the morning. But I happen to be
chairing—not chairing, but being the ranking Republican—wish I
could be chairing once in a while—another subcommittee over in
Judiciary that's involved with the drug issues today, and it did consume me earlier.
But I did have a couple of questions that I don't believe from listening to my colleagues and talking with staff you've had occasion
to fully address this morning.
Yesterday's economic figures came out and I know that they are
certainly showing some more heating of the economy, if you will. I
guess in some quarters the figures were lower than expected and to
some, perhaps, they were too high. The market certainly reacted in
the afternoon to them.
I'm curious to know what you make of those figures. Are they
consistent with what you would have anticipated? I know you've
expressed concern—obviously, we always are concerned with inflation and where it may lead and higher growth in the economy. I
know you've talked about the labor problem and employment.
But what do we make of those figures yesterday?
Chairman GREENSPAN. I think in the physical volume sense, they
came out pretty much as we expected because the GNP accounts
are not new data. In other words, it's not as though new information has come out.
What it is is a very detailed combination of previously published
information which we at the Fed have as well as the Department
of Commerce. So it depends on how one evaluates what those numbers are.
The only thing that I found a bit surprising was the extent of the
rate of inflation published for the second quarter, that the fixed
weight index for the GNP deflator at 4.7 percent seemed somewhat
larger than I would have expected one would come up with, coming
from the already published sets of data.
The reasons for that are the different ways of evaluating certain
numbers. But remember that we have nothing more than effectively the Consumer Price Index, some agricultural prices, wholesale
prices, and we recombine them in somewhat different ways. And
we seasonally adjust them somewhat differently.
But aside from that, I think the numbers continue to essentially
indicate that the economy is clearly in a relatively sustained expansion. And we did not, as a consequence of all of the data that
we had, really have to review the Humphrey-Hawkins report
which was done prior to those data because, in a sense, the numbers essentially came out reflecting the type of economy that we
had previously been evaluating.
Mr. McCoLLUM. Mr. Chairman, I know every person in your position has the difficult tightrope to walk of wearing two or three different hats, managing the Federal Reserve System, giving advice to
Congress on fraud policy questions with regard to where we go
with issues such as Mr. Hubbard was asking about in the banking
area and, of course, advising, counselling, voting, encouraging or
18
whatever, open market considerations, which is the monetary
policy area that we specifically are talking about today.
In wearing those hats and in walking that tightrope, I never
have asked questions, and I'm not going to this morning, ask you to
project or indicate any movement in specific actions of monetary
policy by the Open Market Committee because I think that's inappropriate.
But I am concerned, as I always am, with the media and with
the financial markets' response, sometimes erratically, to comments that are innocuously made that you have to make in public
forums such as this, and your reactions to questions such as I just
asked. Sometimes they read all kinds of things into what seem very
straightforward.
Chairman GREENSPAN. I've noticed.
Mr. McCoLLUM. So I traditionally like to ask the question which
allows the Chairman to not comment on where it's going, but to
give you a chance to breathe some room into the whole process.
The question I'd like to ask in that light, over the last 3 or 4
weeks, has there been anything that's occurred in the economic
picture, including yesterday and those figures you just discussed,
that would radically alter your advice or what we might anticipate
with respect to open market policy, as opposed to the basic policy
movement that you've been conducting here in the last few weeks?
Chairman GREENSPAN. I wouldn't think so, Mr. McCollum. There
have been a lot of data that have come out in recent weeks. Some
have been stronger than I would have expected, some weaker. But
none has altered either my or, as far as I can judge, the Board's
general view as to where we are going and where we have been.
That will inevitably happen. This is, in a certain sense, a period
in which there have been fewer surprises than normal, talking
back into the spring, let's assume. That can't continue. History
tells us that we are going to be surprised by a number of different
things, and if I knew what they were, I wouldn't be surprised.
Mr. McCoLLUM. Well, I can respect that and I know that we're
going to have to vote, Mr. Chairman. I'd just like one brief followup, and that is to this extent.
My observations in listening to you over the last several weeks
since you've been in office and we've had occasion to have you here
as a witness and so forth, have been that the general drift of what
is going on with the open market policy has been to try to manage
a pretty steady-as-you-go ship of state over there.
I don't—and this is just my observation and you can either comment on it or not as you choose—I don't see from what you've told
us today any reason for us to expect dramatic movement toward
huge discount rate increase to make a change or huge opening of
the floodgates of money to flood the market place, that you're still
looking at the parameters that are pretty steady as you go here
and there to make sure that we don't go radically one way or the
other.
If you want to comment, you can. I don't want to, again, get you
into a specific area that you don't want to be in.
Chairman GREENSPAN. Let the record show that I was uncommunicative. [Laughter.]
Mr. McCoLLUM. That's fair enough. Thank you, Mr. Chairman.
19
Chairman NEAL. Thank you, sir.
We have a vote underway now on the rule for the Drought Assistance Act, so we will recess for 10 minutes. Then we will hear
from Mr. Gonzalez.
Mr. GONZALEZ. Mr. Chairman, iet me say, I'm not a Member of
this subcommittee, so I'm here as sort of a guest. There's no use
interfering with the regular Members, even though Mr. Hubbard
very generously offered to accede to me.
I just wanted to say that, first, to thank the Chairman for being
here. But I'm very much disturbed to hear some of the things here.
I know that everbody's loathe to think or talk about taxes or
Texas. [Laughter.]
But since that issue was mentioned, I would like to point out
that if you do have regular meetings with the regulators, and particularly the Home Loan Bank Board, that we make sure that we
realize the dimensions of that problem.
The Chairman came before us the last time, and on the eve of
his appearance, upgraded his size of the hole in Texas 100 percent.
The figures that we're getting indicate that even that revised
figure is very modest and not accurate and that we've got to expect
another 100 percent just in Texas alone.
Now, I think that we've got to recognize that we're not going to
be able to isolate this crisis to Texas. It's going to spill over. We're
going to have to confront it. I think we have to recognize the limitations as to what the industry itself can do and where Congress
should come in.
Now, I know that everybody wants to hold everything together
until November. But I'm just wondering, in case it doesn't.
I just wanted to leave that thought because I think that we've
got to think of taxes and Texas because if we don't admit to the
cause of the dilemma of this monstrous deficit, and that, I think, is
the fact that we drained the Treasury of $755 billion worth of revenues over a 5-year period.
Now, we've got to make it up somewhere. So we've got to think
of taxes. But in the meanwhile, we have the crisis in our financial
institutions, and particularly in these hard-hit areas that seem to
be isolated now, but I think will soon be national.
Thank you, Mr. Chairman.
Chairman NEAL. Thank you, sir. We will recess for 10 minutes
and be back as soon as we can and pursue some other questions on
monetary policy.
Thank you, Mr. Chairman.
[Recess.]
Chairman NEAL. The committee will now resume its hearing.
Mr. Chairman, I would like for you to help us understand the
recent appreciation of the dollar. According to one popular explanation, the major central banks of pur trading partners are cooperating to induce some dollar appreciation to help dampen inflationary pressures in the United States and keep our interest rates from
rising substantially. What have other central banks, particularly
Germany and Japan, been doing over the last few months in terms
of exchange market intervention? What has the Fed been doing?
For sometime, the G7 countries have apparently been operating
under secret ranges for exchange rates. Why are they secret? Why
20
aren't they announced? Have they played any role in encouraging
the dollar's recent strength?
Finally, isn't the dollar's recent strength something a bit worrisome, given that we have only recently begun to make some
progress toward reducing our trade deficit? It appears that the rest
of the world is all too ready to bid up the dollar as soon as it hears
the slightest positive news about our trade performance. If that
continues, will they constantly thwart serious and sustained
progress on trade deficit reductions?
Chairman GREENSPAN. Well, Mr. Chairman, let me first just
quickly comment on the issue of why we don't make ranges of
intervention limits public.
To the extent that specific fixed ranges are made public, we are
in fact on a fixed exchange rate regime. In other words, basically,
going back to the gold standard when we had just so-called gold
point spreads between bid and asked on the currencies and through
the Bretton Woods agreements, we had announced fixed rates.
That is one type of operation for exchange rate regimes which
could be implemented.
The difficulty of doing that in today's environment I believe is
that we would find that we would probably in the process destabilize the system. That is, we would have very great difficulty locking
into a specific set of exchange rates in today's environment and I
think that that's generally agreed upon by all of the major trading
partners.
Nonetheless, we also agree that stability is clearly superior to
volatility and, as a consequence, there have been agreements since
the Louvre accord amongst the G7 to foster stability of exchange
rates and that is essentially what the G7, in consultation, has endeavored to do.
The degree of intervention, as many of our reports have indicated and as many have assumed quite correctly, has obviously been a
good deal less in 1988 than in 1987. Clearly, with the improvement
of the American trade accounts, stability of the American dollar
emerged and has been fostered by actions by the G7 in concert, and
we hopefully will be capable of doing that into the indefinite
future.
The recent strength would become worrisome if, in the words of
the communique which the G7 issued late last year, the dollar rose
to a point which would essentially create difficulties in the international stabilization process; that is, it would be counter-productive
to the type of adjustments which we are all endeavoring to do.
That, in effect, is something which clearly we have stipulated as
a group we would find undesirable.
So, in general, I think the central thesis is stability, and it is stability because it is in our judgment—for all parties, all economies
of the G7—the exchange rate regime which will most foster at this
particular stage the implementation of the type of corrective actions which are required to bring down the cumulative trade surpluses, on the one hand, and specifically our very large trade deficit on the other hand.
Chairman NEAL. Well, is that correct? Is stability at the current
exchange levels the best way to bring our trade deficit down?
21
Chairman GREENSPAN. What I am saying is that the adjustment
process is contributed to best by stable exchange rates in this area.
The reason I say that is, as I've indicated previously, further
downward adjustments in the dollar would not at this stage create
any accelerated improvement in the nominal trade deficit. It is
clear that the process that is already underway and the effects in
the pipeline toward a major rise, in the physical volume of exports
and slowed growth in imports, are a consequence of previous declines in the exchange rate and improved productivity and a
number of other factors. It is not clear that we have capacity in
our industrial area in the United States to actually significantly
improve on that export-import change in physical volume terms.
Chairman NEAL. Because we are producing at near capacity.
Chairman GREENSPAN. Yes. If that is the case, a decline in the
dollar will show up as higher import prices, which will make the
nominal deficit worse, not better. So, as we see it, from the point of
view of the United States, and there are comparable issues in Germany and Japan, that the adjustment process that is currently
going on is moving at a reasonably rapid pace, perhaps about as
fast as one can expect to be achieved. I would say there's really
nothing that would improve that process by moving away from the
central focus of stability.
Chairman NEAL. I must say, in general terms, I agree with you.
However, if the dollar were to continue to appreciate in value, the
impact, it would seem to me, would be on balance negative.
Chairman GREENSPAN. I agree with that. I think that the G7
stipulated that and reaffirmed it at the Toronto summit.
Chairman NEAL. So you would see this recent appreciation as
perhaps an aberration in the longer term trend of stability.
Chairman GREENSPAN. Well, I don't want to comment on specific
movements, Mr. Chairman. I would like to just leave my comments
stay where they are.
Chairman NEAL. It is important to me to know whether the Fed
is or is not actively trying to encourage appreciation of the dollar.
Chairman GREENSPAN. I've read stories that had all sorts of implied secret conspiracies involved which I thought were absolutely
bizarre.
I think that what is in the communiques of the G7 are actually
what went on in the G7 meetings, what people had in mind. People
looking for secret meanings in these things, I think they're looking
beyond reality.
Chairman NEAL. That does not interest me, either.
If I may direct your attention to the chart on the wall which depicts Federal Open Market Committee monetary growth target
ranges and actual M2 and M3 growth.
[A copy of the chart may be found in the appendix on page 83.]
Chairman NEAL. It suggests monetary ease early in the year and
some tightening beginning in the spring as the aggregates approached their upper target ranges.
Would you say this is an accurate depiction of the thrust of monetary policy? Can we say it was fairly easy in the first quarter,
then began to tighten? Given the expected strong growth of the
economy, wouldn't it be wise for the Fed to induce the aggregates
22
to continue the downswing they have now initiated—to finish the
year somewhere below the mid-range?
Chairman GREENSPAN. Certainly, that chart does depict precisely
what it is that we are endeavoring to do with respect to the monetary aggregates. We are endeavoring to hold M2 and M3 within
target.
It's very difficult to say precisely where within the range we will
end up. But, clearly, we are focused to try to be well within the
range because to be significantly on the edge or outside of it would
suggest that our general view of the way we thought that the economy was emerging had changed.
Since, as I indicated earlier, it has not, one can reasonably presume that we will be, if it continues according to our judgments as
to where it's likely to end up, pretty much in the middle of the
range, or substantially there. But whether it's a bit above or a bit
below is, I think, not too easy to determine.
Chairman NEAL. Thank you, sir. Let me yield to Mr. Flake at
this time.
Mr. FLAKE. Thank you very much, Mr. Chairman. I'd like to express my thanks and appreciation to the Chairman for coming to
share his wealth of information with us this morning and to our
Chairman of the Banking Committee for making it possible, in
spite of having kept us out half the night and morning, to get up
even at this early hour to follow through.
Mr. Chairman, I have three questions that are basically unrelated, but may be of some interest.
First of all, having read some of your comments over the last
couple of weeks as it relates to the CRA requirements that have
been bandied back and forth here on the Hill in relationship to
new banking policy and the new banking bill, is how might we be
able, to get the banking community involved in the process of redevelopment, and rebuilding? Then we should be able to move the
persons who are a part of that potential labor force into more legal,
productive kinds of jobs than what they're doing now, which in
most instances is a choice of selling drugs on street corners?
Chairman GREENSPAN. Mr. Flake, I think you're raising one of
the really very difficult problems which is essential for this country to address and address in a way which is not at the margins,
but essentially, it comes to grips with the fundamental issue.
I don't think it's strictly a banking question. I think it is partly a
banking question. But I think what has to be done is for us to find
ways which have been done partly successfully in certain areas, to
find the means of getting business and investment into these areas
which create jobs, create profits, create an environment of growth
and confidence in the future.
Under those conditions, banks come in very rapidly. I'm concerned that we not work it in reverse because the banks are there
basically to service credit needs and economic needs, and it's very
important for us to get the economies going in those sections
through a lot of different activities.
We should try to find successful ventures where we begin to
build up some of those areas. I find it really is extraordinary that
we've made very little progress in a number of those inner city
areas.
23
If we can do that, I think what we're going to find is that banks
will just normally flock in. It's where their business is. It's where
their opportunities are. And competition will basically bring a proliferation of banking.
The one point I want to leave with you, however, is not to think
that we can do it in reverse. The banks are not the first ones in
there. They're sort of somewhere in the middle. We've got to find
investment. We've got to find businesses. We've got to find job-creating activities, financed initially from outside of the area, and
then you get a synergism which develops which we've seen time
and time again happen.
That's the process which I think we've got to find a way of initiating.
Mr. FLAKE. Could we not expand some of our ideas that have
been operative in the development of some Third World nations
where we actually use risk capital? It is a risk situation when
we're dealing with unstable dollar and unstable governments.
Perhaps if we could rethink what it means for us to engage in
domestic development. Since I realize that we're taking a big hit in
some of those Third World nations, it seems to me that the hit
would be much less when we're dealing with the same government,
and the same monetary system. Perhaps we ought to give that a
great deal more thought and perhaps more priority than we do in
developing those areas.
Chairman GREENSPAN. Well, I certainly agree. It's risk capital
that we need. Risk capital emerges when there are opportunities. I
think what we've got to figure out is a way to create opportunities
to get that sort of capital in and find programs which initiate it.
But I think that's exactly the area which is the cutting edge of
the solution, as best I can see it.
Mr. FLAKE. The second question, realizing that you have really
not had an opportunity to see what came out of this body last
night, but have had some opportunity to look at the Senate version
of the banking bill and the numbers that have been given over the
last several weeks in the Wall Street Journal and some other
papers as it relates to the top 25 banks in the world, of which there
is no bank in the United States listed.
What is your feeling in relationship to what the potential bank
bill that we ultimately come out with will do to improve our competitive standing in the world market place? I'd like to know if you
have any particular observations on that?
Chairman GREENSPAN. I certainly don't get concerned by that
ranking of who is first, who is second, who is 25th or 28th or what
have you.
The best and most competitive international bankers are not necessarily those directly on the top. There's a lot of other issues
which create international competitiveness. It's an issue of capital.
It's an issue of managerial skills. It is not an issue of size, after one
gets beyond a certain point.
So I, frankly, have given very little thought to the international
competitive aspects with respect to either the Senate bill or the bill
that's emerging here because I'm not sure it's really all that relevant an issue.
24
I wouldn't, myself, think of the needs of this type of legislation to
give us greater international competitiveness. That comes from
other areas and I think that's not a size question. I don't find
myself particular disturbed by the numbers you are suggesting.
Mr. FLAKE. The last question I guess is of interest regardless of
where people are in terms of the socio-economic ladder. What is
your projection as it relates to the remainder of this year and the
beginning of 1989 in terms of interest rates?
Chairman GREENSPAN. Well, Mr. Flake, I've avoided forecasting
interest rates and I think so has the Federal Reserve Board. I
think I'd just like to leave it at that.
Mr. FLAKE. All right. Thank you very much.
Chairman NEAL. Mr. Wortley?
Mr. WORTLEY. Thank you, Mr. Chairman.
Chairman Greenspan, you look a lot livelier this morning than
some of your staff people who are sitting behind you who had a
long evening.
Chairman GREENSPAN. I should certainly hope so. [Laughter.]
Mr. WORTLEY. I will testify to the fact that they were here. I
don't think they've been home yet.
Congressman Flake just alluded to the competitiveness of American banks. I certainly don't think myself that the consumer aspects
of the bill that was marked up in this chamber at the early hours
of this morning is going to contribute anything positively to the
competitiveness of American banks.
I know you haven't had an opportunity to read the bill. But do
you have some basic observations based upon what your staff may
have told you transpired here this morning?
Chairman GREENSPAN. Well, as you know, Mr. Wortley, I had a
number of reservations about the earlier prints and communicated
that to the chairman of the committee.
From what I understand, there has been, in my view, improvements in the bill, clearly both in the securities titles and elsewhere.
Until I've had a chance to read and discuss it with our technicians—where some of the problems may emerge—I really don't feel
competent to give you a judgment as to anything more detailed
than that.
Mr. WORTLEY. Sure. I can understand.
Chairman NEAL. Would the gentleman yield to me on that point
for just a second?
Mr. WORTLEY. Certainly.
Chairman NEAL. We would like to see your comments when you
have a chance to review it. We worked on it a long time yesterday.
Though we made some improvements, there are still more improvements needed. But your ideas on the subject would be useful to all
of us.
Chairman GREENSPAN. By all means.
Mr. WORTLEY. Thank you. Let's look a little beyond next year
and the balance of this year into the last decade of this century.
Glance at the 1990's and we see what's going to happen in 1992
over in Europe, the European Common Market, when they drop all
of their trade barriers, presumably.
What effect do you think that's going to have on the U.S. economy? Is that going to mean that we're going to have to become a
25
little sharper in the competitive arena? Will it bode well for the
United States because we seem to be a few steps ahead of Western
Europe in our productivity and the like?
Let's also factor into consideration the final decade of this century when there will be a shortage of people in the U.S. labor
market, which may raise the cost of doing business. On the other
hand, it may also make us more efficient and work smarter than
weVe been working in the past because we will have an older,
more experienced work force.
Looking at some of these factors, do you feel bullish about the
last decade of this century?
Chairman GREENSPAN. I do. I think that I do largely because
there is a very significant underlying trend that has emerged in
the world in, I'd say, the last decade. That is a growing recognition
that market economies are the way in which economic wealth can
be created.
We've seen this not only in Europe, where there have been quite
significant changes. We view it as sort of a political shift toward
conservatism. But I think it's fundamentally more an issue not of
conservatism, but of agreement of free market oriented type of
economies. We're even seeing it, obviously, in the socialist bloc, not
only with respect to the Soviet Union, but elsewhere, and most importantly, in the Third World.
That's a deep-seated philosophical recognition of how societies
and economies should be organized.
When one looks at long-term economic growth, I think it is a
mistake to look at demographic factors and econometric projections. I think you have to look at the philosophical culture which
the system functions under. I think that the movement of Europe
toward integration is a very significant, positive force for the world
as a whole.
The negative possibilities are exactly the anti-market issues. For
example, would the Common Market become, in and of itself, a
protectionist vehicle which would raise its barriers to the United
States and the rest of the world? The answer is, if they are on their
current trend, no. To the extent that that is no and to the extent
that they develop, it clearly enhances us because we can trade with
them. It's been very obvious in the post-World War II period that
enhanced trade has been a major factor toward the growth of
standards of living throughout the world.
Mr. WORTLEY. Expanded trade will determine how successful our
own economy will be.
Chairman GREENSPAN. Yes, most certainly.
Mr. WORTLEY. If the European Common Market is prospering,
the U.S. economy should prosper, assuming they keep the trade
barriers down and do not revert back to what you might have suggested a moment ago.
How do you look at the Pacific Rim and where we will stand? Do
you think there will be more concentration of American efforts
toward Western Europe when 1992 rolls around, to the neglect of
the Pacific Rim market, or do you just see the whole thing exploding all around us?
Chairman GREENSPAN. I think one of the extraordinary events of
the last generation has been the major improvements in world tele-
26
communications and in travel. We have really, obviously, in a figurative sense, brought the world together.
Thirty years ago, to make a telephone call to London was a big
deal. Now you call London to get the weather. It's that easy and
it's that cheap.
The costs of communication and transportation having, in relative terms, fallen, has brought us all closer together, and I would
think in those terms, we are going to see significant increases in
international trade and a continued integration of the world economy, both on the Pacific Rim and in Europe, so far as the United
States is concerned.
Mr. WORTLEY. Well, the market place is certainly open 24 hours
a day, whether you're talking about the stock markets or whatever
else.
Just one final question here. The FOMC forecast implies a somewhat slower growth of the economy during the second half of this
year. What really accounts for that projected slowdown? Is it the
fact that the committee itself is considering tightening the money
supply or do they really see other elements there?
Chairman GREENSPAN. People rarely ask that question and the
answer actually is I don't really know. Let me tell you why.
Mr. WORTLEY. Are you a right-handed or a left-handed economist?
Chairman GREENSPAN. I'm a left-handed economist. I don't know
what that means, but
Mr. WORTLEY. We're looking for the one-armed economist.
Chairman GREENSPAN. Yes. What we do is we poll the voting
members of the FOMC and the nonvoting members and we ask
them for their projections. Each obviously has his own view as to
what he thinks will happen and why it will happen, but that's not
part of the survey.
So all we can get in that context is basically the average judgment as each makes that judgment without knowing precisely why
in each individual case. Now, obviously, we can make broad, general judgments as to why those things occur. And we have, in effect.
One obvious explanation of a slowing is we are approaching low
unemployment rates and restraint on capacity. We assume that
most of the members had that in mind.
But that's an inference, and it's not something I can tell you I
know for a fact.
Mr. WORTLEY. Well, that was a very clear and concise answer.
Thank you, Mr. Chairman, very much.
Chairman NEAL. Your projections for real growth have been in
the range of 23A to 3 percent for 1988. Based on statements you
have made, it appears that you think that real growth near 2l/2
percent, is about what we can count on without encountering inflationary pressures.
One of the promises of the Reagan administration's economic
policies, in particular its tax policies, has been that we will grow
our way out of the deficit. Do you think that this is a realistic and
prudent expectation, if, in fact, if we were to pump growth up
beyond the range that the FOMC projects—over 3 percent. Won't
that cause other problems for the economy. Is this a prudent vision
of what it takes to solve our economic problems?
27
Chairman GREENSPAN. Mr. Chairman, I do think that there have
been members of the Reagan administration who have, in a sense,
implicitly or explicitly argued that.
My recollection, however, is that that is not the official position
of the President or his key advisors at any point that I particularly
remember.
My own impression is consistent with that. I don't think that one
grows out of this particular deficit. If I believed that, I wouldn't be
as forceful as I hope I have been on the need to take actions to
bring it down. If we're going to grow out of it, no actions are required. I don't believe that that's a feasible policy goal at this particular stage, nor has it been.
Chairman NEAL. I would agree with that.
Mr. Leach?
Mr. LEACH. Well, thank you. First, just an aside on this pafticular issue.
I think that all of us should recognize that whether or not your
policies are exactly right or wrong at this time, they reflect a great
deal of integrity because they're designed to slow down economic
growth at the time of the election. That implies an independent
Federal Reserve Board.
Some of us on this side of the aisle, Mr. Chairman, think that
this might ultimately lead to disaster, a Democratic administration. But that being said, I think we should honor the integrity
with which the Federal Reserve Board is currently being managed.
But I would like to move away from the larger world view, and
I'm sorry, return again to the sectoral.
We seem to have a problem with Federal insurance of depository
institutions because it's rational for individuals to put their money
in an institution with the highest rate of interest as long as it's federally-backed or perceived to be secure. This implies that institutions which are poorly managed or are in extreme deficit positions
can grow rather extraordinarily, unless there's regulation to curb
this growth.
It's my sense that there has not been enough attention placed on
this issue. It may be that the only way we can protect the Federal
insurance system without changing it dramatically is to reduce
Federal insurance for those institutions least able to manage
growth.
You made a remarkable statement earlier, and I think it's somewhat newsworthy, that you think insolvent thrifts should not be allowed to grow.
Last night, in considering the banking bill, I proposed an amendment that did not receive a great deal of support in this committee.
I suggested a plan to retard the growth of the thrift industry. In
this plan those institutions with a negative net worth should be required to shrink on an annual basis of three times their percentage
negative net worth.
So if an institution has a minus 3 percent negative net worth, it
would shrink 9 percent a year. Those in the 0 to 4 percent positive
category would not be allowed to grow. Those with a 4 to 6 percent
net worth could grow at 2 times their positive net worth. Those
above 6 percent could grow without limit so long as they stayed
above 6 percent.
28
I don't want you to comment precisely on that plan. But one of
the aspects of putting forth that amendment was to suggest that
people think in terms of a plan. A plan that comes from a Republican Member of Congress is not likely to carry much weight. But it
strikes me that if a Republican Member of Congress can devise a
plan in the shower, the Chairman of the Federal Reserve Board,
with the enormous staff behind him, could derive a Greenspan
plan, or a regulators plan, to deal with the macro-economics of the
thrift problem. Such a plan would stop a $50 billion headache from
becoming a $100 billion migraine.
There are tools that regulators can use. One of the most important tools is the power to remove institutional executives and directors.
I would suggest to you that the regulators in concert, led by the
Chairman of the Federal Reserve Board, ought to establish an approach and announce that approach and announce that institutions
that violate this approach will have their management, directors
and executives removed.
It's the only way to curb growth that is excessive. It's the only
way to avoid far harsher kinds of approaches that will be very disruptive to world commerce, such as changing the deposit insurance
system. It's the only way to avoid a much greater taxpayer liability
as time goes on.
In effect Congress has developed a scheme by which high fliers
only incentives are to take risky steps. Congress can only then protect itself if regulators rein in these unwarranted risk takers.
Does the idea of coming up with such an approach strike you as
reasonable? You have acknowledged earlier that zero growth, at a
minimum, for insolvent thrifts makes sense.
Can you follow it with the idea that for those that violate that
prescription, there ought to be steps taken? For example, the removal of officers.
Chairman GREENSPAN. Well, Mr. Leach, let me just go back and
take a look at what the nature of the extreme problem is in certain
instances.
The extreme of this issue occurs when an institution, a depository institution, finds that, for example, not only does it have inadequate interest earnings to pay interest on its deposits, but the amortization of its asset base, in combination with interest earnings,
is inadequate to pay that interest.
What we find under those conditions is that institutions went out
and expanded merely to get deposits to pay interest. It became a
cumulative process which at the root of this issue.
The problem we have is a much broader issue, however, which I
think is going to inevitably require considerable focus by this committee and others within the Congress and the next administration
on the issue of deposit insurance. We have not really reviewed the
system since its initiation. We've all conceptually understood that
the so-called moral hazard question was inevitably a threat to the
system and created many perverse incentives.
I don't, frankly, know what the actual issue is, but the underlying thrust is going to have to be to review the whole system to basically try to find what our alternatives are and restore the system
to the type of balance which we clearly need.
29
Without commenting on your specific proposal, I think that my
concern is that the issue has to be broadened out. But, clearly, specific issues of the type you raise, and without commenting, I'm not
sure whether it's a good or a bad idea. I'd have to really think it
through.
But let me just say that we will have to spend a good deal of
time rethinking the system to make certain that we can restore it
to what it is supposed to be. In that regard, obviously, we at the
Fed have been thinking about this question, will be thinking about
it, and we will be prepared at the appropriate time to be of what
assistance we can be to the Congress when it revisits this issue in
more detail later.
Mr. LEACH. I appreciate that. But let me come back to Federal
Reserve Board responsibility. I don't want to play ping-pong with
who's at fault. On the deposit issue, there are a lot of alternatives
that one can visualize. One is to take away insuring interest and
just insure the deposit itself.
Another is to have differing levels of deposit insurance for institutions, depending on the institutions capital-to-asset ratios.
I'm a little alarmed at your statement that you will make recommendations to the next Congress. First, there is a regulatory responsibility to act. Second, there is a timeframe that cannot be delayed any longer. Sometimes, timing is with us, sometimes it isn't.
But timing-wise, it strikes me
Chairman GREENSPAN. I agree with that.
Mr. LEACH.That the regulators are going to have to come together and address the problem, that the Fed ought to exercise leadership. You, yourself, have an appropriate background in this area.
You have a particularly appropriate staff. You have the capacity to
look at this issue in a macro way, unrelated to my approach.
Approaches can generate other approaches. But any approach
should lay down principles that everybody in the industry understands. And if these principles are violated, there should be punitive action, such as the removal of the violators.
Chairman GREENSPAN. Yes. But we have the legal authority to
do that.
Mr. LEACH. You surely do. Now let me come back and note what
has happened in the last 6 months, without the Federal Reserve
Board in opposition.
At the Federal Home Loan Bank Board, one institution got into
some difficulty because regulators tried to be too tough, and so the
FHLBB changed regulators. Unprecedented in the history of regulating agencies. I have not heard a peep from the Federal Reserve
Board about this case.
We have instance after instance where agreements have been
made to allow insolvent institutions not only to continue, but to
grow. Again, let me talk about the Ben Franklin Savings and Loan
in San Antonio, TX,1 a totally insolvent thrift. Its rescue plan is to
let it grow from $2 /2 billion in size to $5 billion in size over the
next 5 to 6 years.
Incredible thought! You rescue it by impelling growth.
The net worth certificate issue is not only one that puts the taxpayer on the line; it impels growth in the industry.
30
All I'm saying is that somewhere, people have got to come forward. This Congress is institutionally incapable of getting too
tough on an industry this much in trouble. Therefore, I think we
have to look to you to do something within your realm of jurisdiction.
Just as one Member of Congress looking at an institution that is
semi-independent, semi-public, and part creature of this body, all I
would ask is for you to put your best minds to work, come up with
a plan, and take responsibility.
I think you're going to have to do it soon.
Mr. Chairman, I have no further comments.
Chairman NEAL. On the question of FSLIC, not long ago, we had
Chairman Wall of the Federal Home Loan Bank Board before the
committee and we discussed for some time the current situation.
Different opinions were expressed about the magnitude of the problem and our ability to deal with it. I asked Chairman Wall if, based
on the best information he had, did he think that the roughly $42
billion that the FSLIC will have for dealing with the thrift problem
over the next several years, would be adequate for the task at
hand? His answer to me in that public forum was that, to the best
of his knowledge—I'm paraphrasing—it was an adequate amount
of money and they thought they could deal with the problem.
I raise this point because there have been a number of press reports which followed that meeting, which did not reflect that at all.
Indeed a number indicated that the resources have been inadequate and so on. Do you have a view on this?
Chairman GREENSPAN. There is an underlying problem with the
issue which really relates to how one makes that estimate. The
major problem is that we have to have a judgment as to what is
the market value of the properties which underlie the mortgages
because when you're getting toward a very difficult situation, the
mortgages essentially become nonrecourse loans on properties
which then essentially become the asset of the depository institution.
The one thing that is very difficult to make a judgment on is to
what extent that market value is adequate or inadequate, or to
what extent one has to discount it to meet the requirements of the
institution.
Since the amount of property that underlies these mortgages is
so huge, small changes can generate very large dollar amounts relative to what the whole is.
So when somebody tells me that the whole is some particular
number, my assumption is he either has extraordinary insight or
access to information that we don't have.
Nonetheless, you do have to make judgments and you are
making them and we are—I mean, we obviously follow this issue
very closely and are very much acutely aware of the issues which
both you, Mr. Chairman, and Mr. Leach have been raising. But we
know of no way, at least I know of no way, to get that fine-tuned to
a number which everyone says: "This is the accurate number."
I think what we do know is that we have a large problem, and I
think that that is in the process of being addressed, hopefully, and
it will be something which is going to grab our attention, I think,
for the next period of time.
31
Chairman NEAL. Mr. Wall pointed out that he was not estimating the size of the problem. He was saying that what we do know is
that that system will have roughly $42 billion to work with over
the next several years. The question is, based on his best information today, is that going to be adequate to the task? I would not be
critical of him if his judgment changed. Judgments change and circumstances change.
But he seemed to feel confident that that would be enough. Is
there any reason, at this point, based on what information you
have, to doubt that? That is to say, is there something that we need
to do that we are not doing at this point to deal with this problem?
Chairman GREENSPAN. I don't think so. I've talked to Chairman
Wall on numerous occasions and I think he's quite realistic about
what the nature of the problem is, as best I can judge. He has actually got the best data base of anybody I know.
My view would basically be that his data sources have got to be
as good as anybody's and his judgment in this respect has got to be
as good as anybody's. I would see no reason to try to second-guess
him in this respect.
Mr. LEACH. Mr. Chairman?
Chairman NEAL. Yes, sir.
Mr. LEACH. Could I raise something in this regard?
Chairman NEAL. Certainly.
Mr. LEACH. Your point about how real estate goes up and down
in value, the staggering number of properties involved, and therefore, the difficulty to predict a bailout cost, also highlights certain
issues of judgment.
One issue concerns an amendment that I offered last night to the
banking bill which the committee didn't find very worthwhile. Federal banking regulators, in their long history, have had doubts
about using Federal insurance to leverage other people's money in
direct investments.
In the savings and loan industry, some institutions of a given
type are allowed to leverage 300 percent of capital for direct investments, such as buying a piece of real estate, buying a stock market
investment, buying a Wendy's, whatever it may be. This is a rule
and regulation of the Federal Home Loan Bank Board and it's
something that distinguishes the thrift industry from the banking
industry in terms of powers. The weakest of America's two principal financial banking industries has substantially greater powers
to leverage.
Now, as Chairman of the Federal Reserve Board, which has some
accountability to the banking industry, do you think this is reasonable, that thrifts should have this extra power to make direct investments?
Chairman GREENSPAN. Actually, I think there's another issue involved in this question. My major problem with savings and loan
institutions and the nature of the difficulties they have been in
really rests to a large extent on the mismatch between the maturities
Mr. LEACH. Short and long term.
Chairman GREENSPAN.Of the assets and the liabilities.
While one may raise the question you raised, Mr. Leach, de novo,
right from the beginning, nonetheless, there is an aspect of direct
32
investment which is beneficial in this context in the sense that it
tends to be a vehicle which offsets in part the asset liability maturity mismatch. My view of the ultimate resolution of the savings
and loan problem is to make certain that we try to bring that issue
into place.
Mr. LEACH. Let me just say, of all the economic judgments I've
heard you express, that is one that I find the least credible because
in most instances, it's using short-term money for long-term investments—the purchase of a piece of real estate to be owned by the
institution.
That accentuates the mismatch; it doesn't bring it in line.
Chairman GREENSPAN. To the extent that it does, it can, but it
doesn't have to.
Mr. LEACH. It doesn't have to. But, generally, most of this has
been used to buy real estate.
Chairman GREENSPAN. I would just say to the extent that it does
increase the mismatch, it is wrong. To the extent, however, that it
doesn't, it could be beneficial.
Chairman NEAL. Last night, I argued against the gentleman's
amendment because I felt that we simply do not know. As I look
out there, there are some very unhealthy savings and loans who
have engaged in a lot of direct investment. Some of the very best
managed savings and loans, most profitable thrift institutions in
the country, are ones that engage in a lot of direct investment. In
fact, in understanding their philosophy, they are doing precisely
what Chairman Greenspan would recommend. That is to say, they
are matching maturities. If they can take a deposit in for 20 years
at a fixed rate, then they're willing to lend that amount of money
for the same 20 years at a higher rate. If they take it in for 30
days, they put it into something that matures in 30 days. That kind
of management, whether it has been in direct investment or home
mortgages, or whatever, has seemed to me to be what sets apart
the successful institutions from the unsuccessful ones. I have not
been able to see the evidence, although if I saw it, I have no love
for direct investment. That's not the question, it seems to me. I just
don't see any evidence
Mr. LEACH. Well, if the gentleman will yield to me?
Chairman NEAL. Yes, I'll be happy to yield.
Mr. LEACH. Basically, the problem of direct investments is that if
the institution guesses right or has good judgment, it works to the
advantage of the institution. It's heads, the institution wins. But if
it's the reverse, it's tails, FSLIC loses.
So what we're really doing is honoring a speculative kind of investment with Federal insurance. There are good investments in
America. Each of us as individuals can make them. But that
doesn't mean that we ought to be federally insured when we attempt to do this.
Now as far as the evidence is concerned, 2 years ago there was a
Federal Home Loan Bank Board study. This study found that in
closed institutions, enormous problems developed with direct investments which caused enormous losses disproportionate to all
others.
Now, my own guess is that the really smart investor today might
do well. The real high flier might guess wrong, but with the high
33
flier the taxpayer is on the line. If it's such a good idea to have
direct investments, it's interesting that the Federal banking regulators have never authorized it to this degree, and they have good
reason not to have authorized it, in my judgment.
But if I could just return to one other issue, and that's the net
worth certificate issue.
It strikes me that this not only impels growth in the industry; it
becomes a Government-induced Ponzy scheme. All I want to throw
out to you, sir, is that these issues ought to be looked at. As the
Federal banking regulator, first you may be called upon for emergency funding, if Chairman Wall is wrong. Some of us think the
amount of funding will be large and some of us think it will be
needed sooner rather than later. Second, you're responsible for an
industry, the banking industry, that is competing on a surprisingly
unequal playing field.
Now, we all hear many, many times about a level playing field.
But the fact of the matter is that Federal deposit insurance gives
an advantage to anyone that can get a charter, no matter how
weak they are, unless the regulators constrain them.
Chairman GREENSPAN. I agree with that.
Mr. LEACH. So the institutions that you have first and primary
responsibility in regulating are being disadvantaged because another regulator is weaker than you. If I were in your position, I
would be standing on the table doing backflips because you're
going to have growth in the deposit base in those institutions with
the weaker regulators. It's that simple.
Therefore, as one regulator responsible for one industry, you
should say to the other regulator—"You've got to match my standards or you're messing around with my institutions and their ability to make money."
It's a matter of a level playing field, of fairness, as well as, very
interestingly, of taxpayer liability. The taxpayer is concerned with
limiting the liabilities to him or her.
All I'm saying is that ssomehow, somewhere, the Federal banking
regulators, out of deference to another industry, have been very
light-handed. I think it's time for the deferential approach to cease.
Somehow, there's got to be a joint merging together of talent and
judgment within Government to bring some sort of sanity to this
game.
I just wish Congress were willing to act in a more forthright way,
but there are lots of honest differences of opinion. The Chairman
and I differ on this one issue for very reasonable reasons.
On the other hand, I can believe a regulator might share a different perspective from either of us. But my only argument is to develop a perspective and once a perspective is developed, to do everything in your power to ensure that it's followed.
I think, frankly, that means telling the industry that you're
going to replace management. When there are no incentives to
make money, as with hopelessly insolvent thrifts, there become
enormous incentives to pay oneself well, to develop perks, to grow.
If that's the worse thing for the economy, then the only way to rein
it in is to put constraints on growth and to remove people from
office without receiving any perks if they don't follow prudential
regulatory guidelines.
34
Well, I don't mean to be presumptuous in my judgment, but I do
think that these issues have to be looked at in a really comprehensive way. I would like a response from the Chairman the next time
he comes before this committee or another committee of Congress,
on whether he supports a timetable or will agree to come up with a
plan.
Is there any way I can elicit that kind of commitment?
Chairman GREENSPAN. Well, I don't know that I can give you a
commitment, Mr. Leach, but I've been listening to you very closely.
Mr. LEACH. OK. Thank you, sir.
Chairman NEAL. Mr. Chairman, I believe I would state your
opinion accurately to say that once GNP starts growing at much
above 3 percent real growth, we run into some serious inflationary
and capacity problems. Japan seems to be able to grow at over 4
percent without running into those same kinds of problems. The
reason appears to be that they are able to save more.
Do you agree with that analysis? If so, what would you think
that we could do, what would be the most powerful thing that we
could do to increase savings here domestically?
Chairman GREENSPAN. Well, Mr. Chairman, I certainly agree
with ymi that the fundamental reason for the differential growth is
the domestic savings rate.
We have over the years tried innumerable initiatives through
tax incentives, through varieties of other actions, to increase the
domestic savings rate in this country. The evidence suggests we've
not been wholly successful.
One of the reasons why I have argued for moving not to a Federal budget balance, but toward a surplus, is that it strikes me as the
only effective, short-term way—intermediate short term—that we
can sufficiently increase the domestic savings rate in this country,
such that we can increase capital investment and, accordingly, improve the growth in the standard of living of the American people.
I wish there were another way of doing it. I wish there were simpler ways of doing it. But I must admit to you that, having been
through long series of alternate procedures, I'm pretty much convinced that while we might find other ways, that surplus is going
to become crucial to us in the 1990's.
Chairman NEAL. Well, I do not see it, either. Historically, we
have saved at a very low rate and in recent years. Through the economic policy we have been following in the last 8 years has promised to increase sayings, clearly, it has not. The savings rate has
gone down to historic lows.
I am not saying that in a political sense. I am saying that is just
the fact. So tax cuts do not do it. We have built into the tax code in
some of our other policies incentives to spend and not to save—
they are disincentives for saving. We ought to be able to reverse
that at some point.
How would running Federal budget surpluses help us in putting
those savings to productive use?
Chairman GREENSPAN. When one looks at the balance of savings
and investment in an economy, especially such as ours, what is
very clear is that since our gross private savings generation is
modest, and since the Federal Government deficit is a use of those
savings, an absorption of those savings, what is available for pri-
35
vate investment is gross domestic savings minus the Federal deficit
adjusted for the net foreign savings that comes in, or the net American savings that goes out.
Since the Federal Government, by its nature, can finance whatever is required to meet the difference between expenditures and
receipts, it will pay whatever interest rate is required. It, essentially? by that fact, has the first call on domestic savings. It will outbid
anybody else.
Chairman NEAL. Right.
Chairman GREENSPAN. Therefore, while we may not be able to
increase the gross private savings, if we reduce the Federal budget
deficit to zero and then to a surplus, what we are in effect doing is
adding to the domestic savings so that we can finance much higher
levels of investment in this country.
Chairman NEAL. Yes, at lower rates of interest, it would appear,
also.
Chairman GREENSPAN. Yes.
Chairman NEAL. All right, Mr. Chairman, thank you very much
for being with us today.
The committee stands adjourned, subject to the call of the Chair.
[Whereupon, at 12:50 p.m., the hearing was adjourned.]
THE CURRENT STATE OF THE ECONOMY
Thursday, September 8, 1988
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, DC.
The subcommittee met pursuant to call at 2 p.m. in room 2222,
Rayburn House Office Building, Hon. Stephen L. Neal, [chairman
of the subcommittee] presiding.
Present: Chairman Neal, Representatives Barnard, Hubbard, and
Leach.
Chairman NEAL. I would like to call the subcommittee to order.
Today we are delighted to welcome a distinguished panel of business economists who have been invited to offer their analyses of
the current state of the economy, with particular attention to potential threat of inflation and the proper response of voluntary
policy.
This hearing is designed to help the subcommittee assess the
most recent Federal Reserve report to the Congress on monetary
policy. In the 1980's the monetary aggregates have lost much of
their previous usefullness as reliable indicators of the future
impact of monetary policy on our economy. No other kind of indicator has as yet been able to fill the void. Assessments of monetary
policy must therefore be based on a reading of the overall performance of the economy, obviously a more complex and demanding
task than the analysis of a single indicator or several indicators.
Potential for error is large since many forces other than monetary policy affect the economy. Moreover, monetary policy is a powerful but blunt industry. It tends to affect economic activity and inflation with different, changing, and uncertain lags. The potential
is thus very real that we will be tempted to cure problems in the
overall economy through changes in monetary policy, even though
monetary policy is not the real cause of the problem, and can not
offer an effective solution. And, given the lag sense impact, we also
face the danger of misusing monetary policy and trying to steer the
current economy since the force of major policy changes will fall on
the economy several months and often several years from the time
of the action. We have asked our witnesses to draw for us the
shape of the economy as they see it today, its major strengths and
weaknesses and thus the major dangers and risks that we will face
in the future.
From this picture, adjustment on the proper course of monetary
policy should emerge. The picture gained most attention of late is
that of an overheating economy, one about to burst its capacity,
(37)
38
constraints and ignite a serious acceleration of inflation. That is
the picture the Federal Reserve has implicitly drawn by actions
and statements over the last few months.
Is it accurate? Has the Fed overacted or is the Fed still too cautious trying to dampen inflationary expectations with tough talk,
but small steps? Today's witnesses from whom we can expect definitive and unambiguous answers are Mr. Donald Paris, manager of
the Economic departments for the Caterpillar Company; Jerry Jasinowski, chief economist, National Association of Manufacturers;
James Pate, senior vice president, Pennzoil Company, and Richard
Rahn, chief economist, U.S. Chamber of Commerce.
I would like to welcome all of our witnesses today. Thank you for
being with us. We will proceed in the order in which I mentioned
your names. We will put your entire statements in the record. We
would like to urge you to summarize, if you can, so we can have
more time for question and answer. Mr. Paris, please proceed.
STATEMENT OF DONALD G. PARIS, MANAGER, ECONOMICS
DEPARTMENT, CATERPILLAR CO.
Mr. PARIS. Mr. Chairman and Members of the committee, it is a
pleasure to be here today and to try to help resolve a very difficult
question I know you all wrestle with. I am Don Paris. I am the
chief economist at Caterpillar. I have been with the company 26
years and I was educated at the University of Kentucky.
I have three degrees from there and I feel a certain affinity for
this committee in that Representative Carl Hubbard is in my home
district. As you know, Caterpillar is a major multinational company. We engage in the manufacture and sale of construction equipment throughout the world. And last year we had sales of about
$8.2 billion, half of that outside of the United States.
We were the tenth largest exporter. So whenever questions about
monetary policy and exchange rates come up, we naturally become
very interested. The questions posed by your committee are of
great interest.
Interest rates and exchange rates have been a major factor in
the recovery of the U.S. manufacturing sector and I was particularly struck by Chairman Greenspan's recent comments before the
Senate when he indicated that he would rather risk a recession
than to be overly stimulative and have a runaway inflation.
In my view, as you had indicated in your opening remarks, that
is skating a little bit close to the edge. There has been no Federal
chairman to my knowledge who ever deliberately created a recession. They have always been trying to knock inflation down, and
calm down an inflationary boom.
We don't have a boom to calm down as yet. I certainly don't
quarrel with the Fed's desire to get the inflation rate down because
we paid a terrible price when we got it in the seventies, and we
also paid a terrible price for it in the eighties when we had to get
rid of it. But I guess, as you indicated, the relevant question is
whether or not we have the right tools to deal with and to finetune the economy. It is unfortunate that we have to deal with
either forecasts or past history.
39
Now, forecasters haven't been particularly accurate in the last
several years. As a matter of fact, they have called recessions in 3
out of the last 4 years and they have said that inflation was just
around the corner at any moment. And our headlines today seem
to reflect that same kind of feeling. I guess I would have to say we
have got to be a little closer than we were because of time.
Aside from a forecast, we have to rely somewhat on history. I
think an argument can be made that maybe we ought to give a
little extra weight to history. In many analysts' opinion, the tightening of policy through the course of 1987, in order to protect ourselves from perceived inflationary pressures and also to maintain
the dollar within some confines of the Louvre Accord, helped precipitate the October 19 crash.
It is important for you to understand that I am not being critical
of the Fed's performance after the October 19 crash. They injected
liquidity and did what needed to be done as did central bankers of
the world. We had the strongest first half economic growth worldwide we have seen in many years and the inflationary pressures
weren't all that bad either.
That episode should have taught us there is risk of deflation out
there in the world economy. It seems to me that if we run that risk
and do incur a recession, the consequences are much more dire
than a little extra inflation. I think we ought to be very careful
about that. There is no question that the economy is stronger today
than it was in 1987. But what I am questioning is the relative risk
of creating a recession or heading off inflation that may not be just
around the corner.
Now, of course, there are all kinds of anecdotal evidences about
shortages throughout the economy. Some give great validity to
those capacity utilization figures which I don't think are very accurate. What really isn't appreciated is the impact of the globalization of markets on price behavior. There is still a lot of excess capacity outside of the United States.
Foreign manufacturers are willing to utilize their capacity to
retain their employees to retain their customers or their share of
market and to keep their distribution outlets alive. They are not
going to lose market share by indiscriminately raising prices to
jeopardize those gains.
Some are even investing in the United States to build their base
for the long haul, and I ask you to think back on how long it has
been since we have had eight auto manufacturers domiciled in the
United States? That is a tremendous amount of competition.
I think the declining dollar has been a major catalyst in reviving
the U.S. manufacturing sector. After 5 years of expansion it is easy
for us to forget that we came very close to losing our industrial
base during that strong dollar period of the early eighties. There
are those who say that, well, manufacturing really wasn't hurt
that bad. We have become a service oriented economy and maintained a 20 percent share of the total output throughout that
period. So what are you worried about?
I would say to you that I would worry about that because who is
to say that shouldn't have gone to 25 percent? If manufacturing
had been allowed to grow during that period, we could very well
not be facing some of presumed capacity shortages we are today.
40
Caterpillar closed five plants during that period and we changed
our strategy and started shopping the world for the lowest priced
parts and components.
Many of our suppliers had to make similar adjustments, and
those who didn't in time, didn't survive. But there was a lot of restructuring going on. Until recently, the dollars decline had helped
level the playing field for them and provided better export profits
to pay for the capital expansion we have got underway. Our company raised its production schedules 27 percent this last year and our
employment has increased around 4,500 people.
The weaker dollar and stronger domestic economy were major
factors in this recovery. I guess the thing that is frightening to me
is seeing the dollar strengthening again, which could wipe out
some of those gains from hard work that we put in to level that
playing field. The improvement in our trade deficit and growth in
capital investments have depended upon restoring U.S. manufacturers' international competitive position.
I am amazed at how people worry about the well-being of the financial markets. These Wall Street Portfolio managers move in
and out of stocks and bonds in a matter of minutes, but we in manufacturing can't do that. Once we put somebody on the payroll, it is
a great economic cost and hardship to let them go once you find
out you can't afford them.
If you get a factory started and get halfway finished and we have
a few of those, it is a great economic loss when you have to switch
course in mid stream and leave that. This kind of tightening up
and stop and go is difficult for the manufacturing sector.
To make one other point about small manufacturers. Many are
in the South and in the Midwest. They are more vulnerable than
larger companies that have access to the money center banks and
so forth some of these smaller companies have higher borrowing
costs and maybe can't easily handle those currency hedges, for example.
These small manufacturers are providing about two-thirds of the
growth and manufacturing jobs and they have been one of the primary sources of job creation. I think we have to worry about that?.
We intend to use millions of extra profit dollars from the weaker
dollar to pay for our modernization program as we strive to make
our factories more competitive. If we lose that, we will be put
behind in our schedule. It will hurt our ability to compete internationally.
Whenever we think back, and your opening remarks addressed
that, really the world economy is in pretty good shape right now. A
lot of the things that the experts said had to occur are really
taking place. First, the budget deficit had to come down and it has.
Obviously we would like to see it a little smaller, but getting a recession is not any way going to bring the budget deficit down. To
the contrary, worse things always happen than that.
Second, we asked overseas economies to expand, and they are
doing that with a vengeance. Most overseas manufacturers are still
growing and their economies are growing. Japan has been growing
much more rapidly than anybody anticipated and they were one of
the principal targets for that.
41
The third thing is we needed higher capital investment so we can
be a producing nation as opposed to consuming nation. We have
got a capital spending boom going on now and a large part of that
is due to increased exports and the increased cash flow that resulted from a more realistic dollar. That, of course, is necessary to fund
a more modern plant and the new capacity that we need so much.
The fourth thing is that the U.S. economy had to slow down consumer spending, we were too much of a consumer Nation. We
slowed it down to about 2Va percent real growth rate, which compares to around 4 or 5 several years ago. The inflation resistance in
this kind of background is strong; the competition in the finished
goods market is extremely intense.
We have had consumers who have shown an amazing resistance
to price increases. Most major manufacturers were offering rebates,
and if your wife goes to the store, you clip a few coupons for price
cuts. They have whole lines for coupons. That all indicates that
people are not willing to spend willy nilly on any price thrown out
to the consumer.
Wages and manufacturing have been in the 3 percent range and
they make up about 70 percent of the cost of goods.
So I can't see that there is anything to explode either the consumer spending, or to push through higher prices. Productivity is
also improving. The concern about the drought is really a structural phenomenon, not one that should be considered in the monetary
sense.
A lot of people take commodity prices as an indicator of inflation. I think that is the wrong thing to do. Intermediate goods
prices always fluctuate more than the price of finished goods and
whenever the economy is slowing down or going into recession,
those intermediate prices have dropped dramatically. Those people
lost profits and stopped investing and the manufacturers were able
to keep the profits.
When prices go up, manufacturers have to give them back, because you still have a great deal of resistance to price increases by
consumers.
[The information below was subsequently received for the record]
One commodity price that is rising is steel. Those price increases
are not due to market-determined factors but rather to Government-imposed quotas. At Caterpillar, steel plate prices are up 17
percent for example. Monetary policy is not the correct instrument
to control these price increases. Instead, I suggest steel quotas be
terminated.
I would like to start summarizing that I am concerned that we
are risking a recession here with very tight monetary policy. We
have two-thirds of the economy slowing down already.
Twenty-five percent of the economy is made up of capital spending and exports, the sectors that are providing the growth. This
was needed to redress our ravaged manufacturing sector and to improve our trade balance. This will be dramatically affected by
higher interest rates and a run-up in the dollar.
I would urge the Fed to be aware of the risk of precipitating an
unwanted recession by clinging to current policy too long. I know
how forecasters like to wait for one more piece of data before they
42
make up their minds. I am sure that is what the Fed Chairman did
in the past whenever we got into recessions.
I have been in the forecasting game a long time. One of the
worse things you can do is deal in conventional wisdom. I hope the
Fed advisors and the Fed will be cognizant of the need to reverse
policy quickly. There may be a need to do that much quicker than
the evidence and forecasts suggest.
I hope we won't develop a notion that a weaker dollar, more realistically competitive dollar, is bad news. I thank you.
[The prepared statement of Donald Paris can be found in the appendix.]
Chairman NEAL. Thank you, sir. Mr. Jasinowski?
STATEMENT OF JERRY JASINOWSKI, CHIEF ECONOMIST,
NATIONAL ASSOCIATION OF MANUFACTURERS
Mr. JASINOWSKI. Thank you, Mr. Chairman. I would like to make
six points in summary and to introduce the theme of those six
points. My theme is that we are really extremely fortunate to be in
as good an economic situation as we are at this stage of the economic cycle. There are not many major problems around, despite
some long-term problems and imbalances; that the Fed has done a
pretty good job; that we who are outside of the Fed always can find
ways in which we think it could be improved. The National Association of Manufacturers wrote to the Open Market Committee and
the chairman in the early part of this year and expressed our concerns about being too tight following the stock market crash, but in
retrospect it seems to me that the Fed has done a pretty good job
in the period following the crash.
Having said that, I would urge them to retire their efforts to
fight inflation at this point and recognize that the economy is beginning to slow a bit, and that there should be no further moves on
the part of the Federal Reserve at this time to tighten monetary
policy. Now, they ought to take the time to relax. Let's see where
the economy is going from here.
Having made that summary, Mr. Chairman, let me elaborate
with six brief points which are outlined in the testimony and in the
executive summary that you have before you. I will do it in the
context of the letter that you have written to me asking six major
questions because I think that that is a useful focus for my summary.
First, point Number 1, why has the economic expansion continued in as healthy a fashion as it has? First of all, it has changed its
character entirely, going from a consumption driven economy in
the early part of expansion to one driven by trade and capital investment and the come back in manufacturing.
In 1988, 50 percent of the growth in real GNP will be from trade
improvements, and 25 percent will come from capital spending, and
that is a complete reversal of what we had at the early stage. We
have had two economic expansions that followed together very
nicely. It has been very good luck, to some extent, but it has also
been a result of, I think, stimulative tax policy in the early stages
and the administrations good sense to change their exchange rate
43
policy in 1985, for which Secretary Baker deserves substantial
credit.
I see this as continuing over the next 12 months and no signs of
a recession on the horizon right now. The only other thing I would
say here is we are beginning to see a few signs that the economy is
modestly settling down and I would expect trade to slow as you
move into 1989, and capital spending is not going to go on raising
long at the rate it is, but the picture looks remarkably healthy.
Second, do we have a stable inflationary picture? I don't think
we do. Even though I have been reluctant to come to the view that
inflation is picking up modestly, and I still hold the view that the
long-term outlook for inflation is one in which prices will be stable,
or declining in 1989 and thereafter. A lot of this has to do with
longer term structural conditions, having to do with the world
economy, excess supplies, whether it be agriculture or energy or
others.
While there are structural changes that are working against
price increases, I think the evidence clearly indicates that there
has been some modest pick-up in inflation in the last several
months, and that has been due to some underlying wage cost increases that by some measures are up over 4 percent, and a substantial increase in nonwage costs. Most people seem to think that
labor costs are all wages. About 40 percent is tied up with all these
health care cost increases and social security increases and other
increases which are really substantial and have been accelerating.
There are also capacity constraints and there is more than an
anecdotal evidence that steel, plastics, paper, and other commodity
prices are increasing at this point, and are significant.
Finally, although I agree that the food price increase is a temporary phenomenon, it will nevertheless cause prices to increase in
the short run. That is to say, the fourth quarter, and as a result of
all these factors, I see the consumer price index accelerating to
about 6 percent by the end of the year. I think that one can't deny
some inflationary pressures.
Having said that, I would underline that I think these are
recent. They are modest. They are signs that the economy is slowing down and the long-term outlook for inflation is one which
should not cause people to push the panic button.
Item Number three, how do we evaluate the current state of
monetary policy? We have been concerned about the Fed being too
tight, both in and around the stock market crash and then following it. I think the Fed has erred from time to time, as you look
over Federal Reserve policy from 1980 to 1982, but in general its
been pretty good.
People complained about the Fed through most of that time that
they were not expansionary enough. Our analysis leads to the conclusion that had they been far more expansionary, we would have
had a less durable recovery. We could have had more inflation, so
it would have been good in the short term and not necessarily good
in the long term. Those of us who looked at the whole period recognize that the large budget deficit has played an important role in
rising interest rates and other factors.
Having said all that, and not objecting to the recent Federal Reserve actions to raise the discount rate, and frankly, thinking that
44
the Fed didn't leave itself with glory in and around the time of the
stock market crash, until after the crash, when I did think it acted
promptly, and it made a serious mistake by trying to peg the dollar
in 1987, which makes no sense from a trade point of view, and from
a monetary policy view.
Nevertheless, the current stance is about what you could hope
for, given all the factors involved and now I would, as I said, suggested before, urge the Federal Reserve to retire in glory and not
take any further actions at this time to tighten monetary policy because of the risks that are involved and the fact that the economy
seems to be slowing.
My fourth point, which has to do with your question about are
there particular economic developments that we should particularly look at relative to monetary policy, I would say that there are at
least a couple. One, keep your eye on growth. This is not just an
inflation game. And the Fed should be just as concerned about
growth at all times as it is about inflation, and if there are any
signs of a slow down and a major deterioration of growth, they
ought to act to loosen monetary policy.
Second, don't mix up monetary policy and trade policy. We must
continue to improve our exports and continue to improve trade. It
is a major mistake for the Federal Reserve, which they are not
doing now, to peg the dollar, because to some extent against some
countries the dollar is still not at appropriate rates and we ought
not to be trying to peg the dollar.
Point Number five, causes for concern as we look ahead: I think
we are in remarkably good shape overall. I certainly do not think
that the drought is a major cause for concern on either the growth
or inflation side.
I have just come back from Iowa. I don't think Iowa has recovered but my discussions with people out there lead me to conclude
that they are going to do—they are going to come out of this better
than people thought and there is more optimism, at least among
business leaders that I spoke to in that State than I would have
expected.
There is great cause for concern in the savings and loan crisis,
but I think that we are stepping up to that plate and dealing with
it, and beyond that, there is cause for concern about the overall
level of debt. If you look on page 9 of my testimony, you find that,
our level of debt has almost doubled, public and private debt, compared to a post war average.
I think it is healthier debt than we had at an earlier time. But it
has increased substantially. More importantly, I am concerned that
the ratio of debt service to cash flow is at record levels. I would
underline this for you, Mr. Chairman. We now have the—the share
of pre-tax earnings of non-farm, non-financial corporation devoted
to debt service is now over 50 percent compared to 30 percent in
the seventies and 15 percent in the fifties.
As we look to the long term, these levels of debt is an increased
risk, particularly relative to monetary policy.
Item six, I will not summarize to save time. It asks for what
policy changes we need. I will just say that we really need policy
changes that keep our eye on being competitive in world markets
and that means everything from further reductions in the budget
45
deficit to implementing the sensible trade policy in this trade bill
we just passed. We still got exchange rates and a lot of trade issues
before us and tax policy and the other issues before the Congress
should be weighed in the context—does it make America more
competitive? Thank you, Mr. Chairman.
[The prepared statement of Jerry Jasinowski can be found in the
appendix.]
Chairman NEAL. Thank you, sir. Mr. Pate?
STATEMENT OF JAMES L. PATE, SENIOR VICE PRESIDENT,
PENNZOIL CO.
Mr. PATE. Mr. Chairman, Members of this committee, my name
is James Pate. I am senior vice president of Finance and Treasury
of Pennzoil Co. headquarterd in Houston, TX. So I am not, at the
present time, a practicing economist, but I am more than a casual
observer. I appreciate very much this opportunity to share my
views with you and appear before this committee. I have provided,
as you suggested, Mr. Chairman, a rather lengthy written statement, so I will keep my oral remarks brief, and merely summarize
my views on the economy and monetary policy.
At the outset, I would like to emphasize that I am in general
agreement with the Federal Reserves conduct of monetary policy
in recent months, and I am in essential agreement with Chairman
Greenspan's testimony before Congress on July 28. The recent
effort on the part of the Federal Reserve to make small anticipatory changes in an effort to avoid big disruptive reactive kinds of
changes is, in my opinion, a welcomed improvement in the conduct
and implementation of monetary policy. This approach does, as my
colleagues have pointed out, place major reliance on accurately assessing economic conditions and forecasting economic developments.
In recognition of this fact, Chairman Greenspan indicated that if
the Fed were to err, that he would prefer to err more on the side of
restrictiveness rather than stimulus. I can't disagree with that. I
think that is probably the only position the Federal Reserve can
take, but as Don Paris pointed out, erring on the side of restrictiveness poses some very serious risks of causing another financial
crisis and precipitating a recession.
I am sure that the Federal Reserve is aware of this risk, but I
think it deserves emphasis and I also believe that perhaps the
threshold for interest rates is a lot closer, than you might infer
from some of the very upbeat economic data that have been reported recently. Specifically, I do not think the economy is overall
nearly as robust or that inflationary pressures are nearly as great
as generally perceived. Recent strength in the economy has been
highly concentrated in exports and export related segments of
manufacturing. During the past four quarters exports directly contributed $83.3 billion of the $157 billion increase in real final sales,
over half of the increase in real final sales in the past four quarters has been attributable solely to exports.
Indirectly, it has been estimated that exports have contributed
another $40 billion to business spending during this period. This is
a lot of stimulus, a lot of thrust to come from a component which is
46
only about 11 or 12 percent of GNP. On the other hand, consumer
spending, which accounts for roughly two-thirds of total GNP, has
contributed only about $30 billion to real growth in the past year
with almost all of this gain centered in services, not in goods, but
in services. Fixed investment has increased about $27 billion, with
all of the increase in equipment, not in business structures and not
in residential construction expenditures, but in equipment. So economic growth, in my opinion, is very uneven. It is almost lop-sided
and extremely vulnerable to foreign exchange rate changes and,
therefore, to interest rate changes.
With respect to inflation, I don't believe there is any question
wages and prices are headed higher. The consumer price index has
increased during the past year at a 4.5 percent annual rate. In the
month of July it went up 5.2 percent. The producer price index for
all commodities increased 4.2 percent during the past year, 7.8 percent in the last 3 months. Prices of intermediate commodities increased 5.9 percent during the past year; 9 percent in the last few
months. Volatile commodities rose 5.6 percent in the last 3 months.
Labor cost picked up, in part because of the increase in social security. Hourly pay for nonfarm workers rose at an annual rate of
about 2.2 percent in the first quarter and about 5.2 percent in the
second quarter. So signs of higher wages and prices abound, but
this should be no surprise because most of my colleagues that are
active forecasters, I think, have been anticipating higher inflation
in 1988, and 1989 now for some years.
In fact, I would suspect that a careful study would reveal that
more forecasters have overestimated inflation in recent years than
have underestimated inflation. There are no signs of any inflationary surge or wage-price spiral in my opinion. The so-called core
rate of inflation as measured by the producer price index for finished goods, excluding food and energy products, was up only 3.4
percent for the year ended in July, compared to 2.2 percent for the
calendar year 1987. The widely discussed capacity constraints
appear to be rather minor, and again centered primarily in export
related industries. Operating rates for most major industries
remain well below past cyclical peaks. So the recent heightened
concerns about an overheating of the economy and of inflation, I
believe, are a bit exaggerated.
As I mentioned earlier, the current economic strength of the
economy is very much centered in exports. More than half of the
economic growth in the past year has been due to exports. Exports
are expected to remain strong and even increase for several more
quarters. However, they are not likely to contribute thrust to the
economy in the quarters ahead, to the extent that they have during
the past year. At the same time it is difficult to see other sectors of
the economy that might pick up this slack and, therefore, sustain
the high real growth rates that we have seen.
Consequently, economic growth is expected to slow appreciably
in the months ahead. Our forecast is that overall real economic
growth l will slow from 3.3 percent in the first half of this year to
about 2 /2 percent in the second half of this year. On a forth quarter to fourth quarter basis, growth is expected to be about 3 percent in 1988 and about 2 percent or less in 1989.
47
Our forecast is for a moderate acceleration in the rate of inflation with the increase in the consumer price index averaging
slightly over 4 percent in 1988 and roughly 5 percent in 1989. This
may appear to be a rather encouraging outlook. However, my concern is that we are approaching, we are not yet there, but we are
approaching, getting very close to what I would consider to be a
danger zone for interest rates. We recently ran some simulations
with a widely used econometric forecasting model and found it does
not take a very large increase in interest rates in 1988 to produce a
flat economy in 1989. We also found that if you combine a slight
increase in interest rates with just a slight decline in consumer
confidence, you can generate two or more quarters of negative real
growth very, very easily.
Since March, interest rates have been pushed up 130 to 190 basis
points. They are now back to or very close to and in some cases
above the levels that they were at just prior to the October crash.
The financial markets are very, very jittery. The Vk-point increase
in the discount rate on August 9 was quite unnerving and in my
opinion, not fully supported by economic fundamentals.
However, it was probably unavoidable and warranted on the
basis of perceptions and expectations, especially inflationary expectations that were starting to build in the financial markets. There
has developed an enormous preoccupation with the release of every
single economic statistic. The financial community is now attaching far more significance to small month-to-month changes in economic data than is justified on the basis of their statistical integrity.
In conclusion, I want to emphasize once again that we are approaching a danger zone in interest rates. Although the prospects
for overall economic growth and inflation appear rather good at
this time, the risk of pushing rates too high and creating another
financial crisis and recession, I believe, are substantial. Unfortunately, fiscal policy is on hold because of the large budget deficit
and the upcoming presidential election, so the burden of sustaining
economic growth falls at this time entirely on the Federal Reserve.
I think it is extremely important that growth be sustained until
the next administration has the opportunity to deal with the Federal budget deficit problem, the trade imbalances, the Third World
debt problem and the seriously unstable situation with our financial institutions, thrift institutions and commercial banks alike.
In my opinion, our best chance, indeed our only chance, of dealing effectively with these problems is in an environment of economic growth. Thank you, Mr. Chairman, and Members of the
committee for giving me this opportunity to express my views.
Thank you.
[The prepared statement of James Pate can be found in the appendix.]
Chairman NEAL. Thank you very much. We have had the second
bell now for a floor vote. We will recess at this point and be back
in 7 or 8 minutes.
[Recess.]
Chairman NEAL. I would like to call the subcommittee back to
order. I apologize for the interruption. We would like to hear from
Mr. Rahn, at this time.
48
STATEMENT OF RICHARD RAHN, CHIEF ECONOMIST,
U.S. CHAMBER OF COMMERCE
Mr. RAHN. Mr. Chairman, thank you very much on behalf of the
U.S. Chamber of the Commerce. We greatly appreciate your inviting us to testify today.
At the outset, let me commend the members of the Federal Reserve Board for their recent efforts in striving to meet the mandates established for them by law.
I want to state for the record our total agreement with and support for the objective of achieving non-inflationary economic
growth. Any disagreement we have with the Fed in this regard is
over the means, not the end, of monetary policy. While we may
have preferred a more gradual reduction in the inflation rate and
have chosen a different method to reduce inflation, the fact is the
Federal Reserve Board was instrumental in breaking the inflationary spiral of late 1970's, and for that we are thankful.
The question we now face is what should Fed policy be today?
We find the following: Today's persistent inflation in the 4.5 percent range is the remnant of earlier Federal Reserve Board mistakes, which greatly increased the growth of the money supply to
drive down the value of a dollar in 1985 and 1986.
Two, sustained inflation is always a monetary phenomenon and
the trend in the real economy, when divorced from changes in
monetary growth, have little bearing on past, present and future
inflation.
Fed policy is highly discretionary. The long-term goal of monetary policy should be zero inflation.
Consequently, the Fed should establish both price and quality
rules in managing the monetary aggregates. Let me expand on that
very briefly.
We think that in the absence of rules, you will tend to get what
you have had for really the 70 years in which the Fed has been in
existence and that is overshooting the targets. First, there was too
much pressure on the accelerator, and then too much pressure on
the break.
Monetarists, I know, like strict monetary rules. We feel that particularly since you can't forecast velocity with precision, a strict
monetary rule in itself will not accomplish the goal of stable prices.
We think a monetary rule coupled with a price rule, and by that I
mean targeting a basket of commodities which are highly sensitive
to change in monetary policy, will do the job.
In fact, I will go further, and given the worldwide economy we
now have, I think it is important that we all try to target a single
basket of commodities, and we should encourage the central banks
of other countries to do the same thing.
I think if we had the G-7 nations all targeting the same basket,
this would greatly mitigate the huge fluctuations we have in exchange rates and at the same time move all the major industrial
countries toward a zero rate of inflation.
Current Federal policy is inconsistent. While managing a policy
of monetary restraint at home, the Fed, in 1988, has been expanding the money supply internationally to hold down the value of the
dollar.
49
In fact, what happened in recent months I can only say is ridiculous—with the Fed increasing the interest rates here and at the
same time going around selling billions of dollars, particularly to
Europe, to bring down the value and exchange rate. Those dollars
are sent right back to the United States, which inflates our own
domestic money supply. It is like taking money out of one pocket
and putting it into the other pocket.
We accomplish nothing productive by doing that. The secrecy
surrounding Federal policy making and unannounced changes
greatly adds instability in financial markets.
The Fed should make its deliberations open so that policy
changes can be anticipated and the impact on the economy minimized.
You now have a provisional group of "Fed Watchers." Businessmen and lenders and borrowers of funds know that you have an
inflationary risk premium in any interest rate.
We also now have a Federal policy risk premium in addition to
the inflation risk premium because people are trying to figure out
what the Fed's reaction will be. That is why on the nightly news,
good news is reported as bad news and bad news as good news, and
the next day you see these perverse reactions of the markets to the
"good" news and the "bad" news.
I think that part of that risk could be minimized if the Fed operated with much greater openness. They don't have a black box
there full of answers.
We know the folks at the Fed are an able, dedicated group, but
they don't have a monopoly on wisdom or knowledge, and we give
them very blunt instruments. Their information is no better information than any of the rest of us have and yet we expect them to
be wiser.
Of course, they can't be, so they hide behind a veil of secrecy
that serves nobody's interest. A high interest rate policy designed
to slow economic growth is an inappropriate policy at the moment
because it interferes with the credit markets and adds instability to
the economy. And, contrary to intent such a policy, may actually
add to inflationary policies. I will get into more detail on that in a
second.
Again, the Fed is trying to do too much with too little information and too crude instruments. The result is flawed economic
policy. They embarked on a misguided policy of pushing interest
rates up in the erroneous believe that uncontrolled and unguided
economic growth produces inflation.
Growth is neither inflationary or deflationary. It is monetary
policy that determines the rate of inflation. If you have economic
growth where investment is at least equal to growth in consumption, or higher than the growth of consumption, inflationary pressures will be stable or falling.
If we have high levels of investment, like we currently have, and
new capacity coming down stream, particularly in those industries
that are approaching high levels of capacity, then in my judgment,
you will see a reduction in inflationary pressures from these industries, rather than increasing bottlenecks.
In the late 1970's our rate of economic growth was not all that
rapid. Our problem was a lack of capital investment. That is why
50
we ended up with the so-called inflationary bottleneck or the production bottleneck. Demand in many cases was exceeding supply
back then. That was a failure of investment.
The Fed rapidly expanded the money supply in 1985 and 1986 to
reduce the value of the dollar in world markets. As a result, the
dollar dropped against all major foreign currencies by so much, the
Fed began to fear it was falling too fast.
The Fed then appears to have slammed on the monetary breaks
and attempted to avert both the free fall of the dollar and inflation. This is typical of Fed behavior.
If you look over the last 70 years, you find that the Fed tends to
do this in extremes. They often say their job is to lean against the
wind. The problem is again they have no more wisdom, and I think
all the people at the Fed are extremely able, but they don't have
any more wisdom and knowledge than the rest of the financial
markets.
If you look at history, you find the Fed has tended to lean with
the wind, and that is why they always are over correcting at a
later time. As long as we have a totally discretionary monetary
policy, we are going to have problems in using a sensitive commodity basket. You could go back to gold, but that carries a lot of baggage that I am not necessarily advocating.
Finally, part of our public debate over the appropriate monetary
policy as focused on non-inflationary growth potential of the American economy. Recently U.S. real economic growth is above the
post war average and causes concern for many.
There are many elements in the debate, few answers. It is conceivable that growth potential is a great deal higher than the approximately 2.5 percent real growth the Fed assumes in the policy
deliberations. Macro-economic theory sheds little light on growth
potential, but reality does. Currently the labor forces is growing by
1.5 percent, labor productivity is up 1.4 percent annually.
The industrial capacity is growing about 2.5 percent. When these
elements of overall economic growth are added they give an estimate of potential growth in the GNP of over 5 percent.
Whether this is accurate to a decimal point is not the issue. The
point is the Fed may be severely underestimating potential GNP
growth.
How you base these estimates and how these estimates effect
policy should be of vital interest to Americans. Therefore, we suggest the Congress consider a first step in opening up the Fed policymaking procedures by requiring it to publish its Fed open market
committee minutes within 48 hours of completion of the meeting.
In summary, we believe that it is not economic growth that is
causing inflation or making inflation more of a threat to the U.S.
economy. Today's inflation is a remnant of an earlier Fed mistake.
Unfortunately, Congress can't instruct the Fed to use proper economic reasoning, but in current and future hearings held by the
committee, debate over how to view the economy should be expanded. The economy is moving along, I think, at a very good rate.
We are almost at the 6-year anniversary of record peacetime expansion, and we must remember that economic expansions do not
stop or die because of old age. They die because of policy mistakes,
and a major shift in economic policy by too much acceleration or
51
tightening up too much would be a mistake. In my judgment, the
rise in the discount rate was a mistake, not a fatal mistake, but I
hope that the Fed would now begin to allow interest rates to drop a
bit.
I think inflation pressures will be mitigating. Oil prices and a
number of other commodity prices have begun to fall.
The recent economic statistics show softening in the economy.
Clearly the economy is not overheating. A couple of the other
things that are critical to economic performance are more directly
in the control of Congress. I think, for example, it would be a great
mistake to increase taxes.
I think if Congress meets the Gramm-Rudman targets just on the
spending side alone and gets us approximately to a balanced
budget by 1993, that we would be largely out of the woods on the
deficit side. I would urge the Congress not to re-regulate the American economy, including adding such things as a mandated benefits, which increase the cost of doing business and make us less
competitive.
Mr. Chairman, again I thank you very much for the opportunity
to testify today.
[The prepared statement of Richard Rahn can be found in the
appendix.]
Chairman NEAL. Thank you, sir.
I have a bias and that is against inflation. I wish we had better
tools to fight it. I used to think that we had adequate ways to judge
Fed policy when the relationships between monetary growth and
inflation were clearer. Unfortunately, they are now not as clear,
and that creates new complexities for the policy makers and other
businessmen.
Mr. Rahn, you have criticized the Fed pursuing a high interest
rate policy. I must say that seems inconsistent with the rest of
your testimony. You think as I do that inflation is a monetary phenomenon, that the Fed should follow rules in managing the aggregates. I would like to get back to that point in a minute.
Money growth expanded too much in 1985 and 1986. It ought to
have as its goal zero inflation, and I agree with that goal. But, if
the Fed tries to restrain money growth at a time of increasing inflation and fairly strong real growth in the economy, as it appears
to be doing now, wouldn't interest rates surely rise? In other words,
how can you get to the goal zero inflation—at least move in that
direction—without some initial increase in interest rates? It seems
inconsistent to me.
Mr. RAHN. Well, you have got a couple of different effects here.
One is that short-term interest rates are higher than they need to
be because the Fed is selling dollars abroad, which causes the
dollar to fall and in turn induces the Fed to raise interest rates to
prevent foreign capital from pulling out of U.S. paper. This means
the Fed is caught in a viscous circle in which it ratchets up both
ends of the interest rate equation.
The Fed should stop selling dollars abroad, and get out of manipulating the value of the exchange rate.
You can't set the value of the exchange rate and maintain economic growth and get to zero inflation all at the same time. The
Fed is trying to do too many different things.
52
As I pointed out in the testimony, monetary growth was too
rapid during 1985 and 1986. It brought the dollar down very sharply and further in my judgment than it needed to go. So, of course,
in early 1987, they put down the screws and we had relatively slow
monetary growth and a rise in interest rates which is somewhat responsible for setting off the collapse in the stockmarket last October. Part of the problem then were reactions by foreign central
banks who also constantly engage in discretionary manipulation of
interest rates and foreign exchange rates.
Now, yes, you have to raise interest rates somewhat to keep a
real positive real rate of return, if you are going to get yourself
down close to zero inflation.
Our recommendation to the Fed earlier in the year was to step
gently. When they really started slowing down the rate of monetary growth and increasing interest rates, we said they over did it.
Seriously, some rise was appropriate, but our dilemma is, the
lags between changes in monetary policy and the effect on inflation
can be as long as 18 to 24 months. However, the lags on the immediate impact on the economy, whether we are spurring economic
growth or contracting economic growth, as a result of monetary
policy can be very short—from a matter of weeks to just a very few
months.
So, the Fed now is fighting the very inflation they generated in
1985 and 1986, but they can't affect that inflation. All they are
doing is slowing down the real economy. You don't want to overdo
that. That is why I think much more work needs to be done in developing an appropriate basket of sensitive commodities.
Now, a few years ago, about 4 or 5 years ago, several of us started working on this project, but it takes a lot of time. I am arguing
the Fed doesn't have the information at hand right now to bring
inflation down precisely, but they, in our judgment, did overreact
in August. Not that I didn't want to see a little bit of increase in
the interest rates and the slowing of monetary growth. I think they
went too far, which they have typically done when you look at it in
hindsight.
Chairman NEAL. I agree with that goal of zero inflation because,
to me that means we are going to have low short- and long-term
interest rates.
Mr. RAHN. If I can add one thing.
If the financial markets knew that we were really going to have
zero inflation and they knew the commodity—what commodity
basket was being targeted, then these huge inflation and uncertainty premiums that are put into interest rates would quickly disappear.
The reason really, and I am not claiming I have it all worked
out, is how to get from where you are now to where you want to be,
without putting the economy in trouble. We don't want to go
through an experience like in 1981 and 1982.
Again, I have enormous respect for the members of the Fed, and
I know they have a very difficult time here. But I think that they
need to be more explicit on saying how they are going to get there
and at least open it up much more to public discussion than they
have.
53
Just opening up that decision-making process will help. Now, like
you, a number of us talked to them privately and to the staffs and
they are going through the same intellectual struggles we are
going through.
I don't think it hurts confidence to open that up and get many
more people involved. It would reduce the inflation and the Federal
Reserve risk premiums in these interest rates.
Chairman NEAL. I notice, especially the other three witnesses
have a real concern about the potential for a down-turned economy—a recession. I was pleased with the response of the Fed to the
October 19 stock market decline—announcing that they were clearly not going to let the situation get out of hand. They supplied the
needed reserves quickly. I was pleased when they decided to continue their inflation fighting mode again. I agree that they pumped
out too much money over the last several years. They were correcting their own faults, and they had other reasons for that. We held
some hearings on this idea of using commodities as a guide for the
Fed, and we brought up the subject several times.
The Fed is conducting studies on that internally, and we will see
them sooner or later. So far, however, it appears that the evidence
is fairly inconclusive that there is any relationships that we can
count on over time. We certainly ought to look at every possible
option for generating more growth, non-inflationary growth. But
any new approach must be carefully analyzed before it can even be
considered.
Mr. Rahn, you mentioned the Fed's mandate in the early part of
your statement. Where do you find the mandate?
Mr. RAHN. The Employment Act of 1946.
Chairman NEAL. As amended over time?
Mr. RAHN. Over time Congress has given the Fed a number of
instructions. I sound a bit radical today, but I think the Fed has a
problem today of being both a banking regulator and also responsible for monetary policy, and these things at times can put them internally in conflict.
Congress has deliberately put them in a situation where they at
times have conflicting goals.
I think, perhaps, even a broader look over time if you look at all
the things that the Members of Congress in the last 70 years instructed the Fed to do and be responsible for, you would find that
no set of humans, could do all that. Perhaps there ought to be some
division of powers here and limit the Fed's responsibility more to
what we can expect knowledgeable and reasonable people to really
accomplish.
Chairman NEAL. We were also concerned when it appeared that
maybe the Fed was following orders from the Treasury Department
concerning the Louvre Accord. We were critical there and the Fed
made it clear that they were not.
It is my strongly held impression and their testimony will say
the same thing, that they are not fooling around with the value of
the dollar.
Mr. RAHN. They did follow the Louvre Accord. If you take a look
at their actions, it was explicit, and in my own judgment, even
though I tend to be a partisan for this administration, I think the
Louvre Accord was a great mistake. And, I conveyed this over to
54
them. None of us know what the proper foreign exchange rate
ought to be. That is assuming a degree of wisdom that we as economists and I think policy makers don't have. That is why we were
forced to go to fluctuating exchange rates.
When you run the gold system you have a North Star. There
were a lot of problems with the gold, and I am not advocating gold
today. But, it gave a kind of anchor.
None of the currencies now have any kind of anchor, none of the
major currencies. And this puts us all in an endless difficulty—the
Bank of Japan and the Bank of England and all the rest of them.
That is why we have come to feel more strongly about trying to
identify at least the basket of internationally traded commodities
at a one world price can lead us toward more of an anchoring on a
North Star of stability in the system—so we don't have to rely on
the good judgment of people like Secretary Baker and his colleagues around the world.
They are not able—not that they are not very capable men —to
accomplish what they set out to do. We expect more than they can
deliver.
Chairman NEAL. I couldn't agree more. But, the market is so
huge we can't fundamentally alter them alone. We can jiggle them
a little bit here and there, but we can't overcome the fundamental
direction.
Mr. Barnard?
Mr. BARNARD. I apologize to these gentlemen for being tardy, but
as you probably know we have some extensive hearings today on
another very important subject of which will effect the economy,
whether you in the manufacturing, or oil business or the caterpillar business, as we attempt to bail out the savings and loan industry, I guarantee it is going to have its ramifications nationwide,
and that is one of the real serious problems we have been in those
hearings today about.
I would reiterate what the chairman has said. I think inflation
has not been resolved.
I don't think that we can just bask in the sunlight of the last 3
or 4 years and think it wouldn't raise its ugly head.
I am not a Federal Reserve banker, but I do watch very closely
what they do do, in the terms of whether they are overreacting or
underreacting.
I think that is one of the good feature of this committee and
other Members of the committee and Congress, that they do take
very seriously the oversight of what the Fed it is doing, both in the
discount rate and monetary policy. So it is very interesting.
It is very popular today for Members of Congress to take a position because it is a sensitive political issue in the country today,
and that is about taxes.
I don't know whether in your testimony you discussed taxes or
not, but do you have an opinion as to whether or not we can anticipate taxes at all without offering some imbalance in the economy?
The ideal would be for us to balance the budget as quickly as possible by cutting Federal spending. I think you will find both of the
Members of this panel in agreement to that, even though we come
from the other side of the aisle. But we are faced with the situation
and, in fact, I can't recognize that any candidate for the presidency
55
today has given us many concrete proposals as to how they are
going to balance the budget by reducing Federal spending alone.
I think the time has come for us to just anticipate that if we
can't do that, are taxes—<and I am certainly not proposing taxes,
and I have to always say that because the press likes to take
myself as one of the most conservative Democrats in the country,
even from Georgia, and say, aha, he has succumbed to the ills of
raising taxes. I think we at least have to put it on the table to talk
about it.
I am asking you all, do you have a sense that raising taxes is
going to be absolutely unacceptable in any form or fashion?
Mr. Rahn?
Mr. RAHN. I have sort of definite views on this.
What do we know about tax increases? First of all, we know tax
increases slow economic growth. It is going to have an impact on
economic growth if it is at all sizable.
We know historically that tax increases have not led us to smaller deficits. They have frequently led us to bigger deficits. We think
of TEFRA in 1982, which was supposed to bring down the deficit
and growth and spending, $3 for each $1 dollar of tax increase. Everybody seemed to accept it at the time. Now you can't seem to
find anybody party to the agreement in the administration or Congress.
Since W^rld War II there is not much evidence, or any evidence
at all, that taxes have even brought down Government spending or
diminished the deficit.
Mr. BARNARD. Why do you think that is so?
Mr. RAHN. Because with a tax increase—part of the problem is
with the models we use in our revenue estimating. A tax rate increase never brings in as much revenue as it appears on paper it
should, given the proportion of the rate increase, and the other
side, a tax rate reduction never loses as much revenue as you
would expect, as you would expect in a linear cut—that is, if the
fall in revenue were directly proportional to the tax rate cut.
We all know our individual behaviors are changed. Congress
tends to overestimate the revenue coming in from the tax increase
and, of course, the pressures on you gentlemen and all your colleagues from your constituents are always to spend more.
Even in the business community we all talk about how we want
less Government spending, but they always want their additional
amounts of spending for their projects and labor and consumers
and everybody else. Thomas Jefferson clearly identified this when
they had the great deliberations in the Federalist Papers.
So I don't think the empirical evidence is there that a tax increase can get you out of the woods. We are in a better position
now than we were a few years ago to get to a balanced budget, or
close to one, just from restraint in the growth in spending.
After the 1981 tax changes we had a period of years where Federal revenues grew more slowly than nominal GNP growth. Now,
as a result of a number of the tax changes and other changes you
all have made, Federal revenues will grow slightly faster over the
next 5 years than nominal GNP. That means we can have fully
funded social security without any changes in the program, pay all
the interest on the Federal debt, increase all other Federal spend-
56
ing on the average at the rate of inflation, and still have a little bit
left over.
Now, if you want to increase programs—more child care or whatever the priorities of whoever the new President and Congress
are—that means you have to reduce the growth in some of the
other programs. I don't think this is impossible, particularly since
you passed Gramm-Rudman.
If you refrain from tax increases and comply with GrammRudman, you are basically going to get out of the woods.
Mr. BARNARD. You don't think, though, that some of the programs which we will have to decrease funding in and of itself will
be in the infrastructure—roads, highways, airports and so forth—
you don't think that burden that is going to be passed on to local
communities will offset—won't taxes have to be raised at that level
to offset what we would have normally done by raising taxes?
Mr. RAHN. I am not sure that necessitates a shift to increase the
tax burdens for States and localities. In some cases that may well
hurt, as it has in recent years, but I am not sure that is all bad.
Philosophically I tend to be one that believes government is best
closest to home, and a lot of this responsibility got transferred to
the Federal Government over the last few decades that I think
could more appropriately be done in State and local governments.
That is my own philosophical bias on that.
Mr. BARNARD. It can't be done if we don't turn loose some of
those trust funds. You see, that is the thing that concerns me.
When we are using the trust funds which are special purpose
taxes, when we are using the airport trust fund and highway trust
fund to balance the budget, and then when we expect the States to
continue to build the roads and the bridges and the airports, which
the populus is going to ask them to continue to do, that means at
the State level the State is going to have to raise taxes.
Mr. RAHN. I grant you, the way we are doing some of these
things—part of the airport trust fund, for example, makes no
sense. If we are going to have user fees, user fees ought to be real
user fees and not general revenue sources.
When I say no tax increases, that doesn't mean having no
changes to make the tax system a bit more rational by reducing
the impediments on work, saving, investment or not overfunding
trust funds that you are not going to utilize immediately and then
using user fees improperly.
Mr. BARNARD. Does the Chamber support a broad-based consumption tax?
Mr. RAHN. No.
Mr. BARNARD. Does the National Association of Manufacturers?
Mr. JASINOWSKI. We do, and we think that it is an important
option to consider if we are not able to reduce spending to the
amount necessary.
I would agree with Mr. Rahn that that is where the emphasis
should be. But if it is not possible, it then becomes a question of
what do you do and what are the political trade-offs and what are
the economic effects of different kinds of taxes.
Certainly a broad-based consumption tax would help increase
savings in this country, would have favorable effects on investment
and would be a favorable tax from the point of view of internation-
57
al trade. It carries a lot of controversial baggage with it, both in
terms of its impact on inflation and its option for opening up additional revenues to be spent and the fact that politically it is not
something anyone has hitched on to, that we will continue to advocate a broad-based consumption tax.
Chairman NEAL. There was one Congressman, and he is no
longer with us.
Mr. BARNARD. He is probably better off, too, financially.
Mr. JASINOWSKI. It is interesting how good your memories are on
things like that.
Chairman NEAL. Would the gentleman yield to me?
Mr. BARNARD. I have taken more time than I deserved.
Chairman NEAL. None of us likes taxes. If we try to separate the
politics out for a moment, I now see that about 75 percent of our
budget is in three items. It is clear that we are not going to do anything about social security; the defense budget has been holding
fairly level for about 3 years; interest on the national debt we can't
do much about.
The rest—education for example—both the presidential candidates and most of us other candidates say we ought to improve our
education. Some people like to say we are going to get better by
spending less. That is political talk. That is not the way it works in
the real world, I don't think. I must say it is very rare that we can
get more for less. Maybe it can happen.
Doug mentioned one area. I hope that you are all aware more
than most of us that we need to invest in the infrastructure of the
country for the future. Roads and highways and bridges are deteriorating. We have some problems that will impact the life of us all
if we don't do something about them over time. I am talking about
big problems like greenhouse and acid rain and toxic dump waste
and so on. This costs money. You don't get more for less there, for
sure. You have got mammoth environmental expenditures possible,
mammoth infrastructure expenditures, and we want to improve
our educational system.
To leave out of it the social concerns that are arising to our consciousness such as homelessness and hunger, it seems unrealistic to
me to think we are not going to somehow have to deal with those
things.
Mr. BARNARD. Let me throw in one more consideration, and the
thing that concerns me with all of this is another part of the equation, and it is how are we going to increase our rate of savings in
this country?
Chairman NEAL. You have all criticized higher interest rates. I
agree with you, but a good fraction of those higher interest rates
today are the result, it seems to me, of an inflationary expectation
which is directly related to our budget deficit. Real interest rates
remain at historically high levels. It would seem to me in the interest of lower interest rates and increased savings, as Doug mentioned, that we ought to give this deficit a much higher priority.
Mr. JASINOWSKI. If I can make two quick responses to your point,
one I will go back and emphasize again, this idea of a broad-based
consumption tax which deals with most of those problems. I recognize
58
Chairman NEAL. Let me go one step further. If we put a dollar a
gallon on tax on gasoline, for example, that would discourage consumption and would generate a significant amount of money
toward the deficit reduction—some say close to $100 billion. However, it is just not going to happen. It is really not realistic to think
we are going to be able to cut spending on the one hand in the face
of these obvious needs. If we don't do them, someone has to do
them.
Mr. JASINOWSKI. Let me finish my two points. I go back to the
consumption tax at number one, and I don't think over the long
term it is going to be regarded as outrageous and unrealistic.
The second thing is, I certainly don't mean to be presumptuous
to preach to the Congress about how they should manage the reduction of spending, but I have to say from the point of view of
manufacturing corporations that we have reduced employment and
costs by 25 percent plus, and that has not happened in most areas
of the Federal Government. There are areas where that may have
occurred, but it has not happened overall.
So I have to say, Mr. Chairman, that we have
Chairman NEAL. Where is it comparable? You can increase your
productivity by getting new machines, but machines can not
handle constituent problems or make laws.
Mr. LEACH. So can we.
Chairman NEAL. Yes, we can, but so much of what we do is not
of that nature.
Mr. BARNARD. We had an opportunity
Mr. JASINOWSKI. NAM reduced its staff by about 25 people.
Chairman NEAL. Federal Government employment has stayed
the same for 20 years.
Mr. JASINOWSKI. That needs to change.
Mr. BARNARD. We had an opportunity to cut spending across the
board 2.5 percent. It was called a 2 percent deficit package. It got 2
percent of the vote of Congress. I think something like 50 Members
voted for it.
But the problem is, I am not of the opinion that we can't across
the board arbitrarily reduce spending 1 or 2 percent and expect
that we are going to have to go out of business. I don't believe we
will do that.
Chairman NEAL. Jim.
Mr. LEACH. I will take 1 or 2 minutes, because the time is about
up.
I would say this is frankly a very alarming conversation from a
Republican's—these two marvelous conservatives want to raise
taxes. My gosh.
Mr. BARNARD. Like everything else, you came in too late.
Mr. LEACH. I just have a couple of quick questions, one for Mr.
Paris. Moving from macro to micro, you have done so well creating
all these 4,500 new jobs in the last year. Do you want to return to
your other plant and fill it?
Mr. PARIS. I wish we could, but those increases were at existing
facilities.
Mr. LEACH. We are disappointed you moved out.
Perhaps a question for Mr. Pate.
59
The Fed made a fairly controversial decision on raising the discount rate, and I sense in thi* whole group there is some dissent,
but obviously the premise behind it was fine tuning. Subsequent to
that decision we had a little stutter in the July statistics, and in
your industry, Mr. Pate, we appear to be seeing peace at work in
the Middle East, which may imply a little lower priced oil.
One of the questions is, if one accepts the fine tuning premise,
that that is all right, should they fine tune in the very immediate
future and reverse their decision based on those two factors?
Mr. PATE. With respect to the August 9 increase in the discount
rate that I discussed, I was very disappointed that the Federal Reserve did that. I didn't think it was justified by the economic fundamentals. Of course, that was in large part due
Mr. LEACH. Forgetting the decision made then on those economic
fundamentals, has there been a little change in those fundamentals? I mean, petroleum really, as we understand it, kind of cuts
across the economy and looks like it is going to be a little lower
priced.
Mr. PATE. I think that .is right.
Mr. LEACH. The July statistics—is that a basis of those that
might have made a close decision in one direction to make one in
another, or is the Fed too caught up with its own—frankly I think
a factor is the psychology of wanting to be independent of the elections and, for an honorable person, of course you want to be independent in the elections.
I personally felt that might have had as much to do with it as
the concern about inflation. I could be wrong on these close decisions, but might there be a little different case that might be presented, and would you like to say publicly, as an executive vice
president of a major petroleum company, that prices are coming
down?
Mr. PATE. I think that is a good point. Obviously oil prices are
much weaker than most of us had expected. The general forecast
was for oil prices to average about $19.50 this year. The forecast
now is that the price will probably be around $16.50 at best. The
price currently is $14.24, so it is coming down, and with the improved inflation outlook should provide more flexibility to the Federal Reserve.
Mr. LEACH. One other quick concluding sentence.
Mr. Rahn, on page 3 of your statement, it is about the best paragraph I have ever seen for George Bush to use in a debate for Michael Dukakis: the strength of the American economy. I have
never seen it more succinctly put. It is impressive.
Chairman NEAL. Thank you all very much for being with us. I
am sorry the hearing has been disjointed, but we value your testimony. If you have any other ideas in the future, we want and need
them. Stay in touch with us.
Thank you.
[Whereupon, at 3:50 p.m., the hearing was adjourned.]
60
APPENDIX
JULY 28, 1988
61
Statement by
Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System
before the
Subcommittee on Domestic Monetary Policy
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
July 28, 1988
62
Mr. Chairman, and members of the Committee, I appreciate this opportunity to review with you recent and prospective
monetary policy and the economic outlook.
I would also like to
provide a broader perspective by discussing in some detail our
nation's longer-term economic objectives, the overall strategy
for fiscal and monetary policies needed to reach those objectives, and the appropriate tactics for implementing monetary
policy within that strategic framework.
The economic setting and monetary policy so far in 1988.
The macroeconomic setting for monetary policy has
changed in some notable respects since I testified last
February. At that time, the full after-effects of the stock
market plunge on spending and financial markets were still
unclear.
While most Federal Open Market Committee members were
forecasting moderate growth, in view of rapid inventory building
and some signs of a weakening of labor demand, the possibility
of a decline in economic activity could not be ruled out. To
guard against this outcome, in the context of a firmer dollar
on exchange markets, the Federal Reserve undertook a further
modest easing of reserve pressures in late January, which
augmented the more substantial easing following October 19.
Short-term interest rates came down another notch, and with a
delay helped to push the monetary aggregates higher within their
targeted annual ranges.
63
-2-
In the event, the economy proved remarkably resilient
to the loss of stock market wealth.
Economic growth remained
vigorous through the first half of the year.
Continuing brisk
advances in exports, together with moderating growth in imports,
supported expansion in output, especially in manufacturing.
Some strengthening also was evident in business outlays for
equipment, especially computers, and consumer purchases of
durables, including autos.
Financial markets also returned to more normal functioning.
Although trading volumes did not regain pre-crash
levels in many markets, price volatility diminished somewhat and
quality differentials stayed considerably narrower than in the
immediate aftermath of the stock market plunge.
In response,
the Federal Reserve gradually was able to restore its standard
procedure of gearing open market operations to the intended
pressure on reserve positions of depository institutions.
We
thereby discontinued the procedure of reacting primarily to dayto-day variations in money market interest rates that had been
adopted right after the stock market break.
As the risks of faltering economic expansion and
further financial market disruptions diminished, the dangers of
intensified inflationary pressures reemerged.
Utilization of
labor and capital reached the highest levels in many years, and
hints of acceleration began to crop up in wage and price data.
Strong gains in payroll employment that continued through the
spring combined with slower growth in the labor force to lower
64
-3the unemployment rate by about 1/4 percentage point, even before
the strong labor market report for June; the industrial capacity
utilization rate moved up as well.
In part reflecting the
payroll tax increase, broad measures of hourly compensation
picked up somewhat in the first quarter.
Prices for a wide
range of domestic and imported industrial materials and supplies
rose even more steeply than last year.
Finished goods price
inflation has not reflected this step-up in price increases for
intermediate goods, in part as productivity gains kept unit
labor costs under control.
Even so, continued increases in
materials prices at the recent pace were seen as pointing to a
potential intensification in inflation more generally, since
based on historical experience, such increases have tended to
show through to finished good prices.
In these circumstances, the Federal Reserve was well
aware that it should not fall behind in establishing enough
monetary restraint to effectively resist these inflationary
tendencies.
The System took a succession of restraining steps
from late March through late June.
The shortest-term interest
rates gradually rose to levels now around highs reached last
fall.
Responding as well to the unwinding of a tax-related
buildup in liquid balances, M2 and M3 growth slowed noticeably
after April.
In contrast to the shortest-maturity interest rates,
long-term bond and mortgage rates, though also above February
lows, still remain well below last fall's peaks.
The timely
65
tightening of monetary policy this spring, along with perceptions of better prospects for the dollar in foreign exchange
markets in light of the narrowing in our trade deficit, seemed
to improve market confidence that inflationary excesses would be
avoided. Both bond prices and the dollar rallied in June
despite increases in interest rates in several major foreign
countries and jumps in some agricultural prices resulting from
the drought in important growing areas.
The economic outlook and monetary policy through 1989.
The monetary actions of the first half of the year were
undertaken so that economic expansion could be maintained,
recognizing that to do so, additional price pressures could
not be permitted to build and progress toward external balance
had to be sustained. The projections of FOMC members and
nonvoting presidents indicate that they do expect economic
growth to continue, and inflation to be contained.
The 2-3/4 to 3 percent central tendency of FOMC members' expectations for real GNP growth over the four quarters of
this year implies a deceleration over the rest of the year to a
pace more in line with their expected 2 to 2-1/2 percent real
growth over 1989 and with the long-run potential of the economy.
The drought will reduce farm output for a time, and it is
important that nonfarm inventory accumulation slow before long,
if we are to avoid a troublesome imbalance. Still, further
gains in our international trade position should continue to
provide a major stimulus to real GNP growth through next year,
66
-5-
reflecting the lagged effects of the decline in the exchange
value of the dollar through the end of last year.
Although the
month-to-month pattern in our trade deficit can be expected to
be erratic, the improvement in the external sector on balance
over time is expected to replace much of the reduced expansion
in domestic final demands from our consumer, business, and
government sectors.
Employment growth is anticipated to be substantial,
though some updrift in the unemployment rate may occur over the
next year and a half.
Capacity utilization could well top out
soon, as growth in demands for manufactured goods slows to match
that of capacity.
Considering the already limited slack in available
labor and capital resources, a leveling of the unemployment and
capacity utilization rates is essential if more intense inflationary pressures are to be avoided in the period ahead.
Other-
wise, aggregate demand would continue growing at an unsustainable pace and would soon begin to create a destabilizing
inflationary climate.
Supply conditions for materials and labor
would tighten further and costs would start to rise more
rapidly; businesses would attempt to recoup profit margins with
further price hikes on final goods and services.
These faster
price rises would, in turn, foster an inflationary psychology,
cut into workers' real purchasing power, and prompt an attempted
further catchup of wages, setting in motion a dynamic process in
67
-6-
which neither workers nor businesses would benefit.
The hard-
won gains in our international competitiveness would be eroded,
with feedback effects depressing the exchange value of the
dollar.
Excessive domestic demands and inflation pressures in
this country, with its sizable external deficit, would be
disruptive to the ongoing international adjustment of trade and
payments imbalances.
Not only the reduced slack in the economy but also
several prospective adjustments in relative prices have
accentuated inflation dangers.
One is the upward movement of
import prices relative to domestic prices, which is a necessary
part of the process of adjustment to large imbalances in international trade and payments.
Another is the recent drought-
related increases in grain and soybean prices.
It is essential
that we keep these processes confined to a one-time adjustment
in the level of prices and not let them spill over to a sustained higher rate of increase in wages and prices.
Elevated
import and farm prices must be prevented from engendering
expectations of higher general inflation, with feedback effects
on labor costs.
A more serious long-run threat to price
stability could come from government actions that introduced
structural rigidities and increased costs of production.
Protectionist legislation, inordinate hikes in the minimum wage,
and other mandated programs that would impose costs on U.S.
producers would adversely affect their efficiency and
international competitiveness.
68
The costs to our economy and society of allowing a more
intense inflationary process to become entrenched are serious.
As the experience in the past two decades has clearly shown,
accelerating wages and prices would have to be countered later
by quite restrictive policies, with unavoidably adverse implications for production and employment.
The financial health of
many individual and business debtors, as well as of some of
their creditors, then would be threatened.
The long-run costs
of a return to higher inflation and the risks of this occurring
under current circumstances are sufficiently great, that Federal
Reserve policy at this juncture might b« well advised to err
more on the side of restrictiveness rather than of stimulus.
We believe that monetary policy actions to date, together with the fiscal restraint embodied in last fall's agreement between the Congress and the administration, have set the
stage for containing inflation through next year.
The central
tendency of FOMC members' expectations for inflation in the GNP
deflator ranges from 3 to 3-3/4 percent over this year and 3 to
4-1/2 percent next year.
But in one sense the GNP deflator
understates this year's rate of inflation, and the comparison
with next year overstates the pick-up.
The deflator represents
the average price of final goods and services produced in the
United States, or equivalently domestic value added, using
current quantity weights.
This measure was artificially held
down in the first quarter by a shift in the composition of
output, especially by the surge in sales of computers whose
69
-8-
prices have dropped sharply since the 1982 base year used for
constructing the deflator.
Indeed, if the deflator were indexed
with a 1987 base year, it would have risen appreciably faster in
the first quarter.
Another understatement of inflation in the deflator
this year arises from its exclusion of imported goods, which are
not directly encompassed because they are produced abroad.
In
part because import prices have continued to rise significantly
faster than prices of domestically produced goods, consumer
price indexes have increased more than the GNP deflator.
The FOMC believes that efforts to contain inflation
pressures and sustain the economic expansion would be fostered
by growth of the monetary aggregates over 1988 well within their
reaffirmed 4 to 8 percent annual ranges, followed by some slowing in money growth over the course of next year.
M2 should
move close to the midpoint of its range by late 1988, if
depositors react as expected to the greater attractiveness of
market instruments compared with liquid money balances that was
brought about by recent increases in short-term market rates
relative to deposit rates.
M3 could end the year somewhat above
its midpoint, though comfortably within its range, if depository
institutions retain their recent share of overall credit expansion.
The debt of nonfinancial sectors, which so far this year
has been near the midpoint of its reaffirmed 7 to 11 percent
monitoring range, is anticipated to post similar growth through
year-end.
70
-9For 1989, the FOMC has underscored its intention to
encourage progress toward price stability over time by lowering
its tentative ranges for money and debt.
We have preliminarily
reduced the growth range for M2 by 1 full percentage point, to
3 to 7 percent; last February, the FOMC also had reduced the
midpoint of the 1988 range for M2 by 1 percentage point from
that for 1987.
We have adjusted the tentative 1989 range for M3
downward by 1/2 percentage point, to 3-1/2 to 7-1/2 percent.
This configuration is consistent with the observed tendency for
M3 velocity over time to fall relative to the velocity of M2;
over the last decade, the Federal Reserve's ranges frequently
allowed for faster growth of M3 than of M2.
The monitoring
range for domestic nonfinancial debt for 1989 also has been
lowered 1/2 percentage point to a tentative 6-1/2 to 10-1/2
percent.
The specific ranges chosen for 1989 are, as usual, provisional, and the FOMC will review them carefully next February,
in light of intervening developments.
Anticipating today how
the outlook for the economy in 1989 will appear next February is
difficult, and a major reassessment of that outlook would have
implications for appropriate money growth ranges for that year.
Unexpectedly strong or weak economic expansion or inflation
pressures over the next six months also could have implications
for the behavior of interest rates and their prospects for 1989.
The sensitivity of the monetary aggregates to movements in market interest rates means that the appropriate growth next year
71
-10in M2, M3, and debt could seem different next February than now,
necessitating a revision in the annual growth ranges.
As the
aggregates have become more responsive to interest rate changes
in the 1980s, judgments about possible ranges for the next year
necessarily have become even more tentative and subject to
revision.
The persistent U.S. external and fiscal imbalances.
Despite the changes in the economic setting over the
last six months, other features of the macroeconomic landscape
remain much the same.
Most notable are the continuing massive
deficits in our external payments and internal fiscal accounts.
As a nation, we still are living well beyond our means; we
consume much more of the world's goods and services each year
than we produce.
Our current account deficit indicates how much
more deeply in debt to the rest of the world we are sliding each
year.
The consequence of this external imbalance will be a
steady expansion in our external debt burden in the years ahead.
No household or business can expect to have an inexhaustible
credit line with borrowing terms that stay the same as its debt
mounts relative to its wealth and income.
Nor can we as a
nation expect our foreign indebtedness to grow indefinitely
relative to our servicing capacity without additional inducements to foreigners to acquire dollar assets—either higher real
interest returns, or a cheaper real foreign exchange value for
dollar assets, or both.
To be sure, such changes in market
72
-iiincentives would have self-correcting effects over time in
reducing the imbalance between our domestic spending and income.
Higher real interest rates would curtail domestic investment and
other spending.
A lower real value of the dollar would make
U.S. goods and services relatively less expensive to both U.S.
and foreign residents, damping our spending on imports out of
U.S. income and boosting our exports.
But simply sitting back and allowing such a selfcorrection to take place is not a workable policy alternative.
Trying to follow such a course could have severe drawbacks now
that our economy is operating close to effective capacity and
potential inflationary pressures are on the horizon.
The time
is hardly propitious to discourage investment in needed plant
and equipment, to add further impulses for import price hikes on
top of the upward tendencies already in the making, or to push
our export industries as well as import-competing industries to
their capacity limits.
Fortunately, we have a better choice for righting the
imbalance between domestic spending and income—one over which
we have direct control.
That is to resume reducing substan-
tially the still massive federal budget deficit, which remains
the most important source of dissaving in our economy.
The fall
in the dollar we have already experienced over the last few
years, even allowing for the dollar's appreciation from the lows
reached at the end of last year, has set in motion forces that
should continue to narrow our trade and current account deficits
73
-12in the years ahead.
The associated loss of foreign-funded
domestic investment is likely to adversely affect overall
investment unless it can be replaced by greater domestic
investment financed by domestic saving.
A sharp contraction in
the federal deficit appears to be the only assured source of
augmented domestic net saving.
Such a fiscal cutback should
help counter future tendencies for further increases in U.S.
interest rates and declines in the dollar, partly by instilling
confidence on the part of international investors in the resolve
of the United States to address its economic problems.
Fiscal restraint in the years ahead would assist in
making room for the needed diversion of more of our productive
resources to meeting demands from abroad.
Domestic demands will
have to continue growing more slowly than our productive capacity, as seems to have been the case so far this year, if net
exports are to expand further without resulting in an inflationary overheating of the economy.
Absent this fiscal restraint,
higher interest rates would become the only channel for damping
domestic demands if they were becoming .excessive.
If a renewed
decline in the dollar were adding further inflationary stimulus
at the same time, upward pressures on interest rates would be
even more likely.
The restrictive impact would be felt most by
the interest-sensitive sectors—homebuilding, business fixed
investment, and consumer durables.
In terms of federal deficit reduction, the schedule
under the Gramm-Rudman-Hollings law is a good baseline for a
74
-13multi-year strategy, and I trust the Congress will stick with
it.
But we should go further.
Ideally, we should be aiming
ultimately at a federal budget surplus, so that government
saving could supplement private domestic saving in financing
additional domestic investment.
Historically, the United States
was not a low saving, low investing economy.
From the post-
Civil War period through the 1920s, the United States consistently saved more as a fraction of GNP than Japan and Germany,
and we saved much more as a share of GNP then than we have since
the end of World War II.
A turnaround in our current domestic
saving performance is essential to a smooth reduction in our
dependence on foreign saving, and the federal government should
take the lead.
It is also apparent that redressing our external imbalances must encompass cooperative policies with our trading
partners.
These include both the established industrial powers,
the newly industrialized economies, and the developing countries, whose debt problems must be worked through as part of the
international adjustment process.
This is the strategy that U.S. fiscal policy as well as
economic policies abroad should follow in most effectively promoting our shared economic objectives.
The strategic role of
U.S. monetary policy is implied by a clear statement of what
those ultimate objectives are.
We should not be satisfied
unless the U.S. economy is operating at high employment with a
sustainable external position and above all stable prices.
75
-14High employment is consistent with steadily rising
nominal wages and real wages growing in line with productivity
gains.
Some frictional unemployment will exist in a dynamic
labor market, reflecting the process of matching available
workers with available jobs.
But every effort should be made
to minimize both impediments that contribute to structural
unemployment and deviations of real economic growth from the
economy's potential that cause cyclical unemployment.
By a sustainable external position, I am referring to a
situation in which our foreign indebtedness is not persistently
growing faster than our capacity to service it out of national
income.
Our international payments need not be in exact balance
from one year to the next, and the exchange value of the dollar
need not be perfectly stable, but wide swings in the dollar, and
boom and bust cycles in our export and import-competing industries, should be avoided.
By price stability, I mean a situation in which households and businesses in making their saving and investment
decisions can safely ignore the possibility of sustained, generalized price increases or decreases.
Prices of individual goods
and services, of course, would still vary to equilibrate the
various markets in our complex national and world economy, and
particular price indexes could still show transitory movements.
A small persistent rise in some of the indexes would be tolerable, given the inadequate adjustment for trends in quality
improvement and the tendency for spending to shift toward goods
76
-15that have become relatively cheap. But essentially the average
of all prices would exhibit no trend over time. Price movements
in these circumstances would reflect relative scarcities of
goods, and private decision-makers could focus their concerns on
adjusting production and consumption patterns appropriately to
changing individual prices, without being misled by generalized
inflationary or deflationary price movements.
The strategy for monetary policy needs to be centered
on making further progress toward and ultimately reaching
stable prices.
Price stability is a prerequisite for achieving
the maximum economic expansion consistent with a sustainable
external balance at high employment. Price stability reduces
uncertainty and risk in a critical area of economic decisionmaking by households and businesses.
In the process of foster-
ing price stability, monetary policy also would have to bear
much of the burden for countering any pronounced cyclical
instability in the economy, especially if fiscal policy is
following a program for multi-year reductions in the federal
budget deficit.
While recognizing the self-correcting nature of
some macroeconomic disturbances, monetary policy does have a
role to play over time in guiding aggregate demand into line
with the economy's potential to produce.
This may involve
providing a counterweight to major, sustained cyclical
tendencies in private spending, though we can not be overconfident in our ability to identify such tendencies and to
determine exactly the appropriate policy response.
In this
77
-16regard, it seems worthwhile for me to offer some thoughts on the
approach the Federal Reserve should take in implementing this
longer-term strategy for monetary policy.
The appropriate tactics for monetary policy.
For better or worse, our economy is enormously complex,
the relationships among macroeconomic variables are imperfectly
understood, and as a consequence economic forecasting is an
uncertain endeavor.
Nonetheless, the forecasting exercise can
aid policymaking by helping to refine the boundaries of the
likely economic consequences of our policy stance.
But fore-
casts will often go astray to a greater or lesser degree and
monetary policy has to remain flexible to respond to unexpected
developments.
A perfectly flexible monetary policy, however, without
any guideposts to steer by, can risk losing sight of the ultimate goal of price stability.
In this connection, the require-
ment under the Humphrey-Hawkins Act for the Federal Reserve to
announce its objectives and plans for growth of money and credit
aggregates is a very useful device for calibrating prospective
monetary policy.
The announcement of ranges for the monetary
aggregates represents a way for the Federal Reserve to
communicate its policy intentions to the Congress and the
public.
And the undisputed long-run relation between money
growth and inflation means that trend growth rates in the
monetary aggregates provide useful checks on the thrust of
monetary policy over time.
It is clear to all observers that
78
-17the monetary ranges will have to be brought down further in the
future if price stability is to be achieved and then maintained.
But, in a shorter-run countercyclical context, monetary
aggregates have drawbacks as rigid guides to monetary policy
implementation.
As I discussed in some detail in my February
testimony, financial innovation and deregulation in the 1980s
have altered the structure of deposits, lessened the predictability of the demands for the aggregates, and made the velocities of Ml and probably M2 over periods of a year or so more
sensitive to movements in market interest rates.
Movements in
short-term market rates relative to sluggishly adjusting deposit
rates can result in large percentage changes in the opportunity
costs of holding liquid monetary assets.
Depositor responses
can induce divergent growth between money and nominal GNP for a
time.
I might add that it was partly these considerations that
led the FOMC to retain the wider four percentage point ranges
for mon«y and credit growth for this year and next.
Nonetheless, the demonstrated long-run connection of
money and prices overshadows the problems of interpreting
shorter-run swings in money growth.
I certainly don't want to
leave the impression that the aggregates have little utility in
implementing monetary policy.
They have an important role, and
it is quite possible that their importance will grow in the
years ahead.
Currently, the FOMC keeps M2 and M3 under careful
scrutiny, and judges their actual movements relative to
assessments of their appropriate growth at any particular time.
79
-18In this context, these aggregates are among the indicators
influencing adjustments to the stance of policy, both at regular
FOMC meetings and between meetings, as the FOMC's directive to
the Federal Reserve Bank of New York's Trading Desk indicates.
The FOMC also regularly monitors a variety of other monetary
aggregates.
At times in recent years, we have intensively
examined the properties of several alternative measures, and
reported the results to the Congress.
These measures have
included Ml, Ml-A (Ml less NOW accounts), monetary indexes, and
most recently the monetary base.
An analysis of the monetary base appears as an appendix
to the Board's Humphrey-Hawkins report.
This aggregate, essen-
tially the sum of currency and reserves, did not escape the
sharp velocity declines of other money measures earlier in the
1980s.
Its velocity behavior stemmed from relatively strong
growth in transactions deposits compared with GNP, which was
mirrored in the reserve component of the base.
In this sense,
some of the problems plaguing Ml also have shown through to the
base, though in somewhat muted form.
Moreover, the three-
quarters share of currency in the base raises some question
about the reliability of its link to spending.
The high level
of currency holdings—$825 per man, woman and child living in
the United States—suggests that vast, indeterminate amounts of
U.S. currency circulate or are hoarded beyond our borders.
Indeed, over the last year and one half, currency has grown
80
-19-
noticeably faster than would have been expected from its
historical relationships with U.S. spending and interest rates.
Although the monetary base has exhibited some useful
properties over the last three decades as a whole, the FOMC's
view is that its behavior has not consistently added to the
information provided by the broader aggregates, M2 and M3. The
Committee accordingly has decided- not to establish a range for
this aggregate, although it has requested staff to intensify
research into the ability of various monetary measures to
indicate long-run price trends.
Because the Federal Reserve cannot reliably take its
cue for shorter-run operations solely from the signals being
given by any or all of the monetary aggregates, we have little
alternative but to interpret the behavior of a variety of
economic and financial indicators.
They can suggest the likely
future course of the economy given the current stance of monetary policy.
Judgments about the balance of various risks to the
economic outlook need to adapt over time to the shifting weight
of incoming evidence; this point is well exemplified so far this
year, as noted earlier.
The Federal Reserve must be willing to
adjust its instruments fairly flexibly as these judgments
evolve; we must not hesitate to reverse course occasionally if
warranted by new developments.
To be sure, we should not
overreact to every bit of new information, because the frequent
observations for a variety of economic statistics are subject to
81
-20considerable transitory "noise".
But we need to be willing to
respond to indications of changing underlying economic trends,
without losing sight of the ultimate policy objectives.
To the extent that the underlying economic trends are
judged to be deviating from a path consistent with reaching the
ultimate objectives, the Federal Reserve would need to make
"mid-course" policy corrections.
Such deviations from the
appropriate direction for the economy will be inevitable, given
the delayed and imperfectly predictable nature of the effects of
previous policy actions.
Numerous unforeseen forces not related
to monetary policy will continue to buffet the economy.
The
limits of monetary policy in short-run stabilization need to be
borne in mind.
The business cycle cannot be repealed, but I
believe it can be significantly damped by appropriate policy
action.
Price stability cannot be dictated by fiat, but govern-
mental decision-makers can establish the conditions needed to
approach this goal over the next several years.
82
PRESENTATION OF FEDERAL RESERVE
MONETARY AGGREGATE TARGET RANGES
The Federal Reserve establishes annual percentage growth
target ranges for monetary aggregates. The Fed depicts these
ranges in terms of "cones" or "parallel lines" superimposed on a
graph of the actual path of the monetary aggregate. This tends
to suggest that if the monetary aggregate falls within the upper
and lower points of the cones, or parallel lines, at the end of
the year, then the aggregate will be "on target" for the year.
It also suggests that it should more or less stay within the
cone, or parallel lines, during the course of the year.
But these suggestions are misleading. If the aggregate is
plotted monthly or weekly, it could easily fall outside the endof-year range, and the aggregate nonetheless be on target, or it
could fall within the end-of-year range, and the aggregate
nonetheless be off target, for the year. The targets are set as
percent changes from the fourth quarter of one year to the fourth
quarter of the following year — using quarterly averages of the
aggregates. Thus, the final (one or two) monthly observations,
or the final (one through twelve) weekly observations, could, in
principle, be anywhere on the graph, and the aggregate could
nonetheless be on-target (or off-target), since the quarterly
average, not the final observations, determine the outcome.
It would be preferable to show the actual percentage growth
ranges established by the Fed, and to depict the growth of the
aggregate so that it is on-target or off-target, for the year,
according to whether the last observation is inside or outside
the established ranges. This is accomplished by the weekly
plotting of the annualized percent change of a 13-week moving
average, calculated from the last 13-week average of the previous
year. That last 13-week average of the previous year is, in
fact, the aggregate for the last quarter of the previous year.
And the last 13-week average for the current year will be the
aggregate for last quarter of the current year. (13-week moving
averages may differ slightly from reported quarterly aggregates
since not every quarter has exactly 13 weeks, but such
differences are imperceptibly trivial.)
The Fed does not interpret its established growth ranges as
necessarily implying any particular path over the course of the
year. Strictly speaking, the growth ranges apply only to the
aggregates for the last quarter of the current year, compared to
the last quarter of the previous year. There is, strictly
speaking, no sense in which the path between those end points is
"on-target" or "off-target". Nonetheless, it is important to
convey information, during the course of the year, on how the
aggregates are growing, relative to their final growth target
ranges. These 13-week moving average graphs convey that
information more usefully than the typical cones or parallel lines.
M2 & M3
Jan
1988
Sept
Dec
Weekly Data for M2 & M3 are annualized percent changes of 13week moving averages for M2 & M3, calculated from the 4th
quarter 1987 average.
MONETARY BASE & Ml
10.0
7.5
MB
5.0
- Ml
P
E
R
C
E
N
T
2.5
0.0-/
Sept
Jan
Dec
1988
Weekly Data for the FRB Monetary Base (MB) and Ml are annualized percent
changes of 13—week moving averages for MB and Ml, calculated from the
4th quarter 1087 average. The Federal Reserve has established no growth
ranges for MB or Ml.
FEDERAL RESERVE BORROWINGS
VERSUS
INTEREST RATE DIFFERENTIAL
r2.0
1.24
f'
lu
FEDERAL FUNDS RATE
MINUS
DISCOUNT RATE
(RIGHT SCALE)
1
/
i
hi.6
'
/
if*
0.9^
hi.2
S 0-<H
rO.8
en
o
0.3H
ADJUSTMENT + SEASONAL
BORROWINGS FROM FEDERAL
RESERVE BANKS (LEFT SCALE)
HO.4
iiiiiiI
5/06/87
8/26/87
12/16/87
4/06/88
7/27/88
GROSS
16 -i
NATIONAL
SOLID LINE IS ACTUAL GNP
DASHED LINE IS REAL (82$) GNP
DASH-DOT LINE IS GNP DEFLATOR
12 -
PRODUCT
ALL DATA ARE PERCENT
CHANGE FROM SAME QUARTER
ONE YEAR AGO.
ACTUAL
GNP
r 16
- 12
6UJ
o
(X
4-
0-
76
i ii
77
I '80 ' '811 '82" 83
I ' 84
' ' I85' "86 !' "
! 88' '—4
'I"'I
87
87
For use at 10:00 a.m., E.D.T.
Wednesday
July 13, 1988
Board of Governors of the Federal Reserve System
* * * 4 L *£**•'
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 13, 1988
88
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 13, 1988
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
89
Table of Contents
Page
Section 1:
Monetary Policy and the Economic Outlook for 1988 and 1989
1
Section 2:
The Performance of the Economy during the First Half of 1988
6
Section 3:
Monetary Policy and Financial Developments during the First Half of 1988
11
Appendix:
The Monetary Base
16
90
Section 1: Monetary Policy and the Economic Outlook for 1988 and 1989
The economy continued to expand rapidly in the first half of 1988, displaying impressive resilience in the wake of last fall's stock
market break. Especially encouraging has been
the fact that the expansion in activity this year has
been propelled largely by rising exports and business investment, which bodes well for the restoration of better balance in the economy.
With the industrial sector continuing to
enjoy greater growth, capacity utilization rates
have crept higher. At the same time, the civilian
unemployment rate has declined since year-end,
and the average of 5-1/2 percent in the second
quarter was the lowest in nearly fifteen years. Despite the tightening of labor markets, wage increases to date have been notably restrained, on
balance, helping to contain cost pressures in many
sectors. Most measures of price inflation among
finished goods and services also have shown little
if any pickup, although basic commodity prices
have risen considerably, most recently reflecting
the effects of drought on agricultural markets.
During the first half of the year, the Federal Reserve continued to direct its policies toward providing monetary and financial
conditions that would foster price stability over
time, promote sustainable economic growth, and
contribute to an improved pattern of international
transactions. It was recognized that progress toward these goals in 1988 would require relatively
slow growth of domestic demand, which would
allow the economy to accommodate rising external demands on U.S. producers without generating overall inflationary pressures. Consistent with
continued external adjustment and with its commitment to achieving price stability over time, the
Federal Open Market Committee (FOMC) in
February lowered its 1988 target growth ranges
for M2 and M3 to 4 to 8 percent.
At the beginning of the year, the conduct
of monetary policy was complicated by excep-
tional uncertainty about the state of the economy.
Some signs of weakness had begun to emerge,
seemingly lending support to the widely held
view that economic activity would falter after the
stock market break. In particular, inventories had
accumulated at a rapid rate in the fourth quarter of
1987, producing some overhang of stocks at the
retail level. Moreover, other indicators suggested
that the rate of increase in labor demand had
slackened. At the same time, financial markets
seemed to be somewhat fragile, as conditions had
not yet returned to normal following the plunge in
stock prices. The Federal Reserve thus was faced
with the challenge of countering the apparent
near-term weakness of the economy, while taking
account of the longer-range need to ensure that
growth in domestic demand would not become
excessive.
In this situation, and with the dollar finning on foreign exchange markets, the Committee
loosened slightly further the easier reserve conditions that had been adopted following the stock
market plunge. Market interest rates edged down,
which—in conjunction with earlier declines in
rates—helped lift M2 and M3 to near the top of
their 1988 target ranges and resulted in a modest
fall in their velocities (the ratio of nominal GNP
to the money supply) during the first quarter.
Given the risk that economic activity was weakening, as well as the still unsettled conditions in
financial markets, the Committee viewed the
more rapid growth in money as appropriate.
By early spring, however, the bulk of the
incoming data indicated that business activity
had, in fact, remained robust. Additional information available later in the second quarter confirmed the strength of the economy, and high and
rising levels of resource utilization pointed to a
greater potential for a build-up of inflationary
pressures. The costs of allowing inflation to reintensify were seen as quite high, based on the expe-
91
rience of the early 1980s, when the reversal of the
inflation process led unavoidably to sizable losses
in output and to an extended period of high unemployment.
Against this backdrop, the Committee
tightened reserve conditions somewhat in a series
of moves beginning in late March. Market interest
rates responded to the strength in the economy
and to the Federal Reserve's actions by moving
upward. Over the past four months, most shortterm interest rates have increased around one percentage point on balance. Long-term rates
generally rose substantially through late May, but
have declined a little on net since then. The better
performance of the bond market recently has occurred at a time when investor sentiment toward
investment in dollar-denominated assets has been
buoyed by better trade statistics and may also
have reflected favorable market response to the
Federal Reserve's demonstrated resolve to fight
inflation.
Despite the Committee's tightening actions, M2 and M3 continued to expand rapidly
through April, in response to earlier decreases in
interest rates and to a bulge hi transactions balances associated with unusually large individual
tax payments. As the tax-related surge unwound
and the influence of higher interest rates began to
be felt, the two broad aggregates grew at a reduced pace hi May and June, and ended the first
half of the year hi the upper halves of their target
ranges.
Monetary Plans
for the Remainder of 1989 and for 1989
At its meeting last month, the Federal
Open Market Committee agreed to retain the 4 to
8 percent target growth ranges for M2 and M3,
measured from the fourth quarter of 1987 to the
fourth quarter of 1988. In addition, the Committee retained the 7 to 11 percent monitoring range
for the debt of domestic nonfinancial sectors and
again set no range for Ml. Recognizing the variability of the relationship of these measures to the
performance of the economy, the Committee
agreed that operating decisions would continue to
be made not only in light of the behavior of the
monetary aggregates, but also with due regard to
developments in the economy and financial markets, including attention to the sources and extent
of price pressures and to the performance of the
dollar in foreign exchange markets.
In the absence of any significant economic and financial disturbances, the Committee
expected growth in M2 to moderate over the remainder of the year, placing the aggregate around
the middle of its target range at year-end. Growth
in M3 this year is expected to exceed that of M2
but to remain comfortably within its range, on the
assumption that asset expansion at depository institutions would remain fairly robust in the second half. The debt of domestic nonfinancial
sectors is expected to remain near the middle of
its monitoring range, which would put its growth
for the year around the slowest annual pace registered in the past decade.
For 1989, the Committee set, on a tentative basis, target growth ranges of 3 to 7 percent
for M2 and 3-1/2 to 7-1/2 percent for M3, measured from the fourth quarter of 1988 to fourth
quarter of 1989; the monitoring range over the
same period for domestic debt was set at 6-1/2 to
10-1/2 percent. Although uncertain about how
strong the economy might be over the coming
year or so, the Committee recognized that, given
the current high levels of resource utilization, it
was necessary to be particularly attentive to inflationary risks. An acceleration of inflation could
undermine the sustainability of the economic expansion and the international competitive position of U.S. producers. The lower ranges
tentatively adopted for 1989 were believed consistent with a monetary policy that would curb
any tendency for inflation to worsen and would
contribute over time to the restoration of price stability. However, the Committee also noted that
developments over the next half year could alter
substantially the rates of money growth needed to
92
foster satisfactory economic performance in 1989
and beyond. Consequently, it stressed the provisional nature of its decision and the possibility
that the ranges for 1989 might need to be adjusted
when they are reviewed early next year.
The Committee again decided not to set a
range for Ml, given the sharp swings in its velocity in recent years, resulting in part from its increased sensitivity to movements in market
interest rates since deposits were deregulated. In
considering narrow monetary measures, the
Committee also has discussed whether the monetary base could play a useful role in the conduct of
policy. This measure comprises the major monetary liabilities of the Federal Reserve System—
currency in the hands of the public and reserves of
depository institutions—and represents, in a
sense, the "base" of the broader monetary aggregates.* The Committee decided against establishing a range for the monetary base, because it
seemed unlikely to provide a more reliable guide
for policy than the aggregates for which ranges already are established. Although the base has been
less variable in relation to economic activity and
prices than Ml, its velocity nonetheless has fluctuated appreciably and rather unpredictably from
year to year.
Economic Projections
As is indicated in the table on the next
page, the central tendency of the forecasts of
Committee members and nonvoting Reserve
Bank presidents—premised on the monetary policy objectives outlined above--4s for growth in
real GNP of 2-3/4 to 3 percent in 1988, with a
modest slowing of expansion in 1989. Such a
pace of growth likely would generate employment gains sufficient to hold the civilian unemployment rate close to its average second-quarter
level of 5-1/2 percent. Prices, as measured by the
implicit deflator for GNP, are generally expected
to rise 3 to 3-3/4 percent over the four quarters of
1988, similar to last year's rate of advance. For
1989, projections of the increase in the GNP deflator are of course more uncertain, and the central-tendency range widens to 3 to 4-1/2 percent.
The Administration forecast for 1988 is
quite similar to the central tendency of forecasts
of FOMC members and nonvoting presidents.
For 1989, the Administration is projecting
stronger growth of real output than indicated by
the FOMC forecasts, but its expectation for inflation is in the middle of the range of FOMC forecasts. The Administration's projection of nominal
GNP in both years is around the upper end of the
Ranges of Growth for Monetary and Credit Aggregates
(Percent change, fourth quarter to fourth quarter)
Provisional for
1987
1988
1989
M2
5-1/2 to 8-1/2
4 to 8
3 to 7
M3
5-1/2 to 8-1/2
4 to 8
3-1/2 to 7-1/2
7 to 11
6-1/2 to 10-1/2
Debt
8 to 1.1
* The characteristics of the base and its behavior are discussed in detail in an appendix to this report.
93
central-tendency ranges and within the full
ranges, suggesting that the Administration's economic forecast and the FOMC's monetary ranges
are broadly compatible.
Continued improvement in the external
sector is expected to provide the main impetus to
U.S. economic growth over the next year and a
half. Real exports of goods should remain on a
strong upward path, reflecting the improved competitive position of U.S. producers. At the same
time, the growth of real imports is likely to be restrained, owing to the lagged effects of the depreciation of the dollar through the end of last year.
This continued shrinkage of the real trade deficit
is expected to be sufficient to generate some reduction in the nation's deficit on current account
during 1988 and a further decline in 1989.
In contrast to the boost provided by the
external sector, domestic demand is projected to
remain relatively subdued. Consumer spending,
in particular, has been on a sluggish growth trend
since late 1986, and that pattern seems likely to
persist. Moreover, hi an environment of more
moderate growth of overall activity, economywide spending on new plant and equipment may
not rise as swiftly as it has on average over the
past year. Even so, within manufacturing, improved profitability and higher capacity utilization have stimulated a healthy pickup in capital
spending, which should continue for some time.
The performance of the interest-sensitive
sectors, most notably homebuilding and business
investment, will be influenced considerably by
the extent to which the federal government is
competing for available supplies of credit. Accordingly, continued fiscal restraint is essential if
we are to free up resources to support private investment. In this regard, the budget summit
agreement reached last December was a favorable first step, and the Federal Open Market Committee members and other Reserve Bank
presidents have assumed that the necessary legis-
Economic Projections for 1988 and 1989
FOMC Members and nonvoting FRB Presidents
Range
Central
Tendency
Administration
Percent change, fourth quarter to fourth quarter
Nominal GNP
1988
4 to
1989
4 to
Real GNP
1988
1 to
1989
1 to
Implicit deflator for GNP
1988
2-3/4 to
1989
2 to
7
7-1/2
5-3/4 to 6-3/4
5 to 7
6.6
7.1
3-1/4
3
2-3/4 to 3
2 to 2-1/2
3.0
3.3
3 to 3-3/4
3 to 4-1/2
3.5
3.7
5-1/4 to 5-3/4
5-1/2 to 6
5.5
5.3
4
5
Average level in the fourth quarter, percent
Civilian unemployment rate
1988
5-1/4 to 6-1/2
1989
5 to 7
94
mtrve action will be taken to implement the agreement. There is a clear need for further initiatives
to deal with the out-year deficits, which remain
distressingly large; financial events later this year
and in 1989 could be substantially affected by the
developments in the fiscal arena.
acceleration as a consequence of drought conditions; however, it is important to recognize the
temporary nature of this phenomenon, which
should have no lasting effect on overall inflation
so long as it does not become embedded in wage
trends.
Although little change is expected in the
overall pace of inflation this year, as compared
with 1987, the sources of actual and potential
price pressure appear to have changed. In 1987, a
rebound in oil prices was a major factor boosting
the general price level; assuming that world oil
prices remain fairly stable, domestic energy
prices should not be a significant inflationary
force in 1988-89. Labor markets have tightened
considerably since last year, however, and most
measures of wage and compensation rates have
firmed. Although the overall rate of industrial capacity utilization is not high by historical standards, plants are being used very intensively in
some materials-producing sectors; sharply rising
materials prices have raised costs for manufacturers generally. Food prices also have been a less
favorable element in the inflation picture recently, and are likely to experience some further
For 1989, the FOMC central-tendency
range for the GNP deflator wiuens on the upper
end, suggesting the possibility of a pickup in inflation from the pace this year. However, this apparent acceleration of prices largely reflects the
arithmetic implication of an eccentric movement
in the deflator for GNP in the first quarter of this
year. Shifts in the composition of output caused
the deflator to rise at less than a 1-1/2 percent annual rate during that quarter; these shifts are not
expected to be so noticeable in coming quarters.
The view that inflation next year will lot differ
significantly from the pace anticipated over the final three quarters of 1988 reflects the expectation
that business and labor—recognizing the realities
of a highly competitive international marketplace—will continue to exercise restraint in setting prices and wages.
95
Section 2: The Performance of the Economy During the First Half of 1988
The economy continued to expand
briskly in the first part of 1988. Activity was
boosted by strength in capital spending and
growth in foreign demand for U.S. goods. The
rise in overall output during the first six months of
this year supported the addition of about 1-3/4
million jobs to nonfarm payrolls, and the civilian
unemployment rate, which had trended down
throughout 1987, dropped somewhat further
since the beginning of the year to an average level
of 5-1/2 percent in the second quarter.
Despite the greater tightness in labor
markets and the higher rates of capacity utilization now prevailing in some industries, tendencies toward additional inflation have been
limited. Prices of materials and components have
risen sharply, but for finished goods there are
only hints of price acceleration outside the food
sector. Wages, on the whole, have continued to be
fairly well behaved, suggesting a recognition on
the parts of labor and management of the need to
maintain competitive cost structures.
The continued resurgence of manufacturing has been one of the most notable economic
developments this year. During the first five
months of 1988, industrial production expanded
at nearly a 4 percent annual rate, and the rate of
capacity utilization for total manufacturing rose
1/2 percentage point between December and May
to just over 83 percent, the highest level during
the 1980s. Owing to these advances in production, manufacturers have embarked on substantial
programs to invest in plant and equipment, pacing
an economy-wide pickup in the rate of capital
spending. The better balance of expansion also
has been visible in agriculture, although the upturn in that sector has been jeopardized by recent
drought conditions.
The improvements in manufacturing and
agriculture are, in part, reflections of a broader
adjustment of the U.S. external position. The
combination of a lower dollar and domestic cost
containment has translated into a marked turnaround in real net exports. That process also has
been aided by stronger economic growth in other
large industrial countries.
The External Sector
After having trended down for nearly
three years, the dollar has appreciated substantially thus far in 1988 against most major foreign
currencies. The dollar rose sharply at the beginning of the year, responding in part to coordinated
central bank intervention. In recent months, sentiment toward the dollar has been improved by the
release of better-than-expected trade reports and
the firming actions of the Federal Reserve.
The U.S. merchandise trade deficit for
the first quarter was $144 billion at a seasonally
adjusted annual rate, substantially below the figures for the fourth quarter and for 1987 as a
whole. In April, the trade deficit narrowed further. Exports have continued to expand rapidly,
while import growth has slowed considerably.
The strong growth of exports can be attributed
primarily to the increased price competitiveness
of U.S. goods, which reflects the decline of the
dollar in recent years and the tight control over
production costs exercised by domestic firms.
This growth of exports continues to be broadly
based, and foreign sales have been particularly
strong for industrial machinery and for computing equipment. On the import side, the volume of
purchases rose less than 1 percent in the first quarter and apparently declined in April. Imports of
consumer goods excluding autos were essentially
unchanged in the first quarter, continuing the pattern of 1987, while auto imports fell somewhat. In
contrast, imports of capital goods rose considerably, stimulated by the surge in equipment outlays by domestic firms.
96
Real GNP
Percent change from end of previous period, annual rate
H2
Q1
H1
I
I
1983
1984
1985
I
1986
1987
Industrial Production
Index 1977.100
140
130
120
I
1983
i
1984
I
1985
I
1986
1987
19(
GNP Prices
Percent change from end of previous period, annual rate
Fixed-weighted Price Index
H1
H2 Q1
1983
1984
1985
1986
1987
1988
90
97
Foreign Exchange Value of the U.S. Dollar *
Index, March 1973 =100
, 175
125'
I
I
1983
1984
75
1987
1985
1988
U.S. Real Merchandise Trade
Annual rate, billions of 1982 dollars
Imports
1983
1984
1985
U.S. Current Account
1986
1987
Annual rate, billions of dollars
, 50
H1
H2 Q1
200
1983
1984
1985
1986
1987
1988
* Index of weighted average foreign exchange value of U.S. dollar in terms of currencies of other
G-10 countries. Weights are 1972-76 global trade of each of the 10 countries.
98
Economic expansion abroad has continued at a moderate pace, on balance, so far this
year, providing some support for an improved
U.S. trade position. Activity increased sharply in
the major foreign industrial countries in early
1988, while growth in the smaller industrial nations remained subdued. In the newly industrialized countries of Asia, economic activity
continued to expand rapidly. In contrast, growth
slowed in Latin America, primarily due to a sharp
deceleration of activity in Brazil. In the OPEC
countries, activity appears to have stabilized in
1988, after a decline in 1987, as higher volumes
of oil exports have offset the effects on government revenues of a slight softening in prices.
The Household Sector
Consumer spending showed some vigor
in early 1988, after declining in the fourth quarter
of last year. Real outlays increased at a 3-3/4 percent annual rate in the first quarter, as purchases
of motor vehicles bounced back with the expansion of manufacturers' incentive programs, outlays for other durable goods were strong, and
expenditures on services continued to post appreciable gains. Data for April and May suggest,
however, that the growth of consumer spending
slowed from the rapid first-quarter rate.
The buoyancy of consumer spending
early this year can be traced to robust income
growth. Real disposable personal income rose at a
5 percent annual rate, on average, during the
fourth quarter of 1987 and the first quarter of
1988, substantially above the 2 percent rate
posted for 1987 as a whole. However, disposable
income growth appears to have slowed considerably in the second quarter, as a result of a spurt in
nonwithheld tax payments and a slower pace of
employment gains.
Although the pace of consumer spending
thus far this year has been stronger than many expected, the stock market break probably did exert
some restraining effect. This is evident in the personal saving rate, which has averaged 4-1/2 percent for the seven months after October—one
percentage point above the average level during
the first three quarters of 1987. While most
households experienced little direct loss of wealth
from the stock market decline, the startling dimensions of the event obviously affected consumer sentiment last fall. With each passing
month, however, confidence has grown and
helped to sustain the growth of spending.
Residential construction was weak during the first half of 1988. Total housing starts averaged about 1-1/2 million units at an annual rate
through May, almost 9 percent below the 1987 total. In the multifamily sector, building declined
from the already depressed 1987 level. Starts in
this sector have been falling since the end of
1985, as near-record vacancy rates and changes in
the tax laws have reduced the incentive to build
new units. In the single-family sector, building
has fluctuated from month to month, influenced
by movements in interest rates and perhaps by
weather; on balance, the average level of starts
through May was roughly 6 percent below the
1987 pace.
The Business Sector
Business fixed investment advanced
sharply in the first quarter of 1988, owing to a
large increase in purchases of equipment. In recent months, spending appears to have remained
near the high first-quarter level. Surveys of capital spending plans, taken this spring, point to appreciable growth hi investment outlays over the
second half of 1988.
Real outlays for computing equipment
jumped at more than a 90 percent annual rate in
the first quarter, but fell back considerably in subsequent months. Smoothing through this volatility, it appears that demand for such equipment has
emerged from the lull that prevailed during 1986
and the first half of 1987, when excess computing
capacity—as well as concerns about the usefulness of available software—limited purchases.
Outlays for other types of equipment also have
been strong, on balance, since the turn of the year,
largely reflecting the buoyancy of overall eco-
99
Real Income and Consumption
Percent change from end of previous period, annual rate
|
| Real Disposable Personal Income
Eli-i;! Real Personal Consumption Expenditures
Q1
1963
1984
1985
1986
Personal Saving Rate
1983
1984
1987
1988
Percent of disposable income
1985
1986
1987
Private Housing Starts
Annual rate, millions of unKs, quarterly average
Q1
; Single-family
]
1983
1984
1985
1986
t
1987
1988
100
Real Business Fixed Investment
Percent change from end of previous period, annual rate
40
[^Structures
Q1
—
_
— E!jx| Producers' Durable Equipment
n
-
H2
-i
rilm
pi
1 !*;;:!
u
I
\m
I
I
u
HI
la
30
20
10
+
Q
If U
I
-
I
10
20
Changes In Real Business Inventories
Annual rate, billions of 1982 dollars
80
|~"| Nonfarm Less Retail Autos
— [jx] Retail Autos
— 60
Q1
40
H2
- 20
-
0
II
20
I
I
1983
1984
I
1985
i
1986
40
1987
1988
After-tax Profit Share of Gross Domestic Product *
Percent
Nonfinancial Corporations
1983
1984
1985
1986
1987
1988
* Ratio of profits from domestic operations with inventory valuation and capital consumption
adjustments to gross domestic product of nonfinancial corporate sector.
101
nomic activity. In particular, with utilization rates
now at elevated levels in many manufacturing industries, equipment investments have been an attractive way of removing bottlenecks and
achieving a relatively rapid improvement in effective capacity.
Although the data for May showed a surprising jump in nonresidential construction activity, real outlays hi this sector were sluggish
overall during the first five months of the year.
Commercial construction, the largest part of this
aggregate, continues to be restrained by an overhang of vacant space. In addition, oil and gas
drilling, which was up more than 20 percent in
1987, has changed little since last fall, owing in
large part to the general weakness of petroleum
prices over this period. Industrial construction, in
contrast, has risen briskly in recent months.
Nonetheless, even here, the picture is cloudy. Although capacity utilization is high hi a number of
sectors, manufacturers apparently remain cautious about making the large, long-range commitments involved hi building new plants, and new
contracts for industrial construction actually have
trended down since the beginning of the year, after rising hi 1987.
The pace of business inventory investment moderated somewhat during the first four
months of 1988, reducing the concern about excessive stocks that had arisen earlier this year.
This concern had focused on the retail sector,
where inventories at auto dealers and at certain
outlets for nondurable goods (primarily general
merchandise and apparel stores) appeared high
relative to sales at year-end. By cutting production early in the year and offering a variety of
sales incentives, automakers have been able to
bring their inventories into better alignment with
sales. In contrast, inventory-to-sales ratios for
nondurable retail goods continue to hover at levels that are high by historical standards. At the
manufacturing level, inventory positions through
May appeared fairly lean in general, given the
pace of shipments. Much of the recent building of
factory stocks has been in industries where market demand has been robust, such as aircraft, machinery, chemicals, and paper.
Before-tax economic profits of nonfinancial corporations continued to be strong in the
first quarter, with manufacturing firms posting
substantial gains. After-tax profits also rose noticeably, as the maximum tax rate on corporate
profits was reduced from 40 to 34 percent, a
change mandated by the Tax Reform Act of 1986.
Owing to the strong growth of profits, the internal
cash flow of nonfinancial corporations has increased considerably since mid-1987, reversing
the slide of the previous year.
The Government Sector
In real terms, federal government purchases of goods and services—which add directly
to GNP and account for about one-third of total
federal expenditures—fell during the first quarter
and appear to have remained relatively weak in
recent months. This dropoff reflects the winding
down of some major defense procurement programs, restraint on domestic discretionary spending, and net reductions hi farm inventories held
by the Commodity Credit Corporation. However,
on a budget basis, total outlays have been growmg rapidly, owing to continued increases in entitlements, greater demands on deposit insurance
agencies, and increasing net interest payments.
Meanwhile, growth of federal government revenue has slowed compared with the
sharp increase hi FY1987. Although tax receipts
have been pushed up by the robust gains in income and by an increase in the payroll tax rate,
this upward impetus to revenue has been tempered by the final reductions in income tax rates
from the reforms enacted in 1986. In contrast to
its effects this year, tax reform had provided a
substantial boost to revenues in FY1987. On balance, it is quite possible that the budget deficit this
year will exceed the $150 billion shortfall recorded last year.
The state and local sector continues to
operate under budgetary pressure, as operating
102
and capital accounts (which exclude social insurance funds) have been in deficit for the past year
and a half. In the first quarter of 1988, this combined deficit stood at $9 billion, similar to the
shortfall recorded during 1987. Many states have
acted to curb this fiscal erosion, using a combination of tax hikes—primarily sales and excise
taxes—and budget cuts. As a result, the growth of
real spending slowed considerably in the first
quarter, reflecting a sharp decrease hi construction outlays. This was the third such decline hi the
past four quarters, and this downtrend in construction activity has occurred despite continuing
needs to expand and upgrade the basic infrastructure.
Labor Markets
Early in the year, incoming data seemed
to signal some weakening of labor demand. Initial
claims for unemployment insurance, which had
trended up during the final months of 1987, rose
even further just after the turn of the year. Moreover, the first report on nonfarm payroll employment for January showed the smallest monthly
increase since mid-1986. Taken together, these
indicators conveyed a picture of deterioration in
the labor market. However, as subsequent data
were released, it became clear that the underlying
pattern of labor demand had, in fact, remained
healthy. Claims for unemployment insurance
dropped back to relatively low levels and the anemic employment gains for January were revised
up substantially. Moreover, since January, nonfarm payroll employment has advanced more
than 300,000 at a monthly rate, somewhat above
the average increase in 1987. Although the gains
have been concentrated in the service-producing
sector, manufacturing has posted an average
monthly increase of about 30,000 jobs thus far
this year, with the largest advances in the machinery and metals industries.
The combination of strong gains in employment and slower growth of the labor force
over the first half of 1988 lowered the civilian
jobless rate to 5.3 percent in June from 5.8 percent
at the end of last year. Joblejs rates fell for a broad
spectrum of demographic groups over the first
half of the year, and the June rate of unemployment represents the lowest monthly figure since
mid-1974. The June level, however, may be artificially low, owing to the difficulty of adjusting
for seasonal swings in employment at the end of
the school year.
As the unemployment rate dropped last
year, compensation increases—which had been
moderating for several years—leveled out. In the
early part of this year, there were some signs of an
acceleration in labor costs. Hourly compensation,
as measured by the employment cost index, advanced nearly 4 percent between the first quarter
of 1987 and the first quarter of this year, about 3/4
percentage point more than in the previous
12-month period. Although this pickup was related in large part to the strength of labor demand,
it was exacerbated by the rise in the payroll tax
rate that took effect on January 1. By sector, the
sharpest uptick hi compensation rates occurred in
manufacturing, where increases in production
have led to a firming in labor demand. This pattern stands in contrast to trends in the early 1980s,
when pay gains in manufacturing lagged far behind those in the service-producing sector.
Since 1980, output per hour in the nonfarm business sector has risen at an average 1-1/2
percent annual rate. Although this rate is somewhat above the sluggish pace of the 1970s, it remains far below the advances registered earlier in
the postwar period. In contrast, productivity gains
in manufacturing have been quite rapid in recent
years. The first-quarter rise in factory output per
hour was nearly 3 percent at an annual rate, in line
with the average increase registered during 1986
and 1987; these productivity advances have continued to hold down unit labor costs, which fell
1/2 percent over the year ended in the first quarter
of 1988.
Price Developments
Upward pressures on prices appear to
have grown stronger this year, reflecting the
103
Nonfarm Payroll Employment
Net change, millions of persons, annual rate
QTotal
{•^Manufacturing
n.lLrLn_
I
1983
I
1984
1985
1987
Civilian Unemployment Rate
1988
Quarterly average, percent
1 12
10
J_
1983
1984
1985
Employment Cost Index *
1986
1987
1988
12-month percent change
Total Compensation
1985
1987
* Employment cost index for private industry, excluding farm and householdworkers.
** Percent change from March 1987 to March 1988.
104
lagged effects of the earlier depreciation of the
dollar, as well as tighter markets for labor, industrial materials, and farm output. Energy prices, in
contrast, have been restrained this year, on balance, and have provided some offset to these
pressures. For the most part, signs of higher inflation have been confined to price indicators for
commodities and intermediate goods, which have
posted sharp increases. The consumer price index—a measure of inflation for finished goods
and services—showed no acceleration during the
first five months of 1988, rising at the 4-1/2 percent annual rate registered for 1987 as a whole.
increases in import prices spurred by the earlier
depreciation of the dollar. Particularly noteworthy has been a jump in clothing prices, which
have been affected not only by the dollar's movement, but by quotas on apparel imports. In the
service area, medical care costs have continued to
rise rapidly.
At earlier stages of processing, inflation
appears to have picked up for a wide range of
items. On commodity markets, prices of crude industrial materials have remained on an upward
course this year, although the price hikes have
been less pervasive than in 1987. Reflecting, in
part, these developments, the producer price index for intermediate materials other than food and
energy rose at nearly an 8 percent annual rate over
the first five months of this year, up from the 5
percent pace registered last year. Price increases
have been especially large for materials used by
producers of metals, chemicals, paper, and plastic, where output has been strong or capacity utilization rates high.
In the energy sector, spot prices for crude
oil plummeted after OPEC failed last December
to reach a credible agreement to limit production.
The contract price for West Texas Intermediate
(the benchmark crude oil in the United States) fell
from about $18 per barrel in December to about
$16 per barrel in March. Reflecting these developments, retail prices for gasoline fell considerably in the first quarter. During March and April,
prices for crude oil drifted up and, in response,
consumer energy prices rebounded in April and
May. More recently, however, crude oil prices
have receded again, as OPEC's June meeting adjourned without an agreement on production cuts.
In the agricultural sector, tighter crop inventories and stronger grain exports pushed up
farm-level prices early hi 1988. In addition, prices
for grains and soybeans recently have surged in
commodity markets, owing to the drought in major growing regions. It now appears likely that retail food prices will accelerate in coming months
and exert some upward pressure on aggregate
consumer price inflation.
Excluding food and energy, prices at the
consumer level rose at about a 4-3/4 percent annual rate during the first five months of this year.
Consumer price inflation has remained M this
relatively high rate partly because of contivied
-10-
The upward movement of intermediate
goods prices relative to finished goods prices at
the producer level has been quite substantial. Although divergences in the two series, such as the
one that has arisen over the past year, are not unprecedented, disparities typically have not persisted for long. Historical evidence indicates that
higher materials costs, on average, pass through
rather quickly into finished goods prices. In the
recent period, the effect of the sharp rise in materials prices may have been cushioned by restraint
on unit labor costs, by the spreading of overhead
costs over larger sales volumes, and, perhaps, by
efforts to save on or substitute away from higher
cost materials. Nonetheless, past experience suggests that, even if there may not be a significant
delayed pass-through in coming months, the risks
of an acceleration in finished goods prices would
be considerable if the pressures on materials
prices do not ease soon.
105
Consumer Prices
Percent change from end of previous period, annual rate
H1
1983
1984
1985
1986
1987
1988
Consumer Prices Excluding Food and Energy *
Percent change from end of previous period, annual rate
|
| Services Less Energy
f-'i^jiJI Commodities Less Food and Energy
HI
1983
1984
1985
1986
1987
H2
1988
Producer Prices for Intermediate Materials Percent change form end of
Excluding Food and Energy
previous period, annual rate
H1
1983
1984
1985
1986
* Consumer Price Index for all urban consumers.
" Percent change from December 1987 to May 1988.
1987
106
Section 3: Monetary Policy and Financial Developments during the Rrst Half
of 1988
The Federal Open Market Committee has
sought monetary and financial conditions that
promote price stability over time, support sustainable economic growth, and contribute to an improved pattern of international transactions. To
this end, the Committee at its February meeting
established target ranges, measured as growth
rates from the fourth quarter of 1987 to the fourth
quarter of 1988, of 4 to 8 percent for both M2 and
M3. It also set a monitoring range of 7 to 11 percent for the growth of domestic nonfinancial debt
and chose, once again, not to stipulate a range for
Ml growth. The 1988 target ranges for M2 and
M3 represented reductions from last year's
ranges of 5-1/2 to 8-1/2 percent for both aggregates and resulted in a lowering of the midpoint of
the target ranges by one full percentage point.
In widening the target ranges for M2 and
M3, the Committee cited the high degree of variability in the relationship between money and aggregate demand that had appeared in recent years.
As a result of this development, which stemmed
largely from an increased sensitivity of money
growth to interest rate changes, it was felt that a
wider range of monetary growth rates could be
compatible with satisfactory outcomes for the
economy. At the time of the February FOMC
meeting, broader ranges seemed particularly appropriate in light of the uncertain outlook for
spending. More specifically, the eventual effects
on domestic demand of the October stock market
plunge and the subsequent drop in interest rates
remained unclear. Ml had become even more interest sensitive, and it had varied more widely
relative to GNP than had the broad aggregates,
thus making it even more difficult to interpret;
consequently, the Committee decided against establishing a target range for this aggregate.
In setting a monitoring range for domestic nonfinancial sector debt, the Committee an-
ticipated that debt growth would slow hi 1988,
owing to less government borrowing. Nonetheless, the rate of expansion of domestic debt was
expected to exceed that of income. As was the
case for the monetary aggregates', considerable
uncertainty surrounded the prospects for debt
growth, leading the Committee to widen the
monitoring range by dropping the lower limit one
percentage point from the previous year's rate.
During the first part of 1988, monetary
policy was conducted against a backdrop of data
suggesting some weakness in the economic expansion. Reflecting concern about the outlook for
economic growth, the Committee moved in January to ease slightly the degree of pressure on reserve positions. On balance, interest rates fell
during January and February, which, in conjunction with rate declines that followed the stock
market drop in October, contributed to a pickup in
M2 and M3 growth over the first quarter of the
year.
As information suggesting greater economic strength and an increased potential for a
build-up of inflationary pressures became available in March and in subsequent months, and with
M2 and M3 running near the upper ends of their
growth ranges, the Committee moved, in several
steps, to tighten reserve pressures. Owing to the
force of credit demands and the Federal Reserve's
less accommodative posture, interest rates rose on
balance over those months. Late in the second
quarter, growth in the aggregates moderated,
leaving both well within their target ranges as the
first half of 1988 ended.
Behavior of Money and Credit
From the fourth quarter of 1987 through
June 1988, M2 increased at about a 7 percent annual rate, a noticeable increase over its 1987 rate
of 4 percent. The faster growth can be attributed
primarily to the lagged reaction of the public' s de-
107
Growth of Money and Debt
Percentage changes at annual rates
Ml
M2
M3
Debt of domestic
nonfinancial
sectors
Fourth quarter 1987
to second quarter 1988 e
5.0
7.4
7.1
8.5
Fourth quarter 1987
to June 1988 e
5.1
8.2
8.9
9.3
9.1
12.1
7.6
8.9
9.4
4.0
10.4
9.5
12.3
9.9
9.8
10.4
7.7
9.1
5.4
12.3
9.6
10.0
8.9
11.3
14.2
13.3
13.3
9.6
13.2
6.6
0.8
3.9
6.5
2.7
2.8
3.9
6.5
4.6
4.5
5.4
10.5
8.6
7.9
10.1
3.8
6.1
6.7
7.9
7.0
7.1
8.4
8.3
Fourth quarter to fourth quarter
1979
1980
1981
1982
1983
1984
1985
1986
1987
7.7
7.5
5.2 (2.5)*
8.7
10.2
5.3
12.0
15.6
6.2
Quarterly average
1987
Ql
Q2
Q3
Q4
1988
Ql
Q2e
* Ml figure in parentheses is adjusted for shifts to NOW accounts in 1981.
e - estimated
108
Ranges and Actual Growth of Money and Debt
M2
M3
Billions of dollars
Billions of dollars
3250
4000
3150
3900
3800
4%
J
i
l
l
2950
3700
2850
3600
2750
O N D J F M A M J J A S O N D
I I I
O N D J F M A M J J A S O N D
1988
M1
3500
1988
Debt
BIRIons of dollars
Billions of dollars
9400
900
11%
9200
850
9000
7%
800
8800
8600
8400
750
8200
I I i
8000
O N D J F M A M J J A S O N D
1988
O N D J F M A M J J A S O N D
1988
109
mand for M2 balances to decreases in market interest rates relative to deposit rates that occurred
in late 1987 and early 1988. In the second quarter
of 1988, however, the "opportunity cost" of holding M2 reversed its downward trend, and growth
in M2 moderated toward the end of the period.
Also contributing to the May-June slowdown
was the runoff of an unusually large, tax-related
build-up of transactions balances that inflated
both Ml and M2 in April. On balance, M2 velocity is estimated to have declined slightly over the
first half of the year, in contrast to its upward
movement in 1987 when market interest rates and
the opportunity cost of M2 were generally increasing.
A number of the components of M2 contributed to its strengthening in the first hah0 of
year. After declining steadily over the last half of
1987, liquid retail deposits—the sum of other
checkable deposits, savings deposits, and money
market deposit accounts—registered a solid gain
over the first half of 1988, as reductions in market
interest rates during the winter combined with the
slow adjustment of rates on these deposits to increase their relative attractiveness. Growth hi
small time deposits also was particularly strong,
as was that in M2-type money market mutual
fund assets early hi the year. Falling market interest rates, coupled with slow adjustment of returns
on fund assets, provided money funds with a rate
advantage hi the first quarter, thereby leading to
higher asset growth. Rising market rates of interest and the apparent use of money funds to pay
taxes, however, significantly slowed their growth
in the second quarter.
M3 growth increased in the first half of
1988 to a 7 percent rate, following a 5-1/2 percent
increase in 1987. Credit expansion at banks and
thrift institutions, which heavily influences the
overall behavior of M3, remained at roughly the
same pace as last year, but it was financed to a
greater extent over the first half of the year by liabilities included in M3. In particular, inflows to
banks from their foreign branches and borrow-
ings by savings and loans from Federal Home
Loan Banks, which are not included in M3,
dropped off sharply compared with 1987.
Ml grew at a 5 percent rate during the
first half of the year, which although below the
6-1/4 percent rate for all of 1987, was higher than
its growth in the second half of last year. The sluggish growth of Ml, especially in comparison to
that of M2 and M3, owed entirely to weakness hi
demand deposits, which have been declining over
the past year and one-half. In contrast, growth hi
currency and other checkable deposits was robust.
Domestic nonfinancial debt grew at a
8-1/2 percent rate from the fourth quarter of 1987
to June, according to estimates based on partial
data. Debt growth hi the first half represented a
slowdown from last year's 9-1/2 percent rate and
a substantial decline from the 13-1/4 percent rate
of expansion in 1985 and 1986. Nonetheless, debt
continued to grow faster than nominal GNP. Reflecting the effects of smaller federal deficits during the calendar year, growth hi federal debt
slowed from last year's pace and remained at a
rate well below that recorded over most of the
1980s. Nonfederal debt also expanded at a somewhat slower rate, as the growth of the debt of
households and state and local governments declined modestly. In the household sector, a falloff
in mortgage borrowing associated with weaker
housing expenditures offset a pickup in consumer
credit. Business borrowing expanded at roughly
the same pace as hi 1987, with rising interest rates
in the second quarter causing firms to shift more
of their borrowing to short-term instruments.
Implementation of Monetary Policy
In conducting monetary policy, the Federal Reserve directed its operations during the
first three months of 1988 at either maintaining or
easing slightly the degree of reserve pressure that
had prevailed since the October stock market collapse. Thereafter, the System moved in several
steps to firm reserve positions.
110
Short-term Interest Rates
Percent
—l 20
12
3-month Treasury BJH
I
1980
j
v
~~
Xs;
I
1982
1984
Long-term Interest Rates
Percent
1 20
Home Mortgage
Fixed Rate
I
1980
1982
I
1984
NOTE: Last observation is for June 1988.
i
I
Imiinnn
Ill
The early months of 1988 were marked
by widespread concern that the economic expansion might be faltering. Data available in January
and February pointed toward a weakening in domestic final demand, as evidenced by a substantial build-up of inventories in the fourth quarter of
1987 and some softening in labor market data. At
the same time, inflationary pressures and expectations appeared to have diminished somewhat, and
after coming under pressure in late December, the
dollar first rebounded and then stabilized against
most major currencies.
In these circumstances, the Committee
moved in late January to ease slightly the pressure
on bank reserve positions. The provision of nonborrowed reserves through open market operations was increased, the level of discount window
borrowing declined, and the federal funds rate
edged downward. Other market interest rates declined as well; in spite of lower interest rates, the
dollar was relatively stable against most major
currencies.
The downward trend for most market interest rates came to an end in late February and
early March, when incoming information indicated that the economy was considerably stronger
than it was earlier thought to be, and in light of
emerging pressures on industrial capacity and labor markets, the risks of a pickup in inflation appeared to have risen. In this environment,
monetary policy began in late March to become
less accommodative. The restraint in policy was
aimed at moderating potential inflationary pressures by damping domestic demand in order to facilitate a shift of resources to the external sector.
As information pointing to substantial economic
strength became available in April and May, and
with the monetary aggregates growing at rates
near the upper end of their target ranges, the Committee moved again to apply slightly greater pressure on reserve positions. Reflecting both the
System's actions and market concerns about inflation, market interest rates moved higher. Since
late May, however, long-term interest rates have
fallen on balance, despite further increases in
short-term interest rates. The resulting narrowing
of the spread between long- and short-term rates
apparently reflects some lessening of concerns
about inflation, brought about in part by the
firmer monetary policy. Long-term yields also
have benefited recently from the upward movement of the dollar against most major currencies,
as the trade balance has continued to improve.
The change in attitude toward the dollar apparently has encouraged investments in relatively
high yielding dollar assets.
In the aftermath of the stock market crash
last October, the Committee modified the System's procedures by placing greater emphasis on
money market conditions and less on bank reserve positions in carrying out day-to-day open
market operations. In doing so, it was neither the
Committee's intention to alter its operating procedures permanently nor to ignore bank reserve
positions completely. Rather, the thrust of the
modification was to permit greater flexibility in
System operations in light of the volatility and
fragility characterizing financial markets at that
time. During this period, it was considered important to assure the markets of the System's intention to provide adequate liquidity, and it was
feared that significant variation in money market
conditions could add to the unusual uncertainties
already in the markets.
As markets exhibited signs of increased
stability this year, the Committee responded by
gradually placing greater emphasis on reserve positions in conducting System operations, allowing
money markets to respond more sensitively to
changing economic circumstances. The transition
back to the pre-October approach was completed
in the spring.
Other Financial Developments
The collapse of equity prices last October
heightened public concerns about the volatility of
stock prices and the fragility of financial institutions and markets. These concerns became the
subject of studies by a Presidential commission,
112
governmental agencies, and the securities industry. Recommendations from these groups and
from a follow-up Presidential working group focused on ways to avoid excessive stock price
volatility and to strengthen the ability of markets
and related systems to deal with large price movements. Progress has been made in this regard,
with steps having been taken by market participants to address some of the problems revealed by
the market break in clearing and settlement systems. Additional steps have been taken to coordinate trading halts triggered by extreme price
moves and to strengthen capital positions of specialists and other market makers.
In considering the possibility of future
regulatory action in this sphere, it is noteworthy
that the stock market break has not been followed
by any major aftershocks. In part, this reflects the
basic resilience in this period of the economy and
financial markets. In addition, it attests to the general adequacy of the current regulatory framework and monetary policy institutions in
cushioning financial disturbances, so that they do
not spread to the economy as a whole. Thus, while
the additional steps initiated by private entities to
strengthen market mechanisms certainly are desirable, a major extension of the governmental
regulatory apparatus does not seem necessary.
The banking industry also has been the
subject of considerable concern, arising from its
well-publicized difficulties with energy, agricultural, real estate, and developing country loans.
These problems have been highlighted by the
many bank closings and the rescue by bank regulators of several large banks. As a result of large
banks choosing to make sizable increases in loan
loss reserves, profits reported by the banking industry as a whole in 1987 were down nearly 80
percent from 1986. Despite these difficulties,
some bright spots emerged last year, especially
the improved performance of agricultural banks.
It is important to note, however, that throughout
this period of stress in the industry, the commer-
cial banking system has continued to play its crucial role as a provider of credit to the economy.
The savings and loan industry continues
to be under financial stress. Although the majority
of savings and loans are healthy and reasonably
profitable, the industry as a whole reported enormous losses in 1987 and in the first quarter of
1988. Roughly one-sixth of the institutions are insolvent when evaluated in accordance with generally accepted accounting principles, and their
aggregate losses increased in 1987 and in the first
quarter of 1988. The prospects for the recovery of
the insolvent institutions are not bright, implying
that the Federal Savings and Loan Insurance Corporation (FSLIC) will be required either to liquidate them or to assist in their absorption by
stronger institutions.
The deterioration of the savings and
loans industry has affected the financial condition
of FSLIC, whose net worth became more deeply
negative in 1987. Congress approved a plan last
year providing nearly $11 billion to recapitalize
FSLIC. This action has helped FSLIC liquidate
several large and especially troubled savings and
loans, but concerns persist in the market that the
total available new capital may fall short of that
needed for FSLIC to deal fully with the problem
institutions.
The difficulties of many individual depository institutions have been associated, in
most cases, with specific types of loans or certain
regions and countries. However, concerns have
been expressed more generally about the financial health of households and businesses—especially about the ability of these sectors to service
their debts if interest rates were to rise sharply or
business conditions were to weaken significantly.
With regard to households, the rapid
growth of their debt during the current economic
expansion has outstripped that of disposable income. The ratio of household sector indebtedness
to income is at an all-time high (as may be seen in
the accompanying chart). Recent information
113
Household Assets and Liabilities
Total Assets and Debt Relative to Disposable Personal Income*
Percent of DPI
250
225
600
575
>00
500
Credit Market Debt
75
425
I
1974
I
I
1976
I
1978
I
I
1980
I
I
1982
I
I
1984
1
Inili
1986
1988
*Debt and fixed-income assets are at book value; other assets are at either market value or replacement cost.
Nonfinanclal Corporations
Debt to Equity Ratios*
Percent
Debt/Equity
20
1961
1964
1982
"Debt and equity are at market value. In computing net worth, tangible assets are valued at replacement cost or market value,
while financial assets are valued at cost
114
also shows a rising level of personal bankruptcies
and a relatively high level of delinquencies on
certain types of consumer loans.
Although these developments suggest
that debt burdens may be difficult for some
households to manage, other evidence indicates
that most households are able to meet their debt
obligations reasonably well. The trend toward
longer repayment schedules has held down debtservice payments. The increased use of adjustable-rate mortgages has made the financial
positions of many households more vulnerable to
increases in interest rates; however, at the same
time, deposit deregulation has meant that household interest income is more responsive to
changes in rates. Furthermore, for the sector as a
whole, assets have risen more rapidly than debt,
implying increases in household net worth. Indeed, survey information indicates that many
families with consumer debt have substantial
amounts of financial assets that could be tapped to
meet debt-service obligations in the event that incomes proved to be inadequate.
Like households, businesses have added
greatly to their indebtedness in recent years.
Many companies have dramatically increased
their leverage through debt-financed merger,
buyout, and share retirement activity. Reflecting
heavier debt loads, the bite that interest payments
take out of corporate cash flow is near historically
high levels for the nonfinancial corporate sector
as a whole. A downturn in earnings would place
serious debt-servicing strains on many individual
firms. In addition, heavy reliance on floating-rate
loans and short-term debt obligations has rendered many firms vulnerable to a significant rise
in borrowing costs. In reflection of this situation,
downgradings of corporate debt have continued
to exceed upgradings by a large margin.
Firms would not have been able to assume these greater financial exposures were it not
for receptive attitudes among lenders and equity
investors. Companies engaging in restructurings
that have involved the addition of massive
amounts of debt to their balance sheets have been
rewarded with sizable run-ups in their share
prices; this is reflected in the absence of an
uptrend during the 1980s in the market-value
based "debt/equity" measure shown hi the lower
panel of the chart. Moreover, lenders are exacting
relatively small risk premiums on debt obligations incurred by firms, as reflected, for example,
in the spreads between yields on high-grade corporate bonds and Treasury securities or even
those for below-investment grade "junk" bonds.
Nonetheless, our financial history provides numerous reminders of the fragility of this type of
situation: last fall, for example, when confidence
was jolted by the stock market break, yield
spreads widened dramatically, and the availability of new credit to riskier borrowers was sharply
curtailed.
115
Appendix: The Monetary Base
In recent years, the monetary base has received increased attention as the behavior of other
monetary aggregates—especially Ml—has diverged from historical patterns. In part, the appeal
of the base has resulted from the notion that it may
have a reasonably stable relationship with nominal spending. In addition, it is perceived as being
more directly under the control of the Federal Reserve than are the broader aggregates. This appendix reviews the historical and analytical
characteristics of the monetary base. It discusses
its definition, its relation to income and other economic variables, and its control by the Federal
Reserve.
most savings-type instruments hi these measures
either are not reservable or have a much lower reserve requirement applied to them. Moreover,
currency accounts for an even smaller share—on
the order of 5 percent—of these aggregates.
Concepts, Definitions, and Measurement
There are two publicly available measures of the monetary base. One, corresponding to
the uses concept, is constructed by the Board and
the other, a sources concept, is produced by the
Federal Reserve Bank of St. Louis. Besides the
difference in accounting approach, which affects
the treatment of vault cash used to meet reserve
requirements, the two measures differ in the
method of adjustment for changes in reserve requirements and in the method of seasonal adjustment.
The monetary base consists of currency
in the hands of the nonbank public and reserves
held by depository institutions—both reserves required to be held against deposits and the additional, "excess" reserves that depository
institutions choose to hold. Because reserve requirements are substantially higher for transactions deposits (that is, checkable deposits) than
for nontransactions deposits, the bulk of required
reserves—about three-quarters—is related to
transactions deposits. In turn, transactions deposits consist primarily of demand deposits and other
checkable deposits, which are the principal components of the narrow monetary aggregate Ml.
Thus, both through its currency component and
its reserves component, the monetary base is
closely related to Ml. The links between the
monetary base and broader measures of money,
such as M2 and M3, are much looser because
Looking at the base as currency and reserves focuses on the monetary liabilities of the
Federal Reserve—frequently referred to as the
"uses" of the base.* Alternatively, the base can be
measured from its "sources" in the Federal Reserve balance sheet, the assets held by the System
less its nonmonetary liabilities. The two concepts
are identical if all components are measured contemporaneously.
The Board measure constructs the base
from the currency component of the money stock
(currency held by the nonbank public) (76 percent), total reserves (lagged vault cash, up to required reserves, plus reserve deposits at the
Federal Reserve banks) (23 percent), and a third
component that includes current surplus vault
cash held at depository institutions plus servicerelated balances (1 percent).**
* Technically, the base also encompasses a relatively small amount of U.S. Treasury liabilities.
** Vault cash included in total reserves is lagged four weeks, reflecting its use to meet reserve requirements.
Surplus vault cash is bank holdings of currency in excess of required reserves. Service-related balances comprise other balances held by depository institutions at the Federal Reserve, including required clearing balances
and adjustments to compensate for Federal Reserve float.
116
The St. Louis measure, consistent with its
sources concept, comprises Federal Reserve
credit—holdings of U.S. government securities,
discounts and advances, Federal Reserve float,
and other Federal Reserve assets—plus other
sources, including the gold stock, special drawing
rights and Treasury currency outstanding. It subtracts several categories of liabilities, namely,
Treasury and foreign deposits at the Federal Reserve, Treasury holdings of coin and currency,
and certain miscellaneous items. Implicitly, all
vault cash is treated contemporaneously.*
Chart A-l portrays the St. Louis and
Board measures of the monetary base. The upper
panel shows that the two measures have moved
together over time, though the St. Louis measure
generally lies above the Board measure, reflecting differences in techniques for adjustment of
breaks caused by changes in reserve requirements. The lower panel shows that, in terms of
growth rates, the two series track each other
closely.
Growth of the monetary base has been
much smoother on average than that of the other
monetary aggregates (chart A-2).** In large
measure, the smooth growth of the base can be attributed to its large currency component, which
over long periods of time has expanded in a relatively stable fashion. Between 1959 and 1987, the
average quarter-to-quarter fluctuation of growth
in currency in circulation was less than one-fifth
of the quarterly fluctuation in growth of total reserve balances.
While growth in the base has been relatively smooth, its longer-run pattern has not differed markedly from that of other narrow
aggregates. Specifically, the velocity of the
monetary base has behaved similarly to Mi's velocity (chart A-3), with a pronounced break in the
1980s from its earlier behavior. Between 1960
and 1980, the velocities of the base, Ml-A (currency plus demand deposits), and Ml all rose, in
part reflecting the effects on money demand of
the generally rising trend of interest rates. Chart
A-4 shows that fluctuations of base velocity
around its trend during the 1960s and 1970s were
comparable to those of the other aggregates.***
And, in the 1980s, velocity of the base and Ml declined both absolutely and relative to the earlier
trend as deregulation and falling market interest
rates encouraged a large volume of funds to move
into transactions deposits.
Statistical methods of relating growth in
income to past growth rates in the base produce
results that echo this pattern of velocity behavior.
When these relationships are estimated using data
through 1980, they make substantial errors in predicting nominal GNP in subsequent years, much
as do equations involving other aggregates—especially the narrow aggregates. Techniques that
allow for a break in behavior in the early 1980s
make somewhat smaller but still large errors in
* There are two other differences between the Board base and the St. Louis base concerning seasonal adjustment and adjustments for changes in reserve requirements. St. Louis seasonally adjusts the whole base directly
after adding a reserve adjustment magnitude (RAM) to account for regulatory changes in reserve requirements
as well as changes in composition of deposits. For the Board measure, currency, total reserves, and the residual
component are seasonally adjusted separately, after applying to the reserves and residual components certain
break adjustment factors, and finally the components are summed. The Board's break adjustment method is
intended to adjust only for regulatory changes in reserve requirements.
** This and subsequent mentions of the monetary base refer specifically to the Board measure of the base but,
in view of the close relationship between the two measures, should apply nearly as well to the series produced
by the Federal Reserve Bank of St. Louis.
*** Chart A-4 presents velocity measures that remove the time trend estimated from 1960 to 1979.
117
Measures of the Monetary Base
Levels
Ratio scale (billions of dollars)
300
250
200
St. Louis
Board
I I I I I I I I I I I I I I I i I I I I I I I IniiniljJiliiiliiiliii
1960
1965
1970
1975
1980
1985
Quarterly Growth Rates (Annual Rate)
I
I
I
I
I
I
I
I
I
I
I
Percent
I
I
I
I
I
I
1965
1. Seasonally adjusted and adjusted for breaks caused by changes in reserve
requirements.
I
I
I
I
1980
I
I
Illlllllllll III III III
118
Levels of the Monetary Aggregates
(billions of dollars)
Ratio scato
3100
2600
M2
2100
1600
600
450
250
Monetary Base
50
I I I I I I I I I I I I I I I I I I I I I I I I I I I I I
1960
1965
1970
1975
1980
1985
119
Velocities of the Monetary Aggregates
Monetary Base
I
I I I I I I 1 I I I I I I I I I I
1970
1960
I I I I I I I I I I
1980
1975
1985
M1-AandM1
Ratio scale
M1
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
i
I
I
1965
1960
I
I
1980
I
I
I
I
I
I
I
1985
Ratio scale
M2
1.8
I
I I I I I I I I I I I I I I I I I I i
1965
I i
1980
I I I I I I I
1985
120
Chart A-4
Normalized Velocities of the Monetary Aggregates
Monetary Base
1.3
1.2
1.1
1
I
I I I I I I I I I I I I I I I I I I I I I I I I I I I
1960
1965
1970
1975
1980
1985
M1-AandM1
Ratio scale
1.3
1.2
1.1
1
0.9
0.8
1960
1965
1970
1975
1985
1980
Ratio scale
M2
1.3
1.2
1.1
1
0.9
0.8
I
I
I
I
I
I
I
I
I
I
I
I
1970
I
I
I
I
I
1975
I
I
I
I
I
1980
I
I
I
I
1985
I
I
I
0.7
121
the 1980s and leave unanswered questions about
the potential for additional shifts in the relationships.
An examination of the demand properties
of the base can shed light on the determinants of
the behavior of its velocity and the errors made in
predicting GNP. The demand for the base is derived from demands for its components, currency
and reserves. The demand for reserves, in turn,
depends on demands for excess reserves and for
reservable deposits—primarily the transactions
deposits that are included in Ml but also some
that are not in that aggregate, such as interbank
and U.S. government deposits, and certain time
and savings deposits.
Board staff analysis has found that the
demand for the base has substantial interest sensitivity, mainly reflecting the interest sensitivity of
demand deposits and other checkable deposits.*
This interest responsiveness, together with the
drop in interest rates during the 1980s, helps to
explain the turnaround in base velocity, much as
it explains the movements in the velocities of
other monetary aggregates—especially Ml—in
recent years. However, the base probably is less
interest sensitive than are the other monetary aggregates, because of the importance of the currency component, which does not respond very
much to changes in interest rates. This implies
that efforts to control the base to predetermined
target ranges could involve very wide swings in
interest rates. Whether those fluctuations would
be beneficial to the economy depends in part on
the stability of the demand relationship. If the demand for the base is relatively stable, the interest
rate movements would tend to stabilize GNP in
the face of disturbances to spending. But if base
demand tends to move unpredictably, the interest
rate movements associated with controlling the
base would tend to destabilize GNP.
Over long periods of time, the demand
for the base appears to be fairly predictable, especially compared with Ml-A and Ml. Movements
in transactions deposits, especially demand deposits, often have been somewhat erratic, tending
to loosen the relationships of Ml-A and Ml with
GNP, but their effects on base demand are muted
by the fractional nature of reserve requirements.
Another factor contributing to the relative stability of the demand for the base is that unpredictable movements in transactions deposits at times
have tended to offset unexplained changes in currency, perhaps owing to substitution between currency and demand deposits. However, there is
considerable variability in the relationship of the
base to income and other variables over periods of
a year or less—and evidence suggests that at least
over these shorter periods it is no more stable than
M2.
In considering the past and prospective
degree of stability of demand for the base, attention must be directed to its largest component,
currency. Analysts have noted the extraordinarily
large volume of dollar currency outstanding relative to measured U.S. economic activity or the
number of households. Although available data
are inadequate to determine even approximate
magnitudes, it seems likely that a substantial part
of U.S. currency is being employed in support of
activity that is not reflected in U.S. GNP—in particular, activity outside our borders. Especially to
the extent this activity and the currency to support
it move independently of U.S. GNP, this would
tend to reduce the usefulness of the base as an indicator or target.
* An estimated demand equation for the base was derived from the Board staff's standard models of demand
for currency and demand for required reserves on transactions accounts in Ml only. Demands for other components of reserves were not explicitly modeled, as the effects of these components on required reserves are relatively small.
122
Not only is it difficult to account fully for
the level of currency outstanding, but growth occasionally has been at variance with expectations,
despite the relatively stable long-run relationship
with measured income. For example, in the past
year and a half, growth of currency has been
roughly twice as rapid as would be expected on
the basis of historical experience, judging by the
Board staffs quarterly econometric model, with
no obvious explanation for the strength.
Controllability of the Monetary Base
For the most part, the Federal Reserve
historically has supplied the monetary base to accommodate its demand. This has been a consistent policy with regard to demands for currency.
With respect to reserves, the interactions have
been more complex. Except in the early 1980s, reactions to deviations of reserves from expectations have been quite indirect. Any increases or
decreases in the demand for reserves have been
completely accommodated in the short-run.
However, over time persistent deviations in
money (and implicitly reserves) from objectives
have prompted adjustments in monetary policy
when those deviations were judged likely to be
associated with unwelcome developments in the
economy.
Even in the period from late 1979
through late 1982, when the Federal Reserve used
nonborrowed reserves as an operating target to
achieve goals for money growth over time, total
reserves were not closely controlled because borrowed reserves adjusted in response to deviations
in money growth from objectives.
Because of the remaining two-day lag between the ends of the reserve computation and reserve maintenance periods, control of total
reserves or the monetary base would need to be
indirect, working through the effects of changes
in interest rates on the demand for the components of the base in the short run. In this respect,
control of the base is achieved in the same way as
for the broader aggregates. It is likely that the
base, or for that matter any of the broader aggregates, could be controlled reasonably well over a
span of several quarters—a period that would be
meaningful in terms of the effects of monetary
policy. However, the degree of interest rate volatility under base targeting could be quite substantial, especially in the short- to intermediate-run.
Changes in the quantity of the base demanded that
caused the base to deviate from its target would
need to be offset in the short run mainly by
changes in reserves (given the low interest sensitivity of currency demand), which would have
multiple effects on the quantity of money.
123
APPENDIX
September 8, 1988
124
MANUFACTURING
ipTffllBDS5?§M
STRENGTH
TESTIMONY ON
THE RECOVERY AND MONETARY POLICY
BY
JERRY J. JASINOWSKI
EXECUTIVE VICE-PRESIDENT AND CHIEF ECONOMIST
NATIONAL ASSOCIATION OF MANUFACTURERS
BEFORE THE
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE HOUSE COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
SEPTEMBER 8, 1988
NAAt
National Association of Manufacturers
1331 Pennsylvania Avenue, NW, Suite 1500 — North Lobby
Washington, DC 20004-1703 (202) 637-3000
125
The National Association of Manufacturers is a voluntary business association of more than 13,500 corporations, large and small, located in every
state. Members range in size from the very large to the more than 9,000
smaller manufacturing firms, each with fewer than 500 employees. NAM
member companies employ 85 percent of all workers in manufacturing
and produce more than 80 percent of the nation's manufactured goods.
NAM is affiliated with an additional 158,000 businesses through its
Associations Council and the National Industrial Council.
126
EXECUTIVE SUMMARY
1.
The 1983-88 cyclical expansion has been unusually long, but growth
rates have been unusually slow. The causes slow growth did not have to do with
unnecessarily restrictive monetary policies, despite recurrent claims that the
Federal Reserve was "too tight." Instead, they lie primarily with the
overvaluation of the dollar and the resulting deficits on net exports, which in
turn trace back to the excessively expansionist stance of fiscal policy. The
finding of econometric simulations conduted at NAM is that a more restrictive
fiscal policy during the early to mid-1980s would have mitigated many of the
imbalances in the recovery and would have been commensurate with a more stable
growth path than what was actually achieved.
2. Since early 1988, the economy has moved into a period of growth led
primarily by trade and capital investment. The expansion is projected to
continue for at least the next 12 to 15 months, although a recession during the
latter part of 1989 remains a possibility. The major risk is a rise in
inflation followed by a rise in interest rates, effectively choking off demand.
At the same time, the narrow geographic base of the trade boom could lead to a
slowdown in exports, which in turn would depress capital spending.
3. The Federal Reserve has done a decent job in managing monetary policy
over the business cycle. By avoiding continuous stimulus, it was possible to
avoid the destabilizing cycles of reflation-overheating-recession that
characterized the 1970s. Moreover, we do not subscribe to the view that
monetary policy was excessively restrictive during the 1980s. If the Federal
Reserve had been looser in 1980-82, the economy would have achieved only
temporary gains in output relative to actual history, but at the expense of a
higher inflation rate, and these transitory gains would have been completely
lost in a few years.
4. The stance of monetary policy is becoming more restrictive. Given the
strength of expansion, the Federal Reserve has aggressively raised interest
rates in a pre-emptive move designed to prevent the economy from overheating and
reduce inflationary expectations. We consider current policies to be
appropriate inasmuch as it was necessary to stabilize expectations. However, we
would not endorse any further restrictive measures that might increase the risk
of a sharp slowdown. Further, in the event that the economy shows signs of
weakness, we would urge a countercyclical loosening of monetary policy. As a
general principle, we believe that the Federal Reserve's commitment to
controlling inflation should be balanced by a similar commitment to keep the
economy on its equilibrium growth path. At the same time, we do not recommend
explicitly targeting the exchange rate in order to achieve disinflationary
objectives. This runs the risk of inhibiting improvements in the trade deficit
while causing unnecessary increases in domestic interest rates.
127
TESTIMONY ON
THE RECOVERY AND MONETARY POLICY
BY
JERRY J. JASINOWSKI
EXECUTIVE VICE-PRESIDENT AND CHIEF ECONOMIST
NATIONAL ASSOCIATION OF MANUFACTURERS
BEFORE THE
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE HOUSE COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
SEPTEMBER 8, 1988
I am Jerry Jasinowski, Executive Vice-President and Chief Economist of the National
Association of Manufacturers. On behalf of our members, I welcome this opportunity to
present our views on monetary policy and the recovery. In accordance with the substantive
areas listed in your letter of invitation, this statement will address two major themes.
Part I will deal with the current cyclical expansion, its past history, and prospects for
its continuation. Part II will deal with monetary policy.
I. The Current Cyclical Expansion
1.1 The Recovery in Retrospect The cyclical expansion that began in December 1982 is
now in its 70th month, making it unusually long by postwar standards. However, its length
and durability are subject to the caveat that growth rates have been unusually low. Table
1 compares the average growth rates of GNP and industrial production during six prior
expansions and the 1983-88 recovery. During the current recovery, GNP achieved an annual
average growth rate of only 4.3 percent, compared to a postwar average of 5.3 percent.
Similarly, the average rate of growth in industrial production during the 1982-87 cycle
128
was only 5.9 percent, compared to a mean value of 8.8 percent during the six major
previous expansionary cycles.
Table 1: A Comparison of Major Postwar Recoveries*
Dates of Cyclical
Expansion
Length
(Months)
Average Annual
GNP Growth
Average Annual
Industrial Growth
45
39
24
7.2%
4.0
5.1
5.3
36
58
5.5
5.0
8.7
7.3
Weighted Average of Above 51.3
5.3
8.8
Nov. 1982 - Sept. 1988
4.3
6.0
Oct. 1949 - July 1953
May 1954 - Aug. 1957
Apr. 1958- Apr. I960
Feb. 1961 - Dec. 1969
Nov. 1970 -Nov. 1973
Mar. 1975 - Jan. 1980
106
70
13.2%
6.7
11.3
8.4
Two periods are omitted. The 37-month expansion from October 1945 to November 1948
is not comparable, since the economy was dominated by demilitarization after World
War II. The twelve month bridge between the 1980 and 1981 recessions also is omitted
on the grounds that this was not a recovery so much as a transitional period between
two successive phases of a longer-term downturn.
In essence, the expansion went through successive phases; 1] a rapid initial recovery
led by domestic demand in 1983:1 to 1984:2, 2J an extended period of stagnation
characterized by massive trade deficits in 1984:3 to 1986:4, 3J a second rise in growth
characterized by gradual trade improvement from 1987:1 onward.
The causes of the slowdown did not have to do with restrictive monetary policies,
despite recurrent claims that the Federal Reserve was "too tight." Instead, it was
primarily caused by the overvaluation of the dollar, and the resulting deficits on net
exports, which in turn trace back to the excessively expansionist stance of fiscal policy.
Some econometric studies have linked as much as two-thirds of the rise in interest rates
129
and the appreciation of the dollar to the structural budget deficit.
NAM has reached similar conclusions. In order to ascertain the effects of the fiscal
policies of the 1980's, we have conducted historical econometric simulations using the
Washington University Macromodel, a large-scale model with neo-classical properties. The
baseline path was set to replicate history exactly; policy changes imposed retrospectively
at earlier points in the 1980's enable the model to simulate the path that the economy
would have followed if policies had been conducted differently at the time. The finding
was that in simulations where the structural budget deficit was reduced or eliminated,
with monetary policy held constant, the appreciation of the dollar was significantly
reduced, and the net export deficit was reduced by more than half. The implication is
that a more restrictive fiscal policy during the early to mid-1980s would have mitigated
many of the imbalances in the recovery and would have been commensurate with a more stable
growth path than what was actually achieved.
1.2 The Future Path of the Economy The economy managed to survive the 1987 stock
market crash without going into recession, and as of mid-1988 appears to be achieving a
stable growth path. In 1988 there have been two major sources of strength that propelled
the economy to an unexpectedly strong growth rate, improvement in real net exports and an
upturn in investment.
Trade The devaluation of the dollar has generated a major improvement in trade, with
more of the impetus derived from exports than from import-substitution. Even so, the
strength of the trade improvement has been notable. Since the peak of the real trade
deficit in 1986:3, net exports have improved by $66 billion in constant 1982 dollars,
while real exports have risen by $112 billion. The trade improvement is, however, subject
to several risk factors, which raise the possibility that the export boom could slow at
130
some future time. First, the exchange rate realignment has occurred primarily against
Europe and Japan, with very little devaluation occurring against Canada and the Pacific
NICs. Simultaneously, the countries that were the major markets for American exports
during the 1970s, OPEC and Latin America, are experiencing chronic weakness in demand
because of low world oil prices and high foreign indebtedness. A final problem is that
because of the relative price advantages enjoyed by the Asian NICs, decreased imports from
Europe and Japan have been reflected in some industries not so much in recovery of market
share by American producers but rather by corresponding increases in imports from Taiwan
and Korea. Despite these limitations, net exports should improve by roughly $40 billion
over the forecast horizon.
Capital Investment
The strength of capital spending reflects several factors. First,
the decline in investment induced by tax reform in 1986-87 lowered the capital stock below
its optimal level, creating the potential for a rebound. Simultaneously, the trade
improvement has led to greater demand for capital goods in the exporting and importsubstituting industries, particularly in sectors undergoing capacity pressures. A third
factor is revealed in the sectoral composition of the investment boom, with just under
half the increase in equipment comprised by computers and office automation. The high
spending on data processing equipment is explained largely by a fall in relative prices.
Thus, while tax reform raised the user cost of capital by increasing effective tax rates,
this has been outweighed by the falling relative price of data processing equipment. As a
result, spending on equipment is projected to increase by 12.3 percent in 1988.
For all its strength, however, the boom in equipment spending cannot conceal a series
of asymmetries in the composition of investment. Residential investment has been
declining since early 1987, due to a combination of overbuilding of the housing stock, tax
reform and higher mortgage interest rates, and is projected to decline -3.4 percent in
131
1988. Spending on nonresidential structures has been weak throughout the entire business
cycle, with spending on factories, mines and utilities lower in real terms than at the end
of the last recession. While some recovery in structures is anticipated due to high
capacity utilization, outlays for nonresidential buildings are projected to be
approximately level in 1988.
Consumption Consumer activity has held up primarily because of the tax rate reduction
and rapid gains in employment, with the result that spending should average 2.5 percent
growth for the year. This is scarcely robust, but well aboVe the anemic growth in
consumption recorded in 1987 when high debt levels, diminished savings and declining real
wages held expenditures to a 1 percent increase. Real wages should grow more rapidly this
year while unemployment is projected to continue falling, implying faster growth in
disposable income, although debt loads and high interest rates remain a constraint on
consumers. The growth in jobs has been sufficient to maintain consistent growth in real
incomes.
Inflation The major risk for the economy at this juncture is the possibility of an
acceleration in inflation. As of the second quarter, there was evidence of renewed upward
pressure on prices. The implicit price deflator for GNP jumped from an average of 2.5% in
the previous three quarters to 4.1%; the fixed-weight GNP price index increased from an
average of 3.6% to 4.7%, generally higher than anticipated. The CPI is projected to
temporarily approach 6% in 1988:4.
In order to understand the sources of increased inflationary pressures, it is useful
to think of the rate of inflation as a weighted average of several components. The
underlying rate is determined by the trend movement in unit labor costs. The demand-pull
component is influenced by the rate of growth and capacity utilization. Finally, the
relative price component reflects factors such as changes in food and energy costs, and
132
changes in import prices resulting from the exchange rate.
The critical factor driving the underlying rate is the degree of pressure in labor
markets, which is a function of the difference between the current unemployment rate and
its equilibrium or natural level, below which further declines imply continuously
accelerating wages. While the natural rate of unemployment has fallen during the 1980's
due to slower labor force growth — differing estimates yield a mean value of about 5 % —
unemployment is declining more rapidly. Until this year unemployment was sufficiently
above its natural rate that increases in employment raised demand by boosting incomes
without generating any major rise in wage pressures; as of 1988:1, compensation per hour
had risen only at the moderate pace of 3.4% over the same quarter of 1987. However, there
is evidence of considerable emerging pressure in labor markets in the second quarter, with
preliminary estimates suggesting that labor costs are increasing at an annualized rate of
4.5%.
At the same time, unit non-labor payments ~ payroll taxes and employee benefits,
which account for as much as 40% of total costs per worker in some industries, underwent
some acceleration over the last twelve months. In 1987, non-labor costs jumped at an
average rate of 8% in the first three quarters, partly as a result of higher Social
Security taxes, although they declined toward the end of the year. Some of this increase
has yet to be fully reflected in price movements, pointing to additional pressure on
employment costs in 1988.
Working against the acceleration in employment costs, however, is the faster rate of
increase in productivity growth. Output per manhour surged at an atypically high 3.7% in
1988:1, and during the current cyclical expansion manufacturing productivity has averaged
just below 4% per year, above its postwar trend. The high projected growth rate of
capital spending suggests that this increase will be sustainable, implying a considerable
133
offset to unit labor costs.
The effects of demand on inflation have so far been relatively modest, and in fact
have worked for the most part in holding prices back. From 1984:3 until 1986:4 the
economy experienced almost continuous stagnation, and growth rates did not begin to pick
up until 1987. On a fourth quarter-to-fourth quarter basis, however, revised estimates
show real GNP increasing 5.0% in 1987. Although this was primarily a result of the
inflation rate having been revised downward, the pace of expansion implies that the
economy will converge to full capacity more rapidly. Capacity pressures have already
emerged in individual industries, particularly the booming export sectors. By mid-1989,
capacity utilization will impliy additional pressure on output prices.
A greater threat in the near-term has to do with relative price movements. The rise
in energy costs .in early 1988 has now abated, but the severe drought now ravaging the
nation's agricultural regions has unfavorable implications. The devastation of
agriculture actually implies upward pressure on commodity prices in the fourth quarter. A
second factor is the anticipated fall in the dollar. In this respect, import costs are
partially responsible for the substantial spread that has emerged between the CPI and the
more broadly-based GNP Deflator, which is less sensitive to import costs. Some of the
effect of the lower exchange rate have been absorbed in the form of lower profit margins
by foreign exporters, and the fall in the dollar projected here is not sufficient to set
off a major new round in inflation.
Given the above, the upward shift in inflation projected here emerges primarily as the
result of rising wages, non-labor costs, and relative price movements, with some increase
in demand pressure. Specifically, we project that the underlying rate of inflation will
be in the area of 4.5% by the end of the year; most of the increase above this level is a
relative price phenomenon. It should be noted that the Federal Reserve is not expected to
134
accommodate the rise in prices. Tight money in and of itself does not imply that
inflation will not accelerate in the next few quarters, but does effectively inhibit a
return to the high rates of inflation of the 1970's.
A First Look At 1989
In general, two scenarios can be outlined for 1989, 11 slow
stable growth, or 2] a slide into recession toward the end of the year. In the stable
growth alternative, the dollar remains strong enough and wages moderate enough to inhibit
further acceleration in inflation, while the export boom continues to reduce the trade
deficit. For this to take place, however, requires continuous growth abroad as well as
steady gains in employment and further demand for capital goods. Although this depends on
a series of favorable developments taking place simultaneously, it is by no means outside
the realm of possibility.
Recession Risks Nevertheless, a series of factors could combine to throw the economy
into recession. The main risk is that rising inflation will cut into real incomes white
higher interest rates choke off demand. This is of course the conventional mechanism
generating business cycle downturns in the United States, but it would normally operate
only at higher inflation rates than those projected here. Still, this would be sufficient
to insure a downturn if it operated in conjunction with other factors. In this respect, a
second risk is that the narrow geographic base of the export boom will lead to its
exhaustion as growth rates overseas slow down. The European community is currently
projected to attain only a 2 percent growth rate in 1988 and may slow further in 1989.
Under the circumstances, exports could stagnate, and this would also slow the pace of
domestic growth due to the diminished export multiplier. We rate both of these risks as
low at this time.
Credit and the Business Cycle A long-term risk to economic stability, which could
also seriously aggravate any forthcoming recession has to do with the buildup in aggregate
135
debt. As of 1988:1, total Federal and private debt came to $8,498.9 billion, or 182% of
GNP, compared to a postwar average of 135% of GNP until the early 1980's. By comparison,
the ratio of debt to GNP in 1929 just before the Great Depression was 210%, although a
much larger share of this debt was private and much of it was poorly collateralized. Of
the total volume of private debt ($6497.4 billion), $2,907 billion was comprised of credit
to business, while $2,285 billion was in the form of mortgages on residential properties
and $633 billion consisted of consumer installment credit.
The ratio of corporate debt to
the market value of coprorate assets is roughly comparable to the peak values of the
1970's, although high by historical standards. However, the ratio of debt service to cash
flow is at record levels: the share of the pretax earnings of nonfarm nonfinancial
corporations devoted to debt service payments is now over 50%, compared to about 30% in
the 1970's and about 15% in the 1960's. Similarly, the ratio of individual mortgage and
non-mortgage debt to personal disposable income is now approximately 80%, a postwar
record.
The debt buildup implies two major risks. On the one hand, in the event of a
recession, the need to service debt could force a major curtailment of business and
individual spending, leading to a deeper contraction in demand. A more speculative
possibility is the type of "debt-deflation" scenario that was responsible for prewar
recessions and was identified more than a half-century ago as the mechanism primarily
responsible for the Great Depression. In this scenario, cash-flow constraints and the
need to service debt lead to massive deflationary liquidations of collateralized assets,
driving prices down and thereby raising the real value of outstanding obligations. The
fall in the value of collateral in turn triggers bank failures and contraction of the
money supply, exacerbating losses in real activity. This is the same type of mechanism
that took place in the agricultural and energy sectors in the mid-1980's, and is also
136
largely responsible for the wave of bank failures during the last few years. However, the
possibility of debt-deflation taking place throughout the economy rather than in specific
sectors must be judged remote at the present time. Nevertheless, it is indicative of the
risks associated with high levels of private sector indebtedness.
The External Balance and the Business Cycle One of the results of the increasing
foreign indebtedness of the United States is the threat of repatriations of foreign assets
coupled with a plummeting dollar, which would force the Federal Reserve to tighten in
response. While it is possible that this threat will become more serious as the buildup
in external debt produces a loss in foreign confidence in t^e dollar, there is as yet no
evidence that foreign investors will engage in a speculative flight from the the United
States during the forecast horizon. In part, this is the case because of more attractive
returns on financial assets in the United States. Consequently, the possibility of
widespread remissions of foreign assets and a collapse of the dollar should be regarded
only as a longer-term risk factor for the 1990's.
II. The Conduct of Monetary Policy
2.1 The Federal Reserve and the Recovery
The Federal Reserve has done a good job in
managing monetary policy over the business cycle. By avoiding continuous stimulus, it was
possible to avoid the destabilizing cycles of reflation-overheating-recession that
characterized the 1970s. The length of the current expansion traces back in part to the
Federal Reserve's well-timed countercyclical moves—stimulus in 1982:3 to 1983:2,
offsetting restraint in 1983:3 to 1984:2, accommodation in 1984:3 to 1986:4, and moderate
restraint thereafter.
We do not subscribe to the view that monetary policy was excessively restrictive
10
137
during the 1980s. In order to ascertain the probable effects of looser monetary policy
over the last decade, we again used a retrospective simulation of the Washington
University Macromodel. In a counterfactual simulation, we imposed a significantly looser
monetary policy in 1980-81 and 1984, while retaining historical money growth rates
otherwise. The result was that the 1981-82 recession was milder, but the reduction in
inflation was also considerably less. The economy went into recovery with an inflation
rate two points higher than actual history, and inflation began to accelerate as early as
1985, due to lower unemployment. The result was that the economy went into recession in
1986. By 1987, the last year for which the simulation was run, GNP and employment were
lower than in actual history. The implications are significant, inasmuch as they undercut
the claim that the Federal Reserve "sabotaged" the 1981 tax reductions through tight
money. If the Federal Reserve had been looser in 1980-81, the economy would have achieved
only temporary gains in output relative to actual history, but at the expense of a higher
inflation rate, and these transitory gains would have been completely lost in a few years.
In this sense, by achieving greater disinflation in 1980-82, the Federal Reserve set the
stage for a longer and more sustainable period of expansion.
In the wake of the 1987 stock market crisis, NAM member firms were sufficiently
concerned over the risk of recession to warrant urging the Federal Open Market Committee
for a relaxation of monetary policy. In retrospect, we concede that the dangers were less
than we anticipated. The Federal Reserve correctly gauged that the loosening measures it
took in the immediate aftermath of the crash were sufficient to raise liquidity and
restore confidence. Once the danger was over, the Federal Reserve correctly estimated
that the economy would move into a period of accelerated expansion, and that additional
loosening measures were not necessary.
138
2.2 Monetary Policy and the Exchange Rate The major area in which NAM has been
critical of recent Federal Reserve decisions lies with the 1987 Louvre Agreements. These
forced the central bank to peg the exchange rate well above its equilibrium values, and
caused interest rates to rise more rapidly than they would have otherwise, thereby
precipitating the stock market collapse. In our view, pegging the dollar at an overvalued
level has two negative consequences: it not only requires unnecessary monetary restraint,
but also delays the reversal of the trade deficit that would result from a lower exchange
rate. Given a choice between supporting the dollar as a disinflationary move and allowing
the dollar to devalue further, the Federal Reserve should in general permit additional
depreciation. Although this could entail some additional pressure on inflation and slower
growth in domestic demand, these represent the inevitable tradeoffs for reducing the trade
imbalance.
2.3 Monetary Policy in 1988 The Federal Reserve's targets for the monetary aggregates
and the actual growth rates recorded in the first half are given below. In essence, the
monetary and debt aggregates were all comfortably within their target ranges,
notwistanding the increased demand for money implied by higher economic activity. In its
mid-year report to Congress, the Federal Reserve concluded that none of the aggregates
were rising too rapidly or too slowly, and that the current targets would be maintained
until the end of the year. The provisional targets for 1989 call for some further
reduction in the growth rates of the aggregates, which would be appropriate in view of the
expected slowdown in the economy, and consequently in the demand for money. In general,
we view the Federal Reserve's targets as commensurate with stable expansion in 1988.
In the wake of the velocity fluctuations of the I980's which have made the monetary
aggregates somewhat less reliable as policy indicators, increasing emphasis has been
12
139
placed on interest rates. In this respect, rates fell initially after the stock market
crash, due more to decreased demand for credit than the Federal's Reserve's well-timed
loosening actions. After reaching a trough in early 1988, interest rates have climbed in
response to market forces, i.e., higher inflation and increased demand for credit.
Table Two: Money and Credit in 1988
Ml
M2
M3
Debt
None
4-8
4-8
7-11
Actual, 1988:1
3.8
6.7
7.0
8.4
Actual, 1988:2
6.1
7.9
7.1
8.3
Provisional target, 1989
None
3 to 7
3.5-7.5
6.5-10.5
Target and Actual
Target, 1988
Source: Federal Reserve
2.4 The Current Stance of Monetary Policy During the summer, the stance of moi
policy went from moderate to aggressive restraint. After a series of mild tightening
moves since late 1987, the Federal Reserve undertook the significant move of raising the
discount rate in August. This followed in the wake of increasing fears that the economy
was overheating, and can be read as a pre-emptive measure aimed at reducing the
inflationary expectations of the private sector. In so doing, Federal Reserve Chairman
Greenspan also went out of his way to demonstrate that the central bank would not engage
in a pre-election reflation, and that it would not accommodate the emerging acceleration
in wages. The desire on the part of the central bank to establish a reputation for
toughness in fighting inflation in 1988 is paralleled by the early years of the Volcker
Chairmanship, in which the Federal Reserve undertook drastic measures in order to convince
140
the private sector that the OPEC-induced jump in inflation would not be accommodated, and
that the stimulative stance of fiscal policy announced by the newly-elected Reagan
Administration would not be ratified by a looser monetary posture.
Since trade and investment are still projected to experience continued expansion, we
do not consider current policies to be sufficiently restrictive to be a risk factor for
recession, although they are somewhat tighter than what NAM recommended to the FOMC late
last year. Nevertheless, we would not recommend any further restrictive measures at the
current time, since there is some evidence that the pace of economic expansion is cooling
off. For instance, in July the leading indicators fell by -0.8 percentage points, and in
August the unemployment rate increased from 5.4 to 5.6. In keeping with a pragmatic
approach to monetary policy, the option of relaxation at some future point should not be
ruled out. For instance, in the event that a recession should develop in 1989, we would
endorse a countercyclical loosening of monetary policy. In our view, the inflation rate
is not sufficiently high that a long period of slack would be desirable.
III. Conclusions
The recovery has exhibited unexpected resiliency, and should run for at feast an
additional 12 months. Part of this durability traces back to the Federal Reserve's
decision to "front-load" the disinflationary process in 1980-82: by lowering inflation at
the expense of temporary output losses, the Federal Reserve set the stage for a more
sustainable expansion. Our current view is that while monetary policy is inclining toward
restraint, it is not inappropriately tight. As a general principle, NAM supports the
Federal Reserve's commitment to controlling inflation, but we believe that this should be
balanced by a similar commitment to keeping the real growth rate on its equilibrium path.
14
141
Therefore, monetary policy should be loosened in the event of a cyclical downturn. We do
not believe that the central bank should peg the dollar at an overvalued level in order to
achieve inflation targets.
With respect to policy options currently open to Congress, one advantage afforded by
the continuing expansion is that this provides some breathing space to carry out
additional fiscal restraint. Obviously, it would be difficult to achieve deficit
reduction targets if the economy were to go into recession in 1989. However, if the
expansion can be sustained well into next year, a reduction in the structural fiscal
deficit remains a practicable possiblity.
142
Testimony Before The
U.S. House of Representatives
Subcommittee on Domestic Monetary Policy
of The
Committee on Banking, Finance and Urban Affairs
One Hundredth Congress
Washington, D.C.
September 8, 1988
My name is Don Paris.
I am the Chief Economist at Caterpillar Inc.
I have
been with Caterpillar for 26 years and have been in my current position for
20 years.
I have a BS, MS and Ph.D. from the University of Kentucky.
I was
born and raised in Mr. Hubbard's district.
Caterpillar is a major multinational headquartered in Peoria, Illinois.
We
manufacture and sell construction and mining equipment, lift trucks, diesel
engines, turbines and replacement parts for distribution around the world.
Our 1987 sales were $8.2 billion -- about half inside the United States and
half outside.
We exported about $2.2 billion of product, making us
America's 10th largest exporter.
We and our customers are directly affected by U.S. monetary policy.
Naturally, we and other U.S. manufacturers have a great interest in the
questions posed by Chairman Neal.
I want to compliment you on the
questions.
Interest rates and exchange rates have a dramatic impact on U.S. manufacturers.
I was particularly struck by Chairman Greenspan's recent
comments before the Senate.
He said he'd rather risk being overly
restrictive to prevent inflation than to risk being overly expansive to
prevent a recession.
In my view, that's skating too close to the edge.
143
No Fed Chairman has ever deliberately set about creating a recession; they
have all occurred because they were trying to let an inflationary boom down
easily.
But we don't have an inflationary boom yet either.
I don't quarrel with the Fed's desire to be sure we don't ever again
experience the inflation of the '70's.
We had to pay a terrible price for
it when we had it and again when we got rid of it.
A relevant issue is whether or not the tools the Fed has to work with are
precise enough to fine tune the economy.
Even if we're fortunate enough to
have the right tools or indicators to monitor, a decision must be based on
either forecasts or actual results.
Forecasters haven't been particularly accurate in the last three years as
they have called recessions in three of the last four years and the
resurgence of inflation any moment.
The headlines today read just
about the way they have for the last three years.
Aside from forecasts, the Fed has to lean on historical performance.
An
argument could be made to give more weight to what has actually happened in
recent years as a guide to setting policy as opposed to forecasts.
In many analysts' opinion, the Fed slowed money growth and raised interest
rates to restrain perceived inflationary pressures and to abide by the
Louvre accord during 1987.
crash of October 19.
This restraint was overdone and precipitated the
144
It is very important for you to understand that I have to be complimentary
of the Fed's performance in the post October 19 crisis.
They injected
liquidity into the system, restored calm to the markets and helped register
the best worldwide noninflationary performance in the first half of '88 that
we have experienced in many years.
That episode should have taught us a lesson.
There is still a risk of
deflation out there in the world economy; its consequences are probably
"direr" than inflation.
Since spring, we have been witnessing a striking similarity to the events
leading up to October 19.
I don't question that the economy is stronger than it was during 1987, but I
am questioning whether or not it is worth the risk of a recession and a
resurging dollar.
Anecdotal evidence of shortages abound as do questions about the validity of
capacity utilization figures.
What isn't appreciated, though, is the impact
that the globalization of markets has on price behavior.
There is still excess capacity outside the U.S.
Foreign manufacturers are willing to utilize that capacity to retain
employees, customers and distribution outlets in the U.S.
They aren't going
to lose market share by indiscriminately raising prices, jeopardizing recent
gains.
145
Some are investing in the U.S. to build on their base for the long haul.
It's been a long time since the United States had eight companies making
cars domestically.
The declining dollar has been the catalyst to reviving the U.S. manufacturing sector. After five years of expansion, it's easily forgotten how
close we came to losing our industrial base during the strong dollar days.
Now I know some studies show that manufacturing has remained about 20% of
the real economy through the '80's.
They take these data to mean
manufacturing wasn't hurt by the strong dollar.
Well, we would have more
capacity today.
Who's to say that manufacturing shouldn't have reached 25%
of the economy?
Wouldn't we have had a healthier economy if manufacturing
had grown to 25%?
Capacity shortages wouldn't have been as likely.
Caterpillar alone closed five plants in the U.S. and we shopped the world
for the lowest price parts and components.
globally.
We had to do this to survive
Our suppliers made similar adjustments.
They survived with major
cost reduction programs and restructuring their businesses.
The dollar's decline has now helped level the playing field, and improved
export profits are paying for capital expansion.
Caterpillar raised production 27 percent and increased employment over 4500
in U.S. factories in the last 12 months.
The weaker dollar and strong
domestic market were major factors in this recovery.
146
Now we see U.S. policy strengthening the dollar again, which in a short time
may wipe out months of hard work, sacrifice and investment.
The improvement
in our trade accounts and the growth in capital investment have depended
upon restoring U.S. manufacturing's international competitive position.
I am always amazed at how people worry about the nerves and well-being of
financial markets.
Wall Street portfolio managers can move in and out of
stocks and bonds in a matter of minutes.
Manufacturers don't have that luxury.
They have to be cautious in hiring
people because they want to keep them employed.
When a plant is started,
they have to finish it, but this requires several years.
Stopping in the
middle and switching strategies causes financial loss for the economy.
Small manufacturers perhaps are more vulnerable than large companies to
interest and exchange rate changes.
They are not necessarily as well
capitalized as the larger Fortune 1000 companies.
They have higher
borrowing costs and can't easily hedge currency risk.
Small manufacturers have been adding people, expanding production, and
getting more into exports.
They have been the primary source of manu-
facturing job creation.
We estimate that the declining dollar produced $300 million of additional
before-tax profit in the last 18 months for Caterpillar.
We intend to spend
more than that each of the next five years to carry out our factory modernization program.
This activity could be delayed by higher interest rates
and a stronger dollar ... and that would hurt Caterpillar's ability to
compete.
147
Aside from the October 19 stock market crash, the world economy has adjusted
in line with what needed to be done.
1.
The economy is in good shape today.
The U.S. budget deficit had to come down and it has.
I am not
alone in saying that more spending cuts are needed to reduce it
faster.
I don't think risking a recession will cut the deficit.
In fact, recessions always increase deficits.
2.
Overseas economies had to stimulate their internal demand to
provide a larger market for U.S. goods.
That has been occurring,
and in Japan, to a greater measure than expected.
3.
Capital investments had to increase, and we are, in fact, enjoying
a capital spending boom.
The declining dollar has generated sig-
nificant cash flow increases for corporations to fund their capital
spending plans for modernization and new capacity.
4.
The U.S. had to slow consumer spending.
Real consumer expenditures
in the U.S. have slowed to a 2.5 percent real annual growth rate in
since the end of 1986, in contrast to 4 percent to 5 percent in
prior quarters.
Competition for finished goods is very intense throughout the economy.
Consumers have shown an amazing resistance to price increases by
shifting their purchases to lower-priced goods, waiting for a sale, and
clipping coupons and rebates.
Consumer incomes are restraining their
ability to absorb price increases.
They don't appear to need as much
help in resisting price increases as you might think.
148
Wages in manufacturing are very restrained and are increasing less than
3 percent.
When adjusted for volume gains and productivity, unit labor
costs are growing even less.
Wages probably make up 70 percent of the
costs in the economy; and they just haven't exploded yet, and are not
providing the income gains for the consumer to go on a spending binge.
Some analysts point to the drought and the rise in industrial material
prices as indications of a revival of inflation.
view.
I don't share this
During the period of falling commodity prices, those industries
lost money and the final manufacturing sector used those losses to
shore up their profits.
Investment in these primary producing industries declined.
closed or cut back substantially.
Mines were
Higher commodity prices are bringing
jobs and investment back into U.S. mining now.
So we're seeing the
market system at work rather than inflation.
In this period of improving primary goods prices, manufacturers can't
indiscriminately pass on cost increases.
So it is coming out of their
profits.
The weaker dollar has been an important factor in the recovery of the
forest products, pulp, and paper industries.
With their international competitiveness restored, these industries are
operating at high rates and plowing profits back into investments.
149
In short, dangers of inflation are further into the future than present
policy suggests.
Consumer spending is growing less than 2.5 percent,
and government spending on goods and services is about flat in real
terms.
About 75 percent of the economy is growing slowly by anyone's
measure.
Clearly, housing is headed down.
About 25% of the economy composed of exports and capital expenditures
are making up most of the growth.
These sectors will be adversely
effected by high interest rates and stronger dollar.
It follows, therefore, that current policy will delay capacity
expansion and lengthen the time it will take to adjust our trade
imbalance.
In conclusion, I urge the Fed to be aware of a risk of precipitating an
unwanted recession by clinging to current policy too long.
I have been in the forecasting game a long time, and recognize that
indicators and relationships aren't always stable and reliable.
Furthermore, conventional wisdom is equally
capricious.
I hope the Fed's advisors and the Fed itself will be cognizant of the
need to reverse course quickly.
This may need to be done before all
the evidence is in.
I hope we don't develop the notion that a weaker, more realistically
competitive dollar is bad news.
150
Testimony
Before The
U.S. House of Representatives
Subcommittee on Domestic Monetary Policy
of The
Committee on Banking, Finance and Urban Affairs
One Hundredth Congress
Washington, D.C.
By
James L. Pate
Senior Vice President—Finance and Treasurer
Pennzoil Company
Houston, Texas
September 8, 1988
151
Mr. Chairman, and members of the Subcommittee on Domestic
Monetary Policy, my name is James L. Pate.
I am Senior Vice
President - Finance and Treasurer of Pennzoil Company,
headquartered in Houston, Texas.
I appreciate very much the
opportunity to appear before this committee.
At the outset, I would like to emphasize that I am in
general agreement with the Federal Reserve•s conduct of monetary
policy in recent months and I am in essential agreement with
Chairman Greenspan's testimony before this committee on July 28.
The recent tendency of the Federal Reserve to make small
anticipatory adjustments in an effort to avoid big reactive
changes is, in my opinion, a welcome change in the implementation of monetary policy.
However, this approach does heighten
the importance of accurately gauging business conditions and
anticipating economic developments.
In recognition of this
fact, Chairman Greenspan has indicated that he was prepared
to "err more on the side of restrictiveness rather than of
stimulus."
Although I understand the Federal Reserve's position,
given my view of economic conditions and the potentially grave
consequences of an economic downturn, this bothers me somewhat
and I would like to consider the issue, that is, whether the
Fed should err on the side of restraint or ease, in the context
of the questions you provided, Mr. Chairman, in your letter
of invitation.
152
Many analysts are surprised at the continuing robust
expansion of the economy, in light of the persistence
of large budgetary and external imbalances, major swings
in exchange rates and the unprecedented shock of last
year's collapse of the stock market. To what do you
attribute the current strength of the economy? Is our
current growth rate more or less sustainable without
major shifts in economic policy?
The strength and resiliency of the current economic
expansion has been surprising, especially in view of the
unprecedented shocks that have rocked the economy—$200 billion
budget deficits, $170 billion trade deficits, recession in
the "Rust Belt," depression in the oil industry, a gyrating
dollar, a record plunge in the stock market, and then a drought
that even threatened to dry up the Mississippi River.
However,
from the beginning this expansion has been unusual and very
uneven—almost lopsided.
About the only thing typical about this expansion is
that consumer spending played its usual role of providing the
initial impetus to the recovery.
Even so, there were widely
divergent growth patterns among industries.
Those industries
that were interest-rate sensitive or dependent on foreign
markets suffered widespread plant closings even in the midst
of overall economic recovery because of the extreme strength
of the U.S. dollar and persistent high real interest rates.
The dollar peaked in early 1985, consumer spending
moderated in late 1986, and the decline in the value of the
dollar started fueling exports and reviving manufacturing
153
activity just in time to pick up the slack from consumer
spending and sustain the expansion (see Exhibit I).
Growth
is now very much concentrated in exports and export-related
segments of manufacturing.
During the past four quarters,
exports directly contributed $83.3 billion of the $165.1
billion increase in real Gross National Product (GNP).
Indirectly, exports contributed as much as another $40 billion
to the rise in spending for business equipment.
That is a
lot of thrust from a component that accounts for only about
12 percent of total GNP.
Exports are expected to remain strong
for several more quarters and even to increase, but they are
not likely to contribute to overall economic growth to the
extent that they have in recent quarters.
It is very difficult
to see other sectors of the economy accelerating to such an
extent as to sustain recent GNP growth rates.
Thus, economic
growth is expected to slow appreciably in the months ahead.
Our forecast is for a continuation of the export-led
recovery in manufacturing, reinforced by capital investment,
particularly in equipment.
However, overall real growth is
expected to slow from the 3.3 percent pace in the first half
of this year to about 2.5 percent in the second half of 1988.
On a fourth-quarter-to-fourth-quarter basis, growth is expected
to be about 3 percent in 1988 and 2 percent or less in 1989.
Beginning with the recovery of 1983 the current expansion
has combined strong real growth with declining and then
154
stable inflation. Can this fortunate pattern persist?
Do you see evidence, from your vantage point, of serious
inflationary pressures building up in our economy?
Inflation rates are clearly headed higher.
The Consumer
Price Index (CPI-U) has increased at a 4.5 percent annual rate
so far this year and rose at a 5.2 percent rate in July.
The
Producer Price Index (PPI) for all commodities increased 4.2
percent during the past year and 7.8 percent in the last three
months (see Exhibit II).
Prices of intermediate commodities
increased 5.9 percent during the past year and 9.0 percent in
the last three months.
The highly volatile crude commodities
prices increased 1.0 percent during the past year and 5.6
percent during the last three months.
The Commodity Research Bureau (CRB) Futures Index of
prices rose over 16 percent from the end of April to late June,
reflecting sharply higher food prices.
8.5 percent since then.)
(The index has fallen
The CRB Spot Index rose 9.0 percent
for industrial materials from March to June but has exhibited
little change in the past two months.
The Journal of Commerce
Sensitive Commodity Price Index, which concentrates on industrial
commodities, has increased 4.3 percent since early March.
Labor costs have also picked up this year, in part because
of the increase in social security taxes.
Hourly pay for non-
farm private workers rose at an annual rate of 5.2 percent in
the second quarter.
That was more than double the 2.2 percent
rate in the first quarter and was the largest quarterly gain
155
since the third quarter of 1982.
Hourly earnings in manufac-
turing rose 4.6 percent in the second quarter compared to 1.3
percent in the first quarter.
Overall, the outlook is definitely for higher wages and
prices.
However, higher rates of inflation in 1988 and 1989
have been widely anticipated for the past two years.
Recent
anxiety over inflation has probably been somewhat overdone.
There are no signs of a wage-price spiral such as the one that
plagued the 1970's.
And, while capacity utilization rates
are high in several major industries, they are in most cases
below the peak rates reached in previous expansions (see Exhibit
III).
Forecasts of inflation in 1989 have been revised upward
somewhat in recent weeks due to the anticipated effect of the
drought on food prices.
been overdone.
But even this concern appears to have
The recent rain in the Midwest, the decline
in oil prices, and the unexpected rebound in the dollar have
been tempering influences.
The so-called "core" rate of
inflation, as measured by the PPI finished goods index
(excluding food and energy products), was up only 3.4 percent
for the year ended July (up from 2.2 percent for calendar year
1987).
Our forecast is for a moderate acceleration in inflation,
with the CPI averaging slightly over 4 percent in 1988 and
roughly 5 percent in 1989.
156
Many observers view the Fed as applying modest restraint
very gradually and cautiously, in an attempt to calm
inflationary expectations without retarding real growth.
Is this an accurate reading of current monetary policy?
Given your assessment of the threat of inflation, is
the current stance of monetary policy appropriate?
The Federal Reserve has shown intense concern about inflation by tightening four times this year and pushing interest
rates up 130 to 190 basis points since March.
To date, the
Fed's actions appear appropriate and fully justified.
However,
most short-term rates have been pushed back up to levels equal
to, or higher than, what they were prior to the October crash.
This is cause for some concern.
The half-point increase in
the discount rate on August 9 was quite unnerving and, in my
opinion, not fully supported by economic fundamentals.
However,
it was probably unavoidable and warranted on the basis of perceptions and expectations that were starting to develop in the
financial markets.
The financial markets are still very jittery following
the events of last October, and there are good reasons to believe
that even in the absence of any further tightening, overall
economic growth will slow appreciably in the second half of this
year.
Thus, the risks of erring on the side of restrictiveness
and causing another financial crisis or precipitating a recession
in 1989 are substantial.
With our continuing budget deficits,
troubled financial institutions, and Third World debt problems,
a recession must be avoided at least until a new Administration
has the opportunity to deal with these persistent problems.
157
The task confronting the Federal Reserve is formidable.
Somehow it must strike a balance between preventing a sharp
acceleration in inflation and sustaining economic growth while
seeking to stabilize the dollar.
Fiscal policy is on hold
until the next Administration takes office, so monetary policy
is the only available means of stabilizing the economy.
Are there particular economic developments which should
weigh heavily on the current conduct of monetary policy?
For example, some economists think we will need further
dollar depreciation, yet the dollar has been surprisingly
strong on the foreign exchange markets. Is this a cause
for concern indicating that monetary policy might now
be too tight? Or is it a welcome development, one that
will help keep inflationary expectations in check and
interest rates at lower levels than otherwise possible?
As long as the United States continues to run huge budget
deficits and large trade imbalances, international financial
considerations are going to play an important role in the conduct
of U.S. monetary policy.
The recent increase in the value of the dollar has been
due primarily to comparative interest rate differentials and
the anticipation that U.S. monetary authorities will raise
rates further.
In the past month, the interest rate advantage
for dollar investments (overnight to three months) has been
more than 3 percent relative to both yen and deutsche mark
deposits.
Although foreign central banks have reacted by increasing
their own short-term interest rates in an effort to support
158
their currencies, fundamentals favor some further rise in the
value of the dollar near-term.
In the long run the U.S. dollar
should move lower to improve the U.S. trade balance.
However, I
very much agree with Chairman Greenspan that a sharp decline in
the value of the dollar at this time could be counterproductive,
raising import prices and adding to inflationary pressures.
To mention other examples, do the current drought
conditions affecting the agricultural sector, or the
emerging heavy losses among thrift institutions, pose
particular problems that should influence the conduct
of monetary policy?
The drought conditions are causing substantial upward
revisions in food price forecasts.
Before the drought, food
prices were generally expected to rise 4 percent in both 1988
and 1989.
range.
Now the forecasts for 1989 are in the 5-6 percent
From a policy point of view, the drought should be
regarded as a serious but temporary condition that need not
have any lasting effect on overall inflation.
Raw agricul-
tural commodity costs represent a very small proportion of
the prices of food products.
The risk is, however, that
even small increases in retail food prices will affect inflationary expectations and become embedded in wage trends because
grocery stores are where workers first notice higher prices.
The situation among financial institutions is more
critical, and it extends beyond thrift institutions and the
problems of the Federal Savings and Loan Insurance Corporation
159
(FSLIC).
It includes problems affecting some of our nation's
largest commercial banks.
Despite more than five years of
economic growth and an extended period of declining interest
rates, banking problems continue to mount.
Between 1981 and
1987, commercial banks' annual write-offs of bad loans rose
from roughly $4 billion to $16 billion.
Historically, write-
offs double or even triple during recessions, with roughly
one-third concentrated among the weakest 20 percent of the
banks.
That means that even a mild recession at this time
could easily wipe out the capital of at least 20 percent of
our commercial banking system.
An additional consideration in assessing the risks of
higher interest rates and recession is the increasing sensitivity of consumer spending to interest rate changes.
Consumer
spending accounts for roughly two-thirds of gross national
product and has become extremely vulnerable to rising interest
rates because of increased consumer borrowing and a rising
proportion of variable rate debt such as adjustable rate
mortgages, variable rate credit cards, and home equity loans
tied to market interest rates.
Another concern is the highly leveraged condition of
American corporations.
During the 1980's, corporations made
substantial changes in their capitalization, adding significant
debt and buying back substantial amounts of stock.
raised their net interest expense substantially.
This has
Since 1982,
net interest expense has equalled between 40 percent and 60
-10-
160
percent of "profits before tax" (see Exhibit IV).
Prior to
1982, it never exceeded 40 percent; during the 1960's, it was
close to 10 percent.
The relationship between net interest
expense and pretax profits with inventory and capital consumption adjustment (INV&CCADJ) is similar.
This current, highly leveraged condition means that
businesses would be much harder hit by high interest rates
and a recession today than in the past.
During the 1982
recession, profits fell 29 percent, the largest decline in
the 1960-1987 period.
The burden of high interest expense
contributed to the greater volatility in profits.
In 1981,
net interest expense equalled $67.5 billion or 37.2 percent
of profits before tax and 46.8 percent of profits with
INV&CCADJ.
In 1987, the corresponding percentages were 46.9
percent and 41.5 percent.
In 1973, prior to the 1975 recession,
the corresponding ratios were in the 23 percent to 27 percent
range, indicating a much lower sensitivity of profits to
interest rate peaks and economic slowdowns.
The dividend payout rate has also increased substantially.
Dividend payments in the 1980's, as a percent of either profits
before tax or operating profits, substantially exceeded levels
in either the 1960's or the 1970's.
At the same time, undis-
tributed profits, as a percent of either measure of profits,
in 1987 remained near the record low of 1986.
There are undoubtedly many contributing factors to
this trend toward a highly leveraged corporate sector.
One
161
unexplored view is that the inflation-fighting monetary
policies of the early 1980's resulted in high nominal and
real interest rates.
The equity securities of nonfinancial
corporations, as one of many competing assets, had to provide
a rate of return to investors comparable to other financial
instruments.
This was achieved by taking on additional debt
and consolidating firms and/or buying back stock to keep stock
prices attractive, as well as increasing dividend payout rates
to further support the return on holding the stock of nonfinancial corporations.
What all this means is that vulnerability to high
interest rates and recession goes far beyond thrifts and other
financial institutions.
Consumers and corporations will be
hit hard in the next recession—much harder than in the past.
On a more general level, considering macroeconomic policy
as a whole—spending, taxing, monetary policy, exchangerate management—what significant policy changes, if
any, do you see necessary, in the next Administration,
in order to continue reasonable and sustainable economic
growth, without generating serious inflation?
The most urgent business for the next Administration will
be to reduce the federal budget deficit.
Until this happens,
interest rates will remain high and we will continue to depend
on foreign investors to finance our budget deficits.
Also, the next Administration will need to move quickly
on a national energy policy.
Until this happens, the U.S.
162
is going to continue to experience large trade imbalances.
The trends of declining domestic production and increasing
consumption guarantee that oil imports will rise.
For example,
through June of this year total oil imports were up 13% from
the comparable 1987 period and up 23% from the comparable 1986
period.
Currently, oil imports account for roughly one-third
($42 billion) of our trade deficit (see Exhibit V).
In 1995
it is estimated that our oil import bill will be more than
$116 billion.
In addition, the loss of U.S. domestic produc-
tion and the rise in our import dependence will increase our
vulnerability to economic shocks from future oil price spikes.
In brief summary, Mr. Chairman, I am concerned that
interest rates are approaching—they probably are not yet
there, but they are getting very close to—levels that could
precipitate a recession.
My company recently ran some simula-
tions with a widely used econometric model and found that it
does not take a very large increase in interest rates in 1988
to produce a flat economy in 1989 and, if you combine a small
increase in interest rates with just a slight decline in consumer
confidence, you can get two or more quarters of negative real
growth rather easily.
So we are, in my opinion, approaching
a danger zone for interest rates.
In this regard, it is
comforting to hear from Chairman Greenspan that the Federal
Reserve does not contemplate any sharp upward adjustments in
interest rates.
-13-
163
I, too, am concerned about the possibilities of a
reacceleration of inflation.
However, the price increases
we have seen to date are widely scattered and in most cases
related to special circumstances or transitory developments.
They are not the kind of general price increases that would be
significantly reduced by higher interest rates and a slowing
of aggregate demand.
My concern is that the consequences of a recession at
this time could be quite serious.
Our best chance, in fact I
believe our only chance, for reducing our huge budget deficit,
dealing with Third World debt problems, and restoring strength
to our fragile financial institutions is in an environment of
economic growth, albeit slow growth.
Mr. Chairman, and members of this committee, thank you
again for this opportunity to present my views.
CHANGES IN GROSS NATIONAL PRODUCT
(8/25/88 Release)
(Billions of 1982 Dollars)
1986
1985
Gross National Product
Personal Consumption
Durable Goods
Nondurable Goods
Services
Investment
Fixed Investment
ui
I
02
03
$42.3
$21.7
$36.6
38.0
18.3
11.6
7.0
19.4
-21.4
4.6
3 9
Nonres. Structures
Prod. Durable Equip.
-0.1
Residential Invest.
Change in Business Inv.
•25.9
0.7
5.5
4.9
7.9
$26.6
$56.9
38.5
10.9
28.3
18.8
-12.7
7.0
12.7
15.4
13.2
-29.4
29.9
12.0
-8.5
18.3
0.3
9.2
2.6
1.1
-5.8
-4.9
2.1
11.7
•17.4
13.4
-21.0
•5.5
Exports
-5.4
•3.6
-5.0
Imports
-18.8
17.4
12.3
8.5
Military
4 7
Other
State & Local
3.8
3.7
Real Final Sales
68.2
11.2
4.3
3.4
0.9
7.0
20.6
4.2
9.6
4.4
-20.9
Net Exports
Government
Federal
8.2
0.5
33.1
4.8
22.1
2.9
27.6
•0.3
10.6
-2.6
17.0
5.5
57.5
2.3
3.2
14.9
6.9
Q2
03
($7.7)
$9.7
25.8
37.6
10.9
30.9
4.4
0.5
6.3
30.0
-25.9
-24.5
-8.0
-3.9
-3.9
-4.7
-18.5
-5.0
12.2
9.2
-9.4
6.1
38.0
9.6
7.1
-2.4
-10.9
-17.9
-0.3
-17.6
7.0
18.9
10.5
4.4
•2.2
03
$13.4
7.7
-7.8
3.9
11.6
14.4
-6.8
5.0
30.3
-13.5
-18.9
28.1
17.4
15.2
-0.1
2.1
11.3
15.7
-2.8
-0.1
-6.3
16.7
-1.3
-0.8
-5.5
40.3
-2.0
-14.8
-0.4
9.4
8.7
9.7
1.2
6.1
28.6
13.0
13.7
-11.6
8.1
3.1
9.9
26.4
29.9
-24.5
10.9
$32.0
-10.4
-13.5
17.0
$33.1
2.4
2.2
3.3
18.5
$57.7
-11.1
-20.6
22.2
4.6
$42.3
13.5
10.2
7.0
4.0
-19.0
$46.3
18.3
-22.1
-2.4
$42.0
0.7
•0.7
7.6
3.8
-7.6
11.4
3.8
26.9
9.6
7.1
6.8
7.8
22.6
7.1
20.9
-4.7
-1.4
6.9
56.8
2.7
4.1
-2.0
0.6
54.1
4.7
21.5
24.5
18.3
14.6
29.3
13.6
-1.6
-0.7
10.7
-6.5
-1.9
10.0
-2.5
3.9
-10.4
4.9
1.7
7.8
-9.7
1.2
48.3
4.7
5.3
0.7
57.0
9.7
5.6
-1.3
13.5
2.2
12.3
4.2
5.3
-8.1
16.7
8.2
0.0
9.3
-11.2
18.7
3.6
14.7
-3.2
0.5
-1.1
-30.0
17.0
18.9
27.0
13.5
9.9
-16.2
-19.9
-3.6
6.9
4.1
-16.3
3.7
34.2
3.8
-5.4
6.9
3.2
-1.4
4.6
3.6
62.0
GNP Price Deflators (X Change. SAAR)
Implicit Price Def.
2.6X
3.3X
Fixed Weight Def.
3.7
3.3
SOURCE:
U.S. Department of Commerce
2.6X
2.9
3.3X
3.2
0.7X
2.1
3.6X
2.5
4*7X
3.2
2. IX
2.8
3.5X
4.2
3.5X
3.1X
4.2
3.7
2.4X
3.8
1.7X
3.5
5.1X
4.7
M
X
IT
PRODUCER PRICE INDEXES
All Commodities
Finished Coomodities
Percent Change
YR: Month
Level
3 Month
1.2
1 Year
1986:1
1.032
1986:2
1.017
-6.4
-1.5
-0.2
1986:3
1.003
1986:4
0.996
-12.1
-13.2
-3.6
1986:5
1.000
-6.5
-3.4
1986:6
0.999
-1.6
-3.3
1986:7
0.994
-0.8
-3.7
1986:8
0.993
0.994
^2.8
-2.0
-3.3
1986:9
1986:10
0.997
1986:11
0.998
1986:12
0.997
1987:1
.005
1987:2
.010
1987:3
.012
1987:4
.019
1987:5
.026
1987:6
.030
1987:7
.035
1987:8
.038
1987:9
.037
1987:10
.041
1987:11
.042
1987:12
.042
1988:1
.046
1988:2
.048
1988:3
.049
1988:4
.058
1988:5
.065
1988:6
.074
1988:7
.078
SOURCE:
1.2
2.0
1.2
3.2
4.9
6.2
5.7
6.5
7.3
6.4
4.8
2.7
2.3
1.6
1.9
1.9
2.3
2.7
4.7
6.6
9.9
7.8
-2.7
-2.6
-3.1
-3.5
-3.8
-2.6
-0.7
0.9
2.3
2.6
3.1
4.1
4.5
4.3
4.4
4.4
4.5
4.1
3.8
3.7
3.8
3.8
4.3
4.2
Intermediate Commodities
1.054
1.039
1.029
1.023
1.029
1.029
1 .023
1.027
1.030
1.034
1.035
1.034
1.039
1.041
1.045
1.051
1.053
1.054
1.057
1.060
1.064
1.061
1.062
1.059
1.062
1.060
1.065
1.069
1.074
1.078
1.083
3 Month
Percent Change
Percent Change
Percent Change
Level
Crude Commodities
1 Year
Level
1.3
1.023
1.011
-0.4
-5.7
I Month
Level
3 Month
-0.8
0.942
-1.7
0.904
1 Year
-5.9
-0.2
-11.2
-11.3
-1.2
0.999
0.883
-2.2
•11.2
-12.3
-2.6
0.990
-3.8
0.854
-3.8
-1.9
0.988
-8.8
-4.2
0.868
0.0
-19.7
-26.3
-32.4
-15.0
-1.6
0.987
-4.7
-3.9
0.862
-9.2
1.9
0.0
0.0
-0.8
0.4
4.4
3.2
1.6
1.9
2.3
4.3
4.7
4.7
3.5
2.3
2.7
3.8
1.5
0.8
-1.9
0.4
-0.8
2.3
2.7
5.4
5.0
5.3
4.8
-1.8
•1.1
0.980
0.986
-1.4
0.982
-1.9
0.983
-2.5
0.984
-1.4
0.990
0.2
1.6
2.7
2.3
2.4
3.3
3.2
3.3
2.6
2.6
2.4
2.2
1.8
1.9
1.7
2.0
2.3
2.5
0.996
0.998
1.002
1.008
1.013
1.019
1.024
1.027
1.032
1.036
1.038
1.042
1.044
1.048
1.056
1.062
1.072
1.079
Bureau of Labor Statistics, U.S. Department of Labor
-3.2
-0.4
0.8
1.2
-0.8
3.3
5.4
5.8
4.9
4.9
6.1
7.0
6.5
5.6
5.2
4.8
4.4
3.9
3.1
3.9
5.5
7.1
9.5
9.0
-4.2
-3.6
0.866
0.865
-4.1
0.875
-4.2
0.874
-0.9
1.4
5.2
3.7
0.5
7.5
1 Year
-5.7
-9.0
-9.6
-11.7
-9.5
-9.5
-8.9
-6.7
-5.8
-7.1
-8.5
-4.4
0.866
-3.2
0.891
-1.5
0.899
11.9
-0.1
0.906
19.8
0.923
15.2
0.943
21.1
0.946
18.9
0.956
15.1
10.6
0.967
10.6
11.7
1.2
2.0
.6
.0
.5
.2
.1
5.4
5.5
5.3
4.8
5.0
5.4
5.4
5.8
5.9
0.960
0.961
6.1
2.1
0.949
-7.2
0.947
-5.3
0.939
-8.8
0.946
-1.3
0.941
-2.5
0.953
0.964
0.977
0.966
6.1
7.8
16.2
5.6
-9.1
Cn
-5.4
-0.6
2.6
8.1
8.6
9.7
11.0
9.8
8.6
9.4
5.4
5.2
3.9
3.3
2.2
3.3
1.0
w
H-
cr
CAPACITY UTILIZATION BY INDUSTRY
(Percent)
1973-75 Cycle
Industry
Foods
Textile Mill Products
Paper ft Products
Chemical ft Products
Petroleum Products
Rubber ft Plastics Products
Stone, Clay, Glass ft Concrete Products
Primary Metals
Fabricated Metal Products
Nonelectrical Machinery
Electrical Machinery
Motor Vehicles ft Parts
Instruments
Electrical Utilities
High
Low
Nigh
Low
85. 8X
92. IX
95.6X
88.6X
99.6X
97.5X
89.3X
101 .9X
85. OX
89.4X
85. A
97.1X
89.2X
98.7X
77.6X
58.9X
67. 7X
69.2X
85. 1X
88.3X
92.7X
82.9X
91. 7X
89.4X
86.6X
97. IX
87.4X
86.0X
89.9X
93.3X
88.9X
87.6X
76.5X
70.6X
80.2X
67.6X
68.8X
68.7X
62.9X
45. 8X
61 .3X
62.9X
66.9X
47. OX
77.8X
78.2X
83. A
59. 5X
67. IX
67. OX
64.7X
68.2X
63.7X
52.7X
74.9X
83.0X
Most Recent Minus
Previous Highs
1978-82 Cycle
Most
Recent*
80.1X
89.6X
92.8X
85. 9X
84.9X
88.4X
82.4X
89.5X
83. 4X
82.6X
78.0X
81 .6X
81. 5X
86.3X
1973-75
-5.7X
-2.5X
-2.8X
-2.7X
-14. 7X
-9.1X
-6.9X
-12.4X
-1.6X
-6.8X
-7.7X
-15.5X
•7.7X
-12.4X
1978-82
-5.0X
1.3X
0.1X
3.0X
-6.8X
-1.0X
-4.2X
-7.6X
-4.0X
-3.4X
-11.9X
-11.7X
-7.4X
-1.3X
* June or July, 1988
Source: Board of Governors, U.S. Federal Reserve System
H-
cr
Hft
NONFINANCIAL CORPORATIONS
Profits with Inventory and Capital Consumption Adjustment ($ Billions)
uacegory as percent or local
Profits with Inventory and
Capital Consumption Adj.
Profits
Inventory
«._£«.._
.
*
_
Category as Percent of
Profits Before Tax
,
„
ri ui IB ni ici IBA
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
Total
Before
Tax
Tax
Liab.
$39.2
$40.1
$47.3
$52.8
$59.3
$69.1
$73.7
$70.5
$74.8
$69.6
$55.4
$65.2
$75.7
$82.4
$69.4
$91.6
$113.3
$134.9
$146.0
$139.1
$123.1
$144.2
$111.9
$165.6
$222.4
$225.3
$230.6
$237.4
$39.7
$39.5
$44.2
$48.9
$55.4
$65.2
$70.3
$66.5
$73.1
$69.6
$57.0
$65.6
$76.8
$96.9
$107.2
$109.2
$138.3
$160.5
$182.1
$195.7
$181.8
$181.5
$129.7
$159.4
$196.1
$170.2
$172.6
$210.2
$19.2
$19.4
$20.7
$22.7
$24.0
$27.2
$29.5
$27.9
$33.6
$33.4
$27.2
$30.0
$33.8
$40.2
$42.2
$41.5
$52.9
$59.9
$67.1
$69.6
$67.0
$63.9
$46.2
$59.5
$73.5
$69.8
$76.8
$99.0
Capital
Undist. Consump.
Total Dividends Dividends Adj.
$20.5
$20.1
$23.5
$26.2
$31.4
$38.0
$40.8
$38.6
$39.5
$36.2
$29.8
$35.6
$43.0
$56.7
$65.0
$67.7
$85.4
$100.6
$115.0
$126.2
$114.8
$117.6
$83.5
$99.9
$122.5
$100.4
$95.8
$111.2
$10.6
$10.6
$11.4
$12.6
$13.7
$15.6
$16.8
$17.5
$19.1
$19.1
$18.5
$18.5
$20.1
$21.1
$21.7
$24.8
$27.8
$32.0
$37.3
$39.3
$45.5
$53.4
$59.7
$66.5
$69.5
$72.2
$74.8
$83.8
$9.9
$9.5
$12.1
$13.6
$17.7
$22.4
$24.0
$21.1
$20.4
$17.1
$11.3
$17.1
$22.9
$35.6
$43.3
$42.9
$57.6
$68.6
$77.8
$86.9
$69.3
$64.2
$23.8
$33.4
$53.0
$28.2
$21.0
$27.4
SOURCE: Bureau of Economic Analysis, U.S. Department of Commerce
($0.5)
$0.6
$3.1
$3.9
$3.9
$3.9
$3.4
$4.0
$1.7
$0.0
($1.6)
($0.4)
($1.1)
($14.5)
($37.8)
($17.6)
($25.0)
($25.6)
($36.1)
($56.6)
($58.7)
($37.3)
($17.8)
$6.3
$26.4
$55.1
$58.0
$27.2
Net
Interest
Expense
$3.5
$4.0
$4.5
$4.8
$5.3
$6.1
$7.4
$8.8
$10.1
$13.2
$17.1
$18.1
$19.2
$22.5
$28.3
$28.7
$27.5
$30.6
$35.9
$43.5
$55.5
$67.5
$76.6
$69.8
$80.3
$81.1
$84.3
$98.6
Undist. Interest
Undist. Interest
Dividends Dividends Expense Dividends Dividends Expense
27.0%
26.4%
24.1%
23.9%
23.1%
22.6%
22.8%
24.8%
25.5%
27.4%
33.4%
28.4%
26.6%
25.6%
31.3%
27.1%
24.5%
23.7%
25.5%
28.2%
37.0%
37.0%
53.4%
40.2%
31.3%
32.0%
32.4%
35.3%
25.3%
23.7%
25.6%
25.8%
29.8%
32.4%
32.6%
29.9%
27.3%
24.6%
20.4%
26.2%
30.3%
43.2%
62.4%
46.8%
50.8%
50.9%
53.3%
62.5%
56.3%
44.5%
21.2%
20.2%
23.8%
12.5%
9.1%
11.5%
8.9%
10.0%
9.5%
9.1%
8.9%
8.8%
10.0%
12.5%
13.5%
19.0%
30.9%
27.8%
25.4%
27.3%
40.8%
31.3%
24.3%
22.7%
24.6%
31.3%
45.1%
46.8%
68.5%
42.1%
36.1%
36.0%
36.6%
41.5%
26.7%
26.8%
25.8%
25.8%
24.7%
23.9%
23.9%
26.3%
26.1%
27.4%
32.5%
28.2%
26.2%
21.8%
20.2%
22.7%
20.1%
19.9%
20.5%
20.1%
25.0%
29.4%
46.0%
41.7%
35.5%
42.4%
43.3%
39.9%
24.9%
24.1%
27.4%
27.8%
31.9%
34.4%
34.1%
31.7%
27.9%
24.6%
19.8%
26.1%
29.8%
36.7%
40.4%
39.3%
41.6%
42.7%
42.7%
44.4%
38.1%
35.4%
18.3%
21.0%
27.0%
16.6%
12.2%
13.0%
8.8%
10.1%
10.2%
9.8%
9.6%
9.4%
10.5%
13.2%
13.8%
19.0%
30.0%
27.6%
25.0%
23.2%
26.4%
26.3%
19.9%
19.1%
19.7%
22.2%
30.5%
37.2%
59.1%
43.8%
40.9%
47.6%
48.8%
46.9%
168
Exhibit V
U.S. OIL AND PRODUCT IMPORTS AND THE U.S. TRADE DEFICIT
1977
1985
1987
1995
18.4
15.7
16.7
17.7
Oil Production (MMB/d)
9.9
10.6
10.0
7.2
Crude Oil I Products Imports (MMB/d)
8.8
5.1
6.7
10.5
47.8X
32.2X
40.1X
59.3X
US OIL PRODUCTION & CONSUMPTION
Petroleum Products Consumption (MMB/d)*
Percent of U.S. Use from Imports
IMPORT PRICES
Crude Oil (S/bbl)
$14.31
$26.66
$17.71
$30.42
14.00
27.31
17.35
30.40
Crude Oil & Products Imports ($BiIIion)
-45.0
-50.5
-42.3
-116.5
Balance of Payments** Without
Crude Oil ft Products Imports ($8111 ion)
30.5
-65.9
-118.4
11.9
Total Balance of Payments** ($BiIlion)
-14.5
-116.4
-160.7
-104.6
Average Crude t Products ($/bbl)
BALANCE OF PAYMENTS IMPACT
* Nay not equal sum of production and imports because of inventories.
** Current Account Balance of Payments: estimate for 1995 developed
using Data Resources Inc. model.
SOURCE:
PennzoU Company
-19-
169
Statement
of the
U.S. Chamber
of Commerce
ON: MONETARY POLICY
TO: SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
BY: DR, RICHARD W, RAHN
DATE: SEPTEMBER 8, 1988
The Chamber's mission is to advance human progress through an economic,
political and social system based on individual freedom,
incentive, initiative, opportunity and responsibility.
170
The U.S. Chamber of Commerce is the world's largest
federation of business companies and associations and is the
principal spokesman for the American business community. It
represents nearly 180,000 businesses and organizations, such
as local/state chambers of commerce and trade/professional
associations.
More than 92 percent of the Chamber's members are small
business firms with fewer than 100 employees, 59 percent with
fewer than 10 employees. Yet, virtually all of the nation's
largest companies are also active members.
We are
particularly cognizant of the problems of smaller businesses,
as well as issues facing the business community at large.
Besides representing a cross section of the American business
community in terms of number of employees, the Chamber
represents a wide management spectrum by type of business and
location.
Each
major
classification
of
American
business—manufacturing, retailing, services, construction,
wholesaling, and finance—numbers more than 10,000 members.
Yet no one group constitutes as much as 31 percent of the
total membership. Further, the Chamber has substantial
membership in all 50 states.
The Chamber s international reach is substantial as well. It
believes that global interdependence provides an opportunity,
not a threat. In addition to the 56 American Chambers of
Commerce Abroad, an increasing number of members are engaged
in the export and import of both goods and services and have
ongoing
investment
activities.
The Chamber
favors
strengthened international competitiveness and opposes
artificial U.S. and foreign barriers to international
business.
Positions on national issues are developed by a cross section
of its members serving on committees, subcommittees and task
forces. Currently, some 1,800 business people participate in
this process.
171
STATEMENT
on
MONETARY POLICY
before the
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
of the
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
for the
U.S. CHAMBER OF COMMERCE
by
Dr. Richard W. Rahn
September 8, 1988
I am Richard W. Rahn, Vice-President and Chief Economist of
the U.S. Chamber of Commerce.
On behalf of our 180,000 member
businesses, associations, and state and local chambers of commerce,
we thank you for the opportunity to present our thoughts on the
current state of the economy and on the conduct of monetary policy.
At the outset, let me commend the members of the Federal
Reserve Board (Fed) for their recent efforts in striving to meet
mandates established for them by law.
I want to state for the
record our total agreement with and support for the objective of
achieving noninflationary economic growth.
Any disagreement that
we have in this regard is over the means, not the end, of monetary
policy.
And while we may have preferred a more gradual reduction
in the inflation rate and may have chosen a different method to
reduce inflation, the fact is that the Federal Reserve Board was
instrumental in breaking the inflationary spiral of the late 1970s.
And for that, we are thankful.
The question that we now face is
what should Fed policy be today?
We find the following:
o
Today's persistent inflation in the 4.5 percent range is
the remnant of earlier Fed mistakes when it greatly
increased the growth in the money supply to drive down
the value of the dollar.
172
Sustained inflation is always a monetary phenomenon, and
trends in the real economy, when divorced from changes
in monetary growth, have little bearing on past, present
and future inflation.
Fed policy is highly discretionary. The long term goal
of
monetary
policy
should
be
zero
inflation.
Consequently, the Fed should establish both price and
quantity rules in managing monetary aggregates.
Fed policy is inconsistent. While following a policy of
monetary restraint at home, the Fed in 1988 has been
expanding money supply internationally to hold down the
value of the dollar.
The secrecy surrounding Fed policy-making and its
unannounced changes in course greatly adds to instability
in financial markets.
The Fed should make its
deliberations open so that policy changes can be
anticipated, and the impact on the economy can be
minimized.
High interest rate policy to slow economic growth is
inappropriate policy because it interferes in credit
markets, adds instability to the economy and, contrary
to intent, may add to inflationary pressures.
FED POLICY HAS BEEN TOO TIGHT
Since the beginning of 1987, Fed policy has been relatively
tight, with the exception of the short period following the stock
market crash of October 1987.
Since the end of April of this year,
Fed policy has become increasingly tighter as it pursues restraint
in the growth of bank reserves and pushes up interest rates.
Growth in monetary aggregates has been well within its target
ranges for M2 and M3, while Ml has grown at a 4.9 percent annual
rate.
173
3
The Fed's current high interest rate policy comes as an overreaction to the inflation that was caused by its earlier mistakes.
Given the inevitable long time lag (18 to 24 months) before sudden
increases in the money supply show up as inflation, today's high
interest rate policy cannot affect the inflation that was baked in
yesterday —
it can serve only to slow economic growth below what
we could otherwise reasonably expect.
Between 1985 and the end of 1986, the Fed engineered extremely
rapid money growth, while presenting the public with rhetorical
statements in favor of monetary restraint.
For instance, between
the fall of 1985 and the spring of 1987, Mi's 52-week growth rate
remained consistently above 10 percent.
Under prevailing economic conditions at the time, the only
policy objective consistent with this behavior by the Fed was that
of influencing the foreign exchange value of the dollar.
By 1985,
the dollar had hit an all-time high, and many believed that a
weakened dollar was the only solution to the nation's exploding
trade deficit.
It appears that the Fed agreed.
It is no coincidence that the dollar began retreating from its
historically strong position against the yen and the mark at about
the same time that the Fed stepped on the monetary accelerator.
Between January
1986 and January 1987, the dollar depreciated
almost 25 percent against the mark.
During the same period, the
two-year average growth rate of Ml almost doubled.
174
As an increased supply of dollars began to flood the world's
currency markets, the dollar's value on foreign exchange markets
declined
against all major currencies.
Unfortunately, the Fed
seems to have overshot its mark and, by the end of 1986, began to
fear that the dollar was falling too far, too fast.
While the value of the dollar was falling, prices of imports
were rising.
This adjustment in relative prices between imports
and exports coincided with other inflationary signs beginning to
show up in the economy after almost two years of intoxicating
monetary growth.
It was also becoming apparent that money growth
could not remain at such an extraordinary level for much longer
without risking a resurgence of inflation.
The Fed then appears to have slammed on the monetary brakes
in
an
attempt
to
avert both
reignition of inflation.
a
free-fall of the
dollar and
The Federal Reserve Board had become
hoist on its own petard.
INFLATION IS A MONETARY PHENOMENON
What is apparent in reviewing both the Fed's performance and
the deliberations of the Federal Open Market Committee is that the
Fed is acting in a highly discretionary manner, attempting to
manage the course of the U.S. economy according to its own judgement of where the economy is now and where it will be in the next
several quarters.
It is trying to do too much with too little
175
information, too crude instruments and flawed economic theory.
After 70 months of continuous economic expansion, real Gross
National Product (GNP) growth continues to be strong; inflation
remains stable; and unemployment is at 5.6 percent.
For the first
time since World War II, both inflation and unemployment have come
down in tandem.
Not only is this economic expansion of record duration, but
it also has achieved the highest continuous peacetime average real
rate of economic growth (4 percent) during any five-year period in
our nation's history. Inflation has averaged only 3.5 percent over
the same five-year period.
We now have a record-high percentage
of our adult population at work, a record rate of new job creation
concentrated in high- and middle-wage categories, a record rate of
industrial output, a record rate of new business incorporations,
a record rate of real per-capita personal income and the highest
absolute rate of manufacturing productivity of any country in the
world.
This is very good news, one might think.
But in today's
topsy-turvy world, all of this good news seems to be worrisome to
many
economic
analysts
and
policymakers.
Many
people have
convinced themselves that too much economic growth causes inflation
and that to control inflation, the rate of economic growth must be
constrained.
This belief is fundamentally in error, and basing
policy on it will have undesirable consequences.
176
This brings me to the crux of our disagreement with the Fed.
The Fed has embarked on a misguided policy of pushing
interest
rates up, based on the erroneous belief that uncontrolled
unguided economic growth produces inflation.
and
This fundamental
theoretical error then produces expectations of inflation when such
expectations should not exist.
These false expectations, in turn,
lead the Fed to see accelerating inflation where no acceleration
exists.
To the Fed, it appears that all of the good economic news is
scary.
According to pronouncements by Fed members, inflation is
thought to be caused by rapid growth in the real economy —
from
"overheating," "bottlenecks" and "overconsumption." There appears
to be little or no recognition that sustained inflation is always
a monetary phenomenon and that trends in the real economy, when
divorced from changes in money growth, have little bearing on past,
present and future inflation.
PRICE STABILITY BASED ON USING RUI£S
The problems with day-to-day discretionary monetary policy are
that it greatly alters the workings of credit markets and it is
carried out in secrecy.
understood or enumerated.
Fed policy of this type is never well
Almost all new releases of government
economic indicators provoke currency traders and stock and bond
177
7
market participants to dwell heavily on the likely response of the
Fed.
Speculation on the timing and magnitude of Fed intervention
is a major source of uncertainty in credit markets and of instability in the economy.
In the spirit of greater openness with the benefits of reducing risk and providing a more stable reaction on the part of market
participants, many analysts have proposed that the Fed concentrate
its effo'rts following established rules that are flexible enough
to be changed periodically as conditions warrant.
One such rule is to establish target ranges for money supply
growth, which the Fed has done, which allow for sufficient monetary
growth to facilitate economic growth.
Another rule is to monitor
how well any given money growth is promoting price stability by
developing some index of sensitive prices that gives timely, early
warnings of new "inflationary pressures."
The carefully selected
index should have a target range as well.
As long as the index
falls within the known target range, no change in policy direction
is necessary.
understood
that
If the index exceeds this range, it would be
the
Fed
would
alter
monetary
growth
policy
accordingly.
Any combination of rules is not foolproof.
tend to indicate clearly the intent of Fed policy.
is
desirability
of
the
alternative
—
However, rules
The question
ever-changing
Fed
intervention in financial markets to meet secret monetary policy
shifts.
178
The long run goal of price stability should be zero inflation,
with some tolerably small error about that target.
Starting from
today's approximately 4.4 percent rate of increase in prices,
inflation should be brought down gradually without interfering with
the process of real economic growth.
This requires a clear
commitment to set a long-range monetary policy that can be followed
with little deviation.
Every time the Fed disregards the goal of
reducing long-term money supply growth, for instance, to lower the
value of the dollar, inflation tends to crop up anew some 18 to 24
months later.
As we look at the performance of the economy during the
postwar era, we cannot help but conclude that the Fed played an
important role in exaggerating business cycles in the U.S. economy.
This pattern has been especially clear since 1965.
By stimulating
recoveries well beyond the point where inflation becomes a problem,
the Fed has been forced to adopt policies of severe stringency to
reduce the inflation that it largely induced.
Left to its own
judgement, the Fed will persist in the roller coaster policy of
ease and restraint generating new levels of inflation, and the U.S.
and world economies will suffer accordingly.
With reasonably firm rules guiding Fed actions, there would
be no need constantly to guess what policy the Fed is pursuing at
any given time and how the Fed will react to a wide variety of
economic events.
In today's economy, any good news on economic
growth is accompanied with more than a twinge of concern over the
179
9
reaction
of the Fed.
Although
inflation as measured
by the
Consumer Price Index (CPI) has moved very little in the past 18
months, there have been continual expressions of concern over
accelerating
inflation by analysts and the media.
Much of this
speculation has been fueled by statements and actions of the Fed.
FED POLICY IS INCONSISTENT
There is a significant complicating factor in assessing the
conduct of monetary policy this year.
It is becoming more apparent
that the Fed has embarked upon a policy of intervening in foreign
exchange markets to manipulate the value of the dollar.
In 1987,
the Fed and central banks of other nations purchased dollars to try
to halt periodic dollar depreciation.
In the last eight months,
the Fed and other central banks have sold dollars in the face of
a rising dollar.
This policy is puzzling and dangerous given the Fed's concern
with U.S.
"external imbalances."
If the Fed is attempting
to
maintain a small range for the value of the dollar, it may be
inhibiting
the
"imbalances."
one
economic
variable
that
can
remove
the
Equilibrium in the balance of payments requires a
freely fluctuating exchange rate.
There
is a further
complication with
selling dollars on
international markets at a time when there is pressure
for the
dollar to rise and the Fed is pursuing monetary tightening at home.
180
10
Selling
dollars
accommodates
internationally.
the increased demand
for dollars
Yet, if these dollars are spent and invested in
the United States, the Fed is contributing to an increase in the
nation's money supply.
It may be a Catch-22 situation.
High
interest rates at home make investment in U.S. securities attractive to foreign holders of dollars.
the dollar rises.
They demand more dollars and
The Fed then supplies more dollars in order to
stabilize exchange rates, which, in turn, come into the United
States.
This prompts the Fed to raise interest rates even more in
pursuit of its tightening strategy.
In this way, a policy of tightening money supply at home is
inconsistent with a policy of stabilizing exchange rates abroad.
One of these policy objectives must be dropped.
The Fed should
stop intervening in foreign exchange markets.
ECONOMIC GROWTH DOES NOT CAUSE INFLATION
Inflation represents a general rise in prices or, to put it
another way, a decline in the value of money.
History shows that
any given level of inflation can occur with a wide variety of
growth rates in the economy.
What is important is the difference
between the amount of money growth required to keep prices stable
at a given rate of economic growth, and the actual amount of new
money created.
181
ii
Because it seems to have so much trouble finding the right
amount of money growth, the Fed appears to try to manipulate the
rate of economic growth —
the
Army
Corps
of
a truly perverse outcome.
Engineers
determined
that
It's as if
its
surveying
instruments were so imprecise and its engineering theory so flawed
that it could not erect the bridge at the proper elevation or even
get a drawbridge to work right.
Undaunted, it attempts to lower
the river.
By invoicing the phrase "inflationary pressures," the Fed is
saying the river is too high.
The pressures to which they are
referring are related to excessive economic growth, an economy
operating too close to full employment, and domestic demand that
is supposedly about to explode.
Today's
inflation.
economic
growth
does
not
threaten
accelerating
In testimony before Congress last month, Fed Chairman
Alan Greenspan gave a litany of things related to economic growth
that cause inflation.
(Notable by omission was his failure to
mention that inflation is always a monetary phenomenon.)
Perhaps
the things he mentioned were intended to assuage Congress and the
American people, to show the Fed was on top of things and more than
reawiy to be restrictive
in an effort to fight inflation.
But
perhaps the Fed analysts believe that growth causes inflation. If
they do, they are wrong.
What does the Fed emphasize as being important in gauging
"inflationary
pressures"?
It talks about "overheating"
in the
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12
economy stemming from economic growth, which is creating capacity
constraints and tightening
labor and product markets, and the
threat of excessive demand, which is heating up from consumers,
government, investors and foreign buyers.
Among the most promin-
ently mentioned "inflationary pressures" are the falling unemployment rate, increased capacity utilization, rising wages, rising
commodity prices, droughts, higher import prices, a falling dollar
and the desire for greater profits.
The notion that falling unemployment will lead to rising wages
and prices, the "Phillips Curve" in economics, is a discredited
theory. High rates of inflation are associated with high, low, and
medium levels of unemployment.
For much of the 1980s, inflation
and unemployment have fallen.
In the United States in 15 of the
last 38 years, there have been below-average unemployment rates
along with below-average inflation rates.
In the other 23 years,
in which unemployment was above 5.4 percent, the rate of inflation
averaged 4.8 percent, considerably above the average since 1950.
Rising capacity utilization is one of the most frequently
cited
indicators
of
"inflationary
pressure."
In July, the
utilization rate for total U.S. industry rose in July to 83.5
percent, 2 percentage points above the 1967 to 1987 average of 81.5
percent.
today.
However, supply "bottlenecks"
Capacity
industries
that
utilization
supply
declined since December.
in
inputs to
are less of a problem
primary
processing,
"advanced" processing,
those
has
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13
The same Fed statistics also show that, due to increased
investment, capacity growth has increased.
capacity utilization was reached in 1973.
The recent peak for
To reach that same peak
utilization rate by late 1989 with today's capacity growth, output
growth would have to almost double — a highly unlikely occurrence.
As to rising commodity prices and rising import prices, these
are not inflationary.
to
supply
They represent relative price changes due
and demand conditions
for the goods
in question.
Increases in certain prices cause a reallocation of demand toward
goods that become relatively cheaper.
There are ample substitute
suppliers for imported goods and most commodities, which make
reallocation a simple, normal part of everyday business activity.
Even profit-seeking businesses cannot add to inflation.
As
much as they would like to raise prices and add to their profits,
they cannot, unless demand is strong enough and competitors go
along. If one seller raises prices, the others may not follow suit
for the simple reason that they become more competitive relative
to the seller who raises prices.
Their incentive is to undercut
the price rises unless demand is sufficient enough that they can
sell all they want at the higher price.
No business can, therefore, raise its prices just because its
costs go up.
Whether wages rise or prices of other inputs into
production rise, businesses can only profitably raise prices they
charge if competitors
also raise prices.
The rise in com-
petitiveness in the U.S. economy has been a major factor inhibit-
184
14
ing inflation, and there is no evidence that competitive pressures
are slowing down.
Indeed, the competition is more intense due to
the larger amounts of output that must be sold every day.
As to fears of rising and "excessive" demand, there is no
evidence that consumption spending is out of control.
Since 1980,
consumption growth has been just under the increase in overall GNP
growth.
The latest numbers show that consumption is growing more
than a full percentage point below GNP growth.
During the past
year, real GNP grew by 4.3 percent, and consumption grew by only
2.4 percent.
Foreign demand for U.S. exports, however, has
increased. Yet, current governmental statistical releases indicate
that retail sales and other indications of consumer spending are
rising less than production.
The problem with raising interest rates is that it attacks
the supply-side of the economy first by lowering investment and,
hence,
production.
Households
or
consumers,
however, will
experience a rise in disposable income from rising interest rates.
Households are net creditors and rising interest rates increase
their income.
Thus, the Fed has unwittingly chosen a sure path to
reducing economic growth and placing more pressure on prices to
rise.
Households that are not net creditors, mainly lower-income
workers, will not experience rising incomes. If Fed policy retards
economic growth, this will cut back the growth in low-income jobs.
185
IS INFLATION ACCELERATING?
There is no clear trend in reported price statistics.
government statistics on indexes reported recent rises.
Some
However,
most indexes, including the CPI and the GNP deflators, have risen
less in the past year than in the previous year.
rate of increase
For example, the
in the CPI had been falling from the second
quarter of 1987 through the first quarter of 1988.
That served'to
bring the year-over-year rate of inflation down from 4.5 percent
in August 1987 to 3.9 percent in February 1988.
The July 1988 CPI
has risen to a 4.1 percent rate of inflation over July 1987, a
lower rate of increase than the economy experienced one year ago.
There are other indicators of inflation that are pointing to
less inflation.
Commodity prices, which are considered an early
warning of higher prices generally, have stopped increasing at 10
percent rates.
In the last two months, commodity price indexes
increased by only about 4 percent.
Another indicator of inflation is the value of the dollar,
which has been signalling disinflation pressures for most of 1988.
A final indicator, the interest rate yield curve, is also showing
that inflation is not accelerating.
The difference between short-
term and long-term interest rates is considered to be an indication
of how much inflation expectations are built into interest rates.
A small difference (a flat yield curve) indicates a lack of concern
over accelerating inflation.
For most of 1988, the yield curve has
186
16
become flatter, as short-term interest rates have risen and longterm rates have risen to a lesser degree.
CONCLUSION
Part of the public debate over appropriate monetary policy has
focused on the noninflationary growth potential of the American
economy.
Recent U.S. real economic growth is above the postwar
average, and this causes concern for many.
There are many elements to the debate, but few answers.
It
is conceivable that growth potential is a great deal higher than
the approximately 2.5 percent real growth that the Fed assumes in
its policy deliberations. Macroeconomic theory sheds little light
on growth potential.
But reality does. Currently, the labor force
is growing by 1.5 percent; labor productivity is up by 1.4 percent
annually; and industrial capacity is growing at about 2.5 percent.
When these elements of overall economic growth are added, they give
an estimate of total potential growth in GNP of over 5 percent.
Whether this method is accurate to a decimal point is not the
issue.
The point is that the Fed may be severely underestimating
potential GNP growth.* How it makes these estimates and how these
estimates affect policy should be of vital interest to Americans.
Therefore, we suggest that Congress consider a first step in
opening the Fed policymaking procedures by requiring it to publish
its Federal Open Market Committee minutes within 48 hours of
187
completion of its meetings.
In summary, we believe that it is not economic growth, that is
causing inflation or making inflation more of a threat to the U.S.
economy. Today's inflation is the remnant of earlier Fed mistakes.
We have shown that the evidence of accelerating inflation is
unconvincing, and argued that the theory underlying the belief that
growth is inflationary is flawed.
Unfortunately, Congress cannot instruct the Fed to use proper
economic reasoning.
But in current and future hearings held by the
Committee, the debate over how to view the economy should be
expanded and improved.
188
3H.&. $ou*e of »epre*entattoe*
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
ONE HUNDREDTH CONGRESS
tttftyitffton, »C 20515
July 12, 1988
I am pleased to invite you to appear before this
Subcommittee and present your views on the current state of the
economy. The Subcommittee is particularly concerned with the
potential problem of inflationary pressures stemming from the
current economic expansion. Though you may structure your
testimony as you wish, you may find the following questions a
useful guide:
(1) Many analysts are surprised at the continuing robust
expansion of the economy, in light of the persistence of large
budgetary and external imbalances, major swings in exchange rates
and the unprecedented shock of last year's collapse of the stock
market. To what do you attribute the current strength of the
economy? Is our current growth rate more or less sustainable
without major shifts in economic policy?
(2) Beginning with the recovery of 1983 the current
expansion has combined strong real growth with declining and then
stable inflation. Can this fortunate pattern persist? Do you
see evidence, from your vantage point, of serious inflationary
pressures building up in our economy?
(3) Many observers view the Fed as applying modest restrain
very gradually and cautiously, in an attempt to calm inflationary
expectations without retarding real growth. Is this an accurate
reading of current monetary policy? Given your assessment of the
threat of inflation, is the current stance of monetary policy
appropriate?
(4) Are there particular economic developments which should
weigh heavily on the current conduct of monetary policy? For
example, some economists think we will need further dollar
depreciation, yet the dollar has been surprisingly strong on the
foreign exchange markets. Is this a cause for concern,
indicating that monetary policy might now be too tight? Or is it
a welcome development, one that will help keep inflationary
expectations in check and interest rates at lower levels than
otherwise possible?
(5) To mention other examples, do the current drought
conditions affecting the agricultural sector, or the emerging
heavy losses among thrift institutions, pose particular problems
that should influence the conduct of monetary policy?
(6) On a more general level, considering macroeconomic
policy as a whole — spending, taxing, monetary policy, exchangerate management — what significant policy changes, if any, do
you see necessary, in the next Administration, in order to
continue reasonable and sustainable economic growth, without
generating serious inflation?
Please regard these questions as a catalogue of the issues
of concern to the Subcommittee, and feel free to pick from them
the ones you deem most appropriate for the focus of your
testimony.
Si
ouci»»». ~. «~al. Chairman
Subcommittee on Domestic Monetary Policy
@FedFRASER