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CONDUCT OF MONETARY POLICY
Report of the Federal Reserve Board pursuant to the
Full Employment and Balanced Growth Act of 1978,
PX. 95-523
and The State of the Economy
HEARING
BEFORE THE
SUBCOMMITTEE ON
DOMESTIC AND INTERNATIONAL MONETARY POLICY
OF THE
COMMITTEE ON BANKING AND
FINANCIAL SERVICES
HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTH CONGRESS
FIRST SESSION
JULY 19, 1995
Printed for the use of the Committee on Banking and Financial Services
Serial No. 104-26
U.S. GOVERNMENT PRINTING OFFICE
92-345 CC
WASHINGTON : 1995
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
ISBN 0-16-047628-3
HOUSE COMMITTEE ON BANKING AND FINANCIAL SERVICES
JAMES A. LEACH, Iowa, Chairman
BILL McCOLLUM, Florida, Vice Chairman
HENRY B. GONZALEZ, Texas
MARGE ROUKEMA, New Jersey
JOHN J. LAFALCE, New York
DOUG BEREUTER, Nebraska
BRUCE F. VENTO, Minnesota
TOBY ROTH, Wisconsin
CHARLES E. SCHUMER, New York
RICHARD H. BAKER, Louisiana
BARNEY FRANK, Massachusetts
RICK LAZIO, New York
PAUL E. KANJORSKI, Pennsylvania
SPENCER BACHUS, Alabama
JOSEPH P. KENNEDY II, Massachusetts
MICHAEL CASTLE, Delaware
FLOYD H. FLAKE, New York
PETER KING, New York
KWEISI MFUME, Maryland
EDWARD ROYCE, California
MAXINE WATERS, California
FRANK D. LUCAS, Oklahoma
BILL ORTON, Utah
JERRY WELLER, Illinois
CAROLYN B. MALONEY, New York
J.D. HAYWORTH, Arizona
LUIS V. GUTIERREZ, Illinois
JACK METCALF, Washington
LUCILLE ROYBAL-ALLARD, California
SONNY BONO, California
THOMAS M. BARRETT, Wisconsin
ROBERT NEY, Ohio
NYDIA M. VELAZQUEZ, New York
ROBERT L. EHRLICH, Maryland
ALBERT R. WYNN, Maryland
BOB BARR, Georgia
CLEO FIELDS, Louisiana
DICK CHRYSLER, Michigan
MELVIN WATT, North Carolina
FRANK CREMEANS, Ohio
JON FOX, Pennsylvania
MAURICE HINCHEY, New York
GARY ACKERMAN, New York
FREDERICK HEINEMAN, North Carolina
KEN BENTSEN, Texas
STEVE STOCKMAN, Texas
FRANK LoBIONDO, New Jersey
BERNARD SANDERS, Vermont
J.C. WATTS, Oklahoma
SUE W. KELLY, New York
SUBCOMMITTEE ON DOMESTIC AND INTERNATIONAL MONETARY POLICY
MICHAEL CASTLE, Delaware, Chairman
EDWARD ROYCE, California, Vice Chairman
FRANK LUCAS, Oklahoma
FLOYD H. FLAKE, New York
JACK METCALF, Washington
BARNEY FRANK, Massachusetts
BOB BARR, Georgia
JOSEPH P. KENNEDY II, Massachusetts
DICK CHRYSLER, Michigan
CAROLYN B. MALONEY, New York
LUCILLE ROYBAL-ALLARD, California
FRANK LoBIONDO, New Jersey
THOMAS M. BARRETT, Wisconsin
J.C. WATTS, Oklahoma
CLEO FIELDS, Louisiana
SUE W. KELLY, New York
ROBERT NEY, Ohio
MELVIN WATT, North Carolina
JON FOX, Pennsylvania
BERNARD SANDERS, Vermont
(ID
CONTENTS
Page
Hearing held on:
July 19, 1995
Appendix:
July 19, 1995
1
37
WITNESSES
WEDNESDAY, JULY 19, 1995
Greenspan, Hon. Alan, Chairman, Board of Governors, Federal Reserve
System
APPENDIX
Prepared statements:
Castle, Hon. Michael N
Maloney, Hon. Carolyn B
Greenspan, Hon. Alan
38
41
43
ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Board of Governors of the Federal Reserve System, "Monetary Policy Report
To The Congress Pursuant to the Full Employment and Balanced Growth
Act of 1978,*July 19, 1995
(HI)
57
CONDUCT OF MONETARY POLICY
WEDNESDAY, JULY 19, 1995
HOUSE OF REPRESENTATIVES,
COMMITTEE ON BANKING AND FINANCIAL SERVICES,
SUBCOMMITTEE ON DOMESTIC AND INTERNATIONAL
MONETARY POLICY,
Washington, DC.
The subcommittee met, pursuant to notice, at 10:03 a.m. in room
2128, Rayburn House Office Building, Hon. Michael N. Castle
[chairman of the subcommittee] presiding.
Present: Chairman Castle, Representatives Royce, Lucas,
Metcalf, Chrysler, LoBiondo, Watts, Kelly, Ney, Fox, Flake, Frank,
Kennedy, Maloney, Barrett, Fields, and Watt.
Also present: Representatives Leach, Roth, LaFalce, and Bentsen.
Chairman CASTLE. The subcommittee will come to order.
The subcommittee meets today to receive the semiannual report
of the Board of Governors of the Federal Reserve System on the
conduct of monetary policy and the state of the economy as mandated in the Full Employment and Balanced Growth Act of 1978.
Chairman Greenspan, welcome back to the House Committee on
Banking and Financial Services Subcommittee on Domestic and
International Monetary Policy, probably the longest named committee you appear before.
Today we will have 5-minute opening statements by the members of the subcommittee who are present. In addition, some members of the Full Committee will sit with us this morning and they
will be permitted to ask questions if they wish. As always, any prepared remarks presented will be accepted for the record.
As you know, Mr. Chairman, we are in legislative session even
as we speak and we may have to occasionally break for votes. We
will try to do that around the 10 minute mark and resume as
quickly thereafter as the votes end over on the floor. I think you
have been through this before. It's a necessary interruption that we
have to sometimes live with.
By several definitions it might well be claimed that the projected
soft landing has been achieved by the national economy. In the
buildup to this point we have seen the Federal funds rate double
from 3 percent to 6 percent in seven steps over the 13 month period from February 1994 to February 1995. Nearly 2 weeks ago a
signal was sent to the markets via the lowering of the Federal
funds rate by one quarter percent.
Pundits divide on whether the soft landing to slower growth has
been achieved or the economy is being pushed back into recession.
(1)
Reading the indicators at these junctures is at best a chancy business, so we will welcome any comments you care to make on what
you see ahead with regard to inflationary pressures, the international value of the dollar and the future of interest rates, to
name a couple of items.
In addition to the normal complaints from editorial writers regarding the policies of the Fed we are beginning to see arguments
that the Federal Reserve may no longer be relevant as an institution. This argument is the opposite of those who fear your power
to pump up or choke off economic expansions. Indeed, with the
emerging market technologies and the ability to trade and transmit
enormous sums around the world nearly instantaneously, this
school asserts that the Fed is a toothless tiger that no longer influences a large enough part of the economy to matter.
This subcommittee will be inviting you back after the recess as
we continue our exploration of the future of money and the payment system in the dawn of the age of electronic cash and stored
value cards. We will open this investigation next week with testimony by private sector innovators and entrepreneurs in the field.
This will be followed with another hearing involving the views of
the Federal Reserve System, the IRS, the Financial Crimes Enforcement Network, the Secret Service, the Mint, and others concerned with the public policy questions raised by these new facts
and technologies.
Since our last Humphrey-Hawkins hearing, this Congress has altered the expectation of the marketplace by largely enacting the
Contract with America. This has reshaped economic realities by
providing the prospect of a genuinely balanced Federal budget. Significant change also is underway with regulatory reform and major
cuts in domestic and foreign spending that all must affect the Federal Reserve System calculus. Meanwhile the dollar appears to
have bottomed out overseas and may even be demonstrating additional signs of strength relative to most foreign currencies. We
would welcome any insight into how these new factors have shaped
your perceptions or altered your models.
Your chairmanship of the Federal Reserve continues to be
marked by unprecedented openness both with Congress and the
public. This is most appreciated on this side, especially since I
know that changing the culture at the Fed makes your life more
difficult.
That concludes my opening statement. I will turn to Mr. Flake,
the ranking minority Member for his opening statement.
[The prepared opening statement of Hon. Michael Castle can be
found in the appendix.]
Mr. FLAKE. Thank you very much. Mr. Chairman, it is certainly
my pleasure to welcome Chairman Greenspan to this HumphreyHawkins Act subcommittee hearing to discuss the Federal Reserve's conduct of monetary policy.
I also want to commena you, Mr. Chairman, for your leadership
on the various issues of this subcommittee, those which we tackle
today and those which we will tackle in the near future.
Some issues, like the Federal Government's role in minting and
issuing currency, will directly affect the Federal Reserve's ability to
manage and influence the Nation's economy. So I look forward to
seeing the result of our next hearings as we move to discuss those
issues.
Chairman Castle, I will be very brief in my comments, as I want
ample time for Chairman Greenspan's testimony and questions
from the subcommittee.
When we last welcomed Chairman Greenspan there had been a
tremendous amount of concern about the impact of seven interest
rate increases over the past year. My particular concern was the
impact of these increases reflected in the housing market and the
effect that these increases would have on affordable housing
markets.
Although interest rates have decreased, I remain concerned
about the availability of affordable housing units and note indicators for leasing and sales of existing housing along the eastern seaboard. Recent reports suggest that Boston, New York, and the District of Columbia have sagging residential rental markets. I hope
to hear Mr. Greenspan's comment on housing availability and
affordability.
Moreover, I would like to hear comments on the future projections on the average American's ability to find an affordable home.
Mr. Chairman, I have other questions for Chairman Greenspan,
but for now I thank him in advance for his contribution and comments to the Committee and await the hearing of his testimony. I
yield back the balance of my time.
Chairman CASTLE. Thank you, Mr. Flake.
Now we will go, alternating from side to side, through the various members who might wish to make opening statements.
Mr. Lucas.
Mr. LUCAS. No statement.
Chairman CASTLE. Mr. Metcalf.
Mr. METCALF. No opening statement.
Chairman CASTLE. Mr. LoBiondo.
Mr. LoBlONDO. Thank you, Mr. Chairman.
I would like to welcome Chairman Greenspan to the subcommittee. I am sure that we are all very anxious to hear what you have
to say. I want to commend you, Chairman Greenspan, and the
other members of the Federal Open Market Committee for your decision earlier this month to lower the Federal funds interest rate
by 25 basis points.
While I am sure that Chairman Greenspan will not be able to
give a clear indication of what is likely to come from the Fed in
the future, I would hope that it would stick with its tradition of
lowering rates by at least 75 basis points in an easing cycle. Given
that the mortgage lending in my area does not appear to be increasing, I believe that lower rates could help those people who
want to fulfill the American dream of owning a home while at
the same time providing much needed jobs in the construction
industry.
While lower rates may help our economy in the short run, they
are not a long-term answer. They can only remain low so long as
the economy does not show signs of inflation. I believe the longterm answer is a significant reduction in our Nation's crippling
debt.
I am particularly interested in hearing Mr. Greenspan's opinion
of our efforts to reduce the Federal budget deficit. In the last
Humphrey-Hawkins report I was pleased to read the Board's recommendation that both Congress and the Administration make
further progress in reducing the Federal budget deficit.
As we work through the remaining appropriations bills this summer I believe that we must keep in mind that it is through reductions in government spending that we will see a reduction in longterm interest rates, which will then lead to increased productivity
and higher standards of living for our children and grandchildren.
According to data from the Federal Reserve Bank of Philadelphia, important business sectors such as the fabricated metals industry are growing only slightly in my district as well as in your
State of Delaware, Chairman Castle, while more significant growth
is occurring in other parts of the Nation.
We are also seeing declines in other sectors such as industrial
machinery, food, apparel and chemicals. Such information shows
the crucial need for higher levels of productivity that come from
lowering long-term interest rates as a result of the reduction of the
budget deficit.
I would urge my colleagues to examine this and similar information that shows the necessity of acting today to rein in deficit
spending before it is too late.
Thank you, Mr. Chairman, and I yield back the balance of my
time.
Chairman CASTLE. Thank you very much, Mr. LoBiondo.
Mr. Kennedy.
Mr. KENNEDY. Thank you, Mr. Chairman.
Welcome, Mr. Chairman. It's nice to see you this morning. As
you may recall, although it is probably hard to keep everybody up
here straight, I have often felt in the past that the continuous
raises that you have advocated in our interest rates were perhaps
too much, too fast and too quick.
We have seen a number of economic indicators lately that have
indicated that the interest rate increases that the Fed has pursued
have in fact precipitated a real decline in the growth of the economy. The employment rate has fallen significantly since last fall.
The number of workers filing new claims for unemployment compensation has increased. The blue chip economic forecast for real
economic growth for 1995 fell to 2.9 percent. Housing starts have
been declining since the fall. And there is, I think, still a very
strong concern, although the stock market seems to continue to
rise, that the underlying economy is not keeping pace with that
kind of investment.
I would like you, and I am sure you will this morning, to address
your ideas about the fact that while lowering interest rates by a
quarter of 1 percent sends a signal, that perhaps at this point we
need more than a signal, that what we need is a real lowering of
the interest rates to get this economy moving.
I think there is enough sense that we are in sort of economic doldrums and that the overall economy has not had the kind of energy
that had taken place in the previous couple of years, and that people are very, very concerned. Even last night on the news there
were a number of people that were analyzing the market, saying
that it has risen so quickly that it could decline very, very quickly.
It seems to me if you had a real drop in the stock market because people decided they wanted to take profits because the companies' performances couldn't actually keep up with the raises in
stock value that you could end up in a very, very serious recession
in a very short period of time.
I guess my basic point to you is that I think it was an important
step to send a signal of reducing interest rates, but my feeling is
that there should be very serious consideration given toward a real
lowering of interest rates beyond a quarter of 1 percent.
Thank you for coming. I look forward to hearing your statement.
Chairman CASTLE. Tnank you very much, Mr. Kennedy. We appreciate your comments.
Mrs. Kelly.
Mrs. KELLY. I have no statement at this time but reserve my
right to add one to the record later.
Chairman CASTLE. Thank you.
Mr. Royce has just arrived. Do you wish to make an opening
statement, Mr. Royce?
Mr. ROYCE. Yes. Thank you, Mr. Chairman. I just want to welcome Chairman Greenspan. I look forward to hearing his comments
today.
What I would like to do is encourage you, Mr. Chairman, to
speak to the issue of what we here in Congress are doing or should
be doing to help achieve a stable growing economy without inflation. My own view is that the most important contribution that we
could make to that objective would be to balance the budget.
As you know, the House has taken a major step in that direction
by passing a budget resolution which puts us on a glide path to a
balanced budget by 2002. I would be interested to hear whether
you feel that that does in fact put us on the right path.
I believe that balancing the budget and then starting to pay
down the enormous national debt would make your job easier just
as it would ours. Balancing the budget will take pressure off interest rates, free up capital for private investment, improve the competitive position of American industry in the global marketplace,
and reduce the economic pressure on ordinary American families.
For example, I noted recently that at present more than half the
credit generated in the Unitecf States in loans go to Federal, state
and local government. That obviously limits the availability of credit to the private sector. In fact, the same source indicated that only
6 percent of credit goes to private business expansion. Surely balancing the budget will improve this credit drought and give American businesses the capital they need to expand and create jobs.
Thank you again for joining us today, Chairman Greenspan, and
thank you, Mr. Chairman, for allowing me to make that opening
statement.
Chairman CASTLE. Thank you very much, Mr. Royce.
Mrs. Maloney.
Mrs. MALONEY. Thank you very much, Mr. Chairman. I would
like to submit my opening statement for the record. I just would
like to welcome the Chairman. I look forward to your comments,
particularly any ideas that you have about what the Fed can do to
improve the wage prospects of the average working American. They
have not been improving. I look forward to any ideas that you have
of how we can improve the prospects of the average working American family.
Thank you.
Chairman CASTLE. Mr. Leach, would you like to make any kind
of a statement at this time?
Mr. LEACH. Mr. Chairman, no, but I do want to welcome Chairman Greenspan and say that a quick review of your testimony
makes this the most understated optimistic statement of my time
from a Federal Reserve Board Chairman. We welcome your testimony in that light.
Thank you.
Chairman CASTLE. We have two members with us who are not
on the subcommittee, but in light of the fact some of the members
are not here, if they want to make a brief opening statement, I
think it might be appropriate. We will start with Mr. LaFalce and
then we will go over to Mr. Roth.
Mr. LAFALCE. Thank you, Mr. Chairman.
Dr. Greenspan, it is always a pleasure. I hope at some time during your testimony you will address an issue of deep concern to me.
I think the economy and the mix between fiscal and monetary policy is moving in the right direction. I think we have bottomed out
of the decline of our dollar as opposed to other currencies, and so
forth. So what is on the horizon that we should be concerned
about?
While this is not directly within the jurisdiction of the Fed, you
do have a strong voice as Chairman of the Fed to help affect it.
That is a dynamic that is taking place right now in the Congress
and a future dynamic that will take place with the President. Appropriations bills are being passed. It seems to me that these appropriations bills are so confrontational with what would be possibly acceptable to the President that if the bills are presented individually there is going to be a series of vetoes.
Come the end of September, beginning of October, I'm fearful
that we will have very few appropriations bills passed and we
might have to have continuing resolution of whatever duration. But
also there will be an absolute imperative to increase the debt ceiling, and if we do not increase the debt ceiling, government will
cease to function. Not only will government cease to function,
but the bottom could drop out of the markets under those
circumstances.
Also the new majority has a great many reforms of tremendous
controversy, not only between parties but within parties, whether
it's Medicare or Medicaid or welfare reform, and so forth. My big
concern is that we could develop a crescendo here where all these
bills are put in one package, a reconciliation package that will be
totally unacceptable to the President, and he will be forced to veto
it, but it will also contain an increase in the debt ceiling. This could
produce a bit of a crisis in government which could have a very unsettling impact on not only domestic but international markets.
Therefore it is imperative that we proceed on these items individually, welfare reform individually, Medicaid, Medicare, whatever it
might be, individually. The increase in the debt ceiling individ-
ually. The appropriations bills or the continuing resolutions absent
any other substantive changes individually, so as not to precipitate
this crisis which in my judgment is probably the most serious thing
on the horizon over the next several months.
I hope you will comment on that.
Chairman CASTLE. Thank you very much, Mr. LaFalce.
Mr. Roth.
Mr. ROTH. Thank you, Mr. Chairman. Mr. Chairman, Fm not a
member of this subcommittee. I wish I was. I am interested in
what the Chairman has to say and I want to thank you for allowing me to be here today. I have to run back and forth. International
Relations Committee is marking up three bills. Thank you, Mr.
Chairman. It's good to have the Chairman with us.
Chairman CASTLE. I know the feeling about running back and
forth. I've done that too on a few committees in this building.
I believe that completes the opening statements of those present.
If anyone else comes at a later time and wishes to submit an opening statement, it will be accepted unanimously for the record.
At this time, Mr. Chairman, we will turn off the clocks and we
will turn to you, sir, for your statement following which I'm sure
the various members will have questions. We do welcome you. We
do appreciate the very difficult job that you have and the openness
with which you do it, and we look forward to your testimony and
thank you for being here today.
STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD
OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. GREENSPAN. Thank you, Mr. Chairman. I very much appreciate those remarks. It's a pleasure, as always, to appear before
this subcommittee to present the Federal Reserves' semiannual report on monetary policy.
In February, when I was last here for this purpose, I reported
that the U.S. economy had turned in a remarkable performance in
1994. Growth had been quite rapid, reaching a torrid pace by the
final quarter of the year, when real gross domestic product rose at
a 5 percent annual rate and final sales increased at a 5% percent
rate. Inflation had remained subdued through year-end, although
productive resources were stretched. The unemployment rate had
fallen to its lowest level in years, while manufacturing capacity utilization had been pushed up to a historically high level.
As I indicated in February, a slowing of economic growth to a
more sustainable pace with resource use settling in around its
long-term potential was required to avoid inflationary instabilities
and the adverse consequences for economic activity that would invariably follow.
After posting three straight years of consumer price increases of
less than 3 percent for the first time in decades, inflation seemed
poised to move upward. Reflecting market pressures, prices of raw
materials and intermediate goods had already risen considerably,
and a surge in the prices of a variety of imported goods could be
expected to follow the weakening in the dollar through early 1995.
Monetary policy tightenings over the previous year had been designed to K)ster the type of moderation in final demand that would
help damp inflation pressures going forward and sustain the eco-
8
nomic expansion. When we began the policy tightening process, we
knew the previous drags on the economy stemming from balance
sheet stresses and restraints on lending were largely behind us.
But that still did not make it a simple matter to gauge just what
degree of firming in reserve market conditions would be necessary
to produce a financial environment consistent with sustainable economic growth. In the event, the Federal funds rate was raised to
6 percent as the surprising strength in the economy and associated
pressures on resources required a degree of monetary policy restraint to ensure that inflation would be contained.
Fortunately, we started the tightening process early enough and
advanced it far enough that monetary restraint began to bite before
some potential problems could assume major proportions. With inadequate monetary restraint, aggregate demand could have significantly overshot the economy's long-run supply potential and created serious inflationary instabilities.
Moreover, the perceived capacity constraints and lengthening delivery times that come with an overheated economy could have fosterea the development of more serious inventory over-accumulation. In such circumstances, the longer the moderation in output
growth is delayed, the larger will be the inventory overhang and
the more severe will be the subsequent production correction.
As hoped, final sales slowed appreciably in the first quarter of
this year, but inventory investment didn't match that slowing and
overall inventory-sales ratios increased slightly. Although the aggregate level of inventories remained modest, a few major industries, such as motor vehicles and home goods, found themselves
with substantial excesses. Attempts to control inventory levels triggered cutbacks in orders and output that inevitably put a damper
on employment and income.
How the ongoing pattern of inventory investment unfolds is a
crucial element in the near-term outlook for the economy. Production adjustments could fairly quickly shut off unintended inventory
accumulation without a prolonged period of slack output—one that
could adversely affect personal incomes and business profitability,
which in turn could undermine confidence and depress spending
plans.
Under these conditions, final sales should continue to grow
through and beyond the inventory correction, leading to sustained
moderate economic expansion. But a less favorable scenario certainly cannot be ruled out. The inventory adjustment could be extended and severe enough to drive down incomes, disrupt final
demand, and set in motion a period of weak growth or even a
recession.
Useful insights into how an inventory correction is proceeding
often can be gained by evaluating developments in industries that
supply producers of nnal durable products with key primary inputs, such as steel, aluminum, and capital equipment components
and parts. This is because inventory adjustments often are larger
in durable goods and they become magnified at progressively earlier stages in the production process. Typically, when purchasing
managers for durable-goods producing firms find their inventories
at excessive levels, they reduce orders for materials and also for
components of capital goods, and as a consequence suppliers shorten promised delivery times and cut back on production.
In the current instance domestic orders for steel and aluminum
and for some capital equipment components have weakened, but
not enough to have had more than modest effects on production.
Prices of key inputs also suggest that demand so far is holding up
and the inventory correction is contained. The price of steel scrap,
for example, has not fallen, and spot prices of nonferrous metals on
average have stabilized recently after considerable weakness in the
first part of the year. Though still lethargic, the behavior of durable goods materials and supplies markets scarcely evidences the
type of broader inventory liquidation that usually has been at the
forefront of the major inventory recessions of the past.
At the finished goods level, we experienced significant inventory
liquidation in both cars and trucks in May and June. We do not
have comprehensive, up-to-date inventory evaluations for recent
months as yet, but inferring what we can from scattered and partial data, the prospects seem reasonably good for a reduction in inventory investment that moves us a considerable way toward eliminating unwanted stocks.
That process and the longer run outlook for the economy depend
ultimately on the behavior of final sales. In that regard, the slowing of the growth of final sales that began in the first quarter
seems to have continued a little further in the second quarter.
Combining final sales and the likely reduced second quarter pace
of inventory investment, the level of overall domestic production of
final goods and services, or real gross domestic product, evidently
changed little last quarter.
Going forward, of the several credible outlooks, the most probable
is for an upturn in the growth rate of final sales and real gross domestic product over the rest of this year and a moderate pace of
expansion next year with the economy operating in the neighborhood of its potential.
One area of improvement should be our external sector. A significant downside risk when I testified in February related to the situation in Mexico. The economic contraction in that country and the
depreciation of the peso did act to depress our net exports in the
first half of the year. But with the external adjustment of the Mexican economy apparently near completion, this drag should be largely behind us. Moreover, our trade with the rest of the world should
begin to impart a positive impetus to pur economic activity, partly
because of the strong competitive position of U.S. goods in world
markets.
Regarding domestic final demand, financial developments so far
this year should provide important support over coming quarters.
Interest rates, especially on intermediate- and long-term instruments, have fallen a great deal since last fall in reaction to the improved fiscal outlook, the effects on inflation expectations of our
earlier monetary tightening, and, of course, recently, the slowed
economy. Lower interest rates have helped to buoy stock prices,
which have soared ever higher.
The positive implications of the rally in financial markets for
household debt-service burdens and wealth and for the cost of capital to business augur well for spending on consumer durables, on
10
housing, and on plant and equipment. These influences should be
reinforced by the generally strong financial condition and the willingness to lend of depository institutions as well as the receptiveness of capital markets to offerings of debt and equity.
Early signs of a little firming in consumer durable spending are
already visible in the stabilization of the motor vehicle sector. Residential construction also has started to revive, judging by recent
data on home sales and mortgage applications. Unfilled orders are
sizable in the capital goods area, suggesting business investment in
equipment will continue growing, albeit perhaps more slowly than
in the recent past. Finally, rising permits suggest expansion in
nonresidential construction.
An outlook embodying a resumption of moderate economic
growth is conveyed by the central tendencies of the expectations of
the Federal Reserve Governors and Reserve Bank Presidents for
real gross domestic product. After the second quarter pause, a projected pickup in activity in the second half would put output
growth over the 4 quarters of the year in the neighborhood of 1V2
to 2 percent. For next year, projections of real GDP growth center
on 2V2 percent.
The inflation picture is less worrisome than when I testified 6
months ago, just after our last policy tightening. Demands on productive resources should press less heavily on available capacity in
the future than we envisioned in February. This prospect is evident
in the central tendency of the expectations of the Governors and
Presidents for the unemployment rate in the fourth quarter of this
year, which has been3 revised up from about 5V2 percent in February to a range of 5 A to 6V& percent. This outlook for unemployment has been extended through next year as well. Increases in
employment costs to date have been modest, and labor compensation evinces few signs of exacerbating inflation pressures, although
the recent unusually favorable behavior of benefit costs is unlikely
to continue.
Declines in industrial output over recent months have already
eased factory utilization rates closer to their long-term averages.
Reflecting a slowing in foreign industrial economies as well as in
the United States, the earlier surge in prices of materials and supplies has tapered off. Moreover, the stability of the exchange value
of the dollar in recent months bodes well for an abatement of the
recent faster increases in import prices.
Against this background, most Governors and Presidents see
lower inflation over coming quarters than experienced in earlier
months of 1995. The central tendency for this year's 4 quarter rise
in the CPI is 3Vs to 3% percent. And for next year the central
tendency suggests that CPI inflation will be shaved to 2% to SVi
percent.
The success of our previous policy tightenings in damping prospective inflation pressures set the stage for our recent modest policy easing. Because the risks of inflation apparently have receded,
the previous degree of restriction in policy no longer seemed needed, and we were able at the last meeting of the Federal Open Market Committee to3 reduce the Federal funds rate by Vi percentage
point to around 5 /4 percent.
11
Indeed, inflation pressures were damped somewhat more quickly
than we might have expected. This experience underlies the uncertainties and risks in any forecasting exercise. The projections of the
Governors and Presidents are for a rather benign outlook, as are
the views of many private sector forecasters. But these expectations cannot convey the risks and subtleties in the developing economic situation.
A month or so ago I noted publicly that a moderation in growth
was both inevitable and desirable, but that the process could not
reasonably be expected to be entirely smooth, and that accordingly
the risks of a near term inventory-led recession, though small, had
increased. More recent evidence suggests that we may have passed
the point of maximum risk, but we nave certainly not yet reached
the point at which no risk of undue economic weakness remains.
We do not as yet fully understand all the reasons for the degree
of slowing in economic activity in the first half of the year, so we
need to be somewhat tentative in our projections of a rebound. Imbalances seem to be limited, financial conditions should be supportive of spending, and businesses and consumers are largely optimistic about the future. Nonetheless, questions do remain about the
strength of demand for goods and services, not only in the United
States but abroad as well.
Upside risks to the forecast also can be readily identified, particularly if the inventory correction is masking a much stronger underlying economy than appears from other evidence to be the case.
If so, spending could strengthen appreciably, especially in light of
the very substantial increases in financial market values so far this
year.
In a transition period to sustainable growth such as this, reactions to unexpected events may be especially pronounced. This is
not a time for the Federal Reserve to relax its surveillance of and
efforts to analyze the evolving situation. The Federal Reserve must
do its best to understand developing economic trends. While we
cannot expect to eliminate cyclical booms and busts, human nature
being what it is, we should nonetheless try where possible to reduce their amplitude.
Some observers have viewed prospective year-by-year budget deficit reduction as constituting an important downside risk to the
economy. I do not share this concern. In response to fiscal consolidation, financial markets provide an important shock absorber for
the economy. Declines in long-term rates help stimulate private,
interest-sensitive spending when government spending and transfers are reduced.
Clearly the Federal Reserve will have to watch this process carefully and take the likely effects of fiscal policy into account in considering the appropriate stance in monetary policy. But there is no
doubt, in my judgment, that the net result of moving to budget balance will be a more efficient, more productive U.S. economy.
In summary, Mr. Chairman, the economic outlook on balance is
encouraging despite the inevitable risks. The American economy
rests on a solid foundation of entrepreneurial initiative and competitive markets. With the cyclical expansion more than likely to
persist in the period ahead, the circumstances are particularly opportune for pressing forward with plans to institute further signifi-
12
cant deficit reduction. For such actions, by raising the share of national saving available to the private sector, should foster declines
in real interest rates and spur capital accumulation. Higher levels
of capital investment in turn will raise the growth in productivity
and living standards well into the next century.
The Federal Reserve believes that the main contribution it can
make to enhancing the long-run health of the American economy
is to promote stability over time. Our short-run policy adjustments,
while necessarily undertaken against the background of the current condition of the U.S. economy, must be consistent with moving
toward the long-run goal of price stability. Our recent policy action
to reduce the Federal funds rate 25 basis points was made in this
context. As I noted in my February testimony, easing would be appropriate if underlying forces were clearly pointing toward reduced
inflation pressures in the future. Considerable progress toward
price stability has occurred across successive business cycles in the
last 15 years. We at the Federal Reserve are committed to further
progress in this direction.
Thank you very much, Mr. Chairman. I request that my full
transcript be included for the record.
[The prepared statement of Hon. Alan Greenspan can be found
in the appendix.]
Chairman CASTLE. Thank you very much, Mr. Chairman. Without objection, your full transcript will be included for the record.
We appreciate that. We know those words are meaningful, and
when spoken by you they come together very neatly.
We will now proceed with questioning. We will resume the
clocks. Each of us will have 5 minutes. The general rules are that
you can say what you wish in those 5 minutes, at which point we
are quiet, and if you still need to respond, you can, or we go on
to the next person. I will start with the first question.
I want to relate back to when you were here last February. You
painted a picture of an economy whose growth was slowing from
the fast pace of the fourth quarter of 1994, but you reassured us
that "nevertheless, the economy has continued to grow without
seeming to develop the types of imbalances that in tne past have
undermined ongoing expansion."
Later in your testimony, in reference to your forecast for 1995,
you said, "but overall the performance of the economy still should
be good."
By my observation, over the past 3 months total employment in
the United States has fallen by nearly 600,000, industrial production has fallen 3 of the last 4 months, and GDP growth for the second quarter will either be very weak or, using your words, marginally negative. What happened between February and July to
produce an outcome that at least seems so drastically different
from your reassuring forecast?
Mr. GREENSPAN. Mr. Chairman, when you are dealing with a
very rapidly moving economy as we experienced in the latter
months of 1994, and you are putting pressure on it to slow it down
to get it back on track so that the expansion can continue, it is not
easy to make judgments as to precisely how that is going to come
out. It's very much like trying to brake a car when you are coming
up to a particular stop. Sometimes you move from side to side, and
13
you can't predict that in advance. As I said in my prepared testimony, I think that the economy slowed faster than we expected,
considering the way we had imposed a degree of monetary tightening and the balance offerees that we were looking at.
As a consequence of that, we got a quicker response than we had
expected, but it is certainly by no means outside the relative areas
of response that we had anticipated, and it certainly was not a difference in response qualitatively; it was just faster, not different.
Chairman CASTLE. I referenced this in my opening statement.
One of the fascinating developments of the last few years, indeed
the last few months or even weeks or days, has been the rapidity
with which large amounts of money can be transferred from country to country. This has been complemented by the development of
many new financing media which serve as substitutes for the more
traditional financing media furnished by banks.
Have these two developments complicated or diminished in any
way the conduct or effectiveness of monetary policy, or will they in
the future? I am sure it is something that is the subject of a lot
of discussion. If so, how?
Mr. GREENSPAN. Mr. Chairman, we are acutely aware of the very
rapidly changing payment system, both in international finance
and in the internal structure which has evolved in the United
States. We exercise monetary policy by having a certain leverage
on the system. We are the lender of last resort. The Federal Government is the only entity which can create legal tender. As a consequence of that, there are a variety of different means by which
the central bank can create an effective monetary policy.
Over the decades and even in recent years, we have gradually
changed the procedures we employed to exercise that monetary authority as the structure of the financial system changes. I suspect
that we will do so in the future, and it will be dependent upon the
nature of the changes that will be evolving over time. But I see no
reasonably contemplatable notion that somehow or by some means
our leverage will be reduced or eliminated.
Chairman CASTLE. Thank you, sir.
On a different subject, my final question. As you well know,
there have been several competing tax reform programs introduced
in the 104th Congress. Does the Federal Reserve or do you individually favor significant changes to the income tax systems? Do you
support any of the following specific proposals?
A 17 percent flat tax on earned income and the elimination of all
deductions and credits.
A national sales tax on goods and services.
A 10 percent tax rate for families earning up to about $60,000
with families earning more paying progressively higher rates, topping out at 34 percent. This plan would eliminate all deductions except for mortgage interest and would tax money spent on charitable contributions and state and local taxes. Sort of a progressive
simplified tax, I guess.
Mr. GREENSPAN. Mr. Chairman, we at the Federal Reserve do
not, as you might suspect, have any policy position with respect to
any of these initiatives. Nonetheless, we obviously examine them in
some detail, especially if we perceive that they may well be enacted
at some point, because clearly our monetary posture must take into
92-345 0 - 9 5 - 2
14
consideration all various aspects of how the economy is behaving
in addition to the issues I raised in the answer to the previous
question.
I can't give you an answer with respect to how any of us view
personally these various different tax initiatives, but I will tell you
we are watching the process quite closely.
Chairman CASTLE. Thank you, Mr. Chairman. The answer seems
to be you can't give me an answer. I'd love to know what your answer would be if you could give us an answer, but I know you can't,
sir.
Mr. Flake.
Mr. FLAKE. Thank you very much, Mr. Chairman.
You probably noted or received information regarding the home
loan mortgages to minorities which surged in 1994, which has been
revealed today in the American Banker. There are suggestions that
one reason for this increase of loans has much to do with aproaches to CRA. You as the Fed Chair, joined with other reguitors, have done an extensive bit of work over the last several
years. Larry Lindsey, who represented the Fed in the community
reinvestment area, and others have traveled the country, and have
made some determinations in terms of the direction that CRA
ought to go. Yet there are many, even in this body, who have
fought to repeal community reinvestment as we know it.
Mr. Chairman, given these statistics, which are very good and
glowing statistics, would you suggest that this is not the time to
repeal CRA, but rather to let the process that you and others have
been working with over these last several years run its course, and
see if that will indeed get an even greater and glowing report in
the future?
Mr. GREENSPAN. Congressman, let me say that I clearly found
the results that were published quite encouraging. They do show
a significant change. The numbers that we are looking at, as my
colleague Governor Lindsey has said, are startling economic statistics. The orders of magnitude are quite substantial. I must say I
concur in his view.
In my judgment, it clearly indicates that the banking community
is reaching out beyond its normal historic areas of interest in making loans. As you know, under the very extensive restructuring
that we regulators have been implementing in the last year or so
we have come up with a new approach to trying to implement CRA
in an effective manner. And we are doing that because that is what
the Congress stipulates in the law we should be doing, and we will
continue to do that.
We as an organization, as I indicated before with respect to the
question that the Chairman raised about taxes, have tended not to
focus specifically on congressional initiatives. Our job is to fulfill
the legal statutes as promulgated.
If you are asking me, do I think that we are making progress in
this whole area, for a wide variety of reasons, I would say most certainly, yes. I am quite pleased with the progress that is being
made. It is slow; it is not in some cases the way I would like it;
but we are dealing with a very turgid, difficult problem.
I would suggest to you that one of the consequences of the public
discussions on these issues in recent years has been to make the
E
15
banking community, more importantly, the depository institution
system, quite sensitive to the issue that they are really obligated
to make loans throughout their communities and that they should
avoid the deleterious effects on society as a whole of the forms of
discrimination, covert or otherwise, which were undercutting the financial system.
As I have stated many times in the past, I think it is a crucial
aspect of a free market capitalist institution that discrimination
not be involved in the marketplace because it undercuts the efficacy of that.
I think the banking and other depository institutions are beginning to understand that process and are working in that direction.
Without commenting specifically on any legislative initiative, I
have a suspicion that that thrust is going to continue forward, because everyone is beginning to realize it's in the Nation's interest
and indeed in the interest 01 the financial community as well.
Mr. FLAKE. I wholeheartedly agree. I guess my concern becomes
one of, if you do not have the benefit of legal statutes, that might
well be reversed. Will the banks continue to perform as they have?
I'm certain from the relationship I've had with you and with the
other regulators that you will continue to try to assure that discrimination does not apply to lending practices.
Mr. GREENSPAN. That's the law of the land, Congressman, as you
well know, and as far as we are concerned we move in every way
that we can to make certain that the discriminatory practices, especially the more subtle ones which are not necessarily conscious,
do not prevail.
Mr. FLAKE. Thank you. My time has expired. I will have other
questions if we get a second round. I yield back, Mr. Chairman.
Chairman CASTLE. Thank you very much, Mr. Flake.
Mr. Lucas.
Mr. LUCAS. Thank you, Mr. Chairman. I too appreciate the
opportunity to be here to listen to this report on the state of the
economy.
Chairman Greenspan, most Members of Congress have concerns
that are tied closely to their district, and certainly I am no different. In my case, even though 40 percent of my constituency is
urban in nature, I represent otherwise a very predominantly rural
and agricultural district.
I also have the privilege of serving as a member of the Agriculture Committee where we are in the process of drafting the 1995
farm bill.
In light of the potential impact that this public policy could have
on rural economies, I can't help but think back to my days as an
undergraduate student in agricultural economics at Oklahoma
State. I well remember my old ag econ policy professor. He was a
very young man now that I think back, but I think of the gentleman's lectures about how in his perspective the Great Depression
began first perhaps in 1927 in rural America, and it was his view
that the economic conditions that severely impacted my grandparents began with a general decline in farm commodity prices at
that time, and consequently rural America went through a very,
very difficult period long before it made it to the rest of America
in 1929 and 1930.
16
With all of that in mind, I would like to refer to the Fed's June
report on the current economic conditions where it indicated that
crop yields were expected to be below normal and that bankers had
reported an increase in farm loan refinancing requirements. Of
course, with lower crop yields come higher prices, but you have to
have a commodity to sell whatever the price mav be.
I can't help but think about the potentially dramatic cuts in the
farm bill reauthorization we are working on. Those potential cuts
come from both sides of the aisle. That's not a partisan issue.
My personal concern is that if this safety net is removed, it will
perhaps not only jeopardize our Nation's food supplies but the economy of rural America also. I suppose more directly, what are the
implications of substantial, maybe even dramatic cuts in the farm
bill reauthorization, and what would the effect be on this Nation
as a whole if through our actions on Capitol Hill we produce, heaven forbid, a dramatic downturn in the rural economies in this country?
Mr. GREENSPAN. Congressman, I don't want to be a continuous
unanswering witness here, but as I indicated to the Chairman and
then to Mr. Flake, we should not as an institution get involved in
commenting on specific pieces of legislation unless we are directly
involved in the process of implementing that legislation as a primary responsibility of the Federal Reserve.
I grant you it is a very narrow line and it's not an easily sharply
definable issue, because we, as the central bank, are involved in a
lot of different things. Hopefully we are going to try to succeed in
that through what is going to be a very major debate in this country on all various different pieces of legislation that arise as a consequence of the very laudable endeavor to reduce the budget deficit, and hopefully get it to zero.
That is important to us because we are involved in the financing
of the Treasury debt. To that extent, it's the size of the financing
that is crucial to us, not the issue of what tax receipts are, what
expenditures are, and what the various programs are.
I would be delighted at some point to get involved in discussing
the farm economic outlook and the various different aspects of it,
but what I don't want to do is get involved in any way or come out
on one side or the other of what will be an extraordinarily interesting debate on a number of the programs which this government is
involved with.
The one thing I think we are very clear on is that if we have all
of these programs in place, which is currently the case, the American people are supportive of them, all of them, because indeed if
they were not, since we have a very effective democracy, they
wouldn't be in the budget. The problem is not the lack of support
of the programs that are in the budget, it's the fact that when you
add all of the programs up and look at the resources that we have
to finance, we have an arithmetical problem.
All I say to you, without obviously addressing your specific question very purposely, Congressman, is that I hope we come to grips
with this basic issue and resolve the budget problem. While I'm
convinced that every person in the Congress has got certain things
they would hope will not be touched, if we all kept to that view,
the laws of arithmetic would have to be violated if we are going to
17
get to a balanced budget. So I beseech you to recognize that the issues you are raising are very legitimate questions, but the problem
is a much larger one that we have to deal with.
Mr. LUCAS. Thank you, Chairman Greenspan. If there is a second round, I would love to have an opportunity to ask a different
question.
Mr. GREENSPAN. Til be glad to discuss the price of wheat, corn
or soybeans, anything you want, up to a point.
Chairman CASTLE. Thank you, Mr. Lucas. I will let you guys discuss all those prices.
Mr. Frank.
Mr. FRANK. Thank you.
Mr. Greenspan, first, relevant to your discussion with Mr. Flake,
I want to express my appreciation for the testimony and letter Governor Lindsey sent us in which he talked about the interaction
between things like community reinvestment and safety and
soundness and reassured us that there was no evidence that the
legislation undercuts it. That was very helpful. I assume we are
now talking about some legislation where you do have some responsibility, and I take your answer to Mr. Flake to mean that you
believe that the statutes ought to stay in place in terms of nondiscrimination.
Mr. GREENSPAN. The issue that I want to emphasize is that the
efforts that we, the Federal Reserve and the other agencies, are involved with in reducing discrimination have got to move forward
under any set of circumstances, and they will. But I don't want to
comment on any specific pending legislation before this body.
Mr. FRANK. You have perfected the one-way ratchet. You are not
able to comment on anything you don't want to talk about but you
do manage to get into things that you want to, and that's fine.
[Laughter.]
Mr. GREENSPAN. That's why I said it's a very fuzzy line.
Mr. FRANK. There are statutes that you administer. I assume it's
OK for you to comment. Do you think that we should leave those
statutes in place that give you that mandate on anti-discrimination? Absent those statutes, you wouldn't have an anti-discrimination mandate.
Mr. GREENSPAN. No. I'm not sure that I agree with that.
Mr. FRANK. Where would you get it?
Mr. GREENSPAN. The point is that we have a number of various
different statutes that exist for anti-discrimination and the like
which enable us to do a lot of things.
Mr. FRANK. I would like you to tell me in writing which ones you
think should be maintained and which ones repealed.
Mr. GREENSPAN. Are you asking the Federal Reserve Board?
Mr. FRANK. Right. I would ask you to tell me in writing, of the
statues that mandate you to do various anti-discrimination enforcement, if there are any you think should be repealed and which ones
should be maintained
Mr. GREENSPAN. I'll be glad to do that.
Mr. FRANK. Beyond that, you talk about our democracy. I think
it does work very well in most areas, but unfortunately, I think you
and your predecessors out of the best of motives have impaired democracy in one of the most important parts of our life, and that's
18
the economy. The Federal Reserve has become quite strong. It has
survived a lot better than a lot of other political institutions.
You, like most previous Federal Reserve leaders, see inflation as
the major problem. As I read your testimony, for instance, we have
a problem with the standard of living, the wages of workers, but
the wages of workers here appears negative. For instance, on page
8, it is a good thing that "labor compensation evinces few signs of
exacerbating inflation pressures," that is, it's a good thing wages
aren't going up very far.
Mr. GREENSPAN. That's nominal wages. That is not real wages.
That is a very important distinction.
Mr. FRANK. It is an important distinction, but the fact is that
real wages have been suffering for a lot or workers, and that is a
positive in the Fed's overall approach, and the problem we have is
this. You have managed to create a situation in which
Mr. GREENSPAN. The fact that real wages in certain segments of
our society have not moved forward is not a positive.
Mr. FRANK. I read everything I got here today. I don't see any
concern about that. The fact is that the only reference to wages is
to talk about it's a good thing if they don't go up. It may be that
personally and individually you regret that. You are here under the
Humphrey-Hawkins Act, wnich deals with employment, but there
is nothing in here about employment. There is nothing in here
about saying we have a problem. The fact that unemployment is
going to be in a higher range in context appears to be a positive
thing. There is nothing in here which addresses that problem. Not
a word in the testimony and not a word in the report.
The problem is this. With the power the Federal Reserve has
garnered you have become a very powerful force for holding things
down. You are saying that we grew too fast, we created too many
jobs on a net basis over the past couple of years. Unfortunately,
there is nothing in here that talks about the negative social consequences of that. I think we are on the way where you have the
strength that you have as an inflation fighter and don't have any
institutional concern about these other factors.
I understand you believe in the long run we will be better off.
In the long run we will all be dead, and the fact is that the negative social consequences of that kind of erosion which goes
unremarked in your testimony and which your policies in the short
term exacerbate are very negative for this country.
Mr. GREENSPAN. I can't disagree with you more, Congressman. It
has been our experience over the years that if our purpose is to get
a stable, growing economy in which we can achieve increasingly
higher standards of living for not only ourselves—we will all be
dead eventually, I grant you—but for our children and generations
thereafter, if that is our purpose, it is very clear that maintaining
a stable currency, and maintaining a stable non-inflationary environment is a necessary condition for achieving that. It is only the
central bank which has the ultimate capability of making certain
that the degree of inflationary excess engendered by financial conditions can be contained.
So if you are saying to me that we are strongly focused on holding down the inflation rate, I grant you that, and that is basically
what we are all about, but I would disagree with you if you pre-
19
sume that the ultimate focus is not, as I have stated many times
in the past, the maintenance of sustainable long-term economic
growth at the greatest potential that we can have.
Mr. FRANK. What I am saying is that operationally I think your
means have eaten your ends and that given the role that you play
in the economy, that has been the effect. I hope we will have a second round to pursue it.
Chairman CASTLE. Thank you very much, Mr. Frank. Let me just
say, Mr. Chairman, referring to your earlier comments and Mr.
Frank's response, if you perfected that you can't talk about anything you don't want to but can if you do want to talk about it, you
should consider running for Congress. It would work well here.
Mr. Metcalf.
Mr. GREENSPAN. The opening statement, I will say I partly
agreed with the Congressman. He's partly right on that. It was the
rest of his discussion.
Mr. FRANK. Besides, I don't think he wants to step down that
much in power and run for Congress. [Laughter.]
Chairman CASTLE. I can understand that.
Mr. Metcalf.
Mr. METCALF. Thank you.
Chairman Greenspan, in your opening statement you mention
Mexico. About 6 months ago you and I discussed the proposed $20
billion bailout or backing for Mexico. You might remember that I
was pretty vigorously opposed or had deep reservations about that.
About how much of the $20 billion that was finally allotted from
the exchange stabilization fund has been expended and might there
be more?
Mr. GREENSPAN. Out of the ESF it's $11.5 billion and an additional $1 billion in swap arrangements with Mexico. You'll have to
ask the Secretary of the Treasury the second part of the question.
Mr. METCALF. Thank you.
From the view of hindsight, how do you view what we did relative to Mexico? Good? Bad? Indifferent? How would you rate it?
Mr. GREENSPAN. Congressman, as I described it at the time, I
thought it was the least worst of the various alternatives that confronted us. In the event, it has turned out somewhat better than
I would have anticipated. It has by no means completed the task.
There are a lot of gyrations and various other things which inevitably will occur as Mexico works its way back to full stability. But
I don't think there is any question that to date it has gone well and
indeed probably somewhat better than I would have anticipated.
Mr. METCALF. Better than I had hoped too, frankly.
You mentioned
the lower inflation. I think you mentioned CPI of
about 27/s to 3% percent. As I mentioned to you in our discussion
in February, I felt that encouraging foreign entities to help in the
financing of U.S. debt was a pretty big factor along with fighting
inflation. I would like to know, in light of the lowering of the CPI,
and so forth, if lowering interest rates would be a possibility.
Mr. GREENSPAN. I'm sorry. In the context of what?
Mr. METCALF. Of the lowering of the CPI. In other words, right
now inflation is not churning, and maybe we could look forward to
lower interest rates.
20
Mr. GREENSPAN. What the evidence very clearly suggests is that
the expectation of inflation over the maturity of a debt instrument
is a very important factor in determining what the nominal interest rate is. If we continue to get improvements in the inflation putlook, that will be continuously reflected in lower long-term nominal
interest rates. It's a process which works back and forth, as you
well know, Congressman, and it's not a smooth operation.
To the extent that the markets and businesses no longer perceive
inflation as something which they have to take into consideration
in making long-term economic judgments, then there is a tendency
for the inflation premium, so to speak, to be expunged from the
nominal long-term rates, and the rates accordingly turn out to be
lower.
Mr. METCALF. Let's put it this way. At the time that the rates
were very low we were having trouble selling the debt and getting
help on financing the debt. It seems to me that that is pretty
agreed. Can you assure us that that won't be a factor in considering the lowering of the interest rates? I'm in favor of lower interest
rates, obviously.
Mr. GREENSPAN. Congressman, I'm not aware that we have very
many difficulties in selling the Federal debt at lower interest rates.
Indeed, if we did, rates would move up, because essentially what
the Treasury does is to offer Treasury bills, notes and bonds in the
marketplace. It determines the amount that it is offering basically
as a consequence of the difference between receipts and expenditures, and it can't really control that amount of financing. So the
interest rates are set at those levels at which the purchasers of
debt instruments, not only Treasury instruments but all debt instruments, are willing to pay for the instruments. It's the market
which sets those rates.
I don't envisage any conditions, other than very technical issues
with respect to certain types of instruments, of the Treasury experiencing any problems whatever, in the short run, at least, in financing its debt. I do think that the issue that I've raised in previous testimonies, that is if we allow the budget deficit to maintain
the path that is implicit in the current service budget well into the
21st century, I do think that interest rates that the Treasury will
have to pay in order to sell those instruments would go up very
significantly.
Mr. METCALF. I very much agree with you. Thank you.
Chairman CASTLE. Thank you, Mr. Metcalf.
Mrs. Maloney has just returned, but perhaps we should go to Mr.
Watt and then come to Mrs. Maloney.
Mr. WATT. Thank you, Mr. Chairman.
Chairman Greenspan, I apologize for being in and out during the
course of your testimony. I'm trying to participate in the Waco
hearings at the same time I'm doing this. I did, however, have a
couple of areas that I wanted to make inquiry about.
Most of your testimony, probably reflective of your position, deals
with a long-term perspective. I want to deal with a couple of shortterm impacts of the policies that may, as you represent, be positive
long term but in the short term we represent a number of people
who are suffering some of the consequences of those policies.
21
As I recall, at a prior time when you testified before this Committee or another committee, you indicated that it was in effect desirable to have unemployment in our country in the range of 5 percent. Today your testimony suggests that it is clearly desirable long
term to have a balanced budget and that that will yield long-term
positive consequences.
What I want to ask you about is how we deal with the short-term
impact of those policies if those are in fact our long-term government policies. How can we in the interest of implementing those
long-term policies soften the blow for those 5 percent who turn out
to be unemployed, those poor people who turn out to lose substantial expenditures in the process of getting to a balanced budget?
Does your office have a role to play in that process, and if so,
what is that role and how should we be translating what you are
saying to people who in the short term are suffering the consequences of what I may well concede is a long-term good policy?
Mr. GREENSPAN. That is a very important question, Congressman. First of all, let me say I don't recall saying, because I don't
believe it, that any particular unemployment rate, 5 percent or 5V2,
or whatever numbers we are dealing with, is something desirable
in and of itself. I don't believe that.
I do think, however, that when you are dealing with maintaining
the lowest possible rate of unemployment that we can engender in
this country and maintain a stable system, we are talking not
about monetary policy, we are talking about employment policies.
This gets to the question of how do we reduce the actual rate of
unemployment over the longer term to what economists normally
call frictional unemployment, which is essentially voluntary unemployment that occurs as a consequence of people just changing jobs
and the mere fact that they don't immediately get a job.
Mr. WATT. At what rate would you think that frictional unemployment would be?
Mr. GREENSPAN. We haven't really examined this in a number of
years, but I guess it's somewhere between 2 to 3 percent, depending on whatever one determines is frictional. It has not been a subject which, as I recall, has involved considerable efforts in recent
years.
I dp recall several decades ago that there was an official policy
in this government to get the unemployment rate down to 3 percent, which was then perceived to be the frictional rate.
The point that I wish to make is that I do think we ought to engage in various different types of programs, whether it is in the
private sector or in the public sector, to try to bring the elements
of unemployment down, and this is an issue of education, training
and a variety of other issues of which we are all aware.
But it is not, regrettably, an issue which we as central bankers
can do very much about, because we have one single set of instruments which affects the interest rates for the economy as a whole.
We cannot differentiate. We don't have the means to differentiate
between various different segments of the society or different regions of the country. So that our central focus has got to be where
we can actually function, namely, in areas of the total financial system, the total economy, where hopefully our policies will maintain
22
maximum economic growth through maintaining a stable financial
system, and specifically, a stable price level.
If we can do that, what we hope to be able to do as a consequence is raise the overall level, but that does not, as you point
out I think very importantly, say that all individual strata of the
economy are moving together. Indeed, the evidence suggests in recent years that income is being dispersed rather than contracted,
and as I have commented many times before this subcommittee
and on numerous occasions, it is something which I personally
think does not lead to the stability of the society. That is not a Federal Reserve view; it's my own personal view on what has to be
done in this area.
What I am saying is that it's not something which is related to
monetary policy; it's related to a wide variety of other policies
which we will try to support as part of the interaction that monetary policy has with all other policies to a greater or lesser extent,
but it is not something that actions at the central bank as such can
materially affect.
Chairman CASTLE. Thank you very much, Mr. Watt.
Mr. Royce.
Mr. ROYCE. Chairman Greenspan, I apologize for ducking out to
vote on a markup.
About 4 months ago you testified before the House Budget Committee, and at that time you said that the dollar's weakness was
connected to the Federal budget deficit. As a matter of fact, at that
time you linked a 4-day plunge in the value of the dollar with the
Senate's failure to pass a balanced budget amendment. Today in
your testimony you added that a balanced budget amendment
would lead to a more efficient, more productive economy, in your
words.
Mr. GREENSPAN. Actually, I don't think I said balanced budget
amendment. I said a balanced budget.
Mr. ROYCE. A balanced budget. So on that note, since the House
and the Senate have both now put together a plan to lead to a balanced budget within 7 years, my question would be, what would be
the ramifications of such government spending reductions on the
economy, and how would these plans influence the formation and
execution of monetary policy over the short and long run given that
we are moving to just completely zero out that budget deficit?
Mr. GREENSPAN. Congressman, as I've said previously and I hope
reiterated in today's testimony, whatever the effect of stretching
out the form of the budget deficit reduction over a number of years
as contemplated by both the Congress and the President, neither
one of those time horizons is sufficiently short that its impact on
the economy is very abrupt. All of the various programs that I have
observed are stretched out enough that one would be hard pressed
to argue that there is a short-term major up-front so-called fiscal
drag.
One of the reasons why it is not something which is crucially a
concern is that to the extent that long-term interest rates adjust
to the fact that there is a credible expectation of the budget deficit
coming down significantly, that has an immediate offset on any fiscal drag.
23
As I said further in my testimony, should it turn out that indeed
there is more fiscal drag than we realize, and that the economy
slows down even though long-term interest rates come down, the
central bank has a role in responding to that. I've said that many
times in the past and I merely repeat it today.
All in all, I don't think that there is any reason to be concerned
that the contemplated reduction in the budget deficit, or more exactly, the timeframe in which all of the various programs have
been put forward, is in the range where, in my judgment, there
should be any significant macroeconomic effects. There need not be,
if I may put it that way.
Mr. ROYCE. Thank you, Chairman.
Chairman CASTLE. Thank you, Mr. Royce.
Mr. Kennedy.
Mr. KENNEDY. Thank you, Mr. Chairman.
Chairman Greenspan, I was listening to your testimony and you
mentioned this issue of final sales a number of times in your testimony as sort of being ultimately what has to happen in order to
get the economy moving despite all these other sort of hopeful developments. If the economy is dependent on those final sales increasing, doesn't that mean that you are hoping that we continue
a system which tends to stimulate consumption versus investment?
Mr. GREENSPAN. I'm sorry. I meant by final sales to include in
that investment as well as consumption. The way the term is generally used is it is the gross domestic product less any inventory
investment. Unfortunately, a lot of these terms are sort of economist-type terms and they are not often terribly clear, but that term
as I used it does include investment.
Mr. KENNEDY. In other words, if you put money into your checking account or your savings account or an IRA or something like
that, that woula go into your notion of final sales?
Mr. GREENSPAN. No. It's actually the extent to which that is invested. What we would measure is not the IRA or the saving per
se, but what it is invested in—in other words, if you build a machine or you build a factory or you build an automobile.
Mr. KENNEDY. Is a T-bill considered that?
Mr. GREENSPAN. No. It's only an endeavor to capture the amount
of economic activity, final consolidated sales, excluding only the
change in inventory. So it's really a measure of output of goods and
services.
Mr. KENNEDY. I appreciate the lesson in economic terminology,
Mr. Chairman. I guess what I want to try to understand here a little bit is, you've given a lot of what I'm sure even in your own assessment would be fairly dry testimony about all these kind of
terminologies. Even the guys behind you are smiling a little bit. I'm
sure that wouldn't be a technique on your part to lull us all into
a false sense of security.
Mr. GREENSPAN. I wasn't aware that that was possible,
Congressman.
Mr. KENNEDY. In any event, I think ordinary people are concerned about the fact that they have seen their wages really stagnate for a long period of time.
You see almost every major company in the country through this
sort of productivity increase measurement end up laying off lit-
24
erally tens of thousands of the best jobs that America had to offer.
The notion of sort of the "Leave it to Beaver" or "Ozzie and Harriet" lifestyle seems to be evaporating before ordinary citizen's eyes,
and they have had a very deep concern that over the course of the
last decade or two that they are just not able to make it.
They can't keep up with the costs—I don't mean to be putting
you to sleep, Mr. Chairman—but they don't seem to be able to keep
up with the costs of education. What happens is they generally
sense that they are now on a downward competitive path toward
competing with foreigners that are willing to work for much cheaper wages and have much cheaper costs. So for ordinary citizens
their structure and their lives are in decline where they look at the
stock market and they see these stocks gaining each and every
month, the stock market gaining new heights, and they feel this
terrible disconnect. So it no longer feels that what is good for General Motors is good for them. They just feel that all these institutions that are supposed to be protecting them are in fact abandoning them and they are left to try to kind of swim on their own with
absolutely no one really caring about them.
I'm wondering whether or not you can take some of these dry
statistics and put it into the hopes and dreams of ordinary citizens
about the kind of struggles they are trying to face and now they
should be reacting to this message that you are giving.
Mr. GREENSPAN. First of all, the concerns that you exhibit are
quite real. I agree with you in the sense, as I indicated before, that
there has been a regrettable dispersion of incomes which goes back
to the late 1970's and as best I can judge is still occurring. What
that means is that even though we have average real growth in the
society, if there is a dispersion, there has got to be significant segments of the society which are not growing at all or indeed are
going down in real terms.
I think this is a very considerable concern. As a citizen, as I said
before, if you asked me what is the major threat to our society, and
if I were to list a number of different things, I would list tnis as
a crucial issue, because I think if it divides the society, if it creates
the type of concerns that you are suggesting, I do not think that
is good for any democracy of which I'm aware.
It is true that the rise in stock prices does indirectly benefit vast
majorities of people, because a lot of that stock is held by pension
funds and other types of institutions which are where the savings
of the society are held. But there are people without pension funds,
there are people who are scraping to make ends meet where maybe
their parents were doing rather well. Really, for the first time in
the history of this country you have significant evidence that people's major concern is that their children will not live at the level
of standard of living that they themselves have. I find that a very
disturbing fact.
Does it concern the people who work at the Federal Reserve? It
does. Do we think about it? Yes. Do we study that? Yes, we do. In
fact, a lot of the information I get comes out of trying to understand this process.
As I said before, central banks can only do so much. Our job has
to be to essentially try to maintain a staole financial system which
enables the economy as a whole to function in an effective way.
25
If there were vehicles that we could employ which would essentially come to grips with the types of problems that you suggest,
Congressman, I would think we would implement them, but we
don't have that sort of means. What is required to resolve those
types of problems are issues of education, training, and a whole variety of other types of programs both in the private sector and the
public sector. I would not eliminate the private sector from responsibility in maintaining this particular area.
I think it is terribly important not to get monetary policy involved in areas where we cannot effectively help, because if you dilute the process of monetary policy, I think at the end of the day
we will all be most chagrined at the consequences.
XMr. KENNEDY. Mr. Chairman, could I have 30 seconds to
respond?
Chairman CASTLE. Thirty seconds, please, Mr. Kennedy. Then we
need to move on.
Mr. KENNEDY. I appreciate very much your response, Mr. Chairman. I would just point out that in fact through your monetary policy you do in fact affect the fiscal policy of the country and you
have been outspoken on that. It seems to me that there is a necessary consequence of that to also show the kind of leadership that
I think you implied this morning when you talked about the necessity of our investing in education and job training and those kinds
of issues that are necessary to be able to get our wages up so that
we can get the high wage and competitive jobs that are going to
be available to the world, perhaps not to this country, unless we
make those investments in our own people.
Mr. GREENSPAN. A country's standard of living is ultimately a
function of the individuals in the society. People build machines.
They don't happen by themselves. In a sense we talk about human
capital and in a sense real capital, meaning physical machines and
the like, but it is human beings who build the latter. So ultimately
it is the degree of intelligence, insight, ideas, initiative, entrepreneurship in the population of a society which determines its standard of living.
Mr. KENNEDY. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Kennedy.
Mr. Ney.
Mr. NEY. Thank you, Mr. Chairman.
I have a question on the dollar, but I just want to ask for a brief
response based on a question asked earlier by our colleague Mr.
Watt. He asked you to comment on the unemployment factor
which, I understand your answer is a difficult thing to do. On the
other hand, there are multiple reasons for unemployment and we'll
continue to arrive at that real figure of who is unemployed and factor in if you offered everybody in the country a job some people
would not take a job, but there are a lot of people out there that
want a job. I understand it's a complicated puzzle of why we have
the unemployment and actions by Congress down the road on how
we help or hinder people, and that will be decisions made by
Congress.
Looking fiscally, can you comment on the other end of this, that
if in fact the $4.8 trillion would continue over the next 7 years or
26
10 years? Have you ever looked at what that does to create unemployment? Do you have any hard statistics on that?
Mr. GREENSPAN. When economists look out 7, 8, 9, 15 years there
is a tendency to try to judge what the state of the structural labor
market would be out in the forward period independent of how we
get there. It's an endeavor to, for example, beg the question in part
by saying what would the economy's unemployment rate be if certain programs were in place and the system had degrees of mobility and a variety of other elements that are involved in it. So it's
not that we try to forecast the economy and say that the unemployment rate will therefore be X. We usually do it in the other direction. We say at that unemployment rate with the change in the
labor force and the growth in productivity that we expect over that
period of time, what, under those conditions, will be the level of
economic activity or the gross domestic product.
When you go out longer term, the means by which you forecast
change differs from the way we do it short term. I was describing
the process of inventory adjustments and pricing and all of the variety of other elements that get into the short-term forecast, which
tries to balance supply demand incentives and a variety of other
things. When we forecast longer term, we cannot do it that way because we don't have the tools to do it, and we come around it in
a different way.
There is very little that economic forecasting per se in the usual
sense can add to the judgment as to where the unemployment rate
can be unless we are saying that the economy is going to be operating at levels which for some reason or somehow creates a level of
unemployment which is different from what we could achieve. Very
rarely is that done to any extent that I'm aware of.
Mr. NEY. There are also factors out of your control, disasters,
technology breakthroughs, and I understand that. In general, from
what I have read of your statement, you are recognizing that the
deficit as it stands adds money on to someone and that creates a
system where somebody has to pay for that deficit, and it comes
out of people, and it would be better to have less of a deficit,
obviously.
Mr. GREENSPAN. Yes, but I would say that the argument would
be because lowering the deficit increases domestic saving and
therefore domestic investment, the more likely effect of reducing
the deficit is to raise standards of living, because productivity
would be higher, and levels of real income would be higher.
It's not clear to me that the level of the deficit in the structural
sense tells us terribly much about the issue of unemployment except if it engenders an inflationary, unstable society which creates
a higher level of unemployment because the system is inefficient.
But that's a special case, and I don't think that really relates to
the type of issue that you are addressing, Congressman.
Mr. NEY. Thank you. Since I am running out of time, I just want
to add this last question real quick. Since 1945, as you are well
aware, the dollar has remained the principal reserve currency in
international finance. In that context, would you agree or disagree
that the dollar's current status as the world's preeminent reserve
currency is under threat from any changes of its status?
27
Mr. GREENSPAN. There have been a lot of people who have argued that our reserve currency status is in significant difficulty.
The evidence of that is unconvincing.
What we do see is that if you look at the structure of who is holding what type of currencies as a store of value, which is really what
a reserve currency is all about, it is true that the ratio of U.S. dollars to other currencies has gone down, but that is more a reflection of the fact that the other currencies' countries have made very
major changes since 1945. Indeed, both Germany and Japan were
in very serious condition.
You still get the wide predominance of the desire in the world
to store value in U.S. dollars. Despite the problems that we have
had over the years, in my judgment there is no significant evidence
that we have lost an important amount of status. However, I do
state that we should nonetheless be quite careful to preserve our
reserve currency status, because if we were to lose it, it would have
some very significant effects on U.S. interest rates, economic
growth, and a wide variety of related issues.
I must say to you that I find that a number of the people who
are wringing their hands about the decline in the American currency is not something which I think is based in any way on evidence which I find persuasive.
Mr. NEY. Thank you. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Ney.
Mrs. Maloney.
Mrs. MALONEY. Thank you very much. Following up on my colleague's statement, the dollar has declined this year, roughly 10 to
15 percent to the yen since the first of the year. Do you see this
as continuing? Will the dollar continue to decline? Do you see that
it will rise in value, or will it continue to decline?
Mr. GREENSPAN. Congress woman, there are two things that I try
not to comment on at all. One is a forecast of interest rates and
the other is a forecast of the exchange rate. I don't think I could
do it without becoming so utterly unintelligible that it's probably
a waste of your time. [Laughter.]
Mrs. MALONEY. Combined with the decline of the dollar, this past
month we had a record trade deficit of over $11 billion despite the
fact that the dollar had declined. Some people were saying that if
the dollar declined, then our trade deficit would not grow. Certainly the combination of an increased trade deficit and a declining
dollar is not good. Can you comment on that?
Mr. GREENSPAN. I do think that there are numerous things
which engender trade balances. Remember that a significant part
of the higher than expected deficit in last month's figures was a
fairly marked rise in petroleum imports. Clearly that reflects
inventory adjustments in the United States with respect to oil
requirements; it reflects price changes which are sometimes quite
significant.
While I'm not saying if you strip out the oil data that things look
particularly benign, I do think that, as I indicated in my prepared
remarks, we are likely to see a shift in the other direction, that the
net exports of goods and services, which of course is negative at
this stage, is likely to narrow some as the year goes on. I think
that clearly the competitive position of the United States, all things
28
considered, is obviously one that is much better than it was a number of years ago.
So while I am not particularly pleased with the large trade deficits or current account deficits because they add to the net debtor
position of the United States, I can't say that I think that we are
in a trend now which is likely to worsen particularly. But we will
see whether our internal forecast that I indicated does in fact work
out.
Mrs. MALONEY. If the trend continues of increased trade deficits
and the value of the dollar declining, what would that do to the
American economy?
Mr. GREENSPAN. We cannot be unaware of the consequences of
what a currency decline would have on domestic economic events.
As I've said many times in the past, while we don't focus monetary
policy exclusively on our external exchange rate, we do take into
consideration changes in the exchange rate which have domestic
economic effects to which we respond. I find it most unlikely that
one can project continued rises in the trade deficit, because I think
that the various events that we are looking at at this particular
stage suggest that we should start to improve the trade balance at
some point.
Mrs. MALONEY. Earlier, my colleague Mr. Kennedy was very concerned about the American wages, the American dream. Many people are writing about the fact that Americans don't believe that
they will have a better life for their children, and wage statistics
are showing that wages are declining. Can monetary policy have a
direct impact on wages, and if so, what can the Fed do to encourage businesses to raise wages?
Mr. GREENSPAN. I think the crucial issue is the issue of real
wages. It's the purchasing power of the wages that we should be
focusing on. That relates directly over the longer term to the productivity of the economy. If we are asking how do we get the average real wage up, the answer to that is to get greater growth in
productivity, which in turn implies greater investment in the society, which in turn implies greater saving, and is one of the reasons
why I think that getting the budget deficit down, increasing saving
matters a great deal.
The other issue is the issue that we discussed, which is that even
though the averages are rising in real terms, there is a big dispersion that is going on and there are significant numbers of our society who are not experiencing growth, and indeed some of them are
experiencing declines. That requires a different set of policies generally to address that.
If we don't have growing average real incomes, then the issue of
dispersion becomes a particularly crucial one. If you have a significant growth in real productivity, then one can tolerate a modest degree of dispersion, because everyone is going up but at somewhat
different degrees. So it is crucial that we focus first on trying to
get real economic growth at as rapid a sustainable rate by the implementation of effective policies in the area of investment and
incentives.
Mrs. MALONEY. Thank you very much.
Chairman CASTLE. Thank you, Mrs. Maloney.
Chairman Leach, do you have any questions, sir?
29
Mr. LEACH. Thank you, Mr. Chairman.
Mr. Chairman, in your opening statement and in response to
Representative Metcalf you commented on Mexico and noted what
appears to be a near-term stabilizing result of our policies. As you
know, in response to the decisionmaking this January and February of our government, or what was, more precisely, on the Hill
a lack of decisionmaking, I became very concerned that what we
had inaugurated was a major war for financial stability without
the capacity to wage two or three other substantial wars at the
same time, that the international community is quite capable of
being involved in many skirmishes but perhaps not two wars or
three wars at once.
One of the questions that emerged in reviewing the Mexican situation was, what do we have to do to bolster the crisis prevention
and crisis management capacity to the international community?
At the recent G-7 meeting consideration was given to expanding
the surveillance capacity of the IMF, expanding the General Arrangements to Borrow, and also looking at new approaches potentially to enhancing international law. As you know, I'm an advocate
of structuring a Chapter 11 for the world. I'm wondering if you
would care to comment either on the appropriateness of these new
approaches and the need for looking at additional mechanisms as
well as the timing of such.
Mr. GREENSPAN. Mr. Chairman, you outlined the problem rather
well. The difficulty is, as we all are aware, that with the extraordinary changes that have occurred in the international financial
system, the huge expansion of cross-border capital movements, on
the beneficent side, has been quite helpful to economic growth
worldwide, but on the negative side, creates the potential for significant types of disruptions. The Mexican situation is probably the
first major case which the new finance, if we may put it that way,
has experienced.
If you look at the arithmetic, as we all are aware, and indeed I
think I made this point several months ago before your Committee,
the potential for the types of financing vehicles are extraordinarily
large, in my judgment, perhaps outside the realistic range where
governments could get together and continuously make available
unlimited amounts of finance to solve particular problems of liquidity or even insolvency on the part of sovereign nations. Which leads
to the question, are there other mechanisms such as advance surveillance and other types of things which can be put in place which
would ameliorate the effects of a significant problem within a country or make it far less likely to happen? I think there are numerous
instances where progress can be made in that direction.
Nonetheless, at the end of the day one must look at the question
as to whether in fact there is the potential of creating a mechanism
which would be in effect a workout of a form of default or state of
illiquidity or whatever. I think that the international community,
the finance ministers on the one hand, the central bankers on the
other hand, and combined, are exerting considerable efforts in trying to find a means which can come to grips with this issue in an
effective way.
I would say to you only that one of the difficulties that does
emerge, which is something that we have to recognize and see if
92-345 0 - 9 5 - 3
30
we can address, is that the culture of individual sovereign nations
is really quite different. Bankruptcy statutes in an international
fora are not simple legalisms. They reflect the culture of the society
in the sense that we nave had considerable difficulty, for example,
in trying to coordinate private bankruptcy statutes around the
worm.
The reason is that it's not just a question of being unable to
bring the legal codification together. It's the fact that, for example,
in Europe debtors are considered to be something which should be
reined in more than in the United States. That is, our culture
evolved through our problems with large debt in the 19th century
and major changes in our society, and events of populism have removed the debtor prisons and essentially tried to make the debtor
some way capable of restoring himself.
That has created the details of our Chapter 11 or our Chapter
9 and a variety of other things in ways which are culturally balanced for our society between debtor and creditor. There are different balances in other countries.
We are going to have to work as aggressively as we can to find
ways around these differences to recognize that there is an international basis of achieving these ends and an international imperative that we do it, because we are increasingly becoming involved
in a very major international trading and financial system which
is helping all of us, but we have to recognize that there are shortcomings inevitably to that type of system and we have to find
means which address them in a manner which is feasible.
Mr. LEACH. I appreciate your comments. Let me just conclude by
saying as possibly the last speaker, the summation of anyone listening to what has occurred today just underscores the imperative
need for a professional, competent, independent Federal Reserve
System. Without it, I think stability in this country and around the
world would be substantially lessened. You symbolize that, and we
are appreciative. Thank you.
Mr. GREENSPAN. I thank you very much, Mr. Chairman.
Chairman CASTLE. Unfortunately, Mr. Greenspan, Chairman
Leach may not be the last speaker. [Laughter.]
Chairman CASTLE. Mr. Bentsen is with us. He is not a member
of this subcommittee, but he is a distinguished member of the
Banking Committee. If he wishes to ask questions, we would love
to have nim participate.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman Greenspan, I appreciated your comments with regard
to Mrs. Malone/s questions regarding the trade deficit. It appears
that we do have some form of a structural trade deficit that has
been a problem for this country for over a decade. You answered
some of the questions that I had with respect to that. I have two,
though, that I would like to ask you about.
One, in your report you talk about the impact of Mexico. Certainly that has had an impact of declining exports to Mexico. Can
you attribute the increase in the trade deficit over the recent
months just to Mexico, or are there other problems?
The other question I have is a little bit different. You talked
about the increasing oil imports. Heretofore I have been philosophically opposed to any sort of import fee. I think it's inefficient. Do
31
you think that we have reached a point in time or do you think we
will reach a point in time where the increasing oil imports, resulting in an increase in our debtor status, would outweigh the cost of
moving away from a cheap oil policy, that maybe we should look
at some price floor, we should look at some sort of import fee?
Mr. GREENSPAN. Let me comment seriatim, if I may. The loneterm structural trade deficit is ultimately determined not by trade
per se but by the difference between domestic investment and domestic saving. It really gets to the question as to whether in order
to finance our domestic investment we have to borrow from abroad.
The major element of the current account deficit, which is our
total measure of borrowing from abroad, is reflected in the trade
deficit. So that if our purpose is in the long run to resolve the question of the trade deficit, then the most important thing that we can
do, in my judgment, is to reduce the budget deficit, which would
increase domestic saving and hence narrow the gap between domestic investment on the one hand and total domestic saving on
the other, and that will effectively reduce the underlying current
account deficit and therefore the trade deficit.
In remarking to Congresswoman Maloney, I was referring to
shorter run, competitive pressures in the United States. Over the
long run the real crucial issue is the balance with respect to the
budget deficit, domestic saving, domestic investment, and the balancing item in that, which is essentially borrowing from abroad,
which is the current account deficit, which encompasses mainly the
trade deficit.
With respect to the issue of oil, I think we have to recognize that
there is an issue here of how much oil and natural gas and other
energy imports we need for our system. We have production especially of crude in this country, mainly in Texas, the Southwest, and
Kansas and the North Slope, but it is pretty clear that it is very
difficult to get crude production rising. Indeed we have had great
difficulties in the decade holding up oil production. Natural gas, as
you know, is doing better.
It strikes me that unless we can find a way to significantly either
reduce crude oil consumption in the country or augment our production, the arithmetic forces the import numbers. The question
that I would raise is really an issue of when we are concerned, as
a number of us have been over the years, about the security of our
oil supplies, I think we've got a whole series of other issues that
are related.
I certainly know that your uncle was very much involved with
the issue of various questions of fees, quotas, and all those sorts
of issues. We haven't discussed that in recent years, largely because imports had not been growing for a while. Technologies have
improved quite considerably in both production and especially in
keeping down oil consumption. The gas guzzler is hopefully a thing
of the past, and that has made a big difference.
I do think we are running into the question now where this issue
is re-emerging. I don't have much more to add than we have discussed in past years on that particular issue, but I do think it is
interesting that you should raise it, largely because I was looking
this morning at the trade figures, and I'm saying, I haven't seen
this for a while. And we are beginning to see this same phenome-
32
non which inexorably tends to create questions about security of
our oil resources.
Mr. BENTSEN. Thank you.
Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Bentsen.
Mr. Fox.
Mr. Fox. Thank you, Mr. Chairman.
Thank you, Chairman Greenspan, for coming today and enlightening us.
You sometimes use the price of gold as an indicator of future inflation. What do you expect to see in the next 3 to 6 months for
the price of gold? [Laughter.]
I need to call someone right after you give me the answer, by the
way.
Mr. GREENSPAN. When I was indicating before about the types of
forecasts I don't make, interest rates, exchange rates, I guess I
should have added the price of gold to that.
I don't know. But you are quite correct, Congressman. I do think
that there is a considerable amount of information about the nature of a domestic currency from observing its price in terms of
gold. It's a longer term issue; it's an issue which I think is relevant;
and if you dont believe that, you always have to ask the question,
why is it that central banks hold so much gold which earns them
no interest and which costs them money to store? The answer is,
obviously, they consider of it significant value and indeed they consider it the ultimate means of payment, one which doesn't require
any form of endorsement.
So there is something out there that is terribly important which
the gold price is telling us, and I think disregarding it is to fail to
recognize certain crucial aspects of the values of currencies.
I cannot forecast the price of gold. I can, but I shouldn't. I do
think that it is something, which clearly if we fail to keep an eye
on it, we do it at our own peril.
Mr. Fox. What rate of growth do you think the economy can
achieve in 1995 without generating inflation and an interest rate
increase?
Mr. GREENSPAN. There are a lot of economists who have a fixed
notion of where a particular rate of growth will be. I think the
issue, as I've discussed before the Committee many times, is it's a
far more flexible thing than a point estimate. When I use the word
"potential" I use it in a very broad sense, not a fixed specific which,
if the economy runs up against it, it stops dead.
What does actually happen, though, and we observed this in
1994 particularly, is that as you get up to a certain point you don't
stop, but it becomes increasingly more difficult to moye. It's as
though you are running up against a rubber sheet which in the
early stages of pushing it you can move it very readily, but at some
point it really begins to grip, and that's when you get tight labor
markets, shortages of skilled labor, all sorts of problems wnich create inflationary pressures and interest rate increases.
It was pretty clear that in the latter stages of 1994 we were pretty much pressing up against that rubber sheet and having all the
indications of pressures beginning to emerge—of shortages and
lead times on materials delivery stretching out—all the characteris-
33
tics which have historically led to a significant inflationary set of
instabilities.
When you get to the question of exactly where that potential is,
without raising the question of what type of investments you're
making, what type of incentives there are in the society, what type
of entrepreneurial activity you have, what type of tax structure, I
don't think you can basically fix a number very readily, and I
would be disinclined to do that, largely because there is more give
in this area than I think most of my colleagues in the economic
profession would assert.
Mr. Fox. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Fox.
Mr. Chairman, one or two of us have additional questions. We
have been very fortunate this morning in not having a call to a
vote. We have been a long time sitting here too. These questions
might take maybe 10 minutes total or something of that nature. Do
you want to continue on at this point without a break?
Mr. GREENSPAN. Sure. That's fine with me.
Chairman CASTLE. I'm going to ask one question sort of unrelated to anything we have heard here. It's conventional wisdom,
and I assume you have spoken on it before, although I don't know
that, that we need to increase the savings rates by individual
Americans. Various government methods are used to show how
that could be done, all the way from expanding IRAs to 401(k) expansions. I've even had a chance to study the Chilean pension system, which I'm sure you're familiar with, which is a quasi-private
system in that they invest in the private sector of Chile, and in fact
are restricted to keeping their investments there for the most part.
I guess my question is, do you agree with the conventional wisdom that we should increase our savings rates, and if so, is it
something that we should do individually if we are able to do so,
or should there be different government outlets or tax changes that
would allow this to happen?
Mr. GREENSPAN. There are several points. First, the evidence
clearly suggests that the major way to improve domestic saving in
this society is to bring down the budget deficit, because domestic
saving is arithmetically defined as total private saving minus the
budget deficit, which is a claim on that private saving. So obviously
if you reduce the budget deficit, you increase the net domestic saving of the society.
The evidence is more equivocal on the question of whether various different incentives to save in the tax system have produced
aggregate increases in saving. There is a big dispute, for example,
on whether or not 401(k)'s have added to aggregate saving, and it's
a legitimate issue which technicians differ on, and I'm not sure
that I could add terribly much to the discussion.
The Chilean experience is an interesting one in the sense that
they have instituted an interesting way in which their social security system invests directly in private instruments and as such
does increase the private saving of the society. I must say that
there was some element of that in the Kerrey-Danforth Commission recommendations of about a year ago in which they raised
some elements of approaching Social Security over the very much
longer run to have elements in it of private saving. I recall at the
34
time that I thought that was an interesting issue that we ought to
be looking at.
It's a very tough problem. Anyone who seriously thinks you just
can shift from the type of Social Security government system that
we have today to a private system has not experienced looking at
the details of what that transition implies. But I do think that the
issues that were raised by the Kerrey-Danforth Commission are
something we ought to at least focus on for the longer term.
Chairman CASTLE. Thank you, Mr. Chairman.
We have about 12 minutes until the vote. I know Mr. Flake has
a question and Mr. Frank might have a quick question, and Mr.
Leach might. Let's start with Mr. Flake.
Mr. FLAKE. Mine is relatively quick, Mr. Chairman. As you
know, beginning last term we engaged in some discussion about
the BIF/SAIF question and we've had a number of times to ask you
questions on it. Now that it looks as if we have some movement
toward the thrift institutions paying a large amount of up front,
taking care of bonds, with the banks having some level of participation
Mr. GREENSPAN. You mean the SAIF institutions.
Mr. FLAKE. SAIF institutions, and ultimately the merger of charters.
Can you just give us an overview of your feeling if this is a good
direction or if there are other things we ought to consider in this
process?
Mr. GREENSPAN. I must say I too am pleased, Congressman, that
there seems to be some movement in this direction, because I do
think the situation is inherently unstable, and that basically at
some point, in some manner we've got to come to grips and resolve
this issue once and for all.
We are in the process ourselves of looking at very different issues
which relate to this. It is not in our primary focus, obviously. It relates more to the FDIC and the Treasury Department as the lead
elements in this. But hopefully we may be able to add some insights to a potential solution to our colleagues in the lead agencies
in this regard.
Chairman CASTLE. The Chairman had a brief comment he wanted to make.
Mr. LEACH. No.
Chairman CASTLE. Mr. Frank, we have a couple of minutes.
Mr. FRANK. Thank you, Mr. Chairman.
I was interested in your discussion about 401(k)'s. I think that
is an example of the flexibility with which you can embrace certain
subjects when it becomes useful to do that. I wasn't aware that
401(k)'s were at the core of the Fed's statutory mandate.
Mr. GREENSPAN. I was merely repeating, Congressman, what
other economists have concluded.
Mr. FRANK. I understand that, but repetition with the right tone
of voice is sometimes relevant.
Mr. GREENSPAN. I do not deny that. I grant you your point.
Mr. FRANK. Thank you, Mr. Chairman. Let's see if we can extend
that tendency.
I just want to make a statement that obviously we differ here.
I understand the importance of a stable monetary situation and
35
combatting inflation and your role in it. The problem I think it has
come to is this. The Federal Reserve has become by far the strongest institution precisely because you are so insulated from the dayto-day democratic pressures. It is an institution with the staggered
terms, where people's appointments go a long time.
What has happened, I think, is this. In my view there are some
structural changes going on in the economy, particularly in the
area of labor compensation, that have diminished inflationary pressures. What has happened to working people is that they get the
negative aspect of that, that is, the lack of wage increases similar
to what it has been in the past, some of it real, some of it nominal,
but I think both are involved. Particularly people who are the
mainstream workers who are not the most skilled. They get the
negative of that but they don't get the benefit from it in the Fed's
analysis.
While you look at that intellectually in terms of your estimates
of inflation—I think this is what has happened over the past couple
of years—you err on the side of assuming things are as they were.
You are not yet ready to think there might be some real cnanges.
So you then conclude that we had too much employment growth
and that the economy was growing too quickly over the last couple
of years.
The consequence then is to slow that down so that higher unemployment becomes a positive, a lower rate of wage increase, both
real and nominal, is treated, it seems to me, in the statement as
positive, and what we get is a terrible exacerbation of social tensions in this country, an inability to deal as much as we would like,
and it affects immigration, it affects welfare, it affects views of discrimination, because you do have this tightening.
I would say to you, given the centrality of the Fed making economic policy, it isn't enough simply to say, OK, we will be as tough
a we can on inflation; the rest of you figure that out. The consequence of that is terribly destabilizing socially in this country,
and I think you are going to have to help us figure out how we can
deal with that problem of the dispersion that you discussed and its
negative consequences within the framework that you are trying to
pursue.
Mr. GREENSPAN. Let me say in response, Congressman, you are
making an extraordinarily important conclusion if it is true, namely, that there is some fundamental change in the international
structure of our economy such that inflation no longer has any capacity to
Mr. FRANK. Mr. Greenspan, you know you are overstating me.
That's not what I said at all. What I said was, I think the role of
labor has changed and that it is less inflationary. I didn't say there
was no danger at all.
Mr. GREENSPAN. OK. Let me then readjust to the word "less."
We recognize and indeed I have stated in the past that I do believe that there are elements which have created lesser wage pressures. Mainly, as I put it, there is a sense of insecurity among the
large groups of people whose job security has clearly diminished.
In fact, I think the last time I was before this Committee, or a previous time, I stated explicitly that I thought that one of the crucial
issues holding nominal wages in check was a sense of insecurity on
36
the part of a large segment of our job population who essentially
were not pressing for higher wages but were far more interested
in the security of jobs. That fact will keep nominal wage increases
under less pressure than they would have been in the past. That,
other things equal, diminishes inflationary pressures in the society.
I submit to YOU that we do consider that and we do consider that
in some detail in making judgments as to what type of monetary
policy we think is required. If we did not conclude that, I would
suggest to you that a far tighter policy would probably have been
required as we came out of 1993 into 1994 than in fact prevailed.
I say to you that, yes, we do consider that. We do think that is
important.
When you get to the broader questions of income dispersion, I
hope that we intellectually can make a contribution to that, if we
could figure out ways of understanding the process better. In that
regard, all people who are familiar with the structure of these markets, whether they are in the private sector, in universities, in government or the like, have an obligation if they can make some
contribution to this issue to do so.
Chairman CASTLE. Mr. Chairman, we are going to have to run
to our vote. We thank you very much for being here today. The
meeting of the subcommittee stands adjourned.
[Whereupon at 12:25 p.m. the hearing was adjourned.]
37
APPENDIX
July 19, 1995
38
House Committee on Banking and Financial Services
Subcommittee on Domestic and International Monetary policy
Humphrey-Hawkins Hearing with testimony from Alan Greenspan,
Chairman of the Federal Reserve Board, 10:00 a.m., July 19, 1995
Room 2128 Rayburn House Office Building
Chairman Michael N. Castle's Opening Remarks:
Hie Subcommittee will come to order.
The Subcommittee meets today, to receive the semi-annual report of the Board of
Governors of the Federal Reserve System on the conduct of monetary policy and the
state of the economy, as mandated in the Full Employment and Balanced Growth Act of
1978.
Chairman Greenspan, welcome back to the House Committee on Banking and
Financial Services, Subcommittee on Domestic and International Monetary Policy.
Today we will have five minute opening statements by the members present. In
addition, some members of the full Committee will sit with us this morning and ask
questions as well. As always, any prepared remarks presented will be accepted for the
record.
By several definitions it might well be claimed that the projected "soft landing"
has been achieved by the national economy. In the build up to this point we have seen
Federal Funds Rate double from three percent to six percent in seven steps over the
thirteen month period from February 1994 to February 1995. Nearly two weeks ago a
39
signal was sent to the markets via the lowering of the Federal Funds Rate by one
quarter percent. Pundits divide on whether the "soft landing" to slower growth has
been achieved or the economy is being pushed back into recession. Reading the
indicators at these junctures is at best a chancy business, so we will welcome any
comments you care to make on what you see ahead with regard to inflationary
pressures, the international value of the dollar and the future of interest rates, to name
a couple of items.
In addition to the normal complaints from editorial writers regarding the policies
of the Fed we are beginning to see arguments that the Federal Reserve may no longer be
relevant as an institution. This argument is the opposite of those who fear your power
to pump up or choke off economic expansions. Indeed, with the emerging market
technologies and the ability to trade and transmit enormous sums around the world
nearly instantaneously, this school asserts that the Fed is a toothless tiger that no longer
influences a large enough part of the economy to matter. This Subcommittee will be
inviting you back after the recess as we continue our exploration of the future of money
and the payment system in the dawn of the age of electronic cash and stored value
cards. We will open this investigation next week with testimony by private sector
innovators and entrepreneurs in the field. This will be followed with another hearing
involving the views of the Federal Reserve System, the IRS, the Financial Crimes
Enforcement Network, the Secret Service, the Mint and others concerned with the
public policy questions raised by these new facts and technologies.
Since our last Humphrey-Hawkins hearing, this Congress has altered the
expectation of the marketplace by largely enacting the Contract With America. This
40
has reshaped economic realities by providing the prospect of a genuinely balanced
federal budget. Significant change also is underway with regulatory reform and major
cuts hi domestic and foreign spending, that all must affect the Federal Reserve System
calculus. Meanwhile the dollar appears to have bottomed out overseas and may even be
demonstrating additional signs of strength relative to most foreign currencies. We
would welcome any insight into how these new factors have shaped your perceptions or
altered your models.
Your Chairmanship of the Federal Reserve continues to be marked by
unprecedented openness both with Congress and the public. This is most appreciated on
this side, especially since I know that changing the culture at the Fed makes your life
more difficult.
41
COMMITTEC ON BANKMG AND
FINANCIAL SERVICES
Culture** of tfie ffintteb &tate«
o( &epre*nttatibc«
VMtiiqtM, BC 20515-3214
OPENING STATEMENT
"Humphrey-Hawkins Hearing"
Subcommittee on Domestic A International Monetary Policy
Thank you Mr. Chairman.
One of the great advantages of serving on this important Subcommittee is the fact that
twice a year we are fortunate enough to receive the report of the Chairman of the Federal
Reserve Board about the likely prospects for the U.S. economy in the coming 18 months.
The last six months have been extremely interesting. After a considerable period of time
in which interest rates have risen quickly in order to slow inflation, the Federal Reserve Board
recently lowered its discount rate by a quarter of a point.
I look forward to the Chairman's explanation of why the Fed chose to lower its discount
rate, and what his reasoning has been as to the timing of that decision.
The economy docs not appear to be coming hi for the soft landing that we have heard
about. There are conflicting indications. I welcome the opportunity to question the Chairman
about what the likely impact of these indicator* is likely to mean, and his view of the likely
prognosis for the future.
Clearly, the Federal Reserve's actions prior to this date have been effective at slowing
growth and keeping a tight rein on inflation.
At the same time, we hear a growing sentiment that while the economy continues to
grow, and worker productivity is up, wages remain stagnant.
The Fed's policy of working to raise interest rates may have had a beneficial impact
on inflation, but it also makes it more difficult for the average American to realize the
American dream by buying a new home, or financing the purchase of a car, or putting their
children through college.
We know that the Fed practices an inexact science. It has to take action before inflation
begins to show up in the economy, and if it falls to act before inflation shows up, by the time
it does act, it is already too late. This increases the likelihood that the Fed will act too
cautiously, and raise interest rates higher than it needs to, to the detriment of the economy.
42
MALQNEY STATEMSNT/July 19, 1995
pagelofZ
Additionally, I think we have to acknowledge that when we accept an unemployment rate
of five and a half or six percent, that means that a significant portion of our population is
unemployed, underemployed or discouraged from seeking employment. This continued
unemployment acts as a drag on wages, and leads many young people to conclude that they will
have to settle for a standard of living that is lower than that enjoyed by (heir parents.
While I fully support the Federal Reserve Board's efforts to keep inflation under control,
I would like to know whether the Chairman has any ideas about what the Fed can do to
improve the wage prospects for the average working American. If the average working person
is not sharing in the benefits of a growing economy, then there is something seriously wrong.
Our economy should provide Americans with the promise of a better day and a brighter
future. And I look forward to the Chairman's suggestions of how die Federal Reserve is going
to take us there.
Finally, I think that we should note that in the information age. business is developing
new forms of money. Cybecbucks are showing up on the internet Cash transactions are
growing rarer. Many people make payments directly through ATM machines and over the
phone, meaning that fewer checks are written. ATM cards make it easier for Americana to
get foreign currency abroad, without having to bring travellers checks.
All of these changes in the way transactions are made must be having an impact on the
money supply, and the way the Fed does business. I look forward to hearing from the
Chairman what he views these changes in the use of money is likely to have on the way the
Fed does business.
Thank you Mr. Chairman.
43
For release on delivery
10:00 A.M. E.D.T.
July 19. 1995
Testimony by
Alan Greenspan
Chairman
Board of Governors of the Federal Reserve System
before the
Subcommittee on Domestic and International Monetary Policy
Committee on Banking and Financial Services
House of Representatives
July 19, 1995
44
Mr. Chairman and members of the Subcommittee. I am
pleased to appear today to present the Federal Reserve's
semi-annual report on r..netary policy.
In February, when I
was last here for this purpose. I reported that the U.S.
economy had turned in a remarkable performance in 1994.
Growth had been quite rapid, reaching a torrid pace by the
final quarter of the year, when real GDP rose at a 5 percent
annual rate and final sales increased at a 5-3/4 percent
rate.
Inflation had remained subdued through year-end,
although productive resources were stretched:
The
unemployment rate had fallen to its lowest level in years,
while manufacturing capacity utilization had been pushed up
to a historically high level.
As I indicated in February, a slowing of economic
growth to a more sustainable pace, with resource use
settling in around its long-run potential, was required to
avoid inflationary instabilities
and the adverse conse-
quences for economic activity that would invariably follow.
After posting three straight years of consumer price
increases of less than 3 percent for the first time in
decades, inflation seemed poised to move upward.
Reflecting
market pressures, prices of raw materials and intermediate
goods had already risen considerably, and a surge in the
prices of a variety of imported goods could be expected to
follow the weakening in the dollar through early 1995.
45
Monetary policy tightenings over the previous year
had been designed to foster the type of moderation in final
demand that would help damp inflation pressures going forward and sustain the economic expansion.
When we began the
policy tightening process, we knew the previous drags on the
economy stemming from balance-sheet stresses and restraints
on lending were largely behind us.
But that still did not
make it a simple matter to gauge just what degree of firming
in reserve market conditions would be necessary to produce a
financial environment consistent with sustainable economic
growth.
In the event, the federal funds rate was raised to
6 percent, as the surprising strength in the economy and
associated pressures on resources required a degree of
monetary policy restraint to ensure that inflation would be
contained.
Fortunately, we started the tightening process
early enough and advanced it far enough that monetary
restraint began to bite before some potential problems could
assume major proportions.
With inadequate monetary
restraint, aggregate demand could have significantly
overshot the economy's long-run supply potential and created
serious inflationary instabilities.
Moreover, the perceived
capacity constraints and lengthening delivery times that
come with an overheated economy could have fostered the
development of more serious inventory over-accumulation.
In such circumstances, the longer the moderation in output
46
growth is delayed, the larger will be the inventory
overhang, and the more severe will be the subsequent
production correction.
As hoped, final sales slowed
appreciably in the first quarter of this year, but inventory
investment didn't match that slowing, and overall inventorysales ratios increased slightly.
Although the aggregate
level of inventories remained modest, a few major
industries, such as motor vehicles >and home goods, found
themselves with substantial excesses.
Attempts to control
inventory levels triggered cutbacks in orders and output
that inevitably put a damper on employment and income.
How the ongoing pattern of inventory investment
unfolds is a crucial element in the near-term outlook for
the economy.
Production adjustments could fairly quickly
shut off unintended inventory accumulation without a
prolonged period of slack output--one that could adversely
affect personal incomes and business profitability, which in
turn could undermine confidence and depress spending plans.
Under these conditions, final sales should continue to
grow through and beyond the inventory correction, leading to
sustained moderate economic expansion.
scenario certainly cannot be ruled out.
But a less favorable
The inventory
adjustment could be extended and severe enough to drive down
incomes, disrupt final demand, and set in motion a period of
weak growth, or even a recession.
47
Useful insights into how an inventory correction is
proceeding often can be gained by evaluating developments in
industries that supply producers of final durable products
with key primary inputs--such as steel, aluminum, and
capital equipment components and parts.
This is because
inventory adjustments often are larger in durable goods and
they become magnified at progressively earlier stages in the
production process.
Typically, when purchasing managers for
durable-goods producing firms find their inventories
at excessive levels, they reduce orders for materials and
also for components of capital goods, and as a consequence
suppliers shorten promised delivery times and cut back on
production.
In the current instance, domestic orders for
steel and aluminum and for some capital equipment components
have weakened, but not enough to have had more than modest
effects on production.
Prices of key inputs also suggest
that demand so far is holding up and the inventory correction is contained.
The price of steel scrap, for example,
has not fallen, and spot prices of nonferrous metals on
average have stabilized
recently after considerable weakness
in the first part of the year.
Though still lethargic, the
behavior of durable goods materials and supplies markets
scarcely evidences the type of broader inventory
liquidation
that usually has been at the forefront of the major
inventory recessions of the past.
48
At the finished goods level, we experienced significant inventory liquidation in both cars and trucks in
May and June.
We do not have comprehensive, up-to-date
inventory evaluations for recent months as yet, but inferring what we can from scattered and partial data, the prospects seem reasonably good for a reduction in inventory
investment that moves us a considerable way toward eliminating unwanted
stocks.
That process and the longer run outlook for the
economy depend ultimately on the behavior of final sales.
In that regard, the slowing of the growth of final sales
that began in the first quarter seems to have continued a
little further in the second quarter.
Combining final sales
and the likely reduced second-quarter pace of inventory
investment, the level of overall domestic production of
final goods and services, or real GDP, evidently changed
little last quarter.
Going forward, of the several credible outlooks,
the most probable is for an upturn in the growth rate of
final sales and real GDP over the rest of this year and a
moderate pace of expansion next year with the economy operating in the neighborhood of its potential.
One area of
improvement should be our external sector.
A significant
downside risk when I testified in February related to the
situation in Mexico.
The economic contraction in that
country and the depreciation of the peso did act to depress
49
our net exports in the first half of the year.
But with the
external adjustment of the Mexican economy apparently near
completion, this drag should be largely behind us.
More-
over, our trade with the rest of the world should begin to
impart a positive impetus to our economic activity, partly
because of the strong competitive position of U.S. goods in
world markets.
Regarding domestic final demand, financial developments so far this year should provide important support
over coming quarters.
Interest rates, especially on inter-
mediate- and long-term instruments, have fallen a great deal
since last fall, in reaction to the improved fiscal outlook,
the effects on inflation expectations of our earlier monetary tightening, and, of course, recently, the slowed
economy.
Lower interest rates have helped to buoy stock
prices, which have soared ever higher.
The positive
implications of the rally in financial markets for household
debt-service burdens and wealth and for the cost of capital
to businesses augur well for spending on consumer durables,
on housing, and on plant and equipment.
These
influences
should be reinforced by the generally strong financial
condition and the willingness to lend of depository
institutions, as well as the receptiveness of capital
markets to offerings of debt and equity.
Early signs of a little firming in consumer durables spending are already visible in the stabilization of
50
the motor vehicles sector.
Residential construction also
has started to revive, judging by the recent data on home
sales and mortgage applications.
Unfilled orders are siza-
ble in the capital goods area, suggesting business investment in equipment will continue growing, albeit perhaps more
slowly than in the recent past.
Finally, rising permits
suggest expansion in nonresidential construction.
An outlook embodying a resumption of moderate
economic growth is conveyed by the central tendencies of the
expectations of the Federal Reserve Governors and Reserve
Bank Presidents for real GDP.
After the second-quarter
pause, a projected pickup in activity in the second half
would put output growth over the four quarters of the year
in the neighborhood of 1-1/2 to 2 percent.
For next year,
projections of real GDP growth center on 2-1/2 percent.
The inflation picture is less worrisome than when
I testified six months ago, just after our last policy
tightening.
Demands on productive resources should press
less heavily on available capacity in the future than we
envisioned in February.
This prospect is evident in the
central tendency of the expectations of the Governors and
Presidents for the unemployment rate in the fourth quarter
of this year, which has been revised up from about 5-1/2
percent in February to 5-3/4 to 6-1/8 percent.
This outlook
for unemployment has been extended through next year as
well.
Increases in employment costs to date have been
51
modest, and labor compensation evinces few signs of exacerbating inflation pressures, although the recent unusually
favorable behavior of benefit costs is unlikely to continue.
Declines in industrial output over recent months have already eased factory utilization
term averages.
rates closer to their long-
Reflecting a slowing in foreign industrial
economies as well as in the United States, the earlier surge
in prices of materials and supplies has tapered off.
Moreover, the stability of the exchange value of the dollar
in recent months bodes well for an-abatement of the recent
faster increase in import prices.
Against this background, most Governors and Presidents see lower inflation over coming quarters than experienced in earlier months of 1995.
The central tendency
for this year's four-quarter rise in the CPI is 3-1/8 to
3-3/8 percent.
And for next year, the central tendency
suggests that CPI inflation will be shaved to 2-7/8 to 3-1/4
percent.
The success of our previous policy tightenings in
damping prospective inflation pressures set the stage for
our recent modest policy easing.
Because the risks of
inflation apparently have receded, the previous degree of
restriction in policy no longer seemed needed, and we were
able at the last meeting of the Federal Open Market Committee (FOMC) to reduce the federal funds rate by 1/4 percentage point to around 5-3/4 percent.
52
Indeed, inflation pressures were damped somewhat
more quickly than we might have expected. This experience
underlines the uncertainties and risks in any forecasting
exercise.
The projections of the Governors and Presidents
are for a rather benign outlook, as are the views of many
private sector forecasters.
But these expectations can't
convey the risks and subtleties in the developing economic
situation.
A month or so ago. I noted publicly that a moderation in growth was both inevitable and desirable, but that
the process could not reasonably be expected to be entirely
smooth, and that accordingly the risks of a near term inventory-led recession, though small, had increased.
More
recent evidence suggests that we may have passed the point
of maximum risk.
But we have certainly not yet reached the
point at which no risk of undue economic weakness remains.
We do not as yet fully understand all the reasons for the
degree of slowing in economic activity in the first half of
the year, so we need to be somewhat tentative in our projections of a rebound.
Imbalances seem to be limited, finan-
cial conditions should be supportive of spending, and businesses and consumers are largely optimistic about the
future.
Nonetheless, questions remain about the strength of
demand for goods and services, not only in the United States
but abroad as well.
53
Upside risks to the forecast also can be readily
identified, particularly if the inventory correction is
masking a much stronger underlying economy than appears from
other evidence to be the case.
If so. spending could
strengthen appreciably, especially in light of the very
substantial increases in financial market values so far this
year.
In a transition period to sustainable growth such
as this, reactions to unexpected events may be especially
pronounced.
This is not a time for the Federal Reserve to
relax its surveillance of. and efforts to analyze, the
evolving situation.
The Federal Reserve must do its best to
understand developing economic trends.
While we cannot
expect to eliminate cyclical booms and busts--human nature
being what it is--we should nonetheless try where possible
to reduce their amplitude.
Some observers have viewed prospective year-by-year
budget-deficit reduction as constituting an important downside risk to the economy.
I do not share this concern.
In
response to fiscal consolidation, financial markets provide
an important shock absorber for the economy.
Declines in
long-term rates help stimulate private, interest-sensitive
spending when government spending and transfers are reduced.
Clearly, the Federal Reserve will have to watch this process
carefully, and take the likely effects of fiscal policy into
account in considering the appropriate stance in monetary
54
policy.
But there is no doubt, in my judgment, that the net
result of moving to budget balance will be a more efficient,
more productive U.S. economy.
With regard to the money and debt ranges chosen by
the FOMC for this year, the specifications for M2 and domestic nonfinancial debt were left unchanged, at 1 to 5 percent
and 3 to 7 percent, respectively.
The FOMC also made a
purely technical upward revision to the M3 range.
Last
February's Humphrey-Hawkins testimony and report had noted
the potential need for such a revision to this year's M3
range.
Starting in 1989, the restructuring of thrift
institutions and the difficulties facing commercial banks
depressed their lending and their need for managed liabilities.
The FOMC responded by reducing the upper and lower
bounds of the range for M3 to below those of the M2 range.
This year, M3 growth has begun to outpace that of M2. as it
did for several decades prior to 1989.
Overall credit flows
have picked up some, and a higher proportion has gone
through depositories.
As a consequence, while M2 and debt
remain within their respective annual ranges,. M3 has
appreciably overshot the upper end of its range.
The 2
percentage point increase in the upper and lower bounds of
the M3 range to 2 to 6 percent was made in recognition of
the evident return this year to a more normal pattern of M3
growth.
The ranges specified for M2, M3, and debt this year
also were provisionally carried over to 1996.
The Committee
55
stressed that uncertainties about evolving relationships of
these variables to income continued to impair their usefulness in policy.
In summary, the economic outlook, on balance, is
encouraging, despite the inevitable risks.
The American
economy rests on a solid foundation of entrepreneurial
initiative and competitive markets.
With the cyclical
expansion more than likely to persist in the period ahead,
the circumstances are particularly opportune for pressing
forward with plans to institute further significant deficit
reduction.
For such actions, by raising the share of
national saving available to the private sector, should
foster declines in real interest rates and spur capital
accumulation.
Higher levels of capital investment in turn
will raise the growth in productivity and living standards
well into the next century.
The Federal Reserve believes that the main contribution it can make to enhancing the long-run health
of the American economy is to promote price stability over
time.
Our short-run policy adjustments, while necessarily
undertaken against the background of the current condition
of the U.S. economy, must be consistent with moving toward
the long-run goal of price stability.
Our recent policy
action to reduce the federal funds rate 25 basis points was
made in this context.
As I noted in my February testimony,
easing would be appropriate if underlying forces were
56
clearly pointing toward reduced inflation pressures in the
future.
Considerable progress toward price stability has
occurred across successive business cycles in the last 15
years.
We at the Federal Reserve are committed to further
progress in this direction.
57
For use at 10:00 a.m., E.D.T.
Wednesday
July 19,1995
Board of Governors of the Federal Reserve System
Monetary Policy Report to the Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
July 19, 1995
58
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., July 19, 1995
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
59
Table of Contents
Page
Section 1: Monetary Policy and the Economic Outlook for 1995 and 1996
1
Section 2: The Performance of the Economy
5
Section 3:
Financial, Credit, and Monetary Developments
15
60
Section 1: Monetary Policy and the Economic Outlook for 1995 and 1996
During 1994, spending by U.S. households and
businesses grew at an exceptionally rapid pace, and
by the end of the year, demands clearly were taxing
the productive capacity of the economy. Pressures on
resources were particularly intense in sectors of
manufacturing that provide inputs for other producers, and sharp increases in the prices of materials and
supplies signaled what could have been the first stage
of a broader inflationary process. A weakening of the
dollar on foreign exchange markets as 1995 began
heightened that risk. To damp these inflationary pressures and foster a sustainable economic expansion,
the Federal Open Market Committee in February
tightened policy somewhat, extending the series of
actions undertaken during 1994, and the Board of
Governors approved a one-half percentage point
increase in the discount rate.
The economy's growth began to moderate in the
first quarter of 1995. Among the factors contributing
to the slowing were the lagged effects of 1994's
increases in interest rates on housing and other ratesensitive sectors and the impact on U.S. exports of the
sharp contraction in Mexico's economy and fall in the
foreign exchange value of the peso. As final sales
moderated, businesses scaled back their desired inventory accumulation. In some key sectors, the slackening in sales was greater than anticipated, leaving firms
with excess inventories. As businesses took steps to
trim stocks, aggregate production decelerated further
in the second quarter and was probably about flat, as
measured by real gross domestic product. The inventory adjustment was especially large in the motor
vehicle sector, which accounted for much of the
downswing in manufacturing activity in the spring.
Homebuilding also showed marked weakness, in part
because builders hesitated to start new projects until
they could work down stocks of unsold new homes.
While output growth was stalling in the first half of
this year, the still high level of resource utilization of
the economy, as well as the effects of rapid increases
in materials prices, contributed to a pickup in inflation
from its 1994 pace. Nonetheless, by July it appeared
likely that pressures on resources and hence on prices
were in the process of easing. Materials prices were
showing signs of softening, and a period of greater
stability in the exchange value of the dollar suggested
that the rise of import prices might soon slow. With
the threat of future inflation thus reduced, the FOMC
elected to ease the stance of policy slightly at its
meeting in July.
The moderation in economic growth and improvement in inflation prospects over the first half of 1995
sparked a considerable decline in market interest
rates. The greater likelihood of significant progress
toward a balanced federal budget also seemed to
contribute to the decrease in longer-term interest rates.
Intermediate- and long-term yields have fallen 1V* to
!3/4 percentage points since year-end 1994, with the
decline in 30-year fixed mortgage rates this year
reversing most of the increases registered since early
1994. Lower interest rates, solid earnings growth, and
prospects for sustained economic expansion helped
push most broad stock price indexes to record highs.
The drop in longer-term interest rates in the United
States contributed to downward pressure on the foreign exchange value of the dollar in 1995. In terms of
the currencies of the other G-10 countries, the dollar
has declined 7l/z percent on balance. Over the past
half-year, foreign long-term interest rates have fallen
significantly as growth prospects abroad have weakened, but by less than U.S. long-term interest rates. In
addition, the Mexican crisis was seen by market participants as having adverse implications for US.
growth, especially exports, and contributed to the
dollar's decline in terms of currencies other than the
peso in early 1995. With the dollar at times under
greater downward pressure than seemed justified by
fundamentals, the Federal Reserve, acting on behalf
of the Treasury and for its own account, joined other
central banks in concerted intervention in support of
the currency on several occasions in 1995. In recent
weeks, the dollar has fluctuated in a range somewhat
above the lows reached in the spring.
Despite the slower expansion of nominal spending
this year, net borrowing by households and businesses
remained substantial. In fact, total private credit flows
strengthened, offsetting slower growth of federal debt
and an outright decline in state and local government
debt; as a result, total domestic nonfinancial debt
expanded at a SVz percent pace from the fourth quarter of 1994 through May, a little faster than in 1994.
Credit supply conditions remained quite favorable,
with banks continuing to ease terms and conditions of
lending and risk spreads in securities markets persisting at quite low levels. Household borrowing this
year has been a bit more subdued than in 1994 but
still appreciable. Nonfinancial businesses have
stepped up their borrowing considerably, reflecting a
widening gap between capital expenditures (including
inventory investment) and internally generated funds,
61
Ranges for Growth of Monetary and Credit Aggregates1
Percent
Aggregate
Provisional for 1996
M2
1 to 5
1 to 5
1 to 5
M3
Oto4
2 to 6*
2 to 6
Debts
4 to 8
3 to 7
3 to 7
1. Change from average for fourth quarter of preceding
year to average for fourth quarter of year indicated.
2. Monitoring range for debt of domestic nonfinancial
sectors.
along with balance sheet restructuring associated with
stock repurchases and a surge in merger and acquisition activity. Although the decline in long-term interest rates this year has spurred a significant pickup in
bond issuance and fixed-rate mortgage borrowing
very recently, the increase in credit this year has been
concentrated in short-term or floating-rate debt.
Depository institutions, as traditional providers of
short-term and floating-rate credit, have enjoyed a
sharp increase in loan demand. To fund the growth of
their loan portfolios, banks and thrifts pulled in more
deposits, providing a lift to growth of the broad
monetary aggregates. Indeed, M3 expanded at a
6*/4 percent pace from the fourth quarter through
June, slightly exceeding the upper bound of its revised annual range. In their usual fashion, yields on
small time deposits and money market mutual funds
have adjusted with a lag to the declines in market
interest rates this year. Investors have responded by
shifting their portfolios toward these assets, boosting
M2 growth from the fourth quarter through June to
3V4 percent at an annual rate. M2 velocity over the
first half of 1995 is estimated to have held about
steady, in marked contrast to the rise in M2 velocity
over the previous five years.
Unlike the broad monetary aggregates. Ml growth
has been quite sluggish this year. Low interest returns
on transaction deposits have encouraged households
and businesses to move excess balances into higheryielding M2 assets and also into market instruments.
This process has been amplified by the expansion of
retail sweep accounts offered by a few banks that
allow customers to hold a lower average level of
transaction balances. Currency growth—although
slower than the double-digit pace of the last two
years—has remained strong, boosted again by heavy
foreign demands.
•Revised at July 1995 FOMC meeting.
Money and Debt Ranges
for 1995 and 1996
In setting ranges for money and debt in 1995 and
1996, the Committee noted that the velocities of the
monetary aggregates have been behaving more in line
with historical patterns than was the case earlier in the
decade. However, financial innovation, technological
change, and deregulation have blurred distinctions
among various financial instruments that can serve
as savings vehicles and sources of credit. As a
consequence, considerable uncertainty remains about
the future relationships of money and debt to the
fundamental objectives of monetary policy; the Committee will thus continue to rely primarily on a wide
range of other information in determining the stance
of policy.
The Committee retained its current range of 1 to 5
percent for M2 for 1995 and chose the same range for
1996. If M2 velocity continues on a more normal
track, growth of M2 in the upper half of this range in
1995 and near the upper bound of the provisional
range in 1996 would be consistent with the Committee's expectations for nominal income growth. The
existing range was retained for next year in view of
the lingering uncertainties about the money-income
relationship and to serve as a benchmark for the rate
of growth of M2 that would be expected under conditions of reasonable price stability and historical velocity behavior. The Committee also reaffirmed the
3-to-7 percent range for the debt aggregate and carried this range forward on a provisional basis for
1996, concluding that debt growth within this range
would be expected to accompany the moderate economic expansion it was seeking to foster.
With regard to M3, the Committee had noted in its
February 1995 report to Congress that the depressed
62
Economic Projections for 1995 and 1996
Federal Reserve Governors
and Reserve Bank Presidents
Administration
Range
Central
Tendency
33/4 to 51/4
1%to3
3 to 31/2
41/4 to 4%
1^to2
3Va to 3%
5.4
2.4
3.2
51/2 to 61A
5% to 61/a
5.5-5.S3
4% to 5%
1995
Percent change,
fourth quarter to fourth quarter*
Nominal GDP
Real GOP
Consumer price index2
Average level in the
fourth quarter, percent
Civilian unemployment rate
1996
Percent change,
fourth quarter to fourtfi quarter*
Nominal GDP
Real GDP
4% to 5V2
2
Consumer price index
2Ve to 3
21/4 to 2%
2 /2 to 3 /2
2% to 3V4
5.5
2.5
3.2
5Vfe to 61/4
5% to 61/e
5.5-5.83
1
1
Average level in the
fourth quarter, percent
Civilian unemployment rate
1. Change from average for fourth quarter of previous year
to average for fourth quarter of year indicated.
growth of this aggregate in recent years reflected the
balance sheet adjustments of banks and thrifts in
response to the extraordinary strains they experienced
in the early 1990s. The Committee observed-that, as
these institutions returned to health and intermediation resumed more normal patterns, M3 growth could
pick up appreciably and the velocity of M3 might
begin to stabilize or even decline, as it had on average
over several decades before 1990. In the event, M3
has strengthened considerably so far in 1995, apparently for the reasons noted by the Committee in
February. As a consequence, the Committee made a
technical adjustment in its M3 range at the July
meeting—to 2 to 6 percent for 1995—and carried that
range forward on a provisional basis into 1996. The
Committee stressed that this change simply recognized the return of historical financing patterns and
bore no implications for the underlying thrust of
monetary policy.
2. All urban consumers.
3. Annual average.
Economic Projections for 1995 and 1996
The members of the Board of Governors and the
Reserve Bank presidents, all of whom participate in
the deliberations of the Federal Open Market Committee, generally anticipate that, after a weak second
quarter, the economy will experience moderate
growth in the second half of 1995 and in 1996. For
all of 1995, this would produce growth that was
somewhat below forecasts made for the February
meeting. In line with these expectations, the
unemployment rate in the second half of 1995 may
move up somewhat from its recent relatively low
level.
A number of factors should contribute to a pick up
in demand and production over coming months.
Lower interest rates, in particular, likely will directly
stimulate spending on housing, motor vehicles and
consumer durables, and business investment More-
63
over, increases in the value of bond and stock portfolios that have accompanied the decline in interest
rates should strengthen aggregate demand more generally. The strong competitive position of the United
States likely will bolster net export growth on balance
over the remainder of 1995. To be sure, the level of
US. exports to Mexico probably will remain depressed for some time, but Mexico's external adjustment has already been substantial and further declines
in U.S. export demands from this source are likely to
be less severe than in the first half of 1995. Finally,
the anticipated pickup in spending will help businesses work off excess inventories more rapidly and
reduce the need for further production cutbacks to
bring inventories back in line with final sales.
The Board members and the Reserve Bank presidents generally expect the rise in the consumer price
index over the four quarters of t995 to end up around
31A percent, the same as in the first half of the year.
For 1996, inflation is projected to edge down to the
neighborhood of 3 percent. The first-half slowdown in
the industrial sector has reduced pressure on materials
prices; moreover, wage trends have been stable, suggesting that labor costs are unlikely to provide an
impetus to inflation.
The Administration has not released an update of
the economic projections contained in the February
Economic Report of the President. Those earlier forecasts pointed to real GDP growth of 2.4 percent for
1995, well within the central tendency range in the
Federal Reserve's February report. Given the slow
start this year, that growth pace for the year appears
less likely, and the average unemployment rate for
the year probably will be around the upper end of the
5.5 to 5.8 percent range in the Administration's February report. The Administration's 3.2 percent CPI
forecast is in line with the Federal Reserve's central
tendency.
The inflation rates anticipated by the FOMC are
marginally above those prevailing in 1993 and 1994
but are considerably below rates of only a few years
ago—and lower than many observers seemed to
anticipate for the current economic expansion only
a few months ago. Nonetheless, they should be
regarded as only a milepost along the path toward the
long-term goal of price stability. The Federal Reserve
recognizes that eliminating the economic distortions
associated with inflation is the most important longrun contribution it can make to the economic growth
and welfare of the nation.
64
Section 2: The Performance of the Economy
At the end of 1994, resource utilization in the U.S.
economy was high: Manufacturing capacity utilization equaled its 1989 peak, and the unemployment
rate was close to the low point of the late 1980s.
Moreover, economic expansion was still brisk, with
real gross domestic product growing at a 5 percent
annual rate in the fourth quarter. Although inflation
for 1994 as a whole remained moderate, commodity
prices, which can signal the onset of inflationary pressures, were rising rapidly at the end of last year.
Change in Real GDP
Percent annual rate
Seasonally adjusted, 1987 dollars
fl
n
1990
1991
1992
1993
1994
1995
A deceleration in activity was widely anticipated,
and growth in real GDP did moderate to a 23/4 percent
annual pace in the first quarter of 1995. But the
slowing did not stop there: Spending in several sectors of the economy softened in the spring, industrial
production fell, and employment grew relatively little.
The level of real GDP appears to have been essentially flat in the second quarter.
cases, the adjustments were not quick enough to avoid
an unwanted accumulation of inventories. This was
especially true for cars and light trucks, but it
extended to other goods as well. Efforts to trim stocks
reinforced the contractionary forces in the manufacturing sector of the economy.
Despite the fall-off in growth in the first half, the
unemployment rate edged up only slightly, and while
manufacturing capacity utilization fell considerably, it
remained above historical averages. Under the circumstances, it is not surprising that the mounting
inflationary pressures of the latter part of 1994 carried
over into the first pan of this year and that materials
prices surged further. Rising import prices, related to
the depreciation of the dollar, also contributed to
domestic inflation. Reflecting these and other factors,
the consumer price index increased at a 3J/4 percent
annual rate in the first half of this year, up from a
23/4 percent increase for 1994 as a whole.
Nonetheless, increases in hourly wages and benefits remained moderate, holding down unit labor costs.
Furthermore, the drop in manufacturing activity in the
first half of the year contributed to a flattening in
industrial commodity prices, suggesting some lessening of inflationary pressures "in the pipeline." These
favorable factors were reflected in some moderation
of price increases toward midyear.
The Household Sector
After advancing at more than a 4 percent annual
rate in the second half of 1994, growth in consumer
Manufacturing Capacity Utilization Rate
Seasonally adjusted
A slackening in household demand for big-ticket
items was a significant element in the drop-off in
economic growth in the first half. After registering
sizable gains last year, spending on consumer durables weakened considerably early this year. And
residential construction, which continued to grow in
the face of rising mortgage rates last year, began to
fall this winter and was off sharply in the second
quarter. These domestic drags were reinforced by the
effects of the plunge in net exports to Mexico, which
came in the wake of that nation's financial crisis.
With domestic sales and exports softening, businesses cut orders and productioa However, in some
85
80
1989
1991
1993
1995
65
Change in Real Income and Consumption
Percent, annual rate
{j Disposable personal income
Personal consumption expenditures
1990
1991
1992
1993
Seasonally adjusted, 1987 dollars
1994
1995
spending slowed appreciably on average in the first
half of this year. Real personal consumption
expenditures increased at just a Wz percent annual
rate in the first quarter, before picking up moderately
in the second.
Outlays for consumer durables moved up sharply
in 1994, and by the end of the year, the level of
spending was high relative to income. Many households may have brought their stocks of durables up to
desired levels, limiting further purchases this year. In
addition, by early this year, the stimulus to consumer
spending from the massive mortgage refinancing
wave of 1993 and early 1994 likely had been
exhausted. The downturn in interest rates this year
has led to a comparatively modest rebound in
refinancings recently, which may free up some income
for additional spending in coming months.
healthy pace of hiring. But increases in wage and
salary income faded in the spring, reflecting slow
growth in employment and a drop in the workweek.
The deceleration in labor income was only partially
offset by rapid growth in interest and dividend income
in the first half of 1995. Dividend income benefited
from the improvement in corporate profits. Growth in
interest income was strong in the first quarter, reflecting the lagged effects of increases in market interest
rates in 1994, but began to flag in the second quarter
as the decline in market interest rates this year showed
through to interest earnings.
Surveys suggest that consumer confidence remained high through the first half of 1995. Movements in both of the major surveys—from the Michigan Survey Research Center and the Conference
Board—were similar in in the first half of 1995: Both
spent part of the first half of 1995 above their 1994
average values, but by June, both had moved back
down to their 1994 averages.
Early this year, residential construction activity
weakened significantly and single-family housing
starts in the first quarter were 14 percent (not an
annual rate) below their fourth-quarter average. Sales
of new and existing homes also fell in the first quarter,
although not quite so steeply. Single-family starts
edged up in April but more than reversed this gain in
May; however, building permits, a more reliable indicator, moved up in May. New home sales jumped
20 percent in May, to the highest level since late
1993. Although reported new home sales are volatile,
end the initial readings are often revised substantially,
other indicators of housing activity also point in a
Private Housing Starts
Millions of units, annual rate
The slackening in consumer demand in the first
quarter was concentrated in motor vehicles, where
sales fell off after surging in the fourth quarter of
1994. However, real spending on goods other than
motor vehicles also grew less rapidly in the first
quarter than in the second half of 1994. Some of the
deceleration in other consumer durables may have
reflected the weakness in home sales, because families often purchase new furnishings and appliances
when they change houses. Among nondurable goods,
outlays for apparel were especially weak, following
rapid growth in spending in the second half of 1994.
The slowing of consumer spending growth so far
his year has been about in line with the slowing in
icome growth. Through the first quarter, wage and
Uary income posted solid gains, bolstered by a
Quarterly average
1.5
1989
1991
1993
1995
Seasonally adjusted. Value for 199&Q2 is average of April and
May,
66
favorable direction: Applications for mortgages to
purchase homes rose sharply in May and remained
elevated in June, and attitudes of households and
builders toward the housing market became more
positive in the second quarter.
Like single-family homebuilding. multifamily construction fell early this year, with starts off 11 percent
in the first quarter. The drop this year follows a
two-year period of recovery, during which starts
doubled from their thirty-five-year low reached at the
beginning of 1993. Multifamily starts turned back up
in April and May. Prospects for a continued gradual
increase in multifamily starts appear good, as newly
built apartments were quickly filled last year and
vacancy rates for apartments continued to move down
in the first quarter of this year. However, continuing
overhangs of empty apartments in some markets are
likely to keep total multifamily starts well below the
levels of the 1980s.
The Business Sector
In the second half of 1994, nonfarm inventories
increased nearly 5 percent at an annual rate, about
keeping pace with growth in final sales, as firms built
stocks to ensure adequate supplies—or, in some
instances, to beat anticipated price increases. In the
first quarter, inventory growth continued at about its
late 1994 pace, but growth in final sales moved down
to a IV-z percent annual rate, leaving many firms with
stocks they did not want.
line, manufacturers cut production sharply; between
February and May, output dropped 10 percent. The
decline in output of motor vehicles, parts, and related
inputs was the most important factor in the 1 percent
drop in overall industrial production in this period.
Motor vehicle inventories accumulated further in
April when sales fell sharply, but there was some
progress in trimming excess stocks in May and June.
Nonetheless, much of the overhang of vehicles that
developed earlier this year remains.
The inventory buildup outside the motor-vehicle
sector was also quite large in the first quarter, and it
continued at a rapid pace in April. The available data
for May suggest a somewhat smaller rate of increase.
Although stocks of most goods remained in better
alignment with sales than in the motor-vehicle sector,
inventory accumulation has been running ahead of
sales in a few sectors, particularly in apparel, furniture, and appliances. In response, manufacturers have
cut production in these areas. The accumulation of
furniture and appliances is likely related to the dropoff in home sales in early 1995. and the revival in
home sales that appears to be underway should boost
sales in these areas, helping to trim inventories
further.
Change in Real Business Fixed investment
Percent, annual rate
jj Structures
H Producers' durable
equipment
The first-quarter inventory run-up was disproportionately in motor vehicles, as production increased
while sales were falling. To bring inventories back in
Change in Real Nonfarm Business Inventories
Annual rate, billions of 1987 dollars
Seasonally adjusted
-V
P
1
I
1990
1
1991
1992
-
if
!r r
1
1993
- 10
1
1994
1
1
1995
Seasonally adjusted, 1987 dollars.
30
1990
1991
1992
1993
1994
1995
Business fixed investment rose at an extraordinary
pace in the first quarter, with strong gains in both the
equipment and structures components. Real spending
on equipment increased at a 25 percent annual rate
With the exception of motor vehicles, the growth i
equipment spending was widespread in the first quz
ten For structures, real outlays increased at a 12 pf
cent annual rate in the first quarter, following
67
4*/2 percent gain over the four quarters of 1994. The
first-quarter increase in construction was also widespread across components.
Indicators for the second quarter suggest that
growth in capital spending continued to be brisk,
although not quite so fast as in the first quarter.
Shipments of capital goods by domestic manufacturers in April and May were up moderately from their
first-quarter average. And permits for noraesidential
structures, which tend to lead construction by a few
months, indicate that construction should continue to
trend upward, although at a slower pace than early
this year.
The surge in capital spending in recent years has
pushed growth of the capital stock to its fastest pace
since the late 1970s. This improvement in the rate of
capital accumulation may lead to a pickup in productivity growth, but there is as yet little indication of a
significant break with past trends. Indeed, when output is measured using the new chain-type alternative
index—which will become the official measure later
this year—trends in productivity growth in the nonfarm business sector in the 1990s are little changed
from those of the 1970s and 1980s.
Corporate operating profits increased at a 7 percent
annual rate in the first quarter, a somewhat faster pace
than in the second half of 1994. However, first-quarter
profits were boosted by an increase in earnings of
U.S. corporations on foreign operations; profits on
private domestic operations were about unchanged.
The increase in profits on foreign operations resulted
in part from the decline in the exchange value of the
Before-Tax Profit Share of GDP
Nonfinancial corporations
1989
1991
1993
Seasonally adjusted. Profits from domestic operations with
ventory valuation and capital consumption adjustments, divided
gross domestic product of nonfinancial corporate sector.
dollar, which pushed up the value of profits earned
abroad. Private domestic financial profits improved in
the first quarter, in part because of a surge in bank
earnings, which were boosted by strong loan growth.
First-quarter earnings on domestic operations of U.S.
nonfinancial corporations declined slightly, following
solid gains in 1994. Profits were 10.6 percent of the
output of nonfinancial corporate businesses in the first
quarter, about the same as in 1994 as a whole, when
the profit share was the highest since the late 1970s.
In the farm sector, indications are that production
will fall well short of last year's exceptionally high
levels. Weather conditions have been less favorable
than those of 1994, with unusually heavy rains keeping plantings behind schedule across large parts of the
Midwest. Also, with stocks relatively high after last
year's large harvests, the U.S. Department of Agriculture reduced the amount of acreage that farmers contracting for subsidy payments were allowed to plant.
However, livestock production has remained strong
so far in 1995. which will help cushion the effects of
smaller harvests on total agricultural production.
Because of the likelihood that production will fall this
year, farm inventory investment will probably be
smaller this year than in 1994, and stocks of some
crops will likely be drawn down appreciably.
The Government Sector
The federal government deficit has continued to
shrink in the current fiscal year. For the first eight
months of the 1995 fiscal year, the budget deficit was
19 percent below the same period a year earlier.
Nominal expenditures over this period were
4 percent higher than a year earlier, while receipts
were up 8V£ percent. In addition to The strong economic growth of 1994, receipts were boosted by
changes in rules that allowed some individuals to
defer until 1995 certain tax payments that would have
been due in 1994 under previous rales.
Higher interest outlays contributed to the increase
in federal spending in the first part of the 1995 fiscal
year. Excluding interest outlays, nominal federal
spending in the first eight months of this fiscal year
increased about 2 percent, compared with the yearearlier period. Defense expenditures continued to
decline in nominal terms; they have been the main
factor holding down federal spending in recent years.
Spending on income security programs, such as
unemployment insurance and welfare benefits, also
edged down, mostly reflecting the economic expansion. Spending on Medicare and other health programs was up 9 percent in the first eight months of the
68
Change in Real Federal Purchases
Percent, annual rate
Seasonally adjusted
~fU i
;y
5
4-
0
ill-.
5
\
J
i
i
1990
1
1991
1992
J
B
1993
1994
1
t
10
I
i
1*s
1995
fiscal year, while still quite rapid, this growth is
slower than that of the early 1990s, when these expenditures were rising 10 to 20 percent per year. Spending on social security and on other nondefense functions increased less than the recent trend in nominal
GDP.
social insurance funds) totaled $37 billion in the first
quarter of 1995, a small improvement from the deficit
a year earlier. Excluding social insurance, tax receipts
increased 7 percent between the first quarter of 1994
and the first quarter of 1995 while expenditures were
up 6J/4 percent. Transfer payments continue to grow
faster than other spending, although the rate of
increase is well below that earlier in the 1990s.
Real purchases of goods and services by state and
local governments have been rising only moderately
for some time; in the first quarter of 1995, they were
little changed. The slowing in the first quarter was
concentrated in construction spending, which fell
after three quarters of solid increases. Purchases of
other goods and services remained on the gradual
uptrend that has been evident over the past few
years. State and local employment increased about
14,000 per month, on average, over the first six
months of 1995, considerably below the pace of the
1992-to-1994 period.
In real terms, federal purchases of goods and
services—the part of federal spending included in
gross domestic product—fell at an annual rate of
4 percent in the first quarter of 1995. Falling defense
spending more than accounted for the decline. As of
the first quarter, the level of real federal purchases
was 17 percent below the peak reached four years
ago.
The small improvement in the budget situation for
the state and local sector as a whole masks important
differences across levels of government Available
evidence suggests that while state budgets are in
relatively good shape, budgets at the local level
remain under pressure. State aid to localities, particularly to school districts, has been eroding relative to
expenses for several years. Also, local governments
rely more heavily than state governments on property
taxes, and while sales and incomes have rebounded in
the current business cycle expansion, property values
have lagged behind, limiting property tax receipts.
State and local government deficits on combined
capital and operating accounts (that is, excluding
The External Sector
Change in Reai State and Local Purchases
Percent annual rate
Seasonally adjusted
in
1990
1991
1992
1993
1994
1995
The nominal trade deficit on goods and services
widened somewhat in the first quarter, to $120 billion at an annual rate. However, net investment
income improved in the first quarter, as did net
transfers, and as a consequence, there was a narrowing of the current account deficit in the first quarter
from its fourth-quarter level, to $162 billion at an
annual rate. Nonetheless, the first-quarter current
account deficit exceeded 1994's average of $151 billion. In April, the trade deficit increased further from
the first-quarter average.
The quantity of U.S. imports of goods and services
expanded 10 percent at an annual rate during the first
quarter, somewhat less rapidly than in 1994. The
slower pace of U.S. income growth contributed to th
lower import growth; increased imports from Mexic
were a partial offset. In April, real imports continue
U.S. Current Account
Billions of dollars, annual rate
Seasonally adjusted
u
s V
-
LL-
•f
0
\
'
50
•
100
—
LJ
-
-
i
1990
i
i
1991
1992
i
i
1993
i
150
i ?nn
1994 1995
to grow at about the first-quarter pace. The increases
in imports in the first four months of the year were
widespread across major trade categories.
Non-oil import prices rose at a 3Vz percent annual
rate in the first quarter, somewhat less than during the
second half of 1994, when they were pushed up by
large increases in world commodity prices, especially
for coffee. In April and May, non-oil import prices
rose at a nearly 6 percent annual rate, with increases
for most major trade categories. The pickup in price
increases for imported goods reflected, in part, the
recent dollar depreciation.
The quantity of U.S. exports of goods and services
rose at a 5 percent annual rate in the first quarter,
more slowly than the double-digit rate of growth over
the four quarters of 1994. In large part, the weaker
U.S. Trade in Goods and Services
export performance was the result of the macroeconomic adjustments taking place in Mexico and the
reduced Mexican demand for U.S. exports. Preliminary data for April indicated that the quantity of
exports expanded a bit further from the first-quarter
average. For the first four months of the year, exports
to Mexico fell while they increased moderately to
most other areas of the world.
Real output in Mexico declined sharply in the first
quarter as instability in the financial markets weakened confidence and the government implemented a
program of fiscal and monetary restraint. The Mexican economy apparently continued to contract in
the second quarter. The crisis and ensuing policy
responses induced a dramatic reduction in Mexico's
current account deficit during the first quarter of the
year. In the wake of the Mexican crisis, the Argentine
authorities chose to tighten macroeconomic policies,
which has led to a weakening of economic activity in
Argentina. In contrast, Brazil experienced very strong
real output growth in the first quarter as consumption
spending surged; available indicators suggest some
slowing of growth in the second quarter.
In Japan, recovery from the recent recession
remains tentative. First-quarter real GDP growth was
only 0.3 percent at an annual rate; data for the second
quarter also suggest that the recovery may be stalling.
Asset prices have continued to fall, adding to concerns about the lack of progress in improving banks'
balance sheets and limiting the capacity of banks to
extend credit in support of the recovery. In May, the
Japanese government announced another package of
structural reforms and measures to boost domestic
demand. The sluggish pace of activity in Japan and
the rise in the value of the yen have eliminated
inflation: Consumer prices were unchanged over the
twelve months through June.
Billions of 1987 dollars, annual rate
Seasonally adjusted
Imports
650
- 550
450
1990
1991
1992
1993
1994
1995
In other industrial countries, the rate of economic
expansion appears to have slowed from its rapid 1994
pace. In Canada, real GDP growth slowed to less than
1 percent at an annual rate in the first quarter, secondquarter indicators suggest continued sluggishness. In
the United Kingdom, where the expansion has been
vigorous over the past three years, real GDP continued to grow strongly in the first quarter, although at
less than the 1994 pace. In most continental European
countries, the rate of real output growth in the first
half of 1995 was somewhat lower than the rapid pace
during the second half of 1994. In Canada and several
major European countries, measures intended to
reduce government deficits as a share of GDP have
been announced.
70
Inflation rates in the industrial countries generally
remain low. However, in the United Kingdom and
Italy, currency depreciation has added upward pressure on prices, and consumer prices rose 3J/2 percent
in the twelve months through June in the United
Kingdom and nearly 6 percent in Italy. In western
Germany, exchange rate appreciation helped offset
domestic inflationary pressures, and consumer prices
rose only 21A percent through June.
Among our Asian trading partners other than
Japan, real GDP growth has remained near the rapid
1994 pace, in part because substantial depreciations
of those countries' currencies against the Japanese
yen and the German mark stimulated exports. However, economic activity decelerated somewhat in
China and Singapore, reflecting past tightening of
monetary policy and the reduction of spare capacity
in these economies.
Net capital flows into the United States were large
in the first quarter of 1995. Foreign official holdings
in the United States rose more than $20 billion, as
foreign governments made large intervention purchases of dollars in March in response to strong
upward pressure on the foreign exchange value of
their currencies. Sizable official inflows continued in
April and May. In addition, net private foreign purchases of U.S. securities were considerable in the first
quarter, particularly purchases of Treasury bonds and
notes and new Eurobond issues by US. corporations.
Private foreign net purchases of U.S. securities moderated a bit in April and May. In contrast, U.S. net
purchases of foreign securities, which had fallen substantially last year from their 1993 peak, continued to
decline on balance over the first five months of 1995.
U.S. direct investment abroad was considerable in
the first quarter, at $18 billion. Investment in Western
Europe was particularly strong. Foreign direct investment in the United States, at $10 billion, remained
substantial. On net, there was a large outflow of direct
investment in the first quarter, after netting to about
zero in 1994.
Net Change in Payroll Employment
Thousands of jobs, monthly rate
Total nonfarm
300
200
100
1989
1991
Seasonally adjusted.
1993
per month and the quarterly average unemployment
rate edged up from 5.5 to 5.7 percent.
The deceleration in employment was particularly
marked in the goods-producing sector, where payrolls
fell during the second quarter after posting strong
gains in the early months of the year. In construction,
payroll growth averaged 30,000 per month in 1994
and through the first quarter of 1995, but employment
then fell 8,000 per month in the second quarter. Manufacturing job growth also averaged 30,000 per month
in 1994. Factory hiring slowed in the first quarter, and
in the second quarter, 35.000 jobs per month were
lost. The decline in manufacturing employment was
widespread across industries. Employers have also
Civilian Unemployment Rate
Percent
Seasonally adjusted
Vt.
Labor Markets
Employment grew rapidly in 1994, and labor
markets tightened considerably. Although job growth
slowed in the first quarter of this year, it was still
large enough—at 226,000 per month—to keep the
unemployment rate at about the same level as in the
fourth quarter of 1994. In the second quarter, nonfarm
payroll employment growth slowed to only 60,000
1995
1989
1991
1993
1995
A redesigned survey and revised population estimates we
introduced in January 1995; data from that point on are r
directly comparable with those of earlier periods.
71
trimmed the factory workweek, which in 1994 had
reached the highest level since 1945.
Although employment continued to rise in most
service-producing industries in the first half of 1995,
the rate of growth slowed by the second quarter. In
wholesale and retail trade, where 75,000 jobs per
month were added in the second half of 1994, the
pace of job gains fell in the first quarter, and only
12,000 jobs per month were added in the second
quarter. Similarly, in business services, where 46,000
jobs per month were added in 1994, employment
decelerated in the first quarter and was about flat in
the second. Among sectors showing employment
gains in the first half of this year, entertainment industries posted considerable growth, and increases in
employment in the health sector continued to run at
about the same pace as in the second half of 1994.
The rate of increase in hourly compensation moved
down further early this year. The employment cost
index for private industry workers, a measure of
hourly labor costs that includes both wages and benefits, rose 2.9 percent over the twelve months ended in
March 1995, down from a 3.3 percent increase over
the preceding twelve-month period. The increase in
wages and salaries was the same in both periods, but
the pace of benefits gains declined significantly.
The largest contribution to the deceleration in benefits costs in recent years has come from health insurance. Among the factors restraining the increase in
health insurance costs are slower medical-sector inflation, increased use of managed-care plans, and efforts
by employers to shift a greater proportion of health
care costs to employees. Costs of workers' compensa-
Change in Output per Hour
Percent, Q4 to Q4
Nonfarm busing?ss sector
- 2
u
1989
nHiT
n
1991
1993
1995
Seasonally adjusted. Value for 1995 is measured from 1994:Q1
to 1996:01.
tion programs have also contributed to the deceleration in benefits costs; these costs, too, have been
affected by lower medical inflation, although regulatory reform has played a role as well. Unemployment
insurance costs decelerated sharply over the past two
years; firms pay into the unemployment insurance
program on the basis of their recent layoff experience,
and the improved economy through the first part of
this year lowered these payments.
Output per hour in the nonfarm business sector—
measured in 1987 dollars—increased at an annual rate
of 2.7 percent in the first quarter of 1995. Output per
hour increased 2.0 percent over the four quarters
ended in the first quarter, down slightly from the rate
of growth over the preceding four-quarter period.
Change in Employment Cost Index
Percent, Dec. to Dec.
Total compensation
1989
1991
1993
1995
=or private industry, excluding farm and household workers.
lue for 1995 is measured from March 1994 to March 1995.
Price Developments
The pickup in consumer price inflation so far this
year was a bit larger for the index that excludes food
and energy than for overall prices: The CPI excluding food and energy increased at a 3.6 percent
annual rate over the first six months of 1995, up from
a 2.6 percent increase in 1994. The acceleration in the
first half was mostly in non-energy services prices,
which increased at a 4Vt percent annual rate over the
first six months of 1995, up from a 31A percent
increase over the twelve months of 1994. Airfares
took off in the first half of 1995, rising at more than a
40 percent annual rate, after falling 10 percent in
1994; this acceleration accounted for two-thirds of the
pickup in services inflation in the first half. Auto
finance rates also increased rapidly early in
1995—rising at a 38 percent annual rate in the first
72
Change in Consumer Prices
Percent, Dec. to Dec.
1989
1991
1993
1995
Consumer price index for all urban consumers. Value for 1995
is measured from December 1994 to June 1995, at an annual
rate.
four months the year—following a large increase in
the second half of 1994. However, the CPI for auto
finance declined sharply in May and June, as interest rates on auto loans began to reflect the declines in
market rates in the first half of 1995. Price increases
for other services were, on balance, roughly in line
with their rate of increase in 1994.
As a result of the brisk expansion of the industrial
sector in 1994 and the consequent rapid increases in
prices of basic manufactured products, the producer
price index for intermediate materials other than food
and energy increased at a IVz percent annual rate over
Change in Consumer Prices Excluding
Food and Energy
Percent, Dec. to Dec.
the second half of 1994. In the first quarter of this
year, these materials prices rose even faster—nearly
10 percent at an annual rate. The rapid increases in
materials prices began to affect finished goods prices
in early 1995, and the PPI for finished goods other
than food and energy, which covers domestically produced consumer goods and capital equipment,
increased at a 3 percent annual rate over the first six
months of 1995, up from a 1Vfc percent rate of increase
over the twelve months of 1994.
The consumer price index for commodities other
than food and energy increased at a l*/2 percent
annual rate over the first &x months of 1995, about
the same as in 1994. Prices accelerated at the retail
level for some items for which producer prices have
been rising rapidly, such as household paper products.
But this pickup was partly offset by declines in prices
where there have been large inventory buildups. Notably, apparel prices continued to decline in the first
half, and prices of appliances, which had increased in
1994, fell in the first half of 1995.
The slowdown in the industrial sector has begun to
relieve pressure on materials prices, and the PPI for
intermediate materials other than food and energy
increased just 0.2 percent per month in May and again
in June, suggesting reduced pressures .on finished
goods prices in the near term.
Consumer food prices increased at a 13A percent
annual rate over the first six months of 1995, down
about a percentage point from 1994. Coffee prices,
which had increased 64 percent in 1994, fell 12 percent over the first six months of this year. The swing
in coffee prices can more than account for the deceleration in food prices. Prices of meats continued to
fall in the first half of 1995, as production remained
strong.
Energy prices increased at a 2 percent annual rate
in the first half of 1995, about the same as last year.
Natural gas prices have continued to decline. Regulatory changes have led to increased competition among
suppliers of natural gas; in addition, natural gas prices
were depressed early this year by the relatively warm
winter, which held down demand. Gasoline prices
increased at a 12 percent annual rate in the second
quarter, reflecting the ran-up in crude oil prices that
occurred between December and April. Since April
crude oil prices have reversed nearly all of thei
earlier run-up, suggesting that gasoline prices wi1
move down in coming months.
1989
1991
1993
1995
Consumer price index for all urban consumers. Value for 1995
is measured from December 1994 to June 1995, at an annual
rate.
Survey data suggest that expectations of inflati<
have changed little since the end of 1994. Accordi
73
to the survey of households conducted by the Survey
Research Center of the University of Michigan, the
mean expected increase in consumer prices over the
coining twelve months in the first half of 1995 was
the same as in the fourth quarter of 1994. In the
Conference Board survey of households, the expected
rate of inflation over the coming year remained at
41A percent in the first half of 1995, the same as in
each of the four quarters of 1994. Expectations of
inflation over longer periods also have not changed
much on balance this year. In the University of Michigan survey, the expected rate of consumer price inflation over the next five to ten years in the second
quarter of 1995 was the same as in the fourth quarter
of 1994. Similarly, in the May 1995 survey of professional forecasters conducted by the Federal Reserve
Bank of Philadelphia, expectations of inflation over
the coming ten years were about 3l/2 percent, the
same as in the survey taken at the end of 1994.
74
Section 3: Financial, Credit, and Monetary Developments
In charting the course of monetary policy this year,
the Federal Reserve has sought to promote sustainable economic growth and continued progress toward
price stability. Despite the tightening actions
undertaken during 1994, economic data at the beginning of 1995 suggested that the economy was operating beyond its long-run potential and might continue
to do so for some time—a situation that would no
doubt lead to a significant pickup in inflation if
allowed to persist Against this backdrop, the Federal Open Market Committee (FOMC) voted in
February to tighten reserve conditions somewhat
further, resulting in a Vi percentage point increase in
the federal funds rate. In the months following the
Domestic Interest Rates
Short-Term
Monthly
Federal Funds
Three-month Treasury bill
Coupon equivalent basis
Long-Term
Monthly
Home Mortgage
Primary Conventional
12
Thirty-year Treasury bond
i
i
19S3
i
i
1985
i
i
1987
i
i
1989
i
i
1991
i
i
1993
i
i
1995
February FOMC meeting, economic activity
seemedto be leveling out, at least temporarily,
considerably reducing pressures on resources. In early
July, with the risks of a prolonged upturn in inflation fading, the FOMC decided to ease reserve pressures slightly, resulting in a decline in the federal
funds rate of 1A percentage point.
As incoming data in 1995 increasingly suggested
slower economic growth and an attendant relief of
inflation pressures, intermediate- and long-term interest rates moved down substantially. Additional downward pressures seemed also to arise from the growing
conviction of market participants of the commitment
of the Congress and Administration to making
progress toward a balanced budget. On balance, most
longer-term interest rates have declined 120 to
180 basis points since the end of last year with the
sharpest drops at intermediate maturities. The tradeweighted exchange value of the dollar has depreciated about ll/z percent against the other G-10
currencies—in large part reflecting the decline in U.S.
long-term interest rates relative to those in the other
G-10 countries. In addition, the fall in interest rates,
coupled with continued strong corporate earnings,
fueled a runup in equity prices; most major stock
price indexes have climbed 15 to 35 percent since the
beginning of the year.
Despite slower economic expansion this year,
growth rates of broad money and credit have picked
up, and the decline in intermediate- and long-term
interest rates has only recently begun to leave an
imprint on the composition of borrowing. Total
domestic nonfinancial debt increased 5J/2 percent from
the fourth quarter of 1994 through May—a little
above last year's pace—as stronger private sector
borrowing more than offset slower growth of the
federal debt and a decline in state and local government debt. Borrowing in the nonfinancial business
sector has been largely concentrated in short-term or
floating-rate debt such as bank loans and commercial
paper. Recently, however, declines in longer-term
interest rates have stimulated a sharp jump in corporate bond issuance. Household borrowing this year
has been considerable, although below the pace of
1994. Tax-exempt debt is estimated to have declinec
outright again this year as many state and local unit
have called securities that had been advance refundec
Federal debt growth has edged down a bit this yea
extending the trend toward slower expansion of fe
era! debt that began in 1991.
75
Depository institutions have been especially important suppliers of credit to both businesses and households this year. Borrowers' demands were concentrated in the types of credit in which depositories are
traditional lenders and, on the supply side, commercial banks continued to pursue new lending opportunities aggressively. The health and profitability of
depositories have remained solid to date, although
federal regulators have cautioned depositories that
their lending standards should take account of the
potential for deterioration of loan performance in a
less favorable economic climate.
The surge in bank lending and the flattening of the
yield curve this year have provided a significant impetus for growth of the broad monetary aggregates. M3
advanced 61A percent at an annual rate from the
fourth quarter of 1994 through June—slightly above
the upper bound of its revised 2 to 6 percent annual
range set at the July FOMC meeting—as banks pulled
in deposits to fund loans. The drop in market interest
rates has enhanced the attractiveness of M2, which
increased at 33/4 percent rate over the same period—a
little above the midpoint of its annual range. In contrast to the broad monetary aggregates. Ml growth
has been quite weak, reflecting the low yields on
these assets and the implementation by a few banks of
retail sweep accounts which move funds out of NOW
accounts and into nontransaction balances.
The Course of Policy and interest Rates
The Federal Reserve entered 1995 having tightened
policy appreciably during 1994, boosting short-term
rates 2l/2 percentage points. Nonetheless, data
reviewed at the FOMC meeting in December 1994
suggested that pressures on resources were intensifying and that inflation threatened to move higher.
Although the Committee took no action to increase
rates further at this meeting, it did adopt a directive
indicating a bias toward additional tightening in the
intermeeting period.
Information reviewed at the February meeting suggested that despite some fragmentary evidence of
slowing, the economic expansion remained brisk in
an economy already operating at or beyond its longrun potential. The demand for consumer durables and
homes was softening, but output and employment had
posted substantial gains near year-end, and capacity
utilization had moved up from already high levels. In
addition, a marked rise in materials prices during the
;econd half of 1994 posed a threat of increased
onsumer price inflation in coming months. In these
ircumstances, the Board of Governors approved
the pending requests of several Reserve Banks for a
l
/2 percentage point increase in the discount rate, and
the Committee agreed to allow this increase to show
through fully to the federal funds rate. In light of the
tightening of policy called for at this meeting and the
anticipated lagged effects of previous tightenings, the
Committee viewed the odds of a need for further
policy action developing over the intermeeting period
as relatively small and evenly balanced, and therefore
issued a symmetric directive to guide any intermeeting changes in reserve conditions.
In subsequent weeks, evidence suggested that economic activity was moderating, especially in the
interest-sensitive sectors. Financial markets appeared
to view these signs as indicating that the previous
policy actions of the Federal Reserve had substantially reduced the odds of rising inflation, and thus
also the need for additional monetary restraint.
Indeed, yields on Treasury securities at maturities
ranging from one to ten years fell 60 to 70 basis
points between the February and March FOMC
meetings.
At its meeting in late March, it was not clear to the
Committee whether the deceleration in economic
activity was only temporary or was a lasting shift
toward a sustainable rate of economic expansion. On
balance, the Committee viewed the economy as
retaining considerable upward momentum and
observed that the decline in longer-term interest rates,
the rise in stock prices, and the sharp depreciation of
the exchange value of the dollar could be expected to
buoy aggregate demand in the months ahead. Moreover, consumer prices, as anticipated, had risen more
rapidly in 1995. In these circumstances, the Committee determined that it would be prudent to await
further information before taking any additional policy actions, but the Committee's directive included a
bias toward additional monetary restraint over the
intermeeting period. The asymmetric directive was
considered appropriate to emphasize the Committee's
commitment to containing and ultimately reducing
inflation, in a period when it seemed to be moving
higher.
Following the March meeting, incoming data signaled a further deceleration of economic activity. In
addition, financial markets appeared to view budget
discussions in the Congress as foreshadowing significant fiscal restraint over the balance of the decade.
Shorter-term interest rates began to incorporate the
possibility of an easing of monetary policy, and yields
on longer-term securities—especially those at intermediate maturities—moved down sharply as well.
76
The Discount Rate and Selected Market Interest Rates
Daily
12/31 2/4/94
FOMC
3/22 4/18 5/17
FOMC
FOMC
7/6
8/16
9/27
FOMC FOMC FOMC
11/15 12/20
FOMC FOMC
2/1/95
FOMC
3/28
FOMC
5/23
7/6
FOMC FOMC
Note. Dotted vertical lines indicate days on which the Committee announced a monetary policy action.
FOMC indicates days on which the Committee held scheduled meetings.
Information reviewed at the May FOMC meeting
provided persuasive evidence that the pace of the
economic expansion had slowed, relieving pressures
on resources and reducing the threat of a pickup in
inflatioa The Committee observed that an adjustment
to inventory imbalances that had developed earlier
in the year was contributing to the slowdown and
that the underlying trajectory of final sales was still
Treasury Yield Curves on Selected Dates
December 30, 1994
1
3
5 7
10
20
Maturity in years
unclear. The Committee determined that the existing
stance of policy was appropriate in these circumstances and adopted a symmetric directive regarding
potential policy adjustments during the intermeeting
period.
Employment data released shortly after the May
FOMC meeting were surprisingly weak, prompting
considerable speculation in financial markets of an
imminent monetary policy easing. The sharpness of
the downward movement in longer-term rates seemed
to reflect, in addition to economic fundamentals, trading dynamics associated with the attempts of investors to rebalance their portfolios in light of the substantial change in interest rates. At one point in late
June, the spread between the thirty-year Treasury
bond yield and the federal funds rate reached a low of
48 basis points but edged higher in subsequent weeks.
From the information reviewed at the July meeting
of the FOMC, it appeared that the economy flattened
out during the second quarter as businesses sought to
pare inventories to desired levels. This pause in the
expansion, in turn, had alleviated the inflation pressures that had loomed large earlier in the year. In
these circumstances, the Committee voted to east
reserve pressures slightly, resulting in a V* percentagi
point decline in the federal funds rate. Althoug
financial markets had anticipated a decline in rt
77
federal funds rate at some point, both bond and equity
markets rallied strongly after the change in policy was
announced. At the close on July 7, the thirty-year
bond rate was down about 165 basis points from its
recent high of last November.
Credit and Money Flows
The debt of domestic nonfinancial sectors grew
5V-z percent at an annual rate from the fourth quarter
of 1994 through May of this year—a modest pickup
over the pace of recent years but well within its
annual range of 3 to 7 percent. Slower growth of federal debt and a decline in the debt of state and local
governments in 1995 were more than offset by
strength in business and household borrowing.
Although declines in longer-term interest rates and
the flattening of the yield curve have stimulated longterm, fixed-rate borrowing of late, during much of the
year both households and businesses continued to
favor borrowing that was short-term or floating-rate.
In pan, the reliance on such debt contributed to the
larger share of private debt intermediated through the
depository sector. In meeting increased credit
demands, depositories turned more heavily to time
deposits and other liabilities included in M2 and M3.
Stronger funding needs and increased reliance on
deposits provided a considerable lift to growth of the
broad monetary aggregates.
Slower growth of federal debt this year relative to
1994 reflects stronger tax revenues and diminished
growth of expenditures, especially defense-related
outlays. In the state and local sector, debt outstanding
has continued to decline, largely driven by calls of
Debt: Annual Range and Actual Level
Billions of dollars
higher-cost debt issued during the 1980s.1 Yields on
municipal bonds relative to Treasuries had moved up
considerably after Orange County defaulted on its
debt late in 1994 but retraced much of this increase
early in 1995. The ratio of municipal yields to Treasury bond yields has climbed again more recently as
various budget proposals before the Congress raised
the prospect of reduced federal tax advantages for
municipal debt. In addition, the recent decision by
Orange County voters not to raise taxes to cover the
county's losses has tended to boost risk premiums for
the obligations of many municipalities in California
and, to a lesser extent, for other borrowers in the
municipal bond market.
Household Debt Service Burden
as a Percentage of Disposable Income
Quarterly
17
15
i l l
1983
1985
i
i i
1987
1989
1
1991
1993
I
I I
1995
Note. Debt includes household sector mortgage and consumer
debt Debt service is the sum of required interest and principal
payments on mortgage and consumer debt.
Borrowing by households—although off a bit from
last year's pace—has generally remained strong this
year. Consistent with weaker auto sales this year, a
modest deceleration of consumer credit resulted from
slower growth of auto loans. Growth of revolving
credit—principally credit card debt—trended higher
from the already brisk pace recorded last year. The
proliferation of incentive programs offered with many
credit cards has likely encouraged greater convenience use for transactions in recent quarters.
1. Many state and local units took advantage of historically low
long-term interest rates in 1993 to issue bonds that were targeted to
replace existing high-cost debt issued during the 1980s as the call
dates on those bonds arrived. Calls on previously issued debt likely
will continue to depress net state and local borrowing for some
time.
78
Growth of home mortgage debt moderated somewhat in the first quarter, a pattern consistent with the
overall sluggish demand for housing. As long-term
rates moved down this year, the pronounced shift
toward adjustable rate mortgages (ARMs) evident last
year dissipated. As of May. 60 percent of new mortgage originations were fixed-rate mortgages (FRMs).
In addition, the decline in long-term rates in recent
months has sparked renewed interest in refinancing.
Households carrying ARMs with rates that are (or
soon will be) above rates offered on FRMs have
reportedly begun to refinance with FRMs.
Household debt-service burdens—measured as the
ratio of scheduled principal and interest payments on
debt relative to income—have risen in 1995 but
remain well below levels reached in the late 1980s
and early 1990s. Mortgage refinancings undertaken at
lower interest rates in recent years have helped to
keep the level of debt-service burdens relatively low
despite the growth of household debt relative to
income. In fact, some measures of delinquency rates
on home mortgages have edged down this year to the
lowest levels in more than twenty years. The picture
for delinquency rates on consumer credit is less clear.
Some measures such as the delinquency rates on
consumer installment credit remain quite low, while
others—especially auto loans booked at finance
companies—have moved up considerably.
Borrowing by nonfinancial businesses has
increased in 1995, propelled in large part by a rise in
capital expenditures in excess of internal sources of
funds and a jump in merger activity. In addition, a
number of firms have initiated stock repurchases
financed in part with debt. As in 1994, the composiTrends in Corporate Finance
Percentage of GDP
1983
1985
1987
1989
1991
1993
1995
n'on of business borrowing this year has been heavily
weighted toward short-term commercial paper and
bank loans. Lower long-term interest rates, however,
have stimulated a flurry of new bond issues very
recently.
Various unsettling developments in financial markets including the Orange County debacle, losses
associated with complex derivatives and cash instruments, the failure of Barings Brothers, and the financial crisis in Mexico, have had some limited impacts
on the specific companies or sectors involved. However, they have not had a large impact on broad
market perceptions of credit risks; spreads of yields
on short- and long-term corporate debt over Treasuries have widened only a bit this year, likely reflecting
the elevated supply of new corporate debt and perhaps a small uptick in risk premiums.
The gap between the capital expenditures and internal cash flow of nonfinancial corporations (the financing gap) began widening in mid-1994 and has grown
even larger in 1995. In part, the bulge in the financing
gap is the result of the large buildup of inventories
earlier in the year. Most external funding for the
purpose of carrying inventories apparently has taken
the form of commercial paper or bank loans.
A surge in merger activity beginning in late 1994
has also spurred business borrowing. Many of the
largest mergers have been strategic, intra-industry
combinations, concentrated especially in areas such
as defense, Pharmaceuticals, telecommunications, and
(most recently) banking. In contrast to the merger and
acquisition wave during the late 1980s, the current
acquisition boom has not entailed highly leveraged
takeovers financed heavily with junk bonds. Indeed,
until quite recently, junk bond issuance this year has
been anemic. Merger activity in recent quarters has
involved substantial use of stock swaps coupled with
reductions in financial assets and new investmentgrade debt issuance (often in the form of commercial
paper). Survey evidence indicates that banks have
played only a modest role in directly funding recer
mergers, although they have facilitated transactor
by providing backup lines for merger-related con
mercial paper.
Equity retirements associated with mergers to
accounted for a sizable portion of the decline in
equity shares outstanding. In addition, gross issua
of new equity has ebbed as price-earnings ratios I
fallen and many firms have repurchased their s
with both accumulated cash and the proceeds of
debt.
79
however, with many filing for bank charters or being
acquired by banks.
Selected Price-Earnings Ratios
Monthly
Nasdaq
45
35
25
15
1983
1985
1987
1989
1991
1993
1995
The shift to short-term funding in the business
sector has been a boon to intermediaries that tend to
specialize in short-term lending. Finance companies
and commercial banks, in particular, have enjoyed a
prominent role as suppliers of credit over the last
year. To date, there are few indications that the health
of these institutions has deteriorated. Credit ratings
for finance companies have been stable and bank
profitability and capital ratios have been solid.
An important factor contributing to the overall
strength of depository credit has been the stabilization
of the thrift industry, especially savings and loan
associations. After several years of sharp contraction,
thrift assets expanded slightly over the second half of
1994 and continued a modest recovery in 1995. The
number of thrift institutions continues to decline,
The growth of bank credit picked up appreciably
during the first half of 1995, with strength especially
evident in bank loans. Indeed, the share of the
increase in nonfederal domestic debt over the past
twelve months funded by bank loans climbed to
record levels. Surveys of bank lending officers have
indicated banks' increased willingness to extend consumer credit as well as continued easing of terms and
standards applied to business loans. Data from the
Federal Reserve's Survey of Terms of Bank Lending
to Business show that spreads of loan rates over the
federal funds rate for large commercial loans have
been about the same as last year but well below those
prevailing through much of the late 1980s and early
1990s. Comparable spreads for smaller commercial
loans are wider than in the late 1980s but have continued the narrowing trend of recent years. The strength
of bank lending has been viewed favorably in financial markets—bank stock prices have risen this year
about in line with or faster than the climb in broad
stock price indexes, while spreads on bank debt relative to Treasuries have widened only slightly.
Percentage of Change in Domestic Nonfederal
Debt Funded with Bank Loans
Total Risk-Based Capital Ratio
(Domestically Chartered Commercial Banks)
Ratio
(Tier 1 + Tier 2) / Risk weighted assets
0.13
0.12
1975
1980
Note. 12-month changes.
1985
0.11
0.1
0.09
0.08
90
1991
1992
1993
1994
1995
The continued easing of bank lending standards
after more than a year of monetary policy restraint has
attracted the attention of federal regulators. The Office
of the Comptroller of the Currency warned banks
against allowing their standards to fall to a point that
could expose them to heavy losses in an economic
downturn. In the same spirit, the Federal Reserve
80
issued a supervisory letter cautioning banks that loan
terms and standards should be set with a long-term
view that takes loan performance in less favorable
economic conditions into account.
Banks have funded the bulge in their loan portfolios this year in part by liquidating a portion of the
large holdings of securities they had accumulated
earlier in the 1990s.2 In addition, banks have increasedtheir liabilities. Last year, banks relied heavily
on borrowings from their non-US, offices to fund
growth of their domestic assets. Deposit growth at the
foreign offices of US. banks has slowed considerably
this year. Consistent with this development, borrowing by domestically chartered banks from their foreign offices has increased in 1995 but not at the pace
of last year.
M3: Actual Range and Actual Level
Billions of dollars
4550
4500
4450
4400
2%
4300
4250
O N D J F M A M J
1994
Changes in Bank Lending Standards
for Business Loans by Size of Borrower
50
\\A Urge
25
Medium
25
1990
1991
1992
1993
1994
1995
Note. Percentage of banks tightening standards less percentage easing standards.
_ 4350
J A S O N D
4200
1995
growth has averaged 33A percent, placing the level oi
M2 in the upper half of its annual range.
The pickup in M3 growth this year reflects strongei
expansion in both its M2 and non-M2 components
The acceleration of "wholesale" funding sources
especially large time deposits, has been quite markec
this year. Banks' heavier reliance on wholesale funds
is typical during periods in which bank loan portfolios
are expanding swiftly. The non-M2 portion of M3
has also been boosted by a sharp jump in institutiononly money funds. The yields on these funds tend tc
lag movements in short-term market interest ratej
and, as a result, became especially attractive to investors when short-term market interest rates began falling on expectations of a near-term easing of monetary
policy.
M2: Actual Range and Actual Level
Billions of dolla
Depositories' shift back into funding with domestic
liabilities has helped spur the growth of the broad
monetary aggregates this year. From the fourth quarter of 1994 through June, growth of M3 has averaged
6V* percent, placing the level of M3 above the upper
bound of its annual range. Over the same period. M2
2. Published data on changes in securities portfolios at banks
may not accurately portray funding strategies because recent
accounting changes have increased the share of securities and
off-balance-sheet contracts that must be marked-to-market on
banks' balance sheets. Estimates suggest that changes in the market
valuation of securities and off-balance-sheet contracts under these
accounting rules have added about 1 percentage point at an annual
rate to the growth of bank credit from the fourth quarter of 1994
through June of this year.
O N O J
1994
F M A M J J A S O N C
1995
81
M2 Velocity and M2 Opportunity Cost
Ratio scale
Percentage points ratio scale
13
11
9
1.8
1.7
1.6
1.5
1983
1987
1991
.1995
Note. M2 opportunfty cost is two-quarter moving average of three-month Treasury bill
less weighted average rate paid on M2 components.
The acceleration of M2 this year owes chiefly to
the waning influence of previous increases in shortterm interest rates, and a marked flattening of the
yield curve. On balance this year, the returns on assets
in M2 have become more attractive relative to both
short- and long-term market instruments. Sizable
inflows to stock mutual funds have continued, but
theflatter yield curve has damped the demand for
other long-term investments. Inflows to bond mutual
funds—while stronger than during the bond market
rout last year—have been much smaller than inflows
earlier in the 1990s. Also, judging from noncompetitive tenders at recent Treasury auctions, households'
direct investments in Treasury securities have
dwindled sharply this year. At least a portion of the
flows that previously had been directed to mutual
funds and direct investments in securities appears to
have boosted M2 growth. Growth of money market
mutual funds and small time deposits, in particular,
has been especially brisk. Indeed, more than half of
the increase in M2 since April is attributable to a
steep climb in M2 money funds.
M1: Actual Level
In contrast to the broader aggregates. Ml growth
has weakened this year, primarily as a result of wide
opportunity costs on transaction deposits and the
introduction and expansion of retail sweep accounts
at some large banks. Interest rates offered on other
checkable deposits (OCDs) have edged up only
slightly since the beginning of 1994 despite the sharp
rise in short-term market interest rates. Households
have responded by reducing balances in these
accounts in favor of higher-yielding assets. The development of sweep accounts by a few large banks for
their retail customers has facilitated the shift away
from transaction balances. Sweep accounts transfer a
customer's OCD account balances in excess of a
cenain threshold into a money market deposit account
(MMDA). Automatic transfers from the customer's
MMDA account back to the OCD account are initiated as checks and other withdrawals deplete OCD
Billions of dollars
1200
D J F M A M J J A S O N D
1995
1100
82
balances. Such sweep accounts may allow customers
to earn more interest and benefit the bank by reducing
its required reserves.3 Estimates suggest that retail
sweep accounts have reduced Ml by about $12 billion so far this year. These programs affect the composition but not the level of M2 because balances are
swept from transaction deposits into other accounts
included in M2.
The expansion of retail sweep accounts poses some
potential problems for the implementation of monetary policy by the Federal Reserve. To date, such
accounts have been offered by large banks that must
maintain a balance at a Federal Reserve Bank to meet
their reserve requirements. As a result, the reduction
in required reserves associated with sweep accounts
has implied a nearly equivalent reduction in aggregate
required reserve balances; estimates suggest that the
$12 billion dollar decline in OCDs this year translates
to a reduction in required reserve balances of nearly
$1.2 billion.4 In early 1991, following the cut in
reserve requirements at the end of 1990. unusually
low levels of aggregate reserve balances were associated with greater variability in the federal funds rate
as banks' volatile clearing needs began to dominate
the demand for reserves. If many banks begin to offer
retail sweep programs in the future, the aggregate
level of required reserve balances would likely fall
substantially, potentially leading to instability in the
aggregate demand for reserves.
The monetary base expanded at a 5V£ percent rate
from the fourth quarter of 1994 through June. Currency growth this year—at 7V* percent from 1994:Q4
through June—is off a bit from last year's pace but
still quite robust. Foreign demands for U.S. currency
have generally remained strong this year. In concert
with the decline in transaction deposits, total reserves
contracted at a 6 percent rate from 1994:Q4 through
June. In the absence of the increase in sweep
accounts, the decline in total reserves over this period
would have been 21/* percent at an annual rate.
3. Under the current structure of reserve requirements, OCD
accounts are subject to a 10 percent reserve requirement at banks
with more than $54 million of net transaction deposits. By law,
personal MMOAs are exempt from reserve requirements.
4. The reduction in required reserve balances is not necessarily
identical to the reduction in required reserves. This is because
banks typically use vault cash in addition to reserve balances to
satisfy reserve requirements. The level of vault cash held by banks
is primarily determined by their customers' needs. Required
reserves for some banks are nearly or even completely satisfied by
vault cash. In these cases, a reduction in required reserves due to
sweeps would not show through to a decline in required reserve
balances on a one-for-one basis.
Foreign Exchange Value of the Dollar
in Terms of Selected Currencies
December 1993 = 100
Daily
105
95
WK
Japanese yen » «p*1
75
NOJ FMAMJ J A S O N O J F M A M J J
1993
1994
1995
Note. Foreign currency units per dollar.
International Financial Developments
At the turn of the year, the foreign exchange value
of the dollar was under downward pressure, and that
pressure continued through the first months of 1995.
On balance, the multilateral trade-weighted value of
the dollar in terms of the other G-10 currencies has
depreciated about 7J/a percent since the end of
December 1994. The dollar declined as economic
indicators began to suggest that economic growth in
the United States was slowing, lowering the likeliWetghted Average Foreign Exchange Value
of the U.S. Dollar
December 1993=100
Daily
10'
Mil
N D J F M A M J J A S O N D J F M A M J J
1993
1994
199
Note. Index of weighted average foreign exchange
U.S. dollar in terms of currencies of the other G-10 r
Weights are based on 1972-76 global trade of each of tf
countries.
83
U.S. and Foreign Interest Rates
Three-month
hood of further increases in U.S. market interest rates.
In addition, the Mexican crisis appeared to weigh on
the dollar in early 1995. External adjustment by
Mexico was rightly expected to involve, to an
important extent, a corresponding decrease in U.S. net
exports. Primarily for that reason, financial turmoil in
Mexico and depreciation of the peso were seen as
having possible adverse implications for U.S. growth
and external accounts and, in general, as negative for
dollar-denominated assets.
Average foreign
10
The dollar was supported only briefly by the
increase in the discount rate and the federal funds
rateat the February FOMC meeting. With the U.S.
economic expansion softening, market participants
came to expect that no further increases in these rates
were likely in the near term. Downward pressure on
the dollar intensified in late February, and on
March 2, in somewhat thin and disorderly market
conditions, the dollar fell sharply further against the
mark and the yen. The foreign exchange Trading
Desk at the New York Federal Reserve Bank entered
the market, buying both marks and yen on behalf of
the Treasury and the Federal Reserve System. The
next day several other central banks joined the Desk
in concerted intervention in support of the dollar.
Intervention by the Desk on behalf of the Treasury
and the Federal Reserve System totaled $1.42 billioa
In a statement confirming the intervention. Secretary
Rubin highlighted official concern about the dollar's
exchange value. Downward pressure on the dollar
continued, particularly against the yen, and on April 3
and 5 the Desk, acting on behalf of the Treasury and
Federal Reserve System, again joined several other
central banks in intervention to support the dollar.
Secretary Rubin issued a statement that these actions
were in response to recent movement on exchange
markets and that the Administration was committed
to a strong dollar.
Ten-year
12
Average foreign
U.S. Treasury
J
I
1985
I
1987
1989
I
1991
I
I
1993
I
U4
1995
Note. Average foreign rates are the trade-weighted average,
for the other G-10 countries, of yields on instruments comparable
to U.S. instruments shown. The data are monthly.
ated in a range somewhat above its lows of mid-April
and early May. On July 7, following moves by both
the Federal Reserve and the Bank of Japan to ease
monetary conditions, the Desk joined the Japanese
monetary authorities in intervention purchases of dollars; the dollar moved up a bit in response.
The dollar fell further through mid-April, particularly against the yen, and on April 19 it touched a
record low of less than 80 yen per dollar. After
recovering slightly and remaining fairly stable
through mid-May, the dollar rebounded sharply but
subsequently relinquished some of those gains. On
May 31, the Desk—on behalf of the Treasury and the
Federal Reserve—joined the central banks of the
other G-10 countries in intervention purchases of
dollars. Secretary Rubin stated that the intervention
was in keeping with the objectives of the April 28
communique of the G-7 finance ministers and central
bank governors, which endorsed the orderly reversal
of the decline in the dollar in terms of other G-7
currencies. Through May and June, the dollar fluctu-
I
1983
Long-term (ten-year) interest rates in the major
foreign industrial countries have, on average, have
declined about 100 basis points since December, as
economic indicators have suggested some slowing of
real output growth abroad as well as in the United
States. With U.S. long-term rates falling much more,
about 170 basis points on balance, the change in the
long-term interest differential is consistent with some
decline in the exchange value of the dollar. Long-term
24
84
rates have dropped about 150 basis points in Japan,
nearly as much as the decline in U.S. long-term rates.
Rates in Germany are down about 90 basis points.
Three-month market interest rates in these countries
have declined about 90 basis points on average since
year-end 1994; central bank official lending rates
were lowered in 1995 in several countries, including
Japan. Germany, and Canada. Following the Federal
Reserve easing on July 6, the central banks of Canada
and Japan lowered overnight lending rates.
Some of the upward pressure on the mark over the
past several months resulted from shifts within the
Exchange Rate Mechanism (ERM) of the European
Monetary System, as political uncertainties and fiscal
problems in Italy, Sweden, Spain, and later France,
led at times to the selling of their respective currencies for marks. Realignment within the ERM on
March 5 that lowered the values of the Spanish peseta
and the Portuguese escudo contributed to the upward
movement of the mark. In contrast to the dollar's
movement against the yen and the mark since December, the dollar is down only 3 percent in terms of the
Canadian dollar. Early in the year, the U.S. dollar
appreciated against the Canadian dollar, uncertainty
about whether fiscal problems in Canada would be
addressed and spillover from the Mexican crisis
caused the Canadian dollar to fall. Since then, the
Canadian dollar has regained those losses.
Since December 1994, the dollar has depreciated
about 12 percent on balance against the Japanese
yen,despite declines in Japanese long-term rates that
nearly matched the decline in U.S. rates. The yen
fluctuated in response to progress, or lack of progress,
in the resolution of trade disputes with the United
States. Persistent strength in the yen appears to reflect
the large Japanese current account surplus and market
perceptions that some adjustment of that surplus,
through yen appreciation, is inevitable, especially
given the slow growth of the Japanese economy.
Japanese financial markets more broadly have reflected the weak state of the Japanese economy. Stock
prices have fallen considerably so far this year, with
the Nikkei down about 16 percent since the end of
December, and land prices have fallen further. These
declines in asset prices have added to the perceived
risks in the Japanese banking system and concerns
that the recovery in economic activity is stalling.
Over the past several months, the Mexican peso
has recovered somewhat in terms of the U.S. dollar
from the lows reached during the height of the crisis.
On balance, the peso has depreciated 40 percent in
nominal terms from December 19, 1994, before the
crisis broke out. Mexican officials have drawn on the
Treasury Department's Exchange Stabilization Fund
facility and the Federal Reserve's swap line in
addressing addressing Mexico's international liquidity problems. Outstanding net drawings to date total
$12.5 billion. The outstanding total of the government's dollar-denominated short-term obligations,
tesebonos, has been reduced below $10 billion.
Net depreciation of the dollar in terms of the German mark over this period has been about 10 percent.
25
85
Growth of Money and Debt
Percentage change
Period
M1
M2
M3
Domestic
nonfinancial
debt
7.4
9.6
12.4
9.9
9.9
10.9
9.1
9.9
9.6
11.8
14.4
Annuar
1980
1981
1982
1983
1984
8.8
10.4
5.5
8.9
9.3
9.2
12.2
8.1
1985
1986
1987
1988
1989
12.0
15.5
6.3
4.3
0.6
8.7
9.3
4.3
5.3
4.8
7.6
8.9
5.7
6.3
3.8
14.1
13.5
10.2
9.0
7.9
1990
1991
1992
1993
1994
4.2
7.9
14.3
10.5
2.3
4.0
2.9
2.0
1.7
1.0
1.7
1.2
0.5
1.0
1.4
6.5
4.6
4.7
5.2
5.1
5.4 (2.5)2
Quarterly
(annual rate)
1994
Q1
Q2
Q3
Q4
5.5
2.7
2.4
-1.2
1.8
1.7
0.9
-0.3
0.6
1.3
2.1
1.7
5.2
5.4
4.2
5.2
1995
Q1
Q2
0.0
-0.9
1.6
4.2
4.3
6.7
5.5
5.4
1. From average for fourth quarter of preceding year to
average for fourth quarter of year indicated.
2. Figure in parentheses is adjusted for shins to NOW
accounts in 1981.
26
o
@FedFRASER