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CONDUCT OF MONETARY POLICY
Report of the Federal Reserve Board pursuant to the
Full Enipluyment and Balanced Growth Act of 1978
PX. 95-523
the State of the Economy

HEARING
BEFOKE THE

SUBCOMMITTEE ON
DOMESTIC AND INTERNATIONAL MONETARY POLICY
OF THE

COMMITTEE ON BANKING AND
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION

JULY 22, 1998
Printed for the use of the Committee on Banking and Financial Services

Serial No. 105-70

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1998

Fw sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
I S B N 0-16-057571-0




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 K. BEREUTER, Nebraska
BRUCE F. VENTO, Minnesota
RICHARD H. BAKER, Louisiana
CHARLES E. SCHUMER, New York
RICK LAZIO, New York
BARNEY FRANK, Massachusetts
SPENCER BACHUS, Alabama
PAUL E. KANJORSKI, Pennsylvania
MICHAEL N. CASTLE, Delaware
JOSEPH P. KENNEDY II, Massachusetts
PETER T. KING, New York
MAXINE WATERS, California
TOM CAMPBELL, California
CAROLYN B. MALONEY, New York
EDWARD R. ROYCE, California
LUIS V. GUTIERREZ, Illinois
FRANK D. LUCAS, Oklahoma
LUCILLE ROYBAL-ALLARD, California
JACK METCALF, Washington
THOMAS M. BARRETT, Wisconsin
ROBERT W. NEY, Ohio
NYDIA M. VELAZQUEZ, New York
ROBERT L. EHRLICH JR., Maryland
MELVIN L. WATT, North Carolina
BOB BARR, Georgia
MAURICE D. HINCHEY, New York
JON D. FOX, Pennsylvania
GARY L. ACKERMAN, New York
SUE W. KELLY, New York
KEN BENTSEN, Texas
RON PAUL, Texas
JESSE L. JACKSON, JR., Illinois
DAVE WELDON, Florida
CAROLYN C. KILPATRICK, Michigan
JIM RYUN, Kansas
JAMES H. MALONEY, Connecticut
MERRILL COOK, Utah
DARLENE HOOLEY, Oregon
VINCE SNOWBARGER, Kansas
JULIA M. CARSON, Indiana
BOB RILEY, Alabama
ROBERT A. WEYGAND, Rhode Island
RICK HILL, Montana
BRAD SHERMAN, California
PETE SESSIONS, Texas
MAX SANDLIN, Texas
STEVEN c. LATOURETTE, Ohio
GREGORY MEEKS, New York
DONALD A. MANZULLO, Illinois
BARBARA LEE, California
MARK FOLEY, Florida
VIRGIL GOODE, Virginia
WALTER B. JONES JR., North Carolina
BILL REDMOND, New Mexico
BERNARD SANDERS, Vermont
VITO FOSSELLA, New York

SUBCOMMITTEE ON DOMESTIC AND INTERNATIONAL MONETARY POLICY
MICHAEL N. CASTLE, Delaware, Chairman
JON D. FOX Pennsylvania, Vice Chairman
MAXINE WATERS, California
STEVEN c. LATOURETTE, Ohio
BARNEY FRANK, Massachusetts
FRANK D. LUCAS, Oklahoma
JOSEPH P. KENNEDY II, Massachusetts
JACK METCALF, Washington
BERNARD SANDERS, Vermont
ROBERT W. NEY, Ohio
CAROLYN B. MALONEY, New York
BOB BARR, Georgia
MAURICE D. HINCHEY, New York
RON PAUL, Texas
JESSE L. JACKSON, JR., Illinois
DAVE WELDON, Florida
MELVIN L. WATT, North Carolina
MARGE ROUKEMA, New Jersey
DARLENE HOOLEY, Oregon
DOUG K. BEREUTER, Nebraska
JULIA M. CARSON, Indiana
MERRILL COOK, Utah
GREGORY MEEKS, New York
DONALD A, MANZULLO, Illinois
BARBARA LEE, California
MARK FOLEY, Florida




(II)

CONTENTS
Page
Hearing held on:
July 22, 1998

1

Appendix
July 22, 1998

45
WITNESSES
WEDNESDAY, JULY 22, 1998

Greenspan, Hon. Alan, Chairman, Board of Governors, the Federal Reserve
System

1]

APPENDIX
Prepared statements:
Castle, Hon. Michael N
Greenspan, Hon. Alan

46
49

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD
Greenspan, Hon. Alan:
Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978, July 21, 1998
Written response to questions from Hon. Ken Bentsen
Written response to questions from Hon. Michael N. Castle
AFL-CIO, prepared statement, David A. Smith, Director of Public Policy




(III)

73
110
104
115

CONDUCT OF MONETARY POLICY
WEDNESDAY, JULY 22, 1998

U.S.HousE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC AND
INTERNATIONAL MONETARY POLICY,
COMMITTEE ON BANKING AND FINANCIAL SERVICES,

Washington, DC.

The subcommittee met, pursuant to call, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Michael N. Castle,
[chairman of the subcommittee], presiding.
Present: Chairman Castle; Representatives Lucas, Metcalf, Paul,
Weldon, Roukema, Waters, Frank, Kennedy, C. Maloney of New
York, Hinchey, Jackson, Watt and Lee,
Chairman CASTLE. The hearing will come to order, and we welcome you, Mr. Chairman, again, as we do twice a year.
We meet today to receive the annual midyear report of the Board
of Governors of the Federal Reserve System on the Conduct of
Monetary Policy and the State of the Economy, and, as you know,
this is mandated in the Full Employment and Balanced Growth
Act of 1978.
Mr. Chairman, we welcome you back to the House Committee on
Banking and Financial Services and our Subcommittee on Domestic and International Monetary Policy.
The American economy continues to perform well, due in part to
the work of the Federal Reserve. We are not greedy, but we would
be very grateful if you can just announce that the current good economic times will continue for at least another 88 months.
Let me just say this: Sometimes when I give graduation speeches, I tell a little story about a man standing on a plain giving a
speech, and he sees a speck in the horizon, and he doesn't know
what it is. And then after a couple of minutes the speck grows, and
then he realizes it is a herd of buffalo. And then he realizes the
herd of buffalo is getting closer, and he can distinguish what they
are, and he also realizes if he is not through his speech in ten minutes, that he is going to be overrun by the buffalo. With the idea
that I will speak for ten minutes—I will now cut that to eight minutes by the way. The kids didn't even like the ten minutes, I
learned.
But I feel the same way about Asia and with respect to what I
would like to personally extract from this hearing today, and I realize it is very important in your case to make prepared statements,
but it terms of our questions and answers, we need to address
those particular questions.
(l)




I feel that Asian economic problems came upon us unexpectedly.
I don't think we were prepared for it at any segment of the American economy all the way from intelligence to the Government to
the private sector. I think it has been more extensive in terms of
involving countries than perhaps originally anticipated. I think the
longevity of it has extended at least as long as anybody has said,
and perhaps longer. And, of course, the threat of it with respect to
Japan is perhaps greater than we ever expected.
I think the counterpoint to all this, and some of this is set forth,
I have a story from U.S. News and World Report, "Will Japan Trip
the Bull?", the highlights that you talked about, half your testimony before the Senate yesterday, But a good portion of what has
happened so far has actually, in my judgment, been beneficial to
the American economy in terms of reduced prices for commodities,
for oil, for finished products, in terms of capital coming into the
United States to avoid problems in other countries. And, yes, there
have been some slowdowns on some orders and maybe hitting particular segments of our economy, but for the most part you can almost make an argument as good for positive as has been negative.
And yet I have that feeling that we are getting to a precipice at
which point it is going to become quite negative rather rapidly, and
are we ready for tbat? Do we really anticipate where that is going?
When you visited us in February of this year, we discussed our
concern over the troubled Japanese economy. The change in the
Government of Japan has confirmed, in my judgment, that those
concerns were valid. The Asian economic uncertainty, and especially the status of Japan's economy, I believe, are almost certainly
the greatest threat to our own economic health. That is a personal
judgment; you haven't stated that. More than inflation or any domestic problem we have, I think that is by far the greatest threat
to our own economic health, and I hope that you will share with
us today through the question and answer period, as well as your
speech, your impressions regarding the degree of seriousness with
which the Japanese authorities are approaching the solution of
their economic problems.
The rest of Asia is still, at best, digging out of their own problems. Maybe their problems are even worsening, and success, in my
judgment, depends heavily on Japan.
The danger of spreading this international economic flu seems
even more real when we watch the situation in Russia. If oil prices
continue to hover around the current low levels, Mexico may again
be in crisis, and others in Latin America could follow, so I hope you
will comment on the dangers of the regional economic problems reinforcing each other, what they may mean for the world economy.
As you know, the debate continues to rage right here in Congress
almost daily this week, as a matter of fact, over whether the
United States should contribute an additional $18 billion to the
International Monetary Fund to help meet international economic
instability, and I am very eager to hear your views on the role of
IMF in addressing these problems.
While we look to you to alert us to what we should be worrying
about, we also expect that when you address the House, the markets will move up, as opposed to occasions when you address the




Senate, a trend noticed in recent hearings before the House and
the Senate.
The high relative value of the dollar evidently continues to reflect
both the leading position of our economy with regard to Europe, the
Far East, and the capital that arrives from areas suffering economic insecurity. Should we anticipate further action such as the
June 17 intervention to prop up the yen? As a general rule is this
an effective strategy?
As the economy continues to rewrite the traditional models, we
welcome your insight regarding adjustments being incorporated
into your models.
My view is that we must have a full discussion of the potential
impact of events in Japan and Asia on the future of our own economy and working Americans, and what steps we as policymakers
can take to protect our Nation.
As always, we are delighted to have you with us, and we look forward today to a lively discussion.
[The prepared statement of Hon. Michael N. Castle can be found
on page 46 in the appendix.]
Chairman CASTLE. And with that, let me turn to Mr. Frank.
Mr. FRANK. Thank you, Mr. Chairman.
I find today's hearing a little different than usual because I think
for the first time in my memory we do not meet under what I consider to be the imminent threat of a rate increase being rattled by
some of the Chairman's tellings. But I really wanted to talk about,
because I think we have a little breathing space now, the overall
situation.
I noted, Mr. Chairman, that you mentioned yesterday and mention again today the danger of inflation, and we have had this conversation before. You do, when asked, acknowledge that there is a
concern both about excessive growth and about inadequate growth.
But it does seem to me, reading your statements, certainly the emphasis, clearly the thrust, is much more to be concerned with inflation.
Now, that is partly institutional, obviously, and I understand
that you are not, despite what some people say, a one-person board.
We recognize that you serve with a number of other appointees and
regional bank presidents, and that there is more collegiality, in
fact, than journalistic shorthand sometimes suggests, and I understand those concerns that you have to deal with. But what this
comes up with is institutionally a Federal Reserve, which is, it
seems to me—there is a bias from time to time that you vote. You
voted that there is a kind of a predisposition to raise interest rates.
It seems to me that is almost superfluous for you to vote it because
institutionally the Federal Reserve system is clearly more worried
about that.
The problem is that the way things have evolved, the Federal Reserve has become, by far, the most potent economic policymaker in
the country. So what we have is a disproportion here. Triere is no
entity concerned about banking growths that has the ability to
move events, the policy impact and the role that the Federal Reserve has.
Now, I am very pleased that since March of last year, and that
was a fairly minor exception, the Federal Reserve has maintained




what seems to be an appropriate posture, and I understand that
that could not always, for everybody at the Federal Reserve, be an
automatic decision. So I am pleased at the way policy has gone, but
I think we continue to have this problem.
I look at America today. I look at the social problems we still
have, the potential growth in inequity, and that is the real problem.
You know, I have a very odd district. I have a district that the
Massachusetts Legislature was particularly whimsical when they
drew up. They weren't really specifically concerned with me. The
Governor was trying to hurt one guy, the senate president was trying to help another guy. I got what one didn't want and the other
one wanted. One guy didn't get what he didn't want, and one guy
didn't get what he wanted, and I got the remains. I have a district
which, in consequence, if I were African American, would be found
to be unconstitutional. Only white people under current jurisprudence may be the beneficiaries of gerrymandering as blatant as
happened in Massachusetts in 1992, but it gives me a very interesting look.
I have a northern part of my district which is very much benefiting from the world economy, people who work at Fidelity, people
who provide first-rate medical care, people who develop higher
technological and software products. And I have, in the southern
part of my district, people who have worked very hard all their
lives in traditional manufacturing for whom global integration has
not on the whole been a good thing, and they have on the whole
lost out.
One of the problems we have is that not surprisingly, the children of the people who live in the north overwhelmingly live in
homes where there are computers and people to teach them how
to use them; and overwhelmingly people in the south—not overwhelmingly, but the majority of people in the south do not have
that.
Whatever one thinks about current problems, not to resolve those
problems is to guarantee a worsening of inequity with consequent
negative problems to the society, and I worry that we do not have
institutionally any entity that is prepared to take that on and that
there is a kind of a bias.
And finally let me say, if I just may be 30 seconds over, Mr.
Chairman, but I was thinking about Harry Truman the other day
and Harry Truman's famous comment that what he wanted was a
"one-handed economist," because he wouldn't be saying, "... on the
one hand" and "...on the other hand." I would like an economist
whose hands are untied.
What I have found recently is that economists on the whole, and
that includes the economists at the Federal Reserve, a very distinguished aggregation, probably the world's most powerful economists are collected at the Federal Reserve in terms of the impact
they collectively have on public policy. And there is a distrust of
politicians. There is a tendency to filter what you tell us because
you are afraid, I think, that if we are told things unvarnished, we
may react irresponsibly.
For example, when we talk about trade, I have had economists
privately acknowledge to me that, yes, there are negative effects to




trade as well as positive effects, but they believe that the positive
effects greatly outweigh the negative effects, and they are afraid
that acknowledging the negative effects, that we politicians overuse
them.
Similarly I have a sense that the economic dues with regard to
the inflation on employment tradeoff and the fact that there is not
nearly as much of a tradeoff as we thought, I think many economists in their heart of hearts know that things have gotten better,
but are afraid to tell us because they are afraid of populistic viewpoints. They are afraid that if we learn what was happening, we
might kind of slip the traces.
And the thing I want to stress again in closing, and I appreciate
the indulgence, Mr. Chairman, is even from their own standpoint,
they are underestimating the importance of equity. Even as we sit
here today, you and I, Mr. Chairman, and I think my colleagues
who happen to be here today, most of us are strong supporters of
an appropriately worded IMF increase, but we have trouble getting
the votes. Until and unless—and this is the final point I wanted
to make—until and unless we as a society do a better job of addressing equity issues and particularly reassuring people that
globalization is not going to come at the expense of the least educated and the least equipped to compete in the world, we are going
to have a resistance to what you see as our rational self-interest
regarding international economics, and I worry, just to tie this together, that the institutional trigger finger itchiness about interest
rate raising at the Federal Reserve is a constraining factor on that.
Thank you for your indulgence, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Frank.
Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I will abbreviate my
remarks, having heard the extension of your remarks. But I do
want to welcome Chairman Greenspan here today. I believe that he
and the Federal Reserve should be congratulated on their wise conduct of monetary policy. I have no question that it has had positive
effects in terms of sustaining a very healthy economy. I certainly
look forward to what your analysis is today. I believe that you have
shown not only incisive actions, but also clearly articulated your
approach to both national and international economic issues.
Certainly one important issue, most immediate to all of us, and
I will be interested! in your additional comments, is IMF funding.
You and I have always agreed on IMF funding. It is an immediate
issue this week. I am hopeful that we cannot only get the $3.5 billion, but that we will ultimately get the full amount. I would like
to work with you on that and hope that you address this issue with
precision in your statement today.
I certainly understand and want to work with my Republican colleagues in terms of bringing some reforms to the IMF so it is consistent with what we did in the committee in terms of the question
of transparency and conditionally and maybe go farther, but I
would hope that this would be an opportunity for you to stress the
importance of IMF funding and provide your insights on this issue.
I did hear the Chairman's references to the Asian crisis, and specifically to the Japanese banking question. I won't go into that
again, but I do want to say that I hope you will be precise in ad-




dressing the question of the so-called U.S. budget surpluses and
the whole question of tax reductions, whether or not they are appropriate and to what degree they are appropriate now in the context of our total economy, monetary policy and the budgetary questions.
So I am actively looking forward to hearing what you have to
say. You are a true patriot as well as a leader in the world economic situation, particularly our own healthy economy, and hopefully with your leadership we can continue that and spread it to
Southeast Asia as well.
Thank you, Mr. Chairman. Thank you.
Chairman CASTLE. Thank you Mrs. Roukema, and thank you for
abbreviating your statement somewhat. We hope that others perhaps can follow so we can get to the Chairman as soon as possible.
With that let me turn to Mr. Hinchey.
Mr. HlNCHEY. Thank you very much, Mr. Chairman.
Welcome, Mr. Greenspan. Pleasure to see you again. I look forward to your testimony, although some of us had an opportunity
to see it on C-SPAN last nignt. I assume that things haven t
changed all that much in the intervening 24 hours.
The availability of the minutes of the Federal Open Market Committee, even though there is a lag, continue to demonstrate their
value. Among other things, they have shown us that there has been
some disagreement among the members of the FOMC with regard
to monetary policy. And in that regard I want to express my personal appreciation to the leadership that you have shown in resisting what at least a couple of the bankers on the committee would
have done if they had had their way, they would have increased
interest rates, and I think that that would have been a very serious
mistake.
There are those of us who believe that real interest rates, interest rates as a function of inflation, continue to be too high. I am
particularly concerned about our readiness to deal with certain economic circumstances that have begun to express themselves in
some cases rather dramatically and other cases less so. Inflation
remains very, very low indeed. The latest indicators show that over
the course of the last year, June to June, consumer prices and producer prices have gone up less than 2 percent. So inflation remains
very, very low.
We have the Asian crisis, which is now beginning to express
itself more fully, and hear at home, the trade deficit is reaching
enormous proportions. The Asian crisis is principally responsible
for the growing trade deficit, though the strong dollar is also playing a role in it.
There is also the strike at General Motors, as well as an apparent loss in manufacturing jobs. Current figures show manufacturing jobs dropping off in the most recent reporting period. Those,
coupled with a number of other factors which seem to indicate that
the economy is slowing, cause me to be concerned that we are not
doing all that we can to prepare ourselves for the full impact of all
these economic circumstances.
So, I expect that you will address these issues as you did yesterday to some extent before the Senate Banking Committee, and I
would continue to hope that the Open Market Committee and Fed-




eral Reserve generally would express a more deep and accurate realization of the impacts of the Asian crisis because I feel that we
are not preparing ourselves adequately for the consequences. All
the forecasts indicate that we are going to see a downturn in our
economy, and it may be that we can do things that will make it
less serious. I hope that you will address your remarks to that as
well,
I thank you very much.
Chairman CASTLE. Thank you.
The Chairman of the full Banking Committee, Mr. Leach.
Mr. LEACH. Thank you, Mr. Chairman. I will be brief, but I think
it appropriate to reference when the economic circumstances that
are so positive have occurred. I think you will go down as the most
thoughtful and successful Federal Reserve Chairman in the country. Having said that, though, I think it should not be lost on anyone that the most important phenomenon of monetary policy is not
necessarily the individual stewardship of an exceptional Chairman,
but is the independence of the Fed itself. And for those of us in the
Legislative branch, it is important that we realize and recognize
that. In fact, it is not inconceivable that when people write the economic history of the 20th century, the judgment might not be that
the most important institution of governance was established in
this century was the Federal Reserve Board of the United States,
and that it has been the most successful. And we, in that context,
welcome this distinguished Chairman.
Chairman CASTLE. Thank you very much, Mr. Chairman.
I will turn next^I think Mr. Bentsen was the next to arrive. No
statement?
Mr. Watt.
Mr. WATT. Thank you, Mr. Chairman. I will be very brief. I certainly won't take the five minutes.
I just wanted to welcome the Chairman to the subcommittee and
express my thanks to him for his recent appearance in Charlotte
where he was an outstanding success and drew a record crowd to
his comments there.
I resisted the temptation to stop and listen to your comments on
C-Span last night so that I could hear them fresh today, and I am
looking forward to hearing them, I hope that you will specifically
comment on one concern that I have and certainly not professing
to be an expert in this area, but there is a clear interplay between
unemployment and interest rates and inflation, as you see it, and
unemployment in the aggregate clearly has been very low, but in
some parts of our communities, inner cities in particular, unemployment continues to be in double digits. And so I hope you will
address your approach to deciding when to raise interest rates, taking that into account, the global aggregate unemployment picture,
but also how we address the issue of unemployment in some of the
higher unemployment areas in the context of that overall picture.
And if you will address that issue at some point during your stay
here, I would be most appreciative.
Thank you Mr. Chairman. I yield back.
Chairman CASTLE. Thank you Mr. Watt.
Mr. Paul. Thank you.

Mr. Bachus.




8

Mr. BACKUS. Thank you. I am not going to make a statement at
this time.
Chairman CASTLE. Thank you.
Mr. Kennedy.
Mr. KENNEDY. Thank you very much, Mr, Chairman.
Welcome again, Chairman Greenspan. Just a brief statement,
Mr. Chairman.
First of all, after reading today's papers and hearing of your testimony yesterday on the Senate side, I am concerned that we are
in the midst of a dilemma where, when it comes to the major overriding concern of the U.S. economy, we talk about the threat of inflation, which seems driven by the idea that somehow there is an
unemployment number that threatens to create increased prices,
and I worry that we essentially put the poorest of the poor in an
untenable position.
And I recognize, as I have heard you testify many times before,
that this is an issue that you care about, but it is not an issue that
the Fed has direct control over; but it is, on the other hand, an
issue that I think needs to be brought out, and that it is helpful
to have you acknowledge, Mr. Chairman, in the sense that if, as
the statistics that I have seen demonstrate, that the City of Philadelphia has to create by year's end 54,000 jobs for people on welfare, the City of Chicago, 164,000 jobs, the City of Boston has to
create almost 3,000 jobs a month just to get the people that are
going to lose their welfare benefits the work that they need or else
people are going to be thrown out.
We cut the housing budget, and yet what happens is when the
economy of the country rises to a point where we then say now
there is an inflation threat, then you are put in a position where
you and evidently, as I understand, other members of the committee then put a great deal of pressure on the committee in general,
and you in particular, to raise interest rates, therefore cutting off
the very stepladder that these individuals need in order to get a
job, and just when the companies are feeling some pressure to actually reach down into the pool of workers that don't have the job
skills that they really need and give the kind of job training that
these folks have to have in order to get a decent job, we then say,
"Oh, sorry, gang." I guess the overall economy is going to be threatened, so therefore we are going to raise inflation, so therefore we
are goin^ to cut off the ability of these people to ever get out, thereby creating this sort of perpetual hamster-like treadmill of economic life for the very poor.
I just think, Mr. Chairman, you know the power that you have
or have a sense of the power that you have in terms of how many
people listen to you because of the phenomenal record of success
that has occurred in our country since you have been Chairman of
the Fed, which is really astounding. I mean, the economy has
worked at a phenomenal rate, and it is something that you should
take great pride in. But I think that I just want to point out that
while we have this economy that is roaring along for the vast majority of Americans, and that is terrific, there is a whole group of
Americans that is just getting left behind, and we are doing very
little to address those needs and those concerns.




So, I would hope that you would take some time to talk about
what we ought to be doing in order to make certain that everybody
is allowed to participate to grow to their full potential.
Thank you.
Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Kennedy, and I yield to the
Ranking Member of the subcommittee Ms. Waters.
Ms. WATERS. Thank you very much, Mr. Chairman. First I would
like unanimous consent to enter into the record the statement of
David A. Smith, Director of Public Policy for AFL-CIO.
Chairman CASTLE. Without objection, submitted.
[The prepared statement of David A. Smith can be found on page
115 in the appendix.]
Ms. WATERS. I have an opening statement that I would like to
present, Mr. Chairman.
I would like to welcome my friend Chairman Greenspan here
today for the second of our yearly Humphrey-Hawk ins hearings on
the Federal Reserve's monetary policy.
We must not forget that while the Humphrey-Hawkins Act set
up a system for monitoring the formulation of monetary policy by
the Federal Reserve, it also states that a goal of Federal Government economic policy includes the importance of job creation and
the maximization of employment for our Nation's citizens.
I look forward to the opportunity to hear from you, Chairman
Greenspan, in your assessment of the current state of the economy.
Press reports indicate that while you praised our robust economy,
you did express concerns that if the U.S. economic growth did not
slow down, the danger of inflation was real. While I understand the
fears of some that current economic conditions are unsustainable
without creating inflationary pressures, I encourage you, of course,
to refrain from any monetary policy changes that would threaten
the much needed growth of our economy and the positive effect on
our poorest communities.
I question whether the numbers present any indication of such
a trend. Unemployment rates, currently at 4.5 percent nationwide,
have remained at an historic low for more than a year. At the same
time inflation has remained low most recently at nearly zero percent. There are also some signs that the economy may be slowing
as a result of the continued Asian economic crisis. Recent statistics
show the growth rate leveling off as well as an increase in the
stocks of unsold goods resulting from decreased demand for our domestic goods. We have already seen the nationwide unemployment
rate increase from 4.3 percent in April and May to 4.5 percent in
June.
Additionally, as we review the economic indicators and their implications for monetary policy, I hope that we remain cognizant of
the fact that these indicators, while encouraging, do not tell the entire story. Unfortunately many of these statistics do not paint an
accurate picture of the economic conditions across all communities
and populations. For example, while the overall unemployment for
the Nation is 4.5 percent, in California it is 5.7 percent, and in the
Los Angeles/Long Beach recent statistics, we see that the unemployment rate is 6.1 percent.




10

If you look at the unemployment numbers by ethnicity, the disparity is even greater. African Americans as a group have an unemployment rate of 8.2 percent nationwide, more than twice that
of the white population. Those with less than a high school diploma
have an unemployment rate of 7.2 percent compared to 1.7 percent
for college graduates.
My seven other Members of this committee represent many of
those Americans whose success depends on an expanding economy
which can reach down and include the more marginalized sectors
of our country in the economy. Lower unemployment rates create
employment opportunities for some sectors of our society who do
not currently participate in the formal economy. Unfortunately
those in the poor and the lower middle classes tend to be impacted
most severely by the dampening effect of increased interest rates.
Chairman Greenspan has witnessed firsthand during a trip he
made to south central Los Angeles earlier this year the continued
economic disenfranchisement of many of our poor and inner-city
communities.
I see the economic boom we are experiencing as giving a wonderful opportunity to grow all sectors of our economy and all of our
communities. Any calculation of needed changes to monetary policy
through an increase in rates must include this goal.
I look forward to engaging in a dialogue with you, Mr. Chairman,
on these critical issues, and I thank you for being here this morning.
Chairman CASTLE. Thank you Ms. Waters.
Dr. Weldon, you have just arrived. We are still doing brief opening statements if you wish to make one.
Dr. WELDON. I came to hear Mr. Greenspan and not myself.
Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, sir.
Mr. Jackson.
Mr. JACKSON. Just unanimous consent, Mr. Chairman, to enter
my opening remarks in the record, sir.
Chairman CASTLE. Certainly. Without objection they are so entered.
Mr. JACKSON. Thank you.
Chairman CASTLE. Ms. Lee.
Ms. LEE. Thank you Mr. Chairman.
Let me just extend my welcome to you, Chairman Greenspan,
and indicate to you that I am one of the newest Members to the
Banking Committee and the newest Member to the subcommittee.
However, the subject of today's hearing is not new to me. Of course,
I was here during the time when the Humphrey-Hawkins bill was
being debated in 1978. Also, as we know, the first Full Employment Act passed in 1946 is known as the Roosevelt-Truman Full
Employment Act. And my predecessor, Congressman Dellums, actually introduced the first Full Employment Act bill here recently,
H.R. 1050, in the 1993 session, 103rd session of Congress, and it
is also known as the Living Jobs for All Act.
As a member of the California Assembly and Senate, I introduced parallel bills to H.R. 1050, and I mention this because of the
fact that all of these efforts to achieve full employment are efforts
that are part of our history, but also today I am very interested in




11
hearing your testimony with regard to the issues that involve what
actually constitutes full employment in our country.
Thank you very much for this opportunity to meet you actually,
and I look forward to this hearing.
Chairman CASTLE. Thank you, Ms. Lee.
Ms. Kilpatrick, did you wish to say anything at the opening?
Ms. KILPATRICK. Just briefly, Mr. Chairman, thank you very
much, and to Mr. Greenspan, I appreciate your coming and look
forward to listening to your remarks. I did hear yesterday and read
some of your remarks.
The General Motors strike, General Motors is in my district, and,
as you know, the number one corporation in the world. It does not
look like it will be ending soon, although things can change as we
speak. The impact of the strike, the unemployment that it will
cause, as you probably know, Ford and Chrysler farm out much of
their parts. General Motors has parts plants and employ over
150,000 people in those plants, which is the sticking issue in that
strike. What impact, if any, will that have, and has it yet begin to
spill over in the economy? I will be interested in hearing your remarks.
Thank you for coming. Look forward to hearing you.
Chairman CASTLE. Thank you, Ms. Kilpatrick.
I think we have given everybody an opportunity who wanted to
say something to say something, and we now look forward to your
statement, Mr. Chairman. You nave heard the concerns of many of
the Members, and we look forward to your statement and then a
lively discussion and the question and answer period to follow.
STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD
OF GOVERNORS, FEDERAL RESERVE SYSTEM

Mr. GREENSPAN. Thank you very much, Mr. Chairman. I have a
rather extended prepared set of remarks and request that my excerpted version be included in the record, along with the full text.
Chairman CASTLE. Certainly. Both would be included in your
comments. Thank you, sir.
Mr. GREENSPAN. Mr. Chairman and Members of the subcommittee, when I appeared before you in February, I noted that a key
question for monetary policy was whether the consequences of the
turmoil in Asia would be sufficient to check inflationary tendencies
that might otherwise result from the strength of domestic spending
and tightening labor markets. In the event, the contraction of output and incomes in a number of Asian economies has turned out
to be more substantial than most had anticipated. Nonetheless, the
American economy proved to be unexpectedly robust in the first
quarter.
Evidently, optimism about jobs, incomes and profits, high and
rising wealth-to-income ratios, low financing costs, and falling
prices for high-tech goods fed the appetites of households and businesses for consumer durables and capital equipment. In addition,
inventory investment contributed significantly to growth in the
first quarter.
Although national income and product account data for the second quarter have not yet been published, growth of U.S. output appears to have slowed sharply, owing primarily to a further deterio-




12

ration in our trade balance and a slowing pace of inventory investment. Indeed readings on the elements that make up the real GDP
have led many analysts to anticipate a decline in that measure in
the second quarter after the first-quarter surge.
It is worth noting that other indicators of output, including worker hours and manufacturing production, show a somewhat steadier,
though slowing, pace over the first half of the year. And underlying
trends in domestic final demand have remained strong, imparting
impetus to the continuing economic expansion.
Inflation has stayed remarkably damped. The Consumer Price
Index as well as broader measures of prices indicate that inflation
moved down further during the first quarter, even as the economy
strengthened. The more recent price data suggest that overall consumer price inflation moved up in the second quarter, but even so,
the increase remained moderate.
So far this year, our economy has continued to enjoy a virtuous
cycle. Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further
increases in equity values, and the improvements in productivity
have been helping to reduce inflation. In the context of subdued
price increases and generally supportive credit conditions, rising
equity values have provided impetus to spending and, in turn, the
expansion of output, employment, and productivity-enhancing capital investment.
The essential precondition for the emergence and persistence of
this virtuous cycle is arguably the decline in the rate of inflation
to near price stability. In recent years continued low product price
inflation and expectations that it will persist have promoted stability in financial markets and fostered perceptions that the degree of
risk in the financial outlook has been moving ever lower. These
perceptions in turn have reduced the extra compensation that investors require for making loans to, or taking ownership positions
in, private firms.
To a considerable extent investors seem to be expecting that low
inflation and stronger productivity growth will allow the extraordinary growth cf profits to be extended into the distant future. Indeed, expectations of earnings growth over the longer term have
been undergoing continual upward revision by security analysts
since early 1995. These rising expectations have, in turn, driven
stock prices sharply higher and credit spreads lower, perhaps in
both cases to levels that will be difficult to sustain unless the virtuous cycle continues.
Probably only a few percent of the largely unrealized capital
gains have been transformed into the purchase of goods and services in consumer markets, but that increment to spending, combined with the sharp increase in equipment investment, which has
stemmed from the low cost of both equity and debt relative to expected profits on capital, has been instrumental in propelling the
economy forward.
The consequences for the American worker have been dramatic
and for the most part highly favorable. A great many chronically
underemployed people have been given the opportunity to work,
and many others have been able to upgrade their skills.




13

Government finances have been enhanced as well. In the Federal
sector the taxes paid on huge realized capital gains and other incomes related to stock market advances, coupled with taxes on
markedly higher corporate profits, have joined with restraint on
spending to produce a unified budget surplus for the first time in
nearly three decades.
The fact that economic performance has strengthened as inflation
subsided should not have been surprising, given that risk premiums and economic disincentives to invest in productive capital
diminish as the economy approaches price stability. But the extent
to which strong growth and high labor force utilization have been
joined with low inflation over an extended period is, nevertheless,
exceptional.
For one thing, increases in hourly compensation have been slower to pick up than in most other recent expansions, although, to be
sure, wages have started to accelerate in the past couple of years
as the labor market has become progressively tighter. For another,
a couple of years ago, almost at the same time that increases in
total hourly compensation began trending up in nominal terms, evidence of a long-awaited pickup in the growth of labor productivity
began to show through more strongly in the data: this accelerated
increase in output per hour has enabled firms to raise workers' real
wages while holding the line on price increases.
Notwithstanding a reasonably optimistic interpretation of the recent productivity numbers, it would not be prudent to assume that
even strongly rising productivity, by itself, can ensure a noninflationary future. Certainly wage increases per se, are not inflationary unless they exceed productivity growth, thereby creating
pressures for inflationary price increases that can eventually undermine economic growth and employment. Because the level of
productivity is tied to an important degree to the stock of capital,
which turns over only gradually, increases in the trend growth of
productivity probably also occur rather gradually. By contrast, the
potential for abrupt acceleration of nominal hourly compensation is
surely greater.
As I have noted in previous appearances before Congress, employment growth has been significantly outstripping expansion of
the working-age population. This gap will inevitably close. What is
crucial to sustaining this unprecedented period of prosperity is that
it close reasonably promptly, given already stretched labor resources, and that labor markets find a balance consistent with sustained growth marked by compensation gains in line with productivity advances. Whether these adjustments will occur without
monetary policy action remains an open question.
While the United States has been benefiting from a virtuous economic cycle, a number of other economies unfortunately have been
spiraling in quite the opposite direction. The United States, Canada and Western Europe have been enjoying solid economic
growth, with relatively low inflation and declining unemployment,
but the economic performance in many developing and transition
nations and Japan has been deteriorating. How quickly the latter
erosion is arrested and reversed will be a key factor in shaping
U.S. economic trends in the year ahead.




14

In the current circumstances, we need to be aware that monetary
policy tightening actions in the United States could have outsized
effects on very sensitive financial markets in Asia, a development
that could have substantial adverse repercussions on U.S. financial
markets and, over time, our own economy. But while we must take
account of such foreign interactions, we must be careful that our
responses ultimately are consistent with a monetary policy aimed
at optimal performance of the U.S. economy. Our objectives relate
to domestic economic performance, and price stability and maximum sustainable economic growth here at home would best serve
the long-term interests of troubled financial markets and economies abroad.
Although external economic conditions have deteriorated, some of
the key factors that have supported strong final demand by domestic purchasers here remain favorable. With their incomes and
wealth having been on a strong upward track, American consumers
remain quite upbeat. For businesses, decreasing costs of and high
rates of return on investment, as well as the scarcity of labor, could
keep capital spending elevated. These factors suggest some risk
that the labor market could get even tighter, and even if it does
not, under prevailing tight labor markets, increasingly confident
workers might place gradually escalating pressures on wages and
costs, which would eventually feed through to prices.
But a number of factors likely will serve to damp growth in aggregate demand, helping to foster a reasonably smooth transition
to a more sustainable rate of growth and reasonable balance in
labor markets. We have yet to see the full effects of the crisis in
East Asia on U.S. employment and income. Residential and business fixed investment already have reached such high levels that
further gains approaching those experienced recently would imply
very rapid growth of stocks of housing and plant and equipment
relative to income trends.
Inflation performance will be affected by developments abroad as
well as those here at home. The extent and pace of recovery of
Asian economies currently experiencing a severe downturn will
have important implications for prices of energy and other commodities, the strength of the dollar, and competitive conditions on
world product markets.
On a more fundamental level, it is the balance of supply and demand in labor and product markets in the United States that will
have the greatest effect on inflation rates here. As I noted previously, wage and benefit costs have been remarkably subdued in
the current expansion. Nonetheless, an accelerating trend in wages
has been apparent for some time. In addition, a gradual upward
tilt in benefit costs has become evident of late.
Given that compensation costs are likely to accelerate at least a
little further, productivity trends and profit margins will be key to
determining price performance in the period ahead. We at the Fed
will be closely monitoring a variety of indicators to assess the degree to which productivity is on a stronger long-run track after
what is likely to appear in the data as a weak second quarter.
Significant risks attend the outlook. One is that the impending
constraint from domestic labor markets could bind more abruptly
than it has to date, intensifying inflation pressures. The other is




15

the potential for further adverse developments abroad, which could
reduce the demand for U.S. goods and services more sharply than
anticipated, and which would thereby ease pressures on labor markets. While we expect that the situation will develop relatively
smoothly, we believe that given the current tightness in labor markets, the potential for accelerating inflation is probably greater
than the risk of protracted, excessive weakness in the economy,
As I have stated in previous testimony, Mr. Chairman, the recent
economic performance, with its combination of strong growth and
low inflation, is as impressive as any I have witnessed in my near
half-century of daily observations of the American economy. Although the reasons for this development are complex, our success
can be attributed in part to sound economic policy. The Congress
and the Administration have successfully balanced the budget, and
indeed, achieved a near-term surplus, a development that tends to
boost national saving and investment. The Federal Reserve has
pursued monetary conditions consistent with maximum sustainable
long-run growth by seeking price stability. These policies have
helped bring about a healthy macroeconomic environment for productivity-boosting investment and innovation, factors that have lifted standards of living for most Americans. The task before us is
to maintain disciplined economic policies and thereby contribute to
maintaining and extending these gains in the years ahead.
Thank you very much. I look forward to your questions.
[The prepared statement of Hon. Alan Greenspan can be found
on page 49 in the appendix.]
Chairman CASTLE. Thank you, Mr. Chairman.
I yield first to myself for five minutes of questions, and I would
like to go back to my opening statement and what probably was involved in at least a third of your testimony, which is a lot different
than probably would have been a year or two ago, and that is the
Asian crisis which just a year ago was just getting under way.
I like to try to be a little more precise in some of the things we
are trying to determine here. Have we seen the end of it? If not,
and I assume the answer is probably going to be no, how do you
see it playing out? And is it likely to spread to Latin America; help
with the proolems or add to the problems in Russia, for example?
I indicated in my statement that I think if anything, you can almost argue that if you weigh the pluses and minuses, it has actually benefited the American economy more than hurt it because of
the flight of capital and cost reasons and other reasons. But what
are its likely future effects? And I am sure that you almost sit
there and model this stuff on a regular basis in terms of the most
drastic-type things that can happen, but I am more interested in
what everyone views as the most likely scenario. It seems to me
that this has been quite poorly predicted so far, I mean, at least
in terms of the extent of it in many ways. So I am concerned about
the future. I don't expect you to have precise answers because we
are talking about unfolding developments, but I would like to hear
your response to some of those points.
Mr. GREENSPAN. I agree with your comments, Mr. Chairman.
First of all, let me just say that the evidence we have to date as
yet shows no evidence of stabilization and that the most recent
data still exhibit deterioration. The question of most fundamental




16

importance to all of us, obviously, is how long will that continue,
and where will it spread, and to what extent will the stampede of
buffalo, as you implied, stomp over us before we can stem it.
You point out quite correctly that the crisis was not forecast in
any meaningful way by really the vast majority of analysts, and indeed I know of no one who really did say at the point when the
crisis was emerging that it was about to occur. That tells us something very important about the nature of the process itself.
As I have indicated in other testimony, what we have is a situation in which you can build up imbalances in an economy which
may or may not induce significant erosion or major contraction, but
periodically these buildings up of imbalances are like water backing up against a dam. Most of the time they are held by the dam,
but every once in awhile the dam cracks, and you get a huge rush.
It is a vicious cycle indeed, precisely the opposite of the virtuous
cycle that we have seen in the United States. You get an implosion
of confidence in which pessimism feeds on pessimism. Everyone
withdraws from activities related to an economy. Trust, which is
crucial to any particular social organization, especially an economy,
falls, and the situation feeds on itself in a downward spiral.
It is very difficult to forecast where that eventually stabilizes or
how it comes out, but this clearly is the process which we have
seen which is by its nature almost impossible to forecast. We can
stipulate the conditions which are probably necessary for such an
event occurring, but rarely, if ever, the sufficient conditions to do
that.
I would say at this particular time that we do not know at what
point this will turn. It will depend to a very substantial extent on
the restoration of confidence, and the restoration of confidence will
depend on the types of economic policies that these countries are
involved with.
Chairman CASTLE. Thank you, Mr. Chairman.
I am going to ask you one different question. I would love to pursue that line, but as you know, we have a limited time, so I am
going to change subjects altogether because I am interested in another answer.
You have previously suggested that reducing the Federal budget
deficit was a high-priority item, and I agree with that, and because
of this issue, you have urged Congress to defer cutting taxes.
Would the prospect now before us of a large and growing budget
surplus this year and in future years, do you now feel that this
may be an appropriate time for a tax cut?
Mr. GREENSPAN. Mr. Chairman, it is really quite a pleasant
event to have this type of problem confronting us as distinct from
the problem of how do you bring a chronic budget deficit down. So
it is an issue of good choices rather than bad choices.
Let me just first say before we even contemplate what is done
with this extraordinary surplus, which is being projected into the
indefinite future, that we have not been able to forecast with great
accuracy where the budget balance ends up, as the history of recent years has amply demonstrated. There is no doubt that the
very sharp increase in stock market values and the whole huge increase in market wealth, which has occurred both in households
and in businesses in this country, is spilling over into various types




17

of capital gains and incomes coming from stock options and bonus
payments and have markedly increased revenues in our budget.
How we handle those stock market-related taxes, if I may put it
that way, in the future projections is very crucial to how much you
think the surplus out there is going to be.
I merely wish to comment as an issue of caution that while we
haven't seen the other side of a stock market decline, and hence,
its potential impacts on revenues, it is instructive to observe that
the Japanese had a quite similar phenomenon; their revenues rose
far faster in the latter part of the 1980's than their nominal taxable incomes, and subsequent to 1990, it went exactly in the opposite direction.
So before I would be very comfortable about the existence and solidity of these surpluses, I would like to see some evidence in more
detail of how we are projecting and expecting the outcomes of the
revenues on the other side of this cycle.
Having said that, let me just repeat what I have said before you
previously. Reducing the debt to the public is a very important and
useful thing for economic growth. It creates lower interest rates,
the level of interest payments falls, the level of the total spending
falls because of that, the surplus rises even more, and it is a virtuous cycle which evidence suggests decreases real long-term interest
rates, and over the long run probably increases growth. So don't
immediately dismiss the advantages of just having the surplus
exist and the debt be paid off accordingly.
Having said that, I am fully aware that that is very difficult to
do, and if I am given my choice as to the long-term stability of the
fiscal process, I would much prefer to see taxes cut than expenditures raised to diminish the surplus. But my first choice is still to
reduce the debt, which is another way of saying there is no need
to rush into any particular action, because the debt will be reduced
automatically, as long as the surplus exists.
Chairman CASTLE. Thank you.
Ms. Waters.
Ms. WATERS. Thank you very much.
Chairman Greenspan, as you know, there is a raging debate
about replenishment of the International Monetary Fund going on
here in Congress, and we are constantly reminded that the Asian
crisis may cause a tremendous negative impact on our economy.
While some of us are looking at this very closely, we are still concerned about some of the problems that were articulated here this
morning about communities that are still trying to be involved in
this growth that we are witnessing in our own country. So while
we are cognizant and aware of the problem of the Asian crisis, we
are still trying to deal with these communities that are not benefiting from the growth here in America, and we need what we are
calling a domestic fund of some kind in order to invest in these
communities and have some growth.
As I look at the great mergers that are being contemplated and
your role in that, what do you think about capital formation strategies that would encourage those who are moving into these big
mergers to get involved with this? For example, many of the banks
or some of the banks who are talking about merging and some who




18

have merged in the past made commitments or are making commitments.
I am told that Mr. Sandy Weil up at Travelers just made a commitment of $2 trillion to be invested in communities as a result of
the merger. We had Wells Fargo, I believe, when they merged in
California, that made a $40 billion commitment. I think Bank of
America at one point in time made had a $30 billion commitment.
But we cannot track these investments. We do not know what happens with these commitments.
We think that if there is a domestic fund of some kind that is
put together by those who are getting involved in these big mergers, we could help them honor these commitments that they make
for huge sums of money. We believe that there are strategies for
formulation of capital where we could show a return on investment,
where we could help people get involved in joint ventures, we could
invest in businesses that oftentimes are overlooked but have tremendous potential.
We are not talking about grants, we are not talking about giveaways. We are talking about putting together the kind of plans
where people who know what they are doing could take this capital
and place it out there in businesses and opportunities that would
certainly have a return on investment. We need some discussion
about that.
I want to know what you feel about that. Would vou be willing
to even look at some of these plans to at least make some comments about viability or sensibility? We are interested in capital
formation for growth in our communities.
Mr. GREENSPAN. As you know, Congresswoman, I am a very
strong supporter of trying to get equity investments into the inner
cities. Initially it is probably worthwhile to get an awful lot of debt
where it had not been feasible previously. But unless you get a
mixture of debt and equity, you will end up with an extremely difficult balance sheet which is very hard to service and does not promote economic growth. You need risk capital in there.
Ms. WATERS. Yes.
Mr. GREENSPAN, The issue of the substantial agreements or substantial dollar amounts which are involved in a number of these
agreements are not part of the supervisory or regulatory structure
of the Federal Reserve. We cannot enforce a private agreement between two parties.
It strikes me that the problem is to try to trace what they are
doing and what they are not doing, and we try to do as much of
that in our CRA exams as we can. But we cannot get to the point
of literally tracking, dollar for dollar, what they agreed to in a
number of these private agreements. I should think that if there
is a problem of evaluation of action and enforcement, that those
would be issues which would be in some way addressed as part of
the agreement.
In other words, my suspicion is that the vast proportion of these
agreements are entered into with full good will and are probably
very substantially implemented. If there is a concern on your part,
the only way that I am aware of which could conceivably capture
whether or not anything of substance is happening is to have in the
agreements some mechanism by which there is communication be-




19

tween the private parties as to whether or not they are being fulfilled and in what manner.
As I said previously, I suspect that you will find, if you do that,
that in most instances they actually do what they say they are
going to do. But short of some means of evaluation, I, too, would
not know whether or not you could certify that indeed, if a commitment was X, that X was actually implemented.
Chairman CASTLE. Thank you, Ms. Waters.
Mr. Lucas.
Mr. LUCAS. Thank you, Mr. Chairman.
Chairman Greenspan, as you well know, I represent a region of
the Southwestern United States that is very heavily into agriculture production and energy production. In those two industnes,
in agriculture, thanks to, atleast through the first quarter of this
year, some very favorable weather, which has now turned in the
other direction, and to a degree both in agriculture and energy, because of the financial problems in the Western Pacific, Eastern
Asia, the effect it has had on demand, we have had declining cash
prices for both grain and energy.
Could I get you for a moment to share, perhaps, some of your insights or feelings in regard to what the potential impact is on the
economy as a whole as we see this what I would describe as vulnerability of both industries coming to the top, here? I would add, also,
that my constituents think they have damned well done their part
to provide price stability by having declining energy and agriculture prices this quarter.
Mr. GREENSPAN. Most price stability is not voluntary, Congressman.
Mr. LUCAS. Good point.
Mr. GREENSPAN. You can observe the emergence of the crisis last
fall with a dramatic weakening in all sorts of commodity prices,
from oil through materials to agricultural products, pretty much
across the board.
In oil it is fairly apparent that what has happened is that you
have taken out a chunk of the expected increased demand in East
Asia, which has been a very large part of the expected world demand for crude oil. In fact, it is working in reverse.
What happens is that it does not take very long for oil storage
facilities, both at the crude level and at the product level, to fill up
very dramatically. We have even seen examples of inventories now
being held in tankers, which is not an efficient way of doing it. So
we have effectively glutted the market, and the price effect has
been pretty pronounced.
There has been an endeavor on the part of a few producing countries to cut back, and that has evidently firmed the price somewhat
from its June nadirs. But it is still, obviously, quite low and is having a significant impact, incidentally, on drilling rig activity.
Much the same has occurred in agriculture. The weakening of
prices has been fairly pronounced, and we also see it in our export
performance, which is in part being hurt by the fact that a number
of the grain exporters like Canada and Australia, because they are
also commodity producers, have seen their currency weakened visa-vis the American dollar, which means that their competitive positions have marginally improved relative to ours.




20

So all in all, the Asian crisis, as I indicated in my prepared remarks and others of your colleagues have commented on, has had
a positive effect because it has lowered interest rates and a number
of other things in the overall economy, but that has clearly not
been the case in both agriculture and energy in the United States.
Mr, LUCAS. Absolutely. It would appear at least the local perception is that, because both industries are very capital-intensive, if
we continue in the direction we go, and that optimism that permeates, it seems, virtually the whole economy starts to dry up in
those two areas, that by not making the long-term capital investments, that we could come to a point where we will start down a
different trail. And even with the recovery, it might well take another extended period, as we went through in the late 1980's and
early 1990's, to cycle back up again. So there are some real concerns there.
You would agree—I would assume, I think—that you would
agree that the best solution there is to attempt to, in some form
or fashion, help our consumers and customers, so to speak, recover
their vitality?
Mr. GREENSPAN. Indeed.
Mr. LUCAS. Thank you.

Chairman CASTLE. Thank you.
Mr. Frank.
Mr. FRANK. Mr. Chairman, I was impressed, at the bottom of
page 8 onto page 9, you talk about the great many chronically unemployed people given the opportunity to work; people have upgraded their skills, welfare recipients absorbing—there has been a
significant increase in the utilization of sort of low-skilled workers
at that level.
Over what period of time were you talking about?
Mr. GREENSPAN. The last two or three years.
Mr. FRANK. In other words, exactly the time that the last minimum wage increase went into effect. Can we infer from that that
the increase in the minimum wage did not have the negative consequences on employment that some people predicted it might
have?
Mr. GREENSPAN. No. I would say the minimum wage did have a
negative effect. It has just been overwhelmed by far stronger forces.
Mr. FRANK. So overall, if we had not passed the minimum wage,
would employment rates have been higher?
Mr. GREENSPAN. Well, possibly, yes. Let me put it to you this
way.
Mr. FRANK. If they were, wouldn't you have had to raise interest
rates? So in other words, you have told us in your statement that
employment—the biggest potential cloud on the horizon that you
see appears to be the inadequate growth in the worker force.
Mr. GREENSPAN. I would not argue that a rise in the minimum
wage by restricting employment is good monetary policy, because
it reduces
Mr. FRANK. I would not, either. That is not what I am arguing.
What I am trying to do—see, I think what happens is sometimes
there is this ideological screen that gets in the way of the facts. If
the theory is good, so much the worse for the facts.




21

The fact is that you have a whole statement in here about how
we are outrunning our ability to find workers; that the biggest
problem is the work force. That happened during the time the minimum wage was increased, so that any overall negative effect of increasing the minimum wage, in macroeconomic terms, appears to
be zero.
Mr. GREENSPAN. Look, if you are asking me
Mr. FRANK. What I am asking you, I am not "iffing^1—I am asking you what I am asking you, which is, given the circumstances
in which we increased the minimum wage, what negative effects
did that have on the economy?
Mr. GREENSPAN. I would say at this particular stage none. But
the issue is longer term.
Mr. FRANK. I will settle for none now, because the notion that
with that relatively small increase, you are going to have a longerterm effect is fine, because, besides, since you came out against tax
cuts, I don't want to argue with you too much today. We are on the
same side, being against tax cuts. You may have lost yesterday on
the economy, you may lose today that you are against tax cuts. As
to two and three we have different views, but I am with you on
one. The number one priority was tax cuts.
Mr. GREENSPAN. I didn't say I was against tax cuts. I would prefer that at the moment we let the surplus run, because it is
Mr. FRANK. Which means no tax cuts right now?
Mr. GREENSPAN. That is correct, right.
Mr. FRANK. You were not against tax cuts forever, let me stipulate. You have not said that the minimum wage might not cause
problems in 2006, and you have not said you were against tax cuts
forever, but as for now you would prefer letting the surplus accumulate and reducing the debt to cutting taxes?
Mr. GREENSPAN. I would say there are unquestionably numbers
of people, not many, but numbers of people who probably are not
working today because the minimum wage is higher, and could
have been working.
Mr. FRANK. Although, on the other hand, as we say, if, in fact,
that had happened, they probably would still not have been working for different reasons. You would have had to raise interest
rates. We have already stretched
Mr. GREENSPAN. It is a supply factor. I am saying that these people who are held down because they cannot produce at the level of
the minimum wage are being held out of the market.
Mr. FRANK. We are running out of workers in the economy. You
are saying that the economy needs workers, but it does not—these
workers
Mr. GREENSPAN. Unfortunately, what you need is workers whose
productivity matches what they get paid. You do not want to distort the market in that regard. It does not help them.
Mr. FRANK. Except that, again, it seems to me, overall, the point
that we have, in fact, overstretched the work force makes it very
hard.
Let me just go back. I will accept the fact that you said it had
none to date. People can speculate about the future. I will accept
that for now.




22

The other problem we have, though, is the continued disproportion in the values. What is fascinating is how optimism can become
pessimism, and vice versa.
I know there are people for whom every cloud has a silver lining,
but there is this tendency, I think institutionally, for the Federal
Reserve, while some people look for the silver lining in the cloud,
it is your job to remind people that the sun causes cancer, and I
think that is what we are basically doing here.
On page 22, you say, "We expect the situation will develop
smoothly." This is the crux of my concern. "The committee believes
that the potential for accelerating inflation is probably greater than
the risk of protracted, excessive, weakness." It is the imbalance
there.
Yes, I am sure that is true. An acceleration in inflation, versus
two adjectives on weak conditions, weakness, we get one noun and
two adjectives. And the acceleration is the problem over here, but
it is protracted and excessive.
What is the danger of protracted, excessive inflation? That is the
problem. It is the disproportion. Any inflation is to be more feared
than a protracted—it equates to a protracted, excessive weakness.
That is the problem.
There is an institutional bias to overemphasize the threat of inflation and, as I said, if you had said the potential for accelerating
inflation is probably greater than the risk of weakness in the economy, I would have passed over it. If you would have said the potential for rapidly accelerating inflation is greater than the risk of protracted, excessive weakness in the economy, I would give you two
adjectives for one, it would not have been a problem.
But I really do believe this reflects the mindset where any inflation equates as a harm protracted and excessive weakness. I think
that is the danger in the policymaking that I fear.
Mr. GREENSPAN. It is not an institutional bias, it is an institutional evaluation. If, as we think, the evidence has increasingly affirmed in recent years that low inflation or stable prices is a major
contributor to sustainable, long-term economic growth, then if we
are concerned about the reemergence of inflation, as we should be,
it is because it is a threat to sustainable, long-term economic
growth and employment. In that regard, I should think that we
ought to be more concerned about the emergence of inflation than
of temporary economic weakness.
In that regard, yes, I would acknowledge that the central bank's
major concern is stability of the currency, which is what a central
bank should do. I can conceive of an argument which we did have,
say, several years ago where the hypothetical question of price stability increasing economic growth over the long run was an arguable case. We asserted it, but recognized that the evidence was
mixed.
What we have found in the last four or five years is a very considerable addition to the case that a necessary condition for longterm stable economic growth and employment is a stable inflationary environment, a noninflationary environment.
Chairman CASTLE. Ten seconds.
Mr. FRANK. Ten seconds.




23

I don't deny that should be the focus of the central bank. What
I am concerned about is excessive deference to a central bank
which has exactly the orientation you say, which, in my judgment,
exaggerates potential inflation and undervalues growth.
Chairman CASTLE. Thank you.
Dr. Paul.
Dr. PAUL. Thank you, Mr. Chairman.
Mr. Greenspan, over a period of time, the dollar has been weak.
If you look at it from 1971 until now, the curve is obviously downward. If you look at the last three years, the dollar has been relatively strong, and some people consider this a problem. Even our
Government, our Fed and Treasury, just recently thought our dollar was too strong.
Of course, in free markets, the purchasing power of money is
never tampered with, but under today's conditions it was felt that
it was too strong in relationship to the yen. Of course, we intervened and had some effect to the currency markets.
When do you suppose the time would be appropriate for the
money managers to intervene in a much more aggressive manner,
if the dollar continues to be very, very strong, and pressure is put
on the Federal Reserve, political pressure, to say, "We cannot sell
our goods, we want some help"? Can you foresee that? And not a
token amount of interference, intervention in the market, but a
major intervention in the market to change the direction of the dollar, can you foresee that in the near future?
Mr. GREENSPAN. Congressman, let's first emphasize that we do
consult with the Treasury and ultimately the Secretary of the
Treasury is the legally authorized determiner of the extent to
which intervention occurs or doesn't occur. The Secretary has indicated on numerous occasions that it is fundamental values which
will determine the value of the dollar and other currencies, and
over the long run, intervention doesn't do very much one way or
the other. I think that the evidence over the years has demonstrated that that particular statement is clearly sustainable.
I can't anticipate what particular policies will be under hypothetical circumstances. It is an important question, there is no
doubt. But overall, the presumption that somehow we, meaning the
monetary authorities, the Fed and the Treasury, can somehow alter
the value of a currency in a significant manner when fundamentals
are going in the opposite direction is an illusion. We cannot.
Dr. PAUL. So in a way what we have done just recently was just
wasted money, since we do know that intervention does not have
much effect? Why do we bother on occasion
Mr. GREENSPAN. First of all, we don't waste money. We are taking a position in a currency, and very often over the years we turn
out to actually have a profit in the process. When you intervene,
you don't spend the money. You are just taking an investment position or a speculative position.
Dr. PAUL. Unless that currency happens to go down, which it
well could.
Mr. GREENSPAN. Yes. That is certainly the case, and if you do it
in large volume, then the answer is there are speculative risks. We
have taken very few of those.




24
The very few times which we intervened, and we have not intervened for years until this most recent event occured, was when we
believed that the markets were unstable and that intervention
might have an impact. You need both of those conditions to exist.
It was the judgment of the Secretary of the Treasury, to which we
agreed, that action taken would have the effect of breaking a pattern of a very quick run in the currency. I don't think any of us
believed it would have more than a temporary impact.

Dr. PAUL. A very quick question. You seem to welcome, and you
have been quoted as welcoming, a downturn in the economy to
compensate for the surge and modest growth in the economy. Is it
not true that in a free market, with sound money, you never welcome a downturn in the economy? You never welcome the idea of
decreased growth, and you don't concern yourself about this? And
yet, here we talk about when is the Fed going to intervene and
turn down the economy?
It seems that there is a welcoming effect to the fact that the
Southeast Asia has tampered—you know, price pressures. Couldn't
we make a case that the free market would operate a lot better
than the market we use today?
Mr. GREENSPAN. I think you have to define what you mean by
a "free market." If you have a fiat currency, which is what everyone has in the world
Dr. PAUL. That is not free market.
Mr. GREENSPAN. That is not free market. Central banks, of necessity, determine what the money supply is. If you are on a gold
standard or other mechanism in which the central banks do not
have discretion, then the system works automatically,
The reason there is very little support for the gold standard is
the consequences of those types of market adjustments are not considered to be appropriate in the 20th and 21st century. I am one
of the rare people who have still some nostalgic view about the old
gold standard, as you know, but I must tell you, I am in a very
small minority among my colleagues on that issue.
Dr. PAUL. So I guess we have to accept the downturns?
Mr. GREENSPAN. No. We are not accepting downturns, nor do I
think we look at it as desirable. What we do look at is an economy
which is running at a pace which is unsustainable over the long
run and will eventually run off the tracks and create significant
disruption. So we do not look forward to a weakening in growth.
All we are concerned about is a pattern of growth which is sustainable.
In other words, when we talk about our goal as maximum sustainable economic growth, the "maximum" and the "sustainable"
are both crucial elements to that. We can get a maximum growth
in the short run, which is not going to help anybody over a longerterm period. That we would consider to be an unacceptable or undesirable pattern of growth.
Dr. PAUL. Thank you.
Chairman CASTLE. Thank you, Dr. Paul.
Mr. Kennedy.
Mr. KENNEDY. Thank you, Mr. Chairman.




25

I want to go back to the statement I made, Mr. Chairman, at a
time when all of us get to talk and you don't, and you have to listen to us for a minute or two, or for more than that.
I want to lead into it by following up on the comments that you
just made with Dr. Paul. It seems to me that if you look at the general state of the economy, and you look at all the numbers, the aggregate numbers, they are all very, very encouraging. But there are
some storm clouds that would appear out there on the horizon.
You have a major General Motors strike. You have got Bob
Rubin, who has been rumored to perhaps be leaving the Treasury
Department. You have a major crisis that is almost every day on
the front page of the newspapers with regard to Japan, that leads
to an Indonesia crisis. It could lead to a Korea crisis, as well. You
have got a potential war between India and Pakistan. You have
mentioned inflation a number of times, there is a tight labor market, and how all of those sort of play into your maximum sustainable growth policy.
If I understand it, there was a period of time in the late 1960's
that the stock market came close to a thousand points, and it then,
I believe, declined, really, for a period of almost 13 or 14 years. I
think that there is a whole group of investors in this country that,
for the first time in their lives, have an IRA or some kind of Keogh
or retirement plan. They look at these reports that they receive
from their money market managers that tell them every month
that their portfolios have increased by another 5 or 10 or 15 percent, and they look at these numbers that come in, which tell them
that they have for the first time in their lives this real wealth.
I just wonder what advice or what thoughts you have; not really
advice, but whether or not you feel that the notion that somehow
this economy can never, in fact, adjust will create perhaps even
greater problems if, as has always occurred, there is an adjustment, and if, for the first time, people actually see losses, and how
they will react to those losses, and whether or not that bears on
your thinking and perhaps other members of the Market Committee's thinking in terms of how to deal with what you view as, it
seems, unsustainable growth.
Mr. GREENSPAN. We don't view the current growth rate, say, during the last few years, as unsustainable. I have argued elsewhere,
and indeed this morning, that productivity, as best I can judge, is
probably accelerating. That in and of itself, with the same laoor
force, will give you greater economic growth overall. I suspect that
the evidence suggests that that is indeed happening.
But the broader question you are raising is the issue of the emergence of a really quite extensive expansion in the holdings of equities among households which have risen by almost a half, depending on how you mark it, and who holds it,
It does turn out to be that the very substantial amount of capital
ains is in the upper and middle income groups and above, and the
angers that you nave if you count on these types of expansions are
largely whether or not you took out debt against it. In other words,
the only way you can spend, so to speak, your capital gains is either to sell your stock and get the cash or somehow borrow, not
necessarily against the stock, but with the feeling that you have
this huge block of new assets, you feel as though borrowing is not

f




26

a particular problem because your balance sheet is in such good
shape and your net worth is so much better.
The real danger exists if there is an awful lot of debt which, in
the event of a significant stock market contraction, that all of a
sudden becomes unserviceable.
Mr. KENNEDY. Isn't there also an issue, though, Mr. Chairman,
that where people for the first time recognize that they can actually lose money in the stock market, and therefore pull out of the
stock market, that that could create a much greater downturn in
the stock values than might be normally anticipated as a result of
these other economic indicators?
Mr. GREENSPAN. I doubt it. In other words, the market ultimately is driven by real forces. Once you get a decline started, it
is not clear whether, in fact, people choose that as a reason to sell
or to buy. Indeed, most of the evidence of recent years is that people who have built up 401(k)s and other forms of investment and
have become quite familiar with the stock market have been the
ones who have been buying on the declines, and indeed, have
turned out to be prescient, and wealthier.
So it is not clear exactly how they are going to behave. Forecasting that they are automatically going to start to sell any more than
the full professional managers of large pension funds would—is
probably futile, because we
Mr. KENNEDY. Do you believe there is going to be a market correction which could result in a significant contraction in the size
of their portfolios?
Mr. GREENSPAN. I would say, ultimately, yes. History tells us
that there will be a correction of some significant dimension. What
it doesn't help you on very much is when. Indeed, history is strewn
with periodic contractions of significant dimensions, and I have no
doubt that human nature being what it is, it is going to happen
again and again and again. How individuals behave in that particular environment is not clear or necessarily forecastable.
Mr. KENNEDY. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, very much, Mr. Kennedy.
We will next go to Dr. Weldon. After that we will switch sides.
Mr. Leach will be after that, Mrs. Roukema, and then Mr. Metcalf,
just so people will know where they are, because it is always a little bit of a problem. We will keep going in order over here.
Dr. WELDON. Thank you, Mr. Chairman.
Mr. Greenspan, you in your testimony made a statement that
changes in monetary policy here would have an outsized effect in
Asia. I am assuming you are talking about an increase in interest
rates in the United States would have a disproportionately large effect there. Could you just elaborate on that a little bit, please?
Mr. GREENSPAN. Certainly.
The American dollar has become a key currency throughout the
world, and especially in Asia.
Dr. WELDON. Is that really a reserve currency throughout the
world?
Mr. GREENSPAN. To a very substantial extent, the reserves of
central banks are disproportionately in the U.S. dollars, and that
is true of Asia as well as even Europe. The consequences of dollar-




27

denominated interest rate changes, as a result, are really important.
Obviously, if they, as indeed a number of the economies did, tied
their currencies to the dollar, either tightly or sort of in a modest
way, they will pick up dollar interest rate effects in their economies, which has an impact of not insignificant proportions, if, especially, their financial systems are fragile or weak, as they are
today.
So when we discuss monetary policy, one of the major areas
where considerable interest exists far beyond the academic interest
of central bank policy are in those areas which find the value of
the dollar, both in the exchange market and dollar-denominated interest rates, which a lot of them borrow in, of quite significant importance to them.
Dr. WELDON. Are you following the developments in Indonesia at
all?
Mr. GREENSPAN. Yes.
Dr. WELDON. I recently read that the cost of basic commodities
for the Indonesian citizens is extremely high, particularly food. Can
you comment at all on that, and the implications of that? Because
there are some reporters in the media making claims that the
country is on the verge of chaos, and certainly, though our major
concern here today in this hearing is the United States economy
and United States policy, we all know that developments like that
can have implications for us domestically.
Mr. GREENSPAN. Whenever you have a currency fall as sharply
as the rupiah has fallen, which is approximately 80 percent, and
you import any significant amount of materials or foodstuffs, which
they do, then clearly the domestic price of many of the things
which they import obviously skyrockets, unless, as indeed there is
the case currently, at least to the extent that the Government does
not subsidize them. The Indonesian government does do a considerable amount of subsidization for foodstuffs that are imported, but
nonetheless, prices have risen to extraordinarily high levels.
The food distribution system also has been disrupted by a goodly
number of political problems, especially with the ethnic Chinese,
who have been major players in the distribution system in Indonesia. As a consequence, there are concerns, increasing concerns, of
food shortages and food prices which are too high for those average
Indonesian citizens to afford.
Dr. WELDON. I am going to run out of time in a second. Let me
get to the meat of the question that I wanted to ask you. Can you
comment on the involvement of the IMF in the developments of Indonesia, particularly in light of the political situation where many
people are asking for more involvement of the IMF?
Mr. GREENSPAN. Yes. As I indicated to you earlier, the crisis that
emerged in Southeast Asia was not forecastable, and indeed, as it
began to evolve, the extent of how deep it would become was also
not forecastable.
Vicious cycles, which Indonesia's economy was characterized by
more than any of the others, was a massive implosion that was
very difficult to handle, and I think that the IMF has done as much
as it thought it understood it could do. I don't know what alternative policies could have been implemented which would have sig-




28

nificantly altered the pattern that emerged once the vicious cycle
began to accumulate in the degree that it did.
Dr, WELDON. Did the IMF policy play a role in the 80 percent
decline of the value of the rupiah?
Mr. GREENSPAN. I think not. That results largely from the internal policies of the Indonesian government, which were inadequate
to the nature of the problem that they confronted.
Dr. WELDON. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Weldon.
Mrs. Maloney.
Mrs. MALONEY. Thank you, Mr. Chairman.
Good morning, Mr. Greenspan. Reports in the press yesterday
after your testimony interpret your remarks that the Fed will raise
interest rates because of the threat of inflation. Could you clear the
air today, or would you rule out that interpretation?
Mr. GREENSPAN. I don't think that is what I said. I said very
much what I said this morning, which is that there are lots of ifs,
ands, or buts in those types of evaluations. What I did say is that
we are on a path at this particular point, with the working age
population, including immigration, going up at about 1 percent a
year, and the job growth, as a consequence of economic growth affected by increases in productivity, is running 2 percent a year.
That gap is being met by a fairly pronounced reduction in the
number of people who are either officially unemployed or those who
are not in the labor force because they are not seeking jobs actively, but who nonetheless say they would like to work. The combination of those two groups of people in our society is declining
fairly rapidly, reflecting the difference between the 2 percent
growth in employment and the 1 percent growth in the workingage population.
What I have been saying for actually quite a long period of time
is that somewhere, at some point, that gap must inevitably close,
because we will run out of people to employ. Prior to that happening, either it will occur because the economy slows down by itself,
which means that employment growth will slow down closer to the
gain in the working-age population, or if it doesn't happen and
wages accelerate as a consequence, if the laws of supply and demand exist—and you have free labor markets—history tells us that
wages will tend to accelerate.
If that happens in excess of the growth of productivity, and to
date it hasn't, then other actions, mainly monetary policy, may
have to be involved in order to constrain what would be, effectively,
a destabilizing adjustment, which could have a major negative impact on the economic prosperity, which has been so extraordinary
and so beneficial to this economy, especially the remarkable things
it has done to enhance the quality of our work force, who have successively been able to gain the skills and move up the scales because the labor market has been as good as it has.
Mrs. MALONEY. My colleague, Mr. Frank, pointed out today, your
comments on page 22, the potential for accelerating inflation is
probably greater than the risk of protracted, excessive weakness in
the economy. As I said, some of the press interpreted your comments yesterday and then your comments today—they seem to
sound like there is a bias toward raising interest rates. You are




29

saying that that is not true, that you are open to any policy, even
lowering interest rates?
Mr. GREENSPAN. I am saying at the moment that the most probable outcome, as I stipulated in my prepared remarks, and indeed,
I even quoted some of the prepared remarks, is that we are going
to get a continuation of what is really quite a remarkable and benign economic environment.
To the extent that we see that the probabilities that that does
not happen—the minority probabilities, the less than 50 percent
probabilities—are, as best we can judge the environment, more
likely skewed in the other direction, than if we are wrong in the
evaluation we are making, namely, that things will be reasonably
stable and benign, the probability is greater that we will end up
with an acceleration of inflation, as distinct from a weakening, or
as Barney Frank said, an excessive weakening in the economy.
That is a statement of the way we view the probabilities, but let
me assert what I in fact said, and I will repeat it; namely, the most
likely scenario is more of what we have seen in the most recent
past.
Mrs. MALONEY. Very, very quickly and briefly, after the Russian
loan the IMF is dangerously low in their reserves, down to $7 to
$12 billion.
What will happen if we follow the leadership of the Republican
Majority in their call not to fully fund the International Monetary
Fund? What happens with Asia and other countries that look to
the United States for leadership? What will be the impact if we fail
to fund the International Monetary Fund?
Mr. GREENSPAN. Congresswoman, as I have testified before this
subcommittee previously this year, the probability is that if the
funding is not made, that we will probably muddle through; that
the probability that something significantly adverse will happen to
the United States as a consequence is less than 50/50. In fact, it
is a relatively small probability.
Nonetheless, if we are wrong and that probability, that event, actually emerges, then the consequences will be very severely negative for the United States. In my judgment, taking out what is effectively an insurance premium, which I believe the funding of the
IMF would be, is a wise policy.
I am not saying that I think that at the end of the day we should
not be looking at the whole structure of the international financial
institutions, the IMF being, of course, the prominent one. I do
think we are going to have to do that, because the global financial
system is changing. It is just that I am arguing that now is not the
time to do that. We don't have the luxury not to have available an
institution such as an IMF, if it is necessary, to fund and assist in
the containment of crises.
But after this situation in Asia becomes history and the world financial systems stabilize, then I think many of those who have
been arguing that a review of the structure of the system is on the
table I think are correct. We ought to be looking at it.
It is just that this is comparable to when your house is potentially burning down, and your neighbor's house is on fire and the
sparks are going in your direction, your concern is to make sure
that the fire doesn't spread. Tomorrow you can complain to the




30

neighbor that they shouldn't have lit matches in their kitchen or
something like that. It is just the timing is all wrong to do it in
the midst of the fire.
Chairman CASTLE. Thank you, Mrs. Maloney.
Chairman Leach.
Mr. LEACH. Thank you, Mr. Chairman.
Whenever a Federal Reserve Chairman comes to the subcommittee under the Humphrey-Hawkins approach, it is always interesting to try to figure out what perspective to apply. It seems to me
the biggest perspective to apply is that the Federal Reserve of the
United States has just established a new economic doctrine, what
I would describe is as, using your terms of art, Greenspan virtuosity.
You have talked about a new theory of a virtuous cycle, which,
as I read your testimony, is characterized by accelerated productivity, which reduces inflation, which bolsters expectations of future
corporate earnings, which increase equity values.
What is intriguing about this is it is the first conjunction of morality and economics that I have seen in terms of a label, so I have
gone to the standard dictionary to look up what the term "virtuous"
means for most people. "Virtuous" means righteous. It means,
"characterized by chastity, or exhibiting virtue." So I looked up
"virtue." That means moral excellence or righteousness, it means
chastity, it means one of the order of angels. It comes from the
Latin Virtus," which means manliness or goodness. So what we
have is a chaste, manly economic doctrine that I think is of serious
significance.
Having said this, this appears that it is an economic virtue to
have lower inflation. One of the interesting theoretical notions that
has come into being or has been in being in pastimes in history,
and people have thought might be passe, but may not be, is the
question of deflation. Is there virtue in deflation? Is this a circumstance that the Fed is concerned about?
Some have suggested that we may have a global overcapacity in
manufacturing, and that there may be seeds of a deflationary
trend. Is the Fed concerned about this, and will there be a policy
response if there is a concern? Is a policy response other than lower
interest rates the only kind of response to meet this type of circumstance, or might there be others?
Mr. GREENSPAN. Mr. Chairman, let me emphasize that our goal
is price stability, not price deflation; or, more exactly, not noninflation. Noninflation includes price stability and deflation. That is not
the goal, as we see it. Indeed, as we evaluate the relationship between inflation, price stability, and deflation, to the extent we are
able to analytically disengage or disaggregate the effects on the
economy, it appears that both inflation and deflation, because they
create uncertainty and risk premiums, are consistent with a slower
rate of maximum sustainable long-term growth than price stability.
Price stability would have the lowest set of risk premiums, because if you have a set of prices which are generally stable, some
prices w_ill go up, some prices will go down, the risk into the future
is perceived to be less, and hence, the degree of investment will be
more, productivity growth will be more, and standards of living will
be rising faster.




31

So we would be just as adamant against the instabilities and rising risk premiums that would be associated with deflation as we
would with inflation. We do believe that there are forces out there
in the rest of the world which have clearly moved from inflation to
disinflation and, in certain areas, deflation.
We do not believe it has moved anywhere near in that direction
in the United States as yet, but were we to see that occurring, or
were we to see the stampede from a small dot to something much
larger coming, obviously, we would evaluate and respond to it as
we perceive appropriate.
Mr. LEACH. As men and women of virtue? Yes. Thank you.
Mr. GREENSPAN. Yes. With respect to the rest of your statement
and questions, Mr. Chairman, you do leave me speechless.
Chairman CASTLE. Thank you, Mr. Chairman, for your chaste,
manly questions. We appreciate that.
Mr. Jackson.
Mr. JACKSON. Thank you, Mr. Chairman.
Welcome back to our subcommittee, Mr. Greenspan.
Just two questions, if I may. I want to pick up on something that
Representative Maloney said just a few moments ago, in an analogy that you used; her question, again, regarding the International
Monetary Fund.
I believe your quote went something to the effect that when a
neighbor's house is on fire and sparks are coming our way, what
do you do? The IMF is a way to contain the fire. Unfortunately, because this is an election year, the IMF and its replenishment may
be bogged down in election year politics.
Your agency was created, in part, to be free of political influences
and considerations. I am interested in how you and your agency
contain fires of the magnitude of the Asian crisis so that the effects
of contagion or the sparks do not undermine our economic growth
and expansion. And a hypothetical, and I am sure in the world of
economics we deal with them all the time, if the fire does spread,
does that mean higher or lower interest rates?
And then I have a second question unrelated to this one.
Mr. GREENSPAN. Congressman, it is very difficult to evaluate potential hypothetical events without fully grasping all of the complexities of what they are when we make policy. I have tended to
stay away from trying to project what we might or might not do
under certain hypothetical cases, because I have found that, over
the years, when those cases actually emerge, they look quite different from the way I thought they would. The reason is that we
have such an extraordinarily complex economy that it tends to do
things which surprise us more often than not.
Obviously, to the extent that deflationary forces are moving in
the way the Chairman was indicating earlier, clearly they raise
questions as to how we might or might not respond. But raising interest rates in the context of a deflationary set of forces is obviously
not something which central banks as a general rule engage in.
Mr. JACKSON. I guess I am going to follow up on my first question. I want to make it clear that, again, the ability of this Congress—in light of this being an election year, it may not be possible
for us to fully replenish the International Monetary Fund for political reasons. All of us are facing reelection. It is very difficult to




32

argue why we should be bailing Asian economies out and why we
would cast a vote to bail out an Asian economy.
Yet, in your remarks to Mrs. Maloney, you indicated that our
neighbor's house is on fire, which it is clearly on fire. Chairman
Leach and I took a trip, along with Members of this committee, and
we studied the nature of the fire. You said that sparks are potentially coming our way. Now, I don't know what size those sparks
are, but one
Mr. GREENSPAN. Nor do we, essentially.
Mr. JACKSON. I am assuming then that your remarks are either
to downplay the significance of the sparks or to acknowledge that
the sparks are of an enormous magnitude, and one way to contain
the fire is to replenish the International Monetary Fund until such
time as we are able, beyond this particular crisis, to develop the
appropriate international monetary funding agency and discuss
some of the problems that we have with the agency in general.
So in case this institution is incapable of responding to the magnitude of this fire. Whether it is a small fire, whether it is a large
fire, it is clear that your agency is the next line of defense in terms
of fire containment and spark containment. If it is a small crisis,
your agency will respond because the Congress couldn't. If it is a
large crises, your agency will respond because of the nature of the
crisis. And my only question is if it is a fire that is spreading, in
which direction, higher or lower, based upon the magnitude, small
or large, is your agency likely to respond?
Mr. GREENSPAN. Higher or lower interest rates, is that what you
mean?
Mr. JACKSON. It is usually the response from your agency when
there is some
Mr. GREENSPAN. As before, as I indicated in my prepared remarks, it is very clear that the contagion that has occurred and the
crisis that has occurred in Asia, and indeed in a goodly number of
other parts of the world have been factors which we think have diffused some of the underlying inflationary pressures that were
building in the United States. In that regard it is pretty clear that
if those forces, international forces, were not there and events were
developing the way they were in the last two or three years, I
would say that the pressure for us to have tightened monetary policy further would clearly have been higher. So in that regard, obviously, the extent to which there is a degree of weakening in the
rest of the world which is spilling over into the United States, that,
as other things equal, kept interest rates somewhat lower in the
United States, in the short end of the market I should point out.
Mr. JACKSON. I thank you for that response, Mr. Chairman, and
what that tells me is that there indeed then is no pressure on this
Congress at all to replenish the International Monetary Fund because there are international forces that have somehow reconciled
and provided us the time that we need, and unfortunately many of
us in the Congress have been operating as if there is great pressure for us to replenish this particular fund under certain conditions, that notwithstanding.
Mr. GREENSPAN. May I just—no, I would disagree with that.
Chairman CASTLE. May we go on to
Mr. GREENSPAN. Let me disagree with that.




33

My position is that it is precisely because we do not wish the contagion to get out of hand and create exceptional problems for the
United States that I have argued in favor of the replenishment.
Mr. JACKSON. I thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Jackson.
Mrs. Roukema.
Mrs. ROUKEMA. Thank you.
As it turned out, my questions will give you the opportunity to
follow up in a very real way and amplify on what you were just
saying with respect to IMF. I will get to that, but first let me say
that particularly given the report in the Wall Street Journal today
on massive tax cuts being planned by my Republican leadership. I
have heard you, and I hope this group and the press have heard
you loud and clear, that relative to paying down the national debt,
waiting for the surplus to solidify and maintaining the balanced
budget, that you would delay tax cuts.
If you want to comment on that, please dp. Maybe you would like
to tell us which tax cut you would give a priority to.
But first I must get back to that IMF question. I am glad that
you said to Mr. Jackson that it should not be interpreted that you
are not supporting IMF. You do indeed support IMF funding. When
I read my opening statement, I had not known that our House Appropriations Committee yesterday deferred indefinitely, and probably until September, acting on the appropriation for the IMF.
I would like to have you, Mr. Chairman, speak very definitively
on why this is not a bailout and why this is in our own economic
self-interests, and what could be the consequences of deferring indefinitely this proposal.
I am deeply concerned that problems have now resurfaced again
and caused this delay. I am convinced that you and the business
community have got to undertake an offensive here to help us get
the IMF funding passed. We do not want to provoke a worse situation where the contagion really is spread. We are not talking about
cinders any more, or fire hazards from one house to another, but
we are talking a real conflagration.
Mr. Chairman, please.
Mr. GREENSPAN. Congress worn an, I haven't changed my view on
this since we discussed it in this subcommittee early this year, and
indeed even late last year.
The issue is that there are significant emerging contagions
throughout the world. The crisis, as I indicated in my response to
the Chairman's first question, has shown no evidence of stabilization at this point. We do not know how far it is going to carry or
what its spillover is going to be. It is very difficult to forecast this.
There are those who make forecasts. I know that the basis of those
forecasts are very fragile.
As a consequence, the concern that we ought to have is that with
the resources of the IMF significantly depleted, which indeed, as I
indicated in the Senate yesterday, they are, that we can take the
risk that there will not be replenishment, that there will not be significant resources available easily for the IMF to contain the particular conflagrations that may arise which we cannot immediately
foresee. We can essentially position ourselves to hope that nothing
happens as a consequence of these events, and the chances are,




34

frankly, we probably will luck out in that regard, and no particular
action will be required. But if we are wrong in that regard, the consequences could be very substantially negative for the United
States, and as I said to one of your colleagues earlier, I view that
as an issue of taking out insurance, important insurance. While I
acknowledge, as many of the critics of the IMF have indicated, that
there are many things that ought to be changed there, I think now
is not the time to do that. There is more than enough time to address this after this crisis is over.
Mrs. ROUKEMA. Would you care to comment on the question of
waiting until September to act on IMF funding?
Mr. GREENSPAN. There are risks involved in doing that. It is important more that it be done in this particular Congress than it be
delayed, because the real danger is to delay when the Congress is
not in session.
Are there risks in delaying until September? I think there are.
I do not think they are major risks. The real risk is to do nothing
after the Congress adjourns. Then I do think we have a situation
in which there is nositting Congress easily available, and if the crisis were toarise, it would be very difficult to address expeditiously.
Mrs. ROUKEMA. Thank you.
Chairman CASTLE. Thank you, Mrs. Roukema.
Ms. Lee.
Ms. LEE. Thank you, Mr. Chairman.
Chairman Greenspan, I mentioned in my opening statement that
I am still trying to get some understanding of this definition of full
employment as defined by the Humphrey-Hawkins Act. It states
expressly that Congress should establish as a national goal the
right to full opportunities for useful paid employment at fair rates
of compensation for all individuals able, willing and seeking to
work.
Now, we know that in many of our communities, we see thousands of people work and walking around who are unemployed, yet
we have this very low unemployment rate. We also know that
many individuals are working, for instance, 20 hours a week at $8
an hour. Now under the full employment, the Humphrey-Hawkins
Act, what constitutes the unemployment rate, and how do we view
unemployment, or how do we define employment given what we
know that is really occurring with many of our workers in this
country are seeking work and are unemployed?
Mr. GREENSPAN. Congresswoman, the notion of full employment
is something which goes back basically to the early post-World War
II period as a concept which economists and policymakers tended
to deal with in some detail. Prior to that we didn't even have the
data to know what the degree of unemployment was. We didn't, for
example, in the 1930's have the type of data system that we now
have. In the 1950's and 1960's there were many different judgments about what is the rate of frictional unemployment, meaning
the extent to which, if you had a free labor economy, there would
undoubtedly be some people between jobs who are voluntarily unemployed, and clearly you don't wish that number to force people
to work when they don t wish to work.
On top of that, there is supposed to be some various different
evaluations of how much unemployment is stable over the long run.




35
What occurred in the 1970's is a set of stagflations, as they became
to be known, which was really quite alien to the view that low unemployment would increase inflation and you couldn't have inflation with high unemployment. It turned out in the 1970's that you
could. This led to this whole new notion of the optimum unemployment rate, which we now call the NAIRU, which is sort of related
to the Humphrey-Hawkins requirements for the administration of
4 percent and I think it is 3 percent adult unemployment.
But even the NAIRU is now, as you know, coming under considerable uncertainty, and as a result of this, the language in the
Humphrey-Hawkins Act is very rarely directly adhered to. It requires, I recall, in the language that the Administration indicate
how it will obtain the unemployment rates that are embodied in
the statute.
For the first few years, immediately thereafter, I do believe that
such evaluations were embodied in the President's Economic Report. But that has not been the case in recent years. It has gone
by the wayside because it has been perceived of as a more complex
issue. So while it is still in the statute, it really is a throwback to
earlier periods of the notion of full employment and what it means.
I don't know how to interpret it in today's environment. Administrations over the years have essentially chosen to discuss the issue,
but not in the full detailed notions that are embodied in the statute. My own view is that it is probably advisable to revise the statute to bring it up to the realities of the current period, but that
has not been an issue. That has been on the table in the Congress
for quite a long period of time, as I understand it.
Chairman CASTLE. Thank you, Miss Lee.
Mr. Metcalf.
Mr. METCALF. Thank you, Mr. Chairman. I apologize for arriving
late.
You may have covered the question, but I do have a couple of
questions.
As you know, debate has emerged between economists as to the
principle causes of the Asian crisis. One school lays the blame
largely on ample global liquidity combined with weak national financial systems and the corrosive impact of crony capitalism. The
other school asserts that the Asian economies were fundamentally
sound, and that the rational herd instincts of market participants
combined with the pernicious influence of short-term capital flows
and poor IMF policy advice caused the crisis.
Can you comment on who might be right on this?
Mr. GREENSPAN. Yes, I think the first is more right than the second.
Mr. METCALF. OK.
Mr. GREENSPAN. In fact, I don't think the second is right at all.
Mr. METCALF. OK, thank you very much.
Second question. Regarding the Asian situation, I wanted to ask
you how much Japanese markets are redeeming U.S. Treasury
notes? They have been recently redeeming some, and we know that
they hold a significant amount of U.S. treasuries. About how much
do they hold?
Mr. GREENSPAN. I think 400—there is a technical problem that
we have. I will submit a figure for the record. We are unclear on




36

what information is private and what is not. Some of it, obviously,
we get from the Japanese government, which is private, but what
I will do for the record is give you a number. It is several hundred
billion dollars incidentally.
[Chairman Greenspan subsequently supplied the following information:
[According to revised estimates by the Treasury Department, holdings of U.S. Treasury securities by Japanese
residents (official and private) amounted to $264 billion at
the end of April 1998. This estimate is based on the value
of holdings of bonds and notes reported in the 1994 portfolio benchmark survey and Treasury International Capital reports of holding of bills and certificates as of the end
of April 1998. Treasury makes no attempt to adjust their
estimates of foreign holdings for changes in value resulting
from changes in interest rates.]
Mr. METCALF. OK. Several hundred billion. OK.
Do you believe that we could see a scenario here where Japanese
financial institutions feel that they are in such serious trouble that
they dump large amounts of U.S. securities? Now, they are done
with—selling some, but we see this as a potential problem. It
seems to me that it is.
Mr. GREENSPAN. Well, it is conceivable, but remember that the
rate of interest, especially the real rate of interest, doesn't really
depend on who owns which securities, and very recently the Bank
of Japan, in an endeavor with the Ministry of Finance to support
the yen, sold huge amount of U.S. dollars actually through sale of
securities, and the impact on the price was de minimis.
Mr. METCALF. OK. Thank you.
I have no other questions.

Chairman CASTLE. Thank you, Mr. Metcalf.
Mr. Watt.
Mr. WATT. Thank you, Mr. Chairman. I want to apologize to the
Chairman for having to leave. We have a hearing going on in Judiciary right around the corner on hate crimes, and some days I feel
like when I come to the Banking Committee and I go to the Judiciary Committee, it is the difference between day and night as just
a whole dichotomy, two different worlds going on.
I perhaps should not even ask a question and let you out as
quickly as possible since they tell me that the market has gone
down another hundred points today, at least, and as 2 days you
have been over here, we got to stop you from testifying if the market is going to recover.
Chairman CASTLE. Would you yield for a moment, because I
made the statement earlier the market always goes up when he
testifies here, so it is probably a pretty good time to invest because
it is going to turn around and have a big bump before the afternoon is over.
Mr. WATT. Oh, you think it is coming back this afternoon? OK.
Let me ask a question that I hope is not duplicating something
that was asked while I was out. In your opening statement you referred to a dramatic increase in labor productivity, and I recalled
that in your comments in Charlotte, you spent quite a bit of time




37

talking about the impact of technology on productivity. And I guess
the first question I have is is it your assessment that this increase
in labor productivity is attributable to a better prepared work force,
or is that being driven by this technological advance in combination
with just having people working with the technology? Which one of
those things or ones of those things are driving this labor productivity, in your assessment?
Mr. GREENSPAN. I would say it is both, Congressman. That is, it
is an interaction between a highly efficient capital stock in the
United States and an increasingly skilled work force, and it is very
difficult to disaggregate the two. We try in some of our productivity
analyses to do that, and the truth of the matter is if you don't have
any people, having the capital equipment there isn't going to help
you. And if you don't have any capital equipment, having people,
even if they are skilled, isn't going to create very much in the way
of value added.
So it really is an interaction, and we call it labor productivity not
because we are either implying that it is all out of labor, but it is
merely a measure of the aggregate output per unit of labor input,
because ultimately the standard of living of human beings is determined by the output per worker.
Mr. WATT. Let me then spin off from that issue to the question
that I raised in my opening comments and ask you to address, and
that is this issue of the aggregate unemployment, which obviously
is important, but also in some areas, particularly inner-city areas,
unemployment is still very high. Are there policies—or maybe I
should just ask how can the Fed address that, that issue of the specific areas of unemployment, and in your assessments are you looking at just the overall unemployment in determining whether to
raise interest rates, determining whether inflation has taken place
or likely to take place, or how do you factor that in and put it into
the equation?
Mr. GREENSPAN. Remember that what we look at is the potential
development of an inflationary process which we believe would, if
allowed to accelerate, undermine economic growth and, therefore,
employment. Because of the efficiency of the American capital markets, there really is only one set of interest rates for the Nation as
a whole, and the only thing that we have control of, in part at
least, is short-term interest rates because of the Federal funds rate
which we can control arbitrages against other short-term rates, and
as a consequence we sometimes affect the longer-term rates, but
only because—as the impact of short-term rates filters out into
longer-term rates.
What we cannot do is affect interest rates in individual areas of
the country. We used to be able to do that years ago. We cannot
anymore, and we are situated in a manner where we cannot readily affect the distribution of incomes or the distribution of employment nationwide because we only have one instrument with which
we deal, and as a consequence monetary policy per se cannot very
readily impact on individual areas within cities or rural areas.
What we do tend to do is to try through other aspects of the Federal Reserve System, our Federal Reserve Banks and branches'
community affairs divisions, for example, to try to work with individual groups to try to involve them and ourselves in a manner to




38

try, as I indicated earlier to one of your colleagues, to see if we can
get equity capital or debt capital or means of financing which could
be of assistance.
But as far as monetary policy is concerned, we have one tool for
one market, and all we can do is try to attain, as I indicated before,
our ultimate goal, which we perceive to be maximum sustainable
growth for the economy as a whole. We don't have the instruments
in monetary policy to go beyond that.
Mr. WATT. Thank you, Mr. Chairman.
Chairman CASTLE. Thank you, Mr. Watt.
Mr. Bachus has waited patiently.
Mr. BACHUS. Thank you.
Chairman Greenspan, I was looking at your testimony from
March 8th of 1995, where you described the budget deficit as putting upward pressure on interest rates, especially nominal rates,
and that it also tends to be inflationary. And I would suppose, first
of all, that the converse is true; is it not?
Mr. GREENSPAN. Yes it is. In fact, it is quite symmetrical in that
regard.
Mr. BACHUS. Now, Chairman Castle mentioned to you tax cuts,
and he said we are now in a surplus. Being in a surplus, and we
are in a surplus, but whether or not it is transitory, do you think
it is having an effect on the economy now?
Mr. GREENSPAN. Indeed I think it is. Long-term interest rates, I
suspect, are significantly lower than they would have been, for example, if we continued with that $200 billion deficits, and to the
extent that that is the case, interest-sensitive areas of the economy
have prospered to the extent they would not have if we had those
large deficits.
Mr. BACHUS. If we continue to have a surplus, would you continue to think it would be an influencing factor on lowering interest
rates?
Mr. GREENSPAN. Yes, I do. One of the reasons why I have argued
that we shouldn't be hasty in trying to find uses for the surplus
is that the surplus is doing an awful lot of good. It is basically reducing outstanding public debt, reducing interest costs to the
Treasury, and increasing the surplus even more as a consequence.
But the overall effect of large surplus is to increase national saving, reduce long-term interest rates, and create positive add-ons to
the economy.
Mr. BACHUS. You know, you have talked about how you can influence the Fed fund rate, and you talked about an orientation
right now toward preventing inflation as opposed to reducing interest rates; that is, your primary concern is inflation. If we are in a
surplus, and if it has taken off some of the inflationary pressure,
in making interest rate policy decisions, do you consider that we
are in a surplus now? Is that something that you are factoring in?
Mr. GREENSPAN. The way we determine monetary policy is to
look at the development, as I indicated before, of potential inflationary or deflationary processes to which we respond one way or
the other. It is our judgment based on evaluation of the effect of
budget deficit on the economy that the emerging surplus, and indeed we have had one now for a number of months, is acting in




39

a positive manner keeping down inflationary pressures, which
means that less is required on the part of monetary policy.
Mr. BACKUS. So, as it continues, it is something that is a factor
that you consider in setting a Fed fund rate?
Mr. GREENSPAN. Well, we don't consider
Mr. BACHUS. Or in setting monetary policy?
Mr. GREENSPAN. We don't consider it directly, but what we do is
recognize that because it impacts the economy overall, and we respond to the economy directly, the answer is clearly it does have
an effect on how the central bank behaves.
Mr. BACHUS. Back on March 8, 1995, you said that you think one
of the first things that is likely to happen if we do get a budget
surplus is that long-term interest rates will fall significantly. I will
tell you as a Member of Congress that the budget is balanced now,
and we are looking to see those long-term rates
Mr. GREENSPAN. Well, they are. They are significantly below
where they were back then. So, in fact, we have had long-term interest rates down quite considerably since 1993.
Mr. BACHUS. The surplus has only been in effect for the last
Mr. GREENSPAN. That is true, but remember that it is the reduction in the deficit as it moves into surplus that is relevant. There
is no magic point which is—when you go into surplus, all of a sudden something happens. It is a continuum. Just reducing the deficit
has the same effect as eventually just getting into surpluses.
Mr. BACHUS. Thank you.
Now, let me ask one other question, and this is totally switching
gears, but we have talked about the terrible problem in the world
community now with Japan, Asia, Russia and whether or not Russia will fall, whether or not Japan will pull out of its dive. I would
simply ask you if you would like to comment on this.
The debate in Congress seems to be, will Russia fall, will Japan
pull out of its dive characterizes whether we lend them money and
how much. And I would submit to you at least my view is that
whether or not Russia falls, whether or not Japan pulls out is dependent not on whether we lend them money or not, or how much,
but how much they reform their systems.
Mr. GREENSPAN. Absolutely. I agree with that. The issue of lending the money is only useful if it is a transitional bridge to assist
them in reforming their economies. If they don't reform their economies, I don't care how much you lend them, it is not going to help.
Mr. BACHUS. And I think what some of us who have advocated
withholding money, insist on policy changes, and then the money
will come.
Now, you have talked about a fire, but, in Russia for two or three
years now they have not upheld the U.N. sanctions against Iraq;
they have cooperated with Iran, which promotes international terrorism; they have taken a course of action which leads to proliferation of weapons of mass destruction. And I think what some of us
have said is we want to see a policy change. I would say to you
that the proliferation of weapons of mass destruction is probably
more harmful to our economy than a Russian nose dive.
Mr. GREENSPAN. That is the judgment which the Congress is employed to make, tough tradeoffs that you have to be involved with.




40

Mr. BACKUS. And I am not sure, do you consider when you say
we should lend Russia money, you have come
Mr. GREENSPAN. I am not saying we should loan Russia. I am
just saying we should replenish the IMF.
Chairman CASTLE. Mr. Bachus, can you ask a final question?
Mr. BACHUS. Yes. I guess when you say that—do you make foreign policy considerations?
Mr. GREENSPAN. No. I just make them on the grounds of the
issue of international financial stability and how it affects us.
Mr. BACHUS. And you understand there are other factors.
Mr. GREENSPAN. Certainly, of course.
Mr. BACHUS. Thanks.
Chairman CASTLE. Thank you very much. We appreciate it.
Mr. Hinchey.
Mr. HINCHEY. Thank you very much, Mr. Chairman.
On the issue of long-term interest rates, I find myself, of course,
agreeing with Mr. Bachus1 line of questioning just a few moments
ago. I anticipated that real interest rates would be coming down as
the budget deficit was erased and as we moved into a period of surplus and am equally disappointed that we haven't seen that happen. I hope that it will not take a serious downturn in the economy
in order to press the Federal Reserve into doing something about
real interest rates.
Perhaps the most interesting debates that we have had on this
subcommittee since I have been a Member is the efficacy of Humphrey-Hawkins in its dual responsibilities to promote maximum
economic growth while maintaining low inflation, and also the debate that we have had over the course of the last several years on
this subcommittee with regard to the level of growth that the economy could see without triggering an increase in inflation.
Many of us on this side of the subcommittee have argued that
we could see substantially higher rates of growth beginning back
in 1993 in the present context without triggering inflation, and indeed history has borne that out. We have seen the economy grow
very substantially over the last five years, and inflation, if anything, has declined during that time and continues to do so now.
However, there are some very dangerous things that we see abroad
that do not bode well for our economy at home.
The National Association of Purchasing Managers' Index shows
that manufacturing actually began to fall last month. There is a
deepening decline in export orders. The export index fell, as a matter of fact, last month for the sixth consecutive month. The trade
deficit and other factors have resulted in a decline in factory jobs.
We lost 29,000 of these jobs just last month. Perhaps we may see
bigger declines in factory jobs ahead. There is a reduction in the
economic growth and a reduction in wage pressure. Trade deficit in
goods alone for May was a little over $21.5 billion.
So there are indications that we are going to see a sharp decline
in growth ahead, largely attributed to the financial crisis in Asia.
I wonder what you think about all of those factors in concert, Mr.
Chairman, and what we might do, both in terms of monetary and
fiscal policy to, in effect, gird our loins against this onslaught,
which is so apparent and indeed increasingly palpable.




41

Mr. GREENSPAN. Obviously we are looking at the same data base
that you are referring to, and one of the reasons why we have argued that we thought the rate of growth would slow down to a sustainable pace which would not be destabilizing is that we expect
the Asian internationally-related events to be of a nature which
would slow growth in the United States, which it has, as far as we
can judge.
The issue of forecasting how far it will go is exceptionally difficult to do. I have been in the forecasting business for 50 years,
and I know when I can forecast something reasonably well and not.
This is a tough one. It is an exceptionally difficult one to make projections about, which is the reason we spend so much time day by
day just trying to evaluate what is going on and try to be prepared
as best we can for events altering in a manner which we did not
anticipate. So far it has not reached a stage that the Chairman
characterized in his opening remarks, but we recognize that there
has been no evidence of stability yet. Contagion is still there. Latin
America has held up better than we would have expected at certain
occasions. Southeast Asia has turned out to be worse than we had
expected. But all of these pieces have to fit together in an overall
policy framework, and that is what we try to do, and we try to
come to an appropriate balance.
It is certainly the case that inflation has come down in recent
years. It is an interesting issue as to whether, had we not, when
we had the big underlying cost pressures in 1994, engaged in some
tightening to cutoff the top of what we saw was a bulging inflationary set of forces, whether we would have ended up with as benign
an outlook as apparently emerged in the last two or three years.
Let me say with respect to real interest rates, real interest rates
have actually been declining in the long end of the market in the
last couple of years. To be sure, they have risen in the short end
because we have kept the funds rate constant, and inflation expectations have doubtless been declining.
But the ultimate determination as to whether or not interest
rates are containing or expanding the economy can only be judged
by looking at the economy itself, and we see that interest-sensitive
areas of the economy, such as housing and motor vehicles, have
been actually quite strong. If monetary policy were exceptionally
restrictive at this stage, or even mildly restrictive, it is very hard
to make the case that housing starts, for example, would be as
buoyant as they have been, and motor vehicle sales as strong as
they have been.
So while it is certainly the case that short-term real interest
rates have risen, it is quite conceivable that the falling long-term
real rates has more than offset that, but either way we have not
yet seen any constrictive elements within the domestic economy as
a consequence of monetary policy. Obviously, to the extent that we
do see that or the potential of that occurring, that will affect what
our policy is, as it should.
Mr. HlNCHEY. If I can have one more?
Chairman CASTLE. Very briefly. We are running quite late here.
Mr. HINCHEY. I appreciate your sensitivity to that, Mr. Chairman. I don't pretend to have any impact on your philosophy or your
thought process, but I appreciate your sensitivity to this situation.




42

My concern is simply this: Real wages for real workers have recently begun to go up, and they were stagnant for a long, long time,
and there was a lot of unrest in this country, and appropriately so.
because of the fact that people were working harder and longer and
not getting ahead. They have begun to see some progress recently.
I am deeply fearful that if we do not act appropriately, that the
present problems that we are facing, largely originating in Asia,
are going to have an impact on those people who have just now
begun to enjoy the fruits of this growing economy. So whatever we
can do to continue to assure that working people who work for
wages particularly get the benefits of this economy, the better off
we are all going to be in the long run.
Mr. GREENSPAN. I agree with that.
Chairman CASTLE. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman Greenspan, I apologize for having to leave during the
early part of the questioning for some debate on the House floor.
I have a number of questions, a number of which I will, of course,
have to submit for the record, because I have got as much chance
of getting an answer to all them as winning the lottery in the
amount of time that I have. But let me ask one very quickly.
With respect to the IMF, the House Majority Leader Dick Armey
has stated, and I will paraphrase him, that he sees no reason to
support policies of the IMF which are counterproductive. Is it your
opinion that the policies the IMF and the G-7 have imposed on the
Asian countries, specifically South Korea, Thailand, Indonesia, that
those are counterproductive, or do you think those are productive
policies?
Mr. GREENSPAN. Some of them probably were mistaken in the
early stages, but I would say, overall the policies, I think, have
probably been positive.
Mr. BENTSEN. Particularly since, say, the Christmas period
or
Mr. GREENSPAN. In other words, there were a couple of false
starts, and I would certainly scarcely give them an A, but I
wouldn't give our policies As either in many areas, so that it is not
an issue of do they always do exactly the right thing? I think not.
But overall they have been a force mainly for good rather than evil,
if I may put it into moral terms that the Chairman of the committee was putting it in. We are better off having done what has been
done there, especially with endeavoring to contain monetary
growth and monetary base expansion in a lot of these areas, than
where there are no such facilities available.
Mr. BENTSEN. Thank you.
My next question goes to what the Chairman of the subcommittee raised and my colleague from Alabama raised with respect to
the unified budget surplus, and you, I think appropriately, point
out that nonetheless there is still a $5.4 trillion debt outstanding.
If you look at the figures, our debt-to-GDP ratio, and we have had
this discussion before, has doubled since 1981, and our interest on
the debt as a percentage of GDP has increased as well since 1981
to about 3 percent of GDP.
Now, I think what you said was that you would prefer us paying
down the debt, but if we were to break the virtuous cycle of the




43

spending discipline or budget discipline we have had in the last few
years, that you would prefer tax cuts to spending. I assume, because you would believe that, while both are a form of consumption, tax cuts may well be more efficient than Government spending.
My first question is is that correct, but my main question is this:
Wouldn't it be a mistake for us not to use this windfall that we
may or may not have of $1.5 trillion over ten years—and you are
right, we don't know if it is going to stay at that—to pay down the
debt, which, in effect, would be more of an investment nature than
a consumption nature, and can't we look at previous history and
see that consumption, whether for spending or for tax cuts, does
carry a price, and that price being the additional interest costs that
we have had to pay if you look at just the 1981 to 1998 cycle? And
would you feel that any change in the spending caps or in the revenue side which breaches the budget discipline we have had would
have a negative market reaction as well?
Mr. GREENSPAN. It may well incidentally. My concern is that if
you look at our commitments into the future that are currently embodied in the law, that the stability of the system, unless we get
very major continued improvements in revenues, is in doubt. In
other words, long-term CBO and OMB projections over the years
have indicated that we are going to have to adjust, for example, Social Security. There are questions about outlay growth implied in
the aging of the population more generally, which includes both
Medicare and Social Security, and whether or not we have the real
resources to meet those commitments. And what has happened in
the last two or three years is a big bulge in receipts, the source of
which is not altogether clear.
And so my concern is that we commit further to new, various different type of entitlement programs which will make the situation
worse, not better, if it turns out that the presumed receipts are
really ephemeral, and that as I indicated earlier, the Japanese experience, where when they have this huge increase in asset values,
the ratio of their tax receipts to nominal income rose significantly,
and when it turned around, they reversed, and what I am not at
all convinced of at this particular stage is that those very large surpluses which we are calculating are real, and I would be very concerned if we committed them on the expenditure side because I
think it would be difficult to reverse. I think there is less danger
on the tax side.
Mr. BENTSEN. Thank you.
Chairman CASTLE. Mr. Bentsen, this will be the final point.
Mr. BENTSEN. I appreciate that, but nonetheless could you quantitatively state that whether it is expenditure or on the tax side,
it would be better to put it on the investment side in retiring debt
rather than either expenditure or tax reduction?
Mr. GREENSPAN. Yes. My first choice is to retire debt as much
as we can because it has a positive economic impact, and in the
event that some of this expected surplus is indeed ephemeral, it
doesn't create a particular problem for us. But if we commit something which we are not sure we have, we are taking a risk. As I
said in the Senate yesterday, if it turns out that it is just not possible to keep surpluses of these orders of magnitude without using




44

them one form or another, I would very much be inclined to cut
taxes than to put them into expenditure programs, because over
the long run it is easier to get fiscal stability if your expenditure
numbers are not escalating at a pace in excess or nominal income
or nominal taxable base of the society.
Mr. BENTSEN. And it is easier to change the revenue side than
the entitlement side.
Mr. GREENSPAN. Far easier too.
Chairman CASTLE. Thank you, Mr. Bentsen.
And, Chairman Greenspan, we thank you. It is as always a fairly
exhaustive period of time that we go through this, but hopefully
the questions that need to be asked were asked, and the answers
that you should provide were provided, and we appreciate it, and
we appreciate your continuing good work. We need you to go back
in the field and make sure the stock market goes up before the end
of the day.
Mr. GREENSPAN. Yes, sir.
[Whereupon, at 12:53 p.m., the hearing was adjourned.]







APPENDIX

July 22, 1998

(45)

46
House Committee on Banking and Financial Services
Subcommittee on Domestic and International Monetary policy
Humphrey-Hawkins Hearing with testimony from Federal Reserve Board
Chairman Alan Greenspan,
10:00 a.m., July 22, 1998
Room 2128 Raybum House Office Building

Chairman Michael N. Castle's Opening Remarks:
The Subcommittee will come to order.
The Subcommittee meets today, to receive the annual mid-year 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.

The American economy continues to perform well, due in part to the

work of the Federal Reserve. We are not greedy, but we would be very grateful if
you could just announce that the current good economic times will continue for at
least another 88 months.
When the Humphrey Hawkins Act was passed in 1978, the target rate of 4%
unemployment seemed like an unrealistic fantasy, since everyone knew that full
employment was defined as an unemployment rate of about sis percent. Today the
4% rate seems almost in reach and some argue that the second quarter of this year
will prove to have actually been a period of deflation.




47

When you last visited us in February, we discussed our concerns over the
troubled Japanese economy. The change in the Government of Japan confirms that
tbose concerns were valid. The Asian economic uncertainty, and especially the
status of Japan's economy, are almost certainly the greatest threat to our own
economic health, t hope that you will share with us your impressions regarding the
degree of seriousness with which the Japanese authorities are approaching the
solution of their economic problems.
The rest of Asia still is in the process of digging out from their own
problems and success depends heavily on Japan, The danger of spreading this
international economic flu seems even more real when we watch the situation in
Russia. If oil prices continue to hover around their current low levels Mexico may
again be in crisis and others in Latin America could follow. We hope you will
comment on the dangers of the regional economic problems reinforcing each other
and what they mean for the world economy.
As you know, tne debate rages on in Congress over whether the United States
should contribute an additional $18 billion to the International Monetary Fund to
help meet International economic instability and I am very eager to hear your views
on the role of the IMF in addressing these problems.
While we look to you to alert us to what we should be worrying about, we
also expect that when you address the House, the markets will move up— as opposed
to occasions when you address the Senate.




48
The higb relative value of the dollar evidently continues to reflect both the
leading position of our economy with regard to Europe and the Far East, and the
capital that arrives from areas suffering economic insecurity. Should we anticipate
further action such as the June 17th intervention to prop up the Yen?
As a general rule is this an effective strategy?
As the economy continues to rewrite the traditional economic models, we
would welcome your insights regarding adjustments being incorporated into your
models.
My view is that we must have * full discussion of the potential impact of
events in Japan and Asia on the future of our own economy and working
Americans, and what steps we, as policy makers can take to protect our nation.
As always, we are delighted to have you with us and look forward to a lively
discussion.




49
Mt. Chairman and members of the Subcommittee. 1 appreciate this opportunity to
present the Federal Reserve's midyear report on monetary policyOverall, the performance of the U.S. economy continues to be impressive. Over
the first part of the year, we experienced further gains in output and employment, subdued
prices, and moderate long-term interest rates. Important crosscurrents, however, have
been impacting the economy. With labor markets very light and domestic final demand
retaining considerable momentum, the risks of a pickup in inflation remain significant.
But inventory investment, which was quite rapid late last year and early this year, appears
to have slowed, perhaps appreciably. Moreover, the economic and financial troubles in
Asian economies are now demonstrably restraining demands for U.S. goods and
services-and those troubles could intensify and spread further. Weighing these forces,
the Federal Open Market Committee chose to keep the stance of policy unchanged over
the first half of 1998. However, should pressures on labor resources begin to show
through more impressively in cost increases, policy action may need to counter any
associated tendency for prices to accelerate before it undermines this extraordinary
expansion.
Recent Developments
When 1 appeared before your subcommittee in February, I noted that a key
question for monetary policy was whether the consequences of the turmoil in Asia would
be sufficient to check inflationary tendencies that might otherwise result from the strength
of domestic spending and tightening labor markets. After the economy's surge in 1996




50

and, especially, last year, resource utilization, particularly that of the labor force, had risen
to a very high level. Although some signs pointed to stepped-up increases in productivity,
the speed at which the demand for goods and services had been growing clearly exceeded
the rate of expansion of the economy's long-run potential to produce. Maintenance of
such a pace would put even greater pressures on the economy's resources, threatening the
balance and longevity of the expansion.
However, it appeared likely that the difficulties being encountered by Asian
economies, by cutting into U.S. exports, would be a potentially important factor slowing
the growth of aggregate demand in the United States. But uncertainties about the timing
and dimensions of that development were considerable given the difficulties in assessing
the extent of the problems in East Asia.
In the event, the contraction of output and incomes in a number of Asian
economies has turned out to be more substantial than most had anticipated. Moreover,
financial markets in Asia and in emerging market economies generally have remained
unsettled, portending further difficult adjustments. The contraction in Asian economies,
along with the rise in the foreign exchange value of the dollar over 1997, prompted a
sharp deterioration in the U.S. balance of trade in the first quarter. Nonetheless, the
American economy proved to be unexpectedly robust in that period. The growth of real
GDP not only failed to slow, it climbed further, to about a 5Vi percent annual rate in the
first quarter, according to the current national income accounts. Domestic private




51
demand for goods and services—including personal consumption expenditures, business
investment, and residential expenditures—was exceptionally strong.
Evidently, optimism about jobs, incomes, and profits, high and rising
wealth-to-income ratios, low financing costs, and falling prices for high-tech goods fed
the appetites of households and businesses for consumer durables and capital equipment.
In addition, inventory investment contributed significantly to growth in the first quarter;
indeed, the growth of stocks of materials and goods outpaced that of overall output by a
wide margin during the first quarter, adding 1% percentage points to the annualized
growth rate of GDP. Although accumulation of some products likely was unintended,
surveys indicate that much of the stockbuilding probably reflected firms' confidence in
the prospects for continued growth.
As evidence piled up that the economy continued to run hot during the winter, the
Federal Reserve's concerns about inflationary pressures mounted. Domestic demand
clearly had more underlying momemum than we had anticipated, supported in part by
financial conditions that were quite accommodative. Credit remained extremely easy for
most borrowers to obtain; intermediate- and long-term interest rates were at relatively low
levels; equity prices soared higher, despite some disappointing earnings reports; and
growth in the monetary aggregates was rapid. Indeed, the crises in Asia, by lowering
longer-term U.S. interest rates—through stronger preferences for dollar investments and
expectations of slower growth ahead-and by reducing commodiry prices, probably added




52
to the positive forces boosting domestic spending in the first half, especially in the
interest-sensitive housing sector. The robust expansion of demand tightened labor
markets further, giving additional impetus to the upward trend in labor costs. Inflation
was low-though, given the lags with which monetary policy affects the economy and
prices, we had to be mainly concerned not with conditions at the moment but with those
likely to prevail many months ahead. In these circumstances, the Federal Open Market
Committee elected in March to move to a state of heightened alert against inflation, but
left the stance of policy unchanged.
Although national income and product data for the second quarter have not yet
been published, growth of U.S. output appears to have slowed sharply. The auto strike
has brought General Motor's production essentially to a halt, probably reducing real GDP
in the second quarter by about V4 percentage point at an annual rate. The limited available
information on inventory investment suggests that stockholding dropped markedly from
its unsustainable pace of the first quarter. In addition to the slower pace of inventory
building, Asian economies have continued to deteriorate, further retarding our exports in
recent months.
Indeed, readings on the elements thai make up the real GDP have led many
analysts to anticipate a decline in that measure in the second quarter, after the first-quarter
surge. Given the upcoming revisions to the national income accounts, such assessments
would have to be regarded as conjectural. It is worth noting in any case that other




53
indicators of output, including worker hours and manufacturing production, show a
somewhat steadier, though slowing, path over the first half of the year. And underlying
trends in domestic final demand have remained strong, imparting impetus to the
continuing economic expansion.
During the first half of the year, measures of resource utilization diverged.
Pressures on manufacturing facilities appeared to be easing. Plant capacity was growing
rapidly as a result of vigorous investment. And growth of industrial output was dropping
off from its brisk pace of 1997, importantly reflecting the deceleration in world demand
for manufactured goods that resulted from the Asian economic difficulties.
But labor markets, in contrast, became increasingly taut during the first half. Total
payroll jobs rose about one-and-one-half million over the first six months of the year.
The civilian unemployment rate dropped to a bit below 4Vi percent in the second quarter,
its lowest level in three decades. Firms resorted to a variety of tactics to attract and retain
workers, such as paying various types of monetary bonuses and raising basic wage rates.
But, at least through the first quarter, the effects of a rising wage bill on production costs
were moderated by strong gains in productivity.
Indeed, inflation stayed remarkably damped during the first quarter. The
consumer price index as well as broader measures of prices indicate that inflation moved
down further, even as the economy strengthened. Although declining oil prices
contributed to this development, pricing leverage in the goods-producing sector more




54
generally was held in check by reduced demand from Asia that, among other things, has
led to a softening of commodity prices, a strong dollar that has contributed to bargain
prices on many imports, and rising industrial capacity. Service price inflation, less
influenced by international events, has remained steady at about a 3 percent rate since
before the beginning of the crisis.
Some elements in the goods price mix clearly were transitory. Indeed, the more
recent price data suggest that overall consumer price inflation moved up in the second
quarter. But, even so, the increase remained moderate.
In any event, it would be a mistake for monetary policy makers to focus on any
single index in gauging inflation pressures in the economy. Although much public
attention is directed to the CPI, the Federal Reserve monitors a wide variety of aggregate
price measures. Each is designed for a particular purpose and has its own strengths and
weaknesses. Price pressures appear especially absent in some of the measures in the
national income accounts, which are available through the first quarter. The chain-weight
price index for personal consumption expenditures excluding food and energy, for
example, rose 1.5 percent over the year ending in the first quarter, considerably less than
the 2.3 percent rise in the core CPI over the same period. An even broader price measure,
that for overall GDP, rose 1.4 percent. These indexes, while certainly subject to many of
the measurement difficulties the Bureau of Labor Statistics has been grappling with in the
CPI, have the advantages that their chain-weighting avoids some aspects of so-called




55
substitution bias and that already published data can be revised to incorporate new
information and measurement techniques. Taken together, while the various price
indexes show some differences, the basic message is that inflation to date has remained

low.
Economic Fundamentals: The Virtuous Cycle
So far this year, our economy has continued to enjoy a virtuous cycle. Evidence
of accelerated productivity has been bolstering expectations of future corporate earnings,
thereby fueling still further increases in equity values, and the improvements in
productivity have been helping to reduce inflation. In the context of subdued price
increases and generally supportive credit conditions, rising equity values have provided
impetus to spending and, in turn, the expansion of output, employment, and
productivity-enhancing capital investment.
The essential precondition for the emergence, and persistence, of this virtuous
cycle is arguably the decline in the rale of inflation to near price stability. In recent years,
continued low product price inflation and expectations that it will persist have promoted
stability in financial markets and fostered perceptions that the degree of risk in the
financial outlook has been moving ever lower. These perceptions, in turn, have reduced
the extra compensation that investors require for making loans to, or taking ownership
positions in. private firms. With risks in the domestic economy judged to be low, credit
and equity capital have been readily available for many businesses, fostering strong




56
investment. And low mortgage interest rales have allowed many households to purchase
homes and to refinance outstanding debt. The reduction in debt servicing costs has
contributed to an apparent stabilization of the financial strains on the household sector
that seemed to emerge a couple of years ago and has buoyed consumer demand.
To a considerable extent, investors seem to be expecting that low inflation and
stronger productivity growth will allow the extraordinary growth of profits to be extended
into the distant future. Indeed, expectations of earnings growth over the longer term have
been undergoing continual upward revision by security analysts since early 1995. These
rising expectations have, in turn, driven stock prices sharply higher and credit spreads
lower, perhaps in both cases to levels that will be difficult to sustain unless the virtuous
cycle continues. In any event, primarily because of the rise in stock prices, about $12'/i
trillion has been added to the value of household assets since the end of 1994. Probably
only a few percent of these largely unrealized capital gains have been transformed into
the purchase of goods and services in consumer markets. But that increment to spending,
combined with the sharp increase in equipment investment, which has stemmed from the
low cost of both equity and debt relative to expected profits on capital, has been
instrumental in propelling the economy forward.
The consequences for the American worker have been dramatic and, for the most
part, highly favorable. A great many chronically underemployed people have been given
the opportunity to work, and many others have been able to upgrade their skills as a result




57

of work experience, extensive increases in on-lhe-job training, or increased enrollment in
technical programs in community colleges and elsewhere. In addition, former welfare
recipients appear to have been absorbed into the work force in significant numbers.
Government finances have been enhanced as well. Widespread improvement has
been evident in the financial positions of state and local governments. In the federal
sector, the taxes paid on huge realized capital gains and other incomes related to stock
market advances, coupled with taxes on markedly higher corporate profits, have joined
with restraint on spending to produce a unified budget surplus for the first time in nearly
three decades. The important steps taken by the Congress and the Administration to put
federal finances on a sounder footing have added to national saving, relieving pressures
on credit markets. The paydown of debt associated with the federal surplus has helped to
hold down longer-term interest rates, which in turn has encouraged capital formation and
reduced debt burdens. Maintaining this disciplined budget stance would be most helpful
in supporting a continuation of our current robust economic performance in the years
ahead.
The fact that economic performance has strengthened as inflation subsided should
not have been surprising, given lhat risk premiums and economic disincentives to invest
in productive capital diminish as the economy approaches price stability. But the extent
to which strong growth and high labor force utilization have been joined with low
inflation over an extended period is, nevertheless, exceptional. So far, at least, the




58
adverse wage-price interactions that played so central a role in pressuring inflation higher
in many past business expansions—eventually bringing those expansions to an end—have
not played a significant role in the current expansion.
For one thing, increases in hourly compensation have been slower to pick up than
in most other recent expansions, although, to be sure, wages have started to accelerate in
the past couple of years as (he labor market has become progressively tighter. In the first
few years of the expansion, the subdued rate of rise in hourly compensation seemed to be,
in part, a reflection of greater concerns among workers about job security. We now seem
to have moved beyond that phase of especially acute concern, though the flux of
technology may still be leaving many workers wilh fears of job skill obsolescence and a
willingness to trade wage gains for job security. In the past couple of years, of course,
workers have not had to press especially hard for nominal pay gains to realize sizable
increases in their real wages. In contrast to the pattern that developed in several previous
business expansions, when workers required substantial increases in pay just to cover
increases in the cost of living, consumer prices have been generally well-behaved in the
current expansion.
A couple of years ago—almost at the same time that increases in total hourly
compensation began trending up in nominal terms—evidence of a long-awaited pickup in
the growth of labor productivity began to show through more strongly in (he data; and this
accelerated increase in output per hour has enabled firms to raise workers' real wages




59
while holding the line on price increases. Gains in productivity usually vary with the
strength of the economy, and the favorable results that we have observed during the past
two years or so, when the economy has been growing more rapidly, almost certainly
overstate the degree of structural improvement. But evidence continues to mount that the
trend of productivity has accelerated, even if the extent of that pickup is as yet unclear.
Signs of major technological improvements are all around us, and the benefits are evident
not only in high-tech industries but also in production processes that have long been part
of our industrial economy.
Those technological innovations and the rapidly declining cost of capital
equipment that embodies them in turn seem to be a major factor behind the recent
enlarged gains in productivity. Evidently, plant managers who were involved in planning
capital investments anticipated that a significant increase in the real rates of return on
facilities could be achieved by exploiting emerging new technologies. If that had been a
mistake on their pan, one would have expected capital investment to run up briefly and
then start down again when the lower-than-anticipated rates of return developed. But we
have instead seen sustained gains in investment, indicating that hoped-for rates of return
apparently have been realized.
Notwithstanding a reasonably optimistic interpretation of the recent productivity
numbers, it would not be prudent to assume that even strongly rising productivity, by
itself, can ensure a non-inflationary future. Certainly wage increases, per se, are not




60
inflationary, unless they exceed productivity growth, thereby creating pressure for
inflationary price increases that can eventually undermine economic growth and
employment. Because the level of productivity is tied to an important degree to the stock
of capital, which turns over only gradually, increases in the trend growth of productivity
probably also occur rather gradually. By contrast, the potential for abrupt acceleration of
nominal hourly compensation is surely greater.
As I have noted in previous appearances before Congress, economic growth at
rates experienced on average over the past several years would eventually run into
constraints as the reservoir of unemployed people available to work is drawn down. The
annual increase in the working-age population (from 16 to 64 years of age), including
immigrants, has been approximately 1 percent a year in recent years. Yet employment,
measured by the count of persons who are working rather than by the count of jobs, has
been rising 2 percent a year since 1995, despite the acceleration in the growth of output
per hour. The gap between employment growth and population growth, amounting to
about 1.1 million persons a year on average since the end of 1995, has been made up, in
part, by a decline in the number of individuals who are counted as unemployed—those
persons who are actively seeking work--of approximately 650,000 a year, on average,
over the past two and one-haJf years. The remainder of the gap has reflected a rise in
labor force participation that can be traced largely to a decline of almost 300,000 a year in
the number of individuals (aged 16 to 64) wanting a job but not actively seeking one.




61
Presumably, many of the persons who once were in this group have more recently become
active and successful job-seekers as the economy has strengthened, thereby preventing a
still sharper drop in the official unemployment rate. In June, the number of persons aged
16 to 64 who wanted to work but who did not have jobs was 10.6 million on a seasonally
adjusted basis, roughly 6 percent of the working-age population. Despite an uptick in
joblessness in June, this percentage is only fractionally above the record low reached in
May for these data, which can be calculated back to 1970.
Nonetheless, a strong signal of inflation pressures building because of
compensation increases markedly in excess of productivity gains has not yet clearly
emerged in this expansion. Among nonfinancial corporations (our most recent source of
data on consolidated income statements), trends in costs seem to have accelerated from
their lows, but the rates of increase in both unit labor costs and total unit costs are still
quite low.
Still, the gap between the growth in employment and that of the working-age
population will inevitably close. What is crucial to sustaining this unprecedented period
of prosperity is that it close reasonably promptly, given already stretched labor resources,
and that labor markets find a balance consistent with sustained growth marked by
compensation gains in line with productivity advances. Whether these adjustments will
occur without monetary policy action remains an open question.




62
Foreign Developments
While the United Slates has been benefiting from a virtuous economic cycle, a
number of other economies unfortunately have been spiraling in quite the opposite
direction. The United States, Canada, and Western Europe have been enjoying solid
economic growth, with relatively low inflation and declining unemployment, but the
economic performance in many developing and transition nations and Japan has been
deteriorating. How quickly the latter erosion is arrested and reversed will be a key factor
in shaping U.S. economic and financial trends in the period ahead. With all that is at
stake, it would be difficult to overstate how crucial it is that the authorities in the relevant
economies promptly implement effective policies to correct the structural problems
underlying recent weaknesses and to promote sustainable economic growth before
patterns of reinforcing contraction become difficult to contain.
Conditions in Asia are of particular concern. Aggregate output of the Asian
developing economies has plunged, with particularly steep declines in Korea, Malaysia,
Thailand, and Indonesia. Even the economies of the stalwart tigers-Hong Kong,
Singapore, and Taiwan—have softened. Economic growth in China has also slowed,
owing largely to the currency depreciations among its neighbors and the sharp declines in
their demand for imports.
Russia has also experienced some spillover from the Asian difficulties, but
Russia's problems are mostly homegrown. Large fiscal deficits stem from high effective




63
marginal tax rates that encourage avoidance and do not raise adequate revenue. This and
the recent declines in prices of oil and other commodities have rendered Russian financial
markets and the ruble vulnerable, particularly in an environment of heightened concern
about all emerging markets. The Russian government has recently promulgated a set of
new policy measures in connection with an expanded IMF support package in an effort to
address these problems.
In Latin America, conditions vary: Economies that are heavily dependent on
exports of oil and other commodities have suffered as prices of those items have fallen,
and several countries in that region have received more intensive scrutiny in international
capital markets, but, on the whole, Latin American economies continue to perform
reasonably well.
Disappointingly, economic activity in Japan—a crucial engine of Asian economic
growth—has turned down after a long period of subpar growth. Gross domestic product
fell at a 51A percent annual rate in the first quarter. More recently, confidence of
households and businesses has continued to erode, the sharp contraction elsewhere in
Asia has fed back onto Japan, and the dwindling domestic demand for goods and services
in that country has been further constrained by a mounting credit crunch. Nonperforming
loans have risen sharply as real estate values fell following the bursting of the asset
bubble in 1991. Problems in the banking sector, exacerbated by the broader Asian
financial crisis, have led to market concerns about the adequacy of the capital of many




Japanese banks and have engendered a premium in the market for Japanese banks'
borrowing. This resulting squeeze to profit margins has led to a reluctance to lend in
dollars or yen. In response to the weakening economy and deteriorating banking
situation, the Japanese yen has tended to weaken significantly, in often-volatile markets,
against the dollar and major European currencies.
As you know, we have sought to be helpful in the Japanese government's efforts
to stabilize their economy and financial system, reflecting our awareness of the important
role that Japanese financial and economic performance plays in the world economy,
including that of the United Slates. We have consulted with the relevant Japanese
authorities on methods for resolving difficulties in their banking system and have urged
them to take effective measures to stimulate their economy. I believe that the Japanese
authorities recognize the urgency of the situation.
That a number of foreign economies are currently experiencing difficulties is not
surprising. Although many had previously realized a substantial measure of success in
developing their economies, a number had leaned heavily on command-type systems
rather than relying primarily on market mechanisms. This characteristic has been evident
not only in their industrial sectors but in banking where government intervention is
typically heavy, where long-standing personal and corporate relationships are the
predominant factor in financing arrangements, and where market-based credit
assessments are the exception rather than the rule. Recent events confirm that these sons




65
of structures are ill-suited to today's dynamic global economy, in which national
economies must be capable of adapting flexibly and rapidly to changing conditions.
Responses in countries currently experiencing difficulties have varied
considerably. Some have reacted quickly and, in general terms, appropriately. But in
others, a variety of political considerations appear to have militated against prompt and
effective action.
As a consequence, the risks of further adverse developments in these economies
remain substantial. And given the pervasive interconnections of virtually all economies
and financial systems in the world today, the associated uncertainties for the United States
and other developed economies remain substantial as well.
In the current circumstances, we need to be aware that monetary policy tightening
actions in the United States could have outsized effects on very sensitive financial
markets in Asia, a development that could have substantial adverse repercussions on U.S.
financial markets and, over time, on our own economy. But while we must take account
of such foreign interactions, we must be careful that our responses ultimately are
consistent with a monetary policy aimed at optimal performance of the U.S. economy.
Our objectives relate to domestic economic performance, and price stability and
maximum sustainable economic growth here at home would best serve the long-run
interests of troubled financial markets and economies abroad.




66
The Economic Outlook
The Federal Open Market Committee believes that the conditions for continued
growth with low inflation are in place here in the United States. As I noted previously, an
important issue for policy is how the imbalance of recent years between the demand for
labor and the growth of the working-age population is resolved. In that regard, we see a
slowing in the growth of aggregate demand as a necessary element in the mix.
At this time, some of the key factors that have supported strong final demand by
domestic purchasers remain favorable. Although real short-term interest rates have risen
as the federal funds rate has been held unchanged while inflation expectations have
declined, the financial conditions that have fostered the strength in demand are still in
place. With their incomes and wealth having been on a strong upward track, American
consumers remain quite upbeat. For businesses, decreasing costs of and high rates of
return on investment, as well as the scarcity of labor, could keep capital spending
elevated. These factors suggest some risk that the labor market could get even tighter.
And even if it does not, under prevailing tight labor markets increasingly confident
workers might place gradually escalating pressures on wages and costs, which would
eventually feed through to prices.
But a number of factors likely will serve (o damp growth in aggregate demand,
helping to foster a reasonably smooth transition to a more sustainable rate of growth and
reasonable balance in labor markets. We have yet to see the full effects of the crisis in




67
East Asia on U.S. employment and income. Residential and business fixed investment
already have reached such high levels that further gains approaching those experienced
recently would imply very rapid growth of the stocks of housing and plant and equipment
relative to income trends. Moreover, business investment will be damped if recent
indications of a narrowing in domestic operating profit margins prompt a reassessment of
the expected rates of return on investment in plant and equipment. Reduced prospects for
the return to capital would not only affect investment directly but could also affect
consumption if stock prices adjust to a less optimistic view of earnings prospects.
Of course, the demand for labor that is consistent with a particular rate of output
growth also could be lowered if productivity growth were to increase more. And, on the
supply side of the labor market, faster growth of the labor force could emerge as the result
of increased immigration or delayed retirements. Nonetheless, it appears most probable
that the necessary slower absorption of labor into employment will reflect, in part, a
deceleration of output growth, as a consequence of evolving market forces. Failing that,
finning actions on the part of the Federal Reserve may be necessary to ensure a track of
expansion that is capable of being sustained.
Thus, members of the Board of Governors and presidents of the Federal Reserve
Banks anticipate a slowing in the rate of economic growth. The central tendency of their
forecasts is that real GDP will rise 3 to 3'/4 percent over 1998 as a whole and 2 to 2'/i
percent in 1999. With the rise in the demand for workers coming into line with that of the




68
labor force, the unemployment rate is expected to change little from its current level,
finishing next year in the neighborhood of 4'/i to 4H percent.
Inflation performance will be affected by developments abroad as well as those
here at home. The extent and pace of recovery of Asian economies currently
experiencing a severe downturn will have important implications for prices of energy and
other commodities, the strength of the dollar, and competitive conditions on world
product markets. Should the situation abroad remain unsettled, these factors would
probably continue to contribute to good price performance in the United States in the
period ahead. But it is important to recognize that the damping influence of these factors
on inflation is mostly temporary. At some point, the dollar will stop rising, foreign
demand will begin to recover, and oil and other commodity prices will stop falling and
could even back up some. Indeed, a brisk snap-back in foreign economic activity, should
that occur, would add, at least temporarily, to price pressures in the United States.
On a more fundamental level, it is the balance of supply and demand in labor and
product markets in the United States that will have the greatest effect on inflation rates
here. As I noted previously, wage and benefit costs have been remarkably subdued in the
current expansion. Nonetheless, an accelerating trend in wages has been apparent for
some time.
In addition, a gradual upward tilt in benefit costs has become evident of late. A
variety of factors-including the strength of the economy and rising equity values, which




69
have reduced the need for payments into unemployment trust funds and pension plans,
and the restructuring of the health care sector—have been working to keep benefit costs in
check in this expansion. But, in the medical area at least, the most recent deveJopments
suggest that the favorable trend may have run its course. The slowing of price increases
for medical services seems to have come to a halt, at least for a time, and, with the
cost-saving shift to managed care having been largely completed, the potential for
businesses to achieve further savings in that regard appears to be rather limited at this
point. There have been a few striking instances this past year of employers boosting
outlays for health benefits by substantial amounts.
Given that compensation costs are likely to accelerate at least a little further,
productivity trends and profit margins will be key to determining price performance in the
period ahead. Whether the recent strong performance of productivity can be extended
remains to be seen. It does seem likely that productivity calculated for the entire
economy using GDP data weakened in the second quarter. This development clearly
owed, at least in some degree, to the deceleration of output in that period. In
manufacturing, where our data are better measured, productivity appears still to have
registered a solid increase. We will be closely monitoring a variety of indicators to assess
how productivity is performing in the months ahead.
Monetary policymakers see the most likely outcome as modestly higher inflation
rates in the next one and one-half years. The central tendency of monetary policymakers'




70
CPI inflation forecasts is for an increase of \3A to 2 percent during 1998 and 2 to 2l/2
percent next year. As noted, the ebbing of the special factors reducing inflation over the
past year or so, such as the decline in oil prices, will account for some of this uptick. But
the Federal Open Market Committee will need to remain particularly alert to the
possibility that more fundamental imbalances are increasing inflationary pressures. The
Committee would need to resist vigorously any tendency for an upward trend, which
could become embedded in the inflationary process.
The Committee recognizes that significant risks attend the outlook: One is that
the impending constraint from domestic labor markets could bind more abruptly than it
has to date, intensifying inflation pressures. The other is the potential for further adverse
developments abroad, which could reduce the demand for U.S. goods and services more
sharply than anticipated and which would thereby ease pressures on labor markets. While
we expect that the situation will develop relatively smoothly, the Committee believes that,
given the current tightness in labor markets, the potential for accelerating inflation is
probably greater than the risk of protracted, excessive weakness in the economy. In any
case, it will need to continue to monitor evolving circumstances closely, and adjust the
stance of monetary policy as appropriate, in order to help establish conditions consistent
with progress towards the Federal Reserve's goals of price stability and maximum
sustainable economic growth.




71
Ranges for Money and Credit Growth
Indeed, recognition of the benefits of low inflation and our commitment lo the
Federal Reserve's statutory objective of price stability were once again dominant in the
Committee's semiannual review of the ranges for the monetary and debt aggregates. The
FOMC noted that the behavior of the monetary aggregates had been somewhat more
predictable over the past few years than it had been earlier in the 1990s. The rapid
growth of M2 and M3 over the first half of the year, which lifted those measures above
the upper ends of the target ranges established in February, was consistent with the
unexpectedly strong advance in aggregate demand. However, movements in velocity
remain difficult to predict.
The FOMC will continue to interpret the monetary ranges as benchmarks for the
achievement of price stability under conditions of historically normal velocity behavior.
Consistent with that interpretation, the Committee decided to retain the current ranges for
the monetary aggregates for 1998, a:> well as the range for debt, and to carry them over on
a provisional basis to next year. Although near-term prospects for velocity behavior are
uncertain, the Committee recognizes that monetary growth does appear to provide some
information about trends in the economy and inflation. Therefore, we will be carefully
evaluating the aggregates, relative both to forecasts and to their ranges, in the context of
other readings on other variables in our efforts to promote optimum macroeconomic
conditions.




72
Concluding Comments
As I have stated in previous testimony, the recent economic performance, with its
combination of strong growth and low inflation, is as impressive as any I have witnessed
in my near half-century of daily observation of the American economy. Although the
reasons for this development are complex, our success can be attributed in part to sound
economic policy. The Congress and the Administration have successfully balanced the
budget and, indeed, achieved a near-term surplus, a development that tends to boost
national saving and investment. The Federal Reserve has pursued monetary conditions
consistent with maximum sustainable long-run growth by seeking price stability. These
policies have helped bring about a healthy macroeconomic environment for
productivity-boosting investment and innovation, factors that have lifted living standards
for most Americans. The task before us is to maintain disciplined economic policies and
thereby contribute to maintaining and extending these gains in the years ahead.




73

For use at 10:00 a.m., E.D.T.
Tuesday
July 21,1998

••«bl

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 21,1998




74

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C.. July 21.1998
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES
The Board of Governors is pleased to submit its Monetaiy Policy Report to the Congress, pursuant to the
Fun Employment and Balanced Growth Act of 1978.
Sincerely,

Alan Greenspan, Chairman




75
Table of Contents
Page
Section 1: Monetary Policy and the Economic Outlook
Section 2:

Economic and Financial Developments in 1998




1

76
Section 1: Monetary Policy and the Economic Outlook
The U.S. economy posted significant further gains
in the first half of 1998. The unemployment rate
dropped to its lowest level in nearly thirty years, and
inflation remained subdued. Real output rose appreciably, on balance, although much of the advance
apparently occurred early in Che year. Household
spending and business fixed investment, supported by
the ongoing rise in equity prices and the continued
low level of long-term interest rates, appear to have
maintained considerable momentum this year. The
sizable advance in capital spending and the resulting additions to the capital stock should help bolster
labor productivity—the key to rising living standards.
Yet the news this year has not been uniformly
good. The turmoil that erupted in some Asian
countries last year has generated major concerns
about the outlook for those economies and the
repercussions for other nations, including the United
States. Several Asian countries have had sharp
contractions in economic activity, and others have
experienced distinctly sub-par growth. Heightened
uneasiness among international investors has induced
portfolio shifts away from Asia and, to some extent,
from other emerging market economies.
These difficulties have created considerable
uncertainty and risk for the U.S. economy, but they
have also helped to contain potential inflationary
pressures in the near term by reducing import prices
and restraining aggregate demand. In particular, the
substantial rise in the foreign exchange value of the
dollar has. boosted our real imports and—together
with the slower growth in Asia—depressed our real
exports. At the same time, the runup in the dollar and
slack economic conditions in Asia have helped
produce a sharp drop in the dollar prices of oil and
other commodities and have pushed down other
import prices. Shirts in preferences toward dollardenominated assets in combination with downward
revisions to forecasts of inflation and demand have
helped to reduce our interest rates; the lower interest rates have boosted household and business spending, offsetting a portion of the damping of demand
from the foreign sector.
The Asian crisis is likely to continue to restrain
U.S. economic activity in coming quarters. The size
of the effect will depend in large part on how quickly
the authorities in the Asian nations can put their
troubled financial systems on a sounder footing and
carry out other essential economic reforms.
Deteriorating conditions in many countries during the




past tew months created added pressures for reform,
and they underscored the depth and scope of the
problems that must be addressed.
Despite the pronounced weakening of our trade
balance, the already tight U.S. labor market has come
under further strain this year owing to robust growth
of domestic demand. As a result, the outlook for
inflation has taken on a greater degree of risk.
Consumer prices actually rose a bit less rapidly in the
first half of 1998 than they did in 1997, but transitory factors—the drop in oil prices, the runup in the
dollar, and weak economic activity in Asia—exerted
considerable downward pressure on domestic prices.
These factors will not persist indefinitely. Meanwhile,
the pool of individuals interested in working but who
are not already employed has continued to shrink.
The extraordinary tightness in labor markets has
generated a rising trend of increases in wages and
related costs, although faster productivity growth has
damped the effect on business costs so far.
In conducting monetary policy in the first half of
1998, the Federal Open Market Committee (FOMC)
closely scrutinized incoming information for signs
that the strength of the economy and the taut labor
market were likely to boost inflation and threaten the
durability of the expansion. However, despite slightly
larger increases in the CPI in some months, inflation remained moderate on the whole. Moreover, the
Committee expected that aggregate demand would
slow appreciably because of a rising trade deficit
and a considerable slackening in domestic spending.
Although the Committee was acutely aware of the
uncertainties in the economic outlook, it believed
that Che deceleration in demand—and the associated
modest easing of pressures on resources—could well
be sufficient to limit any deterioration in underlying
price performance. On balance, the FOMC chose to
keep the intended federal funds rate at 5Vi percent.

Monetary Policy, Financial Markets, and
the Economy over the First Half of 1998
Output grew rapidly in the first quarter, with real
gross domestic product estimated to have risen
5V4 percent at an annual rate. Business fixed investment soared after a weak fourth quarter, and consumption and housing expenditures expanded at a
strong clip. In addition, contrary to the expectations
of many forecasters, inventory investment rose
substantially from its already hefty fourth-quarter

77
Selected Interest Rates
Percent

- 7

- 6

- 5

7/3

S/20 *24

11/1312/17

1996

2S

S2S

SffiO

7«

Note. Dottea vertical line indicates the day on which the Federal Open Merttst Committee (FOMC) announced a monetary

pace, with the rise contributing more than
1 1 A percentage points to overall GDP growth. At the
same time, the cumulative effect of the appreciation
of the dollar and faster growth of demand here than
abroad resulted in a sharp drop in real net exports,
with both rapid import growth and the first quarterly
drop in exports in four years. Employment continued
to advance briskly, and the unemployment rate held
steady at 4% percent. Hourly compensation accelerated somewhat when measured on a year-over-year
basis, but impressive productivity growth once again
helped to restrain the increase in unit labor costs. The
consumer price index rose only '/* percent at an
annual rate over the first ihree months of the year, as
a sharp drop in energy prices offset price increases
elsewhere.
Falling long-term interest rates and rising equity
prices over the previous year provided substantial
impetus to household and business spending in the
first quarter. Interest rates dropped sharply further in
early January, and although they moved up a little
over the remainder of the quarter, nominal yields on
long-term Treasury securities were among the lowest in decades. Interest rates continued to benefit from
the improvement in the federal budget and the
prospect of reduced federal borrowing in the future;




fl/19

1997

900 11/12 12/16

2/4

3/31

St9

7(1

1998

policy action. The dates on the horizontal axis are those on which
the FOMC neld meetings, Last observations are tor July 17, 1998.

rates were also restrained to a significant extent by the
effects of the Asian crisis. Equity prices increased
sharply in the first quarter, extending their remarkable gains of the previous three years in spite of
disappointing news on corporate profits. Households
and firms borrowed at a vigorous pace in the first
quarter, and growth in the debt of domestic
nonfmancial sectors picked up from the fourth quarter
of 1997, as did the growth of the monetary
aggregates.
At their March meeting, the members of the
FOMC confronted unusual cross-currents in the economic outlook. On the price side, the FOMC noted
that, although the incoming data were quite favorable, transitory factors were possibly masking underlying tendencies toward higher inflation. Moreover,
the available data on household and business spending confirmed the impressive strength of domeuic
demand and highlighted the possibility that developments in the external sector might not provide sufficient offset in coming quarters to avoid a build-up of
inflation pressures. At the same time, the FOMC
noted the substantial uncertainty surrounding the
prospects for the Asian economies. Balancing these
considerations, the FOMC kept its policy stance
unchanged but noted that recent information had

78
altered the inflation risks enough to make tightening
more likely than easing in the period ahead.
The second quarter brought both a marked further
deterioration in the outlook for Asia and some indications that the US. economy might be cooling. In Asia,
evidence of steep output declines in several countries
was combined with mounting concern that economic and financial problems in Japan were not likely
to be resolved as quick)}' as many observers had
hoped or expected. One result was a further rise in the
exchange value of the dollar and a decline in longterm U.S. interest rates. Increasing investor concern
about emerging market economies raised risk spreads
on external debts in Asia, Russia, and Latin America,
The higher value of the dollar and the depressed
income in many Asian countries continued to take
their toll on US. exports and to boost imports in
the second quarter. In addition, a marked slackening
in the pace of inventory accumulation, which was
amplified by the effects of a strike in the motor vehicle industry, was reflected in a sharp slowing in
domestic demand. Nonetheless, the utilization of
labor resources remained very high: In the second
quarter, the unemployment rate averaged a bit less
than 41A percent, its lowest quarterly reading in
nearly thirty years. The twelve-month change in average hourly earnings indicated that wages were rising somewhat more rapidly than they had a year
earlier. And the CPI rose faster in the second quarter
than in the first, mainly reflecting a smaller drop in
energy prices.
Financial conditions in the second quarter and into
July remained supportive of domestic spending.
Yields on private securities declined, although less
than Treasury yields, as quality spreads widened a bit.
Equity prices rose further in early April before falling back over the next two months in response
to renewed earnings disappointments. Prices then
rebounded substantially, with most major indexes hitting record highs in July. The growth of money and
credit slowed a little on balance from the firstquarter pace but remained buoyant Banks and other
lenders continued to compete vigorously, extending
credit on generally favorable terms as they responded
in part to the sustained healthy financial condition of
most businesses and households.
The FOMC left the intended federal funds rate
unchanged at its May and June-July meetings. At the
May meeting, the FOMC reiterated its earlier concern
that the robust expansion of domestic final demand,
supported by very positive financial conditions, had
raised labor market pressures to a point that might




precipitate an upturn in inflation over time. Yet the
FOMC believed that the growth of economic activity would slow. It also judged that the risk of
significant further deterioration in Asia, which could
disrupt global financial markets and impair economic activity in the United States, was rising
somewhat.

Economic Projections for
1998 and 1999
The members of the Board of Governors and the
Federal Reserve Bank Presidents, all of whom
participate in the deliberations of the FOMC, expect
economic activity to expand moderately, on average,
over the next year and a half. For 1998 as a whole,
the central tendency of their forecasts for real GDP
growth spans a range of 3 percent to 3Vi percent. For
1999, these forecasts center on a range of 2 percent to
2'A percent. The civilian unemployment rate, which
averaged a bit less than 4'A percent ia the second
quarter of 1998, is expected to stay near this level
through the end of this year and to edge higher in
1999, With labor markets remaining tight and some of
the special factors that helped restrain inflation in the
first half of 1998 unlikely to be repeated, inflation is
anticipated to run somewhat higher in the second half
of 1998 and in 1999.
The economy is entering the second half of 1998
with considerable strength in household spending and
business fixed investment Consumers are enjoying
expanding job opportunities, rising real incomes, and
high levels of wealth, all of which are providing then
with the confidence and wherewithal to spend. These
factors, in conjunction with low mortgage interest
rates, are also bolstering housing demand. Business
fixed investment appears robust as well: Financial
conditions remain conducive to capital spending, and
firms no doubt are continuing to seek out opportunities for productivity gains in an environment of rapid
technological change, falling prices for high-tech
equipment, and tight labor markets.
Nonetheless, a number of factors are expected to
exert some restraint on the expansion of activity in
the quarters ahead The demand for U.S. exports will
continue to be depressed for a while by weak activity abroad, on average, and by the strong dollar,
which will also likely continue to boost imports. The
effects of these external sector developments on
employment and income growth have yet to materialize fully. In addition, although financial conditions are
generally expected to be supportive, real outlays on
housing and business equipment have reached such

79
Economic Projections for 1998 and 1999
Percent

Federal Reserve governor*
and Reserve Bank presidents

Indicator

Central
tendency

Administration

VAtoZ'A

4<A to 5
3 to 31A
I%to2

4.2
2.4
1.6

4V* to 4'A

4'/4

4.8

4 to SVfe
2 to 3
1'Ato3

4% to 5
2 to 2VS
2 to 2'A

4.1
2.0
2.1

4Vi to 4%

41* to 4%

5.0

Range

1998
Change, fourth quarter
to fourth quarter1
Nominal GDP
Real GDP
Consumer price Index2

4'A to 5
fiV^oSVi

Average level, fourth quarter
Civilian unemployment rate

1999
Change, fourth quarter
to fourth quarter'
Nominal GDP
Real GDP
Consumer price index1
Average Jevef, fourth quarter
Civilian unemployment rate

1. Changa from avwaoi tor fourth quarter olpmtout yaw
to avmgn for tourtn quarter of year mdcawd.

high levels that gains from here are expected to be
more moderate.
With the plunge in energy prices in early 1998
unlikely to be repeated, most FOMC participants
expect the CPI for all urban consumes to rise more
rapidly in the second half of 1998 than it did in
the first naif, resulting in an increase in the CPI of
1*4 percent to 2 percent for \99ft as a whole. The
pickup in the second half should be limited, however, by further decreases in non-oil import prices,
ample domestic manufacturing capacity, and low
expected inflation. Looking ahead to next year, the
central tendency is for an increase in the CPI of
2 percent to 2Vt percent Absent a further rise in the
dollar, the M in non-oil import prices should have
run its course. Moreover, even with the expected edging higher of the unemployment rate next year, the




2. M urban consumers.

labor market wUl remain tight, suggesting potential
ongoing pressures on available resources that would
tend to raise inflation a bit The FOMC wfll remain
ateR to the possibility of underlying imbalances in the
economy that could generate a persisting pickup in
inflation, which would threaten the economic
expansion.
As noted in past monetary policy reports, the
Bureau of Labor Statistics is in the process of
implementing a series of technical adjustments to
make the CPI a more accurate measure of price
change. These adjustments and the regular updating
of the market basket we estimated to have trimmed
CPI inflation somewhat over 1995-98, and a.
significant further adjustment is scheduled for 1999Alt told, tbe published figures for CPI inflation in
1999 are expected to be more than l/» percentage

80
Ranges for Growth of Monetary and Debt Aggregates
Percent

1997

1998

Provisional for 1999

M2

1 to5

1 to 5

1 to 5

M3

2 to 6

2 to 6

2 to 6

Debt

3 to 7

3 to 7

3 to 7

Aggregate

Note. Change from average far fourth quartar of preceding year to average tor fourth quarter of year indicated.

point lower than they would have been had the
Bureau retained the methods and formulas in place in
1994. In any event, the FOMC will continue to monitor a variety of price measures besides the CPI as it
attempts to gauge progress toward the long-run goal
of price stability.

M2 and M3 behavior were disrupted, and the velocities of both aggregates climbed well above the levels
that were predicted by past relationships. However,
since 1994 the velocities of M2 and M3 have again
moved roughly in accord with their pre-1990 experience, although their levels remain elevated.

Federal Reserve officials project somewhat faster
growth in real GDP and slightly higher inflation
in 1998 than docs the Administration. The
Administration's projections for the growth in real
GDP and inflation in 1999 are around the lower end
of the FOMC participants' central tendencies.

The recent return to historical patterns does not
imply that velocity will be fully predictable or even
that all movements in velocity can be completely
explained in retrospect. Some shifts in velocity arise
from household and business decisions to adjust their
portfolios for reasons that are not captured by simple
measures of opportunity cost. Some shifts in velocity arise from decisions of depository institutions to
create more or less credit or to fund credit creation in
different ways. All these decisions are shaped by the
rapid pace of innovation in financial institutions and
instruments. Between 1994 and early 1997, M2
velocity drifted somewhat higher, probably owing to
some reallocation of household savings into bond and
equity markets. But M2 velocity has declined over
the past year despite little change in its traditionally
defined opportunity cost. One explanation may be
that the flatter yield curve has reduced the return on
longer-term investments relative to the bank deposits and money market mutual funds in M2. Another
part of the story may be the booming stock market,
which has reduced the share of households' *inancial assets represented by monetary assets and may
have encouraged households to rebalance their portfolios by increasing their M2 holdings. M3 velocity
has dropped more sharply over the past year, with
strong growth in large time deposits and in institutional money funds mat are increasingly used by
businesses for cash management

Money and Debt Ranges
for 1998 and 1999
At its most recent meeting, the FOMC reaffirmed
the ranges for 3998 growth of money and debt that it
had established in February: 1 percent to 5 percent for
M2. 2 percent to 6 percent for M3, and 3 percent to
7 percent for the debt of the domestic nonflnancial
sectors. The FOMC set these same ranges for 1999 on
a provisional basis.
Once again, the FOMC chose the growth ranges for
the monetary aggregates as benchmarks for growth
under conditions of price stability and historical
velocity behavior. For several decades before 1990,
the velocities of M2 and M3 (defined as the ratios of
nominal GDP to the aggregates) behaved in a fairly
consistent way over periods of a year or more. M2
velocity showed little trend but varied positively from
year to year with changes in a traditional measure of
M2 opportunity cost, defined as the interest forgone
by holding M2 assets rather than short-term market
instruments such as Treasury bills. M3 velocity
moved down a bit over time, as depository credit and
the associated elements in M3 tended to grow a shade
faster than GDP. In the early 1990s, these patterns of




If the velocities of M2 and M3 follow their average historical patterns over the remainder of 1998 and
the growth of nominal GOP matches the expecta-

81
tions of Federal Reserve policymakers, these aggregates will finish this yew above the upper ends of
their respective ranges. Pan of this relatively rapid
money growth reflects nominal GDP growth in excess
of that consistent with price stability and sustainable
growth of real output; the rest represents a decline in
velocity. Absent unusual changes in velocity in 1999,
policymakers' expectations of nominal GDP growth
imply that M2 and M3 will be in the upper ends of
their price-stability growth ranges next year. The debt
of the domestic ncnnnancial sectors is expected to
remain near the middle of its range this year and in
1999.




In light of the apparent return of velocity changes
to their pre-1990 behavior, some FOMC members
have been giving the aggregates greater weight in
assessing overall financial conditions and the thrust
of monetary policy. However, velocity remains
somewhat unpredictable, and all Committee members
monitor a wide variety of other financial and economic indicators to inform their policy deliberations. The FOMC decided mat the money and debt
ranges are best used to emphasize the Committee's
commitment to achieving price stability, so it again
set the ranges as benchmarks for growth under price
stability and historical velocity behavior.

82
Section 2: Economic and Financial Developments in 1998
The U.S. economy continued to perform well in
the first half of the year. The economic difficulties
in Asia and the strong dollar reduced the demand for
our exports and intensified the pressures on domestic producers from foreign competition. But these
effects were outweighed by robust domestic final
demand, owing in pan to supportive financial conditions, including a higher stocfc market, ample availability of credit, and long-term interest rates that in
nominal terms were among the lowest m many years.
Sharp swings in inventory investment were mirrored
in considerable unevenness in the growth of real
GDP, which appears to have slowed markedly in
the second quarter after having soared to nearly
5V4 percent at an annual rate in the first quarter.
Nonetheless, over the first half as a whole, the rise in
real output was large enough to support sizable gains
in employment and to push the unemployment rate
down to the range of 4l/i to 4l/2 percent, the lowest in
decades.
The further tightening of labor markets in recent
quarters has been reflected in a more discernible uptilt
to the trend in hourly compensation. But price
inflation remained subdued in the first half of the
year, held down in part by a sharp decline in energy
prices and lower prices for non-oil imports. Intense
competition in product markets, ample plant capacity, ongoing productivity gains, and damped inflation expectations also helped to restrain inflation pressures in the race of tight labor markets.

The Household Sector
Consumer Spending. The factors that fueled
the sizable increase in household expenditures in
1997 continued to spar spending in the first half of
1998: Growth in employment and real disposable
income remained very strong, and households in the
aggregate enjoyed significant further gains in net
worth. Reflecting these developments, sentiment
indexes suggest that consumers continued to feel
extraordinarily upbeat about the current and prospective condition of the economy and their own financial situations.

Change in Real Income and Consumption
Percent, annual rate

Disposable personal income
Personal consumption expenditures

Qi

illliihlll
1993

Change in Heal GDP
Percent, annual rate

Jluliii
1993

1994

t995

1996




1997

1998

1994

1995

1996

1997

1998

In total, real consumer outlays rose at an annual
rate of 6 percent in the first quarter, and the available data point to another large increase in the second
quarter. Increases in spending were broad-based, but
outlays for durable goods were especially strong.
Declining prices and ongoing product innovation
continued to stimulate demand for personal computers and other home electronic equipment In addition, purchases of motor vehicles were sustained by
a combination of solid fundamentals and attractive
pricing. Indeed, since 1994, sales of light vehicles
have been running at a brisk pace of 15 million units
(annual rate), and, in the second quarter, a round of
very attractive manufacturers' incentives helped lift
sales to a pace of 16 million units.
Spending on services also remained robust in the
first half of the year, with short-run variations reflect-

83
ing in part the effects of weather on household energy
use; outlays on personal business services, including those related to financial transactions, and on
recreation services continued to exhibit remarkable
strength. In addition, real outlays for nondurable
goods, which rose only moderately last year, grew
about 6Vt percent at an annual rate in the first quarter,
and they appear to have posted another sizable
increase in the second quarter.
Real disposable income—that is, after-tax income
adjusted for inflation—remained on a strong uptrend
in early 1998: It rose about 4 percent at an annual rate
between the fourth quarter of 1997 and May 1998.
This increase in part reflected a sharp rise in aggregate wages and salaries, which were boosted by sizable gains in both employment and real wage rates;
dividends and nonfarm proprietors' incomes also rose
appreciably. However, growth in after-tax income
(as measured in the national income and product
accounts) was restrained by large increases in
personal income tax payments—likely owing in part
to taxes paid on realized capital gains; capital gains—
whether realized ot not—are not included in
measured income. Reflecting the movements in
spending and measured income, the personal saving
rate fell from an already low level of about 4 percent in 1997 to 3Vi percent during the first'five
months of 1998.
Residential Investment. Housing activity
continued to strengthen in the first half of 199$, especially in the single-family sector, where starts rose
noticeably and sales of both new and existing homes
soared. Indeed, the average level of single-family
Private Housing Starts
Millions of units, annual rate
Quarterly average

Singia-famfly
1.0

0.5

1986

1990

1992

1994

1906

1998

Now. valuM for 199&Q2 af* fee •wmge of Apr* UN) M*y.




starts over ihe first five months of the year—1 V* million units at an annual rate—was 9 percent above the
pace for 1997 as a whole. Moreover, surveys by the
National Association of Homebuilders suggested that
housing demand remained vigorous at midyear, and
the Mortgage Bankers Association reported that loan
applications for home purchases have been around
all-time highs of late.
The strong demand for homes has contributed to
some finning of house prices, which are now rising in
the neighborhood of 3 to 5 percent per year, according to measures that control for shifts in the regional
composition of sales and attempt to minimize the
effects of changes in the mix of the structural features
of houses sold. In nominal terms, these increases are
well within the range of recent years; however, in real
terms, they are among the largest since the mid1980s—a development that should reinforce the
investment motive for homeownership. Of course,
rising house prices may make purchasing homes more
difficult for some families. But, with income growth
strong and mortgage rales around 7 percent (thirtyyear conventional fixed-rate loans), homeownership is
as affordable as it has been at any time in the past
thirty years. Moreover, innovative programs that relax
the standards for mortgage qualification are helping
low-income families to finance home purchases.
Also, stock market gains have probably boosted
demand among higher-income groups, especially in
the trade-up and second-home segments of the
market
After having surged in the fourth quarter of 1997,
muMfamily starts settled back to about 325,000 units
(annual rate) over the first five months of 1998, a pace
only slightly below that recorded over 1997 as a
whole. Support for multifamily construction continued to come from the overall strength of the economy, which undoubtedly has stimulated more
individuals to form households, as well as from low
interest rates and an ample supply of financing. In
addition, real rents picked up over the past year, and
the apartment vacancy rate appears to be edging
down.
Household Financ*. Household net worth rose
sharply in die first quarter, pushing the wealth-toincome ratio to another record high. Although the
flow of new personal saving was quite smalt, the
revaluation of existing assets added considerably
to wealth, with much of these capital gains accumulated on equities held either directly or indirectly
through mutual funds and retirement accounts. Of
course, these gains have been distributed quite

84
Household Net Worth Relative to
Disposable Personal Income
Percent

Four-quarter moving average

Q1

575
550
525
500
475
450
425

1968

1978

1986

400
1998

unevenly: The 1995 Survey of Consumer Finances
reported that 41 percent of U.S. families own equities in some form, but that families with higher
wealth own a much larger share of total equities.
In the first quarter of this year, the runup in wealth,
together with low interest rates and high levels of
confidence about future economic conditions, supported robust household spending and borrowing. Tht
expansion of household debt, at an annual rate of
7H percent, was above last year's pace and once
again outstripped growth in disposable income. The
consumer credit component of household debt grew
4V4 percent at an annual rate in the first quarter, a
pace roughly double that for the fourth quarter of last
year but near the 1997 average. Preliminary data for
April and May point to a somewhat smaller advance
in the second quarter.
Mortgage debt increased 8W percent at an annual
rate in the first quarter, the same as its fourthquarter advance and a little above its 1997 growth
rate. Fixed-rate mortgage interest rates were 15 basis
points lower in the first quarter than three months
earlier and 75 basis points lower than a year earlier,
which encouraged both new home purchases and a
surge of refinancing of existing mortgages. Within
total gross mortgage borrowing, the flattening of the
yield curve made adjustable-rate mortgages less
attractive relative to fixed-rate mortgages, and their
share of originations reached the lowest point in
recent years. Net borrowing can be boosted by
refinancings if households "cash out" some housing
equity, but the magnitude of this effect is unclear. In
any event, continued expansion of bank real estate
lending and a high level of mortgage applications for




home purchases suggest a further solid gain in mortgage debt in the second quarter. Home equity credit
at banks increased only 2 percent at an annual rate
from the fourth quarter of 1997 through June 1998
after having posted a 15'/4 percent gain last year;
this slowdown may reflect a diminished substitution
of mortgage debt for consumer debt or simply the
increase in mortgage refinancings, which allowed
households to pay down more expensive borne equity
debt or to convert housing equity into cash in a more
advantageous manner.
Despite the further buildup of household indebtedness, financial stress among households appears to
have stabilized after several years of deterioration. In
the aggregate, estimated required payments of loan
principal and interest have held about steady relative to disposable personal income—albeit at a high
level—since 1996. Over this period, the effect on debt
burdens of faster growth of debt than income has
been roughly offset by declining interest rates and the
associated refinancing of higher interest-rate debt, as
well as by a shift toward mortgage debt (which has
a longer repayment period). Various measures of
delinquency rates on consumer loans leveled off or
declined in 1997, and delinquency rates on mortgages have been at very low levels for several years.
Personal bankruptcy filings reached a new record
high in the first quarter of 1998, but this represented
only 6 percent more filings than four quarters earlier,
which is the smallest such change in three years.
Household Debt-Service Burden
Percent of dfepoaabto personal income

17
16
15

14

13
1983

1968

1993

1998

Now. Dtbt aervlc* to flw *un of Mflmtiwl mqufrad internet
end principal payment* on cwwumer and houMhokt-Mcttr mort-

These developments have apparently suggested
to banks that they have sufficiently tightened terms

85
Delinquency Hates on Household Loans
Percent

1988

1990

1992

1994

1996

1998

Mote. Data on credit-card delinquencies are from the Can
Report; data on mortgage ctolinqueticws are 'ram the Mortgage
Bankers Association,

and standards on consumer loans. In the Federal
Reserve's May Senior Loan Officer Opinion Survey
on Bank Lending Practices, relatively few banks, on
net, reported tightening standards on credit card or
other consumer loans. Little change was reported in
the terms of consumer loans.
The Business Sector

Fixed Investment Real business fixed investment appears to have posted another hefty gain over
the first half of 1998 as spending continued to be
boosted by positive sales expectations in many industries; favorable financial conditions; and a perceived
opportunity, if not a necessity, for firms to install
new technology in order to remain competitive. The
Change in Real Business Fixed Investment
Percent, annual rate
[] Structures

Producers' durable
equipment

lUi.lill

10

" I T

10

1993

1994

1995

1996

1997




1998

exceptional growth of investment since the early
1990s has been facilitated in pan by the increase in
national saving associated with the elimination of the
federal budget deficit It has resulted in considerable
modernization and expansion of the nation's capital
stock, which have been important in the improved
performance of labor productivity over the past few
years and which should continue to lift productivity
in the future. Moreover, rapid investment in the
manufacturing sector in recent years has resulted in
large additions to productive capacity, which have
helped keep factory operating rates from rising much
above average historical levels in the face of appreciable increases in output
Real outlays for producers' durable equipment,
which have been rising more than 10 percent per year,
on average, since the early 1990s, moved sharply
higher in the first half of 1998. All major categories
of equipment spending recorded sizable gains in the
first quarter; but as has been true throughout the
expansion, outlays for computers rose especially
rapidly. Real computer outlays received particular
impetus in early 1998 from extensive price-cutting.
Purchases of communications equipment have also
soared, in recent quarters; the rise reflects intense
pressures to add capacity to accommodate the growth
of networking; the rapid pace of technological
advance, especially in wireless communications; and
regulatory changes. A3 for the second quarter, data
on shipments, coupled with another steep decline in
computer prices, point to a further substantial increase
in real computer outlays. Spending on motor vehicles apparently continued to advance as well while
demand for other types of capital equipment appears
to have remained brisk.
In total, real outlays on nonresidenn'al construction flattened out in 1997 after four years of gains,
and they remained sluggish in early 1998. Construction of office buildings remained robust in the first
half of this year, after having risen at double-digit
rates in 1996 and 1997, and outlays for institutional
buildings continued to trend up. However, expenditures for other types of structures were lackluster.
Nonetheless, the economic fundamentals for the sector as a whole remain quite favorable: Vacancy rates
for office and retail space have continued to fall; real
estate prices, though still well below the levels of the
mid-1980s in real terms, have risen appreciably in
recent quarters; and funding for new projects remains
abundant.
Inventory Investment The pace of stockbuilding by nonfarm businesses picked up markedly in

86
1997 and is estimated to have approached $100 billion (annual rate) in the first quarter of 1998—equal
to an annual rate increase of 81/: percent in the level
of inventories and accounting for more than
l'/2 percentage points of that quarter's growth in
real GDP. The first-quarter accumulation was heavy
almost across the board. Among other things, it
included a large increase in stocks of petroleum as the
unusually warm weather reduced demand for refined
products and low prices provided an incentive for
refiners and distributors to accumulate stocks. However, overall sales were also very strong, and with
only a few exceptions—notably, semiconductors,
chemicals, and textiles—stocks did not seem out of
line with sales. In any event, fragmentary data for the
second quarter point to a considerable slowing in
inventory investment that is especially evident in the
motor vehicle sector, where stocks were depleted by
the combination of strong sales and GM production
shortfalls. In addition, petroleum stocks appear to
have grown less rapidly than they did in the first
quarter, and stockholding elsewhere slowed sharply
in April and May.
Change in Real Nonfarm Business Inventories
Percent, annual rate

O1

1993

1994

1995

t996

1997

1996

Corporate Profits and Business Finance.
Businesses have financed a good part of their investment this year through continued strong cash flow,
but they have also increased their reliance on financial markets. Economic profits (book profits after
inventory valuation and capital consumption adjustments) have run at 12 percent of national income over
the past year, well above the 1980s peak of roughly
9 percent. However, the strength in profits has
resulted partly from the low level of net interest payments, leaving total capital income at roughly the
same share of national income as at the 1980s peak.




Corporate Profits and Net Interest
Percent of national income

i i i i
1978

i i i
1983

. i i i LI i i
1988

1993

1998

Note. Corporate profits include inventory valuation and capital
consumption adjustments.

Overall, a major portion of the increase in profits
between the 1980s and the 1990s represents a realignment of returns from debt-holders to equity-holders.
Although their level remains high, the growdi of
profits has slowed: Economic profits rose 4Vt percent at an annual rate in the first quarter compared
with 9'/i percent between the fourth quarter of 1996
and the fourth quarter of 1997. This slowdown may
have resulted from various causes, including rising
employee compensation and the Asian financial
crisis. Quantifying the effect of the Asian turmoil is
difficult: Although only a small share of the profits
of US. companies is earned in the directly affected
Asian countries, the crisis has reduced the prices of
U.S. imports and thereby put downward pressure on
domestic prices.
Nonfinancial businesses realized annualized economic profit growth of only 1 Vt percent in the first
quarter. Because capital expenditures (including
inventory investment) grew much faster, the financing gap—the excess of capital expenditures over
retained earnings—widened. As a result, these businesses used less of their cash flow to retire outstanding equity and continued to borrow at the rapid
pace of the fourth quarter of 1997, with debt expanding at an annual rate of 9 percent in the first quarter of
1998. Outstanding amounts of both bonds and commercial paper rose especially sharply. The decline in
long-term interest rates around year-end encouraged
companies to lock in those yields, and gross bond
issuance reached a record high in the first quarter
of 1998. Borrowing by nonfmancial businesses

87
increased at a slightly slower but still rapid clip in the
second quarter, with little change in outstanding commercial paper but very strong net bond issuance and
some rebound in bank loans.
Despite persistent high borrowing, external funding for businesses remained readily available on
favorable terms. The spreads between yields on
investment-grade bonds and yields on Treasury bonds
widened a little from low levels, with investors favoring Treasury securities over corporate securities as a
haven from Asian turmoil and, perhaps, with disappointing profits leading to some minor reassessment
of the underlying risk of private obligations. The
spreads on high-yield bonds also increased, in part
because of heavy issuance of these bonds this spring,
but they remain narrow by historical standards. In
the Federal Reserve's May survey on bank lending
practices, banks repotted negligible change in business loan standards; moreover, yield spreads on bank
loans remained low for both Urge and small firms.
Surveys by the National Federation of Independent
Business suggest that small firms have been facing
little difficulty in obtaining credit
Spreads Between Yields on
Private and Treasury Securities
Percent

1988 1990 1992
1994
1996
1990
Now. The tprMd an high-yield bond* compare* Iw yMd on
t» Men* Lynch MaHer u kvtox wtti toft m a ttnen-year
TiMsury now ttw *pread on jnnMUneni-grade bondi compere*
t» yield on MooeYe Mex ot A-nM bond* *MI tutt on a tenyear TrMtuiy now.

Net Interest Payments of Nonfinancial

Corporations Relative to Cash Row
Percent

22
18

14

10

1978

1983

1008

1993

1998

payments to cash flow, dropped substantially between
1990 and 1996 and remains modest, despite edging
up in the first quarter of this year. In addition, most
measures of financial distress have shown favorable
readings. The delinquency rale on commercial and
industrial bank loans has stayed very low since 1995,
preserving the dramatic decline mat occurred in the
first half of (he decade. After moving up a little in
[996 and 1997, business failures decreased in the first
five months of 1998-, the liabilities of failed businesses as a share of total liabilities was less than onequarter the value reached in the early 1990s. At me
same time, Moody's upgraded significantly more debt
than it downgraded, and the rate of junk bond defaults
stayed dose to its low 1997 level.
Net equity issuance was less negative in the first
quarter of this year than in the fourth quarter of last
year, but nonfinancial corporations still fetired, on net,
about $100 billion of equity at an annual rate. The
wave of merger announcements this spring will likely
generate strong share retirements over the remainder
of the year. Gross equity issuance in me first half of
1998 was close to its pace of the past several years,
although investors seemed somewhat cautious about
initial public offerings.

Tfc*> Government Sector
The ready availability of credit has stemmed
importantly from the healthy financial condition of
many businesses, which have enjoyed an extended
period of economic expansion and robust profits.
The aggregate debt-service burden for nonfinancial
corporations, measured as the ratio of net interact




CHwwmmtnt The incoming news on
the federal budget continues to be very positive. Over
the twelve months ending in May 199$, the unified
budget registered a surplus of $60 billion, compared
with a deficit of $65 billion during the twelve months
ending in May 1997. Soaring receipts continued to be

88
the main force driving the improvement in the budget,
but subdued growth in outlays also played a key role.
If the latest projections from OMB and CBO arc realized, the unified budget for fiscal year 1993 as a
whole will show a surplus of roughly $40 billion to
$65 billion.
With the federal budget having shifted into surplus,
the federal government is now augmenting, rather
than drawing on, the poo) of national saving. In
fact, the improvement in the government's budget
position over the past several years has been large
enough to generate a considerable rise in gross
domestic saving despite a decline in the private saving rate; all told, gross saving by households, businesses, and governments increased from about
14 W percent of gross national product in the early
1990s, when federal saving was at a cyclical low, to
more than 17 percent of GNP in recent quarters.
This increase in domestic saving, along with
increased borrowing from abroad, has financed the
Surge in domestic investment in this expansion.
Moreover, this year's budgetary surplus will continue to pay benefits in future years because it allows
the government to reduce its outstanding debt, which
implies smaller future interest payments and, all
else equal, makes it easier to keep the budget in
surplus. If, in fact, the budget outcome over the next
several years is AS favorable as OMB and CBO now
anticipate under current policies, the reduction in
the outstanding debt could be substantial.

Saving and Investment
Percent of nominal GNP

Gross domestic investment

16
Grose saving

I 1.1 !._!_

1981

1965

I I

l_l

I I I I

1939

1993

12
1997

Note. Grow saving consists of saving of households, businmaes, and governments. Gross domestic investment Is the sum
of gross private domestic investment and government investment The gap between gross saving and gross domestic towstmem is equal to 9»e sum of ne! torttfln investment and the statistical discrepancy from the national income and product accounts.




Federal receipts in the twelve months ending in
May 1998 were 10 percent higher than in the same
period a year earlier—roughly twice the percentage
increase for nominal GDP over the past year.
Individual income tax receipts, which have been
rising at double-digit rates since the mid-1990s,
continued to do so over the past year as the surge in
capital gains realizations likely persisted and sizable
gains in real income raised the average tax rates on
many households (the individual income tax structure
being indexed for inflation but not for growth in real
incomes). In contrast to the ongoing strength in
individual taxes, corporate tax payments increased
only moderately over the past year, echoing the
deceleration in corporate profits.
Federal expenditures in the twelve months ending
in May 1998 were only 1Vt percent higher in nominal
terms than during the twelve months ending in May
1997, with restraint evident in most categories.
Outlays for defense were about unchanged, as were
those for income security programs. In the latter
category, outlays for low-income support fell as
economic activity remained robust, welfare reform
capped outlays for family assistance, and enrollment
rates in other programs dropped. In the health area,
spending on Medicaid picked up somewhat after a
period of extraordinarily small increases, whereas
growth in spending for Medicare slowed, in pan
because of the programmatic changes that were
legislated in 1997. And, with interest rates little
changed and the stock of outstanding federal debt no
longer rising, net interest payments stabilized.
Real federal outlays for consumption and gross
investment, the pan of federal spending that is
counted in GDP, fell about 2 percent between the first
quarters of 1997 and 1998. The decrease was concentrated in real defense spending, which fell about
2V* percent, roughly the same as over the preceding four quarters; real nondefense spending was
unchanged, on balance. In the first quarter, real federal outlays fell at a ID percent annual rate; the drop
reflected a plunge in defense spending, which appears
to have been reversed in the second quarter.
With debt held by the public close to $4 trillion, the
government will continue to undertake substantial
gross borrowing in order to redeem maturing securities. The government will also continue to adjust its
issuance of short-term debt to accommodate seasonal
swings in receipts and spending. The surplus during
the first half of calendar year 1998—boosted by the
huge inflow of individual income tax receipts—
enabled the Treasury to reduce its outstanding debt

89
Change in Real Federal Expenditures
on Consumption and Investment
P«C«P«.O41£>Q4

1993

1994

1996

1996

1997

1998

Note. Valu»tof 199B:O1 is • quvtorty pecosnt change «t an

S57 billion while augmenting its cash balance
$40 billion. The reduction in debt included net
paydov/ns of coupon securities and bills.
ILooking ahead to projected surpluses for coming
yews, the Treasury announced that it will no longer
issue three-year notes and will auction five-year notes
quarterly rather than monthly. Over the past several
years, die Treasury has accommodated the surprising improvement in federal finances by substantially
reducing both bill and coupon issuance. The Treasury
hopes that concentrating future coupon offerings in
larger, less-frequent auctions will maintain the liquidity of these securities while still allowing for sufficient issuance of bite to maintain their liquidity
as well. These changes are also intended to prevent
further upcreep in the average maturity of the outstanding debt held by private investors, now standing at sixty-five months. The Treasury continues
to work on encouraging the market for inflationindexed securities, issuing a thirty-year indexed bond
in April to complement the existing five-year and tenyear indexed notes.

rent expenditures in the national income and product
accounts, held steady in the first quarter at around
$35 billion (annual rate), roughly where it has been
since 1995. State governments, which have reaped me
main benefits of rising income taxes, have fared especially well: Indeed, all of the forty-seven states whose
fiscal years ended by June 30 appear to have achieved
balance or to have run surpluses in their general funds
budgets in fiscal year 1998.
Real expenditures for consumption and gross
investment by states and localities have been rising
about 2 percent per year, on average, since the early
1990s, and the increase in spending for the first half
of 1998 appears to nave been a bit below that trend.
These governments added jobs over the first half of
the year at about the same rate as they did over 1997
as a whole. However, real construction outlays, which
have been drifting down since early 1997, posted a
sizable decline in the first quarter, and monthly data
suggest that spending dropped further in the spring.
The weakness in construction spending over the past
year has cut across the major categories of construction and is puzzling ia light of the sector's ongoing
infrastructure needs and the good financial shape of
most governments.
Change in Real State and Local Expenditures
on Consumption and Investment
Percent. O4WQ4

- 2

1993

State «mf Local Qonmmmt*. The fiscal
position of state and local governments in the aggregate has aho remained quite favorable. Strong growth
of household income and consumer spending has
continued to lift revenues, despite numerous small tax
cuts, and governments have continued to hold the line
on expenditures. As a result, the consolidated current account of the sector, as measured by the surplus
(net of social insurance funds) of receipts ova cur-




1994

1995

1996

1997

1998

Not*. v*j* fat 1906:01 to a quutarty pwcent chanot it an

State and local governments responded to the low
interest rates during me first hftlf of the year by borrowing at a rapid rate, both to refinance outstanding
debt and to fund new capital projects. Because debt
retirements eased in the first quarter relative to
the fourth quarter of 1997, net issuance increased

90
substantially. Meanwhile, credit quality of state and
local debt continued to improve, with much more
debt upgraded than downgraded in the first half of the
year,
External Sector
Trade and the Current Account. The nominal
trade deficit on goods and services widened to
$140 billion at an annual rate in the first quarter from
5114 billion io the fourth quarter of last year. The
current account deficit for the first quarter reached
$189 billion (annual rate), 2Vt percent of GDP,
compared with $155 billion for the year 1997. A
larger deficit on net investment income as well as the
widening of the deficit on trade in goods and services contributed to the deterioration in the first
quarter of the current account balance. In April and
May, the trade deficit increased further.

The quantity of imports of goods and services
again grew vigorously in the first quarter. The annual
rate of expansion at 17 percent exceeded that for 1997
and reflected (be continued strength of US. economic activity and the effects of past dollar appreciation. Imports of consumer goods, automotive
products, and machinery were particularly robust
Preliminary data for April and May suggest that real
import growth remained strong. Non-oil import prices
fell sharply through the second quarter, reflecting the
rise in the exchange value of the dollar over the past
year.
Change in Real Imports and Exports
of Goods and Services
Percent, Q4 to Q4

[] Imports
| Exports
Q1

U.S. Current Account
Billions of dollars, annual rate

10

10
1993

1994

1995

1996

1997

1998

Note. Value for 1998X31 is a quarterly psrcwnt change *l an
annual rale.

250

1993

1994

1995

1996

1997

1996

Percent of nominal GOP

- 2

- 2

1973

1976

1983

1988




1993

1998

The quantity of exports of goods and services
declined at an annual rate of 1 percent in the first
quarter, the first such absolute drop since the first
quarter of 1994. The weakness of economic activity
in a number of our Hading partners, with absolute
declines in several economies in Asia, and the
strength of the dollar, which also partly resulted from
the Asian financial crises, largely account for the
abrupt bait in the growth of real exports after a
10 percent rise last year. Declines were recorded for
machinery, industrial supplies, and agricultural
products. Exports to the eanerging market economies
in Asia, particularly Korea, as well as exports to
Japan were down sharply while exports to western
Europe and Canada rose moderately. Preliminary data
for April and May suggest that real exports declined
further.
The Capital Account Foreign direct investment in the United States and U.S. direct investment

91
abroad continued at near record levels in the first
quarter of 1998, spurred by strong merger and
acquisition activity across national borders.
In the first quarter, the booming U.S. stock market
continued to attract large foreign interest. Net
purchases by private foreigners were $29 billion, following record net purchases of $66 billion in the year
1997. Foreign net purchases of U.S. corporate bonds
remained substantial, and net purchases of US.
government agency bonds reached a record S21 billion. In contrast, net sales of US. Treasury securities by private foreigners, particularly large net sales
booked at a Caribbean financial center, were recorded
in the first quarter. U.S. net purchases of foreign
stocks and bonds were modest.
Foreign official assets in the United States
increased $10 billion in the first quarter. However, the
net increase in the second quarter was limited by
large dollar sales by Japan.
The Labor Market
Employment ana Labor Supply. Labor
demand remained robust during the first half of 1998.
Growth in payroll employment averaged 243,000 per
month, only a little less than in 1997 and well above
the rate consistent with the growth in the workingage population. The unemployment rate held steady
in the first quarter at 4V* percent but dropped to the
range of 4'/4 percent to 4'A percent in the second
quartet.
The services industry, which accounts for about
30 percent of nonfarm employment, continued to be
the mainstay of employment growth over the first half

Change in Payroll Employment
Thousands of jobs, monthly average

Total nonfarm

400

200

Illllllllll
1993

1994

1995

1996




1997

1996

200

Unemployment Rate

I I I I I I I I I I I II I I I I I I I I J I I I M I I IM

1968 1973

1978

1963

1988

1993

1998

of 1998, posting increases of 115,000 per month,
on average. Within services, hiring remained brisk
at computer and data-processing firms and at firms
providing engineering and managerial services, but
payrolls at temporary help agencies rose much less
rapidly than they had over me preceding few years—
apparently in part reflecting difficulties in finding
workers, especially for highly skilled and technical
positions. Sizable increases were also posted at
wholesale and retail trade establishments and in the
nuance, insurance, and real estate category. Construction payrolls were bounced around by unusual winter
weather but, on average, rose a brisk 21,000 per
month—about the same as in 1997.
In contrast to the robust gains elsewhere,
manufacturing firms curbed their hiring in the first
half of 1998 in the face of slower growth in factory
output. After having risen a torrid Wt percent in
1997, factory output increased at an annual rate of
about IVi percent between the fourth quarter of last
year and May 1998; the deceleration reflected the
effects of the Asian crisis as well as a downshift in
motor vehicle assemblies and the completion of the
1996-9? ramp-up in aircraft production- la June, factory output is estimated to have fallen 'A percent; the
GM strike accounted for die decline.
The labor force participation rate—which measures
the percentage of the working-age population that is
either employed or looking for work—trended up
mildly over the past couple of years and stood at
67.1 percent, on average, in the first half of 1998,
slightly above the previous cyclical highs achieved in
late 1989 and early 1990. Participation among adult
women has picked up noticeably in recent years, after

92
having risen only slowly in the first half of the 1990s,
and participation among adult men, which had been
on a gradual downtrend through mid-decade, appears
to have leveled out. In contrast, participation rates for
teenagers, for whom school enrollment rates have
risen, have continued to sag after having dropped
sharply in the early 1990s. Strong labor demand
clearly contributed importantly to the rise in overall
participation over the past several years, but the
expansion of the earned income tax credit and
changes in the welfare system probably provided
added stimulus.

Change in Employment Cost Index
Percent. Dec. to Dec.
Hourly compensation

Q1

Labor Force Participation Rate
Percent

0
1991

1993

1995

1997

Mote. Data ar« tor private industry, excluding farm and household workers. The valm tor 199&Q1 is measured from March
1997 to March 1996.

66

63

60

i i i i i i i i I ii
1968

1973

1978

LJ 1 I I LJ I 1 I J J I
1963

1988

1993

57

1998

Note. Data before 1994 have been adjusted by the FHB stall
for the redesign ol (he household survey.

Labor Costs and Productivity. Finns no doubt
are continuing to rely heavily on targeted pay
increases and incentives like stock options and
bonuses to attract and retain workers. But the tightness of the labor market also appears to be exerting
some upward pressure on traditional measures of
hourly compensation, which have exhibited a
somewhat more pronounced uptrend of late. Indeed,
the twelve-month change in the employment cost
index (EG) for private industry wotkers picked up
to 3Vi percent in March, compared with 3 percent
for the twelve months ending in March 1997 and
2% percent for the twelve months ending in March
1996. Hourly compensation accelerated especially
rapidly for employees of finance, insurance, and real
estate firms, some of whom received sizable bonuses
and commissions. However, the acceleration was
fairly widespread across industries and occupations
and, given the relatively small rise in consumer prices




over the past year, implies a solid increase in real pay
for many workers.
The acceleration in hourly compensation costs over
the past year resulted mainly from faster growth of
wages and salaries, which rose 4 percent over the
twelve months ending in March; this increase was
about '/i percentage point larger than the one recorded
over the preceding twelve months. Separate data
on average hourly earnings of production or
nonsupervisory workers also show an ongoing
acceleration of wages: The twelve-month change in
this series was 4.1 percent in June, Vt percentage
point above the reading for the preceding twelve
months.
Benefits costs have generally remained subdued,
with the increase over the year ending in March
amounting to only about 2'A percent. According to
the ECI, employer payments for health insurance
have picked up moderately in recent quarters after
having been essentially flat over the previous couple
of years, and indications are that further increases
may be in the offing. Insurers whose profit margins
bad been squeezed in recent years by pricing strategies designed to gain market share reportedly are raising premiums, and many managfrt care plans are adding innovations thai, while offering greater flexibility
and protections to consumers, may boost costs. Additional upward pressure on premiums apparently has
come from higher spending on prescription drugs.
Among other major components of benefits, rising
equity prices have reduced the need tor rums to
pay into defined benefit plans, and costs for state

93
unemployment insurance and workers' compensation have fallen sharply.
Labor productivity in the nonfarm business sector
posted another sizable advance in the first quarter of
1998, bringing the increase over the year ending in
the first quarter to an impressive 2 percent1 Taking a
slightly longer perspective, productivity has risen a
bit more than 1 'A percent per year, on average, over
the past three years, after having risen less than
1 percent per year, on average, over the first half
of the decade. At least in part, the recent strong
productivity growth has likely been a cyclical
response to the marked acceleration of output But it
is also possible that the high levels of business investment over the past several years—and the associated rise in the amount of capital per worker—are
translating into a stronger underlying productivity
trend. In addition, productivity apparently is being
buoyed by the assimilation of new technologies into
the workplace. In any event, the faster productivity
growth of late is helping to offset the effects of higher
hourly compensation on unit labor costs and prices,
thereby allowing wages to rise in real terms.

Prices
Price inflation remained quiescent in the first half
of this year. After having increased 1% percent in
1997, the consumer price index (CPI) slowed to a
crawl in early 1998 as energy prices plummeted, and it
recorded a rise of only about 1 'A percent at an annual
rate over the first six months of the year. The increase
in the CPI excluding food and energy—die socalled "core CPI"—picked up to 21A percent (annual
rate) over the first half of the year. However, this
pickup follows some unusually small increases in the
Change in Consumer Prices
Percent Dec. to Dec.

Change in Output per Hour
Percent. Q4 to Q4
1991
1993
1995
1997
Note. Consumer pries index for all urben consumers. Value tor
1996:H1 is ttw percent Chang* from December 1997 to June
1998 at an annual mte.

01

Change in Consumer Prices Excluding
Food and Energy
Percent, Dec. to Dec.

.III
1991

1993

1995

1997

Note. Nonlarm business sector. Value tor 1998:01 is the
percent change from 1987:01 to 199&Q1.

1. Acco«lpi| to the published data, productivity rose 1-' percent
at in annul rale in It* fiitt quuter. However, these dan we
distorted by uKxmsJtttndetiotrjemeaMucmeatofbouriassociMBd
wilh varying lengths of pay periods acroM mootht. Although the
Bureau of Labor Statistics has already revised the monthly boon
and earnings data to account for these iiKon>istfnriCT. it will not
update the productivity aatutict until AugoK. AH else being equal,
adjusting the productivity data to reflect (be Bureau's revisions to
noun would substantially raise productivity growth in die fint
qoarttf, but it would have little effect on the change over the four
quarters ending in the first quarter.




1991

1993

1995

1997

Note. Consumer price Index for IB urban oonswnera. Value for
199&H1 b ttw percent change from December 1997 to June
1998 at an annual rate.

Alternative Measures of Price Change
Percent
1997:Q1
to

1996:Q1
to
1997:Q1

1998:01

Fixed weight
Consumer price index
Excluding food and energy

2.9
2.5

2.3

Chain type
Personal consumption expenditures
Excluding food and energy
Gross domestic product

2.6
2.3
2.2

1.0
1.4
1.4

Price measure

1.5

Note. Changes are based on quarterly averages.

second half of 1997, and the twelve-month, change
has held fairly steady at about 2W percent since late
last summer. The chain [nice index for personal
consumption expenditures on items odier than food
and energy rose only 1V5 percent over the year ending in the first quarter of 1998—the most recent
information available; this measure typically rises less
rapidly than does foe core CPI, in part because it is
less affected by so-called "substitution bias."
The relatively favorable price performance in the
first half of 1998 reflected a number of factors that,
taken together, continued to exert enough restraint
to offset the upward pressures from strong aggregate demand and high levels of labor utilization. One
was the drop in oil prices. In addition, non-oil import
prices continued to fall, thus further lowering input
costs fen many domestic industries and limiting the
ability of firms facing foreign competition to raise
prices for fear of losing sales to producers abroad.
Prices of manufactured goods were also held in check
by the sizable increase in domestic industrial capacity in recent years and by developments in Asia,
which, among other things, led to a considerable
softening of commodity prices. Moreover, the various surveys of consumers and forecasters suggest that
inflation expectations stayed low—even declined
in some measures. For example, according to the
Michigan survey, median one-year inflation expectations dropped a bit further this year, after having held
fairly steady over 1996 and 1997, and inflation
expectations for the next five to ten years edged down
from about 3 percent, on average, in 1996 and 1997
to 2V» percent in the second quarter of 1998.




The CPI fof goods other than food and energy rose
at an annual rate of 1 percent over the first six months
of 1998, only a bit above the meager 'A percent
rise over 1997 as a whole. In the main, the step-up
reflected a turnaround in prices of used cars and
trucks, and prices of tobacco products and prescription drugs also rose considerably faster than they
bad in 1997. More generally, prices continued to be
restrained by (be effect of the strong dollar on prices
of import-sensitive goods. For example, prices of new
vehicles fell slighdy over the first half of the year
while prices of other import-sensitive goods—such as
apparel and audio-video equipment—were flat or
down. In ihe producer price index, prices of capital
equipment were little changed, on balance, over the
first half of 1998; they, too, were damped by the
competitive effects of falling import prices.
The CPI for non -energy services increased
3 percent over the first six months of 1998, about
the same as last year's pace. After having fallen
somewhat last year, airfares picked up in die first half
of the year, and owner's equivalent rent seems to be
rising a bit faster man it did in 1997. In addition,
increases in prices of medical services, which had
slowed to about 3 percent per year in 1996-97, have
been running somewhat higher so far mis year. Price
changes for most other major categories of services
were similar to or smaller man those recorded in
1997.
Energy prices fell sharply in early 1998 as the price
of crude oil came under severe downward pressure
from weak demand in Asia, a decision by key OPEC

95
producers to increase output, and a relatively warm
winter in the Northern Hemisphere. After averaging
about $20 per barrel in the fourth quarter of 1997, the
spot price of West Texas intermediate dropped to a
monthly average of $15 per barrel in March, where it
more or less remained through the spring. Crude
prices dropped sharply in June following reports of
high levels of inventories and revised estimates of
011 consumption in Asia but have Ynce finned in
response to an agreement by major oil producers to
restrict supply in the months ahead; they now stand
at $14'/2 per barrel. Reflecting the decline in crude
prices, retail energy prices fell at an annual rate of
12 percent over the first half of the year, led by a
steep drop in gasoline prices.
Developments in the agricultural sector also helped
to restrain overall inflation in the first half of this year.
Excluding UK prices of fruits and vegetables—
which tend to be bounced around by short-term
swings in the weather—food prices have been rising a
scant 0.1 percent per month, on average, since late
1997. Although farmers in some regions of the
country are experiencing more prolonged weather
problems, conditions in the major crop-producing
areas of the Midwest still look relatively favorable,
and it appears that aggregate farm production will be
sufficient to maintain ample supplies over the coming year, especially in the context of sluggish export
demand.
Credit and the Monetary Aggregates
Cndit and Depository intermediation. The
total debt of U.S. households, governments, and
nonftnancia] businesses increased at an annual rate of
5V* percent from the fourth quarter of 1997 through
May of this year. Domestic nonfinancial debt now
stands a little above the midpoint of the 3 percent
to 7 percent range established by the FOMC for
1998. Debt growth has picked up since 1997, as an
acceleration of private credit associated with strong
domestic demand and readily available supply has
more than offset reduced federal borrowing. Indeed,
federal debt declined I1/* percent at an annual rate
between the fourth quarter of 1997 and May 1998,
whereas nonfederal debt increased 8W percent
annualized over the same period. The growth of nonrederal debt has slowed only slightly over the past
several months.
Credit on the books of depository institutions rose
at roughly the same pace as total credit in the first half
of the year. Commercial bank credit advanced rapidly
in the first quarter and at a more subdued rate in




Debt: Annual Range and Actual Level
Trillions of dollars

Domestic nonfinancial sectors
15.8

15.6

15.4

15.2

15.0
O

N
1997

D

J

F

M

A

M

J

J

14.8

1998

the second. This slowdown was especially acute in
securities holdings, which had surged in both the
fourth quarter of 1997 and the first quarter of this
year. Responses Jo the Federal Reserve's May survey
on bank lending practices suggest that the earlier
runup in securities reflected the efforts of banks to
boost returns on equity by increasing leverage; much
of the rise in securities holdings was concentrated at
banks that were constrained by recent mergers from
using their profits to repurchase shares. Loan growth
also slowed in the second quarter, although the various loan categories behaved quite differently: Real
estate lending expanded most slowly in May and
June, whereas business leading rebounded in those
months after stalling out in March and April. Outstanding loans at branches and agencies of foreign
banks declined in the second quarter, and survey
responses identified an actual or expected weakening in the capital position of the parent banks as the
primary impetus for a tightening of loan terms and
standards.
The Report of Condition and Income (the Call
Report) showed that banks' return on equity was
about unchanged in the first quarter, staying in the
elevated range it has occupied since 1993. Call
Report data also indicated that delinquency and
charge-off rates on commercial and industrial loans
and on real estate loans remain quite low, while
delinquency and charge-off rates on consumer loans
have leveled off after their previous rise. Indeed, bank
profits have benefited importantly in recent years
from a low level of provisioning for loan losses.
Nevertheless, bank supervisors have been concerned
that intense competition and favorable economic

conditions might be leading banks to ease standards
excessively. They reminded depositories thai credit
assessments should take account of the possibility of
less positive economic circumstances in the future.
TTie trend toward consolidation in the banking
industry continued in the first half of tfae year. Some
of roe announced mergers involve combinations of
banks and nonbank financial institutions, such as
thrifts and insurance companies. Many of the mergers wen designed to capitalize on the economies of
scale and diversification of risk in nationwide banking; other mergers were undertaken to expand the
range of services offered to customers. Although
some observers are concerned that consolidation
might raise banks' market power, greater national
concentration in banking over the past several years

has not increased banking concentration in most local
markets.
The Honotmry Aggtwg*t»*. The broad monetary aggregates grew more rapidly in the first half of
1998 than they did in 1997, although the pace of their
expansion has slowed noticeably in recent months.
M2 grew 7V* percent at an annual rate between the
fourth quarter of last year and June of this year,
placing it wet) above the top of its 1 percent to
S percent growth range. When the FOMC established
this range in February, it noted thai annual ranges
represented benchmarks for money growth under
conditions of stable prices and velocity behavior in
accordance with its pre-1990 historical experience. In
fact, nominal spending and income have grown more

Growth of Money and D*bt
Percent

Period

M2

M1

M3

DomwoC
nonflmnctol
debt

Annual^
1988
1989

4.3
0.5

5.7
52

6.3
4.0

9.1
7.5

1990
1991
1992
1993
1994

4.2

4.1
3.1
1.8
1.3

1.8
1.2
0.6
1.1

2.5

0.6

1.7

6.7
4.5
4.5
4.9
4.9

-1.6
-4.5
-1.2

3.9
4.6
5.7

6.1
6.8
8.8

5.4
55
5.0

7.9
14.4
10-6

1995
1996
1997

Outfleity
(annual rate)1
1998

Q1
02

3,0
0.3

8.0
7.3

0.9

7.3

11.0

6.2

9.6

n.a.

9.8

5.8

Year-tomato*
1998

1. From average for fourth quarter of pracwSng yaw to
avaraga tor fourth quart* of yaar indfcand.
2. From awaga tot ancadng quarto » amrag* tot
quarter mdteaWd.




a From avanga tor fourth quart* of 1997 to avaraga tor
Jur* (May In tha CM* ofdomaMfc nonflnandal dabt).

97
M2: Annual Range and Actual Level
Trillions of dollars

4.25
420

4.15
4.10
4.05
4.00
O

N

D

J

1997

F

M

A

M

J

J

3.95

1998

rapidly than is consistent with price stability and
sustainable real growth, and the velocity of M2
(defined as the ratio of nominal GDP to M2) has
fallen relative to the behavior predicted by the pre1990 experience.
For several decades before 1990, M2 velocity
showed little overall trend but varied positively from
year-to-year with changes in M2 opportunity cost,
which is generally defined as the interest forgone by
holding M2 assets rather than short-term market
instruments such as Treasury bills. The relationship
was disturbed in the early 1990s by a sharp increase
in velocity; however, since mid-1994, M2 velocity

and opportunity cost have again been moving roughly
together, though not in lockstep. Indeed, velocity has
declined recently despite almost no change in the
standard measure of opportunity cost The dip in
velocity may be partly attributable to the flatter yield
curve, which has reduced the return on longer-term
investments relative to M2 assets—bank deposits and
money market mutual funds. Money demand may
also be bolstered by the efforts of households to
rebalance their portfolios in the face of a booming
stock market. By the end of 1997, households' monetary assets had ebbed to the smallest share of their
total financial assets in many years, and households
may want to reduce the concentration of their assets
in relatively risky equities and increase their holdings of less volatile M2 assets. However, in spite of
both the flatter yield curve and the rebalancing
motive, flows into both bond mutual funds and stock
mutual funds have been quite heavy this year.
M2 increased ^V* percent at an annual rate in the
second quarter, compared with 8 percent in the first
quarter. A buildup in household liquid accounts in
preparation for individual income tax payments
substantially boosted money growth in April; the
clearing of these payments depressed May growth by
a roughly equal amount At an annual rate, M2
increased about 6 percent on average over April and
May and about 5 percent in June, suggesting a larger
deceleration than is shown by the quarterly average
figures.

M3: Annual Range and Actual LeveJ
Trillions of dollars

M2 Velocity and the Opportunity Cost
of Holding M2
Ratio scale

5.6

Percentage points, ratio scale

5.5

5.4

5.3

- 1
1978

1983

1988

1993

1998

Note. M2 opportunity cost is a two-quarter moving average of
the three-month Treasury UP rate toss the weighted-average rate
paid on M2 components.




O

N D
1997

J

M

A

M

5.2

1998

M3 grew 9V* percent at an annual rate between the
fourth quarter of hist year and June, placing it far
above the top of its 2 percent to 6 percent growth

98
range. As with M2, the FOMC chose the growth
range for M3 as a benchmark for growth under conditions of price stability and historical velocity
behavior, The components of M3 not included in M2
increased 17'/S percent at an annual rate over the first
half of the year, following an even faster runup in
1997. Rapid expansion of large time deposits in the
first quarter was driven importantly by strong credit
growth at depository institutions. More recently, gains
in this category have diminished as bank credit
growth has slowed. Holdings of institutional money
market mutual funds climbed more than 20 percent in
each of the past three years, and that strength has
mounted in 1998 as businesses' interest in outsourcing their cash management evidently has intensified.
Because in-house management often involves shortterm assets that are not included in M3, the shift to
mutual funds boosts M3 growth.
Ml rose 1 percent at an annual rate between the
fourth quarter of 1997 and June of this year. Currency expanded 6te percent annualized over that
period, a bit below its increase last year. Foreign
demand for U.S. currency apparently weakened
substantially in the first five months of the year, with
an especially large decline in shipments to Russia.
Deposits in Ml declined in the first half of the year
owing to die continued introduction of "sweep"
programs. Ml growth has been depressed for several
years by the spread of these programs, which sweep
balances out of transactions accounts, which are
subject to reserve requirements, and into savings
accounts, which are not Depositors are unaffected by
this arrangement because the funds are swept back
when needed; banks benefit because they can reduce
their holdings of reserves, which earn no interest
New sweeps of other checkable deposits have slowed
sharply, but sweeps of demand deposits into savings
deposits—an activity that has become popular more
recently—continue to spread. Because many banks
have already reduced their required reserves to
minimal levels, the total flow of new sweep programs
is tapering off. although it remains considerable.
The drop in transactions accounts in the fust half of
the year caused required reserves to fall 33A percent at
an annual rate, a much slower decline than in 1997.
The monetary base grew 5W percent over the same
period, as the runoff in required reserves was more
than offset by the increased demand for currency.
The substantial decline in required reserves ova
the past several years has raised concern that the federal funds rate might become more volatile. Required
reserves are fairly predictable and must be maintained




on only a two-week average basis. As a result, the
Federal Reserve has generally been able to supply a
quantity of reserves that is close to the quantity
demanded at the federal funds rate intended by
the FOMC, and banks have accommodated many
unanticipated imbalances in reserve supply by varying the quantity demanded across days. Banks also
hold reserve balances to avoid overdrafts after making payments to other banks. But this precautionary
demand is more variable and difficult to predict than
requirement-related demand, and it cannot be
substituted across days. As required reserves drop,
more banks will hold deposits at the Federal Reserve
only to meet these day-to-day demands, reducing the
potential for rate-smoothing behavior.
So far, however, the federal funds rate has not
become noticeably more volatile on a maintenanceperiod average basis. This outcome has occurred
partly because the Federal Reserve has responded to
the changing nature of reserve demand by conducting open market operations on mote days than had
been customary and by arranging more operations
with overnight maturity, thereby bringing the daily
reserve supply more closely in line with demand. At
the same time, banks have borrowed more reserves at
the discount window and have improved the management of their accounts at Reserve Banks. Between
1995 and 1997, banks also significantly increased
their required clearing balances, which they precottunit to hold and which earn credits that can be
applied to Federal Reserve priced services. Like
required reserve balances, required clearing balances
are predictable by the Federal Reserve and can be
substituted across days within the two-week
maintenance period. Going forward, the Federal
Reserve's recent decision to use lagged reserve
accounting rather than contemporaneous reserve
accounting will increase somewhat the predictability
of reserve demand by both banks and the Federal
Reserve. Still, further declines in required reserves
might increase funds-rate volatility. Moreover, onethird of the banks responding to the Federal Reserve's
recent Senior Financial Officer Survey report that
reserve management is more difficult today than
in the past. One way to diminish these problems
would be to pay interest on reserve balances, which
would reduce banks' incentives to minimize those
balances.

Financial Markets
Ifltenst Rate*. Yields on intermediate- and longterm Treasury securities moved in a fairly narrow

99
Selected Nominal Treasury Rates
Percent

15
Thirty-year
bond

10

I I I I I I 1 I I 1 I 1 I I I I I I M I II

196S

1978

1988

1998

Note. The twenty-year Treasury bond rate is shown until Ihe
first issuance of the thirty-year Treasury bond in February 1977.

band during the first half of 1998, centered a little
below the levels that prevailed in the latter pan of
1997. The thirty-year bond yield touched its lowest
value since the bond was introduced to the regular
auction calendar in 1977; it was also lower than any
sustained yield on the twenty-year bond (the longest
maturity Treasury security before the issuance of the
thirty-year bond) since 1968. Meanwhile, the average yield on five-year notes in the first half of the year
was the lowest since early 1994.
Several factors have contributed to the decline in
intermediate- and long-term interest rates over Ox
past year. For one, developments in the U.S. economy and overseas reduced expected inflation and,
perhaps, uncertainty about future inflation. Between
the second quarter of 1997 and the second quarter of
1998, the median long-term inflation expectation in
the Michigan SRC survey of households dropped
'A percentage point, and the average expectation in
the Philadelphia Federal Reserve's Survey of Professional Forecasters fell almost 'A percentage point
Over the same period, the variance of long-term inflation expectations in the Michigan survey was halved.
This greater consensus of expectations suggests that
people may now place less weight on the possibility
of a sharp acceleration in prices; a reduction in
perceived inflation risk would tend to reduce term
premiums and thereby cut long-term interest rates. A
damping of expected growth in real demand here and
abroad, triggered importantly by the Asian financial
crisis, also has probably pulled rates lower, as has an
apparent shift in desired portfolios away from Asia
and, to some extent, from other emerging market




economies. Lastly, diminished borrowing by the federa] government has restrained interest rates by
reducing the competition for private domestic saving and for borrowed funds from abroad.
Assessing the relative importance of some of these
factors might be aided, in principle, by comparing
yields on nominal and inflation-indexed Treasury
notes. Between the second quarters of 1997 and 1998,
the nominal ten-year yield fell more than 1 percentage point, whereas the inflation-indexed ten-year
yield increased a bit. Unfortunately, the relatively
recent introduction of inflation-indexed securities and
the thinness of trading makes interpreting their yield
levels and movements difficult. In particular, light
trading may lead investors to view these new securities as providing less liquidity than traditional
Treasury notes, and investors may value liquidity
especially highly now in the face of uncertainty about
developments in Asia.
The yield curve for Treasury securities has recently
been flatter than at any point since the beginning of
the decade. For example, the difference between the
ten-year-note yield and the three-month-bill yield was
smaller in the first half of 1998 than in any other halfyear period since early 1990. In that earlier episode,
the yield curve had been flattened by a sharp runup
in short-term interest rates as the Federal Reserve
tried to check an upcreep in inflation. In the current
episode, short rates have held fairly steady, while
long-term rates have declined significantly. Some of
the current flatness of the term structure probably
stems from the apparent reduction in term premiums
noted above. But the flat yield curve may also reflect
the expectation that short-term real interest rates,
which have been boosted by the decline in inflation
over the past year, will drop in the future. Supporting that notion, the yield curve for inflation-indexed
debt has become inverted this year, as the return on
the five-year indexed note has risen above the rerun)
on the ten-year indexed note, which exceeds the
return on the new thirty-year indexed bond.
Equity Prices. Equity markets have remained
ebullient this year. The S&P 500 composite index
rose sharply in the first several months of 1998; it
then fell back a little before moving up to a new
record in July. The NASDAQ composite, NYSE
composite, and Dow Jones Industrial Average followed roughly similar patterns, and these indexes
now stand about 17 to 28 percent above their yearend marks. Small capitalization stocks have not fared
so well this year, with the Russell 2000 index up
about a third as much on net

100
Major Stock Price Indexes
Index (December 31,1996.1001

Daily
160
150

SAP 500

survey—is little changed since year-end. As a result,
the forward-earnings yield on stocks exceeds the teal
yield on bonds by one of the smallest amounts in
many years. Apparently, investors share analysts'
expectations of robust long-term earnings growth, or
they are content with a much smaller equity premium
man the historical average.

140
130
120
110
100
J

M

M

J

S

N

J

M

1997

90

M

1998

Note. Last observations are for July 17,1998.

The increase in equity prices combined with the
recent slowdown in earnings growth has kept many
valuation measures well above their historical ranges.
The ratio of prices in the S&P 500 to consensus
estimates of earnings over the coining twelve months
reached a new high in April and has retreated only
slightly from that point At the same time, the real
long-term bond yield—measured either by the tenyear indexed yield or by the difference between the
ten-year nominal Treasury yield and inflation
expectations in the Philadelphia Federal Reserve's

International Developments
Events in Asia, including in Japan, have continued
to dominate developments in global asset markets so
far in 1998. During the first months of the year, many
financial markets in Asia appeared to stabilize, and
progress in implementing economic and financial
reform programs was made in most of the countries
seriously affected by die crises. In early April, the
agreement between Korean banks and their external
bank creditors to stretch out short-term obligations
was implemented, ending an interval of rollovers by
creditors that was endorsed by the authorities in
countries that bad pledged to support the Korean
program. Indonesia reached a second revised agreement with the International Monetary Fund (IMF) in
April on a reform program, which was subsequently
derailed by political strife and the resignation of the
president in late May; the change in political regime
was followed by calm, and a new agreement was
reached with the IMF management in late June and
approved by the IMF Executive Board on July 15.
Daily Value of Foreign Currencies
Index of (foreign currencies (July 2,1997-100}

Equity Valuation and Long-Term Interest Rate
Percent

.Dairy

90
S&P 500 ewnings-price

70

50

30

J

1978

1983

1988

1993

1998

Note. The earnings-price ratio is based on the consensus
estimate of eammos over the coming twelve months derived from
the forecasts cotettati by UBJEJS imema&onM. inc. The real Interest rate is the yield on the ten-year Treasury note less tne tenyear inflation expectations from the Philadelphia Federal Reserve
Survey of Professional Forecasters.




A

S

O

N

1997

D

J

F

M

A

M

J

J

10

1998

Note. Last observations are for July 17,1998.

After rising sharply during the final months of
1997 through mid-January of 1998, the exchange
valve of the dollar in terms of the currencies

101
of Korea, Indonesia, Thailand, and other ASEAN
countries partly retraced those gains during February, March, and April. Since then, however, market
pressures have again led to further sharp increases in
the exchange value of the dollar in terms of the
Indonesian rupiah while the dollar has changed little
against most of the other Asian emerging-market currencies. Since the end of December, the dollar has
declined, on balance, 24 percent against the Korean
won and nearly 14 percent against the Thai baht and
has risen moderately in terms of the Taiwan dollar
and increased about 130 percent in tenns of the
Indonesian rupiah.
During the first weeks of the year, the dollar depreciated in tenns of the Japanese yen as improved
prospects elsewhere in Asia and market uncertainty
regarding potential intervention by the Japanese
monetary authorities lent support to the yen. Indications that significant measures for economic stimulus
might be announced also put upward pressure on the
yen. In February, the dollar resumed its appreciation
with respect to the yen. The rise in the dollar was
only temporarily interrupted by sizable intervention
purchases of dollars by Japanese authorities in April.
Upward pressure on the dollar relative to the yen
intensified in late May and June. Renewed signs of
cyclical weakness in the Japanese economy and lack
of market confidence in the announced programs for
addressing the chronic problems within the financial
sector contributed to pessimism toward the yen.
Persistent weakness in the Japanese economy and
the yen, in turn, heightened concerns about prospects
elsewhere in Asia; the lower yen adversely affected
the competitiveness of goods produced in the Asian
emerging-market economies and raised questions

U.S. Exchange Rates with Japan and Germany
DM/S

Nominal

140

1.B

130

1.7

120

1.6

110

1.5

100

1.4

90
80

1.2

1993 1994 1995 1996 1997 1996




about the sustaioability of current exchange rate policies in China and Hong Kong.
On June 17, the monetary authorities in the United
States and Japan cooperated in foreign exchange
intervention purchases of yen for dollars. This
intervention operation was the first by US. authorities since August 1995. In announcing the market
intervention. Treasury Secretary Rubin cited Japanese
government plans to restore the health of their financial system and to strengthen Japanese domestic
demand. He pointed to the stake of Asia and the
international community as a whole in Japan's success. The yen rose somewhat following the exchange
market intervention and has since partially given back
that gain. In the wake of the recent election, which
cost the LDP numerous seats in the upper house of
the Diet and precipitated the resignation of Prime
Minister Hashimoto, the yen changed little. On balance, the dollar has appreciated about 7 percent in
terms of the yen since the end of December.
Equity prices in the Asian emerging-market
economies have been volatile so far this year as well.
These prices recovered somewhat in the first weeks of
the year in response to the market perception that the
crisis was easing; after fluctuating narrowly, they
began moving back down in March and April, reaching new lows in June in Korea, Thailand, and Hong
Kong. On balance, these equity prices have moved
down about 25 percent (Singapore and Malaysia) to
up about 20 percent (Indonesia) since the end of last
year. Equity prices in Japan also rose early in the year
on improved optimism but men gave back those gains
over time with the release of indicators suggesting
additional weakness in the Japanese economy. Since
the middle of June, Japanese equity prices have
rebounded on the perception that significant fiscal
stimulus is now more likely. On balance, Japanese
equity prices are up about 9 percent from their level
at the end of last year. Japanese long-term interest
rates continued through May on their downward
trend that began in mid-1997, declining an additional SO basis points during the first five months.
Since then, long-term interest rates have retraced
more than half of that decline, in part in response to
the announcement of the plan for financial restructuring and in part in response to the outcome of the
recent election, which heightened expectations of
additional fiscal stimulus.
The Asian financial crises nave resulted in a sharp
drop in the pace of economic activity in the region.
Output declined precipitously in the first quarter
in those countries most affected, such as Korea,

102
U.S. and Foreign Interest Rates
Yield on Three-month Bank Liabilities
Percent

U.S. large CD

Yield on Ten-year Government Securities
Parcent

United States

I

I

L

I

1993 1994 1995 1996 1997 1998
Indonesia, and Malaysia, and slowed in other Asian
economies, such as China and Taiwan, that have suffered a loss of competitiveness and reduced external
demand as a consequence of the crises. Data for
recent months suggest that additional slowing has
occurred and that the risk of further spread and
deepening of cyclical weakness throughout the region
cannot be ruled out Depreciation of their respective
currencies has led to acceleration of domestic prices
in several of these economies, particularly in
Indonesia and Thailand.
Real GDP in Japan also fell sharply in the rust
quarter, and output indicators suggest a further
decline in the second quarter. Consumer price inflation remains very low, Japanese authorities have
announced a series of fiscal measures that are
expected to boost domestic demand during the second




half of tins year. In addition, officials have announced
a package of steps directed at restoring the soundness of the financial sector, including (1) introduction of a bridge bank mechanism to facilitate the
resolution of failed banks while permitting some
of their borrowers to continue to receive credit,
(2) measures to improve the disposal of bad bank
loans, (3) enhanced transparency and disclosure by
banks, and (4) strengthened bank supervision. These
actions are intended to restore confidence in Japanese
financial institutions and in the prospects for the
economy more broadly.
In the other major industrial countries, economic
developments so far this year have generally been
favorable. The exchange value of the dollar in terms
of the German mark has fluctuated narrowly and, on
balance, is little changed since the end of December. Market perceptions that progress toward the start
of the dual stage of European Monetary Union
(EMU) is going smoothly and signs of momentum in
the US. and German economies resulted in tittle pressure in either direction on the exchange rale. The
dollar also fluctuated narrowly against the U.K, pound
with little net change so far this year. Moves to
tighten monetary conditions in the United Kingdom
lent support to the pound, countering* some tendency
for weak external demand to depress the currency.
The Canadian dollar rebounded following a tightening of monetary conditions by the Bank of Canada
on January 30. Since early March, however, it has
tended to move down as market participants have
come to believe that further upward shifts of official
interest rates are unlikely and as weakness in global
commodity markets, partly the result of reduced economic activity in Asia, have weighed on the currency. The exchange value of the U.S. dollar in terms
of the Canadian dollar reached new highs in July
and, o^fealance so far this year, has risen about
Long-term interest rates have declined and equity
prices have generally risen strongly in European
and Canadian markets this year. Despite signs
of strengthening activity in Germany and other
continental European countries and continued healthy
expansion in the United Kingdom and Canada, longterm rates have moved down since December; long
rates are about 60 basis points lower in Germany and
less than ball that amount lower in Canada. Shifts of
international portfolios away from Asian assets and
toward those perceived to be safer have probably
contributed to rate declines in Continental Europe and
in the United States. Stock prices have also continued
to rise in Europe and Canada. Since December, the

103
gains have ranged from about 40 percent in Germany
and France to about 10 percent in Canada.
The pace of real economic activity improved
somewhat in the first quarter in Germany and on
average in the eleven countries slated to proceed with
currency union on January 1, 1999.! Production and
employment data for more recent months suggest
continued expansion. Business confidence has firmed
as progress toward EMU has continued. Domestic
demand is becoming more buoyant in several of these
countries, offsetting weakening of external demand
arising from events in Asia. On average, inflation
remains subdued within the euro area. In the United
Kingdom and Canada, real output continues to
expand at a relatively rapid rate. U.K. inflation
threatens to exceed the government's target of
2'/> percent, and the Bank of England raised its
official lending rate 25 basis points in June in order to
lessen price pressures. Consumer price inflation in
Canada remains very low.
Events in Asia have spilled over to affect developments in Latin American countries. Declines in global
oil prices have contributed to downward pressure on
the exchange value of the Mexican peso. The peso
declined sharply in terms of the dollar at the start of
the year but then stabilized in February through May
as Asian markets partially recovered. It depreciated
further in May and June, resulting in a net decline of
2, Those countries are Austria. Belgium, Finland. France,
Ireland, Italy, Germany, Luxembourg, the Netherlands, PoftugaL
and Spain.




about 9 percent in terms of the dollar so far this year.
The Brazilian exchange rate regime of a controlled
crawl and the Argentine regime of pegging the peso
to the dollar remain in place, and Brazilian shortterm interest rates have been lowered from the very
high levels to which they were raised when the Asian
crisis intensified in late 1997. Equity prices in these
three Latin American countries have been volatile,
rising early in the year and giving back those gains
since April. On balance this year, equity prices have
declined about 10 percent in Mexico and Argentina
and have risen about 8 percent in Brazil.
Real output growth remains strong in Mexico and
Argentina, but the rate has slowed somewhat from
last year's vigorous pace. In Brazil, economic activity has weakened more sharply, in part in response to
the tightening of monetary conditions that followed
the outbreak of the Asian crisis.
Lower global oil prices have combined with a
poorly functioning domestic tax system to trigger a
financial crisis in Russia. Russian officials have
reached agreement with IMF management on a
revised program that includes proposed increased
funds from the IMF and other sources. To help
finance this program, the General Arrangements to
Borrow are being activated in light of the inadequacy
of IMF resources to meet actual or expected requests
for financing and a need to forestall impairment of
the international monetary system. The General
Arrangements to Borrow provide the IMF with
supplementary lines of credit from the G-10

104
Chairman Greenspan subsequently submitted the following in response to written
questions from Chairman Castle in connection with the July 22, 1998, hearing before the
House Banking Subcommittee on Domestic and International Monetary Policy;

International Issues
You were recently in Japan and had a first-hand opportunity to assess the health of
the Japanese financial system. Can you give the Subcommittee your perspective of
the health of Japan's banks and financial institutions, and in addition comment on
the dollar magnitude of the bad loan problem that remains to be resolved?
Japanese banks remain burdened with sizable portfolios of problem assets, and will
not return to full health until these assets are removed from the banks' balance sheets and
bank capital has been rebuilt. Japanese officials are currently debating the appropriate
measures needed to bring about these results. As of the end of March, Japanese
depository institutions repotted nonperforming loans (past-due and restructured loans) of
¥35 trillion, which is 5 percent their total loans or 7 percent of Japan's GDP. Another
measure of problem loans is credit exposures that are "classified assets" (assets for which
full repayment is questionable, or would be questionable without additional risk
management measures), which are reported at ¥88 trillion for Japanese depositories as of
die end of March 1998, or 11 percent of their total credit exposure.

While in Japan, you also had a first-hand opportunity to assess the government's
proposed "Total Plan** to reform the banking sector. While key details of the plan
remain to be clarified, at this stage do you betieve the bridge bank scheme Is
conceptually sound?
•

Does the policy thrust behind the bridge bank scheme correct the ffls of
the banking system, such as non-performing loans, excess capacity,
competition from pubttc financial institutions on private banking, and
the lack of incentives for bank management?




105
Do you believe implementation of the Total Plan would support the real
economy in Japan? Why or why not?
The policy thrust behind the Total Pian includes the following measures:
• promote the restructuring of financial institutions and to ensure that sound
borrowers of a failed bank would continue to receive credit by creating a mechanism for
establishing a bridge bank, which would run the operations of a failed bank until me bank
could be wound down, sold, or merged;
» promote the disposal of bad loans by encouraging the disposal of bank loans by
the Cooperative Credit Purchasing Corporation (CCPC) and the Resolution and Collection
Bank (RGB);
• improve transparency and disclosure by requiring all banks to report according
to so-called "SEC-equivalent" standards; and
• strengthen bank supervision by mandating a long-overdue intensive inspection of
the nineteen major banks.
Full and vigorous implementation of the Total Plan should over time help improve
the economy in Japan. Banks will be more willing to lend when collateral values become
more clear, after the collateral backing bad loans has been sold to the market. Banks will
find borrowing less costly after uncertainty about the condition of Japanese banks has
been reduced via improved disclosure and supervision.




106
Even in the best case scenario-rapid and appropriate financial system restructuring
and permanent net tax cuts-isn't it likely that Japan's economy will remain weak for
the second half of 1998 and into 1999? If that is the case, how can Japan possibly
serve as an engine of Asian growth anytime m the near future?
Given the deep macroeconomic and structural problems racing the Japanese
economy, coupled with declining confidence of Japanese households and firms and the
resulting contraction of economic activity, it seems unlikely that Japan will serve as an
engine of growth anytime soon. Nevertheless, aggressive action to address the bad-loan
problems, reform the banking system, and restructure the economy more broadly should
prepare die way for sustained private-demand-led growth in Japan. Although me benefits
of such policies will likely not be immediate, these actions are necessary to strengthen die
Japanese economy in the medium- to long-run and to make Japan an engine of
growth-not only for Asia, but also for me rest of the world.
What is the nature and severity of risk to the U.S., regional, and global economy if
Japan is unable to implement the kinds of reforms that restore domestic and
international confidence in hs financial system?
Weakness of consumer and business confidence, stemming to a considerable extent
from die large and growing bad debt problems in the Japanese banking system are at the
core of Japan's economic problems today. Failure to deal effectively widi these problems
will make it very difficult to engender a full and lasting recovery in Japanese economic
activity. Continued weakness in Japanese domestic demand will depress demand for
imports from elsewhere in Asia as well as from the United States, weighing on economic
recovery in Asia as well as on the U.S. trade deficit. Failure to restore the health of




107
Japan's banking system also has potentially negative implications for financial
intermediation elsewhere in Asia and in the United States, where Japanese banks have
been important players in the recent past.
As you know, a debate bas emerged between economists as to the principal causes of
the Asian crisis. At the risk of oversimplification, one school attributes the crises
largely to ample global liquidity in combination with weak national financial systems
and the corrosive impact of "crony capitalism." The other school asserts that the
Asian economies were fundamentally sound and that the irrational herd instincts of
market participants combined with the pernicious influence of short-term capital
flows and poor IMF policy advice to cause the crisis. Could you explain to the
Subcommittee in greater detail why you believe the explanation of the first school is
more persuasive than the second?

During the hearing, Congressman Metcalf raised a similar question, and I
responded that I think the first view is more right than the second.
To elaborate, each of the two "schools" identified has some valid arguments.
Although neither school is entirely correct, the weight of evidence would seem to favor
attributing primary responsibility for the financial troubles in Asia to the inability of
domestic financial systems in the borrowing countries to cope efficiently and prudently
with international capital flows, the scale of which had grown substantially in recent
years.
When assessing the debate about the causes of the "Asian crisis," it is important to
distinguish among the various economies involved; each economy's problems and
circumstances are unique, albeit with some common elements. The differing
circumstances in each economy mean that some evidence can be marshaled for just about
any argument regarding the causes of the problems in Asia.




108
However, there would appear to be two very important common elements in the
experiences of the Asian economies that have been the hardest hit so far:
(1) these economies relied greatly-and excessively, as is now clear—on foreign
borrowing, especially short-term borrowing; and
(2) the domestic financial infrastructures, including bank supervision and
regulation, in these economies were inadequate, with the abuses of so-called
"crony capitalism" too often being a cause or a consequence of these structural
shortcomings.
In some cases, macroeconomic policies also were not consistent with domestic and
external stability, and exchange rates were becoming increasingly out of line with
economic fundamentals, although perhaps not alarmingly so.
On the other hand, the Asian economies had many strengths as well, including
vibrant export sectors, relatively low rates of inflation, and very high savings and
investment rates, although, to be sure, not all of the investments had been in sound
projects.
During the successive waves of market sell-offs in various Asian economies,
market participants have been reacting to real concerns regarding the profitability of their
various investment positions. However, to an outside observer, it would seem that in at
least some instances markets have over-reacted. Certainly some Asian currencies have
reached depreciated levels that would seem to be far removed from what standard
economic analysis would indicate to be their fundamental values.




109
The international community, centering its efforts on the IMF, appropriately has
stepped forward to contain the potential damage both to the individual Asian economies
and to the international financial system more generally.
With regard to formulating the appropriate course of action in each Asian
economy, the IMF and the international community more generally are clearly facing
difficult and largely unprecedented situations and are required to make difficult decisions.
Market forces have made exchange rate pegs untenable. Fundamental structural
adjustments are necessary but will take time and much effort to accomplish.

Structural

adjustments also entail fiscal costs which must be financed in a non-inflationary manner.
Taking into account such factors as the adjustment and stabilization processes that have
developed over the past several months, the IMF has shown constructive flexibility in its
policy advice to the troubled borrowing economies.




110
Chairman Greenspan subsequently submitted the following in response to written
questions from Congressman Bentsen in connection with the July 22, 1998, hearing
before the House Banking Subcommittee on Domestic and International Monetary Policy:

1. Absent an increased assessment on member nations, including the proposed $17.9
billion from the United States, the IMF has begun to draw on its General
Arrangements to Borrow account. ID addition to the GAB, the IMF also holds gold
reserves valued at approximately $40 billion. Do you believe the IMF has sufficient
resources to meet its existing and proposed obligations in Asia and Russia? Is the
use of GAB funds and gold reserves for these purposes, in your opinion, sound fiscal
policy for the IMF?

Taking into account the IMF's already existing obligations, including committed
but undisbursed credits under its programs for Korea, Indonesia, Thailand, and Russia,
IMF liquidity has been diminished to such an extent mat it would be very difficult for the
IMF to provide adequate support in the event that additional major countries meet with
significant external financial distress. Measures of the IMF's liquidity—the fraction of its
liquid resources that are available for future lending—currently are at less than half of
their level at the end of 1996, before the Asian financial crisis, and are well below their
long-term average as well. An adequate level of liquidity is necessary not only to finance
additional programs, if mey are needed, but also to allow for the possibility that one or
more creditor countries might encounter financial problems requiring them to wimdraw
some of their reserve positions in the IMF. An increase in the amount of resources
available to the IMF would help to restore its liquidity and provide it with greater
flexibility in being able to respond to future financial problems. A more important
consideration at this time in my view is the fact mat adding to the IMF's financial




Ill
resources would provide appropriate insurance against the risk of major disruption of the
global economy and financial system.
The use of GAB funds on a sustained basis or its gold reserves are not the answer
to the IMF's liquidity problem. Resources available through the GAB are intended to be
used only in response to problems with systemic implications for the international
financial system, and hence could not be used to finance many of the programs supported
by the IMF. The IMF's gold reserves provide crucial backing of its financial position,
and cannot be sold without approval of 85 percent of its members' voting power.

2. In your testimony, you state that the Asian economic downturn is responsible for
the fall in oil prices and such prices should rebound over time. Are you asserting
that the Asian crisis is the only reason for falling oil prices?

Crude oil prices have declined by about 33 percent since October of last year.
One can reasonably attribute about half of this decline to the reduction in oil demand in
Asia as a result of the economic crisis in that region. Several other factors contributed to
the decline: last winter's warm weather, which reduced demand for heating oil, OPEC's
decision last November to increase crude oil production, and the depreciation of most
European currencies against the dollar, which raised me price of oil and reduced demand
for it in that region. The combination of these factors led to a runup in the level of crude
oil inventories that has continued to restrain prices.




112
3. With deflated oil prices and the drought in many agriculture states such as
Texas, is the Federal Reserve projecting any additional weakness in diner the
national economy or regional economies as a result? Is such weakness already
accounted for in your current projections?
We in the Federal Reserve have been aware of the developments to which you
refer. Although there are a variety of causal factors behind them, the slump in Asia and
the appreciation of the dollar have played a significant role. The oil and agriculture
sectors have been among the hardest hit by the Asian crisis; although the weakness in
prices of commodities has blunted inflationary pressures and been a boon for the
purchasing power of consumers, many producers have suffered appreciable contractions
of their revenues. As I noted in my testimony, we have attempted to take these forces
into account in our forecast, but uncertainties remain considerable and we shall have to
continue monitoring developments closely to make sure that our assessments are correct.

4. As you know, some including House Budget Committee Chairman John Kasich,
have proposed using projected future budget surpluses for tax cuts totaDmg $700
billion. Given your statements expressing concern about the strength of the economy
and potential wage and price pressure, would the Fed view such cuts as potentially
creating too much stimulus for a growing economy? Would such a cut raise the
specter of the Fed imposing contractionary monetary policies such as rate hikes to
keep the money supply within projected bands and inflationary pressures under
wraps?
It is fair to say that, up to now, the U.S. economy has not been suffering from a
lack of domestic private demand. Far from it, as the recently released second-quarter
GDP figures once again attested. Under the circumstances, as I've remarked, it is quite
fortunate that there has been a degree of fiscal restraint at the federal level. The swing




113
into budgetary surplus has not only helped to mute inflationary pressures but has freed up
domestic saving to help finance productivity-enhancing business investment. I would
hope that we could sustain that direction, preserving the projected-and not yet fully
realized-surpluses, especially given the longer-range budgetary problems associated with
the interaction of our entitlement programs and the aging of the population over the
coming decades. I would not want to anticipate the direction of monetary policy, which
depends on the overall economic picture, rather than any one element.

5. On page 17 of your report, the Fed states that "employer payments for health
insurance nave picked up moderately hi recent quarters after having been...flat," Is
the Fed foreseeing an uptick in health care costs along the lines of the late 1980's?
We have already seen an acceleration of employer costs for health insurance.
According to the Bureau of Labor Statistics' Employment Cost Indexes for private
industry, health insurance costs rose about 2-1/2 percent over the past year, versus about
3/4 percent in the year ended June 1997. Reports on the emerging trend in health
insurance costs have been somewhat inconsistent, but on die whole they point to at least
some further pickup. A return to the huge annual increases of several years ago,
however, is not commonly foreseen. Some analysts argue that the changes in market
structure~lhe shift to various kinds of managed care arrangements among other thingsare a lasting damping force on increases in the relative price of health care; and it is
thought that employers are more focused than they once were on containing health
insurance expenses along with other costs (implying, among other things, that they will




114
be more resistant to premium increases and more inclined to pass increases on to
employees in one way or another).

6. What measures, if any, is the Fed proposing to address liquidity concerns in the
banking system as a result of the Y2K issue?

The Federal Reserve has several means to meet unusual demands for liquidity at
the century date change or at any other time.

Open market operations are used to supply

sufficient reserves to ameliorate any overall pressures in money markets. And, individual
depository institutions have access to the Federal Reserve's discount window to meet
liquidity needs that cannot be accommodated through normal channels.
We are working closely with other bank and thrift supervisors, depository
institutions, and other market participants to assure as smooth a century date change as
possible in U.S. financial markets, but we recognize the considerable uncertainties
involved and hence the potential for unusual liquidity needs. Along with the other
supervisors of depository institutions, we will be encouraging depositories to have
contingency plans to deal with disruptions to their usual sources of liquidity. As an
element of such plans, depositories may wish to execute necessary agreements and make
collateral arrangements to facilitate discount window borrowing should that be necessary;
the Reserve Banks will be working with depositories to help them with these preparations.




115
STATEMENT OF DAVID A. SMITH
DIRECTOR OF PUBLIC POLICY, AFL-CIO
BEFORE THE HOUSE BANKING COMMITTEE
ON THE HUMPHREY-HAWKINS HEARING
July 23,1998
The AFL-CIO appreciates the opportunity to submit this statement for the record of
today's Humphrey-Hawkins hearing. All working Americans and their families have a high stake
in the achievement of the Humphrey-Hawkins Act's full employment targets. It is good news for
America's workers that the nation's unemployment rate is edging closer to our historic full
<.
employment targets than at any other time since this landmark legislation was adopted in 1978.
While the reduction in unemployment over the last few years is gratifying, it is by no
means guaranteed that this fw>rable trend will continue, or that the Humphrey-Hawkins target of
a national unemployment rate no higher than four percent will actually be achieved. Much will
depend on economic policy decisions, of which none will be more important than the monetary
policy decisions of the Federal Reserve's Open Market Committee.
We urge Chairman Greenspan and his FOMC colleagues to use the tools of monetary
policy to guide the economy toward its full employment potential. With inflation low and
declining while unemployment has been decreasing, four percent unemployment should no longer
be dismissed as an unrealistic goal.
The most serious threat to reaching that goal are the shock waves set offby the severe
financial and economic crisis which has enveloped much of East Asia, and which apparently is
spreading to other parts of the world, including Russia.
No serious observer would deny that the movement of a tidal wave of capital from East
Asia and elsewhere to the relative safety, security and high returns of U.S. financial markets has
been a hallmark of the current financial crisis. In an effort to stem the outflow, defend their
currencies and satisfy the austerity conditions imposed by the IMF, the countries hit hardest by the




116
crisis have been forced to boost their domestic interest rates to astronomical and punishing levels.
Meanwhile, the largest economy in Asia and the second largest in the world, Japan, is
caught in a deepening economic crisis. In an effort to jump start its stalled economy, Japan's
central bank has cut interest rates to record lows. Low interest rates, however, have done little to
stimulate Japan's economy, in part because a banking crisis has curtailed lending but also in part
because capital has left the country in pursuit of higher returns on investment in the U.S. The exit
of capital has battered the yen, making Japanese exports hyper-competitive and stimulating the
outflow of even more capital.
The human costs of East Asia's financial crisis are staggering. In Indonesia, Thailand,
South Korea and elsewhere bankruptcies and unemployment are mounting, and the worst is yet to
come. Rudimentary or nonexistent social safety nets in these countries mean that the unemployed
are left largely to their own devices. Beyond the human tragedy, the inadequate safety net
worsens these economies' downward spiral, as the unemployed are forced to curtail their
purchases when they lose their jobs. Deficit spending to mitigate the crisis is out of the question,
partly as a result of IMF austerity conditions and partly because of the need to prevent further
exodus of capital.
One obvious step which the U.S. could and should take to ease Japan's and the East Asian
economic crisis is to lower our interest rates in order to slow down the torrent of capital pouring
into our financial markets. Lower U.S. interest rates in and ofthemselves will not resolve the
crisis, but they would clearly ease it. Compared with the cost of IMF bailouts both to U.S.
taxpayers and to the people of East Asia who are bearing the burden of economic austerity, lower
U.S. interest rates are a dirt cheap policy alternative.
The crisis in Japan and the rest of East Asia has already begun to have a negative impact
on the U.S. economy. In May, the nation's trade deficit in goods and services increased to $15.7




117
billion, an all-time monthly high. For the first five months of 1998, the U.S. trade deficit in goods
with the Pacific Rim countries totaled $59 billion, a 43 per cent jump from the first five months of

1997.
Much of the recent deterioration in the nation's trade position is attributable to declining
US. exports, brought about by the collapse of currencies and bank lending in Asian countries
which, as a result, can no longer afford or finance the purchase of U.S.-made products. Declining
exports and accelerating imports have begun to hit U.S. manufacturing employment, which has
been weak for most of this year. In May and June, this weakness yielded to outright employment
declines totaling 51,000 jobs.
Evidence is mounting, moreover, that the worsening of the nation's trade position and the
declines in manufacturing employment may already have triggered a marked slowdown or even
contraction in the U.S. economy.
In view of the time lag between changes in monetary policy and their impact on the
economy, it would be far better to lower U.S. interest rates now than to wait for the East Asian
economic crisis and the weakness in the U.S. economy to worsen. There is little downside to
lowering U.S. interest rates. Inflation remains tame, as the June figures for both the CPI and PPI
attest. Now is the time to lower interest rates, to ease the East Asian economic crisis and keep
the U.S. economy on course to, at long last, reaching the Humphrey-Hawkins Act's full
employment goal.





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