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For release on delivery 10 a m E D T July 20, 1994 Testimony by Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs United States Senate July 20, 1994 Mr Chairman and members of the Committee, I appreciate this opportunity to discuss with you recent economic developments and the Federal Reserve's conduct of monetary policy The favorable performance of the economy continued in the first half of 1994 Economic growth was strong, unemployment fell appreciably, and inflation remained subdued To sustain the expansion, the Federal Reserve adjusted monetary policy over recent months so as to contain potential inflation pressures Our actions this year can be understood by reference to policy over the previous several years Through that period, the Federal Reserve moved toward and then maintained for a considerable time a purposefully accommodative stance of policy During 1993, that stance was associated with low levels of real short-term interest rates--around zero We judged that low interest rates would be necessary for a time to overcome the effects of a number of factors that were restraining the economic expansion, including heavy debt burdens of households and businesses and tighter credit policies of many lenders By early this year, however, it became clear that many of these impediments had diminished and that the economy had consequently gained considerable momentum In these circumstances, it was no longer appropriate to maintain an accommodative policy Indeed, history strongly suggests that maintenance of real short-term rates at levels prevailing last year ultimately would have fueled inflationary pressures Accordingly, the Federal Open Market Committee at its meeting in early February decided to move away from its accommodative posture by tightening reserve market conditions Given the level of real short-term rates and the evident momentum in the economy, it seemed likely that a substantial cumulative adjustment of policy would be -2- needed However, Committee members recognized that financial markets were not fully prepared for this action About five years had passed since the previous episode of monetary firming, and a number of market participants in designing their investment strategies seemed to give little weight to the possibility that interest rates would rise, instead, many apparently extrapolated the then-recent, but highly unusual, extended period of low short-term interest rates, fairly steady capital gains on long-term investments, and relatively stable conditions in financial markets concerned that a marked shift m Many Committee members were the stance of policy, while necessary, could precipitate an exaggerated reaction in financial markets With this in mind, we initially tightened reserve conditions only slightly-- just enough to raise the federal funds rate 1/4 percentage point And the financial markets did indeed react sharply, with substantial increases in longer-term interest rates and declines in stock prices Markets remained unsettled for several months, and we continued to move cautiously in March and April in the process of moving away from our accommodative stance By mid-May, however, a considerable portion of the adjustment in portfolios to the new rate environment appeared to have taken place With financial markets evidently better prepared to absorb a larger move, the Federal Reserve could substantially complete the removal of the degree of monetary accommodation that prevailed throughout 1993 The Board raised the discount rate 1/2 percentage point, a move that was fully passed through to reserve market conditions by the FOMC Overall, the federal funds rate increased 1-1/4 percentage points during the first half of the year, and real short-term rates likely rose a similar amount Partly to minimize any market confusion about the extent of -3- and rationale for our moves, the Federal Reserve has announced each action and, in relevant instances, provided an explanation At its meeting in early July, the FOMC faced considerable uncertainty about the pace of expansion and pressures on prices going forward, and it made no further adjustment in its policy stance Nonetheless, it is an open question whethei our actions to date have been sufficient to head off inflationary pressures and thus maintain favorable trends in the economy Labor demand has been quite strong, pointing to robust growth in production and incomes To be sure, some hints of moderation in the growth of domestic final demand have appeared, and the recent indications of accelerating inventory accumulation may suggest an unwanted backing up of stocks Conversely, the inventory accumulation may reflect pressures on firms who had brought inventories down to suboptimal levels and now need to replenish them In the latter case, stock-building may continue at an above-normal rate, supporting production for quite some time Moreover, the improving economic conditions of our trading partners should add impetus to aggregate demand from the external sector How these forces balance out in the coming months could be critical in determining whether inflation will remain in check, for the amount of slack in the economy, while difficult to judge, appears to have become relatively small Concerns that productive capacity could come under pressure and prices accelerate are already evident in commodity and financial markets, including the foreign exchange market An increase of inflation would come at considerable cost We would lose hard-won ground in the fight against inflation expectations --ground that would be difficult to recapture later, our long-run economic performance would be impaired by the inefficiencies associated with higher inflation if it persisted, and harsher policy -4- actions would eventually be necessary to reverse the upsurge in inflationary instabilities We are determined to prevent such an outcome, and currently are monitoring economic and financial data carefully to assess whether additional adjustments are appropriate The economic figures that have formed the backdrop for our policy actions so far this year confirm that a rapid expansion has been in progress Following growth at an annual rate of 7 percent in the fourth quarter of last year, real gross domestic product rose at nearly a 3-1/2 percent rate m the first quarter A conceptually equivalent measure of aggregate output, gross domestic income exhibited even larger g a m s in the fourth and first quarters At this stage, available data leave some uncertainty regarding the pace of economic activity over the past three months Nonetheless, the evidence in hand makes it reasonably clear that growth remained appreciably above its longer-run trend The robust expansion over the first half of 1994 has been reflected in substantial increases in employment Since last December, nonfarm payrolls have risen by 1-3/4 million workers, bringing the gain in jobs since the expansion got underway to 5 million Reflecting this hiring, the civilian unemployment rate has fallen to 6 percent Although labor markets have tightened considerably in recent months, aggregate measures of wage and compensation rates have not yet evidenced persuasive signs of acceleration Similarly, the increases in the consumer price index excluding food and energy, at about a 3 percent rate over the last six months, have remained near last year's pace, while the overall CPI has risen at a reduced rate of about 2-1/2 percent To be sure, price pressures have been manifest at earlier stages of processing Costs of many commodities and materials have been climbing, in some cases reflecting the tightening of industrial -5- capacity utilization, which is now at its highest level in five years But these pressures have been offset by favorable trends in unit labor costs resulting from marked improvements in productivity--especially in manufacturing-- in recent years The accumulating evidence of stronger-than-expected economic growth here and abroad, combined with changing expectations of policy actions by the Federal Reserve as well as other central banks, prompted considerable increases in long-term interest rates in occasionally volatile markets over the first half of the year Market participants concluded that, with aggregate demand stronger, higher real rates would be necessary to hold growth to a sustainable pace Inflation expectations may also have been revised higher as the performance of the economy seemed to make further near-term progress against inflation less likely and raised questions about whether price pressures might intensify To a degree, the very volatility of markets probably augmented the backup in long-term interest rates One of the effects of the extended market rallies of recent years was to promote a rather complacent view among investors about the risks of holding long-term assets In response they gradually increased the proportions of their portfolios devoted to stocks and bonds, driving up their prices still further and narrowing risk spreads But when developments earlier this year surprised investors and diminished their confidence in predicting future market conditions, they pulled back from long positions in securities until returns rose to compensate them for the additional price risk The recent weakness in bond prices was not limited to the United States, but was accompanied by a surge in foreign interest rates This surge was particularly informative, ordinarily one would -6- expect that as interest rates go up in one country, they would not increase to the same extent in others because exchange rates also would be expected to adjust The initial jump in foreign interest rates was a sign of the extraordinary increase in uncertainty as, evidently investors attempted to reduce their price-sensitive long positions by selling stocks and bonds regardless of currency denomination or economic conditions in the country of issuance Roughly concurrently, moreover, signs that the slump in some foreign industrial economies was ending also were becoming apparent As a result, market participants anticipated stronger credit demands abroad and a reduced likelihood of further easing by some foreign central banks, and intermediate- and longer-term rates in many of our trading partners rose as much as or more than in the United States Rising foreign interest rates, concerns in markets about the prospects for reduced trade tensions and about U S inflation contributed to considerable activity directed at rebalancing international investment portfolios One effect of this activity appears to have been a substantial decline of the foreign exchange value of the dollar on net over the past six months Foreign exchange rates are key prices in the American economy, with significant implications for the volumes of exports and imports as well as for the prices of imports and domestically produced items that compete with imports The foreign exchange value of the dollar also can provide useful insights into inflation expectations If we conduct an appropriate monetary policy--and appropriate economic policies more generally--we shall achieve our goals of solid economic growth and price stability, and such economic results will ensure that dollardenominated assets remain attractive to global investors, which is -7- essential to the dollar's continuing role as the world's principal reserve currency Rising interest rates and considerable volatility in financial markets do not seem to have slowed overall credit flows this year At about a 5-1/4 percent annual rate through May, domestic nonfinancial sector debt has increased within its 4-to-8 percent monitoring range The composition of debt growth, however differed from the patterns of the previous few years has Expansion of federal debt has slowed as the actions of the Congress and the Administration as well as cyclical forces have narrowed the budget deficit considerably The total debt of businesses, households, and state and local governments, by contrast, has risen this year at a brisker pace, though growth has remained quite moderate in comparison with the average experience of recent decades The pickup this year indicates both that private borrowers have become less cautious about taking on debt and that lenders have become more comfortable lending to them Although household debt-income ratios remain high, debt- service burdens have fallen appreciably, partly reflecting the refinancing of mortgages at lower interest rates The lower debt burdens evidently have fostered a more favorable attitude toward credit among households, and consumer installment borrowing has accelerated, with strong growth of consumer loans at banks Banks have been increasingly willing to extend credit, easing their terms and standards on business loans considerably In addition, some firms have turned to banks for financing because of the turbulence in bond and stock markets this spring Total bank lending has strengthened materially and, with continued acquisitions of securities, total bank credit has picked up as well Nonetheless, growth of the monetary aggregates remains damped, as banks have relied heavily on non-deposit sources of funds to finance loan growth Expansion of M2 has been quite slow this year, leaving this aggregate near the lower end of its l-to-5 percent annual range M3 actually has edged down, and thus is just below its 0-to-4 percent range for 1994 The weakness in the broader aggregates has not been reflected in the growth of income again this year, representing a continuation of the substantial increases in velocity that we have experienced over the past few years behavior, however The factors behind this have changed somewhat The diversion of savings funds from deposits to bond and stock mutual funds, which sharply depressed money growth in past years, seems to have slowed substantially, the experience with capital losses this spring apparently has heightened some investors' appreciation of the risks of such instruments On the other hand, rising short-term market Interest rates, combined with the usual lag in the adjustment of deposit rates, have been a significant restraint on growth of the aggregates this year, in contrast to 1992 and 1993 The increases in market rates this year have exerted a particular drag on the narrower monetary aggregates, as well as on the closely related reserves and monetary base measures Ml has expanded at only a 4 percent rate so far this year, compared with 10-1/2 percent increases in each of the previous two years Mi's velocity has continued to fluctuate sharply, limiting its usefulness in formulating and interpreting monetary policy The growth of Ml this year would have been even lower were it not for continued heavy demands for U S currency abroad Flows of currency overseas have an even greater effect proportionately on the monetary base, which -9- has growth rapidly this year despite declines in the reserves of depository institutions In reviewing its ranges for money growth in 1994, the FOMC noted that further increases in velocity of M2 and M3 were likely Although yields on deposits will probably continue to rise further in lagged response to increases in market rates, the wider rate disadvantage of deposits is likely to persist, and savers will continue to redirect flows into market instruments As a result, growth of both aggregates near the lower bounds of their 1994 ranges is considered to be consistent with achieving our objectives for economic performance, and the ranges were left unchanged The Committee also decided on a provisional basis to carry forward the current ranges for the monetary aggregates to 1995 We were not confident that we could predict with sufficient accuracy the money - income relationships that were likely to prevail next year to modify the ranges Moreover, further permanent reductions of the monetary ranges did not seem necessary, as those ranges are already low enough to be consistent with the goal of price stability and maximum sustainable economic growth, assuming an eventual return to more stable velocity behavior From that point of view, we felt that maintenance of the current monetary ranges would give the clearest indication of the long-run intentions of policy Regarding domestic nonfmancial sector debt, we made no adjustment to this year's monitoring range, but elected to set a provisional monitoring range for 1995 of 3 to 7 percent, a percentage point lower than this year's A lower range would conform with some deceleration in nominal income, in the process of containing inflation and ultimately making progress toward price stability The reduction is not intended to signal an increased emphasis on the debt measure, -10- but it is supported by our view that rapid debt growth, if sustained, can eventually lead to significant imbalances that are inimical to stable, nonmflationary growth As usual, we shall review carefully all of the provisional ranges for 1995 in February Given the rapid pace of financial change, considerable uncertainties continue to attend the relationships of all of the aggregates to the performance of the economy and inflation, and we do not expect in the near term to increase the weight accorded in policy formulation to these measures However, the processes of portfolio reallocation that have generated these recent shifts may be slowing We shall continue to monitor monetary growth, and financial flows more generally, for information about the course of the economy and prices in coming to decisions regarding adjustments to the stance of monetary policy We expect that expansion of money and credit within the ranges we have established will be consistent with continuation of good economic performance With appropriate monetary policies, the Board members and Reserve Bank Presidents see the economy settling into more moderate rates of growth over the next six quarters and inflation remaining relatively subdued Specifically the central tendencies of our forecasts are for real GDP to expand 3 to 3-1/4 percent over 1994 and 2-1/2 to 2-3/4 percent next year The consumer price index is projected to increase 2-3/4 to 3 percent this year In 1995, inflation may be about the same as in 1994 or slightly higher, the recent depreciation in the dollar is likely to put upward pressure on inflation over the next year if it is not reversed With the pace of hiring likely to about match that of labor force growth, the unemployment rate is expected to remain close to its recent level -11- Mr 1996 Chairman, you also asked for economic projections for I fully appreciate your purpose in requesting this information However, my colleagues and I don't think we can best communicate our policy intentions through additional numerical forecasts Rather, we believe our intentions are best conveyed in terms of our declared objective of fostering as much growth of output and employment as can be achieved without placing destabilizing inflationary pressures on productive resources There is considerable uncertainty about what that goal implies for the expansion of GDP and rates of unemployment That said, it may be useful to note that the assumptions underlying the medium-term projections provided to you by the Administration and the Congressional Budget Office (CBO) are within the mainstream of thinking among academics and private business economists These projections do not attempt to anticipate cyclical movements, but instead represent estimates of the likely performance of the economy in the neighborhood of its potential The Administration, for example, projected in its most recent forecast that the economy will expand at a 2 5 percent rate in the second half of the 1990s and unemployment will average 6 1 percent These projections are consistent with common estimates of the economy's potential growth rate and fall within the range of typical estimates of the so-called "natural rate" of unemployment Uncertainties around these estimates arise because identifying economic relationships is always difficult, partly owing to limitations of the data But more fundamentally, all policymakers recognize that notions of potential GDP growth and the natural rate of unemployment are considerable simplifications, useful in conceptual models but subject to a variety of real-world complications Our economy is a complex, dynamic system, comprising countless and diverse -12- households, firms, servxces multitude of markets products, and prices, interacting in a Estimates of macroeconomic relationships, as best we can make them, are useful starting points for analysis --but they are just starting points Given questions about the aggregate relationships, policymakers need to look below the surface, in markets themselves, for evidence of tightness that might indicate whether inflationary pressures are indeed building One important source of such evidence is the reports we receive from our Reserve Banks through their extensive contacts in their communities These reports are released to the public in the "beige book" and are updated-- frequently on the basis of confidential information from individual firms and financial institutions --by the Reserve Bank officials at our meetings and through normal intermeeting communications Another source of useful information is individual industries and trade groups, which provide many timely indicators that are sensitive to supply-demand conditions in particular sectors If the economy were nearing capacity, we would expect to see certain patterns in the statistical and anecdotal information with increasing frequency and intensity Reports of shortages of skilled labor, strikes, and instances of difficulties in finding workers in specific regions all would be more likely workers To attract additional employers would presumably step up their use of want-ads and might begin to use nonstandard techniques, such as signing or recruiting bonuses More firms might choose to bring on less skilled workers and train them on the job All of these steps in themselves could add to costs and suggest developing inflationary imbalances firms experienced difficulty in expanding production to meet rising demand, we would also expect to see increasingly frequent signs of As -13- shortages of goods as well as labor in obtaining certain materials Businesses might have difficulty Vendor performance would deteriorate, and lead times on deliveries of new orders would increase Pressures on supplies of materials and commodities would be reflected in rising prices of these items Of course, we would not expect to see these phenomena occur simultaneously throughout the economy-- quite the contrary And, to a degree, these symptoms occur in a few sectors even in noninflationary economies But a noticeable step-up in their incidence could constitute evidence of an incipient inflationary process In recent months, we have seen some of these signs There are reports of shortages of some types of labor--construction workers and truck drivers, for instance Indexes of vendor performance have deteriorated considerably, and manufacturers are paying higher prices for materials used in their production processes As yet, these sorts of indications do not seem to be widespread across the economy Nonetheless, we shall need to be particularly alert to these emerging signs in considering further adjustments to policy in the period ahead Financial flows may also impart useful warnings of price pressures For example, persistent unsustainably low real interest rates might prompt very rapid credit growth, as expectations of price increases led households and firms to accelerate purchases of durable goods and equipment and finance these expenditures by stepping up the pace of borrowing Although consumer borrowing has accelerated considerably of late, overall debt growth has so far remained moderate In light of the uncertainties about aggregate measures of our economic potential, the Federal Reserve cannot rely heavily on any one -14- estimate of either the natural rate of unemployment or potential GDP growth Most important, we have no intention of setting artificial limits on employment or growth Indeed, the Federal Reserve would be pleased to see more rapid output growth and lower unemployment than projected by forecasters such as the CBO and the Administration-provided they were sustainable and consistent with approaching price stability I should note, however, that most Federal Reserve policymakers would not regard the inflation projections of these other forecasters, which generally do not foresee further progress toward price stability over the medium term, as a desirable outcome A more significant issue for economic policymakers than the precise values of such estimates is what can be done to maximize sustainable employment and economic growth We need, for example, to give careful attention to the problem of unemployment, as noted by the G-7 leaders at their recent summit We could raise output and living standards around the world and at the same time ease many social problems if more people were working Here at home, nearly eight million Americans are looking for work At this stage of the business cycle--having experienced almost forty months of expansion and particularly strong growth recently--most of this unemployment probably is not due to a shortfall in aggregate demand Rather, a good deal of it is likely "frictional," reflecting the ordinary process of workers moving between jobs, or "structural," resulting from longer-term mismatches between workers and available jobs Monetary policy, which works mainly by influencing aggregate demand, is not suited to addressing such problems But we ought to be encouraging other measures to increase the flexibility of our workforce and labor markets Improving education and training and facilitating better and more rapid matching of workers with jobs are -15- essential elements in making more effective use of the U S force labor Just as important, Congress should avoid enacting policies that create impediments to the efficient movement of individuals across regions, industries, and occupations, or that unduly discourage the hiring of those seeking work Competitive markets have shown a remarkable ability to create rising standards of living when left free to function Congress and the Administration also can continue to contribute to the growth of our economy's capital and productivity through a sound fiscal policy The extension of the spending caps in last year's budget agreement was a significant step in putting fiscal policy on a more sustainable long-run path Budget deficit reduction has proved to be particularly timely, by reducing the government's claim on savings just as households and firms are seeking more capital to finance investments But under current law, the deficit as a percent of GDP will begin to expand again as we move into the next century, with unacceptable consequences for financial stability and economic growth The primary cause of this increase will be federal outlays, which will almost surely again be rising at a pace that will exceed the growth of our tax base Only by reducing the growth in spending is ultimate balance achievable As I have emphasized many times, the Federal Reserve also can contribute to the achievement of our overriding goal--maximum sustainable economic growth--by pursuing and ultimately achieving a stable price level Without the uncertainties engendered by inflation, households and firms are better able to plan for the future And firms focus on maximizing profitability by holding down costs and increasing productivity rather than by using inflationary conditions to support price increases There is some evidence to -16- suggest that the stronger trend of productivity growth we have witnessed over the recent past is due at least partly to the beneficial effects of low rates of inflation Our nation has made considerable progress in putting the economy on a sound footing in the past few years To preserve and extend these advances, our monetary and fiscal policies will need to remain disciplined and focused on our long-term objectives, we would be foolish to squander our recent gains for near-term benefits that would prove ephemeral Indeed, by fostering progress toward price stability, achieving lower federal budget deficits, and encouraging competitive markets both here and abroad, we will help ensure the continued vitality of our nation's economy now and for many years into the future
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