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For release on delivery 2 00 p ID E S T February 20, 1996 Statement by Alan Greenspan Chairman Board of Governors of the Federal Reserve System before the Subcommittee on Domestic and International Monetary Policy Committee on Banking and Financial Services U S House of Representatives February 20, 1996 I appreciate the opportunity to appear before this Committee to present the Federal Reserve's semiannual report on monetary policy The United States economy performed reasonably well in 1995 One-and-three-quarter million new jobs were added to payrolls over the year, and the unemployment rate was at the lowest sustained level in five years Despite the relatively high level of resource utilization, inflation remained well contained, with the consumer price index rising less than 3 percent--the fifth year running at 3 percent or below A reduction in inflation expectations, together with anticipation of significant progress toward eliminating federal budget deficits, was reflected in financial markets, where long-term interest rates dropped sharply and stock prices rose dramatically over the year This outcome was influenced in part by monetary policy actions taken by the Federal Reserve in recent years Responding to evidence that inflationary pressures were building, we progressively raised short-term interest rates over 1994 and early 1995 Rates had been purposely held at quite low, stimulative levels in 1993 We moved in 1994 to levels more consistent with sustainable growth Our intent was to be preemptive--to head off an incipient increase in inflationary pressures and to forestall the emergence of imbalances that so often in the past have undermined economic expansions As we entered the spring of 1995, it became increasingly evident that our policy was likely to succeed Although various price indexes were rising a bit more rapidly, there were indications that pressures would not continue to intensify, and might even reverse to a degree Moderating overall demand growth left businesses with excess inventories In response, firms initiated production cutbacks to prevent serious inventory imbalances, and the growth of economic -2- activity slowed substantially With inflation pressures apparently receding, the previous degree of restraint in monetary policy was no longer deemed necessary, and the Federal Open Market Committee consequently implemented a small reduction in reserve market pressures last July During the summer and early fall, aggregate demand growth strengthened As a result, business stocks of raw materials and finished goods appeared somewhat better aligned with sales In sum, the economy, as hoped, appeared to have moved onto a trajectory that could be maintained-- one less steep than in 1994, when the rate of growth was clearly unsustainable, but one that nevertheless would imply continued significant growth in employment and incomes Importantly, the performance of the economy seemed to be consistent with maintaining low inflation Despite the step-up in growth and the relatively high levels of resource utilization, measured inflation abated a little, and many of the signs that had been pointing toward greater price pressures gradually disappeared Expectations of both near- and longer-term inflation fell substantially over the second half of the year, as gauged by survey results as well as by the downward movements in longer-term interest rates The fall in bond rates was also encouraged by improving prospects for significant progress in reducing the federal budget deficit The declines in actual and expected inflation meant that maintaining the existing nominal federal funds rate would raise real short-term interest rates, implying a slight effective firming in the stance of monetary policy Such a shift would have been particularly inappropriate because economic growth near the end of the year seemed to be slowing, and some FOMC members were concerned about the risks of -3- prolonged sluggishness Consequently, the Committee decided in December that a further reduction in the funds rate was warranted Information becoming available in late December and January raised additional questions about the prospective pace of expansion The situation was difficult to judge, partly because economic statistics were more sparse than usual, owing mainly to the government shutdowns In addition, harsh weather in January disrupted both data flows and patterns of economic activity But several indicators-- including initial claims for unemployment insurance, purchasing managers' surveys, and consumer confidence measures --appeared to signal some softening in the economy Consonant with this pattern, some Reserve Bank Presidents reported that they seemed to be detecting anecdotal indications of weakness in the expansion within their districts with somewhat greater frequency than previously Moreover, growth in several of our major trading partners seemed to be lagging, which could tend to moderate demand for exports A number of factors have prompted the recent tendency toward renewed weakness Some are clearly quite transitory-- related, for example, to bad weather or the Federal government shutdown may be somewhat more significant, but still temporary Others The constraint on government spending while permanent budget authorizations are being negotiated is one Another may be a temporary reduction in output in some industries as businesses have further adjusted inventories to disappointing sales As I noted last July, the change in the pace of inventory investment when the economy shifts gears can be substantial Inventory investment surged in 1994 and into the early months of 1995, but proceeded to fall markedly throughout the rest of the year This has placed significant downward pressure on output, which should lift -4- as inventory adjustments subside But for the moment, the pressures remain, in the motor vehicle industry and elsewhere Ultimately, of course, it is the path of final demand after the temporary influences work themselves out that determines the trajectory of the economy There are some factors, such as high consumer debt levels, that may be working to restrain spending But as I shall be detailing shortly, a number of fundamentals point to an economy basically on track for sustained growth, so any weakness is likely to be temporary Nonetheless, the Committee decided in late January that the evidence suggested sufficient risk of subpar performance going forward to warrant another slight easing of the stance of monetary policy Given the subdued trends in costs and wages, the odds that such a move would boost inflation pressures seemed low In assessing the likely course of the economy and the appropriate stance of policy, one question is the significance, if any, of the age of the business expansion Some analysts, viewing recent weakness, have observed that the expansion is approaching the start of its sixth year and is now one of the longer peacetime spans of growth in the past half century not necessarily die of old age Economic expansions, however, do Although the factors governing each individual business cycle are not always clear, expansions usually end because serious imbalances eventually develop When aggregate demand exceeds the economy's potential, for example, inflationary pressures pick up The inevitable increase in market interest rates, as inflation expectations rise and price pressures intensify, depresses final demand Lagging demand in turn sets off an inventory correction that frequently triggers a downturn in the economy As I noted, we acted in 1994 to forestall such a -5- process Monetary policy began to tighten in advance of the buildup of inflationary pressures and, at least to date, these pressures appear to have been held in check Capital expenditures by households and firms can also contribute significantly to the development of cycle-ending imbalances The level of stocks of such real assets have effects on output very similar to those of business inventories In typical cycles, capital expenditures tend to grow rapidly in the early stages of recovery Pent-up demands coming out of a recession by consumers and businesses are satisfied by rapid growth of spending on capital assets There is a limit, however, on, say, how many cars people choose to own, or how many square feet of floor space retailers need to service customers Spending on such assets generally tends to grow more slowly after the pent-up demand is met As with business inventories, the downshifting of spending on consumer durable goods or business plant and equipment may not occur smoothly The dynamics of expanding output and rising profit expectations often create a degree of exuberance which, as in much of human nature, tends on occasion to excess--in this case, in the form of a temporary over-accumulation of assets The ensuing correction in demand for such assets triggers production adjustments that can significantly mute growth for a time or even cause a downturn if the imbalances are large enough The current extent of any asset overhang is difficult to determine The growth of demand for durables and some categories of capital goods evidently has slowed, but the available evidence does not suggest a degree of saturation in capital assets that would tip the economy into a downturn Moreover, financial conditions are likely to be generally supportive of spending The low level of long-term interest rates -6- should have an especially favorable effect Low rates increase the affordability of housing for consumers and foster investment in productive plant and equipment by businesses The decline in interest rates also has contributed to a pronounced rise in stock prices The spread of mutual fund investments has meant that the gain in wealth as financial asset prices have risen has been shared by an ever-wider segment of households These developments should tend to counter, in part, the depressing effects on spending of rising debt burdens In addition, with the condition of most financial institutions strong, lenders are likely to remain willing to extend credit to firms and households on favorable terms We have seen some move by lenders toward tighter standards, but these actions are a modest correction after a marked swing toward ease and should not constrain the availability of funds to creditworthy borrowers Against this backdrop, Federal Reserve policymakers expect the most likely outcome for 1996 as a whole is further moderate growth On the new chain-weighted basis, the central tendency of the forecasts of Board members and Reserve Bank Presidents is for real gross domestic product to expand 2 to 2-1/4 percent on a fourthquarter to fourth-quarter basis, similar to the Administration's outlook With output expanding roughly in line with standard estimates of the increase in the productive capacity of the economy, the unemployment rate is expected to remain around recent levels, as is also forecast by the Administration The Federal Open Market Committee expects a continuation of reasonably good inflation performance in 1996 The success during 1995 in keeping the increase in the consumer price index below 3 percent in the fifth year of an expansion illustrates that an extended period of growth with low inflation is possible And most on the -7- Committee anticipate consumer price inflation at or somewhat below 3 percent in 1996 Although well-known biases in the CPI, as well as the more favorable price performance of business equipment, which is not included in that index, indicate that the true rate of inflation for the whole economy would be significantly lower than 3 percent, the Committee recognized that its expectations for inflation do not imply that price stability has as yet been reached Nonetheless, keeping inflation from rising significantly during economic expansions will permit a gradual ratcheting down of inflation over the course of successive business cycles that will eventually result in the achievement of price stability To emphasize its continued commitment to price stability, the Committee chose to reaffirm the relatively low ranges for money growth in 1996 that it had selected on a provisional basis last July These ranges are identical to those employed in 1995--1 to 5 percent for M2 and 2 to 6 percent for M3 percent range for debt The Committee also reaffirmed the 3 to 7 Patterns of money growth and velocity have been erratic in recent years, but should the monetary aggregates at some point re-establish their previous trend relationships with nominal income, average growth near the center of these ranges should be consistent with the eventual achievement of price stability Determining whether further changes to the stance of monetary policy will be necessary in the months ahead to foster progress toward our goals will be a continuing challenge In formulating monetary policy, while we have in mind a forecast of the most likely outcome, we must also evaluate the consequences of other possible developments Thus, it is sometimes the case that we take out monetary policy "insurance" when we perceive an imbalance in the net costs or benefits of coming out on one side or the other of the most probable scenario For example, in our most recent actions, we saw a decline in the federal funds rate as not increasing inflationary risks unacceptably. while addressing the downside risks to the most likely forecast In assessing the costs and benefits of adjustments to the stance of policy, members of the Committee recognize that policy affects the economy and inflation with a lag and thus needs to be formulated with a focus on the future Over the past year, we have kept firmly in mind our goals of containing inflation in the near term and moving over time toward price stability, and they will continue to guide us in the period ahead Structural forces may be assisting us in this regard Increases in producers' costs and in output prices proved to be a little lower last year than many had anticipated While it is too soon to draw any definitive conclusions, this experience provides some tentative evidence that basic, ongoing changes In the structure of the economy may be helping to hold down price pressures These changes stem from the introduction of new technologies Into a wide variety of production processes throughout the economy Successive generations of these new technologies are being quickly embodied in the nation's capital stock and older technologies are, at a somewhat slower pace, being phased out As a consequence, the nation's capital stock Is turning over at an increasingly rapid pace, not primarily because of physical deterioration but reflecting technological and economic obsolescence The more rapid advance of Information and communications technology and the associated acceleration in the turnover of the capital stock are being mirrored in a brisk restructuring of firms In line with their adoption of new organizational structures and technologies, many enterprises are finding that their needs for -9- various forms of labor are evolving just as quickly In some cases, the job skills that were adequate only five years ago are no longer as relevant Partly for that reason, most corporate restructurings have involved a significant number of permanent dismissals The phenomenon of restructuring can be especially unfortunate for those workers directly caught up in the process Many dedicated, long-term workers In all types of American businesses--including longestablished, stable, and profitable firms--have been let go An important consequence of the layoffs and dismissals associated with restructuring activity Is a significant and widely reported Increase in the sense of job insecurity Concern about employment has been manifested in unusually low levels of indicators of labor unrest low last year Work stoppages, for example, were at a fifty-year And contract negotiators for labor unions have sought to obtain greater job security for their members through very longterm labor contracts, including some with virtually unprecedented lengths of five or six years Of particular relevance to the inflation outlook, the sense of job insecurity is having a pronounced effect in damping labor costs For example, the increase in the employment cost index for compensation in the private sector, which includes both wage and salary payments and benefit costs, slowed further in 1995, to 2-3/4 percent, despite labor market conditions that, by historical standards, were fairly tight With productivity also expanding, the increase in unit labor costs was even lower In manufacturing, such costs have actually been falling in recent years While the link between labor costs, which account for two-thirds of consolidated business sector costs, and prices is not rigid, these very limited -10- increases in labor expenses nonetheless constitute a significant restraint on inflation In addition to its effect on labor costs, the more rapid pace of technological change is reducing business costs through other channels Initially most important, the downsizing of products resulting from semiconductor technologies, together with the Increasing proportion of national output accounted for by high-tech products, has reduced costs of transporting the average unit of GDP Quite simply, small products can be moved more quickly and at lower cost More recently, dramatic advances in telecommunications technologies have lowered the costs of production for a variety of products by slashing further the information component of those costs Increasingly, the physical distance between communications endpomts is becoming less relevant in determining the difficulty and cost of transporting information Once fiber-optic and satellite technologies are in place, the added resource cost of another 200 or 2,000 miles is often quite trivial As a consequence, the movement of inputs and outputs across geographic distance is progressively becoming a smaller component of overall business expenses, particularly as intellectual-and therefore immaterial--products become proportionately more important in the economy This enables an average business firm to broaden markets and sales far beyond its original domicile Accordingly, fixed costs are spread more widely For the world market as a whole, the specialization of labor is enhanced to the benefit of standards of living of all market participants To be sure, advancing technology, with its profound implications for the nature of the economy, is nothing new, and the pace of improvement has never been even But it is possible that we -11- may be in the midst of a quickening of the process It is possible that the rate at which earlier computer technologies are being applied to new production processes is still increasing This would explain the recent decline in the growth of unit costs Nonetheless, we have to be careful in projecting a further acceleration in the application of technology indefinitely into the future, as would be required for technological change to depress the rate of increase in unit business costs even more Similarly, suppressed wage cost growth as a consequence of job insecurity can be carried only so far At some point in the future, the tradeoff of subdued wage growth for job security has to come to an end While it is difficult to judge the time frame on such adjustments, the risks to cost and price inflation going forward are not entirely skewed to the downside, especially with the economy so recently operating at high levels of resource utilization In light of the quickened pace of technological change, the question arises whether the U S economy can expand more rapidly on an ongoing basis than the 2 to 2-1/4 percent range for measured GDP forecasted for 1996 by government agencies and most private forecasters without adding to inflationary pressures, which in turn would undermine growth The Federal Reserve would certainly welcome faster growth-- provided that it is sustainable The particular rate of maximum sustainable growth in an economy as complex and ever-changing as ours is difficult to pin down Fortunately, the Federal Reserve does not need to have a firm judgment on such an estimate, for persistent deviations of actual growth from that of capacity potential will soon send signals that a policy adjustment is needed Should the nation's true growth potential exceed actual growth, for example, the disparity and lessened strain -12- would be signaled in shorter lead times on the delivery of materials, declining overtime, and ebbing inflationary pressures Conversely, actual growth in excess of the economy's true potential would soon result in tightened markets and other distortions which, as history amply demonstrates, would propel the economy into recession Consequently, we must be cautious in reaching conclusions that growth in productivity and hence of potential output has as yet risen to match the evident step-up in technological advance The hypothesis that advancing technology has enhanced productivity growth would be more persuasive if national data on productivity increases showed a distinct improvement To a degree, the lack of any marked pickup may be a shortcoming of the statistics rather than a refutation of the hypothesis Faulty data could be arising in part because business purchases are increasingly concentrated in items that are expensed but which market prices suggest should be capitalized Growing disparities between book capital and its valuation in equity markets may in part reflect widening effects of this misclassification If this problem is indeed growing, we may be underestimating the growth of our GDP and productivity This classification problem compounds other difficulties with measuring output in the increasingly important service sector The output of services --and the productivity of labor in that sector--is particularly hard to measure In part, the statisticians have simply thrown up their hands, gauging output in some service industries just in terms of labor input By construction, such a procedure will miss improvements in productivity caused by other inputs In manufacturing, where output is more tangible and therefore easier to -13- assess, measured productivity has been rising briskly, suggesting that technological advances are indeed having some effect Nonetheless, there is still a nagging inconsistency The evidence of significant restructurings and improvements in technology and real costs within business establishments does not seem to be fully reflected in our national productivity measurements It is possible that some of the frenetic pace of business restructuring is mere wheel spinning-- changing production inputs without increasing output-- rather than real increases in productivity One cause of the wheel spinning, if that is what it is, may be that it takes some time for firms to adapt in such a way that major new technology is translated into increased output In an intriguing parallel, electric motors in the late nineteenth century were well-known as a technology, but were initially integrated into production systems that were designed for steam-driven power plants It wasn't until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, that firms were able to take full advantage of the synergies implicit in the electric dynamo, thus achieving dramatic increases productivity Analogously, existing production systems today to some degree cannot be integrated easily with new information and communication technologies Some existing equipment is not capable of control by computer, for example Thus, it may be that the full advantage of even the current generation of information and communication equipment will be exploited over a span of quite a few years and only after a considerably updated stock of physical capital has been put in place While the Federal Reserve does not need to establish -14- targets- - and definitely not limits--for long-term growth, it is helpful in coming to shorter-run policy insights to have some judgments about the growth in potential GDP in the past and what it is likely to be in the future are based on experience Judgments of potential, quite naturally, Through the four quarters of 1994, for example, real GDP, pressed by strong demand, rose 3-1/2 percent If that were the true rate of increase in the economy's long-run potential, then we would have expected no change in rates of resource utilization Instead, industrial capacity utilization rose nearly 3 percentage points and the unemployment rate dropped a percentage point Moreover, we began to see signs of strains on facilities, deliveries of materials slowed appreciably and factory overtime rose sharply These signs of developing pressures on capacity suggest that the growth rate in economic potential in 1994 was below 3-1/2 percent In general, as we get close to presumed potential, we are required to step up our surveillance for inflationary pressures Estimates of potential growth necessarily recognize that expansion in the economy over time comes essentially from three factors--growth in population, increases in labor force participation, and gains in average labor productivity Of these factors, the first two are determined basically by demographic and social factors and seem unlikely to change dramatically over the next few years Thus, the source of any significant pickup of output growth would need to be a more rapid pace of productivity growth Here, the uncertainty of the pace of conversion of rapid technological advance into productivity gains is crucial to the determination To be fully effective in achieving potential productivity improvements, technological innovations also require a considerable amount of human investment on the part of workers who have to deal -15- with these devices on a day-to-day basis not have progressed very far On this score, we still may Many workers still possess only rudimentary skills in manipulating advanced information technology In these circumstances, firms and employees alike need to recognize that obtaining the potential rewards of the new technologies in the years ahead will require a renewed commitment to effective education and training, especially on-the-job training This is especially the case if we are to prevent the disruptions to lives and the nation's capacity to produce that arise from mismatches between jobs and workers We need to improve the preparation for the job market our schools do, but even better schools are unlikely to be able to provide adequate skills to support a lifetime of work Indeed, the need to ensure that our labor force has the ongoing education and training necessary to compete in an increasingly sophisticated world economy is a critical task for the years ahead Our nation faces many important and difficult challenges in economic policy Nonetheless, we have made significant and fundamental gains in macroeconomic performance in recent years that enhance the prospects for maximum sustainable economic growth Inflation, as measured by the consumer price index, has been gradually reduced from a peak of more than 13 percent in 1979 to 2-1/2 percent last year Lower rates of inflation have brought a variety of benefits to the economy, including lower long-term interest rates, a sense of greater economic stability, an improved environment for household and business planning, and more robust investment in capital expenditures The years ahead should see further progress against inflation and the eventual achievement of price stability We have also made considerable progress on the fiscal front Over the past ten years and especially since 1993, our elected -16- political leaders, through sometimes prolonged and even painful negotiations, have been successful in reaching several agreements that have significantly narrowed the budget deficit be done But more remains to As I have emphasized many times, lower budget deficits are the surest and most direct way to increase national saving Higher national saving would help to reduce real interest rates further, promoting more rapid accumulation of productive capital embodying recent technological advances Agreement is widely shared that attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the nation's demographics m the first few decades of the next century Lower inflation and reduced budget deficits will by no means solve all of the economic problems we face But the achievement of price stability and federal budget balance or surplus will provide the best possible macroeconomic climate in which the nation can address other economic challenges
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