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Statement by

Alan Greenspan

Chairman, Board of Governors of the Federal Reserve System

before the

Committee on the Budget

U S

House of Representatives

March 2, 1989

Mr. Chairman, members of the Committee, it is a pleasure to
appear before you this morning to discuss economic policy, in the
context of the broad objectives that are relevant to both of us in our
respective spheres of policy making

I have provided our recent

Monetary Policy Report and I shall avoid consuming a lot of your time
discussing the details presented in that document

I believe that it

would be useful, however, if I were to review briefly where the economy
has been over the past year and where it appears to us to be going
This may help to bring into focus the challenges that face monetary and
fiscal policymakers

Principal among those challenges, in the view of

the Federal Reserve, is setting the stage for sustainable, balanced
growth, in part by preventing a corrosive inflationary psychology from
taking hold.

Fiscal as well as monetary policy has a role to play in

achieving that objective, and proceeding expeditiously is much more
likely to get the job done.
Overall, the past year has been a good one for the economy
In 1988, real GNP grew about 3-1/4 percent, adjusted for crop losses
caused by the drought, and payroll employment rose more than 3-1/2
million

Prospects had been uncertain as the year began, given the

worldwide stock market break in October 1987, but gradually, it became
clear that the economic expansion remained well on track and that market
confidence was on the mend.

Demand for goods and services was robust,

and sizable g a m s in employment and output pushed levels of resource
utilization still higher

The unemployment rate fell to, and then

below, 5-1/2 percent, the lowest level since the mid-1970s, and the

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average manufacturing capacity utilization rate rose to the highest
level since the late 1970s

As these developments unfolded, it became

clear that the balance of risks was shifting in the direction of higher
inflation

Consequently, the Federal Open Market Committee has applied

increased pressures on bank reserve positions, in a series of steps
beginning in the spring of 1988 and extending into this year

In

addition, the discount rate was raised from 6 to 6-1/2 percent in
August, and again last week to 7 percent
The policy restraint has led to an appreciable rise in
short-term market interest rates

Also, growth of money has moderated,

as rates on deposits lagged the rise in market rates

M2 and M3

finished the past year around the middle of their 4 to 8 percent annual
target ranges, and they have grown relatively slowly in recent months
Despite tightening money markets, longer-term interest rates
have been relatively stable

Yields on Treasury bonds, for example,

remained in a fairly narrow range around 9 percent for most of last year
and, although rising most recently, are still not much above 9 percent
With inflation expectations apparently fairly stable and the expansion
sustained, investments in the U S

have looked attractive; the dollar's

average value against major foreign currencies recovered from the late1987 plunge and has been relatively stable for many months
Some of the developments of the past year suggest, however,
that we still have work to do if we are to succeed in our task of
achieving the goals of balanced expansion and the reduced inflation
needed to sustain it

In the area of your direct interest, the federal

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budget, the deficit remains large
low

Meanwhile, private saving remains

The continued imbalance of domestic saving and investment is

mirrored in the persistent large trade and current account deficits
In addition, although overall inflation last year—in the area
of 4 to 4-1/2 percent—was only a little above the general range in
which it had fluctuated in the mid-1980s, underlying trends were
troubling

At the consumer level, the drought boosted food price

inflation in 1988, but this was more than offset in the aggregate
figures by a leveling off of energy prices
turning up

Now energy prices are

More fundamentally, prices of consumer goods and services

other than food and energy accelerated last year and this faster pace
extended into January.
Furthermore, some signs have emerged of greater pressures in
production costs
year.

Wage increases accelerated toward the end of last

Moreover, benefits took an unusually large jump in 1988, boosted

in part by a sharp rise in health insurance costs and a hike in social
security taxes—both of which add to business costs as directly as do
wages.

Overall, the employment cost index, a comprehensive measure of

hourly wage and benefit rates, rose 5 percent in 1988, up significantly
from 1987.

Materials inputs also were adding to costs, the producer

price index for intermediate materials and supplies excluding food and
energy has been rising at about a 7 percent annual pace for some time
The large increases in the producer finished goods and consumer price
indexes in January could be early warnings that the cost-price process
is gathering force

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At the same time, the economy generally remains vigorous

The

available data for January suggest that we moved into 1989 with
considerable upward momentum

Moreover, widespread inventory overhangs

or constricted profit margins, which typically have signaled the last
phases of expansions, are not apparent.

With the economy already

operating at high levels of labor and plant utilization, and given the
disturbing signs of strengthening price and cost pressures, the momentum
of expansion implies risks that clearly remain on the side of
accelerating inflation

It is just such an acceleration that could feed

the kind of imbalances that ultimately bring expansions to an end.

The

Federal Reserve's earlier money market tightening and the discount rate
action last week were taken to forestall such imbalances in order to
keep the economy on a more sustainable path toward price stability
The same determination to resist any pickup in inflation and
especially to move over time toward price stability shaped the
Committee's recent decisions with respect to target or monitoring ranges
for money and credit in 1989

To this end, the Committee lowered the

range for M2 by a full percentage point to 3 to 7 percent and reduced
the range for M3 by 1/2 percentage point to 3-1/2 to 7-1/2 percent

The

Committee also lowered the monitoring range for domestic nonfinancial
sector debt by 1/2 percentage point to 6-1/2 to 10-1/2 percent
The Federal Reserve expects its policy in 1989 to support
continued economic expansion, even while putting in place conditions for
a gradual easing in the rate of inflation over time

However, in light

of present conditions, the central tendency of forecasts made by members
of the Federal Reserve Board and presidents of Federal Reserve Banks is

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for inflation to rise slightly in 1989, with the CPI edging up to the
4-1/2 to 5 percent range
With restraint on inflation requiring that we limit pressures
on our productive resources, some slowing in the underlying rate of
growth of real GNP is expected in 1989

The central tendency of GNP

forecasts for this year of Board members and Reserve Bank presidents is
2-1/2 to 3 percent from the fourth quarter of 1988 to the fourth quarter
of 1989, abstracting from the expected rebound from last year's drought
losses, real GNP is projected to grow at closer to a 2 percent rate
Net exports are likely to continue to improve as we make further
progress on reducing our external imbalances, but this implies the need
for counterbalancing restraint on domestic demand

With demands for

labor growing more in line with expansion of the labor force, the
unemployment rate is expected to remain near its recent level during the
course of the year
Looking beyond a one-year horizon, the primary role of monetary
policy in the pursuit of the goal of maximum sustainable growth is to
foster price stability

By this we mean establishing an environment

where expected changes in the average price level are small enough and
gradual enough that they do not materially enter business and household
financial decisions

Price stability—indeed, even preventing inflation

from accelerating—requires that aggregate demand be in line with
potential aggregate supply
a monetary phenomenon

Inflation in the longer-term is essentially

But large budget deficits contribute to the

problem; they tend to put inordinate strains on financial markets and
they directly fuel excess demand on resources

Thus, in the present

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circumstances, fiscal policy can help to smooth our progress over the
next few years toward better price performance

Prompt and sustained

action is becoming increasingly urgent
The situation today differs markedly from that of the
mid-1980s, when the U S

economy was recovering from a deep recession

Then, with utilization of labor and capital still quite low, we were
able to bring these resources back into the production process at a pace
that substantially exceeded their underlying growth rates.

And in those

circumstances, the growth of real GNP could be relatively rapid while
the inflation performance was reasonably good.
But as a result of the robust expansion, the U S. economy has
absorbed much of its unused labor and capital resources

No one can say

precisely which level of resource utilization marks the dividing line
between accelerating and decelerating prices

However, the evidence—in

the form of direct measures of prices and wages—clearly suggests that
we are now in the vicinity of that line
Thus, the thrust of both monetary and fiscal policies in the
short run appropriately is more toward restraint than stimulus

The

extent and duration of the financial market pressures that are likely,
until overall demand moderation is achieved, will depend on the size and
credibility of deficit reducing measures

In this context, credibility

will be much enhanced by a multi-year approach to budget action
I am mindful that, owing to significant efforts by the
executive branch and the Congress, coupled with strong economic growth,
the deficit has shrunk from 5 to 6 percent of GNP a few years ago to
a bit over 3 percent today

And abstracting from the effects of

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economic expansion, the cyclically adjusted, or structural, deficit as a
share of potential GNP has fallen by 1-1/4
1986 peak
large

percentage points from its

Nonetheless, at about 3 percent, this share is still very

Since the end of World War II, the structural deficit has

exceeded 3 percent of potential GNP only since 1983
I am also mindful that the progress that has been made in
narrowing the structural deficit in the past two years is even greater
when we look only at the so-called "primary" portion of the deficit,
that is when interest costs are removed

Interest outlays, of course,

are now very large and their level will remain high as long as our stock
of Treasury debt remains large

Nevertheless, growth in the interest

component of the budget is volatile

It is spurred by large deficits,

but it also picks up when interest rates are rising and then subsides
when interest rates come down

For example, annual growth in interest

costs averaged around $13 billion from 1980 to 1985, but since then
has slowed to an average of about $7 billion per year
The most effective way to keep interest costs down is to
forestall another virulent burst of inflation expectations such as we
experienced a decade ago

Simple arithmetic tells us that a 1

percentage point increase in actual inflation raises the cost of indexed
programs by 1 percent

But if the faster rate of inflation were to

become embedded in expectations throughout the financial structure,
interest rates, and ultimately federal debt service costs, would rise by
more than 10 percent from their current levels

We are fortunate that

inflation expectations so far seem not to have worsened, and long-term
interest rates have risen little in the past year despite a tightening

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in money markets

Both fiscal and monetary policies have a role to play

in maintaining this situation
For the longer-term, fiscal policy also has a special
contribution to make in promoting growth in our production or supply
capabilities.

Reducing the deficit is the surest way to raise national

saving, thereby lowering the average level of real interest rates,
boosting domestic investment and reducing our reliance on foreign
capital

The federal deficits of recent years are threatening precisely

because they have been occurring in the context of private saving that
is low by both historical and international standards.

In the 1980s,

net personal plus business saving in the United States has been about 2
percentage points lower relative to GNP than its average in the
preceding three decades.

Internationally, government deficits have been

quite common among the major industrial countries in the 1980s, but
private saving rates in most of these countries have exceeded the
deficits by very comfortable margins

In Japan, for example, about 15

percent of its private saving is estimated to have been absorbed by
government deficits, even though the Japanese general government has
been borrowing over 2-1/2 percent of its gross domestic product in the
1980s

In contrast, about half of private U.S. saving in the 1980s has

been absorbed by the combined deficits of the federal and state and
local sectors.
Under these circumstances, such large and persistent deficits
are slowly but inexorably damaging the economy

The damage occurs

because deficits, which must be financed regardless of the level of
interest rates, tend to pull resources away from interest elastic

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private investment.

When the pool of private saving is small, federal

deficits and private investment tend to be forced into competition and
private investment loses

To the extent that more resources are

demanded than are available to be financed, interest rates will rise
until sufficient excess demand is crowded out of the private sector
In the short run, the Federal Reserve can hold down nominal
interest rates but the result largely would be more inflation, with
little or no lasting effect on real interest rates and the allocation of
real resources

All else equal, any crowding out of productive

investment damps the growth of the nation's capital stock and the result
is less capital per worker than would otherwise have been the case
This will surely engender a shortfall in labor productivity growth and,
with it, a shortfall in growth of the standard of living
Moreover, the higher real interest rates associated with
increased borrowing by the Treasury in the 1980s have been associated
with a shift in the composition of investment away from long-lived
assets, such as factories, and toward computers and other shorter-lived
equipment

Evidence points to a recent decline in the average service

life of measured consumption spending as well, and suggests a systematic
tendency for the average service life of all spending to move inversely
with real rates of interest

That is, the higher are real interest

rates, the heavier is the concentration on spending that satisfies
immediate desires or yields its returns quickly
Not surprisingly, we have already experienced a disturbing
decline in the level of net investment relative to GNP, as depreciation
has speeded up, reflecting shorter investment horizons

Net investment

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has fallen to 4 7 percent of GNP in the 1980s from an average level of
6 7 percent in the 1970s and even higher in the 1960s.

The effects of

this decline in the net investment share has been offset, to some
extent, by increased productivity of certain short-lived capital such as
computers, but nonetheless, slower investment has been associated with
weak productivity performance
The U S

net investment ratio is low, not only by our own

historical standards, but by international standards as well.
International comparisons of net investment should be viewed with some
caution because of differences in the measurement of depreciation and in
other technical details.

Nevertheless, the existing data indicate that

total net private and public investment as a share of gross domestic
product over the period between 1980 and 1986 was lower in the United
States than in any of the other major industrial countries except the
United Kingdom
Even this U.S

investment performance may not be sustainable

The negative effects of federal deficits on growth in the capital stock
in the 1980s may have been attenuated for a while by the strength of
aggregate output growth over much of the past six years.

Such rates of

output growth undoubtedly boosted sales and profit expectations and,
hence, business investment, but they cannot be maintained
Furthermore, net inflows of foreign saving in recent years have
been an important addition to aggregate saving.

In the 1980s, our

ability to tap foreign saving has moderated the decline in the
investment-GNP ratio

While the federal deficit rose by about 2-1/2

percentage points relative to GNP between the 1970s and the 1980s, net

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inflows of foreign saving have mounted, on average, to almost 2 percent
of GNP—an unprecedented level—from close to zero before
We welcome the discipline and efficiency gains of an open
economy, but the continuation of inflows of foreign saving at current
levels may be neither desirable nor possible

Evidence for the United

States and for other major industrial nations over the last 100 years
indicates that, for most countries, such sizable foreign net capital
inflows have not persisted; hence, they may not be a reliable substitute
for domestic saving on a long-term basis.

In other words, domestic

investment tends to be supported by domestic saving alone in the long
run
Let me conclude by reiterating that the budget deficit must be
brought down.

While it is beguiling to contemplate the healthy growth

of recent years in the context of large budget deficits, it is fanciful
to conclude that these deficits have no adverse consequences.

The

prospect of a continuing imbalance between domestic saving and
investment—with the accompanying constraints on growth and
modernization of capital and the substantial reliance on foreign
saving—poses risks for the future

Forward looking investors may react

to those risks today in financial markets

I do not underestimate the

difficult decisions that you must make if we are to achieve the
necessary reduction in the deficit

But allowing deficits to persist

courts instability in the near term and threatens potentially
significant reductions over time in the United States standard of
living