Testimony of Chairman Alan Greenspan Chairman Greenspan presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, on July 21, 2005 |
Mr. Chairman and members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress.
In mid-February,
when I presented our last report to the Congress, the economy, supported by
strong underlying fundamentals, appeared to be on a solid growth path, and
those circumstances prevailed through March. Accordingly, the Federal Open
Market Committee (FOMC) continued the process of a measured removal of monetary
accommodation, which it had begun in June 2004, by raising the federal funds
rate 1/4 percentage point at both the February and the March meetings.
The
upbeat picture became cloudier this spring, when data on economic activity
proved to be weaker than most market participants had anticipated and inflation
moved up in response to the jump in world oil prices. By the time of the May
FOMC meeting, some evidence suggested that the economy might have been entering
a soft patch reminiscent of the middle of last year, perhaps as a result of
higher energy costs worldwide. In particular, employment gains had slowed from
the strong pace of the end of 2004, consumer sentiment had weakened, and the
momentum in household and business spending appeared to have dissipated
somewhat. At the May
meeting, the Committee had to weigh the extent to which this weakness was
likely to be temporary--perhaps simply the product of the normal ebb and flow
of a business expansion--and the extent to which it reflected some influence
that might prove more persistent, such as the further run-up in crude oil
prices. While the incoming data highlighted some downside risks to the outlook
for economic growth, the FOMC judged the balance of information as suggesting
that the economy had not weakened fundamentally. Moreover, core
inflation had moved higher again through the first quarter. The rising prices
of energy and other commodities continued to place upward pressures on costs,
and reports of greater pricing power of firms indicated that they might be more
able to pass those higher costs on to their customers. Given these
considerations, the Committee continued the process of gradually removing
monetary accommodation in May. The data released
over the past two months or so accord with the view that the earlier soft
readings on the economy were not presaging a more serious slowdown in the pace
of activity. Employment has remained on an upward trend, retail spending has
posted appreciable gains, inventory levels are modest, and business investment
appears to have firmed. At the same time, low long-term interest rates have
continued to provide a lift to housing activity. Although both overall and
core consumer price inflation have eased of late, the prices of oil and natural
gas have moved up again on balance since May and are likely to place some upward
pressure on consumer prices, at least over the near term. Slack in labor and
product markets has continued to decline. In light of these developments, the
FOMC raised the federal funds rate at its June meeting to further reduce
monetary policy accommodation. That action brought the cumulative increase in
the funds rate over the past year to 2-1/4 percentage points. Should the prices
of crude oil and natural gas flatten out after their recent run-up--the
forecast currently embedded in futures markets--the prospects for aggregate
demand appear favorable. Household spending--buoyed by past gains in wealth,
ongoing increases in employment and income, and relatively low interest
rates--is likely to continue to expand. Business investment in equipment and
software seems to be on a solid upward trajectory in response to supportive
conditions in financial markets and the ongoing need to replace or upgrade
aging high-tech and other equipment. Moreover, some recovery in nonresidential
construction appears in the offing, spurred partly by lower vacancy rates and
rising prices for commercial properties. However, given the comparatively less
buoyant growth of many foreign economies and the recent increase in the foreign
exchange value of the dollar, our external sector does not yet seem poised to contribute
steadily to U.S. growth. A flattening out
of the prices of crude oil and natural gas, were it to materialize, would also
lessen upward pressures on inflation. Overall inflation would probably drop
back noticeably from the rates experienced in 2004 and early 2005, and core
inflation could hold steady or edge lower. Prices of crude materials and
intermediate goods have softened of late, and the slower rise in import prices
that should result from the recent strength in the foreign exchange value of
the dollar could also relieve some pressure on inflation. Thus, our baseline
outlook for the U.S. economy is one of sustained economic growth and contained
inflation pressures. In our view, realizing this outcome will require the
Federal Reserve to continue to remove monetary accommodation. This generally
favorable outlook, however, is attended by some significant uncertainties that
warrant careful scrutiny. With regard to the
outlook for inflation, future price performance will be influenced importantly
by the trend in unit labor costs, or its equivalent, the ratio of hourly labor
compensation to output per hour. Over most of the past several years, the
behavior of unit labor costs has been quite subdued. But those costs have
turned up of late, and whether the favorable trends of the past few years will
be maintained is unclear. Hourly labor compensation as measured from the
national income and product accounts increased sharply near the end of 2004. However,
that measure appears to have been boosted significantly by temporary factors.
Other broad measures suggest that hourly labor compensation continues to rise
at a moderate rate. The evolution of
unit labor costs will also reflect the growth of output per hour. Over the
past decade, the U.S. economy has benefited from a remarkable acceleration of
productivity: Strong gains in efficiency have buoyed real incomes and
restrained inflation. But experience suggests that such rapid advances are
unlikely to be maintained in an economy that has reached the cutting edge of
technology. Over the past two years, growth in output per hour seems to have
moved off the peak that it reached in 2003. However, the cause, extent, and
duration of that slowdown are not yet clear. The traditional measure of the growth
in output per hour, which is based on output as measured from the product side
of the national accounts, has slowed sharply in recent quarters. But a
conceptually equivalent measure that uses output measured from the income side
has slowed far less. Given the divergence between these two readings, a
reasonably accurate determination of the extent of the recent slowing in
productivity growth and its parsing into cyclical and secular influences will
require the accumulation of more evidence. Energy prices
represent a second major uncertainty in the economic outlook. A further rise
could cut materially into private spending and thus damp the rate of economic
expansion. In recent weeks, spot prices for crude oil and natural gas have
been both high and volatile. Prices for far-future delivery of oil and gas
have risen even more markedly than spot prices over the past year. Apparently,
market participants now see little prospect of appreciable relief from elevated
energy prices for years to come. Global demand for energy apparently is
expected to remain strong, and market participants are evidencing increased
concerns about the potential for supply disruptions in various oil-producing
regions. To be sure, the
capacity to tap and utilize the world's supply of oil continues to expand.
Major advances in recovery rates from existing reservoirs have enhanced proved
reserves despite ever fewer discoveries of major oil fields. But, going
forward, because of the geographic location of proved reserves, the great
majority of the investment required to convert reserves into new crude oil
productive capacity will need to be made in countries where foreign investment
is currently prohibited or restricted or faces considerable political risk.
Moreover, the preponderance of oil and gas revenues of the dominant national
oil companies is perceived as necessary to meet the domestic needs of growing
populations. These factors have the potential to constrain the ability of
producers to expand capacity to keep up with the projected growth of world
demand, which has been propelled to an unexpected extent by burgeoning demand
in emerging Asia. More
favorably, the current and prospective expansion of U.S. capability to import
liquefied natural gas will help ease longer-term natural gas stringencies and
perhaps bring natural gas prices in the United States down to world levels. The third major
uncertainty in the economic outlook relates to the behavior of long-term
interest rates. The yield on ten-year Treasury notes, currently near 4-1/4
percent, is about This decline in
long-term rates has occurred against the backdrop of generally firm U.S.
economic growth, a continued boost to inflation from higher energy prices, and
fiscal pressures associated with the fast approaching retirement of the
baby-boom generation.1
The drop in long-term rates is especially surprising given the increase in the
federal funds rate over the same period. Such a pattern is clearly without
precedent in our recent experience. The
unusual behavior of long-term interest rates first became apparent last year.
In May and June of 2004, with a tightening of monetary policy by the Federal
Reserve widely expected, market participants built large short positions in
long-term debt instruments in anticipation of the increase in bond yields that
has been historically associated with an initial rise in the federal funds
rate. Accordingly, yields on ten-year Treasury notes rose during the spring of
last year about 1 percentage point. But by summer, pressures emerged in the
marketplace that drove long-term rates back down. In March of this year,
long-term rates once again began to rise, but like last year, market forces
came into play to make those increases short lived. Considerable
debate remains among analysts as to the nature of those market forces.
Whatever those forces are, they are surely global, because the decline in
long-term interest rates in the past year is even more pronounced in major
foreign financial markets than in the Two distinct but
overlapping developments appear to be at work: a longer-term trend decline in
bond yields and an acceleration of that trend of late. Both developments are
particularly evident in the interest rate applying to the one-year period
ending ten years from today that can be inferred from the U.S. Treasury yield
curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004,
it had declined to about 6-1/2 percent--an easing of about 15 basis points per
year on average.2
Over the past year, that drop steepened, and the forward rate fell 130 basis
points to less than 5 percent. Some, but not all,
of the decade-long trend decline in that forward yield can be ascribed to
expectations of lower inflation, a reduced risk premium resulting from less
inflation volatility, and a smaller real term premium that seems due to a
moderation of the business cycle over the past few decades.3
This decline in inflation expectations and risk premiums is a signal
development. As I noted in my testimony before this Committee in February, the
effective productive capacity of the global economy has substantially
increased, in part because of the breakup of the Soviet Union and the
integration of China and India into the global marketplace. And this increase
in capacity, in turn, has doubtless contributed to expectations of lower
inflation and lower inflation-risk premiums. In addition to
these factors, the trend reduction worldwide in long-term yields surely reflects
an excess of intended saving over intended investment. This configuration is
equivalent to an excess of the supply of funds relative to the demand for
investment. What is unclear is whether the excess is due to a glut of saving
or a shortfall of investment. Because intended capital investment is to some
extent driven by forces independent of those governing intended saving, the gap
between intended saving and investment can be quite wide and variable. It is
real interest rates that bring actual capital investment worldwide and its
means of financing, global saving, into equality. We can directly observe only
the actual flows, not the saving and investment tendencies. Nonetheless, as
best we can judge, both high levels of intended saving and low levels of
intended investment have combined to lower real long-term interest rates over
the past decade. Since the
mid-1990s, a significant increase in the share of world gross domestic product
(GDP) produced by economies with persistently above-average saving--prominently
the emerging economies of Asia--has put upward pressure on world saving. These
pressures have been supplemented by shifts in income toward the oil-exporting
countries, which more recently have built surpluses because of steep increases
in oil prices. The changes in shares of world GDP, however, have had little
effect on actual world capital investment as a percentage of GDP. The fact
that investment as a percentage of GDP apparently changed little when real
interest rates were falling, even adjusting for the shift in the shares of
world GDP, suggests that, on average, countries' investment propensities had
been declining.4 Softness in
intended investment is also evident in corporate behavior. Although corporate
capital investment in the major industrial countries rose in recent years, it
apparently failed to match increases in corporate cash flow.5
In the United States, for example, capital expenditures were below the very
substantial level of corporate cash flow in 2003, the first shortfall since the
severe recession of 1975. That development was likely a result of the business
caution that was apparent in the wake of the stock market decline and the
corporate scandals early this decade. (Capital investment in the United States
has only recently shown signs of shedding at least some of that caution.)
Japanese investment exhibited prolonged restraint following the bursting of
their speculative bubble in the early 1990s. And investment in emerging Asia
excluding China fell appreciably after the Asian financial crisis in the late
1990s. Moreover, only a modest part of the large revenue surpluses of
oil-producing nations has been reinvested in physical assets. In fact, capital
investment in the Middle East in 2004, at 25 percent of the region's GDP, was
the same as in 1998. National saving, however, rose from 21 percent to 32
percent of GDP. The unused saving of this region was invested in world
markets. Whether the excess
of global intended saving over intended investment has been caused by weak
investment or excessive saving--that is, by weak consumption--or, more likely,
a combination of both does not much affect the intermediate-term outlook for
world GDP or, for that matter, U.S. monetary policy. What have mattered in
recent years are the sign and the size of the gap of intentions and the
implications for interest rates, not whether the gap results from a saving glut
or an investment shortfall. That said, saving and investment propensities do
matter over the longer run. Higher levels of investment relative to
consumption build up the capital stock and thus add to the productive potential
of an economy. The economic
forces driving the global saving-investment balance have been unfolding over
the course of the past decade, so the steepness of the recent decline in
long-term dollar yields and the associated distant forward rates suggests that
something more may have been at work over the past year.6
Inflation premiums in forward rates ten years ahead have apparently continued
to decline, but real yields have also fallen markedly over the past year. It
is possible that the factors that have tended to depress real yields over the
past decade have accelerated recently, though that notion seems implausible. According to estimates
prepared by the Federal Reserve Board staff, a significant portion of the sharp
decline in the ten-year forward one-year rate over the past year appears to
have resulted from a fall in term premiums. Such estimates are subject to
considerable uncertainty. Nevertheless, they suggest that risk takers have
been encouraged by a perceived increase in economic stability to reach out to
more distant time horizons. These actions have been accompanied by significant
declines in measures of expected volatility in equity and credit markets
inferred from prices of stock and bond options and narrow credit risk
premiums. History cautions that long periods of relative stability often
engender unrealistic expectations of its permanence and, at times, may lead to financial
excess and economic stress. Such perceptions, many
observers believe, are contributing to the boom in home prices and creating
some associated risks. And, certainly, the exceptionally low interest rates on
ten-year Treasury notes, and hence on home mortgages, have been a major factor
in the recent surge of homebuilding, home turnover, and particularly in the
steep climb in home prices. Whether home prices on average for the nation as a
whole are overvalued relative to underlying determinants is difficult to ascertain,
but there do appear to be, at a minimum, signs of froth in some local markets
where home prices seem to have risen to unsustainable levels. Among other
indicators, the significant rise in purchases of homes for investment since
2001 seems to have charged some regional markets with speculative fervor. The apparent froth
in housing markets appears to have interacted with evolving practices in
mortgage markets. The increase in the prevalence of interest-only loans and
the introduction of more-exotic forms of adjustable-rate mortgages are
developments of particular concern. To be sure, these financing vehicles have
their appropriate uses. But some households may be employing these instruments
to purchase homes that would otherwise be unaffordable, and consequently their
use could be adding to pressures in the housing market. Moreover, these
contracts may leave some mortgagors vulnerable to adverse events. It is
important that lenders fully appreciate the risk that some households may have
trouble meeting monthly payments as interest rates and the macroeconomic
climate change. The U.S. economy
has weathered such episodes before without experiencing significant declines in
the national average level of home prices. Nevertheless, we certainly cannot
rule out declines in home prices, especially in some local markets. If
declines were to occur, they likely would be accompanied by some economic
stress, though the macroeconomic implications need not be substantial.
Nationwide banking and widespread securitization of mortgages make financial
intermediation less likely to be impaired than it was in some previous episodes
of regional house-price correction. Moreover, a decline in the national
housing price level would need to be substantial to trigger a significant rise
in foreclosures, because the vast majority of homeowners have built up
substantial equity in their homes despite large mortgage-market-financed
withdrawals of home equity in recent years. Historically, it
has been rising real long-term interest rates that have restrained the pace of
residential building and have suppressed existing home sales, high levels of
which have been the major contributor to the home equity extraction that
arguably has financed a noticeable share of personal consumption expenditures
and home modernization outlays. The trend of
mortgage rates, or long-term interest rates more generally, is likely to be
influenced importantly by the worldwide evolution of intended saving and
intended investment. We at the Federal Reserve will be closely monitoring the
path of this global development few, if any, have previously experienced. As I
indicated earlier, the capital investment climate in the United States appears
to be improving following significant headwinds since late 2000, as is that in Japan.
Capital investment in Europe, however, remains tepid. A broad worldwide expansion
of capital investment not offset by a rising worldwide propensity to save would
presumably move real long-term interest rates higher. Moreover, with term
premiums at historical lows, further downward pressure on long-term rates from
this source is unlikely. * * * We collectively
confront many risks beyond those that I have just mentioned. As was tragically
evidenced again by the bombings in London earlier this month, terrorism and
geopolitical risk have become enduring features of the global landscape.
Another prominent concern is the growing evidence of anti-globalization
sentiment and protectionist initiatives, which, if implemented, would significantly
threaten the flexibility and resilience of many economies. This situation is
especially troubling for the United States, where openness and flexibility have
allowed us to absorb a succession of large shocks in recent years with only
minimal economic disruption. That flexibility is, in large measure, a
testament to the industry and resourcefulness of our workers and businesses.
But our success in this dimension has also been aided importantly by more than
two and a half decades of bipartisan effort aimed at reducing unnecessary
regulation and promoting the openness of our market economy. Going forward,
policymakers will need to be vigilant to preserve this flexibility, which has
contributed so constructively to our economic performance in recent years. In conclusion, Mr.
Chairman, despite the challenges that I have highlighted and the many I have
not, the U.S. economy has remained on a firm footing, and inflation continues
to be well contained. Moreover, the prospects are favorable for a continuation
of those trends. Accordingly, the Federal Open Market Committee in its June
meeting reaffirmed that it ".
. . believes that policy accommodation can be removed at a pace that is likely
to be measured. Nonetheless, the Committee will respond to changes in economic
prospects as needed to fulfill its obligation to maintain price stability." Footnotes
1. Under current law, those longer-run pressures on the
federal budget threaten to place the economy on an unsustainable path. Large
deficits could result in rising interest rates and ever-growing interest
payments on the accumulating stock of debt, which in turn would further augment
deficits in future years. That process could result in deficits as a
percentage of gross domestic product rising without limit. Unless such a
development were headed off, these deficits could cause the economy to stagnate
or worse at some point over the next couple of decades. Return to text
2.
Dollar interest rate swaps five years forward and maturing in ten years
declined 19 basis points per year on average over the same period. Comparable euro
(pre-1999, Deutschemark) swaps declined 27 basis points, sterling swaps
35 basis points, and yen swaps 23 basis points. Return to text
3.
Term premiums measure the extent to which current prices of bonds discount
future uncertainties. Return to text
4.
Nominal GDP figures by country are estimated in dollars by the International
Monetary Fund using purchasing power parities (PPP) of currencies. These GDP
figures are used to calculate weights applied to national saving and investment
rates to form global measures. When the GDP figures are instead measured at
market exchange rates, the results are similar. The PPP estimates emphasize
the economic factors generating investment and the use of saving. Exchange
rates emphasize the financial forces governing the financing of investment
across borders. Both approaches are useful. Return to text
5.
A significant part of the surge in cash flow of U.S. corporations was accrued
by those financial intermediaries that invest only a small part in capital
assets. It appears that the value added of intermediation has increased
materially over the past decade because of major advances in financial product
innovation. Return to text
6.
The decline of euro, sterling, and yen forward swap rates also steepened. Return to text
July 2005 Monetary policy report | 2005 Testimony
50 basis points below its level of late spring 2004. Moreover, even after the
recent widening of credit risk spreads, yields for both investment-grade and
less-than-investment-grade corporate bonds have declined even more than those
on Treasury notes over the same period.
United States.
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Last update: July 21, 2005, 10:00 AM