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[109 Senate Hearings]
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S. Hrg. 109-204
FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 2005
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU-
ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
__________
JULY 21, 2005
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina JON S. CORZINE, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Peggy R. Kuhn, Senior Financial Economist
Martin J. Gruenberg, Democratic Senior Counsel
Aaron D. Klein, Democratic Economist
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
----------
THURSDAY, JULY 21, 2005
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Schumer.............................................. 2
Senator Allard............................................... 2
Senator Reed................................................. 3
Senator Bunning.............................................. 3
Senator Bennett.............................................. 5
Senator Dole................................................. 5
Senator Crapo................................................ 6
Senator Sarbanes............................................. 15
Senator Corzine.............................................. 25
WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal
Reserve System, Washington, DC................................. 6
Prepared statement........................................... 31
Response to written questions of:
Senator Reed............................................. 36
Senator Bennett.......................................... 36
Senator Corzine.......................................... 38
Additional Material Supplied for the Record
Various charts submitted to the Committee........................ 40
Letter to Senator Bennett from Alan Greenspan dated September 2,
2005........................................................... 53
Monetary Policy Report to the Congress, July 21, 2005............ 59
(iii)
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 2005
----------
THURSDAY, JULY 21, 2005
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:07 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order.
We are very pleased this morning to welcome Chairman
Greenspan once again before the Committee on Banking, Housing,
and Urban Affairs to testify on the Federal Reserve's Semi-
Annual Monetary Policy Report to the Congress.
The June meeting of the Federal Open Market Committee
marked the 1 year anniversary of incremental increases in the
Federal funds rate from a low of 1 percent. These measured
changes appear to have been accommodated pretty well by the
economy. GDP has sustained a strong rate of growth, increases
in core inflation have been moderate, and we have seen a
continued decline in unemployment. The country is also
fortunate to have enjoyed an unexpected increase in tax
revenues and subsequent reduction in the Federal deficit for
this fiscal year. But as your report highlights, Mr. Chairman,
there are also some cautionary factors that we need to be
mindful of in the months ahead.
This morning we will have ample opportunity to discuss in
greater detail the Federal Reserve's performance in carrying
out monetary policy and its views on the future direction of
our Nation's economy. I look forward, as others will, to raise
a number of issues during our discussion.
Chairman Greenspan, I am told that today marks the 18th
anniversary of your first appearance before the Congress for
the nomination to be Federal Reserve Chairman. Since that time,
you have made 34 appearances before this Committee to discuss
monetary policy and conditions alone. While this morning may be
your last appearance--I hope it will not be, but it could be--
as Federal Reserve Chairman testifying on the Federal Reserve's
Semi-Annual Monetary Policy Report, the Committee would
certainly extend a warm welcome to you at any time should we
end up hosting you again in February of 2006.
But on behalf of the Committee, I want to thank you for
your many years of service and your respected counsel. I
suspect that this Committee may still be interested in hosting
you as a witness on other topics in the months ahead. Beyond
your tenure, Mr. Chairman, your voice will undoubtedly continue
to be valued after your departure from the Fed. We hope you
will continue to accept our invitation in the years ahead.
Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman. I just ask to
make a brief statement.
First, I want to join you, Mr. Chairman, in thanking
Chairman Greenspan for his amazing service to this country and
his willingness. I only served under two Fed Chairmen, both of
whom have been very accessible, but your accessibility and
interest in things that we ask you about is just incredible,
and we appreciate that. And one of the things that we have
worked together on, of course, is the Chinese currency, and as
you know, this morning the Chinese made their first step to
revalue their currency. So, I just wanted to read a brief
statement on that.
And what I believe, Mr. Chairman, is that this is a good
first step, albeit a baby step. It is smaller than we had
hoped. But to paraphrase the Chinese philosophers, a trip of a
thousand miles can well begin with the first baby step.
The most significant thing about this move is that the
Chinese, in effect, have conceded that pegging their currency
is bad for China, for the world economy, and for the United
States. And we are glad they have come to this understanding.
If there are not larger steps in the future we will not have
accomplished very much. But after years of inaction, this step
is welcome.
Again, I want to thank Chairman Greenspan. I want to thank
Senator Graham as well as Senator Bunning and Senator Dole on
this Committee, and Senator Bayh, Senator Reed, and some others
who were part of our effort, and we are beginning to bear some
fruit.
So, I thank you, Mr. Chairman.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Thank you, Mr. Chairman, for holding this
hearing, and I would like to join my colleagues in welcoming
Federal Reserve Board Chairman Greenspan to the Committee today
to discuss monetary policy and the state of the U.S. economy.
I also look forward to the opportunity to hear from
Chairman Greenspan. His expertise and insight is always helpful
to the Committee.
Chairman Greenspan, I was pleased to hear in your testimony
before the House yesterday that the outlook for the U.S.
economy is positive and one of sustained growth. Under your
leadership, the Federal Reserve Board has done a good job
monitoring the U.S. economy and managing monetary policy, as
appropriate. Since this will be the last time you will be
delivering the Fed's monetary policy report in your current
term--and I hope you continue to serve--I want to take this
opportunity to congratulate you on a job well done. I also want
to thank you on behalf of the American people for your years of
public service. We have all been the beneficiaries of your
careful approach, and your service has set a high standard.
Thank you for taking the time out of your busy schedule to
be here, and I look forward to hearing your testimony.
Chairman Shelby. Senator Reed.
STATEMENT OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman. And let me
commend you, Chairman Greenspan, for your extraordinary service
over 18 years, and I think you will continue to be invited back
to the Committee for many years to come.
We have a challenging economy before us. Last June,
employment added about 146,000 jobs, which might be appropriate
at the end of an expansion, but we are coming out of a long,
protracted job slump. And this is far from the numbers we saw
in the Clinton Administration of 200,000 to 300,000 jobs a
month. So we have essentially a jobless recovery, and the
unemployment rate, although it edged down to 5 percent, the
Boston Fed points out there is still considerable evidence of
hidden unemployment that does not show up. Labor force
participation has not rebounded in this recovery. A study finds
that the labor force shortfall is between 1.6 million and 5.1
million people. Employers are not hiring as though they believe
the economy is strong, and potential workers are staying out of
the labor force.
We have discussed many times, Mr. Chairman, the fact that
there are disturbing trends in the distribution of earnings.
Things seem to be getting worse in this recover, with most of
the gains from productivity going into profits, not wages, and
overall real earnings remaining stagnant. And the only group
that seems to be doing exceptionally well are those at the top
of the distribution of earnings and wages. People in the middle
and further down are seeing their purchasing power fall because
of rising costs of gasoline, food, medical care, housing,
really eating into their ability to maintain their families.
And then we have seen some news that the deficit--progress
has been made, but if you look behind the numbers, it looks
like a one-time situation where certain tax advantages came to
pass in this particular period but are not sustainable over a
longer time. The deficit still is extraordinarily burdensome on
our economy as we go forward. Low national savings rates and
the widening trade deficit are problems that we have to deal
with, an we are not dealing with them effectively and
permanently.
I hope at the hearing today, Mr. Chairman, that you will
touch on these issues, and once again let me commend you for
your service and judgment in so many different ways. We have
disagreed, but it has been a productive exchange, and I thank
you for that.
Chairman Shelby. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman, particularly for
holding this meeting today. I would especially like to thank
Chairman Greenspan for delivering what will probably be your
last monetary policy report to Congress.
According to the Congressional Research Service, this is
the 35th time that you have appeared before a Committee on
which I sit. I think I am finally starting to understand your
statements and answers----
[Laughter.]
Which probably means it is time for one of us to go.
[Laughter.]
Seriously, I will miss our sparring, and I thank you for
your service. I am sure you would be disappointed if I gave you
a speech full of flowery tributes, and I would hate for you to
be disappointed in what could be your last appearance before
this Committee. So, I will point out my differences with the
FMOC latest monetary policy decision. As my good friend and
fellow Hall of Famer Yogi Berra once said, it is deja vu all
over.
Once again, I believe the FMOC is taking us down the
economic path that is fraught with peril by unnecessarily
raising interest rates. Surveys show that Americans are much
more worried about filling their gas tanks than they are about
fitting into their swimsuits this summer, which may be a first.
But, nonetheless, despite record high energy prices, the FMOC
continues to raises rates. I believe that you are fighting an
inflationary bogeyman that does not exist.
This reminds me of the summer of 2000 when all signs
pointed toward a recession, but the FMOC refused to cut
interest rates. When you finally did cut rates on January 3,
2001, in an emergency meeting after refusing to cut them at the
FMOC's regular meeting on December 19, 2000, the damage was
done and the recession then took place. That was greatly
exacerbated by September 11, and it was already underway before
that took place.
I am very concerned with the Federal Reserve's continuing
raising interest rates. The FMOC, it seems to me, continues to
fix an economy that just is not broken. It is almost as if the
Fed is frightened by success. The FMOC is once again throwing a
wet blanket on the inflationary fire that does not exist.
As I have said before, I do not believe the Federal Reserve
economic models are factoring in the impact of new technologies
on the economy. I also do not believe they take into account
the psychological effect of higher energy prices and economic
worries in general. People in my State get nervous about our
economy's future every time they fill up their gas tank. I also
know that despite very good economic numbers, many Americans
are worried about the future. They are worried that if they
lose their current job, they will be unable to find another. I
believe we are coming to a critical point in our economy--a
point where it cannot sustain higher and higher interest rates.
We almost have an inverted curve, as you know. There are only
20 basis points between the 5-year note and the 10-year note
right now.
As our interest rates rise, our economy will suffer.
Housing starts will be down, and we will lose the economic
momentum that we have enjoyed. We just got good news about
increased tax revenues helping reduce our deficits. I know you
are a deficit hawk, Mr. Chairman. I hope you will do what you
can to sustain our growth and help reduce the deficit.
Once again, thank you, Mr. Chairman, for coming before this
Committee today and for your long and distinguished service to
our country.
Chairman Shelby. Senator Bennett.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you very much, Mr. Chairman.
Chairman Greenspan, listening to all of the comments about
your service and your performance here reminds me of the story
of Henry Kissinger, who was in a group and the person presiding
over that particular event said, ``We have with us today Henry
Kissinger, who needs no introduction.'' And Henry Kissinger
said, ``While it is true that I need no introduction, no one
enjoys an introduction more than I do.'' And you do not need
the kind of praise that is being heaped upon you, but I hope
you enjoy it because it is certainly deserved. And I want to
join in it.
We appreciate your testimony here today. I have looked
through it, and I look forward to asking you some questions
about it. But I would hope that the tradition that when
Greenspan speaks the entire country listens will hold true for
your testimony today, because the recovery that we are in could
be labeled ``the Rodney Dangerfield recovery'': It don't get no
respect. And your comments about where we are and how robust
the recovery is I think should get a lot of respect and a lot
of currency.
So, I appreciate your testimony and look forward to having
the opportunity to question you here today.
Chairman Shelby. Senator Dole.
STATEMENT OF SENATOR ELIZABETH DOLE
Senator Dole. Thank you, Chairman Shelby.
I want to join with Senator Schumer in recognizing the
importance of China's removal of their peg of their currency to
the dollar. This is significant and an important first step
toward our long-term goal of having the yuan freely float.
Welcome, Chairman Greenspan, for what appears to be your final
semi-annual report to the Congress. Your service as Chairman of
the Federal Reserve has been truly admirable and deeply
appreciated. While some may worry if the overall economy will
continue to improve without you in the Chairman's seat, I know
that your efforts have put us on the track to find long-term
sustainable growth.
The times during which you have served, Mr. Chairman, have
been filled with extraordinary events and personalities. Over
your 18 years as the Chairman of the Federal Reserve, the
American people's understanding of the markets has dramatically
improved, as has our understanding of the role of the Federal
Reserve Board. I believe the relatively new measured pace that
the Federal Reserve has adopted in its adjustments to the rates
is part of this progress, and this predictability has benefited
our economy.
Three weeks ago, the Federal Open Market Committee again
raised its target for the Federal funds rate and the discount
rate by 25 basis points. This was the ninth straight increase
in the
Federal funds rate. The release noted robust underlying growth
in productivity and a gradually improving labor market. These
observations appear to indicate a positive track for economic
expansion in the coming years. While these trends certainly are
encouraging, I continue to be concerned about the slower pace
of job creation.
As you well know, the State of North Carolina continues to
experience dramatic losses in employment, especially in textile
and furniture manufacturing. While the national economy may be
trending positively, we continue to focus special attention on
those who have lost their jobs as their companies struggled to
compete with foreign firms that operate with dramatically lower
cost structures. Congress continues to debate the positives and
negatives of free trade, and I continue to believe we must work
on agreements that bring new benefits to American workers and
consumers while minimizing the negative effects.
In this changing economic environment, there are fewer and
fewer opportunities for lower-skilled workers. The opportunity
gap is widening. We must do everything in our power to make
sure that these people do not fall through the cracks. We must
educate our less-skilled workers so they take advantage of new
jobs created by the expanding economy. To this end, I believe
we should take steps to improve trade adjustment assistance and
continue to make the goal of strenghtening our community
colleges a top priority.
In addition to the President's $125 million proposal to
establish a new community college access grant program, which
is included in this year's Labor-HHS-Education appropriations
bill, Senator Baucus and I have introduced legislation, S.
1068, which provides better links between our higher education
institutions and the business community. This will help prepare
a new generation of skilled workers so our workforce will
remain strong and competitive in years to come. The bill is
currently in the Senate HELP Committee, and I look forward to
working with Chairman Enzi to see that it becomes law.
And, of course, I also remain concerned about high energy
prices, the rise in steel prices, and the growing size of our
trade deficit. But in spite of these concerns, I am confident
that through increased trade, hard work, global communications,
and improved education of our workforce, we will achieve new
levels of opportunity for the people of North Carolina and for
all Americans.
I look forward to hearing from you on these and other
matters, Chairman Greenspan. Thank you very much for joining us
today.
Chairman Shelby. Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman. I came to
listen to Chairman Greenspan, so I will save everybody from
having to listen to my opening statement.
Chairman Shelby. Thank you.
Chairman Greenspan, your written statement will be made
part of the record today. You proceed as you wish. Welcome
again to the Committee.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Chairman Greenspan. Thank you, Mr. Chairman. I have
excerpted only part of that rather extended statement.
Mr. Chairman and Members of the Committee, I am pleased to
be here to present the Federal Reserve's Monetary Policy Report
to the Congress.
In recent weeks, employment has remained on an upward
trend, retail spending has posted appreciable gains, inventory
levels have been 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.
Should the prices of crude oil and natural gas flatten out
after their recent run-up--the forecast currently embedded in
futures markets, incidentally--the prospects for aggregate
demand appear favorable, and upward pressures on inflation
would be reduced.
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.
Over the past 2 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.
Energy prices represent a second major uncertainty in the
economic outlook. A further rise could materially cut into
private spending and thus damp the rate of economic expansion.
More favorably, the current and prospective expansion of
U.S. capability to import liquefied natural gas will help ease
long-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 10-
year Treasury notes, currently near 4\1/4\ percent, is about 50
basis points below its level of late spring 2004.
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.
Some, but not all, of the decade-long trend decline in bond
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.
In addition to these factors, the trend reduction worldwide
in long-term rates surely reflects an excess of intended saving
over intended investment. What is unclear is whether the excess
is due to a glut of savings 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
savings, into equality. 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-1990's, a significant increase in the share
of world gross domestic product produced by economies with
persistently above average saving--predominantly 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.
Softness in intended investment is also evidence. Although
corporate capital investment in the major industrial countries
rose in recent years, it apparently failed to match increases
in corporate cashflow.
Whether the excess of global intended saving over intended
investment has been caused by weak investment or excessive
saving--that is, 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.
Inflation premiums in forward rates 10 years ahead have
apparently continued to decline, but real yields have also
fallen markedly over the past year.
Risk takers apparently 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 and
equity in credit markets. 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 10-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 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.
Historically, it has been rising real long-term interest
rates that have restrained the pace of residential building and
have suppressed existing home sales.
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 are the Federal Reserve will be closely monitoring the path
of this global development few, if any, have previously
experienced.
We collectively confront many risks beyond those I have
just mentioned. As was tragically evidenced again by the
bombings in London earlier this month--and, I might add, some
questions about what is going on in London today--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 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.''
Thank you very much. I look forward to your questions.
Chairman Shelby. Thank you, Mr. Chairman.
Mr. Chairman, some Fed watchers speculate that the Federal
Open Market Committee may halt its incremental increases after
reaching a Federal funds rate of 4 percent in November, which
assumes three additional quarter-point increases in upcoming
FOMC meetings. Mr. Chairman, to what extent does the Federal
Open Market Committee consider the long-term interest rate in
pursuing changes to the Federal funds rate? For example, would
the Federal Open Market Committee continue raising the Federal
funds rate even if the yield curve, which Senator Bunning
alluded to, becomes inverted in the months ahead?
Chairman Greenspan. First of all, I cannot comment for the
Federal Open Market Committee's actions in the future because
we have not taken them, and we will obviously engage in ongoing
deliberations to make judgments at each of our meetings. But I
think there is a misconception relevant not to what we may do
but to the importance of an inverted yield curve.
It is certainly the case that if you go back historically,
an inverted yield curve has actually been a reasonably good
measure of potential recession in front of us. The quality of
that signal has been declining in the last decade, in fact,
quite measurably, and the reason basically is that it was a
good measure in the early period when commercial banks were the
major financial intermediaries, and when you had long-term
interest rates rise. I should say that when short-term interest
rates--rise relative to long-term interest rates, it usually
implied a squeeze on the profitability of commercial banks
because they tend to hold somewhat longer maturities on the
asset side of their balance sheet than on the liability side.
As a consequence, that squeeze was usually associated with an
economy running into some trouble.
But extraordinary new avenues of financial intermediation
have developed over the last decade and a half, and, therefore,
there are innumerable other ways in which savings can move into
investment without going through the commercial banks. As a
result, a straightforward statistical analysis of the efficacy
of the yield curve inversion as a forecasting tool has
diminished very dramatically because of economic events.
So, yes, we do look at the structure of long-term rates and
the inversion of yields as well as a whole panoply of
everything else, before we make judgments as to the Federal
funds rate. Our basic goal, as I have indicated many times
here, is essentially to create an environment which sustains
maximum sustainable growth, and we have always argued--because
the data are so persuasive that inflation stability is a
necessary condition to achieve that goal. In that context, we
make our judgments meeting by meeting.
Chairman Shelby. But is the possibility of an inverted
yield curve still relevant to your thinking along with other
factors?
Chairman Greenspan. Yes, it is, and even though its
forecasting or anticipatory capability is greatly diminished,
it is not zero.
Chairman Shelby. I want to touch on something else that you
have spoken on many times here, and that is the GSE's. You
stress the need for any GSE reform, Mr. Chairman, to provide
clear guidance over the GSE's portfolio. You have also
indicated that you do not believe that focusing GSE's on their
core mission and securitization mission would not adversely
impact liquidity in the mortgage markets.
As this Committee moves forward hopefully toward a markup
next week, I would ask you to elaborate again for the record on
the issue of the GSE's' role of providing liquidity in the
mortgage markets and how you see the GSE's' securitization and
portfolio business affecting the GSE's' ability to carry out a
liquidity role. In other words, how important is the portfolio?
And I know you have spoken of the risk for the GSE's being in a
portfolio and so forth.
Chairman Greenspan. First of all, Mr. Chairman, let me
stipulate that the secondary mortgage market functions of the
GSE's are critical to our evolving economy. And indeed, I might
say that is one of the means of improved intermediation which I
was referring to previously. So let me just say that the actual
actions taken by the GSE's to purchase mortgages, securitize
them, and sell them into the market has been an extraordinarily
valuable addition to American finance.
Chairman Shelby. It brought liquidity to the housing
market.
Chairman Greenspan. It brought very significant liquidity
to the housing market and indeed has offered the mortgage
instrument in a securitized form to a much broader segment of
American investors, and that has been very helpful to them as
well.
That particular function is unaffected, in our judgment,
whether purchases of mortgages by the GSE's are securitized and
sold off in the market, held as mortgages on the balance sheet
of the GSE, or securitized and held on the balance sheet. So,
in effect, the composition of the secondary market purchases--
which is what their charter is all about--as best we can judge,
between portfolio accumulation and securitization, has very
little effect on market liquidity, interest rates, or anything
else except the profitability of the GSE's.
It is strikingly obvious to those of us who have looked at
this in some detail that the motive for accumulating portfolios
is solely, essentially in all respects, profitmaking.
Now, I have no objection to that. Indeed, they are
profitmaking organizations. They are chartered as such. And
indeed their shareholders could very well presumably sue if
they did not pursue those goals. But accumulating portfolios is
not adding liquidity to the housing market, nor in our judgment
is it assisting the market generally. In addition, because it
is a highly leveraged operation, and one which requires very
sophisticated hedging of interest rate risk, it is imparting a
significant potential systemic risk to the American financial
system.
Chairman Shelby. Thank you.
Senator Sarbanes.
Senator Sarbanes. Senator Reed.
Chairman Shelby. You want to defer to him? Go ahead,
Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman.
Just to follow up with respect to the GSE's, there are
several issues here. One is liquidity to the market, which you
talked about. Another is systemic risk. It strikes me, though,
that many institutions that you regulate have very large
portfolios, and they maintain them to increase their profits,
which is not something bad. Would you urge that we enact
legislation to set limits on these portfolios?
Chairman Greenspan. No, we do not, and the major reason is
that these are not leveraged in anywhere near the extent to
which the GSE's are.
A critical aspect here of the problem is the fact that the
GSE's have relatively small amounts of capital relative to the
assets they hold. Indeed, they hold 1 to 2 percent of assets.
The commercial banks, as you know, are several multiples above
that. And indeed interest rate risk originally was not even
hedged at all by commercial banks and savings and loans in the
very early years, largely because their capital was adequate to
self-insure.
The GSE's cannot self-insure. Their capital segment in
their balance sheet is too small. They cannot risk not fully
hedging their position.
Senator Reed. You raise, I think, an interesting point
because the typical way risk is managed in a regulatory process
is to increase capital rather than to put limits on growth
portfolios. That is essentially what the Federal Reserve does.
If you are concerned about the ability to manage risk in an
institution, your first response, your first authority is to
increase capital, which to me, frankly, is probably an
appropriate response to some of the risk that has been
illustrated in GSE's.
Let me change the subject slightly, and that is, I presume
that the current portfolio does not engender great risk since
many of your institutions hold a great deal of the paper of
these GSE's. They must find that these investments are prudent.
Chairman Greenspan. They hold them wholly because there is
a perception they are guaranteed by the full faith and credit
of the U.S. Government, despite the fact that the debentures
which they buy literally say, as required by law, that this
instrument is not backed by the full faith and credit.
The problem basically is if you ask anybody on Wall Street,
they do not care about the status of the GSE's, the financial
state. It goes up and it goes down. The stock prices of these
companies move all over the place, but the yield spread against
U.S. Treasuries locks, and the reason is that they do not
envisage their holdings of GSE's to have anything to do with
the GSE's.
Senator Reed. Are there some investors that buy the debt
and equity of companies you regulate because they feel that you
could never let them go out of business, the ``too big to
fail'' phenomenon?
Chairman Greenspan. If, in fact, we found that the
debentures that they issued had very narrow spreads against
U.S. Treasuries, I would say yes. But they do not. There are
very substantial spreads. The only way you can tell whether
they believe it is to watch the spreads. The spreads of
comparable debentures for large commercial banks or even large
mortgage holding commercial banks is very substantially higher.
Senator Reed. Let me change the subject. I mentioned in my
opening remarks the study by the Boston Federal Reserve with
respect to labor participation, which suggests there is a
significant and growing lack of participation in the labor
force which distorts our ability to see how well we are doing
with respect to recoveries. In fact, one thing that I found
interesting was the ratio of employment to population, 62.7
percent, is below the level at the start of the economic
recovery in November 2001. And this is the first time the ratio
has failed to surpass its trial level so far into a recovery.
The reality is--this is not just statistics--there could be
millions of people who have been discouraged by the workforce
not working, and we have to respond to that.
Can you comment?
Chairman Greenspan. Yes. We have looked at the Boston
report, and I must say Board staff does not come up with
numbers anywhere near what they have. We have, as I think it
is, less than half a percentage point.
Senator Reed. Could you share those numbers with us, Mr.
Chairman?
Chairman Greenspan. Certainly we can. But let me express to
you very succinctly why that is the case.
Labor force participation over the longer-run has been
driven by two factors here of importance. One is, as you know,
a very marked increase in the participation of adult women in
the labor force, which has been going up very dramatically for
decades; it finally reached a level which is about as high as
apparently it is going to go, and it has flattened out.
At the same time, the demographics are moving closer to
retirement ages where the ordinary early retirement begins to
occur. So those two structural factors are very dominant forces
as to why we have not gotten that pickup that you were
mentioning. And the result is that there is some evidence that
the participation rate is down partly because of economic
forces, but our numbers are nowhere near the dimensions that
the Boston Fed is showing.
Senator Reed. Just if I may make a final point, if, in
fact, there is this type of employment slack in the economy, it
would argue against precipitously increasing the interest rates
because you still have some capacity, I would suspect.
Chairman Greenspan. Well, it would certainly be arguing
against concerns with respect to rising unit labor costs and
the elements underlying the economic outlook, which we
obviously appraise, of course.
Senator Reed. Thank you.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
Chairman Greenspan, I have been in some other hearings on
the Pension Guaranty Corporation, and they face a deficit of
over $20 billion presently. With a large number of pension
plans appearing to be teetering, we appear to be facing a very
serious situation in that Pension Benefit Guaranty Corporation.
What impact do you think would the dumping of a few more
large pension plans on the PBGC have on the economy, if any?
Chairman Greenspan. It is difficult to judge. It has
similar effects of other types of deficits in the Federal
system. It clearly is negative, and I think it is a worrisome
thing for American taxpayers, needless to say. But it is hard
to see at this stage any spillover effects yet on economic
forces.
As large as the numbers are, relative to a $12 trillion
economy obviously they are not yet critical. My main concern is
that it ultimately will require U.S. Treasury bonds to fill in
the gap, which is another way of saying increasing the deficit
and increasing the Federal debt.
Senator Bunning. Do you have any comment on this morning's
report that the Chinese are moving away from the dollar peg
toward a currency basket?
Chairman Greenspan. I have not had a chance to look at the
full detail of what is going on, but I must say I associate
myself with Senator Schumer. This is certainly a good first
step. It is the type of step that you would want to take when
you have a decade-long fixed structure. And so they have been
cautious, and I think admirably so. But I look at it as the
first step in a number of further adjustments as they
invariably increase their participation in the world trading
markets. And so I believe it is a good start.
Senator Bunning. Yesterday, in response to a question from
Congressman Royce of California regarding moving the goalpost
on this legislation, you claimed that the Federal Reserve had
no concerns regarding the portfolios of Fannie Mae and Freddie
Mac until recently. These companies have been around in one
form or another since 1938.
How is it that the portfolios of the two largest financial
services companies in the country, which you claim pose a
systemic risk to the Nation's financial security, went
unnoticed until the past year by the Federal Reserve?
Chairman Greenspan. Well, that is a good question. First of
all, the portfolios did not exist in any substantial form prior
to, say, 1990.
Yesterday, I was asked why I have not previously raised the
issue. Let me answer this very simply. It has taken me quite a
good deal of time to disentangle the very complex structure of
these institutions to really understand how they work, what
motivates them, and where the sensitive points are.
When I first looked at this situation, I knew what the
stock of the debt was and the types of risks that held. But I
was not aware of how sensitive their profitability was between
securitizing and selling mortgages that they purchased and the
amount that they accumulated in their portfolio.
It is only fairly recently that it finally became clear to
me that that was basically how the system works, and I must say
that it was a revelation in certain respects. The more I have
looked at it since, I am impressed at how quickly, once they
realized in the early 1990's how important a vehicle this was
to profitability, how aggressively they pursued it.
Senator Bunning. Last question. Do you believe energy
prices have stabilized, or do you believe consumers and
businesses can expect lower or higher energy prices?
Chairman Greenspan. Senator, I cannot answer that question,
and I tried to express some of the reasons in the formal
remarks which I put in the record. The big problem is that
demand has picked up and has been going forward now, especially
because of increased pickup in oil demand in emerging Asia,
and, incidentally, also in the United States, the consequence
of which has been, after a very gradual rise over the years,
the rate of increase has picked up enough that it has eaten
into the excess capacity of the system.
As I point out in my prepared remarks, the geographic
location of proved reserves is relatively concentrated in the
Middle East, and most of the oil-producing countries who
perceive they had poor results when private international oil
companies were extracting their oil have essentially restricted
the entrance of either the majors who have significant
financing capabilities. The result of this is that they have
found, because of their growing population needs, they require
a goodly chunk of the revenues from oil to finance their
domestic needs. Therefore, there has been, as best we can
judge, an inadequate amount of investment to convert the proved
reserves into actual productive oil capacity, that is, oil
wells and the infrastructure in which you can actually extract
it. The markets, as far as long-term futures are concerned,
have expressed real concern about the balance of supply and
demand.
But let me just say this to you: It is a very narrow
balance, and it can go either way. So we have had a very
significant run-up, and it is perfectly credible that it could
go down for a while. But I do think that we are in a position
where forecasting the direction of oil is a particularly tricky
issue short term, but longer term, unless we address the issue
of getting adequate investment to convert the proved reserves
into productive oil capacity, we are going to have trouble
meeting long-term demands of the world a decade forward or
thereabouts.
Senator Bunning. Thank you, Mr. Chairman.
Chairman Shelby. Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Mr. Chairman.
First of all, Mr. Chairman, I am pleased to welcome you
back before the Committee. I think, if I am correct, this will
be your last opportunity to come before us to submit a report
on the conduct of monetary policy by the Fed pursuant to the
changes that were made to the Federal Reserve Act to require
the semiannual report to the Congress. I know we worked
together on bringing about that change. My recollection is you
were supportive of it at the time.
Chairman Greenspan. I was.
Senator Sarbanes. And I hope you feel that it has proven
out. I think it has been very beneficial to have these two set
periods for an open report by the Fed with respect to the
development of monetary policy. And before, we were on a kind
of ad hoc, hit-or-miss basis. I do not think that was really
very satisfactory, and my perception is that it has worked very
well, and I hope you feel the same.
Chairman Greenspan. I certainly agree with you, Senator.
Senator Sarbanes. Thank you. Now, first, I have a few
questions I want to put to you. There is a vote on, so we will
try to do the best we can within its constraints.
I want to address minimum capital standards for the banks
to begin with in the context of the efforts to negotiate the
Basel Capital Accords. Congress has expressed concern
repeatedly that the minimal capital requirements on federally
insured banks should be preserved in hearing after hearing. And
we have been regularly assured by the bank regulators that that
would happen.
Therefore, it was with some concern that we read the
comments by Federal Reserve Governor Bies back in March when
she spoke to the Institute of International Bankers Annual
Washington Conference, and I will just quote the article
reporting on that speech. ``Ms. Bies made it clear the Fed
still intends to jettison the straight capital assets leverage
ratio eventually. It is a position some other regulators,
particularly Mr. Powell at the FDIC, oppose. Executives at the
largest banks, however, have argued it makes no sense to
implement Basel II without also lifting the leverage minimums.
`The leverage ratio down the road has got to disappear,' Ms.
Bies said. `I would say to the industry, if you work with us
and be patient, we understand the concerns about leverage
ratios, and as we get more confidence in the new risk-based
approach, it will be easier for us to move away from the
leverage ratio.' ''
And at a hearing before this Committee, you were asked
about the minimum capital issue, and you responded as follows,
and this was to Senator Bunning: ``I think the issue that is
raised with respect to the leverage ratio is that it duplicates
numbers of other types of measures of capital. As you move into
the Basel II framework, which is a far more sophisticated
capital ratio, the need to get the old-fashioned leverage
ratio, which has worked for many generations--we basically
employed as a sole measure of capital--the need for that is
significantly diminished.''
So we had that indication of the attitude at the Fed on
this issue. Recently, at the end of May, Governor Bies gave
another speech. She said, ``While the regulatory capital
requirements ultimately produced by Basel II would be, we
believe, considerably more risk-sensitive than the current
capital regime, this is not the only capital regulation under
which U.S. institutions would operate.''
More than a decade ago, the Congress, as part of the FDIC
Improvement Acts, prompt corrective action to find a critically
undercapitalized insured deposit institution by reference to a
minimum tangible equity to asset requirement, a leverage ratio.
The agencies have also used other leverage ratios because
experience has suggested there is no substitute for an adequate
equity to asset ratio.
Federal Deposit Insurance Corporation, which was
responsible to the Congress for the management of the critical
deposit insurance portion of the safety net, has underlined the
importance of that minimum leverage ratio. The Federal Reserve
concurs with the FDIC's view.
Just to be clear, what is the Fed's view on the minimum
capital issue, and does the Fed take the position that the
leverage ratio down the road has to disappear?
Chairman Greenspan. The general view that we are
endeavoring to express is that when you have a Basel type
capital accord down the road, which is essentially fully
sensitive to the various different capital needs of an
institution, that there is no further need for other measures
because, by definition, the system is fully controlled.
We are not yet there with respect to Basel II. As I have
often said, there will be a Basel III and there will be a Basel
IV because the technologies are changing, commercial banking is
evolving, and supervision and regulation should not be fixed,
it should actually endeavor to adjust to the changing structure
of a financial or commercial banking system.
So when we get to the point--and I do not think we are
there yet--that the various structures defining what capital
should be address everybody's concerns about supervision and
control, then there is no longer a need for a minimum capital
requirement. It would be merely duplicative, and indeed, if the
system is working well, it is actually inoperative. We are not
there yet, and I think what Governor Bies is trying to say is
that we recognize that that not yet being there, there is still
a role for minimum capital and a leverage ratio.
But that does not change the fact that when we get a
sufficiently sophisticated structure of capital supervision,
that issue will become moot. So it is really a question of, as
you quoted earlier, the word is ``eventually,'' and where that
is, I do not yet know. But I do know, as indicated by both
Governor Bies and Chairman Powell, that we are not there yet.
Senator Sarbanes. One quick question and then I will----
Chairman Shelby. Proceed.
Senator Sarbanes. Every statistical study shows a marked
growing inequality in the distribution of income and wealth in
the country. The disparities are actually the largest of any of
the advanced industrial countries, and they also loom out at
you when you look at the United States in historical terms
unless you go way back into----
Chairman Greenspan. The ``Gilded Age'' as they like to say.
Senator Sarbanes. --the Roaring 1920's or the Roaring
1890's or something. What is your view of that development?
Chairman Greenspan. I think it is a very disturbing trend,
Senator, and the reason I say that is twofold. One, it is a
reflection, as best I can judge, of a faulty educational system
in the United States. As you know, we receive relatively poor
marks internationally, especially as our students move from the
4th grade to the 12th grade. That, as I think I have testified
here before, creates a inadequate movement of students through
high school, into college, and into skilled jobs, so that the
total supply of skilled workers is sufficiently large relative
to the increasing demand for skills because of technology to
keep the skilled wage level down.
We have been unable to do that, and indeed, we end up with
too many people who are lesser skilled, vying for jobs which
are declining in number, so that the wage rates there are
constricted, and it is causing this rather major dispersion.
A free market democratic society is ill-served by an
economy in which the rewards of that economy distributed in a
way which too many of our population do not feel is
appropriate. More importantly, they do not feel the advantages
and benefits coming from the system that a smaller but still
significant group have experienced. So, I am concerned about
this. I think it is a major issue in this country.
Senator Sarbanes. Thank you very much.
Thank you, Mr. Chairman.
Senator Allard. [Presiding.] Thank you, Senator Sarbanes.
The Chairman has stepped out. My turn is next, so I will go
ahead and resume questioning.
As Chairman of the Housing Subcommittee, I would like to
discuss a number of issues related to housing. Your testimony
mentioned exotic loan products, and that caught my attention
because I believe that Colorado is probably one of the higher
States as far as foreclosures are concerned. Many in Congress I
think have shared your concerns about those certain loan
products such as interest-only loans, and also what we call
negative advertising loans.
My question is, do these loan products create new
sustainable homeownership? In other words, these new products,
are they replacing the conventional loan, and are there some
negative results as a result of that?
Chairman Greenspan. Well, Senator, actually all of these
loans, properly used, are not bad instruments. In other words,
they give the consumers, the mortgagors, indeed the mortgagees
as well, a broader set of instruments which can be employed, so
there is greater consumer choice.
Our concern is that a number of these instruments are being
used to enable people to purchase homes who would otherwise not
have been able to do so. In other words, they are stretching to
make the payments, and that is not good lending practice for
banks or other purveyors of mortgages, and certainly it is not
good practice on the part of pending homeowners.
It is a concern to us. Fortunately, it is not a large
enough part of the market to create serious systemic problems,
but it is an issue, and we at the Federal Reserve and other
banking supervisors are looking at that. We are examining these
issues, and we are making decisions as to what, if any,
guidance to the banking system we would endeavor to convey.
Senator Allard. So just to follow up on that, you do not
see any need for any kind of legislative remedy or anything at
this point in time?
Chairman Greenspan. We do not need any legislative remedy.
It is wholly under the regulatory authorities of the banking
agencies.
Senator Allard. Do you think the banks are utilizing proper
underwriting standards for these type of products, and are we
having more of a problem in certain States than in other
States?
Chairman Greenspan. I do not know that. That is factually
capable of being ascertained, and I assume some of my
colleagues do know the answer to that question. It is not, in
my judgment, at least what I have heard, an issue that is
critical or something that requires immediate response. But it
is enough of an issue that I think we have to look at it, and
that is what we are doing, we are looking very closely.
Senator Allard. I appreciate your response on that.
Now, on various occasions you have downplayed the idea of a
national housing bubble, and have instead pointed to a
situation which some regions of the country are exhibiting
signs of, I quote, ``froth'' I guess. And I am pleased to hear
comments that while housing prices may well decline, such a
decline would not necessarily derail the economy. Would you not
agree though that while this may be true for the Nation as a
whole, a correction could have a significant impact within a
specific community or region? Could you please elaborate what
the future could hold for such a city or region, and what can
or should be done to mitigate the damage such a correction
could cause?
Chairman Greenspan. We have had such experiences in the
past, and quite correctly, there have been regional problems
associated with unwinding of frothy local housing markets.
One thing that obviously is an issue with respect to the
overall economy of these metropolitan areas, is that unlike
earlier history, we have developed a mortgage instrument to a
point, and the ability to extract equity from homes to such an
extent, that now a surprisingly large proportion of consumer
expenditures and home modernization outlays are financed by
home equity extraction. That is clearly a consequence of one,
house turnover, largely because, of course, the seller of the
home extinguishes a mortgage which is less than the mortgage of
the buyer of the home, which is essentially a reduction or
extraction of equity from that home of that exact difference.
Then of course there are cash-outs, which have increased over
the years, associated with refinancing, and then finally, a
significant amount of extraction of unrealized capital gains
essentially from home equity loans.
These are large enough to be an issue in the overall
consumption expenditures of a local community, and in the event
that you begin to get a retrenchment in house turnover, which
would presumably be associated with unwinding of a frothy
market, you would probably also have impacts on consumer
expenditures in that particular area.
There are obviously national implications of this as well.
We would expect as the housing boom eventually simmers down, as
we have long expected it would but find no evidence that it is
about to, that it would begin to have some impact on
consumption expenditures, and if not for the fact that we
perceive capital investment picking up the slack, it would give
us some pause as to
economic consequences of the adjustment process.
Senator Allard. Mr. Chairman, you kind of moved into my
second question where people were extracting this equity out of
their home. If the value of these homes should begin drop or
something, that could create some problems for our national
economy, or would it not?
Chairman Greenspan. Well, the run up in prices has been so
significant, and the accumulated equity has been so large,
indeed, it has been larger than the debt increase. So that the
ratio of equity in homes to debt has been rising in the most
recent period. So there is a fairly significant buffer. But
there is no question that, if you confronted a situation of
declining house turnover and even declining house prices, home
equity extraction would be expected to decrease.
Senator Allard. Mr. Chairman, I have a few questions, if I
may proceed.
Chairman Shelby. [Presiding.] You go ahead, you take your
time.
Senator Allard. This has to do with the terrorist attacks
and the security in our financial industry. Do you believe that
the financial services industry is prepared to protect people,
processes, and infrastructure against potential disruptions
from a terrorist attack, and do you see any further steps that
need to be taken if not?
Chairman Greenspan. This is obviously under significant
discussion now with the question of the expiration of TRIA. It
gets to the base of a very difficult question: How does a
civilized society with an economy based on the rule of law deal
with the losses from violence?
What we have done over the years is very successfully
construct an insurance system which basically has picked up a
lot of different losses from disruption from violence, from
everything else, and it is a very sophisticated system which
has evolved over the years and is still evolving.
We are now confronted with something different, and it is
different because of the technological changes and the ways in
which things can be destroyed. There is a potential very large
scope of damage that can occur, which the existing insurance
system would have difficulty figuring out how to insure and
basically cope with the problem.
This is why I have argued that there should be a fall-back
position for very large terrorist attacks, where as the
Government socializes a good deal of potential violence--and
that is what our military budgets are, that is what our police
forces are--there is a role if this terrorism level continues
to pose the potential for very large disasters.
So, I would perceive that until and unless we get this
issue of terrorism to a dimension where the private sector can
fully handle it, there is a role here for Government.
Senator Allard. So you think that at this particular point,
it might be appropriate for the Congress to provide some
subsidy to the terrorist insurance, on the umbrella coverage?
Chairman Greenspan. Yes. But I think the Administration's
proposals of delimiting some of it and having very large
copayments are very sensible. The reason is that to the extent
you socialize risks, you cause the misallocation of capital in
a market economy and this reduce the standards of living, and
so you have a tradeoff here. The more socialization of risk
that you create, which is what we are talking about, the more
potential distortion in the private sector's capital account
allocation. So we have to be very careful about what types of
things we are trying to insure against, and it should be very
succinctly limited to very large events. Part of the reason is
that the technology has never been there for a small number of
people to create as much damage as they apparently can with
essentially various different forms of terrorism, which we have
not really experienced in this country, and hopefully will
never.
If we, however, can find ways of diminishing the risk, at
some point it is conceivable the private sector could handle
the whole thing.
Senator Allard. Thank you, Mr. Chairman. You have been very
tolerant.
And thank you, Chairman Greenspan.
Chairman Shelby. Senator Bennett.
Senator Bennett. Thank you very much.
Several items, Chairman Greenspan. In your prepared
testimony, in that portion which you read to us, you made
reference to--let me read it because I was struck by it as
important to note--``A prominent concern is the growing
evidence of antiglobalization sentiment and protectionist
initiatives, which if implemented, would significantly threaten
the flexibility and resilience of many economies. The 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.''
I am fishing here for a comment on the importance of CAFTA.
I think economically CAFTA is a relatively small deal because
the economies of Central America are not that vital to our $12
trillion economy, but symbolically I think CAFTA is a very big
deal, and I get the sense from your testimony that you would
agree. But I want to give you the opportunity to comment rather
than just put words in your mouth.
Chairman Greenspan. I do, Senator, and the reason is it is
part of the very critical issue of globalization. We in this
country have embraced globalization over the decades, very much
to our benefit. The world trading system has expanded
dramatically. World standards of living have expanded
dramatically, and it is we in the United States who have
benefited the most.
We recognize, however, that the very nature of
globalization, which creates ever higher standards of living,
also is a process which we call ``creative destruction,'' which
essentially means that the depreciation reserves of obsolescent
capital get employed to finance cutting edge capital, and the
differential productivity between the obsolescent capital and
the newer capital creates the
increase in standards of living. That is the actual thing which
engenders the result.
The problem with creative destruction is that it is
destruction, and there is a very considerable amount of turmoil
that goes on in the process. As I have mentioned here many
times, we hire and essentially let go a million workers a week
in this country. It is a huge churning turnover. What we must
focus on is that as we gain the benefits of globalization, it
is important that the problems of those who are on the
destruction side of the globalization problem be addressed
appropriately.
As Senator Dole said earlier today, we have to get focused
on training, on the issue of various different means to retrain
workforces which are being altered, or doing what is required
to recognize the nature of the problems of those people who are
associated--it is a minority of the people, but it is a large
enough minority that we have to address the fact that they are
in serious trouble on occasion.
Senator Bennett. When you are a member of the minority, it
is not a small problem.
Chairman Greenspan. It is 100 percent of the problem.
Senator Bennett. Let me turn again to the GSE's and the
issue. One of the facts of life that I have learned here is
that you can tell how a piece of legislation is going to affect
the marketplace by seeing who is lined up on which side of the
issue. And as people have come to see me, pleading that heavy
restrictions be put on the portfolio size of the GSE's, and
then others have come to see me pleading that nothing be done
with respect to the portfolios of the GSE's, aside from the
GSE's themselves--you know, you kind of set aside their
statements because their position is fairly clear. A pattern
has seemed to emerge. The small banks, the mortgage brokers,
the homebuilders, realtors, are all saying do not mess with the
portfolios of the GSE's. The big banks, Citibank, Wells Fargo,
saying yeah, absolutely do this to the GSE's.
This may be an oversimplification, but as I sort through
the advocates on either side of this fight, I find it is kind
of rural on one side and big city on another. It is kind of
small bank brokerage operations that deal with small
institutions on one side, big banks on the other. The
implication being that the independent banks, the community
banks are benefitted by the present situation and the big banks
are competing with the present situation; therefore, the one
would like to see it stay and the other would like to see it
change.
Fannie Mae and Freddie Mac do not require anybody to sell
them a mortgage. The market works. People bring it to them. And
the only reason that somebody would bring a mortgage to Fannie
Mae would be if the price were better or if the service were
better. And as I have talked to people on the anti side, if you
will, they have indicated that they believe if Fannie Mae and
Freddie Mac are constrained in their portfolios, that the price
will go up and they will be forced to deal with other
institutions where they think the service--if the price goes
up, they still would rather deal with Fannie Mae because they
think it is more convenient, they move more rapidly, they are
much more flexible.
What would you say to these groups, legitimate groups, who
are not shareholders of Fannie Mae or Freddie Mac? How would
you reassure them that if we did what you wanted to do, they
were going to be just fine?
Chairman Greenspan. It is a question of fact. See, here is
what the problem is, to directly relate to your issue. I am a
community bank and I have been very appreciative of the
secondary mortgage market to take the mortgages I have and sell
to them. They are confronted with an issue of uncertainty as to
what would happen in the event if the portfolio of the GSE's
went down. The GSE's and a lot of other people say it is going
to cause interest rates to go up. Nobody says, including the
Federal Reserve, that will cause interest rates to go down.
So, they are confronted with an uncertainty of the fact
that they seem to be better off with the status quo. The truth
of the matter is they are not. That is, there is no evidence
that the amount of purchases made by Fannie, Freddie, and
indeed a very large and increasing private sector, would be
bidding significantly different prices for their home
mortgages. And the decision whether those accumulated mortgages
by, say, Fannie and Freddie, end up in their portfolio or end
up securitized and sold into the marketplace is essentially
made after they are purchased from, let us say, a community
bank.
So there is an understandable concern if you are not fully
familiar with how the markets work and there is no potential on
the other side. In other words, if I am confronted with very
little knowledge but I know the chances are only that a certain
thing can go in the wrong direction for me, I will argue for
the status quo. Now, that is a perfectly understandable and
reasonable case, and that is true, incidentally, I think, of
the homebuilders as well. I think they are mistaken. Indeed, I
know they are mistaken. But I fully understand where they are
coming from.
So the concern that I have is that over the longer-run they
are actually at risk here, as we will all be at risk if indeed
there is a systemic problem. Then there will be very serious
problems for the housing market and they will find that they
are at significant risk. They do not perceive that now because
they do not perceive what could conceivably be occurring in the
future, which is what is motivating Federal Reserve. So it is a
difficult issue of who knows what about what is going on. I do
not find any difficulty in understanding where these various
positions are coming from. And I would make the same argument,
incidentally, in reverse, for the big banks.
Senator Bennett. If I may, Mr. Chairman, go forward with
that.
Chairman Shelby. Go ahead.
Senator Bennett. You would make the same argument in
reverse?
Chairman Greenspan. Yes, in other words----
Senator Bennett. The big banks presumably will increase
their market share----
Chairman Greenspan. Yes, what I am basically saying is I
think that the amount of market share that they think that will
occur as a consequence of this is not obvious to me in any
particular way.
Senator Bennett. Okay, so you are saying that the big banks
who are beating on me, you have to do this, this is a terrible
competitive they are going to be disappointed.
Chairman Greenspan. Well, unless they are using the
arguments that I am using. We have to distinguish between the
mortgage market and the securitized market. In the securitized
market, yes, the commercial banks will probably pick up some
advantages because indeed that will be one of the purposes of
changing the system. I think, however, that the nature of the
argument misses the really fundamental point, which is that we
are creating a potential very serious systemic risk. And to
have arguments that are going on about whose market share or
whose potential profits will change in somewhat different ways,
I think, is missing the much larger point.
Let me respond in writing to you about how I think the
specific changes might occur in these markets. There are
changes. I do not want to deny that there will be changes. But
I think people extraordinarily exaggerate what the implications
are. And for the self-interest of all parties, in my judgment,
making certain that we do not have a systemic problem occurring
because there is a very large accumulation created by
incentives to hold ever-increasing portfolios to get ever-
increasing incomes, in the long-run will redound to nobody's
benefit, because we will all lose.
Chairman Shelby. Mr. Chairman, I would also request a copy
of that letter, if you would, please.
Senator Bennett. Yes, that would be very helpful. And my
time is gone, but I look forward to having additional
conversations with you about this.
Thank you very much.
Chairman Shelby. Chairman Greenspan, since we are talking
about GSE's, how many companies with $12 billion accounting
errors--which would be representing a significant portion of
the capital of that company--see no increase in debt cost in
the market after that? I am referring to Fannie Mae.
Chairman Greenspan. It is very simple. Because it has
nothing to----
Chairman Shelby. Oh, it is the implicit guaranty.
Chairman Greenspan. Yes. It has nothing to do with the
status of Fannie Mae or Freddie Mac.
Chairman Shelby. Thank you.
This Committee has previously raised questions with you,
Mr. Chairman, and Treasury Secretary Snow regarding the large
Chinese and Japanese official holdings of U.S. Treasuries. Your
report today indicates that data from Treasury indicates that
demand for these securities from foreign official investors has
ebbed during the first 5 months of this year. Obviously, the
Chinese Government announcement to switch to a currency basket
in setting its peg could also affect that demand.
Mr. Chairman, do you anticipate that long-term rates may be
affected by the changes in foreign official demand, or do you
expect such changes to unfold slowly over time and thus be
absorbed into the market?
Chairman Greenspan. Well, two things happened. We have
estimated, I think I have testified before, that the
accumulation on foreign account has probably subtracted
something under 50 basis from long-term interest rates in the
United States. Should that unwind, that is about the order of
magnitude we are talking about. But markets anticipate what is
likely to occur. As a consequence of that, you could very well
get changes that are up front in anticipation of things that
will go on longer term.
Chairman Shelby. Factored it in, in a sense?
Chairman Greenspan. Yes. In other words, the markets do not
wait--they anticipate. So we could get some impact sooner
rather than later.
Chairman Shelby. Mr. Chairman, the Chinese Government
today, as we have been talking about, announced a 2 percent
reevaluation of its currency and the move to a currency peg
linked to a basket of currencies rather than just linked to the
U.S. dollar. Other Asian countries, like Japan and Korea, who
have extensive trade relationships with China, have grown
accustomed to China's fixed exchange rate policies. How will
China's other Asian trading partners manage this transition by
the Chinese, and won't these countries have to allow more
flexibility in their currencies in order to see a more level
playing field for the United States?
Chairman Greenspan. I think we are already seeing that. I
mean, Malaysia this morning also moved, as I recall.
Chairman Shelby. So the market again anticipated this move
and has reacted to it?
Chairman Greenspan. Yes. If you look, for example, the
dollar weakened significantly against the yen this morning, as
a consequence of this move.
Chairman Shelby. Mr. Chairman, your testimony also
discussed at length what others have referred to as the savings
glut. One factor you note is corporate behavior and the
softness in capital investment. This is particularly puzzling
in light of strong profits in the corporate sector and lower
interest rates. Could you touch further on the potential causes
of this behavior and whether our Nation's economy has ever
experienced similar circumstances? Should the situation
persist, how would this affect the Federal Reserve's growth
projections?
Chairman Greenspan. Well, as I indicated in my prepared
remarks, capital investment in the United States is expanding,
and indeed we are expecting it to expand a good deal further.
Chairman Shelby. Do you think it is adequate?
Chairman Greenspan. It is less than one would have
expected, given the levels of cashflow and, indeed, other
measures that usually were associated with capital investment.
I attribute this in my remarks to the aftermath of the stock
market liquidation and the corporate scandals, which had a
fairly profound effect on corporate governance and on the risk
aversion of corporate managers. I think we are still seeing the
aftermath of that, although there is some evidence that it is
beginning to dissipate, and that is one of the reasons we
perceive that the outlook for capital investment in the United
States is quite favorable.
Chairman Shelby. Thank you.
Oh, excuse me, Senator Corzine. My eyes aren't as good as
yours.
Senator Corzine.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Your eyes are pretty good, particularly
when we are looking at legislation, Mr. Chairman.
I appreciate the Chairman being here. Let me ask, have you
commented today, with respect to the House bill, with regard to
GSE's?
Chairman Greenspan. I have not, Senator.
Senator Corzine. Do you have views with regard to the House
bill?
Chairman Greenspan. You are talking about what the House
Financial Services Committee voted on?
Senator Corzine. Yes.
Chairman Greenspan. That question was asked me yesterday at
that Committee, and I said it did not address the problems that
I thought were extant with respect to the GSE's, and indeed,
went further and said that we would probably be better off with
no bill than a bill of that nature.
Senator Corzine. And your major problems?
Chairman Greenspan. Largely the issue of portfolio to what
we have been discussing with----
Senator Corzine. And I know you have spoken often about
this, but have you narrowed or become more precise on how you
believe those portfolios restrictions should----
Chairman Greenspan. I thought that the particular
formulation by the Secretary of the Treasury with respect to
what he thought would be an appropriate bill struck us as
pretty much where we thought it should be. That is essentially,
as you may recall, stipulating that the level of portfolio
should reflect, aside from obvious liquidity needs and the
turnover of very vast amounts of mortgages, the charter
requirements of the GSE's, but that strictly for the purpose of
creating increased earnings would not be a justification for
building up portfolios.
Senator Corzine. But are you suggesting, and is the
Treasury Secretary suggesting, in your view, that would be
based on risk-based modeling with respect to what was an
appropriate----
Chairman Greenspan. You mean for the GSE's?
Senator Corzine. Yes.
Chairman Greenspan. No. We are not raising the question
with respect to the portfolios as a risk to the GSE's; on the
contrary. It is expanding their profitability and everything
else that goes with it. Our concern is the systemic risk, not
safety and soundness risk. The House bill specifically puts the
capability of a regulator to adjust portfolios on the basis of
safety and soundness, which I read refers to the safety and
soundness of the GSE's, not the systemic questions that we
raise.
Senator Corzine. Is that consistent with bank regulation?
Chairman Greenspan. No, it is a different standard.
Senator Corzine. It is a different standard for GSE's?
Chairman Greenspan. Yes, indeed. At least in my judgment.
Senator Corzine. And could you explain to me why that
systemic risk is so much different in an institution of a
trillion dollars in one format versus a trillion dollars in
another format?
Chairman Greenspan. Let me be very explicit. It has to do
with the extent of leverage. In commercial banks, for example,
I should say capital is several multiples, many multiples
higher than what the GSE's are holding. As a consequence, banks
do not, in our judgment, raise the level of systemic risk that
the GSE's raise. It is a different order of magnitude largely
because of, one, the size of the leverage and two, the extent
to which the financial markets grant the GSE's effective U.S.
Treasury status with respect to their bond issuance, when they
do not do for commercial banks.
Senator Corzine. Okay, so if it were capital, then risk
capital associated with the underlying assets should put them
on an equal playing field, I would think. If their regulator
chose risk capital measures----
Chairman Greenspan. There would be two issues here.
Unquestionably, if their risk-based capital were raised to the
level of where the commercial banks are, that would assuage a
good deal of the problem. It would still leave the issue,
however, of the ability of the part of these institutions to
raise any amount of capital at very low interest rates,
irrespective of the status of the institution. Indeed as the
Chairman pointed out, how is it possible I do not know whether
that was just before you came in or not----
Senator Corzine. I apologize. I had other things----
Chairman Greenspan. --how is it possible to have these huge
accounting losses and serious questions about what the earnings
of these institutions are and have virtually no effect on the
rates at which they can sell debentures. The reason,
essentially, is that the financial state of Fannie and Freddie
has almost nothing to do with what the interest rate is on
their debentures or their ability to actually sell them.
Senator Corzine. Supply and demand, at some point, has
impact on rates.
Chairman Greenspan. It does, and it will eventually occur
with U.S. Treasury issues, and I presume at that time it will
affect the GSE's.
Senator Corzine. May I ask one other question?
Chairman Shelby. Go ahead.
Senator Corzine. Have you been asked about TRIA?
Chairman Greenspan. Yes, I have.
Senator Corzine. I will check the record, then, unless you
want to repeat.
Chairman Greenspan. I will be glad to respond in writing to
you if there are other things that you would like.
Senator Corzine. Please. Thank you.
Chairman Shelby. I will get Senator Bennett first. I think
he has a question.
Senator Bennett. Yes, one quick additional issue that I
would like to raise with you again just to get this on the
record.
As we grapple with the Social Security problem, and I am
trying to craft a solution that deals with the solvency
challenge, I think the political situation says that the
personal accounts will be a fight we will have at some future
point. I think there are good enough idea that they will stay
around and I think eventually the Congress will adopt them. But
in this Congress, there does not seem to be an appetite to do
that and the solvency issue is still very much with us. So, I
have tried to craft a bill to deal with that, as my colleagues
know.
But in this process, I come back to an issue that you have
commented on in the past and I would like to get a fresh
response from you so that I am not guilty of using outdated
information. This has to do with the professional consensus
among economists which says that the CPI overstates changes in
the cost of living, and the Bureau of Labor Statistics in 2002,
perhaps in response to that consensus, began publishing a new
index called the Chain CPI. I had a little trouble
understanding what that meant. But it takes into account the
fact that consumers will make substitutions in their purchases.
If the price of X goes so high, they will switch to Y, and so
their standard of living presumably has not changed that much,
but the cost of living is better measured by the chain CPI.
My staff on the Joint Economic Committee has come up with
information that the implications of using the chain CPI as
opposed to the CPI are huge. Over 10 years, the Boskin
Commission says, quoting CBO, that if CPI overstated the cost
of living by 1.1 percent per year, the standard programs that
we have in place would increase the national debt by a trillion
dollars over a 10-year period. And Congress may want, as a
matter of policy, to say let's increase the national debt by a
trillion dollars in order to increase these programs by more
than the cost of living, but at least the stated position of
Congress in the current law is that we simply want to have the
actual cost of living taken care of.
Another side of it is that CPI is tied to the taxation
bracket, which means that people get a massive tax cut over
time with respect to the issue of bracket creep. Bracket creep
is dampened by using the CPI. So you get less revenues and more
expenditures by doing this, which means that the trillion-
dollar number may be exacerbated by the impact on the tax side.
I do not think they took the tax side into consideration when
they looked at the expenditure side.
Could you comment on all of this and where you think we as
policymakers should go on this issue?
Chairman Greenspan. We at the Federal Reserve Board have
been looking at this for a number of years. I think our most
recent estimate is that the Consumer Price Index itself is
biased upward by a little under 1 percent at this stage.
Senator Bennett. That is a little less than the Boskin
thing, so it would not be quite a trillion dollars.
Chairman Greenspan. Yes. The reason for that is, remember
that the Bureau of Labor Statistics has made a number of
changes addressing the problems of the Boskin Commission, which
in retrospect probably underestimated the extent of what the
issue of the bias was. Because if you take our current
evaluation and add back the BLS adjustments, I think we go
higher than the Boskin Commission data would suggest.
What we also find is that the CPI chain index takes off
roughly half of that bias. It does not take the whole bias out,
and indeed, if the Congress literally wanted to have an index
which was the optimum estimate of what the cost-of-living
change really was, you would need to find a mechanism that
actually made the adjustment for the full bias. And that, you
know, is close to the 1.1 percent number to which you were
referring.
I think that is very difficult to do unless you get, as I
suggested many years ago, a commission which would sit there
each year, reevaluate what the nature of the bias was, and set
what the adjustment for all Federal programs would be. Short of
that, switching to the chain index, which is just a reweighting
in a fully mechanical, understandable way by the BLS, would
give us a far superior, less biased measure of what the cost of
living is. It will not go all the way, but it will take a good
deal out of both, obviously, the tax side and the spending
side.
Senator Bennett. Thank you very much.
Chairman Shelby. Mr. Chairman, just for the record again, I
would like to know what size portfolio, in your judgment,
roughly, should the GSE's maintain?
Chairman Greenspan. I do not have a specific number. It is
significantly below where it is now. They still have very
significant needs for liquidity, but incidentally, that
liquidity should be in Treasury bills. But they do not want to
hold Treasury bills, because to sell debentures and invest in
Treasury bills does not make any money; in fact, you would
probably lose something. It is the selling of debentures to
invest in mortgage-backed securities which gives you a nice big
fat yield.
So the presumption that is often stated--that they need
this whole stock of mortgage-backed securities for liquidity
purposes--raises a very interesting point: How in the world
does holding mortgage-backed securities in your portfolio give
you the capability of buying other mortgage-backed securities?
In other words, the only thing that will do that----
Chairman Shelby. That is a bogus argument, really.
Chairman Greenspan. Yes. The only thing that will do that
is if they built up either cash balances or Treasury bills or
something which they could liquidate quickly and employ. The
presumption that you have a large portfolio of mortgage-backed
securities for the purposes of liquidity presupposes that you
sell a mortgage-backed security to get the cash to support
another mortgage-backed security. That obviously is a zero-sum
game.
So the amount of liquidity that is involved and required,
strikes me as something that the regulator has to make a
judgment on. But I do think that what should be specified is
what that portfolio could be held for. There are liquidity
purposes; there are a significant number of mortgages which
cannot be securitized, a lot of them basically under affordable
housing programs, and we would say they should be held in the
portfolio; and a number of other things. But essentially
restrict it to the purposes of the charter.
Chairman Shelby. The mission, huh?
Chairman Greenspan. Yes.
Chairman Shelby. Thank you.
Senator Schumer.
Senator Schumer. Well, thank you, Mr. Chairman. I apologize
for being away for a long, busy day in many ways.
I know you have talked a little bit about the Chinese
currency, so I will not have you repeat that. You were asked
about terrorism insurance, so I will not have you repeat that.
And I could not agree with you more, the private market cannot
handle this alone.
I have one topic I would like to ask about, and I thank the
Chairman.
As you know, Mr. Chairman, there are ongoing discussions as
to whether we should fully repeal the estate tax--this is a tax
that affects about one American in 100--or whether there can be
some reasonable or permanent compromise that can garner the
necessary 60 votes, because it breaks the Budget Act, as you
know.
The Federal deficit this year, excluding Social Security,
will be huge, more than half a trillion this year alone. You
also know, of course, that full repeal would cost $300 billion
in the next 10 years and $750 billion if you go between 2011
and 2020--you know, the years that the present law is not in
effect. And that would be if the costs are not offset.
So my question is, given these deficits and the cost of
repeal, if there are no offsets, can we afford to repeal the
estate tax and increase the deficit by another $750 billion, if
there are no offsets?
Chairman Greenspan. I think that is the critical question
because, as I have testified on numerous occasions, I am
strongly in favor of reducing taxes on capital, but under
PAYGO. As a consequence, I would say if there are no offsets,
obviously PAYGO is operative in that respect and the issue is
moot.
Senator Schumer. The issue is not moot.
Chairman Greenspan. Well, the issue--in other words, if
you--the issue----
Senator Schumer. Not everyone has your view.
Chairman Greenspan. Okay. Well, that is a----
Senator Schumer. But I just--if we could just translate----
Chairman Greenspan. I will rephrase.
Senator Schumer. If we could just translate that into a
straight--you know, into----
Chairman Greenspan. I am trying not to translate.
Senator Schumer. Oh, c'mon. This is your last time here. We
have a big, big deficit.
Chairman Greenspan. You mean I am going to become perfectly
clear the last time I come here?
Senator Schumer. Yeah, exactly.
[Laughter.]
But is it unfair to say you would advise not to repeal the
estate tax if there are not offsets, if there is no PAYGO?
Chairman Greenspan. That is correct. I think that PAYGO is
an essential ingredient going forward and that all programs,
both the spending and revenue programs, come under that.
Senator Schumer. I take it there is a proposal for a
compromise, which would cost about 80 to 90 percent of the full
cost. In other words, some have proposed going to a capital
gains rate rather than the 55 percent--that would be 15--and
raising the floor to about $7.5 million. It is now, I do not
know, it was originally 1. I think it is 1.5 now. It is one and
a half now; it goes up and then it goes back down.
I take it that would cost, instead of $750 billion over the
next 10 full years, v2011 to 2020, that would cost $600, $625,
$630 billion. I take it, again, without PAYGO, without an
offset, you would think we should not do that at this point.
Chairman Greenspan. That is correct.
Senator Schumer. Thank you, Mr. Chairman.
Chairman Shelby. Chairman Greenspan, thank you for your
appearance today and all the other appearances and your service
to the country.
The hearing is adjourned.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF ALAN GREENSPAN
Chairman, Board of Governors of the Federal Reserve System
July 21, 2005
Mr. Chairman and Members of the Committee, I am pleased to be here
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 2 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 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 2 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 10-year Treasury
notes, currently near 4\1/4\ percent, is about 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.
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
The unusual behavior of long-term interest rates first became
apparent last year. In May and June 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 10-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
United States.
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 1 year period ending 10 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.
---------------------------------------------------------------------------
\2\ Dollar interest rate swaps 5 years forward and maturing in 10
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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\3\ Term premiums measure the extent to which current prices of
bonds discount future uncertainties.
---------------------------------------------------------------------------
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-1990's, 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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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 cashflow.\5\ In the United States, for example, capital
expenditures were below the very substantial level of corporate
cashflow 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 1990's. And
investment in emerging Asia excluding China fell appreciably after the
Asian financial crisis in the late 1990's. 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.
---------------------------------------------------------------------------
\5\ A significant part of the surge in cashflow 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.
---------------------------------------------------------------------------
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
10 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.
---------------------------------------------------------------------------
\6\ The decline of euro, sterling, and yen forward swap rates also
steepened.
---------------------------------------------------------------------------
According to estimates prepared by the Federal Reserve Board staff,
a significant portion of the sharp decline in the 10-year forward 1
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 10-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 antiglobalization 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.''
RESPONSE TO A WRITTEN QUESTION OF SENATOR REED
FROM ALAN GREENSPAN
Q.1. I mentioned in my opening remarks the study by the Boston
Federal Reserve with respect to labor participation, which
suggests there is a significant and growing lack of
participation in the labor force which distorts our ability to
see how well we are doing with respect to recoveries. In fact,
one thing that I found interesting was the ratio of employment
to population, 62.7 percent, is below the level at the start of
the economic recovery in November 2001. And this is the first
time the ratio has failed to surpass its trial level so far
into a recovery. Can you comment?
A.1. At my July 21 testimony before the Senate Banking
Committee, you asked if I could provide additional detail
concerning the Board staff's assessment of recent developments
in labor force participation and their implications for the
interpretation of the unemployment rate as a measure of slack
in the labor market. As I noted in my response at the hearing,
while cyclical factors likely have contributed to the weak
recovery in labor force participation, our staff estimates that
part of that weak performance in recent years can also be
traced to a downtrend in the underlying rate of participation.
The change in the overall trend has occurred both because the
trend in the participation of adult women appears to have
flattened out and because the large baby boom cohorts are
moving into the age range in which their labor force
participation will likely drop off sharply as many workers in
these cohorts retire. More specifically, we estimate that the
underlying trend in the participation rate has fallen from a
little more than 66\1/2\ percent of the civilian working-age
population in 2001 to about 66\1/4\ percent this year. Because
the participation rate in recent months has averaged just over
66 percent, we estimate that the implied cyclical shortfall in
participation equates to a few tenths of a percentage point on
the unemployment rate.
Our estimates are broadly similar to those of the
Congressional Budget Office. Differences between our estimates
and those reported in the Boston Fed study that we discussed at
my hearing primarily reflect different views about the
evolution of trends in participation for various demographic
groups and different ways to measure the size of the current
participation shortfall. In particular, the Boston Fed study
examines a range of alternative trajectories for participation
rates for women and older workers and calibrates the size of
the estimated current shortfall as a percentage of the labor
force. Of course, all such estimates are subject to
considerable uncertainty, and our understanding of the
relationship between labor force participation and labor market
slack will undoubtedly benefit from additional research on this
topic.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT
FROM ALAN GREENSPAN
Q.1. What guidance could you offer for selection of an index to
use for maintaining purchasing power over time in Federal
programs with cost-of-living adjustments?
A.1. As you know, I have long advocated improvements in the
price indexes published by the Bureau of Labor Statistics
(BLS). As you have indicated, this issue is important for
several reasons. In addition to the need for accurate measures
of inflation, price indexes are used for the automatic
inflation adjustments of many Federal tax and spending
programs, and inaccurate price measures can lead to adjustments
that are inconsistent with true changes in the cost of living.
In recent years, the BLS has taken important steps to
improve the quality of the price indexes. However, reviews of
the academic literature on price measurement suggest that
frequently cited consumer price indexes published by the BLS
still tend to overstate
increases in the cost of living. This evidence indicates that,
if Congress intends the inflation adjustments to compensate for
changes in the cost of living, adjustments based on the CPI-U
or CPI-W will be too large, perhaps by a significant amount.
Q.2. Do you believe that replacing the CPI-U with the C-CPI-U
in indexing Federal programs would be truer to the original
intent of Congress in making cost-of-living adjustments?
A.2. As indicated, research suggests that the CPI-U and CPI-W
overstate increases in the cost of living. A portion of this
measurement error owes to substitution bias, and, to address
this problem, the BLS recently developed the Chained CPI-U (C-
CPI-U).
Although the C-CPI-U is still subject to other sources of
bias--especially those related to changes in the quality of
existing products and introduction of new goods and services--
basing inflation indexation of Federal programs on the C-CPI-U
would, in my view, give us a less biased measure of changes in
the cost of living.
Q.3. Because construction of the C-CPI-U requires data on the
changing expenditure patterns of consumers as relative prices
shift, the index is subject to revision as better data on
expenditures become available. However, this presents a problem
because retroactive adjustments may become necessary as
revisions are made if the C-CPI-U were to be used for
indexation purposes in Federal programs.
One possible way to overcome such a problem would be to use
``true up'' factors as revisions are made. For example, if last
year's C-CPI-U growth was revised down by 0.2 percent and this
year's C-CPI-U growth was 1.4 percent, then we could actually
increase whatever is being indexed by only 1.2 percent (this
year's 1.4 percent less a ``true up'' factor of 0.2 percent to
reflect the revision). Assuming that errors are unbiased
(essentially, that revisions have mean zero), such a procedure
should average out correctly over time. However, in the short-
run, revision issues could be significant.
If you believe that the C-CPI-U represents a truer measure
of the cost of living than the CPI-U, how would you address the
problem of data revisions?
A.3. As you noted, the indexation of Federal programs to a
price index that is subject to revision, such as the C-CPI-U,
does lead to certain complications. If the index is
subsequently revised, then programs tied to that index will
have been set at levels learned, ex post, to have been
inappropriate. (Of course, use of a price index that is not
subject to revision also may generate inappropriate adjustments
to Federal programs, and the absence of revision may mean that
any such errors are never corrected.) The complications
introduced by such revisions are readily surmountable, however.
Indexation formulas may be structured in ways that take such
revisions into account and ensure that, in the period following
the revision, the programs are set back at appropriate levels.
The use of ``true up'' factors, as you suggest, is one way to
achieve this goal.
Q.4. If you were to change the price measure used in indexing
Federal programs, how would you respond to a criticism that
such a change is merely a sneaky way of cutting benefits and
increasing taxes?
A.4. As indicated above, I believe that it would be desirable,
insofar as possible, to index Federal programs in a way that
captures actual changes in the cost of living.
Q.5. In remarks on price measurement at the Center for
Financial Studies in Frankfurt, Germany on November 7, 1997,
you advocated establishment of an objective, nonpartisan, and
independent national commission to set annual cost-of-living
adjustment factors for Federal programs. Do you still feel that
it would be beneficial to establish such a commission? How
would you constitute such a commission? Would you be willing to
coordinate research efforts of Federal Reserve staff with those
of my staff on the Joint Economic Committee to help explore the
possibility of formalizing such a commission?
A.5. Further improvements in our price indexes would be a
welcome development. In the meantime, it is important to
consider how best to index Government programs, given price
measures still appear to suffer from significant biases. Many
approaches to this latter problem have the potential to yield
progress, including the establishment of an independent
commission.
RESPONSE TO A WRITTEN QUESTION OF SENATOR CORZINE
FROM ALAN GREENSPAN
Q.1. This morning, the Senate Agriculture Committee is marking
up legislation reauthorizing the Commodities Futures Trading
Commission. The proposed legislation would modify the Commodity
Futures Modernization Act (CFMA) of 2000, which, as you know,
this Committee and Agriculture jointly worked on to develop.
That effort was based on recommendations from the President's
Working Group (the Federal Reserve, Treasury, SEC, and CFTC) on
Financial Markets.
Yesterday, you expressed concerns to Agriculture Committee
Chairman Chambliss about the legislation in response to a
letter from Senator Crapo. Those concerns seem to revolve
around the fact that the President's Working Group has not had
the opportunity to review or deliberate key proposals contained
in the draft reauthorization legislation. SEC Acting Chairman
Glassman has expressed a similar concern, and Chairman Shelby
and Ranking Member Sarbanes have done so as well.
As you know, of major concern with the draft legislation
are the provisions that would modify portions of the CFMA that
were painstakingly crafted to balance the differing interests
of all Federal financial regulators. I wonder if you could
discuss more in depth the nature of the concerns you expressed
in your letter and what specific harm could come from
Congressional action that, done in haste, could disrupt the
balance and legal certainty the CFMA struck which has aided the
development of important financial markets and reaped
significant benefits for the broader economy?
A.1. The Federal Reserve Board believes the CFMA has
unquestionably been a successful piece of legislation. It
enacted provisions that excluded transactions between
institutions and other eligible counterparties in over-the-
counter financial derivatives and foreign currency from
regulation under the Commodity Exchange Act (CEA). This
exclusion resolved long-standing concerns that a court might
find that the CEA applied to these transactions, thereby making
them legally unenforceable.
Another important part of the CFMA addressed problems
associated with ``bucket shops'' that were marketing foreign
currency futures to retail customers (that is, an individual or
business that does not meet the definition of eligible
counterparty). The legislation marked up by the Senate
Agriculture Committee in July 2005 would apply the CEA as a
whole to certain retail foreign currency contracts, regardless
of whether they are futures contracts. We seriously question
whether it is necessary to apply all the provisions of the CEA
to these transactions in order to enable the CFTC to address
fraud, and believe that a broad application of the Act could
have unintended consequences.
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