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he taketh some more.

Damn the FED!

CBS Marketwatch article and commentary
Greenspan sticks to his script
Fed chairman repeats mixed testimony on economy
By Rex Nutting,
Last Update: 1:08 PM ET July 24, 2001

WASHINGTON (CBS.MW) -- Federal Reserve Chairman Alan Greenspan said
again that the economy remains fragile and that more rate cuts may be

In testimony on Capitol Hill on
Tuesday, Greenspan spoke to the
Senate Banking Committee,
repeating remarks he gave last
week to a House committee. See
full story.

While the central banker said
risks to growth remain, he insisted
the monetary policy is not
impotent, as some commentators
have feared.

"At the end of the day, [monetary
policy] does seem to be
effective," he said.

Greenspan said the Fed's
aggressive 275 basis points of
rate cuts this year had helped to
"lay the groundwork" for an
ultimate recovery, but he gave no
indication that the slowdown has
run its course.

"The uncertainties surrounding the
current economic situation are
considerable, and, until we see
more concrete evidence that the
adjustments of inventories and
capital spending are well along, the risks would seem to remain mostly tilted toward
weakness in the economy," he said.

"We have moved a considerable distance in the direction of monetary stimulus," he
said. "Certainly, should conditions warrant, we may need to ease further." Read his
written testimony.

Slow capital spending, weak foreign economies and a vulnerable consumer remain
the biggest risks to a quick recovery, Greenspan said.

In response to questions, Greenspan said Wall Street's ongoing re-evaluation of how
technology companies ought to be valued doesn't mean the productivity revolution
was a fraud nor is it yet finished.

"We are only part way through a technological expansion," he said.

Greenspan defended his record of the past several years. He said monetary policy
could not prevent "euphoria" from building among investors and said the Fed didn't
wait too long in cutting rates once it realized how steep the decline was.

Sen. Phil Gramm, R-Texas, praised the Fed chief. "If this is the bust, then the boom
was sure as hell worth it," Gramm said.

Views on many issues

As always, the senators wanted Greenspan's views on every conceivable issue. He
said financial markets are signaling that Argentina's condition is improving and said
that the risks of contagion from emerging markets are less now than in 1997.

Greenspan said the key issue for Social Security reformers is not the exact form of
financing the retirement program, but the necessity of increasing national savings to
provide "an adequate capital stock to accommodate both retirees and workers in the

He said the assets in the Social Security Trust Fund are "real" in the sense that they
are claims on real flows of income. The president's commission on Social Security is
debating a draft report Tuesday that concludes that Social Security has no real

High long-term interest rates don't reflect heightened inflationary expectations, he
said, but supply issues as well as expectations that the economy will recover and
rates of return will rise.

Low commodity prices, on the other hand, don't show an incipient danger of deflation,
he said. He looks at commodity prices as signals for industrial demand, not monetary
liquidity, he said.

Greenspan's testimony has bolstered the market's expectation of another rate cut on
Aug. 21. The federal funds futures market is now saying there's a 91 percent chance
of a 25-basis-point cut in August with a 33 percent chance of another move in

The forecast

In its official forecast, the Federal Open Market Committee said the economy should
grow about 1.25 to 2 percent in 2001. Read the committee's report.

Since the economy grew about 1 percent in the first half of the year, the forecast
encompasses a wide range of outcomes for the rest of the year, from continued
stagnation to a rebound to 3 percent growth.

In 2002, the FOMC said the economy should grow about 3 to 3.25 percent, near its
full potential.

The FOMC expects the jobless rate to rise from 4.5 percent now to about 4.75 to 5
percent by the end of the year and to 4.75 to 5.25 percent at the end of 2002.

Greenspan spent a considerable amount of time in his prepared testimony
downplaying the risk that the Fed's easing might reignite inflationary pressures.

"Overall prices seem likely to be contained in the period ahead," he said. Energy
prices have fallen and pressure on unit labor costs has dissipated. At the same time,
businesses lack the power to raise prices.

The official forecast calls for a return to more moderate inflation in 2002 of 1.75 to 2.5
percent in the personal consumption expenditure price index.

Actual transcript of his speech

Testimony of Chairman Alan Greenspan
Federal Reserve Board's semiannual monetary policy report to the
Before the Committee on Financial Services, U.S. House of
July 18, 2001

Chairman Greenspan presented identical testimony before the Committee on
Banking, Housing, and Urban Affairs, U.S. Senate, on July 24, 2001

I appreciate the opportunity this morning to present the Federal Reserve's
semiannual report on monetary policy.

Monetary policy this year has confronted an economy that slowed sharply
late last year and has remained weak this year, following an extraordinary
period of buoyant expansion.

By aggressively easing the stance of monetary policy, the Federal Reserve
has moved to support demand and, we trust, help lay the groundwork for
the economy to achieve maximum sustainable growth. Our accelerated
action reflected the pronounced downshift in economic activity, which
was accentuated by the especially prompt and synchronous adjustment of
production by businesses utilizing the faster flow of information coming
from the adoption of new technologies. A rapid and sizable easing was
made possible by reasonably well-anchored inflation expectations, which
helped to keep underlying inflation at a modest rate, and by the prospect
that inflation would remain contained as resource utilization eased and
energy prices backed down.

In addition to the more accommodative stance of monetary policy, demand
should be assisted going forward by the effects of the tax cut, by falling
energy costs, by the spur to production once businesses work down their
inventories to more comfortable levels, and, most important, by the
inducement to resume increases in capital spending. That inducement
should be provided by the continuation of cost-saving opportunities
associated with rapid technological innovation. Such innovation has been
the driving force raising the growth of structural productivity over the last
half-dozen years. To be sure, measured productivity has softened in recent
quarters, but by no more than one would anticipate from cyclical
influences layered on top of a faster long-term trend.

But the uncertainties surrounding the current economic situation are
considerable, and, until we see more concrete evidence that the
adjustments of inventories and capital spending are well along, the risks
would seem to remain mostly tilted toward weakness in the economy.
Still, the FOMC opted for a smaller policy move at our last meeting
because we recognized that the effects of policy actions are felt with a lag,
and, with our cumulative 2-3/4 percentage points of easing this year, we
have moved a considerable distance in the direction of monetary stimulus.
Certainly, should conditions warrant, we may need to ease further, but we
must not lose sight of the prerequisite of longer-run price stability for
realizing the economy's full growth potential over time.

Despite the recent economic slowdown, the past decade has been
extraordinary for the American economy. The synergies of key
technologies markedly elevated prospective rates of return on high-tech
investments, led to a surge in business capital spending, and significantly
increased the growth rate of structural productivity. The capitalization of
those higher expected returns lifted equity prices, which in turn contributed
to a substantial pickup in household spending on a broad range of goods
and services, especially on new homes and durable goods. This increase
in spending by both households and businesses exceeded even the
enhanced rise in real household incomes and business earnings. The
evident attractiveness of investment opportunities in the United States
induced substantial inflows of funds from abroad, raising the dollar's
exchange rate while financing a growing portion of domestic spending.

By early 2000, the surge in household and business purchases had
increased growth of the stocks of many types of consumer durable goods
and business capital equipment to rates that could not be sustained. Even
though demand for a number of high-tech products was doubling or tripling
annually, in some cases new supply was coming on even faster. Overall,
capacity in high-tech manufacturing industries, for example, rose nearly 50
percent last year, well in excess of its already rapid rate of increase over
the previous three years. Hence, a temporary glut in these industries and
falling short-term prospective rates of return were inevitable at some
point. This tendency was reinforced by a more realistic evaluation of the
prospects for returns on some high-tech investments, which, while still
quite elevated by historical standards, apparently could not measure up to
the previous exaggerated hopes. Moreover, as I testified before this
Committee last year, the economy as a whole was growing at an
unsustainable pace, drawing further on an already diminished pool of
available workers and relying increasingly on savings from abroad.
Clearly, some moderation in the pace of spending was necessary and
expected if the economy was to progress along a more balanced growth

In the event, the adjustment occurred much faster than most businesses
anticipated, with the slowdown likely intensified by the rise in the cost of
energy that until quite recently had drained businesses and households of
purchasing power. Growth of outlays of consumer durable goods slowed
in the middle of 2000, and shipments of nondefense capital goods have
declined since autumn.

Moreover, weakness emerged more recently among our trading partners in
Europe, Asia, and Latin America. The interaction of slowdowns in a
number of countries simultaneously has magnified the softening each of the
individual economies would have experienced on its own.

Because the extent of the slowdown was not anticipated by businesses,
some backup in inventories occurred, especially in the United States.
Innovations, such as more advanced supply-chain management and flexible
manufacturing technologies, have enabled firms to adjust production levels
more rapidly to changes in sales. But these improvements apparently have
not solved the thornier problem of correctly anticipating demand. Although
inventory-sales ratios in most industries rose only moderately, those
measures should be judged against businesses' desired levels. In this
regard, extrapolation of the downtrend in inventory-sales ratios over the
past decade suggests that considerable imbalances emerged late last year.
Confirming this impression, purchasing managers in the manufacturing
sector reported in January that inventories in the hands of their customers
had risen to excessively high levels.

As a result, a round of inventory rebalancing was undertaken, and the
slowdown in the economy that began in the middle of 2000 intensified.
The adjustment process started late last year when manufacturers began to
cut production to stem the accumulation of unwanted inventories. But
inventories did not actually begin falling until early this year as producers
decreased output levels considerably further.

Much of the inventory reduction in the first quarter reflected a dramatic
scaling back of motor vehicle assemblies. However, inventories of
computers, semiconductors, and communications products continued to
build into the first quarter, and these stocks are only belatedly being
brought under control. As best we can judge, some progress seems to have
been made on inventories of semiconductors and computers, but little gain
is apparent with respect to communications equipment. Inventories of
high-tech products overall have probably been reduced a bit, but a period
of substantial liquidation of stocks still seemingly lies ahead for these

For all inventories, the rate of liquidation appears to have been especially
pronounced this winter, and the available data suggest that it continued,
though perhaps at a more moderate pace, this spring. A not inconsequential
proportion of the current liquidation undoubtedly is of imported products,
and thus will presumably affect foreign production, but most of the
adjustment has fallen on domestic producers.

At some point, inventory liquidation will come to an end, and its
termination will spur production and incomes. Of course, the timing and
force with which that process of recovery plays out will depend on the
behavior of final demand. In that regard, the demand for capital equipment,
particularly in the near term, could pose a continuing problem. Despite
evidence that expected long-term rates of return on the newer technologies
remain high, growth of investment in equipment and software has turned
decidedly negative. Sharp increases in uncertainties about the short-term
outlook have significantly foreshortened the time frame over which
businesses are requiring new capital projects to pay off. The consequent
heavier discounts applied to those long-term expectations have induced a
major scaling back of new capital spending initiatives, though one that
presumably is not long-lasting given the continuing inducements to embody
improving technologies in new capital equipment.

In addition, a deterioration in sales, profitability, and cash flow has
exacerbated the weakness in capital spending. Pressures on profit margins
have been unrelenting. Although earnings weakness has been most
pronounced for high-tech firms, where the previous extraordinary pace of
expansion left oversupply in its wake, weakness is evident virtually across
the board, including most recently in earnings of the foreign affiliates of
American firms.

Much of the squeeze on profit margins of domestic operations results from
a rise in unit labor costs. Gains in compensation per hour picked up over
the past year or so, responding to a long period of tight labor markets, the
earlier acceleration of productivity, and the effects of an energy-induced
run-up in consumer prices. The faster upward movement in hourly
compensation, coupled with the cyclical slowdown in the growth of output
per hour, has elevated the rate of increase in unit labor costs. In part, fixed
costs, nonlabor as well as labor, are being spread over a smaller
production base for many industries.

The surge in energy costs has also pressed down on profit margins,
especially in the fourth and first quarters. In fact, a substantial portion of
the rise in total costs of domestic nonfinancial corporations between the
second quarter of last year and the first quarter of this year reflected the
increase in energy costs. The decline in energy prices since the spring,
however, should be contributing positively to margins in the third quarter.
Moreover, the rate of increase in compensation is likely to moderate, with
inflation expectations contained and labor markets becoming less taut in
response to the slower pace of growth in economic activity. In addition,
continued rapid gains in structural productivity should help to suppress the
rise in unit labor costs over time.

Eventually, the high-tech correction will abate, and these industries will
reestablish themselves as a solidly expanding, though less frenetic, part of
our economy. When they do, growth in that sector presumably will not
return to the outsized 50 percent annual growth rates of last year, but rather
to a more sustainable pace.

Of course, investment spending ultimately depends on the strength of
consumer demand for goods and services. Here, too, longer-run increases
in real incomes of consumers engendered by the rapid advances in
structural productivity should provide support to demand over time. And
thus far this year, consumer spending has indeed risen further, presumably
assisted in part by a continued rapid growth in the market value of homes,
from which a significant amount of equity is being extracted. Moreover,
household disposable income is now being bolstered by tax cuts.

But there are also downside risks to consumer spending over the next few
quarters. Importantly, the same pressure on profits and the heightened
sense of risk that have held down investment have also lowered equity
prices and reduced household wealth despite the rise in home equity. We
can expect the decline in stock market wealth that has occurred over the
past year to restrain the growth of household spending relative to income,
just as the previous increase gave an extra spur to household demand.
Furthermore, while most survey measures suggest consumer sentiment has
stabilized recently, softer job markets could induce a further deterioration
in confidence and spending intentions.

While this litany of risks should not be downplayed, it is notable how well
the U.S. economy has withstood the many negative forces weighing on it.
Economic activity has held up remarkably in the face of a difficult
adjustment toward a more sustainable pattern of expansion.

The economic developments of the last couple of years have been a
particular challenge for monetary policy. Once the financial crises of late
1998 that followed the Russian default eased, efforts to address Y2K
problems and growing optimism--if not euphoria--about profit
opportunities produced a surge in investment, particularly in high-tech
equipment and software. The upswing outstripped what the nation could
finance on a sustainable basis from domestic saving and funds attracted
from abroad.

The shortfall of saving to finance investment showed through in a
significant rise in average real long-term corporate interest rates starting
in early 1999. By June of that year, it was evident to the Federal Open
Market Committee that to continue to hold the funds rate at the
then-prevailing level of 4-3/4 percent in the face of rising real long-term
corporate rates would have required a major infusion of liquidity into an
economy already threatening to overheat. In fact, the increase in our target
federal funds rate of 175 basis points through May of 2000 barely slowed
the expansion of liquidity, judging from the M2 measure of the money
supply, whose rate of increase declined only modestly through the
tightening period.

By summer of last year, it started to become apparent that the growth of
demand finally was slowing, and seemingly by enough to bring it into
approximate alignment with the expansion of potential supply, as indicated
by the fact that the pool of available labor was no longer being drawn
down. It was well into autumn, however, before one could be confident
that the growth of aggregate demand had softened enough to bring it into a
more lasting balance with potential supply. Growth continued to decline to
a point that by our December meeting, the Federal Open Market
Committee decided that the time to counter cumulative economic weakness
was close at hand. We altered our assessment of the risks to the economy,
and with incoming information following the meeting continuing to be
downbeat, we took our first easing action on January 3. We viewed the
faster downshift in economic activity, in part a consequence of the
technology-enhanced speed and volume of information flows, as calling
for a quicker pace of policy adjustment. Acting on that view, we have
lowered the federal funds rate 2-3/4 percentage points since the turn of the
year, with last month's action leaving the federal funds rate at 3-3/4

Most long-term interest rates, however, have barely budged despite the
appreciable reductions in short-term rates since the beginning of the year.
This has led many commentators to ask whether inflation expectations
have risen. Surely, one reason long-term rates have held up is changed
expectations in the Treasury market, as forecasts of the unified budget
surplus were revised down, indicating that the supplies of outstanding
marketable Treasury debt are unlikely to shrink as rapidly as previously
anticipated. Beyond that, it is difficult to judge whether long-term rates
have held up because of firming inflation expectations or a belief that
economic growth is likely to strengthen, spurring a rise in real long-term

One measure often useful in separating the real interest rates from inflation
expectations is the spread between rates on nominal ten-year Treasury
notes and inflation-indexed notes of similar maturity. That spread rose
more than three-fourths of a percentage point through the first five months
of this year, a not insignificant change, though half of that increase has
been reversed since. By the nature of the indexed instrument, the spread
between it and the comparable nominal rate reflects expected CPI
inflation. While actual CPI inflation has picked up this year, this rise has
not been mirrored uniformly in other broad price measures. For example,
there has been little, if any, acceleration in the index of core personal
consumption expenditure prices, which we consider to be a more reliable
measure of inflation. Moreover, survey readings on long term inflation
expectations have remained quite stable.

The lack of pricing power reported overwhelmingly by business people
underscores the quiescence of inflationary pressures. Businesses are
experiencing the effects of softer demand in product markets overall, but
these effects have been especially marked for many producers at earlier
stages of processing, where prices generally have been flat to down thus
far this year. With energy prices now also moving lower and the lessening
of tautness in labor markets expected to damp wage increases, overall
prices seem likely to be contained in the period ahead.

Forecasts of inflation, however, like all economic forecasts, do not have
an enviable record. Faced with such uncertainties, a central bank's
vigilance against inflation is more than a monetary policy cliche; it is, of
course, the way we fulfill our ultimate mandate to promote maximum
sustainable growth.

A central bank can contain inflation over time under most conditions. But
do we have the capability to eliminate booms and busts in economic
activity? Can fiscal and monetary policy acting at their optimum eliminate
the business cycle, as some of the more optimistic followers of J.M.
Keynes seemed to believe several decades ago?

The answer, in my judgment, is no, because there is no tool to change
human nature. Too often people are prone to recurring bouts of optimism
and pessimism that manifest themselves from time to time in the buildup or
cessation of speculative excesses. As I have noted in recent years, our
only realistic response to a speculative bubble is to lean against the
economic pressures that may accompany a rise in asset prices, bubble or
not, and address forcefully the consequences of a sharp deflation of asset
prices should they occur.

While we are limited in our ability to anticipate and act on asset price
bubbles, expectations about future economic developments nonetheless
inevitably play a crucial role in our policymaking. If we react only to past
or current developments, lags in the effects of monetary policy could end
up destabilizing the economy, as history has amply demonstrated.

Because accurate point forecasts are extraordinarily difficult to fashion,
we are forced also to consider the probability distribution of possible
economic outcomes. Against these distributions, we endeavor to judge the
possible consequences of various alternative policy actions, especially the
consequences of a policy mistake. We recognize that this policy process
may require substantial swings in the federal funds rate over time to help
stabilize the economy, as, for example, recurring bouts of consumer and
business optimism and pessimism drive economic activity.

In reducing the federal funds rate so substantially this year, we have been
responding to our judgment that a good part of the recent weakening of
demand was likely to persist for a while, and that there were significant
downside risks even to a reduced central tendency forecast. Moreover,
with inflation low and likely to be contained, the main threat to
satisfactory economic performance appeared to come from excessive
weakness in activity.

As a consequence of the policy actions of the FOMC, some of the stringent
financial conditions evident late last year have been eased. Real interest
rates are down on a wide variety of borrowing instruments. Private rates
have benefited from some narrowing of risk premiums in many markets.
And the growth of liquidity, as measured by M2, has picked up. More
recently, incoming data on economic activity have turned from persistently
negative to more mixed.

The period of sub-par economic performance, however, is not yet over,
and we are not free of the risk that economic weakness will be greater than
currently anticipated, and require further policy response. That weakness
could arise from softer demand abroad as well as from domestic
developments. But we need also to be aware that our front-loaded policy
actions this year coupled with the tax cuts under way should be
increasingly affecting economic activity as the year progresses.

The views of the Federal Reserve Governors and Reserve Bank
Presidents reflect this assessment. While recognizing the downside risks to
their current forecast, most anticipate at least a slight strengthening of real
activity later this year. This is implied by the central tendency of their
individual projections, which is for real GDP growth over all four
quarters of 2001 of 1-1/4 to 2 percent. Next year, the comparable figures
are 3 to 3-1/4 percent. The civilian unemployment rate is projected to rise
further over the second half of the year, with a central tendency of 4-3/4 to
5 percent by the fourth quarter and 4-3/4 to 5-1/4 percent four quarters
later. This easing of pressures in product and labor markets lies behind the
central tendency for PCE price inflation of 2 to 2-1/2 percent over the four
quarters of this year and 1-3/4 to 2-1/2 percent next year.

As for the years beyond this horizon, there is still, in my judgment, ample
evidence that we are experiencing only a pause in the investment in a
broad set of innovations that has elevated the underlying growth in
productivity to a rate significantly above that of the two decades preceding
1995. By all evidence, we are not yet dealing with maturing technologies
that, after having sparkled for a half-decade, are now in the process of
fizzling out. To the contrary, once the forces that are currently containing
investment initiatives dissipate, new applications of innovative
technologies should again strengthen demand for capital equipment and
restore solid economic growth over time that benefits us all.

July 2001 Monetary policy report

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