Statements to Congress.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, U.S. Senate, January 21, 1997

I am pleased to appear here today. In just a few weeks the Federal Reserve Board will submit its semiannual report on monetary policy to the Congress. That report and my accompanying testimony will cover in detail our assessment of the outlook for the U.S. economy and the challenges facing monetary policy. This morning, I would like to offer some personal perspectives on the current economic situation.

I think it is fair to say that the overall performance of the U.S. economy has continued to surpass most forecasters' expectations. The current cyclical upswing is now approaching six years in duration, and the economy has retained considerable vigor, with few signs of the imbalances and inflationary tensions that have disrupted past expansions. Although the data for the fourth quarter are still incomplete, it is apparent that real gross domestic product posted an increase in the neighborhood of 3 percent over the four quarters of 1996. This increase may seem quite moderate compared with the gains registered in some earlier years of the postwar period; however, at a time when the working age population is expanding relatively slowly and unemployment is already low, this economic growth is appreciable indeed. It was enough to generate more than 2 1/2 million new payroll jobs last year and to cause the unemployment rate to edge down to 5 1/4 percent--a figure roughly matching the low of the last cyclical upswing, in the late 1980s. But, in contrast to that earlier period, we have not experienced a broad increase in inflation; in fact, by some important measures of price trends, inflation actually slowed a bit in 1996.

The balance and solidity of the expansion last year can be seen in the composition of the growth. Notably, consumers appear to have been rather conservative in their spending. In some instances, they may have been constrained by the debt-service burdens accumulated over the previous few years; but in the aggregate, households experienced an enormous further accretion of net worth as the stock market continued to climb at a breathtaking rate. Judging from historical patterns, such an increase in wealth might have inspired households to spend an enlarged share of their current income; but, if we take the available data at face value, households appear instead to have set aside a greater share of their income for financial investment. Perhaps Americans are finally becoming conscious of the need to accumulate additional assets to ensure not only that they can handle temporary interruptions in employment but also that they will have the wherewithal to enjoy a lengthy retirement down the road.

Be that as it may, the increased flow of private savings--and a reduced call upon those savings by the Treasury--helped to fund substantial increases in fixed investment last year. Homebuilding activity was up considerably; notably, single-family housing starts were robust once again and helped to push the nation's homeownership rate to a fifteen-year high. In addition, business fixed investment posted another strong advance. Firms acquired large amounts of computing and telecommunications equipment in particular, seeking to enhance the efficiency of their operations as well as their overall productive capacity. At the same time, they accumulated inventories rather cautiously: Stock-to-sales ratios, which had risen in 1995, were in many cases near historic lows as of November 1996, the most recent month for which statistical information is available.

The growing economy had beneficial effects on the finances of many states and localities, which consequently could spend more on needed infrastructure and vital services and, in some instances, trim taxes. Of course, overall government sector purchases were held down by the ongoing efforts to reduce the federal deficit. It clearly was private demand that drove economic growth last year.

To be more specific, it was domestic private demand that did so, for net exports fell, on balance, in 1996. The volume of goods and services we sold abroad grew appreciably, despite moderate economic expansion by our major trading partners, but our imports continued to grow at a rapid clip. In fact, imports provided a safety valve in a U.S. economy marked by a high degree of resource utilization.

I have already noted that our unemployment rate reached the lowest level in some time. Moreover, throughout the year, we heard reports from around the country that qualified workers were in tight supply. Although increases in hourly compensation remained relatively subdued--an important fact to which I shall return in a few moments--they did become more sizable, and they raised unit costs when employers were unable to enhance productivity commensurately. Thanks to the very substantial additions to facilities in the past few years, physical capacity in the manufacturing sector was not greatly strained.

The question is, of course, where do we go from here? Can we continue to achieve significant gains in real activity while avoiding inflationary excesses? Because monetary policy works with a lag, it is not the conditions prevailing today that are critical but rather those likely to prevail six to twelve months, or even longer, from now. Hence, as difficult as it is, we must arrive at some judgment about the most probable direction of the economy and the distribution of risks around that expectation.

Fortunately, economic events are not wholly random and unforecastable. There are certain principles, and certain empirical regularities in behavioral relations, that we can follow with some degree of confidence. For example, capital investment responds in a predictable way to the rate of growth of the economy, expected profitability, and the cost of capital. Similarly, housing activity, with some qualifications, moves inversely with mortgage rates. And the largest component of final demand, personal consumption expenditures, generally follows income over time. Many of these relationships are embedded in the traditional notion of the business cycle developed by Wesley Clair Mitchell three-quarters of a century ago and worked out with Arthur F. Burns, one of my predecessors, in the definitive tome Measuring Business Cycles. Their insights remain relevant today.

Even so, each cycle tends to have its own identifying characteristic. For example, in the late 1980s and the recessionary period of the early 1990s, the economy was dominated by the sharp fall in the market value of commercial real estate; because such real estate served as a major source of loan collateral, the drop in its value had a profoundly restrictive influence on the willingness and ability of commercial banks to lend. As you may recall, at that time, I characterized the economy as trying to advance in the face of fifty-mile-an-hour headwinds. The severe credit restraint was only grudgingly responsive to the extended efforts of the Federal Reserve to ease monetary conditions.

Similarly, the dramatic rise of inflation and of inflation expectations in the 1970s was key in shaping the cyclical patterns of that period. One manifestation was the impetus to spending on houses, cars, and other consumer durables from buyers' efforts to beat future price increases. Countering this inflation required a major monetary tightening, which moved both nominal and real interest rates up sharply and led to substantial contractions in housing and other interest-sensitive sectors in the early 1980s.

In contrast, as I have mentioned several times to the Congress over the past few years, perhaps the dominant characteristic of the current expansion is low inflation and quiescent inflation expectations, which have helped create a financial environment conducive to strong capital spending and longer-range planning generally. I emphasized this point in our Humphrey-Hawkins testimony of a year ago. Since then, increases in hourly compensation as measured by the employment cost index have continued to fall far short of what they would have been if historical relationships between compensation gains and the degree of labor market tightness had held.

Reaching some judgment about the reasons for this departure from past patterns is important. As I see it, heightened job insecurity explains a significant part of the restraint on compensation and the consequent muted price inflation.

Surveys of workers have highlighted this extraordinary state of affairs. In 1991, at the bottom of the recession, a survey of workers at large firms indicated that 25 percent feared being laid off. In 1996, despite the sharply lower unemployment rate and the demonstrably tighter labor market, the same survey organization found that 46 percent were fearful of a job layoff.

The continued reluctance of workers to leave their jobs to seek other employment as the labor market has tightened provides further evidence of such concern, as does the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five-and six-year contracts-contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security.

Thus, the willingness of workers to trade off smaller increases in wages for greater job security seems to be reasonably well documented for this particular business cycle expansion. The unanswered question is why this insecurity has persisted even as the labor market has, by all objective measures, tightened considerably. One possibility is the ongoing concern of workers about job skill obsolescence. The reality of this obsolescence is evidenced by the marked expansion of on-the-job training programs, especially in technical areas, in many of the nation's corporations. No longer can one expect to obtain all of one's lifetime job skills with a high school or college diploma. Indeed, continuing adult education is perceived to be increasingly necessary to retain a job.

Certainly, there are other possible explanations of the softness in compensation growth in the past few years. The sharp deceleration in health care costs, of course, is cited frequently. Another possibility is the heightened pressure on firms and their workers in industries that compete internationally. Domestic deregulation has had similar effects on the intensity of competitive forces in some industries. In addition, the continued decline in the share of the private work force in labor unions has likely made wages more responsive to market forces-indeed, the converse is also true in that the new competitive realities have in many instances undermined union strength. In any event, although I do not doubt that all these explanations are relevant, I would be surprised if any were dominant.

Another potential explanation is that persistently low price inflation is constraining wage increases. Historical evidence clearly indicates that price inflation is a factor in wage change. But, if the causation is running mainly from product markets, where prices are set, to labor markets, where wages are set, then we would expect to see some squeeze on profit margins. Clearly, this is not the case at present. Rather, owing in part to the subdued behavior of wages, profits and rates of return on capital have risen to high levels. The high rates of return, in turn, seem to be inducing competitive pressures that limit the ability of firms to raise prices relative to their underlying cost structures because they fear that competitors anxious to capture a greater share of the market will not follow suit. Thus, the evidence seems more consistent with the view that wage restraint is damping price increases than the other way around.

If the job insecurity paradigm that I have outlined is the key, then we must recognize that, as I indicated in last February's Humphrey-Hawkins testimony, "suppressed wage cost growth as a consequence of job insecurity can be carried only so far. At some point in the future, the trade-off of subdued wage growth for job security has to come to an end." In short, this implies that even if the level of real wages remains permanently lower as a result of the experience of the past few years, the relatively modest wage gains we have seen are a transitional rather than a lasting phenomenon. The unknown is how long the transition will last. Indeed, the recent pickup in some measures of wages suggests that the transition may already be running its course. If so, the important question from a monetary policy point of view is whether prospective labor market conditions will be consistent with the maintenance of satisfactory price performance.

I would like to conclude with a brief discussion of some issues of measurement and economic data that may be useful as you begin your deliberations on the 1998 budget. One issue you will have to grapple with is the growing consensus that the consumer price index--and other broad price measures that rely heavily on CPI data in their construction--are substantially overstating changes in the true cost of living. From your perspective, one important implication of the CPI bias is that it creates an automatic and presumably unintended real increase in social security and other indexed federal benefits and a real cut in indexed individual income taxes each year. Less widely recognized is the fact that, for a given level of nominal spending, the upward bias in the CPI in many cases is mirrored in a downward bias in estimates of real spending; this muddies the interpretation of both recent economic developments and longer-run trends in our economic performance.

Several researchers have attempted to quantify the bias in the CPI and other broad measures of prices. One set of studies has examined the detailed microstatistical evidence on price measurement. The Boskin Commission drew heavily on these studies and concluded that the CPI is currently overstating changes in the true cost of living approximately 1 percentage point per year. In addition to some technical factors associated with its construction, the CPI overstates inflation because of the slow introduction of new products and inadequate adjustment for quality improvements.

Recently, researchers at the Federal Reserve Board have looked at the measurement issue from a macroeconomic perspective. This analysis, which questions whether the pattern implied by the published price, output, and productivity statistics makes sense, also suggests that the inflation rate is overstated. In particular, the research finds that measured real output and productivity in the service sector of the economy are implausibly weak, given that the return to the owners of these businesses that is implicit in our aggregate statistics on GDP apparently has been well maintained. The published data indicate that the level of output per hour in several service-producing industries has been falling for more than two decades--that is, that firms in these industries have been getting less and less efficient for more than twenty years. This pattern is highly unlikely. Price mismeasurement seems to be the most probable explanation of the data anomalies, and the order of magnitude appears consistent with the microstatistical results.

The evidence that inflation has been slower and that real growth has been faster than the official measures indicate is welcome, in part because it suggests that the nation's current level of economic well-being is higher than we had thought. But I want to make clear that revising our historical estimates of real growth to incorporate better price data would have no material effect on measures of the degree of resource utilization because such a revision implies faster growth in potential output as well as actual output; accordingly, it does not alter the relationship between resource utilization and inflation. Nor does it change the outlook for the federal budget deficit, apart from any modifications to the indexing formulas for entitlements and income taxes.

Certainly, the judgment that aggregate productivity has been growing faster than indicated by the official statistics seems reasonable in light of the significant business restructurings and extraordinary improvements in technology in recent years. I do not mean to imply, however, that we should assume that the full productivity gain from information technology has already been reaped. Clearly, it takes some time for firms to adopt production techniques that translate a major new technology into increased output. In an intriguing parallel, electric motors in the late nineteenth century were well known as a technology but were initially integrated into production systems that were designed for steam-driven power plants. Not until the gradual conversion of previously vertical factories into horizontal facilities, mainly in the 1920s, were firms able to take full advantage of the synergies implicit in the electric dynamo and thus achieve dramatic increases in productivity. Analogously, not all of today's production systems can be easily integrated with new information and communication technologies. Some existing equipment cannot be controlled by computer, for example. Thus, the full exploitation of even the current generation of information and communication equipment may occur over quite a few years and only after a considerably updated stock of physical capital has been put in place.

Although such a scenario is quite plausible, we cannot be certain when, or if, it will occur. Thus, we must be vigilant to ensure that our economy remains sufficiently flexible for entrepreneurial initiatives. And we must continue our efforts to further enhance productivity growth by raising national saving and spurring capital formation. Attaining a higher national saving rate quite soon is crucial, particularly in view of the anticipated shift in the nation's demographics and associated pressures on federal retirement and health programs in the first few decades of the next century. Reducing the size of the federal budget deficit, and over time moving the unified budget into surplus, would go a substantial way in that direction.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Finance, U.S. Senate, January 30, 1997

I appreciate the opportunity to appear before you today. The committee is faced with a number of complex policy issues that will have an important bearing on the fiscal health of the nation and the welfare of our people well into the next century. I will be happy to respond to questions relating to any of those issues, but in my formal comments this morning I intend to focus on the accuracy of the consumer price index.

I would like to begin by commending this committee for having done so much to bring the issue of possible bias in the CPI to the attention of the Congress and of the nation in general. The hearings conducted by this committee in 1995, as well as the report produced by the advisory commission that was sponsored by this committee, have advanced the discussion considerably. These efforts, along with the continuing contributions of the Bureau of Labor Statistics (BLS) research staff, have added importantly to our understanding of the sources of measurement error in the CPI.

Any index that endeavors to measure the cost of living should aim to be unbiased. That is, a serious examination of all available evidence should yield the conclusion that there is just as great a chance that the index understates the rate of growth of the target concept as there is that it overstates the truth. The present-day consumer price index does not meet this standard. In fact, the best available evidence suggests that there is virtually no chance that the CPI as currently published understates the rate of growth of the appropriate concept. In other words, there is almost a 100 percent probability that we are overcompensating the average social security recipient for increases in the cost of living and almost a 100 percent probability that we are causing the inflation-adjusted burden of the income tax system to decline more rapidly than I presume the Congress intends.

A major reason for this is that consumers respond to changes in relative prices by changing the composition of their actual market basket. At present, however, the market basket used in constructing the CPI changes only once every decade or so. Moreover, new goods and services deliver value to consumers even at the relatively elevated prices that often prevail early in their life cycles; currently, that value is not reflected in the CPI.

For that and other reasons outlined in the Boskin Commission report and other studies, we know with near certainty that the current CPI is off. We do not know precisely by how much, however. There is, nonetheless, a very high probability that the upward bias ranges between 1/2 percentage point per year and 1 1/2 percentage points per year. Although this range happens to coincide with the one I gave two years ago, it does reflect both the improvements in the index that the BLS has implemented since then and the emergence of evidence suggesting that the initial problem was of a slightly greater dimension than had previously been estimated. This estimate is consistent with a number of microstatistical studies as well as an independently derived macroevaluation by the staff at the Federal Reserve Board, which I will discuss shortly.

In judging these evaluations, it is incumbent upon us to resist the evident strong inclination to believe that precision is the equivalent of accuracy in price bias estimation. If we cannot find a precise estimate for a certain bias, we should not implicitly choose zero as though that were a more scientifically supportable estimate.

There is no sharp dividing line between a pristine estimate of a price and one that is not. All of the estimates in the CPI are approximations, in some cases very rough approximations. Further, even very rough approximations can give us a far better judgment of the cost of living than holding to a false precision of accuracy. We would be far better served following the wise admonition of John Maynard Keynes that "it is better to be roughly right than precisely wrong."

Estimates of the magnitude of the bias in our price measures are available from a number of sources. Most have been developed from detailed examinations of the microstatistical evidence. However, recent work by staff economists at the Federal Reserve Board has added strong corroborating evidence of price mismeasurement using a macroeconomic approach that is essentially independent of the exercises performed by other researchers, including those on the Boskin Commission. In particular, employing the statistical system from which the Commerce Department estimates the national income and product accounts, the research finds that measured real output and productivity in the service sector are implausibly weak, given that the return to owners of businesses in that sector apparently has been well maintained. Taken at face value, the published data indicate that the level of output per hour in a number of service-producing industries has been falling for more than two decades. In other words, the data imply that firms in these industries have been becoming less and less efficient for more than twenty years.

These circumstances simply are not credible. On the reasonable assumption that nominal output and hours worked and paid of the various industries are accurately measured, faulty price statistics are almost surely the likely cause of the implausible productivity trends. The source of a very large segment of these prices is the CPI.

For this exercise, the study used the gross domestic product chain-weighted price measures. Although these price measures are based on many of the same individual price indexes included in the CPI, they do not suffer from upper-level substitution bias. Hence, the price mismeasurement revealed by this data system largely reflects shortcomings in quality adjustment and in the treatment of new goods and services. If, instead of declining, productivity in these selected service industries was flat, to up a modest 1 percentage point per year, the implicit aggregate price bias associated with these service industries alone would be about 1/2 percentage point or so per annum in recent years--very similar in magnitude to the Boskin Commission estimate of total quality adjustment and new products bias.

To be sure, it is theoretically possible that some of the measured productivity declines in these service industries merely reflect mispricing of intermediate transfers among various industries. Such an occurrence would cause an understatement of productivity in some sectors but a corresponding overstatement in others. But the available evidence suggests that for these particular service industries this theoretical possibility is not of a sufficiently large empirical magnitude to overturn the basic conclusion that there are serious measurement problems in our price statistics. Moreover, the study did not attempt to evaluate possible quality and new products bias in other industries.

Some observers who are skeptical that the bias in the CPI could be very large have noted that the evidence on the magnitude of unmeasured quality change and the importance of new items bias is incomplete and inconclusive. Without a doubt, quality change and new items are among the most difficult of the problems currently confronting the BLS. But since I raised this issue two years ago in my testimony before this committee, a number of studies have documented significant new examples of cases in which the current treatment in the CPI results in an overstatement of the rate of growth of the cost of living.

Certain components of the CPI are doubtless biased downward because quality change is handled inappropriately. One instance in which there may well be a problem in this regard pertains to new vehicles, where it may be more appropriate to treat pollution control and mandatory safety equipment, at least in part, as raising price to a consumer rather than improving quality as is the present practice. But the potential downward bias introduced by current methodology for such equipment can only be slight. We should be prepared to embrace credible new research on quality adjustment, regardless of whether that research points to additional sources of upward bias or previously undetected instances of downward bias. Nonetheless, currently available evidence very strongly supports the view that, on balance, the bias is decidedly toward failing to appropriately capture quality improvements in our price indexes. There is little reason to believe that this conclusion will change unless we alter our procedures.

A more difficult quality-related issue is whether to reflect changes in broad environmental and social conditions in price measures that are used for indexing various components of federal outlays and receipts. That is, should the CPI reflect the influence of factors such as the level of crime, air and water quality, and the emergence of new diseases, which are not specifically related to products that consumers purchase? There is little in the record to suggest that, when it enacted the indexation of social security benefits in 1972, the Congress intended for the beneficiaries of that program to be compensated for changes in such environmental and social factors. Nor do these issues appear to have been raised when the Congress debated the indexation of various tax parameters during the 1 980s. Taking account of such conditions, particularly those that lie outside the markets for goods and services, would be an interesting exercise in its own right but would appear to extend well beyond the original intent of the Congress.

A considerable professional consensus already exists for at least two actions that would almost surely bring the CPI into closer alignment with a true cost-of-living index. First, we should move away from the concept of a fixed market basket at the upper level of aggregation and move toward an aggregation formula that takes into account the tendency of consumers to alter the composition of their purchases in response to changes in relative prices. The BLS already calculates such an index on an experimental basis with a lag of about a year. If the Bureau adopts the Boskin Commission's recommendation that it publish a "best practice" version of the CPI with a lag of a year, it should, without question, build that index on the foundation of a variable market basket.

There is a somewhat more difficult issue as to whether the concept of a variable market basket can be applied in "real time," that is, with the same degree of timeliness that characterizes the current CPI. It is not possible to implement the textbook versions of any of the so-called superlative index formulas in real time because those formulas require contemporaneous data on expenditures, and those data are not presently available until about a year after the fact. However, this hardly forecloses the possibility of implementing an approximation to a superlative formula, and work should continue on the development of such an approximation.

A second area that will require attention is the aggregation of prices at the most detailed level of the index. This is a highly technical area and an important example of how research by the staff at the BLS has advanced our knowledge. Without going into the details of the matter, it is sufficient to say that a selective move away from the current aggregation formula is warranted and would probably make a modest further contribution to bringing the index more in line with the concept of a cost-of-living index.

Beyond these rather limited steps, most of the needed developments will require time, effort, and quite possibly additional resources. It is important that the Congress provide the Bureau with sufficient resources to pursue the agenda vigorously. These are difficult problems and cannot be solved tomorrow or next week. But with adequate support and diligent effort, the pace of improvement should quicken. Moreover, an accelerated pace of BLS activity and heightened congressional interest should galvanize analysts outside the government to contribute to the research effort.

Where will this longer-term effort be required? One of the key areas, by all accounts, is quality adjustment. As the Bureau has rightly noted, they do indeed already employ a variety of methods to control for quality change, but available evidence suggests that these are not sufficient to the task. Unfortunately, making improvements on this front will be difficult: Each item will have to be considered on its own, and there may well be limited transfer of knowledge from one item to the next.

Another key area on the longer-term agenda will be the estimation of the value of new products to consumers. Significant innovations, such as the personal computer, the cellular telephone, and the heart bypass operation, create value for consumers, even at their typically high initial prices; moreover, this value is even greater at the much lower prices that often prevail when new products are, in fact, introduced into the CPI. A true cost-of-living index would reflect this value and its implication for the true rate of growth of the cost of living. The CPI does not reflect it and accordingly fails to capture a significant offset to price rises in other products. Deriving an estimate of this value and building it into the CPI will not be an easy undertaking. But conceptually, it is unquestionably the right direction to be heading, and some recent research suggests that it could measurably affect the index.

Over time, we will need to investigate alternative sources of data. Already, there is interesting work being done to develop techniques for processing data collected from bar code scanners at the checkout counter. Scanner data will allow the BLS to track not just a small sample of products but virtually the entire universe of products in selected lines of business and, perhaps most importantly, virtually the universe of transactions, regardless of whether those transactions happen on a weekday, at night, or on a holiday.

We should also move to improve our understanding of the value that consumers place on their own time. Absent such knowledge, it will be impossible for the BLS to estimate the value of many goods and services that mainly serve to enhance convenience and save time.

Finally, we will have to attempt to build an understanding of why consumers shop at the places they do: What characteristics of an outlet are important and how much so? Location, hours of operation, inventory, and quality of service are all likely influences on the value that consumers place on their shopping experience, and all will be important in helping the BLS to develop a more sophisticated statistical method for dealing with the appearance of new consumer outlets, including those that operate over the Internet.

Even if the BLS moves aggressively, some upward bias will almost surely remain in the CPI. at least for the next several years. Two years ago, in testimony before this committee, I suggested that a workable structure for dealing with this situation might involve a two-track approach. That suggestion still seems to me to make sense. The first track would involve action by the BLS to address those aspects of the bias that can be dealt with in relatively short order, say within the next year. The second track would involve the establishment of an independent national commission to set annual cost-of-living adjustment factors for federal receipt and outlay programs. The commission would examine available evidence on a periodic basis and estimate the bias in the CPI, taking into account both the latest research on the sources and magnitudes of the bias and any corrective actions that had been taken by the BLS. This type of approach would have the benefit of being objective, nonpartisan, and sufficiently flexible to take full account of the latest information. Moreover, there is no reason why the two tracks could not proceed in parallel.

Without the second track, we are implicitly assuming, contrary to overwhelming evidence, that the most accurate estimate of the bias is zero. There has been considerable objection that such a second track procedure would be a political fix. To the contrary, assuming zero for the remaining bias is the political fix. On this issue, we should let evidence, not politics, drive policy.

We have an overarching national interest in building a better measure of consumer prices and in implementing more rational indexation procedures. Through these efforts, we are most likely to ensure that the original intent of the relevant pieces of legislation will be fulfilled in insulating taxpayers and benefit recipients from the effects of ongoing changes in the cost of living. At present this objective is not being met.