Statements to the Congress.

Statement by Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, February 8, 2000

I am pleased to appear on behalf of the Federal Reserve Board to discuss issues regarding recent bank failures as well as steps being taken to minimize unnecessary costs to the bank insurance fund and disruption to the financial system or the public that failures could pose. Recent experience has shown that despite vibrant economic conditions and a banking industry in exceptionally strong financial condition, small pockets of lax standards, excesses, or fraud, even within smaller organizations, can cause noticeable losses to the insurance fund. Today, I will discuss current strategies to minimize the frequency and costs of these unusual cases, recognizing that no supervisory program can prevent all failures. To do so, even if achievable, would require a degree of intrusiveness that would impose unusually high costs and impede market discipline.

I would like to underscore before I begin that a fundamental economic function of banking organizations is to assume and manage risk. A highly risk-averse banking industry--either self-imposed or required by the banking agencies--would inhibit financial capital from flowing to its highest and best use and prevent the economy from functioning optimally. To achieve the level of prosperity that we are experiencing now, the banking industry must accept and manage a level of risk that does not totally eliminate the potential for failure. That said, failures as the result of fraud obviously should be avoided, taking into account, of course, the limits of what examinations can accomplish as well as supervisory costs.

TRENDS IN BANK FAILURES

When banking conditions were troubled in the late 1980s and early 1990s, hundreds of banks failed because of troubled real estate markets, regional economic recessions, and lax lending standards. Those failures and their attendant costs placed a great deal of pressure on the Bank Insurance Fund. In 1991 the number of commercial banks on the problem bank list of the Federal Deposit Insurance Corporation (FDIC) exceeded 1,000 institutions with more than half a trillion dollars in assets. As banking conditions and the economy improved during the 1990s, the industry worked to return to sound lending principles, and the number of failing and problem banks fell to levels more in line with other quiescent periods in banking. For example, since the beginning of 1993, only six state member banks have failed--a failure rate lower than any similar period in the last two decades. The six banks ranged in asset size from $15 million to $280 million. As of year-end 1999, there were 1,010 state member banks with combined assets of $1.3 trillion.

This past year, one state member bank with $17 million in assets failed, with an estimated cost to the FDIC of approximately $1.6 million. While the number of recent bank failures is minimal, the number of state member banks rated 3, 4, or 5 has increased for two consecutive years, to 43, the highest level since 1995. Nonetheless, the current level of state member banks in less than fully satisfactory condition remains less than 5 percent of total state member banks supervised by the Federal Reserve, both in terms of number and assets. Although still modest by historical standards--the comparable number of problem state member banks in 1991 was 248--the current trend in the number of problem banks suggests that bank failures during 2000 may rise somewhat, while remaining at fairly modest levels. This assumes, of course, continuation of current, strong economic conditions.

Despite the moderate rise in institutions with less-than-satisfactory ratings, the banking industry appears to be better prepared today to weather an economic downturn than it was during previous recessions. Today, most banking organizations are highly profitable. In addition, they hold greater amounts of capital, are more geographically diversified, and are engaged in a greater variety of activities that diversify their risks. While some relaxation in lending standards has caused us to issue warnings to the industry, such relaxation does not appear to be on par with the excesses prevalent in the 1980s. Also, banks appear to be more attentive to their lending standards, are employing formal internal risk grades to a greater degree, and are more mindful of concentrations of credit risk and other issues than they were in the past.

On the other hand, banks today face new challenges. For one, banks have been gradually losing their lower cost and more stable retail deposit base and have become more dependent on wholesale sources to fund their balance sheet growth. At the same time, banks are still learning to manage the risk of newer and more complex activities. Some smaller institutions, in particular, face a challenge in managing this risk as they take on growth in higher risk portfolios such as subprime loans and as they employ more sophisticated portfolio management techniques such as securitizations. Challenges in managing risk are likely to increase for both large and small banking organizations, as well as for bank supervisors, as bank affiliations expand, encompassing securities, insurance, and other new financial activities.

THE RISK-FOCUSED PROCESS

To meet the challenge of more complex financing techniques, products, and delivery systems and to avoid the excesses and mistakes of the past, banks--in particular, large banks--have been implementing more formal and complex risk-management systems. Smaller banks may increasingly rely on less formal or less sophisticated systems to manage risk in small portfolios.

Similarly, supervisors have refined their approach to supervision of banks of all sizes by adopting a risk-focused approach to meet new challenges. The risk-focused approach emphasizes the need to assess the adequacy of internal systems and controls and to recognize weaknesses in "process" before such weaknesses have permeated the bank's balance sheet and adversely impacted financial performance. At the same time, however, sufficient testing of the loan portfolio and other transactions to ensure that the "process" is, in fact, being used, and that safe and sound risk-taking is occurring, remains as important today as it was in the late 1980s and early 1990s in identifying traditional credit and control problems.

THE BALANCE BETWEEN RISK ANALYSIS AND TRANSACTION TESTING

In carrying out risk-focused supervision, a balance must be struck between evaluating the soundness of both an institution's risk-management process and overall risk profile, on the one hand, and testing transactions to verify that the bank's controls are functioning properly, on the other. For our part, we have calibrated that balance based on the supervisor's level of comfort in the bank's management team and the level of problems, weaknesses, or exceptions uncovered in our review. As an examiner's level of discomfort increases, the level of transaction testing and verification procedures increases. I should emphasize that Federal Reserve examinations of banks continue to involve an in-depth review of the loan portfolio, though with newly improved sampling techniques, when appropriate, to ensure that our coverage of the portfolios is more likely to detect any embedded problems.

At the same time, however, it is important to note that these reviews have become less frequent for most small banks (with assets of $250 million or less) in recent years. Statutory changes have extended the maximum time between examinations from one year to eighteen months for well-capitalized and well-managed banks to minimize regulatory burden to those organizations. Absent indications of deterioration, material change, or unusual circumstances in those organizations, we have tried to adhere to the extended cycles and thereby limit supervisory burden on these banks. To limit the regulatory burden of dual examinations, Federal Reserve examinations of well-capitalized and well-managed state member banks are frequently conducted on an alternating basis with the states. Less frequency in examinations by either the Federal Reserve or the state, of course, increase the risk of an unpleasant surprise at the next examination, or even between examinations. As set forth in legislation, that risk has been judged to be acceptable given the tradeoff between the benefits of more constant supervision and the attendant regulatory burden to community banks.

Moreover, we have implemented a number of measures to minimize the risk presented by less frequent on-site presence in smaller; well-capitalized, and well-managed institutions. For example, we conduct off-site monitoring of these institutions based on quarterly financial and other reports. Additionally, we contact bank management between examinations to identify changes in such areas as lending and key management that could affect the bank's financial condition. This monitoring and interim contact provides value in that it may trigger acceleration of a regularly scheduled examination or result in an unscheduled visitation if deteriorating or unusual financial performance or other material changes are noted. Notwithstanding these efforts, off-site monitoring cannot detect the valuation deficiencies that may be revealed in the on-site testing of individual loans or transactions.

A further challenge to the supervisory program is, ironically, the infrequency of substantive problems in banking organizations. As many of the more seasoned examiners of the 1980s and early 1990s are retiring, the examiners hired over the past several years have little experience to fall back on when encountering questionable portfolios or valuations or unusual transactions. While we have beefed up training to deal with this gap, there is obviously nothing like actual experience in dealing with difficult supervisory situations.

IDENTIFYING PROBLEMS IN EARLY STAGES

A key objective of risk-focused examinations is to identify problems at an early stage. Toward that objective, we have tracked changes in bank lending standards through such measures as an in-depth and virtually simultaneous review of lending standards at selected banks and periodic surveys of senior lenders and examiners on banks' lending standards and conditions. As a result of these and other measures, we have identified a level of relaxation of lending standards for some credits that raises supervisory concerns. In response, we have issued guidance to the industry regarding undue reliance on overly optimistic assumptions, as well as improvements that could be made in stress testing and other analysis. Another aspect of our monitoring involves institutions that specialize in potentially higher risk activities. In particular, the Federal Reserve is monitoring the activities of state member banks engaged in subprime lending activities as well as those retaining recourse in securitized assets. In, addition, our surveillance program uses bank Report of Condition and Income (Call Report) data and econometric relationships to flag for review institutions that are statistically at higher risk of failure.

OTHER PREVENTIVE INITIATIVES

In addition to the steps in our supervisory program I have just discussed, we are also engaged in other preventive initiatives. For example, we have worked with the other agencies in issuing guidance regarding the risk associated with subprime lending. Currently, we are discussing with the other banking agencies the issuance of further guidance or regulation on subprime lending, including whether formal, explicit capital requirements should be introduced, and if so, what those requirements should be.

Similarly, we also participated in interagency guidance regarding the valuation of residual loan assets associated with securitization programs. Improper valuation of residual assets, of course, caused a portion of losses borne by the insurance fund in 1999. We have been working with the other banking agencies on an initiative to better incorporate the risks associated with securitizations into the minimum capital standards. Moreover, we are working with supervisors here and in other countries to modernize the international capital standards, enhance supervision, and heighten the positive effect of market discipline on banking organizations.

COMBATING FRAUD

Our risk-focused approach coupled with industry sound-practice guidance and other supervisory responses are effective tools for meeting our objectives of maintaining a sound banking system. More recently, however, the incidence of fraud at banking organizations has raised different challenges. The examination process is not designed to ferret out fraud; indeed, examinations rely to a significant degree on internal and external auditors to validate the accuracy of the financial data that are the raw material of the examination process. Nonetheless, the examination process often tends to be the pressure point under which fraud is ultimately detected and revealed. That said, it is extremely difficult to detect fraud perpetrated by individuals intent upon coveting up outright theft or severe problems through forging, hiding, or destroying documents and other techniques.

To address the risk that fraud places on the banking organizations that we supervise, the Federal Reserve has undertaken numerous initiatives to combat fraud within those institutions. Training for examiners on detecting various types of fraud and abuse is provided in numerous programs offered by the Federal Reserve and the Federal Financial Institutions Examination Council (FFIEC). Examiners receive specialized training in areas such as potential abuse and conflicts of interest by management. Moreover, in conjunction with the FFIEC, all of the federal bank supervisory agencies recently began developing a CD-ROM training and reference tool that identifies and describes various types of improper activity relating to insider abuse, loan fraud, money laundering, and fraudulent monetary instruments. This CD-ROM tool will be accessible to examiners while in the field. Also, several years ago, in response to major fraud such as that which occurred in the case of the Bank of Credit and Commerce International, the Federal Reserve Board created a special investigations unit consisting of senior investigators and examiners. This unit investigates potential fraud that is identified during the course of an examination and forwards useful and relevant information to law enforcement for potential criminal prosecution, as appropriate.

In addition, we are also re-evaluating our reliance on internal and external audit evaluations. The appropriate degree of reliance on internal and external auditors is much easier to determine when there are indications that bank management may not be fully trustworthy or is less than forthcoming in providing requested information. In such cases, direct asset verification or more in-depth investigation would clearly be warranted. Absent such indications of wrongdoing or "red flags," however, a reduction in reliance on internal and external audit evaluations could result in increased burden to the many banking organizations that are not engaged in fraud.

COORDINATION WITH OTHER AGENCIES

Another key part of our supervisory strategy has been to coordinate closely and share information with other regulators and authorities involved with institutions we supervise. As we take on our responsibilities as umbrella supervisor of financial holding companies, our efforts at coordination and information sharing will only increase.

As the federal supervisor for state-chartered banks that are members of the Federal Reserve System, we work closely with state banking authorities. As the supervisor for bank holding companies, we coordinate supervision and share information with the Office of the Comptroller of the Currency, the FDIC, and the Office of Thrift Supervision when institutions they supervise are within bank holding companies. In addition, in supervising U.S. subsidiaries of foreign banking organizations, we cooperate and share information with foreign bank supervisors.

With regard to failing and problem state member banks, we coordinate closely with the FDIC early in the process, when material problems are first identified. In addition, we also work with the FDIC to improve the process of resolving insured depository institutions so as to minimize disruption to payments system transactions. Clearly, as insurer, the FDIC has an important interest in understanding risk to the fund and working as a partner in developing resolution strategies that minimize costs to the insurance fund and disruptions to the financial system. When the FDIC has requested to exercise its special examination authority for state member banks, we have benefited from its expertise and assistance in resolving problem institutions and believe that, historically, both agencies have benefited from information sharing.

The proposed H.R. 3374, the "Federal Deposit Insurance Corporation Examination Enhancement and Insurance Fund Protection Act," shifts to the chairperson of the FDIC authority that currently resides in the board of directors of the FDIC to authorize a special examination of any insured depository institution. The bill would also require the FDIC to make all reasonable efforts to coordinate any special examination with the primary federal banking supervisor for the insured depository institution and to give notice to certain agencies not represented on the board of the FDIC whenever a special examination is scheduled of an institution supervised by the unrepresented agency. In addition, the bill requires the banking agencies to provide to the FDIC, as promptly as practicable, any examination report prepared by the agency and to establish procedures for providing the FDIC access to any additional information needed by the FDIC for insurance purposes. Recent events have certainly highlighted the importance of interagency coordination and sharing of information. While we do not necessarily view the legislation as essential--because it mandates cooperation and coordination that should already be taking place--we see no harm in formalizing those processes.

With regard to enhancing cooperation, I would note that we not only collaborate with the FDIC on problem institutions but also assist its efforts to understand risks to the insurance fund more broadly. For example, the FDIC has asked to participate in examinations of a few state member banks that are engaged in subprime lending or other specialized activities, and we have welcomed its assistance in assessing the financial condition and risks of these institutions. In addition, we are discussing with the FDIC whether it may benefit from participation in examinations of larger state member banks because, at present, institutions supervised by the FDIC tend to be smaller banking organizations. In working to expand cooperative efforts, of course, we must all be mindful of the potential burden on banks and establish arrangements that minimize unnecessary disruptions, especially where an organization is not believed to pose significant risks.

CONCLUSION

In closing, I would like to underscore that supervisors face a growing challenge of identifying weaknesses in banking organizations in the midst of strong economic conditions that may mask embedded problems. I would be remiss if I did not note that when the economy weakens--as it ultimately will--we can expect bank losses from both previous risk-taking and bad luck. We can also expect an increase in bank failures. As Chairman Greenspan has said, the optimal failure rate is not zero, and when the macroeconomy suffers, we will see an increase in failures. Fraud and bad judgment will come to light that we and our fellow supervisors missed. As noted earlier, only a very intrusive process would reduce further those kinds of failures.

Finding the right balance between analysis of an institution's risk-management process and risk profile and performing in-depth transaction testing of its assets and systems is the art of the supervisory process that determines whether or not we are effective supervisors. Training and experience improve those judgments over time, and we are working on strengthening the Federal Reserve's ability to attract, develop, and retain supervisors that can meet that challenge and make those judgments.

In going forward, the recent fraud-related bank failures have caused us to challenge our assumptions regarding the reliability of some of the information we have come to depend on during examinations. When cracks appear in the veneer of what otherwise seems to be a well-run operation, they will be met with a greater dose of skepticism and a higher level of testing and verification. We must, of course, be careful not to overreact and become any more aggressive or intrusive than is required. The Federal Reserve recognizes that, as a bank supervisor, we are assuming an important public trust, and we will continue to try to minimize excesses in the banking system, reduce losses to the insurance fund, and maintain a stable and productive banking system.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, February 10, 2000

I am pleased to be here today to underscore the importance of this committee's efforts to modernize the Commodity Exchange Act (CEA) and to express my support for the recommendations for amending the act that were contained in the report by the President's Working Group on Financial Markets entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act.

THE NEED FOR LEGISLATION

Over-the-counter (OTC) derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to assume them. A growing number of financial and nonfinancial institutions have embraced derivatives as an integral part of their risk-capital allocation and profit maximization. In particular, the profitability of derivative products has been a major factor in the significant gain in the finance industry's share of American corporate output during the past decade--a reflection of their value to nonfinancial industry. Indeed, this value added from derivatives itself derives from their ability to enhance the process of wealth creation throughout our economy.

In light of the importance of OTC derivatives, it is essential that we address the legal uncertainties created by the possibility that courts could construe OTC derivatives to be futures contracts subject to the CEA. The legal uncertainties create risks to counterparties in OTC contracts and, indeed, to our financial system that simply are unacceptable. They have also impeded initiatives to centralize the trading and clearing of OTC contracts, developments that have the potential to increase efficiency and reduce risks in OTC transactions. As I shall discuss more fully later in my remarks, rapid changes in communications technology portend that time is running out for us to modernize our regulation of financial markets before we lose them and the associated profits and employment opportunities to foreign jurisdictions that impose no such impediments.

To be sure, the Congress and the Commodity Futures Trading Commission (CFTC) have taken steps to address these concerns about the CEA. The Futures Trading Practices Act of 1992 gave the CFTC authority to exempt OTC derivatives from most provisions of the act. In early 1993 the CFTC used that authority to create an exemption for OTC derivatives that reduced legal uncertainty for a wide range of transactions and counterparties. Unfortunately, some subsequent actions by the commission called into question market participants' understanding of the terms of the 1993 exemption. Now, under the leadership of Chairman Rainer, the commission is considering reaffirming and expanding the terms of the 1993 exemption. Nonetheless, even with such an important and constructive step by the commission, legislation amending the CEA would remain critically important. The greatest legal uncertainty affecting existing OTC transactions is in the area of securities-based contracts, where the CFTC's exemptive authority is constrained. Furthermore, as events during the past few years have clearly demonstrated, regulatory exemptions, unlike statutory exclusions, carry the risk of amendment by future commissions.

PRINCIPLES OF REGULATION

Imposing government regulation on a market can impair its efficiency. Thus, when evaluating the need for government regulation, one must clearly identify the public policy objectives of the regulation. As the working group's report discusses, the primary public policy purposes of the CEA are to deter market manipulation and to protect investors against fraud and other unfair practices.

We must, of course, assess whether government regulation is necessary to achieve those objectives. The regulatory framework of the CEA was designed for the trading of grain futures by the general public, including retail investors. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to manipulate the price of grain by cornering a market. Furthermore, grain futures prices are widely disseminated and widely used as the basis for pricing grain transactions off the futures exchanges. The fact that grain futures serve such a price-discovery function means that if attempts to corner a market result in price fluctuations, the effects would be felt widely by producers and consumers of grain.

OTC DERIVATIVES

The President's working group has considered whether regulation of OTC derivatives is necessary to achieve these public policy objectives of the CEA. In the case of financial OTC derivatives transactions between professional counterparties, the working group has agreed that such regulation is unnecessary and that such transactions should be excluded from coverage of the act. Importantly, the recommended exclusion would extend to those securities-based derivatives that currently are subject to the greatest legal risk from potential application of the CEA.

The rationale for this position is straightforward. OTC transactions in financial derivatives are not susceptible to--that is, easily influenced by--manipulation. The vast majority of contracts are settled in cash, based on a rate or price determined in a separate highly liquid market with a very large or virtually unlimited deliverable supply. Furthermore, prices established in OTC transactions do not serve a price-discovery function. Thus, even if the price of an OTC contract were somehow manipulated, the adverse effects on the economy would be quite limited. With respect to fraud and other unfair practices, the professional counterparties that use OTC derivatives simply do not require the protections that CEA provides for retail investors. If professional counterparties are victimized, they can obtain redress under the laws applicable to contracts generally.

The working group also considered whether the introduction of centralized mechanisms for the trading and settling of what heretofore have been purely bilaterally negotiated and settled transactions would give rise to a need for additional regulation. In the case of electronic trading systems, the working group concluded that regulation under the CEA was unnecessary and that such systems should be excluded from the act, provided that the contracts are not based on nonfinancial commodities with finite supplies and that the participants are limited to sophisticated counterparties trading solely for their own accounts. Electronic trading of such contracts by such counterparties, it was reasoned, would be no more susceptible to problems of manipulation and fraud than purely bilateral transactions. It was suggested that some limited regulation of such systems might become necessary in the future if such trading systems came to serve a price-discovery function. But it was agreed that creation of a regulatory system for such systems in anticipation of problems was inappropriate. As I have already noted, the vast majority of OTC derivatives simply are not susceptible to manipulation. Thus, even if those contracts come to play a role in price discovery, regulation of the trading mechanism might still be unnecessary.

In the case of clearing systems for OTC derivatives, the working group concluded that government oversight is appropriate. Clearing tends to concentrate risks and responsibilities for risk management in a central party or clearinghouse. Consequently, the effectiveness of the clearinghouse's risk management is critical for the stability of the markets that it serves. Depending on the types of transactions cleared, such oversight might appropriately be conducted by the CFTC under the CEA. Alternatively, it might be conducted by the Securities and Exchange Commission, the Federal Reserve, the Office of the Comptroller of the Currency, or a foreign financial regulator that one of the U.S. regulators has determined satisfies appropriate standards. Provided such government oversight is in place, OTC transactions that would otherwise be excluded from the CEA should not fall within the ambit of the act because they are cleared. If market participants conclude that clearing would reduce counterparty risks in OTC transactions, concerns about legal risks associated with the potential application of the CEA should not stand in their way.

TRADITIONAL EXCHANGES

The working group's report does not make specific recommendations about the regulation of traditional exchange-traded futures markets that use open outcry trading or that allow trading by retail investors. Nevertheless, it calls for a review of the existing regulatory structures, particularly those applicable to financial futures, to ensure that they are appropriate in light of the objectives of the act. Consistent with the principles of regulation that I identified earlier, the report notes that exchange-traded futures should not be subject to regulations that are unnecessary to achieve the CEA's objectives. The report also concludes that the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved.

I want to underscore how important it is for us to address these issues promptly. I cannot claim to speak with certainty as to how our complex and rapidly moving markets will evolve. But I see a real risk that, if we fail to rationalize our regulation of centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of global investors without imposing so many regulatory constraints.

My concerns on this score stem from the dramatic advances in information technology that we see all around us. In markets with significant economies of scale and scope, like those for standardized financial instruments, there is a tendency toward consolidation or even natural monopoly. Throughout much of our history this tendency has been restrained by an inability to communicate information sufficiently quickly, cheaply, and accurately. In recent years, however, this constraint is being essentially eliminated by advances in telecommunications. We have not yet seen clear evidence of a trend toward natural monopoly. But the diffusion of technology often traces an S-shaped curve, first diffusing slowly but then rapidly picking up speed. Once we reach the steep segment of that S-curve, it may be too late to rationalize our regulatory structure.

Already the largest futures exchange in the world is no longer in the American heartland; instead, it is now in the heart of Europe. To be sure, no U.S. exchange has yet to lose a major contract to a foreign competitor. But it would be a serious mistake for us to wait for such unmistakable evidence of a loss of international competitiveness before acting. As our experience with the vast eurodollar markets demonstrates, once markets with scale and scope economies are lost, they are very .difficult, if not impossible, to recapture.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, February 17, 2000 (Chairman Greenspan presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, US. Senate, February 23, 2000.)

I appreciate this opportunity to present the Federal Reserve's semiannual report on the economy and monetary policy.(1)

There is little evidence that the American economy, which grew more than 4 percent in 1999 and surged forward at an even faster pace in the second half of the year, is slowing appreciably. At the same time, inflation has remained largely contained. An increase in the overall rate of inflation in 1999 was mainly a result of higher energy prices. Importantly, unit labor costs actually declined in the second half of the year. Indeed, still-preliminary data indicate that total unit cost increases last year remained extraordinarily low, even as the business expansion approached a record nine years. Domestic operating profit margins, after having sagged for eighteen months, apparently turned up again in the fourth quarter, and profit expectations for major corporations for the first quarter have been undergoing upward revisions since the beginning of the year-scarcely an indication of imminent economic weakness.

THE ECONOMIC FORCES AT WORK

Underlying this performance, unprecedented in my half-century of observing the American economy, is a continuing acceleration in productivity. Nonfarm business output per workhour increased 3 1/4 percent during the past year--likely more than 4 percent when measured by nonfarm business income. Security analysts' projections of long-term earnings, an indicator of expectations of company productivity, continued to be revised upward in January, extending a string of upward revisions that began in early 1995. One result of this remarkable economic performance has been a pronounced increase in living standards for the majority of Americans. Another has been a labor market that has provided job opportunities for large numbers of people previously struggling to get on the first rung of a ladder leading to training, skills, and permanent employment.

Yet those profoundly beneficial forces driving the American economy to competitive excellence are also engendering a set of imbalances that, unless contained, threaten our continuing prosperity. Accelerating productivity entails a matching acceleration in the potential output of goods and services and a corresponding rise in real incomes available to purchase the new output. The problem is that the pickup in productivity tends to create even greater increases in aggregate demand than in potential aggregate supply. This occurs principally because a rise in structural productivity growth has its counterpart in higher expectations for long-term corporate earnings. This, in turn, not only spurs business investment but also increases stock prices and the market value of assets held by households, creating additional purchasing power for which no additional goods or services have yet been produced.

Historical evidence suggests that perhaps three cents to four cents out of every additional dollar of stock market wealth eventually is reflected in increased consumer purchases. The sharp rise in the amount of consumer outlays relative to disposable incomes in recent years, and the corresponding fall in the saving rate, has been consistent with this so-called wealth effect on household purchases. Moreover, higher stock prices, by lowering the cost of equity capital, have helped to support the boom in capital spending.

Outlays prompted by capital gains in excess of increases in income, as best we can judge, have added about 1 percentage point to annual growth of gross domestic purchases, on average, over the past five years. The additional growth in spending of recent years that has accompanied these wealth gains, as well as other supporting influences on the economy, appears to have been met in about equal measure from increased net imports and from goods and services produced by the net increase in newly hired workers over and above the normal growth of the work force, including a substantial net inflow of workers from abroad.

But these safety valves that have been supplying goods and services to meet the recent increments to purchasing power largely generated by capital gains cannot be expected to absorb an excess of demand over supply indefinitely. First, growing net imports and a widening current account deficit require everlarger portfolio and direct foreign investments in the United States, an outcome that cannot continue without limit.

Imbalances in the labor markets perhaps may have even more serious implications for inflation pressures. While the pool of officially unemployed and those otherwise willing to work may continue to shrink, as it has persistently over the past seven years, there is an effective limit to new hiring, unless immigration is uncapped. At some point in the continuous reduction in the number of available workers willing to take jobs, short of the repeal of the law of supply and demand, wage increases must rise above even impressive gains in productivity. This would intensify inflationary pressures or squeeze profit margins, with either outcome capable of bringing our growing prosperity to an end.

As would be expected, imbalances between demand and potential supply in markets for goods and services are being mirrored in the financial markets by an excess in the demand for funds. As a consequence, market interest rates are already moving in the direction of containing the excess of demand in financial markets and therefore in product markets as well. For example, BBB corporate bond rates adjusted for inflation expectations have risen more than 1 percentage point during the past two years. However, to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this increase, propelling equity prices and the wealth effect higher. Should this process continue, however, with the assistance of a monetary policy vigilant against emerging macroeconomic imbalances, real long-term rates will at some point be high enough to finally balance demand with supply at the economy's potential in both the financial and product markets. Other things equal, this condition will involve equity discount factors high enough to bring the rise in asset values into line with that of household incomes, thereby stemming the impetus to consumption relative to income that has come from rising wealth. This does not necessarily imply a decline in asset values-although that, of course, can happen at any time for any number of reasons--but rather that these values will increase no faster than household incomes.

Because there are limits to the amount of goods and services that can be supplied from increasing net imports and by drawing on a limited pool of persons willing to work, it necessarily follows that consumption cannot keep rising faster than income. Moreover, outsized increases in wealth cannot persist indefinitely either. For so long as the levels of consumption and investment are sensitive to asset values, equity values increasing at a pace faster than income, other things equal, will induce a rise in overall demand in excess of potential supply. But that situation cannot persist without limit because the supply safety valves are themselves limited.

With foreign economies strengthening and labor markets already tight, how the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace, without destabilizing the economy in the process.

TECHNOLOGICAL CHANGE CONTINUES APACE 

On a broader front, there are few signs to date of slowing in the pace of innovation and the spread of our newer technologies that, as I have indicated in previous testimonies, have been at the root of our extraordinary productivity improvement. Indeed, some analysts conjecture that we still may be in the earlier stages of the rapid adoption of new technologies and not yet in sight of the stage when this wave of innovation will crest. With so few examples in our history, there is very little basis for determining the particular stage of development through which we are currently passing.

Without doubt, the synergies of the microprocessor, laser, fiber-optic glass, and satellite technologies have brought quantum advances in information availability. These advances, in turn, have dramatically decreased business operational uncertainties and risk premiums and, thereby, have engendered major cost reductions and productivity advances. There seems little question that further major advances lie ahead. What is uncertain is the future pace of the application of these innovations because it is this pace that governs the rate of change in productivity and economic potential.

Monetary policy, of course, did not produce the intellectual insights behind the technological advances that have been responsible for the recent phenomenal reshaping of our economic landscape. It has, however, been instrumental, we trust, in establishing a stable financial and economic environment with low inflation that is conducive to the investments that have exploited these innovative technologies.

Federal budget policy has also played a pivotal role. The emergence of surpluses in the unified budget and of the associated increase in government saving over the past few years has been exceptionally important to the balance of,the expansion because the surpluses have been absorbing a portion of the potential excess of demand over sustainable supply associated partly with the wealth effect. Moreover, because the surpluses are augmenting the pool of domestic saving, they have held interest rates below the levels that otherwise would have been needed to achieve financial and economic balance during this period of exceptional economic growth. They have, in effect, helped to finance and sustain the productive private investment that has been key to capturing the benefits of the newer technologies that, in turn, have boosted the long-term growth potential of the U.S. economy.

The recent good news on the budget suggests that our longer-run prospects for continuing this beneficial process of recycling savings from the public to the private sectors have improved greatly in recent years. Nonetheless, budget outlays are expected to come under mounting pressure as the baby boom generation moves into retirement, a process that gets under way a decade from now. Maintaining the surpluses and using them to repay debt over coming years will continue to be an important way the federal government can encourage productivity-enhancing investment and rising standards of living. Thus, we cannot afford to be lulled into letting down our guard on budgetary matters, an issue to which I shall return later in this testimony.

THE ECONOMIC OUTLOOK

Although the outlook is clouded by a number of uncertainties, the central tendencies of the projections of the Board members and Reserve Bank presidents imply continued good economic performance in the United States. Most of them expect economic growth to slow somewhat this year, easing into the 3 1/2 to 3 3/4 percent area. The unemployment rate would remain in the neighborhood of 4 to 4 1/4 percent. The rate of inflation for total personal consumption expenditures is expected to be 1 3/4 to 2 percent, at or a bit below the rate in 1999, which was elevated by rising energy prices.

In preparing these forecasts, the Federal Open Market Committee (FOMC) members had to consider several of the crucial demand- and supply-side forces I referred to earlier. Continued favorable developments in labor productivity are anticipated both to raise the economy's capacity to produce and, through its supporting effects on real incomes and asset values, to boost private domestic demand. When productivity-driven wealth increases were spurting demand a few years ago, the effects on resource utilization and inflation pressures were offset, in part, by the effects of weakening foreign economies and a rising foreign exchange value of the dollar, which depressed exports and encouraged imports. Last year, with the welcome recovery of foreign economies and with the leveling-out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign economic activity is expected to continue this year, and, other things equal, the effect of the previous appreciation of the dollar should wane, augmenting demand on U.S. resources and lessening one source of downward pressure on our prices.

As a consequence, the necessary alignment of the growth of aggregate demand with the growth of potential aggregate supply may well depend on restraint on domestic demand, which continues to be buoyed by the lagged effects of increases in stock market valuations. Accordingly, the appreciable increases in both nominal and real intermediate- and long-term interest rates over the past two years should act as a needed restraining influence in the period ahead. However, to date, interest-sensitive spending has remained robust, and the FOMC will have to stay alert for signs that real interest rates have not yet risen enough to bring the growth of demand into line with that of potential supply, even should the acceleration of productivity continue.

Achieving that alignment seems more pressing today than it was earlier, before the effects of imbalances began to cumulate, lessening the depth of our various buffers against inflationary pressures. Labor markets, for example, have tightened in recent years as demand has persistently outstripped even accelerating potential supply. As I have previously noted, we cannot be sure in an environment with so little historical precedent what degree of labor market tautness could begin to push unit costs and prices up more rapidly. We know, however, that there is a limit, and we can be sure that the smaller the pool of people without jobs willing to take jobs, the closer we are to that limit. As the FOMC indicated after its last meeting, the risks still seem to be weighted on the side of building inflation pressures.

A central bank can best contribute to economic growth and rising standards of living by fostering a financial environment that promotes overall balance in the economy and price stability. Maintaining an environment of effective price stability is essential because the experience in the United States and abroad has underscored that low and stable inflation is a prerequisite for healthy, balanced, economic expansion. Sustained expansion and price stability provide a backdrop against which workers and businesses can respond to signals from the marketplace in ways that make most efficient use of the evolving technologies.

FEDERAL BUDGET POLICY ISSUES

Before closing, I should like to revisit some issues of federal budget policy that I have addressed in previous congressional testimony. Some modest erosion in fiscal discipline resulted last year through the use of the "emergency" spending initiatives and some "creative accounting." Although somewhat disappointing, that erosion was small relative to the influence of the wise choice of the Administration and the Congress to allow the bulk of the unified budget surpluses projected for the next several years to build and retire debt to the public. The idea that we should stop borrowing from the social security trust fund to finance other outlays has gained surprising--and welcome--traction, and it establishes, in effect, a new budgetary framework that is centered on the on-budget surplus and how it should be used.

This new framework is useful because it offers a clear objective that should strengthen budgetary discipline. It moves the budget process closer to accrual accounting, the private-sector norm, and--I would hope--the ultimate objective of federal budget accounting.

The new budget projections from the Congressional Budget Office (CBO) and the Administration generally look reasonable. But, as many analysts have stressed, these estimates represent a midrange of possible outcomes for the economy and the budget, and actual budgetary results could deviate quite significantly from current expectations. Some of the uncertainty centers on the likelihood that the recent spectacular growth of labor productivity will persist over the years ahead. Like many private forecasters, the CBO and the Office of Management and Budget assume that productivity growth will drop back somewhat from the recent stepped-up pace. But a distinct possibility, as I pointed out earlier, is that the development and diffusion of new technologies in the current wave of innovation may still be at a relatively early stage and that the scope for further acceleration of productivity is thus greater than is embodied in these budget projections. If so, the outlook for budget surpluses would be even brighter than is now anticipated.

But there are significant downside risks to the budget outlook as well. One is our limited knowledge of the forces driving the surge in tax revenues in recent years. Of course, a good part of that surge is due to the extraordinary rise in the market value of assets, which, as I noted earlier, cannot be sustained at the pace of recent years. But that is not the entire story. These relationships are complex, and until we have detailed tabulations compiled from actual tax returns, we shall not really know why individual tax revenues, relative to income, have been even higher than would have been predicted from rising asset values and bracket creep. Thus, we cannot rule out the possibility that this so-called tax surprise, which has figured so prominently in the improved budget picture of recent years, will dissipate or reverse. If this were to happen, the projected surpluses, even with current economic assumptions, would shrink appreciably and perhaps disappear. Such an outcome would be especially likely if adverse developments occurred in other parts of the budget as well--for example, if the recent slowdown in health-care spending were to be followed by a sharper pickup than is assumed in current budget projections.

Another consideration that argues for letting the unified surpluses build is that the budget is still significantly short of balance when measured on an accrual basis. If social security, for example, were measured on such a basis, counting benefits when they are earned by workers rather than when they are paid out, that program would have shown a substantial deficit last year. The deficit would have been large enough to push the total federal budget into the red, and an accrual-based budget measure could conceivably record noticeable deficits over the next few years, rather than the surpluses now indicated by the official projections for either the total unified budget or the on-budget accounts. Such accruals take account of still growing contingent liabilities that, under most reasonable sets of actuarial assumptions, currently amount to many trillions of dollars for social security benefits alone.

Even if accrual accounting is set aside, it might still be prudent to eschew new longer-term, potentially irreversible commitments until we are assured that the on-budget surplus projections are less conjectural than they are, of necessity, today.

Allowing surpluses to reduce the debt to the public, rather than for all practical purposes irrevocably committing to their disposition in advance, can be viewed as a holding action pending the clarification of the true underlying budget outcomes of the next few years. Debt repaid can very readily be reborrowed to fund delayed initiatives.

More fundamentally, the growth potential of our economy under current circumstances is best served, in my judgment, by allowing the unified budget surpluses presently in train to materialize and thereby reduce Treasury debt held by the public.

Yet I recognize that growing budget surpluses may be politically infeasible to defend. If this proves to be the case, as I have also testified previously, the likelihood of maintaining a still satisfactory overall budget position over the longer run is greater, I believe, if surpluses are used to lower tax rates rather than to embark on new spending programs. History illustrates the difficulties of keeping spending in check, especially in programs that are open-ended commitments, which too often have led to larger outlays than initially envisioned. Decisions to reduce taxes, however, are more likely to be contained by the need to maintain an adequate revenue base to finance necessary government services. Moreover, especially if designed to lower marginal rates, tax reductions can offer favorable incentives for economic performance.

CONCLUSION

As the U.S. economy enters a new century as well as a new year, the time is opportune to reflect on the basic characteristics of our economic system that have brought about our success in recent years. Competitive and open markets, the rule of law, fiscal discipline, and a culture of enterprise and entrepreneurship should continue to undergird rapid innovation and enhanced productivity that in turn should foster a sustained further rise in living standards. It would be imprudent, however, to presume that the business cycle has been purged from market economies so long as human expectations are subject to bouts of euphoria and disillusionment. We can only anticipate that we will readily take such diversions in stride and trust that beneficent fundamentals will provide the framework for continued economic progress well into the new millennium.

(1.) See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 85 (March 2000), pp. 161-87.