Statements to the Congress.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on the Budget, US. House of Representatives, March 8, 1995

I appreciate this opportunity to discuss the Federal Reserve's conduct of monetary policy. Because I presented our semiannual Monetary Policy Report to the Congress just two weeks ago, I will review only briefly the current outlook before focusing on some key longer-term issues bearing on macroeconomic policy, issues that are highly relevant to recent foreign exchange market developments.(1)

The weakness of the dollar against other major currencies is both unwelcome and troublesome. Dollar weakness, while very likely overdone, is unwelcome because it adds to potential inflation pressures in our economy. As I have emphasized numerous times in the past, it is important that we contain such pressures. Dollar weakness is also troublesome because it is doubtless symptomatic of some of the underlying problems confronting the longer-term health of the economy: inadequate national savings, continuing large budget deficits, and a persistent current account imbalance.

The Current Outlook

Turning to the economic outlook, the data that have been published thus far in 1995 have offered some indications that the expansion may be slowing from its torrid and unsustainable pace of late 1994. Although hours of work lengthened in January, employment growth slowed from its average of recent quarters and the unemployment rate rose. Moreover, recent readings on retail sales suggest a more moderate rate of increase, and housing activity has shown some softness. Nonetheless, to date, the real economy appears to have continued to grow, without seeming to develop the types of imbalances that in the past have undermined ongoing expansions.

The degree of the strength of the expansion this year is likely to depend on the same elements that contributed strongly to last year's solid performance: plant and equipment outlays and inventory investment. Although the recent newly revised survey by the U.S. Department of Commerce of plant and equipment investment intentions of U.S. business points to more modest increases in capital spending than were reported for last year, there are, as yet, few indications of that degree of slowing in orders for nondefense capital goods or in contracts or permits for private nonresidential building. Indeed, backlogs of equipment orders are rising relative to sales, and business profitability, a key factor in investment plans, continues to exceed expectations. The investment plans of manufacturers, whose capacity is clearly stretched, reflect this strong demand for capital goods. But planned spending outside of manufacturing, especially among utilities and service industries, is evidently softening. Of course, at this stage the lack of a historical track record for this new survey makes it very difficult to draw firm conclusions from these figures.

Inventory investment contributed the better part of I percentage point to overall economic growth last year, and while that type of boost to growth this year seems most unlikely, there is little evidence that an overhang has developed that will lead to an abrupt adjustment of production any time soon. Standard inventory - sales ratios remain on the low side of historical experience; those ratios look even lower, compared with historical experience if one subtracts wholesale and retail markups from the published inventory investment figures to get a better handle on the underlying physical units of stocks. Moreover, even if there were a swing in inventory investment, it would have a more muted effect on domestic production than the inventory cycles of just a few years ago. Rough estimates suggest that currently perhaps a quarter of the nominal value of all wholesale and retail stocks are imported, whereas the share was markedly less as recently as the late 1970s.

As I indicated in my recent testimony, while there are signs that spending is slowing, the jury remains out on whether that will be sufficient to contain inflation pressures. We must remember that the nation has entered 1995 with its resources stretched. If we are to do our part in helping the economy operate at its fullest potential over time, we need to remain watchful to ensure that any upswing in the inflation rate does not become firmly entrenched.

Gauging Inflation Risks

I remain firmly of the belief that a key ingredient in achieving the highest possible levels of productivity, real incomes, and living standards over the long run is the achievement of price stability. Thus, I see it as crucial that we extend the period of low inflation, hopefully returning it to a downward trend in the years ahead. The prospects in this regard are fundamentally good, but there are reasons for some concern, at least with respect to the nearer term. These concerns relate primarily to the fact that resource utilization rates have already risen to high levels by recent historical standards.

Clearly, one factor in judging the inflationary risks in the economy is the potential for expansion of our productive capacity. If "potential GDP" is growing rapidly, actual output can also continue to grow rapidly without intensifying pressures on resources. In this regard, many commentators, myself included, have remarked that there might well be more than a cyclical character to the evident improvement of U.S. competitive capabilities in recent years. But it is still too soon to judge whether that improvement is a few tenths of a percentage point annually or even more. It is fair to note, however, that the fact that labor and factory utilization rates have risen as much as they have in the past year or so does argue that the rate of increase in potential is appreciably below the 4 percent growth rate of 1994.

Knowing in advance our true growth potential obviously would be useful in setting policy because history tells us that economies that strain labor force and capital stock limits tend to engender inflation instabilities that undermine growth. It is true, however, that in modem economies output levels may not be so rigidly constrained in the short run as they used to be. It is possible for the economy to exceed "potential" for a time without adverse consequences by extending work hours, by deferring maintenance, and by forgoing longer-term improvements. Moreover, as world trade expands, access to foreign sources of supply augments, to a degree, the flexibility of domestic productive facilities for goods and some services.

Aggregative indicators, such as the unemployment rate and capacity utilization, may be suggestive of emerging inflation and asset-price instabilities. But these indicators cannot be determinative. Policymakers must monitor developments on an ongoing basis to gauge when economic potential is actually beginning to become strained - irrespective of where current unemployment rates or capacity utilization rates may lie. If we are endeavoring to fend off instability before it becomes debilitating to economic growth, direct evidence of the emerging process is essential. The Federal Reserve will remain watchful of these developments, while remaining focused on its longer-run goal - the eventual achievement of price stability. We can do no less if we are to maximize our opportunity for advancing the economic well-being of the nation.

Fiscal Policy

We must recognize that the productive potential of the U.S. economy will be shaped significantly by the actions of this Congress regarding the federal budget deficit. Too much of the small pool of national saving goes toward funding the government. In the past few years, we as a nation have been able to finance our investment by tapping saving from abroad. The United States has been running persistent and growing deficits in its current account position vis-a-vis the rest of the world. This ability to finance our domestic investment from abroad highlights the openness of world capital markets. But it would certainly be unwise and probably impossible to rely on them forever. Indeed, given the recent weakness in the foreign exchange value of the dollar, world capital markets may be sending us just that message. This suggests that a key element in dealing with the dollar's weakness is to convincingly address our underlying fiscal imbalance.

If we are to sustain the higher levels of investment that are crucial to achieve healthy increases in productivity and to remain a viable competitor on world markets, we must raise the level of domestic saving and reduce our reliance on foreign saving. Reliable and robust estimates of the determinants of private saving have eluded economists for many years; we can only conclude that there is no sure-fire scheme that this Congress could adopt to entice our citizens to save more. But the government can decide to use less private domestic saving than it does now. By trimming the deficit, those resources will likely be put to more productive uses, leading to benefits in the form of improved standards of living.

Trimming the deficit would doubtless make the economy more vibrant and less reliant on foreign sources of capital over time. But there would be shorter-run benefits as well. While there is some uncertainty about the causes of the apparent relatively high real long-term rates around the world, the majority of analysts agree that in the United States the current sizable federal deficits - and their projected growth over the decades ahead - play a significant role. In part, this owes to market participants' perception of the risks to future monetary policy that are posed by persistent large federal budget deficits. While we at the Federal Reserve have clearly avoided it in recent years, world history is replete with examples of fiscal pressures leading to monetary excesses and then to greater inflation. Progress in addressing the federal deficit would do much to eliminate any lingering suspicion that the Federal Reserve would ultimately accommodate fiscal imbalances by monetary excess. This would help to lower inflation-risk premiums that are embedded in dollar-denominated assets. All told, a credible program of fiscal restraint that moves the government's finances to a sounder footing almost surely will find a favorable reception in financial markets. That market reaction, by itself, should serve as a source of stimulus that would help to offset, in whole or in part, the drag on spending that otherwise would be associated with reductions in federal outlays and transfers over time.

Conclusion

I can assure the members of this committee that we at the Federal Reserve share your goal - the largest possible advance in living standards in the United States over time. That goal can be best achieved if our actions ultimately allow concerns about the variability of the purchasing power of money to recede into the background. Price stability enables households and firms to have the greatest freedom possible to do what they do best - to produce, invest, and consume efficiently. Moreover, a credible program of fiscal restraint will do much to free up private resources for more productive purposes.

Formidable challenges will confront policy - both fiscal and monetary - in the years ahead. It is, of course, unrealistic to assume that we can eliminate the business cycle, human nature being what it is. But containing inflation and thereby damping economic fluctuations is a reasonable goal. We at the Federal Reserve look forward to working with the Administration and the Congress in meeting our common challenges.

Statement by Lawrence B. Lindsey, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Banking and Financial Services, US. House of Representatives, March 8, 1995

I appreciate the opportunity to provide the Federal Reserve's perspectives on the status of the Community Reinvestment Act (CRA) and our efforts to reform our system for assessing CRA performance. Although the agencies have submitted a joint statement, which I believe lays out in fair and comprehensive form the history and status of our CRA efforts, I would like to take some time to emphasize a few additional points.

First, let me say that the Federal Reserve Board fully supports this effort to reform our CRA regulations. It is, as a rule, advisable to take a close look at regulations periodically, and the CRA was overdue for such a look, even absent the President's prompting of July 15, 1993. During the past twenty months, I have been the Board's representative in the interagency process. This has involved not only formal meetings and hearings but also informal trips around the country to see how the CRA is actually working in practice. Our efforts to date have been an exhaustive - and at times exhausting - process of finding an appropriate balance among the sometimes conflicting objectives of the CRA.

It is no secret that CRA reform has involved a longer process than any of us wanted. But I believe that the issue before us is too important to rush. The nature of the law itself and the resulting plethora of tough issues that confront the agencies have posed many challenges - some foreseen, others not. I believe that the time we have spent on this project will, in the long run, prove to be time well spent. We do no one any favors if we institute a set of regulations that are unworkable in the field or produce bizarre anomalies as they are applied to the many and diverse markets with which we are dealing. Further, we will not be aiding the process of extending credit in traditionally underserved markets if we adopt regulations that cannot stand the test of time and do not have broad support and acceptance by those involved in the process. In particular, we will be doing more harm than good if we treat the CRA as anything other than a way of developing and extending profitable market opportunities for financial institutions.

In my statement for the Board, I would like to focus on several reasons why the process has been so difficult and taken so long. In so doing, I would also like to explore some of what I believe are the misunderstandings about the CRA, including assertions that the CRA process as presently constituted has had so little impact and is so unworkable that it requires radical revamping. Finally, I would like to outline some of the key principles the Federal Reserve believes should be reflected in any CRA reform.

CRA Difficulties

Some of the central issues with which the agencies are now dealing, in fact, have been well known from the beginning. In part, that is because those issues derive from the unusual content and structure of the law itself and have plagued the CRA implementation process in varying degrees ever since the act was passed in 1977. There are, in short, inherent, unavoidable contradictions in any scheme to administer the CRA. Moreover, the agencies have been charged with developing that process with a minimum of congressional guidance.

In the absence of very much legislative direction, the agencies have been asked to do the following:

* Develop clearer, more objective criteria or standards for measuring CRA performance but without forcing institutions to engage in governmentally mandated or sanctioned credit allocation activity or to compromise the safety and soundness of insured institutions

* Assemble sufficient information about the needs of communities and bank activities to enable the agencies and the public to determine whether performance standards have been met, while minimizing compliance burden on the institutions and protecting the confidentiality of the financial situation of the bank's customers

* Ensure consistency in CRA evaluations while maintaining enough flexibility and judgment to consider fairly the vast differences among banks in size, capacity, business strategies, and product mix, and the diversity of communities in terms of their size, economic condition, programs, and resources.

These goals are often contradictory. All of these core issues involve important matters of public policy and difficult trade-offs. Let me briefly elaborate on the inherently contradictory nature of these objectives. Consistency and objectivity are laudable goals. But to be implemented in a regulatory scheme, they require both a set of statistical data and a formulaic basis for evaluating those data. The more rigid the formulas that are applied, the greater the consistency but the lower the variety of outcomes and allowance for local circumstances that is permitted.

Some may argue that a sufficiently detailed set of data and complex set of formulas will permit regulators to capture the variety of local circumstances that exists. Ultimately such quantifiable evaluations could be applied to individual loan decisions. Such an approach is now a risk in such areas as fair lending, for example. But given the public nature of the CRA disclosure process, such detailed data collection and reporting involve a degree of intrusion into the affairs of a bank's customers that we have tended, in this country, to find objectionable. Carried to its logical conclusion, such a process would tend to replace examiner judgment and personal evaluations of character and creditworthiness with evaluations based solely on quantifiable criteria. In my view, while such an approach may seem superficially fairer than the current system, it might ultimately reduce economic opportunity and might prove counterproductive in aiding traditionally underserved populations.

In addition, given the complexity and diversity of our financial system and the markets it serves, one may suspect whether any nationally imposed set of formulas on performance, no matter how sophisticated, could ever be made to work. As a result, subjectivity and some degree of inconsistency and attendant unfairness will be inherent in any CRA enforcement process we develop.

I believe that my colleagues and I have confronted these issues head-on and are evolving a set of rules that balances the maximum amount of flexibility in implementation with the spirit of objectivity and consistency in CRA enforcement that the President called for. However, getting to that point has not been easy.

Nature of the Law

As our joint statement indicates, the CRA is indeed a highly unusual law. At first glance, the CRA's mandate to us as a regulatory agency appears fairly simple. Under the CRA, we have four primary duties: to encourage banks to help meet the credit needs of their communities, including low- and moderate-income areas; to assess bank records of performance through examinations; to produce publicly available evaluations of bank CRA performance; and to take their records of performance under the CRA into account when evaluating proposals for expansion.

Note that all of these requirements are for regulatory action. Although the CRA says that we are to encourage banks to help meet community credit needs, the act does not require any specific bank actions. The CRA reminds banks and thrift institutions about their charter obligations, but it does not specifically define them in a way that would provide guidance on reinvestment questions. The act also says that banks should "help" meet community credit needs, but it does not specify what kind of help, or how much help, is necessary or appropriate.

Further, in calling on the supervisory agencies to assess bank performance, the act does not tell us or the banks what good CRA performance is or what types of specific measures the regulators might use to define good performance. The CRA also requires that the agencies consider an institution's CRA performance when reviewing its applications involving depository facilities, but it leaves to the agencies the task of determining what the consequences of poor CRA performance will be and when and how those consequences should be applied.

Even on relatively simple but important matters, such as what constitutes an institution's community, whether "services" should be included in the concept of helping meet credit needs, and whether banks should be judged on credit extended to low-and moderate-income persons or only to borrowers in low- and moderate-income neighborhoods, the act provides little help to regulators, bankers, or community representatives.

In the absence of guidance on principles, standards, or definitions in the CRA, the agencies have been forced to attempt to add much more substance through regulation than is usual for the agencies, to an extent that may be unique for financial regulators. And as this committee knows, the public policy process requires consideration of highly divergent views and interests in an attempt to strike a compromise acceptable to affected parties. This is not a comfortable role for the agencies.

It is not my purpose to suggest that the Congress should rewrite the law to clarify its intent. I am simply attempting to describe the circumstance in which we have found ourselves and indicate that this too has contributed to the difficulty of the reform process. Moreover, there are other factors that have complicated the task.

Public Scrutiny and Involvement

Although it is extremely vague, the CRA is unusual in quite another way. Virtually every other banking law and regulation involves two primary parties - the agency and the bank. The CRA, however, compels the agencies to look beyond the bank itself and assess the role the bank plays in its community. While supervision of the safety and soundness of financial institutions involves us in a primarily two-way conversation with the bank about its policies, practices, and financial condition, the CRA brings a third-party to the table - the bank's community or the public at large.

As the members of this committee are well aware, the "public" is a large and amorphous group of diverse interests. Often, the voice of the public is interpreted as belonging to the individual or group that can marshal the greatest communication skills. Thus, even a theoretical three-way conversation about the CRA among the agencies, banks, and the public is, in practice, hard to hold and often can be quite contentious.

One of the reasons for the increasingly contentious nature of the discussion is that the CRA has become much more prominent and important to the involved parties. Public disclosure of CRA evaluations, which began a few years ago as a result of amendments to the act, has focused greater attention on this issue. More than ever, the CRA performance of financial institutions is being discussed in the press and media, and virtually every group or association with a constituency focused on housing and community development has demonstrated some interest in the CRA over the past few years. On the local level, elected officials, trade unions, church groups, and civil rights groups have become active in CRA protests. In those instances where governmental dollars for economic development have dwindled, communities have often turned their attention to the private sector and the prospect that the CRA will be a strong encouragement to private financial institutions to assume a more direct role in revitalization.

Much of this public interest is based on a realistic understanding of what the CRA says and how private financial institutions work. But some is not. Public pressure, at times, has brought needed correction to insensitive or recalcitrant institutions. At other times, the ability to threaten adverse publicity and delay has no doubt led to abuses in demands from particular special interest groups claiming to represent the public.

The CRA has also become increasingly important to the management of financial institutions. Many now recognize that in an era of growing competition, CRA performance may be critical to an institution's ability to adjust to the new banking environment. CRA-related activities can help develop new markets, potentially profitable business, and can improve a bank's public image. Also, bankers, and even some bank analysts, now recognize that cleaning up the deficient CRA record of an institution, both before and after consummation of a merger or acquisition, can be a costly process.

Consequently, for both the public and financial institutions, concerns about CRA performance have intensified. This has produced a commonality of interest in clarifying standards. However, views about the appropriateness of the law, the attributes of good CRA performance, and the effectiveness of the supervisory agencies have become increasingly divergent.

Evolving Views

Some may think that the current reform effort is simply directed at correcting the administration of the law to return to what it should have been from the inception of the CRA in 1977. But this may be too limited a view. In fact, given the increasing intensity of interest in the CRA over the years from all sides, the expectations about the CRA performance of banks have evolved considerably.

In the CRA's early years, a commonly held view was that the CRA's essential purpose was geographic in nature: to help ensure that banks would not ignore the needs of low- and moderate-income areas in their communities. Today, however, there is a widely held view among community groups that banks can, and should, do more. This may involve aggressive outreach, the use of new marketing tools, and the evolution of new loan products designed to increase loan approvals to low- and moderate-income borrowers.

The current emphasis is not on simply ensuring that segments of communities are not ignored but on dynamic, affirmative efforts. As a result, even institutions that have demonstrably increased mortgage and other credit extensions in lower-income areas, and have expanded their participation in community development, are not infrequently criticized for failure to do more. I might add that we regulators have, to a substantial degree, concurred with the evolution in thinking in this area. Our expectations of what banks should be expected to do to comply with the CRA are much more aggressive than they were ten or fifteen years ago.

CRA Complaints

Not surprisingly, along with these rising expectations, many in the banking community have come to view agency CRA efforts as increasingly burdensome and unfair. These views have intensified even as the agencies have taken explicit steps to reduce burden, especially for small banks.

At the same time, community and consumer groups often view agency efforts as weak and have suggested a number of changes, including new disclosure provisions, to help ensure that banks and supervisory agencies approach their CRA responsibilities effectively. Further, community groups say that the CRA ratings are much too high, and they contend that the banking agencies are much too lenient. They point to the fact that more than 90 percent of the institutions do get a satisfactory or better rating.

Both bankers and community representatives have alleged that the evaluations of the agencies are not equally comprehensive and that the CRA ratings assigned are not always the same for banks that appear to have similar performance. And both bankers and community groups continue to charge that the agencies appear more interested in ensuring that institutions have the appropriate CRA procedures and paperwork than actual lending programs in their communities.

All of these frustrations are real, but as I have tried to indicate they are probably natural products of the CRA law itself as well as the 1990's view of the CRA, which is quite different from its modest beginnings in 1977.

Although the complaints about the CRA are real, to some extent I believe that many are based on misunderstandings. First, I want to note here that the Board is not particularly disturbed by the ratings distribution for state member banks, which are virtually identical to those of other regulators. Yes, more than 90 percent do pass. But CRA ratings are not, and frankly for several reasons should not be, as some have suggested, the result of "grading on a curve."

I do not mean to say that the Board or the other agencies have been infallible in assigning ratings. But at the Board, we have put tremendous resources behind intensive examiner training on the CRA, fair lending, and other related issues. A great deal of time and effort also have been spent, especially over the past three years, in reviewing CRA evaluations to ensure that they reflect what we believe are fair outcomes and are as comprehensive and consistent as we can make them.

Moreover, through our community affairs programs at Reserve Banks, the Federal Reserve System has developed or sponsored over the past five years more than 650 educational conferences, seminars, and workshops for bankers and others on the CRA and the types of community development lending and investment programs available to help them respond to community credit needs. We believe that these programs - attended by thousands of bankers - have had a positive effect.

Finally, we have been examining each state member bank for CRA performance once every eighteen months to two years for more than sixteen years. The cumulative effect of our training, educational programs, and examinations, I believe, makes it highly likely that most banks generally understand their CRA obligations and should know what needs to be done to achieve adequate performance.

And frankly, our goal - the goal of the CRA, I believe - is to encourage all institutions to have, in substance, good or outstanding CRA programs. Just as we would not entertain the notion that bank CAMEL ratings should somehow be proportional - meaning that at least a certain number of banks should, a priori, fail their safety and soundness examinations - we do not believe that this

(1.) See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 81 (March 1995), pp. 219-43. should be assumed for bank CRA performance ratings. Just as we try to heir banks with financial problems solve them and return to safe and sound operations, we also have been helping banks with CRA problems improve their programs. CRA evaluations are certainly not grading on a curve. We believe that all banks could be outstanding if they chose to be.

The regulatory burden of the CRA may have been overstated somewhat by the industry. Most of the more vigorous complaints about regulatory burden come from community bankers who understandably remain concerned and pressed by the cumulative effects of all of the consumer laws and regulations passed over the past twenty-five years besides the CRA. Cumulatively, these regulations have been costly to all institutions and certainly have fallen disproportionately on smaller banks. Given the CRA's vague prescriptions and the uncertainty of the examination process, the CRA may have become a stalking horse for frustration with regulatory costs in general.

My point is that I think some caution is called for in assessing die extent of the CRA's burden, and its purpoted enforcement.

The CRA'S Impact

Despite the CRA's lack of clarity and the criticisms of the CRA from all quarters, I believe that the CRA has had a significant impact on the availability of credit in low- and moderate-income areas. In fact, I fear that the focus on the imperfections of the CRA - many of them probably unavoidable - has misdirected the public debate. Far too much emphasis has probably been placed on the problems of the CRA, rather than on its strengths. Here is a government program that has entailed little bureaucracy, great local autonomy, and virtually no federal tax dollars to administer. Yet its impact on communities can probably be measured in billions of dollars in community and economic development activity, benefiting the most distressed parts of communities.

The CRA has helped stimulate loans for home mortgages, housing construction and rehabilitation, and small and minority business development in low- and moderate-income communities. Banks and thrift institutions have made tremendous strides to explore new loan underwriting standards to better accommodate the circumstances of lower-income borrowers without sacrificing safe and sound lending principles. The Home Mortgage Disclosure Act (HMDA) data for 1992 and 1993 show encouraging signs that the greatest percentage of growth in home mortgages is to low-income and minority borrowers.

More banks and thrift institutions are seeking and participating in public-private partnerships in both urban and rural communities than ever before. A growing number of bank-led community development corporations or multibank lending consortia are supporting home ownership, small business development, and other projects benefiting low- and moderate-income areas. Moreover, all this has been accomplished with no significant adverse effect on safety and soundness. And though, as I have said, we support this reform effort, the record suggests that we want to be very cautious in avoiding unintended consequences from any proposed changes in the CRA.

Federal Reserve Principles for

CRA Reform

Finally, let me be clear about the Federal Reserve's position on a number of issues related to the CRA and the reform process. First, as indicated, in our view, the CRA has had a beneficial effect on many communities and institutions. On balance, we believe that the law is worthy of being maintained, provided it is administered in a sensible fashion.

Second, one of the major risks in the reform process is that changes we may make to the CRA's regulations could result in unintended and unwarranted credit allocation. I want to emphasize that the Board is very concerned about this prospect. Let me assure this committee that the Federal Reserve has no wish to produce a regulatory scheme that would result in governmentally imposed credit allocation driven from Washington. But despite our best intentions, this is an undeniable risk. One of the strengths of the CRA that we should take special care to preserve is its flexibility and responsiveness to local conditions. Under any scheme, banks should still be able to determine how best to serve the needs of their communities. We must not substitute the judgment of the agencies for the judgment of the banks. I do not believe that any other alternative would be acceptable to the Board, and we will not endorse any reform approach - no matter how well intentioned - that violates this principle.

Third, we must be very cautious in attempting any revision of the regulations, given the uncertainties involved in how an entirely new set of regulations will actually affect bank behavior. I am particularly concerned about the unintended consequences of regulation, which may actually harm existing minority-owned or minority-oriented financial institutions, undermine the efforts of small community-based banks or nonprofit institutions, or cause banks to leave markets or avoid experimentation because of a fear of increased risk. Wholesale or radical change invariably ends up as counterproductive. Underserved markets do not need alternating periods of extreme policy activism followed by extreme neglect. They require steady, moderate, predictable, and workable efforts.

In that regard, I would emphasize that the Board historically has endeavored to steer a steady course on die CRA, adopting modest changes in policy to respond reasonably to new conditions and expectations but avoiding radical changes that could have unfortunate consequences. We believe that approach has been the correct one.

Fourth, any pursuit of more objectivity in the rating scheme must be tempered with a recognition of the potential adverse consequences of any mechanical system that does not allow considerable agency judgment. I think that was brought home clearly in the responses by many in the banking industry to the first reform proposal, which proposed a formulaic market share test as the primary element in a rating system. There were just too many unforeseen problems with the concept.

Fifth, any reform structure must recognize the uniqueness of small institutions and the disproportionate burden they bear from any regulation, CRA or otherwise. I believe that any final proposal will accommodate a, streamlined examination for smaller banks, though it will not exempt them from their CRA obligations.

Sixth, any increased data reporting must be justified. It is important to bear in mind that the primary cost of detailed data reporting is not borne by the banks but by their customers. The detailed reporting of individual loans now required under HMDA, for example, means that applicants' incomes and other sensitive pieces of information are placed in the public domain. While the Congress has determined that the benefits of such reporting outweigh the costs in that particular instance, the assumption that further detailed reporting is necessarily beneficial should be carefully scrutinized.

Seventh, while we can understand the desire to develop additional incentives for good CRA performance, discussion of a variety of safe harbor proposals over the years has generally provided protection to too many institutions whose performance may be barely satisfactory and too few when limited to only those rated "outstanding." One solution that the Congress may want to consider is to establish a new rating category of "strong satisfactory" and focus some benefits to institutions at that level or higher.

Finally, we believe it especially important that the commitment to safety and soundness be maintained. Community reinvestment must be economically sound and ultimately engender adequate rates of profitability if it is to be sustained. If the CRA is to work over the long term, economic sense, not shifting views about CRA obligations, must be the driving force. Giving money away is not what the CRA is, or should be, about, and while some flexibility in loan terms may at times be appropriate, we do not support anything other than safe, sound, and profitable lending.

Conclusion

The CRA reform process has been very arduous and difficult and certainly has taken longer than desired. But I believe that the Board, along with the other agencies, has made a good faith effort to adhere to the President's request. The Board has devoted a tremendous amount of time and energy, as have the Reserve Banks, to the reform process.

Our work is not done, however, and we welcome this committee's interest in this process. Our task is to develop a CRA regulation and evaluation process that is superior to the one now in place but one that will not have adverse long-term consequences. I can assure you of the Federal Reserve's commitment to this goal.

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Finance, U.S. Senate, March 13, 1995

I am pleased to appear here today to address some of the issues surrounding the adjustment of federal programs for movements in the cost of living. For the current fiscal year, roughly 30 percent of total federal outlays are indexed to movements in consumer prices, with social security, Supplemental Security Income, veterans' pensions, military retirement, and civilian pensions accounting for the bulk of this spending. On the tax side, indexation is largely confined to the individual income tax, which accounts for about 45 percent of federal receipts. The Congress explicitly intended, in enacting the indexation of these spending and tax programs, to insulate those affected individuals from the consequences of increases in the cost of living. The vehicle chosen for making these adjustments was the consumer price index (CPI), and the issue at hand is whether that price index is appropriate for the task.

If it is not, there are significant implications for the budget deficit, and there is the potential for considerable unintended transfers of wealth. As I noted in testimony earlier this year, if annual inflation adjustments to indexed programs and taxes were reduced 1 percentage point - and making the admittedly strong assumption that there are no other changes in the economy - the annual level of the deficit would be lower by about $55 billion after five years, including die effects of lower debt levels. The cumulative deficit reduction over this period would be nearly $150 billion, and these savings would continue to grow in subsequent years.

I believe that the evidence suggests that some adjustment to our indexing procedures is warranted. I am certain that many of the technical details will be elaborated in your discussions later this morning, but let me briefly outline some of the conceptual issues. To begin, a review of the legislative history surrounding indexation does not reveal a full appreciation for the important distinction between the CPI and a true measure of the cost of living. The CPI is constructed to measure price changes for a fixed market basket of goods and services. At present, that market basket - at least at the higher levels of aggregation - is fixed to spending patterns that prevailed in the period from 1982 to 1984. Economic theory indicates that changes in a fixed-weight price index such as the CPI form an upper bound to changes in the cost of living, even if all of the individual prices used in the index are measured without error. The reason is that the use of fixed weights is appropriate only if there is no possibility for consumers to offset any of the consequences of increased prices for some goods by substituting others. While the degree of substitutability among products may be open to question, it is undeniable that such substitution does indeed occur.

Other technical aspects to the construction of the CPI also suggest that it may overstate cost-of-living changes. Researchers at the Bureau of Labor Statistics (BLS) have found that an interaction between the use of fixed weights at the most disaggregated level and the manner in which new samples of retail outlets are linked into the index may be resulting in an overstatement of price increases. In January, the Bureau implemented procedures that should alleviate this so-called "sample rotation bias" at grocery stores, but the problem likely remains for other categories. More generally, the BLS is experimenting with a geometric weighting scheme that offers broader relief from this technical problem.

Over the postwar period, there has been a marked tendency for consumers to shift purchases from high-priced, full-service stores to lower-priced, discount retailers. The BLS uses surveys of consumer buying patterns to keep abreast of these developments. On the basis of these surveys, a new sample of retail outlets is drawn for roughly one-fifth of U.S. cities each year. Thus, with some lag, innovations in retailing are captured in the CPI. However, at the time when new outlets are rotated into the sample, if prices are found to be lower at the new establishments than at those being rotated out of the sample, the differential is, in effect, attributed to lower quality rather than to lower prices. Even granting that the quality of service and ambience may differ between the new and old outlets, presumably some of the shift in shopping patterns reflects the fact that consumers can purchase the same goods at lower prices. Consequently, some of the price declines associated with the growing importance of discount retailers may not be fully captured by our statistics.

In sum, the fixed-weight nature of the CPI and other aspects of its construction point in the direction of an overstatement of increases in the cost of living. Even if this upward bias were only a fraction of a percentage point per year, the relentless compounding of such a discrepancy ultimately would have budgetary consequences meriting serious attention.

There are, however, reasons for suspecting that weighting and construction are not the only factors leading the CPI to overstate changes in the cost of living. A more difficult but, to my mind, no less important issue concerns making adequate adjustment for the improvement in the quality of goods and services over time. I would note that the BLS does make adjustments for quality changes in the CPI. What is at issue is whether the implemented procedures, or for that matter any practical procedures that could be established in the foreseeable future, can be expected to account fully for quality changes across the vast array of goods and services available in our economy.

In many respects, the issue of price measurement has as its mirror image the fundamental problem of defining with precision a unit of output. If this conundrum could be resolved, not only would we have more accurate price measures but we would have correspondingly better measures of output and productivity. But defining a unit of output is an exceptionally difficult task when the characteristics of products and services are changing rapidly and along many dimensions. Under these circumstances, disentangling price change from quality improvement presents a formidable challenge.

Nowhere are these challenges more acute than in the area of medical care. What is the appropriate unit of output? Should one price procedures, treatments, or cures? Should the comfort or satisfaction of the patient be accounted for in price measurement? The past century has witnessed astonishing improvements in medical care. Cures and preventive treatments have become available for previously untreatable diseases. Medical advances have also led to new treatments that are more effective and that have increased the speed and comfort of recovery.

Technological innovations have been exceptionally rapid in the medical field. A case study of CAT scanners documented the dramatic and swift improvements in quality that occurred after their introduction in the early 1970s. Substantial gains were made in scan time, resolution, and the speed of image reconstruction. These characteristics, in turn, have a direct bearing on the comfort and convenience of the patient and the quality of the diagnosis provided by the doctor. Conventional price measures will almost surely miss much of this type of quality improvement because of the enormous complexity involved in defining the output that is being consumed and measuring the corresponding unit price of that output.

Although medical care is perhaps the most striking example of rapid - and difficult-to-measure - quality improvement, similar problems occur across a broad range of goods and services. Research has found that quality improvement may not be adequately captured for goods and services ranging from complicated capital equipment to power tools to consumer appliances to the simple consumption of household lighting.

To be sure, there are offsets to unmeasured increases in quality. The downward adjustment made to measured auto prices for the cost of mandated pollution control devices is one example cited in a recent study by the Congressional Budget Office: Although this equipment may provide a benefit to society, the owner of the automobile likely captures little of the direct benefit associated with his or her increase in outlays. Other products may be made more poorly in ways that escape detection in our price statistics. But given the perpetual advance of knowledge and technology, these cases are surely overwhelmed by a tendency for the quality of goods and services to rise over time in a manner that is difficult to define and measure. Those who remember with fondness the products of yesteryear are probably suffering either from fading memories or excessive sentimentality.

The difficulties confronted in price measurement are not confined to the quality advances of existing products. The continual introduction of new goods and services onto the markets of our dynamic economy creates additional challenges for price measurement. In some cases, a new good may be similar to an improved version of an old good. In other cases, new products may deliver services to consumers that effectively were not available before - for example, personal computers, videocassette recorders, and cellular phones. New goods and services are incorporated in our price measures but only with a lag. This lag can create an upward bias because new products often experience their largest price declines early in the product cycle. The more spectacular examples involve consumer electronics, such as computers and communications equipment, but the entry of an enormous amount of new products onto the markets every year makes this a more pervasive problem than is commonly understood. While any one product may not figure prominently in household budgets, the totality of new products and the often large price declines that occur before they are incorporated in our price measures suggest that this problem may not be trivial.

These difficulties should not be read as a blanket indictment of our current statistical procedures. The consumer price index is a fundamentally sound statistical program. The BLS has, over the years, made frequent and significant improvements in the CPI, and further improvements should be, and are, on their agenda. Updated market baskets, experimentation with alternative indexing formulas, and ongoing research on the application of hedonic indexes offer the possibility of better measurement in the future.

But even the implementation of improvements in the CPI can lead to distortions when this measure is used directly as a cost-of-living escalator. For example, the BLS made a significant change in how it calculates the CPI in 1983, when it shifted from a method in which the price index for housing was constructed as if each household was paying the current home price and mortgage rate on its residence to one that is a more realistic measure of the cost of home occupancy. Because of the run-up in house prices and interest rates between the 1960s and early 1980s, the official CPI rose about 9 percent more than indicated by the newer, superior measure. By the time the index was changed, this overstatement had added substantially to the level of outlays in the large indexed federal programs. Once the additional interest outlays required to finance the cumulatively higher federal debt are added in, a rough estimate suggests that, all else equal, the deficit for fiscal year 1994 would have been smaller by $50 billion had the overindexing not occurred.

The fundamental problem is that we have legislated a mechanical procedure to implement cost-of-living adjustments when - given the problems inherent in any statistical measure of aggregate prices - there is a need for the application of sound judgment. If indexation had prevailed for only a short period of time, the discrepancy between the CPI and a true measure of the cost of living would not have resulted in any appreciable problem. But left in place over long periods of time, as has now occurred and is envisioned continuing in the future, the discrepancy will compound in a manner that cumulates to very substantial magnitudes.

For this reason, I suggest that the Congress give careful consideration to the establishment of an independent national commission to set annual adjustment factors for federal receipt and outlay programs. The members of this commission could review the available price statistics, taking into account the differences between these measures and the concept of a true measure of the cost of living. In addition, periodic review would allow the discrepancy to be adjusted for improvements in the available statistics as well as for insights developed from outside research. Careful consideration could be given to die establishment of a special cost-of-living adjustment for retirement benefits to reflect the buying patterns of die affected population. The replacement of a mechanical procedure by the informed judgment of experts would best ensure that the original intent of the legislation would be fulfilled - to insulate taxpayers and recipients of benefits from the effects of changes in the cost of living.

The issue that we are discussing today demonstrates clearly the long-lived consequences of having allowed inflation to increase in the late 1960s and 1970s. Had the inflation environment of the 1950s and early 1960s been maintained, no widespread application of indexation would have emerged; there simply would have been no need for it. Indexation was viewed as a way of mitigating the effects of inflation. It succeeded in many respects, but we have also seen another example of the operation of the "Law of Unintended Consequences" in the enlargement of our budget deficit. I believe that, if the Federal Reserve can maintain a proper direction for monetary policy, we shall make this whole matter moot. But in die interim, we should at least attempt to refine our indexation procedures so as to ensure that the distortions are minimized.

Resignation of Governor John P. LaWare

as a Member of the Board of

Governors

John P. LaWare on March 27, 1995, submitted his resignation as a member of the Board of Governors, effective April 30.

Governor LaWare, who had been a member of the Board since August 15, 1988, submitted his letter of resignation to President Clinton. In view of his impending departure from the Board, Governor LaWare did not attend the meeting of the Federal Open Market Committee on March 28, 1995.

Before becoming a member of the Board, Governor LaWare served as chairman and as a director of Shawmut National Corporation, a superregional bank holding company in New England. His banking career spanned thirty-five years, beginning in 1953 after service in the U.S. Air Force.

The text of his letter of resignation appears below.

March 27, 1995

The Honorable William Jefferson Clinton The President of the United States The White House

Dear Mr. President:

I hereby submit my resignation as a Member of the Board of Governors of the Federal Reserve System effective April 30, 1995.

It has been a distinct honor and privilege to serve as a Member of the Board and the Federal Open Market Committee with such distinguished colleagues and under the outstanding leadership of Chairman Alan Greenspan. In my opinion, it has been important for the Board to have an experienced banker as a Member during these past six-and-a-half years. The Board has an important role vis-a-vis the banking system as a supplier of services, supervisor and regulator. The quality of Board deliberations and decisions on banking matters is enhanced by the direct participation of a Member with personal private sector experience in banking. Therefore, I respectfully recommend that, in your search for a successor to my seat on the Board, every effort be made to nominate a person with that background.

Respectfully yours,

John P. LaWare

The text of the letter from President Clinton appears below:

The White House Washington

April 5, 1955

The Honorable John P. LaWare Board of Governors of the Federal Reserve System Washington, D.C. 20551

Dear John:

I have received your letter advising me of your resignation from the Board of Governors of the Federal Reserve System. As you requested, I hereby accept your resignation, effective April 30, 1995.

I appreciate your dedicated work for the federal government. Your skill and experience have been of tremendous value to the Board, helping to ensure a stable monetary system and greater prosperity and opportunity for our fellow citizens. I will certainly keep your suggestions in mind as we seek a worthy successor.

On behalf of all who have benefited from your service, I thank you for a job well done. Hillary joins me in extending best wishes for every future success.

Sincerely,

Bill Clinton

After the announcement of Governor LaWare's resignation, Alan Greenspan, Chairman of the Board of Governors, issued the following statement:

I deeply regret, but understand, the decision of Governor John LaWare to retire from public service. His advice and counsel during his more than six and one-half years as a member of the Board have been outstanding and in the best interest of the country. He has been not only a valuable and trusted colleague but also a close friend. To say he will be missed i& truly an understatement. I wish him well in whatever future endeavors he undertakes.

Issuance of Final Guidelines

on an Internal Process for Appealing

an Adverse Material Supervisory

Determination

The Federal Reserve Board on March 24, 1995, issued final guidelines on an internal appeals process for institutions wishing to appeal an adverse material supervisory determination. The guidelines were effective immediately.

The Riegle Community Development and Regulatory Improvement Act of 1994 requires that the Board (as well as other federal banking agencies) establish an independent, intra-agency appellate process, which will be available to review material supervisory determinations made at insured depository institutions, such as an adverse examination report.

Issuance of Final Rule

to Regulation E

The Federal Reserve Board on March 16, 1995, issued a final rule to its Regulation E (Electronic Fund Transfers) to give financial institutions more flexibility in identifying consumer accounts on receipts at automated teller machines (ATMs).

The final rule, effective April 24, 1995, no longer requires that terminal receipts uniquely identify the consumer's account or card. This change will allow institutions to truncate the number on the receipt and will help protect consumers and financial institutions against fraudulent withdrawals of funds.

In some fraud schemes, criminals manufacture counterfeit ATM cards by using valid account numbers from receipts discarded by consumers at ATMs. They then withdraw funds by using the personal identification number that, without the consumer's knowledge, they have observed the consumer enter at the ATM. The amendments to Regulation E are designed to address these problems.

Issuance of Amendments to

Regulation Z and Revisions to Its

Official Staff Commentary

The Federal Reserve Board on March 16, 1995, issued amendments to its Regulation Z (Truth in Lending), requiring new disclosures for reverse mortgages as set forth in the Home Ownership and Equity Protection Act of 1994.

A reverse mortgage transaction is a loan secured by the equity in a home. In a reverse mortgage, disbursements are made to homeowners - typically on a monthly basis and typically to the elderly - until the homeowner dies, moves permanently, or sells the home. The lender relies on the home's future value for repayment.

The amendments would impose disclosure requirements about the potential cost of the transaction on creditors offering reverse mortgages and would impose substantive limitations on home mortgage transactions having rates or fees above a certain percentage or amount.

On March 28, 1995, the Federal Reserve Board issued revisions to the official staff commentary to its Regulation Z. The rule is effective April 1, 1995; however, compliance is optional until October 1, 1995.

The revisions to the commentary clarify regulatory provisions and provide further guidance on issues of general interest, such as the treatment of various fees and taxes associated with real estate-secured loans, including charges by third parties, and a creditor's responsibilities when investigating a claim of an unauthorized use of a credit card.

Availability of Transcripts

of 1989 Meetings of the

Federal Open Market Committee

The Federal Reserve on March 21, 1995, made available for public inspection transcripts of meetings of the Federal Open Market Committee (FOMC) that were held during 1989. The package includes transcripts of eight regularly scheduled meetings and six telephone conference calls.

This action is in line with procedures adopted by the FOMC at its last meeting that called for the public release of transcripts for an entire year with a five-year lag.

The 1989 transcripts have been lightly edited to enhance readability and to redact confidential material such as information pertaining to individual foreign central banks and private business information.

Last year, the Committee issued transcripts for meetings and conference calls held in 1988, 1987, and the last half of 1986. Earlier transcripts will be made available as soon as editing can be completed.

Start of Education Campaign

on the Sale of Mutual Funds

and Annuities at Banks

The Federal Reserve announced on March 20, 1995, that it would soon begin a nationwide education campaign about the sale of mutual funds and annuities at banks.

The campaign, entitled "Mutual Funds: Understand the Risks," will begin with a series of seminars for retirees and those planning for retirement. The seminars will be hosted by the twelve District Federal Reserve Banks and will emphasize that mutual funds and annuities, unlike certificates of deposit, are not insured by the Federal Deposit Insurance Corporation or in any way guaranteed by the banks that sell them.

The Federal Reserve developed the program in cooperation with the American Association of Retired Persons and conducted pilot seminars in the Boston area in late 1994.

A short video providing basic information about mutual funds is also under development for use by the Federal Reserve, bankers, and consumer groups in their education programs. In addition, the Federal Reserve will provide banks with training on the interagency guidelines governing the retail sale of mutual funds and other uninsured products on bank premises.

Additional information about the seminar program may be obtained from the District Federal Reserve Banks.