Testimony of Federal Reserve Officials.

Testimony of Dolores S. Smith, Director, Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services, U.S. House of Representatives, July 12, 2001

I appreciate the opportunity to appear before this subcommittee to offer staff comments on H.R. 1701, the Consumer Rental Purchase Agreement Act, which would amend the Consumer Credit Protection Act. I am the Director of the Federal Reserve Board's Division of Consumer and Community Affairs, which carries out the Board's responsibilities for administering a number of the consumer protection laws that make up the Consumer Credit Protection Act, including the Truth in Lending Act and the Consumer Leasing Act.

H.R. 1701 would require cost disclosures for "rental-purchase" agreements, which are also known as "rent-to-own" transactions. The bill has substantive provisions. For example, it establishes consumers' right to reinstate an agreement after failing to make a timely payment. The bill also would prohibit certain provisions in rental-purchase contracts, such as confession-of-judgment clauses that prevent consumers from defending any legal action brought under the contract. H.R. 1701 treats rent-to-own transactions differently from both credit sales and traditional leases and would, therefore, cover them under a separate regulatory scheme altogether.

The Federal Reserve Board has not taken a position on H.R. 1701. However, I am glad to share the Board staff's observations--about the bill and some of the issues raised--in response to your request.

Rental-purchase transactions involve short-term, renewable rentals of personal property, typically on a week-to-week or month-to-month basis. For example, a consumer may rent a television set, major household appliances such as a washing machine or refrigerator, or home furnishings such as living room furniture. By renewing the rental from one period to the next, a consumer can ultimately purchase the item after making a specified number of payments, but the consumer is not obligated to do so.

Rental-purchase transactions typically are for less than four months initially--although they often extend for longer periods. These agreements are not covered by the disclosure requirements of the federal Consumer Leasing Act, which applies to leases that initially exceed four months. Nor are these transactions generally credit sales for purposes of Truth in Lending Act disclosures. Contracts in the form of a lease are treated as credit under Truth in Lending only if the consumer is obligated to purchase the property and pay an amount equal to or exceeding the total value of the property; such an obligation does not typically exist in rent-to-own transactions.

Under the Consumer Leasing Act, consumers receive federally mandated disclosures concerning the cost of the transaction prior to entering into the lease. These disclosures include a description of the leased property, an itemization of any up-front payments, a payment schedule showing the amount of each periodic (typically monthly) payment, a listing of any other charges the consumer will have to pay, and the total of payments that the consumer will have paid by the end of the lease. There are also disclosures regarding early termination charges, late payment fees, property maintenance responsibilities, and the consumer's options for purchasing the property.

Under the Truth in Lending Act, consumers must receive disclosure of the key costs and terms of credit transactions before they become obligated for the extension of credit. Consumers receive disclosures that include the amount of credit extended (known as the amount financed), the cost of credit expressed as a dollar amount (the finance charge) and as an annual percentage rate (APR), the total amount the consumer will pay, and a payment schedule showing the timing and amount of each payment.

ASSESSING THE NEED FOR LEGISLATION

While, currently, there is no federal regulation of rental-purchase transactions, laws governing these transactions have been adopted in forty-seven states. These laws were enacted largely with the support of the industry. All of the state laws have been enacted since 1984 (twenty-four of them since 1990).

In the early 1980s, before any action was taken at the state level, representatives of the rental-purchase industry supported federal legislation to cover these transactions. For firms operating in multiple states, a uniform regulatory framework eases the compliance costs. At the time, federal legislation was also advocated by the industry to clarify that rental-purchase transactions are leases under the tax laws, and to preclude states from applying their credit laws and usury limits to these transactions. The subsequent enactment of state laws and other legal developments may have settled these issues to some extent.

In the early 1980s, some consumer advocates also favored federal legislation covering rental-purchase transactions because of the lack of state law consumer protections. Since the mid- to late 1980s, however, consumer advocates have generally objected to legislation proposed at the federal level for several reasons--because they believe the federal proposals provided insufficient consumer protections; because federal legislation might have preempted state laws that they viewed as more protective; and, in the case of some consumer advocates, because they continued to view rent-to-own transactions as credit sales under the Truth in Lending Act.

Given the existing body of state law, the subcommittee is to be commended for holding these hearings to explore--with industry representatives and consumer advocates--the need for federal legislation. The views of the state agencies charged with administering and enforcing the applicable state laws should also be helpful in this process. Much can be learned, for example, about the effectiveness and adequacy of the existing state laws and the states' experience in enforcing them. I expect you will find the Federal Trade Commission's survey on the rent-to-own industry particularly useful in identifying and discussing relevant issues. The FTC report on its survey of rent-to-own customers has been a primary--and important--source of information for the Board staff's consideration of these issues.

EFFECTIVE DISCLOSURES

Several provisions of H.R. 1701 focus on consumer disclosures in advertising, on price tags, in catalogs, and in contracts. Disclosures are most effective when consumers receive them early enough in the process to use them as a shopping tool, and when the disclosures are presented in a way that enables consumers to focus on the key costs and terms. We also offer the general observation that, while disclosure is important, too much information can sometimes obscure the basic, key information consumers may need to make an informed choice.

The fact that rent-to-own transactions have characteristics of both sales and leases is important to consider in determining what disclosures consumers need. Although there may be some disagreement about the purchase rate for rent-to-own merchandise, the percentage of purchases by customers who enter into these transactions appears to be substantial. The FTC's survey found that about 70 percent of rent-to-own merchandise was purchased by consumers. But as the FTC report also notes, industry sources have consistently maintained that the purchase rate is considerably lower, about 25 percent to 30 percent.

Under H.R. 1701, key cost disclosures must be provided on merchandise tags or labels for property that is displayed or offered in a dealer's place of business. As the bill recognizes, such disclosures could be a useful shopping tool for consumers. Only eighteen states currently require merchandise disclosures, so this is one aspect in which federal law could directly enhance state-law protections, although some firms may voluntarily be providing these disclosures.

As to the content of merchandise tags, we concur with the FTC report's assessment about disclosure of total cost for purposes of comparison shopping. Because many customers may end up purchasing the property, merchandise tags and labels should show the total cost to purchase the item, as provided in H.R. 1701, and not just the rental fee. Of the states that require merchandise tags, all but a few require inclusion of the total purchase price. Consumers could use the total purchase cost disclosure while shopping, to compare the dealer's purchase price with the prices offered by other rent-to-own dealers.

In addition to the total rental-purchase cost, H.R. 1701 would require merchants also to disclose a "cash price" for the property covered by the rental-purchase agreement. This disclosure would enable consumers to compare the cash price from a rent-to-own dealer with the sale prices at traditional retail stores. In making this comparison, a consumer could judge whether the rent-to-own dealer's cash price is reasonable for the goods and services being provided, and they can look at the difference between the dealer's cash price and the total purchase price under the rental-purchase agreement.

H.R. 1701 also requires that more detailed disclosures be made in connection with the rental-purchase agreement, at or before the date of consummation. Most of the cost disclosures would have to be grouped together and segregated from other information. Disclosures about other terms and conditions must be clearly and conspicuously included in the rental-purchase agreement. This segregation is consistent with the approach used in the Consumer Leasing Act and Truth in Lending Act, and is an approach that we believe is effective in calling the consumer's attention to the most important terms.

THE STANDARD FOR PREEMPTION OF STATE LAWS

You asked us to comment on the impact of H.R. 1701 on state law. A bill establishing federal minimum standards for consumer disclosures in rental-purchase transactions may offer some benefits to consumers and to the industry. The effect of any federal legislation on the ability of states to retain more protective statutory provisions, or adopt new consumer protections, should also be taken into account.

H.R. 1701 would amend the Consumer Credit Protection Act. But as drafted, the bill applies a standard for preemption that differs from the standard used under other titles of the act. Under the existing federal statutes, a specific provision in state law is generally preempted only to the extent that the state provision is inconsistent with the federal statute. H.R. 1701 contains this language but omits other language used in the Consumer Credit Protection Act statutes. The omitted language provides that a state law is not inconsistent with the federal statute if it is found to give greater protection to the consumer.

The preemption provisions in H.R. 1701 would expressly preclude states from requiring an APR disclosure or subjecting rental-purchase transactions to state credit laws, including usury limits. It is not clear whether the preemption provisions in H.R. 1701 are intended to limit the states' ability to retain (or adopt) more protective rules on other aspects of rent-to-own transactions. For example, some states mandate longer reinstatement periods than the periods specified in H.R. 1701. The effect on these laws should be clarified.

RULEWRITING AUTHORITY

You also have asked us to comment on whether the FTC or the Federal Reserve should write the regulations implementing H.R. 1701, and who should be responsible for enforcing these regulations. As drafted, the bill currently gives rulewriting authority to the Federal Reserve Board. We strongly urge that further thought be given to whether the Federal Reserve is the appropriate agency to regulate these transactions.

The Federal Reserve has no supervisory relationship with rent-to-own dealers, which are firms that are not generally subject to Board regulations governing financial services. These transactions are not covered by the existing credit or leasing regulations, and hence the Board's staff has no direct experience with industry practices and how rental-purchase transactions are conducted.

We believe the Federal Trade Commission's experience in regulating the trade practices of commercial firms makes that agency the more logical choice for writing regulations. As H.R. 1701 recognizes, the FTC is the most appropriate agency for purposes of enforcement because it is the principal agency charged with enforcing the Consumer Credit Protection Act with respect to companies that are not depository institutions. The Federal Reserve and the other federal banking agencies have enforcement authority under that act only with respect to the depository institutions they supervise.

Testimony by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, US. House of Representatives, July 18, 2001. (Chairman Greenspan presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, US. Senate, on July 24, 2001.)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Testimony of Laurence H. Meyer, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives, July 26, 2001

It is a pleasure, Mr. Chairman, to appear before this subcommittee to present the views of the Board of Governors of the Federal Reserve System on deposit insurance reform as proposed by the Federal Deposit Insurance Corporation (FDIC) this past spring. At this point, the Federal Reserve Board's views are necessarily general because the FDIC's recommendations were purposefully quite broad.

That said, on behalf of the Board I want to compliment the FDIC for an excellent report that highlights the issues and develops an integrated framework for addressing them. We urge the Congress to use that framework for promptly developing a detailed legislative proposal that addresses the most important deficiencies in our current deposit insurance system. I hope my comments this morning will be helpful in doing so.

BENEFITS AND COSTS OF DEPOSIT INSURANCE

As background to our suggestions, the Board believes it is important first to understand the benefits and costs of deposit insurance. Deposit insurance has played a key--at times even critical--role in achieving the stability in banking and financial markets that has characterized the past almost seventy years. Deposit insurance, combined with other components of our banking safety net--the Federal Reserve's discount window and payment system guarantees--and with enhanced macroeconomic stability resulting from monetary and fiscal policies, has meant that periods of financial stress are no longer characterized by depositor runs on banks and thrifts. Quite the opposite: Asset holders now seek out deposits as safe havens when they have strong doubts about other financial assets.

Looking beyond the contribution of deposit insurance to overall financial

stability, we should not minimize the security it has brought to millions of households and small businesses. Deposit insurance has provided a safe and secure place for those households and small businesses with relatively modest amounts of financial assets to hold their transaction and other balances.

These benefits of deposit insurance, as significant as they are, have not come without cost. The very same process that has ended deposit runs has made insured depositors largely indifferent to the risks taken by their banks because their funds are not at risk if their institution is unable to meet its obligations. As a result, the market discipline to control risks that insured depositors would otherwise have imposed on banks and thrifts has been weakened. Relieved of that discipline, banks and thrifts naturally feel less inhibited from taking on more risk than they would otherwise assume. No other type of private financial institution is able to attract funds from the public without regard to the risk it takes with its creditors' resources. This incentive to take excessive risks is the so-called moral hazard problem of deposit insurance, the inducement to take risk at the expense of the insurer.

Because of the reduced market discipline and moral hazard, there is an intensified need for government supervision to protect the interests of taxpayers and, in essence, substitute for the reduced market discipline. Deposit insurance and other components of the safety net also enable banks and thrifts to attract more resources than would otherwise be the case. In short, insured banks and thrifts receive a subsidy in the form of a government guarantee that allows them both to attract deposits at lower interest rates than would be required without deposit insurance and to take more risk without the fear of losing their deposit funding. Put another way, deposit insurance misallocates resources by breaking the link between risks and rewards for a select set of market competitors.

From the very beginning, deposit insurance has involved a tradeoff. On the one hand, there are benefits from the contribution of deposit insurance to overall financial stability and the protection of small depositors. On the other hand, deposit insurance imposes costs from the inducement to risk-taking, the misallocation of resources, and the increased need for government supervision to protect the taxpayers' interests. The crafting of reforms of the deposit insurance system must struggle to balance these tradeoffs. Moreover, the Board urges, we should be reasonably certain that any reforms are aimed primarily at protecting the public interest and not the profits or market shares of particular businesses.

The Federal Reserve Board believes that deposit insurance reforms should be designed to preserve the benefits of heightened financial stability and the protection of small depositors without at the same time increasing moral hazard or reducing market discipline. This view underpins the response of the Federal Reserve Board to the FDIC's recommendations. In addition, although at this time we are responding to very broad recommendations, we urge that the implementing details be kept as straightforward as possible to minimize the risk of unintended consequences that comes with complexity.

RECOMMENDATIONS FOR REFORM

The FDIC has made five broad recommendations.

Merging BIF and SAIF

The Board strongly supports the FDIC's proposal to merge the Bank Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF) funds. Because the charters and operations of banks and thrifts have become so similar, it makes no sense to continue the separate funds. Separate funds reflect the past, but neither the present nor the future. Equally important, the insurance products provided to the two sets of institutions are identical, and thus the premiums should be identical as well. Under current arrangements, the premiums could differ significantly if one of the funds fell below the designated reserve ratio of 1.25 percent of insured deposits and the other fund did not. Merging the funds would also diversify their risks and reduce administrative expenses.

Statutory Restrictions on Premiums

Current law requires the FDIC to impose higher premiums on riskier banks and thrifts but restricts its ability to impose any premium on well-capitalized and highly rated institutions whenever the corresponding fund's reserves exceed 1.25 percent of insured deposits. The Board strongly endorses the FDIC recommendations that would (1) require that a premium be imposed on every insured depository institution, no matter how well capitalized and well rated it may be or how high the fund's reserves, and (2) eliminate the statutory restrictions on risk-based pricing.

The current statutory requirement that free deposit insurance be provided to well-capitalized and well-rated banks when FDIC reserves exceed a predetermined ratio maximizes the subsidy provided to these institutions and is inconsistent with efforts to avoid inducing moral hazard. Put differently, the current rule requires the government to give away its valuable guarantee when fund reserves meet some ceiling level. This free guarantee is of value to banks and thrifts even when they themselves are in sound financial condition and when macroeconomic times are good. At the end of last year, 92 percent of banks and thrifts were paying no premium. Included in this group were banks that have never paid any premium for their, in some cases substantial, coverage and fast-growing entities whose past premiums were extraordinarily small relative to their current coverage. We believe that these anomalies were never intended by the framers of the Deposit Insurance Fund Act of 1996 and should be addressed by the Congress.

The Congress did intend that the FDIC impose risk-based premiums, but the 1996 act limits the ability of the FDIC to impose risk-based premiums on well-capitalized and well-rated banks. And these two variables--capital strength and examiner overall rating--do not capture all of the risk that banks and thrifts could create for the insurer. The Board believes the FDIC should be free to establish risk categories based on any well-researched economic variables and to impose premiums commensurate with these risk classifications. Although a robust risk-based premium system would be technically difficult to design, a closer link between insurance premiums and individual bank or thrift risk would reduce moral hazard and the distortions in resource allocation that accompany deposit insurance.

We note, however, that significant benefits in this regard are likely to require a substantial range of premiums but that the FDIC has concluded in its report that premiums for the riskiest banks would probably need to be capped in order to avoid inducing failure at these weaker institutions. We believe that capping premiums may end up costing the insurance fund more in the long run should these weak institutions fail anyway, with the delay increasing the ultimate cost of resolution. The Board has concluded, therefore, that if a cap is required, it should be set quite high so that risk-based premiums can be as effective as possible in deterring excessive risk-taking.

Designated Reserve Ratios and Premiums

The current law establishes a designated reserve ratio for BIF and SAIF of 1.25 percent. If that ratio is exceeded, the statute requires that premiums on well-capitalized and well-rated banks must be discontinued. If the ratio declines below 1.25 percent, the FDIC must develop a set of premiums to restore the reserve ratio to 1.25 percent; if it appears that the fund ratio cannot be restored to its statutorily designated level in twelve months, the law requires that a premium of at least 23 basis points be imposed on the least risky category of banks.

These requirements are clearly pro-cyclical, lowering or eliminating fees in good times when bank credit is readily available and fund reserves should be built up, and abruptly increasing fees sharply in times of weakness when bank credit availability is under pressure and fund resources are drawn down to cover the resolution of failed banks. The FDIC recommends that surcharges or rebates should be used to bring the fund back to the target reserve ratio gradually. The FDIC also recommends the possibility of a target range for the designated reserve ratio, over which the premiums may remain constant, rather than a fixed target reserve ratio and abruptly changing premiums.

We strongly support such increased flexibility and smoothing of premiums. Indeed, we recommend that the FDIC's suggested target reserve range be widened in order to reduce the need to change premiums sharply. Any floor or ceiling, regardless of its level, could result in requiring that premiums be increased at exactly the time when banks and thrifts could be under stress and, similarly, that premiums be reduced at the time that depositories are in the best position to fund an increase in reserves. Building a larger fund in good times and permitting it to decline when necessary are prerequisites to less variability in the premium. In addition to widening the range, the Board would recommend that the FDIC be given the latitude to temporarily relax floor or ceiling ratios on the basis of current and anticipated banking conditions and expected needs for resources to resolve failing institutions.

Rebates

Since its early days, the FDIC has rebated "excess" premiums whenever it felt its reserves were adequate. This procedure was replaced in the 1996 law by the requirement that no premium be imposed on well-capitalized and highly rated banks and thrifts when the fund reaches its designated reserve ratio. The FDIC proposals would re-impose a minimum premium on all banks and thrifts and a more risk-sensitive premium structure. These provisions would be coupled with rebates for the stronger entities when the fund approaches what we recommend be a higher upper end of a target range than the FDIC has suggested, and surcharges when the Fund trends below what we suggest be a lower end of a target range.

The FDIC also recommends that the rebates not be uniform for the stronger entities. Rather, the FDIC argues that rebates should be smaller for those banks that have paid premiums for only short periods or that have in the past paid premiums that are not commensurate with their present size and hence FDIC exposure.

The devil, of course, is in the details. But this latter proposal makes considerable sense, and the Board endorses it. There are over 900 banks--some now quite large--that have never paid a premium, and without this modification they would continue to pay virtually nothing, net of rebates, as long as their strong capital and high supervisory ratings were maintained. Such an approach is both competitively inequitable and contributes to moral hazard. It should be addressed.

Indexing Insured-Deposit Coverage Ceilings

The FDIC recommends that the current $100,000 ceiling on insured deposits be indexed. The Board does not support this recommendation and believes that, at this time, the current ceiling should be maintained.

In the Board's judgment, it is unlikely that increased coverage, even by indexing, today would add measurably to the stability of the banking system. Macroeconomic policy and other elements of the safety net, combined with the current, still-significant level of deposit insurance, continue to underpin the stability of the financial system. Thus, the problem that increased coverage is designed to solve must be related to either the individual depositor, the party originally intended to be protected by deposit insurance, or to the individual bank or thrift. Clearly, both groups would prefer higher coverage if there were no costs. But Congress needs to be clear about the problem for which increased coverage would be the solution.

Depositors

At the Federal Reserve, we frequently receive letters from banks urging that we support increased deposit insurance coverage. But we virtually never receive similar letters from depositors, who are not shy about sharing their many other concerns. This experience may reflect the fact that, as our surveys of consumer finances suggest, depositors are adept at achieving the level of deposit insurance coverage they desire by opening multiple accounts. Such spreading of asset holdings is perfectly consistent with the counsel always given to investors to diversify their assets--whether stocks, bonds, or mutual funds--across different issuers. The cost of diversifying for insured deposits is surely no greater than doing so for other assets. An individual bank would clearly prefer that the depositor maintain all of his or her funds at that bank and would prefer to eliminate the need for depositor diversification by being able to offer higher deposit insurance coverage. Nonetheless, the depositor appears to have no great difficulty--should he or she want insured deposits--in finding multiple sources of fully insured accounts.

In addition, the singular characteristic of postwar household financial asset holdings has been the increasing diversity of portfolio choices. The share of household financial assets in bank deposits has been declining steadily throughout the postwar period as households have taken advantage of innovations that make available to them attractive financial instruments with market rates of return. There has been no break in that trend that seems related to past increases in insurance ceilings. Indeed, the most dramatic substitution out of deposits in recent years has been from both insured and uninsured deposits to equities and mutual funds. It is difficult to believe that a change in ceilings during the 1990s would have made any measurable difference in that shift. In fact, bankers' comments and the data indicate that the weakness in stock prices in recent quarters has been marked by increased flows into bank and thrift deposits.

Depository Institutions

Does the problem to be solved by increased deposit insurance coverage concern the individual depository institution? If so, the problem would necessarily be concentrated at smaller banks that generally do not have access to the money market or foreign branch networks for supplementary funds. Since the mid1990s, banks' U.S. assets have grown at an average annual rate of 7.7 percent. Adjusted for the effects of mergers, the smaller banks, those below the largest 1,000, have actually grown at a more rapid average annual rate of 13 percent. Uninsured deposits at these smaller banks have also grown more rapidly than at larger banks--at average annual rates of 20.5 percent at the small banks versus 10.9 percent at the large banks, both on the same merger-adjusted basis. Clearly, small banks have a demonstrated skill and ability to compete for uninsured deposits. To be sure, uninsured deposits are more expensive than insured deposits, and bank costs would decline if their currently uninsured liabilities received a government guarantee. But that is a different matter and raises the issue of a subsidy in its starkest terms. I might add that throughout the 1990s, small banks' return on equity was well maintained. Indeed, the attractiveness of banking is evidenced by the fact that 1,363 banks were chartered during the past decade, two-thirds since 1995, when bank credit demands began to intensify.

Some small banks argue that they need enhanced deposit insurance coverage to equalize their competition with large banks because depositors prefer to put their uninsured funds in an institution considered too big to fail. As I have noted, however, small banks have more than held their own in the market for uninsured deposits. In addition, the Board rejects the notion that any bank is too big to fail. In the Federal Deposit Insurance Corporation Improvement Act of 1991, the Congress made it clear that the systemic-risk exception to the FDIC's least-cost resolution of a failing bank should be invoked only under the most unusual circumstances. Moreover, the resolution rules under the systemic-risk exception do not require that uninsured depositors and other creditors, much less stockholders, be made whole. Consistent with this view, the market clearly believes that large institutions are not too big for uninsured creditors to take at least some loss, with spreads on their subordinated debt larger than those on similar debt of large and highly rated nonbank financial institutions. Indeed, there are no Aaa-rated U.S. banking organizations.

Another argument often raised by smaller banks regarding the need for increased deposit insurance coverage is their inability to match the competition from those large securities firms and bank holding companies with multiple bank affiliates, offering multiple insured accounts through one organization. While the Board believes that such offerings are a misuse of deposit insurance, raising the coverage limit for each account would also increase the aggregate amount of insurance coverage that large multi-bank organizations would be able to offer, so the disparity would remain.

CONCLUSION

The Board commends the FDIC for its review, analysis, and recommendations for reform of the deposit insurance system. There are several aspects of that system that need reform. The Board supports, with some modifications, all of the FDIC's recommendations except indexing of the current $100,000 ceiling. The thrust of our proposed modifications would call for a wider permissible range for the size of the fund relative to insured liabilities, reduced variation of the insurance premium as the relative size of the fund changes with banking and economic conditions, and a premium net of rebates.

There may come a time when the Board finds that households and businesses with modest resources are finding difficulty in placing their funds in safe vehicles or that there is reason to be concerned that the level of deposit coverage could endanger financial stability. Should either of those events occur, the Board would call our concerns to the attention of the Congress and support adjustments to the ceiling by indexing or other methods.

But today, in our judgment, neither financial stability, nor depositors, nor depositories are being disadvantaged by the current ceiling. Raising the ceiling now would extend the safety net, increase the government subsidy to banking, expand moral hazard, and reduce the incentive for market discipline, without providing any real public benefits. With no clear public benefit to increasing deposit insurance, the Board sees no mason to increase the scope of the safety net. Indeed, the Board believes the time has come to draw the line on expanding government guarantees.

Discontinuation of "Testimony
of Federal Reserve Officials" in the
Federal Reserve Bulletin

"Testimony of Federal Reserve Officials" will not be
reprinted in the Federal Reserve Bulletin after the
December 2001 issue. When testimony is released to
the public, it is simultaneously placed on the Board's
web site (www.federalreserve.gov/boarddocs/testimony/),
which also has testimony back to 1996. Paper copies of
testimony are also available by mail from Publications
Services, mail stop 127, Board of Governors of the
Federal Reserve System, Washington, DC (tel. [phone]).

Other reprints will also be eliminated from the Bulletin
after December 2001: the monthly report on industrial
production and capacity utilization, the FOMC minutes,
the quarterly report "Treasury and Federal Reserve
Foreign Exchange Operations," by the Federal Reserve
Bank of New York, and the annual report "Open Market
Operations," also by the Federal Reserve Bank of New
York (the text portion of "Open Market Operations" will
be reprinted in the Board's Annual Report rather than in
the Bulletin). The documents are widely distributed when
originally published, and several sources for historical

information are available.

(1.) See "Monetary Policy Report to the Congress," Federal Reserve Bulletin, vol. 87 (July 2001), pp. 501-27; also on the Board's web site at www.federalreserve.gov/boarddocs/hh/.