Statements to Congress.
The Board of Governors appreciates the opportunity to discuss our efforts to streamline the disclosure requirements for home mortgage loans under the Truth in Lending Act (TILA) and unify them with those of the Real Estate Settlement Procedures Act (RESPA).
Simplifying and streamlining the regulatory requirements under these two statutes is something that the Board and the Department of Housing and Urban Development (HUD) have been working on jointly for several years. The results of our efforts, which are described in more detail later, generally have been well received. These regulatory changes have been relatively minor, however, because TILA and RESPA serve quite different purposes and contain distinct statutory disclosure requirements. Unquestionably, each statute directly affects consumer mortgage loan transactions, and the disclosure requirements are, in fact, related. But given the statutory requirements, there is little room for our agencies to simplify and combine disclosures in any significant way by regulation. The Board supports the congressional directive to explore ways to change the two statutes to better serve the homebuying public.
Our testimony discusses how TILA and Regulation Z (Truth in Lending) regulate home mortgage lending. It describes the agencies' efforts to simplify and streamline TILA and RESPA, including our joint efforts over the years to harmonize the regulations whenever possible. Finally, the testimony outlines our plan to develop legislative recommendations.
The task facing the agencies has evolved over the past year. In the legislation enacted last September, the directive was to simplify and unify the disclosures given to consumers under the two existing statutes. That, in and of itself, can be viewed as a narrow mandate.
As you heard from industry and consumer representatives last week, however, there is a significant and growing interest in more sweeping reform. If it is possible for those parties, along with HUD and the Board, to reach consensus on reform, we have before us a unique opportunity to make significant changes to the way in which consumers shop for and obtain mortgage loans. These changes could improve the usefulness of the information that consumers receive and at the same time reduce regulatory burden for the home mortgage industry. To the extent that beneficial change is possible, we hope to facilitate it in any way that we can.
The Truth in Lending Act
The purpose of TILA is to promote the informed use of consumer credit, primarily through disclosure, with some substantive provisions. RESPA is both a disclosure law and one that indirectly regulates prices. It requires disclosure about settlement costs but also prohibits kickbacks and referral fees to protect consumers from unnecessarily high settlement costs, as the HUD testimony will explain.
TILA requires standardized disclosures about credit terms and costs. Creditors must disclose the cost of credit as a dollar amount (the finance charge) and as an annual percentage rate (the APR). Uniformity in creditors' disclosures is intended to assist consumers in comparison shopping. TILA requires additional disclosures for a loan secured by a consumer's home and permits consumers to rescind certain transactions that involve their principal dwelling. The Board's Regulation Z implements the act, and an official staff commentary interprets the regulation.
The disclosure rules that creditors must follow vary depending on the type of credit that is being offered. For example, there are separate rules for closed-end credit, such as automobile or home mortgage loans, and for open-end credit, such as credit cards or home equity lines of credit. There are additional rules governing reverse mortgages and mortgages that have rates and fees above a certain amount.
These regulatory requirements generally are derived from detailed disclosure provisions in TILA, except for certain rules governing adjustable rate mortgage loans. The statutory provisions dictate what information must be disclosed, the format in which it is disclosed, and when it is disclosed.
Regulatory Streamlining Efforts to Date
The Board has always made a conscious effort to ensure that TILA rules are compatible with RESPA. For example, Regulation Z has long permitted creditors to substitute both the RESPA good faith estimate and settlement statement (commonly referred to as the HUD-1) for the itemization of the "amount financed" disclosure required under TILA. When RESPA was amended in 1992 to cover subordinate lien loans, the Board worked closely with HUD on the regulations that implemented the changes. Thus, in amending Regulation X (Borrowers of Securities Credit) to cover those loans, HUD incorporated a number of the definitions and concepts found in the Board's Regulation Z. The amendments to Regulation X also permit Regulation Z's disclosures for home equity lines of credit to substitute for RESPA disclosures.
Over the past five years, the agencies have continued to work together to streamline the rules to the extent possible. One recent example was an amendment to the Regulation Z commentary designed to avoid conflict between RESPA's escrow accounting rules and TILA's rules for calculating prepaid finance charges, such as private mortgage insurance. We are confident that the cooperative relationships that have developed between the agencies will stand us in good stead as we tackle the job of preparing legislative recommendations.
Congressional efforts to simplify the disclosure schemes have been discussed and debated for several years now. In early 1995, there were legislative proposals that would have transferred authority for RESPA to the Board, a transfer that the Board opposed as it would not have satisfied concerns about the statute. These proposals also would have directed the Board to simplify the disclosures under TILA and RESPA. In light of this potential responsibility, the Board undertook a review of the regulatory and statutory requirements of both TILA and RESPA to identify areas where it might be possible to streamline the two regulations. Because the proposed transfer of authority for RESPA would not have been accompanied by any statutory changes, however, the list of potential regulatory changes was short. The list included things like changing the definition of a "business purpose loan" in Regulation X to match that in Regulation Z, developing a commentary to Regulation X similar to Regulation Z's, and adopting the same record retention requirements in Regulation X as are in Regulation Z.
During this process there were informal meetings with industry and consumer group representatives, and we also sought the views of the Board's Consumer Advisory Council. While representatives from all of these groups, including the council, expressed some dissatisfaction with the current statutes and regulations, there were few concrete suggestions about how to improve the situation without major statutory changes. When the Congress subsequently directed the Board and HUD to streamline the disclosures -- first by making regulatory changes if possible and second by making legislative recommendations -- we took the opportunity to formally ask interested parties what they would like to see by way of reform.
In December 1996, the Board and HUD published a joint Advance Notice of Proposed Rulemaking in the Federal Register (Attachment A).(1) In that notice, the agencies requested specific recommendations on how TILA and RESPA disclosures could be made more consistent (including ways that the disclosures could be combined, simplified, or improved), and how the timing and format of the disclosures could be made more compatible. The Board and HUD received about eighty comment letters, primarily from creditors and their representatives, as is typically the case for agency proposals.
The comments covered a wide range of issues. Many commenters requested changes that required legislative action, for example, changing the timing of disclosures. A significant number of commenters requested more sweeping reform, such as eliminating the APR. In some instances, commenters recommended consolidating the disclosures in ways that, while not common in the industry, are permitted under the existing rules. For example, a significant number of commenters recommended the consolidation of the "early" TILA and RESPA disclosures for home purchase loans on a single form. The Board has subsequently clarified, through its commentary to Regulation Z, that there is no prohibition against putting multiple disclosures on the same page or form, provided the TILA disclosures are segregated from other information.
The Need for Legislative Changes
The timing rules and the different disclosure requirements in TILA and RESPA are major obstacles to harmonizing the rules by regulation, beyond the actions that the agencies have taken. After a review of the public comments and upon further analysis, the Board and HUD thus concluded earlier this year that legislative changes are needed to accomplish congressional purposes. The Board published a Federal Register notice on April 2, stating our belief that making minor regulatory amendments would not be significant enough either to materially improve the disclosures for consumers or to justify the cost of the changes for the industry.
You asked the Board to comment on whether the purposes of TILA and RESPA might be better achieved by consolidation of the two statutes. At this stage it is not entirely clear whether targeted amendments to the existing statutes, or the creation of a new statute, would best accomplish the needed changes. These are among the issues that the Board and HUD are currently considering and that we will address in our recommendations to the Congress.
Timetable for Legislative Recommendations
The Board and HUD have a number of efforts under way to help us in developing our legislative recommendations. The Board's Federal Register notice of April 2 reopened the comment period for an additional 90 days so that interested parties could submit legislative proposals. That comment period ended on June 30, and we have received more than 100 comment letters. Perhaps because of coverage of the reform issue in a nationally syndicated column, most of the letters from this second round of comments are from consumers. Although the Board is still in the process of reviewing and analyzing the letters, we can provide some general impressions about them.
Consumers' primary concern is that they do not receive disclosures about mortgage costs earlier in the process. Under the existing rules, lenders are not required to provide the TILA disclosure, or a good faith estimate of the transaction costs, until at least three days after the consumer applies for the loan; and to apply, the consumer may have to pay a non-refundable fee. Most consumers who commented would prefer to receive disclosures that help them comparison shop before they apply for a loan and pay a fee. Second, consumers want the cost disclosures to be as accurate as possible so that they are not confronted with unexpected charges at the loan closing. And third, commenters generally believed that the disclosures could be less complex and therefore more useful.
Creditors that commented continue to support more fundamental reform, and a number of them reported that they are working on legislative proposals. As mentioned earlier, it now appears that this process for change has moved beyond streamlining and unifying disclosures to consideration of significant statutory reform. Despite the closing of the comment period, the Board would welcome these proposals whenever their sponsors are ready to share them.
During the past two months, the Board and HUD have held meetings with a number of consumer advocacy and industry groups involved in the legislative reform process. These meetings have been designed to give interested parties an opportunity to share their concerns about TILA and RESPA, and ideas about reform, without having to be concerned that they are being locked into any particular position.
In addition, the Board and HUD will hold a joint public forum in which the groups involved in the RESPA-TILA reform initiative, as well as members of the public, can discuss the benefits of and problems associated with the current statutory schemes and the principles that should guide any reform effort. This one-day forum will be held at the Federal Reserve Board on July 30.
After the forum, the Board and HUD will identify potential areas for legislative recommendations. These meetings will address issues raised in the comment letters received, the information gathered from the public forum and informal meetings, and other background information. If needed, we may hold additional meetings in September with the groups involved in the reform process to discuss more specific proposals.
At the end of this process, likely some time in October, we will work with HUD to begin drafting the legislative recommendations. Our goal is to provide recommendations to the Congress by the end of the year.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Subcommittee on Finance and Hazardous Materials of the Committee on Commerce, Us House of Representatives, July 17, 1997
I appreciate the opportunity to present the views of the Board of Governors on the Financial Services Competition Act of 1997. The Banking Committee is to be commended for addressing the complex issues associated with financial modernization. The committee has taken a major step forward in permitting affiliations of banking, securities, and insurance organizations within an appropriate framework for consolidated oversight. We believe such affiliations would improve the efficiency and competitiveness of the financial services industry and result in more choices and better services for consumers. However, in addressing financial modernization the bill encompasses a large number of far-ranging provisions. The Board has difficulty with the way some of the issues are resolved in the bill before you. Thus, while reemphasizing our support for much of the general thrust of the bill, I would like today to highlight our major concerns.
Banking and Commerce
The need to respond to the effects of technology is one of the major reasons we are here today. Technology has already eroded many of the previous distinctions between banking and nonbank finance, thereby supporting the desirability, if not the necessity, of permitting the merging of all financial activities.
It seems clear that the same forces are in the process of blurring the boundaries between financial and nonfinancial businesses. Most of us are aware of software companies interested in the financial services business, but some financial firms, leveraging off their own internal skills, are also seeking to produce software for third parties. Tracking software of shipping companies lends itself to payment services. Manufacturers have financed their customers' purchases for a long time but now are increasingly using the resultant financial skills to finance noncustomers. Moreover, many nonbank financial institutions are now profitably engaged in nonfinancial activities.
Current facts and future trends, in short, are creating market pressures to permit the common ownership of financial and nonfinancial firms. The Board, in fact, has concluded that it is quite likely that in future years it will be close to impossible to distinguish where one type of activity ends and another begins. Nonetheless, the Federal Reserve Board also has concluded that it would be wise to move with caution in addressing the removal of the current legal barriers between commerce and banking because the unrestricted association of banking and commerce would be a profound and surely irreversible structural change in the U.S. economy.
Were we fully confident of how emerging technologies would affect the evolution of our economic and financial structure, we could presumably develop today the regulations that would foster that evolution. But we are not, and history suggests we cannot. We thus run the risk of locking in a set of inappropriate rules that could adversely alter the development of market structures. Our ability to foresee accurately the future implications of technologies and market developments in banking, as in other industries, has not been particularly impressive. As Professor Rosenberg of Stanford University has pointed out, ". . . mistaken forecasts of future structure litter our financial landscape." Consider the view of the 1960s that the "cashless society" was imminent. Nonetheless, the public preference for paper has declined only gradually. Similarly, just a few years ago conventional wisdom argued that banks were dinosaurs that were becoming extinct. The reality today is far from it. Even more recently, it was argued that banks and nonfinancial firms had to merge to save the capital-starved banking system. Today, as you know, virtually all of our banks are very well capitalized.
All these examples, and more, suggest that if we dramatically change the rules now about banking and commerce under circumstances of great uncertainty about future synergies between finance and nonfinance we may well end up doing more harm than good. And, as with all rule changes by government, we are likely to find it impossible to correct our errors promptly, if at all. Modifications of such a fundamental structural rule as the separation of banking and commerce accordingly should proceed at a deliberate pace to test the response of markets and technological innovations to the altered rules in the years ahead.
Excessive delay would doubtless produce inequities. Expanded financial activities for banking organizations require, and the Banking Committee's Financial Services Competition Act provides, that those firms operating in markets that banks can enter, in turn, be authorized to engage in banking. However, some securities and insurance firms, as well as some thrift institutions, already own -- or are owned by -- nonfinancial entities. Continuing the commerce and banking prohibitions would thus require the divestiture or grandfathering of all nonfinancial activities by those organizations that wanted to acquire or establish banks.
But the fact is that we do not -- and the Board's view is that we need not -- have to make today as sweeping a banking and commerce decision as the Competition Act proposes. That bill would permit both banks and nonfinancial corporations each to originate up to 15 percent of their revenue from the other's activities. While there is some limit on the original size of each nonfinancial firm acquired by a bank holding company and on the original size of the one bank that a nonfinancial company could purchase, the subsequent growth is only constrained by the 15 percent revenue limit. This constraint may be more apparent than real, given the ongoing growth and consolidation of the financial services industry. In our judgment, these baskets are far larger than what is needed either as a controlled experiment or to permit unfettered consolidation with banks of those financial firms that have commercial affiliates. Moreover, the Banking Committee bill would permit additional bank and commercial affiliations beyond these holding company affiliate baskets and permit some affiliation within the bank or a bank subsidiary. Any commercial (or financial) activity that had been authorized by the Office of Thrift Supervision for thrift institutions or by the Federal Reserve Board's regulation for overseas operations of U.S. banks would be permitted to banks in the United States by the Banking Committee bill. Thus, over and above the basket, U.S. banks could create subsidiaries that invest up to 3 percent of the bank's assets in the equity of OTS-approved commercial enterprises. In addition, applying the Board's foreign market rule to domestic operations would mean that banks themselves could invest in the equity of individual nonfinancial firms. The Board's foreign market rule, authorized by statute, was promulgated to assist U.S. banks to achieve a level playing field with their foreign competitors in foreign markets. We see no compelling need to apply that rule to U.S. banks' domestic operations. We are also concerned that the grandfather date for savings and loan holding companies continues to shift with the date of enactment of the bill, thereby encouraging an increase in the number of commercial firms that seek to affiliate with insured savings associations before new rules come into effect.
The Competition Act, in the Board's view, goes well beyond what both commercial banks and nonfinancial firms need to meet the requirements of today as well as in the foreseeable future. The Board believes it would be virtually impossible to reverse such a change in the legal framework without major damage to established business relationships. Thus, any errors from larger-than-needed initial authorizations could result in significant problems. Moreover, the authorization of commercial activities through banks and their subsidiaries directly extends the subsidy of the safety net over a much wider range of activities, not to mention potentially undermining the safety and soundness of insured banks.
A number of observers have argued that there is no subsidy associated with the federal safety net for depository institutions -- deposit insurance, and direct access to the Federal Reserve's discount window and payment system guarantees. The Board strongly rejects this view. In saying this, the Board fully agrees that mandated government supervision and regulation impose significant costs on banks, costs that, in many cases, can and should be reduced. But given that these costs cannot be avoided by a bank, no rational bank manager would ignore the opportunity to take advantage of the lower cost of funds, or equivalently, the lower capital ratio, that access to the safety net demonstrably provides. While it is true that the safety net does increase the possibility of loss to taxpayers, a far larger public policy concern is that it provides banks with a government-sanctioned competitive advantage over nonbank firms. In the Board's view, unless the Congress explicitly desires to expand access to the safety net and tilt the competitive playing field further, a core component of any prudent financial modernization strategy should be to minimize the chances that safety net subsidies will be expanded into new activities and beyond the confines of insured depository institutions.
Because the subsidy created by the federal safety net grants access to the "sovereign credit" of the United States, bank creditors are willing to accept a lower risk premium on bank liabilities and capital than otherwise would be the case. For fully insured deposits this risk premium is reduced essentially to zero. But other debt instruments also benefit, and the capital ratio demanded by the market is lower. The end result is that banks enjoy a lower total and marginal cost of funding, including lower capital ratios, than would otherwise be required by the market.
While some benefits of the safety net are always available to banks, it is critical to understand that the value of the subsidy is smallest for very healthy banks during good economic times and greatest at weak banks during a financial crisis. What was it worth in the late 1980s and early 1990s for a bank with a troubled loan portfolio to have deposit liabilities guaranteed by the Federal Deposit Insurance Corporation to be assured that it could turn illiquid assets to liquid assets at once through the Federal Reserve discount window and to tell its customers that payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not basis points but percentage points. For some, it meant the difference between survival and failure. In contrast today, when the economy is performing well and the banking industry has just experienced its fifth straight year of record profits, it is perhaps too easy to ignore the value of the safety net and see only its costs. The Board believes that prudent public policy should take a longer view.
In the Board's judgment, the bank holding company organizational form has, by the record, proved to be an effective means for limiting the safety net subsidy primarily to banks. There is clear evidence that market participants understand that regulatory policy is focused on the bank, and thus markets distinguish between the bank and its holding company parent and affiliates. Given this success, the holding company structure should, in the Board's view, not be abandoned. Indeed, our strong preference is for the holding company format to be retained for new activities that will under expanded authorities benefit from direct access to the federal safety net. Thus, we would recommend that the Financial Services Competition Act's provisions that allow expanded activities to be conducted either in a holding company subsidiary or in a direct operating subsidiary of a bank be amended to require that new activities be conducted only in a holding company subsidiary.
The Board supports the provisions of the Banking Committee's Competition Act that continue consolidated oversight of the bank holding company. In our judgment, it is essential that these provisions be retained and not weakened. The historical experience in supervising bank holding companies has shown that knowledge of the financial strength and risks inherent in a consolidated holding company can be critical to protecting an insured subsidiary bank and resolving problems once they arise. Examples are easy to recall: Bank of Credit and Commerce International, Continental Illinois, Barings PLC, thrift institutions, and Texas banks all exhibited problems that spread quickly among their affiliates or required a consolidated approach to resolve the problems at least cost and disruption to the overall financial system.
Moreover, continued gains in technology and in innovative risk-management techniques permit organizations of all kinds to manage and control their activities on an increasingly centralized basis, with less attention paid to the individual legal entities that make up the organization. In that environment, it seems to the Board that oversight on a consolidated basis of an organization's broad-based activities has become more crucial in recent years, not less. Bank supervisors throughout the world recognize this point and have adopted consolidated oversight as a fundamental principle. The Congress also recognized the necessity of consolidated oversight for the U.S. banking system, by requiring, as a condition for a foreign bank's entry into this country, that the bank be subject to consolidated home country supervision. What is necessary for foreign banks entering the United States is surely just as necessary for U.S. banks and the U.S. banking system.
Crisis Management and Systemic Risk
We believe that the Federal Reserve needs to continue to have consolidated oversight authority, especially for organizations in which the bank is large enough that its failure could cause disruptions in financial markets sufficient to affect economic activity. Critically, the central bank has the responsibility to forestall financial crises (including systemic disturbances in the banking system) and to manage such crises once they occur.
Supervisory and regulatory responsibilities afford the Federal Reserve both the insight and the authority to use crisis management techniques that are less blunt than open market operations and more precisely calibrated to the problem at hand. Such tools not only improve our ability to manage crises but, more important, help us to avoid them. Indeed, we measure our degree of success in this area not by the number of crises we assist in containing but rather in the number of crises that could have erupted but did not. The use of crisis management techniques requires both the authority that comes with supervision and regulation and the understanding of the linkages among supervision and regulation, prudential standards, risk-taking, relationships among banks and other financial market participants, and macroeconomic stability. The objectives of the central bank in crisis management are to contain financial losses and prevent a contagious loss of confidence so that difficulties at one institution do not spread more widely to others. The focus of its concern is not to avoid the failure of entities that have made poor decisions or have had bad luck but rather to see that such failures -- or threats of failures -- do not have broad and serious impacts on financial markets and the national, and indeed the global, economy.
The Federal Reserve's ability to respond expeditiously to any particular incident does not necessitate comprehensive information on each banking institution. But it does require that the Federal Reserve have in-depth knowledge of how institutions of various sizes and other characteristics are likely to behave and what resources are available to them in the event of severe financial stress. We currently gain the necessary insight by having a broad sample of banks subject to our supervision and through our authority over bank holding companies.
Payment and Settlement Systems
A key element of avoiding systemic concerns is management of the payment system. Virtually all of the U.S. dollar transactions made worldwide -- for securities transfers, foreign exchange and other international capital flows, and for payment for goods and services -- are settled in the U.S. banking system. A small number of transactions that comprise the vast proportion of the total value of transactions are transferred over large-dollar payment systems.
A critical component of these systems is the Federal Reserve's wire transfer network, Fedwire. Fedwire and a very small number of private clearing-houses are arguably the linchpin of the international system of payments that relies on the dollar as the major international currency for trade and finance. Disruptions and disturbances in the U.S. payment system thus can easily have global implications.
In all of these payment and settlement systems, commercial banks play a central role, both as participants and as providers of credit to nonbank participants. Day in and day out, the settlement of payment obligations and securities trades requires significant amounts of bank credit. In periods of stress, such credit demands surge just at the time when some banks are least willing or able to meet them. These demands, if unmet, could produce gridlock in payment and settlement systems, exposing financial markets to dangerous stress. Indeed, it is in the cauldron of the payment and settlement systems, where decisions involving large sums must be made quickly, that all of the risks and uncertainties associated with problems at a single participant become focused as participants seek to protect themselves from uncertainty. Better solvent than sorry, they might well decide, and refuse to honor a payment request. Observing that, others might follow suit. And that is how crises often begin.
Limiting, if not avoiding, such disruptions and ensuring the continued operation of the payment system requires broad and in-depth knowledge of banking and markets as well as detailed knowledge and authority with respect to the payment and settlement arrangements and their linkages to banking operations. This type of insight and authority -- as well as knowledge about the behavior of key participants -- cannot be created on an ad hoc basis. It requires broad and sustained involvement in both the payment infrastructure and the operation of the banking system. Supervisory authority over the major bank participants is a necessary element.
Changing Role of Consolidated Oversight
The modernizing of our financial system -- especially the combining of banks, securities firms, and insurance companies, as well as possibly banking and commerce -- requires that the role of consolidated oversight also be reviewed.
The necessity to understand and review centralized risk management and control mechanisms, and similarly to review intra-organizational fund transfers involving the insured depositories, does not require bank-like supervision of nonbank affiliates. The Competition Act appropriately recognizes this. It would require that the banking agencies rely to the fullest extent possible on examination reports and other information collected by supervisors of other regulated entities. In addition, the bill would require that the banking agencies defer to the Securities and Exchange Commission in interpretations and enforcement of the federal securities laws and to the state insurance commissioners and to state insurance laws. The bill continues to allow the Federal Reserve Board to establish capital adequacy guidelines at the holding company level. However, the bill sets important limits on these holding company guidelines. For example, the consolidated supervisor may not impose capital requirements on any nonbank subsidiary that is in compliance with applicable capital requirements of another federal or state agency. In addition, holding company capital guidelines must take full account of the capital position of these regulated nonbank subsidiaries when establishing consolidated capital guidelines and full account of capital levels in unregulated subsidiaries when those levels are consistent with industry norms. The bill requires the Federal Reserve Board to address the use of double leverage (that is, the use of debt at the holding company to fund equity and subordinated debt at a regulated institution) but prohibits the establishment of a capital ratio that is not risk weighted. In addition, the bill requires that the consolidated supervisor consult with other supervisors, including, in particular, supervisors of nonbanking entities, before establishing capital guidelines for holding companies.
All of these -- the capital and examination rules -- are extremely important provisions both for existing bank holding companies and for securities firms and insurance companies that wish to affiliate with banks. Such provisions would greatly enhance the "two-way street" by eliminating unnecessary burden and red tape.
The Board believes that bank holding companies need to continue to have consolidated oversight both to protect the safety net and to limit the transference of the safety net subsidy. We believe that the Federal Reserve must not have its ability impaired to monitor banking organizations in order to respond effectively to systemic crises, to manage the risk in the payment system, and to ensure the safety and stability of our financial system.
* The Board supports the overall thrust of the Banking Committee bill that is now being reviewed by this committee. We strongly support the bill's approach to affiliations of banking, securities, and insurance organizations.
* We are, nonetheless, concerned that the bill goes unnecessarily far at this time in mixing commerce and banking. There is no reason not to proceed in incremental steps; first to integrate banking and finance with the minor and quite limited combinations of banking and commerce that this requires and only later, as these developments mature, assess the desirability of fully dismantling the barriers between banking and commerce.
* In addition, we think it unwise to permit banks to conduct new activities in their own subsidiaries because of the extension of the safety net subsidy directly to those subsidiaries. We have concluded that the holding company framework provides the best insulation against the transference of that subsidy beyond the bank and creates the most level playing field for affiliations of banks and other financial firms.
* Consolidated oversight of bank holding companies is critical both to protect the safety net and to minimize its transference. We believe that the central bank's role in the prevention and containment of financial crises and as guarantor of the payment system requires that we continue to have consolidated oversight responsibility for most holding companies. This strong expansion has produced a remarkable increase in work opportunities for Americans. A net of more than 13 million jobs has been created since the current period of growth began in the spring of 1991. As a consequence, the unemployment rate has fallen to 5 percent -- its lowest level in almost a quarter century. The expansion has enabled many in the working-age population, a large number of whom would have otherwise remained out of the labor force or among the longer-term unemployed, to acquire work experience and improved skills. Our whole economy will benefit from their greater productivity. To be sure, not all segments of our population are fully sharing in the economic improvement. Some Americans still have trouble finding jobs, and for part of our workforce real wage stagnation persists.
In contrast to the typical postwar business cycle, measured price inflation is lower now than when the expansion began and has shown little tendency to rebound of late, despite high rates of resource utilization. In the business sector, producer prices have fallen in each of the past six months. Consumers also are enjoying low inflation. The consumer price index (CPI) rose at less than a 2 percent annual rate over the first half of the year, down from a little more than 3 percent in 1996.
With the economy performing so well for so long, financial markets have been buoyant, as memories of past business and financial cycles fade with time. Soaring prices in the stock market have been fueled by moderate long-term interest rates and expectations of investors that profit margins and earnings growth will hold steady, or even increase further, in a relatively stable, low-inflation environment. Credit spreads at depository institutions and in the open market have remained extremely narrow by historical standards, suggesting a high degree of confidence among lenders regarding the prospects for credit repayment.
The key question facing financial markets and policymakers is what is behind the good performance of the economy and will it persist. Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy. The Federal Reserve has been aware of this possibility in our monetary policy deliberations and, as always, has operated with a view to supplying adequate liquidity to allow the economy to reach its highest potential on a sustainable basis.
Nonetheless, we also recognize that the capacity of our economy to produce goods and services is not without limit. If demand were to outrun supply, inflationary imbalances would eventually develop that would tend to undermine the current expansion and inhibit the long-run growth potential of the economy. Because monetary policy works with a significant lag, policy actions are directed at a future that may not be clearly evident in current experience. This leads to policy judgments that are by their nature calibrated to the relative probabilities of differing outcomes. We moved the federal funds rate higher in March because we perceived the probability of demand outstripping supply to have increased to a point where inaction would have put at risk the solid elements of support that have sustained this expansion and made it so beneficial.
In making such judgments in March and in the future, we need to analyze carefully the various forces that may be affecting the balance of supply and demand in the economy, including those that may be responsible for its exceptional recent behavior. The remainder of my testimony will address the various possibilities.
Inflation, Output, and Technological Change in the 1990s
Many observers, including us, have been puzzled about how an economy, operating at high levels and drawing into employment increasingly less experienced workers, can still produce subdued and, by some measures even falling, inflation rates. It will, doubtless, be several years before we know with any conviction the full story of the surprisingly benign combination of output and prices that has marked the business expansion of the past six years.
Certainly, public policy has played an important role. Administration and congressional actions to curtail budget deficits have enabled long-term interest rates to move lower, encouraging private efficiency-enhancing capital investment. Deregulation in a number of industries has fostered competition and held down prices. Finally, the preemptive actions of the Federal Reserve in 1994 contained a potentially destabilizing surge in demand, short-circuiting a boom-bust business cycle in the making and keeping inflation low to encourage business innovation. But the fuller explanation of the recent extraordinary performance may well lie deeper.
In February 1996, I raised before this committee a hypothesis tying together technological change and cost pressures that could explain what was even then a puzzling quiescence of inflation. The new information received in the past eighteen months remains consistent with those earlier notions; indeed, some additional pieces of the puzzle appear to be falling into place.
A surge in capital investment in high-tech equipment that began in early 1993 has since strengthened. Purchases of computer and telecommunications equipment have risen at an annual rate of more than 14 percent since early 1993 in nominal terms, and at an astonishing rate of nearly 25 percent in real terms, reflecting the fall in the prices of this equipment. Presumably, companies have come to perceive a significant increase in profit opportunities from exploiting the improved productivity of these new technologies.
It is premature to judge definitively whether these business perceptions are the harbinger of a more general and persistent improvement in productivity. Supporting this possibility, productivity growth, which often suffers as business expansions mature, has not followed that pattern. In addition, profit margins remain high in the face of pickups in compensation growth, suggesting that businesses continue to find new ways to enhance their efficiency. Nonetheless, although the anecdotal evidence is ample and manufacturing productivity has picked up, a change in the underlying trend is not yet reflected in our conventional data for the whole economy.
But even if the perceived quicker pace of application of our newer technologies turns out to be mere wheel-spinning rather than true productivity advance, it has brought with it a heightened sense of job insecurity and, as a consequence, subdued wage gains. As I pointed out here last February, polls indicated that despite the significant fall in the unemployment rate, the proportion of workers in larger establishments fearful of being laid off rose from 25 percent in 1991 to 46 percent by 1996. It should not have been surprising then that strike activity in the 1990s has been lower than it has been in decades and that new labor union contracts have been longer and have given greater emphasis to job security. Nor should it have been unexpected that the number of workers voluntarily leaving their jobs to seek other employment has not risen in this period of tight labor markets.
To be sure, since last year, surveys have indicated that the proportion of workers fearful of layoff has stabilized and the number of voluntary job leavers has edged up. And, indeed, perhaps as a consequence, wage gains have accelerated some. But increases in the employment cost index still trail behind what previous relationships to tight labor markets would have suggested, and a lingering sense of fear or uncertainty seems still to pervade the job market, though to a somewhat lesser extent.
Consumer surveys do indicate greater optimism about the economy. However, it is one thing to believe that the economy, indeed the job market, will do well overall, but quite another to feel secure about one's individual situation, given the accelerated pace of corporate restructuring and the heightened fear of skill obsolescence that has apparently characterized this expansion. Persisting insecurity would help explain why measured personal saving rates have not declined as would have been expected from the huge increase in stock market wealth. We will, however, have a better fix on saving rates after the coming benchmark revisions to the national income and product accounts.
The combination in recent years of subdued compensation per hour and solid productivity advances has meant that unit labor costs of nonfinancial corporations have barely moved. Moreover, when you combine unit labor costs with nonlabor costs -- which account for one-quarter of total costs on a consolidated basis -- total unit costs for the year ended in the first quarter of 1997 rose only about 1/2 percent. Hence, a significant part of the measured price increase over that period was attributable to a rise in profit margins, unusual well into a business expansion. Rising margins are further evidence suggesting that productivity gains have been unexpectedly strong; in these situations, real labor compensation usually catches up only with a lag.
While accelerated technological change may well be an important element in unraveling the current economic puzzle, other influences have been at play as well in restraining price increases at high levels of resource utilization. The strong dollar of the past two years has pared import prices and constrained the pricing behavior of domestic firms facing import competition. Increasing globalization has enabled greater specialization over a wider array of goods and services, in effect allowing comparative advantage to hold down costs and enhance efficiencies. Increased deregulation of telecommunications, motor and rail transport, utilities, and finance doubtless has been a factor restraining prices, as perhaps has the reduced market power of labor unions. Certainly, changes in the health care industry and the pricing of health services have greatly contributed to holding down growth in the cost of benefits, and hence overall labor compensation.
Many of these forces are limited or temporary, and their effects can be expected to diminish, at which time cost and price pressures would tend to re-emerge. The effects of an increased rate of technological change might be more persistent, but they too could not permanently hold down inflation if the Federal Reserve allows excess liquidity to flood financial markets. I have noted to you before the likelihood that at some point workers might no longer be willing to restrain wage gains for added security, at which time accelerating unit labor costs could begin to press on profit margins and prices, should monetary policy be too accommodative.
When I discuss greater technological change, I am not referring primarily to a particular new invention. Instead, I have in mind the increasingly successful and pervasive application of recent technological advances, especially in telecommunications and computers, to enhance efficiencies in production processes throughout the economy. Many of these technologies have been around for some time. Why might they be having a more pronounced effect now?
In an intriguing paper prepared for a conference last year sponsored by the Federal Reserve Bank of Boston, Professor Nathan Rosenberg of Stanford documented how, in the past, it often took a considerable period of time for the necessary synergies to develop between different forms of capital and technologies. One example is the invention of the dynamo in the mid-1800s. Rosenberg's colleague Professor Paul David had noted a number of years ago that it was not until the 1920s that critical complementary technologies of the dynamo -- for example, the electric motor as the primary source of mechanical drive in factories, and central generating stations -- were developed and in place and that production processes had fully adapted to these inventions.
What we may be observing in the current environment is a number of key technologies, some even mature, finally interacting to create significant new opportunities for value creation. For example, the applications for the laser were modest until the later development of fiber optics engendered a revolution in telecommunications. Broad advances in software have enabled us to capitalize on the prodigious gains in hardware capacity. The interaction of both of these has created the Internet.
The accelerated synergies of the various technologies may be what have been creating the apparent significant new profit opportunities that presumably lie at the root of the recent boom in high-tech investment. An expected result of the widespread and effective application of information and other technologies would be a significant increase in productivity and reduction in business costs.
We do not now know, nor do I suspect can anyone know, whether current developments are part of a once-or-twice-in-a-century phenomenon that will carry productivity trends nationally and globally to a new higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion. The recent improvement in productivity could be just transitory, an artifact of a temporary surge in demand and output growth. In view of the slowing in growth in the second quarter and the more moderate expansion widely expected going forward, data for profit margins on domestic operations and productivity from the second quarter on will be especially relevant in assessing whether recent improvements are structural or cyclical.
Whatever the trend in productivity and, by extension, overall sustainable economic growth, from the Federal Reserve's point of view, the faster the better. We see our job as fostering the degree of liquidity that will best support the most effective platform for growth to flourish. We believe a noninflationary environment is such a platform because it promotes long-term planning and capital investment and keeps the pressure on businesses to contain costs and enhance efficiency.
The Federal Reserve's policy problem is not with growth, but with maintaining an effective platform. To do so, we endeavor to prevent strains from developing in our economic system, which long experience tells us produce bottlenecks, shortages, and inefficiencies. These eventually create more inflation, which undermines economic expansion and limits the longer-term potential of the economy.
In gauging the potential for oncoming strains, it is the effective capacity of the economy to produce that is important to us. An economy operating at a high level of utilization and growing 5 percent a year is in little difficulty if capacity is growing at least that fast. But a fully utilized economy growing at 1 percent will eventually get into trouble if capacity is growing less than that.
Capacity itself, however, is a complex concept, which requires a separate evaluation of its two components, capital and labor. It appears that capital, that is, plant and equipment, can adapt and expand more expeditiously than in the past to meet demands. Hence, capital capacity is now a considerably less rigid constraint than it once was.
In recent years, technology has engendered a significant compression of lead times between order and delivery for production facilities. This has enabled output to respond increasingly faster to an upsurge in demand, thereby decreasing the incidence of strains on capital capacity and shortages so evident in earlier business expansions.
Reflecting progressively shorter lead times for capital equipment, unfilled orders to shipment ratios for nondefense capital goods have declined 30 percent in the past six years. Not only do producers have quicker access to equipment that embodies the most recent advances, but they have been able to adjust their overall capital stock more rapidly to increases in demand.
The current lack of material shortages and bottlenecks, despite the high level and recent robust expansion of demand, is striking. The effective capacity of production facilities has increased substantially in recent years in response to strong final demands and the influence of cost reductions possible with the newer technologies. Increased flexibility is particularly evident in the computer, telecommunications, and related industries, a segment of our economy that seems far less subject to physical capacity constraints than many older-line establishments, and one that is assuming greater importance in our overall output. But the shortening of lags has been pervasive even in more mature industries, in part because of the application of advanced technologies to production methods.
At the extreme, if all capital goods could be produced at constant cost and on demand, the size of our nation's capital stock would never pose a restraint on production. We are obviously very far from that nirvana, but it is important to note that we are also far from the situation a half-century ago when our production processes were dominated by equipment such as open hearth steel furnaces, which had very exacting limits on how much they could produce in a fixed time frame and which required huge lead times to expand their capacity.
Even so, today's economy as a whole still can face capacity constraints from its facilities. Indeed, just three years ago, bottlenecks in industrial production -- though less extensive than in years past at high levels of measured capacity utilization -- were nonetheless putting significant upward pressures on prices at earlier stages of production. More recently vendor performance has deteriorated somewhat, indicating that flexibility to meet demands still has limits. Although further strides toward greater facilities flexibility have occurred since 1994, this is clearly an evolutionary, not a revolutionary, process.
Moreover, technology and management changes have had only a limited effect on the ability of labor supply to respond to changes in demand. To be sure, individual firms have acquired additional flexibility by increased use of outsourcing and temporary workers. In addition, smaller work teams can adapt more readily to variations in order flows. While these techniques put the right workers at the right spots to reduce bottlenecks, they do not increase the aggregate supply of labor. That supply is sensitive to changes in demand, but to a far more limited extent than for facilities. New plants can almost always be built. But labor capacity for an individual country is constrained by the size of the working-age population, which, except for immigration, is basically determined several decades in the past.
Of course, capital facilities and labor are not fully separate markets. Within limits, labor and capital are substitutes, and slack in one market can offset tightness in another. For example, additional work shifts can expand output without significant addition to facilities, and similarly more labor-displacing equipment can permit production to be increased with the same level of employment.
Yet despite significant increases in capital equipment in recent years, new additions to labor supply have been inadequate to meet the demand for labor. As a consequence, the recent period has been one of significant reduction in labor market slack.
Of the more than 2 million net new hires at an annual rate since early 1994, only about half have come from an expansion in the population aged 16 to 64 who wanted a job, and more than a third of those were net new immigrants. The remaining 1 million plus per year increase in employment has been pulled from those who had been reported as unemployed (600,000 annually) and those who wanted, but had not actively sought, a job (more than 400,000 annually). The latter, of course, are not in the official unemployment count.
The key point is that continuously digging ever deeper into the available working-age population is not a sustainable trajectory for job creation. The unemployment rate has a downside limit if for no other reason than unemployment, in part, reflects voluntary periods of job search and other frictional unemployment. There is also a limit on how many of the additional 5 million who wanted a job last quarter but were not actively seeking one could be readily absorbed into jobs -- in particular, the large number enrolled in school and those who may lack the necessary skills or face other barriers to taking jobs. The rise in the average workweek since early 1996 suggests employers are having increasingly greater difficulty fitting the millions who want a job into available job slots. If the pace of job creation continues, the pressures on wages and other costs of hiring increasing numbers of such individuals could escalate more rapidly.
To be sure, there remain an additional 34 million in the working-age population (age 16-64) who say they do not want a job. Presumably, some of these early retirees, students, or homemakers might be attracted to the job market if it became sufficiently rewarding. However, making it attractive enough could also involve upward pressures in real wages that would trigger renewed price pressures, undermining the expansion.
Thus, there would seem to be emerging constraints on potential labor input. Even before we reach the ultimate limit of sustainable labor supply growth, the economy's ability to expand employment at the recent rate should rapidly diminish. The availability of unemployed labor could no longer add to growth, irrespective of the degree of slack in physical facilities at that time. Simply adding new facilities will not increase production unless output per worker improves. Such improvements are possible if worker skills increase, but such gains come slowly through improved education and on-the-job training. They are also possible as capital substitutes for labor but are limited by the state of technology. More significant advances require technological breakthroughs. At the cutting edge of technology, where America finds itself, major improvements cannot be produced on demand. New ideas that matter are hard won.
The Economic Outlook
As I noted, the recent performance of the labor markets suggests that the economy was on an unsustainable track. Unless aggregate demand increases more slowly than it has in recent years -- more in line with trends in the supply of labor and productivity -- imbalances will emerge. We do not know, however, at what point pressures would develop -- or indeed whether the economy is already close to that point.
Fortunately, the very rapid growth of demand over the winter has eased recently. To an extent this easing seems to reflect some falloff in growth of demand for consumer durables and for inventories to a pace more in line with moderate expansion in income. But some of the recent slower growth could simply be a product of abnormal weather patterns, which contributed to a first-quarter surge in output and weakened the second quarter, in which case the underlying trend could be somewhat higher than suggested by the second-quarter data alone. Certainly, business and consumer confidence remains high and financial conditions are supportive of growth. Particularly notable is the run-up in stock market wealth, the full effects of which apparently have not been reflected in overall demand but might yet be.
Monetary policymakers, balancing these various forces, forecast a continuation of less rapid growth in coming quarters. For 1997 as a whole, the central tendency of their forecasts has real GDP growing 3 percent to 3 1/4 percent. This would be much more brisk than was anticipated in February, and the upward revision to this estimate largely reflects the unexpectedly strong first quarter. The central tendency of monetary policymakers' projections is that real GDP will expand 2 percent to 2 1/2 percent in 1998. This pace of expansion is expected to keep the unemployment rate close to its current low level.
We are reasonably confident that inflation will be quite modest for 1997 as a whole. The central tendency of the forecasts is that consumer prices will rise only 2 1/4 percent to 2 1/2 percent this year. This would be a significantly better outcome than the 2 3/4 percent to 3 percent CPI inflation foreseen in February.
Federal Open Market Committee (FOMC) members do see higher rates of inflation next year. The central tendency of the projections is that CPI inflation will be 2 1/2 percent to 3 percent in 1998 -- a little above the expectation for this year. However, much of this increase is presumed to result from the absence of temporary factors that are holding down inflation this year. In particular, the favorable movements in food and energy prices of 1997 are unlikely to be repeated, and non-oil import prices may not continue to decline. While it is possible that better productivity trends and subdued wage growth will continue to help damp the increases in business costs associated with tight labor markets, this is a situation that the Federal Reserve plans to monitor closely.
I have no doubt that the current stance of policy -- characterized by a nominal federal funds rate around 5 1/2 percent -- will need to be changed at some point to foster sustainable growth and low inflation. Adjustments in the policy instrument in response to new information are a necessary and, I should like to emphasize, routine aspect of responsible policymaking. For the present, as I indicated, demand growth does appear to have moderated, but whether that moderation will be sufficient to avoid putting additional pressures on resources is an open question. With considerable momentum behind the expansion and labor market utilization rates unusually high, the Federal Reserve must be alert to the possibility that additional action might be called for to forestall excessive credit creation.
The Federal Reserve is intent on gearing its policy to facilitate the maximum sustainable growth of the economy, but it is not, as some commentators have suggested, involved in an experiment that deliberately prods the economy to see how far and fast it can grow. The costs of a failed experiment would be much too burdensome for too many of our citizens.
Clearly, in considering issues of monetary policy we need to distinguish carefully between sustainable economic growth and unsustainable accelerations of activity. Sustainable growth reflects the increased capacity of the economic system to produce goods and services over the longer run. It is largely the sum of increases in productivity and in the labor force. That growth contrasts with a second type, a more transitory growth. An economy producing near capacity can expand faster for a short time, often through unsustainably low short-term interest rates and excess credit creation. But this is not growth that promotes lasting increases in standards of living and in jobs for our nation. Rather, it is a growth that creates instability and thereby inhibits the achievement of our nation's economic goals.
The key question is how monetary policy can best foster the highest rate of sustainable growth and avoid amplifying swings in output, employment, and prices. The historical evidence is unambiguous that excessive creation of credit and liquidity contributes nothing to the long-run growth of our productive potential and much to costly shorter-term fluctuations. Moreover, it promotes inflation, impairing the economy's longer-term potential output.
Our objective has never been to contain inflation as an end in itself, but rather as a precondition for the highest possible long-run growth of output and income -- the ultimate goal of macroeconomic policy.
In considering possible adjustments of policy to achieve that goal, the issue of lags in the effects of monetary policy is crucial. The evidence clearly demonstrates that monetary policy affects the financial markets immediately but works with significant lags on output, employment, and prices. Thus, as I pointed out earlier, policy needs to be made today on the basis of likely economic conditions in the future. As a consequence, and in the absence of once-reliable monetary guides to policy, there is no alternative to formulating policy using risk-reward tradeoffs based on what are, unavoidably, uncertain forecasts.
Operating on uncertain forecasts, of course, is not unusual. People do it every day, consciously or subconsciously. A driver might tap the brakes to make sure not to be hit by a truck coming down the street, even if he thinks the chances of such an event are relatively low; the costs of being wrong are simply too high. Similarly, in conducting monetary policy the Federal Reserve needs constantly to look down the road to gauge the future risks to the economy and act accordingly.
Growth of Money and Credit
The view that the Federal Reserve's best contribution to growth is to foster price stability has informed both our tactical decisions on the stance of monetary policy and our longer-run judgments on appropriate rates of liquidity provision. To be sure, growth rates of monetary and credit aggregates have become less reliable as guides for monetary policy as a result of rapid change in our financial system. As I have reported to you previously, the current uncertainties regarding the behavior of the monetary aggregates have implied that we have been unable to employ them as guides to short-run policy decisions. Accordingly, in recent years we have reported annual ranges for money growth that serve as benchmarks under conditions of price stability and a return to historically stable patterns of velocity.
Over the past several years, the monetary aggregates -- M2 in particular -- have shown some signs of reestablishing such stable patterns. The velocity of M2 has fluctuated in a relatively narrow range, and some of its variation within that range has been explained by interest rate movements, in a relationship similar to that established over earlier decades. We find this an encouraging development, and it is possible that at some point the FOMC might elect to put more weight on such monetary quantities in the conduct of policy. But in our view, sufficient evidence has not yet accumulated to support such a judgment.
Consequently, we have decided to keep the existing ranges of growth for money and credit for 1997 and carry them over to next year, retaining the interpretation of the money ranges as benchmarks for the achievement of price stability. With nominal income growth strong relative to the rate that would likely prevail under conditions of price stability, the growth of M2 is likely to run in the upper part of its range both this year and next, while M3 could run a little above its cone. Domestic nonfinancial sector debt is likely to remain well within its range, with private debt growth brisk and federal debt growth subdued. Although any tendency for the aggregates to exceed their ranges would not, in the event, necessarily call for an examination of whether a policy adjustment was needed, the Federal Reserve will be closely examining financial market prices and flows in the context of a broad range of economic and price indicators for evidence that the sustainability of the economic expansion may be in jeopardy.
The Federal Reserve recognizes, of course, that monetary policy does not determine the economy's potential. All that it can do is help establish sound money and a stable financial environment in which the inherent vitality of a market economy can flourish and promote the capital investment that in the long run is the basis for vigorous economic growth. Similarly, other government policies also have a major role to play in contributing to economic growth. A continued emphasis on market mechanisms through deregulation will help sharpen incentives to work, save, invest, and innovate. Similarly, a fiscal policy oriented toward limited growth in government expenditures, producing smaller budget deficits and even budget surpluses, would tend to lower real interest rates even further, also promoting capital investment. The recent experience provides striking evidence of the potential for the continuation and extension of monetary, fiscal, and structural policies to enhance our economy's performance in the period ahead.
Chairman Greenspan presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, US Senate, July 23, 1997.
Statement by Alice M. Rivlin, Vice Chair, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, US. House of Representatives, July 23, 1997
I would like to begin by expressing my appreciation to the committee for holding this hearing to solicit a wide range of views on appropriate monetary policy at this extremely favorable moment in our economic history. All too often congressional hearings are called when something bad is happening. In a deteriorating situation, the Congress finds it necessary to survey the damage, assess responsibility, and call for better policies in the future.
At the moment, however, the economy as a whole is functioning amazingly well. Employment is high and rising, unemployment is low, incomes are increasing, profits are high, the federal budget deficit is plummeting, state and local finances are increasingly strong, and inflation is benign. The overriding economic objective -- shared by all participants in the economy -- is to keep the good news flowing. We all want the economy to grow at its highest sustainable rate, to keep unemployment and inflation low, and, above all, to avoid recession as long as possible.
Thoughtful people, at the Federal Reserve and elsewhere, have somewhat different views about why the economy is doing so well and how best to keep it going. Your invitation to share those views is timely, constructive, and welcome.
I would like briefly to discuss three questions:
1. Why is the economy performing so well -- and, in particular, why do we have so little inflation with such low unemployment?
2. Why is it so important, especially right now, to keep the economy growing at its highest sustainable rate and to avoid recession?
3. What policies -- monetary and other economic policies -- are most likely to keep economic performance high and sustained?
Why Is the Economy Doing So Well?
Most economists are frankly surprised that the economy has been able to grow fast enough to push unemployment rates below 5 percent without generating accelerating inflation. Until recently, most students of the economy thought that unemployment rates below 5.5 percent to 6.0 percent (estimates differed) for an appreciable period would lead to rising labor costs that would be passed on in higher prices and start a self-perpetuating wage-price spiral that would be hard to reverse. True, unemployment had been lower in the 1960s while inflation remained low, but the structure of the economy and the characteristics of the labor force subsequently changed in ways that seemed to make the economy more inflation-prone for given levels of unemployment. The experience of the period since about 1970 appeared to confirm that inflationary pressure emerged at unemployment rates appreciably higher than those of the 1960s.
Five years ago, most economists would have thought the Federal Reserve irresponsible and derelict in its duty if it had not used monetary policy to slow an economy operating at such a high level that unemployment remained less than 5.5 percent for more than a short time. The inflation might not appear immediately, but it was thought to be inevitable, and allowing it to get up a head of steam before acting was taking a high risk of having to react more strongly, perhaps strongly enough to bring on a recession.
Nevertheless, the unemployment rate has been below 5.5 percent for more than a year and below 5.0 percent in 1997, while inflation has shown no signs of picking up -- indeed, producer prices have actually been falling. The Federal Reserve, except for a quarter point tightening of the federal funds rate in March (after months of inaction), has left the monetary levers alone. Is the Federal Reserve ignoring risks of future inflation?
The answer depends on whether the coexistence of higher growth and lower unemployment with benign inflation is explained by a fundamental improvement in the structure of the economy making it less inflation-prone, by temporary factors that might return to "normal" and kick off an inflationary wage-price spiral, or by some combination of the two. The honest answer is: We do not know yet.
One surprise has been that such tight labor markets have not resulted in more rapid increases in wages and other labor compensation. Part of the explanation, as Chairman Greenspan noted in his testimony on July 22, may lie in less aggressive behavior on the part of workers. Workers may be more reluctant than previously to bargain for higher compensation or to take drastic action, such as striking or quitting to look for a better job. They may be reluctant because they are insecure in the face of rapidly changing technology, for which they fear they may not have the right skills, because they have recent memories of company "downsizing," or because they are less likely than in previous tight labor markets to be members of a union. These explanations of less aggressive worker behavior are plausible but likely to be temporary. Workers are not likely to get more insecure as low unemployment continues, and union strength is unlikely to ebb further.
Part of the explanation of moderate compensation increases may also lie in more aggressive employer resistance to labor cost increases than in previous cycles. Business owners and managers appear to believe strongly that they are operating in such a competitive environment -- whether domestic or international -- that they cannot pass cost increases on to their customers in higher prices because they would lose those customers to competitors overseas or down the street. Low import prices resulting from growing international competition and the strong dollar reinforce this perception. Domestic markets have also become more fiercely competitive as the result of deregulation, lower transportation and communication costs, and more competitive business attitudes. These competitive forces, well known to workers, may give employers a plausible reason -- or at least an excuse -- for strong resistance to wage and benefit demands.
The subdued inflation rate itself, moreover, has dampened inflationary expectations. These lower expectations contribute both to diminished compensation demands of workers and stiffer employer resistance to those demands. An important contribution to lower total compensation costs has also come from the slowdown in the rise of health benefit costs associated with the shift to managed care and the general reduction in the rate of health care inflation. It is not yet clear how much of this slowdown is temporary.
The other surprise is that prices have shown no reaction to the moderate compensation increases that have occurred. Increased foreign and domestic competitiveness is certainly part of the answer, but the remarkable fact is that this competition has not generally eroded profit margins. Persistent high profits suggest that, on the average, employers have been able to increase productivity enough to absorb larger compensation increases without comparable price increases. Whether they will be able to continue to do so is the crucial unanswered question facing monetary policy makers at the moment. Measured productivity has grown slowly for more than two decades and did not accelerate in this expansion as economists hoped it would. Nevertheless, output per hour seems to have picked up a little recently, which is surprising late in an expansion when productivity increase normally slows. If productivity growth were on the verge of sustained acceleration, a possibility discussed in Chairman Greenspan's testimony, it would greatly increase the chances of higher sustained growth without accelerating inflation. There are reasons to be optimistic, but only time will tell if the optimists are right.
Why Is Sustained Growth So Important Now?
It is always desirable to live in an economy that is growing at a healthy rate. The general standard of living rises and average people are normally better off. Not only do private resources grow, giving consumers more and better choices, but public resources also grow, making it easier to solve public problems and improve national and community infrastructure. Healthy growth has to be sustainable, not bought at the price of environmental degradation or inflationary overheating that turns a boom into a bust.
Nevertheless, there are at least three reasons why it seems especially important for the United States in the next few years to do everything possible to keep the economy growing at a healthy sustainable rate and avoid recession.
Recent legislation requires extremely ambitious state and federal efforts to reduce dependency and channel large portions of the present and future welfare population into self-supporting jobs. For these efforts to be even moderately successful will require effective skill training and job placement, adequate child care, and, above all, low unemployment rates and plentiful entry level jobs. If economic expansion continues and labor markets remain tight, there is a good chance that many families who would otherwise have depended on welfare can acquire the job skills and experience that can enable them to live more independent and satisfying lives. If the economy slides into recession before welfare recipients have time to establish new skills, work patterns, and eligibility for unemployment benefits, welfare reform is almost certain to be a failure, if not an outright disaster.
Partnerships for community development are beginning to create new hope for some devastated areas of big cities, smaller towns, and rural areas. Partners include business and community groups, financial institutions, and governments. With continued economic growth and low unemployment, these efforts could transform many blighted areas into viable communities with decent housing and an economic base. Recession, especially a deep one, would dry up public and private resources and greatly reduce the chances of successful community development.
Preparing for More Older People
Perhaps the biggest challenge to the U.S. economy (indeed to all industrial economies) over the next couple of decades is the prospective rise in the ratio of elderly to working-age people. Barring a huge increase in working-age immigrants or dramatic increases in the length of working life, the number of retirees will rise much faster than the working population beginning early in the next century. No matter what combination of public and private pensions are used to sort out the claims of retirees to a share of the nation's output, the only way to guarantee a rising standard of living for both retirees and workers is to greatly increase the future productivity of that workforce. A high growth economy over the next decade could generate enough saving and investment to make that increased future workforce productivity feasible. Slower growth and repeated recessions could make the burden of an aging population far heavier and policy choices more contentious.
WHAT POLICIES ARE NEEDED?
These three challenges to the U.S. economy simply reinforce the need to keep the economy on the highest sustainable growth track attainable and to keep recessions as shallow and infrequent as possible. The biggest problem for monetary policy at the moment is that no one knows what growth rate is sustainable. It may be true that the structure of the economy has changed in ways that make a higher growth rate sustainable without inflation than we thought possible a few years ago - or it may not be true. The question turns on whether productivity growth has shifted up out of the doldrums of the past couple of decades. It is possible that it has but by no means certain.
This leaves monetary policymakers with the difficult job of watching all the signs, weighing the risks, and making a new judgment call every few weeks. At the moment, there seems to be little risk of the economy slowing down too much in the near term and sliding into recession. Growth has already slowed from its clearly unsustainable pace in the first quarter, but all the current signs point to continued economic expansion for the rest of this year and into the next. The risks seem higher on the other side -- that many of the factors holding down inflationary pressures will prove temporary and that the rebound of productivity necessary for higher sustainable growth will not occur or not prove robust and durable. The Federal Open Market Committee has to weigh the risk of slowing the economy unnecessarily against the risk of waiting too long and having to put the brakes on harder later. Waiting longer may increase the possibility of overheating followed by recession. It is a tough call. I cannot promise we will make the right decisions, but I can promise we will try.
It is important not to overestimate the role of monetary policy and the Federal Reserve. Monetary policy can help keep the economy from falling off the sustainable growth track in either direction -- either by overheating and generating enough inflation to unbalance the economy and threaten growth or by chugging along too slowly with excessive unemployment. But monetary policy cannot do much to determine how high the sustainable growth rate is. How fast the economy can grow is determined by how rapidly the employed labor force is increasing and how fast the productivity of that workforce is growing. There are only two ways to get more output: Either more people work or working people produce more (or both).
In the 1960s and 1970s, the U.S. workforce was growing rapidly as the large baby boom generation reached working age and women, especially mothers, moved into the workforce in much larger proportions than previously. But those two trends have run their course. The labor force is likely to grow slowly over the next few years, about 1 percent per year. The main hope for increasing labor force growth, besides encouraging more immigration, is that continued tight labor markets plus increased flexibility in employment hours will gradually begin to reverse the trend to early retirement that has reduced labor force participation among older people. Continued employment opportunities combined with well-designed training programs, especially in computer-related skills, could also attract into the labor force people who are not actively looking for work because they do not think they have the skills to get a "good" job-principally older workers and young people who have dropped out of school.
Indeed, the shortage of workers with modern technical skills may he the biggest problem facing the U.S. economy at the moment, as well as its biggest opportunity. As long as labor markets stay tight, investment in skill training is likely to pay off handsomely both for individuals and for companies that can retain the trained workers long enough to benefit from their increased productivity. Public investment in training for workers with low skills -- often unsuccessful when jobs are scarce -- also stands a far better chance in tight labor markets of moving workers into jobs in which they can gain increasing skills, experience, and higher wages. Continued low unemployment rates, plus public and private investment in skill training are essential, not only for successful welfare reform but also for modernizing the skills of the portion of the workforce whose real incomes and opportunities have declined both relatively and absolutely in the past couple of decades.
The other key to productivity increase, of course, is continued investment, both public and private, in research and development and the technology and infrastructure needed for continuous modernization of the economy. Stable low inflation tends to foster long-term planning and investment by businesses and households. A high growth economy should generate more of the saving needed to finance the investment. Reducing the public dissaving inherent in running a deficit in the federal budget also adds to national saving. Near-term reform of social security and Medicare in ways that add to national saving, public and private, could make a significant contribution to future productivity increase and hence to raising the future rate of sustainable economic growth.
In summary, the objective of economic policy -- monetary policy included -- is to keep the economy on the highest sustainable growth path. No one knows exactly what that rate is right now, or what it can be in the future, but a combination of policies, intelligently pursued, can raise it as far as possible. These policies include the following:
* Wise monetary policy that helps the economy expand and keeps labor markets tight without incurring excessive risk of accelerating inflation
* Investment in skills by individuals, firms, and the public and nonprofit sectors
* Increased saving (public and private) invested in research, technology, and infrastructure.
The Federal Reserve will do its part, in the face of huge uncertainties, to steer an appropriate monetary policy. Fiscal and other policies, both public and private, are needed to take full advantage of the opportunity we have today to keep the U.S. economy operating at a high level in the future.
I am pleased to have this opportunity to meet with you this morning to discuss my views on the conduct of monetary policy. I am well aware that, despite the recent good performance of the economy, some members of this committee have reservations about the conduct of monetary policy, specifically the decision to raise the federal funds rate 1/4 percentage point on March 25. I am also aware that there has been interest by some members, particularly Congressman Frank, in my views, specifically my views about the relevance of the NAIRU (nonaccelerating-inflation rate of unemployment) concept to understanding recent economic performance and risks to the outlook. I welcome the chance to discuss these issues with you this morning.
Achieving price stability in the long run and preventing an increase in inflation in the short run are not ends in themselves. They are a means to the end, important because they are the best way that the Federal Reserve can contribute to achieving the highest sustainable level of production and the maximum sustainable rate of growth for the American people. This is a key point. While there may be, from time to time, differences about how to reach these common goals -- indeed, it would be amazing if there were not -- there is no disagreement about the goals.
The history of business cycles has repeatedly taught us that the greatest risk to an expansion comes from failing to prevent an overheated economy. The best way to ensure the durability of this expansion is, therefore, to be vigilant that we do not allow the economy to overheat and produce the inevitable rise in inflation. Failure to heed this lesson of history would result not only in higher inflation but also in cyclical instability and higher unemployment rates.
One way of explaining the recent good performance in the economy is that policymakers have created a favorable environment for the private sector and then gotten out of the way, allowing the natural dynamism of our economy to operate to its potential. Monetary policy has laid the groundwork of stable, low inflation -- an environment conducive to long-term planning by households and businesses. Fiscal policy has helped lower the deficit and thus has increased national saving and reduced its competition for funds with the private sector. Trade policy has opened markets and increased competition, allowing consumers access to the wider variety of goods and increasing the pressure on producers to raise efficiency and quality. Regulatory policy subjects more and more markets to the discipline of competition. The star of this show is the private sector. Our job is not to mess it up. We can mess it up either by inappropriate action or by the failure to take appropriate action.
CHALLENGES IN THE GOOD NEWS ECONOMY
Recent economic performance has been extraordinarily favorable. Growth over the past year has been among the strongest in the past decade. The unemployment rate has declined to the lowest level in a quarter century. Inflation is the lowest in more than thirty years. Equity prices have soared. Consumer confidence is at record levels. The performance of this "good news" economy is enough to make you want to cheer.
I have noted on several occasions that U.S. policymakers, including the Federal Reserve, would probably be inclined to accept more credit for this performance if they had forecast it or even could explain how it was possible. Herein lie the challenges: First, how do we explain such favorable performance, and specifically what accounts for the favorable combination of low inflation and low unemployment? Second, what can monetary policy do to help extend the good performance; specifically, how should monetary policy be positioned in light of the uncertainties in the current environment so as to balance what I call regularities and possibilities -- regularities that suggest there are limits to the economy's productive capacity, at any point in time, and to the growth of capacity over time and possibilities that suggest these limits may have become more flexible in recent years.
THE ART AND SCIENCE OF FORECASTING AND POLICYMAKING
When I won awards for economic forecasting while in the private sector, I was always asked about my recipe for forecasting. My response was: Take one part science and mix it with one part art and one part luck. The science refers to the model that guided the forecast, to the historical regularities that the model uses to help predict future performance. The art refers to the forecaster's judgment. I never made a forecast by standing back and letting die model do all the work. Judgment was equally important to the end product. We constantly had to consider what parts of the model could be trusted better than others and what to do when some parts of the model got off track. That is where a forecaster earns his living and makes his reputation. Finally, I never ignored the contribution of good fortune to my forecasting success.
It is not very different for policymakers. Models and historical regularities are important underpinnings of any preemptive policy. Such a policy depends on forecasts because you are attempting to avoid problems that would occur if you failed to act. But judgment is essential, too, and more so when historical regularities are called into question, as is the case today. A policymaker, like a forecaster, has to adjust on the fly, before there is time to even determine, with certainty, why the models are off track and certainly before they can be corrected. Historians may put this all in perspective in due time. Perhaps. But policy is made in real time.
In recent years monetary policy has not simply been guided by historical regularities about the relationship between inflation and unemployment inherited from the 1980s and early 1990s. Rather, monetary policy has been adaptive, pragmatic, and flexible in response to evolving economic circumstances. Such an adaptive approach does not throw out the framework that has successfully guided forecasting and policymaking in the past but attempts, in real time, to adjust that approach based on the current data.
KEY ISSUES IN THE ECONOMIC OUTLOOK
The economy appears to have slowed to near a trend rate in the second quarter after surprisingly robust growth in the previous quarter. The underlying fundamentals of the expansion continue to look quite positive. There is solid momentum in employment and income, financial conditions are highly supporting, and consumer confidence has soared to record levels. I do not see any obstacles to the continuation of the expansion, with growth near trend, through 1998.
There are in my judgment two key issues in the outlook related to monetary policy, and these focus on the interaction among growth, utilization rates, and inflation. First, will growth rebound to an above-trend rate, raising utilization rates still further? Second, are prevailing utilization rates already so high that inflation will begin to rise, even if growth remains at trend? These are the same questions I raised in my first speech after coming to the Board, in September 1996. They are the key questions that affected my judgment about the appropriate posture of monetary policy over the past year, and they remain relevant today.
ANSWERS TO YOUR QUESTIONS
Let me briefly now turn to some specific questions that you raised in your letter of invitation or that were the subject of Congressman Frank's comments on my April 24 speech.
WHAT DO I THINK OF THE NAIRU CONCEPT AND ITS USEFULNESS TODAY?
NAIRU stands for nonaccelerating-inflation rate of unemployment. The relationship between inflation and unemployment, based on NAIRU, is called the Phillips Curve.
According to this concept, there is some threshold level of the unemployment rate (NAIRU) at which supply and demand are balanced in the labor market (and perhaps in the product market as well). This balance yields a constant inflation rate. You asked what the relationship was between full employment and inflation. In this model, there is no relationship between full employment and inflation. At full employment, defined as the rate of unemployment equal to NAIRU, inflation is constant, but any constant level of inflation is possible at full employment. The rate of inflation in the long run is therefore not determined by the unemployment rate at all. It is determined by the rate of growth of the money supply. This, of course, gives monetary policy unique responsibility for inflation in the long run.
If the unemployment rate falls below this threshold, inflation rises over time, indefinitely, progressively, and without limit. It is a process that feeds upon itself, because once inflation begins to rise, further price increases feed into wage increases. The basic framework is based on supply and demand. At NAIRU, supply and demand are balanced, so inflation is stable, matched by expected inflation. The trigger for increases in inflation is excess demand for labor and goods. The unemployment rate is a proxy for the balance between supply and demand in the labor market, for the degree of excess demand. Historically the balance between supply and demand in the product market -- that is, for final goods and services -- has closely paralleled the balance in the labor market, so that the unemployment rate has effectively summarized the relationship between supply and demand in both the product market and the labor market.
It has always been the case that the application of the NAIRU concept has been more difficult in practice than in theory. Sometimes the Phillips Curve has made large errors; occasionally the equation has overpredicted or underpredicted for a considerable period of time. The value of NAIRU has also varied over time, for example, in response to changes in the composition of the labor force. Of course, if NAIRU moves frequently without explanation, the concept would not be very useful, either for forecasting or for policymaking. But the fact is that, relative to other equations used to forecast macroeconomic performance, the Phillips Curve was one of the most reliable, if not the most reliable, equation during the fifteen years before 1994. During this period NAIRU either appeared to be relatively constant or moved predictably with changing labor force composition. More recently, there has been a run of overpredictions, beginning in late 1994 for wages and the past year or so for prices. These errors are the very heart of the challenge of explaining the recent surprisingly favorable performance and of the challenge of setting monetary policy today. I will turn to the possible sources of these errors below.
The accompanying table provides some outside estimates of NAIRU. The sources include the Congressional Budget Office (CBO), the President's Council of Economic Advisers (CEA), which develops, along with the Office of Management and Budget and the Treasury Department, the economic assumptions underlying the Administration's budget projections; two leading model-based forecasting firms -- DRI and Macroeconomic Advisers; and estimates from Professor Robert Gordon of Northwestern University, whom I consider the leading academic authority on NAIRU. All those represented in the table view NAIRU as a central and important concept for forecasting inflation and identifying long-run values to which the actual unemployment rate will gravitate. The range of estimates is from 5.4 percent to 5.9 percent. Professor Gordon's work suggests that, after having fallen for a couple of years, NAIRU has stabilized, remaining unchanged over the past year.
Obviously, I am not alone in using this concept in important policy work. For example, in its budget projections, the CBO is very disciplined in assuming that the unemployment rate gradually gravitates to NAIRU. If we begin with an unemployment rate below their estimate of NAIRU, the CBO assumes a period of below-trend growth to allow the unemployment rate to return to their estimate of NAIRU and to prevent on ongoing increase in the rate of inflation. This is the model and forecast upon which your budget deal is based. In the conduct of monetary policy, the process of analysis is more decentralized. There is no single model or forecast, no single measure of NAIRU (not everyone on the Federal Open Market Committee even believes that the concept is useful), no single measure of trend growth. But each of us is dedicated to making disciplined judgments about the economy.
I have said on several occasions that (1) I continue to believe that NAIRU is an important and useful concept; and (2) I believe that NAIRU is lower recently than it had been in the 1980s. I believe that NAIRU has declined from about 6 percent at the end of the 1980s to about 5 1/2 percent currently. However, as has always been the case and is certainly true today, there is uncertainty about the precise estimate of NAIRU. Clearly, many believe it is higher, as reflected in this table. Some also believe it is lower. I constantly re-evaluate my own estimate of NAIRU in light of the recent data.
HOW FAST CAN THE ECONOMY GROW?
The next question you asked is how fast the economy can grow. Over the short run, that depends on the amount of slack in the economy. Once the economy has moved to capacity, the maximum sustainable growth rate is limited by the rate at which productive capacity expands over time. This limit is generally referred to as trend growth. Productive capacity expands both because of increases in physical inputs (labor and capital) and because of improvements in technology -- more people working with more and better equipment. Once full employment is reached, the labor force expands with increases in the working age population, augmented by any trend in the labor force participation rate. The contribution of growth in capital stock and of technological improvements is summarized in the growth in labor productivity.
The accompanying table also provides outside estimates of trend growth. Note that they all fall within a very narrow range, just above 2 percent per year. There has been very little change in these estimates in recent years. About half of the increase in trend gross domestic product is attributable to the long-term trend in labor force growth and about half to the long-term trend in productivity growth. The narrowness of the range of estimates in this table should not suggest the absence of an important degree of uncertainty about trend growth, and I will consider in the next section some reasons why trend growth could turn out to be higher.
If output grows at the trend rate, resource utilization rates will generally be constant. If output grows faster than the trend rate, demand increases relative to supply and resource utilization rates will rise. At some point, above-trend growth will raise utilization rates to a point where excess demand puts upward pressure on inflation.
Note that trend growth does not cause inflation. The higher the trend rate of growth, the better, as Chairman Greenspan noted yesterday in his testimony. And while above-trend growth itself does not raise inflation, it does raise utilization rates which, after some point, will result in higher inflation. I will come back to this thought when I answer your question about the rationale for the March 25 policy action.
HOW DO YOU EXPLAIN THE RECENT FAVORABLE PERFORMANCE OF INFLATION
The answer here, unfortunately, is not as well as I would like. It is important, as a forecaster and policymaker, to understand how much you know and how little you know. In this spirit, I believe that the recent performance of the economy is to some degree a puzzle. I cannot solve that puzzle completely, but I am quite sure of some of the factors that have been important, and I can speculate about some other factors that might be important. In the final analysis, we have to make monetary policy before we have all the answers, though we can, and do constantly, review our models in light of new data to refine our thinking.
The clearest and perhaps the most important factor is the temporary confluence of favorable supply shocks over the past couple of years; by favorable supply shocks, I refer to developments that have recently lowered the prices or slowed the rate of increase in the prices of specific goods, unrelated to the overall balance between supply and demand in U.S. labor and product markets. The list of favorable shocks is well known and generally widely appreciated. First, non-oil import prices have declined, in large measure because of the appreciation of the dollar from mid-1995 through early 1997. This has both lowered the price of imported goods and constrained the pricing power of domestic firms that compete with imports. Second, the cost of employee benefits has risen more slowly, especially the cost of employer-provided health care, tempering the rise in compensation per hour. Third, most recently, energy prices have declined sharply this year, and food prices are increasing less rapidly. Fourth, the price of computers is falling even faster, reflecting, in part, the rapid pace of technical change.
Some believe the collection of these temporary factors fully accounts for the recent favorable performance of inflation, and such a view is not entirely implausible. But I do not hold this view. I believe that other longer-lasting factors may also be contributing. One possibility is an intriguing anomaly of the current expansion. I noted above that the change in utilization rates in the labor and goods markets (the unemployment rate and the capacity utilization rate) usually mirror one another over the cycle. In the current episode, these two measures have diverged to a greater degree than has been typical in the past. This divergence is likely related to another defining feature of this expansion, the investment boom which has raised the level of net investment to the point where the capital stock is expanding rapidly, raising capacity and preventing the increase in demand from overtaking supply. The unemployment rate is signaling that the labor market is tight; but the capacity utilization rate indicates that supply and demand are well balanced, at least in the industrial sector of the economy. As a result, there has been some upward pressure on wages, but no pass-through to higher price inflation. Firms report an absence of pricing leverage because nothing gives a firm pricing power like excess demand and there is no apparent excess demand for U.S. firms, especially in the global market place where there is plenty of slack abroad.
The most intriguing explanations of the recent favorable performance are structural changes which may have expanded the limits to productive capacity and trend growth. These possibilities come in two forms: structural change in the labor market which lowers NAIRU and structural change in the product market, specifically higher productivity growth, which, at least temporarily, also lowers the NAIRU and which pushes out the limit of trend growth.
One explanation for why we can sustain stable inflation with lower unemployment is the worker insecurity hypothesis. According to this theory, corporate restructuring, globalization, and technological change have increased workers' insecurity about their jobs. As a result, workers have been willing to accept some restraint on their real wages in order to increase their prospects of remaining employed, leading to a more moderate rate of increase in wages than would otherwise have occurred at any given rate of unemployment. While this is consistent with a decline in the NAIRU, we cannot very precisely test the worker insecurity hypothesis itself. But it does fit some of the facts of the current labor market experience. My conclusion is that NAIRU has declined, even taking into account the role of temporary factors, though I cannot pin down definitely the source of the decline. I am simply adjusting my estimate to the data. The worker insecurity hypothesis is a possible explanation.
An example of a product market structural change would be an increase in trend productivity growth. This is clearly the most intriguing of all the potential explanations because it ties together so many puzzles. It can explain why we are in a midst of an investment boom, why the profit share of income has been rising, why inflation is so well contained, and why stock prices have soared. The only problem is the data. It is true that productivity has increased more rapidly recently. This is not clear-cut evidence of a shift in the productivity trend, however, because productivity normally accelerates when output growth rises, as it has over the past year. There is, however, some support for the view that we are experiencing a speed-up in the trend rate of productivity growth. For example, if we measure productivity from the income side rather than the product side of the national accounts, we do observe a sharper acceleration in productivity. This income-side measure of productivity provides at least a tantalizing hint of an increase in trend productivity growth. This would also be consistent with a considerable number of reports by businesses that they are realizing new efficiencies in production, both through corporate reorganization and through the application of new technology.
WHAT WAS THE RATIONALE FOR THE MARCH 25 THIGHTENING?
The discussion of the rationale for the March 25 policy move to follow is my personal view. During the period from June 1996, when I joined the Board, through February 1997, utilization rates had remained in a very narrow range, in the case of the unemployment rate only a shade below my estimate of NAIRU. Recall that the unemployment rate averaged 5.4 percent in 1996. There was some risk that utilization rates were already so high that inflation might increase over time, but this risk was not clear enough, in my judgment, to justify action. I viewed growth as either close to trend already or about to slow to trend, implying that there was negligible risk that utilization rates would rise further. So, before March 25, the Federal Reserve's posture was one of "watchful waiting," but with an asymmetric directive, based on the judgment that the risks were weighted toward higher inflation.
In March, my view was that there was sufficient momentum in growth to justify a forecast that utilization rates would rise materially further, in the absence of a change in policy. The policy action was clearly a preemptive one, based not on inflation pressures evident at the time but on inflation pressures likely to emerge in the absence of policy action. As the Chairman has repeatedly emphasized, lags in the response to monetary policy make it imperative that monetary policy be forward looking and anticipatory, not backward looking and reactive.
One of the principles of prudent monetary policy management, in my judgment, is to lean gently against the cyclical winds. This means that when growth is above trend and utilization rates are increasing, it is often prudent to allow short-term rates to rise. Monetary policy should not sit on interest rates and wait until the economy blows by capacity and inflation takes off. To do so would risk a serious boom-bust cycle and would require abrupt and decisive increases in interest rates later to regain control of inflation. A small, cautious step early is the recipe for avoiding the necessity of a sharper destabilizing move later on.
What does the record show? Growth was much stronger in the first quarter than I had anticipated and appears to have slowed to trend in the second quarter. The legacy of the robust first-quarter growth was a decline in the unemployment rate to below 5 percent in the second quarter. I call the March 25 move, as a result, "just-in-time" monetary policy. I believe it was prudent. I voted in favor of it because I thought it would help to prolong the expansion and contribute to the goal of maximum sustainable employment and maximum sustainable growth.
I welcome the opportunity to appear before the Committee on Banking and Financial Services this morning to provide my views on the conduct of monetary policy in conjunction with the semiannual report to Congress under the Humphrey -- Hawkins Act. There can be no doubt that the ultimate goal of monetary policy in the United States today must be to achieve the highest level of sustainable economic growth, which, in turn, will promote the highest possible standard of living for all our citizens and the greatest number of jobs. But in saying this, I want to be clear as to what we can expect monetary policy to do and what we know it cannot do.
What monetary policy can do is to anchor inflation at low levels over the long term and thereby lock in inflation expectations. In addition, monetary policy can help offset the effects of financial crises as well as prevent severe downturns of the economy.
Over the past twenty years, a widespread consensus has emerged among policymakers and economists that a monetary policy to stimulate output and reduce unemployment beyond its sustainable level leads to higher inflation but not to lower unemployment or higher output. Moreover, although some countries have managed to experience rapid growth in the presence of high inflation rates, often with the help of extensive indexation, none has been able to do so without encountering severe difficulties at a later stage. It is thus widely recognized today that there is no long-run tradeoff between inflation and unemployment. As a result, we have witnessed a growing commitment among central banks throughout the world to price stability as the primary goal of monetary policy.
One point is worth emphasizing: Allowing even a moderate level of inflation to persist without a commitment to bring that level downward toward price stability permits -- and may even encourage -- expectations for still sharper price rises in the future.
What monetary policy cannot do, in and of itself, is produce economic growth. Economic growth stems from increases in the supply of capital and labor and from the productivity with which labor and capital are used, neither of which is directly influenced by monetary policy. However, without doubt, monetary policy can help foster economic growth by ensuring a stable price environment.
Some would argue that establishing price stability as the primary goal of monetary policy means that a central bank would no longer be concerned about output or job growth. I would like to make explicit for the record that I believe this view to be simply wrong. Price stability is the absolutely essential means to produce sustained economic growth. Moreover, there need be no inconsistency between seeking long-run price stability and leaning against short-run business cycles. Indeed, a stable price and financial environment that the public expects to persist almost certainly will enhance the capacity of monetary policy to fight occasions of cyclical weakness in the economy. This is a key point -- and is often overlooked.
In my view, a goal of price stability requires that monetary policy be oriented beyond the horizon of its immediate impact on inflation and the economy. This horizon is about two to three years, and it is important, in part, because it sets the stage for what comes later. But the longer-run purpose of today's policy actions should be to lay the foundation for price stability and sound economic growth over the coming decade.
This orientation properly puts the focus of a forward-looking policy on the time horizon most important to household and business planning. This is the horizon that is relevant for the definition of price stability articulated by Chairman Greenspan: that price stability exists when inflation is not a consideration in household and business decisions.
A central bank's commitment to price stability over the longer term, however, does not mean that the monetary authorities can ignore the short-term impact of economic events. It is important to recognize that, even if we set ourselves successfully on the path to price stability and even if, as a result, price expectations are contained, we still will not have eliminated all sources of potential inflation. The reality is that monetary policy is only one of many influences on the economy.
For example, supply shocks that drive prices up sharply and suddenly -- such as the two oil shocks of the 1970s -- are always possible. In such an eventuality, the appropriate monetary policy consistent with a goal of price stability would not be to tighten precipitously but rather to bring inflation down gradually over time as the economy adjusts to the shift in relative prices. In the event of a shock to the financial system, the appropriate monetary policy might require a temporary reflation.
As you can see, I believe that monetary policy must be exercised cautiously. Why do I say this? Because the economy is not perfectly flexible and pushing hard in the face of rigidities can cause unnecessary problems. For example, contracts, especially wage contracts can outlast a good part of, or even exceed the duration of, short-term shocks. In the short term, therefore, monetary policy must accept as given the rigidities in wages and prices that these contracts create. Abrupt shifts in policy, given these rigidities, especially a monetary tightening in the face of wages that are unlikely to be cut, can cause unacceptable rises in unemployment and drops in output. In my view, therefore, a key principle for monetary policy is that price stability is a long-term goal and a means to an end -- to promote sustainable economic growth. But even if we agree that price stability must be the primary long-term goal of monetary policy, what exactly does price stability mean in practice? We know that, as currently measured, a zero inflation rate is not the same thing as price stability. This is because of well-known errors in measuring inflation that stem from many factors, including how quality improvements and new products are valued in the consumer price index. Although there is much research on this topic, economists and policymakers cannot agree upon a single number for the magnitude of this measurement error. In most studies, the error has been estimated to range from 0.5 percent to 2.0 percent. Therefore, as a practical matter, price stability may best be thought of as an inflation rate, measured by the consumer price index (CPI), falling somewhere within this range.
But, we may well ask, why is price stability so important and so desirable? Price stability is both important and desirable because a rising price level -- inflation -- even at moderate rates, imposes substantial costs on society. These costs are both economic and social. The economic costs entail, for example, the following: (1) increased uncertainty about the outcome of business decisions; (2) negative effects on the cost of capital resulting from the interaction of inflation with the tax system; (3) reduced effectiveness of the price and market systems; and (4) in particular, distortions that create perverse incentives to engage in nonproductive activities.
The costs of inflation-induced nonproductive activities -- such as tax code dodges or overinvestment in the financial sector -- decrease the resource base available to an economy for growth. A move to price stability gives an economy the necessary incentives to shift resources back to productive uses.
Rapid moves toward price stability from high inflation, however, do have their costs under certain circumstances. I have already described the rigidities caused by contracts. The overdevelopment of a sector for no reason other than the inflation rate is another of those circumstances. The removal of the distortionary incentive -- inflation -- leads to a rapid transfer of resources out of that sector, causing unemployment and business failures to follow: What was boom, goes bust. Countries that have seen overexpansion of the financial sector have experienced the sharp contraction of that sector when inflation finally was brought down. This implies an additional argument for price stability. Namely, in a low-inflation environment, these boom -- bust cycles created by distortionary incentives are less likely to emerge and can be more easily contained when they arise.
The avoidance of such unnecessary boom -- bust cycles also limits the serious social costs that inflation can impose. These social costs are all too often underestimated in economists' typical calculations of inflation's costs. For one, inflation may strain a country's social fabric, pitting different groups in a society against each other as each group seeks to make certain its wages keep up with the rising level of prices. Moreover, as we all know, inflation tends to fall particularly hard on the less fortunate in society, often the last to get employment and the first to lose it. These people do not possess the economic clout to keep their income streams steady, or even buy necessities, when a bout of inflation leads to an increase in prices they must pay. When the bust comes, they also suffer disproportionately by being among the first to lose their jobs. They also are not users of sophisticated financial instruments to protect their modest savings from confiscation by inflation.
There can be no doubt that a stop -- go, boom -- bust economy significantly reduces the overall economic welfare of its citizens. Such an economy produces serious and dangerous tensions within a society because the benefits and pain of an inflationary environment are unequally distributed. Because of these realities, I am convinced that price stability is important and desirable not simply for purely economic reasons but for broader public policy reasons as well.
In a word, I believe that the less fortunate in our society particularly benefit from an environment of price stability and the economic growth that it fosters, as we currently are seeing in our economy. Sustained economic growth brings a lower level of unemployment, higher labor force participation, and greater availability of jobs to those who are not easily hired because they need more training and help from their employers. Over the long term, I am convinced strong economic growth can be sustained only if the benefits of the economic pie -- more and better jobs, higher incomes, improved housing, and a higher standard of living -- are shared by all parts of our society -- rich and poor, skilled and less skilled. Unless all parts of society share in -- and therefore have a stake in -- economic growth, we cannot have the social and political cohesion that is essential to sustain growth.
From a personal perspective, I am convinced that much of the success the Federal Reserve has had in containing inflation in recent years reflects monetary policy actions that preempted inflationary pressures before they actually showed up in general prices. When the Federal Reserve began firming monetary conditions in February 1994, it did so because of the potential it saw for inflation re-emerging. The main reason we need a preemptive approach, in my view, is because monetary policy works with uncertain and long time lags. Although most of its effects on output take place within one to two years, its effects on inflation take even longer -- over a three-year time frame, which is the appropriate horizon for monetary policymakers.
When one stands back and considers monetary policy over the past several decades, the case is strengthened for a preemptive approach to squeeze off incipient inflation before it shows through in broader price increases. Economic analysis has shown not only that an overheating economy has a strong effect in raising inflation but also that reducing inflation is a very painful process. We learned these lessons during the long and costly disinflation of the early 1980s, after the explosion of inflation in the 1970s. Thus, both analysis and experience reinforce the need for preemptive monetary policy actions. Failure to contain inflationary pressures at an early stage makes it much costlier to deal with inflation later.
Because of its long and variable lags, monetary policy also requires of Federal Reserve officials the experience and courage to deal with what will always be a level of uncertainty. The Federal Open Market Committee has been willing to deal with the uncertainty caused by the overestimation of inflation and the underestimation of growth of most economic models in the past year or more. In my view, the Committee's policy has been an important ingredient in the excellent economic performance we have been enjoying.
I believe that there is broad support within the United States today for a rigorous and consistent anti-inflation policy. Moreover, I am pleased by the credibility the Federal Reserve appears to have earned in controlling inflation over the past several years, while encouraging both growth of the real economy and financial system stability.
Finally, I am convinced that no central bank can maintain price stability over the longer term without public support for the necessary policies. Only with the confidence of the public in their policies and their own vigilance in implementing these policies can central banks in democracies ultimately succeed in achieving price stability to maximize economic growth. This is the goal we at the Federal Reserve work toward each day.
I am pleased to be here today to discuss the Federal Reserve's planning process and the efforts we are making to measure and improve our performance in the spirit of the Government Performance and Results Act (GPRA). I am personally a long-term proponent of GPRA and worked hard on its implementation when I was at the Office of Management and Budget. While the Federal Reserve does not receive appropriated funds and is not, strictly speaking, covered by the act, we are eager to participate in the processes and activities set forth in the act. GPRA fits well with the new efforts the Federal Reserve has undertaken to plan further ahead, to use our resources more effectively, and to coordinate activities across the whole System more explicitly. The testimony is a brief progress report on those efforts.
Planning at the Fed
In its briefest form, the Federal Reserve's mission is to "foster the stability, integrity and efficiency of the nation's financial and payment systems so as to promote optimal macroeconomic performance." This mission derives directly from the Federal Reserve Act of 1913, which established the Federal Reserve as the nation's central bank, and has three main elements:
* To formulate and conduct monetary policy toward the achievement of maximum sustainable long-term growth; price stability fosters that goal.
* To promote a safe, sound, competitive, and accessible banking system and stable financial markets through supervision and regulation of the nation's banking and financial systems; through its function as the lender of last resort; and through effective implementation of statutes designed to inform and protect the consumer.
* To foster the integrity, efficiency, and accessibility of U.S. dollar payments and settlement systems; issue a uniform currency; and act as the fiscal agent and depository of the U.S. government.
The activities involved in carrying out this broad mission are extremely diverse, ranging from setting short-term interest rates to processing checks and cash to examining depository institutions. Allocation of the resources the Federal Reserve uses to do its job depends heavily on the state of the economy (both national and international), how well or badly the financial services system is functioning, and what additional tasks (such as implementation of the Community Reinvestment Act and expansion of our oversight of foreign banks operating in the United States pursuant to the Foreign Bank Supervision Enhancement Act of 1991) the Congress assigns to us.
To carry out this multifaceted mission, the Congress established a highly decentralized Federal Reserve System with a complex governance structure. Leadership and direction are vested in the Board of Governors, but only about 1,700 staff members (out of about 24,900) work for the Board in Washington. The regional Reserve Banks carry out the bulk of operations and have substantial autonomy. As a result, planning and resource allocation at the Federal Reserve have historically been quite decentralized, and major changes have required painstaking consensus building across the Board-Bank structure.
The regional structure of the Federal Reserve is one of its great strengths. The twelve regional Federal Reserve Banks work closely with the banks in their region and are closely tied into their regional economies. The development of Federal Reserve policy is greatly enriched by the in-depth knowledge that the regional banks have of the industrial, agricultural, and financial forces shaping different parts of the economy. The challenge confronting strategic planning at the Federal Reserve is to find a balance between decentralized regional planning, which preserves the strengths of the regional structure, and the need for a more comprehensive national plan aimed at increasing efficiency by rationalizing die allocation of resources across regions and functions.
In recent years, major changes have occurred in the allocation of Federal Reserve resources in response to unfolding events. When serious problems developed in the banking industry in the 1980s and in response to increased supervisory responsibility for foreign banking entities, more Federal Reserve resources were channeled into supervision and regulation. Rapidly changing technology, especially telecommunications and automation, has revolutionized Federal Reserve operations and required considerable investment in hardware, software, and expertise. Consolidation of the banking industry, evolution of payment systems patterns and technology, growth in derivatives, globalization of financial services, concerns about equal credit opportunity and fair housing issues, efforts to reduce systemic risk in the payments area, and changes in monetary aggregates have all caused planning and resource adjustments.
Rapid technological change has also created opportunities for Systemwide efficiencies resulting from consolidation of activities in one or more Reserve Banks. A number of the twelve regional banks have developed specialized activities serving other regions. For example, FRAS (Federal Reserve Automation Services) is headquartered in Richmond but provides mainframe data processing and data communications services to all parts of the System. This consolidation and specialization has enabled the Reserve Banks to centralize operations of many of their mission critical applications such as Fedwire, automated clearinghouse (ACH), and accounting. Continued technological advance, as well as further consolidation in the financial services industry, is likely to lead to further specialization among regional Federal Reserve Banks.
New Strategic Planning Activities
In the face of accelerating change, the Federal Reserve recently recognized the need for a more comprehensive planning framework. In 1995, a System Strategic Planning Coordinating Group was appointed, consisting of Board members, Reserve Bank presidents, and senior managers, representing the full range of the Federal Reserve's activities. This group produced an "umbrella" framework, designed to enable the Board, the Reserve Banks, and product and support offices to produce their own more detailed plans and decision documents under the "umbrella."
This framework, which is the basis for the document submitted to the House and Senate Banking Committees, sets forth the mission of the Federal Reserve referred to above. It also discusses the "values" of the Federal Reserve, its goals and objectives, and key assumptions as well as the external and internal factors that could affect the achievement of those goals and objectives. With the overall framework as a reference point, strategic planning activities are proceeding with new energy at the Reserve Banks, at the Board, and with respect to crosscutting major functions such as the payments system and bank supervision and regulation.
Individual Reserve Banks have reviewed their operations from the ground up and reassessed their structure and effectiveness in carrying out their missions. Some of the Banks have launched fundamental re-engineering efforts that are resulting in substantial changes in management structure and operations. The Federal Reserve Bank of Chicago calls its effort "Fresh Look;" the Federal Reserve Bank of Cleveland is engaged in "Transformation: 2000."
Board Planning and Budgeting
At the Board, we have restructured the annual planning and budget process to put more emphasis on planning (and less on detailed line-item budgeting), to lengthen the planning and budgeting horizon, and to involve the Board itself more heavily in setting priorities. To this end, we have established a Budget Committee of the Board (consisting of myself and Governors Phillips and Kelley) assisted by a staff planning group drawn from across the major functions of the Board. We are working with a four-year planning horizon and intend to produce the Board's first biennial budget (1998-99) to go into effect on January 1, 1998. Our hope is that the new process and structure will give the Board a better understanding of the options it faces with respect to alternative ways of carrying out the Federal Reserve's mission and a clearer basis for deciding on priorities.
Payments System Study
A major study of the Federal Reserve's role in the payments system, currently under way, is another example of strategic planning with respect to a major portion of the Federal Reserve's activities, under the general umbrella of the strategic planning framework.
Because payments technology and the structure of the financial services industry are changing rapidly, it seemed important to focus both on how die payment system was evolving (and should evolve) and what role the Federal Reserve should play in that evolution. The United States is amazingly dependent on paper checks -- Americans wrote 64 billion checks in 1996 -- while most of the industrial world is shifting rapidly to more efficient electronic-based payments.
The study, directed by a committee of two Governors and two Federal Reserve Bank presidents, has drawn on analytic resources across the Federal Reserve System and outside. We began by examining the consequences of substantially altering the role of the Federal Reserve in the retail payments system (checks and wire transfer system known as ACH). We analyzed the impact of scenarios ranging from withdrawal of the Federal Reserve from the check and ACH markets to more aggressive leadership by the Federal Reserve in making the payment system more efficient and less dependent on paper.
To get maximum input from the participants in the payment system -- banks, clearinghouses, vendors, consumers, and others -- in helping us assess alternatives for the future, we held a series of "forums" around the country in May and June. We had enthusiastic and extremely helpful participation from a wide range of institutions. We learned a lot from the process and are now reassessing the alternatives, conducting additional analyses, and preparing to present preliminary options to the Board. I look forward to sharing the study with this committee.
The payments area is a good example of the dilemma posed for planners by rapid technological change. While rapidly evolving technology makes focusing on future options imperative, it also makes it extremely important to remain flexible. Laying out a blueprint for the payments system of the next ten or even five years, and rigidly following it, would almost certainly be a mistake. The technology is moving so rapidly that investments made now may well be obsolete in a short time.
A major theme of the GPRA is the identification of specific measures of performance of projects and programs that can be used to evaluate their effectiveness. As in most organizations, performance measurement at the Federal Reserve is more advanced -- and more feasible -- in some types of activities than in others.
In the payment services areas, the Reserve Banks have measured their performance through various financial measures for many years. For example, the Monetary Control Act of 1980 imposes market discipline on the Federal Reserve by requiring it fully to cover its costs of providing services to depository institutions, and compliance with this requirement is monitored closely. Frequently, private competitors provide or could provide these services, and our ability to recover our costs, adjusted to include a factor for imputed profits, taxes, and cost of capital, help determine whether it is beneficial for the economy that we stay in the business. In addition, the Federal Reserve has traditionally measured unit costs for its financial services and has developed various indexes that allow a Reserve Bank to measure its cost performance over time and in comparison with other Reserve Banks. Private sector benchmarks are also being developed. The Federal Reserve also tracks quality measures for many Reserve Bank services. Finally, the Federal Reserve monitors the progress of the Reserve Banks against various strategic objectives.
Similarly, in bank supervision, the Federal Reserve has long used a variety of measures of the effectiveness of its examination process, but the measurement challenge has taken on new importance as supervision becomes more automated and more focused on analyzing risk. To meet this challenge, the Federal Reserve is working closely with other regulators to standardize and improve examination techniques and has established a steering committee to oversee implementation of a risk-focused examination program and to design a management information system that will permit the Board to evaluate better the efficient use of examination resources among the Reserve Banks. For instance, supervisory data are used to determine in advance of on-site examinations what factors (CAMELS rating, asset size, location, and loan types) are most predictive as to the resources needed for examinations, and which institutions, particular lending areas, or other service lines may require more intensive review. Such programs are low-cost because they use information that we already collect and are effective and cost-saving because they provide a systematic way to plan and prioritize our time and resources.
In other areas, such as the research and statistical analysis on which monetary policy is based, performance measurement is -- and will remain -- far more problematic. The performance of the economy itself is not so hard to measure and right now is highly positive. But it is not clear how much of the economic progress can be attributed to monetary policy and even less clear how particular monetary policy actions are related to the quality and quantity of research and analysis produced by the Fed's research staff.
GPRA provides the opportunity for a major improvement in the management and effectiveness of federal agencies. It provides the impetus for agencies to clarify their missions and objectives, measure their performance better, and improve their efficiency and effectiveness. It must, however, avoid the risk of becoming, like some previous efforts to improve government management, largely a paper exercise that produces many numbers and reports but few real results.
The Federal Reserve welcomes the opportunity to participate in the GPRA process. We will work hard to fulfill the vision of the framers of the act and avoid the pitfalls. We will have to respond in ways that are appropriate to the Federal Reserve's diverse missions and decentralized structure. I believe we have made significant progress toward the GPRA-type strategic planning and are on the track to making more in the immediate future.
I am pleased to appear before the subcommittee today to discuss the Federal Reserve's efforts to address the Year 2000 computer systems problem. I will discuss what action is being taken by the Federal Reserve System to address internal systems, our supervisory efforts, coordination with the industry, and contingency planning.
Year 2000 Readiness
It is crucial that the Federal Reserve maintain reliable services to the nation's banking system and financial markets. I want to assure you that the Federal Reserve is giving the Year 2000 its highest priority, commensurate with our goal of maintaining the stability of the nation's financial markets and payments systems, preserving public confidence, and supporting reliable government operations.
The Federal Reserve System has developed and is executing a comprehensive plan to ensure its own Year 2000 readiness, and the bank supervision function is well along in a cooperative, interagency effort, to promote early remediation and testing by the industry. The supervision function is completing an assessment of the industry's readiness, will examine every bank subject to our jurisdiction by mid-1998, and will review their progress as part of all examinations conducted throughout the remaining months before the millennium.
We are taking a comprehensive approach to preparedness that includes assessments of readiness, remediation, testing, and updating proved plans and techniques used during other times of operational stress in order to be prepared to address potential century data change difficulties. All Federal Reserve computer program changes, as well as system and user-acceptance testing, are scheduled to be completed by year-end 1998. Further, critical financial services systems that interface with customers will be Year 2000 ready by mid-1998, permitting approximately eighteen months for customer testing.
Many top personnel in the Federal Reserve System are working hard to manage this initiative. Our staff is putting in many extra hours to prepare for testing with customers, planning for business continuity in the event of any unanticipated internal systems problem, and enhancing our ability to respond to possible operating failures of depository institutions. While there are challenges before us, I can report that we expect to be fully prepared for the century date change.
Federal Reserve Readiness
The Federal Reserve recognized the potential problem with two-digit date fields more than five years ago when we began consolidating our mainframe data processing operations. Our new centralized mission-critical applications, such as Fedwire funds transfer, book-entry securities, and automated clearinghouse, were designed from inception with Year 2000 compliance in mind. The mainframe consolidation effort also necessitated extensive application standardization, which required us to complete a comprehensive inventory of our mainframe applications, a necessary first step to effective remediation. Like our counterparts in the private sector, the Federal Reserve System still faces substantial challenges in achieving Year 2000 readiness. These challenges include managing a highly complex project involving multiple interfaces with others, ensuring the readiness of vendor components, ensuring the readiness of applications, testing, and establishing contingency plans. We are also faced with labor market pressures that call for creative measures to retain staff members who are critical to the success of our Year 2000 activities.
According to industry experts, one-quarter of an organization's Year 2000 compliance efforts are devoted to project management. Managing preparations for the century date change is particularly resource-intensive given the number of automated systems to be addressed, systems interrelationships and interdependencies, interfaces with external data sources and customers, and testing requirements. In addition, Year 2000 preparations must address computerized environmental systems such as power, heating and cooling, voice communications, elevators, and vaults. In die case of the Federal Reserve, management of this project is particularly challenging because it requires coordination among Reserve Banks, the Board of Governors, government agencies, numerous vendors and service providers, and approximately 13,000 customers.
In late 1995, a Federal Reserve Systemwide project was initiated, referred to as the Century Date Change (CDC) project, to coordinate the efforts of the Reserve Banks, Federal Reserve Automation Services (FRAS) -- the Reserve Banks' centralized mainframe data processing and data communications services organization -- and the Board of Governors. Our project team is taking a three-part approach to achieve its objectives, focusing on planning, readiness, and communication. Our planning began with a careful inventory of all applications and establishment of schedules and support mechanisms to ensure that readiness objectives are met. The readiness process involves performing risk assessments, modifying automated systems, and testing internally and with depository institutions, service providers, and government agencies. Finally, we are stressing effective, consistent, and timely communication, both internal and external, to promote awareness and commitment at all levels of our own organization and the financial services industry, more generally. Some of our most senior executives are leading the project, and the Board is now receiving formal status reports at least every sixty days. Any significant compliance issues will be reported to the Board immediately.
A significant challenge in meeting our Year 2000 readiness objectives is our reliance on commercial hardware and software products and services. Much of our information processing and communications infrastructure is composed of hardware and software products from third-party vendors. Additionally, the Federal Reserve utilizes commercial application software products and services for certain administrative functions and other operations. As a result, we must coordinate with numerous vendors and manufacturers to ensure that all of our hardware, software, and services are Year 2000 ready. In many cases, compliance will require upgrading, or even replacing, equipment and software. We have completed an initial inventory of vendor components used in our mainframe and distributed computing environments, and vendor coordination and system change are progressing well.
As we continue to assess our systems for Year 2000 readiness, we are preparing a central environment for testing our payment system applications. We are establishing isolated mainframe data processing environments to be used for internal testing of all system components as well as for testing with depository institutions and other government agencies. These environments will enable testing for high-risk dates such as year-end 1999, beginning of year 2000, and February 29, 2000 (leap year). Testing will be conducted through a combination of future-dating our computer systems to verify the readiness of our infrastructure and testing critical future dates within interfaces to other institutions. Our test environments will be available to our customers for testing on a twenty-four hour basis, six days a week. Network communications components will also be tested and certified in a special test lab environment at FRAS.
The testing effort for Year 2000 readiness within the Federal Reserve will be extensive and complex. Industry experts estimate that testing for readiness will consume about half of total Year 2000 project resources. To leverage existing resources and processes, we are modeling our Year 2000 testing, both internally and with depository institutions, on proved testing methods and processes. Our customers are already familiar with these processes and testing environment. We will finalize and distribute our testing strategy to depository institutions by the end of September this year and begin coordinating test schedules January 1998. As I noted earlier, the Reserve Banks are targeting June 1998 to commence testing with their customers, which allows an eighteen-month time period for depository institutions to test their systems with the Federal Reserve.
The next challenge I would like to discuss regards retaining staff members critical to the success of the project. As I mentioned earlier, we have placed a high priority on our CDC project and as such have allocated many of the best managers and technical staff in the Federal Reserve System to work on the project. The information technology industry is already experiencing market pressures due to the increased demand for technical talent. As the millennium draws closer, the global market requirements for qualified personnel will intensify even further. We are responding as necessary to these market-induced pressures by offering incentives to retain staff members in critical, high-demand positions.
Our focus at the Board goes beyond the immediate need to prepare our systems and ensure reliable operation of the payments infrastructure. We are also working hard to address the supervisory issues raised by Year 2000 and are developing contingency plans that I will discuss later.
Banks rely heavily on their automated information processing and telecommunications systems to participate in the global payments system, to exchange information with counterparties and regulatory agencies, and to manage their internal control systems and sophisticated computer equipment. As a bank supervisor, the Federal Reserve has worked actively with the other banking agencies to advise the industry of our concerns and to develop a thorough understanding of the industry's readiness. In this regard, the Federal Reserve is closely monitoring Year 2000 preparations and compliance of the institutions we supervise so that we can act aggressively to identify and resolve problems that arise.
Early this year, the Federal Reserve and the other regulatory agencies developed a uniform Year 2000 assessment questionnaire to collect and aggregate information on a national basis. We have received more than 1,000 responses from financial organizations and service providers supervised by the Federal Reserve. Based on these responses and other information, we believe the banking industry's awareness level has improved substantially during 1997 and is reflected in the intensified project management, planning, budgeting, and renovation efforts that have been initiated.
Generally speaking, the nation's largest banking organizations have done much to address the issues and have devoted significant financial and human resources to preparing for the century date change. Many larger banks are already renovating their operating systems and have commenced testing of their critical applications. Large organizations appear capable of renovating their critical operating systems by year-end 1998 and will have their testing well under way by then. Some of these organizations have recently come to realize that their initial resource and cost estimates to address this project need to be raised, given the magnitude of the tasks to be performed and the growing scarcity of available programming staff with the skills necessary to renovate older systems.
Smaller banks, including the U.S. offices of foreign banks and those dependent on a third party to provide their computer services, are generally aware of the issues and are working on the problem; however, their progress is less visible and will be carefully monitored as part of our supervision program. Many of these organizations appear to have underestimated the efforts necessary to ensure that their systems will be compliant. Accordingly, we will direct significant attention to ensure that these banks intensify their efforts to prepare for the Year 2000. We intend to update our assessment periodically to maintain a current awareness of the industry's readiness.
Our focus on the industry's readiness began last year, when the Federal Reserve commenced examining banks' plans and initiatives for the century date change. Through mid-year 1998 we will continue this program and conduct a thorough Year 2000 preparedness examination of every bank, U.S. branch and agency of a foreign bank, data processing center, and service provider that we supervise. Our examination program includes an extensive review of each institution's Year 2000 project management plans to evaluate their sufficiency, to ensure the direct involvement of senior management and the board of directors, and to monitor their progress against the plan. Our examiners are actively engaged in ensuring that the board of directors and senior management are addressing the issues and assembling the necessary resources. Based on the examination results and the findings collected during the current assessment program, we are identifying those institutions that require intensified supervisory attention and establish our priorities for subsequent examinations.
We are mindful that extensive communication with the industry and the public is crucial to the success of our efforts. Our public awareness program includes communications related to our testing efforts and our overall concerns about the industry's readiness. We continue to advise our customers of the Federal Reserve's plans and time frames for making our software Year 2000 ready. We have inaugurated a Year 2000 newsletter and have just published our first bulletin addressing specific technical issues. Copies of our recent newsletter and the bulletin are provided as Attachments 1 and 2 respectively.(1) We have also established an Internet Web site to provide depository institutions with information regarding the Federal Reserve System's CDC project. This site can be accessed at the following Internet address: http://www.frbsf.org/fiservices/cdc.
To heighten the industry's awareness level, the Federal Financial Institutions Examination Council (FFIEC), issued a policy statement on May 5 entitled "Year 2000 Project Management Awareness," which updates the supervisory guidance first issued in 1996. The statement emphasizes the regulators' concerns that inability to provide a compliant hardware and software environment to support the upcoming century date change would expose a bank to inordinate operational, financial, and legal risks. A set of uniform examination procedures accompanying the statement provides guidance for examiners as well as bank management, stressing the need for sponsorship at the highest levels of the organization to effectively manage the remediation process and address any deficiencies that may surface.
Bank management must not only be aware of the many Year 2000 problems but must also be sensitive to the magnitude of the efforts needed to achieve compliance and the consequent budgetary implications. Industry experts maintain that costs to perform Year 2000 renovation tasks will increase as the demand for skilled information technology professionals grows. Accordingly, the interagency policy statement emphasizes the need for bank management to be aggressive in securing sufficient human and computer resources. The statement also encourages banks to be largely completed with their renovation and well into testing of their major applications by year-end 1998 so that any substantive problems can be addressed in 1999.
The statement also calls upon banks to consider the Year 2000 risks posed by their borrowers and customers, as banks could be adversely affected by borrowers who are not prepared for Year 2000 processing. Corporate customers who have not considered Year 2000 issues may experience a disruption in business, resulting in financial difficulties that could negatively influence their creditworthiness. Examiners now verify that a bank incorporates a borrower's Year 2000 preparedness into its underwriting standards and that loan officers assess the extent of Year 2000 computer problems that may influence a borrower's ability to repay its loans on a timely basis.
On behalf of the FFIEC, the Federal Reserve has developed a Year 2000 information distribution system, including an Internet web site and a toll free Fax Back service (888-882-0982). The web site provides easy access to policy statements, guidance to examiners, and paths to other Year 2000 web sites available from numerous other sources. The site has been used heavily since its introduction in early May of this year. The FFIEC Year 2000 web site can be accessed at the following Internet address: http://www.ffiec.gov/y2k.
The Federal Reserve has also produced a ten-minute video entitled "Year 2000 Executive Awareness" intended for viewing by a bank's board of directors and senior management. The video presents a summary of the Year 2000 five-phase project management plan outlined in the interagency policy statement. In my introductory remarks on the video, I note that senior bank officials should be directly involved in managing the Year 2000 project to ensure that it is given the appropriate level of attention and sufficient resources to address the issue on a timely basis. The video has already been distributed to banks and their service providers and can be ordered through the Board's Web site.
We are also taking steps to provide this information to foreign bank supervisors. With regard to the international aspects of the Year 2000 issue, U.S. offices of foreign banks pose a unique set of challenges. Based on our assessments, we are concerned that some offices may not have an adequate appreciation of the magnitude and ramifications of the problem and may not have committed the resources necessary to address the issues effectively. This is a particular concern for foreign bank offices that are dependent on their foreign parent bank for information processing systems.
Therefore, we are working through the Bank for International Settlements' (BIS) committee of bank supervisors composed of many of the international agencies responsible for the foreign banks that operate in the United States. Through several presentations and the distribution of the interagency statement and the Year 2000 video to the BIS Supervisors Committee, we have sought to elevate foreign bank supervisors' awareness of the risks posed by die century date change and to solicit their assistance in monitoring the state of overall preparedness of foreign bank parents to ensure that they consider the needs of their U.S. offices.
We are also participating in the BIS Group of Computer Experts' meeting of G-10 and non-G-10 central banks in September, which provides a forum to share views on and approaches to dealing with Year 2000 issues, and have been active in various private sector forums. The participants will discuss their involvement with raising bank industry awareness, remediation of payment systems, and the readiness of the central banks' internal systems. Information garnered from this meeting will assist the BIS Committee on Payment and Settlement Systems, as well as the Federal Reserve, in understanding the current state of preparedness of payment systems on a global level.
Because smooth and uninterrupted financial flows are obviously of utmost importance, our main focus is our preparedness and the avoidance of problems. But we know from experience that upon occasion, things can go wrong. Given our unique role as the nation's central bank, the Federal Reserve has always stressed contingency planning -- for both systemic risks as well as operational failures.
In this regard, we regularly conduct exhaustive business resumption tests of our major payment systems that include depository institutions. Moreover, as a result of our experience in responding to problems arising from such diverse events as earthquakes, fires, storms, and power outages, as well as liquidity problems in institutions, we expect to be well positioned to deal with problems in the financial sector that might arise as a result of CDC. We are, of course, developing specific CDC contingency plans to address various operational scenarios. Our existing business resumption plans will be updated to address date-related difficulties that may face the financial industry.
We already have arrangements in place to assist financial institutions in the event they are unable to access their own systems. For example, we are able to provide financial institutions with access to Federal Reserve computer terminals on a limited bases for the processing of critical funds transfers. This contingency arrangement has proved highly effective when used from time to time by depository institutions experiencing major hardware-software outages or that have had their operations disrupted due to natural disasters such as the Los Angeles earthquake, Hurricane Hugo in the Carolinas, and Hurricane Andrew in South Florida. In these cases we worked closely with financial institutions to ensure that adequate supplies of cash were available to the community and also arranged for our operations to function virtually without interruptions for twenty-four hours a day during the crisis period. We feel the experience gained from such crises will prove very helpful in the event of similar problems triggered by the century date change. We are also beginning to formulate responses for augmenting certain functions, such as computer help desk services and offline funds transfers, to respond to short-term needs for these services.
Although operational contingency is something that the Federal Reserve is confronted with on a daily basis, preparation for contingencies in the century date change environment does offer some new and significant challenges. For example, in the software application arena, the normal contingency of falling back to a prior release of the software is not a viable option. This underscores the importance of the rigorous assessment and testing to which all applications must be subjected.
Beyond reliance on a sound plan and effective execution of the plan, the Federal Reserve is not totally dependent upon any single system for executing payment orders. While we have very sophisticated automated systems in place, such as Fedwire and our automated clearinghouse systems, we also operate paper-based payment systems that offer a set of alternatives in the event of a disruption in a segment of the electronic payment system.
Clearly, the Federal Reserve and other bank supervisors expect depository institutions to work diligently and effectively to ensure that automation issues associated with the Year 2000 are resolved fully and in a timely fashion. However, we anticipate that at least a few financial institutions will experience difficulty in completing their Year 2000 preparations in a timely manner, and we are developing plans to address such cases. The Federal Reserve will identify and monitor these organizations closely and work to ensure that senior management and boards of directors are aware of their Year 2000 issues, cost implications, and possible consequences. A bank's need for adequate preparation for the Year 2000 is regarded as a safety and soundness issue. When progress is deemed to be substantively less than satisfactory, resulting in excessive risk and a possibly unsafe or unsound condition, we will address the issue in a manner consistent with our long-standing supervisory approach to dealing with other safety and soundness issues. The full range of our supervisory tools and remedies are available, including intensified monitoring, progressively more detailed reporting requirements, presentations to the board of directors, insistence on bank commitments to initiate corrective action, and, ultimately, possible use of enforcement actions as appropriate.
We recognize, nonetheless, that despite their best efforts, some depository institutions may experience operating difficulties, either as a result of their own computer problems or those of their customers, counterparties, or others. These problems could be manifested in a number of ways and would not necessarily involve funding shortfalls. Nevertheless, the Federal Reserve is always prepared to provide information to depository institutions on the balances in their accounts with us throughout the day so that they can identify shortfalls and seek funding in the market. The Federal Reserve will be prepared to lend in appropriate circumstances and with adequate collateral to depository institutions when market sources of funding are not reasonably available. The terms and conditions of such lending may depend upon the circumstances giving rise to the liquidity shortfall.
Discussions are also under way with, the other federal banking agencies to ensure that we are jointly prepared to address the challenge resulting from serious operating problems. If such operating problems were not correctable within a reasonable time frame, it could necessitate a federal resolution comparable to that used for a bank that has become capital insolvent.
Our preparations for possible liquidity difficulties also extend to the foreign bank branches and agencies in the United States that may be adversely affected directly by their own computer systems or through difficulties caused by the linkage and dependence on their parent bank. Such circumstances would necessitate coordination with the home country supervisor. Moreover, consistent with current policy, foreign central banks will be expected to provide liquidity support to any foreign banking organizations that experience a funding shortfall.
As I indicated at the outset, the Federal Reserve views its Year 2000 preparations with great seriousness. As such, we have placed a high priority on the remediation of date problems in our systems and the development of action plans that will ensure business continuity for the critical financial systems we operate. While we have made significant progress in validating our internal systems and planning for testing with depository institutions and others using Federal Reserve services, we must work to ensure that our efforts remain on schedule and that problems are addressed in a timely fashion. In particular, we will be paying special attention to the testing needs of depository institutions and the financial industry and are prepared to adjust our support for them as required by experience. We believe that we are well positioned to meet our objectives and will remain vigilant throughout the process.
As a bank supervisor, the Federal Reserve will continue to address the industry's preparedness, monitor progress, and target for special supervisory attention those organizations that are most in need of assistance. Lastly, we will continue to participate in international forums with the expectation that these efforts will help foster an international awareness of Year 2000 issues and provide for the sharing of experiences, ideas, and best practices.
(1.) The attachments to this statement are available from Publications Services, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.
(1.) The attachments to this statement are available from Publications Services, Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551.
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|Publication:||Federal Reserve Bulletin|
|Date:||Sep 1, 1997|
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